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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 1146
House of commons
TAKEN BEFORE THE
Private Finance Initiative
Tuesday 14 June 2011
Richard Abadie, Andy Friend, James Wardlaw and Professor Dieter Helm
Steve Allen, Professor James Barlow, Anthony Rabin and Jo Webber
Evidence heard in Public Questions 1-134
USE OF THE TRANSCRIPT
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Taken before the Treasury Committee
on Tuesday 14 June 2011
Mr Andrew Tyrie (Chair)
Mr Andrew Love
Mr David Ruffley
Examination of Witnesses
Witnesses: Richard Abadie, Partner, PricewaterhouseCoopers, Andy Friend, Chairman, InfraMed, James Wardlaw, Managing Director, Goldman Sachs, Professor Dieter Helm, Oxford University, gave evidence.
Q1 Chair: Thank you very much for coming before us this morning. I am sorry that we have started a little bit later than planned. We will try to keep broadly to time. There is a lot of stuff to get through in a short period. We are very grateful to those of you who have also submitted written evidence, and if, at the end of what I hope will be crisp replies to our questions, you have further material you want to add, please don’t hesitate to put it in writing.
To begin the session, can I ask each of you whether you feel PFI needs radical change and, while you are thinking about that, whether you think in particular it is sustainable to continue with a 6% discount rate in view of what has been going on in the markets? Who wants to start? Professor Helm is going to make a start.
Professor Dieter Helm: Whether you think the PFI arrangements are well designed and whether you think they are sustainable depends on the question to which you think PFI is an answer. So, if you think it is an attempt to get future generations to pay for the infrastructure that is now being built on their behalf, then the answer is probably no. It is probably an unfair bargain too, because of course our generation has not maintained the infrastructure properly, which the next generation will inherit. That is the first part.
If you think it is an exercise to get investment off the public balance sheet so that the debt numbers look better than they otherwise would have done, it succeeds in that dimension so far, but of course it just reflects the fact that we have no national balance sheet to set against our assets and liabilities. Because we have cash-based national income accounts, essentially we discriminate against the future in favour of the present spending as against investment.
Q2 Chair: So, you are saying it works as an accounting fiddle but not as a sustained and fair way of transferring resources from one generation to another?
Professor Dieter Helm: It just gets national economic decisions wrong because, effectively, what it does is say, "Since we are only interested in cash in national income accounts, we are not interested in the question of what level of investment we should carry out to set against so we can set assets against liabilities".
Q3 Chair: Can this largely be solved by altering the discount rate or do we need to do more than that? Do we need to look at the structure of PFI?
Professor Dieter Helm: The discount rate is the third issue, which is: have you efficiently allocated the risk within the PFI between the state and the market? The answer is reflected in the 6% that is used, and that is almost certainly the wrong answer. What you should do is allocate the political and regulatory risk to the state-that is where they are caused-and the CAPEX risk and the operational risk to the private sector. Then you would have a cost of capital for finance that would be significantly lower than 6%. Do remember that currently, when we are trying to mobilise something like £100 billion of CAPEX before 2020 on the various Government plans we have at the moment, the current real interest rate in this country is minus 5%, and in those circumstances we choose to use a real positive discount rate because we are shifting political and regulatory risk on to precisely those people who can’t bear it. In terms of inefficiency, it is quite hard to think of many other aspects of the British economy that are more inefficient than that risk allocation.
Chair: I think that was fairly clear and pretty blistering. Does anybody want to qualify or challenge that? Don’t feel obliged to come in if you all agree.
Richard Abadie: I am happy to make just a follow up. I will keep it a lot shorter, I promise. I guess, of your two questions, effectively the first one is: does the model need to be adjusted in any shape or form? I think every form of procurement can be improved, and I think through today you will hear of some changes we can make, and it is particularly around some of the risks that are allocated to the private sector that I think can be improved. It has come through in most of the submissions that you have seen. I can go into that later.
I think, around the discount rates-I have a lot of thoughts, and clearly I don’t have Dieter’s experience in regulated assets-I would observe that the discount rate is set and has been fixed for some time, but had come down from a high discount rate of 8% probably back in 2003, I think it was. There is a real discount rate underlying that of 3.5% and there is an inflation assumption of 2.5% implicit in that. Inflation is not running at 2.5% now. I don’t know what the long term inflation is; that is not my area of expertise, but if you simply treated the inflation element of that as a variable you would have a discount rate that is higher; more like 8-8.5% in the current market. That is not appropriate either, but I don’t think that the discount rate in itself is going to solve or sort out any concerns you have with the PFI. Importantly, that discount rate does not only apply to PFI; it is applied to basic investment decisions made by Government in all sorts of areas. As contained in the Green Book, it is not a PFI-specific discount rate, so I think it is a much wider question than just for us in terms of the PFI.
Chair: Does anybody else want to chip in at this stage? Mr Friend.
Andy Friend: If I could go to the more general proposition: do we require radical surgery or more minor evolution? I think my answer, Chairman, would be that we need both at this point in history. Hopefully, we are moving beyond the world in which the off balance sheet tail was wagging the value-for-money dog. I genuinely believe we have done that. There were clear examples earlier in the decade-many of the written submissions to you refer to that-where there was distortion in the structuring of deals in order to achieve a particular accounting treatment. I think, in the position we are in at the moment, there is a raft of things that can be done, for example, in relation to insurance where perhaps inappropriate risk is transferred, where the public sector could act as co-insurer in relation to perhaps putting the Debt Management Office into a role in relation to managing the derivatives that enter into these deals. Also, to think beyond that, it is clear that we have had over the last 10 years an evolution in terms of the public sector, first through negotiation and then by contract, sharing in more of the refinancing gains. I think maybe we are now in the territory where the public sector might contemplate having a right to refinance the senior debt and the capital structure of such propositions when you get into the operational stage.
Chair: We will come on to that in a moment. Mr Wardlaw, any comments?
James Wardlaw: I only offer one thought, and that is that PFI has been an important tool in the past for procuring social infrastructure, and I make a distinction between social and economic infrastructure. A lot of the future spend, the future requirement, is going to be increasingly directed towards the economic infrastructure, by which I think we mean energy transport, those kinds of areas, rather than schools and hospitals and buildings. I think that as we look forward to the future, the role of PFI in relation to financing economic infrastructure is much more limited. Andy Love, do you have some questions?
Mr Love: I am number 27 or 28.
Chair: Andrea, why don’t you come in?
Andrea Leadsom: Same initials. Thank you, Chairman.
Mr Love: We don’t look alike.
Andrea Leadsom: No, we don’t. We are both relieved about that. Good morning.
Chair: Not as much as we are.
Mr Love: I don’t think I can answer that.
Q4 Andrea Leadsom: I am unusually speechless; it is rare for me.
I want to press you a bit more on the off balance sheet financing. Mr Friend, if I get it right, you said you think the off balance sheet tail is no longer wagging the value-for-money dog, and I am still puzzling over that. Is it not the case that one of the biggest drivers for the continuation of PFI is precisely that, that it is still at a national debt level, albeit organisationally it is now off balance sheet? Nevertheless, in national debt statistics it is still off balance sheet. Don’t you think that remains a big driver for PFI?
Andy Friend: It may at the national policymaking level. I think what I observed-and I was active in the market up to 2006-was that both at the programme and at the project level, the off balance sheet treatment contributed very much to the repeated phrase in the evidence before you: it was the only game in town, therefore we went for it. At the programme level, I believe in certain situations it encouraged over-consumption and decisions to be too lightly taken in terms of procuring very substantial capital assets, perhaps without due consideration of either the alternatives-of which there are many, much less developed in the UK market than elsewhere-or the long term obligations.
At the deal level, in terms of the single project as opposed to the programme, I think that the lawyers in the early part of the last decade were the sort of guardians of PFI theology. They were often confronted by people in local organisations who had neither adequate senior backing nor necessarily the commercial skill-base that was required, and PFI theology said you would transfer any risk you could identify, so we had things like energy tariff risk being transferred. Now, how a private sector provider of a capital asset is in a better position to manage energy tariff risk than a public authority with its potential buying power, I don’t know. I will not bore the Committee by going through all the potential areas, but what I was referring to was that I think that was very much in play in an earlier era.
I think in the last few years my observation is that we have begun to move beyond that. The job of work still to be done is to stack PFI up within an analytical framework, with adequate backup from the centre, to decentralised organisations so it can be compared against joint ventures, municipal enterprise, local asset-backed ventures and the right blend of capital grant and debt raised in the private way, and I think we are quite a long way still, despite repeated recommendations from many committees such as yourselves and many NAO reports, from establishing that transparent framework.
Q5 Andrea Leadsom: Mr Abadie, in the submission from PwC you say, "If Government had previously required all PFIs to count towards national debt, there would have either been fewer projects-less investment in infrastructure-or higher national debt". So, would you agree that the classification of debt has driven behaviour?
Richard Abadie: I do. I am with Andy on that. I think in the early days of PFI it was seen as an instrument to enable additional investment in infrastructure, and I stand behind the words, clearly, that I submitted. I think that if we had not done it we would have spent less on social and economic infrastructure.
I would touch on-if we jump to where we are today, though, looking forward rather than looking backwards-the Accounting Guidelines, and there are three different things we are concerned about. One is accounting, and that is where the phrase "balance sheet" comes from, really. We are looking at how departments budget, and we are also looking at national accounts, which you referred to, which are really statistical. In the submission I wrote, I did reflect on the national accounts side and the statistical side that the most important reason we prepare national accounts is not for internal UK purposes. We prepare them for European purposes to comply with Maastricht . When we do set the way we account for these on national accounts, it is important that we do set them consistent with the rest of Europe . Currently, the gui delines that are being followed b oth in the UK and across Europe are a set of guidelines called ESA 95. CIPFA have commented in their submission to you that it may change, and I don’t think we should jump ahead of that , because we do want comparability around debt across the rest of Europe, and if they do change , let’s make sure we change consistently with the rest of the European countries, which is different to balance sheet accounting and budgeting. I am talking specifically because you have focused on that on the national accounting side.
Q6 Andrea Leadsom: Thank you. Professor Helm, if I could ask you: what is to stop, other than the implications for the national debt statistics, the Government from borrowing through Government gilts at a significantly cheaper rate than PFI providers could finance themselves in the private market, and lending the money to those projects? Would you not agree that the public sector is incurring quite a significant increased cost in PFI projects going forward, as a result of Government’s requirement to keep this all off the national debt statistics?
Professor Dieter Helm: Let me unpack that. First of all, the important thing when people say "Is this off balance sheet?" is that there is no balance sheet for it to be off. It may be that that is in fact a requirement for the way national income accounts have to conform to EU and international standards. It does not stop you having a national balance sheet and being able to looks to see: what are the assets of this economy? What are the liabilities? Have we been running them down? Have we been depreciating them? Are we giving the next generation a decent set of infrastructure to pass on? Up until PFI, it would have been financed out of tax revenue so that the current generation would have paid, instead of consuming, to carry that forward.
Q7 Andrea Leadsom: Or borrowed it?
Professor Dieter Helm: Or borrowed it, yes, of course. The second thing is that it is not true that the investment would necessarily have been lower had there not been a PFI. The utility model, which is not on the cash terms of the Government, transfers to the state, once assets are completed, the regulatory and political risk and creates in the refinancing a regulator asset base. The water companies have carried out a very large amount of CAPEX, as have other parts of the privatised utilities, so there is a perfectly durable alternative model for doing this. It is just a different way of doing the contracting, but it takes the refinancing point-not the CAPEX risk, but the refinancing point-and takes at that point the risk away from the managers of the project, because there is nothing they can do about it at that stage. I think that is an important component.
You ask a third point which is: could the Government borrow it? Well, if the Government had a balance sheet, the Government could borrow as a liability and set that against an asset. Let me give you a hypothetical example; I am not proposing this, but let me give you a hypothetical example. Supposing the Government wants there to be 10 nuclear power stations in this country at £5 billion each. That is £50 billion over the next 10-15 years. Supposing it borrowed a fund called the Nuclear Bond Fund, and it borrowed £50 billion and it just asked the builders of those stations to bid for that money. So, it is the Government borrowing but the private sector is doing the CAPEX and the OPEX thereafter. It would currently borrow probably the negative real interest rate. The private sector for a nuclear power station may be 10% or 15% real. It doesn’t take first year undergraduate maths to work out there is a colossal difference between those numbers, and why would we never even contemplate that possibility? Because it would be called a cash-in number of £50 billion in Government accounts. I am not advocating doing that, and I think my utility model and the revenue asset base avoids having direct Government borrowing for this purpose, because it addressed the central issue, which is the allocation of political and regulatory risk in projects where the difference between the marginal cost and the average cost is enormous, therefore, there are substantive sunk costs, therefore you require a long term contract and it is basically: who takes the risk that this Government or some future Government will behave like the German Government in, say, nuclear power, and simply just change their mind? That is the bit.
Chair: A very quick last question and a quick reply.
Q8 Andrea Leadsom: Yes. Sorry, to come back on that, just to be very clear, you are saying that the only reason why the Government would not do that is because of the impact on Government borrowing? That the only reason for not taking the advantage of Government’s excessively cheaper cost of funds is because of the impact on the debt statistics?
Professor Dieter Helm: If it is direct financing, the answer to that is yes. If it is a utility model and creating a regulated asset base for renewables, nuclear and things of that ilk, much of the £200 billion, which is half the £400 billion-plus we need to spend by that period of time, could be done without, in the current arcane accounting rules, mucking things up, but shifting political and regulatory risk through a duty to finance functions. The effects of this are truly enormous. Capital expenditure is about the cost of capital, the cost of capital and the cost of capital, and we are about to pay an enormous premium-in fact, we already are-on the renewables, the nuclear, and a whole host of other infrastructure, which will be a burden on future taxpayers and future customers.
