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SP Paper 182 FI/S3/08/R8

8th Report, 2008 (Session 3)

Inquiry into methods of funding capital investment projects

CONTENTS

Remit and membership

Executive summary
Report
Introduction
Evidence taken by the committee
Purpose of the report
Structure of the report
Current funding methods
Key issues in comparing PPP/PFI and conventional borrowing

Overview
Comparative Studies
Conventional Borrowing
Accounting treatment
Cost of finance
Risk
PPP/PFI refinancing
Competition and complexity in procurement
Options appraisal
Service delivery, quality and flexibility
Governance and accountability

Non-profit distributing organisation
Other approaches
Key issues in the current context
The Scottish Futures Trust
Abbreviations used in the report
Glossary of key terms

ANNEXE A: EXTRACTS FROM THE MINUTES

ORAL EVIDENCE AND ASSOCIATED WRITTEN EVIDENCE

Please note that all oral evidence and associated written evidence is published electronically only, and can be accessed via the Finance Committee’s webpages, at:

http://www.scottish.parliament.uk/s3/committees/finance/inquiries/capitalInvestment.htm

9th Meeting, 2008 (Session 3), Tuesday 15 April 2008

WRITTEN EVIDENCE

Glasgow City Council
Health Facilities Scotland
Transport Scotland
Scottish Funding Council
City of Edinburgh Council
Scottish Water

ORAL EVIDENCE

Lynn Brown, Executive Director of Financial Services, Glasgow City Council
Douglas Griffin, Director of Finance, NHS Greater Glasgow
Peter Haggarty, Assistant Director, Health Facilities Scotland
Guy Houston, Director of Finance and Corporate Services, Transport Scotland
Riona Bell, Director of Funding, Scottish Funding Council
Donald McGougan, Director of Finance, City of Edinburgh Council
Douglas Millican, Finance and Regulation Director, Scottish Water

SUPPLEMENTARY WRITTEN EVIDENCE

Scottish Funding Council

10th Meeting, 2008 (Session 3), Tuesday 22 April 2008

WRITTEN EVIDENCE

Scottish Council for Development and Industry
British Telecom
Audit Scotland
CIPFA in Scotland

ORAL EVIDENCE

Iain Duff, Chief Economist and Policy Manager, Scottish Council for Development and Industry
Martin Southern, Senior Consultant, BT Public Services Scotland
Russell Frith, Director of Audit Strategy, Audit Scotland
Angela Scott, Head of CIPFA in Scotland

SUPPLEMENTARY WRITTEN EVIDENCE

British Telecom
Audit Scotland
CIPFA in Scotland (on asset management)
CIPFA in Scotland (on government deficit and debt)

11th Meeting, 2008 (Session 3), 29 April 2008

WRITTEN EVIDENCE

PricewaterhouseCoopers
Dundas and Wilson C.S. LLP
KPMG
McGrigors LLP
Dr Jim Cuthbert and Margaret Cuthbert, Public Interest Research Network, University of Strathclyde
Margaret Cuthbert and Dr Jim Cuthbert
Mark Hellowell, Research Fellow, Centre for International Public Health Policy, University of Edinburgh
PPP Forum

ORAL EVIDENCE

Paul Brewer, Partner, Public Private Advisory,
PricewaterhouseCoopers
Amanda Methven, Partner, Planning and Projects Group, Dundas and Wilson C.S. LLP
Jenny Stewart, Head of Infrastructure and Government, KPMG
Michael Watson, Partner, Banking, Energy and Infrastructure and Procurement, McGrigors LLP
Nigel Middleton, Managing Director, Barclays Private Equity
Darryl Murphy, Managing Director, Infrastructure Finance, HSBC
Iain Wales, Head of Structured Finance for the UK and Ireland, Dexia Public Finance Bank
Dr Jim Cuthbert and Margaret Cuthbert
Dr Iain Docherty, School of Business and Management, University of Glasgow
Mark Hellowell
Jan Love, PPP Forum

SUPPLEMENTARY WRITTEN EVIDENCE

McGrigors LLP
Barclays Private Equity
Mark Hellowell
Dr Jim Cuthbert
Dr Jim Cuthbert and Margaret Cuthbert (on the capital charge)
Margaret Cuthbert and Dr Jim Cuthbert (on refinancing)
Dr Jim Cuthbert and Margaret Cuthbert (on NPDO schemes)

12th Meeting, 2008 (Session 3), Tuesday 6 May 2008

WRITTEN EVIDENCE

Architecture + Design Scotland
Mott MacDonald
Keppie Design
Robertson Capital Projects
Balfour Beatty Capital
Ogilvie Group Developments
Quayle Munro
Forth Electrical Services Ltd
Canmore Partnership Ltd

ORAL EVIDENCE

Gareth Hoskins, Board Member and Scotland's Healthcare Design Champion, Architecture + Design Scotland
Alan Ledger, Project Director, Mott MacDonald
David Stark, Managing Director, Keppie Design
Alan Fordyce, Managing Director, Robertson Capital Projects
Ian Rylatt, Managing Director, Balfour Beatty Capital
Steven Tolson, Director, Ogilvie Group Developments
Jo Elliot, Deputy Chief Executive, Quayle Munro
Dylan Fletcher, Group Board Director, Forth Electrical Services Ltd
Andrew Gordon, Chief Executive, Canmore Partnership Ltd

SUPPLEMENTARY WRITTEN EVIDENCE

Architecture + Design Scotland
Mott MacDonald
Ogilvie Group Developments
Canmore Partnership Ltd

13th Meeting, 2008 (Session 3), Tuesday 13 May 2008

WRITTEN EVIDENCE

British Medical Association
UNISON
UNISON (further submission)

ORAL EVIDENCE

Jon Ford, Head of Health Policy and Economic Research Unit, British Medical Association
Dave Watson, Scottish Organiser, Policy, UNISON
Ken Wimbor, Assistant Secretary, the Educational Institute of Scotland

14th Meeting, 2008 (Session 3), Tuesday 20 May 2008

WRITTEN EVIDENCE

Falkirk Council
Argyll and Bute Council
Cordale Housing Association (submission to Scottish Government’s consultation)
Network Rail
Northern Ireland Strategic Investment Board
ProCure21, Department of Health
The EDI Group Ltd

ORAL EVIDENCE

Dougald Middleton, Head of Transport and Distribution, Ernst and Young
Bryan Smail, Head of Treasury and Investment and Project Director, Falkirk Council
Bruce West, Head of Strategic Finance, Argyll and Bute Council Michael Gerrard, Deputy Chief Executive, Partnerships UK;
Stephen Gibson, Director, Cordale Housing Association;
Robert MacDowall, Director, DTZ;
Ron McAulay, Director for Scotland, and Fred Maroudas, Director of Finance, Network Rail
Martin Spollen, Strategic Adviser, Northern Ireland Strategic Investment Board
Ray Stephenson, Programme Manager, ProCure21, Department of Health
Ian Wall, former Chief Executive, The EDI Group Ltd

SUPPLEMENTARY WRITTEN EVIDENCE

Argyll and Bute Council

15th Meeting, 2008 (Session 3), 27 May 2008

WRITTEN EVIDENCE

John Swinney MSP, Cabinet Secretary for Finance and Sustainable Growth

ORAL EVIDENCE

John Swinney MSP, Cabinet Secretary for Finance and Sustainable Growth

SUPPLEMENTARY WRITTEN EVIDENCE

John Swinney MSP, Cabinet Secretary for Finance and Sustainable Growth

19th Meeting, 2008 (Session 3), 9 September 2008

WRITTEN EVIDENCE

Canmore Partnership Ltd
Glasgow City Council (submission to the Scottish Government’s consultation)
McGrigors LLP
UNISON

ORAL EVIDENCE

Paul Brewer, Partner, Public Private Advisory,
PricewaterhouseCoopers
Lynn Brown, Executive Director of Financial Services, Glasgow City Council
Andrew Gordon, Chief Executive, Canmore Partnership Ltd
Donald McGougan, Director of Finance, Edinburgh City Council
Dougald Middleton, Head of Transport and Distribution, Ernst and Young
Nigel Middleton, Managing Director, Barclays Private Equity
Angela Scott, Head of CIPFA in Scotland
Dave Watson, Scottish Organiser, Policy, UNISON
Michael Watson, Partner, Banking, Energy and Infrastructure and Procurement, McGrigors LLP

OTHER WRITTEN EVIDENCE

Submissions were also received from the following organisations in response to the original call for evidence.

Aberdeen City Council
Association of Scotland’s CollegesBank of Scotland
Carillion Private Finance
CBI Scotland
CIPFA Directors of Finance
Comhairle nan Eilean Siar
Fife Council
Grant Thornton
HBJ Gateley-Wareing
Institute of Chartered Accountants in England and Wales, Institute
Members Group in Scotland
Institute of Value Management
NHS Lothian
Scottish Enterprise Edinburgh and Lothian
Scottish Environmental Services Association
STUC

In addition, submissions were also received from the following organisations in response to the Committee’s request for views on the Scottish Futures Trust proposals.

Architecture + Design Scotland
Cordale Housing Association
Ian Wall
NHS Greater Glasgow and Clyde
Scottish Funding Council

Remit and membership

Remit:

1. The remit of the Finance Committee is to consider and report on-

(a) any report or other document laid before the Parliament by members of the Scottish Executive containing proposals for, or budgets of, public expenditure or proposals for the making of a tax-varying resolution, taking into account any report or recommendations concerning such documents made to them by any other committee with power to consider such documents or any part of them;

(b) any report made by a committee setting out proposals concerning public expenditure;

(c) Budget Bills; and

(d) any other matter relating to or affecting the expenditure of the Scottish Administration or other expenditure payable out of the Scottish Consolidated Fund.

2. The Committee may also consider and, where it sees fit, report to the Parliament on the timetable for the Stages of Budget Bills and on the handling of financial business.

3. In these Rules, "public expenditure" means expenditure of the Scottish Administration, other expenditure payable out of the Scottish Consolidated Fund and any other expenditure met out of taxes, charges and other public revenue.

(Standing Orders of the Scottish Parliament, Rule 6.6)

Membership:

Jackie Baillie (Deputy Convener)
Derek Brownlee
Joe FitzPatrick
James Kelly
Alex Neil
Jeremy Purvis
Andrew Welsh (Convener)
David Whitton

Committee Clerking Team:

Clerk to the Committee
Susan Duffy

Senior Assistant Clerk
Mark Brough

Assistant Clerk
Allan Campbell

Committee Assistant
Stuart McLean

Inquiry into methods of funding capital investment projects

executive summary

This executive summary outlines the key themes and recommendations arising from the report.

Purpose of this report

The context in which this report has been produced is one of on-going development of the Scottish Government’s proposed Scottish Futures Trust. The report seeks to identify major issues that should be considered in any approach to public capital investment, along with key points that should be addressed in the development of the Scottish Futures Trust to ensure that it operates in an appropriate way and delivers value for money (paragraph 12).

Current funding methods (paragraphs 15-37)

The report describes the range of ways in which investment in capital projects can be undertaken, such as prudential borrowing including borrowing from the Public Works Loan Board, bond finance and various models of PPPs/PFIs.

The Committee also received written evidence about a range of other models, variants and combinations of different approaches, some of which would require legislative change. The Committee did not examine those proposals which would require legislative change, but recommends that the Scottish Government should investigate them further (paragraph 37).

Key issues in comparing PPP/PFI and conventional borrowing (paragraphs 38-173)

Many of the key points raised in evidence can apply to all approaches to capital investment. However the evidence tended to focus on comparing PPP/PFI and conventional borrowing.

Accounting treatment (paragraphs 47-61)

Although in itself not part of the analysis of PPP/PFI and conventional borrowing, accounting treatment forms an important part of the background context. The UK Government has announced that from 2009-10 onwards Government would prepare its accounts using the International Financial Reporting Standards (IFRS). However, at the time of the publication of this report, the UK Government had yet to explain what effect IFRS could have on the options available to public bodies to fund capital investment.

It is clear that the application of IFRS may have implications for the funding of capital investment and the Committee is disappointed that the situation remains uncertain. The Committee believes that decisions need to be taken as soon as possible, recommends that the Scottish Government continues to pursue this issue with the UK Government and hopes that the UK Government will provide more clarity on the issue (paragraph 61).

Comparing the cost of finance (paragraphs 62-78)

It is difficult to make direct comparisons between the actual costs of borrowing from the private sector and borrowing through government sources such as the Public Works Loan Board (PWLB). There are a number of factors to be considered, such as the risk of default and the expected returns.

The Committee notes that there have been difficulties in providing comparable information on life-cycle costs for different methods of funding and procurement. The Committee believes that such information should be available for projects on a consistent and comparable basis and calls on the Scottish Government to develop and publish a robust investment option appraisal framework capable of producing comparable information on whole-life costs for future projects regardless of which method of procurement or operation is used. (paragraph 78).

Assessment of risk (paragraphs 79-95)

A key element in the funding of capital projects is the assessment of risk. Risk can present itself in a number of ways, such as the possibility of cost and time over-runs, maintenance requirements and usage which differ from expectations, changes in service delivery, interest rate movement and other financing changes.

From the evidence, it would appear there is a lack of clarity on how risk is and should be measured. This results in risk being measured in a variety of ways which makes it difficult to make an accurate comparison between different projects. Therefore, the Committee recommends that the Scottish Government explore how improvements can be made to ensure that risk is measured and accounted for in a systematic manner to ensure consistency across all methods of investment and to ensure accurate comparisons can be made (paragraph 95).

PPP/PFI refinancing (paragraphs 96-109)

Refinancing refers to the process by which the private sector can rearrange its bank loans at a lower interest rate once the project is signed and make a financial gain from this. The scope for refinancing of PPP/PFI deals has been one of the areas that has attracted substantial comment. Whether the public sector’s interests are protected should the private sector benefit from refinancing opportunities has a significant influence on the perception of the extent to which PPP/PFI deals represent value for money. The Committee heard considerable evidence on this, and the extent to which this aspect of contracts has now become standardised to help protect the public sector’s interests.

The Committee notes that varying practices have been adopted in the past on the distribution of refinancing gains between the private and public sectors, and acknowledges some concern that the benefits may not always have been secured by the public sector. The Committee welcomes further recent guidance from the UK Government on the subject and recommends that the method for triggering refinancing provisions, and the sharing of any benefit accruing via them, should be transparent and equitable (paragraph 109).

Competition and complexity in procurement (paragraphs 110-121)

A number of issues were raised in evidence with regard to procurement, such as competition, lead times, the cost of tendering and competitive dialogue.

