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The history and horror of the PFI

Written by Warwick Lightfoot Friday, 06 July 2012 00:21
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John Major, both as Chancellor and Prime Minister, was

interested in involving the private sector in financing and improving
the management of public sector investment.

 

From the early1980s public sector investments had been subjected to strict tests to
assess their rate of return. In the 1981 these tests were summarised
in the so-called Ryrie Rules named after their author Sir John
Ryrie, the Treasury official who chaired the committee that constructed
them. They were formulated in 1981 when the UK had a
significant nationalised industry sector and have to be understood
in that context. The public sector can borrow relatively cheaply
in the gilt market and that can lead to an over-accumulation of
public sector capital that cannot be justified in terms of its social or
economic returns. This was plain from the nationalised industries
themselves, which in the 1970s absorbed around 20 per cent of
UK fixed capital investment and accounted for about 15 per cent
of employment yet only produced around 10 per cent of GDP.
The principal recommendation of the committee was that to guard
against such an over-accumulation of capital a special discount factor
of 6 per cent should be applied to public sector investment. In
practice the rules presented a significant obstacle in the way of government
departments engaging in capital projects unless they could
be demonstrated to offer value for money on quite a strict test.

It should be noted that the rules, apart from the specific issues
involved, were formulated against a particular policy background.
The first was the priority given in the periods between 1975 and
1986 to controlling public spending in general and capital spending
in particular to reduce government expenditure and borrowing,
given the impact that the PSBR had on the counterparties
that made up the broad money supply, M3. There was also was a
recognition on the part of the Treasury and Conservative Ministers
such as Sir Geoffrey Howe, Jock Bruce-Gardyne and Layfield that
in the 1960s and early 1970s governments had been too willing to
spend money on wasteful infrastructure projects and other investment
that did not stand up to proper scrutiny and turned out to
be white elephants. Indeed Nigel Lawson and Jock Bruce-Gardyne
had written a book about it called ‘The Power Game: An examination
of decision-making in Government’ (1976). The most notorious
example of this was the Humber Bridge project. This was
announced by the Minister of Transport, Barbara Castle, to try to
save a safe Labour seat in a difficult by-election in Hull in 1966. The
financial consequences of this continued to cause problems for the
Treasury right up until the 1990s.


The Ryrie rules were much maligned. They became a sort of
Treasury bogeyman which lobby groups both inside government
spending departments and outside blamed for every disappointment
they received. The detail of the rules may have been slightly
too tightly drawn, but their fundamental purpose was to prevent a
repeat of the sort of episode exemplified by the Humber Bridge.
There is no doubt that they were frustrating to ministers and a
whole range of government departments. They also effectively
frustrated business lobby groups that had an interest in public sector
investment, or to be more precise a vested interest in the contracts
they could receive from being paid to construct the roads and
bridges and so on that would be involved. These vested interests
were opposed to legitimate public policy interests in, say, suitable
transport connections for their employees and suppliers, which is
part of the general interest and debate about the provision of public
infrastructure.


In the second half of the 1980s these business interests, often
from the construction and civil engineering industries, mounted a
sustained lobby against the strictures of the Ryrie rules. In order to
get around the matter of capital spending representing public expenditure
and needing to be financed by government borrowing,
these business lobbies argued that they could pay for the construction
themselves. They would use their own balance sheets to borrow
to pay for the construction and the public sector could lease
back the building or road, paying some sort of user fee or annual
charge. It was an attractive proposition. Government ministers got
their chosen capital projects and firms got the contracts to build
and manage them.


There was from the start a fundamental flaw in these attractive
propositions. The British government can borrow more cheaply
than any private sector borrower. This means that, however the arrangements
are structured, the financing in the long term would
turn out to be more expensive than the taxpayer footing the bill in
the normal way. And if borrowing is needed nothing is cheaper for
the British government than the gilt market. The British government
can always mobilise huge sums of money for public spending
and complex investment projects more cheaply than private sector
investors. The Treasury does this through general taxation and its
capacity to borrow in the gilt market. It is, moreover, something
that has been demonstrated from the time of the original creation
of the Bank of England and funded national debt in 1694, through
to the Napoleonic Wars and the financing of the two world wars
in the 20th century.


The decision to go ahead with the Channel Tunnel, which was
intended to be privately financed without any public finance, was
a fillip to the private finance lobby. Given the huge time and cost
overruns on many large public sector infrastructure projects from
hospitals to roads, a further argument was developed to support the

private finance initiative. This was that the private sector is so efficient
it could manage these complex projects much better than the
private sector and yield efficiency savings so great that they would
more than compensate for the additional cost of private finance
making these schemes. There is no doubt that this had a nugget of
respectability; the inefficiency of public sector procurement and
infrastructure investment was a serious matter. The suggestion of
transferring the genuine risk and associated costs of such projects
to the private sector was an interesting and worthwhile proposition
to explore.


