PFI (private finance initiative) – the mechanism for funding major infrastructure and construction projects, where completed assets remain, at least initially, in private ownership, and the cost of their construction is paid off, often with significant interest, over many years with public sector money – has been going through somewhat of a negative PR period.
To put it mildly and not without some justification, PFI has a public perception problem. This is something I discussed only recently in an article titled ‘Is This The End for PFI?’. I believe that PFI, undertaken in the right way for a limited and specific portfolio of projects, has a valid place in the project funding world. However, it is far from perfect, so in recognition of this, and the mood of the general public against the blurring of the line between public and private project funding, responsibility and ethos, the mechanism for investigating a shift in the way PFIs are formed and executed continues to be well overdue. Is there a way of selectively culling problem areas and replacing them with a more current or public sector leaning mindset? Essentially, is there a better way of structuring a PFI?
A New Report: Private Finance: Press Reset – Rebuilding Trust and Strengthening Partnerships
With this thought in mind I came across an interesting report titled ‘Private Finance: Press Reset – Rebuilding Trust and Strengthening Partnerships’ from The Infrastructure Forum (TIF), which describes itself as a forum for “improving the quality of policy ideas for the UK and the EU since 1992” bringing together policymakers, regulators and others together to improve regulation, legislation and policymaking.
In its opening statement it considers the decline in support for PFI to be due to an oversimplification of funding options in people’s eyes, looking at the ownership of major infrastructure projects through a black and white lens. It considers either they’re in private ownership (“high risk transfer, high cost of capital models and/or profit-maximising short-termist behaviour”) or public (“low cost of capital, strong public ethos but poor cost controls”) when in reality there are a multitude of options in between.
The report’s author, Paul Davies, quite rightly believes that PFI offers significant benefits, but that the British public simply have no trust in PFI in its current format, hence the suggestion that it may be time for a major shift in thinking.
He suggests two fundamental changes:
1. “The introduction of radical new governance for private ownership, enshrining a commitment to long-term social objectives as part of its stewardship, and a very different approach to ownership that clearly aligns shareholder, government, lender and the public’s interest in having long-term sustainable infrastructure.” The introduction of some public sector aspirations into the private model.
2. A model that “combines a structure that allows a low cost of capital with that new strong governance, with clear long-term objectives and a public service ethos”. A best of both world’s approach.
The report states that “there is much the public and private sectors can do together to rebuild trust and work together partnerially.” But it falls short of recommending full public sector ownership during the operation of these projects because “the public sector lacks the breadth of skills across government and where it has delivered projects successfully, it has often relied on importing private sector skills”.
The ‘mixed economy’ approach that TIF recommends is “where the public sector can enjoy private sector skills around managing risk, cost controls and technical due diligence but where it can also trust private owners will take a long-term approach, be flexible and customer focused”.
The report is split into 12 sections, each of which we have summarised below. Though should you wish to see the full report to form your own opinions, you can find it here:
1. A Difference of Opinion of PFI
Public and private sector perceptions of each other’s record on infrastructure ownership seem to be poles apart, with the private sector believing that there is plenty of clear and quantifiable evidence to show that their way is best for all concerned, and the public sector pointing to ambiguities, generalities and public failures.
The private sector points to a track record of ‘reducing and controlling costs’, a transformation across utilities and transportation, the poor historic record of public ownership and, where failures like Carillion occur, a largely private sector absorption of losses incurred.
The public sector believes that private sector ownership leads to poor value and service, limiting contracts, uncomfortably high profits from public sector projects, and as, in reality, the government is responsible, the private sector takes on too little risk.
The report does not conclude which of these polarised perceptions is, in their opinion, correct, but they do suggest that because of the public’s negative view of big business and private sector aspirations there is likely to be political will for change, and suggesting a hybrid option would certainly be better than what it seems to consider to be a knee-jerk reaction to total public sector delivery.
2. An Existential Threat to PFI
This perception of buying out PFI agreements is what the Labour Party appears to be promising the electorate: an end to private sector involvement in public sector projects. It is possible that the general public are leaning towards this view as well, thanks to a healthy diet of negative media reporting (in fairness, this perception is not entirely unjustified) on PFIs.
Therefore, while it might be possible to win the intellectual argument on the basis the private sector is able to evidence the benefit it brings to these types of projects and the successes they have achieved, the chasm between the two sides’ perceptions on ownership is likely to mean that there are too many fundamental ideological differences for the private sector to win the war.