The Committee recommends that the Scottish Government should:

  • re-examine when and how competitive dialogue procedure needs to be applied, and the extent to which experience in other countries might lead to more efficient systems;

  • consider how to retain and recycle knowledge so that repeated development costs are minimised;

  • consider other ways to ensure participation of smaller Scottish companies; and

  • investigate instances of limited competition for recent projects and seek to address this issue in any future capital investment arrangements (paragraph 121).

Options appraisal (paragraphs 122-129)

The Committee believes that a broad range of options for funding and procurement of capital projects should be in place. The Committee notes the Scottish Government’s decision to make NPDO models the default form of private finance, and the statement in the Value for Money Guidance that, where NPDO is not suitable, other private finance models will be assessed1. The Committee recommends that public bodies should select the method of financing which delivers best value to the taxpayer. The Committee, therefore, agrees by division that all methods of finance should be considered equally on their merits. A minority of the Committee endorses the Scottish Government’s position that the NPDO model should be the default option (paragraph 129)2.

Delivery of facilities on time and on budget (paragraphs 131-135)

The ability to deliver a facility on time and on budget, and operate it to achieve the desired service output, are key components of considering the merits, and value for money, of different approaches to capital investment. As with other facets of value for money, it is a difficult comparison to attempt.

The Committee recognises that there are potential difficulties in comparing PPP/PFI and conventionally procured projects and differing views over whether PPP/PFI delivers to time and budget. However, it also assumes that there is no reason why incentives and disciplines, which it is asserted are inherent in PPP/PFI projects, cannot be more widely used in projects funded wholly by the public sector. The Committee recognises that incentives appropriate to the public sector will need to be devised but it recommends that the Scottish Government ensures that comparable project management approaches are applied in any future arrangements (paragraph 135).

Service operation (paragraphs 136-139)

Aside from simple cost factors, an essential element of value for money is whether the asset delivers what was promised and it is also important for all long-term projects to feature benchmarking and market testing throughout their lives. A report from the House of Commons Public Accounts Committee highlighted some concerns in this area.

The Committee believes that periodic benchmarking and market testing are essential to ensure contracts are delivering best value for the taxpayer, and recommends that the Scottish Government includes such procedures in future projects and ensures that these procedures themselves work in the best interests of the taxpayer. The Committee notes the concerns raised by the Public Accounts Committee, and recommends that they are addressed in contracts for all future projects (paragraph 139).

Flexibility (paragraphs 149-167)

The ability of services to respond flexibly to changing service needs is an element of quality – but, when considering capital investment projects over a 30-year timeframe, it is also fundamental to a comparison of the long-term costs of different funding approaches. The Committee heard a wide range of evidence on the perceived inflexibility of PPP/PFI contracts but also the potential benefits of having whole life maintenance costs being built into a contract, as tends to be the case under PPP/PFI.

The Committee believes that it is important that, however they are provided or funded, public services are capable of evolving over time to meet changing demands and the expectations of users. The Committee believes that the public sector should only enter into long-term arrangements or contracts if sufficient flexibility can be built in without excessive cost, or if there can be certainty around the future demands on services (paragraph 167).

Governance and accountability (paragraphs 168-173)

Throughout the inquiry, a number of witnesses emphasised the importance of identifying and monitoring the costs of PPP/PFI projects to assess value for money. The Scottish Information Commissioner has recently decided that contract information relating to a number of operational PPP/PFI schemes should be disclosed. Nonetheless, it appears that disclosure of material relating to schemes at earlier stages is likely not to be forthcoming. There has been an ongoing review of the operation of the Freedom of Information (Scotland) Act 2002, and one of the issues raised by the Scottish Information Commissioner and the Scottish Government is the extent to which it should apply to private companies delivering public functions.

The Committee takes account of the recent decisions of the Scottish Information Commissioner and recommends that a review is concluded on what information can be made public with regard to all types of contracts for public works, with a view to being as open and transparent as possible (paragraph 173).

The Non-Profit Distributing Organisation approach (paragraphs 174-207)

The basic structure of a contract under the NPDO model is the same as for traditional PPP/PFI. However there is a cap on the return for the private sector and in some projects any refinancing gains have been shared with a charity established for community benefit.

Governance (paragraphs 184-186)

The involvement of stakeholder and independent directors in NPDOs was said by a number of witnesses to offer greater transparency on the operation of the special purpose vehicle (SPV), although there appears to be no empirical evidence of this effect or of any greater community involvement to date.

The Committee recommends that the Scottish Government ensures that consistent guidance is in place to ensure that the operation of charitable bodies established as part of NPDO schemes is conducted in a transparent manner, and that the governance arrangements and financial controls are at least as strong as those applying to the public sector generally. The Committee further recommends that the Scottish Government considers whether and how NPDO models might develop in the future without the automatic need for the use of a separate charitable body (paragraph 186).

Costs (paragraphs 187-192)

Despite the change of structure, the actual process for securing the best value funding package remains largely the same for the NPDO model as for PPP/PFI, and under NPDO the public sector still pays a fixed unitary charge over the life of a project in the same way as for conventional PPP/PFI. A range of evidence was received on whether NPDO is cheaper overall than PPP/PFI.

The Committee notes that comparative costs between all funding models have been difficult to determine throughout this inquiry. The Committee calls on the Scottish Government to develop a robust framework capable of producing comparable information on whole-life costs for future projects regardless of which method of procurement or operation is used (paragraph 192).

Market acceptance (paragraphs 193-203)

There was much debate during the evidence sessions around the acceptability of the NPDO model to the market, particularly around the balance of refinancing provisions.

The Committee notes concerns raised by some witnesses on the potential for refinancing provisions in NPDO schemes to discourage some investors, and calls on the Scottish Government to review how refinancing provisions in NPDO models might be amended to ensure that they achieve intended aims without discouraging investment (paragraph 203).

Transferability (paragraphs 204-207)

Witnesses generally agreed that, while the NPDO schools models used so far cannot simply be transferred to areas with different risk profiles and delivery capabilities, the key concepts of the NPDO approach can be applied in different sectors and to projects with different risk profiles.

However, the Committee cannot offer any recommendations or conclusions about the operation of the NPDO model as there is not yet enough evidence about its effectiveness as an alternative to PPP/PFI (paragraph 207).

Key issues in the current context (paragraphs 222-279)

Asset management (paragraphs 225-249)

In a supplementary submission to the Committee, Angela Scott from CIPFA Scotland made a number of suggestions to improve asset management in the public sector. The Committee notes that these suggestions had not been put through CIPFA’s own internal governance procedures and therefore are not to be interpreted as the position of CIPFA.

The Committee concurs with CIPFA’s suggestions and recommends that the appropriate bodies examine ways in which these suggestions can be taken forward (paragraph 249).

Conventional public borrowing (paragraphs 250-258)

Under Section 66 of the Scotland Act 1998, Scottish Ministers may only borrow money from the UK Government and may only borrow for the purpose of meeting a temporary shortfall in the Scottish Consolidated Fund or providing a working balance in the Fund. Local authorities can fund capital projects under the prudential borrowing regime, either on the open market (which has rarely been used) or through the Public Works Loans Board. However, a similar prudential borrowing framework is not in place for other parts of the public sector in Scotland.

The Committee notes that borrowing powers are already available to local government in Scotland, and could in theory be extended to other public bodies. The Committee notes the restriction set out in the Scotland Act on borrowing by Scottish Ministers and the apparent uncertainty on the consequences of extending such powers for the amount of funding provided to the Scottish Government under the current Statement of Funding Policy. The Committee further notes the uncertainty on the extent to which there is scope to extend the existing prudential borrowing regime without a restriction being imposed by HM Treasury.

The Committee urges the Scottish Government to seek clarification from the UK Government on the scope to extend the existing prudential borrowing regime, both in terms of the amount borrowed and the bodies capable of undertaking such borrowing (paragraph 258).

Variations and joint working within the public sector (paragraphs 259-263)

Several witnesses indicated that variations between public bodies in several respects, including governance structures, powers, funding practices, and accounting and tax treatment mean that they have different levels of flexibility in their capital investment options.

The Committee considers that the current framework makes it difficult for joint working and joint funding to take place and, therefore, recommends that the Scottish Government liaises with the UK Government to determine why various bodies must operate under different regimes and whether it is possible to simplify the current system (paragraph 263).

Managing market capacity (paragraphs 264-270)

Several issues emerged related to the theme of how the public sector can manage the way in which projects are offered to the market in order to ensure optimum delivery and value for money. In this context, any potential hiatus in the pipeline of deals coming to the market is a concern, especially given the long lead time that projects have in procurement.

The Committee recommends that every effort is made to ensure that public bodies maintain a steady flow of capital projects to provide a regular supply of project opportunities for the construction industry and that there is sufficient transparency to ensure that the construction industry is aware that such opportunities exist (paragraph 270).

Skills (paragraphs 271-279)

Throughout the inquiry, there has been wide consensus that the skills of the public sector are vital to ensuring value for money is achieved in capital investment, regardless of the procurement and funding model.

To ensure a steady flow of capital projects from public bodies, it is important that there are sufficient skills within the public sector and the Committee recommends that every effort is made to ensure that there is and will continue to be sufficient skills capacity in the public sector (paragraph 279).

The Scottish Futures Trust (paragraphs 280-316)

On 20 May 2008, the Scottish Government published a strategic business case, entitled Taking Forward the Scottish Futures Trust. In evidence the Cabinet Secretary for Finance and Sustainable Growth explained that the proposed SFT is about securing less expensive funding, but also “a new approach to the organisation and packaging of infrastructure investment opportunities in Scotland”. He said that it had three key components: reliance on the use of the NPDO model for financing projects; providing central expertise in project development; and aggregating projects to guarantee efficiencies in risk, finance and delivery arrangements3.

The Committee believes that while it is the Scottish Government’s view that the SFT will become a more attractive source of funding for national and local projects, that has yet to be proven. The Committee believes that the current economic climate may make it more difficult to introduce a new funding model for capital projects. The Committee, therefore, recommends that no infrastructure projects, national or local, should be delayed or postponed pending the introduction of the SFT funding (paragraph 316)4.

introduction

1. On 25 September 2007, the Finance Committee agreed its approach to conducting an inquiry into the methods of funding capital investment projects.

2. The Committee agreed that the remit of the inquiry would be to consider and report on the advantages and disadvantages of different actual and proposed models of funding capital investment projects. This was designed to encompass the implications of the different models for public bodies’ costs and revenue streams and for the management and public benefit of the projects.

3. The inquiry was conducted against the background of the Scottish Government consulting on a proposed Scottish Futures Trust, which it described as a model “whose main aim is to provide an alternative means to PFI for channelling public and private capital into infrastructure investment programmes.” Its aim is to provide a more attractive approach by addressing some perceived criticisms of the PPP/PFI model that have been widely applied in the last 10-15 years, redirecting “excess profits made from traditional PFI funding” and improving partnership and management.1

4. In order to consider future policy development, the Committee examined evidence from the recent history of capital investment in Scotland in some detail. The Committee considered the key public sector perspective of what is required in order to ensure a good service outcome for the public, in terms of both value-for-money and quality of service delivery. However, it also sought to understand the conditions, approaches and mechanisms to ensure deliverability through sufficiency in both content and quality of private sector engagement and involvement with public projects.

5. At the time of conducting this inquiry, the long-term effects of the current financial situation on capital investment were not yet known.

evidence taken by the committee

6. An open call for written evidence was issued in September 2007. Over 30 submissions were received by the closing date in December. A substantial volume of evidence was received on a range of issues – including finance, procurement, project management, service design and delivery.

7. The Committee took oral evidence over the course of seven meetings in April and May 2008, hearing from a very wide range of witnesses who have substantial experience of all aspects of the recent history of capital investment in Scotland, and who are involved in the market currently. Witnesses included:

  • a range of public sector bodies
  • legal and financial advisers
  • lenders and investors
  • academic and financial commentators
  • architects and designers
  • constructors
  • project managers and operators
  • trades unions

The Committee concluded this phase of its inquiry by taking evidence from the Cabinet Secretary for Finance and Sustainable Growth.

8. Towards the end of this phase, the Scottish Government published a strategic business case on its proposed Scottish Futures Trust. The Committee, therefore, took further evidence on this on 9 September from a range of stakeholders.

9. Some of the witnesses appearing before the Committee had previously responded to the open call for written evidence, and many then provided additional written evidence when called to give oral evidence. A number of witnesses were also asked to provide supplementary material on particular points raised during oral evidence, and very helpfully did so. The Committee would like to record its thanks to all those who provided written or oral evidence to the inquiry.

10. The Committee would also like to record its appreciation of the assistance it has received throughout this inquiry from its independent adviser, Grant Thornton – represented by Nathan Goode and Marianne Burgoyne of its Government and Infrastructure Advisory team. Both the advisers and SPICe produced a number of briefing papers which were of considerable assistance to the Committee.

11. The Committee's remit is restricted to considering matters related to the policy and administration of the Scottish Government. However, as the issues around the options for funding capital investment projects relate fundamentally to the policy frameworks and principles for public finance management set at a UK level, the experience of projects elsewhere in the UK formed an important part of the evidence. For this reason, the Committee was dismayed that its invitations to Treasury officials and to the Chief Secretary to the Treasury, The Rt Hon Yvette Cooper MP, to give evidence were declined. The Committee did receive a written submission from the Treasury later in the inquiry.

purpose of the report

12. The context in which this report has been produced is one of on-going development of the Scottish Government’s proposed Scottish Futures Trust. The report seeks to identify major issues that should be considered in any approach to public capital investment, along with key points that should be addressed in the development of the Scottish Futures Trust to ensure that it operates in an appropriate way and delivers value for money.

structure of the report

13. The report is structured as follows:

  • A brief summary of some of the main funding options that the public sector may use (paragraphs 15–37)
  • A detailed examination of how PPP/PFI and ‘conventional borrowing’ compare in key respects, including:
    • Accounting treatment (paragraphs 47–61)
    • Cost of finance (paragraphs 62–78)
    • Risk (paragraphs 79-95)
    • PPP/PFI refinancing (paragraphs 96-109)
    • Competition and complexity in procurement (paragraphs 110-121)
    • Options appraisal (paragraphs 122-129)
    • Service delivery, quality and flexibility (paragraphs 130–167)
    • Governance and accountability (paragraphs 168-173
  • An examination of the non-profit distributing organisation model which has been developed to address some past concerns (paragraphs 174–207)
  • A summary of key points from other approaches to improving capital investment (paragraphs 208–221)
  • Some key issues in the current context (paragraphs 222–279)
  • An examination of the Scottish Government’s proposed Scottish Futures Trust (paragraphs 280–316).

14. This structure includes specific conclusions or recommendations on particular issues, and highlights a number of broad areas around which the Committee makes recommendations for any future approaches to public sector capital investment.

