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PRACTICE BRIEFING Practice briefing

The private finance initiative and

value for money
363
Michael Pitt and Norman Collins
Liverpool John Moores University, Liverpool, UK, and
Andrew Walls
MOD, Rosyth Shipyard, Rosyth, UK

Abstract
Purpose – The paper aims to define and measure value for money (VFM) within the concept of
private finance initiative (PFI), and investigate the principal factors in which opinions are formed.
Design/methodology/approach – Literature review of texts, published papers, and reports are
used to identify relevant parameters to the research. The sources support the arguments of opinion
within the paper.
Findings – PFI is still perceived by the government as the most cost effect means of procuring public
infrastructure. The positive aspects of PFI are the competition generated by the concept, and improved
risk management. Negative aspects include the lack of agreed formulae by all stakeholders by which
to benchmark VFM, and an increasing sceptical electorate to the PFI concept of providing short and
long term VFM.
Research limitations/implications – By virtue of PFI being a dynamic, changing, and complex
means of procurement, this research will be valid in its own right. However more up to date
government policies must be consulted to take the determination of VFM in any further research.
Practical implications – The research and conclusions will provide add to the current debate as to
the viability of PFI, with VFM the main key point as to the ongoing success of the governments
strategy this method of procurement.
Originality/value – The paper adds, to the “VFM” drivers that have been identified by identifying
principle factors in creating VFM. This will be a sound basis for the justification of VFM in PFI.
Keywords Partnership, Private finance, Public finance
Paper type Research paper

1. Introduction
Under the private finance initiative (PFI) the performance of projects in terms of
completion of work within time and budget is a considerable improvement when
compared to projects procured in a traditional manner (Comptroller and Auditor
General, 2003) (Table I).
Construction companies involved in PFI expect to make anything from three to ten
times as much profit when compared to the profit made on traditional contracts. This
increase in profits is made because the construction companies are assuming the risks
previously retained by the client and not by “profiteering” (Walker, 2004). The Journal of Property Investment &
fluctuation in margin is attributed to the amount of equity held in the consortium Finance
Vol. 24 No. 4, 2006
completing the PFI by the construction company. pp. 363-373
The public sector comparator (PSC) is deemed by some commentators to be flawed. q Emerald Group Publishing Limited
1463-578X
One area of question is that the PSC may inflate the cost of risks transferred to the DOI 10.1108/14635780610674534
JPIF private sector. Risks which are transferred to the private sector have to be identified,
24,4 quantified and costed it is these that can easily be inflated to make the PFI option
appear to provide “value for money” (Centre for Public Services, 2001). Other reasons
cited by the CPS include under-estimating PFI monitoring costs and/or showing higher
costs under the PSC model.
A survey of 200 members of the Association of Chartered Certified Accountants
364 found that only 1 percent strongly agreed that PFI provided value for money (Staff and
Agencies, 2002).
The HM Treasury’s document on PFI (HM Treasury, 2003) states the following:
The government aim in procurement decision-making is to secure the maximum
improvement in public services from investment through maintaining an unbiased stance
on which procurement route will offer value for money in each case.
This quote quantifies the Government stance on the value for money (VFM) issue
within PFI However with this alliance of public and private sector interests there is a
conflict from the onset of any negotiations of a PFI project.
All stakeholders agree that the fundamental requirement of PFI is that it must offer
value for money on a project-by-project basis. The real difficulty appears to come when
stakeholders assess value for money relative to their own positions and interests in the
PFI process.
PFI is one of several procurement routes that fall under the general heading of
public private partnerships (PPP), the rational of PPP is described as, “the combination
of the resources of the public and private sectors, in the quest for more efficient service
provision” (Akintoye et al., 2003). At present PFI is the most frequently used form of
PPP. Government publications (Public Private Partnerships, 2000) subdivide the PPP
label into three different types of “partnership”:
(1) The introduction of private sector ownership into state owned businesses
(strategic partnering).
(2) The PFI and other arrangements (design and build, prime contracting) where
the public sector contracts to purchase quality services on a long term basis so
as to take advantage of private sector management skills with the incentive of
having private finance at risk.
(3) Selling government services into wider markets and other partnership
arrangements where private sector expertise and finance are used to exploit the
commercial potential of government assets.

