ࡱ> xzwq` fbjbjqPqP  ::^%f*f*f*8**, @2**" + + +---???????$=AhCr?h1-^-h1h1? + +?444h1$ + +?4h1?44rV>T2? +*  f*2H>V?4?0 @>zD3D2?D2?$-.4O/t/---??n4X--- @h1h1h1h1 d ^ Response to SCOTTISH FUTURES TRUST: CONSULTATION PAPER Jim Cuthbert Margaret Cuthbert March 2008 1. Introduction This is our response to the consultation exercise on the proposal for a Scottish Futures Trust. Section 3 of this note contains our substantive comments and proposals on various aspects of the Futures Trust proposal: section 3 starts with answers to the specific questions posed in the Consultation document, but then goes on to discuss a number of other issues which we feel are very significant. However, it is our firm view that discussion of the Futures Trust can only take place against a background of a clear understanding of how the traditional PFI model has actually performed. Section 2 of this paper therefore gives a brief outline of the evidence that is now available, (mainly through the Freedom of Information Act), on a number of PFI schemes. 2. Evidence on the Characteristics of Past PFI Schemes Largely because of the Freedom of Information Act, we have been able to analyse the detailed financial projections for six PFI schemes: these are the financial projections produced at the time of contract by the consortia operating the schemes. We have also been able to examine a substantial amount of the supporting documentation to the Final Business Cases and in the Contracts. This section briefly summarises the main findings and conclusions we drew from this information. Fuller details can be found in the two attached papers, (Cuthbert and Cuthbert 2008, a and b), which have been submitted to the Finance Committee of the Scottish Parliament in relation to their Inquiry on Capital Finance. The following three summary statistics encapsulate key features of these six PFI schemes. The Net Present Value (NPV) of the non-service element of the Unitary Charge, relative to the amount of capital raised. To calculate this, we used the financial projections: these give a detailed breakdown of the different uses on which the unitary charge is projected to be spent over the lifetime of the project. This enables the unitary charge to be separated into that element covering services, (for example operations and maintenance), and the non-service element, (covering taxation, debt service on senior and subordinate debt, and dividend returns to equity holders). The non-service component of the Unitary Charge was then expressed in NPV terms, (discounting at 5%, approximately the relevant National Loan Fund rate), and expressed as a ratio to the amount of capital raised for the construction of the facility. This ratio thus gives an indicator of the cost of the facility to the public sector customer, relative to the cost of borrowing the required amount of capital at NLF rates. The aggregate projected dividend payment to equity owners, in comparison to the input of equity capital to the project. This is an indicator of the projected profitability of the project to the equity owners. The Internal Rate of Return, (IRR), projected to be earned on the input of capital to the project by means of subordinate debt and equity. However, IRRs quoted in isolation are not in themselves meaningful, since the return to the lender depends not just on the interest rate earned, (the IRR), but on the average outstanding debt on which this return is earned over the lifetime of the project: (if interest is allowed to accumulate over the early years of the project then the average debt on which the IRR is earned may be much larger than the original amount borrowed). Accordingly, we have calculated for each scheme not just the IRR earned on the aggregate of subordinate debt plus equity, but also the average notional debt on which the IRR was earned, expressed as a percentage of the capital originally raised. Taken together, these measures give a good indication of the scale of the projected returns on equity in the broad sense, (where equity in the broad sense is taken as the sum of subordinate debt and equity proper). Table A shows the first of these statistics for the six schemes: that is, the amount of capital raised, and the ratio of the NPV of the non-service element of the unitary charge to the amount of capital raised. We re-emphasise that these ratios are based on the non-service elements of the unitary charge: and are therefore not affected by the expenditure on services, such as operations and maintenance, which is also part of the PFI deal. For three out of the six PFI deals, the ratio is very close to, or above, two: in other words, at the same cost as implied by the projected sequence of non-service unitary charge payments, twice the original amount of capital could have been borrowed from the NLF. In all cases, the margins in Table A are much greater than the margins of risk conventionally assumed to be transferred to the private sector under PFI. The conclusion to be drawn from Table A is that, in all of these cases, PFI has proved to be a very expensive method of procuring the basic capital facility. Table B shows the second of the above statistics: that is, the projected return to equity holders by way of dividends.  In all cases, the projected dividends appear extremely high relative to the input of equity capital: (for example, in the case of Hairmyres Hospital, an input of equity capital of 100 is projected to yield aggregate dividends of 89 million). Table C shows the projected returns on equity in the broader sense of subordinate plus equity proper, in terms of projected IRRs together with associated average debts on which the IRR is earned.  