Q9 John Thurso: Mr Wardlaw, in the paper you contributed: Delivering a 21st Century Infrastructure for Britain, you talk about the availability of debt finance. To what extent is the availability or the lack of availability of debt finance, its increased cost and the shortening maturity dates threaten the PFI concept?
James Wardlaw: I think that paper is now nearly two years old. I think we have seen through a number of processes since then that the availability of debt finance is materially improved, particularly on the sale of High Speed 1, which was a mature asset that did not involve any construction risk because it was already built. The level of interest from banks in participating in the backing any of the bidders was enormous and right back to pre-crisis levels. In terms of the cost of that finance, it is definitely higher. In PFI terms-and I have never been a PFI practitioner, I must say-the levels were 60 over swaps at the peak, and now we are talking 250 and more. I think it is very difficult to imagine in the environment in which the banks operate, which you know better than I do, in terms of capital constraints and so on, that it will not go back to those previous levels.
Q10 John Thurso: Would you say there is a shift between the pre-crash model and the post-crash model between bond finance and bank finance towards bank finance?
James Wardlaw: I think it is coming back again, but the appetite and the cost of much longer term finance from the banking community is very, very much more challenged, so the idea of commitments of 25-30 years to PFI projects is a lot more difficult and a lot more challenging for most banks now, and they have to compete for capital with other lending sectors in a way that simply did not operate prior to the crash, and they are having to do that against targets for declining risk-weighted assets as well. The pie is shrinking and they are competing for that.
Q11 John Thurso: Does that explain why the banks have shifted to a club arrangement rather than a syndicated arrangement?
James Wardlaw: The syndicated market will come back and people will be prepared to take-certainly for assets where there are a clear number of precedents, that will come back, but it hasn’t yet and people are not comfortable in underwriting their ability to sell on to other participants at prices that don’t involve significant losses. It is about confidence in your fellow banker, that he is going to step up to the plate in the same terms as you are.
Q12 John Thurso: The likelihood is that the step change in the cost of capital upwards is probably locked in for the foreseeable future?
James Wardlaw: Yes, and also that the willingness of people to finance remains quite short and, therefore, for the mature assets once they are in-the are post-construction, the desire to get it into the capital markets and funded by institutional investors and money managers, in the way that I have described in the paper, is absolutely the way forward because you will not be able to get that 30-year commitment otherwise. It does raise an important issue in the context of refinancing the risk and the response to the notion that PFI debt is very expensive. One way of getting around that is in a sense to finance, with bank finance, the construction period and, once it is financed, recognise that the risk profile has changed significantly and then refinance that into the capital markets with the institutional market. But the public sector procuring authority is then taking that refinancing risk and the risk that interest rates will be significantly higher at that point in time, even though the spread-the margin-may be significantly lower because you have substantially de-risked it. That is a second order issue relative to the risk that interest rates rise significantly over the next few years.
Q13 John Thurso: The cynic in me, having dealt with a lot of bankers over the last few years, says they will be doing everything possible to make the maximum profit out of the risk they are assuming in the early part, and that that is the real challenge.
James Wardlaw: I think that the first stage period is the most challenging part from a financing point of view, because the number of people who are interested and willing to finance green field construction is a materially smaller number than the number of banks and other financial institutions, institutional investors, who are prepared to finance it once it is constructed.
Q14 John Thurso: Taking on the point that Professor Helm was making earlier, is that not precisely where the fact that Government could be involved-Government can deliver the best possible value because it can make such a material reduction in cost in that early phase-should outweigh the risks? In fact, it is almost impossible to transfer sufficient risk to make a saving for Government.
James Wardlaw: I think, in pure financial terms, that is purely in terms of the cost of debt finance, but I think we should not lose sight of the benefits that come from the procurement process in the early stages, which involves looking at the whole life cost of the asset and a greater focus on what it is that you want to procure before you sign the contract. That has typically been the case in the context of-
John Thurso: Let me come to Mr Abadie, because that is-
James Wardlaw: I think it is more his territory.
John Thurso: Exactly. Let me move on to him, because that is precisely the point that you make in your submission, is it not?
Richard Abadie: I will have to come back just to answer that. James has said quite a lot about the debt markets and the capital markets, and I did not want to lose one threat that you highlighted, which is the difference between, say, the bond markets and the bank markets. While we are raising finance in the UK for some of these PFI deals and infrastructure deals, most of the organisations that invest or lend to our transactions are global entities. They do this all over the world. I do business all over the world in the infrastructure space, and while James is exactly right that there has been a decrease in debt availability and prices have gone up, most of the projects we are involved in do get funded, so it is not as if there is a massive imbalance between supply and demand for finance.
In the UK, given that we are cutting back on the amount of PFIs we are doing, as you cut back on the amount of demand for debt you are going to find that the supply exceeds the debt and prices will come down. They will never come down-and this is not a PFI issue-to the levels pre-credit crunch. That was a phenomenon that we are never going to experience again, at least in my working career, of credit margins on deals, be they mortgaged deals, be they infrastructure deals, be they corporate loans, in the 20 to 50 basis points. It is not going to happen again. I do think we are in a world of more expensive debt.
The other thing I would just want to touch on is: in terms of the capital markets, a lot of the reason the bond markets were active in infrastructure in particular, and other markets, was around structured products. A lot of the risk that you would have found, for example, in PFI deals pre-credit crunch-if you had capital market investors or capital bonds being issued on the back of projects, the risk was underwritten by the monoline insurers. I am sure this Committee has debated that before. They have gone. There is nobody prepared to take that risk, so we are back into a predominantly bank market. James is spot on; around the world, a lot of the logical way to fund infrastructure is in the bank markets during the build phase, and take it out in the capital markets.
Back to your question, though: doesn’t it make sense for Government to fund the asset in the early days? I would hypothesise the inverse, actually. One of the clear benefits of contracting out to the private sector is the transfer of construction risk. Let them build it, let them give you a fixed price for it and if something goes wrong-and Andy has a lot of examples of these. He has personally been involved in-
Q15 John Thurso: One point there: absolutely, you do a design and build to a fixed cost and stand back and say, "Get on with it", and the private sector does that and builds a golf club house. It is what you do. What is special about the fact that you also have to get them to do the financing? Why can’t you separate the financing from the transfer of the risk? That is a contractual element.
Richard Abadie: I think that is a very good question. One of your panel members in the next session is Steve Allen from TfL, and he will touch on that. What you need are sophisticated procurers. It is all fine entering into design and build contracts, but you need to be able manage that contract to effectively avoid blowback risk coming back on yourself. We have a number of examples, and the most recent one is the Edinburgh tram project up in Edinburgh, where costs have just gone totally out of control. The asset will not be delivered, if you believe what you read in the press, and it looks like £350 million will have been lost net-net. Design and build would not necessarily have helped, because the procurer was unable to transfer that risk to the private sector and make the risk stick.
Q16 John Thurso: Just to-because you can always come up with one example on one side-look at the NDA contract for the decommissioning of Dounreay and the way in which it is being done, and you have a hopefully very fine procurement, which is driving costs down and shortening the time of decommissioning. It is the mechanics of how you do it, not the finance. That is what I am trying to separate.
Richard Abadie: I will put it slightly differently, and there are key points here. One is: do you have a sophisticated public sector client who can insure the risks that seek to transfer through contracts are borne by the contractor? If you believe that, and I believe TfL is such an entity, you are in a very different place where you can, on balance, leave a lot of the integration risk with the public sector entity because they can manage the risk themselves. When it comes to the finance, the analogy I would draw around PFI is that either the taxpayer bears the risk of something going wrong or the financier does, and it maybe not that binary that it is one or the other, but the difference with the private finance is that if something does go wrong, you at least have somebody else taking the risk besides the taxpayer. There are examples, and I am sure you will appreciate this, if somebody offers you a design and build price and then goes bankrupt, and it is that type of risk that you are trying to head off. It is not only the building risk, the physical infrastructure building; it is the risk of something going wrong with the actual supplier. We have had examples even in the PFI area where people such as Jarvis went into liquidation-they went insolvent. The question is where did those risks wind up. There are examples where the equity and the debt in these infrastructure projects took that risk.
John Thurso: If you look at the banking crisis, you could say it has come back to haunt us.
Chair: It has.
Q17 Michael Fallon: Mr Wardlaw, you distinguished between economic and social infrastructure. Just taking social infrastructure, how much risk transfer really takes place when the Government has taxpayers and voters to hold them accountable for the future of a school or a hospital?
James Wardlaw: I am not sure this is the question best asked to me because I am not a PFI practitioner and therefore in terms of the risk transfer-I think that there are two major risks. Clearly, there is the construction period and the period up to construction, and then once it is operational, then the risks are once it is operating. One can have a view in certain of these situations where you are producing a fairly standardised product that those risks are de minimis and are reduced over time as you do more and more schools and more and more hospitals. I was struck the other day talking to a fellow at Barclays who mentioned that they had had no problems at all with one of their projects until year eight, when some operational problem blew up and it had a material impact on their economics. So, I don’t think we should be dismissive of the fact that there are quite substantial risks even at the low risk, low return end of things. I would not want to suggest that they are completely without risk but, Andy, you and Richard are probably better placed to comment than me.
Andy Friend: I think one of the tests about whether risk has actually been transferred is the corporate history that has in a sense already been referred to. There was a comment in the recent NAO paper, "Lessons from PFI and other projects", which said that maybe the taxpayer was paying for risk transfer that was not being achieved in practice. I think one does need to distinguish between what risks there are. It is not risk in globo, and clearly the risk of procuring the wrong asset for your public service or the risk of in extremis having to step in to make sure that the public service still continues to function cannot ultimately be transferred, but what can be transferred are many of the construction phase or long-term operational risks. I was Chief Executive of John Laing Plc when a project that had been entered into in 1998 went badly wrong, the National Physical Laboratory. We booked £68 million of losses on that. Sir Robert McAlpine, £100 million on Dudley Hospital. One can work down Mowlem, Skanska, various losses, particularly in the sphere of public accounting and debt company reporting; it is clear where PFI losses have indeed crystallised, but under other procurement forms with most likely-and I take the fact that there has been improvement in many of the mechanisms. They have actually been to the public sector account and have involved much greater additional cost in terms of getting those projects operational.
Q18 Michael Fallon: What about the other side? There has been some research on some of the earlier hospital projects that showed significantly excessive rates of return achieved.
Andy Friend: I think that is right, and the research certainly demonstrated that. You will recall I am sure that in the early days of PFI it was only by negotiation at the time of refinancing that the public sector got a share, and that was four deals. I think before 2002, most were about 25%. It then went to 50% and is now more commonly 70% by contractual right. I think that when we talk about PFI, with the benefit of 19 years of experience, the structure of public services has gone through many changes: the contracting industry has changed in many different ways; the interplay between the bank and the bond markets, and in one sense the vintage of experience is very important, and regarding the particular extraordinary gains that were highlighted in the first few years of the last decade, my belief is they are not occurring in the same way now and that there is greater transparency, visibility and contractual rights.
Q19 Michael Fallon: What was the effect of those excessive returns in the early years? If PFI was so profitable then, why didn’t we seek more competition for this kind of investment? Why didn’t we see those rates coming down more rapidly? Why didn’t we see construction costs, which still seem very out of line here compared to other European countries? Why didn’t we see those falling?
Andy Friend: If you are sitting on a public company board or even a private company board and you are looking at the equity participation in these projects, you are considering not only the rate of return that you may earn from a particular project but you are also considering the costs of business in terms of participating in that market. So, you are also looking at the cost of failed bids, and I think the CBI submission-or is it the Major Contractors’ submission-refers to £12 million for an average hospital bid to £2 million for a school’s bid. We at Laing thought we were doing well if we won 40% of what we were shortlisted for. So, you are writing off those. I think that there is a history that everybody in a sense must ‘fess up to, of a lot of programmes being begun under PFI that were either then radically changed or where projects were cancelled at a very late stage, so we had a number of projects that were cancelled under considerable expenditure of being in the preferred bidder phase when you are doing all the detailed design and mobilisation.
However, pressure of competition did bring equity rates of return down. From my own experience, I know that from what was being bid in the mid teens for an equity rate of return, the pressure of competition was driving people to put in bids at 10% and 11% a few years later. I am not sure how it has evolved since, but that certainly was a progression.
James Wardlaw: I think it is also important that a lot of those refinancing gains were driven by the falling interest rates. In the current interest rate environment it is far more likely, I would have thought, on the balance of probability, that interest rates will start rising again. On the refinancing gains of those early years, the same conditions don’t really apply.
Q20 John Mann: I am struggling with your answers, Mr Friend, because if you take the PFI schools, they are all off the peg. They are not bespoke designs. The PFI schools are all off the peg; "Here’s what you get". I am struggling to see any risk being transferred in building a school. Professor Helm, perhaps you can correct me, but it looks to me very straightforward: "Here is the school; here is land. Off the peg, here’s the design. How many do you want?"
