The Private Finance Initiative - Essay Example

The Private Finance Initiative in the UK, its Evolution, Drawbacks and Advantages. The Private Finance Initiative is a concept that involves private entities financing the construction and maintenance of major public utilities such as roads, schools and hospitals. The investment by the private entity is then recouped albeit with an interest from the government or local authority that authorised the project. The Private Finance Initiative has been touted by economic experts as one the most cost effective methods of providing quality service to the public. PFI as it is commonly known was introduced in Britain in the early 1990's by the then conservative government led by veteran administrator John Major. The basic premise behind the concept was to involve private players in service provision hence lessening the burden on the government. It was also meant to bring a touch of professionalism that is common in the private sector in provision of public services. The entry of Britain in the European Union also played a significant role in the starting of this scheme. New EU laws put a cap on government expenditure resulting from both internal and external debt. These laws consequently put a major strain on government expenditure on public projects such as new schools, roads and hospitals. Technical experts therefore resulted to PFI in order to expedite the provision of essential public services. In some circles the scheme was also known as the Private-Public partnership or simply the PPP. While the scheme was designed to ensure efficient provision of public services and reduce government borrowing from the public sector, it drew some criticism in some quarters. Some economic experts and political scientist pointed holes at the idea saying that it was a blatant display of government inefficiency. There was also fear that providers of these public services may be motivated by profits and end up providing mediocre services. In public finance, the government provides public goods since unlike private players; it is not motivated by profits. That is why payment of taxes is compulsory. If any government fails in this role then it has no mandate to govern the citizens and should not be in power, argued some scholars. History of Private Finance Initiative. As noted earlier the Private Finance Initiative was the brainchild of the conservative government then led by John Major. It was billed as the most cost effective means of service provision to the public. As expected this attracted the wrath of the then opposition labour party who accused the government of engaging in unplanned privatisation of key government services. Courtesy of some wheel dealing and backroom consultations the labour party warmed up to the idea and consequently the Private Finance Initiative was implemented. In spite of its initial opposition to the idea, the labour went ahead to adopt PFI when it eventually swept to power under the stewardship of the youthful leader Tony Blair. The chancellor Gordon Brown who was one of the most vocal opponents of the scheme beat a hasty turn around and became scheme's number one supporter. The chancellor praised the scheme pointing out that it was due to PFI that over 150 new schools were built, 40 new hospitals constructed and a dozen road and rail projects constructed within a very short span of time. Economists at the treasury also argued that it was due to PFI that the government had spent more on capital projects and there was less public borrowing by the state. PFI was well manifested in London as it was responsible for the building of the ultramodern London Underground system. Mayor Ken Livingstone was forced to eat humble pie and support the project after its success. Akintole et al (2003) points out that Private Finance Initiative was one of the thorny issues in the labour government. There was the usual criticism that public assets were managed by private individuals in a questionable manner for a very long period of time. It was also quietly pointed out that some highly important projects were carried out in a reckless manner by the profit conscious individuals in the private sector. In most circumstances the risk of these projects was carried by the government. The huge profits gained by the private sector in PFI was also a cause of concern to some critics. However this notion was discounted by players in the industry who were quick to remind the critics that they were not charitable organisations and must be paid for the services rendered on behalf of the government. Today the PFI initiative is still operational in the UK albeit at a much lower scale. However it has spread to other countries especially in Africa under the codename of Private-Public partnership. (PPP) While its success is subject to debate objective analysts admit that it is successful and will be around for quite sometime. As recently as March 2009 the chancellor announced that treasury had worked out steps for the provision of services courtesy of PFI amidst the worldwide financial crunch. The economic downturn that has been felt around the world has made it hard for individuals to raise money from the banking industry which has been hit hard by the financial turmoil. To cover for this gap the British government has already laid out elaborate plans for major infrastructural PFI to put some life to major projects worth billions of pounds which cannot be guaranteed bank financing. Private Finance Financing has consequently boomed under the labour administration despite of its initial opposition to the idea. Although trade unions and some academics still oppose the idea, it has proved to be a worthy one and its contribution to the economy and the public well being is immense. While the future of PFI is not certain in the UK with the possible change in government, one thing is clear. The model has worked and is worth venturing into by developing economies around the world. Operation of Private Finance Initiative. Having looked at the history and the