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Michael
Mainelli
Executive Chairman, Z/Yen Limited
[An edited version of this article appeared in "PFI and PPP: Could They Result in Enron UK?", Balance
Sheet, The Michael Mainelli Column, Volume 11, Number 2, pages 39-43 (July
2003)]
Know the one about the £392 billion organisation with off-balance sheet
finance? Wouldn't you like to know about special purpose entities, off-shore
accounts, strange sale and buy-back arrangements or arcane percentage ownership
and disclosure rules before investing? Wasn't Anthony Hilton comparing this
organisation's "financial smoke and mirrors" to Enron in The Evening
Standard [11 March 2002]? Welcome to the world of PFI, PPP and the UK
government.
What are PFI and PPP? Governments have always paid private contractors to
build roads, government offices, schools, air bases, prisons and hospitals out
of tax money. Typically, governments pay to have things built, then pay to have
them run. The Conservative government created the Private Finance Initiative (PFI)
in 1992. Under PFI, contractors paid for the construction costs (private
finance) and then rented the finished project back to the public sector, often
for terms of 20, 25 or 30 years. When Labour came to power in 1997, the previous
Government's Private Finance Initiative was further developed under the rubric
of Public-Private Partnerships (PPP), despite Labour's intense criticism of PFI
in opposition. Sir Malcolm Bates led a review of PFI in 1997 which led to 29
recommendations for improvement, among them a Treasury Task force to act as a
centre of PFI expertise and new legislation clarifying the powers of NHS trusts
and local authorities to enter into PFI deals. A cynic might note that anything
on which two opposing political parties agree must be harmful to citizens. To
paraphrase Adam Smith, "politicians seldom meet together, even for
merriment and diversion, but that the conversation ends in a conspiracy against
the public."
Today, any collaboration between public bodies and private companies tends to
be referred to as PPP by the government and PFI by the private sector supplying
it. PFI has gone global too. Many banks have international PFI units providing
finance to many of these deals. Further, many PFI companies, e.g. large
construction contractors, promote PFI deals to private sector companies - PFPF
Initiatives if you will.
How Big is PFI/PPP?
By the end of 2002 a total of 524 UK deals with a capital value of £23
billion were signed - there are eight private prisons; major road schemes like
the Thames crossing and the Birmingham relief road; six major completed NHS PFI
projects, with a further 17 hospitals and other facilities under construction
and 45 more planned. The complexity of PFI/PPP contracts and the political
obstacles for big, controversial schemes, such as the whopping £13 billion
London Underground PPP planned for 2003, mean that progress in some areas has
been slow, but the Institute of Fiscal Studies points out that PFI already
represents 10.3% of publicly sponsored investment.
Source: Office of Government Commerce, 2002
The government seems eager to expand PPP as a way to secure the improvements
in public services that Labour promised at election time. If privatisation
represents a take-over of a publicly-owned commodity, then PPP is supposed to be
seen as more like a merger. Both sides share risks and, hopefully, both sides
see benefits.
Is PFI/PPP Successful?
PFI/PPP advocates say that many hospitals and schools would not be built at
all without private finance - the public money was simply not available. Performance-related penalties in most PFI/PPP contracts will ensure a continuing
improvement in standards, far in advance of anything that could be achieved in
the public sector. And look, taxes don't have to be raised.
Critics often focus on failed PFI/PPP projects, but traditional public sector
projects fail quite often. A National Audit Office Report (NAO), PFI:
Construction Performance (5 February 2003), examined 37 major PFI
construction projects contrasting them favourably with earlier public sector
projects. 22% of the PFI projects were over-budget, but the NAO had found in
similar public sector construction project reviews that 73% of projects were
over-budget. There were equally dramatic improvements in delivery time. On the
other hand an Audit Commission report, PFI in Schools (January 2003),
found that the quality of schools built under traditional public sector
procurement was better than PFI schools.