CURRENT funding methods

Overview

15. The total Scottish Budget is known as Total Managed Expenditure (TME) and comprises Departmental Expenditure Limit (DEL) and Annually Managed Expenditure (AME). AME covers expenditure which is difficult to predict precisely but where there is a commitment to spend or pay a charge. Examples include teachers’ and NHS staff pensions and motorway and trunk road interest charges. The DEL is the discretionary element of the budget and is made up of DEL Resource and DEL Capital. DEL Resource is equivalent to the in-year costs of providing services but also includes PPP/PFI unitary charge payments. Table 1 below presents the elements comprising the 2009-10 budget.

Table 1: Allocation of TME to DEL and AME: Cash Terms2

£m 2009-10 Budget
Total Departmental Expenditure Limit (DEL) of which: 29,297.9
DEL Resource 25,775.0
DEL Capital 3,522.9
Annually Managed Expenditure 5,462.6
Total Managed Expenditure 34,760.5

PPP payments are made from the DEL resource budget and in 2009-10 are projected to be £680 million. Figure 1 below depicts the proportions of the 2009-10 DEL budget which the government plans to spend on DEL resource (minus PPP/PFI Unitary Payments), PPP Unitary Payments and DEL capital.

Figure 1: 2009-10 DEL by Resource, PPP/PFI Unitary Payment and Capital

16. The Scottish Government’s Infrastructure Investment Plan 2008, which was published in March 2008, states that “infrastructure investment in Scotland already utilises a variety of funding methods and that is set to continue…The majority of investment continues to be made by the public sector at its own hand.”3

17. In the Draft Budget 2009-20104, total capital spending by the Scottish Government in 2009-2010 is shown as £3.5 billion. Table 5 of the Draft Budget gives an estimate of £369 million of capital spending by the private sector on signed deals and Table 6 shows estimated payments under PPP contracts of £680 million in 2009-10.

18. There are a range of ways in which investment in projects can be undertaken such as prudential borrowing including borrowing from the Public Works Loan Board, bond finance and various models of PPPs/PFIs. The following sections describe each of these current funding methods in detail. Proposed funding methods are considered later in the report.

Prudential borrowing

19. The Scottish Government funds the debt servicing costs (i.e. principal and interest) of some borrowing, known as ‘supported borrowing’, through the financial settlement. This is a capital allocation for each local authority to direct towards its own priorities. Unsupported borrowing, arranged under what is known as the ‘prudential regime’, is financed through local authorities’ own general resources.

20. The Local Government in Scotland Act 2003 repealed previous controls on local authority borrowing and introduced the “prudential borrowing framework”. This allows local authorities the freedom to determine for themselves how much they can afford to borrow – based on the primary criterion of affordability - and proceed with investment without central government approval. This flexibility is underpinned by the requirement to follow a professional framework developed by the Chartered Institute of Public Finance and Accountancy (CIPFA), known as the “prudential code”5 and it has given local authorities increased flexibility. The City of Edinburgh Council described it as “a great enhancement to local authorities’ ability to invest sustainably and properly”.6

21. Under the prudential code, local authorities must assess the impact of borrowing in the context of their financial sustainability throughout the whole term of the loan, allowing a wide assessment of affordability and also opening opportunities for borrowing against savings and future income streams.

22. The NHS – and other Scottish central government bodies – are not generally able to borrow on their own account. However, CIPFA stated that a freedom (subject to monitoring and regulation) similar to prudential borrowing powers has been extended to foundation hospital trusts and, more recently, NHS trusts in England.7

23. Other approaches to providing flexibility similar to that offered by prudential borrowing have been developed elsewhere in the public sector. The Scottish Funding Council (SFC) described the flexibility of individual colleges and universities to borrow up to delegated amounts, with a system for the SFC to assess affordability before consenting to any higher amounts.8 It also explained that while it is not allowed to borrow and cannot issue bonds, it is developing a central borrowing facility on which individual institutions can draw. The mode of finance for this facility has not yet been decided.9

Public Works Loan Board

24. Prudential schemes also allow for local authorities to borrow from the Public Works Loan Board (PWLB) – a statutory body in the UK Debt Management Office, which can offer fixed and variable rate loans to prescribed bodies at more favourable rates than can be achieved in the market. Smaller projects are capable of being funded under the prudential approach, whereas they have not tended to be suitable for PPP/PFI funding. With local authorities’ freedom to judge affordability, there is also a responsibility to report to central government to allow monitoring of overall borrowing.

Bond Finance

25. Schedule 3 of the Local Government (Scotland) Act 1975 permits local authorities to raise money through issuing bonds – tradeable debt instruments. This remains a possible option, and is discussed further in regard to the Scottish Futures Trust at paragraph 290 below. However, in terms of current approaches to capital investment, the City of Edinburgh Council stated that bonds are not generally the most attractive option as access to the PWLB now provides sufficient borrowing at a lower rate than would be available in the bond markets.10 The Scottish Funding Council (SFC) also said that it was examining a group borrowing facility because “issuing a bond to a much smaller organisation would not be attractive to lenders”.11 Several witnesses referred to bond issues from Network Rail and Transport for London – which have been backed by central government guarantees and offered at extremely competitive rates.

PPP/PFI

26. The private sector has always been involved in public capital projects in a range of roles, even if only as a construction contractor. The Private Finance Initiative (PFI) was introduced by the Conservative government in 1992 to open up opportunities for more private sector involvement in the provision and modernisation of public services. PFI combines the public procurement of capital assets from the private sector with an approach to contracting for private provision of certain services. In the PFI model, the private sector contractor also raises the capital finance for the project. In 1997, the Labour government adopted the term Public Private Partnerships (PPP) which, according to the then Chancellor, the Rt Hon Gordon Brown MP “reinvigorated”12 PFI. PPPs are arrangements typified by joint working between the public and private sector. PPP is not a single model, rather it is an umbrella description and PFI is a form of PPP. Since 1997, the two terms have tended to be used interchangeably. There are many forms of PPP around the world, and the Committee’s advisers produced a briefing on international PPP structures.13

27. There is a huge range of variation in projects under the PPP/PFI concept. The most common involves private sector contractors designing, building, financing and operating facilities to fulfil an output specification set by the public sector commissioning body, such as a local authority or health board. Despite the variation, the general principles and the methods of securing funding are generally similar.

28. A contract to deliver a project is established between the public sector body and a special purpose vehicle (SPV) that is set up by a private sector consortium to deliver the project. The capital finance raised by the private sector is secured primarily on the revenues that will be generated by the project over the life of a contract – typically 25 to 30 years. The PPP/PFI contractor will receive a guaranteed spread of revenue payments over the contract period. The public sector does not own the capital asset during the contract period. Contracts will either provide for ownership of the asset reverting to the public sector at the end of the period or remaining with the contractor. Some evidence indicated that contracts may also specify that the public sector owes valuable residual obligations to the contractor for a further period.14

29. Different models are possible for the revenue payments to the SPV. In some cases there may be an agreement that the contractor receives payment through user charges. In others the payment is a fee (the ‘unitary charge’15) from the public body for the use of the facility. Central government support for these costs (known as ‘level playing field support’ and then ‘revenue support’ in Scotland, and as ‘PFI credits’ in England) has been available to public bodies to support the costs of PPP/PFI projects. In Scotland, this has met 80% of the costs.

30. According to Mark Hellowell from the Centre for International Public Health Policy as of October 2007, the total capital value of PPP/PFI contracts across the UK was £56.9 billion. Of this, £5.2 billion was spent in Scotland (equivalent to £1,028 per head); £50 billion in England (£1,017 per head); £1.1 billion in Northern Ireland (£631.4 per head) and £618 million in Wales (£213 per head).16

31. HM Treasury’s published forecasts show the aggregate future revenue commitments under PFI deals for the years 2006-2032 to be £155 billion. The flow of projects is also expected to continue in future, with the 2007 UK budget providing for a further £10.9 billion PFI credits for an expected £22.2 billion worth of projects to reach financial close by April 2011.17 The Scottish Government stated that unitary charges on existing capital investment deals already create a stream of commitments to 2041-42 for all variants of the model. The commitment totals £500 million of revenue in 2007-08, rising by 13.9%, 15.6% and 17.1% in the next three years respectively, to reach £787 million in 2010-11, and only beginning to decline significantly after 2032-33.18

32. The following table shows the unitary payments made by Scottish and UK governments on PPP/PFI deals in recent years, including non-profit distributing organisation deals19:

Year Scotland £m UK £m
1997-98 2 169
1998-99 14 621
1999-00 51 882
2000-01 73 1,242
2001-02 144 1,909
2002-03 287 2,239
2003-04 360 2,955
2004-05 374 3,623
2005-06 405 3,999
2006-07 443 4,755
2007-08 509 5,350
2008-09 608 6,043
2009-10 705 6,566
2010-11 794 6,695

Use of surplus assets

33. Receipts generated from disposing of assets are one source of funds available for use for capital investments. Receipts from the sale of assets in the local government sector can be retained to be used for a capital purpose or to make principal repayments on a loan. However, receipts in the health, central government, further and higher education and registered social landlord sectors generally have to be remitted back to Scottish Ministers. Bodies often obtain permission in advance from Ministers to sell assets and retain receipts where this retention is an essential part of a business case for funding larger capital projects. As these projects will almost always be sanctioned or funded by Ministers, permission is rarely withheld.

34. As an example of the potential scale of this option, the City of Edinburgh Council stated that it has generated almost £300 million through asset sales since 1996 and plans for a further £115 million over the next four years.20 Several witnesses mentioned other approaches to using surplus assets, such as the potential for joint public-private ventures – for example, where a local authority can contribute land to a project in order to help lever in potential private sector investment in infrastructure and facilities. However, careful consideration needs to be given to potentially significant issues of business transparency and accountability where public contributions are made to such projects.

35. Witnesses generally agreed that the opportunities from, and approaches to, asset sales are very variable across the public sector and across the country, and opportunities may be expected to diminish in the future. Edinburgh city council said that asset holdings are, in any event, insufficient to generate receipts to meet overall investment needs.21

Other methods

36. The Committee also received written evidence about a wide range of other models, variants and combinations of different approaches. Oral evidence received on different approaches such as the Local Improvement Finance Trusts (LIFTS) is discussed in the section entitled “Other Approaches”. CIPFA stated that leasing of some assets is an option where it can provide better value than borrowing – for example, where it can allow flexibility in harnessing changing technology.22 In some cases authorities may have the option of using revenue budgets to fund capital expenditure directly, if other budgetary pressures allow. Direct central government capital grants have also been provided to support particular initiatives or to focus expenditure on a particular service area – for example, the fire capital grant.

37. Some other suggestions advocated approaches that may require legislative change. For example, Edinburgh city council discussed the possibilities of local tax increment financing or supplementary business rates schemes to underpin and stimulate targeted infrastructure development in a particular area. It expressed concern that – in contrast to experience in other countries - there is currently no incentive for local authorities to increase the revenue received from non-domestic rates. It suggested that allowing local authorities to retain a proportion of increases would allow them to finance, under the prudential framework, investment in infrastructure.23 The Committee did not examine these proposals from the Council in detail, but recommends that the Scottish Government should investigate them further.

key issues in comparing PPP/PFI and conventional borrowing

Overview

38. During evidence to the inquiry, the following were raised as key issues that need to be addressed in relation to capital investment. Many of the key points raised in evidence may apply to all approaches to capital investment and may offer lessons for any future capital investment approach. However, the evidence to the Committee tended to focus largely on comparing PPP/PFI with conventional public borrowing.

39. The choice of method should be based on the objectives and benefits that the public sector seeks to achieve through a particular project, the risks that are inherent in trying to achieve those objectives, and an assessment of which parties have the skills, capability and knowledge best to take on those risks. BT Scotland and others suggested that only when these factors are determined should the best financial mechanism for sharing the risk and, equally, allocating reward for achievement of the benefit, be devised in order to meet the public sector’s objectives.24

40. As stated in the introduction, the long-term effects of the current state of the financial markets on capital investment are not yet known. However, an issue which should be borne in mind in the current climate is the reluctance of financial institutions to lend money and even where institutions are still prepared to lend, they are tending to lend less than they did previously. Additionally, it is not clear at this stage to what extent the changes in public finances could impact on the borrowing rates offered by the Public Works Loan Board.

Comparative Studies

41. A proper comparison depends on the extent to which the different factors can be identified and assessed for similar projects procured under different routes – and the evidence indicated that there has not been such a study. The interaction of many factors over a long period of time means that it is difficult to produce a straightforward list of projects and assess what their costs would have been under different procurement and financing routes. To achieve an accurate comparison, a number of PPP/PFI and conventional procurements would need to be examined in detail (both in terms of the infrastructure and the associated operations) over a substantial length of time. However, evidence suggested that obtaining appropriate comparative data is extremely challenging.

42. Examinations of public capital expenditure have tended to focus on one approach and to emphasise the need for caution in making comparisons. Audit Scotland published a study of PPP/PFI schools projects in 2002.25 This reported benefits for the projects in terms of project management, risk transfer and financial control. However, it stated that the benefits were not necessarily unique to PPP/PFI and suggested that comparisons are inherently uncertain and subjective. This relative lack of comparison makes it difficult to establish in isolation whether the perceived benefits of a facility derive from the PPP/PFI method or simply from the fact that the facility is new. Audit Scotland stated that there is, “a risk that procurement decisions were driven by stereotypes of poorly performing alternatives to PFI rather than good evidence of demonstrable benefit”.26

43. Commentators also generally emphasise that operational experience of PPP/PFI contracts is still relatively limited and, consequently, that comparative whole-life costs cannot yet be fully assessed. There has also been some concern that the selection of projects to study can create very significantly biased results – and different commentators sometimes appear to have used the same projects to support contradictory conclusions.

Conventional Borrowing

44. A number of witnesses emphasised the perceived strengths and weaknesses of the traditional public borrowing approach. Conventional borrowing has been described as a comparatively cheap and flexible approach, retaining all control of the project within the public sector. It is also a method in which the public sector retains complete ownership of the asset. However, there have also been criticisms of it, as typified by separation of construction from maintenance, under-investment in life-cycle costs, a lack of focus on whole-life costs and poor management disciplines.

45. Many witnesses outlined the perceived strengths and weaknesses of the PPP/PFI model, often presenting them as contrasts to the perceived weaknesses of conventional borrowing. For example, Dundas and Wilson, a legal firm which has acted as an adviser for PPP projects, summarised the key benefits as: cost certainty while allowing the cost to be spread; risk transfer that equates to value for money; disciplines that lead to improved deliverability of projects to time, budget and performance criteria; and a focus on whole-life considerations being integral to the contract.27 Others emphasised the improved relationships that may be gained from the public sector dealing with a single contractor which is incentivised to deliver.

