What could a new PFI look like?
Summary: How could PFI be reborn?
The Private Finance Initiative (PFI) was responsible for funding 694 projects across the UK. Initially loved by markets, hated by the left, and the doyenne of the centre, its gloss faded over time. Project failures and continuing bad publicity made it a problem for Government, while project disputes, especially in the NHS, made it unpopular with banks and investors.
And yet, calls to bring it back are increasing in volume. So how do we create a new PFI which is better than the original? I suggest the following:
The article:
outlines some of the problems with PFI,
explains each of the changes suggested above and how they could underpin a better model, more suited to today’s market conditions,
touches on how this would (or won't) affect capital budgets.
What’s wrong with PFI and PF2?
PFI delivered a lot of projects. It enabled the injection of a lot of new funding into public infrastructure, without adding to government debt. It also transferred risk, with the private sector taking responsibility for project delivery and quality. It was by no means all bad.
However, there were problems:
For the public sector:
Pace and cost concerns
The level of scrutiny and the rigour of PFI processes often meant that the deals took a long time to be executed. Of course, even traditionally financed deals are now often protracted.
When deals are terminated, the costs to Government can be significant, involving re-procurement, rectification and, frequently, litigation.
The cost to the public sector was sometimes high, having been set in higher interest rate environments and in a world where the public sector was expected to benefit from above-inflation spending settlements. This meant that costs increased at a faster rate than public sector budgets could readily accommodate.
Performance concerns
Some projects have failed to deliver on the specifications contracted for, through alleged poor quality design, construction or quality control. Examples I’ve seen include fire compartmentalisation, dampers and doors; ground source heating and cooling; ligature points; and leaks/flooding.
Significant overruns frequently contributed to the bankruptcy of contractors including Carillion, Laing and Jarvis, leaving the public sector holding the bag in a situation where it had intended to transfer this risk.
Market concerns
Further, these corporate collapses have started to change investor and contractor appetite for the deals on offer and therefore reduced competition for new projects.
Relationship concerns
Relationships can be poor, with contract managers on both sides citing a lack of partnership working, with the public sector frequently complaining of failure to acknowledge the defects, inadequate rectification plans and a combative approach.
The public sector often found itself dealing with new investors and outsourced PFI management companies without the rich background to the projects that the original deal team had. This meant a lack of understanding of what was important to the public sector and a loss of the context against which the contracts had originally been drafted.
Complexity
For some public sector entities, the contracts were too complex and therefore under-managed.
For the private sector:
Risk and cost concerns
Contractor failures, like Carillion, led to banks and investors making significant losses - and of course the elimination of major contractors from the market.
Litigation and disputes are also costly for the private sector, and erode returns.
Relationship and trust concerns
Public sector contract managers were perceived, in some cases, to be gaming the payment mechanism, against the spirit of the original agreements. Consultants were seen to be being brought in by the public sector with this specific aim in mind. This eroded trust.
The private sector often found itself dealing with new public sector management teams who lacked the rich background to the projects that the original deal team had. This meant a lack of understanding of how and why solutions and workarounds had been devised and a loss of the context against which the contracts had originally been drafted.
They complain that reasonable approaches to rectification were being rejected in favour of demands for solutions which they consider went beyond the scope of the original contract.
The upshot of this is that both sides are wary of new deals and some contractors, in particular, are now refusing to engage in fixed price contracting for these deals. The suggestions that follow look at what could be improved to address these concerns in each part of the deal cycle, from initiation, through delivery and management.
Initiation: What should change?
Simplify the approvals process, particularly for devolved entities
What’s needed? Reduce the number of levels of approval for the many business cases needed by devolved entities, in order to deliver a project.
How could it be done? One option is through devolving capital allocations when a programme is approved: The delivery of that approved project within a programme would then already be agreed, within defined boundaries. Another option would be to give devolved entities a direct line to Treasury, just as spending departments already have.
Why is it needed? The intricate approval processes faced by devolved government entities in the UK, such as the NHS and Local Governments, highlight the necessity for a more streamlined approach. Unlike Central Government departments, devolved authorities often grapple with substantial delays in executing capital projects. This is especially pronounced in the case of PFI, where finalising and executing a contract can be prolonged, even after undergoing a rigorous procurement process. Intermediate approval bodies frequently demanded additional information or requested alterations to the project scope at the eleventh hour.
