Equity investors have helped to deliver many public sector infrastructure projects via the Private Finance Initiative and have managed them in ways from which the public sector can learn. Against a background of limited information, evidence gathered by the National Audit Office raises concern that the public sector is paying more than it should for equity investment.

Banks or bondholders provide around 90 per cent of the project funding for a PFI project on the condition that the remaining money is provided by the investors as risk capital or equity, which will be lost first if the project runs into difficulty.

Investors are rewarded for taking risks. The risks the investors bear are mainly the costs of bidding; that their contractors may fail to perform; or that other project costs the investors bear the risk for will be higher than envisaged. However, the investors limit their risk by passing it to their contractors. In addition, the government is a very safe credit risk and many projects such as hospitals and schools are repeat projects.

The Treasury and departments to date have relied on competition to secure efficient pricing of the contract but have not gathered systematic information to prove the pricing of equity is optimal. The NAO report identifies three potential inefficiencies in the pricing of equity. These are the time and costs of bidding; minimum rates set by investors, which sometimes do not reflect the actual risks the project will face; and bank requirements.

Today’s report concludes that, generally, public sector authorities have not been equipped with the skills and information required to challenge investors’ proposed returns rigorously. The NAO shows how further analysis during the bidding process would help authorities to assess the reasonableness of the investor returns. As an illustration, the NAO estimates that around 1.5 per cent to 2.2 per cent of the annual service payments in three projects it analysed were difficult to explain in terms of the main risks investors said they were bearing.

Some investors in successful projects have gone on to sell shares in their equity to release capital and fund new projects. This has also resulted in accelerating the receipt of their returns. Analysis by the NAO has shown that investors selling shares early have typically earned annual returns of between 15 per cent and 30 per cent. The NAO recommends that the Treasury should use its current review of PFI to consider alternative investment models that limit the potential for very high investor returns in relation to risk.

The NAO has concluded that lessons from the large body of experience of using PFI can be applied to improve other forms of procurement and help Government achieve its aim of securing annual infrastructure delivery cost savings of £2 billion to £3 billion. Government should also do more to act as an ‘intelligent customer’ in the procurement and management of projects.

To secure the best value for money from all types of procurement, the public sector needs to develop the ‘enablers of success’ which the NAO has identified. These are collecting better data to inform decision-making; ensuring projects have the right skills; establishing effective arrangements to test, challenge and, if necessary, stop projects; and using commercial awareness to obtain better deals.

The case for using private finance in public procurement needs to be challenged more, given the spending watchdog’s previous analysis that the cost of debt finance has increased since the credit crisis by 20 per cent to 33 per cent. Also, under the national accounting rules, privately financed projects will often still be off balance-sheet which may continue to act as an incentive to use PFI. The NAO concludes that, in the current climate, the use of private finance may not be as suitable for as many projects as it has been in the past.

There has not been a systematic value for money evaluation of operational PFI projects by departments. There is, therefore, insufficient data to demonstrate whether the use of private finance has led to better or worse value for money than other forms of procurement. The NAO calls on the Treasury and departments to identify alternative methods for delivering infrastructure and related facilities services, building on the lessons learnt from PFI, to maximise value for money for government.

The NAO welcomes the current plans of the Treasury and Cabinet Office to strengthen project assurance. The NAO highlights the need for independent challenge capable of stopping projects which do not give the prospect of value for money. This is particularly important as there is still a shortage of the skills needed to manage and oversee complex major projects. Better contract management skills are particularly needed to obtain best value during the contract period, including by ensuring the public sector shares in cost efficiencies achieved in existing contracts.

The National Audit Office has concluded that, by setting up an Infrastructure Financing Unit, HM Treasury helped reactivate the lending market for private finance projects which was putting government PFI programmes in doubt as a result of the credit crisis. While the extra finance costs for projects in 2009 were value for money in the short term to achieve the government objective of stimulating the economy, the Treasury should not presume that continuing the use of private finance at current rates will be value for money.

Bank lending was so restricted in late 2008 that no sizable contracts could be let. The Treasury helped to reactivate the lending market for infrastructure projects and improved the market confidence by setting up its own Finance Unit in March 2009. The Unit helped to finalize a large waste treatment and power generation project. Subsequently, 35 projects, including the contract to widen and maintain the M25, were signed without any further public lending.

In line with policy on acting to stimulate the economy, the Treasury and other government departments gave priority to closing deals at the prevailing market rates, even if this meant the public sector paying more, and the banks carrying less risk. Analysis by the NAO suggests that higher financing costs increased the annual charge of PFI projects by six to seven per cent and that between £500 million to £1 billion of higher cost has been built in over 30 years, partly offset by an increased public sector share of refinancing gains.

The opinion of the NAO is that the extra finance costs of projects financed in 2009 were value for money in the context of stimulating the economy. The NAO also considered whether reconsidering business cases – which might result in projects being postponed or discontinued – would have improved value for money. The NAO found that this might have put policy objectives to give a boost to the economy at risk and would not have been a reasonable yardstick to assess the protection of value for money.