46. Dundas and Wilson also highlighted several areas that may be perceived as weaknesses: high costs of procurement; higher cost of finance; inflexibility of contractual arrangements; and a perception of high private sector profits being made from public services. A significant portion of the evidence heard by the Committee focused on examining all of these perceptions.

Accounting treatment

47. Although in itself not part of the analysis of PPP/PFI and conventional borrowing, accounting treatment forms an important part of the background context. One of the reasons advanced by many witnesses for the growth in the use of PPP/PFI was its ability to secure investment additional to that which could be secured through conventional public capital spending. However, several witnesses expressed uncertainty about the effect that accounting treatment changes may have on achieving this.

48. At present, if a project is financed under PPP/PFI, the unitary charge paid for the use of the building and services provided is accounted for as current spending. Treasury guidance allowed most PPP/PFI transactions to be classed as ‘operating leases’ rather than ‘finance leases’. The capital expenditure associated with projects does not normally score as public expenditure and the public sector’s future liability for the debt is not recognised on the balance sheet. This is known as ‘off-balance sheet’ financing. Normally, with appropriate transfer of risk to the private sector, a PPP/PFI project would be expected to fall ‘off balance sheet’.

49. Audit Scotland said that, in previous years, “Government was prepared to support a number of capital projects, but only if they were off balance sheet. Of course, that led to all sorts of incentives for public bodies to organise contracts to meet the accounting criteria that got them off balance sheet.”28 However, Audit Scotland stated that the accounting methods currently used for PPP/PFI projects are, in practice, “leading to inconsistent accounting and balance sheet treatments” and “resulting in a number of large capital assets being on nobody’s balance sheet”.29

50. In the 2007 UK Budget, the then Chancellor of the Exchequer announced that from 2008-09 onwards Government would prepare its accounts using the International Financial Reporting Standards (IFRS). This results from a global desire for standardisation in reporting requirements. Financial statements play a particular role in transparency and existing public sector accounting frameworks are, therefore, in the process of moving to these new common rules. One likely area of change is the public sector accounting treatment of PPP/PFI assets.

51. Under IFRS, there is not one single standard that directly addresses accounting for PPP/PFI projects. However, there is an assumption that the fixed asset, where it is used for public service delivery, will be recognised on the public sector user’s balance sheet. The extent to which PPP/PFI projects will be recognised in public sector accounts in this way will depend on the precise nature of the concession, potentially including issues such as who retains ownership of the infrastructure at the end of the contract and where the control, risk and reward lies. Similarly, some leases may require to be reclassified as ‘finance leases’ and recognised on the balance sheet as the consequence of capital expenditure.

52. The Treasury currently produces information on the proportion of PPP/PFI commitments accounted for on the public balance sheet as part of its regular update on PPP/PFI data.30 However, there is as yet no clear picture of exactly how much liability from PPP/PFI is likely to move onto the public sector balance sheet, although it is expected that the vast majority will have to do so at a value reflecting the point reached in the contract. The terms of all individual contracts need to be examined, and the application has now been delayed until 2009-10 for central government and health bodies, because neither the Ministry of Defence nor the Department of Health – the two biggest PPP/PFI users – is sufficiently advanced in identifying the movements required. Local government will apply IFRS from 2010-11. It is considered possible that a very significant portion of the total value of existing PPP/PFI schemes could be added and, of course, the same consideration applies to any future schemes.

53. Although the Chief Secretary to the Treasury declined to give oral evidence to the Committee, her office responded to a request for further information on 14 August 2008. Among other issues, the Chief Secretary was asked what effect IFRS could have on the options available to public bodies to fund capital investment.

54. In that letter, the Treasury stated that, “No decisions have yet been made on the budgeting implications of IFRS. However, it is the intention that decisions on whether or not to use private finance should continue to be made on value for money grounds. In devolved spending areas these value for money judgements are a matter for the Scottish Executive to make within their block budget.”31

55. Decisions on this have implications for central government policy, and may affect the appetite for different approaches to capital investment. One of the UK Government’s self-imposed fiscal rules has been that public sector net debt (PSND) should remain below 40% of GDP over the economic cycle. It has been suggested that part of the attraction of PPP/PFI schemes has been that the off-balance sheet accounting adopted to date has allowed significant levels of capital investment to be made in recent years without increasing PSND. A number of witnesses to the Committee’s inquiry commented on this ‘additionality’.

56. The forecasts in the UK Budget 2008 show PSND rising to 39.8% of GDP in 2010-11, meaning that the addition of only a small portion of PPP/PFI liability would breach the 40% rule.32 On 20 October 2008, the regular joint statement on public sector finances by the Office of National Statistics and the Treasury showed that net debt in September 2008 was equivalent to 43.4% of GDP, or 37.9% of GDP if Northern Rock is excluded. In his Mais lecture, the Chancellor of the Exchequer indicated that the self-imposed fiscal rule would not be applied in the current economic climate. He stated “to apply the fiscal rules in a rigid manner today would be perverse. We would have to take money out of the economy, exacerbating an already difficult situation”.33 In the 2008 Pre-Budget Report, the Chancellor of the Exchequer stated that, in the current exceptional economic circumstances, allowing borrowing to rise is the right choice and set what he described as a “temporary operating rule” to govern borrowing in the current economic context. He projected that UK net debt as a share of GDP would increase to 48% in 2009-10, 53% in 2010-11 and would peak at 57% in 2013-14, and then subsequently falling as a share of the economy by 2015-16.34

57. At the time of conducting this inquiry, the exact method of accounting for PPP/PFI projects had not yet been resolved by the Treasury and its position on whether application of IFRS will, in fact, lead to any significant reclassification of PPP/PFI debt remained unclear. No further detail was provided in the 2008 Pre-Budget Report. However, the Committee understands that the Financial Reporting Advisory Board has recently approved the final version of the IFRS-based Financial Reporting Manual to be issued by the Treasury for the opening balance sheet, shadow accounts and first full IFRS accounts. That manual includes specific rules for accounting for PPP/PFI projects, and it is expected that the impact of these rules will be that the draft opening balance sheets will show the vast majority of existing PPP/PFI schemes in health and central government to be on balance sheet.

58. A number of witnesses emphasised that it is unclear what effect the implementation of these proposed accounting changes would have on the market for infrastructure investment – both in terms of the Government’s appetite for encouraging PPP/PFI-style investment, and of any impact on the private sector’s willingness to invest in such schemes.

59. Audit Scotland confirmed that accounting treatment is a technical issue, with no difference in cash flows whichever approach is used.35 NHS Greater Glasgow and Clyde stated that the public sector hopes “that someone will work out a way of ensuring that the change, which is a non-cash item, has no impact on our ability to provide services”.36

60. The key point made by many witnesses with regard to IFRS application is that on-balance sheet accounting will at least force public authorities to think more clearly about the merits of different approaches. Several witnesses emphasised that accounting determination should never in any event be influencing capital investment decisions and the choice of procurement and funding methodology. Quayle Munro stated that, “There is a great liberation in that, as it allows us to think up many different structures that may have the effect of improving value for money.”37 Audit Scotland stated that assessment of projects should now “more genuinely reflect their overall value for money as there are no incentives for bodies to construct contracts in ways to simply achieve an off balance sheet accounting treatment.”38

61. It is clear that the application of IFRS may have implications for the funding of capital investment and the Committee is disappointed that the situation remains uncertain. The Committee believes that decisions need to be taken as soon as possible, recommends that the Scottish Government continues to pursue this issue with the UK Government and hopes that the UK Government will provide more clarity on the issue.

Cost of finance

Project finance

62. Finance for each PPP/PFI project will have different characteristics, depending on the nature of the project, its size and risk profile, and market conditions at the time. The terms offered by the funding providers will also be dependent on a number of factors, including current market conditions and the risk associated with the project. However, the basic structure of the finance will be similar.

63. The finance to meet the capital costs of a PPP/PFI project has tended to consist predominantly of debt (known as senior debt), with a smaller proportion of equity, or risk capital – typically in a 90:10 debt:equity ratio. The special purpose vehicle (SPV) is responsible for securing the debt funding required to construct the asset. The ability to secure a predominance of debt (i.e. loans to be repaid on set terms) reflects the secure and predictable cash flows expected from the contract.

64. Shareholders supply the remainder by providing equity finance (risk capital) in recognition that there are risks which debt providers would be unwilling to bear. Finance from equity holders normally includes a large element of sub-ordinated or junior debt. The providers of equity finance (usually construction contractors, major service providers and financial investors) will expect to receive a higher return than debt providers as, in the event of default, junior debt ranks lower and is only repaid once all senior debt claims have been satisfied. However, using junior debt results in a more tax efficient structure than pure equity alone.

65. The unitary charge paid by the public sector commissioning body is calculated by reference to the costs incurred by the SPV. The charge is usually split into availability and service elements. The availability element (often approximately 60% of the total unitary charge according to Mark Hellowell of the Edinburgh University Centre for International Public Health Policy39) is a fixed cost, providing the SPV with the income required to meet its capital financing costs, taxation and equity dividends and to build up reserves to meet life-cycle costs. The service element includes payment for service costs, routine maintenance and management.

66. Normally the debt-service element remains roughly constant. However, because some or all of the unitary charge is index-linked, the gap between revenues and fixed costs widens over time, potentially increasing profits if variable costs can be controlled. In different models of PPP, that profit would be directed to different entities (e.g. the SPV of a PPP/PFI scheme, or a charity of an NPDO scheme). Financial models tend to provide for debt to be repaid some years before the end of the contract, potentially further enhancing profit in the later years of projects. However, this ‘tail’ has reduced in later projects as the risks of PPP/PFI projects have become better understood and more acceptable to funders. The financial model also aims to deliver a target rate of return over the life of the contract, with different returns at different stages. Very substantial shareholder dividends could be expected to be concentrated in the final years of a project.

67. The characteristics of the funding package secured will have a significant impact on the level of the unitary charge. The SPV is responsible for securing the best value funding package, running a funding competition to seek to ensure both value for money and deliverability. The funding package chosen in the particular circumstances - bank, bond or a mixture of both - will be dependent on the package that offers best value to the public sector. As experience of the risks has developed, bidders have been able to develop instruments to hedge some of them and offer lower unitary charges.

Comparing the cost of finance

68. It is difficult to make direct comparisons of the actual costs of borrowing from the private sector and through government sources such as the PWLB. There are a number of factors to be considered, such as the risk of default and the expected returns. McGrigors stated that it could not identify any figures to allow direct comparison of PPP/PFI and PWLB projects.40

69. Government borrowing is the cheapest way of raising funds as it is backed by tax revenues and so is regarded as virtually risk-free, and with no margins or fees levied. Scottish Enterprise stated that the PWLB rates in October 2007 were 4.85% for 30-35 year loans.41 The City of Edinburgh Council said that, currently, “Every £10 million of borrowing would cost us about £800,000 per annum over a 20-year period”.42

70. Overall, there was a consensus among witnesses that the cost of private capital is higher. Various examples were given of the cost of senior debt raised privately for PPP/PFI projects. CIPFA, citing the 2002 Audit Scotland report, stated that private financing costs were 2.5%–4% above those of direct public borrowing, adding costs of between £0.2-£0.3 million a year for each £10 million invested.43

71. Evidence generally indicated that the gap between the costs of public and private borrowing has narrowed as the PPP/PFI market has matured. The Treasury stated in December 2006 that the cost of debt finance on recent PFI hospital deals was 0.7% above government gilt rates.44 In April 2008, KPMG stated to the Committee that rates have reduced considerably and, in the last six months, would typically be 0.6% above PWLB rates.45 At the time of writing this report, there were indications that debt margins were rising.

72. As noted above, higher risk attaches to the capital raised through equity and sub-ordinated or junior debt, resulting in higher expected returns. Canmore suggested that a fair return on risk capital is 14%. Balfour Beatty Capital also suggested this figure, and explained how elements of that return cover other costs, such as those for unsuccessful bids.46

73. A number of witnesses mentioned the impact that the current tightness in the credit markets may have on privately-financed projects, but there was no clear consensus. Some indicated that the availability and pricing of debt would be more conservative for an unpredictable period, leading to less competition to fund projects. However, others emphasised that the public sector ‘covenant’ of guaranteed income streams and a consequently very low risk of default puts the public sector in a powerful position to benefit from a “flight to quality” where, comparatively, “the tightest possible deals can be cut”.47 However, in the current climate, pricing is still rising due to the limited availability of credit even for what could be termed ‘secure’ clients such as the public sector.

74. PWC emphasised that there are ways of reducing the cost of debt, although “these will need to be carefully calibrated so as not to weaken its disciplinary influence”.48 The PPP Forum also highlighted potential policy initiatives to reduce the cost of private capital while still maintaining the disciplines it brings. It suggested increased use of public sector contributions or government-backed guarantees for a proportion of the debt.49 Several witnesses highlighted that Transport for London and Network Rail are able to raise funds at very low margins (around 0.3%) above government gilt rates as a result of being backed by government guarantees. Carillion highlighted credit guarantee finance, where HM Treasury essentially raises funds from the market and lends on to PFI contractors. Others highlighted different approaches to bundling projects (both at the level of an individual procuring authority, and at a programme level), to secure the benefits of aggregation.

75. Although not directly a point about the cost to the public sector of securing private capital, a number of witnesses emphasised particular examples of high returns that have subsequently been secured by the private sector as evidence of the costs being too high. BT Scotland acknowledged that, with PPP/PFI, “over the years, some projects have been far too expensive or the system has not given the benefits that were wanted”.50

76. Margaret Cuthbert, an economist whose research in recent years has concentrated on public finance in Scotland cited the example of the Hairmyres Hospital project, where she stated that a total gross (non-discounted) return of £89.1 million over the life of the project was expected to accumulate to junior debt providers whose equity stake was only £100.51 Dr Jim Cuthbert argued that a major element of what is perceived as excess profit is a result of “inappropriate indexation of the non-service element of the unitary charge”, and that the extent to which this has been corrected needs to be examined.52 Analysing this, they argued that, for the same stream of availability charges due for the new Edinburgh Royal Infirmary, “the public sector could have borrowed 2.04 times the amount of capital which was actually raised”.53 Others suggested that, without indexation, the unitary charge would simply need to be higher so that the same amount of money goes through the financial model over the life of the contract to achieve the target rate of return.

77. Mark Hellowell also stated that the source of ‘excess returns’ has not been sufficiently well studied.54 Neither is it sufficiently clear from the evidence heard the extent to which some of the examples cited by witnesses can be regarded as examples of bad practice and poor deals negotiated in the early years of PPP/PFI when risks were uncertain, and unlikely to be repeated now or representative of the sector as a whole. Significant standardisation in contract terms and approaches is said to have followed Treasury guidance produced in 1999. Notwithstanding the issues noted above, the Treasury suggests throughout its guidance that the additional cost of private finance is not so significant that it inherently undermines the potential for PPP/PFI to demonstrate value-for-money. PWC emphasised that, while a local authority pays a higher cost of capital, “it is buying something completely different from what it would be buying if it raised money against its own balance sheet to fund a project.”55 The question is whether the increased financing costs are adequately off-set by any benefits that other factors such as whole-life costing and appropriate risk-sharing in PPP/PFI are said to bring to projects. These points are examined further below.