On robust examination, however, the arguments in favour of the
PFI never stood up. I worked at the Treasury when it was first explored
by John Major’s government. It was plain to me that it could
not deliver what it was cracked up to offer. It was supposed to give
the taxpayer investment projects - from schools to railways - more
efficiently managed and at a lower cost, compared with normally
financed government investment. This was always implausible. As
well as the crude business and political vested interests in play, the
PFI in the 1990s at a glance played well in relation to other less
venal parts of the broader public policy agenda. On the face of it
the PFI was consistent with the notion of making the public sector
more efficient by bringing in the private sector. It ideologically appeared
to fit consistently with contracting and privatisation. It was
seen as bringing in private sector disciplines where the activities
themselves could not be privatised.


The PFI also fitted neatly into what might be called the New
Zealand public sector reform agenda. In the 1980s a Labour government
in New Zealand embarked on a radical market-oriented
economic and public sector reform programme. It was driven forward
by the Finance Minister, Sir Roger Douglas. By the 1990s a
cross-party consensus in New Zealand had embarked on such a
comprehensive range of public service change and employed the
price mechanism in so many different ways that the country became
the benchmark of effective policy making. ‘New Zealand’s
new public management’ became the model that much of the
world including the UK and US looked to. Its agenda is probably
most concisely summarised by in a Brookings Institution paper
written by Donald Kettl entitled ‘The Global Public Management
Revolution’ (2000). Among these reforms was the introduction of
accruals accounting, combined with ensuring that the public sector
properly looked after the assets on its balance sheet. One of the
criticisms of the public sector was that it allowed its capital assets
to depreciate through poor maintenance in a way the private sector
would not. The PFI structure played very well in the context
of that debate. The contracts would specify annual maintenance,
and government departments when making contracts would have
to fess up to the full depreciation cost of the investment they were
embarking on. There is no doubt that the PFI was worked up to fit
the zeitgeist of the period.


After the 1992 election the Major government in the ‘Autumn
Statement’ went ahead with the PFI, overriding the traditional
Treasury reservations about it. The much-loathed Ryrie rules themselves
had in fact been replaced in the spring of 1989. Relatively
few projects, however, went ahead, because the Treasury rightly retained
rules about there being a genuine transfer of risk between
the public and private contractor, which in practice vitiated many
proposals. Even so, by 1996 there were enough PFI projects in play
to enable the economists from Goldman Sachs to express concern
at the time of Kenneth Clarke’s final Conservative Budget about
the extent of the government’s off-balance sheet private finance
liabilities.


After 1997 that test concerning risk transfer to the private sector
was further relaxed, if not completely abandoned, and the specific
rules about PFI contracts genuinely transferring risk to the private
sector went. The purpose of these changes was to enable as
much PFI-financed investment to take place as possible because
it was a way of obtaining off-balance sheet capital spending that
was neither fully scored for government expenditure nor for public
borrowing. This new iteration of the PFI rules also neatly fitted into
the modified New Labour zeitgeist: it was a private sector solution,
it appealed to vested business interests and it fitted with a new
framework of national accounts accounting. In 1998 the Treasury
announced a new framework of national public sector accounting
that contributed to changing the presentation of government
borrowing to separate out borrowing to finance capital investment
from borrowing to finance current consumption spending. This
new presentation of the public accounts was to facilitate Gordon
Brown’s much-trumpeted fiscal rules. These were that the government
should only borrow for investment and over the economic
cycle the stock of government debt should be set at a stable and
prudent level in relation to national income – 40 per cent was the
chosen ratio of GDP. These rules were dressed up as strict, but on
any careful examination were plainly elastic. Such things as how
tightly do you define investment and what constitutes the economic
cycle obviously offer the Treasury huge scope in financial
casuistry, normally to claim that they have met such rules. The PFI,
however, was an additional convenience in obtaining public investment
outside the rules that relate to government borrowing even if
in the end it turns out to be more expensive.


