PFI: Is Gordon Brown “economically illiterate”?
“Peter Robinson, the IPPR [Institute for Public Policy Research]'s chief economist, says the idea the government could not have afforded new schools and hospitals without the PFI is ‘economically illiterate’. He says it's just wrong to present the PFI as a free lunch from the City: it is simply an alternative and more expensive financing method. …
“The funding still comes from the taxpayer over the lifetime of the project, and it will only prove a cheaper route if the firms make significant efficiency savings.
“‘The argument about extra investment has been made in the past, because if the private sector pays the capital costs up front then they do not show on the government's balance sheet, even though they remain public liabilities,’ the IPPR says. ‘This is little more than an accounting trick: the public finances are no more or less sustainable than if the scheme had been carried out in a traditional way.’
“In the short term, taking the financing of the PFI projects back into the public sector would not endanger either of Mr Brown's fiscal rules. The first allows him to borrow for investment purposes, while with public debt now just 30% of GDP, the government has room to manoeuvre under its second rule, which fixes a ceiling for indebtedness of 40% of GDP.
“Privately, Treasury officials say the PFI projects could be financed conventionally without breaking either of these rules.” (Privately financed revolution, Charlotte Denny, Guardian, 3 October 2002)
What is going on at the IPPR, which up until recently was New Labour’s favourite think tank? Back in March they published a report, which was highly critical of the mess New Labour has made of the pensions system since 1997. Now, IPPR’s Chief Economist declares PFI, New Labour’s preferred mechanism for building schools and hospitals, to be both unnecessary and expensive.
A few days earlier Gordon Brown told the Labour Party conference that PFI was vital to their programme for modernising public services. “I have to tell you but for PFI we simply could not have started so many [schools and hospitals] so quickly in so many communities”, he said. The message from the party leadership to conference was that opposing PFI is equivalent to opposing new schools and hospitals. Nevertheless, conference approved a resolution calling for a review of PFI.
So, despite his formidable reputation, is the Chancellor actually “economically illiterate”? Of course, not. He’s just devious. He knows very well that new schools and hospitals could be paid for by the state borrowing (more cheaply) in the conventional manner. And he is careful never to say dogmatically that PFI is essential to the building schools and hospitals. Instead, he engages in devious formulations, which give the impression that it is essential, while not quite saying so. That is true of his conference speech and of his article in the Times on 26 September justifying PFI.
The leadership lost the vote on PFI at conference, but it cannot be said that they lost the argument, because the opposition to PFI, chiefly from the trade union movement, failed yet again to make a coherent case against it. It will be easy for the leadership to ignore the vote as they said in advance they would.
The central objection to PFI is that it is, as Peter Robinson says, an expensive method of public borrowing, more expensive that the conventional method. It is more expensive because the state can always borrow more cheaply than the private sector, and the essence of PFI is that the state employs a private agent to borrow on its behalf. As such, PFI is a waste of taxpayers’ money and a prudent Chancellor would ban its use for public projects rather than insist on its use as Gordon Brown is doing.
It would be nice to report that the New Labour leadership is reeling from the battering it got at conference for wasting taxpayers’ money. It would even be nice to report that one or two opponents of PFI made this point clearly at the conference or in the accompanying public discussion. Sad to say, this fundamental point about PFI was, to the best of my knowledge, never clearly made. The nearest approach to it was a remark in the conference debate by Louisa Was, a delegate from Bolsover, who compared paying for hospitals via PFI to “putting the bill for your semi-detached on your Barclaycard” rather than a conventional mortgage. (She also suggested that PFI actually stood for “Pay For it Indefinitely”.).
This failure to attack PFI at its weakest point is unfortunately a characteristic of the trade union opposition to PFI. I have just read a 44-page report by the GMB about its “Keep Public Services Public” campaign. The report contains lots of interesting information about the use of PFI and related matters, but there isn’t a single mention of the fact that the central flaw in it is that it is an expensive method of public borrowing, the use of which wastes taxpayers’ money. How the union expects to win a campaign against PFI while keeping quiet about its basic flaw is a mystery.
The first thing that needs to be emphasised about PFI is that it is public borrowing, which like conventional public borrowing has to be paid back with interest by the state. This is not always obvious. Indeed, one could be forgiven for thinking that PFI is an extraordinary act of philanthropy by private companies, who are generously donating money to build public schools and hospitals.
