What are some of the key benefits assumed to be obtained from Private Finance Initiative (PFI) contracts? The extent to which PFI contracts are delivering ‘efficiency’ and ‘risk transfer’ for the UK government
The PFI, known as Private Finance Initiative, is a government procurement approach created to build Public-Private Partnerships (PPPs). Under the approach, private organizations finance, design, construct and operate long-term infrastructure projects within a predetermined deadline and budget (HM Treasury, 2018). First introduced in 1992 by the UK government, PFI has been widely accepted by both the Conservative and the New Labour governments. Up until 31 March 2017, there were 715 PPPs projects were either operational or in construction, with a total capital value of £59.1 billion (HM Treasure, 2017). PFI allows the public sector to procure high-quality services from the private sector with defined targets. In the UK, PFI has been penetrating into every aspect of public services like health, education, correctional facility or transportation. The government has encouraged cooperation between public and private sector hoping to bring the technique and management expertise and the efficiency of private finance into the public service territory. There are four major principles that PFI schemes seek to obtain including output specifications, risk allocation, project lifetime performance, and performance-related rewards (Audit Commission, 2001). Initially, PFI was considered can bring a degree of pragmatism and an interest-balancing mechanism into the public service area and contribute to the delivery of value for money. However, over the years, some of the assumptions and arguments of PFI have been regarded as utterly ossified. This essay intends to review the key benefits of PFI and illustrate to what degree PHI help the UK government improve efficiency and transform risks to the private sector.
2. Major Benefits of Private Finance Initiative
2.1 Long-term Partnership
Partnering is a vital component of PFI contracts. Most of PFI projects can last up to 30 years or more. Given the length of the contract and the degree of involvement, mutual commitment is required from both parties to generate fruitful results. A successful relationship between the purchaser and the contractor can provide a strong motivation for them to learn from each other and continuously to improve the performance of a PFI project (Robinson & Scott, 2009). PFI is an important strategy that the government applies to deliver superior public services. As for the private organizations who take PFI contracts, they need to put their capital at risk and deliver defined outputs in order to be paid. Consequently, there are strong motivations for both parties to work closely. Private organizations will have a better chance to meet the contract provisions if they have a clear understanding of the scheme’s objectives. And purchasing bodies’ leaders and board members are also motivated to convey the scope of the project and the detailed commitment they desired from the private sector since the failure of such projects could bring political ramifications. Therefore, PFI can propel both parties to work towards a consolidated outcome.
2.2 Risk Transfer
The average capital value associated with building or improving PFI projects is over £100 million (Hellowell & Polllock, 2009). If the government adopts the traditional funding method to finance these schemes the potential financial burden could be enormous. PFI offers an ideal solution for the government to avoid these financial risks. The capital costs related to PFI projects are not incorporated into government departments’ budgets, and then certain risks are transferred to the private sector. PFI contracts are displayed as off-balance sheet items, hence a considerable amount of costs will not be considered as national debts. Since PFI adopts a get something now and pay later model, PFI costs are generally treated as expenses by the government departments that purchase the facility and service. These expenses are called unitary charges which include capital repayments, interests, as well as maintenance fees and other on-going operational expenses (Audit Commission, 2001). In addition, if PFI projects are being delayed or completed with over budget the public sector would not take these risks since risks being transferred to the private sector, and therefore, value for money for public services are created.
2.3 Management and Cost Efficiency
Given the length and the complicity of PFI projects, it would be better to put those projects in the hand of those who are most able to manage them. Under the conventional route, purchasing bodies, usually, government departments, have to be hands-on in every aspect of a construction project. This may include due diligence, fund-raising, project management, and on-going operation and maintenance. For most public sector organizations it would be a compelling or even unconquerable challenge. Outsourcing these public projects to private business entities that possess strong financing and management skills would be a sensible option. Additionally, PFI contracts usually require project bidders to deliver outputs timely and under a fixed contract price, the potential financial consequences would encourage contractors to consistently improve efficiency and increase the productivity of construction.
2.4 Public Saving
As a government procurement method, PFI can help public sector reduce the overall cost of using large-scale public services. The government and local authorities can deliver all sorts of public undertakings without a large amount of external borrowing. According to Grimsey and Lewis (2005), through using PFI contract the UK government only required to invest around 10-13% in the total investment. PFI can significantly reduce government debts and thereby help the government better prepared for uncertainties such as future economic stability, cost of borrowing and taxation. Initial capital investment and on-going costs related to PFI projects are provided by the private sector party which may raise funding through share capital and external borrowing. The purchasing party returns contractors’ investments through periodic unitary charge over a long period of time. PFI can help the government save costs and delay repayment compared with traditional procurement approach.
3. Efficiency Improvement and Risk Transfer Effect of PFI
The fundamental reason for the UK government to introduce PFI procurement approach is the unsatisfied performance of conventional public procurement method in the area of failing to deliver a project on time and on budget. To improve the public project performance and efficiency, the private sector was brought into the government procurement process. Private business entities are considered to be more competent and experienced to carry out large-scale construction projects and are usually more disciplined with capital allocation and controlling expenditure. The fierce competition during the contract bidding process encourages private firms keeping the budget low. Since the public sector only starts the repayment when the project is fully operational, private firms are strongly propelled to keep construction time short. Then innovations in design, construction and management process were developed to seek cost and productive efficiency.