The remarkably effective lobbying of many business interests under
John Major had unlocked the door to the PFI, but the transfer
of risk rules until 1997 had meant that the scale of the programme
was relatively modest. Under New Labour, however, there was a
flood of PFI projects. As interest rates fell PFI projects were refinanced,
but the taxpayer continued to be locked into contracts at
the old rate of interest. After the millennium and the stock market
‘tech wreck’ many traditional construction and engineering companies
marketed themselves to investors and fund managers as not
‘boring old-fashioned construction firms’, but exciting sexy ‘private
finance firms’ with ‘secure and lucrative’ public sector contracts.
These contracts have turned out to be much more expensive
for the taxpayer than normal public expenditure. They have not

obviously reduced all the normal procurement risks in the way
that had been alleged. And they may have contributed to making
public expenditure less efficient because of their inflexibilities and
the perverse incentives that they create. Moreover, a flood of capital
investment in, for example, school laboratories, hospital operating
facilities and university libraries will not yield expected benefits
without adequate current or revenue expenditure to provide for
their day-to-day use and services. An increase in school physics
laboratories is of little use without a matching increase in suitably
trained science teachers. There have also been a host of complaints
about the quality of the buildings and their availability in
the evening or at weekends. A private contractor has no incentive
to make a facility available to the wider community if it is outside
their contract. Where facilities such as bridges have been constructed
there are also a wide range of complex issues surrounding user
charges and ensuring that a monopoly position is not exploited by
the firm providing the facility. There is no clear evidence that the
PFI has provided a step change in public sector efficiency any more
than the other innovations that have been tried.
In many respects, as Mayor of London Ken Livingstone was the
sort of politician who exemplified what went wrong with public
spending after 1998. As he jokingly, although provocatively told one
Greater London Authority Assembly member ‘Remember, I am a
tax-and-spender.’ That was reflected in both the threefold increase
in the budgets that the Mayor presented and the council tax precept
for which he was responsible rising over two and a half times.
Yet Ken Livingstone got one thing right as Mayor of London. He
was against Gordon Brown’s decision to pay for the modernisation
of the London Underground through the Treasury’s creation of a
hybrid public private partnership (PPP). The collapse of Metronet
is an illustration of the broader concerns about value for money in
the PFI.


The Treasury was determined that the modernisation would be
financed off the government’s balance sheet through the private
finance framework. Given the risks involved, private investors
would not accept the transfer of these risks, so a conventional PFI
arrangement could not be established. Instead a complicated hybrid
PPP was established. A consortium of companies came together
in a specially set up company called Metronet. Along with
Tube Lines, Metronet was awarded a thirty-year contract to reverse
decades of neglected capital investment in London Underground’s
rail infrastructure. The Public Accounts Committee report, ‘The
Department for Transport: The failure of Metronet’ (2010) explains
what happened. The taxpayer lost between £170 million and £410
million as a result of Metronet’s poor financial control and inadequate
corporate governance. The report describes the Department
of Transport’s assumption that Metronet would put in place robust
financial management controls and strong corporate governance
arrangements as ‘naive’ and unsurprisingly ‘did not hold’. Transport
for London and the Mayor London could not exercise effective
oversight of the arrangement because they could not obtain the information
needed to oversee the contract. The arbitration arrangements
were flawed because the Arbiter could only get involved if
invited to do so by all the parties involved. The Department had no
right of access to the Arbiter and could not direct him to carry out
an investigation. The Department for Transport failed to plan for
the additional risks arising out of Metronet’s ‘tied supply’ chain. In
this extraordinary arrangement, Metronet’s suppliers were its own
shareholders. Each of the companies invested £30 million of equity
and £40 million of debt into Metronet. The Department of Transport
assumed that Metronet would have a firm grip on its suppliers.
There was, however, a ‘conflict of interests caused by Metronet’s
shareholders being its main suppliers’. The owners of Metronet instead
had little interest in establishing effective controls to ensure
that it made a return on its PPP contract, given that as suppliers
they would make money by working for it. This meant that there
was little incentive to control costs. In 2007 the cost of refurbishing
each of the Tube stations that Metronet worked on was twice
the estimated cost in the budget. The Department of Transport also
assumed that Metronet’s bankers would exercise strong financial
oversight of Metronet’s business operations. In fact, they successfully
reduced their own risk before they signed the PPP contracts
by obtaining a guarantee that London Underground would meet
95 per cent of Metronet’s borrowing in the event of a default. Metronet’s
lenders then reduced their risk further by obtaining a letter
of comfort from the Department of Transport that it would fund
the 95 per cent guarantee if London Underground could not do so.
The Department of Transport was therefore very naive to expect
institutions lending money to Metronet to exert strong financial
oversight of it when the taxpayer had taken on all but 5 per cent of
the lenders’ risk. The Public Accounts committee concluded that
it was ‘appalled by the cavalier attitude to protecting public money
that the Department displayed by claiming that its decision to use
Metronet contracts had been vindicated because there would have
been an even greater loss had the upgrades been overseen by London
Underground’. Moreover, the Department for Transport had
ignored recommendations made by the National Audit Office in
2004 to avoid a hands-off approach to overseeing the upgrading of
the London underground railway.


