Thursday, 17 February 2011

PFI - it's all about risk

PFI consortia are being lined up by the government's spin machine as the next cohort of bad boys who are robbing the taxpayer; operating costs of the PFI schemes now live are running at some £8bn a year, and the government wants to see reductions. 

One of the most fundamental problems with PFI is that the contracts were all written by civil servants who have little or no knowledge of the way in which the private sector prices risk. Their explicit aim was to transfer risk from the public to the private sector, get the costs of risk off the Treasury's books, and this they have done - but at a cost. Take the example of a student's Hall of Residence procured under a DBFO (design, build, finance, operate) PFI framework. The consortium has two partners, a construction firm and a facilities management organisation. The contract period is 25 years. 

First, development risk. Given an adequate outcome specification (the Employer's Requirements) D&B is a highly cost effective way for clients to develop assets. Unless of course, as is the case with our example Hall, the government were a year late in letting the contract but still insisted on the original completion date, resulting in a cost per square meter some 40% higher than it could have been. The government are utterly crap at programming an adequate lead-in time for major capital projects, and internal client delays rather than site delays are invariably the major reason for development cost over runs for such schemes. 

Secondly, operating risk. And this is where the risk-transfer is most poorly understood. The contract is 25 years, about the same as the economic life of the Hall's building systems and roof. If the private sector is taking the risk of no down-time to the building, it will cost-in some expensive mid-term major repair and replacement work whilst maintaining occupation. Ker-chink. The private sector is also taking income risk; the government's forecasts are based on a simple 95% occupancy during the life of the facility. The private sector may estimate 75% occupancy and add something for irrecoverable bad-debts. Ker-chink. The private sector takes the risk of highly specified cleaning and maintenance standards with severe financial penalties, so costs-in the standard it thinks it can achieve consistently plus an allowance to cover the cost of the penalties. Ker-chink. The government has also transferred large parts of inflation risk to the private sector, so the FM contractor makes 'safe' estimates of cost increases; if these are just 0.75% higher each year than the reality, the contract becomes highly profitable after just three or four years. Ker-chink. And don't mention window-cleaning; the civil servants have warranted the contractor's window-cleaner access to the students' bedrooms from 8am. Ker-chink Ker-chink.

In every case, the private sector has made perfectly reasonable allowances for the risks the government is seeking to transfer; the government's desire for cost-certainty has outweighed commercial sense. The only way to claw-back costs is to re-allocate risk. Simple, no? Er, no. If the government takes back risk, the potential cost of the risk is a liability that must appear in the government's accounts. 

Which is why the government is adopting the only tactic that it can see - to bully the consortia into surrendering profits at the threat of being black-listed from public sector work. 


Weekend Yachtsman said...

Another thoughtful and percipient post, Mr. R, thank you.

Even though I work in the construction industry, to my shame I had never considered this properly until now.

Of course, we still can't afford these contracts, but as you have pointed out, that means we couldn't afford the buildings in the first place, except on a build-and-ignore basis.

Clearly the "old" way was for the State to keep all those risks in-house, and then when things turned up, as they do, they didn't have the money to fix them, with crumbling and dilapidated results we see all around us.

English Pensioner said...

From my experience in the Civil Service, they have no idea whatsoever as how to cost projects. They place great faith in tendering and believe that the largest companies will give best value for money.
Having also worked on the other side, I know that their faith is entirely misplaced. When tendering, a company's aim is not to offer the lowest possible price, but to try and find out what their competitors are likely to tender and merely underbid, but this could still be double what the price ought to be. And quite often they would not be able to underbid small companies, but applied pressure to suggest that the small companies wouldn't have the resources if there were problems, a view which was generally accepted as it was considered less risky (and no way do civil servants take any risk which might affect their careers!)
Your arguments are valid, but I bet these companies profits are many times more than if they'd undertaken a build and maintain contract for someone like Tesco or M&S.

Raedwald said...

EP - quite right about tenders. We had one not so long ago that looked so much trouble that we carefully constructed an expensive and losing bid so as to show willing, and then were offered the job as everyone else had done the same ....

Anonymous said...

Thank you for the informative article.I now have some idea of PFI.