Today’s NAO report into PFI and PF2 comes in a week when the collapse of Carillion reveals how little risk is transferred to the private sector when things go wrong.
Taken together they should finally put the nail in the coffin of the use of private finance to fund public infrastructure projects. The NAO’s report (conceived before the demise of Carillion was even known about) amounts to a demolition job of all the arguments used by the Treasury since 1992 to justify using private finance over public borrowing.
They show that the high price paid for using private finance to build and then provide public services cannot be justified in terms of “risk transfer” or greater efficiencies. It is in reality an accounting ruse to keep debt off the public sector balance sheet, which the report describes as a “fiscal illusion”. Even a slight adjustment to the discount rate used by the Treasury to measure Value for Money causes the private finance advantage over public sector borrowing to disappear.
However, what the NAO report also shows is that the way these deals with private providers were structured puts the private sector in the driving seat if termination is ever considered.
As a result, the tight knot which requires the public sector to continue making payments to the private sector cannot be unpicked without huge expense to the tax payer.
In order to ensure that PFI schools and hospitals were off balance-sheet the contracts were structured in such a way as to ensure that the risks of the project were transferred to the private contractor. This typically involved the PFI consortium (organised as a company called a Special Purpose Vehicle, or SPV) taking on the risks of construction delays, any potential problems in providing facilities management services to the hospital and the school, as well as maintaining the buildings.
In addition, under the contracts the private sector had to bear the risk of inflation and interest rates changing, or the government introducing new taxes, and provide insurance for the schools and hospitals.
However, the public sector had to pay for the PFI companies and their lenders taking on these risks by paying inflated prices – astonishingly, the NAO estimate that a hospital built using PFI would be 70% more expensive than a hospital built using public borrowing.
But because the private sector was providing the much-needed capital it was also able to dictate terms to the public sector and struck contracts which protected their investment no matter what, even if the public sector no longer needed to use the school or hospital.
A shocking example of this within today’s NAO report is the fact that Liverpool City Council is paying around £4 million each year for Parklands High School which is now empty. Between 2017-18 and the contract’s end in 2027-28, it will pay an estimated £47 million. The school cost an estimated £24 million to build.
But the standard PFI contracts issued by the Treasury went even further: in the event that the public authority wants to terminate the deal they are required to pay compensation to the banks and the private equity funds which have lent money to build the hospital as well as those who hold shares in the project. (See here for the full 400-page contract document)
As the NAO explain, this compensation includes:
- The amount of debt outstanding needs to be repaid;
- The equity investors (or shareholders) will need to be paid the return expected at the start of the contract(although if the investors have already achieved the expected return no compensation will be required) or the expected return for the remaining part of the contract;
or the market value of the equity and shareholder loans – assessed as if the contract was to continue to run.
The NAO also note that the services will need to be re-provided, and any redundancy payments covered.
To give some indication of how big a bill the public sector might face if it had to compensate lenders for terminating PFI deals the NAO analysis shows that almost half of the money £10.5bn which is paid each year to PFI companies goes to pay lenders and shareholders.
However, there is also a hidden cost which the NAO identifies in the report which adds hugely to the cost of a public sector buy out. The financing arrangements for PFI often rely on interest-rate “swaps” – a complicated financial transaction whereby a deal is made by the private company to insure against the possibility that interest rates will rise by fixing them for the duration of the 30 year contract.
When most of the current PFI deals were signed, interest rates were much higher than they are now – in effect the fall in interest rates means that the PFI companies paid money to insure against the wrong outcome.
As the NAO point out, in addition to paying compensation to the lenders and to the shareholders, if the public sector terminates a contract the cost of these “swaps” must also be covered. The NAO estimate that in the largest 75 PFI deals this would cost £2.3bn or 23% more than the £10bn of outstanding debt in these deals.
In a prior report the NAO note that when Northumbria Healthcare NHS Foundation Trust bought out a private finance deal in 2014 it paid a reported £24 million in “swap” breakage costs and £4 million to compensate unsecured loan holders, as well as repaying the underlying debt at a total cost of £54 million.
Multiply the costs of buying out these “swaps” over the course of the 700 or so existing PFI projects, on top of repaying the lenders their investment and the shareholders their returns, and the huge cost to the public purse of buying out these contracts becomes clear.
In addition to the huge amount of upfront funding required there is a practical problem here; most government departments do not have access to this cash. The NAO point out that in the cases of successful terminations by TfL and Northumbria Healthcare NHS Foundation Trust both had borrowing powers that most government departments currently do not have.
So what can be done?
If the costs of buying out the PFI deals are prohibitive, what levers are left to deal with the iniquities revealed by the NAO report and the collapse of Carillion?
The NAO suggests that buying out the equity stake in PFI deals would be much more affordable than compensating lenders and shareholders for their losses through termination. This, they argue, might allow the government to require the re-financing of the loans on more favourable terms. Given the current market worries about PFI and PPP after the collapse of Carillion, there may be some merit in this. However, as we have shown in a previous report, the returns on PFI are so significant, the price at which investors would be willing to sell might be extremely high.
A further tool that is left is taxation. This week, in the light of the collapse of Carillion the Labour Shadow Chancellor, John McDonnell, suggested prohibiting dividends being paid from PFI to offshore shareholders as a temporary measure, before terminating PFI contracts – in effect a form of taxation, whilst Labour MP Stella Creasy has proposed a windfall tax on PFI operating companies.
And whilst objections have been raised about the unfairness of taxing retrospectively, PFI companies have already benefitted significantly from a reduction in corporation tax on their profits from the 30% that they expected to pay when many of them signed the deals (an expectation which they built into their profit margins) to the 17% they will pay in 2020. Indeed our research has found that PFI operating companies with NHS contracts will benefit from an estimated £190m as a result of corporation tax cuts from 2008-2020.
It is relevant that investment bankers, realising that the chances of terminating PFI deals are minimal, see the idea of a tax as a “credible threat”. It might also have the added bonus of getting PFI providers to consider renegotiating their contracts with government, and there are signs that this is happening. As we know, just 8 companies own or have equity stakes in 92% of all the companies holding PFI contracts with the NHS. If a renegotiation could be done with each of these 8 companies across all their contracts greater savings could be achieved across government.
Whilst the NAO report is likely to add to the public and political outrage around PFI, the pressing need is to focus on viable solutions to deal with its legacy.