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.

The case for a National Investment Bank

One of the policy proposals put forward in the leaked Labour Party manifesto last week was the establishment of a National Investment Bank (NIB) to facilitate £250bn of spending on infrastructure over the next ten years. There was no detail in the document about how this might be set up, but there is some merit to the idea if done properly and in this post I offer a look at how it might work.

It is important to be clear at the outset what it should not be. It should not be a conduit for monetary creation by the Bank of England – the so-called People’s QE plan proposed by Jeremy Corbyn when he took over as Labour leader in 2015. PQE essentially requires the central bank to buy the bonds necessary to capitalise such an institution. But this policy is fraught with danger primarily because it erodes the boundaries between government and central bank to an unacceptable degree. In the form envisaged, it allows government to force the central bank to create money to finance whatever projects it deems fit. Moreover, a policy which requires monetary creation on such a scale would also have potential inflationary consequences and no central banker worth their salt is ever likely to endorse such a plan.

That said, there is no reason why a NIB should not work. The UK has tried it before and it was remarkably successful though perhaps not in the way initially envisaged. The Industrial and Commercial Finance Corporation (ICFC) was set up in 1945 by the Bank of England with funding from major commercial lenders to provide capital to small and medium-sized companies. In order to free itself from the constraints of relying on the clearing banks for funds, the ICFC began to tap the market to raise capital. This had an adverse side effect in as much as it raised pressure to generate greater returns on equity, which in turn led to a shift away from longer term, less attractive returns which its core mission delivered, to shorter term higher return projects, which caused problems during times of economic downturn. But by the 1980s it had shifted focus to become a leading provider of finance for management buyouts and had expanded internationally. It became a public limited company in 1987, when the banks sold their stakes, and it was fully privatised in 1994.

Currently, the UK is the only G7 economy not to have an institution which provides finance to the SME sector. In Germany, the Kreditanstalt für Wiederaufbau (KfW) has supported industry since 1948 and in the US, the Small Business Administration (SBA) has operated since 1953. Admittedly, the UK government did dip its toes into the water recently when it established the Green Investment Bank (GIB) in 2012. But despite apparently being successful, it was sold to Macquarie Bank last month for a price (£2.3bn) less than the initial £3.8bn of capital injected by the government.

In an excellent paper commissioned for the Labour Party in 2011, the lawyer Nick Tott outlined the case for a NIB.  But just to show that the case was not party political, former MPC member Adam Posen made a similarly excellent case in a 2011 speech which suggested that not only was there a case for a NIB, but that there was a need for an “entity to bundle and securitize loans made to SMEs … to create a more liquid and deep market for illiquid securities.” The biggest question remains how to capitalise such an institution. The government could commit up to £5bn as initial seed capital – after all it put almost £4bn into the GIB – and it could issue another (say) £5bn of bonds backed by Treasury guarantee. In future years it could divert part of the income generated by National Savings and Investments (NS&I) which raised £11.3bn for the Exchequer in 2015-16 and has assets of £120bn.

Admittedly, this is pretty small scale stuff and would be in no way able to fund the £25bn per annum of infrastructure which the Labour Party is calling for. This is probably a good argument in favour of limiting the remit of such an institution to SME lending rather than big public infrastructure projects. That, after all, is what such institutions do in other countries. Moreover, as Tott points out, it “would need a wide measure of independence from government.” It cannot simply be an arm of government to finance all sorts of pet projects, otherwise those who brand it a return to 1970s-style profligacy will likely be proved right.

A NIB would have to be run along commercial lines. As Posen pointed out, “The existing banks will scream about the unfair cost of capital advantage such an institution would have, but ... since the major banks in the UK have benefitted from a too-big-to-fail situation, any disadvantage they have in funding conditions is offset by the funding advantage they have over smaller or newer financial institutions, which they have gladly accepted. [Admittedly] public sector banks do tend to underperform private banks in credit allocation, and do tend to erode private banks’ profits. Yet most if not all countries have ongoing public lenders of various types (even the US has the SBA), and their existence on a limited scale, while perhaps wasteful at the margin, does not lead to the destruction of the private-sector banking systems in those countries … Let us remember that the UK and other western private-sector banks did that themselves during a period of financial liberalization and privatization unprecedented in postwar economic history.”

There are good reasons why the UK needs to do something to raise investment. For one thing, it is about to lose its EU funding which will put a hole in the transfers to many of the English regions (places like Hartlepool, which were very much pro-Brexit, have received considerable funding in recent years). A more generic macroeconomic problem is that the rate of business investment growth has been below the rate of depreciation since the great recession. This is not an issue which gets much airplay in the big picture story, and I am not sure of the extent to which it represents a change in business behaviour or whether it is a measurement problem. But it means in effect that the UK capital stock is declining, which may be one explanation behind the slowdown in potential growth in recent years. The UK needs to raise its investment levels. Whether a NIB is the right way to go about it remains to be seen. But it is an idea which should not be dismissed out of hand.