According to an NAO report (2010), PFI hospital contacts are generally well managed. They have been delivering satisfactory performance in terms of hospital service and maintenance. As one of the metrics to evaluate PFI efficiency and performance, Trusts are allowed to charge payment deductions for projects that failed to match contractual standards. 43% of Trusts did not have any deductions and for those did charge deductions, the overall percentage only accounted for a small portion of the entire unitary charge (NAO, 2010). Another indicator that was used to assess contractual service is the rate of performance of ProjectCo provided by all NHS Trusts. 67% of Trusts rated PFI services are satisfactory and 15% rated these services are beyond satisfactory, meaning PFI achieved, at least partially, value for money.
Figure 1: NHS Trusts’ assessment of PFI contract performance
Source: National Audit Office Survey, 2010
Department for Transport (DFT) also offered some evidence to prove the cost efficiency of PFI. In its 2012 report, this government department evaluated whether HS2 Ltd.’s proposed high-speed rail network scheme delivered good value for taxpayer’s money (DFT, 2012). The department used benefit-cost ratio (BCR) as a criterion to gauge the performance of HS2 which includes phase 1(London to West Midlands) and phase 2 (West Midlands to Leeds and Manchester).
Figure 2: DFT’s Value for Money Criterion
Source: Department for Transport, 2012
Figure 3: Benefit-Cost Ratio Walkthrough in 2011
Source: Department for Transport, 2012
DFT concluded that the benefit-cost ratio in phase 1 is 1.6 which lies in the middle of the medium value for money category. The department also reported a projected BCR of the entire contract is between 1.8 and 2.5 which suggested that this PFI project should be able to generate high value for the government.
Although both NHS Trusts and DFT expected to save costs by involving private contractors, the chance to make savings from PFI schemes is still debatable. According to NAO (2011), expenses with current PFI contracts will reach almost £200 billion in 2040. The reason why Trusts cannot sufficiently benefit through efficiency improvement is there is no evidence to suggest PFI contracts can produce mutual benefits. For example, the contracts do not require private firms to share gains with public sector bodies through efficient management or service delivery (NAO, 2010). Additionally, Trusts and other public sector bodies cannot access to contractors’ accounting book, therefore, it would be impossible for them to understand cost drivers or examine whether the cost efficiency achieved by PFI at the cost of harming services to patients or other service receivers. Actually, based on the report of Lafond et al. (2014), it’s getting harder for NHS Trusts to balance their budgets. It seems they were overspending in every facet. Hospital staffing costs and expenditures on contract and agency staff increased significantly over the past few years. NHS England combined over spent £1.2 billion on permanent staff and £300 million on contract and agency staff. Besides, drug costs rose almost 12% which deteriorated NHS Trusts’ finances even further. These research outcomes were echoed by another NHS Trust’s annual report which presented a retained deficit of £37.8 million in 2013/2014 (Peterborough and Stamford hospitals, 2014).
Another significant advantage of PFI is its risk transfer effect. PFI schemes involve many complex elements and the purchasing body has to pay for the facility and service over a very long period of time. The negotiation process often establishes a clear link between capital and additional payments and project budget and quality. If a contract got delayed or was not fully functional, the public sector body is entitled to reduce a certain degree of unitary charges. Then, the PFI approach transfers project risks from the public to the private area. In fact, most contractors understood the needs of the purchasers and were able to protect their benefits during the construction and on-going operational period (NAO, 2010). This risk allocation mechanism provides a strong incentive for private contractors to take measures to avoid any adverse influence to PFI projects and thereby benefit public services.
Over the past few years, many have been arguing that the PFI mechanism has become unsustainable because of the balance of power and interest was already disrupted. The private sector was once thought can bring competition into the public area and provided better facility and service within a reasonable budget. Nevertheless, the UK government has been performing poorly in PFI contract negotiation and today PFI projects would cost taxpayers more without getting good value (NAO, 2011). Another impact that changes the risk transfer mechanism is private firms may try to pass risks back to the taxpayers when they are under pressure to deliver projects. For instance, one NHS Trust confessed it had given up to charge deductions from the contractor because preventative maintenance was yet to be completed. If these preventative maintenance means are not available, hospitals would have to pay patients’ transfer fees. Since provisions of PFI contracts are fixed, once the contract was signed it would be almost possible for the public sector to alter any term or to better manage contractors. The assumed efficient process for building large infrastructures has in many cases become the opposite.
PFI was once considered an innovative method to help the government smartly deliver public services with a limited budget. After almost forty years of development, this approach has reached a crossroads where the existing financing of public services needs to be reformed. The public sector may still need to buy assets from the private sector, it’s just the government has to be reminded how to spend more wisely and avoid pushing the nation into excessive debts. To allow the public sector to act as wise customers, the government departments and organizations need to be informed with accurate and detailed project data and to become more skilful in terms of assessing complex PFI projects. Through creating mutual benefits, PFI can fully boost its efficiency and maximize value for money.