The most vocal opposition has come from trades unions. Unions believe that
companies turn a profit by cutting employees' wages and benefits. Unions refer
to jobs being 'privatised'. Union members are shifted into the private sector,
where they have fewer employment rights and benefits such as pensions and
childcare. UNISON has attacked the independence of private sector evaluations of
PFI/PPP, How the Big Five Accountancy Firms Influence and Profit from
Privatisation Policy (June 2002).
According to a survey conducted by Labour Research Department for the GMB
union, the 'rent' for PFI projects in the health service alone will top £13
billion. The union says profits for the companies involved will total between
£1.5 billion and £3.4 billion over the next 30 years, about £5 a year for
every taxpayer in the country. UNISON's General Secretary, Dave Prentis, says
"it cannot be right that during a period of unprecedented public investment
huge profits are going into private pockets…"
It seems no off-balance sheet 'Enron' is complete without an offshore tax
scandal. The Inland Revenue itself provided this with STEPS (strategic transfer
of the estate to the private sector). In March 2001, the Inland Revenue
announced a PFI deal with the UK-registered Mapeley Limited, transferring to it
the "ownership and management" of 600 buildings for £220 million. In
reality, the Inland Revenue sold the properties to a Bermuda-based sister
company called Mapeley Steps Limited while paying rent to a UK company called
Mapeley Steps Contractors Limited. Unfortunately for the tax collectors, this
deal created maximum embarrassment because it minimised the tax paid by Mapeley
to an insignificant sum.
So What?
It is important to keep PPP and PFI in perspective. Government still funds
the majority of public works directly. The government has hardly given up on the
use of the public sector, however, it is gearing up for a massive increase in
private involvement in public services in the years ahead. The problem is
distinguishing the government's key objective - using private sector expertise
or hiding public sector debt?
There are supposedly two principal advantages of PFI/PPP over traditional
government procurement:
- PFI/PPP transfers the risk of delivery to the contractor, i.e. if a
hospital or road is not "fit for purpose", the contractor puts its
future monies at risk;
- PFI/PPP allows government to fund more infrastructure projects today.
The first point confuses the problems within government contracting processes
with the presumed advantages of PFI/PPP. Seeking to have contractors pay for the
consequences of their decisions, e.g. a hospital with a design that incurs huge
cleaning bills or a school that cannot accommodate the planned number of
children, has always been possible with traditional government procurement. True, risk transfer was too rarely invoked. Yet this author was involved in a
number of pre-PFI, pre-1992 government projects where risk transfer was
successfully applied. Risk can be transferred to contractors without them having
to fund projects in toto.
The NAO observes that PFI/PPP projects have a typical risk-profile - high in
the early stages of implementation and low in the operational stages. There can
be advantages in separating the capital part of the project from the operational
part of the project, e.g. when the operator is under-performing, government can
easily re-compete the operational contract without getting involved in lengthy
legal processes to redress a part-owner. It would be churlish to criticise this
first point overmuch. PFI/PPP, as the NAO report demonstrates, provides public
sector facilities better than had they been managed by the public sector,
although the NAO has subsequently investigated ways of re-financing PFI/PPP in
order to bring costs down.
Within the second point lies the 'Enron' argument. Private sector funding
allows the government to get new hospitals, schools and prisons without raising
taxes, but at the cost of long-term contractual commitments. The accounting
standards relevant to PFI and similar transactions are Financial Reporting
Standard 5 (FRS5) "Reporting the Substance of Transactions" and
Statement of Standard Accounting Practice 21 (SSAP21) "Accounting for
Leases and Hire Purchase Contracts". FRS5 requires the substance of an
entity's transactions to be reported in its financial statements, regardless of
legal form. Treasury bases its public sector accounting on the presumption that PFI/PPP deals are contracts for services. Despite the capital involved in
implementation, the significance is that PFI/PPP contracts are not taken to be
lease transactions, thus SSAP21 is irrelevant. The key question in these
long-term contracts is, in short, has the government a liability to pay rather
than an annual operational bill. Should the full liability of these 10, 15, 20,
25 and 30 year contracts be on the public-sector balance sheet?
