Lifting the Lid on PFI PDF Print E-mail
Jim and Margaret Cuthbert unveil new evidence to show how PFI has conned taxpayers and resulted in huge profits for investors. Jim and Margaret Cuthbert look at why PFI is bad for everyone, especially tax payers and conclude that there is an urgent need for an inquiry into the operation of PFI and it’s impact in delivering vital public services  

This article explains the basics of why the Private Finance Initiative, (PFI), is a bad deal for the taxpayer. We describe here some of the major PFI errors which can now be identified, and we quantify the effects. The results, in terms of the burden being placed on each and everyone of us, are staggering: as we shall see, PFI can well be described as “one for the price of two”. There is now an urgent need for a full public inquiry into the way PFI has operated: there should be a moratorium on the signing of any future PFI deals until required changes have been made: and any past PFI deals shown to involve excessive and unreasonable profits should be reopened.


Although introduced by the last UK Conservative government, PFI was enthusiastically taken on by Labour. It involves private sector suppliers not only designing and building, but also maintaining and operating, major items of public sector infrastructure like schools, hospitals and roads over a large number of years. Instead of the public sector itself borrowing money to pay for the capital expenditure, what the public sector pays is an annual unitary charge for the use of the facility over its lifetime. All of the individual costs borne by the PFI supplier, such as capital repayment and interest charges, maintenance, and service provision, together with supplier profit, are bundled up into the single unitary charge.


The scale of PFI is huge. In Scotland alone, PFI deals in operation or signed cover capital expenditure of £5.1 billion, almost all under Labour. A further £1.7 billion future deals are in preparation.


Serious concerns about PFI emerged very quickly. One concern, for example, was whether risk was actually transferred to the private sector. Another concern was that the PFI approach also seemed to have an effect on the type of project being undertaken: there have been many examples where a public authority has started off with plans for a fairly modest refurbishment, but has ended up having been convinced that what was actually required was a much more expensive new build project. Yet another concern was with the scale of PFI projects: many projects are so large and complex that the degree of competition has been limited. As one supplier noted, an advantage of PFI from the supplier’s point of view was that “tender costs and complexity reduce competition”.


But the major worries about PFI have related to cost. For example, it became clear that many new hospitals were having to be planned on the basis of reduced bed numbers, in order to make the forecast unitary charge payments affordable: (for example, to make the New Royal Infirmary of Edinburgh PFI scheme affordable, a 24 per cent reduction in acute bed numbers was required across the Lothian Health Board area.) Suspicions really started to crystallise when several PFI suppliers were able to extract large capital gains from their PFI projects, at an early stage in the life of the project, effectively by capitalising their anticipated future profit streams. In several cases, the capital gains extracted were several times the original inputs of capital by the PFI contractor.


Concerns such as the above have been articulated by a number of critics, notable among these being Allyson Pollock, now at Edinburgh University, and her colleagues. The Government, however, (both at Westminster, and the previous administration at Holyrood), have countered criticism by their usual technique of unsubstantiated assertion: and they were greatly helped in this because the required detail about projected costs and finances was hidden away under the cloak of commerciality in confidence.


Recently the situation has radically changed: what has happened is that detailed financial projections for the operation of PFI schemes have started to become available, because of the operation of the Freedom of Information Act, (FoI). These are the actual financial projections produced by the consortia running the PFI schemes: and are normally included as confidential annexes to the Final Business Cases of PFI projects. Unison has recently mounted a concerted campaign using FoI to request copies of large numbers of full Final Business Cases. Most of the responses still contain large blanks where the financial information has been removed: however, the vital financial detail has been provided for a number of important PFI projects. This has allowed us to analyse a number of the financial projections, and this provides the basis for the key findings on which we report below.


Before moving on to the detail however, we should record our appreciation both of Unison and the FoI Act which has enabled this information to be brought into the open.


As noted above, the PFI consortium charges an annual unitary charge to the public sector client. This unitary charge has to pay for all the costs incurred by the provider, and yield a profit. Typically, to finance the initial construction, the PFI consortium will borrow the necessary capital. Most of the finance has tended to come from banks at a “competitive” rate. The remainder is usually made up of a mixture of what is called subordinate debt, that is money lent by the members of the consortium itself at a higher rate of interest, and of equity, where members of the consortium put share capital into the venture. Usually, the amount put in by the consortium by way of subordinate debt and share capital would be around 10 per cent of the capital value of the project.