Professor Dieter Helm: I have a lot of sympathy with that question because I think there is a basic confusion going on here. The state will always be using the private sector to do things, whether it be to do cleaning or to build buildings, to build schools or to build hospitals. That is called public procurement. There is a huge amount of public procurement goes on, and if you want a school built then you specify what it is, you specify where it is and the state may be good or bad at doing procuring: it may not specify it properly; it may make it too rigid; it may make it too small; it may make it too big, but you could have endless inquiries into public procurement, and much of the comments we have heard are about public procurement. The PFI is a special kind of public procurement. It is called private finance initiative, so it is a procurement that requires you to do the financing as well, and it pays you back with a service contract that lasts for the life of the asset. This puts together OPEX, and you might well want to contract out running a school, in terms of cleaning or building maintenance or whatever. You can separate that. You can separate the capital job, and of course the private sector’s risk, once it has made a bid and it says, "I will build you this school for £1 million", is to deliver on that budget. The financing bid is what adds to the cost here, and the point that James made is absolutely right. When we start to look at what the total lifecycle returns of these projects are, it depends on exogenous things like whether the interest rate falls. Why? Because refinancing is of the essence of what is going on here. You do your capital project, you try to do it for the budget, you do your project finance, you do all that stuff, and when you have finished, it is finished, and that is the refinancing point. That in the utilities is the point where the asset goes into a regulatory asset base and then earns just a marginal cost of debt, which is very much lower than the marginal cost of debt that is being done in these businesses, and you might take a bonus in it if it turns out the interest rate is lower than you anticipated.
Q21 John Mann: There is an additional downside, isn’t there, and the additional downside is that if it was traditional public procurement, if you specify wrongly, you have the control that costs you to re-specify.
Professor Dieter Helm: Yes.
John Mann: So, for example, if in PFI you build a swimming pool that is wrongly designed and , even though it is off the peg , your PFI contractor doesn’t spot it either and it is buil t, y ou are stuck with that with PFI for 25 years.
Professor Dieter Helm: That is precisely the point, and essentially what PFI does-and even PPP as in the case of the London Underground contracts-is it bundles together lots of different aspects in a project into a fixed project, and the point here is that the Government and the state is such an incredible or non-credible contractor to the private sector. There is always the incentive they might come back and change things differently, but people want a very rigid contract. That is why you get these long periods of contract where you can’t do anything about it and if you want to change anything you pay some huge sum for some apparently trivial change in the frame, and there are many examples of that.
The solution to that problem is to take the point of the construction completion. You built your hospital; you built your school. Now, in the more RAB-based model, it reverts to a refinancing where there is an assurance you can finance the functions, and then you have control over the assets. Water companies don’t say in the utility model, "Oh dear, we can’t change the operation of a sewage works for 35 years or the charging base that falls through to customers because we signed a 30 year or 40 year contract and that is the way we are getting our money back". The other side of this is that when you do a construction of public procurement, the thing costs £1 billion or £1 million and you pay that sum. It is done. In this game you don’t get the money back except out of the service costs that come through for some time in the future.
Q22 John Mann: Therefore, that element of risk-the risk that you have your design wrong, say, on the swimming pool-isn’t transferred. It is simply lost. It disappears because you can’t do anything about it. Isn’t the fundamental problem, taking the schools as an example, that the same public servants who would be dealing with public procurement and may well have got it wrong in the past are precisely the same public servants, say, in the local authority, wanting the new schools and getting the credits, who didn’t have the expertise or the specialism to do so and, therefore, were getting carried away with, "This is the only game in town. Here’s what you have. Here’s how much it will cost you, and we’re buying off the peg", not understanding precisely what they were doing. Isn’t that lack of capacity in public sector procurement a key part of the problem that we have had?
Professor Dieter Helm: I think the point I was making is rather separate from that and I wanted it as a separate structural point about the design of these things, as opposed to the quality of the people making the decisions. There is clearly an issue about how good people are at doing public procurement, but I have no expertise to criticise particular abilities of particular groups to make those decisions. It may or may not be as you describe.
Richard Abadie: Mr Chairman, could I follow up on that? I can’t leave some of those comments unanswered. I don’t think we have time in this hearing to go into a full debate about RAB versus PFI, but I would like to comment on something Dieter said. We have maybe forgotten that most of the infrastructure in this country, including the assets that have found their way into the Regulatory Asset Base, were built by Government. They were not all built by the private sector. They were privatised at a point in time with a massive asset base and then handed over to the private sector to manage, operate and upgrade. The other thing is that those are customers paying for those assets. At some point in time, school pupils and maybe patients in hospitals will pay for these assets. I don’t believe it is going to be any time soon, but when that happens then we can start looking at some of the benefits that Dieter is alluding to.
I would like to come back, though, which I can’t let go, about your swimming pool example. Under PFI, Government does not have to pay for that asset until they are happy with the asset. So during the construction phase, if it is badly designed, Government at the end-and they may or may not do so, it is entirely up to them-have to inspect the asset and decide whether they are content with it. If they are content with it, they sign off and they start the payments. Bear in mind they now pay for this asset over 25 years, so for the sake of argument if, in James’ example in year eight, it springs a massive leak because of a defect, under the contract the Government can cancel the contract. That does not mean it is without cost, but they can cancel the contract.
Q23 John Mann: They can cancel it if it is a leak, but if it is wrongly specified at the beginning-
Richard Abadie: By whom?
John Mann: By whom?
Richard Abadie: The question is: by whom? You mean the public sector has wrongly specified the asset?
John Mann: Yes , and the contractor has wrongly assessed it as well.
Richard Abadie: Why would they-
John Mann: Why would it happen? Incompete nce somewhere, but the point is that with PFI , there is nothing can be done. Th e risk of that mistake does not transfer anywhere.
Richard Abadie: I guess we may be disagreeing here. In public procurement, if the public sector incorrectly specifies the condition of the pool and the pool leaks later on, the Government has that risk. The Government probably will have to dig up the pool and replace it. We have an example, specifically, I think, in Tower Hamlets, of one construction around a poor piece of infrastructure. Where it was procured, the costs have absolutely blown out and the pool has still not-
John Mann: No, with PFI , in the middle of the contract , you can’t do that , and that is the point.
Richard Abadie: You can.
John Mann: No, you can’t and-
Richard Abadie: There are variations of contract.
John Mann: -indeed, if you take the eight PFI schools in my area, when precisely these kinds of problems occur because of the nature of the PFI contract , you cannot then re-specify. You are stuck with what you h ave. If there is a mistake, yes; if there is a hole in a swimming pool , of course you can, but if there was a mistake within it, if the school needs to change size for example, or whatever else, you can’t do that within PFI , and that is a weakness within the system.
Richard Abadie: There are variation mechanisms in the contract-and I know because when I was in the Treasury we wrote some of them-that allow you to vary the contract. I think you are touching on-
John Mann: That depends what the various mechanisms are. That is the very point. That is the very point, that you are tied in with PFI, and once you are tied in there is nothing you can do beyond that.
Q24 Chair: Whether or not you accept that the contracts can be altered, do you agree that there has been excessive profitability, Mr Abadie?
Richard Abadie: I would say-and I think I put it into my submission, although I can’t remember the exact words I used-that in the early contracts, and I think I used the phraseology of something like the investors of those early contracts have made returns beyond what they could have reasonably expected, and I believe that honestly.
Q25 Chair: But not any more. We are all in signing up plans now, are we?
Richard Abadie: There are two things: one is that there are very few contracts being let but, more importantly, you have a very tightly competed regime. So you have defined contracts, defined risk allocation and, effectively, if you go back to the point that it is well understood what you are bidding for, you have full competition on construction, operating expenses and interest in negative terms.
Q26 Chair: With great respect, you make money selling these projects or advising on these projects, don’t you?
Richard Abadie: It is a very small part of our business. I do work on PFI, but as I think I put into the preamble to our return, my business makes money on advising Government on any procurement. PFI is one of the areas we work on. Currently we are working with the Ministry of Defence on fighter aircraft and submarines, which are upgrades that have nothing to do with private finance.
Chair: You did not mention aircraft carriers there.
Richard Abadie: No, no, I avoided that one.
Q27 Jesse Norman: Mr Abadie, how many PFI contracts has PricewaterhouseCoopers advised on in the last 10 years?
Richard Abadie: Globally, it is about-
Jesse Norman: No, in this country.
Richard Abadie: I don’t have the number. I can come back to you if it is handy.
Jesse Norman: Is it 10, is it 50?
Richard Abadie: No, no, it is substantial.
Jesse Norman: 100?
Richard Abadie: It will be more than that. I didn’t want to give you a number guessing. We and our competitors would have advised the public sector on most of the contracts that have taken place.
Q28 Jesse Norman: So if there have been 600 then, between four of you, you might have done 150 or 200 yourself?
Richard Abadie: Easily.
Jesse Norman: You will be on one side or the other , so if there are 1,200 , you might have done 400 contracts?
Richard Abadie: We are not involved in all of them but, yes.
Q29 Jesse Norman: Thank you for that. Could you tell me: how much have those contracts earned for PricewaterhouseCoopers over the last 10 years?
Richard Abadie: Again, I have absolutely no idea.
Q30 Jesse Norman: What would the average value be of a contract to PricewaterhouseCoopers?
Richard Abadie: I can talk about the current environment because it is very current. If there were BSS schools still taking place, the public sector would procure financial advisors and they would probably get £250,000 to £400,000, normally on an incentivised basis, to advise on a school.
Q31 Jesse Norman: On a school, and how much on a hospital?
Richard Abadie: Again, we haven’t done hospitals for some time, unfortunately, so I can’t give you an answer, but it would probably be more than that. It may be £500,000 to £800,000.
Q32 Jesse Norman: Would that have been the same, say, in 2007?
Richard Abadie: Again, I can’t comment. I would have to go back and look at that data. I would emphasise as well, just to be clear, that is over the life of the procurement from business case through financial close, so that is probably over a three to five-year period.
Q33 Jesse Norman: All right, but if there were 400 projects you advised on and, say, they earned £500,000 each, it would be the order of £200 million to £400 million?
Richard Abadie: No. Certainly not.
Jesse Norman: Less than that?
Richard Abadie: Yes, so again, maybe the 400 is wrong. I don’t know where you want to go with the questioning, but I am happy to take that if-
Q34 Jesse Norman: No, let me tell you where I want to go. How much have fees declined over the last 10 years?
Richard Abadie: Hugely.
Q35 Jesse Norman: What would they have been 10 years ago?
Richard Abadie: Again, I don’t know. What I can tell you is that again, like Government, it has become a sophisticated procurer in the public procurement space, and become very sophisticated as to how they appoint advisors. Our rates in advising the public sector have come down materially. Government, through OGC and other initiatives across Government, have framed their contracts where they complete with their advisors and retain them on agreed rates.
Q36 Jesse Norman: Would you be willing to submit some aggregate numbers for the amounts of money you have earned on PFI in this country over the last 10 years?
Richard Abadie: Probably not. I believe that is commercially confidential. If you would like it in private, and it would not be disclosed otherwise, I would be happy to have that conversation.
Q37 Jesse Norman: That would be helpful and I appreciate that. Would you be wi lling to work with the Treasury, and encourage PwC as a whole to work with the Treasury, on the Code of Conduct that it is seeking to arrange at the moment?
Richard Abadie: As James would know, we have people on secondment to Government on a regular basis, including myself at a point in time. We had some-
Q38 Jesse Norman: Do you have somebody in Treasury at the moment?
Richard Abadie: We don’t have somebody in Treasury. We have somebody in the Ministry of Defence helping them with looking at their contracts and how they can reduce the cost of those contracts.
Q39 Jesse Norman: You would be prepared to talk to them about how fees could be part of that yourselves?
Richard Abadie: If you are specifically referring to the Treasury, we talk to them all the time. That is the nature of the market.
Q40 Jesse Norman: That sounds like a yes. Thank you.
Professor Helm, just very quickly, was it your recommendation that the Government should be looking to set up a proper national balance sheet over a period of time?
Professor Dieter Helm: Yes. I proposed that some time ago, and indeed I have done a little bit of work with the Treasury to try to make progress. I can’t say it is going a long way, but the usual objection is, "Well, there are these international standards we have to abide by". My response to that is: it is illustrative to start to construct a national balance sheet to see what the assets and the liabilities are. It tells you, for instance, what our true deficit might look like. I have no idea what our financial deficit in this country is, because I don’t know whether we have just been eating up assets and depleting our infrastructure or not. We depleted all the North Sea and that doesn’t show on any accounts. The question here is twofold. One is: it would help the Government to understand what the financial position in this country is, but secondly, it would sort out the difference between current spending and capital spending, and it would make a lot of sense for us to engage in the £500 billion of CAPEX that is required. If we are creating assets against that, that is a different kind of problem than our current spending, and I wanted to make one point: nothing that we are currently doing gets anywhere near approximating the level of CAPEX per annum in the infrastructure generally that the Government’s plans and the previous Government’s plans require. We are adrift by at least a factor of 2, so if you want to carry out the infrastructure, you have to will the means as well as the ends.
Q41 Jesse Norman: Thank you for that. I am conscious of the passage of time, so I would be very grateful for very quick answers. Do you think it would be a good idea to have a right to demand a refinancing at the point that construction risk ends in a contract?
Professor Dieter Helm: Yes.
Q42 Jesse Norman: Thank you. Do you think that the Government’s high discount rate historically prejudiced procurement in favour of PFI?
Professor Dieter Helm: Probably.
Q43 Jesse Norman: Thank you. On a regulated asset basis-
Chair: You are doing very well.
Jesse Norman: I am sorry. I f you would like to write to us , obviously we would be very grateful for that. You have written very eloquently about regulatory asset bas es, and you have talked about it today as a concept. Is it the case that the kind of financing you have in mind would be cheaper than PFI but more expensive than Government borrowing?
Professor Dieter Helm: It would be substantially cheaper than PFI. It is not clear whether it would be at or above Government costs of borrowing.
Q44 Jesse Norman: All right. Can we have some indicative numbers as to the kind of levels you have in mind?
Chair: You can write to us.
Professor Dieter Helm: The answer to that question is: look at the costs of refinancing on regulatory asset bases, which are currently trading at 25% above in the utility sector. That gives you a very clear indicator of the numbers. They are much lower.
