Memorandum by Professor Allyson Pollock
Capital investment in the NHS under the 1990
NHS and Community Care Act: the impact of moving from government
grant to debt finance in an under-funded system.
1. The founding principles of the NHS are
comprehensive care and services free at the point of delivery,
delivered on the basis of equity. As a national health service
it has neither local tax raising nor income generating powers.
Indeed such powers would contravene the spirit of the NHS, returning
health services to the inequitable situation which pertained pre-1948relying
on the wealth of local areas and introducing regressive elements
to its funding.
2. The goal of equity is achieved by using
the mechanisms of risk pooling and cross subsidisation. Risk pooling
and cross subsidisation were embedded in the structures for the
funding and organisation of services. These structures have until
1991 shielded the NHS from the adverse consequences and extra
costs of market forces.
3. From 1948 until 1991 funding for NHS
capital investment was distributed as government grants, and planning
structures were evolved to link planning, population needs, and
funding. However, as documented by the official NHS historian
Charles Webster, the NHS inherited badly run-down estate with
enormous inequities in the pattern and distribution of services
across the country.
From the outset, capital funding was inadequate and the new hospital
building programme did not start until 1962 and was never completed.
In recent years net expenditure on capital investment has been
negative, indicating that the NHS was consuming itself in order
to pay for capital investment (fig 1).
4. The NHS brought all hospitals and health
service facilities apart from GP practice premises under public
control and ownership. No charge was made on capital as to do
so would have aggravated the inequities in distribution.
5. The implementation of the internal market
and the purchaser-provider split in 1991 established shadow market
mechanisms and structures which allowed NHS services to be priced,
bought, and sold. The new pricing mechanisms also involved trusts
having to establish the costs of treatment and account for the
use and consumption of capital, known as capital charging. No
longer funded by block grants administered by health authorities,
NHS service providers had to win contracts from NHS purchasers.
Hitherto, private sector provision to the NHS had been curtailed
by the financial and organisational arrangements that protected
services from the market. Now the intention was to put the public
sector on the same footing as the private sector, thereby facilitating
the entry of private sector providers.
6. An important consequence of the internal
market was to undermine the principle of cross subsidisation by
requiring a costing methodology which would allow each element
of the service to be priced for the market place. This includes
a cost for capital. However, unlike factories products where the
cost of raw materials and plant can be divided by the number of
products, accurate costing for complex patients and treatments
is impossible. Pricing also introduce new transaction costs and
new inefficiencies by requiring the elimination of cross subsidisation
and hence risk pooling mechanisms of services.
7. The introduction of capital charges ended
the era of funding NHS investment using government grant. The
government switched to debt finance, requiring NHS services to
make a return on capital employed and paying the government as
banker and shareholder. From 1991, NHS hospitals were established
as trusts with three statutory duties all of which are financial.
Trusts were required to (i) make a 6 per cent return on capital
employed equivalent to an interest charge and public divided (ii)
break even after paying interest (not dividends) and (iii) stay
within the external financing limit. There is no logic in requiring
NHS services to make a return on capital because the value of
NHS estate is a function of historical supply and location and
in any case there is little logic behind requiring government,
as owner of capital, to pay itself for the use of that capital.
However, despite this major change in policy neither the rationale
for requiring NHS trusts to make a return on capital, nor the
choice of a 6 per cent rate of return on capital employed have
ever been challenged or properly evaluated.
8. Trusts reflect the additional costs of
capital charges in the prices they charge to the purchasers. Health
authorities receive capital charges on the basis of the services
within their area, not on the basis of the contracts they place.
Trusts charge purchasers on the basis of their capital costs and
not o the basis of the allocations purchasers receive to cover
the cost of capital. The capital charge element of the price is
an important lever in establishing different prices referred to
as Reference Costs across NHS providers thereby enabling competition
for services and the forcing down of prices, as the government
funds services on the basis of average prices. The main point
to note is that pricing is an arbitrary, unscientific and inexact
mechanism as it involves different assumptions and there is no
standardised methodology for pricing any of the components which
make up the service. More importantly it removes the crucial element
of cross subsidisation.
9. Capital charges are supposed to be resource
neutral. However they are a source of leakage since services formerly
supplied by the NHS and provided by the private independent sector
also include a charge for capital. It can thus be seen that even
at the system level capital charges are not being as resource
neutral as they were originally intended to be.
