Public-private partnerships: An assessment

Modern economies depend on infrastructure that we generally take for granted. Indeed, we often only notice it when it fails. But the capital investment to build the roads, rail and hospitals upon which we depend does not come cheap, nor indeed does the funding required to run them on a day-to-day basis. Increasingly, therefore, governments have turned to the private sector to provide the required funding.

Such schemes generally involve a private investor assuming financial, technical and operational risk in return for a guaranteed fixed return from the public sector which acts as the final consumer of the service provided. This risk transfer puts the onus on the private sector to deliver a project as efficiently as possible in order to maximise the difference between the initial outlay and the revenue stream provided by the government. As a consequence, the public sector is off the hook for any cost overruns associated with big capital investment projects. A further advantage for the government is that much of the finance for such projects is treated as an off-balance sheet item in the public accounts which obviously flatters the public sector debt position, and provides an incentive for governments to put projects out to private sector tender.

In addition to capital investment, numerous day-to-day functions (e.g. the cleaning of public buildings, rubbish collection, IT and even law enforcement in the US) are increasingly contracted out to the private sector. The idea is that opening up the bidding process to competitive tendering puts downward pressure on costs so that we get the same services as before, only at lower cost. But the practice is rather different. A recent report by the UK National Audit Office found “no evidence of operational efficiency” in the hospital sector and that “the cost of services, like cleaning, in London hospitals is higher under PFI (Private Finance Initiative) contracts.” The NAO also found evidence that in an attempt to meet pre-specified levels of service “the contractually agreed standards under PFI have resulted in higher maintenance spending in PFI hospitals.”

Another problem, which was thrown into stark relief this week following the announcement that Carillion Plc – a major UK government contractor – has gone into liquidation, is the extent to which risk is really transferred away from the public sector. Although the company has ceased to trade, the economy still depends on many of the services which it provided. If no other buyer is found and the government does not step in, services such as the running of schools and prisons, the maintenance of railway infrastructure and the construction of major hospital projects, will cease. This is unthinkable. After all, Carillion ran all the catering, cleaning, laundry and car parking at the James Cook Hospital in Middlesbrough (NE England). A collapse of ancillary services will mean the closure of the hospital, which the government simply cannot allow to happen. So it could be forced to step in.

The UK railway industry has proven to be particularly troublesome with regard to private sector participation. The system is designed such that operators bid for a licence to run a rail franchise for a fixed period and it is their responsibility to balance costs and revenues to ensure it can make a profit over the lifetime of the contract. There have been numerous instances of problems in the bidding process, including dubious bids and companies suffering financial difficulties. The latest such occurrence took place in late 2017, when the government allowed the private sector operator of the main London-Edinburgh route simply to walk away from its contract without any penalties after it overbid for the franchise, with the result that it cannot now make sufficient profit from the deal. Virgin Trains will not now pay a reported £2 billion, which is the sum outstanding over the remainder of the franchise which runs until 2023.

It has been widely suggested that this was allowed to happen for political reasons. A company that walks away from its obligations is unable to bid for a tender for the next three years. With a number of other franchises coming up for renewal over that period Virgin would be ineligible to participate, which would be bad for them and reduce the government’s choice of partners nominally capable of running such a franchise. Whatever the truth of the matter, the government’s action creates moral hazard by undermining the basis of private sector participation if taxpayers are acting as the ultimate backstop.

There are thus serious questions as to whether public-private partnerships (PPPs) deliver value for money, particularly when the government can raise finance at a lower cost than the private sector – the UK government can borrow at rates just over 1% whereas the private sector weighted average cost of capital (WACC) is above 4% (chart). Moreover, PPPs generally deliver a rate of return between 10% and 15%, implying that PPPs are very lucrative for the private sector. This might be acceptable if private investors were bearing all the risk, but where the government is forced to act as a backstop this is clearly not a good deal for taxpayers. Consequently, serious consideration has to be given as to whether PPPs are meeting the needs of taxpayers. This does not necessarily mean that they should be abandoned altogether, but they need to be used more judiciously to meet public investment needs.