When a Central Government Department assumes the role of the sponsor, it can readily adapt to changes during project development, with the business case owner typically serving as the Departmental approver. However, for devolved authorities, engagement from the Department and particularly HM Treasury (HMT), in the day-to-day development of cases is limited. Consequently, the approval process becomes protracted, exasperating, and entangled in multiple layers of decision-makers. This complexity impedes project agility and poses challenges in progressing projects from one stage to the next.
The argument presented here is not in favour of centralisation but for a more efficient devolution of funding and decision-making, albeit within well-defined boundaries. For instance, an overarching fiscal approval could be established by department, region, or devolved authority, enabling project sponsors to manage and advance projects within those specified limits, without reference back.
Standardise the cost of capital
What’s needed? A single cost of capital to apply to devolved entities, regardless of the source of the funding, whether through PFI, borrowing or Treasury capital.
How could it be done? Treasury could include PFI “debt” in its Treasury management programme and pool costs with other forms of funding to create a single revenue-neutral cost of capital.
Why is it needed? PFI projects were signed between 1992 (the M6 project) and 2016 (the Midland Metropolitan Hospital). Over this period, interest rates experienced significant fluctuations, along with changes in the risk premiums imposed by banks and equity holders. Interest rates varied by 5 to 8%, initially as the private sector became more comfortable with the contracts, and then during, and again after, the banking crisis.
Consequently, public sector entities incur very different funding costs (or cost of capital) depending on prevailing market conditions at the time of project initiation. While Treasury centrally manages debt across government, individual PFI projects must navigate and manage their own costs. For instance, a PFI-funded hospital from the 90s within the NHS carries a markedly different cost of funds compared to one funded in 2006 or 2016. Moreover, these costs differ from the standard 3.5% for budget-funded capital expenditure and from the interest rates of the former NHS borrowing facility, the Independent Trust Financing Facility. However, all these hospitals operate within the same revenue parameters, dictated by tariff or block funding models that do not account for varying funding costs. This leads to disparities, creating winners and losers within the system, contradicting the broader government approach to Treasury Management.
A more effective approach would involve consolidating the funding cost elements of PFI unitary charges with other quasi-interest costs, such as the Public Dividend Capital (PDC) regime and borrowing charges. This consolidation would help balance disparities. Establishing a centralised capital fund could average out these diverse sources, providing a uniform cost of capital applicable to all NHS Trusts or government bodies, irrespective of their funding model.
This standardised cost of capital could be implemented across the government and incorporated into funding settlements. Such an approach would eliminate the influence of cost of capital outliers on the performance management of devolved entities (ie Trusts with expensive PFI costs being at a competitive disadvantage). Consequently, Treasury could concentrate on overseeing and managing the cost of funding across the system, while public bodies could focus on delivering optimal services within equitable funding constraints.
Delivery: What should change?
Widen the available contracting techniques
What’s needed? A balance of risk in construction contracts which is more acceptable to the current contracting market and allows for the risk of very large projects to be shared between Government and contractors.
How could it be done? Allow for new contracting techniques, like alliancing, to be included as a possible basis for the new PFI contracts.
Why is it needed? In the aftermath of heightened PFI disputes and the notable collapse of Carillion, contractors have grown cautious about engaging in the fixed-price contracting that formed the core of PFI's risk transfer model. Indeed, many contractors have withdrawn from offering PFI-style fixed price projects, particularly in the healthcare sector. It's important to note that not all contractors have taken this stance, and there are contractors willing to deliver fixed pricing, especially for contracts valued below £500 million.
In order to meet the construction capacity requirements for a truly transformative infrastructure pipeline, it’s going to be impractical to insist that all contractors adhere to fixed-price commitments. This doesn't imply abandoning fixed-price contracting altogether but rather being open to exploring alternative models. One such model gaining traction globally, including in the UK, is the alliancing model. This approach involves establishing a Target Outturn Cost (TOC) and incentivising contractors to deliver at or below this cost, with any resulting savings shared. The model also allows for exceeding the TOC, but with a reduction or elimination of contractor profit depending on the extent of the overrun. While the alliancing model has its drawbacks, the public sector is becoming more adept at its implementation. Examples from Australia highlight increased rigour in competitively setting the TOC, along with stronger rules regarding eligible expenditures and defined criteria for savings.
We should give public bodies flexibility to choose from amongst these options and to negotiate PFI documentation and commitments around them. The result should be greater competition and capacity.
