What's wrong with PFI?

PFI was supposed to be the saviour of the public sector, but it’s costing the taxpayer a fortune and could prove to be a painful thorn in Gordon Brown’s side. So will private finance initiatives survive?

PFI is the private finance initiative' for funding large-scale state spending. The idea came from the Tories, but has been warmly embraced by New Labour, which sometimes prefers to talk about PPP' public-private partnerships. Under PFI, the government has signed more than 750 deals with private companies to build, service and maintain all kinds of big projects in the public sector, from schools and hospitals to prisons, roads and defence facilities.

PFI: What's in it for the private sector?

It's been good news for the private sector, because PFI has become a booming £4bn-a-year industry, involving money up front plus lucrative servicing contracts and a predictable revenue stream for years. Under a typical arrangement, a private company raises the money, builds the school, and so on, and puts servicing teams in place. It then receives regular payments from the government for decades, before ownership of the facility reverts back to the state.

PFI: What's in it for the state?

That's more contentious. Supporters of PFI argue that it allows the state greater access to private capital and gives the private sector more confidence to get involved with government projects. That was certainly the reasoning so enthusiastically taken up by the Labour party from 1997 onwards, when Tony Blair's first health secretary, Alan Milburn, declared that when it came to building hospitals, it was "PFI or bust". However, sceptics have frequently argued that PFI is little more than a gigantic accounting fiddle or hire-purchase scheme, keeping current infrastructural spending off the government's current accounts and shifting it on to future generations so that Gordon Brown keeps his much-vaunted reputation for prudence.

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Is there any truth in that?

Yes. In theory, there is nothing wrong with PFI. But in practice, the numbers haven't always quite added up for the taxpayer. Instead, the private-sector companies involved in the deals appear to be making spectacular profits and the government is getting stuck with nasty looking long-term payment commitments. So far, for example, £54bn has been spent on infrastructure and services under PFI, but and these are the government's own figures the long-term cost to the taxpayer of that £54bn is going to be more like £160bn.

Clearly, there is no reason why the PFI contractors shouldn't make a profit, even a good profit (dealing with the government is never risk-free), but right now they are making so much money that it is clear there's a problem. As MPs on the Public Accounts Committee (PAC) the watchdog charged with making sure the government gets value for money put it, civil servants are regularly "being outwitted by their commercially sophisticated private-sector counterparts" and making bad deals for the taxpayer.

Just how bad are these PFI deals?

In the early days of PFI, many investors made huge, one-off profits from refinancing their debts on more favourable terms once the most risky stage of the project putting up the building itself was done. The recent PAC report cites the Norfolk & Norwich Hospital, where debt refinancing boosted returns for its builders from 16% to 60% private investors got a windfall of £80m. As a result of this and many similar cases, in 2002 the Government agreed a voluntary code with the industry under which investors handed back a percentage of refinancing profits; initially 30% and now 50%.

However, while that sounded like a good way to try to redress the balance, it hasn't worked. The gains for government have been much lower than anticipated £93m by the end of 2006, instead of the £175m-£200m predicted. For this, the PAC blames the fact that renegotiation is often undertaken by civil servants "painfully lacking in commercial experience". Worse, the code doesn't cover the onward sale of equity stakes to third parties, an area where PFI investors are now making even bigger profits.

How does this work?

A PFI deal is typically structured as a consortium a special-purpose vehicle' made up of a construction company, a bank, and a support-services firm. The equity is split between the three. However, they are free to sell the equity on to third parties as and when they believe they can make the best return. In The Sunday Telegraph, Liam Halligan gives several examples of PFI consortium members "cashing out" in grand style. Mowlem invested £3.4m in the Docklands Light Railway in east London, and sold its stake in 2003 for £19.4m. The equity in the rebuilding of the M40 motorway has been resold at least five times, with Carillion and Laing making huge returns. Last autumn Carillion again sold equity in PFI projects, including Rye Hill Prison, for £46m, more than six times its investment.

Why should investors care about PFI?

Because it's been good for business and it should also benefit taxpayers. If it continues not to benefit taxpayers, it will soon no longer be good for business either. Currently, the big pension and insurance funds see the infrastructure sector in general, and PFI in particular, with its low-risk income flows and high returns, as very attractive. Standard & Poor's believes that institutional investors have earmarked £100bn-£150bn to invest in infrastructure deals. But if the rumbles of discontent currently kicking off get too loud, and particularly if PFI becomes a focus for Tory attacks on Gordon Brown's economic record (and it's got to be tempting...), there is a risk that the profits the private sector is able to make from it will fast go from too high to too low.

Simon Wilson’s first career was in book publishing, as an economics editor at Routledge, and as a publisher of non-fiction at Random House, specialising in popular business and management books. While there, he published Customers.com, a bestselling classic of the early days of e-commerce, and The Money or Your Life: Reuniting Work and Joy, an inspirational book that helped inspire its publisher towards a post-corporate, portfolio life.   

Since 2001, he has been a writer for MoneyWeek, a financial copywriter, and a long-time contributing editor at The Week. Simon also works as an actor and corporate trainer; current and past clients include investment banks, the Bank of England, the UK government, several Magic Circle law firms and all of the Big Four accountancy firms. He has a degree in languages (German and Spanish) and social and political sciences from the University of Cambridge.