Capital punishment: Public Finance

Posted on June 8, 2009 · Posted in Public Finance

New Labour has made great play of its shiny new schools, hospitals and transport projects. But, reports Paul Gosling, this great building programme is about to come to a grinding halt as capital spending is expected to halve over the next four years

On the surface, there are positive signs for public sector capital projects. Two major Private Finance Initiative projects – the widening of London’s M25 orbital motorway and the Greater Manchester Waste Management scheme – have been signed off. And Treasury guidance that many PFI projects can still be treated as off-balance sheet will make it easier for departments to gain approval for schemes.

But this is a very superficial analysis. The M25 and Greater Manchester schemes might be exceptional cases, with other PFI projects remaining stalled. In any case, PFI projects comprise only 10%–12% of total government investment. The statistic that matters is in the chancellor’s April Budget. It shows that capital expenditure is scheduled to halve from £44bn in the 2009/10 financial year to a mere £22bn four years later. It is true that £44bn (representing 3.1% of gross domestic product) is a historically high figure and the forecast for the following year (£36bn or 2.5% of GDP) is still above average. However, from then on it looks bleak – public bodies face a collapse in capital spending.

Net investment is expected to be £29bn in 2011/12, £26bn in 2012/13 and then £22bn (1.3% of GDP) in 2013/14. This is a consistent decline and one that was not even hinted at in the Pre-Budget Report five months earlier. It is not simply that capital budgets will be cut so severely that only essential schemes go forward. Revenue budgets will also be squeezed for many years ahead, leaving little room to commit revenue funds to support new PFI and public-private partnership schemes.

The Budget Red Book makes great play of the capital projects that the government has completed over the past five years – including 140 new schools, 61 major hospital schemes, 229,000 new affordable homes and the West Coast Mainline upgrade.

Similar success stories will be a lot harder to find in the next five years. The public sector will have difficulty coming up with capital projects that will get approved, and concerns about this go beyond the public sector. Before the Budget, the CBI business group called for a minimum of 2.25% of GDP to be spent on infrastructure.

And David Gavaghan, chief executive of the Strategic Investment Board – which oversees infrastructure investment in Northern Ireland – argues that even this would be far too little. Quoting the Organisation for Economic Co-operation and Development in his support, he says: ‘There is a fairly well established rule of thumb that in a developed economy, if a country wants to remain competitive, it needs to invest on average 5% of its GDP on its civic infrastructure.’

Nor is there much scope for shifting spending from capital to revenue budgets to support infrastructure renewal through the PFI and PPPs. Glenn Stone, global head of project finance at consultancy Grant Thornton, says: ‘My view is that within 12 months there will be huge reductions in departmental budgets. And my concern is that with PPPs there is inevitably an affordability problem.’

This perspective is widely shared – to the extent that some experts believe that the PFI/PPP industry in the UK is about to shrink severely. To suggest it will disappear might be an overstatement, but the focus will inevitably move to other markets – the emerging economies and some parts of Europe. In place of PFI/PPP, private sector partners will increasingly look to different structures of joint ventures with public bodies, based around outsourcing and new sources of revenue generation.

PFI/PPP projects that do proceed will have to go through a much tougher approval process. ‘Poor quality projects are going to disappear,’ suggests Stone. ‘Bad schemes should not be funded. They probably were.’

There is a widespread view that lending to PFI and PPP schemes will not return to previous levels. This analysis appears to be shared even by Partnerships UK – the public-private partnership promoting these schemes. Stone says it is projecting fewer PPPs coming to market this year than last year, which itself was substantially down from previous years.

‘Major banks are not in the market,’ says Stone. ‘And they are probably not coming back for the foreseeable future.’ He believes that increasingly – not just in the UK, but across Europe – the European Investment Bank will have to prop up PPPs, with banks lending to the EIB while reducing new direct exposure to projects.

Nick Prior, a partner in Deloitte’s government and infrastructure team, believes that market conditions remain difficult. ‘One ought not to be too influenced by the M25 and Greater Manchester Waste PFI deals closing at this time as a reference for any change in government’s attitude to the PFI – because they have been going on for a long time and they were finally pushed over the line,’ he says.

‘What is more indicative of the government’s renewed commitment to the PFI is two particular things. One is Tifu – the Treasury’s Infrastructure Finance Unit [which is able to fund PFI schemes directly] – and secondly the renewed confirmation of the accounting treatment, which does demonstrate that the PFI remains a favoured procurement solution.’

Prior points out that despite the pressures on revenue budgets, extending procurement over 25 years remains easier to achieve than the one-off hit taken by traditional procurement of capital items.

There must be capital spending cuts, but where they will fall is unknown. Gemma Tetlow, senior research economist at the Institute for Fiscal Studies, says: ‘At the moment, we haven’t got any plans, we haven’t seen any aspirations from government. It is not clear where [the cuts] are going to come from.’ She suggests that logically some of the largest capital budgets – such as housing, transport and school building – are the most vulnerable.

