Salmond rewrites the PFI rule book

By Ian Fraser

CA Magazine

October 8th, 2007

Paying for big public projects could be about to change. Ian Fraser looks at the Scottish National Party’s plans to get value for taxpayers’ money

SCOTLAND’S first minister Alex Salmond was recently put on the spot over in the Holyrood parliament over his minority government’s mixed messages and apparent prevarication on the future of public private partnerships (PPPs).

While dozens of sizeable PPP projects are sprouting up across Scotland – including 11 new secondary and primary schools across the Highlands in a partnership between Highland Council, Morrison Construction and Noble Fund Managers – the flood of new projects has become a trickle since Salmond’s party gained power on 3 May.

And now there are real fears the trickle is becoming a drought. Supporters of the funding mechanism, which remains controversial even after all these years, suspect that the SNP is going to call time on the PPP party that has continued more or less unabated since the late 1990s. The minority administration’s recent scrapping of plans for a PPP-funded prison in Bishopbriggs only heightened such fears.

In a parliamentary exchange on 6 September, Cathy Jamieson joked about the inconsistency of the SNP’s approach to PPP. The Scottish Labour deputy leader pointed out that, while the finance secretary John Swinney has indicated that PPPs would be allowed to continue as one an array of possible procurement options for the public sector, Alex Neil, a more fundamentalist SNP MSP, has declared that detailed plans for scrapping PPP would be announced within the next few months. Mimicking a phrase associated with retired footballer Kenny Dalgliesh, Jamieson said: “Is PPP being scrapped? Maybes aye or maybes naw?”

The SNP has consistently questioned whether “the privatisation of public services” creates good value for money for taxpayers. Ahead of the first Holyrood elections in May 1999, the SNP came up with an alternative. Initially dubbed Scottish Public Service Trusts, these were presented a kinder, gentler version of PFI that would limit the ability of rapacious capitalists to make excess profits at the public’s expense.

However the idea turned out to be still-born after it was dismissed as “unfeasible” by Peter Burt, the respected former chief executive of Bank of Scotland. After that PR disaster, it was seven years before the SNP had another stab at creating a serious alternative to PPP. Ahead of the last Holyrood elections in September 2006 they came up with their refreshed approach, the Scottish Futures Trust (SFT).

This time around people involved in the PPP industry – including professional advisors and finance houses – did not harbour quite the same antipathy towards the SNP’s proposals. Indeed some are even prepared to accept, so long as it is properly crafted, the proposed alternative might even be preferable to the current model.

However they do complain that the proposal remains too vague to be of much real value at present. Some also complain that the “working party” that has been formed to fine-tune the proposals is made up solely of politicians and civil servants – with a dearth of people with any experience of the capital markets.

There is a widespread belief that, given the vague nature of the SNP’s proposals, it will be a long time before they become a workable alternative to PPP. Rhona Harper, a partner in Shepherd + Wedderburn, says: “I think the SNP is being rather naive in their timescale. It’s going to be at least two years from when they decide what form it will take to any projects being signed off.”

In his response to Jamieson’s parliamentary question, Salmond insisted that his SFT proposal would turn out to be attractive to both the public and private sectors that they would find PPPs hard to justify once it comes on stream. He said: “We will be bringing forward a range of options which, as I put it in the SNP election campaign, will crowd out PPP by offering better mechanisms to fund the capital stock of Scotland.”

One problem is that in current vacuum, few skilled professionals and construction companies involved the PPP sector are prepared to hang around twiddling their thumbs. Instead construction companies, facilities management firms and advisory firms are already diverting resources to places where PPP’s future is not in doubt. These include India, Africa, Latin America and Eastern Europe. Closer to home, they are also refocusing resources on England, The Republic of Ireland, France and Germany. Michael McAuley, a partner at Dundas & Wilson, says: “There is a definite nervousness in the construction industry and the fledgling facilities management sector about what is going to happen.”

Of the four main construction players initially active in PFI in Scotland – Amey, Jarvis, Morrison and Miller – only Morrison and Miller are still involved. Several other UK and overseas players including Amec, Balfour Beatty, Bilfinger Berger, Carillion and Hochtief have flocked to Scotland in recent years but the current hiatus has made some of them reconsider their commitment to this market.

David Nash, a partner in law firm Pinsent Masons says one consequence of the current delay will be a lack of bidders for future PPP projects. Paradoxically, that could mean that in a less competitive climate for tenders, the taxpayer gets worse value for money. Dawn Construction’s managing director Ray Eve is also concerned that the recent switch from contracts based around ITN (invitation to negotiate) to ones based around ITPD (invitation to participate in negotiations) is pushing up bidders’ costs and could further undermine PPP’s attractiveness.

Few in the advisory community see PPP as a panacea. Unlike Salmond, however, they argue that the funding mechanism has been finessed over the years to the extent it is much more likely that the state is getting a good deal. They also openly acknowledge that many early projects – including the Skye Bridge, Inverness Airport and West Lothian College (all three of which ended up having to be bought back by the public sector) were poorly conceived and that early refinancing gains gave the sector a bad name.

However most advisors in PPP put these down to experience and say such mistakes have been all but eradicated.

There is a widespread view that, in his determination to rubbish PPP as representing poor value for money, Salmond has used flawed evidence. S+W’s Harper acknowledges that private finance costs more than public finance. However she is incensed that the scheme’s critics – including the University of Edinburgh’s professor Allyson Pollock) tend to highlight the higher cost of borrowing under PFI without taking into account what the public sector gets in exchange for this financial premium. Harper says these include risk transfer, timely deliver of assets and lifelong maintenance. Harper says: “Before PPP, the culture was one of design build and bugger off.”

