Risk & Economy » Regulation » Saving Private Finance

In December last year, top brass from Europe’s armed forces gathered in Paris to listen to representatives of Her Majesty’s Government spread the word about one of Tony Blair’s flagship policies – the private finance initiative. The Defence Partnerships conference attracted delegates from 17 countries and dozens of companies, including most of the world’s major arms manufacturers. The aim? “Identifying and pursuing opportunities for private sector involvement in defence-related services.”

Centre stage was the UK government plan to “pay privately for the defence we cannot afford publicly”. Although it is nothing new to have a country’s armed forces backed by civilian contractors, the British proposal was different. Under the UK deals, military equipment (including everything from transport aircraft to supply trucks) and services (from training to the provision of office accommodation and married quarters) will be leased from private companies. The private sector takes on the risk of meeting military requirements, where and when required. The military then only pays for the equipment and training personnel it uses, without having to shell out up front. Meanwhile, the private sector can cover costs by leasing its equipment, services and personnel to other customers during down time.

However, these contracts do not involve leasing armoured fighting vehicles, jet fighters, frigates, or any other front-line kit or personnel. Rather, as one senior British officer said: “It is like going into battle with Eddie Stobart trucks bringing up the rear”.

Our partners in Europe are still digesting what they learned, but one thing that must have stood out is the fact that results of the British experience have so far been mixed. Actually, “mixed results” is the phrase most frequently applied to the policy across the board. Initially welcomed by industry and treated with grave suspicion by the public sector and trade unions, PFI has been on a roller-coaster ride in recent months.

In essence, PFI is a procedure for procuring finance for large capital projects previously funded entirely from the public purse. The scheme was introduced in 1992 by the Conservative government and adopted and extended after Labour came to power.

Labour’s vision is that schools, hospitals and even housing estates should be designed, built, financed and operated by private companies for periods of anything up to 60 years, although more usually for 25 to 30 years.

The private companies are then regularly paid out of public funds – depending on performance – to run the project for the agreed period. When the agreement eventually expires, control of the project reverts to the public sector.

The attraction of PFI for the government is that it gets around tough Treasury regulations preventing the public sector raising private cash.

It also excuses the government from making expensive one-off payments to fund large-scale projects. And if a private company misses performance targets it is paid less. The attraction for private companies is that if the project is delivered as specified, PFI guarantees regular payments for an extended period.

Since May 1997, some 400 PFI deals worth about £16bn have been signed; a further 300 projects worth about the same again are in the pipeline.

It is planned that PFI will pay for 26 hospitals by 2005 and will help in renewing and refurbishing 450 schools. But the policy has its critics. “Build now, pay more later”, say some.

A gravy train that involves paying large sums to consultants to set up complex contracts, say others. Indeed, most PFI contracts are as thick as the London phone book and minutely detail every conceivable circumstance that might affect shareholders up to, and including, earthquakes and nuclear war. And, as with any form of hire purchase, buying a product over a long period of time is more expensive than paying cash.

So far, the government has been deaf to the critics. Then came transport secretary Stephen Byers. His actions in winding up Railtrack as a plc cast a pall over the policy. From the City’s viewpoint, partnership hinges on the reliability of contracts – and they don’t look particularly solid after Byers’ apparent expropriation.

As a result, investors are now anxious to know where PFI policy is headed. So far, the government has introduced it into the NHS building programme and hopes to use it on the London Underground and the railways.

PFI is already an integral part of defence planning. The MoD is considering 50 projects, including some of the largest PFIs ever planned, which will be worth over £1bn a year to the defence industry, in addition to the £400m being paid through existing contracts.

But the MoD is also responsible for some of the worst relationships between government and the private sector, which highlight the difficulties PFI can cause. For example, in the course of a £12m PFI contract to run the RAF mail the MoD accused one contractor of being “only interested in maximising profits with the minimum of capital outlay”. A £70m PFI contract for a defence fixed communications service showed “a gap between the authority’s expectations and the reality of the contract”.

Meanwhile, Brown & Root, the UK’s fifth largest defence contractor, has a bid in to supply the RAF with air-to-air refuelling aircraft and heavy-lift transport planes. It has been talking with the MoD for five years about PFI deals and says the MoD has a problem defining its needs. Peter Smart, director of defence business at Brown & Root, says: “What’s caused us concern is that there are a number of programmes that set off down a PFI route, and for reasons not always sound, they (the MoD) flip it.

Large elements on both sides still have to accept that these negotiations are a thoroughly different way of doing business.”

Also having trouble is US software solutions company Electronic Data Systems (EDS), the government’s largest IT contractor, which couldn’t meet its contract to deliver a £300m payroll system to the MoD, threatening payments to 300,000 military personnel and 800,000 pensioners. Reportedly, the government had to finance the overspend. But companies tend not to suffer too much under PFI. On the back of its involvement, EDS last October reported third-quarter profits up 20% at $334m and well above target for the full year.