Radically improve and intensify construction quality checks
What’s needed? A much more stringent, frequent and wide ranging system of checks on contractors during construction.
How could it be done? A radically enhanced clerk-of-works role involving numerous in-flight checks and rigorous checks back to the specification documents.
Why is it needed? In a number of cases, the quality of the projects delivered hasn’t lived up to the proposals initially made. Instances of inadequate adherence to construction specifications and quality standards, coupled with insufficient oversight by the public sector, have manifested in tangible issues such as inoperable ground source heating and cooling, unsafe patient facilities, below standard ventilation and non-compliance with fire regulations. In the case of Royal Liverpool, it was reported that design shortfalls and cracks in beams might have compromised the structural integrity of the constructed facilities. These examples underline the importance of bolstering construction quality control measures.
A comprehensive acceptance testing process, coupled with regular and comprehensive in-flight reviews, serves as the lynchpin for ensuring that the constructed facilities meet the specified standards and requirements and for reducing the chance of latent defects. An enhanced and continuous clerk-of-works-style role, with clear accountability to the public sector, would be a terrific start.
This probably also requires more attention being given to crystal-clear specifications. Clear and unambiguous specifications provide a roadmap for contractors, helping construction to align with the intended design and functionality. Enforcing stringent controls at every stage of the project lifecycle could foster a culture of precision and accountability among contractors and stakeholders.
Management: What should change?
Lock in the original investors and contractors for longer
What’s needed? Better organisational memory and accountability.
How could it be done? Possibly through an enhanced change-in-control mechanism which requires a full and clean six-facet survey against the specification, minimum performance levels against the contract, a stronger pre-approval of transferees and a minimum time elapsed before any change can be contemplated.
Why is it needed? A common concern raised by the public sector is that the original decision-makers for the deal have moved on, making it challenging to refer back to the initial proposal documents or past discussions. Of course, this issue also applies to the public sector's PFI project teams, who have typically moved on. However, for the private side, there are additional challenges:
Sales of Project Equity: Equity is often acquired by investors who aren't actively involved in day-to-day project discussions or who have new incentives. This can include passive investors or new teams looking to drive value from their investment, creating pressure to find savings and efficiencies, which may impact the project's performance for the public sector client.
Secondary Market Debt Sales: This results in senior lenders who are more distant from the original deal and commitments.
Outsourcing Management to SPV Companies: Management companies often have a specific mandate to deliver efficiencies. To remain competitive with customers, they might lack the resources to closely manage routine maintenance, lifecycle, and repairs.
Determining how to maintain sponsors' commitment for an extended period is not straightforward. However, one possible approach could be to mandate that investors and lenders remain involved with the project for the first five to ten years. An exit would be contingent on a thorough assessment of the facility's condition, with the goal of identifying and addressing all existing and potential future issues. Conditions could also be set regarding the project's performance before any handover, and the public sector could have a say in determining future funders.
Give the public sector a voice in the PFI vehicle
What’s needed? A public sector voice in the PFI delivery vehicle, helping to translate between the two parties and holding the vehicle to account for the originally promised outcomes.
How could it be done? Two options would be (a) a shareholding and seat at the Board; or (b) a golden share arrangement.
Why is it needed? It’s common to find that there is a real disconnect between the senior management for a PFI project delivery vehicle and the public sector client. A seat at the board, through a shareholding, might somewhat stifle discussion amongst private investors but it might also avoid problems before they arise and lead to a greater spirit of partnership. This is, after all, something which is already in place for NHS LIFT and, initially, in the Building Schools for the Future (BSF) programme. This inclusion could promote collaboration and ensure that the public sector client can actively participate in discussions related to project delivery, risk management, and performance evaluation.
Another option is a public sector golden share. A golden share provides the public sector with a protective mechanism, allowing it to exert influence over critical decisions without unduly interfering in day-to-day operations. This measure safeguards public interests, ensuring that the original objectives of the PFI project are prioritised and sustained over time.
Professionalise public sector contract management
What’s needed? Stronger management of the contract from Day One.
How could it be done? Professional contract managers, supported by central advice, guidance and support.
Why is it needed? In the early days of PFI, particularly, it’s recognised that there was often little attention given to contract management by the public sector and this meant, in some cases, that standards dropped. We need to do better next time and set the tone from the start.
Consideration could be given to a centre of excellence for pooling knowledge and innovations - supporting the public sector to get best value. Or this could be done by greater investment and attention being given to contract management initiatives that the Infrastructure and Projects Authority is already delivering.
