UK: PRIVATE FINANCE PUBLIC INTEREST. - Billions of pounds worth of business is up for grabs and years of neglect of Britain's infrastructure could be at an end as the state spins off more functions to the private sector. Only companies ready to operate f

by Roger Eglin.
Last Updated: 31 Aug 2010

Billions of pounds worth of business is up for grabs and years of neglect of Britain's infrastructure could be at an end as the state spins off more functions to the private sector. Only companies ready to operate facilities as well as build them need apply.

It is, says Neville Simms, the chief executive of Tarmac, like the swing of a giant pendulum. In the 18th and 19th centuries, the country's roads and canals, and later railways, were built by the private sector for private use. But somewhere along the line, as government grew and assumed more functions, the pendulum swung back, says Simms, and the private initiative was lost.

Privatisation has been an important step towards restoring the private sector's role. But now ministers want to see the pendulum swing back even further. Instead of being a provider of services, they envisage a streamlined public sector spinning off many of its functions to private companies. From prisons to hospitals, roads to bridges, and computer centres to schools, the state will contract out the construction of capital assets and the provision of services to a new breed of organisation. Constructors will become operators as well as builders of facilities. 'We are changing the role of government,' says the chancellor, Kenneth Clarke. 'We are moving government to being a provider of private investment opportunities and a purchaser of services.'

The opportunities are vast. Propagandists of the Government's Private Finance Initiative (PFI) see companies running the army's vast vehicle fleet, as well as accommodating and feeding service personnel. Construction of badly needed roads, railways and bridges, often blocked by public spending curbs, will now move ahead without obstacle. 'This is the Heineken of privatisation - taking the private sector to parts of the government machine not reached by previous privatisations and contracting out,' says Eurotunnel chairman Sir Alastair Morton, who has been closely involved with the PFI for the past two years.

Sceptics say they have heard it all before and question whether anything has really changed. Who will persuade a Treasury that has spent decades refining its grip on public sector spending that it now has to relinquish a great deal of control? Who is to convince industrialists, used to working on public projects, with safe returns and minimal risks, that they should develop new forms of organisation and a willingness to take on a greater part of the risk? How are the sceptics to be convinced that they must either come to terms with the new order or lose out in the race to win a share of the billions of pounds of business the new-style acquirer will be seeking to buy?

'Some people are critical,' says Simms. 'But I am enthusiastic about the progress made. If I wasn't, Tarmac would not be putting so much time and effort in to developing projects.' At John Laing, commercial director Philip Rees takes a positive view. ' I think we all recognise that it is a necessary move forward,' he says. 'The chances of the Government being able to carry out all the capital infrastructure spending envisaged is remote without private sector finance.' He believes the private sector can contribute a lot by 'providing more cost-effective and improved levels of service'.

One short answer is for the sceptics to pay a visit to the modest, sixth-floor office of the Private Finance Panel Executive in Old Queen Street, just around the corner from the Treasury. There Douglas Hogg, a member of the panel's executive committee, brandishes the panel's first report with 11 closely typed pages listing 685 proposed PFI projects. Most are at an early stage and only 25 were out to tender in early March, but Hogg is convinced that momentum is building. 'When you publish figures like these people can see it is real,' he says.

The target is to convert some of the projects listed into £5.3 billion of business this year. Although about half this total is accounted for by the Channel Tunnel's high-speed rail link, numerous consortia - among them the Spanish company, Dragados - are showing interest in projects for new roads and the Docklands Light Railway extension. Two prisons and the DSS's £150 million computer centre in Newcastle number among projects receiving similar interest.

Recent years have seen much debate about the role of private capital in public spending. Progress had been tortoise-like before Norman Lamont, then chancellor, took up the baton in his 1992 Autumn Statement. But even with such support progress continued to be slow. Insiders admit that there was insufficient appreciation 'that the thing would require positive management and pushing from the centre'. After the 1993 budget the Private Finance Panel was set up with Treasury sponsorship and Eurotunnel's outspoken Morton as its chairman. Yet only days after Morton brought Hogg, one of his trouble-shooters at Euro-tunnel, in to help, the two realised that more resources were needed. The territory they had to cultivate was wide. Hogg reckons there are 17 or more major government spending departments, close to 500 local authorities and 460 national health service trusts. The first step was to expand the team, first to six executives and now to 12.