Chasing PFI deals and entering the bidding can cost contractors millions but the costs are more than compensated for by the regular income winners receive. The RAF recently signed a £275m helicopter training contract with Canadian company CAE. When the RAF isn’t using its facilities, CAE has contracts to train the Dutch and Canadian air forces. John Reid, editor of Jane’s World Defence Industry, says: “That is a good case because it’s possible to identify exactly what the requirements are and excess capacity is sold on. Both parties seem happy.” Indeed, in its financial Q2, ending last November, CAE’s profits rose by 7% and it reported record order books.

Other defence contractors, such as Rolls-Royce and Vosper Thorneycroft, have set up special units to take advantage of the contracts available.

Meanwhile, consultants and service companies, such as WS Atkins, Serco and Amey, which supply accommodation and maintenance for the MoD, have boasted about the benefits of PFIs and reported half-year profits up 12%, 18% and 40% respectively.

Whitehall believes 80 of the first 100 private finance initiative projects deliver good service or better value for money than conventional funding, according to the first survey of the policy conducted by the National Audit Office last year. The biggest failing appears to be the lack of training for civil servants on how to handle contractors, which the report says leaves the public sector vulnerable to misunderstanding business methods. Edward Leigh, Tory chairman of the Commons Public Accounts Committee, warned “there is no room for amateurism in managing public services. It is not acceptable that some authorities provide little or no training in contract management.”

Consequently, Sir John Bourn, the comptroller and auditor general, has laid down six improvements to running PFI schemes, including extra flexibility for changes in a deal without incurring penalty points or extra finances.

The difficulties caused by government handling of Railtrack appear more intractable. The financial institutions which fund many PFIs continue to view the incident as a betrayal of trust by the government and will be looking at PFI contracts much more carefully in future. All eyes are on whether the government compensates Railtrack shareholders fairly. According to one financial consultant, “Unless the government gives Railtrack shareholders a fair price, people like Innisfree and Barclays Capital will walk away.” If they do that, the government can bury PFI.

Yet the government remains defiant, insisting that the Railtrack case is a one-off, different from all the other PFIs because no formal contract exists guaranteeing shareholders anything. And the City may find its ability to punish the government is limited, especially if the economic indicators look flat for the foreseeable future. For where else would companies get such good returns as from PFI deals?

What’s most likely is that the City will choose to walk away from some projects while still carrying out some straightforward PFI work, which is just too lucrative to be jettisoned. One result of this kind of thinking is that City lawyers are now starting to redraft their contracts and a new phrase is being inserted. In these partnerships, the state must not act “capriciously”. The consensus is that everyone can sleep easy as long as ministers refrain from “fiddling around”.

Support services company WS Atkins is well placed to take advantage of the huge growth in PFI. Founded in 1938 by Sir William Atkins as a civil engineering group, it made its name on post-war projects such as the construction of the Drax power station and development of the Selby coal field. In the 1960s it expanded overseas, winning work on the giant El Hadjar steel plant in Algeria.

Atkins is now throwing itself headlong into the public sector, with 13 PFI projects up and running. Chief executive Robin Southwell says: “There has been a paradigm shift in the delineation between private and public.

Industry has to step up to new responsibilities and be far more engaged in developing the fabric of society than it was.” The company sees the recent announcements from government and the Strategic Rail Authority about pumping billions of pounds into the crumbling infrastructure, as underlining its enthusiasm for PFI. “We now have a government that is determined to spend more on railways, we have an electorate which desires that more is spent and passengers that want more spent. This is a golden era, in many ways,” Southwell says.

Atkins’s turnover from rail operations rose 38% to around £40m last year, with much of it derived from contracts connected with modernisation of the west coast main line. A shortage of skilled rail engineers in the UK has sent Atkins abroad in search of staff, and it is looking to recruit up to 500 in China. They will be based in Beijing or Shenzen, but will work on Railtrack schemes via computer links to the UK. Their contribution will be vital to future Atkins operations, especially after Stephen Byers confirmed the government’s plans to press ahead with its Public Private Partnership proposals for the London Underground.

That decision came after reports by Ernst & Young and PricewaterhouseCoopers backed the proposal – the latter arguing the PPP will be £2bn cheaper than any alternatives.

For the Metronet and Tubelines consortiums the £16bn project looks particularly sweet – they get up to a fifth of their investment back every year. Metronet, which is backed by Balfour Beatty and WS Atkins among others, and Tubelines, whose shareholders include Amey, Jarvis and Bechtel, will put around £700m of investment into the project, and will raise a further £4bn from the markets. Byers says they can expect returns of between 15% and 20% per annum.