Our examination of detailed financial projections for a number of PFI projects confirms just how hugely profitable PFI can be for the private sector consortia. But the important thing which our work suggests is that a large part of this profitability stems from two elementary mistakes made by the public sector in their negotiation of PFI contracts. We will start by looking at the nature of these mistakes first, and then consider their financial implications. Further details of some of the work reported on here can be found on our website, at


The first key mistake we uncovered related to the way in which the unitary charge payment to the PFI provider is uprated, or indexed, through time. Normally, some simple uprate rule is applied to the unitary charge, whether as a whole or to each of its constituent parts, so that they increase in line with inflation, or some fraction of inflation. However, using a simple uprate rule like this neglects the fact that a major part of the supplier’s financing costs, namely, debt charges, will not be increasing, but will be declining through time: this is because, as debt is repaid, the payment of interest each year will decline. The difference, between that increasing element of the unitary charge which covers financing costs and profit, and the declining cost of servicing debt, is available as a large profit: a profit which has not been earned through excellent performance, but through what amounts to financial sleight of hand.


This, however, is where we come to the second major mistake the public sector has made in the way it considers PFI projects. One of the key measures which the public sector uses in assessing the profits made by PFI providers is what is called the Internal Rate of Return, (or IRR), on the finance put into the project by the consortium. This is called the IRR on equity, (though here “equity” is interpreted as provision of finance by the consortium by means both of subordinate debt and equity proper.) The IRR is, effectively, the projected rate of interest earned on the consortium’s initial financial input to the project. The public sector regularly quotes the IRR on equity for individual PFI projects, usually as a justification for the reasonable rate of return being earned by the operating consortium. The big mistake is that IRRs are typically quoted on their own: but in fact the definition of IRR implies that there is a notional outstanding debt, on which this IRR is being earned. IRRs on their own are meaningless: the average debt on which this rate of return is actually being earned must also be quoted. A little thought tells us that, if the consortium is earning an IRR of 15 per cent to 20 per cent per annum on equity, (which the Treasury seems to regard as reasonable), but postpones taking dividend payments until near the end of the project, then the outstanding debt on which the IRR is being earned will rapidly snowball: so the actual financial return to the consortium, which is determined by the IRR and the average outstanding debt, can only be calculated if both the IRR and the average outstanding debt are quoted together.


So what does the data tell us about the size of the profits earned? Let us start with one example, a hospital project in England with a capital cost of just under £70 million. To finance the building the consortium borrowed over £60m from banks, at an interest rate of just over 6 per cent: the consortium itself provided almost £10m subordinate debt for the project, for which it received a more generous 15 per cent, and the consortium also put in an equity stake of £1,000: (no, we have not misread the decimal point: we genuinely mean one thousand pounds). The project shows the classic signs of inappropriate indexation, with the senior debt being paid off quickly, and hence senior debt charges declining rapidly - but with the whole unitary charge being indexed over the full thirty year life of the project at 3 per cent per annum. As a result, the projected returns to the consortium are eye-watering: the £1,000 equity input is projected to earn dividends totalling to more than £50m. Taking account of projected undistributed reserves at the end of the project, the consortium’s own financial projections indicate that the consortium is expecting to reap a cash return of more than £90m in total on its investment, (by way of subordinate debt and equity), of less than £10m.


Cash returns on this scale are staggering.  But simply aggregating cash returns accruing over a long time period is misleading, since a given amount of cash today can be invested, and is therefore worth more than the same amount of cash at a future date. It is also useful to have a standard approach to looking at different PFI financial projections - all of which are slightly different in detail. To get round these two problems, we developed two standard summary measures for comparing different PFI schemes.


First, we split the projected sequence of unitary charge payments for a PFI scheme into its service element, (that is, that part covering operations and maintenance), and what we have called the non-service element, (that is, covering interest and repayment of principal on senior and subordinate debt, taxation, and profit). We then discounted the non-service element of the unitary charge by an appropriate discount rate to give the Net Present Value (NPV) at the start of the project: and we compared this NPV with the original capital cost of the building and equipment. The discount rate we chose was the interest rate which the public sector would have paid if it had borrowed the resources itself: so the comparison of the NPV with the capital cost gives us an indication of how much more the public sector is paying for the building and equipment under PFI than if it had been able to go out and purchase these directly.