It has been clear, for many years, that to win back public opinion on PFIs a change at a foundational level would be required. It is also clear that this change will need to be a significant and unambiguous one.
3. Improving PFI
Here, the TIF report refers to the recent National Audit Office (NAO) review on PFI. The NAO states that on the whole, PFIs are delivered on time, more often than non-PFI projects and with greater cost certainty than public sector run projects. However, there were four primary areas of concern that point to a need for greater collaborative working between the private and public sectors:
- Operational inflexibility
- Questionable value for money
- Scope change reluctance
- A lack of transparency.
4. Rebalancing the Approach to Private Finance
Private sector involvement on public sector projects came about largely because “publicly-owned infrastructure suffered from cost overruns on major projects, lack of cost control, budget annuality, and a lack of experience”. So, to suggest that all private sector involvement should end is to wilfully forget both past evidence and history. This reality and that of the public’s distrust of the wholly private sector model means a ‘mixed economy’ solution may well be the best way forward – lower cost delivery, greater access to wider skills and better governance. The key here is to find a model that rebalances the trust element (between parties and with the general public who are the end users) on major infrastructure projects.
5. Institutionalising Trust
One of the primary issues that give rise to a lack of trust is the private sector’s pursuit of maximising profit, on the very rare occasion, with arguably questionable integrity. It does not sit well with the ethos of the public sector, which is supposed to be assuring value for taxpayers’ money by investing it wisely and frugally. Put simply, if a company is looking to make profit on a project, the public sector perception is often that the taxpayer is paying the fat cats to get even fatter.
The reality is, of course, very different. While the private sector must generate profits to keep shareholders happy, this does not have to run contrary to the needs of the taxpayer. If a project is delivered with lower costs and greater efficiency than it would have been by the public sector, then any profit they achieve from this is merely incidental to the greater benefits the taxpayer receives from the project. However, this seems to be a message that goes unnoticed.
The problem is that while projects may be delivered with greater efficiency, it is common for the private sector supplier to enter into a complex refinancing arrangement in order to maximise profits in a shorter space of time. In turn, this can lead to the potential for more regulation to prevent abuse and private sector management can end up more focused on this regulation than managing the ongoing maintenance of the infrastructure they created. Innovation, staff morale and quality of service are, therefore, all limited. This is just one of many issues that needs to be addressed in any new PFI structure.
6. A New Finance Model
A mixed economy approach would take the best of private and public models, where investors are attracted into long-term commitments to offer stability as well as low-cost finance and a revised form of governance is created. The TIF report suggests this might look something like the Thames Tideway Tunnel (TTT) project model and lists its key features as:
- “A lower level of risk transfer to underlying contractors, with cost risk shared between the TTT company and customers, as out-turn costs are added to a Regulated Asset Base, the return of which appears in customer bills
- A cost of capital at 2.497%; a small premium over government’s cost of capital but which allows the introduction of private sector experience, management, cost controls and separation
- Levels of government support in areas such as liquidity, to help improve credit rating
- Pricing not completely fixed at the outset but reflects actual outcomes
- TTT is classified as off government’s balance sheet.”
7. Trusted Governance
“Healthy relationships are built on trust not contracts or regulation.” This is true, but how to build that trust and sustain is a little more complicated. Essentially, private sector partners need to ‘evidence’ (not just state) that they are in it for more than just the money. They need to evidence a commitment to stewardship which at least matches their commitment to their shareholders’ financial expectations. They also need to evidence, as an organisation, they have social values at their core. This is not an easy thing to achieve, to convince an organisation to even attempt it will be difficult enough, but for them to successfully shift public opinion on what they stand for will be a tough task. Ultimately, the private sector organisations will be judged on their behaviours, not their intentions. The report suggests three ways in which this might be attempted:
- Institutionalise social objectives in your Articles of Association
- Create a Trust Board above executive management to ensure these social objectives are upheld.
- Partnership behaviour to involve employees and customers in decisions, listening more.
8. Enshrining Values of Trust
Trust is hard won and easily lost, so there are certain activities any organisation needs to do in order to protect that trust once it’s won, and that’s to evidence their commitment to it through measures and policies that show at the very core of the business. In private sector organisations working on public sector projects, the primary trust issues surround the perceived motivation of the organisation and to whom it owes its allegiance – shareholders or end users. The following may be considered to enshrine values of trust:
- A focus on building long-term value, relationships and returns rather than short-term profits.
- Long-term asset management strategies to ensure future regular investment in infrastructure upkeep.
- Greater willingness and flexibility to accommodate change.