Q45 Jesse Norman: Are you comfortable that the regulatory asset base concept could be extended to procurement, which does not involve users as, for example, most utility procurement does?
Professor Dieter Helm: Yes, certainly, and that is why I disagree with Richard very strongly. It is important to distinguish between customers and taxpayers but, ultimately, it is a question of revenue flow and the degree of security that attaches to that revenue flow. The problem in PFI, in many cases, is that the revenue flow depends on Government directly rather than indirectly via a regulated body. I have thought of the institutional structure to overcome that, which is my view about what a national infrastructure bank should look like. It is more serious in the taxpayer case. That is why the gains from what I am proposing would be much bigger in the PFI territory than in the conventional territory that is recommended, and these are very substantial differences and it is the cost of capital that really matters in infrastructure spend.
Jesse Norman: For the avoidance of doubt , it is tens of billions of pounds in the short term, hundreds of billions of pounds.
Professor Dieter Helm: Take my little trivial example about the nuclear power stations. Just do the maths. 1% on the cost of capital on £500 billion is an enormous sum.
Jesse Norman: Even by PFI standards. Thank you.
Chair: One last question.
Q46 Jesse Norman: Thank you for that, Mr Chairman. Is there not a danger, since RAB, as you have described it, would also be off balance sheet, that it could also be used to disguise future costs in the way that PFI has?
Professor Dieter Helm: You say "off balance sheet". There is no balance sheet. When I have my national balance sheet, if ever it was done, so we could look at the state of our economy, you would treat the RAB as part of the assets of the country against which the liabilities are set, so it is the other way round. We are definitely going to put all this lot on the balance sheet, right? It is the national balance sheet, not the national cash position, and we are going to look at the liabilities and we are going to look at the assets, and we are going to see whether this generation is treating the next generation decently in providing for the depreciation of the assets properly-maintaining our roads, our schools and so on-and providing the CAPEX going forward. So it is all on the proper balance sheet.
Chair: This really is Jesse’s last question.
Q47 Jesse Norman: Right, but if I may say so, that is an equivocation, because I take the point, but you are surely not tying your recommendation about RAB to the creation of a balance sheet in the national accounts. This could go ahead as it is.
Professor Dieter Helm: Absolutely.
Q48 Jesse Norman: Good. So the question is: could the same kinds of fiscal distortions that we have seen with PFI arise in RAB, given the way the accounting treatment works or the statistical treatment works?
Professor Dieter Helm: The answer comes back to the question that, I think, Mr Mann asked, which is: in the model I am describing, the focus is on getting public procurement right. Can I guarantee that my approach gets public procurement any more right than PFI? Slightly, yes, because I am only doing the procurement and not confusing it with the finance. So it will be better, but will there still be mistakes? Yes, and that is for committees like yourselves to work out how we can do public procurement in general better, but it is a consequence of failure to do public procurement right, not the added specialism of this peculiar kind of public procurement, which is to bundle the finance and fossilise the contract and put in the inflexibility that costs us so much both in terms of the efficiency of the project and in terms of the cost of capital that really matters to this country. Now we really do have to do something about our infrastructure.
Chair: That was not quite as good as your earlier ones, but it was very interesting.
Q49 Mr Ruffley: Thank you, Chairman. Mr Wardlaw, your paper in 2009 for the Policy Exchange talks about a UK infrastructure bank. How would that be an alternative to the PFI deals we have been talking about this morning?
James Wardlaw: I think we are sort of getting it. It is called the Green Investment Bank. It is clearly focused on renewables and green energy, which is a particular requirement of our economic infrastructure at the moment. What I hope for the Green Investment Bank is really the question I think now, two years on, in this respect. That is that I would hope it will play an important role in facilitating private finance, private sector capital, and that it will not just be about how it can dispense or invest £3 billion of its equity. It is about how it can mobilise and facilitate the private sector capital that is required for that investment.
Q50 Mr Ruffley: I am not quite clear, with respect, how that model improves conventional PFI and how it is different from conventional PFI.
James Wardlaw: I think the nature of the assets that we are looking to invest in as a country and create to meet the renewables target and so on has a very different set of risks to-
Q51 Mr Ruffley: Perhaps you could describe those, because I am interested in your proposal.
James Wardlaw: An offshore wind farm is a very different risk proposition to a school, and the nature of the risks that you are entailing as a contractor, both in the construction and the operation, are very substantially different. There is a lot of technology risk in some of the renewable areas, which is frankly unproven. Building a school or building a hospital is again, I am afraid, a very different proposition. The nature of the risks that the private sector would be taking on in that context I think are very different to historic PFI, if I can put it like that.
I do think that in terms of-and I come back to the original comment-the distinction between social and economic infrastructure, the economic infrastructure is really about where public spending is being directed and public sector investment. This Green Investment Bank has an important role to play, I think, in mobilising the private sector to invest capital in this sector.
Q52 Mr Ruffley: How will it differ from the kind of conventional PFIs that we have been talking about this morning?
James Wardlaw: Because of the capital structures, I think the nature of risk transfer is likely to be very different. Your conventional PFI transaction with 25 or 30 years on a 90:10 capital structure with a unitary charge that is payable by public sector authority, that standardised PFI formula, I don’t think is necessarily appropriate for early-staged or even developing technologies in the renewable space for offshore wind, or whatever. I don’t see the-
Q53 Mr Ruffley: Perhaps Mr Abadie can shed a bit more light. The conventional PFI that we have all been used to and we have been talking about today: is that a thing of the past? Do you think, this infrastructure bank, not just for renewables but for other forms of procurement, is the way ahead? Can you perhaps give us a sense as to what the differences are and what the advantages are, rather than traditional PFI?
Richard Abadie: I would start off by saying I am supportive of an infrastructure bank as well.
Mr Ruffley: Fine.
Richard Abadie: So I have no disagreement with James. At the end of the day, a bank is a source of capital. The question is-back to Dieter’s argument about a RAB-what the cost of capital is. It is conceivable that if the Government set up an infrastructure bank, probably owned by Government, so it may count towards Government debt, which is a big question in its own right, it is likely to be able to borrow cheaper than you can borrow money at an individual project level for PFI.
To take us slightly away to PFI to where James was going in the renewable space, banks do not like lending to development renewable assets. I think what you are finding is if we do set up a green-
Chair: Why is that?
Richard Abadie: James touched on it: technology risks and everything else that comes with it.
Q54 Chair: Where are the risks going to go in these schemes that you are planning?
James Wardlaw: Equity, much more equity. A conventional PFI has a 90:10 capital structure. It has 10% equity. I think you will find in a lot of these renewable projects, where there is uncertain technology, you need a lot more equity risk than that.
Richard Abadie: Just to touch on that, James, it is even being done on our big utilities balance sheets right now, so arguably all equities.
Q55 Mr Ruffley: So which other utilities are you referring to?
Richard Abadie: Centrica, EDF. Those are the guys that are developing a lot of the renewable energy that we are creating at the moment on their balance sheet. PFI, to simplify, is a non-recourse structure. People put their money in and if it goes wrong at least there is no recourse to their balance sheets, arguably. On these deals you find the big utilities having to develop renewable infrastructure on their own balance sheets rather than using increasingly highly leveraged structures.
James Wardlaw: The UK banks probably have between 70% and 80% of their lending books in onshore wind. The rest of it is a very small proportion of the total, so the bank debt is a relatively small proportion of the total capital structure of these deals.
Q56 Mr Ruffley: Can I ask you to venture an answer to this question? If it is such a new and welcome model, why has it not been used before in this country, do you think? Mr Wardlaw?
James Wardlaw: Why hasn’t the idea of a national infrastructure bank been used before?
Mr Ruffley: Yes.
James Wardlaw: Well, I think to some extent we have suffered without. Many other countries in Europe have benefited from having a national infrastructure bank or a state development bank: KfW, Eco in Spain, and CDC in France. I think that it has been an important part of the armoury of tools to enable infrastructure to be constructed in a public sector context.
Q57 Mr Ruffley: Would you say that HM Treasury are 100% supportive and 100% enthusiastic about the Green Investment Bank?
James Wardlaw: No, but you would have to ask them. You would have to ask them, and I used to work there as-
Q58 Mr Ruffley: You used to work at the Treasury, and I am just asking you to give us an educated assessment as to why, if this is such a great alternative, and you have been advertising its benefits and advantages, it is not being enthusiastically embraced by HM Treasury?
James Wardlaw: This Committee-
Mr Ruffley: No, it is a serious point: the kind of technical objections that a Government Department might have with this proposal and this model.
James Wardlaw: I think that their concerns go to the heart of the issue about regaining control of the public finances. That is fundamentally the issue here. It is about the state of the public finances. £3 billion of equity is a massive commitment to the Green Investment Bank in the context of the state of the public finances, and I think that that is the primary driver.
Q59 Mr Ruffley: So you think it is a problem with deficit reduction rather than with the actual workings of the model?
James Wardlaw: Correct.
Q60 Mr Ruffley: Final question for Professor Helm: you spoke very eloquently about intergenerational equity issues, and I am very struck by what you said. I just have this question: you are quite right to remind us that we don’t have a proper understanding of the assets of the UK right across the piece. How difficult can it be to draw up that set of assets on a national set of accounts in a fairly reliable way? That is the first question. The second question is: have you spoken to Ministers about this? Because I notice that you advise DECC and you advise Defra, and it struck me as a very large lacuna in British policymaking, and I wondered whether it would it be very expensive to do, and what have Ministers said about the concept?
Professor Dieter Helm: It depends whether you want a perfect set of accounts. Then it is really difficult. In practice it is to just get on with it. "Let’s have a look at what has happened to the oil Let’s see what electricity networks looks like. Let’s have a look at the water networks." You just do it pragmatically. We are never going to get a perfect replication of the assets in this economy, but we get a pretty handle on the big items pretty quickly and we can tell whether we are depreciating rapidly or not. So, the answer to that is it is not difficult.
Secondly, have I talked to Ministers and others about it? Yes, I was one of the three advisors to the project set up under the National Infrastructure Plan. It is in there. They would look at extending the RAB-based model; I have been working on that. In some sense it would be quite reassuring to discover that there is some sort of huge flaw in this idea and some reason why you can’t pursue it.
Mr Ruffley: Yes.
Professor Dieter Helm: My take on this is nobody disagrees, in principle, it is just they don’t like the fact of what it might reveal. Think about it. Supposing it is true, supposing that we have been running down infrastructure for the last 25 years in this country at the same time we have been expanding our public debt, and so on, supposing our electricity system is not fit for purpose, supposing our water system needs to be investigated, supposing our road system needs upgrading, supposing our rail needs to be done, supposing we depleted the North Sea, then what it would reveal is we are much worse off than we thought we were, because essentially our underlying asset base has shrunk but we have tried to keep our spending up higher. This is, in that sense, quite a can of worms for people to look at, because it raises profound questions about how we are, in our generation, tailoring our spending to the needs of future generations. We should hand on the infrastructure. That is the most basic sense of a sustainable economic policy, so I suspect that what it might turn up maybe somewhat alarming to some, but can we do it? It is pretty straightforward. Is there any objection in principle? How could there be? How could you not want to know the answer to this question?
Chair: It is a pretty big can of worms that you are proposing to take a look at. We are going to concentrate on one small bit today and in this inquiry, which is on PFI. I am going to try to bring in Andy Love, finally.
Q61 Mr Love: Finally. I start from the proposition that, even accepting some of the improvements that Mr Abadie particularly was highlighting earlier on, any objective assessment of PFI suggests that, in terms of value for money, it started off poor and has deteriorated significantly, with little prospect-for the reasons outlined about financing-that that is going to improve. In those circumstances, what I want to do is to investigate, first of all, the feasibility of some form of PFI rebate, some renegotiation, to gain for the public sector some of the benefits that have accrued to the private sector. Mr Abadie, you are very much involved in this. Is that practical, feasible and sensible, in the circumstances?
Richard Abadie: It is a question that is clearly on a lot of people’s minds in the private sector at the moment. The honest answer is Andy is probably best able to comment on that because he is currently running an investment fund, so he would know the impact.
Mr Love: We will come to him.
Richard Abadie: It is not going to be easy. I will tell you here that, as PwC, we are one of the big suppliers to Government. We were called in by the Minister for the Cabinet Office with a view to giving a "rebate" to Government, which we signed an MOU about and we have done. When you approach all the parties in the supply chain in PFI, be they equity investors, lenders, contractors and operators, they may have different views.
I think a lot of the talk at the moment is about going back to the equity guys and getting a rebate from them, in particular. It will be difficult-and I am not involved in any of these discussions-because many of the guys that originally signed up these deals have moved on, and in their place have come pension funds and third party investors. So, while the PPP company that you are negotiating with architecturally is the same, the investors could well be different in many instances, and I know the Treasury is committed to trying. I am not clear in my own mind how successful they will be. It is a question of the size of the "rebate".
Q62 Mr Love: We will come to that, because I think there are some real concerns about how serious the Treasury are about doing this. The Treasury undertook this role because it was suggested to them by a consulting firm that they appointed that they should received £200 million. As much as £500 million has been suggested in political circles. What do you think, Mr Friend? Can we renegotiate?
Andy Friend: I think the problem with renegotiating at the equity level, as Richard has referred to, is that I think the current Treasury estimate is that 55%-perhaps slightly more-of the original equity has moved on, and it has been brought across a wide variety of institutions now, and that is the problem. If you look at something like the Lend Lease projects that were done, they have established an infrastructure fund. The principal investor in that is PGGM. PGGM is a Dutch pension fund. Other pension funds from Australia and Canada have invested into intermediate vehicles. Many UK local authority pension funds have invested into, say, the retail funds that Henderson put together that acquired the company that I used to work for, John Laing, and delisted it from the stock exchange. I think at that level, while it is seductive, particularly at a time of national fiscal very severe constraint, it is difficult in practice to implement.