In his Times article on 26 September, Gordon Brown wrote that PFI “provides private money to invest in the health service”; in his conference speech, he spoke of PFI providing “private money additional to public investment, helping us to provide in constituencies that desperately need them schools and hospitals”. It’s a donation, isn’t it? How could anybody object to the use of private money to build schools and hospitals when it appears to be a free lunch?
But it is far from being a free lunch. What happens is that money is borrowed by a PFI contractor to built a school or a hospital and the state pays the interest and repays the capital over 25 years or so, and purchases services (for example, maintenance and cleaning) at the same time. That is public borrowing by another (more expensive) means. The state does not pay the interest and repay the capital directly to the lender, but it is part of the overall charge for renting the building, and purchasing other services, paid to the PFI contractor.
Like a mortgage?
John Prescott shared with Gordon Brown the burden of defending PFI before and during the party conference. He advanced the dangerous argument that using PFI to build a hospital or a school was like taking out a mortgage on a house and having use of the property while paying off the mortgage. The analogy is, to say the least of it, less than perfect.
First of all, nobody in his right mind consciously chooses anything other than the cheapest mortgage available when buying a house. PFI is equivalent to demanding an 8% mortgage when a 6% one is available.
Secondly, you can only take out a mortgage on a house you own. An NHS Trust that commissions a hospital may never own it (of which more later); it will certainly not own it until the end of the contract term. Until then, the PFI contractor who built it owns it.
That has very serious consequences. While you are paying off your mortgage, you are free to make any alterations you like to your house, subject only to planning permission. You can even sell it and buy another one. However, if a PFI hospital becomes unsuitable for the delivery of the services required (which isn’t a remote possibility after a couple of years let alone 25), the NHS Trust is not free to make alterations to make it more suitable, since it doesn’t own it.
That is a matter for the PFI contractor who owns the building. Changes to the building, and to the services delivered in the building, can only be effected with his permission and he is therefore in a position to make the Trust pay through the nose for the changes. He cannot be blamed for that: he would be failing in his duty to his shareholders if he didn’t exploit this monopoly handed to him by the state in order to enrich his shareholders.
That is another serious problem with building schools and hospitals using PFI, a problem that will become more and more apparent as time passes.
This government is ostensibly seeking to increase competition, and lower cost, in the supply of public services by introducing private providers. It is ironic that it is going about it in such a way as to eliminate competition in large areas of the public sector for the next 25 or 30 years and to grant monopolies to a few private consortia, monopolies which are enshrined in legally binding contracts (and cannot even be overturned by Parliament) committing the state to paying loads of taxpayers’ money for many years.
Who owns PFI assets?
Who will eventually own PFI-built assets? It used to be the case that only roads and prisons built in this way were scheduled to revert to the public sector at the end of the contract term. Hospitals and schools were to remain the property of the private contractor. This caused an outcry in the case of, for example, the new Edinburgh Royal Infirmary, since it amounted to the privatisation of public assets by the backdoor, old publicly owned assets being replaced by new privately owned assets.
The New Labour leadership have all along attempted to dampen down opposition to PFI by insisting that it is not privatisation, which they imply only evil Tories engage in. Of course, it is not privatisation in the sense of selling, or giving away, public assets to the private sector, but there is a fine distinction between that and replacing old publicly owned assets with new privately owned assets.
The Government has now changed this practice for PFI-built hospitals at least and contracts now give the NHS Trust the option to take ownership of the hospital at the end of the contract term – no doubt in exchange for loads of money. This makes it easier to say that the use of PFI isn’t privatisation. But we will have to wait for 25 years or more to see how things work out in practice.
It is the very foolish for any organisation to contract to purchase services from a single supplier for 25 years. The threat that a contract is not going to be renewed is the most effective lever an organisation has to ensure that services are delivered as required. With a 25-year contract, the supplier doesn’t need to worry about that for a very long time.
It is even more foolish to take out a long-term contract in circumstances where the services required cannot be predicted accurately 25 months hence let alone 25 years hence. How could anybody have known in 1977 what services are needed, for example, in a hospital today, when medical technology and medical practice has changed out of all recognition in the interim?
No doubt PFI contracts prescribe a mechanism for the modification of the PFI property and the services to be delivered in it, but the public body asking for a modification is at the mercy of the PFI contractor that owns the property and provides services in it. Nobody else can provide the services, and the service has to be provided, so the public body is in a hopelessly weak bargaining position when it comes to agreeing the extra cost to the taxpayer.
