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Select Committee on Public Accounts Twenty-Eighth Report

1. Choosing whether to go ahead with the PFI option

Assessment of options

1. PFI contracts are generally long term arrangements involving public expenditure over extended periods, often for 30 years or more. The public sector does not have to find the money up-front to meet the initial capital costs. But the cash payments thereafter will generally be higher than in an equivalent conventionally-financed project (Figure 1). The PFI approach can enable departments to undertake projects which they would be unable to finance conventionally since they do not need to find all the money for the capital asset during its construction. PFI deals can therefore be attractive in the short term. But there is a risk that this attractiveness may distort priorities in favour of those projects which are capable of being run as PFI projects.

Figure 1: Timing of payments under the PFI and conventional procurement

Note: In conventional contracts the private sector is paid for the construction of the asset and the public sector makes separate arrangements for the ongoing maintenance and operation of the asset. In PFI contracts the private sector is paid on the basis of the service provided over the lifetime of the contract. The regular unitary charge paid to the contractor is intended to cover the cost of construction, maintenance and operation of the asset.

Source: National Audit Office

2. Since the Government can borrow money at lower interest rates than private companies, PFI deals will generally cost more to finance than publicly funded projects. For the PFI route to be worthwhile, the higher financing costs and any other potential disadvantages need to be more than outweighed by the benefits achieved. Such benefits might include a better allocation of risk between the public and private sectors; improved delivery as a result of the incentives offered to private contractors through the payment mechanism; and closer integration between design, construction and operation. Some of the potential benefits and disbenefits of PFI deals are shown in Figure 2.

Figure 2: Potential benefits and disbenefits of PFI deals

Benefits Disbenefits

There can be greater price certainty. The department and contractor agree the annual unitary payment for the services to be provided. This should usually only change as a result of agreed circumstances. The department is tied into a long-term contract (often around 30 years). Business needs change over time so there is the risk that the contract may become unsuitable for these changing needs during the contract life.

Responsibility for assets is transferred to the contractor. The department is not involved in providing services which may not be part of its core business. Variations may be needed as the department's business needs change. Management of these may require re-negotiation of contract terms and prices.

PFI brings the scope for innovation in service delivery. The contractor has incentives to introduce innovative ways to meet the department's needs. There could be disbenefits, for example, if innovative methods of service delivery lead to a decrease in the level or quality of service.

Often, the unitary payment will not start until, for example, the building is operational, so the contractor has incentives to encourage timely delivery of quality service. The unitary payment will include charges for the contractor's acceptance of risks, such as construction and service delivery risks, which may not materialise.

The contract provides greater incentives to manage risks over the life of the contract than under traditional procurement. A reduced level or quality of service would lead to compensation paid to the department. There is the possibility that the contractor may not manage transferred risks well. Or departments may believe they have transferred core business risks, which ultimately remain with them.

A long-term PFI contract encourages the contractor and the department to consider costs over the whole life of the contract, rather than considering the construction and operational periods separately. This can lead to efficiencies through synergies between design and construction and its later operation and maintenance. The contractor takes the risk of getting the design and construction wrong. The whole life costs will be paid through the unitary payment, which will be based on the contractor arranging financing at commercial rates which tend to be higher than government borrowing rates.

Source: National Audit Office

3. Before embarking on the PFI route, departments need to consider the available options for financing their projects. As well as the PFI, the options may include other types of partnership arrangements with the private sector and various forms of conventional finance. The assessment should include a realistic and comprehensive analysis of costs, benefits and risks. Such appraisals are not always being done adequately, however, with the PFI option too often being seen as the favoured route before a proper assessment has been carried out.

4. The question also arises as to whether the benefits of the PFI approach—particularly the use of private sector skills and the more appropriate allocation of risk—are sufficient to justify the extra cost of using private finance. One of the valuable features of private sector financing of PFI projects is the extensive due diligence that private sector risk-takers carry out. But the returns to financiers need to be commensurate with the risks that they are actually taking and this in turn depends on the market being well informed and truly competitive. External financing of PFI projects could be good value if the extra costs are justified by the risks transferred and if due diligence serves to manage those risks more effectively. But it is also possible that these benefits could be obtained more cheaply through alternative forms of financing. A thorough evaluation of the advantages and disadvantages of possible alternative financing structures for PFI deals is needed.

