PFI and PPP: could they result In Enron UK?

Citation

Mainelli, M. (2003), "PFI and PPP: could they result In Enron UK?", Balance Sheet, Vol. 11 No. 2. https://doi.org/10.1108/bs.2003.26511bab.003

PFI and PPP: could they result In Enron UK?

Michael MainelliMichael Mainelli is Executive Chairman of Z/Yen Limited.

Know the one about the £392 billion organization with off-balance sheet finance? Would 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? Anthony Hilton compared this organization'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, and 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 center 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 percent of publicly sponsored investment (see Figure 1).

Figure 1 UK PFI/PPP capital expenditure

The government seems eager to expand PPP as a way to secure the improvements in public services that Labour promised at election time. If privatization 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 do not 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 favorably with earlier public sector projects. A total of 22 percent of the PFI projects were over-budget, but the NAO had found in similar public sector construction project reviews that 73 percent 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 "privatized". 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 Privatization 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 "strategic transfer of the estate to the private sector" (STEPS). 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 minimized 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:

1. 1.

   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; and

2. 2.

   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 criticize 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 us get back to the land

A bit of detail may give quite a bit of flavor. 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":

1. 1.

   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;

2. 2.

   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;

3. 3.

   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;

4. 4.

   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 do not 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 privatization. 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 have been able to do is to cut the national debt as a result we have 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 does not 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 percent) which calculates £100 of annual public spending for 10 years as £1,000, but £100 spent on the private sector for ten 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 (see Figure 2) and 44 health projects (see Figure 3) 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.

Figure 2 Capital versus committed running costs – education sample of 18

Figure 3 Capital versus committed running costs – health sample of 44

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 in Table I.

Table I

Granted, we are extrapolating the costs based on less than 5 percent 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 maneuver upon election, thus restricting their ability to fulfill 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 organization, the UK's Defence Evaluation and Research Agency, and becoming a director of Z/Yen (Michael_Mainelli@zyen.com).

Z/Yen Limitedis a risk/reward management firm working to improve business performance through better decisions. Z/Yen undertakes strategy, finance, systems, marketing and organizational 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".

Z/Yen Limited, 5-7 St Helen's Place, London EC3A 6AU, UK; Tel: +44 (0) 207-562-9562.