This is a direct result of the public body taking out a contract for a service delivery for a period so long that service needs cannot possibly be predicted. Why are public bodies encouraged by the Treasury to engage in this foolishness? The answer is that the inappropriately long service contract is dictated by the fact that the PFI contractor has to borrow over a long period – 25 years or more – in order to keep the cost of borrowing within reasonable bounds. To borrow over that period, the consortium has to be guaranteed an adequate income stream throughout that period in order to service the borrowing. So, there has to be a contract for service delivery for 25 years or more, even though service needs cannot possibly be predicted for anything like that length of time.
In other words, the inappropriately long service contract is a necessary condition for getting unnecessarily expensive finance for public projects via PFI. Gordon Brown has brought the world of Alice in Wonderland to the provision of public services.
Of course, the Government is fully aware that 20 to 30 year contracts for the supply of public services are not wise. You have only to look on the Department of Education & Skills website to confirm this. There you will find a Purchasing Guide for Schools produced by the Department’s Value for Money Unit, which contains the following good advice in a section entitled “Contracts longer than three years”:
“Anything that is longer than three years may result in inflexibility, particularly if the agreement does not allow the school to vary its requirements in the light of changing circumstances.”
Despite this good advice to beware of contracts in excess of 3 years, there have been many examples of school Boards of Governors being bludgeoned into accepting 25-year PFI contracts for school maintenance and cleaning, for example, in the Haringey Schools PFI scheme (details of which are described in an excellent report by Melanie McFadyean & David Rowland, commissioned by the Joseph Rowntree Reform Trust).
That is not the whole story. It is foolish for anybody to take out a long-term contract for the supply of services, since it reduces the leverage he has on the supplier to deliver. An alternative lever is that he can easily terminate the supplier’s contract on the grounds of inadequate delivery.
However, it is in general very difficult for a public body to terminate a PFI contract. The Treasury advises that it be so:
“The Contract must achieve a fair balance between the (Public Sector) Authority’s desire to be able to terminate for inadequate service provision … and the Contractor’s and its financiers interest in restricting termination to the severest of defaults” (Treasury Taskforce, Standard Contract Terms, 188.8.131.52).
If the public authority terminates the contract, the income stream used by the contractor to service his debt is cut off at a stroke. Therefore, the easier it is to terminate a contract for inadequate service provision the greater the risk that the contractor will default – and the higher the interest rate he will be charged by his financiers at the outset.
That’s what the Treasury advice above is about: in its negotiations with the contractor, the public authority must bear in mind that easy contract termination translates directly into high interest charges to the contractor, which the public authority will have to pay. So to keep the cost of borrowing down the contract must be difficult to break, even if the service delivered under it is wholly inadequate. For example, rather than having a contract terminated immediately, the contract should allow for long “rectification periods” during which the contractor has the chance to improve service delivery.
(In addition, it now appears to be a common, if not universal, feature of PFI contracts that, if a public authority terminates the contract, it is obliged either to find a successor to take over the debt or to take it over itself. This is another mechanism geared to keeping the interest rate down, since it amounts to the state guaranteeing the contractor’s loan.)
This absurd situation has come about because under PFI the state is buying both finance to built PFI assets and services delivered in them under a single contract. To minimise the cost of finance, the contract needs to be long-term and unbreakable, but to ensure good service delivery the contract needs to be relatively short-term and breakable if service is not delivered adequately. PFI is an inappropriate coupling of the purchase of finance and purchase of services in a single long-term contract.
The obvious answer is to decouple them and have two contracts between the public body and the PFI contractor, an unbreakable one for finance and one for services which is breakable if delivery isn’t up to scratch. But that would never do since then the state would plainly be liable for PFI debt, and treating it as public, rather than private, debt could not be avoided (of which more below).
PFI: the only way
The Government’s answer to all criticism of PFI is that it is playing a vital role in the modernisation of Britain’s public services. That can hardly be denied since Gordon Brown has decreed that it be so.
The interesting question is why he has decreed that it be so, at considerable cost to the taxpayer for the next 20-30 years. The great man is always very reticent on this point and there was only the tiniest hint about his reasons in his conference speech, when he said:
“It is, friends, a question of trust and with promises to keep and fiscal discipline to maintain it is my duty to say to the British people that we will hold to our long term course for building schools and hospitals so that every community has the high standard of public service they need and deserve.”
