Definitions

Private Finance Initiative

Private Finance Initiative

The Private Finance Initiative specifies a method, developed initially by the United Kingdom government, to provide financial support for "Public-Private Partnerships" (PPPs) between the public and private sectors. This has now been adopted by parts of Canada, France, the Netherlands, Portugal, Ireland, Norway, Finland, India, Australia, Japan, Malaysia, the United States and Singapore (amongst others) as part of a wider reform program for the delivery of public services which is driven by the WTO, IMF and World Bank as a part of their 'deregulation' and privatization drive.

These projects aim to deliver all kinds of works for the public sector, together with the provision of associated operational services. In return, the private sector receives payment, above the price that the Public Sector could have achieved the work, linked to its performance in meeting agreed standards of provision.

Overview

PFI is used in both central and local government. In the case of projects procured by local government authorities, the capital element of the funding enabling the local authority to pay the private sector for these projects is given by central government in the form of what are known as PFI "credits". PFI is not just a different way of borrowing money; the loans are paid back over the period of the PFI scheme by the service provider who is at risk if the service is not delivered to standard throughout. The local authority then procures a partner to carry out the scheme and transfers detailed control, and in theory the risk, in the project to the partner. The cost of this borrowing as a result is higher than normal government borrowing (but cheaper when better management of risks is taken into account) but does not all appear as borrowing in public accounts.

Each PFI project is different depending on local circumstances. However there are some common threads that run through all projects. The public sector authority signs a contract with a private sector "Operator". During the period of the contract the Operator will provide certain services, which are currently provided by the local authority. The Operator is paid for the work over the course of the contract and on a "no service no fee" performance basis. The authority will design an "output specification" which is a document setting out what the Operator is expected to achieve. If the Operator fails to meet any of the agreed standards it should lose an element of its payment until standards improve. If standards do not improve after an agreed period, the public sector authority is entitled to terminate the contract.

PFI is therefore dependent on both the standard of contracts used and the determination of the parties to enforce them.

The UK National Audit Office scrutinises public spending on behalf of Parliament and is independent of Government. It provides review reports on the value for money of many PFI transactions and makes recommendations. The Public Accounts Committee and Audit Commission also provide reports on these issues.

A notable example of PFI, and the only UK mission so far funded under the scheme, is the British Embassy in Berlin. The largest PFI in the world, as of 2006, will be the AirTanker provision of the Future Strategic Tanker Aircraft to the UK's Royal Air Force, valued in excess of £10 billion over 27 years.

Examples

The Private Finance Initiative was begun under the Conservative government of John Major in 1992. It immediately proved controversial, as it was perceived by critics within the Labour party such as Patricia Hewitt as a back-door form of privatisation (House of Commons, December 7 1993). Nonetheless, the Treasury found the scheme advantageous and pushed Labour to adopt it after the 1997 General Election. PFI has continued and, indeed, expanded under Labour. This has been strongly criticised by many trade unions and elements of "Old Labour". The 2002 Labour Party Conference passed a vote against PFI, though this did not change the government's policy.

According to Treasury and NAO reports, PFI deals are very much more likely to be delivered on time and on budget - a study by the Treasury in July 2003 showed that the only deals in its sample which were over budget were those where the public sector changed their minds after deciding what they wanted and from whom they wanted to buy it. It is claimed there is a far greater visibility of long-term consequences of decisions made by politicians and civil servants through PFI deals than conventionally where most of the long-term consequences and obligations of decisions are obscured from public scrutiny. This is not agreed with by those who believe that the details of these deals are wilfully complex and buried in confidential documents and footnotes.

As against that, however, there have been a number of high-profile PFI failures, many of which have been exposed by Private Eye, a British satirical magazine. One of the most shocking examples they have brought to light is the Mapeley-STEPS deal. Under this deal the buildings of the Inland Revenue and the contract for their maintenance was given to a company based in a tax-haven. Later that year Mapeley hiked their charges so eliminating the original benefits to the public sector.

