Select Committee on Health Appendices to the Minutes of Evidence


APPENDIX 22

Supplementary Memorandum by Professor Allyson Pollock (PS 54C)

CAPITAL INVESTMENT IN THE NHS—IS IT VALUE FOR MONEY?

SUMMARY

  Government officials, civil servants, and NHS directors of finance and chief executives present the case for a PFI project as providing value for money (VFM), implying that it is cheaper.

  This is misleading. The VFM analysis is not a cash analysis, but rather an economic appraisal designed to give the right answers. It is not a guide to affordability.

  VFM comparisons do not give us information about the relative costs of schemes to an individual NHS organisation.

  VFM compares the costs of a privately financed project with the public sector comparator discounted over the lifetime of the project, to produce a Net Present Value (NPV).

  Three factors skew the VFM appraisal in favour of private finance: the profile of expenditure payments in combination with a discount rate, the level at which the discount rate is set, and assumptions about risk transfer.

  The payments for the public sector comparator (PSC) are front-loaded whereas private finance initiative (PFI) payments are spread over 30 years. Applying a discount rate favours the option that delays expenditure into the future. The long repayment period under PFI is critical in demonstrating that PFI is value for money. It is essential to note, however, that the public sector could also spread payments for the PSC scheme over a 30-year period thus removing the disadvantage given to the PSC.

  Social welfare economists state that the choice of a 6 per cent discount rate is too high for the opportunity cost of public capital. This high rate materially affects the outcome and favours private over public projects.

  Regarding risk transfer, in each of six PFI hospital schemes the VFM case could not be made prior to risk transfer even after taking into account the payment profile and discounting. In addition in these schemes for most of the schemes the value of the risk transferred is the difference between the costs of the PSC and the PFI.

CONCLUSION

  The function of the economic appraisal is to disguise the true costs of using private finance. It does this by inflating the cost of the PSC by a value broadly equivalent to increased costs of using private finance. Risk transfer assumptions are the main mechanism for disguising the true costs of using PFI compared with a public sector alternative.

  The decision to use private finance, which is an untried and untested method of planning and funding new capital investment in the NHS, turns on marginal benefits of less than 1 per cent of the total VFM case and unsubstantiated and untested claims about risk transfer.

14 December 2001

VALUE FOR MONEY IS NOT A CASH COST. IT IS AN ECONOMIC APPRAISAL

  1.  The value for money (VFM) case of a PFI scheme is an economic appraisal which aims to compare the economic cost of the NHS borrowing money directly to build the hospital and of providing the services within the hospital itself, with the cost of using the private sector. The former is known as the Public Sector Comparator (PSC), the latter as the PFI option.

  2.  There are two points to note about the VFM appraisal:

    (i)  first, there is very little chance of the publicly funded option being allowed to proceed. Central government has signalled that PFI is the only source of funds for refurbishing and building hospitals. As far as health officials are concerned, if the PFI option is found to be more expensive than the PSC then the refurbishment or rebuilding of a hospital will not go ahead. The NHS is very aware of the lack of other options and is thus keen to show that PFI schemes are both affordable and value for money. There is thus an incentive to show that the PSC is more costly than the PFI option;

    (ii)  second, the VFM analysis does not compare the actual cash costs of the PFI option and the PSC option. This prevents decision makers from assessing either the true cost implications or the real efficiency savings associated with each scheme. Thus VFM comparisons do not give us information about the relative costs of schemes to an individual NHS organisation. According to NHS Executive guidance:

        NHS economic appraisals are often represented by Discounted Cash Flow (DCF) analysis, a technique used to assess the relative economic costs of investment options to the public sector as a whole (that is, not to individual NHS organisations). It is a means of expressing within a single criterion (for example, Net Present Costs or Equivalent Annual Costs) the total cost implications of developments when summed over a given appraisal period (typically 60 years) and discounted to reflect the public sector time preference.[34]

  3.  It is not uncommon for civil servants and DoH officials to confuse and conflate VFM with affordability. However, government guidance makes clear that a VFM analysis is economic not financial. An economic analysis includes non-cash elements and applies to costs and benefits across the public sector. In an economic analysis, non-cash elements may be given a financial value for comparative purposes but this does not make them cash costs.[35]

How does the VFM analysis compare with the cash costs to the public body?