What I think is more feasible is a vigorous, taskforce-based approach that would require the Infrastructure UKs, the local partnerships of this world and the local authority bodies, on a case-by-case basis to work through: what is the potential for varying scope? What is the potential for increasing productivity? What is the potential for taking back risks that were transferred at a price, like insurance risk, the energy risk I referred to earlier, and literally cutting a deal case-by-case? My perception is that there would be a willingness in the private sector on a case-by-case basis.
I think the problem with the blanket is everybody gives back whatever percentage is, measuring it, who now owns it and who has paid for what they now own, on a different price basis, and also the hazard that it creates in terms of UK reputation. We have a national infrastructure plan. £160 billion of the £200 billion in the next five years is to be derived from the private sector. If you look at the sale of HS 1, four sovereign wealth funds have come into the Gatwick ownership structure since it was divested from BAA and bought by GIP, the infrastructure fund.
I think these things need to be borne in mind as we play the larger game, which is: how do we finance and fund the nation’s infrastructure needs over the next decade? While I absolutely understand why, from your constituents and-
Q63 Mr Love: Well, answer the question that you are hinting at: will this have an impact on future investment in PFI and would it be dramatic? Would it-
Andy Friend: What will have an impact on future investment in PFI is whether the public sector can create both the knowledge base and the skill base to put PFI as one tool in the toolbox against the other public sector procurement options and make conscious decisions that are not driven by "the only game in town", so that it is only used in those situation where you and your colleagues can be convinced that it is value for money and where many of the faults that have been discovered in the prior model have been rectified by change.
Chairman, I come back to your opening statement: does it require incremental change? Does it require radical change? I think it probably requires both. I think it may even require-
Mr Love: I am sorry to cut you short, but I notice that Mr Wardlaw was gesticulating when I talked about whether it would have any impact on the investors and investing community.
James Wardlaw: I was struck by a slide that I saw recently from one of the people at the Infrastructure Planning Commission, which showed that 78% of their applications in their process at the moment basically come from overseas. The implications on the decisions that are made by people who are outside this country and whether to invest in the UK, and in the UK’s infrastructure, seems to be an important part of the equation, not just on the slightly narrow impact on future PFI. I think there is a really important issue here about the perception of political and other risk around the UK and the UK’s infrastructure, because those investors, those contractors, those utility companies outside the UK who are making these decisions have alternative places to put their capital. That was the only point I wanted to make.
Q64 Mr Love: Can I move on just a second because I am up against a time block, like everyone else? When it was suggested that the profits that were being made were excessive, Mr Abadie, you said that in the early days they were beyond what they would have expected. Now, whichever one of those two it is, is there an argument that since there is market failure here-because clearly, even although there has been high profitability, it hasn’t brought in other competitors to reduce that profitability-is there a role for regulation? Should we regulate the returns so that people make a fair return but not the excessive returns that have been happening so far?
Richard Abadie: I take that as two questions. The second one is the regulation one. I do want to comment on market failure. I don’t believe there has been market failure in PFI. If you look at the people that used to be bidding-again, we have far fewer projects going forward-for these projects, it is a who’s who of international contractors, equity funds, investors and lenders, so I don’t believe there is any concern about market failure, in that sense. I believe we have competition and, to give credit to Treasury and all the procuring authorities, they have driven competition very hard. In certain instances-
Q65 Mr Love: So why hasn’t the profitability come down? Why doesn’t it draw in other competitors? If they are competing, as you suggest, why has profitability remained stubbornly high?
Richard Abadie: I wouldn’t say they are stubbornly high, and I don’t want to forget your regulation point because I do agree with that. In the mid 1990s to late 1990s, before I became involved in the sector, you used to be able to borrow debt on a 30-year project for 10 years. Now you can borrow for 25 years, so effectively what has happened is that the weighted average cost of capital in PFI has come down. When you are saying costs have stayed stubbornly high, I don’t know specifically what element you are referring to, but the cost of capital has definitely come down and stabilised pre the credit crunch. Some would argue it has gone down to unsustainably low levels.
Debt and equity prices: equity prices have gone up slightly post the credit crunch. Debt prices have gone up and margins have gone up quite significantly, as James has alluded to. None of those are based on a non-competitive market. The only thing, if you did want to comment on competition, is that the formation of consortia-multidisciplinary consortia, where you have a contractor, an operator, lender, investor and everything else-may reduce to an element some of that competition because it is a complex asset. You have to group entities together. Most of the projects that we have been involved in have had somewhere between three and five bidders bidding very aggressively in competition for these assets, and ultimately competition drives price.
If I can come back to the regulation point, I do believe in my submission I did comment, and I can’t remember exactly what my words were, that there is an argument to say that equity returns-and this is always easy with hindsight-should have been regulated. Just to be clear, that is equity returns going up and equity returns going down, because some losses would have had to have been protected through whatever the regulation of those equity returns would have been. Again, that is probably a discussion for another day-I am conscious of time-but there is some argument that we could have, through the contractual structures we had in place, looked at regulating or providing some fixed return.
Chair: We now have to move on. If you have more you would like to say in writing, please do.
Richard Abadie: Very well.
Chair: Andy has one more quick question.
Q66 Mr Love: Just about whether or not taxation can play a role here. That is something that is very rarely heard and I am not putting it forward as a proposal, but is there a role for some sort of surcharge tax in relation to clawing back the excessive profits that have been made so far? Could it work? Is it practical?
Andy Friend: Again, I can understand, from the public sector interest point of view, why one might advance such a notion, but I go back to, say, a current event: the changing tariffs in relation to solar in Spain. That has contaminated the view of the Spanish market in terms of infrastructure investment across quite a wide spectrum of players, so I think things that are imposed and are unexpected, in the law of unintended consequences, will bring us downsides in other forms.
Q67 Mr Love: So the investor community would take that very negatively?
Andy Friend: In terms of the bigger game, which is projects going forward. I come back to the point I was making. I think there is a willingness in the private sector to address palpable inefficiencies where they can be identified and where the public sector can put in place sufficiently robust management resources, and not by going out to large numbers of consultants and advisors. If you go back through the 130 reports that have been written on PFI since the likes of Alfred Bates wrote one in 1997, I reckon a good two-thirds of them refer to the need to invest seriously in commercial skills in the public sector, and I do not believe that we have done that consistently. That is the sort of thing we need to be doing together with a case-by-case investigation.
Q68 Mark Garnier: Mr Abadie, can I carry on with this topic of the profitability of the equity elements of PFI contracts? Dexter Whitfield of the European Services Strategy Unit has given us a written submission in which he has analysed 63 transactions involving 154 PFI projects. He tells us that if you look at the average operating profit in the UK construction building activities-there are four major PFI construction companies: Balfour Beatty, Carillion, Costain and Care Group-was 1.5% according to their company annual reports and accounts, so that is the profit they are making on their own projects. Yet, when you look at the sales of PFI equity, between 1998 and 2010, Balfour Beatty’s average profit has been 71.4%; Carillion have been amateurs really at 41% and relatively low down the scale; the Lend Lease Corporation, 78.2%; Costain, 43%. These are pretty colossal profits when you compare it with their normal return on investment. Can you explain that?
Richard Abadie: Yes. If you mean technically whether I can explain it or I can try to give a summary as to the perception, on the construction side, the contracting margins, so part of the supplier chain, the builders-the builders’ margins in PFI are not materially different to what they do every day of the week. So whether they build a school conventionally or design and build to a PFI contract, you are probably looking at similar construction margins. I think you have Anthony Rabin on the next panel who is a senior director in Balfour Beatty. You can ask him that specific question as well around the construction margins, and you may want to ask him around the equity.
In terms of the equity returns, the question I ask myself-and there is a secondary market angle to this-is: what is an appropriate return for infrastructure as an asset class? That includes PFI and it includes economic infrastructure that James has talked about. How does that compare to property, to private equity and to all the other asset classes at the stock exchange, if you want to invest in the stock exchange? It is current and recent, so it is probably true over the last, at least, five to seven years. The equity returns that investors are looking for from PFI assets, when they bid these assets, and it is transparent through the financial models that they submit, are probably in the region of 10-13%. It is an IRR. So, yes, the cash may go up at the end but on average it is 10-13%. When I look at private equity, which requires 20-25% plus type returns, I am comforted that the returns are not as extravagant as private equity may take. That having been said, private equity is taking a fundamentally different risk in terms of business investment.
On the flip side, is it Government gilts? No, it is not. It doesn’t have the riskless nature of the Government gilt, which admittedly is a fixed income instrument that probably yields you, if you are in a fixed income fund, somewhere between 3-5%. I know we talk about profitability of equity. It is a question of trying to place it in its respective place in all the other asset classes that investors invest in.
Q69 Mark Garnier: Yes, but according to this report, every single profit is way above what you just described. Off the top of my head, the average is probably a lot higher; 60%. If you look at it by sector, you have Health profitability. On 14 PFI transactions that have been transacted, the average profit is 67%. Defence, which is pretty stable now, is only two projects, so it is a relatively small sample, but 134.5%. These are colossally big profits. Presumably, there is an opportunity cost to the taxpayer?
Richard Abadie: Correct. You are right. It came out of the taxpayers’ pockets. The opportunity cost is-
Chair: It is good business, isn’t it?
Richard Abadie: If you want investors in infrastructure-I mean, I can’t remember, and you would have to probably ask some of the other panellists, for example, what the implied equity return is in regulated asset bases, in HS 1 sales. They may be slightly below the 10-13% I was quoting, but I can assure it is not materially different. Just to be clear, on the 10-13% that is per annum.
Now, I think where some of those returns are coming from is that Balfour Beatty, for example-you have mentioned them-will invest in an infrastructure asset through the equity up front, they will build the asset up, they will carry the construction risk, and a little bit like Dieter was referring to about trying to get debt into the asset post construction, Balfour Beatty’s business is not to invest in infrastructure equity for the long run. They will try and sell on that equity. If you look in the UK, we have £50 billion worth of PFIs that have been built. Probably 10% of that is equity. It is about £5 billion of equity in this infrastructure asset class. The contractors cannot carry all that equity themselves. They have to recycle that equity to inject into other parts of their business or back into PFI, if that is the case. So, some of those profits would have come from on-selling their investments to infrastructure funds to private equity funds if they are participating in those, maybe selling them to pension funds-
Q70 Mark Garnier: Could you expand on that, because it is something that-
Professor Dieter Helm: Can I explain this bit here? If it is true that there is no market failures in construction then the return on construction will be normal. If it is true there are no market failures in operation then the return will be normal. It goes to the heart of your PFI issue. It all comes from the financing. Then the question is: by bundling this together, is this an efficient way of delivering what, in the financing, should be referring back to what other infrastructure assets might earn once they are at the refinancing point, and that is the huge gap between what the PFI costs and what the utility model costs. That is the gutter. If there are market failures in construction, it would be different.
Q71 Mark Garnier: Yes. So, the PFI is a much more expensive way?
Professor Dieter Helm: Your returns are a function of the fact that the cost of capital relative to what people are refinancing at creates an enormous gulf. It comes back to my point: you might see the returns coming down, but against a world in which the real interest rate in this country is currently minus 5% real. It is an enormous windfall against the setting.
James Wardlaw: I haven’t read this paper, it would be interesting to see how much of those returns that you were talking about was accounted for by the differential debt costs, refinancing at much lower interest rates.
Mark Garnier: Well, these are equity sales.
James Wardlaw: Yes, I know, but the equity sale benefits from the-the equity pockets the difference in effect between the interest rates, so in a declining interest rate environment, which we have had through much of that period, a lot of that benefit, if they refinanced, would have accrued to the equity.
Mark Garnier: Yes.
James Wardlaw: So the equity returns that you talk about. Not only that, but those returns are obviously not per annum.
Mark Garnier: No, that is a fair point.
James Wardlaw: So, I don’t know, I think it would be quite interesting to see how much of it was made by pure equity returns and how much of it was by debt refinancing, because I think going forward you won’t see those debt refinancing benefits.
Richard Abadie: Can I touch on one more issue?
Chair: Very briefly.
Richard Abadie: I am very conscious of the time, Mr Chairman; I will try to be brief. Investors in PFI are very small subsets of the people interested in infrastructure. Not many of the investors in infrastructure want to invest in construction risk, so even if the pricing is higher it doesn’t automatically hold that the pricing in some of the other infrastructure asset costs-I would hypothesise that 80- 90% of the money raised to invest in infrastructure is not interested in PFI, and that is speaking directly to the funds.
Q72 Chair: We are very grateful to you for coming before us today. There has been some very interesting and, in some areas, conflicting evidence. I want to end with one question that you can answer with a "Yes" or "No", and if you answer "Yes" we would like to see it, which is: have any of you-and there have been 130 reports mentioned earlier-seen anything written that provides convincing evidence that the benefits of PFI outweigh the financing cost to Government?
James Wardlaw: The 2003 report produced by the Treasury called Meeting the Investment Challenge.
Chair: Yes, we have looked at it. That convinced you, did it?
James Wardlaw: That had a-
Chair: Why don’t you drop us a line telling us why you were convinced by that document?
Professor Dieter Helm: In aggregate, no, is my answer.
Chair: It seems to me that we are getting pretty scant replies to this.
Professor Dieter Helm: In aggregate, no.
Chair: Thank you very much for coming forward. We are going to take a five-minute break and reconvene at 11.50am, and the second session will last strictly one hour.