The above perhaps explains why the acronym PPP can be used, and is used widely,
when authors refer specifically to PFIs. As this paper deals specifically with the private
finance initiative and not another procurement route within the PPP stable the
acronym PFI will be used in this paper.

Traditional (%) PFI (%)

Table I.
The performance of Projects over budget 73 22
projects Projects late 70 24
The aim of this paper is to review VFM issues that relate to the PFI procurement Practice briefing
process and to summarize informed opinion made to date as to whether or nor PFI has
indeed delivered VFM. It is based on a review of literature and not as such empirical
research. The paper has been structured as follows. Section 1 provides the introduction.
Section 2 discusses the definition and the measurement of VFM. Section 3 outlines the
PFI background, structure and process. Section 4 reviews the principle creators of
VFM. Finally, section 5 summarizes the findings of this review. 365

2. Value for money – definition and measurement

PFI is a procurement route that if selected, it is deemed to offer the best VFM as
measured against alternative procurement routes (Heald, 2003). The value for money
assessment is not an exact science, the net result being that opinions on VFM vary
from stakeholder to stakeholder. The two ends of the spectrum of interest are the
commercial interests of contractors and, the interests of the taxpayer, both choosing
different indices to argue their case as to VFM. This immediately raises the question,
”VFM for who and what”
VFM is defined by HM Treasury (2003) as “the optimum combination of whole-life
costs and quality (or fitness for purpose) to meet the user requirement”; in seeking
VFM for PFI the Government seeks to ensure that:
.
The evaluation of which procurement option to use is undertaken with no
inherent preference for one option or another. There should be no dogmatism in
this choice. Decisions should be made on the best evidence available.
.
Value for money is not taken to be least cost. There is a need to ensure that
quality standards are maintained, for example in the design of public
infrastructure, and the long-term viability of the PFI contractor to service the
project throughout the life of that project, is assured.
.
The commitment to value for money should not be at the expense of the terms
and conditions of the employees transferred or subsequently employed by a PFI
contractor.
.
A full evaluation of the costs and benefits on a whole-life basis is always
undertaken, including an assessment of risk, to all stakeholders.
As public procurement involves the expenditure of tax payers money there is a constant need
to ensure that the money has been spent economically, efficiently and effectively. Where it
can be shown that money has been spent in this manner it is reasonable to conclude that
value for money has been achieved.
The process to confirm VFM within PFI procurement is gradual. The PFI procurement
process is described by the Treasury Taskforce (HM Treasury, 1999), as 14 stages,
from stage 1 “Establishing business needs,” to stage 14 “The contract management
phase.” Justification of the PFI starts at stage 3 with a “business case and the reference
project”, this is revisited at stage 9 and then again at stage 12 when the PFI proposition
is tested for the last time in terms of risks transferred, value for money and
affordability. It is at this stage (stage 12) that the public sector comparator (PSC) is
compared with the cost of the preferred bid in order for the PFI project to illustrate
VFM.
JPIF The PSC is defined (Treasury Taskforce Private Finance, 1997) as a “hypothetical
24,4 risk-adjusted costing, by the public sector as a supplier, to an output specification
produced as part of a PFI procurement exercise”
The PSC has been criticised both in terms of its construction and the manner in
which it is used. The formation of the PSC is completed, largely, very early in the
procurement process (stage 3) and because of this, it may not present a realistic
366 comparison by the time it comes to be used in stage 12 when it is compared against the
preferred bidders cost. Inherent in this exercise at stage 12 is the assumption that the
comparison is “real”, this may not be the case. Thus the public authority may only be
able to proceed with the project if they proceed down the PFI procurement route if there
is no government funding for the project they wish to procure (Kee and Forrer, 2002).
In addition to this the PSC appears to be used as a test that the project either passes
or fails. It is argued that (reference) decisions on PFI deals need to be based on a
realistic, systematic and comprehensive analysis of the benefits and risks as well as the
costs with the PSC being just one of the factors in this assessment.
Although efforts continue to be made to improve the value of the PSC, it is
important to note that the PSC will neither ascertain whether or not the consortium will
deliver the project on time and within the budget, nor will it be able to measure the
quality of the bid.
It is worthy of note that as of November 2000 some 16 potential PFI projects had
been rejected because either they failed to provide VFM, or they were deemed
unaffordable (Spoehr et al., 2002).
Clearly the formation and use of the PSC is fundamental to the successful
implementation of PFI. However, the PSC is seen as a measure of VFM and not indices
that can add or subtract value on a specific project.
The argument that this paper implies is that although the PSC is a useful tool, it is
inadequate and should not be wholly relied on as an indication of VFM in a PFI project.