  4.  Table 1 sets out the annual cash flow associated with the PFI scheme and with a hypothetical public sector scheme for Carlisle Hospital PFI. It shows the actual cash difference between the schemes and the effect on this cash difference first of risk transfer and then of discounting.

  5.  In the Carlisle Hospital PFI scheme the actual cash costs of the PFI option and the PSC over 30 years were £573.9 million and £491.8 million respectively. From this it is clear that the public sector option was £82.1 million cheaper.

  6.  The figures used by the NHS trust to justify the use of PFI, however, were not cash costs. Instead, the figures were presented in terms of Net Present Values (NPVs) (see below). Under this method of economic appraisal the PSC was valued at £174.7 million while the PFI option was said to be £0.7 million cheaper at £174.7 million as table 1 shows.

Table 1

COMPARISON OF CASH AND NPV COSTS OF PFI AND PSC IN THE CARLISLE PFI HOSPITAL SCHEME

Scheme
Total cash cost over 60 years
£ million
Total risk valuation
£ million
Risk adjusted total cash cost
£ million
Total discounted cost (60 year NPV) £m
PFI
573.9
+1.0
574.9
174.0
PSC
491.8
+59.6
551.4
174.7
Difference between the PSC and PFI
+82.1
  
+23.5
-0.7


  Carlisle PFI—Economic treatment (30 year concession: 60 year NPV)

  Source: Derived from Carlisle Hospitals PFI Full Business Case, Appendices Volume 1, appendix B.

THE VALUE FOR MONEY APPRAISAL

  7.  The value for money appraisal is a function of:

    —  the application of a discount rate to a schedule of annual payments; and

    —  the valuation of the risks transferred to the private sector.

DISCOUNTING

What are Net Present Values and how are they arrived at?

  8.  A Net Present Value (NPV) is the cost today of paying for something at some point in the future. Discounting thus places a lower value on expenditure occurring in later years as Figure 2 demonstrates.


  9.  The graph shows the NPV in today's prices of delaying £1 million expenditure from year 1 to year 30 using a discount rate of 6 per cent per annum. Thus it can be seen that the effect of delaying £1 million worth of expenditure to year 30 gives it an NPV of £174,000. The further into the future one makes payments, the lower the cost is said to be at today's value.

  10.  The reason why the PFI has a lower NPV than the PSC lies in the different assumed expenditure profiles for the two schemes (ie, when payments are made). Under PFI, payments to the Special Purpose Vehicle (SPV), the company established by a PFI bidder specifically for the project, are spread over 30 years. Under the PSC option, however, payments are made very early on in the project (they are "front loaded"). As shown above, payments which are made later are said to cost less than payments which are made sooner. Table 2 demonstrates the effect of discounting on the payments made each year under the PSC option and the PFI option.

  11.  There are two points to note from table 2:

    —  The time that a payment is made affects the value of the payment. As can be seen from the table, under the PSC most of the payments are made at the start of the project thus giving them a higher value. For PFI, payments are spread across the contract period thus giving them a lower value.

    —  The cash cost of the PSC at £115 million is lower than the PFI option of £130 million. The situation is reversed after discounting, when the NPV cost for PFI lower than the PSC. This is because the PFI payments are spread over 30 years and take place further into the future. This is despite the fact that the actual cash cost of the scheme is higher. PFI appears to be value for money in this instance only because the expenditure profile is different from the PSC option.

  12.  The long repayment period under PFI is critical in demonstrating that PFI is value for money. It is critical to note, however, that the public sector could also spread payments for the PSC scheme over a 30-year period thus removing the disadvantage given to the PSC.

Table 2

EFFECT OF DISCOUNTING ON THE EXPENDITURE PROFILES OF PFI AND PSC (£M)

  
Public Sector Comparator
Private finance option
Years
Annual expenditure
Payments discounted at 6%
Annual expenditure
Payments discounted at 6%
1
15
15.00
0
0.00
2
25
23.58
13
12.26
3
30
26.70
13
11.57
4
10
8.40
13
10.92
5
5
3.96
13
10.30
6
5
3.74
13
9.71
7
5
3.52
13
9.16
8
5
3.33
13
8.65
9
5
3.14
13
8.16
10
5
2.96
13
7.69
11
5
2.79
13
7.26
Total
115
97.12
130
95.68

THE CHOICE OF DISCOUNT RATE

  13.  The choice of discount rate can also determine whether or not a project appears to be value for money. The discount rate for comparing the PFI with the PSC is set by central government at 6 per cent. Most economic commentators believe that this rate is too high and unfairly disadvantages the PSC.[36]

  14.  The VFM appraisal for Carlisle compared the cost of the PFI scheme against the PSC. As recommended by the Treasury, a 6 per cent discount rate was applied to the payment profiles for each option.