78. The Committee notes that there have been difficulties in providing comparable information on life-cycle costs for different methods of funding and procurement. The Committee believes that such information should be available for projects on a consistent and comparable basis and calls on the Scottish Government to develop and publish a robust investment option appraisal framework capable of producing comparable information on whole-life costs for future projects regardless of which method of procurement or operation is used.

Risk

Overview

79. A key element in the funding of capital projects is the assessment of risk. Risk can present itself in a number of ways, such as the possibility of cost and time over-runs, maintenance requirements and usage which differ from expectations, changes in service delivery, interest rate movement and other financing changes. A number of issues associated with risk were raised in evidence.

Methods of risk transfer

80. In traditional procurement methods, the public sector does not pay for risks through a premium being added to borrowing costs. The taxpayer effectively underwrites the risks, and provides capital at a lower cost. However, the risks still exist and the public sector then bears the costs when risks materialise and must be addressed. It is just that the costs of the risks are not built into the up-front cost of borrowing.

81. Evidence to the Committee suggested that the risks in capital projects are not generally insurable, but operate in “an entirely bespoke situation”.56 Quayle Munro stated that, “If an easy way of insuring such risks existed, I would like to think that we would have found it by now.”57 However, the question appears to be not so much whether some form of insurance model is a better approach to funding capital expenditure than the financial returns implied by PPP/PFI. Rather, it is whether, in approaches where they are not costed in at the beginning, the public funds will be available - and appropriately prioritised - for the necessary extra expenditure should the risks materialise. The public sector generally requires a suite of insurances to cover all aspects of the physical project itself.

82. PPP/PFI projects are said to provide value for money through the private sector taking on, pricing, and managing these project risks more effectively than the public sector could. As the PPP/PFI contractor will only start to receive payments when the delivery of public services starts – and will suffer deductions if specified performance criteria are not met - the effective transfer of risk is said to provide robust discipline and incentives to supply services on time and consistently to the stated quality.

83. Witnesses indicated that the risk model is an essential element of lenders’ decision-making. Due diligence by senior debt funders will rigorously test the capability of the PPP/PFI contractor to manage the risks that affect performance, in order to ensure repayment of the debt. Banks also impose discipline throughout the period of the loan through close monitoring of project performance. However, according to Mott MacDonald, a global management, engineering and development consultancy, “when the public sector funding route is taken it is up to the client to impose that discipline on himself.”58 Similarly, the equity holders have an incentive to manage the project actively. Balfour Beatty Capital explained that, beyond a contractor’s liquidated damages liabilities, “equity provides another layer of what is, in effect, a cash-collateralised performance bond that has to be burned through before the company fails”.59 Robertson Group also emphasised that, after other bonds and guarantees, “A 100 per cent liability sits on companies such as ours.”60

Risk premium

84. Essential to any assessment of whether value for money is achieved through PPP/PFI is the question of whether optimal financial risk is effectively transferred to the private sector without the guarantee by the taxpayer against loss, and how the private sector seeks to cost the return it demands in order to accept this. It will generally be necessary to identify and cost risks individually to assess whether the expected benefits of PPP/PFI are sufficient to outweigh its perceived extra costs and disadvantages. Public bodies need to consider individually, and on a case-by-case basis, whether it is better to accept residual liability or to pay the premium required by the private sector. As Ian Wall said, “We cannot get rid of risk; rather, we must decide whether to accept it or pay someone else to accept it.”61

85. The higher the risk being accepted by the contractor, the greater the risk premium that is likely to be included in the bid costs to compensate them for their exposure. Determining whether the premium is acceptable to the public sector can be inherently problematic as some risks are difficult to quantify and it is always a matter of judgement – although experience of actual outcomes is increasing all the time. Several witnesses emphasised that the fact that many PPP/PFI projects are highly profitable does not mean that there is no risk and is not in itself an indication that the projects, as signed, did not represent good value for the public - but simply that the SPV has successfully managed risks.62

Level of risk for the private sector

86. It is difficult to identify robust data on the profitability of projects and to identify whether any projects have in fact made a loss. A survey undertaken by KPMG in 2007 found that 83% of managers indicated that the contract was delivering a positive annual profit, with 70% having done so in each year of operation. In 25% of these cases, profits have been better than expected, and significantly better in 3% of cases. 17% of contracts were not delivering profits, 38% were delivering less profit than expected and 11% were delivering significantly less than expected.63 This does not answer the question as to whether any projects have made a loss. When asked whether, apart from the East Lothian schools project, any projects had made a loss, Jan Love from the PPP Forum described situations where there had been a lower than expected profit. When pressed on whether that could equate to making a loss she responded that “there are schemes where people have made losses….I can’t give examples because they are individual companies.”64

87. The early PPP/PFI deals were said by some witnesses to have been priced on terms that reflected the uncertain risks of a new market, thus giving potential for significant gains if the risks were successfully managed out. Several witnesses emphasised that this is balanced by the fact that real risks were accepted and investors lost money on some projects. Many witnesses acknowledged that the need to get up to speed and make a new model work had contributed to some poor decisions and poor-value projects in the early years of PPP/PFI. Equally, many witnesses emphasised that the PPP/PFI market has matured. Over time it has also been acknowledged that PPP/PFI may be more suited (and more likely to be judged better value for money) to some types of public service projects than others.

88. The number of examples of project failure, where risk has been taken on but not managed successfully, appears to be low. Barclays Private Equity stated that, “PFI/PPP would not exist as a procurement mechanism if such difficulties were commonplace, but we have suffered financial loss and have had to put more money into a project merely to enable it to be delivered for the public sector.”65

89. A number of witnesses cited the example of the East Lothian schools project – where problems arose due to insolvency of a contractor/investor at an early stage of construction – as illustration of how the risk transfer in PPP/PFI is effective in dealing with project failure at no additional cost to the public sector, albeit with, in that case, considerable delay in services being delivered.66 Under traditional public borrowing, the local authority would have had no insulation against meeting these extra costs itself or abandoning the project.

90. The Committee was made aware of three other projects where the public sector had bought out the contract for very considerable assets – the Skye Bridge, West Lothian College and Inverness Airport terminal. However, these are not examples of contractor failure. A paper from the Committee’s adviser indicated that these are examples where changes in service delivery or policy priorities had a significant impact on the attractiveness and continued suitability of the original PPP/PFI contract to the public sector body. 67

91. Dr Iain Docherty from the University of Glasgow also suggested that, on very large or complex projects, such as the Metronet concession for the London Underground, “the public sector always retains the bottom-line risk”.68 There was no clear evidence presented on whether this is as a result of poorly-constructed contracts, or whether it is inevitable once projects become over a certain critical size or importance. Mott MacDonald cited the Channel Tunnel Rail Link where, in a package underpinned by Eurostar revenues, the successful bidder agreed to take on the risk but got its forecast of demand substantially wrong – obliging the UK Government to intervene and provide guarantees to ensure project delivery.69 Clearly, transfer of risk is essentially related to a correct assessment of controllability of risk, and the governance structure of the project reflecting this.

92. The Committee heard a range of views on whether the transfer of risk is effective and the allocation of risks between the public sector and the contractor is optimal. Balfour Beatty Capital stated that, “The value attaching to these risk transfers almost always outweighs the higher cost of finance.”70 However, Mark Hellowell cited a study to argue that the actual cost of capital in PPP/PFI projects significantly outweighed what should have been expected for an investment with the particular project’s risk. He also cited research to suggest that the assessment of the value of risks transferred is “highly subjective”.71

Assessment of risk

93. Economist Margaret Cuthbert and Dr Jim Cuthbert who was previously the chief statistician at the then Scottish Office stated that, on the new Edinburgh Royal Infirmary project (when value for money assessment could be said to have been in its early stages), certain risks were invalidly included in the assessment.72 With regard to risk, they also stated that, “if you hand out to five different PFI schemes the expected value of something going wrong – if there is a 20 per cent chance of the project going wrong, you will hand out 20 per cent of the expected cost – in four out of five cases, the project will not go wrong and that cost will be banked as a windfall profit. In the remaining case, the project will go wrong and the 20 per cent that you have handed out will not cover the cost, so the scheme will go bust.”73 The Cabinet Secretary argued that profit from refinancing (see below) inevitably means that, “the natural conclusion must be that we have come to the wrong conclusions on the actual risk transfer involved”.74 However, Dundas and Wilson stated that there appears to be no empirical evidence on whether it is better value for the public sector to retain the risks of asset management and deal with them in-house or through short contracts.75

94. Some witnesses emphasised that the public sector has tended not to appreciate risk adequately and has, as a result, been demonstrated to be prone to ‘optimism bias’ – a systematic tendency in risk assessment mechanisms to assume the best possible timetable and cost outcomes. However, there was no clear evidence on whether there is any inherent reason why the private sector should manage risk better than the public sector. This is a particularly complex issue, with risk profiles varying at different stages of projects, and perceptions of risk varying as experience of different projects has developed. However, as outlined in the Scottish Public Finance Manual, all capital projects with a total budget exceeding £5 million must be assessed for their level of risk.76 High risk projects must undergo a ‘gateway review’ (for PPP projects this is termed a ‘key stage review’) which is undertaken at each key decision stage by a small independent team. Some witnesses argued that the private sector’s expertise is focused on managing certain kinds of risks. However, there was little direct evidence presented of effective risk management on an individual project basis.

95. From the evidence, it would appear there is a lack of clarity on how risk is and should be measured. This results in risk being measured in a variety of ways which makes it difficult to make an accurate comparison between different projects. Therefore, the Committee recommends that the Scottish Government explore how improvements can be made to ensure that risk is measured and accounted for in a systematic manner to ensure consistency across all methods of investment and to ensure accurate comparisons can be made.

PPP/PFI refinancing

96. Refinancing refers to the process by which the private sector can rearrange its bank loans at a lower interest rate once the project is signed and make a financial gain from this.

97. The scope for refinancing of PPP/PFI deals has been one of the areas that has attracted substantial comment. Whether the public sector’s interests are protected should the private sector benefit from refinancing opportunities has a significant influence on the perception of the extent to which PPP/PFI deals represent value for money. The Committee heard considerable evidence on this, and the extent to which this aspect of contracts has now become standardised to help protect the public sector’s interests.

98. Following completion of the construction phase and experience of the early operational period (typically one year for standard projects) of a project, many of the most significant risks are deemed to have been overcome. This enables contractors to reduce their financing costs as funders may be prepared to offer them improved terms to reflect the reduced risk. Some commentators suggested that the opportunity for substantial refinancing gains has arisen mainly from very conservative and unfavourable funding terms offered in early PPP/PFI deals before the market and associated risks were fully understood.

Refinancing of debt

99. The majority of the benefit of refinancing will be derived through being able to change the gearing - increasing the proportion of senior debt in the project to replace some of the equity (or sub-ordinated or junior debt). Balfour Beatty Capital stated that, typically, the cost of equity or sub-ordinated debt investment is a 14% real cash return77 - while some witnesses suggested around 6% as a typical cost of senior debt. A change in the ratio of the two can, therefore, produce a potentially significant gain.

100. Interest rate movements since the agreement of financial terms for the project would generally only have an impact in relation to any additional senior debt, due to penalty conditions connected with making changes to the original tranche of debt. Refinancing can also extend the term of senior debt – which, at the outset of a 30-year project, may typically have been on a 25-year term. Extending repayment later into the project allows extra borrowing against the security of several extra years’ revenues, creating cash which can be returned to shareholders but adding debt to the project.

101. Margaret Cuthbert and Dr Jim Cuthbert raised a number of high profile early PPP/PFI projects, highlighted by the National Audit Office (NAO), where very significant refinancing gains were made – for example, the Norfolk and Norwich University Hospitals NHS Trust, where the contractor (Octagon) increased its investors’ internal rate of return to 60%, from the 19% predicted when it bid for the contract.78 These rates appear to have been used as a proxy for whether the projects represent value for money.

102. However, there has also been some concern that refinancing leads to the public sector’s potential exposure to additional risks coming at a time when the PFI contractor has received most of the benefits of refinancing and might then become less rigorous about managing performance. Margaret Cuthbert and Dr Jim Cuthbert stated that restructuring allows investors to take out the net present value of future profits, dissipating the reserves and the discipline of the private sector to deal with any future potential difficulties – such as increased maintenance costs. They stated that, in accepting a share of the refinancing gains, the Norfolk and Norwich Trust agreed substantial increases in termination liabilities and a five-year extension to the contract.79 The NAO has suggested that this kind of deal reflected a lack of negotiation skills by the public sector at a local level.80

103. Regardless of actual profit levels, the perception appears to be established that significant refinancing gains for the private sector, combined with additional risks for the public sector, indicate that public benefit is not being maximised. In early PPP/PFI projects, the public sector contracting authority did not receive any direct benefit from refinancing. Following examples of very substantial gains being made on early projects, the UK Government acknowledged that considerable sums had potentially been lost to the public sector by not having a contractual entitlement to share refinancing gains. This led to provision being made for the public sector to share in refinancing gains – thus improving the potential value for money of deals.

104. It was clear from evidence from contractors and financiers that they believe the private sector should be rewarded for the risk that it takes – which is not shared with the public sector - and the way in which it has managed a project. However, it was also clear that it had been accepted that refinancing gains should be shared with the public sector. Canmore Partnerships summed this up by saying: “What is a fair return? I would say 14 per cent, which is why I would accept a capped return of 14 per cent. Is refinancing good value? Yes, if it happens. Should it be shared with the public sector? Of course it should.”81

105. The position on refinancing gains when the Committee took its evidence was that the UK Government had initiated a new approach to PPP/PFI contracts, requiring refinancing gains to be shared equally between the public and private sector for all deals signed after July 2002. In deals signed prior to this date, a voluntary code of conduct issued by the Office of Government Commerce in 2002 set the expectation that the private sector would voluntarily share 30% of any refinancing gain.82 In October 2008, this approach was further modified. Refinancing gains will be shared equally where there is a refinancing gain of up to £1 million. The private sector will receive 40% and the public sector 60% of refinancing gains up to £3 million and where refinancing gains are over £3 million, private sector investors will receive 30% of the gain while the public sector will receive 70%. This approach is mandatory for all projects that were still in competitive procurement at 1 November 2008 (ie, where final bids have not been receive or the competitive dialogue procedures have not been closed). It is therefore, not mandatory for projects at preferred bidder stage or where final bids are received before 1 November 2008. However, this approach is “encouraged” where it is not mandatory.83 In addition, the Scottish Government states in its recently published NPD explanatory note that it has adopted the same position for NPDO projects.84

Refinancing of equity

106. Some initial equity investors have sought to sell their investments in PPP/PFI projects, resulting in the development of a secondary market for equity. Unlike refinancing of debt, there is no guidance from the Treasury requiring provisions for any gains made from the refinancing of equity to be shared with the public sector. Equity investors have put at risk their own capital that would have been lost in the event of project failure. Refinancing of equity is, therefore, seen by the Treasury as a legitimate source of return for the private sector.

