Private Finance Initiative (PFI)

Private Finance Initiative (PFI)

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Private Finance Initiative (PFI)

Private Finance Initiative (PFI) remains a critical mechanism whereby intensive public infrastructure projects are successfully delivered. Traditionally, governments around the world have utilized a number of strategies in the delivery of public goods and services, which have been inclusive of private-public partnerships. Developing and develop countries are in constant pursuit of the best returns and optimal cost for public projects. In addition, PFI is a relatively effective and innovative capital budgeting strategy for management and financing of public projects.

The private and public sector in the United States are deeply embedded in the delivery of goods and services to the public[1]. Contractors are increasingly becoming an effective and appropriate means of delivery of different ancillary elements of government functions and operations such as construction, stationery, maintenance, and others. In addition, it is critical to note that governments usually contact a number of output functions and activities to the public such as ambulatory and refuse collection services.

Supporters of Private Finance Initiative (PFI) argue that it resonates with prevailing global demands and trends towards privatization of delivery of public services as it provides a new public management model. Private Finance Initiative (PFI) is driven by the need to pursue enhanced efficiency across the public sector by focusing on utilization of entrepreneurial, managerial skills and expertise in the management of resources, initiation, and completion of projects. Returns from private-public partnerships may include partial or full revenues collectible from delivery of goods and services by a select PFI entity. PFI negotiations involve a variety of parties namely public sector agencies, private sector consortium and financial institutions involved in the provision of financial facilities for completion of a project.

In PFIs, the private sector is tasked with the provision of designs and development of public assets, by seeking finance and operation of services that use the established asset. The United Kingdom Treasury conducted a study aimed at apprising PFI processes, which was indicative of the need for quantitative economic assessments to be carried out early on in PFI procedures to ensure that market conditions for operation of a project or asset are understood adequately.

Advocates of the system have argued that projects executed through PFIs attract low investments when compared to conventional procurement strategies. On the other hand, it is argued that PFI projects are relatively efficient when compared to conventional projects given that they are reliant on private sector innovation, technology, and expertise in the assessment of risks and benefits associated with a project, which leads to enhanced management and transference to private sector entities or institutions[2].

A treasury committee in the year 2000 in the United Kingdom noted that the initial justification for undertaking PFIs was the opportunity it provided for enhancing investments in the public sector. In addition, PFIs were viewed as a means of addressing under investments associated with private-public investments. Furthermore, the attention shifted from the generation of capital towards the creation of value for money on projects undertaken through PFIs. Creation of value for money has been termed as one of the main benefits associated with PFIs as it provides a means of achieving an optimum combination of overall costs and quality of the goods or services accruable from an asset or project. Furthermore, the success of PFIs is influenced by the capacity to achieve optimal efficiency than other projects within the public sector given that governments have relatively low capital costs when compared to the private sector.

Studies note that governments are able to raise relatively cheap financing when compared to private sector entities given that it is a risk-free borrower due to its powers over taxation policies and systems

On the other hand, critics claim that the real costs associated with debt are similar across public and private sectors, given that despite the public sector having low-interest costs, taxpayers have to contemplate the possibility of project failure and inefficiencies with the probability of high rates of return for bearing risks of project failure. Additionally, it is argued that the real costs of capital for governments are the opportunity cost associated with the use of such funding. Irrespective of the theoretical framework utilize, the value for money theoretical model is reliant on a number of factors related to service and product quality of a given project or asset while taking into consideration risks associated with both private and public sectors.

Capital costs is one of the primary factors out of a possible fifteen, which should be considered in the assessment of the best procurement route to be utilized such that value for money for the taxpayers is achieved. A competitive tension between PFI bidders is necessary if PFIs are to take advantage of opportunities inherent in private sector service delivery and procurement, which ensures that the taxpayers pay minimal costs for projects. Studies note that issues such as prolonged tendering processes and exorbitant bidding costs are a hindrance towards the engagement of an incremental number of private entities in procurement and service delivery in the public sector.