Another example comes from a government report leaked on 17 June 2005. A new privately financed hospital in Leeds had "breached every section of the fire safety code". The Skye Bridge PFI scheme infamously cost the public £93m (and required the closure of the existing ferry to prevent competition), although it should have cost only £15m to build. Equally, the fact that major risks can be effectively transferred has been demonstrated in a number of cases, most notably the National Physical Laboratory Laboratory; this deal ultimately caused the collapse of the building contractor when the cost of building a complex scientific laboratory was very much larger than estimated. The laboratory was ultimately built, but the cost of doing so caused the winding up of Laser, a joint venture between Serco Group and John Laing . A recent BBC Radio 4 investigation into PFI noted the case of Balmoral High School in Northern Ireland due to close because of lack of pupils but whose PFI deal is due to run for another 20 years at the cost of millions of pounds to the taxpayer.

Furthermore, the scale of PFI projects in the health & education sectors since 1997 is now having a serious impact on public service budgets. Because the projects are more expensive in the private sector (on average 30% more than if the Government borrowed the money and did the work in the public sector) the payments to the private owners of the PFI schemes are stretching already constricted budgets. Many Health Trusts are in serious difficulty already, and when the level of spending falls in 2007, some may become insolvent. The Government is already in negotiation with private healthcare providers to come in and run 'failing' Trusts. A recent investigation by Professor Jean Shaoul of Manchester Business School into the profitability of PFI deals based on accounts filed at Companies House revealed that the rate of return for the companies on 12 large PFI Hospitals was 58%.

Kent Police have recently taken delivery of two new PFI Police Stations serving the Medway area and the North Kent area (Gravesend and Dartford), the new buildings take into account the modern needs of the police better than the 60s/70s buildings. The advantage is that the old buildings can be sold for income or redeveloped into the police estate.

Controversy

Controversy is caused by the off-balance-sheet nature of PFI contracts. Under UK accounting, the PFI company does not enjoy the risks and rewards of the building - the government carries demand risk, for example - so the building is not shown on its balance sheet. Instead its main asset is the finance debtor - the long term contractual obligation of the government to pay for the building. For the government accounting, the fact that it pays a single charge (the 'Unitary Charge') for both the building and its maintenance is sufficient for it to be classed as a revenue item, so neither the building or the long-term obligation to pay appear of the government's balance sheet. Were the total PFI liability shown on the UK balance sheet - as would be required under UK accounting standards - the government's finance would look somewhat different.

Financial Structure

The typical PFI provider has three parts or legal entities: a holding company (known for short as Topco), a capital equipment or infrastructure provision company (known for short as Capco), and a services or operating company (Opco). The main contract is the concession contract between the Government and Topco. Topco then flows down requirements to Capco and Opco, with legal contracts to enforce. These two legal entities then typically flow down their requirements to subcontractors, again with contracts to match. Typically the main subcontractors are the same companies as the shareholders of the Topco. Large PFIs are often let to consortiums of companies rather to individual firms. The Capco may not be a separate legal entity but rather one of the prime shareholders taking on the responsibility to provide the capital equipment (e.g. the hospital).

Large PFI projects are funded through the sale of corporate bonds, issued by the company running the PFI. An essential feature of PFIs is that these bonds are rated as BBB- by a credit rating agency (for example Standard and Poors). BBB- is the lowest investment grade rating, any lower than that and the bond receives speculative or 'junk' status. If a rating of better than BBB- is given then the Government is likely to want to renegotiate the deal, to lower the unit price it pays for the service. Any lower than BBB- means that investors would be unlikely to take on the risk. So although bond rating typically affects the cost of borrowing for corporates, in the PFI case it effects the whole viability of the deal. The reason for existence of the treasury team in the PFI supplying company is to gain an investment grade rating. A PFI firm will typically go to two of the three main credit rating agencies, sharing details of their financial model, concession contract and capital equipment solution.

Smaller PFI projects - the majority by number - are funded directly by banks in the form of senior debt. Senior debt is generally slightly more expensive than bonds, which the banks would argue is due to their more accurate understanding of the credit-worthiness of PFI deals - they may consider that the monoline providers underestimate the risk, especially during the construction stage, and hence can offer a better price than the banks are willing to.

Refinancing of PFI deals is also common. Once construction is complete, the risk profile of a project is much lower, so cheaper debt can be obtained. This refinancing may be done via bonds - the construction stage is financed using bank debt, and then bonds for the much longer period of operation. In most PFI contracts, the benefits of refinancing must be shared with the procuring authority.

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