The NAO recommends that there now be a thorough project by project review of the forward programme to apply more exacting and narrower criteria than applied to projects at the height of the crisis.

The use of PFI by local authorities to improve housing, usually in areas with a high need for housing and where stock condition is particularly poor, has had a measure of success. However, according to a report today by the National Audit Office, risks to value for money of the programme have not been managed.

In the context of this programme, PFI has been a flexible and useful funding route for local authorities to improve existing housing and build new stock. However, the majority of projects required significant increases in central funding prior to contract signature and all have suffered delays. One early project cost the Department for Communities and Local Government over three times more than expected in its business case. Twenty one of the 25 projects which have been signed to date have experienced cost increases, with 12 of these over 100 per cent.

The Department did, however, take steps to ensure funding increases were valid and there have been no increases in central government funding for projects following contract signature.  All signed projects, for which the NAO was able to obtain data, were delayed, on average by 2 years and 6 months.  For early projects this was partly because PFI was new to the housing sector and the Department had to develop its understanding of stock condition issues. A particular complexity for the Department and all parties involved was achieving a robust cost for projects at the outset.

Local authorities have reported that their initial choice of PFI was driven by the funding structures of the Department and policy constraints rather than a pure focus on value for money. Some local authorities themselves have concerns that PFI procurement can be excessively costly and takes too long when compared with other routes. At the programme level, the Department has undertaken only limited evaluation of whether housing PFI delivers value for money compared to alternative investment routes.

The Department’s programme management for early projects was also weak and under-resourced. Some local authorities and private sector contractors expressed concerns over the capacity of the Department and the Homes and Communities Agency (which took over responsibility for delivering the overall housing programme in December 2008) and the level of expertise among some staff. While there have subsequently been steps to address these issues, they have posed a risk to effective delivery of projects.

The limited evidence available to allow the NAO to compare costs of housing projects funded using PFI with those using alternative forms of funding raises concerns about the value for money of the PFI housing programme. While the capital cost of PFI housing projects is similar to other developments, the Department’s evaluation to date has not taken account of the full costs. Procurement also tends to take more time, which can increase procurement and tender costs for local authorities and bidders.

The National Audit Office reports today that most PFI hospital contracts are well-managed and the evidence indicates that they are currently achieving the value for money expected when the contracts were signed. There continue to be risks, however, to the long-term value for money of these contracts.

Today’s report, which focuses on the stage of the contract once buildings are opened for use, not on the decision to use PFI as a procurement route, suggests that most contracts are performing satisfactorily or better and meeting the expectations of Trusts. The cost and performance of services such as cleaning, laundry and portering in PFI hospitals are similar to those provided in non-PFI hospitals. While catering is on average slightly cheaper in PFI hospitals, hospitals with PFI buildings spend more on maintenance annually to keep the buildings to a specified high standard.

Today’s report emphasizes the challenge involved in managing PFI contracts. Most Trusts are managing their contracts well day-to-day and understand the risks to value for money. However, risks remain and, while many Trusts have recently increased the resources they dedicate to managing PFI contracts, some Trusts are not devoting enough resources. Twelve per cent (9 of the 76) operational PFI contracts have no-one from the public sector assigned to contract management.

It is likely that Trusts will be expected to make efficiency savings over the next few years, but their ability to make savings from their PFI contracts is very limited. Because Trusts pay an index-linked fixed sum, it is difficult for them to make savings without cutting back on services. Contractors who secure economies of scale through managing multiple PFI contracts are rarely required to share these efficiency gains with Trusts.

The Department of Health is responsible for helping Trusts manage their contracts and, while good practice is spread among Trusts, there is a lack of central data on the performance of the PFI portfolio. The Department does not use the leverage over the market it possesses from having 76 contracts in force. With more information on Trusts’ projects, the Department could use this leverage to update contracts on common issues or facilitate performance and efficiency improvements.

Despite managing the later stages of the procurement well, the MOD’s ability to get the best deal it could was undermined by shortcomings in the way it conducted the procurement and assessed alternative options. Although the project to provide air-to-air refuelling and military transport aircraft has achieved its delivery milestones since contract signature, it is still likely to be delivered five and a half years later than planned.

The MOD began the planning process with the assumption that the FSTA project would be delivered using a private finance deal, and therefore “off-balance sheet”. This assumption was driven by affordability pressures and the prevailing policy to use PFI wherever possible. The selection of a PFI option was made without a sound evaluation of alternative procurement routes to justify why the PFI route offered the best value for money.

The original requirement for FSTA did not envisage the aircraft flying into high threat environments such as Afghanistan. When the need for possible additional aircraft protection measures arose, the Department sensibly did not alter its requirement for fear of prejudicing ongoing commercial negotiations. Having established that these modifications are likely to cost several hundred million pounds, the MOD is considering the costs and technical requirements. Even if MOD were to choose to go ahead with the relevant modifications, they would not be available for a number of years.