Examination of Witnesses
Witnesses: Steve Allen, Managing Director, Finance, Transport for London, Professor James Barlow, Imperial College, Anthony Rabin, Deputy Chief Executive, Balfour Beatty, and Jo Webber, Deputy Director of Policy, NHS Confederation, gave evidence.
Q73 Chair: Thank you very much for coming before us this morning. It is still this morning by a whisker. I am sorry we are a bit behind schedule. We are going to try to run this session as crisply as possible. Can I ask any of you who want to answer how much risk is really being transferred in these projects from the public to the private sector? Does risk transfer really take place? Who would like to have a go at that?
Professor James Barlow: I think I can talk about the healthcare sector. Undoubtedly some of the project risks are being transferred from hospital trusts to the private sector, to the SPV, and the operational risks remain with the hospital and the trust. In the case of healthcare PFI, I think that is where a lot of the problems lie, because I think it is extremely difficult to identify what those risks are, given the fast-moving, rapidly changing nature of healthcare, so the whole question of how much risk you shift from one party to the other is rather difficult to determine.
Chair: So there isn’t much risk transferring now?
Professor James Barlow: Probably the answer is no, and I was quite staggered by some of the figures given at the end of the last session about the rates of return in healthcare, given the limited amount of risk transfer that has been observed, I think.
Q74 Chair: Does anybody want to dissent from that view?
Anthony Rabin: May I dissent, Mr Tyrie? I think that in principle there are a number of risks that can be transferred under the PFI mechanism. The first and fairly obvious point is the project management of risk associated with a large capital project, which, dare I say it-at least historically-hasn’t universally been managed well by other forms of procurement. So, that is certainly one risk.
Chair: So that is the build rather than the management?
Anthony Rabin: Yes. I will go further and say the design and build and its integration with the operational needs of whatever the particular circumstances are.
Chair: What about on the management side?
Anthony Rabin: I think, on the management side, it depends a little on what the nature of the contract is. There is a tendency to split this into what are called hard services and soft services. The hard services, certainly as I see it, are an integral part of what might be deemed to be whole life risk, which is another, I believe, major element that is transferred and is probably in reality rather difficult to do other than through the mechanism of the PFI. I think in relation to soft services, for example, in a hospital, such as cleaning and meals, there may or may not be risk transfer. I don’t personally think that they are essential to the debate that this Committee is having this morning.
Chair: Sorry, I didn’t understand that last bit. You don’t think it matters where the risk is?
Anthony Rabin: No, I said I don’t think that the issue of whether or not risk is being transferred in those soft services is necessarily the central issue that appears to be occupying this Committee this morning.
Q75 Chair: Where the risk lies is an important issue, wouldn’t you agree?
Anthony Rabin: Certainly, but the essence of the argument lies in the hard services and how they relate to the transfer in relation to design and build risk and then the consequent whole life risk.
Q76 Chair: But you can point to a project which, in your view, a reasonable man would conclude had seen substantial risk transfer?
Anthony Rabin: Yes, I think many of the larger projects have and do see such substantial risk transfer.
Chair: On the management side, not on the design and build?
Anthony Rabin: Yes, indeed.
Chair: Perhaps you would drop us a line with a list of those sometime.
Anthony Rabin: Certainly.
Q77 Michael Fallon: How will the NHS cope when it is locked into 30-year contracts for large hospitals, where more treatment and care is simply moved away from that kind of provision?
Jo Webber: I think this is going to be a challenge, because I think that what has happened is that a lot of people now have large buildings that they are committed to over a long period of time, when the most recent sort of direction of travel for care is to have it much closer to home, much more around people in their own communities. It is very difficult to change a very high-value environment like a ward environment into something that is affordable. Despite what previous witnesses said, I think it is very difficult and expensive to make variations to contracts, and the square footage costs of building wards is very different from the square footage costs of building, say, office accommodation.
Q78 Michael Fallon: Professor Barlow, what will the NHS do with hospitals that it doesn’t need?
Professor James Barlow: A very good question. I think my colleague here has stated that it is incredibly difficult to adapt some of these buildings, and I think one problem is that we have large, highly-specified buildings that are inflexible. Undoubtedly we needed new hospital infrastructure at the time PFI started out, so in that sense, I think PFI was extremely beneficial. It rapidly saw a lot of new buildings built, but my concern really is about the inflexibility of these buildings and the impossibility of, over a 30 or 40-year period, predicting what the demand is going to be like for the bed spaces in those buildings. That is what I meant earlier when I said that a lot of the risk remains with the trust, because they have to carry on paying for these contracts even if the demand is going down, and as we know, it is. How much of that demand risk is contractable-can be written into contracts and shared or transferred-is another matter. I think it is extremely difficult.
Q79 Michael Fallon: But given the particular inflexibility of these contracts for healthcare, would the Government be justified in revisiting these contracts now?
Professor James Barlow: Again, I think the point was made in the last session that on a case-by-case basis, there might be a need to go back and look at how they are performing, yes.
Q80 Michael Fallon: But if that doesn’t happen, presumably some trusts are going to get into very severe financial difficulties continuing to pay the rent.
Professor James Barlow: I think we have seen some of that already in some cases.
Jo Webber: Yes, I would absolutely agree that there will be a big affordability challenge over a long period. It will have different impacts on different parts of the country, I think, and I think it is interesting to look at how you might close some acute facilities or downsize some of the services that you deliver from acute facilities when you may have organisations that are too large to fail in some areas or are delivering other things that you can’t deliver elsewhere. There may well be a knock-on impact on the non-PFI hospitals of trying to keep the PFI hospitals going, because some of them are too large to fail.
Q81 Michael Fallon: I think there are examples of that at the moment. So, the level of these rental payments and the inflexibility of these contracts is a serious distortion of finance within the health service at the moment.
Jo Webber: I think I should say, having talked to some of our members who are obviously in receipt of PFI contracts, at the moment they are managing to deal with these issues, but you are in a situation where the financial pressures are going to get greater over the next few years, certainly, so it will become more of a challenge for people over the next few years.
Q82 Michael Fallon: The health service is now subject to pretty tough targets on efficiency savings. Those do not apply to the services being provided under PFI. Is that right?
Jo Webber: I am not sure that that is right, because the efficiency savings are on the whole of the hospital or the local health economies and services. The issue is whether financing your PFI debt means that there are some things that you would otherwise have invested in that you now no longer can afford to invest in.
Q83 Michael Fallon: Yes, but the specific search for efficiency savings: the PFI contractor is exempted from that, is he not, because he has his contract?
Professor James Barlow: They would be incentivised to search for efficiency savings inasmuch as they relate to the bits of the contract that they are responsible for, whether facilities management or maintenance of the building and so on.
Q84 Michael Fallon: Are any of you clear about this? Do the efficiency savings targets apply to services provided under PFI?
Anthony Rabin: Perhaps I can contribute here. The contracts themselves may well be several years old and therefore will have their own specifics, and whatever the new regime is that may or may not be applied to the NHS won’t apply to them. However, there is nothing to stop them; indeed, some contracts do have built-in efficiency savings. Let me give you one example, which is our schools contract with Hertfordshire, whereby it is a long programme over a reasonable number of years. We commit that over the course of a number of years we reduce the build cost per square foot, so it can be done.
Q85 Michael Fallon: Yes, but that is a construction cost. What I am asking you about is the actual service delivery, particularly in hospitals.
Jo Webber: The efficiency savings apply to the organisation, to the hospital. They are not carved down into efficiency savings in particular services, so it is for the hospital to decide how they get those efficiencies out of the services that they provide.
Michael Fallon: But they can’t do that by revisiting any part of the contract.
Jo Webber: They can’t do that by revisiting the PFI, unless they can get a variable one.
Q86 Michael Fallon: So, the pressure on the non-PFI side is all the greater because of that. Is that right?
Jo Webber: Yes, I think that is probably right, but it is not an efficiency saving on a particular service. The trust has to make efficiency savings rather than individual services.
Q87 Michael Fallon: So, we have a funding model for hospitals particularly that has been developed by the Treasury and by the last Government without really considering the full implications for service delivery?
Jo Webber: When a lot of PFI projects started, obviously we were in a very different financial situation. The efficiency targets are for the whole of the hospital and arrive basically through the tariff system, so this is about the rate of inflation of the tariff for the services that are provided by the hospital. That is their major source of income. What has happened recently is that the tariff has been held at a particular level so that with inflation working at the same time, what we have is a relative deflation of the tariff, so income is deflating through the tariff, but it is up to the hospital locally to decide, particularly if it is a foundation trust, perhaps its designation services, what it is going to deliver with the income that it gets.
Professor James Barlow: To follow on from that, if it was identified that a particular efficiency saving could be had from closing beds and devolving services into the community, then the nature of the PFI payment and contracts may make that difficult. So, yes, it does have an effect.
Michael Fallon: Well, it could be legally impossible.
Professor James Barlow: Possibly impossible.
Q88 Chair: Are these NHS contracts unaffordable because of the characteristics of PFI, because of the high cost of capital?
Professor James Barlow: I think again it goes back to the discussions in the previous session about the cost of borrowing and whether Government can borrow at a lower rate-
Chair: Yes, but what is the answer? This is a fairly straightforward question. Is that the cause?
Professor James Barlow: It is probably more-yes, the cost of capital is higher, certainly, yes.
Chair: The answer is yes?
Professor James Barlow: Yes.
Jesse Norman: Your question, Mr Chairman, doesn’t engage with the issue of whether the cost of capital is higher because PFI is the mechanism being used.
Chair: Well, it engages with the differential between the long gilt market and the cost of capital in these projects.
Q89 Jesse Norman: I mean, we have already had evidence that PFI is an intrinsically expensive way to fund systems, so it will undoubtedly have an effect, from what you are saying.
Just to cover some others: in the case of Herefordshire Hospital, which was commissioned in 1998, where my constituency is, there are no efficiency uplifts built into the contract; there are no benchmarking characteristics built into the contract. The contract cannot be unilaterally revisited by the hospital. It is a fixed nut that has to get paid regardless of whatever the costs of other flows or any other costs are on the hospital. That doesn’t disagree with your experience in terms of the fixed nature of the cost that has to go to service the PFI annual payment versus the changing nature of the costs and efficiency savings placed on the rest of the hospitals?
Jo Webber: Herefordshire was one of the early PFIs, I believe. It was very close to the beginning. I have to say that the contracts have changed and the experience and expertise of the providers in specifying has changed over the course of it. There has been a lot of learning from the early contracts about how they might be better specified.
Jesse Norman: That is a polite way of saying that it was a bad contract.
Jo Webber: All I am saying is that we have learnt from the experience of the early contracts.
Q90 Jesse Norman: Okay. Can I ask about the issue of procurement of PFI contracts? We have had a lot of testimony that it has been extremely expensive; we have had a lot of testimony that competition has been limited and there is a high level of complexity. Is that something you could comment on, any of you? We have had a lot of testimony separately that the fact that the financing has to be lined up at the point of signature is extremely expensive and that the procurement costs are not included in the unitary payment disguises the true expense. Could you just comment on that? Maybe Mr Rabin.
Anthony Rabin: Yes, sorry. Your points were that it was expensive and that there is limited competition. I am sorry, there was a third point I didn’t get.
Jesse Norman: Expensive, complex, limited competition and that the expense specifically was driven up by having a deal ready at the point of signature at the end of the procurement competition, and finally that since the procurement costs themselves were not included in the annual charge, they were in some sense rolled into the capital cost. They were never visible. They were kept separate from the running charge to the hospital.
Anthony Rabin: Perhaps I can take those in turn then. Is the procurement expensive? Yes, relative to other forms of procurement it probably is expensive. It is more complex; there is a whole machinery about PFI that you need to get right, otherwise it doesn’t work, so almost by definition it will. I think that the cost of procurement has come down sharply over the past 15 years or so as the public sector and the private sector have learnt that we all collectively can be more efficient. It probably still is.
Is there competition? I think this was your next question. Yes, I think there is. I think there is quite effective competition, and I don’t see any evidence that the competition is any less now than it was previously.
Q91 Jesse Norman: Let me give you a piece of evidence. It looks like there are only four advisors who are ever used on the accounting side, and a small number of legal advisors. There doesn’t seem much competition in that area.
Anthony Rabin: But neither of those are our particular industry, so it is rather difficult for me to comment on those. I am not sure I am the best person to ask, certainly.
Jesse Norman: But you see these contracts every day. I mean, you must be able to comment on the expense of those or the degree of competition in them.
Anthony Rabin: I would perceive from our side of the table that there is a reasonable amount of competition, but as I said, it is from the other side of the table.
You asked about whether the costs of procurement are wrapped up into the cost of the underlying contract. Yes, they are. The underlying contract ultimately comes out as a unitary charge that does not distinguish between repayment of capital and operating cost-it is a single charge-but almost inevitably will take some account of the underlying cost of the procurement.
Q92 Jesse Norman: Right, so they are capitalised. We never see them at the time they get paid; they just get rolled into the capital?
Anthony Rabin: They will be transparent to the advisors of the relevant public sector organisation, who will scrutinise them carefully to make sure that they are appropriate.
Chair: We are going to have to move on shortly.
Q93 Jesse Norman: Professor Barlow, just to ask a question which I know you want raised, Mr Chairman, do you think PFI has been beneficial for innovation in the National Health Service? Do you think we have more innovative and better hospitals as a result of PFI than we would have had otherwise, or is the opposite true?
Professor James Barlow: I think "no" is the short answer to that. I think the way risk was devolved and transferred has meant that it has made very difficult to stimulate any kind of innovative thinking about the design of the buildings, any real sort of attempt to think about future flexibility and so on, certainly in the early PFI projects that we looked at.