Table 3

COMPARISON OF PFI AND PSC OPTIONS IN NPVs

Discount rate %
PSC £m
PFI £m
Difference in
favour of PFI £m
6.0
174.3
172.6
1.7
5.5
185.8
186.7
-0.9
5.0
198.8
202.0
-3.2
4.5
213.9
219.5
-5.6
4.0
231.2
239.3
-8.1
3.0
275.0
288.6
-13.6


  15.  As can be seen from table 3, when a 6 per cent discount rate is used the PFI scheme is said to have a value for money margin of £1.7 million. However, when the discount rate is altered only very slightly to 5.5 per cent the PSC appears to be better value for money. Indeed, the lower the discount rate the better value for money the non-PFI option appears.

  16.  In the end, the trust chose to use the PFI even though it appeared to be only marginally better value for money than the PSC option. Moreover, the scheme would not have been considered value for money at all if the discount rate had been lowered by only half of 1 per cent.

  17.  Having examined the first part of the VFM analysis it is now necessary to turn to the second part of the economic appraisal which is risk transfer.

PLACING A VALUE ON THE RISKS INVOLVED IN THE PROJECT

  18.  It is important to remember that PFI is presented by the government as the only source of finance. In these circumstances those constructing business cases for PFI projects are under pressure to come up with the "right" answers. Identifying and placing a value on which risks exist over the course of a 25-35 year contract relies on subjective judgement. At the point when the contract is drawn up risk valuation is theoretical and not real.

  19.  A sample of hospitals in the public expenditure memorandum shows that none of the new hospitals showed value for money after discounting (see tables 4 and 5). However, the PSC at this stage has not been adjusted to take account of the risks associated with the project. The cost of the PSC thus needs to be "risk adjusted" that is, the potential cost of something going wrong with the project needs to be added to the PSC.

  20.  The effect of adding in a cost for risk transfer was to add almost £50 million to the cost of the PSC in Carlisle hospital. Table 4 shows that for each of six PFI hospital schemes the VFM case could not be made prior to risk transfer despite the more advantageous payment profile and discounting. Risk transfer accounted for the whole VFM case. In table 4 it is interesting to note the enormous variation in the value of risks as a proportion of the schemes and how the value of the risk transferred is the difference between the costs of the PSC and the PFI. Thus the whole function of the economic appraisal is to disguise the true costs of using private finance by inflating cost of the PSC by a value broadly equivalent to or greater than the difference in costs.

WHY IS PFI SO EXPENSIVE?

  21.  Risk transfer is used to disguise the higher costs to the public of using private finance. There are four reasons for higher costs under PFI:

    —  The lending rate: Andersen/LSE[37] say that senior debt finance cost "will be 1 to 3 percentage points about the public sector borrowing rate". But senior debt is only the most secure (ie, cheapest) component of PFI borrowing.

    —  Returns to shareholders: equity typically makes up a minimum 10 per cent of capital, and equity returns at the new hospital at Dryburn in North Durham were stated to be 18.5 per cent. At Haverstock School in Camden the school was budgeting on returns of 15 per cent.

    —  The amount of capital to be raised (total capital cost) through loans or equity; PFI total capital cost is inflated by financing costs. These include certain professional fees arising from private lending but are mainly the product of capitalising interest due during the construction period (rolled up interest). Financing costs at Dryburn, Carlisle and Worcester were, respectively, £18.2 million, £16.7 million and £29.9 million.

    —  Transaction costs of PFI preparation: these costs include professional fees for contract specification, etc. They are not always identified. For example, NHS Estates showed that the Carlisle SPV did not identify any costs "prior to the date of the signature of the agreement unlike the PSC where the Trust has identified a cost associated with the preparation of the business case." NHS Estates assumed that the costs were capitalised.[38]

RISKS RETAINED

  22.  Risk is transferred through the PFI contract and by no other means. If the SPV has not taken on a liability through the contract, it remains with the NHS.

  23.  Furthermore, the transfer of risk only has meaning if the SPV faces financial loss if something goes wrong. It is not enough for the trust to assert that risk has been transferred. It has to show that legally enforceable financial sanctions of sufficient seriousness to "incentivise" the SPV are available.

