Michael Burnett: How Labour mismanaged Public Private Partnerships - and how we should reform them
Michael Burnett was a candidate for the European Parliament in the West Midlands in 2009.
PPP was the Labour government’s name for the Private Finance Initiative (PFI) introduced by the Major government. Concessions such as toll roads have been around for many years but the massive expansion of PPP since 1997 has been driven by a different type of PPP, so-called “public service PPP”, i.e. where the payment for the service comes not from end users but direct from public budgets.
Can public service PPP make sense? In concept, they do. They are based on the sound idea that government buys services through an integrated contract for both asset construction and operations which is bid for by a competitive process and paid for by a series of fixed equal instalments over the life of the service contract. The equal instalments cover the capital costs and operating costs so in effect the cost of construction is spread over the life of the service contract. It can be thought of as a form of leasing. The private partner is usually paid nothing until the service is being provided ie nothing during the construction phase. The advantages of this approach - the “no service, no payment principle” - are that:
- Because the private partner is paid nothing during the construction phase it has proved to be a strong driver to on-time construction;
- Because the private partner is remunerated for a fixed sum over the life of the service contract it acts as an incentive to “fit for purpose” construction: i.e. it helps to avoid on the one hand over-engineering in design and construction and on the other hand poor quality design and construction which could lead in both cases to expensive operating costs.
So what’s gone wrong with the use of PPP in practice?
Government departments and other public bodies have been under pressure to use PPP even when it did not clearly represent value for money compared with other ways of delivering public investment. This could easily be done by making it clear that there would be no capital allocation for non-PPP schemes. The highly subjective and potentially imprecise risk transfer adjustment offers plenty of scope to achieve the “right” result. So PPP has sometimes been used when it was not appropriate (how often is difficult to tell because commercial confidentiality is often used to avoid making figures public).
The risk transfer adjustment assumes that, if a transferred risk materialises, it does not then revert to the public sector. But this idea has not always been sustainable. The government could not accept the consequences of the financial failure of NATS – the private partner selected for the UK’s air traffic control PPP in 2001 – which faced it after the significant reduction in air traffic after September 11th. It had to offer immediate financial assistance to the company in order to create the space for a restructuring and refinancing arrangement.
PPP have usually involved long periods of negotiation with the winning bidder after the competitive award procedure. Significant contracts details are often finalised when the public sector is in a weaker position ie after competition has been eliminated. This has often occurred because of the failure to require bidders to obtain committed lender funding as part of their bids.
The length of the service element of PPP contracts is in many cases for periods well beyond a reasonable planning horizon for public services (20-30 years typically). The public sector is committed to pay for these services but may not need them in future or may want them delivered differently. Any change – additional services, changes in the way services are delivered, or performance standards for services – has to be negotiated with the incumbent supplier without competition, placing the public sector in a weak bargaining position.
Lenders in practice have taken very little risk. For example, to make the London Underground PPP bankable, the government guaranteed 95% of bank debt, even if the service provider failed (as Metronet did).
The government failed to effectively regulate key developments in the PPP market such as:
- Significant increases in equity returns through debt re-financing after the construction phase. The public sector now shares in re-financing gains, but it is still far from easy in some cases to calculate the re-financing gains and in some cases re-financing has led to an increase in the length of already very long contracts and thus a potential increase in the termination liabilities;
- The development of secondary markets in PPP equity stakes ie where the original investors sell their shares to third parties. These raise fundamental issues about the relative commitment of the public and private sectors to PPP contracts and potentially undermine the “design, build and operate” logic of PPP.
In short, PPP are a useful tool for delivering public infrastructure which have been overused and misused by the current government – and something which the current government will have to put right as a matter of priority.
So what should we do now we have the opportunity to reform PPP?
Firstly, keep demolishing the Gordon Brown myth that PPP has delivered value for money based on savings achieved in the procurement phase. Value for money in PPP contracts should be based on an assessment of the quality and cost of services over the entire life cycle of contract, so at present it is too soon to say if PPP will represent value for money in delivering public infrastructure
Secondly, use PPP only when it is clearly value for money in the procurement phase ie if the PPP option is a given percentage better than the alternatives. So they remain still value for money against the alternatives even when the value for money in the original deal reduces over time.
Thirdly, improve PPP governance ie make sure that value for money in the PPP procurement phase is realised during the contract execution phase. This means ensuring that the public sector gives sufficient attention to managing PPP contracts awarded and using auditors to validate continuing value for money
Finally, use the government’s market clout to change the PPP model to give better value for money for the public sector. This shouldn’t be a difficult message for a government in hard economic times to get construction companies, FM service providers and lenders to understand.