PricewaterhouseCoopers partner Jon Sibson, who is government and public sector leader, says: ‘You would think that social infrastructure is what they would want to protect. There will be a lot of emphasis on getting infrastructure funded by the private sector and taking it away from the public purse altogether, with self-funded projects.’

There is a widespread view that defence projects could be hit worst of all, even if the Conservatives win the next election. Alternative scenarios – cutting back on school building, health infrastructure or social housing – are likely to be politically unattractive and to some extent impractical. In any case, the use of the PFI for defence procurement is now recognised as being too inflexible for most military needs, so where military procurement does proceed, it will need to be financed traditionally.

It is also widely believed that transport programmes are the most likely to go ahead, because private sector finance can be secured against future years’ revenue streams. Projects might include railway rolling stock, rail line upgrades, new stations and even, perhaps, toll roads.

‘It’s got to be where there are payment streams,’ says Sibson. ‘This is most at home with transport really, or where there is co-location of public services.’

Another self-financing possibility is for new prisons to be financed by the sale of old ones based in sought-after housing areas, he suggests. He cites Pentonville Prison, which is located in the expensive central London borough of Islington. However, this would mean that new prison building would be dependent on the resuscitation of the property market. A similar constraint exists on new social housing schemes, while most regeneration projects could be impossible to finance for the foreseeable future.

‘The opportunity for regeneration schemes is severely impeded by the property recession,’ says Deloitte’s Prior. ‘I am sure the Homes and Communities Agency does have a plan [to invest in social housing]. But I don’t know where they are going to fund it from.’

Local authorities also face severe constraints on capital and revenue projects – not least with the Conservatives’ commitment to freeze council taxes for two years if they win the next general election.

Brian Standen, finance and commercial director of 4Ps – the body working with local authorities to support PFI and other capital procurement – says that while councils are being encouraged to maintain or increase capital spending in the short term as part of the response to the recession, the pressures will reverse in the medium and longer term. ‘There’s bound to be a substantial impact on local government in a few years’ time,’ he says.

Anticipating this, the 4Ps is encouraging councils to make more intelligent use of assets, to enable disposals when the property market recovers, and to use redundant assets as their contribution to capital projects, such as new offices, service centres and regeneration schemes. This will involve, if 4Ps has its way, much greater co-location of services across local government functions, between different types of public bodies and even bringing together public services with commercial operations – such as in new shopping centres.

‘The amount of money [available to contribute to capital programmes] will be less, but we have got a couple of years to think about the impact and to make the best use of assets,’ says Standen. Co-location will not only provide opportunities to maintain capital budgets where they would otherwise dry up, but should also produce revenue savings by reducing building and staffing overheads.

But, again, this approach assumes that the property market will recover – and the extent and timing of any recovery remains uncertain. ‘We are all anticipating that the current recession/depression is short term,’ says Standen. ‘If we took the view that it isn’t, then a number of challenges face the economy. We are looking for local authorities to position themselves for when the economy recovers.’ But Standen is pessimistic about the scale of recovery in the PFI market.

The government insists its ambitious programme for the replacement and upgrading of schools – Building Schools for the Future, overseen by Partnerships for Schools – remains on track. A PfS spokeswoman says: ‘PfS is working extremely hard to ensure that the current economic conditions do not impact on the delivery of BSF. While conditions continue to be undoubtedly challenging, due to the proactive steps taken, BSF has come back faster and stronger than other sectors.’

PfS adds that there are currently 20 ‘financial institutions’ willing to lend to BSF, compared to the 20 ‘banks’ that were lending to schemes in the summer of 2007. This implies both that the programme is able to survive relatively unscathed at present, and that life insurance companies and pension funds are taking up some of the slack from banks’ withdrawal from the market.

The situation is more uncertain in the health sector, where the big hospital building programme has largely ended. Nick Prior at Deloitte suggests there is not at present an obvious commitment to spending on a new generation of community health projects.

But there is a continued commitment to the Lift (Local Improvement Finance Trust) programme to replace and upgrade primary care facilities, although not necessarily on the scale previously. Chris Whitehouse, chair of the Lift Council – which represents investors – says: ‘The current market view is that a reduction in capital expenditure in itself is not an imminent threat to Lift activities. However, it is the first step in the overall reduction in revenue budgets for health. As Lift schemes create a revenue charge, this is of more concern to our members.’

Whitehouse believes that this financial context means that Lift schemes must provide better solutions, including greater co-location of public services, more savings from shared buildings and better value for money. In fact, what might be termed the ‘Lift approach’ could become the most common template across the public sector, with a widespread rationalisation of buildings.

A new approach to efficiency savings focused on capital investments can now be expected. The alternatives have suddenly become very limited.