Q94 Jesse Norman: Do we have better hospitals that we would have had if we had procured them by some other mechanism, by the extra cost?
Professor James Barlow: In the 1960s and 1970s we had a huge hospital building programme that was centrally driven, and there was a great deal of design innovation, so I will leave that you to decide that.
Jesse Norman: Sorry, your view is there was a lot of innovation in the 1960s and there has not been today?
Professor James Barlow: There was more design innovation in the 1960s and 1970s.
Chair: Your answer was that it stifled innovation.
Professor James Barlow: It stifled it, yes.
Jesse Norman: You are suggesting also the quality of hospitals was less good than it would have been if it had been procured in a different way.
Professor James Barlow: Sorry?
Jesse Norman: You seem to be suggesting the quality is less good overall than it would have been.
Professor James Barlow: No, I was not talking about quality. I mean, the whole life-
Chair: You are talking about innovation.
Professor James Barlow: I am talking about design and flexibility and adaptability. The quality of the buildings is not something I can comment on, but certainly the way in which PFI focused interest on whole life casts, I think, should drive up quality.
Q95 John Mann: Mr Rabin, what percentage of the new school PFIs did your company bid for, approximately?
Anthony Rabin: I’m not sure I have an answer. Over the whole period, I would think a fair proportion of those that were put out for tender we would have bid for. I don’t have that number. I can supply you with that number.
John Mann: Hospitals as well. What kind of-
Anthony Rabin: Yes. We would be a major competitor in both hospitals and schools.
John Mann: In virtually all of them?
Anthony Rabin: No, not I think in virtually all, but in a significant number. As I said, I don’t have the figures.
John Mann: What is "a significant number"? Is it up to 30, 50, 70?
Anthony Rabin: I would guess that one in three possibly we would have bid for, something like that.
John Mann: One in three?
Anthony Rabin: But that is a guess.
Q96 John Mann: Yes, okay, but let us say it is one in three. I mean, why didn’t you bid for more than that?
Anthony Rabin: Because there is a limit to the amount of resource that we have, and when I talk of resource, I mean human resource.
Q97 John Mann: Yes. There are not that many competitors in the field, are there, so this lack of competition: what impact do you think that had on price?
Anthony Rabin: I’m not sure I would agree with you as to the lack of competition. I think that there are a significant number of competitors. It depends a little on what you are talking about. I mean, are you talking about a very large hospital or are you talking about a small school? I think it is rather difficult to generalise, but I think that there are enough competitors such that the public sector does get value for money.
John Mann: When you won the contract for the eight schools in my area, you were the only serious bidder.
Anthony Rabin: That is not something we were aware of at the time.
Q98 John Mann: No, but that is a question: perhaps capacity was such that you are all doing so much work that you could not bid for everything and therefore you did not, and therefore there wasn’t a competitive price in it.
Let me ask about how you would vary a contract. I raised the issue earlier of, say, a swimming pool that goes wrong, or wrongly specified. How much would it cost? What is the obstacle? Is there an obstacle? What is the obstacle to fixing something like that that is suddenly identified part-way through the project?
Anthony Rabin: I don’t think there are any obstacles in principle, and may I say I am not aware that we have a swimming pool problem in your particular constituency, but-
John Mann: Okay, but your company build a school, for example, where the swimming pool didn’t meet the spec because it was architecturally wrongly designed, and the hockey pitch was a foot too small to be competition-level. When that was raised, it wasn’t possible to change it, and I am trying to work out why.
Anthony Rabin: I would very much doubt that that would be the case.
John Mann: Well, it was the case.
Anthony Rabin: If things are not according to spec, then inevitably the public sector has the right to demand what it has paid for. That is very simple.
John Mann: No, no, no, if it is specified wrongly. Do not fall into the trap we had before. If it is specified wrongly in whatever way, incompetently, how much would it cost the public sector to fix that?
Anthony Rabin: I think, if it is specified wrongly, as in the public sector said, "I want X and now I want Y" if that is what I understand you to mean, then that is going to be a very individual process that will revolve around what X was and what Y now is. I don’t think I can answer that.
John Mann: You see, I am just trying to get my head around the flexibility, because I could give you numerous examples where changes couldn’t be made because the contract had already been let, from lighting to corridors, to some that at great expense were changed, like how many sockets there were, but anything other than sockets couldn’t be changed because of the price. I am just interested to see, because that is not my experience of public procurement generally, why that was such a problem and why it was so expensive to change.
Anthony Rabin: I am not aware that it would be any more expensive to change a PFI contract in that respect than it would be if the public sector had procured your example of a swimming pool and then found it wanted a different one. I don’t see why.
Q99 John Mann: It would be useful, in that specific example, which is Valley School in Worksop, just to get a note with the swimming pool and why it was impossible to fix it for the Committee just to see, because I remain mystified.
Has public use of the schools that you have built gone up or gone down since you have been managing them?
Anthony Rabin: I believe it has gone up, but once again, I don’t have statistics to hand. I am very happy to provide them to this Committee.
Q100 John Mann: That would be very useful. Looking at the future, two issues: if the public sector wanted to bring back in insurance on the basis it could be done more cheaply by the public sector than by you, would you regard that as a sensible and positive potential change for the future? Secondly, on retrofitting, let us say that Parliament, Government, decided to legislate in the next 20 years for retrofitting schools to bring technology, solar panels or whatever, into the National Grid. Who would pay for that, in your view, and who would profit from the proceeds of that?
Anthony Rabin: The answer to your first question is definitely, and I think there is much wastage in the whole concept of insurance at the moment, and I think in not all but in certain circumstances it would be much better value if those risks were borne by the public sector. That, I think, is an answer to your first question.
In respect to specification change halfway through a contract, once again, I think it will depend entirely on what the specification was and what that contract was. It is very different.
John Mann: Yes, but the obvious one that might come from politicians is-let us call it a green retrofit. That is the most obvious one that politicians at some stage might decide to legislate for. How would you see the funding and the profits, if there were some from that, working?
Anthony Rabin: The best way-
Chair: Can we have a crisp reply to that, sorry, because we are going to have to move on?
Anthony Rabin: The best way would be to have that discussion at the start of the contract to allow the public sector sufficient flexibility that it was able to make choices some way down the contract, and indeed, if that is done then the private sector can arrange for such financing to be provided at that future time.
John Mann: Finally, do you have a price on insurance?
Chair: No, I am sorry, John, but we are going to have to move on.
Q101 John Thurso: Can I ask some questions about special purpose vehicles that are used in constructing the finance? Clearly they are necessary in order to undertake the financing, but there are, I presume, pros and cons that come with that. Can I start with you, Professor Barlow? What are the pros and cons?
Professor James Barlow: Of a special purpose vehicle?
John Thurso: That construct.
Professor James Barlow: It is a vehicle for bringing together the various parties that are necessary to deliver the project in a financial and contractual framework. It gets them talking to each other and gets them discussing what the alternative ways of delivering the project are. The cons I would say probably revolve around-certainly in the early days of PFI, there was a lot of talk about the sort of imbalance in knowledge and power between either side of the table, so the SPV and its advisors, and, in healthcare, the trust and their advisors, and the impact that had on negotiations. You may have another view on that.
Jo Webber: I would absolutely agree. I think what has happened over the years is that the public sector body has developed more expertise, either inhouse or by buying in expertise, so that those conversations are more balanced now than they were. Not to say there isn’t more there could be done, but it is one way of ensuring that everything is sort of slotted together, not just the design and construction, but the way in which the facility is going to be run afterwards and the way in which a lot of the maintenance contracts and so on are going to be bundled together afterwards.
I have to say, though, certainly in some of the later cases, people are looking at how much they want all of those areas bundled up together, and I know that you have had evidence from North Tees, who are looking to unbundle some of those, some of the maintenance side of that and the fitting-out side of that to both give them some more control within the situation, but also obviously to keep costs down.
Q102 John Thurso: So, one of the cons, clearly, is that you have somebody who is inserted between the provider and the user, and that was a defect in the early days.
Jo Webber: Yes.
John Thurso: Can that defect be remedied?
Jo Webber: Yes, I think it probably can. I think the bottom line is that we have a lot of new buildings in the NHS which we otherwise would probably not have had, or certainly not at the rate of increase that we have done, and that has enabled us to meet some of the initiatives going forward: things like infection control, single rooms and so on. We don’t want to lose that on the way forward, but we do need to keep the costs down.
Q103 John Thurso: Mr Rabin, from the other side of the fence, as it were, what do you see as the pros and cons?
Anthony Rabin: I would entirely agree. I think that they are a necessary evil, if I can put it like that; otherwise it is not possible to construct the financing. The real issue for us is: do they get in the way between our clients, our customers and those who provide the services? They shouldn’t. They probably have done in the past. We work extremely hard to make sure that they don’t.
John Thurso: I like that description: "a necessary evil" required for the financing, which basically both sides you then have to manage.
Anthony Rabin: Yes.
Q104 John Thurso: Mr Allen, TfL do that very successfully, because you have been managing out some of your bad PFIs. What are, in your mind, the pros and cons of the PFI and the SPV?
Steve Allen: We inherited a number of PFIs when TfL was created that had been entered into by predecessor bodies, and with some of those, I guess that we saw that the risks were not well aligned, and as a result, the PFIs were not very successful. A good example would be the Croydon tram link project, where the SPV was, under the original contract, taking revenue risk despite the fact that revenues are part of a London-wide revenue pooling system, so in actual fact, the ability of the concessionaire to influence those revenues was very small. They had difficulty in managing the risks associated with competing bus services and so forth. That was an example of an inefficient allocation of risk, and ultimately we decided to restructure it by buying out the company.
Q105 John Thurso: Is there a lesson to be learnt from TfL in that one of your core competencies is procurement, or should be, whereas that is not necessarily the case in other areas of the public sector?
Steve Allen: Yes. I think because of the size of the organisation, the nature and the complexity of the contracts that we have, both PFI and other contracts, it has enabled us and required us to build up an expertise in letting and managing those sort of contracts that it probably wouldn’t be economic for other public authorities to try to build that expertise.
Q106 John Thurso: One last question for you, Ms Webber. In your submission, you have a rather short but fascinating paragraph suggesting an NHS bank. Can you very briefly tell me what that is?
Jo Webber: The concept behind it is that this is funded through capital elements of the the DEL, and is worked almost like a retail bank. A lot of foundation trusts do have money that they can invest short-term or long-term. One thing we would say though is that it would have to be run as a bank and that this would need banking expertise to run it. It is not something that the NHS has done in the past, and neither is it its core business. It would need expertise in to run it, but it could be used for capital refinancing, for capital investment.
John Thurso: Interesting. Is there something more worked up?
Jo Webber: We have some more that we could send to you.
John Thurso: I think that would be quite fascinating to have.
Q107 Chair: You don’t use PFI at all at the moment, do you?
Steve Allen: The last PFI contract we let was the extension of the DLR to Woolwich, and we are talking on Crossrail as to whether the-
Chair: So you are examining one use?
Steve Allen: Yes, the rolling stock for Crossrail, maybe.
Q108 Chair: But you think it is too inflexible. That is what your evidence suggests.
Steve Allen: Yes. I think PFI does tend to be an inflexible route of procurement, and is therefore only suitable for procurements where you don’t need to change what it is you require over the life of the contract. If you look at things like roads or new railways, where once you have designed where the transport scheme is going to go, you fundamentally are not going to change it, those have been more successful examples of PFIs than things that are intimately involved with the operations of transport; for example, the experience of the London Underground PPP, where it was much too closely intertwined with the day-to-day operations.
Q109 Chair: So it can work on the CAPEX side, but not the management?
Steve Allen: There is clearly a maintenance side on a road asset or a bridge or a railway, but that is obviously a much smaller part of the overall cost of the project.
Q110 Mark Garnier: Ms Webber, in your reply to Mr Norman, you said that you had learnt the lessons of some of the earlier PFI projects. Was Worcester Royal one of those lessons that you learnt?
Jo Webber: I don’t know the details of Worcester Royal or the experience around Worcester Royal, I am sorry.
Q111 Mark Garnier: No, fair enough, I was just wondering. But there is an important point with this. I don’t know if you were here in the earlier session, but there was a submission from Dexter Whitfield, who is the Director of the European Services Strategy Unit, and he has done some research into profits from PFI equity sales. What is very interesting is that looking at the ones he has analysed, he has analysed 14 PFI transactions in the health sector with around 18 projects, total value £129.3 million, with an average profit of 66.7%. Doesn’t that make you rather annoyed that there is so much profit for the people who are providing PFI for you?
Jo Webber: Obviously we have to look at the amount of efficiencies that we could get out of the PFI contracts. I think it is difficult to see how you extract these. Obviously the point was made earlier about looking at things on a case-by-case basis, and I know there is some work going on within the Treasury around the Romford PFI, trying to look at that and really extract the information from that. The problem is things like renegotiation costs, like alternative uses, like the extent to which the NHS could afford the rebuilding programme that has been going on without using something like PFI to get private capital in in the amount that it has been to get the projects under way. Some 101 of the 135 new NHS hospitals have been through PFI between 1997 and 2009, so it is a substantial amount, but obviously looking for how you get efficiencies and how you get the most effective contract is something that you need.
Q112 Mark Garnier: You made reference to the NHS bank, which sounds very interesting, and presumably from the NHS and national health economy, that would be extraordinarily useful if you were maintaining or keeping that profit within the health economy, so obviously it would be very helpful if you pass some more details on.
Jo Webber: Yes.
Q113 Mark Garnier: Mr Rabin, keeping with the profits, Balfour Beatty in this analysis have sold five PFI projects with a total value of £37.8 million. You have an average profit of 71.4% on that. You have done very well.
