Friday, 11 December 2009

Is private finance the right answer?

There is much written about the Private Finance Initiative (PFI) and about Public Private Partnerships. The UK government is clearly keen to involve the private sector in the provision of public services. While such partnerships can be very beneficial, the replacement of public investment by private capital is worrying. What is more worrying is the seemingly uncritical acceptance of this policy by the construction industry. Is this because private finance is such a blindingly obvious solution to various problems, or is it just that searching questions have not been asked?

PFI has long been an alternative to borrowing for under-funded governments. Although it can provide necessary infrastructure, it also carries a service charge, such as tolls for roads, for the duration of the agreement. The end user still pays, whether through taxation or directly to the concessionaire at the point of use. The key feature of private investment is that the money comes from revenue streams instead of from capital investment. Is PFI cheaper because the value of a pound in the future is less than the value of a pound today? This advantage needs to be weighed against the fact that governments ought to be able to borrow more cheaply than the private sector (and the private sector must make a profit). On the face of it, net expenditure is likely to be more if the private sector raises capital and charges government for service provision.

There is great enthusiasm for PFI: Contractors and designers are hungry for the extra work; governments are relieved of the need to use the public sector borrowing. By reducing the PSBR, the balance of payments is instantly improved and the government will appear to be handling the economy very well. They may even be able to cut taxes. All this is splendid during a transition period, before these new facilities come on stream. However, the private sector invests in these things because of the income stream. That income will be from revenue instead of capital funds. By the time this pressure for increased government spending forces taxes to be raised, the government that got us into this position will be long gone. Are we mortgaging our future for the sake of someone’s short-term political advantage?
It seems that when there is any kind of public sector mis-management, the only possible answer is to relieve public sector agencies and departments of future responsibility and transfer it to the private sector – a very defeatist attitude. Why don’t they learn how to manage? Apparently, no one in the public sector knows how to manage so private capital has to be used to give private sector managers the incentives to manage efficiently and this somehow will produce efficiency gains.

The public sector may indeed be inefficient, but surely it can be improved? Are we to understand that the government must never have control over capital investment in case they invest wrongly and that the service providers must have private money because the government is too stupid to give them the right amount of money? This seems to be an extreme reaction. The solution, surely, is to learn from mistakes.

There are political risks involved in partnering with government. PFI has been introduced during an era when successive UK governments have downplayed ideology in favour of appeal to the electorate. But if there is ever a return to a more ideological era, policy changes and government involvement in infrastructure decisions will increase. Such risks will inevitably increase the cost of capital. Thus we move from a situation where the government could borrow cheaply because it was backed by taxation to one where we are going to have to pay more to compensate investors for the fact the government might change its mind about an operating contract at some point over the 25-30 year life of the deal.
There are contractual risks in any construction project. Unpredictable risks are, by definition, difficult and expensive to price for, so they are usually taken by the client (an example being unforeseeable ground conditions). This makes sense when the client is the government. If they pay for things when they go wrong, they pay for what it actually costs, rather than for a contractor’s accumulation of contingencies for when hazards occur. But in PFI, the contractor is not employed by the government. We still encounter the same construction risks, but the client is an “SPV”, which has an inflexible source of funding. Presumably, the clauses relating to unforeseeable ground conditions ought to be crossed out, or at least modified, but it appears that these clauses are not modified. The risks are dealt with as if the client for the construction project is the government; is there a rational risk apportionment strategy at work here? Large, repeat clients can cover the risk. One-off clients cannot. An SPV is a one-off client with no financial resource of its own.

The potential gain using PFI is an efficiency gain brought about because of the reputed expertise of the private sector to be lean and efficient. Added to this are financial benefits of using cheaper future money instead of expensive current money. However, the advantage brought by PFI has to be weighed against the disadvantages; higher cost of capital in the private sector, payment for the revenue stream for the facility, paying for the long-term risk of changes in government policy and transferring major risks to SPVs with inadequate financial reserves. It seems that the whole idea is built upon the dubious assertion that the public sector is completely incapable and the private sector is completely capable. But does the private sector have a blemish-free record of managing major ventures? How many major failures have there been in the private sector recently? I would love to see this debate taken beyond the immediate concerns of firms hungry for work and placed into the longer-term context of the future health of the UK.

Originally published in Construction News in 2002

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Reading, Berkshire, United Kingdom

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