controversies surrounding PFI, then it is imperative to understand how the whole process works. This includes the checks and balances that the government uses to ensure that tax payer's money is used optimally and for the good of the public. The PFI scheme works in fairly simple and straight forward manner. It works in the same way that a bank operates when it gives loans to individuals and business organisations. Think of it this way, you want to buy a house but you do not have the necessary funds to acquire it upfront. The option here is that you walk into a bank get a loan and pay the owner of the house. In this case you own the house but then you still pay the bank monthly instalments towards servicing the loan. In the case of PFI the process is just the same except that the government is the buyer of the "house" now. The government is duty bound to provide public services and goods to the public. These public goods and services may include roads, schools and hospitals among others. In most cases demand of these services outstrips supply and the government is forced to seek for a strategic investor to fill in the gap. Consequently a private entity offers to buy a public good in the understanding that the government will pay in the future at a profit. Both parties stand to gain from the deal since the private investor makes profits from the investment and the government fulfils its mandate of providing services to the public. The government quite often uses some checks and balances to ensure that the PFI is not used to benefit enterprising individuals at the expense of the taxpayer. That is why there is a department at the treasury that acts as a coordinator of all projects carried out through the Private Finance initiative. This department is tasked with the role of ensuring that there is transparency in the procurement process of PFI projects. The department also makes sure that government staff are technically equipped to understand the projects that are carried out under PFI. This goes along way in ensuring that mediocre work is not done by contractors. All the PFI projects are also scrutinised by the National Audit Office. This office is independent from the government and it ensures that public funds are not misused by the government. This office is crucial since it provides the government with raw data regarding the value of public project to guard against overpricing by private investors who collude with government officials. At the end of the day, this office must provide its unbiased assessment on each and every project that is carried under PFI so as to ensure that the taxpayer gets maximum utility in the project. These checks and balances have gone a long way in ensuring that PFI is successful. The department of coordination at the treasury in particular has played a key role in ensuring that the operations of PFI are smooth and efficient. Since this model was introduced and adopted, hardly has there been any case of funds embezzlement by the government or shoddy work done by the private contractors. It is worth noting that since the PFI model was introduced by the conservative government in the early 1990's, over 55 billion pounds has been spent on such projects. Most projects carried out under this initiative have always been world class. A good example is the London Underground system as well as a number of hospitals that have been built in Birmingham. Today PFI account for up to 13 percent of the total infrastructural development in the UK. Characteristics of PFI projects Most PFI projects have some unique characteristics that make them quite distinct. The first major characteristic of these projects is that they are long term projects. An average project could last up to 60 years. In most cases these projects involve infrastructural development and involve heavy investment of initial capital. Due to the level of investment cancelling PFI project is quite a messy affair which can only be handled by top-notch lawyers. It is worth noting that since the model begun, no project has ever been cancelled by the government. This does not imply that the PFI provider is allowed to offer mediocre services to the public. Should this happen then the government has the right to reduce the annual repayment fee and urge the operator of the service to raise the standards. In this case the government sets the standard of the services to be provided and the provider abides by them. The services provided should also not fall below reasonable society expectations. Corporate bonds are the key source of finance for most PFI projects. However where the project is relatively small then providers can turn to banks as a source of finance. The major drawback for using banks as a source of finance for PFI projects is that it is quite expensive and consequently not cost effective. Economic experts have also pointed out the fact that banks are vulnerable as witnessed in the recent financial crunch that left banks with no cash to lend. David (2006), pp, 86-88 says that it doe not make too much economic sense to use banks as the major source of finance in PFI Under some circumstances both sources of finance may be applicable. This may be the case of a project that requires high initial capital and at the same time require some running cost. In such circumstances a bank loan may be used as the major source of finance at the initial stages of construction and then supplemented by a corporate bond to cover the running cost. Another unique characteristic of PFI is the ownership of the finished project. After the agreed period of use is over, then the private investor takes owns the facility and can either sell it or use it for any other purpose. Let us take the example of a health facility that is constructed under a lease agreement of 40 years. The private investor will have the responsibility of maintaining this facility for the 40 years and during this time it will be used as a public facility. When this period lapses, then the health facility will now be owned by the investor not the