The public sector comparator

5. A public sector comparator is a costing of a conventionally financed project delivering the same outputs as those of the PFI deal under examination. It is just one of a number of ways of evaluating a proposed PFI deal. It is directly relevant only when the publicly financed option on which it is based is a genuine alternative to the PFI deal. This is most likely to arise at the outset of a project.[3]

6. The use of public sector comparators has been the subject of considerable debate about their reliability, accuracy and relevance in the contexts in which they have come to be used. We have seen many cases where the public sector comparator has been incorrectly used as a pass or fail test. In these cases the desire to show that the PFI deal is "cheaper" than the public sector comparator has led to manipulation of the underlying calculations and erroneous interpretation of the results. There are likely to be qualitative and non-financial differences between the options that cannot simply be subsumed in a difference in forecast cost.

7. The accuracy of public sector comparators is limited. They are prone to error because of the complexity of the financial modelling that is often used. They are also dependent on uncertain forecasts. This places a limit on the accuracy which can be achieved, however much work or analysis may be done. Further work takes time and money without necessarily adding to the value of the public sector comparator as a decision tool. There is also a risk that the users of the public sector comparator will believe that it is more accurate than it could ever be. Decisions can be made on the basis of small and spurious differences between the public sector comparator and the PFI option.

8. Examples of some significant weaknesses in the use of public sector comparators are set out in Figure 3.

Figure 3: Weaknesses in the use of public sector comparators

PFI deal Committee's findings

Dartford and Gravesham Hospital (12^th Report, Session 1999-2000) The NHS Trust did not detect significant errors in the public sector comparator. The Trust also did not quantify the full effects of changes in contract terms and of the sensitivity of the deal to changes in key assumptions, as the deal went forward. Had the Trust known that the savings were marginal when negotiating the deal, it might have made different decisions and achieved better value for money.

Airwave (64^th Report, Session 2001-02) A public sector comparator was not prepared until late in the procurement, and after a decision to use the PFI had already been made. It is therefore doubtful that the use of a comparator added to the decision-making process.

MOD Main Building (4^th Report, Session 2002-03) The public sector comparator gave a central estimate for the cost of a conventionally financed alternative to the PFI deal as £746.2 million, compared to an expected deal cost of £746.1 million. Such accuracy in long term project costings is spurious, and the small margin in favour of the PFI deal provided no assurance that the deal would deliver value for money.

West Middlesex Hospital (19^th Report, Session 2002-03) The NHS Trust's advisers strove to make slight adjustments to the calculations, well within the range of error inherent in costing a 35 year project, so that the PFI cost appeared marginally cheaper than the public sector comparator.

Comparison with the best alternative option available

9. Once the stage of choosing between PFI and non-PFI options has passed, the public sector comparator becomes less relevant. At all times, however, during the procurement negotiations departments need to keep in view the best alternative to proceeding with the PFI deal. In some cases the best alternative may be the public sector comparator project but it is likely that as time passes the real alternative to proceeding with the PFI deal will be some other project: a different technical solution, or a project delivering different benefits. Retaining a choice of action is particularly important during negotiations with bidders to maintain pressure on the price and avoid increases in the cost of the deal.

Financing costs

10. Financing costs are a major component of the contract price and the prices of alternative sources of finance can fluctuate over time. The value for money case for PFI depends on it bringing benefits that outweigh the extra costs of private finance. But the way in which financing costs are made up is often not transparent. For example, in the MOD Main Building deal (4^th Report, Session 2002-03) the Department could not quantify the extra costs of private finance. It was therefore not clear whether the returns being made were reasonable in relation to the risks being borne. Closer attention to financing costs would have been particularly helpful during the 16 months it took to close the deal. Reducing the length of that period, postponing the choice of finance to the end to get the cheapest form available, and a better informed approach to the financing markets prior to closing the deal all might have helped to secure savings on this project.

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