In all cases the IRRs are high, in the upper teens, or just over 20% per annum. But what is even more striking is how high the average debts are on which these returns are projected to be earned. In all cases, the average debt, (averaged over the lifetime of the project), is more than 100% of the original input of capital, and in four of the six cases, the average debt is more than twice the original capital input. The material now available under Freedom of Information therefore presents clear evidence of the high costs, and high profits, which can be associated with conventional PFI. In addition, however, the Freedom of Information material provides a good deal of information on how this situation has arisen. There are a number of aspects to this. First, there is clear evidence of inappropriate indexation of the Unitary Charge. In particular, the non-service element of the Unitary Charge is typically indexed in such a way that it basically increases through the whole life of the project, (sometimes at less than the full rate of inflation). However, in all of the cases considered, the senior debt service element within the non-service element of the Unitary charge declines in some cases terminating altogether five years or so before the end of the project: (see the Charts attached to Cuthbert and Cuthbert (2008a), for a graphical demonstration of this.) The fact that the non-service element as a whole goes up, while senior debt charges go down, leaves an increasing wedge between the two which is available to be taken largely as profit. It was originally suggested in Cuthbert (2007) that inappropriate indexation of the non-service element of the Unitary Charge might be one of the principal drivers of excess profits in PFI schemes. Two important points to emerge from the Freedom of Information material now available are: that this information fully confirms the hypothesis put forward in the original Cuthbert (2007) paper that what was happening would have been immediately apparent if appropriate monitoring information had been gathered and analysed on all PFI schemes. All of this still leaves a major question, however. PFI schemes have to go through formal exercises to show that the PFI option represents value for money relative to a public sector comparator, and also to show that the PFI option is affordable. Why did the excess costs and profitability as demonstrated in the financial projections now available under FoI, not show up at the value for money and affordability stages? This is the other major area on which the FoI information now throws a great deal of light. Detailed examination of this material has enabled the identification of a large number of problem areas and issues surrounding the procedures of PFI, which are likely to hugely distort the value for money and affordability exercises. These issues are discussed in Cuthbert and Cuthbert (2008b), and include errors in the assessment of risk: the effect of VAT and capital charges: the effect of the discount factor used in the value for money comparisons: the fact that affordability assessments tend to be carried out for a single year only: problems with land sales tied to the deal: undue optimism in assessing affordability: lack of expertise and deficiencies in central support. Overall, the Freedom of Information material which is now available not only demonstrates that things have gone badly wrong with PFI in the past, in terms of excess costs and profits: it tells us a lot about the procedural mistakes which allowed things to go wrong. It is this background which informs our comments in the next section on the proposed Futures Trust. 3. The Futures Trust Proposal Answers to Consultation Questions 1. How would the availability of expertise and support from SFT change the way public bodies handle infrastructure investments? Response: This will depend critically on the level of expertise, the quality and level of support, and how available that expertise and support is made to the public sector bodies involved in negotiating contracts with the private sector. Looking at PFI experience, as detailed in the two attached Cuthbert and Cuthbert papers, current expertise and support has not been of sufficient quality and quantity, either centrally or in individual cases to achieve best value for money or affordability. These questions need to be specifically addressed, so that the Futures Trust ushers in fundamental changes in the quality of expertise, management and monitoring. 2. What are the advantages and disadvantages in setting up SFT to generate surpluses to invest in further projects? Response: a. There is a danger that focusing on the question of profits leads us away from what should be the core issues. Given the figures shown in Table 3 of Cuthbert and Cuthbert, 2008a, (attached), there would indeed appear to be plenty of scope for the Futures Trust to borrow from banks etc., earn a turn, and still lend more cheaply to the SPVs than the current cost of finance for PFI schemes. So the Futures Trust could indeed generate a profit: and if that was ploughed back into further investment then that would clearly be, in one sense, a good thing. But rather than concentrating on profit, the much more fundamental question which needs to be asked is: If PFI just now is one hospital for the price of two, and the Futures Trust gets this down to one for the price of one and three quarters, is this the direction we should really be going in? (Further, if the Futures Trust projects are not off the governments books, then there is no capital charge advantage.) Before going ahead with the Futures Trust there needs to be a clear demonstration, not just that it will improve, but that it will radically improve, on the existing PFI in terms of cost. Unless this can be clearly demonstrated, then why bother with the Futures Trust at all? Instead, efforts should be put into making the maximum use of existing government capital resources and capital financed from revenue, extracting maximum value for money from capital spend, (including more of an emphasis on refurbishment rather than new build), and rectifying anomalies like VAT and capital charges which currently bias the system against refurbishment and traditional public sector procurement. So, in a sense, our answer to question one is: do not think about profit so much as what the final cost will be of capital goods procured, whether