107. A number of witnesses also suggested that, as the market has matured and there appears less development risk in PPP/PFI projects, pension funds are buying stakes in projects on the secondary market because of their attractive profile of sustained and stable guaranteed return over a long period. There is a possibility that increased investor interest in infrastructure funds and the introduction of new sources of capital may assist in increasing competition for new projects. However, there is also the risk of reduced competition as a result of shares becoming too concentrated in a few funds – particularly as one of the reasons for refinancing can be to create added efficiencies through portfolio effects.85 Batching of PPP/PFI assets in investment portfolios may risk distancing investors from the operation of projects, potentially dissipating the disciplines to resolve problems that are said to be a key benefit of the PPP/PFI approach.

108. A change in equity ownership of the private sector PPP/PFI contractor is seen by some as a transaction that is outside the public sector’s interest. However, an understanding of how value for money can be appraised (and ensured for future deals) depends in part on access to information about what is in the contract. The Treasury publishes information on the equity holders in current PPP/PFI projects,86 although the House of Commons Committee of Public Accounts has recommended that this needs further work to be comprehensive. The NAO suggested that it is not clear that all early refinancings will necessarily have been reported to public sector commissioning bodies.87

109. The Committee notes that varying practices have been adopted in the past on the distribution of refinancing gains between the private and public sectors, and acknowledges some concern that the benefits may not always have been secured by the public sector. The Committee welcomes further recent guidance from the UK Government on the subject and recommends that the method for triggering refinancing provisions, and the sharing of any benefit accruing via them, should be transparent and equitable.

Competition and complexity in procurement

110. A number of issues were raised in evidence with regard to procurement, such as competition, lead times, the cost of tendering and competitive dialogue.

Competition

111. Sufficient competitive pressure is essential to ensure good value for money in any contractual situation. For PPP/PFI contracts, strong competition is said to play a central role in ensuring that risk transfer is effective and properly priced. Any factors which may lead to a reduction in competition therefore need to be examined carefully.

112. No evidence was presented on the level of competition among contractors bidding for contracts to build facilities procured using conventional borrowing. A number of witnesses suggested that there may be anecdotal evidence that the level of competition for PPP/PFI contracts has reduced in recent years. Jenny Stewart of KPMG cited factors such as the global market that now exists and skills shortages and stated “the point is not as much about the funding model per se as it is about the general issue of being in a global marketplace. Trying to attract people to Scotland is very important.”88 The NAO has reported that PPP/PFI projects generally attract a relatively low level of competition and cited the two main issues as the general complexity of tendering for PPP/PFI contracts and the particular pressures created by the ‘competitive dialogue’ procurement procedure.89

Lead times

113. There was some contradictory evidence on whether conventional or PPP/PFI contracts are more prone to long lead times – complicated by the need to disentangle contractual complexity from the effects of the procuring authority changing plans. CIPFA suggested that using a borrowing model it was possible to design, procure and build two schools in 18 months, while it took two years simply to set up the contracts for a PPP/PFI project undertaken around the same time.90 However, Keppie Design cited the example of 15 and 16 years taken to design and build Ninewells Hospital and Aberdeen Royal Infirmary using public funding and separating design and construction.91 Avoiding changes in specification by the commissioning authority through improved management would clearly bring benefits in both PPP/PFI and conventional procurement.

Cost of tendering

114. The cost of the tendering process for PPP/PFI projects is generally accepted to be high compared to traditional procurement, regardless of the size of the project – although it should be noted that a PPP/PFI contract also has to deal with issues such as service and maintenance levels and costs.. Various witnesses cited different figures for bidding costs, ranging from 1% to 3% of capital costs. Ogilvie Group stated that costs for abortive bids may regularly be over £1 million, which cannot be sustained by medium-sized Scottish businesses.92 Audit Scotland estimated that the total of all set-up and adviser costs in the schools projects it examined were between 5% and 15% of capital cost.93 Barclays Private Equity also indicated that, because an SPV generally exists to run one particular project, knowledge recycling by both private and public sectors is poor, leading to repeating of development costs each time.94

115. The alleged high transaction and development costs to both public and private sectors were said to have several effects. They have established a presumption that PPP/PFI projects with a low capital price are likely to represent poor value for money, and a number of adverse comments on PPP/PFI appear to relate to smaller projects which some witnesses acknowledge with hindsight were not appropriate for this funding approach. Bid cost also appears to be at least part of the reason for some infrastructure projects being bundled together for offer to the market – with, for example, a single contract being offered for provision of several schools. Several witnesses emphasised that, while there may be a strategic rationale for it, bundling and focus on high value contracts can have the effect of putting projects out of the reach of all but the biggest companies, potentially excluding many Scottish businesses. The high costs are also one of the reasons for a variety of centralised and standardised approaches to contracts and the tendering process, in an attempt to limit the new advisory and developmental work that is required on each new project.

Competitive Dialogue

116. The private sector has expressed some concern about the high costs incurred by preferred bidders. However, many witnesses emphasised that the difficulty of high bid costs has been multiplied by the ‘competitive dialogue’ procedure introduced in 2006 as a result of an EU procurement directive, which prevents early selection of a preferred bidder. Keppie Design stated that it “would almost go as far as saying that PFI is dead because of competitive dialogue, which makes a complicated process even more complicated”.95

117. Ogilvie also argued that competitive dialgoue is making it difficult for small and medium-sized Scottish businesses to participate. Therefore, it could potentially be argued that this militates against economic growth. Robertson Group estimated that it has “tripled or quadrupled our bidding costs, which are now several million pounds”.96 It can only afford to bid on one project at that level in a year, and all companies must seek to recover these higher costs from future successful bids, pushing the overall cost to the public sector up and potentially reducing competition and the potential for value for money.

118. Balfour Beatty Capital, however, argued that competitive dialogue has “brought benefits in terms of certainty of cost and commercial terms”.97 While acknowledging the cost issues, NHS Lothian stated that the procedure enables bidders to bring forward a variety of solutions to meet descriptive requirements and, therefore, “presents great opportunities to secure innovation”.98 Mark Hellowell also argued that the early selection of preferred bidder in other procurement methods risks changes to project specification coming at a high price as they are made in the conditions of monopoly.99

119. Robertson Group, however, also suggested that the process puts a huge burden on public sector organisations as they continue detailed design dialogue with more than one bidder through to the stage of being fit to go through the planning process, with “more design team meetings under competitive dialogue than…days during the bidding process”.100

120. While acknowledging the legal requirement to apply the competitive dialogue procedure, several witnesses did question whether it is being applied overly rigorously, and queried whether the directive may allow room for more flexibility of application.101 Roberston Group argued that there would be no legal difficulty in applying the invitation to negotiate or restricted procedures more widely.102

121. The Committee recommends that the Scottish Government should:

  • re-examine when and how competitive dialogue procedure needs to be applied, and the extent to which experience in other countries might lead to more efficient systems;
  • consider how to retain and recycle knowledge so that repeated development costs are minimised

  • consider other ways to ensure participation of smaller Scottish companies

  • investigate instances of limited competition for recent projects and seek to address this issue in any future capital investment arrangements.

Options appraisal

122. The stated policy of the UK Government has been that PPP/PFI should only be used where it offers cost-effectiveness. It, therefore, developed a framework to allow PPP/PFI routes to be compared with other procurement methods at a project planning stage to identify the best value-for-money option. A public sector comparator (PSC) of a project’s outline business case was developed. This is a method to assess the net present value of the costs associated with a hypothetical traditionally-procured public sector capital project, adjusted for a risk factor, and then compared against the costs associated with a PPP/PFI scheme.

123. A range of private sector businesses emphasised strongly that value for money has been at the forefront of project delivery in Scotland. KPMG stated that, on the projects it has advised, it is content that, “the analysis was sufficiently rigorous to justify a value-for-money equation in favour of PFI/PPP.”103 CBI Scotland stated that, in the vast majority of cases, PPP/PFI compared well with the PSC. It said that average savings compared to the PSC in the health sector were around £2.5 million per project between 1999 and 2002, and in education between 1999 and 2003 an average saving of 4.1%. It also said that a Treasury taskforce report found that an average saving of closer to 17% among a sample of 29 projects from all sectors.104 Several public sector witnesses also said that their deals do appear to them to have been good value.

124. In its 2002 report on PFI schools, Audit Scotland stated that the PSC/PFI comparison on its own did not provide decisive evidence on best value. It also concluded that, while the analysis provided by a PSC was a useful aid to decision-making, there was an inherent uncertainty and subjectivity associated with the process105. Some witnesses went further and criticised the concept of the PSC as an inherently flawed process that is structurally biased towards the PPP/PFI route. Mark Hellowell stated that the validity of this approach to value-for-money assessment is manipulated in favour of PPP/PFI and has been questioned by academics and public auditors.106 This critique centred on a number of points. A fundamental point is that it is difficult to construct a valid hypothetical public sector model for the comparison on a genuinely like-for-like basis as there have been relatively few large non-PFI projects recently. The basic premise of making project approval dependent on a satisfactory PSC outcome (not only at outline business case stage but also at contract signature) was considered by many to have influenced the approach of PSCs. Equally, the simple pass/fail nature of the tests may not give an accurate estimate of the potential benefits of a particular approach.

125. On the detail of the calculation, Dr Jim Cuthbert and Margaret Cuthbert argued that resource costs, as measured in current cost accounting terms, greatly overstate the actual financing costs of capital assets, significantly distorting the value for money test in relation to many PPP/PFI schemes. They suggested that it has burdened the public sector side of the comparison with the costs of current cost depreciation and capital charge, through the effects of the discount factor used, and giving an “unreasonably optimistic view of the long term affordability of the PFI option”.107 They suggested that many PPP/PFI value-for-money appraisals were similarly distorted until the Treasury refined the PSC in 2003 by revising the discount rate used from 6% to 3.5%.

126. Audit Scotland stated that using this rate is equivalent to including a specific provision for the cost of finance. However, it stated that, while these revisions are an improvement, the actual costs of debt funding are not included in the comparison, making it difficult to use effectively.108 It stated that the PSC has been perceived as a simple pass/fail test, but without adequate analysis of the reasoning.109 By way of contrast, the CBI Scotland stated that the PSC does not measure some claimed benefits of PPP/PFI, such as “managerial dynamism and potential for future innovation”.110 Mark Hellowell also argued that PPP/PFI costs are not revised upwards to include ‘optimism bias’, while those of the public sector option are – and he challenged the empirical basis cited in support of taking this asymmetrical approach.111

127. The appraisal system has evolved as the Treasury has sought to improve the assessment process, and a broader understanding of value for money is now encouraged – recognising that it depends as much on operational performance as getting the best deal initially. Mark Hellowell stated that, “There is no longer a PSC process running through procurement in England. There still is in Scotland.”112 The Scottish Government Financial Partnerships Unit updated its value-for-money guidance in 2007, consistent with Treasury policy and guidance. It applies to assessing investment decisions at different levels: at an overall programme level it is used to assess those programmes that are suitable for PPP/PFI; if a PPP/PFI route is chosen the individual investments and projects are reviewed for value for money through business case analysis; and further assessments are made during the procurement process. The aim is to provide a high-level justification if a PPP/PFI route for investment is selected.

128. More fundamentally than the detail of the framework itself, several witnesses argued that it has been operated in the context of a false choice and thereby undermining value-for-money conclusions. Several other witnesses were critical of the uneven incentives created by central government subsidy for the revenue costs of PFI projects – known as level playing field support in Scotland and as PFI credits in England. Glasgow City Council stated that, “The attraction of PPP was that 80 per cent of the capital was funded by the Scottish Executive”.113 A number of witnesses suggested that, for certain projects particularly in the health and education sectors, authorities knew that they would not get funding for new facilities unless they used the PPP/PFI route. Audit Scotland emphasised the pressure that may be felt by procuring authorities as government support policies meant that “no project at all could proceed if the PSC suggested the PFI was not economic”.114 Unison suggested that, “If there was a level playing field, most projects would not touch PFI with a barge pole.”115

129. The Committee believes that a broad range of options for funding and procurement of capital projects should be in place. The Committee notes the Scottish Government’s decision to make NPDO models the default form of private finance, and the statement in the Value for Money Guidance that, where NPDO is not suitable, other private finance models will be assessed.116 The Committee recommends that public bodies should select the method of financing which delivers best value to the taxpayer. The Committee, therefore, agrees by division that all methods of finance should be considered equally on their merits. A minority of the Committee endorses the Scottish Government’s position that the NPDO model should be the default option.117

Service delivery, quality and flexibility

130. As noted above, many witnesses emphasised that value for money is now recognised to be as much about operational performance as simple cost comparisons. Evidence explored a number of aspects of operation in some detail.

Delivery of facilities on time and on budget

131. The ability to deliver a facility on time and operate it to achieve the desired service output are key components of considering the merits, and value for money, of different approaches to capital investment. As with other facets of value for money, it is a difficult comparison to attempt. The Committee heard considerable debate on the extent to which time and cost over-runs on projects are less under PPP/PFI than under conventional public procurement. A number of studies have examined cost and time over-runs on the construction of both conventionally-procured and PPP/PFI projects, and many witnesses argued that PPP/PFI projects generally seem to offer greater price and time certainty during construction.

132. In a 2003 report, the NAO found that almost three-quarters of projects secured under traditional methods came in over budget or late, compared to less than a quarter of projects procured via PPP/PFI. KPMG stated that only 20% of PPP/PFI projects are not on time and budget, and those 20% miss only by a fraction.118 Where PPP/PFI projects are late or over budget, the private sector bears the financial cost (although the residual impact on service delivery rests with the public sector). The NAO also found that 88% of the PPP/PFI projects it surveyed were delivered on budget, and of those that were not this was caused by the public sector changing specification rather than by the contractor.119

133. Many witnesses argued that the incentives that are integral to a PPP/PFI contract mean that time and cost over-runs and potential project failures are minimised, because of the due diligence disciplines and the constant policing of progress by investors. However, evidence to the Committee suggested that there is a significant debate over whether there is any inherent reason why – given the appropriate skills - appropriate disciplines to reduce the potential incidence of over-runs should not be built into the contract terms and project management approach for traditional procurement. Mott MacDonald stated that, “there is no reason why it should not be applied, provided that clients can manage the multiplicity of stakeholders and political pressures”.120 However, optimism bias is said to partly explain the apparent tendency for over-runs to be more typical in conventional projects.

