Wednesday, 25 March 2009

For Steve

Here, a quick recap of an earlier post - the collapse of the monoline insurance market meant it was no longer possible to do £100m plus PFIs as monoline wrapped bonds sold onto institutional investors. Big PFI projects instead went back to the banks who, due to liquidity constraints, were (and are) only willing (and able) to handle (a) smaller tranches of individual loans (b) for shorter terms e.g. 7 rather than 25 years (c) and even then only at significantly higher margins.

This left PFIs struggling to raise money on anything even approaching acceptable terms from what had suddenly become an enlarged and much more expensive herd of cats (that being the technical term for a syndicate of banks). The end result was that getting senior debt became the exception rather than the rule and more and more projects couldn’t get signed off.

So the PFI model of mixing government finance, private equity stakes and private debt effectively broke down last year. This was a shame because bringing forward PFI projects was touted by government as a counter-cyclical response to the credit crunch and subsequent recession i.e. a fundamental part of current economic policy. For instance, a January 2009 Department of Transport document on road capital projects emphasised its counter-cyclical benefits e.g. in government right now every policy needs to tick the counter-cyclical spending box cos we’ve all rediscovered Keynes.

To sort this out government finally bit the bullet on March 3rd when the Chief Secretary to the Treasury announced the setting up of a dedicated team, department unit or whatever that will lend to pretty much every current and new PFI project either in isolation or in conjunction with commercial lenders and the European Investment Bank. In other words if a PFI can’t borrow from a bank it can borrow from the Treasury.

Hang on a mo you’re thinking doesn’t the “P” in PFI stand for private not public? Ahh, the Chief Secretary to the Treasury over-emphasised, there’s still the private equity interest in each PFI so it still is “P” for private (give or take the fact that’s only ever been a wee tottie bit of the cash involved). Besides, the loans will be on what’s explicitly referred to as a “commercial” basis, the risk involved will still be transferred to the private sector, via the private equity stake, and what’s currently envisaged is that when things return to normal the loans will be sold on to private investors and the team, unit, department or whatever it is will shut up shop.

So that’s alright then isn’t it? Ish, I mean the stuff will still get built, but this new approach still leaves a coupla wee things to ponder. One is that the Treasury needs to intervene at all because doing so makes clear right now a wholly private sector funded PFI would fail the value for money test that needs to be passed to justify using private rather than public finance. Then there’s the Treasury’s reference to the loans being made on a “commercial” basis. A polite person might describe that as a rhetorical flourish, an honest person would describe it as mince. By definition, the loans can’t be on commercial terms because the Treasury is only intervening due to the fact the commercial terms currently available are unacceptable.

Instead, “commercial” here simply means interest will be charged on debt lent via contractually specific loans. Arranging things this way will make it easier to eventually sell on the debt while neatly confirming the government’s continued commitment to PFI.

Lets try and be understanding for a minute, this approach could arguably be justified on the grounds that we are currently living in exceptional times. Except it effectively assumes private finance will pass the value for money test in due course i.e. in a future nobody can predict give or take the fact we know the cheap private credit PFI depended on is less likely to be available due to the current regulatory response to bank liquidity and balance sheets that will permanently constrain their ability to throw cheap debt at things.

But, hang on a mo, isn’t the government doing this as a counter-cyclical response to the recession? Yup. But, won’t charging interest reduce the total amount being spent on new construction because interest will have to be (re)paid as well as the capital? Err, possibly. So that means the taxpayer will get less bang for their counter-cyclical buck? I’m sorry I don’t quite understand. Well won’t fewer new schools and hospitals get built? Perhaps. So less people will be employed building things and more kids will have to be taught in poor quality buildings for longer essentially because of an ideological commitment to PFI? I really think you need to look at the bigger picture here, after all PFI is a key means of transferring risk from the public to the private sector.

Transferring what risk? Well take the Scottish Parliament for example - generalist civil servants managed a wholly government funded project requiring specific skills and repeatedly caved into incessant political tinkering that led to costs reaching astronomical levels, I mean how good an argument in favour of PFI do you need? Ahh, so a PFI establishes a discipline whereby the sponsor agrees a detailed set of specs they are more likely to stick to while whoever won the construction contract has to work within the costs they originally estimated in their tender regardless of whether it turns out the land has all sorts of unexpectedly expensive problems to deal with? Pretty much, I mean look at the example of the PFI contract to build a National Physical Laboratory where, after getting their costs wrong, the private sector ended up losing an estimated £100m on facilities that eventually cost government £140m. Now that’s risk transfer or to be precise that’s the transfer of “construction” risk because the time things are most likely to go wrong is when stuff is getting built. Aye fair enough, but isn’t it much better just to moan about how much PFI costs? Well it certainly makes for better headlines.

