Graeme Davies assesses the PFI era - and how we'll be living with it for years to come.
4 December 2018 | Graeme Davies
When chancellor Philip Hammond hailed the end of the private finance initiative (PFI) in his recent Budget announcement, few tears were shed. In fact, pretty much the only people mourning the death of PFI are likely to be the select group of financiers and companies to have benefited from the government's desire to keep infrastructure spending and assets off the balance sheet over the past two-and-a-half decades.
While delivering the death knell to PFI was politically expedient for the chancellor - it was a fairly glaring land grab of Labour policy - it also makes financial sense, given the growing concerns over the hefty PFI-related debts that many public authorities and bodies are faced with servicing over many years to come.
But in many ways the announcement was also largely symbolic. As a mechanism for funding new projects, PFI has been distinctly out of favour for some time, with negative sentiment towards PFI only exacerbated by Carillion's spectacular fall from grace earlier this year. Indeed, Mr Hammond has never signed off on a PFI contract in his time as chancellor - a role he has fulfilled for more than two years.
The problem is the sheer scale of use of PFI and PF2 during the past 20 years, and the long-term nature of PFI contracts, which means financial obligations continuing to stretch beyond the end of the next decade. And there are more than 700 PFI or PF2 projects across the UK.
Perhaps such long-term costs and commitments could be partially justifiable if the government were getting good value for money. After all, the theory underpinning PFI from the beginning was that involving the private sector would improve public works efficiency.
But a report by the National Audit Office (NAO) found that the financial burden of PFI actually meant that the full life cycle cost of a school built using PFI financing would prove to be about 40 per cent higher than the same project delivered by the public sector itself, and hospital costs were likely to be more than 60 per cent higher. The NAO estimated that existing PFI and PPP projects on the government's books were costing £10.3 billion a year in 2016/17 and would cost the taxpayer a further £199 billion by the 2040s.
Such has been the scale of opportunity to make money in the financing of PFI that a whole secondary market in PFI has emerged over the years including a raft of investment funds listed on the stock market with the express intention of investing in long-term infrastructure assets and deals, often with the intention of refinancing them to get a better margin to return to their own shareholders. The future of this sub-sector is discussed in greater depth below.
It's not difficult to see why the government finally called time on PFI. Although it may have served a purpose in getting infrastructure projects off the government's own balance sheet it is difficult to argue that the taxpayer has seen any other advantage from the majority of such schemes. In many cases, financing costs have begun to outweigh any efficiency gains made by using PFI to maintain and renew our infrastructure.
NHS: pain management required
The situation is at its most glaring in the NHS, which has used PFI extensively over the years. The long tail of payments linked to financing PFI projects in the NHS could have a considerable sting in it.
A recent report by the Centre for Health and the Public Interest (CHPI) revealed that finance payments on PFI projects for the NHS will continue rising for another decade, peaking in 2029-30 at around £2.7 billion a year. Such was the popularity of PFI as a mechanism for projects in the NHS that more than 100 NHS trusts have ongoing PFI contracts, with some having to commit 5 per cent or more of their total budgets just to PFI financing payments - and many such payments are rising with inflation. In some cases, central government is already making supporting payments to some trusts that are in financial difficulty to allow them to continue to serve their debt.
Some commentators are concerned that the NHS will start to buckle under the strain of its PFI obligations over the next decade and have suggested potential remedies. Indeed, the Centre for Health and the Public Interest's recent report suggested that more trusts could cancel PFI deals due to underperformance. There is already a precedent for this. But many trusts running technically underperforming contracts have decided against taking such action because of the potential costs of replacing these contracts or lacking the wherewithal for taking on the responsibility of delivering such contracts in-house.
With the CHPI estimating that another £1 billion in profits for PFI operators will flow out of the NHS in the coming three years, its authors suggested five possible solutions that could be applied across the UK's PFI universe, not just in the health sector. First, improved monitoring and enforcement of PFI contracts; second, the centralising of PFI debts, which would offer relief to individual trusts; Third, a windfall tax on the profits of PFI operators that could feed back into the NHS, or the costly options of either buying out PFI contracts or wholesale nationalisation of the PFI operating companies.
The final and most drastic option would cost an estimated £2.6 billion but would allow the government to attempt to refinance the current costly PFI debt en masse as lower rates, making potentially significant savings over the long run.
What will replace PFI?
The long tail of PFI contracts across the country is a concern. But of perhaps equal interest to the FM sector is what the government will replace it. After all, during his Budget speech the chancellor confirmed that Britain has a pipeline of infrastructure plans worth £600 billion - half to be funded by the private sector.
Clearly there is still little appetite in the current government to put future infrastructure projects on its own books, so will we simply see future projects funded through essentially a new version of PFI or PF2? Hammond is known to be a fan of public private partnerships (PPP) as a method of delivering infrastructure projects. but this is effectively PFI under another name.
The extreme solution to this thorny problem is effectively that being proposed by Labour - that the government should 'nationalise' the country's PFI assets, buying out private shareholders and compensating them for future index-linked returns at potentially considerable expense before then using the size of its portfolio to secure a refinancing at more favourable terms, saving the country considerable sums against what it is scheduled to pay out for PFI over the next decade and beyond.
But the Conservatives will never countenance this transfer of assets back on to the public balance sheet. What is far more likely is that a new funding structure will be created which will not differ too radically from those that currently exist. After all, when PFI and PPP projects have been done correctly with sufficient oversight and rigour in the management of projects they have been able to deliver reasonable value for the taxpayer. And, up to now, no one has come up with a suitable alternative that matches the government's desire to run a leaner balance sheet while still delivering the infrastructure necessary for the country.