it be by PFI, Futures Trust, or any other arrangement. b. If the Futures Trust is operating through the funding of SPVs, then these SPVs themselves would presumably be not-for-profit organisations. This then raises a number of issues about ensuring that concealed profits are not taken by the private sector. There are many ways in which the private sector participants could realise excessive profits without it being received in the form of dividends. For example, steps would need to be taken to ensure that profits were not creamed off through excess charges for subcontracting during the construction phase and in the provision of services: to guard against profits being exported through refinancing deals which sold off future income streams at less than a proper market value: against profits being exported through the value of residual rights at the end of the concession period of the contract: and against unduly expensive arrangements for handling change. 3. What are the advantages and disadvantages in public authorities entering into agreements with SFT for the use of facilities? Response: This question presumably relates to the possibility that the Futures Trust might move into the role of owning and managing assets itself, rather than simply operating as a financial intermediary, channelling funds to SPVs. One aspect which would have to be considered very carefully would be the extra risk to which the Futures Trust would be exposed under this mode of operation. An advantage of the SPV mode of operation is that this isolates the consequences of a project going wrong to within the limited liability confines of the SPV. But if the Futures Trust had direct responsibility for a range of projects, then just one major project going wrong might bring down the whole edifice: (imagine the consequences, for example, if the Futures Trust had had the Scottish Parliament project on its books.) It would be unwise to go down this road unless the question of isolating risk is properly addressed. 4. What would be the advantages and disadvantages of using a greater degree of standardisation based on exemplar, energy efficient, sustainable designs to meet public authority requirements? Response: Probably considerable: but there would probably also be very considerable benefits from standardising contracts, and other procedures, (like financial modelling.) 5. Are there any difficulties envisaged in transferring/selling public sector owned sites to the SFT investment vehicle for use in providing the new facility? No response The questions posed in the consultation document do not include the following, which we think are also of importance: The importance of tackling the UK Treasury on aspects of their current capital procurement and accounting policies. In several respects, current Treasury policies run counter to one of the basic fundamentals of government as expressed in the consultation document, namely, All levels of government in Scotland have a duty to create and maintain the assets which underpin public services and economic activity, and they have a duty to ensure value for money through the most efficient forms of delivery and to provide for the long-term protection of these assets. Current policies on VAT imply a cost penalty on refurbishment as opposed to new build solutions, and also on capital investment in the public sector as opposed to private sector solutions. The present regime of current cost accounting, and capital charges, in the public sector, likewise penalises public sector solutions relative to a private sector approach. The Treasury needs to be challenged on both these aspects, to help restore a more level playing field, rather than the current bias in favour of the private sector. At present, a half of all PFI schemes, as measured by value, are classed as being on the books under current accounting rules: (see ONS(2006)). To the extent that Futures Trust schemes do actually come on the books, (whether under the current accounting rules, or in the light of likely future changes), then they will count against capital expenditure in the Scottish Budget and will incur a capital charge. In such circumstances they become an expensive way of financing capital investment. Given this, there needs to be much more detailed consideration than is given in the SFT consultation document as to whether locating the Futures Trust in the private sector will actually achieve the hoped for benefits. The question of bundling of new build projects in PFI schemes. A characteristic of PFI projects has been their sheer size: for example, an entire hospital, or several new schools. Projects tend to be so large that the degree of competition for major PFI projects has been limited. As one major PFI supplier noted in an internal document, an advantage of PFI from the suppliers point of view was that tender costs and complexity reduce competition. Further, under bundling, a second concern relates to the impact of these very large PFI projects on Scottish firms and the Scottish economy. In effect, a large part of the public sector capital investment programme, a potential engine of growth for the Scottish economy, has been wrapped up and handed in the first instance to companies outside Scotland. Further, PFI deals cover design, service delivery, and equipment, as well as build. Projects therefore involve a great deal of softer high value work: research and development, consultancy, geology, management information systems, etc.: in fact, all of the types of work which we recognize that Scotland needs to be fostering among its businesses and its labour force for our future economic development. Efforts need to be made to ensure that the public sector uses its capital investment programme to stimulate such development in Scotland: and not, as at present, to contrive purchasing schemes which actively militate against Scottish companies competing. Public procurement of capital investment programmes should be providing major opportunities in Scotland for research and development, for