Salmond has said that his proposed SFTs will be dependent on issuing bonds at 4%, along similar lines to the municipal bonds issued to finance public sector works in the United States. However Uilleam Cameron, a partner at accountants KPMG, questions whether this will be possible in the centralised UK economy.

He says: “The only way to obtain debt more cheaply [than through PPP] is through sovereign borrowing, but only the Treasury has the ability to raise money in that way. The Scottish government does not have a credit rating. It would need primary legislation and the acquiescence of Westminster. That is unlikely to be achievable within the timeframe Salmond is talking about.”

McAuley added: “My key concern is that the SNP’s proposed model could, in fact, end up being more expensive than PFI. This would be particularly true if it required the creation of a large organisation along the lines of the European Investment Bank. That would be a tremendous additional overhead.”

However Edinburgh-based Deloitte director Christopher Blunt is more optimistic about prospects for the SNP’s proposals. He says: “There is potentially a very big prize. But it is going to take a lot of work to get there.”

The big question is: will SFT funded projects be off- or on-balance sheet? Most people are making the assumption they will be off.

Blunt also warns that there could be challenges in finding appropriate talent to work for the new EIB-style body and that its very existence will cause antagonism with the Treasury.

So, as the SNP’s “working group”, one of whose prominent members is Sandy Rosie, head of the Scottish Executive’s financial partnerships unit – hammers out proposals for the future shape of PPP in Scotland, what should they be taking into account?

One model that will almost certainly shape their thinking is the not-for-profit version of PFI pioneered by Argyll & Bute. Recently used for a £80m schools project, this has since been adopted for both Falkirk and Aberdeen City councils for schools projects. “I think the SNP are very interested in the NPDO (non profit distribution organisation) model, which they see as tackling at least some of their concerns,” says Harper.

Dundas & Wilson’s McAuley says: “I certainly believe the NPDO model has legs. If you look at the four different parties that are involved in a PPP-type contract: the building contractor’s role does not change under the NPDO model, nor does that of the facilities management partner, nor that of the senior lender. The only real difference is that equity investors see their returns capped.”

He is confident that if the SNP uses the NPDO model as its starting point, the alternative proposals will have little impact on the private sector’s desire to participate.

McAuley also recommends that the working group could look to Northern Ireland, where a Strategic Investment Board has had centralised responsibility for procuring large scale infrastructure projects since 2003. “I think Scotland should look very closely at a model along these lines. If you take that as your model it would add clarity to how the Scottish Futures Trust could operate.”

Cameron says: “Our preference is for the SFT to be along similar lines to the European Investment Bank – essentially a body which is one step removed from government that handles both the raising of the money and the delivery of the infrastructure. The trouble is there are not many models for that sort of thing anywhere else in the world.”

Uncertainty over PPP’s future in Scotland is being played out against the backdrop of a wider UK-wide loss of appetite for the funding method, in which the high-profile collapse of tube maintenance joint-venture Metronet played a big part.

More ominously for the sector, EU-inspired changes to accounting regulations are expected to force PPP assets onto the public sector’s balance sheet.

This could well lead to a sudden loss of appetite for the funding mechanism in the corridors of power.

Neither Gordon Brown nor Tony Blair has ever publicly admitted it, but one reason they adopted PFI with such gusto (even though it was originally a Thatcherite policy) was it enabled them to play a sophisticated game of smoke and mirrors with the public accounts.

In effect, it permitted them to borrow the billions they needed to finance the delivery of hundreds of vote-winning shiny happy schools, hospitals, prisons, roads and infrastructure projects, without the tiresome need to make it look as if they were borrowing money. The off balance sheet nature of PFI meant it had not impact on the Public Sector Borrowing Requirement, and Gordon Brown was able to present himself as the most fiscally responsible chancellor of all time.

However, the enforced adoption of IFRS by the public sector means the scope for such trickery will evaporate.

It is also expected to have different impacts north and south of the border.

In England, some PPP assets are already on the public sector’s balance sheet but, according to KPMG’s Cameron, this “hasn’t been happening” in Scotland because Scottish deals are structured differently.

He says: “The PSBR situation is very tight in Scotland, if they were to be included on the public sector’s balance sheet, something else would have to come off.” He said that one possible option would be the privatisation of Scottish Water.

At Dundas & Wilson, McAuley says the switch to IFRS accounting is, more than anything else, going to “make the public sector stop and think” about its commitment to PPP. He agrees with Cameron that the change will have a much bigger impact on PPP in Scotland than down south.

“That’s because the Scottish government is not permitted to borrow money. If they do lose the benefit of putting assets off balance sheet, I think they’re going to struggle to justify some PPP projects.”

Deloitte’s Blunt, however, is more upbeat about the change. “It could be a wake-up call for the public sector” ensuring that, if they do embark on PFI projects, they do so for the right reasons. In future, I suspect PFI will only be used if it genuinely produces better value-for-money. If it means that only the good projects go ahead, it will not be bad thing,” he says.

So how should Jamieson’s question about whether PPP will be scrapped in Scotland be answered? In my view, as long as Salmond’s proposed alternative model makes commercial sense to the private sector, then the traditional PPP model will be used less and less frequently.

And as Blunt says, only “good” projects, where PPP funding has palpable advantages over other funding routes for current and future generations of taxpayers, will be able to get the go-ahead.

This article was publised in the relaunch edition of CA Magazine October 2007 under the headline “Bridging Finance”.

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