Certainly PF2 does not appear to have proved itself as a suitable alternative and the Scottish government's bid to resolve its PFI issues by using non-profit distributing vehicles has not proved to be any more efficient.
Some big decisions now need to be made by the government for it to deliver on its infrastructure promises. Is there an appetite among the government to take on the hefty construction costs of projects upfront itself, or will it look to spread costs over a long period using the relatively low cost of borrowing currently available?
What is certain is that the most public and painful collapse of Carillion earlier this year appears to have been the final nail in PFI's coffin, but the use of PFI and PPP has been on the wane in recent years anyway. Some form of private financing will be required for the government to continue to fulfil its infrastructure promises, but what form it takes, and whether it will be a genuine departure from PFI remains to be seen.
The impact on FM
How will the facilities service market be affected?
David Millar, MD, Eastern & Wychwood: Facilities service delivery of some type will still be needed for the existing infrastructure, so the FM industry will still be required. That's not going to change. But it might be that - if legacy buildings have to be retained for longer than planned because there are no PFI schemes to replace them - a number of smaller schemes might come to the market. Occupiers will need to do something, since investment in infrastructure assets will have been decreased or stopped in the preceding months or years on the basis that a PFI/PPP or PF2 scheme was on the table.
Other types of funding will have to emerge to fill the gap left by PFI to build new infrastructure. What's currently available will not solve all the need. If the FM industry can step up to the mark and take on board additional risk by investing in infrastructure projects, then it could open up opportunities in areas that might previously have been awarded to just one group. Meanwhile, if the government agenda of pushing more business out to SMEs is followed, perhaps smaller FM companies could gain more work if the government has an influence or a share in schemes.
A Chris Kenneally, CEO Cordant Group: Existing service providers who rely on PFI contracts will have to find alternate markets to focus on, which will no doubt have a negative impact on their margins because PFI contracts have normally good, high-margin opportunities. This will cause some disruption on the markets as stakeholders look for new models and replacement income opportunities.
It should also assist the government in its strategy to end the monopoly of large service providers controlling the sectors and thus enable SME providers to win more business.
A Martin Reed, CEO, Incentive FM Group: The long-term service tie-on of the PFI structure has limited the government departments in their ability to look at a wider pool of FM service provision and especially medium-sized businesses such as ours. We were never big enough, or stupid enough, to get involved with PFI schemes, but we are certainly big enough and smart enough to provide FM services to them. Hopefully, this change of strategy will benefit the government with wider options, smarter procurement and ultimately a better value service proposition for our government buildings.
Q How was the outsourced FM market been affected by PFI during its time - and how will competition between service providers change now?
A Millar: In many ways PFI led to the consolidation of the industry into a small number of larger players as only those big enough could win work. That is why many of the construction groups were able to win large PFI deals, as they both needed construction work and saw the benefit of ongoing FM income, as well as the profit from financing the deal.
PFI also reduced 'client intelligence' as in a number of cases buyers reduced their in-house teams since, in theory at least, a total FM solution was being provided at a fixed cost and with watertight guarantees.
PFI/PPP has enabled a lot to change for the better, but unfortunately there has been profiteering. There have been bad cases that inevitably hit the headlines, and in many respects FM has been the scapegoat for other parties who, through SPV structures or shell companies, keep out of the spotlight.
What shape competition might take for the FM service providers will depend on the desire of buyers to break up the market and introduce increased diversity. While I know there is a wish to create a greater level of choice for buyers, there is a fear that the bottom-line cost will mean that although 'big is bad' then it might be a case of 'better the devil you know'.
A Kenneally: PFI has had a huge impact on the market. Many service providers have benefited and so have the local communities where the money was invested. We must not forget the positive impact of PFI - new schools, hospitals and military establishments - dramatically improved property infrastructure that has benefited all stakeholders.
Going forward, service providers will have to find different ways to service these markets and retain value for stakeholders. Increased competition at reduced pricing is not the answer - the industry needs to focus on value and purpose rather than improved margins.
Q How is the relationship between public sector organisations and outsourced FM supplier likely to change?
A Millar: This depends on where the money will come from. Whatever your views, there is a need for significant investment in UK infrastructure. Who pays for that, and where the cash comes from - anything from a Government Investment Bank to the private sector - is up for political debate.
The issue will be: how can the public sector take a commercial market approach when it is often restricted by multiple layers of approvals and subject to tight procurement rules? We need a more balanced approach to contracting; the fixed price, profit-at-any-cost mentality isn't healthy and in the end buying big to gain efficiency reduces choice. A more mature approach is needed.
It's chicken and egg. Buyers will say that the industry needs to show they can deliver what they want, but industry will in turn judge what buyers will buy, and how they then contract, and develop accordingly.
A big step in this would be for the contribution of SMEs to be recognised in tender assessments. Why not value diversity and contribution to the local economy, then follow this up as they do in the USA with defined measures that buyers/prime contractors must adhere to? We could learn from that.
Suppliers need to consider how they can pull smaller firms into their pool of contractors and create a healthy environment where smaller businesses can flourish. This is not cheap, nor the lowest-price solution - so buyers need to score this accordingly to reflect the wider benefits to UK Plc.
A Kenneally: One of the key elements will sit with procurement and how they react to the changes. If they focus on cost reductions it will end up with an industry that cannot add value into their sector.