THE PRIVATE FINANCE INITIATIVE

This is where the PFI comes in. It is a new way for government to buy the services needed for the public. The Private Finance Initiative recognises that what people are most interested in is enjoying good public services rather than buying capital assets. It is transforming the public sector from being an owner of capital assets and direct provider of services, into a purchaser of services from a private sector partner responsible for owning and operating the capital asset that is delivering the service.

The public sector becomes an enabler. It decides in broad terms the service it requires, then the private sector is challenged to bid for the work involved in designing, building, financing and operating that service. The capital and management skills are provided by the private sector, but the service is still very much a public one.

The scale of opportunity for these partnerships is enormous. The Government hopes that at least £14,000 million of deals will have been agreed by the end of 1998/9.
Of course, this is just the capital spend by the private sector. The total value of these schemes to the economy is well in excess of this if the purchase of services by the public sector during the life of the contract are added.

There are two rules - and two rules alone - governing PFI. First, to get the go ahead, projects must represent value for money. A PFI project should ensure that the taxpayer gets a service that is better in overall cost and quality than any realistic alternative.

The second rule is that risk must be transferred. Of course, private capital is welcome to the public sector, but only if it represents money at risk, giving the private sector a stake in the success of the venture. If insufficient risk is transferred, a project will not represent value for money and will not be pursued under PFI.

Equally, PFI does not mean transferring every single risk to the private sector. The Government is well aware that risk transfer has a bearing on the price of borrowing. The important question is who is best placed to manage each risk.

The challenge is to devise the best possible allocation of risk. This means pricing the risks in a project and placing each with the party best suited to manage it. Legislative or outline planning risk is usually best left with government. Performance risk or the risk of a project not being completed on time is best carried by the private sector.

People sometimes think that pricing a risk increases its cost. It does not, but whereas the private sector will specifically charge for a risk, the risks borne by the public sector all too often lie submerged until they come back to haunt us. Costs soaring during construction and completion delays - an all too familiar tale of the taxpayer having to part with more money than anticipated. Some people instinctively say that private finance will always be more expensive. Through the gilts market, Government can always borrow more cheaply than the private sector. However, the point about money is not how much it costs but how much of it is used. The PFI is about creating the incentives that create efficiency. Private sector partners have their own money at risk. They can bring management expertise across the life of a project that can more than outweigh the extra cost of their borrowing. In the past, because the public sector had no incentive to make a profit or recoup the cost of capital, it demonstrated weaknesses in managing large projects.

Because it is convinced of the opportunities presented by PFI, the Treasury will no longer approve the spending of taxpayers money to build a capital project unless private finance options have been fully explored and found to be unsuitable. As the benefits of the pioneering projects become clear to consumers and contractors, it believes the choice of private finance will increasingly be seen as natural and logical.

Involving a private sector partner in every stage of a project is leading to significant performance improvements compared with old-style public sector procurement. For example:

• when designing and building a traditionally financed public project, the cost of public money is not brought home to public sector officials. There is a temptation to over specify, leading to gold-plated projects;
• publicly managed projects have been characterised by a history of cost over-runs, all too often borne by the taxpayer. Under PFI, the private sector partner carries the risk. The private sector must recoup financing and other costs and therefore has every incentive for tight project management and the best use of capital;
• conventionally, a builder puts up a structure, takes his fee and moves on. It is not the builder or designer who has to live with the asset. The public sector is left to manage an asset that they are unlikely to be best placed to operate. A PFI deal harnesses the operating expertise of the private sector contractors involved in the design and build stages;
• the private sector partner only gets paid if the asset works to specified levels of service. The public sector will expect projects to be maintained and operated to a high standard. Under-achievement can trigger off penalties and withdrawal of payments. Meeting the standards means the taxpayer benefits from a high quality service and the private sector partner is rewarded with a fair return. Incentives can be written into contracts to ensure that assets are enhanced as technology develops.

In other words, the private sector contractor has a continuing association with the project. It is in his interests to build to time a high quality project that will be durable and easy to operate. Quite simply, to get it right.

The PFI has had tough questions to answer but new projects are being announced all the time. The process is developing but there is always room to learn lessons from experience and new projects are showing the way. The Government does not hide from genuine problems. Far from it. After listening to constructive critisism, the Treasury responded with an Action Plan to drive PFI forward:

• the elimination of unnecessary bureaucracy that stands in the way of a rapid adoption of PFI across government;
• the publication of a new, practical PFI handbook - 'Private Opportunity, Public Benefit';
• the training of 5,000 - 10,000 civil servants to accelerate the learning process within government;
• the strengthening of the Private Finance Panel, a team of independent PFI experts, with extra resources;
• the intensification of the Treasury's central role in driving PFI forward.

Following consultation with industry and government departments, a set of principles to smooth the procurement process and set out best practice will be published by the Treasury. These draw on experience to date and build on the Action Plan. Issues to be addressed include:

• increasing the accountability for seeing a project through;
• ensuring that proposals are well thought through from the outset and thereby offer the prospect of good PFI projects;
• improving the quality of project documentation;
• improving the procurement process by speeding it up, reducing the cost and increasing the transparency.

The Private Finance Panel has started producing case studies of lessons learned from major PFI contracts.

The PFI is nothing less than a re-invention of the way public services are delivered and it requires an ongoing effort to clear obstacles to good deals as they arise. To help this process government departments are developing their own in-house expertise, usually through their own Private Finance Unit. Local authorities have set up a Unit at their association to progress private partnerships.

These units are there to make sure that opportunities for improving value for money through an injection of private money into public services are fully explored. The Treasury believes this commitment to PFI will bring more and better projects for public use.

When something is new, people inevitably show signs of caution. The PFI requires fundamental change on both sides. The public sector must give up control of how to deliver services and focus simply on what it is they want. The private sector must understand that it must take on new risks for projects to represent value for money and realise that it must operate as well as build. The signs are encouraging. Three years in, privatisation had delivered £1 billion of deals. PFI is already several times that over the same period.

The Government wants public sector services to develop and therefore recognises the value of PFI. Making good projects happen is now the priority. Partnership between the public and private sector is set to grow. The PFI is unlocking new resources and will increasingly replace old-style public sector capital spending and service procurement. The PFI has a significant future of public service provision.

---

© Crown Copyright. Economic Briefing may be reproduced for educational use, and extracts may be used, except for advertising, without specific permission, provided that the source is acknowledged

---