End of the line for the PFI?

Posted on April 27, 2007 · Posted in Public Finance

In the early days of New Labour, the Private Finance Initiative was seen as the only game in town for funding major public sector projects, but the Metronet crisis could mean the game is up, writes Paul Gosling.

The administration of contractor Metronet seems to place question marks over the very principles underlying the Private Finance Initiative and public-private partnerships. It is not just a question of what happens to the contracts for the maintenance and improvement of the London Underground, but also of whether the whole New Labour strategy for renovating and replacing public assets has gone down the Tube.

These were already difficult times for the PFI. New accounting rules and serious problems with hospital and school schemes have cast doubt over its future. And it is the adoption of international accounting standards for government accounts that present arguably the biggest threat.

In Gordon Brown’s last Budget as chancellor, he announced that from 2008, government accounts would be prepared in accordance with International Financial Reporting Standards in place of UK Generally Accepted Accounting Practice.

According to the Budget papers, this will ‘bring benefits in consistency and comparability between financial reports in the global economy and…. follow private sector best practice’. But what they will also do, theoretically at least, is to bring billions of pounds of PFI deals on to the public sector balance sheet that have previously been off-balance sheet.

Critics have always claimed that one of the reasons for the new prime minister’s enthusiasm for the PFI has been that it helped him to finance much of the public infrastructure rebuilding programme without immediately paying for it, or without the cost appearing as public debt. This has enabled him to make much of his adherence to the sustainable investment rule – keeping public debt below 40% of national income. Both the chancellor and the Treasury have denied all suggestions of statistical fiddling.

A Treasury spokesman says: ‘We will move to IFRS, but it is too early to say what effect this will have on the PFI.’

He points out that, for the present at least, there is no reduction in forward commitments to the PFI, with the latest Budget papers showing plans over the next five years for £26bn of PFI spending on hospitals and £13bn for local government schemes.

But Carl Emmerson, deputy director at the Institute for Fiscal Studies, explains that the Treasury is now very close to the sustainable investment borrowing ceiling, which would be breached if off-balance sheet schemes were now placed on-balance sheet. Of the total £53.4bn capital values of PFI schemes declared by the Treasury, some £29.1bn (54.5%) is currently off-balance sheet.

The likely approach by Chancellor Alistair Darling will be to raise the 40% borrowing ceiling, suggests Emmerson. But simply raising it by the 3% or so necessary to cover the PFI schemes moving on-balance sheet would leave Darling and Brown open to fresh allegations of statistical manipulation.

Consequently, predicts Emmerson, Darling will replace the sustainable investment rule with a new rule which has a much higher ceiling and encompasses other long-term debt – particularly liabilities of public sector pensions. Last month, the then Treasury chief secretary Stephen Timms told the Commons that, as at the end of the 2005 financial year, the total figure for public pension liabilities was estimated to be £530bn. Others have put the figure even higher, at up to £800bn.

Ideally, says Emmerson, the new accounting rules would have no impact on the future of the PFI. ‘What we would like to happen is that all PFI deals are done for economic efficiency reasons, because they are the most economic way or are the best way to deliver, so this would make no difference,’ he says. ‘In future no-one will be able to make allegations that a deal is done as an accounting trick.’

But it would be naïve to suggest that accounting treatment has had no impact on PFI approvals, concedes Chris Nicholson, UK head of public sector at KPMG. ‘The theory of the PFI has always been that projects should be treated the same whether they are on- or off-balance sheet, so in principle this should not have any effect,’ he says. ‘But in practice a scheme being off-balance sheet was a factor in some instances in going for the PFI, so the accounting change could deter some PFI projects going forward in the future.’

There is an alternative prediction, though – that the new accounting standards might somehow not be applied to schemes already up and running. One person close to the Treasury suggested that it should not be assumed that despite the move to IFRS, all off-balance sheet PFI schemes will necessarily move on-balance sheet.

What is indisputable is that the PFI environment is meanwhile being damaged on other fronts, particularly by Metronet going into administration. Strictly speaking, Metronet is a PPP partner, not a PFI contractor – but in practice, PPPs and PFIs are part of a single sector and what damages one equally affects the other.

Metronet has two contracts, together worth £30bn, to upgrade the Underground’s Bakerloo, Central, Circle, District, Metropolitan and Victoria lines. But there has been conflict from the beginning between Metronet – a joint venture bringing together WS Atkins, EDF, Balfour Beatty, Thames Water and Bombardier – and Transport for London. Although TfL acts as the client body, the contract was imposed by the Treasury, at the insistence of Gordon Brown. As such, the near collapse of Metronet is personally damaging to Brown.

There has been a perpetual problem with contract management and keeping costs under control. Metronet and TfL each blamed the other, but the scheme’s arbiter has ruled that most of the problem lies with Metronet. There have so far been cost overruns of £551m, but only £121m of this is to be met by TfL – recognised as the result of upgrades in specifications. As a result, Metronet has insufficient funds to keep going, unless it is bailed out by its shareholders, client or government.