The panel members themselves are high-powered; Malcolm Bates, deputy managing director of GEC; NFC chairman Sir Christopher Bland; Howard Davies, director general of the CBI; Royal Insurance chairman, Allan Gormly and Sheila Masters, a partner at KPMG. Dubbed parish priests, their 'parishes' cover major spending departments such as transport, education and defence. They deal at the level of ministers and permanent secretaries; the panel executives relate to senior civil servants.

The recognition by Morton and Hogg that the job was bigger than envisaged has meant a year of hard spade-work. One of the panel's principal roles has been as an interface between public and private sector, 'acting as honest broker between the conflicting interests that may be perceived or real,' says Hogg. The other vital job has been to shop around the public spenders, explaining the PFI and digging out suitable projects. Each department now has a private finance unit carrying on this work.

One teething problem is that from the start the Treasury said it would not set rules for its implementation but rather rely on the development of custom and practice. Rees at Laing likens this to building up a body of case law and says it means there has been some ambiguity. 'But this is very much an initial problem,' he adds. 'This approach is going to leave it flexible and open to entre-preneurial ideas to come forward.'

What will surprise the sceptics is the extent of the Treasury's support. Those with long experience of its mandarins will know that it is not sufficient for chancellors to express enthusiasm. To avoid it becoming a case of 'No, minister', officials must be equally enthused. 'People say the Treasury will never do it,' says Hogg. 'But the culture has changed enormously in the past year. The curious thing is that it is really the Treasury making the pace. They are setting the policy, supporting the initiative, creating the panel and even doing it with their own building.' Earlier this year it was announced that the Treasury was seeking a private sector partner to join in the £200 million modernisation of its historic Great George Street HQ.

The Treasury is motivated by more than a desire to shift the burden of spending to the private sector, however. Officials see an opportunity for better management of spending and greater value for money - which, in turn, should create room to modernise worn-out infrastructure that currently stands as the legacy of years of neglect. As long as spending remains so intimately linked with overall economic strategy, such neglect will be inevitable. As critics have consistently pointed out, the present system, which fails to distinguish between current and capital spending, is biased against capital spending. The temptation is always to keep spending within budgets by taking the easy way out and trimming capital projects.

In contracts negotiated under the PFI the distinction between current and capital spending will be less obvious. A typical contract will contain an element of capital spending for providing the asset and current spending for the provision of service from it over a period of time, with the two merging into one financing stream. This will mean the Government making some changes to accounting conventions - work which is reportedly under way. It has also led to criticism that the PFI is just a clever way of bending the public spending rules.

No one is claiming that the PFI will conjure up a new treasure chest of cash for capital projects. But two points stand out. First, managing spending more effectively implies there will be budget savings that can be translated into more projects. And, second, if the private sector can see a return from the project, it stands a better chance of going ahead than under the old order. Officials believe that, as the system builds up, the only real constraint will be the public appetite for services rather than the availability of capital.

In the private sector, GEC-Alsthom has been one of the major beneficiaries of the new regime. How it came to be the supplier of new trains for the London Underground's Northern Line is an early and - for would-be participants - a model example of the PFI at work. It started with ABB, GEC-Alsthom's rival in the rolling-stock business, supplying new trains for the Central Line. ABB suggested it made sense to go on and re-equip the worn-out Northern Line. LU thought it a good idea but pointed out that it did not have the money. Under the old scheme of things, the matter would have ended there. But ABB, in a break with the past, offered to lease the stock. LU then went to the Government with the proposition only to find it rejected - on one count, because a lease was only disguised capital spending, and on another, because it would mean that LU was simply paying more for borrowing than it would in its own right.

In conjunction with Morton, the Treasury suggested an operating lease rather than a straight financial one. It went to a contest between GEC-Alsthom and ABB, with the former winning. 'Its proposition was much more akin to selling a train service to LU than what was essentially a deferred train purchase scheme. It was much cheaper than the original purchase deal,' says one insider.

Interested companies would do well to scrutinise the deal. Anyone whose mind-set is still focused on selling equipment or construction services to the public sector is in danger of missing out. As the Government switches to buying rather than supplying services, so suppliers have to respond in kind. Contractors will no longer simply build hospitals, roads or prisons. They will have to enter long-term contracts which will mean them playing an important part in operating the facility.