3. PFI background and structure

The idea that a private company might design, finance, build and manage, what we
would now term public sector infrastructure is not new. In the first half of the
nineteenth century canals, railways and the like were undertaken on the basis of
private promotion (Winch, 2000). However the financial crash of 1866 took away much
of the competitive advantage of the promoters, or contractors, with the result that
banks preferred increasingly to lend to governments and established firms rather than
finance speculators projects. Thus, from the latter half of the nineteenth century to the
current inception of PFI in 1992, the involvement of a private company in the public
infrastructure was largely either as a supplier contracted to provide an asset or service
financed and funded by the public authority or as a provider of finances to the public
authorities but not both.
The then Conservative Government’s Chancellor of Exchequer, Norman Lamont,
who had the full backing of the Prime Minister John Major, first launched PFI in 1992.
When Kenneth Clarke succeeded Lamont, he continued with progressing the
legislation. The main projects at the start were mainly transport based, the most high
profile being the construction of the channel tunnel. In 1997 the labour government
were elected, they further developed PFI under the umbrella of a PPP. However the
labour government, while in opposition did not appear to give much support to
PPP/PFI. As Heald (2003) describes in his paper, labour was antagonistic in opposition Practice briefing
and the Liberal Democrats were publicly hostile.
The aim was to increase the involvement of the private sector in the provision of
public services (Allen, 2003). The reasoning for this was to encourage investment in a
fading infrastructure of public projects from a source untapped previously and to bring
in “private expertise” to the completion of public works. In addition it was seen as a
means of reducing government borrowing and increasing investment in public 367
infrastructure (Dixon et al., 2005).
This initiative superseded the Ryrie Rules that had been retired in 1989. The Ryrie
Rules had been introduced in 1981 in order to “establish criteria under which private
finance could be introduced into nationalized industries” (Allen, 2003). The principles
behind the Ryrie Rules were similar to those behind PFI with the exception that the
Ryrie Rules required public expenditure to be reduced, pound for pound, as a
consequence of the use of private finance.
There was an initial “crisis” in the flow of PFI projects, contractors were lukewarm
over the prospect of private roads, but became more interested when hospitals, prisons
and urban development, were introduced to the concept. Here they believed they could
obtain higher returns and access “surplus” land and property for development (Centre
for Public Services, 2001). There was also much concern at the time, as there is today,
from trade unions that the transfer of undertakings (protection of employment)
regulations 1981 (TUPE) would undermine workers rights. This is still the case, the
unions are deeply concerned that the government will allow pay and conditions to be
cut under PFI schools and hospital deals (Mathiason, 2004). However PFI received a
substantial boost with the change in government in 1997. The new Labour government
did much to increase the use of PPP of which PFI remains the dominant form. Since
then much has been done to encourage the use of PFI, however the principles (Grout,
1997) underlying the heart of PFI remain the same as they were in 1992, these are:
.
financing is to be predominantly (usually fully) from the private sector and the
contractual structures relate to the consumption of services not the asset itself;
. a “substantial” amount of risk must be transferred into the private sector; and
.
the project must be shown to offer value for money to the tax payer.