Transport analyst Christian Wolmar believes the failings involving Metronet offer lessons to the wider PFI industry. ‘The collapse of the Metronet contract shows there are clear limits to what can be undertaken through PFI/PPP schemes,’ he says. ‘The Underground contract was too big, too complex, used too many new techniques such as output-based payments and was based on the refurbishment of assets whose condition was never ascertained before the contracts were signed. Even though the private sector took on only a limited amount of risk, clearly it was too much. And yet, the cost of passing on that risk meant the contracts were overpriced.’

However, Barclays Bank’s director of PFI and structured finance, Hayley Rees, suggests these factors are particular to these contracts and that the impact will be limited. ‘I think everyone will consider this as a stand-alone specific project, which won’t affect the rest of the market,’ she says.

Rees concedes, though, that it might force observers to recognise that PFI and PPP schemes do not absolve public bodies from risk exposure. ‘A lot of people just look at the PFI and think it’s risk-free, which it actually isn’t. But people will still say this is the Tube and our project is completely different. [The earlier problems with] Jarvis did not actually seem to have too many ramifications in the market.’

Yet, one way or another, the public sector will have to pick up the pieces. Metronet is in administration, not receivership, and will continue trading. But it is unlikely its backers will bankroll its way through its current and projected losses. As was learned with the near collapse of Jarvis, public bodies might now find that there are no copper-bottomed guarantees that the private sector will underwrite liabilities.

Ironically, though, while public bodies must live with the uncertainty of a changing private sector environment, contractors can be assured of guaranteed payments under PFI contracts, however radically different the public sector environment becomes.

An extreme example has emerged in Belfast. Balmoral High School was completed in 2002 using the PFI but is scheduled to close next year – leaving the education and library board committed to paying the annual £370,000 PFI repayments. The school opened with 326 pupils and an assessment that pupil numbers would grow to 500. Instead they fell to about 150, making the school unviable.

A spokesman for the Belfast ELB said that with impending inquiries by the Northern Ireland Audit Office and the Assembly’s public accounts committee, it was unable to comment on the closure. But ELB chair Jim Rodgers recently told Radio 4’s File on 4 programme that the board got its figures wrong because it was unable to predict that many families would be forced out of the catchment area by intimidation.

Wrong public sector predictions are also causing problems in the health sector. People close to the PFI industry admit that they do not expect to see any further multibillion-pound acute hospitals being built – partly because the big schemes have been approved and are under way and also because it looks as if the future lies with smaller specialist hospitals and ‘polyclinics’.

It remains possible that smaller units will be financed through the PFI. The preferred industry model now is that used in Local Improvement Finance Trusts, providing primary care centres, and Building Schools for the Future, where single contracts batch together several smaller schemes.

There is interest among some clients and contractors in using this framework in other sectors, possibly including specialist hospitals, to provide buildings that are more generic in character and can be adapted for other uses if client requirements change.

Barclays Bank reports a willingness by some construction companies to offer contracts that do not include facilities management and act, in effect, as a conventional and flexible lease. If this type of structure proves practical, it could calm concerns among public sector clients unhappy with the cost and unresponsiveness of some facilities management providers, as well as overcome their sense of being ‘locked into’ buildings that become outmoded as operational requirements evolve.

It also seems likely that the focus of the next round of PFI contracting will move on to new activity areas. In particular, Partnerships UK – the public-private partnership established by the Treasury to promote the PFI and other private sector involvement in public services – is working closely with the Department for Environment, Food and Rural Affairs to provide a model for PFI contracting in waste management. This is viewed as an urgent priority as the only realistic means of the UK government avoiding being fined by the European Commission for infringements of waste management and landfill directives.

The Treasury also expects the PFI to move into regeneration in a big way, reflecting its frustration that this is not moving faster and across larger sites.

But despite the commitment to much greater house building, the PFI will not necessarily be a vehicle for achieving this. In fact, because of the changes in accounting standards and the practical problems, PFI will now be seen less often as the obvious or only choice for public sector procurement.

‘The PFI has a future, but as part of a spectrum of different types of partnership between the public and private sectors,’ says KPMG’s Nicholson. ‘If you look back five or ten years, it was the PFI or nothing and various projects were fitted into the PFI strategy. But now it is recognised that the PFI is not appropriate for all projects, as has already been accepted with IT projects. We will see greater flexibility and more incremental acquisitions, as with the IT sector, and some more conventional funding for procurement. But that is not to say that partnership between the public and private sectors is finished – far from it.’

Yet the impression remains of a sector that is nervous, fearing fallout from Metronet’s problems. An industry normally bullish and keen to talk has gone silent – three of the sector’s largest financiers and four of its largest advisers either declined to talk to Public Finance or failed to return calls. This probably indicates how much of the industry is directly affected by Metronet. But it also suggests that confidence has been replaced by anxiety.