134. There is a potential difficulty in comparing like-with-like as (while the bulk of capital spending has always been made through approaches other than PPP/PFI) there have been relatively few large comparable conventionally-procured projects in Scotland in recent years. It is also difficult to capture data for the full life-cycle costs of comparable projects, meaning that it is less easy to test whether approaches have improved. Mark Hellowell stated that there is little valid evidence to support claims that PPP/PFI delivers to time and budget, and that these factors have never properly been compared to modern public procurement.121

135. The Committee recognises that there are potential difficulties in comparing PPP/PFI and conventionally procured projects and differing views over whether PPP/PFI delivers to time and budget. However, it also assumes that there is no reason why incentives and disciplines, which it is asserted are inherent in PPP/PFI projects, cannot be more widely used in projects funded wholly by the public sector. The Committee recognises that incentives appropriate to the public sector will need to be devised but it recommends that the Scottish Government ensures that comparable project management approaches are applied in any future arrangements.

Operation

136. Aside from simple cost factors, an essential element of value for money is whether the asset delivers what was promised. Tying together the design, construction and maintenance of assets is a key perceived benefit of PPP/PFI. Integrating the operation of a facility into the contract, together with provision for deductions from the unitary charge for non-performance, is said to create strong disciplines to ensure operational delivery and to fix things that go wrong.

137. Empirical evidence seems to support this effect (although it should be noted that much of this is not current). The general conclusion from the Audit Scotland 2002 schools report was that the required outputs were being delivered, to the required standard and on time. A KPMG survey in 2007 of private sector project managers reported that 94% of contracts were meeting service level agreements.122 However, the Educational Institute of Scotland (EIS) stated that a 2004 survey showed that only 30% of its members believed that new or refurbished schools under PPP/PFI delivered value for money, and identified problems in relation to facilities management, basic maintenance and basic janitation.123 Direct evidence from users of services is more difficult to gather.

138. It is also important for all long-term projects to feature benchmarking and market testing throughout their lives, with external examination and comparison to ensure continuing value for money in the cost of on-going service provision. PPP/PFI contracts typically include provision for testing the value of services such as cleaning or catering every five or seven years. KPMG’s survey found that 85% of projects include such requirements. While there are relatively few contracts that are far enough advanced to have experienced this comparison, BT stated that it, “interestingly, usually results in improvements on both sides”.124 However, a report by the House of Commons Committee on Public Accounts found that, “there is a lack of comparative data to check whether prices proposed by incumbent suppliers are competitive” and that early experience shows that, “PFI contractors are using these processes [benchmarking and market-testing] to secure price increases and that some authorities are cutting services to pay for them”.125

139. The Committee believes that periodic benchmarking and market testing are essential to ensure contracts are delivering best value for the taxpayer, and recommends that the Scottish Government includes such procedures in future projects and ensures that these procedures themselves work in the best interests of the taxpayer. The Committee notes the concerns raised by the Public Accounts Committee, and recommends that they are addressed in contracts for all future projects.

Quality of services and service user experience

140. One of the fundamental questions about comparison of approaches to capital investment is whether one project type produces better outcomes than others. Again, comparisons in key sectors such as health and education are limited by the

relatively few recent non-PPP/PFI projects. Responses to surveys also have the potential to be clouded by the fact that a facility is likely to be regarded as good by reason of the simple fact that it is new.

141. However, a KPMG survey on schools reported that, “overall, schools procured through PFI deliver better educational outcomes faster than those procured conventionally.”126 It stated that the overall rate of improvement is 20% higher in PFI schools, rising to 92% higher when comparing only fully rebuilt schools. The survey suggested caution about the findings given the small sample, short time-frame of operation and complex and dynamic nature of educational attainment. However, it also stated that it is the fullest body of evidence yet available on this subject anywhere in the world. It suggested that further study should be undertaken on the reasons for the effects it reported.

142. Empirical evidence on any relationship between capital procurement method and service quality appears to be limited. Architecture + Design Scotland (A+DS), however, stated that the majority of PPP/PFI schools projects it reviewed failed to live up to service quality expectations.127 Canmore stated that “there is no evidence to suggest that PPP design generally compares unfavourably with the designs used in direct, traditional procurement”.128 Keppie Design, however, compared any modern approach favourably with the 1960s and 1970s when the emphasis was on providing ‘lowest capital cost’ schools and hospitals that turned out to be very poor quality.129

143. Some of the evidence to the inquiry explored the possible reasons for any quality concerns with PPP/PFI. A+DS commented on the potentially greater propensity to encounter disconnect between clients or service users and designers in PPP/PFI than in traditional procurement, meaning that the personal touch can be lost.130 All witnesses agreed that the initial project briefing period is key, and A+DS said that some procurement methods provide more support than others through that process to eventual service delivery.131

144. Unison argued that this ‘disconnect’ is one facet of PPP/PFI undermining the concept of “public service ethos and team delivery”.132 However, several witnesses emphasised that this is partly due to bundling of projects (which has sometimes been seen in schools projects and some local health facility projects) and partly a consequence of a dash to replace failing public infrastructure quickly. In a desire to upgrade quickly, there is a trade-off to be had with individualisation of design.

145. The bundling of projects to secure cost-effectiveness in PPP/PFI may constrain the flexibility for consultation. The question appears to be whether there is a necessary and qualitative difference in clients’ participation and influence in PPP/PFI – whether, for example, issues such as confidentiality aspects arising out of the financing model constrain the ability to consult service users? Glasgow City Council suggested that this is not the case, but that the costs associated with detailed consultation may be the constraint.133 However, NHS Greater Glasgow and Clyde emphasised that, given that it has to ensure that the asset is fit for service delivery, the private sector contractors in a PPP/PFI project are very keen to ensure that they engage effectively with the needs of staff and service users.134

146. There are, however, good examples of design working with service users, and so disconnect is not inevitable. A+DS suggested that the public sector comparator should include greater recognition of design quality aspirations.135 Several witnesses emphasised that the heart of the issue is simply about a client knowing what it wants and driving that through clearly. Mott MacDonald said that it is possible to provide high quality services whichever procurement method is applied.136 Detailed written submissions from Keppie Design and A+DS suggested some key procurement cultural and procedural changes that are required to ensure that quality of design is maximised (and also indicated that they should be pursued across all procurement routes).

147. Some witnesses commented on the potential for standardised designs to contribute to improvement. However, A+DS expressed particular concern about using a greater degree of standardisation based on exemplar designs, although it recognised some benefits and economies of scale through appropriately repeating small components of a design.137

148. In connection with design quality and sustainability, some witnesses acknowledged that there is a perceived unwillingness in some PPP/PFI situations to invest in what may be regarded as relatively innovative (and therefore higher risk) features – for example, biomass heating systems. A+DS stated that any perceived extra risk can be problematic if design teams are brought in after inappropriate cost plans have been set.138 Ernst and Young said that there was no reason why such features could not be included, provided that the specification was clear from the outset and that the public sector did not disincentivise the contractor by requiring disproportionate penalties for non-performance on one aspect such as this.139

Flexibility

149. As noted at paragraph 46 above, the relative inflexibility of PPP/PFI contracts is regarded as one of their weaknesses. A number of commentators have questioned whether PPP/PFI projects – which typically have 25 or 30-year terms - are sufficiently flexible to allow models of service delivery to be adapted to changed needs or policy priorities in the future. Barclays Private Equity acknowledged that this is fundamental to the fact that projects are debt funded and the sole source of repayment relates to a single facility.140

150. The ability of services to respond flexibly to changing service needs is an element of quality – but, when considering capital investment projects over a 30-year timeframe, it is also fundamental to a comparison of the long-term costs of different funding approaches. The evidence on flexibility covered two aspects: at a project level, the ease with which the contractual structure allows adjustments to be made; and, at a general level, the implications of having substantial fixed forward commitments for the way in which a public body can apply its funds to its priorities.

151. Some witnesses emphasised that the inevitability of a facility dating and requiring substantial expenditure to change is a concern for infrastructure regardless of procurement and funding method, and is not intrinsically an issue for PPP/PFI. Scottish Water also emphasised that the ease with which changes can be made competitively depends greatly on the nature of the asset.141

152. The balance of evidence suggests that this is a particular problem of the PPP/PFI approach. Dr Iain Docherty stated that, “change of use or on-going mid-life refreshments – which are normal over a 30-year period…[tend] to be charged at a premium rate”142, although there are limited numbers of projects old enough to have experienced significant change.

153. While there may be contractual mechanisms to test value for money for changes, contracts may also lock the public body into dealing with the initial provider to make any changes rather than examining a range of ways to achieve them, reducing the options for securing good value. A recent NAO report - which examined this issue in some detail - confirmed these views.143 Pricing life-cycle maintenance in at the beginning of a 30-year project clearly presents significant challenges, with the alternative simply being that the public body bears the pricing risk at the time of the maintenance requirement.

154. Trades unions suggested that a traditional procurement approach is always likely to provide for greater flexibility. In terms of individual contracts, Unison emphasised that the unitary charge for a PPP/PFI contract is costed on the original assumptions about service requirements. Many witnesses acknowledged that these can quickly become outdated. The BMA gave an example of hospital contracts that were based on a presumption of patient throughput being about 85%. The policy focus on waiting lists then almost immediately required higher throughput, with the unintended consequence that higher throughput resulted in financial penalties for the public sector under the PPP/PFI contracts.144 However, questions were raised over whether the service itself could be an inhibitor of change and that such potential inflexibility could arise under conventional procurement as well as PPP/PFI.145

155. In part, this problem could be viewed as related to the public sector’s skills in designing an appropriate specification at the outset, and some witnesses suggested ways for the public sector’s approach to be improved. It is important to exclude the potential for concern about flexibility to be used as a cover for allowing costly indiscipline and indecision in the procurement process to be sanctioned. Mott MacDonald stated that a, “process of iteration…and continual refinement and development of the requirements is not the most efficient way to deliver a capital project.”146

156. Transport Scotland emphasised that the problem with specification changes relates to the public sector’s skills as a client, and that the key should be effective project management that gets the specification and any necessary flexibilities right from the outset.147 On this issue – as on several others – some witnesses emphasised that the PPP/PFI market has changed significantly over recent years and many of the issues raised in comparisons using early projects may now be treated very differently as the public sector’s approach to procurement has developed.

157. However, no evidence was presented on whether improved specification could overcome flexibility concerns. It is not clear whether there is a way to overcome this problem in PPP/PFI with more sophisticated contract terms, without it being at disproportionate cost, and without undermining the certainty that comes from having whole-life costs built in. Equally, there was no evidence presented on whether more recent contracts have been more successful at building in flexibility in a cost-effective way.

158. Ian Wall said, “I would be surprised if anyone around this table really thought that a contract could be written that explains and covers every eventuality.”148 Any attempt at building in flexibility would appear likely to increase the costs significantly, and still be unlikely to be able to anticipate adequately the service trends that may develop over 25-30 years.

159. Other witnesses indicated that the issue of flexibility is a particular reason why PPP/PFI approaches have come to be seen as unsuitable for use in particular sectors, acknowledging that the certainty required to make PPP/PFI a viable business proposition for investors is unduly restrictive for their needs. PPP/PFI is said to be a good approach for a client with stable long-term goals and service delivery patterns. The Scottish Funding Council stated that, “We have found that the concession-type contracts in PFI and NPD [non-profit distributing] projects do not work in a sector in which there is dynamic in the specification.”149 Evidence identified other features, including that PPP/PFI is generally unsuitable for refurbishment projects where risk is difficult to transfer. In recent years the Treasury has also stated that PPP/PFI is unlikely to be suitable for small capital value projects and for IT projects. Dr Iain Docherty went further, arguing that it is precisely in the education and health sectors in which PPP/PFI has been most used that, “new technology and working practices are changing how services are delivered and in which the pace of change is the fastest.”150

160. Related to the perceived inflexibility of PPP/PFI, however, is the benefit of whole-life maintenance costs being built into a contract. Keppie Design emphasised the potential importance of this as the lifetime maintenance costs of a facility are likely be in a ratio of 5:1 to initial capital costs.151 The contractual inclusion of lifetime costs in PPP/PFI seems to be widely acknowledged as having forced discipline on this issue and brought it to the fore, and the attraction of this approach was emphasised by many witnesses who commented on the dilapidated state of some public infrastructure in the past. Keppie Design stated that, “One hospital in Scotland has a maintenance backlog of £120 million, but that could not happen under PPP”.152

161. The Committee heard mixed views on whether the improvements which PPP/PFI is said to bring to public capital investment can be harnessed for good value and retained without the perceived downsides of the PPP/PFI approach, such as undesirable operational constraints. PWC suggested that its experience is that a single contract for through-life services associated with an asset is very difficult to achieve with another model. It has tried, but is “finding it difficult to get the hard and objective focus on getting it right first time that a bank brings. Equity is the integrator. The banks bring the discipline.”153

162. Other witnesses suggested that it is possible to achieve discipline in other approaches. Mott MacDonald said that there are design, build, operate and maintain contracts that do not have the private finance element.154 CIPFA stated that “there is no reason why there should not be such a focus under traditional procurement”.155 However, the maintenance budget, if separate, is often an easy target when there is pressure for savings. Glasgow City Council acknowledged that, “Local authorities have not dealt with the life-cycle maintenance issue particularly well.”156 NHS Greater Glasgow and Clyde also stated that there has tended to be “too much focus on the availability of capital to get a project established and less clarity about the certainty of the on-going funding that pays for the maintenance, capital charges, [etc]…that are associated with improving and creating an asset over a number of years.”157

163. In considering the implications of future commitment of revenue funds, some witnesses argued that the unsuitability of locking up funds in PPP/PFI contracts is far more widespread and fundamental. Trades unions suggested that the operational benefits of PPP/PFI projects having whole-life costs built in may be regarded as likely to take some time to become apparent, by which time the issue of inflexibility may come to the fore. The BMA stated that “it does not seem sensible to pre-empt income so far down the line”.158


Footnotes:

1Scottish Government, November 2008. Value for Money Assessment Guidance: Capital Programmes and Projects. Para 1.17 states: “For sectors where it is viewed that NPD is not suitable, consultation with the Scottish Futures Trust is required in order to determine the appropriate Private Finance model to test.” Available at: http://www.scotland.gov.uk/Resource/Doc/919/0068647.doc [Accessed: 27 November 2008]

2At its meeting on 25 November 2008, the Committee divided on the proposition that all methods of finance should be considered equally on their merits. For: 5 (Jackie Baillie, Derek Brownlee, James Kelly, Jeremy Purvis and David Whitton); Against: 3 (Joe FitzPatrick, Alex Neil and Andrew Welsh); Abstentions: 0.