For the English hospital example discussed above, the NPV of the non-service element of the unitary charge is, in fact, almost double the original capital cost of the hospital. In other words, for this hospital, it could truly be said that the taxpayer has got “one for the price of two” through using PFI. But this is by no means a unique example. We have analysed in detail three Scottish projects. For one of these, a PFI funded major educational establishment, the NPV of the non-service element of the unitary charge was more than double the capital cost - so this example is actually marginally worse than the English hospital example. For a recent significant schools project, the NPV of the non-service element of the unitary charge was more than 50% above the capital cost.


The second standard summary measure we developed relates to the internal rate of return (IRR). For each of the projects we have examined in detail, we calculated the pre-tax IRR on equity: (that is, on equity broadly defined as subordinate debt plus equity proper). But in addition, we also calculated the average notional outstanding debt on which this return was earned. In all of the three cases considered above, the pre-tax return on equity was just above 20 per cent: (which would correspond to a net post-tax return in the mid-teens, which the Treasury would probably regard as acceptable). However, the really significant point is that, in each case, the average debt on which this IRR was earned was very much larger than the actual input of capital via subordinate debt and equity: in the most extreme case, the average debt was more than 2.5 times the initial input of subordinate debt plus equity: in another case, more than twice: and in another case 1.5 times. This confirms that the IRR alone, (generous as it may seem), in fact grossly underestimates the true scale of return accruing to the operating consortia in some PFI projects.


Our analysis confirms therefore, that the returns arising from inappropriate indexation are enormous - as we have seen “one for the price of two” is an appropriate designation of some PFI schemes.


What we have described so far in this article are definite errors and mistakes we have uncovered in the practice of PFI. It would be wrong, however, for us to give the impression that we understand everything that is wrong with PFI - far from it. Our detailed examination of PFI financial projections indicates that there are other important aspects of the process which require much closer investigation. For example, once the construction stage of the project is completed, there is often projected to be a significant financial reserve left from the original project finance, which is then paid into reserve accounts to earn interest for the operating consortium. At its worst, this could mean that the public sector is paying, via its expensive unitary charge payment, to fund the consortium to borrow money which the consortium then pays into an interest bearing account for its own ultimate benefit. There needs to be a much more detailed accounting for the cost elements which are actually contributing to the cost basis of the unitary charge.


What we have shown in this article is that, once PFI is examined in the light of the facts which are now becoming available because of the Freedom of Information Act, it can be seen to be nothing short of a disaster. The effects, however, go beyond the question of costs alone - even though no country, whether it be Scotland or the UK as a whole, could long support buying its capital assets on a “one for two” basis. But in addition, PFI has also had a marked, and negative effect on the industrial structure of Scotland. Given the large size of PFI projects, local firms have great difficulty in competing. The effect, in the Scottish context, is that local firms have either been squeezed out, or, (if they did get a foothold in the PFI world), are more susceptible to being taken over by international players attracted by large PFI profits. So not only are we paying excessively for PFI services: at the same time PFI contributes to our losing control of our own economy.


So what needs to be done: we suggest that a number of actions are required. Firstly much more needs to be done to improve the availability of information. The detailed financial projections should be published for all past schemes, and also for any future schemes. In addition, standard indicators should be published for all schemes. In the light of our own work, we suggest such indicators should include the Net Present Value of the non-service element of the unitary charge, in comparison with the capital value: and also the projected internal rate of return on equity, together with the corresponding average notional outstanding debt on which the IRR will be earned.


Secondly, any future PFI projects should be unbundled into smaller projects as far as feasibly possible, so that a genuinely competitive market has the chance to become established, and to allow local firms to compete.


Thirdly there has clearly been a systemic failure in the existing mechanisms designed to secure value for money from PFI schemes. There needs to be a full and detailed inquiry to establish exactly why the reality of PFI as it is now emerging is so different from the utopian view presented by PFI adherents like Partnerships UK.


In our view the problems with PFI are so grave that tinkering is not the appropriate approach at this stage. We would seriously suggest that there should be a moratorium on all future PFI projects, until the full facts of what has gone wrong, and why, have been established: preferably this should be done through a public enquiry. Moreover, if it is established that excessive and unreasonable profits have resulted from past PFI schemes, then efforts should be made to re-open them. 

 Margaret Cuthbert is an economist. Jim Cuthbert was formerly Chief Statistician at the Scottish Office
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