Competitive dialogue strategies have been utilized in procurement and service delivery, as an effective approach towards encouraging communication between suppliers and procurers. A critical feature of this strategy is the development of an agreement between parties involved in the tendering phases before the winning bidder is selected. In the event that a government issues specific outcomes that should be achieved by a project, then private sectors are able to use such guidelines as scope for innovation in design and development of projects and assets for public use[3]. The association of PFI payments to quality of service delivery, as opposed to asset or project costs, ensures that contractors are provided with incentives to take into consideration maintainability, sustainability, reliability, and effectiveness of project design.

PFIs are contrasted from conventional procurement in public sector, whereby the public sector is involved in the design specification. The risks associated with conventional procurement strategies includes minimized capital cost projections in seeking approval of a project, potential for challenges associated with maintenance backlog as a result of unreliable and poor project design. Evidence on the role of PFIs in enhancing innovation in public service delivery has included differing perspectives. Studies take note of incidences where PFI projects have resulted in the development of projects with low slippage and minimal budget overruns when compared to conventional procurement strategies.

PFIs should focus on the provision of incentives to contracting parties such that they are able to undertake comprehensive and accurate estimate of construction costs with the aim of reducing risks associated with excessive costs and poor performance in public projects. Despite the extensive flexibility, availed private entities in PFI deals, significant contractual changes were not subjected to competitive include and project management function by public sector agencies was not provided with sufficient resources for effective management of changes in project scope. In essence, certainty and reliability in regard to cost estimates provide a means of ensuring that value for money objectives are achieved. In addition, this may be achieved through best risk management practices, enacting project certainty regarding achievement of the desired quality of services and projects.

While conventional procurement involves the payment for inputs, PFIs involves the payment for outputs or outcomes, whereby payment is made for services delivered by utilizing private-sector developed projects or assets. Therefore, PFI strategies should be oriented towards reducing risks accruable to governments from ownership of an asset, which is deemed as unreliable and inappropriate regarding the expected outcomes regarding service and asset quality based on costs. If an asset were insufficient to meet service needs of the public, a government would not make payments for the asset in the form of service charges.

Two main advantages of PFI over conventional strategies have been identified. The first advantage is that PFIs provide a consistent and planned strategy towards the maintenance of assets, given that a contractor is obligated to ensure that an asset is adequately maintained until completion of a contract[4]. Additionally, if an organisation fails to adhere to set out maintenance standards, it may be penalized for failure to meet agree on reliability, usability, and performance threshold. Secondly, pricing or costs function within the public sector with knowledge on the estimated cost of a contract on a long-term basis. Such eliminates the probability of replacement costs of an asset, which may arise unexpectedly, or in the event of delay because of budgetary constraints.

PFIs are associated with the transference of risks to the private sector, as it results in the allocation of specific risks to parties poised to manage and influence such risks. A number of risks have been associated with transference into the private sector namely:

1. Cost overruns risk in the development phase
2. Timely conclusion of the project

• Adhering to specific standards of asset delivery and completion

1. Underlying contractor or operator costs
2. Risks from physical damage and industrial action to an asset
3. Demand risk whereby there is a risks that the demand for a project is lesser or greater than estimated by the contractor

• Risk of obsolescence of the project after completion, rendering it unsustainable and ineffective in delivery of specific services
• Risk of generation of third party revenues, resulting in diversion of funds meant for the government

1. Residual value risk arising from variations in the expected versus actual value of the asset upon completion

Essentially, the benefits associated with PFIs are accrued from the presumption that a number of diverse risks associated with critical investments are absorbed by parties best positioned to manage such incidences. A number of risks are best absorbed by the public sector given that it may be positioned optimally to handle them. For instance, risks that are related to uncertainty regarding the demand levels for government services should be best absorbed by the public sector. If the public sector absorbs such risk through service charge which variety with demand volume, it becomes possible to add premiums to PFIs bids with the aim to cover uncertainty risk associated with the ability to meet service costs.