10. Moreover at local level capital charges
can represent a real cost or a real saving depending on how services
have been priced. There is a lack of transparency in the formula
and methods of calculating and allocating capital charges to purchasers
and from purchasers to providers of health care. There has never
been an evaluation of the capital charging regime, with respect
to equity and planning.
11. Two arguments are commonly made to support
the introduction of capital charging. The first, that the introduction
of capital charges would increase the efficiency of the NHS's
use of assets, has no evidence to support it. On the contrary,
the problem stemmed from government failure to inject sufficient
capital funds.2 The second claim is that because capital charges
are or have been non-cash allocations they are resource neutral
and there is no net effect on local services. That being the case
one might ask why the government chose to put in this complex
12. In an under-funded NHS the introduction
of capital charges has had catastrophic effects. Their introduction
in NHS trusts in the 1990s had strongly negative effects on trust
assets and finances. Aggregated financial accounts of NHS acute
hospital trusts in England for 1992-98 inclusive show that trusts
as a whole failed to make the 6 per cent target rate of return
in all years except 1992 and 1994 (table 1). Even then, many trusts
were unable to break even after paying interest. The cost of capital
charges to the NHS as a whole might have been zero; but their
average cost to each NHS acute hospital trust in 1998 (the first
year when the government collected the full 6 per cent) was £393,000.
In fact, the situation was so parlous that the Department of Health
decided not to collect the full 6 per cent until 1998.
13. The National Audit Office annual accounts
show that in 1999-2000 78 trusts were in serious financial difficulties,
failing to meet all their statutory financial duties.
The Department of Health's recent departmental report
lists as one of the causes of trusts failing in their financial
duties "financial problems in Health Authorities leading
to Trusts being unable to agree prices sufficient to cover their
costs plus the 6 per cent rate of return" (12.24, p 92).
14. The second argumentthat capital
charges have forced NHS trusts to weigh the worth of capital expenditure
against the opportunity costs forgone and that that is a good
thingignores their actual impact. Trusts were reluctant
to undertake any new investment because increasing the value of
the asset bare increases capital charges. In other words at the
local level charges acted as a real cost pressure. Capital charges
deterred trusts from undertaking what the DoH regarding as a reasonable
amount of expenditure for capital goods. In the first three years
of their operation, NHS acute hospital trusts in England underspent
on their capital budget by an average of £200,000 per year.
Between 1993 and 1997 NHS backlog maintenance costs rose from
£2.4 billion to £3.1 billion.
15. These shortfalls were a direct consequence
of underfunding and the reluctance to take on the debt servicing
costs arising from capital charges. Capital charges encouraged
NHS trusts to sell NHS assets. As well as contributing to longer
waiting lists, the loss of capacity arising from such sales and
consequent reductions in bed numbers has been regretted in the
report of the National Beds Inquiry
and in the NHS Plan.5 Capital charges have had a strongly negative
impact on the capital base of the NHS (and especially on planned
capital expenditure) and in particular accelerated the decline
in service capacity. The volume and scale of land sales and disposals
has not properly been recorded or been made subject to parliamentary
scrutiny. Nor has the DoH published a proper estimate of the cash
released from land sales, nor has it described how land sales
and the subsequent use of PFI (see below) affect the capital charging
16. Just as the rationale behind the policy
which saw a switch fro government grant to debt finance has never
been questioned, neither has the switch to private finance the
system where the government borrows indirectly by raising funds
for capital investment through an intermediary of businesses and
banks. In the case of hospitals, a consortium of bankers, builders
and service operators known as a special purpose vehicle raise
the finance for capital investment, in return for which they design
build and operate the buildings and receive an annual fee which
covers cost of capital, interest and services.
17. In the absence of government grant or
public finance for new capital expenditure private finance is
the only source of funds for new investment. This means that trusts
have had not only to consider capital charges on retained estate
but also the effect of diverting revenue budgets to service the
real debts of the new owners of capital, ie the PFI consortia.
18. The government and its civil servants
persistently challenge the notion that PFI is responsible for
the reductions in bed numbers and claim either that the clinicians
decide the bed numbers or that reductions in bed numbers were
simply a function of previous trends. But as we have repeatedly
shown using government data, while reductions in bed numbers have
been occurring, the DoH bed statistics indicated a flattening
out of efficiency savings from increasing the proportion of day
case surgery, reducing length of stay and increasing bed occupancy
rates as early as 1995.