Anthony Rabin: Perhaps I can start by saying I don’t have those numbers at my fingertips. I am very happy to provide a breakdown to the Committee if that is what you would like. Perhaps I can address the more generalised point, which is: what is a fair profit? What is a return? Looking at accounting profit, it seems to me to be potentially misleading. Let’s round numbers. I could give you a figure of, say, a profit of 60%, but wouldn’t you in turn like to know whether I had made that over one year, in which case it would be 60%, or 15 years, in which it would be 4%? The answers are rather different, so it does seem to me a more reliable measure-and I think it is a very important point, and as a taxpayer, certainly I am as exercised as anybody else-that we get value for money. It seems to me it is more useful to look at these things in terms of rates of return.
Now, the NAO I think has looked at this from time to time. The NAO I think has concluded that at least historically, investment rates of return at the point of bid tend to be in the, I think, 13-15% per annum range. It would seem to me that that would be the subject matter of whether that is the right rate, whether it is too high, too low or whatever. I would suggest to you that it is not a particularly high rate given that there are significant risks. Mr Friend alluded to those in the earlier session, that not everybody makes a profit at all out of this. I think it is easy to focus on the profits and to ignore those losses. We, as investors, have to take a balanced view.
Q114 Mark Garnier: Yes. These numbers are obviously the averages, so this is taking an average. No, it is a very fair point. We don’t know whether this is over one year or over a period of potentially 12 years, and some of these will obviously be over that, but it would be very helpful if you-I think this is freely available-could have a look at that and get back to us and let us know what it is.
Anthony Rabin: I am very happy to do that.
Mark Garnier: But what I would say though, just as a broader point, is that you are the second-most profitable of the ones on the manifest. Balfour Beatty is the second-most profitable, with Carillion at 41%, John Laing at 59%-and I’m going to just rattle these numbers off-Serco Group, poor fellows, have only made 20%, but then maybe it is just because that is one year, but we don’t know. But it would be very helpful. That is fine, thank you.
Q115 Andy Love: Can I come to the issue of possible renegotiation of contracts? I think it has arisen out of the debate we had in the previous sessions, and indeed, in this one, and in the last one we focused entirely on whether there would be a rebate arising from that renegotiation, but perhaps taking on board the point that Mr Fallon made earlier on about NHS contracts, whether creating some greater flexibility within the contract would also be something subject to renegotiation. Can I take the producer point of view first of all perhaps, Mr Rabin, and get your view about renegotiation: whether it is feasible, and how it could be managed?
Anthony Rabin: I think that renegotiation is always feasible and, potentially in some cases, desirable. I do very strongly believe that that should be at a local level between the buyer of services and the provider of services rather than at an omnibus global level. I don’t think there is a one size fits all there. We are very concerned to offer our clients the best value for money, and indeed are actively engaging with them in how we can provide that. If that means contract renegotiation, that is fine.
Q116 Andy Love: From the National Health Service Confederation point of view, one of the things that has always mystified us is that we have in the National Health Service a very top-down body, yet in terms of PFI contracts, it has been very decentralised. We are now talking about decentralisation. I would like to ask you: isn’t there a role for centralisation in terms of PFI and getting a team together that can do this sort of renegotiation and gain most rather than leave it to individual initiative at each trust level?
Jo Webber: No. I think this is something that has to be done on a contract-by-contract basis, because the contracts are different, because as you go through the history of PFI-
Q117 Andy Love: No, I wasn’t suggesting that. I was suggesting that rather than have the contract negotiated by local managers at an individual level, you would have somebody come from the centre as well with the expertise, because clearly one of the issues here has been the quality of the management in terms of the National Health Service in negotiation with the private sector.
Jo Webber: I think you could possibly make the point about a pool of expertise that could be called on. I wouldn’t go for somebody coming out and negotiating the contract for you. I think, if nothing else, that expertise needs to be developed inhouse if you are really going to get the right relationship with the SPV and you are really going to get the best out of the contract. In terms of renegotiation, with the NHS changing at the speed it does, anything that allows contracts to be more flexible and to look at space in a different way and the way in which you use space in a different way would be helpful.
Q118 Andy Love: Can I ask you, Mr Allen, because you have the most experience here of this process. Now, it is much more straightforward, I think, for TfL in the sense that you raise your own finance, so you can purchase, if you like, but how difficult did you find it?
Steve Allen: Certainly having the ability to borrow ourselves directly gives us a lot more flexibility in looking at different procurement approaches, and it also gives us some flexibility in renegotiating existing contracts in that we can buy the debt back and refinance it on our own terms, and we have had examples of that. Fundamentally, it depends on the contract you let at the outset. You can build certain amounts of flexibility into the contract that you let if you can foresee what flexibilities you need, but there will always be limits around that, and it will affect the appetite of people to bid and the price that they will bid for that.
If you are trying to renegotiate something that was a very fixed contract that has perhaps been let in the early stages of PFI, that is extremely difficult, and if I go back to the Croydon example, essentially what we had to do was buy the SPV from the shareholders because there wasn’t the flexibility to renegotiate the terms of the contract. So even though it wasn’t a very successfully performing contract because they weren’t maintaining the asset terribly well, we still to buy the equity back from them in order to put the asset on a proper footing.
Q119 Andy Love: I will come back to you just in a second, but let me just ask Mr Rabin-it arises from that-the private sector hasn’t shown itself very amenable in the past to either sharing the financial benefits of PFI or, indeed, in negotiating more flexibility. Mr Allen’s example suggests to us that they will be very tough. Isn’t there some recognition in the private sector that especially at this time of some limitation in funding in the public services that the private sector through PFI has to make some contribution towards this?
Anthony Rabin: I can only speak for ourselves and I can only speak for my company. As far as my company is concerned, yes, of course we have an absolute recognition that these are difficult times and that we wish to play our part, and as I said earlier, we would be very happy, and indeed, we are in dialogue with some of our clients as to how to assist in making that transition.
Q120 Andy Love: Perhaps we could get some information on that. Can I just ask Dr Barlow: did you want to comment?
Professor James Barlow: Simply to make the point, I am just questioning on what grounds one is seeking a rebate. I mean, if it is simply because the market conditions have changed, there is less money in the NHS and less demand for bed spaces in a given hospital, that is a completely different matter from the swimming pool being too small and wrongly specified. Given that you can’t readily specify and measure and guarantee particular levels of demand in the future, I am just wondering whether you might get fairly short shrift from investors in the private sector.
Andy Love: I do accept that point. I don’t think what we are here discussing today only comes up in the context of particularly the National Health Service. What we are here to discuss today is whether or not PFI was value for money, and I think it is in that context, and we accept that the negotiations have to go on at a local level individually with each PFI contractor. I think the other point forms a backdrop to that, and some recognition, which I don’t think there has been much sign of in the past, that the private sector recognises it as in a partnership of PFI nature, then there needs to be give and take on both sides.
Q121 Michael Fallon: Mr Allen, how does the financial cost of PFI compare with other sources of finance that you could be using?
Steve Allen: I suppose at the time most of the PFI contracts that we have were let there was no alternative source of finance for the sort of predecessor entities, so there was no valid comparison. Now that we have the ability to borrow directly, we do have that comparator, and so you can, in a very real sense, assess the value for money of the PFI solution.
Q122 Michael Fallon: So what is the answer?
Steve Allen: Our cost of borrowing is probably something to the order of between 0.5% and 1% above gilt rates, because we are not Government guaranteed, so we do pay a bit more than gilts. I think somebody earlier was talking about 250-so 2.5%-above swap rates for PFI finance, so there is a significant premium for the cost of finance through a PFI.
Q123 Michael Fallon: Have you identified any particular efficiencies in your sector that you can put against that extra financial premium?
Steve Allen: I think it is hard to say that if you look across all the projects, overall PFI is value for money against that additional cost of finance.
Q124 Andrea Leadsom: Mr Allen, again, can you just confirm that it is the finance that is the difference in the value to the taxpayer, not the construction? Do you fund and procure directly just because it is cheaper, or are there other perceived benefits to you as well?
Steve Allen: I think again, as other people have said, there are the underlying components of the project that you ought to be able to contract for at the same price, so it should not cost you any more to build the asset under a PFI contract; it should be exactly the same as if you procured it. In theory, at least, everything that you can do in procurement terms under PFI you ought to be able to do directly, if you have access to the finance.
Q125 Andrea Leadsom: But can I very specifically ask you, for example, if you procure something-to use Mr Mann’s example-and you have specified it wrongly, is it your view that it would be easier to then change your incorrect specification through a direct procurement or through a PFI, or does it not make any difference?
Steve Allen: No. The involvement of the finance in the PFI makes it more inflexible, because it is not just a question of negotiating with the contract who built the asset. Particularly if the change is going to require some significant amount of funding, they are going to negotiate with the equity investors and with the debt holders as well.
Q126 Andrea Leadsom: So it is the bundling up that makes it less flexible?
Steve Allen: Yes, and that was one of the perceived advantages of the PFI in the first place, that one of the major causes of cost overruns in procurements is the variations, is the specifying authority changing its mind as to what it wants, and it was specifically putting something of a straitjacket around that that was a perceived benefit to the PFI.
Q127 Andrea Leadsom: It does seem to me that from the evidence we have heard today, what we have had is really a series of PFI projects that have been poorly negotiated by the public sector that really the private sector, in an oligopolistic fashion-I think there hasn’t been enough competition-saw coming. Therefore, it sort of slightly amazes me, Professor Barlow and Ms Webber, that you say that it would not make sense to have some kind of central, at least, contracting expertise. I think you have just said that you think each contract should be negotiated separately. Surely that merely continues the risk that the private sector are going to lock you in to inflexible arrangements, where they may take the profit and you will take the risk.
Professor James Barlow: I don’t think I said we should not have some centralised skills.
Q128 Andrea Leadsom: But to what extent is the NHS learning from previous mistakes?
Professor James Barlow: In the past, the problem is it has been particularly devolved, decentralised, fragmented, and compared to what it was like 30 years ago, the reason we are a central repository of knowledge on how to write contracts, what makes a good design and it has been broken up. It is now back down to ground level-
Q129 Andrea Leadsom: If you could suggest one change, what would it be?
Professor James Barlow: I think that would be one of the major changes I would suggest: simply have a better mechanism for pooling expertise and knowledge on the client side, i.e. the NHS side, and sharing that knowledge so your negotiations are slightly more evenly balanced.
Q130 Andrea Leadsom: What prevents the NHS from doing that right now? Is there some reason why they are unable to share expertise? Ms Webber, you have just said that you think each contract should be negotiated separately by separate teams. What is to prevent the NHS unilaterally deciding to share expertise and negotiate centrally?
Jo Webber: What I said was I think if there is a pool of expertise that is held centrally, fine, but each contract will have to relate to local circumstances, and in an environment where you have increasingly more stand-alone foundation trusts, they would expect to have a lot of control over what that specification was, a lot of control over how their PFI looked, and really to be thinking those strategic thoughts about what they needed in the future out of a building and a set of services that they didn’t need in the past, so I would be slightly concerned if what we were developing was a central contract for this, because it does need to be locally flexible.
Q131 Andrea Leadsom: But it seems that those are two different points, aren’t they?
Jo Webber: Yes.
Andrea Leadsom: Deciding what you need from your hospital rather than someone else’s hospital is entirely different from negotiating terms that mean that if the spec should change there should be flexibility in meeting that spec, and surely that is where the shared knowledge just hasn’t happened.
Jo Webber: Where you have a central resource that you could loan out to help and support people locally, that will be fine, but you will also need to develop expertise within the NHS organisation so that the longer-term issues of contract negotiation, of making sure that everything was running, of controlling it, could take place within the trust. We need to build up the expertise at the same time as having some support for people when they are doing the original contract negotiations.
Q132 Andrea Leadsom: But it is not clear to me-just one last thing-I have avoided talking about the cost of it, but obviously if you had some kind of central negotiating, you would also presumably get a better deal on the price of it, but it still isn’t clear to me. Why hasn’t this happened? We have been doing these PFI contracts for 20 years, so why hasn’t the NHS built up this pool of expertise and been as aggressive as anybody in negotiating terms and pricing?
Jo Webber: The vast majority of NHS PFIs have taken place since 1997, and I don’t think there were very many before that.
Andrea Leadsom: 14 years; still a long time.
Jo Webber: I think the other thing is that there has been a learning process going forward. I wouldn’t entirely agree that we have learned nothing from the last 14 years of contract negotiations, but I agree that going forward we need to get better at it than we are at the moment.
Q133 Andrea Leadsom: Are there plans in place to do that?
Jo Webber: In the current situation with the way in which the reforms of the NHS are going, whatever they look like after today, obviously, I think the issue is how you ensure that you have a system of a lot of stand-alone foundation trusts clubbing together with support from the centre to get that expertise in place.
Andrea Leadsom: So there is nothing in place at the moment-
Jo Webber: There is nothing in place at the moment.
Andrea Leadsom: -that is creating that move? That is a shame.
Chair: Very depressing evidence we have had this morning, looking at it overall.
Q134 Jesse Norman: A situation like, for example, the one in Hereford is where they are opposite a company, Semperian, which has 106 PFI contracts, so the reality is they have no power to bring that party to the table and negotiate specific contract variations, because the other party can always look elsewhere. What would make a huge difference would be if the Department of Health or the NHS was saying, "We as a group are negotiating with you, Semperian, across 20 hospitals. Now, can we talk turkey?" Do you agree?
Jo Webber: That is one model.
Chair: Thank you for that brief answer, and thank you very much for coming this morning. It has been extremely enlightening, again a very wide range of views. We have learnt a great deal and we are going to go away and consider the evidence that we have had, both orally and in writing. Thanks for coming.