The hint is in the phrase “with … fiscal discipline to maintain”. The implication here that borrowing the necessary sums by conventional means would have caused him to break the fiscal rules he has set for himself, that is, public borrowing for investment is allowed but total National Debt should not exceed 40% of GDP (which was one of the Maastricht criteria, and is now part of the rules of the Euro zone).
Gordon Brown’s addiction to PFI as a means of financing public projects is driven by the fact that from the outset PFI debt has been not treated as public borrowing for accounting purposes and therefore doesn’t contribute to the PSBR [Public Sector Borrowing Requirement]. This piece of trickery means that the Chancellor can say he is maintaining “fiscal discipline” while running up vast amounts of expensive PFI debt to build schools and hospitals, but cannot when he borrows more cheaply by conventional means.
It is true that under PFI the private contractor does the borrowing. But the state is contractually bound to make payments to the private contractor, which are in part used to service the loan. In other words, if the contract goes to full term without the contractor defaulting, the state is as liable for paying off PFI debt as it is for conventional public sector borrowing. The only difference is that it pays off PFI debt through a private sector intermediary.
What happens if the contractor defaults on PFI debt depends on what it says in the contract between the public body and the contractor, which is not generally in the public domain. But, as we have said, it is increasingly the case that the public body is contractually obliged to take responsibility for the debt or find another contractor who will.
In practice, the state is never able to escape responsibility for the delivery of essential public services. And if existing private delivery arrangements break down, the state will have to take responsibility for putting together new arrangements. In all probability that will include taking responsibility for existing PFI debt, whether it is legally obliged to or not.
The state has legal liabilities as a consequence of PFI debt just as it has legal liabilities for debt generated by conventional borrowing. That they are treated differently for accounting purposes, with PFI excluded from the PSBR, in other words, not counted “officially” as government borrowing, is accounting trickery with no logic to it. The state can no more escape liability for PFI debt than Enron could escape liability for its off balance sheet debts.
This piece of accounting trickery lies at the root of Gordon Brown’s insistence that public bodies go down the PFI route to borrow money. He is very fond of boasting about how since he became Chancellor he has reduced the National Debt, and the amount of current expenditure necessary to service the National Debt. PFI debt is “officially” not public borrowing and “officially” doesn’t add to the National Debt, and therefore it can be run up at will without undermining his ability to continue boasting. Public borrowing by conventional means would threaten that ability, even though it would save taxpayers’ money.
There is not the slightest doubt that the money raised for public projects via PFI could have been raised by the, less expensive, traditional route. It is “economically illiterate” to say otherwise, to use Peter Robinson’s phrase. It is simply the case that Gordon Brown has banned the traditional route for his own political purposes.
Even the most partisan supporters of PFI admit that the state can borrow more cheaply than any private sector agent acting on behalf of the state. It is even admitted in official documents: for example, in the Treasury document Public Private Partnerships: The Government’s Approach, published in 2000, where is says that “the private sector ’s cost of borrowing is higher than that of the public sector”. For obvious reasons, Gordon Brown didn’t labour this point in his speech at party conference.
The usual justification for using PFI borrowing despite this obvious drawback is that (1) the difference is small (1-3%) (bought at the price of almost unbreakable contracts, as we have seen) and (2) that this extra cost of borrowing must be balanced against “efficiency savings”, which we are assured flow from employing the private sector to deliver public services.
One doesn’t have to be a genius to see that this isn’t a justification for using PFI at all. There isn’t a God given rule saying that one must buy finance and services in a single contract. In fact, as we have seen, there are very good reasons for not doing so.
In the PFI method of procurement the public authority employs a private contractor under a single contract to (1) provide finance for the project, (2) undertake the building work, (3) maintain the building, and (4) provide other services in the building for 25 years or more. The range of the latter varies from contract to contract, but in the case of a hospital it could include cleaning, the provision of porters, catering and laundry. Public employees working in these areas will be forced to transfer to the private sector.
Before PFI, finance was raised in the conventional manner but the private sector was always employed under contract to do the building work. Other services used to be carried out wholly by public employees, but since the 80s contracting out has increased the role of the private sector. The proponents of PFI claim that “efficiency savings” is a characteristic of private sector involvement, but they point especially to the benefit from having the same contractor build and maintain assets, the reasoning being that if a contractor has to maintain a building for 25 years he will build it to a good standard in the first place.