government. The private investor can choose to demolish it and build a hotel. In other words, he has the sole rights to that property. In most cases the PFI provider operates using three different facets. There is the parent company also know as the holding company, the technical company that provides the infrastructure and finally the service provision one. The parent company handles the management part while the technical one handles the technical part of the project. This includes the actual building and design of the project. Finally the service provision company handles other auxiliary services that are essential to the provision of services to the public. Private Finance Initiatives mostly operate in two levels. They operate under the central and the local government. Under the local government, PFI may operate in areas such as provision of local health services, water provision and garbage collection and disposal. In the central government this largely includes building of infrastructure that is used by the entire country. An example of a PFI project that falls under the central government is the Future Strategic Tanker Aircraft that was built for the Royal Air force at a cost of 10 billion pounds. A project like the hospital at Kent may be classified as a PFI project that falls under the local government. In this case the government is the sole client and purchaser of PFI. However it does this on behalf of the general public. Douglas James a respected urban planning scholar at Leicester University argues that PFI is a perfect example of the old analogy of killing two birds with one stone. The scholar says that in this case the government gets someone to borrow from and the same person builds the infrastructure and runs it on its behalf. Employees of these facilities are counted as public officials as long as the lease agreement is in place. Private Finance Initiative provides an opportunity for low risk investment for the general public. They are also considered very safe lending areas by banks and other lending institutions. This unique advantage stems from the fact that the government hardly defaults on repayment. Individuals who invest in corporate bonds that finance PFI also stand a good chance of a steady flow of income for a sustained period of time. This level of almost secure investment is rare especially when the turmoil in the financial markets is taken into consideration. Finally PFI operations guarantee full return of the initial investment. Unlike other business operations that may be negatively affected by economic downturns and recession, this is not the case with Private Finance Initiatives. The investor is guaranteed a specific return per year through out the contractual period. This includes a full return on the capital employed, the cost of borrowing as well as a certain percentage in profit. PFI mostly involve three distinct entities. There is the government which is the sole provider of public services and the private consortium that provides the services on behalf of the government at a cost. Finally there is the party that provide the funds to facilitate the completion of the project. The final party includes banks and other financial institutions that fund infrastructure development. In some instances financing may be done through corporate bonds that are issued in the stock market. Advantages of Private Finance Initiatives PFI projects have received their fair share of criticism from politicians, trade unions and scholars. The labour party which had initially opposed the idea later changed tune and supported it after the idea proved to be worthwhile. The major plus for PFI projects is their value for money. The widely held belief that there is greater efficiency in the private sector than the public sector still holds today. The public has more confidence in the private than the public sector because they are not only effective but also efficient in service provision. The notion of value for money courtesy of PFI is supported by Harvard economist Grey Hey who points out that the long term nature of the projects enables the public to enjoy quality services for a long period of time. The government pays for these services in instalments hence there is less financial burden for the government and ultimately the taxpayer. PFI projects are awarded on a competitive basis based on the principle of the highest quality and low cost. This competition is a key factor in ensuring low cost and high quality services are provided in the long term. Results based pay is another major strategy that has been effectively used by the government to ensure that excellent services are provided by private providers. In this case the government sets the standard of services it is willing to pay for and the private supplier agrees to play by the rules. Another major advantage of PFI is the transfer of risk from the public to the private sector in provision of essential services. There is always inherent risk involved in the construction of heavy infrastructure such as bridges and roads. Highly skilled labour is also required for the completion and running of such projects. In this case of PFI this burden is passed to the private sector and the public only get to enjoy the services of the finished project. Past experience has proved that PFI projects are certain to be completed on time and without exploding the budget. This is unlike government sponsored projects that always require time extension thus making them expensive. It also argued that PFI projects are more transparent and more likely to meet the specifications set by the government. Finally PFI helps the government to avoid public sector borrowing while at the same time investing in capital expenditure and provision of key public infrastructure. PFI has been billed by economic experts as the most effective method of infrastructure development while at the same time checking on government debt. This may be the only alternative in local authorities where there is a cap on borrowing and spending. In the government