The MOD will pay on average £390 million per annum for the core FSTA service, which includes use of the aircraft and related services and infrastructure. However, the MOD also has responsibilities to support the effective delivery of the service and ensure that it obtains value for money from the contract. Any significant delay to the planned redevelopment of the main operating base at RAF Brize Norton, scheduled for shortly after FSTA’s entry into service, would affect the smooth operation of the service.

Given the delay to FSTA, the MOD is being forced to rely on ageing and increasingly unreliable Tristar and VC10 aircraft to provide air-to-air refuelling and air transport to Afghanistan. While the MOD has been successful in fulfilling these priority roles, flying hours across both fleets have reduced by 21 per cent since 2002-03. To assist in delivering its air transport requirements the MOD also charters passenger aircraft, at a cost of approximately £175 million between 2006-07 and 2008-09.

British Energy was the largest independent energy generator in the UK and owner of sites viewed by industry as the most suitable for new nuclear power stations. The Government sold its 36 per cent interest in the company to EDF Energy for £4.4 billion in January 2009. The final cash offer from EDF was 774 pence per share – 10 per cent higher than the valuation by the Shareholder Executive, the Government agency that managed the sale. Movement in energy prices after completion of the sale show that EDF put forward its offer when energy prices were at a peak.

The Government’s primary objective for the sale was to ensure nuclear operators are able to build and operate new nuclear stations from the earliest date with no public subsidy. The Department of Energy and Climate Change did not seek, and EDF did not offer, any binding commitment to build new nuclear power stations as a condition of the sale. But EDF’s acquisition of British Energy has improved the prospect of investment in new nuclear power stations.

While the Government no longer has a direct financial interest in British Energy, it remains responsible for funding any shortfall in the future cost of decommissioning British Energy’s existing nuclear power stations. The Shareholder Executive did not carry out a formal assessment of the impact of the sale on the risks that taxpayers might have to bear if, for example, the new owner operated British Energy’s power stations in a way that required earlier decommissioning.

Today’s overview of the government’s response to the crisis shows that the purchases of shares by the public sector together with offers of guarantees, insurance and loans made to banks reached £850 billion, an unprecedented level of support. However, there have been no disorderly failures of UK banks and no retail depositor in a bank operating in the UK has lost money. And, by the end of November 2009, the banking sector as a whole had benefited from improved confidence. But, in 2009-2010, lending to businesses is not likely to meet targets.

The scale of the loss to the taxpayer will not be known for years to come. The Treasury estimated in April 2009 that there may be a loss to the taxpayer of between £20 billion and £50 billion, the wide range reflecting the inevitable uncertainty involved in such an estimate. Total losses will depend on losses from the Asset Protection Scheme and the price at which the government sells its holdings in RBS and Lloyds.

The Treasury expects by April 2010 to have spent £107 million on advisers, some of whom had to be employed at short notice. In total, just under £100 million is expected to be refunded by the banks. Two sets of financial advisers – from Credit Suisse and Deutsche Bank respectively – who were each appointed on retainers of £200,000 a month for a year. The contracts included provisions for success fees of up to £5.8 million, payable at the Treasury’s discretion.

As a condition of the recapitalisation scheme, RBS and Lloyds agreed to targets for retail mortgage lending and business lending: RBS would lend an additional £25 billion in 2009-10, and Lloyds an additional £14 billion. To date, both banks are on track to meet their retail mortgage lending commitments but lending to businesses is likely to fall short of the targets. The Treasury is monitoring progress and meets each of the banks regularly. The only formal sanction available if targets are not met is a potential refusal to extend guarantees for wholesale borrowing under the Credit Guarantee Scheme.

The existence of the contract allowed for a smooth estates merger, following the merger of the two departments in 2005. HMRC has the flexibility to vacate up to 60 per cent of its estate over the 20 year contract, allowing it to save up to £1.2 billion. But it has not recognised the contract as a major strategic asset nor committed appropriate commercial skills to managing it. As a result, the total possible savings available now amount to £900 million. To date, the contract has cost £312 million more than originally forecast, as a result of fewer instances than forecast of vacating buildings, unrecoverable VAT payments, and changes in requirements.

To achieve savings on its estate, HMRC is now planning to vacate a significant number of its buildings by 2011. This vacations programme creates areas of specific financial pressure for Mapeley, exacerbated by the economic downturn and falling property values. HMRC does not yet have an agreed way forward with Mapeley. If Mapeley were to default on the contract, HMRC could incur significant one-off and ongoing costs.

The NAO’s 2004 report found that the Department secured a competitive price from Mapeley but warned that good risk management would be essential on the 20 year deal signed in 2001. However HMRC has generally reacted to risks and issues as they arise rather than strategically managing the contract. It lacks full visibility of all the gains and losses that Mapeley has obtained from the contract, which would be critical to inform any negotiations.

There is now a significant risk that HMRC will not achieve value for money over the rest of the contract unless it strengthens its management of the contract. There needs to be active management at Board level and HMRC needs to develop an estates strategy. HMRC should monitor overall value for money and form an effective partnership with Mapeley.