  24.  However, for various reasons including no alternative providers and no public capacity, the public may not be able to enforce the contract. Take the recent problems with the Passport Agency PFI contract. The SPV (Siemens) which had been contracted to develop a new IT system for processing passport applications was, under the contract, supposed to take on the risk of late delivery or system failure. In the event when the IT system encountered difficulties the processing of passports was disrupted, long queues developed outside Passport Offices around the country and the additional cost of rectifying the problem was passed on to the public in the form of higher charges. The overall cost to the public sector of service failure was £12.6 million, which was in part recouped by an increase in the fee for a standard 10-year passport from £21 to £28. Siemens made a derisory compensation payment of £2.45 million over several years, thus it was clear that the risk of something going wrong was still borne and paid for by the public.[39]

  25.  The same applies to a hospital. If a ward is out of action the SPV will not receive full payment under the contract. However, this will cause disruption to patients and staff and will impede health care delivery. Alternative arrangements would have to be made and additional cost may well be incurred by the hospital. While in theory the SPV takes on the risk of a ward not being available, in practice the patients and staff will still suffer adverse consequences.

Table 4

A COMPARISON OF THE COSTS OF HOSPITALS UNDER PUBLIC AND PRIVATE FINANCE (£000)

Hospital
  
PSC
PFI
Swindon and Marlborough
NPC
1,246.7
  
1,263.3
  
  
Risk
64.6
  
47.3
  
  
Risk adjusted cost
1,311.3
  
1,310.6
Kings Healthcare
NPC
29,935.4
  
29,958.3
  
Risk
24.7
  
0.9
  
  
Risk adjusted cost
  
2,906.1
  
29,959.1
  
St George's Healthcare
NPC
552.4
  
564.3
  
  
Risk
13.6
  
1.1
  
  
Risk adjusted cost
  
565.9
  
565.3
South Durham
NPC
665.3
  
671.4
  
  
Risk
9.5
  
0.4
  
  
Risk adjusted cost
  
674.8
  
671.8
Hereford Hospitals
NPC
665.9
  
680.3
  
  
Risk
26.7
  
4.8
  
  
Risk adjusted cost
  
692.6
  
685.1
South Tees Acute Hospital
NPC
201.7
  
230.5
  
  
Risk
69.9
  
1.8
  
  
Risk adjusted cost
271.6
  
232.2


  Source: Department of Health. Expenditure questionnaire 2000. Memorandum to the Health Committee, NHS resources and activity. London: The Stationery Office, August 2000.

Table 5

A COMPARISON OF THE DIFFERENCE BETWEEN THE PSC AND THE PFI AND THE RISK TRANSFER

Hospital
Difference between the value of the
PSC and the PFI
£ million
Net value of the risk transfer
£ million
Swindon and Marlborough
-16.6
17.3
Kings Healthcare
-22.9
23.8
St George's Healthcare
-11.9
12.5
South Durham
-9.1
9.1
Hereford Hospitals
-14.4
21.9
South Tees Acute Hospital
-28.8
67.8


  Derived from Table 4.

Professor Allyson Pollock

Chair, Health Policy and Health Services Research Unit, School of Public Policy, UCL

Director, Research and Development, UCL Hospitals NHS Trust



34   NHSE. Principles of GEMS for FBC option appraisal. Original emphasis. Back

35   Carlisle Hospitals FBC, Appendices Volume 1, Appendix B: Discounted cash flows for each option and underlying assumptions, paragraph 10 General Assumptions for example in the case of Carlisle, it compares PFI and PSC VFM costs under the heading (p 2) "How was the private sector option preferable in financial terms ie value for money?". Back

36   Ulph D. Contract Theory and the Public Private Partnership proposals for the London Underground Railway System. Available at: http://www.indsoc.co.uk/tube/report/Appendix-II-Prof-Ulph-report-230900.pdf. Back

37   Arthur Andersen & Enterprise LSE. Value for money drivers in the Private Finance Initiative. URL: http://www.treasury-projects-taskforce.gov.uk/series-1/andersen/7tech-contents.html. Back

38   Carlisle Hospitals FBC, Appendices Volume 1, Appendix G, paragraph 8.1.e. Back

39   J Shaoul "Passport to Paralysis" Public Finance 21-27 July 2000. Back


 
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