Supplementary Memorandum by Professor
Allyson Pollock (PS 54C)
CAPITAL INVESTMENT IN THE NHSIS IT
VALUE FOR MONEY?
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.
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
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
(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.
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
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
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
COMPARISON OF CASH AND NPV COSTS OF PFI AND
PSC IN THE CARLISLE PFI HOSPITAL SCHEME
|Scheme||Total cash cost over 60 years
|Total risk valuation|
|Risk adjusted total cash cost|
|Total discounted cost (60 year NPV) £m
|Difference between the PSC and PFI||+82.1
Carlisle PFIEconomic treatment (30 year concession:
60 year NPV)
Source: Derived from Carlisle Hospitals PFI Full Business
Case, Appendices Volume 1, appendix B.
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
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
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
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.
EFFECT OF DISCOUNTING ON THE EXPENDITURE PROFILES OF PFI
AND PSC (£M)
| ||Public Sector Comparator
||Private finance option
||Payments discounted at 6%
||Annual expenditure||Payments discounted at 6%
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.
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.
COMPARISON OF PFI AND PSC OPTIONS IN NPVs
|Discount rate %||PSC £m
||PFI £m||Difference in
favour of PFI £m
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.
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
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
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
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
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
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.
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.
A COMPARISON OF THE COSTS OF HOSPITALS UNDER PUBLIC AND
PRIVATE FINANCE (£000)
|Swindon and Marlborough||NPC
| ||Risk adjusted cost
|Risk adjusted cost||
|St George's Healthcare||NPC
| ||Risk adjusted cost
| ||Risk adjusted cost
| ||Risk adjusted cost
|South Tees Acute Hospital||NPC
| ||Risk adjusted cost
Source: Department of Health. Expenditure questionnaire
2000. Memorandum to the Health Committee, NHS resources and activity.
London: The Stationery Office, August 2000.
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
|Net value of the risk transfer|
|Swindon and Marlborough||-16.6
|St George's Healthcare||-11.9
|South Tees Acute Hospital||-28.8
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
NHSE. Principles of GEMS for FBC option appraisal. Original emphasis. Back
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
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
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
Carlisle Hospitals FBC, Appendices Volume 1, Appendix G, paragraph
J Shaoul "Passport to Paralysis" Public Finance 21-27
July 2000. Back