Except, wouldn’t establishing an arms length government construction agency or an independently chaired quango to agree final specs with say an executive appointed on 5 year terms, thus at a remove from political tinkering, have much the same effect? Perhaps. And see this risk transfer thing? Uh huh? Well has the credit crunch no suddenly made clear that relying on PFI to finance the construction of infrastructure actually builds a new and unanticipated risk into the provision of basic services and infrastructure i.e. we’ve now learned the reality is that rather than transferring risk, PFI simply swaps one risk (construction) for another? (bank liquidity). Err, yes, but these are exceptional times, so shut it.

And see this funding of this new PFI arrangement? Aye, what? This emphasis on clawing back departmental underspends to create a pot to finance the loans, does that no mean that rather than any additional spending its simply generating different spending with the total unchanged? Mebbe. So it’ll have a limited net effect or even less of an effect given interest will be charged? Well that’s certainly something to consider, however, the announcement also made clear there is now additional scope for government to undertake additional borrowing to fund the loans, so we could well see some real net gains, plus there is the “multiplier effect” due to the types of activity likely to be financed. What’s a “multiplier”? Well buying bricks to build a hospital means brick makers have more money to go out and buy things and so on. So will this multiplier effect outweigh the consequences of charging interest? Err, I don’t know.

And see with the financing being funded via a clawback from existing departmental budgets AND additional government borrowing, does that mean government can borrow for capex cheaper than the private sector? Don’t know. Are you getting huffy? No am no. Aye you are, its no my fault PFI has suddenly become a wholly redundant exercise what with the debt required currently unavailable and the fact that when any Treasury loans are eventually sold down the risk transfer will be completely negligible given it’ll be wholly post construction. Well no one knows the future, so I couldn’t possibly comment.

Aye fair do Nostradamus, its no as if it isn’t feckin obvious, but howabout this risk transfer thing one last time? What about it? Well, is that why post-construction PFI projects typically go back to their lenders and refinance i.e. renegotiate cheaper credit? Yup. So this post-construction refinancing was that why whoever provided the equity in the first PFIs made huge gains simply because the Treasury hadn’t taken it into account? I think that’s a very, very simplistic account of a complex situation. Aye, anyway, what about now? Well, for a few years now any refinancing gains have had to be shared with the Treasury i.e. the taxpayer. Really? That sounds pretty reasonable then. Yup, but again it doesn’t make for good headlines.

So can I ask another question? Sure. Why are you doing this analysis as a fake conversation kinda Q&A session? No idea I should probably stop, there again it is a useful device for pointing out PFI’s practical limitations.

But, isn’t having a go at PFI right now like shooting fish in a barrel? Sort of, except there’s a political consensus in favour of it – the Tories like it as do the leaders of the Labour party, who cares about the LibDems while the SNP’s Scottish Futures Trust alternative looks more and more like a joke every day.

Why does that matter? Well it means any criticisms of PFI tend for the most part to be couched in ideological terms rather than practicalities and as such can be easily rebutted. You know the kind of thing “PFI is the creeping privatisation of the NHS”. To which anyone can say whoop-de-feckin do, isn’t the point of the NHS to provide universal access to the best medical treatment available rather than debate who the providers are (for those interested in this kind of stuff the relevant thing would be the debate over clause 4 of the Labour party constitution and its subsequent rewriting)?

So are there any other practical criticisms of PFI? Yup. Such as? Well, a good one is the fact that by locking local authorities, NHS trusts etc. into 25 year contracts, the client can’t change how they deliver services or at least not without incurring mucho penalty costs. So say in 10 years time it turns out transferring more medical services to GPs would save more lives, there could be an off-puttingly large penalty cost due to it taking business away from PFI hospitals.

Fair do’s, so setting aside the “oohhh, we’re all indebted cos of PFI” and “oooohhhh its privatising the delivery of public services” mince, all this means PFI –

1) No longer passes the value for money test i.e. government borrowing would be cheaper. Moreover, the cost of borrowing from banks is unlikely to fall back to the kind of low levels seen before the credit crunch, ever!
2) It turns out the risk transfer argument is actually about swapping risks and if it involves selling on debt in however many year’s time will simply see government reducing its indebtedness i.e. PFI is simply about playing with balance sheets
3) Government charging interest could well raise the cost of capital spending beyond what it might otherwise have been, reducing the amount of work that gets done as a result
4) The notion of this being counter-cyclical is consequently open to serious scrutiny as a result of these interest costs and the clawback from existing budgets.
5) The market discipline PFI imposes could potentially be permanently achieved by other means that avoid the additional cost of borrowing from the private sector.

“Again I think you’re taking a much too simplistic approach here”, said the Treasury civil servant with responsibility for PFI policy.

P.S. Steve, I hope this makes sense

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