budget, PFI is not counted as government expenditure but is put in a special account called the off balance account. Unlike in privatisation where government gives up ownership of public enterprises, PFI ensures more indirect involvement of the government in the provision of public goods and services. This is crucial since government is not profit motivated but only ensures that the public get high quality services. Drawbacks of Public Finance Initiatives. The success of the Private Finance initiative notwithstanding, a number of drawbacks have been pointed out by scholars and other government bureaucrats. The first major drawback of PFI projects is that they lack transparency. Financial experts point out that PFI projects do not fall under the public borrowing account and consequently are not factored in the government budget. Such projects are referred to as off-balance-sheet and they do not reflect the true picture of the national debt. Accountants find it hard to audit these projects and consequently some money is lost in the process. The issue of abnormal profits has also been raised by some financial experts. Joe Coleman of KPMG says that in some cases some PFI investors have earned up to 58% in returns. The NHS is one area where PFI have been largely successful. However the British Medical Journal says that hospitals have turned to be more expensive since the introduction of this concept. The increase in cost of public services therefore goes against the idea of providing quality services to the public at an affordable cost. All PFI projects are long term in nature and the government binds itself to pay for service delivery for a very long period of time. Friction may arise where the service supply by the investor falls short of the expected standards. It is difficult to maintain the same level of service through out the contract period and the government is forced to pay money evenly the level of service notwithstanding. In some instances, the level of services at some PFI hospitals has dropped significantly and this has been a source of conflict between the government and PFI operators. The rule of equitable service provision which is applicable in government is not common in the private sector. In most PFI projects such as hospitals, there is always an agreement that the public will also contribute in the running of the hospital through cost sharing. Where some fees is to be contributed by the public, low income earners may end up not enjoying the services if they fail to raise the required fee. This goes against the equitable service provision rule which is practiced by the government. In some instances the governments ends up paying more money as subsidies to cater for service provision to the low end market. PFI leads to unfair distribution of resources. The government may be forced to shift spending priorities in the long term since there are some PFI projects that are favoured by private investors while others are not. Should the PFI favoured projects fall in one area, then the rest of the country will be forced to pay for the project in form of taxes while they may actually never enjoy the service. A good example is the preference to build hospitals in London while a similar project in Kent was cancelled after private investors failed to bid for the job. In some instances PFI has led to wastage of resources by the government which the public ends up paying for. A case in point is a school which was built at a cost of over 15 million pounds in 2002 but later closed since there were no pupils. To this date the public still pays this debt. The government sometimes fails to do a proper feasibility study and thus falls prey to private investors who are out to make a quick kill. There are a number of hospitals which have been built under the PFI but turned out to be very expensive hence remaining empty. Conclusion. The major selling point for Private Finance Initiative is no doubt its value for money. While the idea has had its fair amount of challenges and hit the ceiling in some projects, it has been widely successful. Some of the major projects that have been successfully completed through PFI include the London Underground system and the 10 billion pounds Future Strategic Tanker Aircraft that was built for the Royal Air force. There is also the Queen Elizabeth hospital in London and the Walsgrave hospital which was built in Coventry at a cost of 410 million pounds. While there are some bottlenecks and challenges in the implementation of PFI, the advantages far outweigh the disadvantages. The labour party which once opposed the initiative embraced the model as an idea whose time has come. PFI model has also spread to other countries particularly in Africa under the Private-Public sector Partnership. The major grey areas that have been identified need to be polished if PFI is to be the ultimate success story in the UK. Grey areas that the government needs to polish include a thorough definition of the service that is to be provided in the long term and consistency in delivering the service. The government must also have a good grasp of the level of risk it faces and how this risk can be allocated between the public and the private sector. Finally it is essential that the government understands that the traditional role of government as the supplier of public goods and services does not change. Consequently the entire role cannot be left to the private investors who always have one eye on profits. If these bottlenecks are checked then the PFI model will play a major role in the provision of cost effective services to the public. Reference. Akintole, A. Matthias, B. and Cliff, H. (2003) Public-Private partnership, Managing risks and opportunities. London: Wiley -Blackwell publishing David, J. (2006) The labour party economic policies. London: Elgar Publishing Douglas, H. (2001) Business strategies for government, London: Nicholas Brealey Publishing. Douglas, J.(2003) Effect of private finance initiative on NHS, British Medical Journal, August pp 14-17. Read More