Thus the selection of PFI as the procurement process of choice must be made on the
basis of PFI offering best VFM when compared against other procurement routes –
both traditional and other routes from within the PPP set.
A PFI is usually commissioned by an awarding authority, and executed by a
consortium. The awarding authority is the public sector client responsible for
procuring the project. An awarding authority may be a central government
department, local authority, or government agency. The objective of the awarding
authority is to achieve value from public money by transferring to the private sector
the risk associated with providing infrastructure and services (Fox and Tott, 1999).
The consortium will have been assembled for a particular PFI project and will often be
a joint venture by several different types of organisations, e.g. contractors, facility
management companies and financiers (debt and equity). The joint ventures are often
referred to as special purpose vehicles (SPV). The SPV has two principle benefits in the
area of risk management. First, it allows the project specific risks to be allocated to the
JPIF most appropriate consortium member, and second, it allows a company to finance a
24,4 project without putting the entire company at risk.
Prior to starting “work on site” the PFI will have gone through the clearly defined 14
stage process that has been developed, and continues to be developed, in order to
confirm that the PFI procurement route, for a specific project, represents VFM. At
present the primary test of VFM is the comparison of the proposed PFI against a public
368 sector comparator.
It is important that this process should be critically reviewed at all stages by all
stakeholders to ensure true VFM.

4. Principle factors in creating VFM

A key question must be addressed, “what characteristics of the PFI procurement
process substantiate the use of PFI and, importantly, allow the PFI to show VFM
relative to other procurement routes?” A review of informed literature on PFIs would
indicate that a variety of the characteristics of the PFI are promoted as key to the
creation of VFM. The aspects of the PFI procurement process most frequently
mentioned from attributed sources are listed and discussed below.
Many of these are similar to the “VFM drivers” identified in the report “Value for
money drivers in the private finance initiative” (Arthur Andersen and Enterprise LSE,
2000). Unfortunately no empirical research to date appears to have identified the
principle forces within the PFI dynamics. However there is a strong body of opinion
within the literature that would support the characteristics given below.

4.1 Risk allocation – optimal allocation and valuation of risk

From a financial perspective it is reasonable to suggest that the required rate of return
on an investment increases as the riskiness of the investment increases (Brigham,
1985). Thus the theory and practice that in PFIs risk should be borne on the basis of the
principle that the party best able to control or manage a risk should take responsibility
for the risk (Merna and Smith, 1999) in order to achieve the optimum (lowest) cost is
sound. Additionally, risks that cannot be controlled by either party are normally borne
by the public authority.
The allocation and valuation of risk is a complex task that has considerable impact
when the costs of the consortium are compared with the PSC. The NAO reported
(Comptroller and Auditor General, 2003) that for 17 PFIs the savings shown against the
PSC were less than the cost of the risks transferred to the public authority in 15 out of
the 17 PFIs. The allocation of risk is seen by many as the most crucial element in a PFI
being able to achieve VFM. This is illustrated clearly by the statistics quoted above
and the comments made by industry.

4.2 A focus on outputs rather than inputs – out-put based specification

This type of specification is one of the main technical differences from traditional
project procurement. The client describes the outputs they require from the contract
rather than describing the inputs they require in order to meet the output they need.
Additionally the output specification should provide the bidder the opportunity to
prioritise the service by defining the clients required level of criticality (relates to the
event impacting on the asset) and functionality (relates to the assets importance).
4.3 Competition Practice briefing
A PFI project, like a conventional project, has to go through the tendering process
where, normally, several SPVs tender against a common set of parameters, terms and
conditions. Where a PFI has been won in open tender it makes the argument for VFM
easier to substantiate. The element of competition has additional benefits to the client
during negotiations, however this needs to be balanced against the bidding costs as
these will more than likely be recovered elsewhere. The use of “competition” as the 369
ultimate illustration of VFM ignores the value of the PSC and the fact that PFI
procurement might be inappropriate in certain instances.