Only someone who believed in the tooth fairy could have imagined
that the PFI could offer both genuine value for money and the
real transfer of risk from the taxpayer to private sector. But there
were many politicians and businessmen and women who found it
convenient to believe in fairy tales when it came to the PFI. For
politicians its attraction was straightforward. It enabled them to announce
spending today that would neither have to be paid for until
tomorrow nor breach their framework of fiscal rules. For politicians
it had all the attraction of the Enron factor: off-balance sheet
accounting. For business, it meant lucrative government contracts
ultimately paid for by the taxpayer and huge scope to manipulate
the financial arrangements of the projects for the benefit of their
shareholders. The scope for this has been so great that traditional
construction companies have rebranded themselves to their investors
as ‘sexy and exciting’ service companies generating predictable,
recurring revenues from PFI contracts. The only surprise in all this
has been the way the Treasury and Gordon Brown embraced it.
Traditionally, the Treasury under all previous governments has been
the Praetorian Guard protecting the taxpayer. Yet over the PFI in
general and the PPP for the Tube, the Treasury sold the long-term
interests of the taxpayer down the river.


The lesson from this saga is that there are some risks that only
the taxpayer and the public sector can sensibly take on. They cannot
ever be effectively transferred to the private sector at a reasonable
cost. These big infrastructure projects need to be funded by the
state. The issue should not be how could the Treasury get them
financed by the private sector, off-balance sheet, at greater longerterms
cost. Instead, the question should be whether the project is
justified on a rigorous and robust application of full cost benefit
analysis.


London as a regional economy is in an odd position. It is by any
international standard an economic powerhouse. London desperately
needs a huge improvement in its rail transport infrastructure.The lessons of PFI and Metronet’s collapse are that in

the long run, investment funded by the taxpayer saves money and
in London would generate a stronger economic and tax base for
Britain as a whole.
Public sector investment is most cheaply financed by the government
itself through its power to tax and capacity to borrow.
Off-balance sheet public expenditure is in the long run more expensive
and its clumsy and perverse incentives can actually result
in less efficient public expenditure. Moreover, the private finance
does not offer any kind of silver bullet to increase public expenditure
efficiency. If anything it is part of the potential fundamental
government failure that mirrors the notion of market failure of
allocating resources through bureaucratic and political mechanisms
rather than the price mechanism. In that sense, PFI as an attempt to
‘reform’ the public sector and achieve a step change in performance
is another disappointment, albeit an unusually expensive and in that
sense an egregious public sector reform failure.
In many respects the principal lesson to be drawn from the PFI
episode and the Metronet saga in particular is that in terms of large
and complex infrastructure projects it is almost always the state that
will have to take on the burden of the risk. These risks are too great
to be transferred to the private sector at reasonable cost. Moreover,
it is not clear that these risks can ever in practice be completely
transferred because the political and public interest is so great that
if the private sector were to step away the public sector would have
to step in. Where such risks are transferred, leaving aside the direct
long-term public sector costs to the taxpayer, there are in many
cases other equally burdensome costs that relate to user charges,
pricing and completion policy. The state has to recognise that it will
have to construct and acquire expensive capital assets. That cannot
be evaded. In terms of their long-term cost and efficient management
that will normally mean they have to be bought, paid for and
controlled by the public sector in the normal way. That means that
public sector capital investment projects have to be rigorously assessed
to ensure that they will earn an appropriate rate of return.
And that capital investment and any borrowing that may attach to
it have to be scored on the government’s balance sheet as government
spending and borrowing. The practice of employing the PFI
to avoid placing that spending and borrowing on the public sector
balance sheet should ended. That does not mean that in no circumstances
can there ever be any use of the private sector in public sector
procurement or financing of public sector investment. Nor does
it mean that there are no circumstances where private finance cannot
be used. Rather, such investment should be subjected to proper
scrutiny and assessment and there should not be an off-balance
sheet bogus accounting incentive for public investment to be carried
out through the private sector as a mechanism for avoiding the
rigorous assessment that should take place. This means abandoning
the PFI as it has been used in the UK. That would represent a step
to realism about the costs, burdens and efficiency of public sector
capital spending.


That would involve a significant reordering of public expenditure
priorities. There are now some 800 PFI projects, amounting to
£65 billion. The House of Lords Committee on Economic Affairs
in its report on the PFI has recommended that estimates of the
total level of off-balance sheet public sector liabilities be published
alongside statistics for the level of public sector debt.

Last modified on Friday, 06 July 2012 09:01

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