A Bit Abstract? - Well Let's Get Back to the Land
A bit of detail may give quite a bit of flavour. Inland Revenue Tax Bulletin
40 has a section which looks at land transfer in some depth. The Inland Revenue
notes that "PFI transactions are by their very nature complex". The
bulletin covers the Inland Revenue's views on FRS5, and has "found that
land is introduced into a PFI project by the purchaser" (government) in
four ways: "
- the purchaser has land surplus to its requirements and introduces that
land as a payment (in money's worth) on account of future unitary
receipts;
- the purchaser has previously identified land which is surplus to its
requirements, has entered into an agreement for the disposal of that land to
a developer and arranges for all or part of the proceeds to be paid direct
by the developer to the operator as a payment on account of future unitary
receipts;
- land is introduced by the purchaser as a payment in money's worth in order
to reduce the capital cost of the project to the operator;
- the proceeds arising from the disposal of land are introduced by the
purchaser in order to reduce the capital cost of the project to the
operator."
While the tax bulletin dwells largely on the private sector's tax issues, in
reality all four transactions above should affect the public sector balance
sheet, but don't under today's regime. No wonder some critics say that the
government is just mortgaging the future and that charges should appear against
the national balance sheet.
One of the analytical problems is distinguishing concessions from service
provision, from service provision with large upfront capital spend, from
privatisation. Some would argue that a concession for building a road which is
repaid from tolls is a valid off-balance sheet transaction. There is no
commitment to pay. The asset, having paid its capital costs and, presumably
having returned a profit to the concessionaire, reverts to government. There are
a number of concession-type arrangements, e.g. bandwidth for television or
mobile phones. These grey areas of government accounting, although frequently
contentious, have not been too material in the past.
Money for Nothing?
Stephen Byers speaking about railways and government funding with John
Humphrys stated [On the Record, BBC broadcast, 20 January 2002]
"..remember under the last Tory government national debt was increasing
dramatically. We were spending more in repayments on the national debt than we
were on our school system. What we've been able to do is to cut the national
debt as a result we've now got more money which we can spend on a sustained long
term basis in essential services."
This has led some critics to note that the long-run cost of paying the
private sector to run these schemes is more than it would cost the public sector
to build them itself. This argument notes that the government's cost of capital
is always lower than a private sector firm's, so why doesn't the government fund
its own projects more cheaply. Proponents of PFI/PPP note that the private
sector is better at delivering value for money and does not waste as much as
government. However, would the government's cost of capital rise if the scale of PFI/PPP liabilities were material?
Another criticism is that the formula used to compare the public sector
equivalent to a PFI/PPP provision is flawed. The formula uses a discount rate
(6%) which calculates £100 of annual public spending for 10 years as £1,000,
but £100 spent on the private sector for 10 years as £736. If the project term
is extended over decades, the perceived advantage of PFI/PPP balloons.
What Might be the Scale of Off-Balance Sheet Finance?
One way of examining the potential scale of off-balance sheet finance is to
see what the long-term cost commitments are for operational costs. However, the
government does not release these figures in most cases, citing commercial
confidentiality.
Let's examine a sample where we can obtain the data. We looked at 18
education projects and 44 health projects where the running costs were
available. The 18 educational projects' capital costs were £868 million and the
committed running costs were £2.787 billion. Running cost commitments expired
in 2032. As can be seen by inspecting the following graph, there is a 20 year
period where the commitment is a steady £100 million per annum.
The 44 health projects' capital costs were £210 million and the committed
running costs were £1.041 billion. Running cost commitments expired in 2036. For health, there is a 20 year period where commitments are a fairly steady £30
million per annum.
Given that we do not have running costs for most PFI projects, we can only
estimate the total running costs and annual commitments for UK PFI/PPP from the
total capital figure. Thus, an
extrapolation table using the education and health sample is set out below:
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UK PFI/PPP Capital Cost
of £23 billion
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Based on Education
Sample
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Based on Health Sample
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Average of Education
& Health
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Steady 20 year period
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£2.650 billion
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£3.286 billion
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£2.774 billion
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Total committed running costs
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£73.849 billion
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£114.014 billion
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£81.673 billion
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Granted, we are extrapolating the costs based on less than 5% of total PFI/PPP. However, by adding back capital expenditure these estimates are not too far off
Treasury's current statement of £4.5 billion of expenditure in 2002/2003 on PFI
(excluding London Underground), which includes both capital and running costs. The aggregate is also close to Treasury's estimate of £98 billion of payments
by the public sector over the next 25 years from signed deals. We are not
provided with information on assets transferring from the public to the private
sector on completion of the contracts, e.g. the land transfers referred to
earlier. These might well make the actual costs significantly higher.