Be that as it may, it is obvious that private sector “efficiency savings”, if there are any, does not need to be combined with expensive finance. There is no reason, apart from Gordon Brown’s passion for Enron style accounting, to prevent the finance being raised by conventional means, in which case the private sector builder would be paid up front, the building would pass into public ownership, on completion. The maintenance of the building for 25 years could be part of the initial building contract. And the provision of other services need not be but if they are contracted out at least contract(s) can be more appropriate for service delivery, that is, relatively short-term and breakable if service is not delivered adequately.
The inappropriate coupling of the purchase of finance and purchase of services in a single long-term contract, which is inherent in PFI procurement, would be avoided.
Advantages of PFI?
A great deal of nonsense is talked about the advantages of PFI procurement over the conventional method, not least by the Chancellor. Listen to this from his Times article:
“Before the PFI private companies handed projects over to the public sector with little or no obligation to repair their own faults, and certainly none for future upkeep. The public sector met the costs of the building and responsibility for its upkeep. The private contractor could walk away with no ongoing responsibility for the quality of their work.”
If before PFI private companies had “no obligation to repair their own faults”, then there was something seriously wrong with the project contract. Imposing such an obligation does not require a switch to PFI procurement but a contract that says the contractor doesn’t get all his money until he has repaired his own faults. Likewise, there is nothing to stop a contractor being made responsible for the future upkeep of what he has built within the conventional procurement method. What the Chancellor claims as advantages in PFI procurement are nothing of the sort.
Another major claim for PFI procurement is that time and cost overruns are a thing of the past. Time and time again, government spokesman cited London Underground’s failure to complete the Jubilee Line extension on time as evidence that its maintenance must be contracted out under a PFI scheme. This is another example of claiming advantages for PFI procurement that are readily available in conventional procurement with an appropriate contract and the will to enforce it, in particular, a contract that lays down penalty clauses for late completion.
Lamont says NO
Finally, let me quote from two interested parties in the PFI debate. First, from Norman Lamont, the man who invented PFI. In his account of his time in government published in 1999, he wrote:
“The PFI is not a ‘free lunch’. For private finance to work properly it has to provide greater value and efficiency to make it worthwhile. The Government can always borrow money more cheaply than any private sector borrower, so the efficiency test for a private finance project has to be real. Secondly, it is an essential that the risk in the project really is wholly transferred to the private sector, otherwise privately financed public expenditure ought to count towards Government borrowing. Lastly, there is a risk that the private sector may provide finance up front but that the long-term consequences will be the silting-up of public expenditure with a stream of never-ending rental payments. I suspect that in the long run some of these projects will go wrong and appear again on the Government’s balance sheet, adding to public expenditure. We shall see.” (In Office, p309)
Secondly, on Today on Radio 4 on 1 October, the morning after the Labour conference debate on PFI, it was put to him that the Conservative Party had introduced PFI. He replied that that was true but they anticipated that it would be used to attract private investment into projects that would be additional to public provision. This Government appear to be using PFI as a means of keeping public expenditure off the balance sheet, he went on. There is a scent of Enron economics about what they are doing. We always knew that the private sector borrows money at a higher rate. PFI looks cheaper in the short term but in the long run it is likely to be much, much more expensive.
Accountants say NO
And finally the opinions of public sector accountants. The Association of Chartered Certified Accountants (ACCA) recently (September 2002) published a report on a survey about PFI of a cross-section of their members working in the public sector. Nearly 200 of them responded. The report is entitled Do PFI schemes provide value for money?. I quote from its summary:
“Only 1% of the respondents strongly agreed that PFI generally provides value for money whilst well over half of the respondents disagreed with this statement. The survey also showed that most public sector accountants believe that public sector organisations are prevented from achieving value for money as PFI is the only available option for obtaining much needed capital investment in public services. In addition, less than 1 in 7 of those returning the questionnaire felt that PFI schemes are objectively tested to see if they provide value for money.
“PFI is the route the government prefers for all major public sector capital schemes and few such schemes are now able to use traditional direct public sector procurement. Comments from the respondents to the survey, however, indicate deep scepticism with the potential benefits of the public sector adopting the PFI approach.
“These comments included:
‘an extremely expensive option generated through political dogma which ought not to be necessary if central government were prepared to allow organisations to borrow money to invest’
‘I believe that PFI is a short-term quick fix, but in the longer term it is very costly to the public purse. The government itself can raise finance at the lowest interest rate.’”
Labour & Trade Union Review