The end of the road for PFI

The private finance initiative (PFI) was supposed to save the taxpayer money and improve public services. It hasn't and many people want it scrapped. Ben Judge reports.

How does PFI work?

The government spends more than £50bn a year on large capital infrastructure projects, 90% of which are publicly financed. But over the last 20 years or so, many big projects, particularly in health and education, have been built under the private finance initiative (PFI, and PF2, a revised version in operation since 2013). In a PFI deal, a private company known as a special purpose vehicle (SPV) is set up and raises finance via borrowing and issuing equity. It engages a main contractor (which is likely to be an investor in the SPV) and pays it for construction. The taxpayer then makes payments to the SPV over the next 25 to 30 years, which cover debt repayments and an inflation-linked service charge.

How much has been spent?

Over the last 20 years, capital investment in private finance contracts has averaged £3bn a year, though the number of deals and the total invested has fallen significantly recently. In the five years to 2007/2008, says the National Audit Office (NAO), the average yearly spend was £5.5bn. In the last two years, that has fallen to less than £0.5bn. There are currently more than 700 PFI and PF2 contracts operational with a capital value of about £60bn. In 2016/2017, annual charges amounted to £10.3bn, and annual payments averaging around £7.7bn extend to the 2040s, totalling £199bn. Most of the money has gone on new schools and hospitals.

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Why use PFI?

Officially, the benefits include certainty about construction costs; improved efficiency; higher quality and better-maintained assets; and transference of risk to the private sector. But perhaps the most attractive reason for hard-pressed chancellors (most notably Gordon Brown the Blair government was an enthusiastic user of PFI contracts) is that PFI spending is kept off the government balance sheet. If the money were borrowed through traditional public methods it would count towards the public-sector borrowing requirement, inflating the public debt. PFI does not.

Has it worked?

No. Privately financed projects are more expensive than public ones, says the NAO. It cites one group of schools that cost 40% more than if they had been financed publicly; the Treasury Committee estimated one hospital cost 70% more. Most obvious is the higher cost of initial finance up to 5% more. Even a small difference can significantly increase the costs: paying off £100m over 30 years costs £34m at 2%; at 4%, this rises to £73m. Another drawback is "operational inflexibility" changes to contracts can be expensive, with contractors charging hefty fees to do so. Contractors also have "little incentive" to co-operate with public bodies wanting to make savings and in some cases SPVs are "not complying with their contractual obligations to share savings", says the NAO.

What's the future for PFI?

PFI seems to be falling out of favour with everyone politicians, the public and even some of the main contractors. Firms are becoming more reluctant to engage in public-private partnerships since the collapse of Carillion, which was heavily involved in PFI contracts. The Times reported in January that building firms including Balfour Beatty and Galliford Try have "warned ministers they will no longer accept fixed-price PFI deals". Public-sector union Unison has called for PFI companies to face a windfall tax on their profits, pointing out that corporation tax was 30% when many of the contracts were signed, but has since fallen to 19%. The Labour Party is vowing to do away with PFI altogether.

Could Labour do this?

It would be difficult. "Contract termination requires significant upfront funding," says the NAO. PFI compensation requirements are complex and vary from project to project, but the standard contract used since 2004 requires compensation for debtors, including the amount of debt outstanding plus "a premium to allow investors to get a similar return from investing in another bond". Since many contracts were agreed when interest rates were much higher than they are now, the use of interest-rate swaps, which replaced variable rates with fixed ones, was widespread. The NAO estimates swap breakage fees for the largest contacts would be over £2bn. For equity investors, the level of compensation could include the expected return they would expect to get if the contract were allowed to run its full course, or the market value of equity and shareholder loans. Labour has said it would contemplate changing the law to allow them to take over contracts without compensation. But this would severely damage the UK's reputation as a safe place to do business.