Private finance grows up in public

After a messy start, the PFI is emerging as a better way of managing state projects, says Peter Rodgers

Want a large apartment with high ceilings and a view of St James's Park? Property developers have proposed turning the best bits of the Treasury in Whitehall into luxury flats, to pay for refurbishing the rest of the now run-down building as offices. The proposal stems from the Government's Private Finance Initiative, the grand plan to persuade the private sector to pay for public projects.

The idea that one of the most famous civil service buildings in London should be treated like a run-of-the-mill property development is bound to provoke renewed criticism of the PFI, which has been hammered by industry, the press and - most recently - the Commons Treasury Select Committee.

But in fact, the plan has emerged just as the PFI as a concept begins to come in from the cold. There is a growing appreciation in industry and on both Labour and Tory front benches that ridicule of the PFI has been reaching a crescendo just as those with a serious business or political interest have decided the scheme is going to work well. Indeed, Labour claims to have invented the idea in the first place, and wants only to improve the PFI and alter some of its priorities, not abolish it.

Significantly, the City has also woken up to the PFI's potential, with the launch over the summer of four specialist investment funds devoted entirely to PFI projects. Just as important, the project finance departments of a number of big international banks, such as Bank of America, have been quietly putting a great deal of effort into developing specialist teams to finance PFI schemes.

It is easy to see why the PFI has been so unpopular. Far from being a carefully thought-out programme, it began as a political gimmick by Norman Lamont when he was Chancellor, aimed at maintaining the momentum of priv- atisation in another form, and taking pressure off public spending by bringing in private money. It was a classic case of the right idea being produced for the wrong reasons, in this case an over-hasty political timetable.

Privatisation began slowly, 15 years ago, with a few modest disposals such as the radiochemical company Amersham Inter- national, from which many lessons were learnt before the big money was raised from sales such as BT and British Gas.

In contrast, the PFI was launched with grand targets to achieve before anyone had worked out the details. Not surprisingly, it failed dismally to achieve its early objectives. The last two years have been spent trying to put that right, like a learner realising he needs driving lessons after setting off down the motorway without L-plates.

Victims of the bad driving, such as the construction industry - which has been starved of orders because of the delays in getting PFI projects off the ground - have been complaining loudly and appeared at one stage to be pull-ing out in a huff. But recent evidence is that, far from quitting, they are stepping up their efforts while focusing them more carefully on fewer projects.

In the early stages, the number of companies on shortlists of bidders for some projects ran to as many as eight, each spending a fortune on preparing their proposals. Recent shortlists have been restricted to two or three serious contenders.

With a steady stream of PFI contracts starting to emerge, attitudes to the PFI in industry are changing rapidly. Although a CBI report this summer contained trenchant criticisms of the way the PFI operates, this was a far cry from the prevailing view last year, when industry thought the PFI stood for "Private Finance Impediment". The CBI's attack sounded harsh, but Treasury officials and ministers in charge of the PFI were grateful, as the criticisms helped them to force improvements in PFI procedures through the rest of the Treasury and other Whitehall departments.

Some departments, such as health, have failed to find ways of implementing any substantial projects. In the case of hospital construction, this arises from a dispute about the legal basis of hospital trusts, but elsewhere officials have proved all too capable of bogging themselves and contractors down in a morass of detail. It may take a big hospital project or even the refurbishment of the Treasury building to convince the world at large that the PFI is really overcoming its teething troubles.

Under the PFI, the government buys not an asset but a flow of services over the years - rather than paying, as in the past, for the facilities to be built and then assuming the cost of operations. Taxpayers' money starts to flow out only when the service comes into operation.

In the early stages of the PFI, much of the criticism of the scheme centred on claims that it provided not only an excuse for cutting government spending but also a method of paying for public projects on the nev- er-never.

It is true that, just like a family budget, too much hire purchase can lead to a painfully high burden of payment in the long term. But since the long-term payments can be calculated, there is no reason why they cannot be monitored and controlled if the figures are published for public and City scrutiny.

Another criticism was that as risk capital is involved, the finance will cost far more than for a government project, which is financed essentially by borrowing in the gilts market at cheaper rates than the private sector.

Certainly, some of the risk of failure of a PFI project is transferred to the private sector, which as a result is demanding much higher returns. The contractors do not receive payments if the service they provide fails to meet agreed standards.

According to analysts at Robert Fleming, contractors have recently been tendering for conventional public-sector projects at zero or even negative margins, and then squabbling for extra payment to make any money. Tarmac now says it is aiming for much higher margins of 5 per cent in PFI contracts where it has an equity stake.

But criticism of the cost of capital is a red herring. Under the PFI, the issue for the taxpayer is payments for services delivered, not the cost of capital to the contractors, which is absorbed in their overall calculations. PFI contracts are a good deal for the taxpayer whenever efficiency savings are higher than the financing penalty. Evidence is growing that this penalty is dwarfed by the benefits of efficiency gains.

Over the life of a PFI project, about 30 per cent of the costs are for construction and 70 per cent for operating the facility. Based on the contracting out programmes, efficiency gains of 20 per cent are easily achievable on the operational side.

On construction costs, there are many glaring examples in National Audit Office reports going back decades of huge and damaging cost overruns - an average of 24 per cent, according to the Treasury. Weight the two sets of savings, and they come to 21 per cent of the total. The financing cost penalty compared with gilts works out at about 3 per cent, or one- seventh as much as the savings.

These are Treasury estimates, but they stand up to scrutiny as being in the right ball park. Just think of the British Library, which started with no budget at all and has now reached pounds 415m; and the Limehouse Link in London's Docklands, which doubled in cost to pounds 293m.

Then look at the PFI project for the National Insurance computer system, where the overrun of pounds 20m was picked up by the contractors, Andersen Consulting; or the Fazakerley and Bridgend prison contracts, where the savings over 25 years are likely to be about 10 per cent compared with a public project.

In the past, any such claims about cost savings over a long period in the future would have been met with deep scepticism. The difference is that the private sector can now be forced to pick up the cost of its own mistakes. The reality of the PFI, behind the political mistakes that have given it such a messy beginning, is that it is a mechanism for managing projects better and more efficiently after decades of scandalous waste.