Furthermore, demand risk associated with third party users of a service is best absorbed by private sector players as it encourages the use of third-party assets such that there is a reduction in costs subsumed by the public sector in regard to PFI charges for services. Sub-optimal allocation of risks across the private and public sectors is bound to result in cost consequences for a PFI project. Such is influenced by the fact that businesses are involved with raising finance for projects in capital markets with the costs of financing being pegged on the investor perception of risk of a project. In addition, the risk is influenced by the possibility of repayment or non-repayment as well as returns on investment on a given project.

Critics argue that a number of risks such as cost overruns in development or underlying costs for contractors of a given service may be a challenge to transfer in part or fully to private sector players. Studies conducted in Manchester, UK on PFI NHS healthcare facilities noted that the annual charges accruable to PFI contractors by hospital trusts were relatively higher than expected, which raises concerns over the reliability and effectiveness of PFIs in achieving value for money in public projects[5].

Essentially the overall risk burden of PFIs is absorbed by financial backers such as lenders and shareholders. These parties assume the financial risk of possible failure in achieving the desired returns on investment, which are necessary to make debt repayments. In addition, the government may be better positioned than the private sector in the absorption of risks associated with the cost of finance due to its risk-free solvency nature.

Essentially, Private Finance Initiatives (PFI) is critical and effective tools in the provision of efficient and innovative services across various areas such as healthcare, education, infrastructure, and defense. The success of PFIs is reliant on three critical and complex issues. First, a government should be able to provide accurate definitions and over time, goods and services it aims to purchase or deliver to the public. Secondly, adequate understanding and subsequent allocation of different risks into private and public sectors is critical for the success of PFI. Third, the public sector should endeavor to deliver competitive markets for delivery or production of goods and to ensure that such markets are managed effectively and efficiently. If such problems are addressed, PFI provides a relatively cost-effective means of delivering goods and services to the public.

References

A Bentz, PA Grout, and M L Halonen, What Should Governments Buy from the Private Sector–Assets or Services? (2005)

E Ahmad, A Bhattacharya, A Vinella and K Xiao, Involving The Private Sector And Ppps In Financing Public Investments: Some Opportunities And Challenges (Asia Research Centre Working Paper 67, 2014)

E Lossa, G Spagnolo and M Vellez, The Risks and Tricks in Public-Private Partnerships (Working Paper n. 64. IEFE-The Center for Research on Energy and Environmental Economics and Policy at Bocconi University, December 2013)

FB Brude and Roger Strange, How Banks Price Loans to Public-Private Partnerships? Evidence from the European Markets, Journal of Applied Corporate Finance • Volume 19 Number 4 2007 29-41

House of Commons, Private Finance Initiative – Its Rationale and Accounting Treatment, (House of Commons, June 2008)

JE Kee and J Forrer, Private Finance Initiative—The Theory behind the Practice, (14th Annual Conference of the Association for Budgeting and Financial Management October 10-12, 2002)

P Edwards, J Shaoul, A Stafford, L Arblaster, Evaluating The Operation Of PFI In Roads And Hospitals (Research Report No. 84 Certified Accountants Educational Trust, London, 2004)

The Trade-Union Coordinating Group, The Real Cost of Privatization (Trade-Union Coordinating Group, 2013)

[1] E Lossa, G Spagnolo and M Vellez, The Risks and Tricks in Public-Private Partnerships (Working Paper n. 64. IEFE-The Center for Research on Energy and Environmental Economics and Policy at Bocconi University, December 2013) 16

[2] Edwards, J Shaoul, A Stafford, L Arblaster, Evaluating The Operation Of PFI In Roads And Hospitals (Research Report No. 84 Certified Accountants Educational Trust, London, 2004) p.43

[3] House of Commons, Private Finance Initiative – Its Rationale and Accounting Treatment, (House of Commons, June 2008) p. 27

[4] A Bentz, PA Grout, and M L Halonen, What Should Governments Buy from the Private Sector–Assets or Services? (2005) p. 18

[5] JE Kee and J Forrer, Private Finance Initiative—The Theory behind the Practice, (14th Annual Conference of the Association for Budgeting and Financial Management October 10-12, 2002)  p. 29