Why Private Finance Initiatives were a Deeply Flawed Financing Model
This article was first published by Professor Ciaran Connolly on The Conversation.
It was Norman Lamont who first announced a new way of paying for public buildings and infrastructure in November 1992.
In a speech to the House of Commons, the then chancellor of the exchequer said he was looking to encourage more private financing for such projects.
Speaking only a few weeks after the government had been rocked by Black Wednesday, he reassured the house he would “ensure that sensible investment decisions are taken whenever the opportunity arises”.
So began the era of private finance initiatives (PFIs), which saw more than 700 contracts signed off in the UK until the government stopped doing them in 2018. They produced projects with assets worth approximately £60 billion, which are costing the taxpayer £170 billion – that’s a gap of £110 billion between what the assets are worth and what the taxpayer is paying for them.
So now that PFI has reached its 30th anniversary, how should it be remembered?
What they are
PFIs have paid for everything from roads to bridges to schools to hospitals, not to mention military training facilities, water and waste projects, sports facilities and prisons. Transport projects came first, such as the Severn River crossings and the M6 Toll Road. A refurbishment of some HM Treasury buildings was another early project, and was often cited by Conservative ministers as evidence of the Treasury’s belief in these schemes.
Generally PFIs – or public-private partnerships (PPPs), as they are sometimes known – involve a consortium of private companies financing, building, maintaining and operating assets for 25 to 30 years. Once operational, the public body effectively makes leasing payments to the lead contractor – subject to the assets being available and meeting key performance indicators.
The Treasury persistently claimed, at least initially, that this link between payments and performance would ensure the private sector bore most of the risks. By putting these experts in charge, it was argued that project management would improve. This was going to lead to more and better infrastructure, delivering value for money for taxpayers.
Rhetoric vs reality
PFI has certainly seen many infrastructure projects completed and facilities modernised which would not have been possible under traditional public procurement. But as far as the supposed benefits are concerned, the evidence suggests a disconnect between political rhetoric and reality.
Borrowing costs are one unavoidable problem, since contractors will most likely have a lower credit rating than the government. These costs get passed on to the taxpayer, which has constrained what authorities such as the NHS can spend on essential services, forcing them to reduce budgets accordingly. It also created pressure to reduce project costs, leading to poorer infrastructure.
There’s evidence from PFIs in health and roads that performance-based payments don’t incentivise contractors. The financial incentives are often inadequate, since they form only a small portion of leasing payments, and it’s difficult to develop key performance indicators for long projects anyway.
There are also endless issues around asset risks. With schools, for example, empirical studies highlight inherent complexities and subjectivity in how risks were allocated. According to this research, public authorities and their financial advisers could “manipulate” accounting numbers to make it look as though more risk was being transferred than was necessarily the case.
High returns earned by private investors also suggest departments were overpaying for transferring project risks. For example, equity returns in the M25 motorway project were approximately 30% – more than double the expected annual returns in PFIs.
Another issue is the difficulty in foreseeing and estimating all risks over a project’s lifetime. For example, the mid-1990s PFI contract for modernising the National Insurance Recording System (NIRS-2) experienced multiple delays and renegotiations during the pre-contract stage on account of uncertainties around future IT requirements. The Inland Revenue reportedly received only limited compensation from the contractors for these delays, yet did not take further action to avoid prejudicing “the partnership relationship”.
Sometimes failures to estimate risks helped to push contractors into bankruptcy. The classic example is Carillion in 2018, whose collapse was partly due to problems with PFI hospital contracts in Birmingham and Liverpool. Similarly with the London Underground modernisation in the early 2000s, poorly foreseen costs caused contractor collapses. The incomplete project reverted to the government, costing taxpayers billions of pounds.
Future concerns
These difficulties help show why the UK government ultimately scrapped PFI. It had also found it more difficult to make austerity savings in the 2010s because of PFI payments, while unfinished projects such as the Birmingham and Liverpool hospitals involved in the Carillion collapse produced waves of negative publicity.
Meanwhile, existing contracts remain a concern. Leaving aside leasing costs, one critical issue is contracts expiring at the end of their lifetimes. PFI holding companies aren’t required by law to to disclose much financial information, so there are unknowns around the state of many assets. Some could be passed on to the public in poor condition, and services could be disrupted as a result.
A recent parliamentary review pointed to uncertainties around funding to help better manage the expiry of contracts. The review also found an absence of clear guidelines for contract expiry in some of the oldest contracts (meaning the ones due to expire soonest), and limited trust between procuring authorities and their contractors.
The government’s Infrastructure and Projects Authority recently published guidance for procuring authorities around contract expiries, but said nothing about making available technical, commercial, financial or legal expertise. Authorities will need to organise this in-house, raising the prospect of hiring expensive private consultants with taxpayers’ money.
Three decades after PFI launched as a “sensible” form of infrastructure investment, it’s now seen by the government’s Office for Budget Responsibility as a fiscal risk. This is both because PFIs have been allowed to remain off the government’s balance sheet and because the risks often revert to the government if a contract fails.
PFI may have seemed sensible on paper, but successive governments appear to have implemented it to make projects happen faster, often to score political points. To make the best of a bad situation, changing the rules around the financial reporting of PFI holding companies and making sufficient resources available to manage asset handovers to public authorities would be a step in the right direction.
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