4.4 Contract duration and scope

The duration of the contract and the scope of the contract works are very closely linked.
The long duration of PFI contracts and the inclusion of the facilities management
function allow the consortium to consider properly whole life costing issues in order to
minimize the contract period costs. Additionally best value, synonymous with VFM,
cannot be achieved unless, during initial procurement, bidders grasp the opportunity to
integrate design, construction and facilities management issues to minimize life cycle
costs and optimise operational efficiency (McDowall, 2001).
Additionally, the manner in which PFIs are structured requires the consortium to
construct the asset(s) before it can receive payments. This very often results in the
consortium investing more in the initial stages of the contract than would be done
under standard procurement arrangements to hasten the completion of the building
relative to “traditional” construction. The long duration of the contracts, 25 to 35 years,
allows the consortium to recoup the initial outlay, therefore without this time the PFI
would be very unlikely to illustrate VFM against a PSC. This is supported by the
minutes of evidence taken before the treasury committee that stated, “most PFI
projects will not deliver value for money against a public sector comparator without
the inclusion of services”. Reports by the National Audit Office have confirmed the
intrinsic value of services in achieving this in current projects.

4.5 Bid costs

This is really the antithesis of competition. The barriers to entry of new competitors to
PFI procurement are high, some would claim that there are benefits (Lenihan, 2002).
The bid costs for a PFI are typically in the order of, approximately, 3 per cent of the
contract value (ref NAO). The absence of competition from the procurement process
can only result in a loss of credibility, and potentially VFM, from the PFI procurement.
Bid costs can therefore be seen as having a negative and real impact upon PFI and
VFM, particularly so when the number of bidders is reduced to one. The risks
associated and the reasons for the number of bidders falling to one are ignored at the
authorities peril, e.g. Libra PFI.

4.6 Innovation
The ability of the SPV to innovate is directly related to the quality of the output
specification and the element of competition during the initial stages. This has been
exemplified in successive rounds of PPP (PFI) prison procurement that showed that a
combination of innovation and competition led to reductions in costs at each stage (HM
Treasury, 2003)
JPIF 4.7 Borrowing costs – financing of the project
24,4 The fact that the government can borrow more cheaply than the private sector is an
accepted fact. It is assumed by many that the differential in the cost of capital between
the public and private sectors means that the consortiums higher cost of capital will
have a negative impact on the VFM case, but, it is argued determining VFM is not
simply about comparing interest rates. This is not correct when the cost of the project
370 is the same regardless of the procurement route (Grout, 1997). Thus if the cost of capital
is to be considered it should be on the difference between the cost of purchasing the
asset traditionally and through PFI. Therefore the cost of capital has a lesser role to
play in the VFM argument than many may first appreciate. Additionally, there is
always the assumption made that the government would be able to raise the capital if
the project were not to proceed as a PFI.

4.8 Private sector management skills

For a variety of reasons that no one appears to be able to put their finger on these skills
are viewed as essential. Whether or not there is a real difference between management
skills of the private sector and the public sector is open to debate. However there is a real
difference between the systems and procedures required within the public sector when
compared to the private. It could be argued that the levels of accountability, less in the
private sector, and delegation of authority, more in the private sector, allow “things to
happen faster” and thus the perceived value of “private sector management skills”.

4.9 Client Management skills

Some of these skills have already been identified elsewhere as they relate, directly, to
the quality of the output specification and the running of the competition, or tender.
These two aspects fall within the remit of PFI procurement – a much larger and more
complex task and one that places a very high demand on the capability of the public
sector team. Additionally it would also appear to be common sense that the overall
project success is to a very large determined by the ability of the client to adopt and
sustain the Best Value regimes through out the project life (Akintoye et al., 2003).

4.10 Performance measurement and incentives

These do not of themselves materially affect the empirical argument for or against
VFM however they will increase the confidence of the client if they are set and
apportioned correctly. Recent commentary has stated that the simplistic assumption
that there is a necessary and direct relationship between project incentives and
performance outcomes is doubtful (Bresnen and Marshall, 2000). This is reinforced by
the later comment that incentives, in the main, are not yet used or refined to best effect
(HM Treasury, 2003).

4.11 Contract flexibility

In recent times the issue of Refinancing has appeared. The trend of interest rates over
the last ten years has generally been downward, thus the cost of financing a PFI has
fallen and there are large amounts of money to be made by refinancing the project. In
order for VFM to be achieved the contract terms and conditions need to provide the
appropriate flexibility, particularly in the manner in which gains are to be shared
between the customer and the authority.
 By examining the above characteristics critically, this will be a firm datum to define Practice briefing
and quantify VFM within PFI. Thus the resultants can be further considered to ensure
if true VFM has been attained.