The new-style contracts will inevitably be complex. Take, for example, the provision of a road. Part of the contract will deal with the road's construction and should be familiar enough to contractors. More complex, however, will be the section dealing with the provision of road services over a period of, for example, 25 years. The public-sector client will define the 'service standard' required and may well go as far as laying down the periods when carriageways can be closed for maintenance. These two elements in the contract may well relate to each other: a contractor may decide to spend more on construction quality, thereby saving on maintenance.

One of the best yardsticks to date is the contract to re-equip London Underground's Northern Line. Here GEC-Alsthom has contracted to deliver and maintain 100 tube trains over 20 years and provide an eightfold increase in their reliability. In this instance, the contractor has extensive experience of operating railways and can handle the project alone. Other contractors may not have the expertise. In many instances it means a successful bidder will have to form a consortium with a partner from an entirely different sector. Prisons might be built and run by a grouping of contractor and Group 4, which already runs private jails; for a hospital a winning combination might be made up of contractor, medicare company and service group.

The successful contractor will need to adapt to new organisations which, in some instances, like the Treasury's proposed property re-development, will mean working closely with the public sector. 'There are going to be huge partnership issues,' says Simms. 'There will be new forms of enterprise which will be needed as the Government moves from being a provider to a purchaser of services. These will be organisations that don't exist now. They will become operating companies taking over the role that government handled too expensively and inefficiently.' Rees believes that having one turnkey provider on contracts is the only way to ensure that the public gets the much better deal in terms of quality of service that the PFI offers. Some information technology companies working on major outsourcing contracts are already garnering the required expertise. And as outsourcing spreads into other areas, as more companies pare back their non-core businesses, this will expand.

The other feature of the GEC-Alsthom deal is that the company will embrace a significant degree of risk. At the end of the first 20-year contract, it will only have been paid two-thirds the capital value of the trains - a keen incentive to make sure it performs well enough to receive the vital second-stage contract.

Some contractors such as Joe Dwyer, chief executive of Wimpey, have questioned whether the sort of returns they believe the Treasury will find acceptable will be high enough to attract companies. There are no plans to lay down specific rates of return, however. The chancellor himself has made it clear that there will not be 'a cap' and that rates of return will be defined by who wins what are competitive contracts.

Who will bear the risk is one of the PFI's most contentious features. Stan Webster, a partner at Coopers & Lybrand, differentiates degrees of risk. Where 'controllable risks' relating to such features as design and construction are passed to the private sector, value for money should be improved, but problems arise when the risks are outside the control of the private sector - which could include planning and market risk.

Laing's Rees claims it is not a worry. There is a debate, he says, about where the burden should lie. Some risks are obviously more appropriate to the private sector whereas political risk, 'which covers a multitude of sins', obviously belongs to the public sector. The important thing, he says, is analysing which is which and setting up a mechanism for splitting it. Whitehall's experience has convinced it that handling risk is not its forte. 'The Government does not handle risk well,' says one official. 'It either ignores it or pays almost any price to avoid it.'

Contractual negotiations under the PFI will inevitably be complex. Firms will either need considerable skill or good advisers to agree risk-sharing and long-term contractual liabilities. Initially it may mean greater cost, but this should diminish with the spread of experience. In the meantime the panel hopes to develop a series of 'templates' of standard procedures to follow particularly for deals involving local authorities. Current negotiations with individual departments can be slow, says Rees, partly because of the detail that has to be sorted out. But at this stage he is sympathetic: 'Many of the precedents to be set over the next six months will have a long-term impact.'

With PFI contracts being advertised every day in the Official List companies slow to respond seem certain to pass up a valuable chance. Those first to gain experience will be best placed to capitalise on it. And if the privatisation saga is anything to go by, the PFI concept will soon start to spread overseas. The talk of billions of pounds worth of business up for grabs seems no exaggeration. ' I foresee that before many years private contracts will be the usual way of meeting the Government's capital spending requirements,' says the chancellor.


Department Cap value (£m)

Channel Tunnel Rail Link Transport 2700

Northern Line Trains Transport 400

CAA Air Traffic Control Centre Transport 250

Treasury Building refurbishment Treasury 200

A1(M) upgrade Transport 190

National Insurance IT systems DSS 150

Post Office Counters automation DTI 150

Dalmuir water & sewerage system Scottish Office 102

Docklands Light Railway extension Environment 100

Liverpool Royal Docks

Exhibition Centre Environment 100

Bridgend Prison Home Office 70

Fazakerley Prison Home Office 70

Durham Hospital Health 40

Bishop Auckland Hospital Health 35

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