3Scottish Parliament Finance Committee. Official Report, 27 May 2008, Cols 560-1.

4The Committee divided on a proposal to insert the following paragraph before paragraph 316: “The Committee found no clear evidence that a separate limited company, the Scottish Futures Trust, is required to deliver better co-ordinated, managed and delivered infrastructure investment. Neither did the Committee receive clear evidence that any other funding option is to be available offering better value for money separate to all existing NPDO, PPP, prudential borrowing and traditional capital financing methods and believes any function to deliver better value for money and efficiency should be carried out by central government as part of its existing drive for better value for the public purse.” The proposal was disagreed to on a casting vote. For: 4 (Jackie Baillie, James Kelly, Jeremy Purvis and David Whitton), Against: 4 (Derek Brownlee, Joe FitzPatrick, Alex Neil and Andrew Welsh), Abstentions: 0.

1 Scottish Government. (2007) Consultation on the role of a Scottish Futures Trust in infrastructure investment in Scotland. Scottish Government. Available at: http://www.scotland.gov.uk/Publications/2007/12/19093017/0 [Accessed 15 September 2008]

2 The figures in this table do not take account of the re-profiling of £227 million of capital expenditure from the 2010-11 budget to 2009-10, announced by the Cabinet Secretary for Finance and Sustainable Growth in a letter to the Finance Committee dated 1 December 2008.

3 Scottish Government. (2008) Infrastructure Investment Plan 2008. Available online at: http://www.scotland.gov.uk/Publications/2008/03/28122237 [Accessed: 10 December 2008]

4 Scottish Government. (2008) Draft Budget 2009-10. Available online at: http://www.scotland.gov.uk/Publications/2008/09/12140641 [Accessed: 10 December 2008]

5 CIPFA. (2003) The Prudential Code for Capital Finance in Local Authorities. London: CIPFA.

6 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 342.

7 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 382.

8 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 342.

9 Scottish Parliament Finance Committee, Official Report, 15 April 2008, Cols 340-341.

10 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 341.

11 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 340.

12 House of Commons Hansard, 2 July 1997, Col 315.

14 Margaret Cuthbert and Dr Jim Cuthbert: The Royal Infirmary of Edinburgh – A case study on the workings of the Private Finance Initiative. Written submission to the Finance Committee.

15 The ‘unitary charge’ is calculated by reference to the costs incurred by the project company, including costs of: construction, service, financing, insurance and other project costs.

16 Mark Hellowell, Centre for International Public Health Policy. Written submission to the Finance Committee.

17 HM Treasury. (October 2007) 2007 Pre-Budget Report and Comprehensive Spending Review.HM Treasury. Available at: http://www.hm-treasury.gov.uk/pbr_csr07_index.htm [Accessed: 10 December 2008]

18 Scottish Parliament Finance Committee. Official Report, 27 May 2008, Col 562.

19 Sources: Scottish Government. (2008) personal communication, and UK Treasury, PFI Signed Projects List. Available at: http://www.hm-treasury.gov.uk/d/pfi_signed_projects_list.xls [Accessed: 3 December 2008]. UK figures exclude Scotland.

20 City of Edinburgh Council. Written submission to the Finance Committee.

21 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Cols 335-6.

22 CIPFA Directors of Finance Section. Written submission to the Finance Committee.

23 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 361.

24 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 368.

25 Audit Scotland for the Accounts Commission. (2002) Taking the initiative - Using PFI contracts to renew council schools, June 2002. Available online at: http://www.audit-scotland.gov.uk/docs/local/2002/nr_020612_PFI_schools.pdf [Accessed: 10 December 2008]

26 Audit Scotland. Written submission to the Finance Committee.

27 Dundas and Wilson. Written submission to the Finance Committee.

28 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 392.

29 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 388 – gives the example of Kilmarnock Prison, which is not on the balance sheet of either the provider or the Scottish Prison Service.

30 The Treasury’s PFI Signed Projects List – March 2008 lists 103 projects in Scotland, of which the capital value for only two is listed as scored on the public balance sheet. Available online at:
http://www.hm-treasury.gov.uk/d/pfi_signed_projects_list.xls [Accessed: 10 December 2008]

31 Letter from the Assistant Private Secretary to the Chief Secretary to the Treasury to the Clerk to the Finance Committee dated 14 August 2008.

32 This forecast was made before the extra borrowing announced by the Chancellor on 13 May 2008 to fund increases in income tax personal allowances, and does not include the impact of further spending on supporting the banking industry.

33 The Mais Lecture on Maintaining Stability in a Global Economy given by the Chancellor of the Exchequer at the Cass Business School, London, 29 October 2008

34 House of Commons Hansard, 24 November 2008, Cols 493-4

35 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 383.

36 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 352.

37 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 489.

38 Audit Scotland. Written submission to the Finance Committee.

39 Mark Hellowell, Centre for International Public Health Policy. Written submission to the Finance Committee.

40 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 413.

41 Scottish Enterprise. Written submission to the Finance Committee.

42 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 330.

43 CIPFA Scotland and CIPFA directors of finance section, joint response to Scottish Futures Trust consultation

44 Treasury evidence quoted in House of Commons Committee of Public Accounts. 25th Report, Update on PFI debt refinancing and the PFI equity market, (April 2007) HC158 (2006-07). Available online at: http://www.publications.parliament.uk/pa/cm200607/cmselect/cmpubacc/158/158.pdf [Accessed: 10 December 2008]

45 KPMG. Written submission to the Finance Committee.

46 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 476.

47 Scottish Parliament Finance Committee. Official Report, 20 May 2008, Col 539.

48 PricewaterhouseCoopers. Written submission to the Finance Committee.

49 PPP Forum. Written submission to the Finance Committee.

50 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 372.

51 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 449.

52 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 436.

53 Jim Cuthbert and Margaret Cuthbert, 2008. Written submission to the Finance Committee.

54 Mark Hellowell, Centre for International Public Health Policy. Written submission to the Finance Committee.

55 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 413.

56 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 415.

57 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 484.

58 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 455.

59 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 477.

60 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 477.

61 Scottish Parliament Finance Committee. Official Report, 20 May 2008, Col 544.

62 See Balfour Beatty Capital, Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 476.

63 KPMG. (2007) Effectiveness of operational contracts in PFI. Available online at: http://www.kpmg.co.uk/pubs/305432_PFI.pdf [Accessed: 10 December 2008]

64 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 444.

65 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 428.

66 See written submission to the Finance Committee by Dundas and Wilson

67 The Committee’s adviser provided background details on the costs of these buy-outs to the public sector.

68 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 446.

69 Mott McDonald. Supplementary written submission to the Finance Committee.

70 Balfour Beatty Capital. Written submission to the Finance Committee.

71 Mark Hellowell, Centre for International Public Health Policy. Written submission to the Finance Committee.

72 The Royal Edinburgh Infirmary: A Case Study on the Workings of the Private Finance Initiative, Margaret Cuthbert and Jim Cuthbert, 2008. Written submission to the Finance Committee.

73 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Cols 446-447.

74 Scottish Parliament Finance Committee. Official Report, 27 May 2008, Col 577.

75 Dundas and Wilson. Written submission to the Finance Committee.

76 Scottish Government. (2007) Scottish Public Finance Manual. Available online at: http://www.scotland.gov.uk/Topics/Government/Finance/spfm [Accessed: 10 December 2008]

77 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 476.

78 Margaret Cuthbert and Jim Cuthbert, PFI: Refinancing, supplementary written submission to the Finance Committee, May 2008

79 Margaret Cuthbert and Jim Cuthbert, PFI: Refinancing, supplementary written submission to the Finance Committee, May 2008

80 Referred to in House of Commons Committee of Public Accounts. 25th Report, Update on PFI debt refinancing and the PFI equity market, (April 2007) HC158 (2006-07). Available at: http://www.publications.parliament.uk/pa/cm200607/cmselect/cmpubacc/158/158.pdf [Accessed 17 October 2008]

81 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 486.

82 Office of Government Commerce, Refinancing for early PFI transactions Code of Conduct, October 2002. Available online at: http://www.hm-treasury.gov.uk/d/PPP_Refinancing_Code_of_Conduct.pdf [Accessed: 10 December 2008]

83 HM Treasury. (2008) Standardisation of PFI Contracts: Amending Refinancing Provisions. Available at: http://www.hm-treasury.gov.uk/d/sopc4_addendum171008.pdf [Accessed 7 November 2008]

84 Scottish Government. (2008) NPD explanatory note. Available online at: http://www.scotland.gov.uk/Topics/Government/Finance/18232/NPDExpNote [Accessed: 10 December 2008]

85 Dundas and Wilson, quoted in Margaret Cuthbert and Jim Cuthbert, PFI: Refinancing, supplementary written submission to the Finance Committee, May 2008

86 HM Treasury, PFI Equity Holders – November 2007.

87 National Audit Office, PFI Refinancing Update, November 2002. Available online at: http://www.nao.org.uk/publications/nao_reports/01-02/01021288.pdf [Accessed: 10 December 2008]

88 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 442.

89 National Audit Office. (2007) Improving the PFI tendering process. Available online at: http://www.nao.org.uk/publications/nao_reports/06-07/0607149.pdf [Accessed: 10 December 2008]

90 CIPFA Directors of Finance Section. Written submission to the Finance Committee.

91 Keppie Design. Written submission to the Finance Committee.

92 Ogilvie Group. Written submission to the Finance Committee.

93 Audit Scotland for the Accounts Commission, Taking the initiative - Using PFI contracts to renew council schools, June 2002. Available online at:http://www.audit-scotland.gov.uk/docs/local/2002/nr_020612_PFI_schools.pdf
[Accessed: 10 December 2008]

94 Barclays Private Equity. Supplementary written submission to the Finance Committee.

95 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 464.

96 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 468.

97 Balfour Beatty Capital. Written submission to the Finance Committee.

98 NHS Lothian. Written submission to the Finance Committee.

99 Mark Hellowell, Centre for International Public Health Policy. Written submission to the Finance Committee.

100 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 468.

101 For example, see Ogilvie Group, Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 474.

102 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 469.

103 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 412.

104 CBI Scotland. Written submission to the Finance Committee.

105 Audit Scotland. (2002): Taking the Initiative: Using PFI contracts to renew council schools. Available online at: http://www.audit-scotland.gov.uk/docs/local/2002/nr_020612_PFI_schools.pdf [Accessed: 10 December 2008]

106 Mark Hellowell. Centre for International Public Health Policy. Written submission and Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 449.

107 Jim Cuthbert and Margaret Cuthbert, The capital charge: problems arising from the misapplication of current cost accounting, supplementary written submission to the Finance Committee, May 2008

108 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 384.

109 Audit Scotland. Written submission to the Finance Committee.

110 CBI Scotland. Written submission to the Finance Committee.

111 Mark Hellowell, Centre for International Public Health Policy. Written submission to the Finance Committee.

112 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 449.

113 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 343.

114 Audit Scotland. Written submission to the Finance Committee.

115 Scottish Parliament Finance Committee. Official Report, 13 May 2008, Col 511.

116 Scottish Government, November 2008. Value for Money Assessment Guidance: Capital Programmes and Projects. Para 1.17 states: “For sectors where it is viewed that NPD is not suitable, consultation with the Scottish Futures Trust is required in order to determine the appropriate Private Finance model to test.” Available at: http://www.scotland.gov.uk/Resource/Doc/919/0068647.doc [Accessed: 27 November 2008]

117 At its meeting on 25 November 2008, the Committee divided on the proposition that all methods of finance should be considered equally on their merits. For: 5 (Jackie Baillie, Derek Brownlee, James Kelly, Jeremy Purvis, David Whitton); Against: 3 (Joe FitzPatrick, Alex Neil, Andrew Welsh); Abstentions: 0.

118 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 407.

119 National Audit Office. (2003) PFI: Construction Performance. Available online at: http://www.nao.org.uk/publications/nao_reports/02-03/0203371.pdf [Accessed: 10 December 2008]

120 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 452.

121 Mark Hellowell, Centre for International Public Health Policy. Written submission to the Finance Committee.

122 KPMG. (2007) Effectiveness of operational contracts in PFI. Available online at: http://www.kpmg.co.uk/pubs/305432_PFI.pdf [Accessed: 10 December 2008]

123 Scottish Parliament Finance Committee. Official Report, 13 May 2008, Cols 505 and 508, EIS and Royal Incorporation of Architects in Scotland, EIS survey of new and refurbished schools, report of findings, May 2004

124 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 379.

125 House of Commons Committee of Public Accounts. (2007). 63rd Report, HM Treasury: Tendering and benchmarking in PFI (November 2007) HC754 (2007-08). Available online at: http://www.publications.parliament.uk/pa/cm200607/cmselect/cmpubacc/754/754.pdf [Accessed: 10 December 2008]

126 KPMG. (2008) Investment in school facilities and PFI – do they play a role in educational outcomes?. Available online at: http://www.kpmg.co.uk/pubs/310991.pdf [Accessed: 10 December 2008]

127 Architecture + Design Scotland. Written submission to the Finance Committee.

128 Canmore Partnership Ltd. Written submission to the Finance Committee.

129 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 454.

130 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 454.

131 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 453.

132 Scottish Parliament Finance Committee. Official Report, 13 May 2008, Col 504.

133 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 347.

134 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 347.

135 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 454.

136 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 453.

137 Architecture + Design Scotland. Written submission to the Finance Committee.

138 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 459.

139 Scottish Parliament Finance Committee. Official Report, 20 May 2008, Col 530.

140 Barclays Private Equity. Supplementary written submission to the Finance Committee.

141 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 350.

142 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 437.

143 National Audit Office. (2008) Making changes in operational PFI projects. Available online at: http://www.nao.org.uk/publications/nao_reports/07-08/0708205.pdf [Accessed: 10 December 2008]

144 Scottish Parliament Finance Committee. Official Report, 13 May 2008, Col 513.

145 Scottish Parliament Finance Committee. Official Report, 13 May 2008, Cols 516-517.

146 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 456.

147 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 350.

148 Scottish Parliament Finance Committee. Official Report, 20 May 2008, Col 545.

149 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 345.

150 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 438.

151 Keppie Design. Written submission to the Finance Committee.

152 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 457.

153 Scottish Parliament Finance Committee. Official Report, 29 April 2008, Col 406.

154 Scottish Parliament Finance Committee. Official Report, 6 May 2008, Col 461.

155 Scottish Parliament Finance Committee. Official Report, 22 April 2008, Col 387.

156 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 336.

157 Scottish Parliament Finance Committee. Official Report, 15 April 2008, Col 360.

158 Scottish Parliament Finance Committee. Official Report, 13 May 2008, Col 505.

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