54: Seize the initiative!
Private finance in public infrastructure
The problem: capital starvation
Governments cannot finance all the requests they receives for capital investment. There is a limit to the amount of tax they can raise, the funds they can borrow and the money they and print without risking inflation. However, there are many worthwhile capital infrastucture projects that need financial support. How can the private sector help?
The idea: use private investment
The public sector can get round these problems by purchasing not just construction, but also facilities management services for a lengthy period, from a private sector partner. The aim is to tap the expertise and know-how of the private sector to provide innovative way of delivering public projects and services. Given a profit incentive, the private sector is better able to manage many types of risk. It is often better value for money. This form of finance improves the national infrastructure which, in turn, makes the economy more competitive.
Example: the private finance initiative
Since its launch in 1992, the United Kingdom's Private Finance Initiative (PFI) became an established means of delivering many public services which require significant investment in capital assets. It has been used throughout the public sector, particularly new schools, colleges, prisons (see the chapter Competing for Convicts) and hospitals.
Between 1992 and 1998 £10 billion of projects were signed, including Britain's first privately financed hospital at Dartford, Kent; the highly successful Manchester Metrolink; the Docklands Light Railway; the Heathrow Express; the second Severn River bridge; the bridge connecting the Isle of Skye with the mainland of Scotland; and several new prisons.
The first aim of PFI is to get capital into public infrastructure projects that would otherwise have to wait. Like a family taking out a mortgage to finance a house, PFI enables government to have the benefits of new infrastructure today while paying for it over future years.
However, the aim is also to do much more than this. If the private sector can design and build new infrastructure projects, such as prisons or hospitals, more quickly than the government, then the costs of capital are cut and the new infrastructure should come onstream more cheaply: which will be reflected in the price that the government ends up paying. And private-sector investors have a keener interest in ensuring that the new infrastructure is built in ways that make it easier and cheaper to run, and that the buildings themselves are kept in good order and maintained up to a high specification. There is also the hope that private-sector companies will come forward with completely new ideas on where they believe new infrastructure (such as new roads) could profitably be built.
Despite misgivings, the Labour government elected in 1997 has recognized the need for private-sector expertise in the delivery of public infrastructure and public services, and has in fact given enthusiastic support to an expanded and refined PFI programme. It has widened the range of public-private strategies for co-operation under the general heading of Public-Private Partnerships (PPPs), of which PFI is now merely one element. The Treasury been encouraging officials to submit ideas for PFI and PPP projects. With much of the amenable infrastructure now already covered by such arrangements, the volume of private-sector capital spending within government departments and local authorities is now projected to level out.
Meanwhile the UK's PFI experiment has attracted worldwide interest. More than two dozen countries including the Netherlands, South Africa and Portugal are now considering their own schemes. The world's largest private finance project is the new light rail transit system in Kuala Lumpur, Malaysia.
|Table: Estimated/projected capital spending by the private sector under PFI contracts|
| 2000-01 2001-02 2002-03 2003-04|
|Defence 121 147 200 100|
|Foreign Office & Overseas Dev't 7 7 6 7|
|Agriculture, Fisheries & Food 0 0 0 0|
|Trade & Industry 36 61 24 26|
|Environment, Transport, Regions 619 639 855 1015|
|Education & Employment 15 28 9 0|
|Home Office 160 136 297 0|
|Legal Depts 37 36 13 6|
|Culture, Media & Sport 0 0 0 0|
|Health 491 501 235 67|
|Social Security 42 17 67 14|
|Scotland 540 289 78 20|
|Wales 160 11 0 0|
|Northern Ireland 39 26 4 0|
|Chancellor's Departments 104 87 19 6|
|Local authorities 1352 1404 1215 1150|
|TOTAL 3878 3548 3064 2430|
Assessment: need for initiative
As with many bold experiments, however, the PFI programme experienced a series of problems after its launch.
Seize the Intitiative!, Allan Stewart's study for the Adam Smith Institute, argues that PFI was handicapped initially by a raft of legal and technical obstacles. Essentially, bureaucrats were unwilling to surrender their control over projects and insisted on over-specifying the brief to the private sector. Instead of asking private-sector innovators how they would build and operate in order to achieve the desired outcomes, government departments thought in terms of specifying traditional inputs, and that is what they asked the private sector to produce. Consequently, opportunities for innovation and fresh ideas in the delivery of public services were lost.
This was unfortunate, because the PFI was never designed to be a mortgage scheme by which governments could commission buildings now and pay for them later: it was intended as a way in which private-sector expertise could be brought into the way that infrastructure was provided and services were run.
A review under businessman Sir Malcolm Bates, completed in Spring 1999, concluded that there was a serious shortage of the necessary skills within the public sector to undertake good PFI deals. As experience has been gained on both sides, this problem is now somewhat diminished, but it remains true that the public sector is a rather poor purchaser of services, and that it has little idea about the costs that can be caused by indecision and delay in the framing of contract specifications - nor motivation to reduce them.
Another problem was that the private sector became worried about the risks involved in dealing with local government agencies such as local health or education authorities. A PFI contract might last fifteen or twenty years: what would happen to the private-sector provider if the local authority failed, went bankrupt, and could not pay its bills?
In response to this concern, NHS Trusts and local authorities now have clearer legal authority to sign PFI deals, and the government has agreed to underwrite any contractual arrangements they enter into under them. So private providers and their financial backers can be confident that the contract will be honoured from the public-sector side. Political risks remain, however, as the government's unwillingness to subsidize the privatized company Railtrack demonstrate.
In fact, the issue of risk has been central to the PFI debate all along. The Treasury insisted that in order to qualify as a true public-private venture, and not just as a disguised form of borrowing that would have to be recorded as such on the government's books, PFI ventures would have to reflect real risk for the investors. However, investors have complained that officials have had unrealistic views of what risks the private sector can reasonably bear, and have tried to load them with all kinds of unaffordable uncertainties. Meanwhile, the public-sector officials have resisted any form of risk, specifying contracts in minute detail, and so denying the private operators the freedom they need to manage risk in their own way.
The PFI programme was pushed forward by a dedicated 'Taskforce' in the Treasury. Building on this, the government then established Partnerships UK, a joint venture with private-sector banks and other businesses. Describing itself as a 'PPP developer, the aim of this body is to help on project evaluation, contract standards, and implementation issues; and it takes direct equity stakes in projects that it supports.
For further information:
Copyright 2002: Adam Smith Institute
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