business growth in Scotland, and for training, education, and skills. The potential influence of the vehicle, PFI or Futures Trust on the type of project being undertaken. The PFI approach appears to have had a definite impact on the type of project being undertaken: there have been many examples where a public authority has started off with plans for a fairly modest refurbishment, but has ended up having been convinced that what was actually required was a much more expensive new build project. How will the Futures Trust guard against this? Re-opening Past Schemes. The Futures Trust Consultation document states that no attempt will be made to re-open past PFI contracts. This decision should be re-examined. Evidence from information now available under FoI, as well as evidence from re-financing deals which have been carried out, confirms the excessive levels of profit and cost associated with many PFI schemes. It is also clear by now that voluntary concordats designed to share with the public sector profits released from re-financing, are largely ineffectual. Whether or not any legal challenge is possible to past contracts, it is clear that the State, through the sheer size of its public sector procurement programme, has considerable negotiating power vis a vis PFI practitioners. There should first of all be a systematic exercise to determine which past PFI deals involve excess profitability: and then renegotiations should be conducted as appropriate. Need for Improved Monitoring. The financial projections analysed in Cuthbert and Cuthbert (2008a) clearly demonstrate the value of this type of information in throwing light on the operation of PFI deals. The Futures Trust, and the Scottish government, should take steps to greatly improve the central monitoring of the PFI process. Ideally, detailed financial projections should be published for all schemes, past and present, together with summary statistics such as those developed in the paper Cuthbert and Cuthbert (2008a): for example, the Net Present Value of the non-service element of the Unitary Charge in comparison with the amount of capital raised: the Internal Rates of Return on different funding sources, together with associated average debts: and, (a matter not covered in the Cuthbert paper), benchmark statistics for the service component of contracts. Given the recent Information Commissioner ruling on the new Royal Infirmary of Edinburgh, no issues of confidentiality arise. In any event, for future schemes, publication of such data could easily be made a condition of the contract. Handling of Risk. There are real problems with the way risk is handled in conventional PFI schemes, (some of which are identified in Cuthbert and Cuthbert 2008b): and it is most unfortunate that the Futures Trust consultation makes no reference to this issue. In fact, the proposed Futures Trust structure offers an opportunity to handle risk in a much more rational fashion than is done under existing PFI arrangements. At present, risk is handled in PFI on an expected value basis. The cost of a particular outcome is multiplied by the probability of that outcome to give the expected cost: and that expected cost is added to the NPV of the PSC in the Value for Money comparison. Given the way value for money comparisons are carried out, this comes close to paying the PFI provider a premium equal to the expected cost of the risk, as the incentive to take the risk on. But this expected value approach makes little sense. Suppose that there are five PFI schools handled by five separate contractors: for each school, there is a potential adverse event which would cost 1 million, but which will occur with probability 0.2. Under the expected cost of risk approach, each of the five contractors would be handed a premium of 0.2 times 1m, that is 0.2 million. On average, for four of the schools, the adverse event will not occur so the contractors in these schools will each pocket the 0.2m as a profit. For the fifth school where the adverse event does occur, the premium of 0.2m comes nowhere near the cost of 1m, and the contractor would probably go bankrupt, (with the ultimate cost coming back to the public sector in all probability). This simple example highlights the difficulty with handling risk as is done at present. A more rational way of handling risk is on an insurance basis and this is where the Futures Trust structure opens up a real opportunity. If the Futures Trust was acting as a financial intermediary, funding individual Special Purpose Vehicles, then the Futures Trust could also act as an insurer. The risk element of the Unitary Charge of each project would go, not to the SPV, but to the Futures Trust: the Trust would pay out a pre-specified amount to individual SPVs against the specified risk, if and when required. This approach Is a much more rational approach to handling risk. Opens up the possibility of a profitable sideline for the Futures Trust. Means the Futures Trust would have to ensure that risk was being accurately and carefully assessed so overall assessment and costing of risk should greatly improve. References Cuthbert, J.R., (2007): The Fundamental Flaw in PFI? The Implications of Inappropriate Indexation of That Element of the Unitary Charge Covering Capital Finance Costs: paper to be published by STUC; copy available on website www.cuthbert1.pwp.blueyonder.co.uk (a) Cuthbert, J.R., Cuthbert, M., (2008): The Implications of Evidence Released Through Freedom of Information on the Projected Returns from the New Royal Infirmary of Edinburgh and Certain Other PFI Schemes: Submission to Scottish Parliament Finance Committee, March 2008 (b) Cuthbert, M., Cuthbert, J.R., (2008): The Royal Infirmary of Edinburgh: A Case Study on the Workings of the Private Finance Initiative: Submission to Scottish Parliament Finance Committee, March 2008 ONS, (2006): Including Finance Lease Liabilities in Public Sector Net Debt : PFI and Other. Authors, Chesson, C. and Maitland-Smith, F.     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