Limit the degree to which contract management can be outsourced
What’s needed? A more direct and constructive relationship between the principals to the contract.
How could it be done? Through defining areas of contract management which need to be done by the contracting parties, not via agents or sub-contractors.
Why is it needed? This is one of the recommendations I’m least sure about because there is certainly a case for bringing in specialist expertise to manage projects, whether you are the private or public project sponsor. There’s also probably a case for outsourcing more mundane elements of the job like SPV accounting. However, the relationship between customer and provider needs to be managed by the principals and those principals need to be responsible and accountable for the performance of the contract. Much of the concern from the private sector has stemmed from the public sector bringing in teams which are strongly incentivised to find problems and ignore examples of good practice. Likewise on the private sector side, too often SPV management companies or service providers will be tasked with finding ways to deliver more and more cheaply, often ignoring valid operational concerns.
In essence, external entities may not be as invested in the long-term success of the project, nor the long-term relationship, as internal teams would be.
On- or off- Balance Sheet?
No discussion of PFI would be complete without a nod to that bizarre and nonsensical lease accounting standard, IFRS16. This document envisages a strange new accounting world where both the landlord and the tenant can own the same asset at the same time, and has run roughshod over capital allocation approaches in the public sector. The upshot though is simple: Any English NHS entity constructing an asset through PFI, new or old, will require capital budget cover (NHS CDEL). Meanwhile, Central Government Departments and devolved Governments continue to use the old way of accounting for PFI, but they still need to apply IFRS16 for property leases. So, while use of traditional PFI can help governments to manage reported borrowing at a National Accounts and even Department level (where IFRS16 is not adopted), IFRS16 stymies this for English NHS budgets - and so PFI, old or new, will not help to stretch limited NHS capital expenditure budgets, unless the Department takes a different approach. So what can be done? First, a complication and then some options.
The complication that has to be noted is that, even without IFRS16, some of the suggestions that I've made around making PFI work would bring PFI on balance sheet not just for the NHS but also for national accounts (ie make it count against the capital budget). I remain optimistic, though, that a determined Government could find a solution to change national accounting treatment, or change our fiscal rules, to allow a more sensible commercial balance.
So, how to deal with IFRS16? The most obvious is for the Department to allow the NHS to access additional capital for PFI, adjusting their capital budgets upwards when they do. This means effectively passing on to the NHS the benefits of ignoring IFRS16 at national accounts level. The Department is already doing this as a transitional measure for leases. Let's make it permanent.
But what about "new" PFI? If old PFI won't be accepted by the NHS and industry, but "new" PFI is on balance sheet, what then? This is a problem already faced for property leases which are on balance-sheet for NHS and national accounts. My suggestion for leases and new PFI would be the same:
First, let's drop Philip Hammond's NHS PFI ban. It's over-interpreted as it is (capturing things way beyond PFI) and arbitrary.
Second, disapply IFRS16 for all forms of public sector accounts and use the old rules for accounting, across the public sector. Just because the International Accounting Standards Board asks you to do something silly, doesn't mean that you should do it.
Third, investigate how to change the rules of the game. We supposedly now have national sovereignty. Can we use some of this to set some accounting rules which work for the public sector? This means exploring whether, in the context of international financial treaties (specifically the UN/IMF System of National Accounts) there is room to move to allow some of the commercial concessions that I propose, while maintaining off-balance sheet treatment.
If that doesn't work, then accept the accounting consequences but implement the same approach anyway - ie if you use a lease or new PFI model, you get additional CDEL, just like I suggest for original PFI. You would need to explain it to the markets and you would need to do some forward planning for those projects to allow Treasury to anticipate the impact on national accounts - but no privately funded project ever happened overnight. Importantly, there would be no cash impact to manage since the projects would be privately funded. While this may lead to a rise in reported national borrowing, Government could elect to report, alongside this rise, the improvement in the state and size of the country's infrastructure base.
Increase underlying capital budgets, particularly in healthcare - and commission work to demonstrate the positive economic impact of health infrastructure development and of a well-functioning, even world-leading, healthcare system.
The combination of these approaches would effectively implement a version of Gordon Brown's famous Golden Rule: "over the economic cycle, the Government will borrow only to invest and not to fund current spending", which I would adapt and reverse to say that borrowing is ok if you get an asset out of it.