What starts to get frightening however is the outlook for expenditure
commitments. The planned London Underground PPP of £13 billion for 2003
dominates the near future. Yet on current trends the government will spend an
additional £55 billion on PFI/PPP over 2003 through 2010, i.e. £68 billion in
total. On the above health and education estimates, this will result in
commitments of £241 billion in running costs. For the 20 year median commitment
this is around £8.2 billion per annum. Combined with the existing £2.8
billion, £11 billion in public expenditure will be committed for decades.
Markets and Governments
But surely government can handle this? Well, clearly government is big, but
government running costs are not really £392 billion. The amount of capital
expenditure in 2001/2002 was £24 billion - remember, PFI is not capital
expenditure. So at £14 billion for 2003, PFI/PPP has become a material
percentage of government capital expenditure. About £180 billion is really
payments managed by government, e.g. social security, CAP, public service
pensions. This leaves £188 billion of expenditure on services. Much of this
expenditure is also committed, but even if it were at the discretion of
management, as we have seen above, £11 billion will be committed to PFI/PPP
payments. If we believe union estimates, the committed figure will rise to £30
billion a year - roughly £10 billion in central government contracts, £5
billion in education and £5 billion in local authority contracts.
To paraphrase von Clausewitz, perhaps "economics is merely a
continuation of politics by other means." PFI/PPP are providing "jam
today" for the government, but committing the UK public sector to
significant future payments for capital projects undertaken today. At somewhere
between £10 billion and £30 billion of running costs on current projections,
this is a straightjacket on change in a public sector with a "managed"
expenditure of £188 billion. Capital markets are beginning to note the scale
and implications of PFI/PPP, but the real effect may be to affect UK attitudes
to finance and government for generations.
On coming to power, a new government is faced with continuing for decades the
operational contracts of the previous administration's PFI/PPP, or defaulting on
those contracts. The government either fails to implement its pledges or
radically adjusts the risk for private sector contractors dealing with
government by breaking PFI/PPP contracts. If the latter, the UK incurs increased
costs for several decades in direct contracts and in debt service.
The Conservatives have joined the trades unions in fighting PFI/PPP, claiming
that it amounts to some £100 billion of off-balance sheet borrowing. Referring
to PFI/PPP commitments, Shadow Chancellor Michael Howard said: "there is a
black hole in the public accounts, a hole entirely the making of this
chancellor" [27 November 2002]. Perhaps the Conservatives would be better
to target the 'democratic deficit' they initiated, one that will leave them or
the Liberal Democrats little room to manoeuvre upon election, thus restricting
their ability to fulfil their mandate.
Michael Mainelli, FCCA, originally did aerospace and
computing research, before stooping to finance. Michael was a partner in a large
international accountancy practice for seven years before a spell as Corporate
Development Director of Europe's largest R&D organisation, the UK's Defence
Evaluation and Research Agency, and becoming a director of Z/Yen (Michael_Mainelli@zyen.com).
Z/Yen Limited is a risk/reward management firm working to
improve business performance through better decisions. Z/Yen undertakes
strategy, finance, systems, marketing and organisational projects in a wide
variety of fields (www.zyen.com), such as recent projects developing a
stochastic risk/reward prediction engine and benchmarking of transaction costs
across 25 European investment banks. Michael's humorous risk/reward management
novel, "Clean Business Cuisine: Now and Z/Yen", written with Ian
Harris, was published in 2000; it was a Sunday Times Book of the Week and even
Accountancy Age described it as "surprisingly funny considering it is
written by a couple of accountants".
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