- Shared project management/oversight, by appointing public sector client members to the board or a supervisory position.
- Share ownership of the business between public and private organisations, and possibly even some end users so everyone gains when profits are made.
- Greater engagement with communities to discover and act on their concerns and expectations.
- Link management pay to evidenced long-term performance.
- To ensure that financial structures are limited to those that might be considered prudent and in line with the values you’re looking to enshrine.
9. Trust Needs Long Term Investors
The report goes on to suggest that private sector organisations should give up their short-term aspirations in favour of long-term sustainable models, because these will in fact offer a greater return for investors. A focus on refinancing and short-term profits relies on minimum viable practices which will result in the infrastructure project never achieving what it has the potential to achieve.
However, it is perceived that a longer-term perspective may well produce a far more viable and saleable business in the end, offering investors a more attractive long-term investment opportunity. This may not be suitable on every project due to the risk factors, but there will be plenty where this will be both sensible and effective at rebuilding trust.
10. Reforming the Public Sector
Not to seem one-sided in the discussion, the report then turns to the public sector to identify what needs to change there. It is suggested that too much risk transfer to private sector partners is creating an ever-shrinking pool of those willing to work on such projects. It goes on to suggest that more needs to be done to encourage procurement decisions based more on long-term commitment and solid governance rather than simply the lowest cost option.
Current PFI models encourage risk transfer not only to the private sector prime partner, but for the prime partner to attempt to pass this risk onto subcontractors who are even less able to survive the impact if the project does not go according to plan. At the same time, as the number of PFI contracts dwindles, increased competition for those that exist means a temptation for private sector organisations to bid low to win the project at a return that turns out to be unsustainable.
“Models that share the risk, allow a cost of capital closer to government’s and have governance aligned to public sector values would be a far more sustainable outcome for much of infrastructure procurement.”
11. Using the New Model
The ‘mixed economy’ approach suggested appears to combine the best of both worlds – low cost finance along with values and governance more closely aligned to that of the public sector. It can also give access to the private sector’s greater pool of expertise and drive for innovation which gives a project a greater chance of long-term profitability for all concerned and benefits the public sector (as well as the shareholders).
Moving forward, the new model will need to be adaptable to the needs and expectations of the individual project. We all understand there is no one-solution-fits-all, but elements from the suggestions offered in the report can be applied to both new and existing projects.
Primarily, it’s about earning back trust for a mixed model to avoid a wholesale move to public sector-only solutions that, in both the view of the NAO and TIF, may well end up of less value than the suggested improvements to the joint public-private model.
12. Rethinking Balance Sheet Treatment
One of the primary drivers for PFI has always been an unhealthy obsession for the government with keeping project liabilities ‘off balance sheet’. The primary reason for choosing PFI is usually cited as being related to risk transfer, greater skills in the private sector and so forth. However, one practical reality is that sometimes departments need projects to go ahead and, because of the reluctance to have the commercial risk on the public sector balance sheet, PFI often provides a means to move forward.
Our own experience is that we still see situations when a large programme of work has a lack of independently verifiable evidence in its business case, then uses the PFI model in the expectation that the programme/project will magically justify itself by transferring the commercial risk to the private sector partner and keep the liabilities off the public sector balance sheet. In an ideal world, balance sheet considerations should really be a secondary factor. But in turn, politics can often be the primary consideration.
Conclusion of the Report
“In many infrastructure sectors, the current approach does not seem sustainable; short-termism from the private sector does not sit well with long-term infrastructure investment in public assets, the public sentiment is against private ownership, the level of risk transfer under PPPs is too great, and the cost of capital is too high relative to public sector alternatives. But a switch to public sector delivery is also undesirable; the capabilities do not exist, the approach would not foster a strong contracting industry, the focus on costs and clarity of objectives would be lost.”
The TIF report suggests that the time is right for a change and the need for this change to be significant is self-evident from the distaste the general public currently has for private participation. It points out that private participation has its place and the wholly public ownership model would be a mistake. I’m struggling to disagree with these fundamental statements without the right level of investment being made by the government in public sector employees that have deep levels of specialist domain expertise to drive maximum value out of these types of strategic and complex relationships/contracts. Notwithstanding this, it will likely be a long hard struggle for trust to be won back for even a mixed economy model, but the efforts may well be worth it in the end.
For support and advice on PFI financial issues, including how to achieve cost savings, contact us on t. 0845 345 0130 or email: advice@bestpracticegroup.com. Further information on driving maximum performance from PFI contracts can be found by downloading our free white paper.
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