Moreover reductions in acute beds have plateaued since 1995. It
was notable that all PFI schemes involved major reductions in
acute bed numbers and services and that rehab and longer stay
beds are being closed to fund PFI hospitals.26, 27, 28, 
19. The reductions in bed numbers are also
the result in part of the introduction of the capital charging
regime which created a pressure locally to decrease the estate
(see above). Capital charges were a new claim on scarce revenue
budgets and their effect has been compounded by the switch to
using private finance which is very expensive. PFI and capital
charges, as finance directors acknowledged, created a major affordability
gap. This arose between what the purchasers (health authorities
and trusts) said they could afford and the requirements of the
PFI consortia. The affordability gap arose in part because of
the high costs of any new investment. It can be seen (table 2)
that the capital value of the new estates is much higher than
the asset value of the hospitals they are replacing, even through
the new schemes are generally situated on smaller and cheaper
land sites and one hospital with a much smaller capacity is replacing
up to two or three hospitals. Moreover most if not all of these
schemes have seen a rapid escalation in costs from outline business
case of more than 200 per cent (table 3).
20. The higher capital expenditure necessarily
incurs higher capital charges in the form of PFI payments and
a capital charges on retained estate and equipment.
21. Regardless of the reasons for the higher
cost and the cost escalation, the important point to note is the
impact on the revenue budget where the annual cost of capital
to PFI hospitals has risen from an average of 9 per cent of annual
revenue to 20 per cent (table 4). The escalating costs of using
PFI and the increased leakage of money from the revenue budget
results in reductions in the budget available for care.
22. All cost increases resulting from capital
investment have to be met from the revenue budgets. Our research
into the first 14 PFI hospitals has shown that the affordability
gap is bridged in four ways: (i) through subsidies and smoothing
mechanisms from the Treasury for the first batch; (ii) the diversion
of regional capital budgets which were originally intended for
other parts of the NHS; (iii) through diversion of resources from
other services and land sales; and (iv) through cuts in the actual
23. Attempts to keep the costs down have
seen dramatic average bed losses of 30 per cent in the first 11
PFI hospital schemes and reductions in clinical budgets of up
to 20 per cent, the relocation to cheaper land sites in order
to offset the higher costs by land sales, and the removal of equipment
from the schemes.
24. The source of evidence for the downsizing
in bed numbers and staff budgets lies in the planning documentation
which underpins the Full Business Cases. Trusts have been given
unprecedented control over the planning of new hospitals, employing
their own management consultants and advisors. Formerly regions
did planning on the basis of population needs. Now health authorities,
regions, and clinicians have no active input into determining
service capacity. Many of the full business cases do not give
detailed caseload and bed planning numbers. There has been a major
and unexplained departure from traditional normative and trend
based planning. Moreover, much of the planning shows a failure
to adhere to standardised DoH definitions of caseload and beds,
making interpretation and comparison of previous and current bed
numbers and caseload almost impossible. This has led to statistical
25. The planning documentation available
reveals that management consultants were either incompetent or
simply doing the task they had been asked to do, namely, using
unrealistic performance targets for length of stay, occupancy,
and day case surgery to justify major reductions in bed numbers.
Many of the plans use selective non-evidence-based reviews of
admissions to claim that caseload could be deflected to alternative
settings, but the location, nature and costs of alternative settings
are not provided.
26. Civil servants have pointed out that
bed numbers are now increasing in PFI schemes since the National
Beds Inquiry. But three points should be noted. First, there has
been no increase in the baseline of total bed numbers, but rather
13,000 NHS beds have closed since 1997. The reported increase
in general and acute beds is simply a reclassification of the
beds and not an actual increase in the overall total number of
NHS beds. Second, it is not entirely clear in which sector the
increased bed provision is to be provided ie whether in public,
for-profit, acute, or nursing home beds. The final and most important
point concerns how the increase in beds and services are being
funded. Where PFI schemes have increased bed numbers from the
original plans this must increase costs. It is important to ascertain
how service increases are being funded and whether it is at the
expense of the system as a whole.