Conclusion
The PFI is a complicated and protracted method of procuring government projects, 371
largely, but not exclusively, roads, schools, hospitals and prisons. In the 12 years that
PFIs have been in existence many opinions have been voiced on whether or not the PFI
procurement route is one that can provide VFM. Maltby (2003) suggests the Treasury
should be applauded, with dogma thriving in the PFI debate, but still questioning the
effectiveness of PFI. Importantly, though, there does not appear to be anyone willing of
able to confirm from an objective stance, that PFI offers VFM. Until a legal definitive
definition of VFM in the context of PFI, this situation is likely to continue for some
time.
The high profile of the criticism of PFI projects in the media and, research in
published journals, have encouraged trends to develop slowly, and more precise and
objective information is appearing in the public domain. The government is keen to put
the positive case for PFI over to the electorate, and is aware of the implications of the
Freedom of Information Act 2002.
To move the debate of VFM forward, and to promote all stakeholders to reach an
agreement on VFM, a balanced argument must be set out.
Positive messages include:
. PFIs are seen as attractive by large contractors thus the benefits of competition
in terms of VFM remain.
.
Between 1997 and 2001 the cost of finance (adjusted for the change in interest
rates) has reduced and the affordability of the PPPs to the public sector clients
(Middleton, 2001) has improved. This change is attributed to a greater
understanding of PPP, improved risk management and competition to provide
finance (usually in the form of debt). It is acknowledged that the author refers to
PPP rather than PFI but as the subject matter being discussed is “finance” it is
considered reasonable to assume the author is talking about PFI.

Less reassuring messages:

.
The selection of PFI can enable the Public Authority to proceed with work they
are unable to fund in a conventional manner. This short-term view may well
distort priorities in favour of projects that can be procured through the PFI route.
.
There is an over reliance on the use of the PSC as the sole measure of VFM
(Comptroller and Auditor General, 2003). This is aggravated by the fact that the
PSC construction is also the subject of criticism (Comptroller and Auditor
General, 2003) and, more virulently by the Centre for Public Services (2001).
.
The absence of reliable information of PFIs has already been alluded to in the
text. A recent study (Gosling, 2004) stated that only 50 per cent of the
information requested from Public Authorities was made available for
inspection. Whilst the reasons for withholding some or all of this information
may well be legitimate this does little to improve the credibility of PFI.
JPIF .
The trends and statements made above plus the review of VFM characteristics in
24,4 section 4 illustrate that VFM is not an exact science and that it is very hard, if not
impossible, to make a categorical statement that PFI does provide VFM.
.
There is evidence that there is a will by all stakeholders to make the concept of
PFI work. VFM in schools projects were highlighted by a report from the
Foundation for Built Environment (2004). Learning from hindsight it is now
372 recognized that the main key to success is a good working relationship and close
involvement of the school working with the awarding authority (LEA) and
contractor. Post project evaluation should include PFI aspects such as risk
allocation, FM systems and non-financial aspects, Broadbent et al. (2003).
.
The benefits of PFI are to a large degree self-evident, e.g. certainty of time and
expenditure. However, at what cost, both now and in the future? It is therefore
suggested that if PFI is to be continued it needs to continue to develop openness
to the scrutiny of fact, by all parties. The government must take note of this need
for openness, as there is an ongoing need to satisfy a somewhat sceptical
electorate.
.
There needs to be a balance, whatever methodology is used to quantify VFM, to
the satisfaction of all parties, the UK exchequer, the UK taxpayer and the
awarding authority sponsoring the project, and to ensure the financial viability
and sustainability of the contractor, not only designing and building the project
but also providing the facilities management and other support services. There
appears to be a lack general understanding of the diverging interests, and ideals
between all the parties concerned with a PFI project.

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Corresponding author
Michael Pitt can be contacted at: m.r.pih@ljmu.ac.uk

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