27. Although more money has been pledged
to the NHS under the Comprehensive Spending Review, it is not
known whether it will be enough to cover the increased cost of
capital, let alone keep pace with service needs. The review allows
for average annual real terms increases of 6.1 per cent in NHS
UK funding over the four years to 2003-04. But NHS pay and prices
increase faster than inflation and many trusts report annual cost
pressures of 6 per cent just to maintain current service levels
and eliminate deficits. Moreover much of the new money has been
earmarked for modernisation and is not being distributed to the
28. Trusts are under a great deal of pressure
not to reveal their financial difficulties or the real cuts, which
are taking place in services. The new performance framework is
tied to performance targets for the NHS which includes a financial
requirement to break even. Trust chief executives' and directors'
pay and careers are predicated upon gaining a three star rating.
The new performance framework which allows three star trusts new
earned autonomies includes greater financial decision-making and
control over the use of resources from land sales and entering
PFI deals and setting up private companies. While providers are
in an increasingly powerful position regarding the planning of
services they are now also responsible for their own investment
and their own revenue to break even. The government has introduced
new guidelines and powers which will for the first time in 50
years introduce a time limit to NHS care through the creation
of an intermediate care sector. Trusts will have the potential
to redefine some NHS care as personal care and to introduce charges
29. This has major implications for accountability
and transparency. Under these conditions, it will become increasingly
difficult for the public to understand what is going, on how care
is being paid for and how it is being redefined. This has the
potential to increase inequalities in access and will invariably
lead to increasing fragmentation and loss of co-ordination in
planning and providing care.
30. The system of capital charges (public
debt finance) makes new investment unaffordable whether public
or private. There is no logic in requiring NHS services to make
a return on capital because the value of NHS estate is largely
a function of historical supply and location. Private finance
diverts scarce resources away from services to paying the new
owners of capital, and exacerbates under-funding and decreases
the volume of services available to the public.
31. If the government is committed to an
affordable universal national health service and to expanding
the range and volume of services which have been lost, it would
abandon the system of debt financing, reinstate government grant,
and properly resource the revenue requirements. It would also
abolish the internal market and pricing and restore planning structures
thereby reversing the trend which has seen population needs divorced
from service planning.
32. The indications are that the retention
of market structures, the establishment of trusts, the capital
charging regime, the requirement to use private finance, and the
new freedoms of trusts to engage in commercial ventures will return
the NHS to a pre-1948 situation where trusts become increasingly
reliant on the wealth of the local area.
Many PFI hospitals, for instance Carlisle and UCLH, are actively
seeking charitable funds to help with revenue funding of new capital
MEAN REQUIRED AND ACTUAL CAPITAL CHARGES
PER NHS TRUST (£000)
|Year||No of trusts
||Average total income per trust
||Average operating surplus
as a % of income
|Required capital charges
||Actual capital charges
Figures are for all NHS acute care trusts in England, 1992-98
Source: Fitzhugh directory of NHS trusts.
Required capital charges = 6 per cent on capital value plus
Actual capital charges = surplus (to pay interest and dividends)
TABLE SHOWING ESCALATION IN ASSET VALUES OF A SAMPLE OF
HOSPITALS PRIOR TO AND AFTER PFI
| ||Net book value|
|Bishop Auckland (1998)||18
|University College London Hospital (2000)
|University Hospital Birmingham (2000)||145
|Norfolk and Norwich (1998)||18
|Swindon and Marlborough (2000)||21
|South Bucks (2000)||88
|South Derbyshire (2000)||130
Source: Annual reports and accounts; Department of
Health press releases.
COST OF CAPITAL AS A PERCENTAGE OF INCOME, PRE AND POST
| ||Capital as % of income
||Capital as % of projected income
|Norfolk and Norwich||0.7
|South Tees Acute Hospitals||3.9
|Dartford and Gravesham||7.5
|Swindon and Marlborough||3.3
|North Durham Healthcare||2.9
Sources: Fitzhugh Directory 1999; Health Committee,
Public Expenditure on Health and Personal Social Services 2000.
Memorandum received from the Department of Health containing replies
to a written questionnaire from the Committee. London: the Stationery
Office 2000; NHS Trusts Annual Accounts, 1998-99, 1999-2000.
Figure 1. Financing of hospital and community health
services capital expenditure, 1986-87 to 1998-99
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