The maelstrom that has enveloped the financial sector since the latter half of 2007 has claimed many victims. As credit for all kinds of economic activity dried up, so too did funding for the private finance initiative (PFI): the mechanism for infrastructure delivery so expanded by Labour since its election in 1997.

In February, Tim Pearson, a private equity boss and spokesman for the PPP Forum – the trade body covering public-private partnerships – warned of a possible 40 per cent gap in funding for the £13bn worth of PFI deals still out to tender, including the plan to widen the M25 motorway around London.

As Pearson issued his warning, officials at the Treasury – which has overall responsibility for PFI schemes – were working to find a mechanism to plug the funding gap. The seizing-up of credit markets was particularly threatening for larger schemes, such as the M25 project and the planned new waste-disposal system in Greater Manchester.

While companies entering into smaller-scale PFI projects were still able to secure lending from banks – albeit at more costly rates – bigger schemes, which are largely funded through sales of long-term bonds, were in severe difficulties.
“The bond market for the larger projects is no longer there, and that is one of the contributory factors to the lack of liquidity,” says Nick Prior, a former head of PFI at the Ministry of Defence who now works for consultancy Deloitte.

To replace that shrivelled bond market, and stave off the threat of high-profile capital projects failing, last month the Treasury announced plans to become a player in the PFI lending market. With last week’s confirmation that the Manchester recycling scheme is to go ahead thanks to assistance from central government, the Treasury is hopeful the PFI market will stabilise sooner rather than later. But why was it so essential that the Treasury acted to preserve PFI, and what might its intervention mean for the future of a system that currently handles a substantial proportion of all public sector capital investment?

At its simplest, PFI involves a government department or public agency contracting a private company (or, more often, a consortium) to build and maintain a chunk of infrastructure. Contractors then lease the goods back to government over an agreed period of time, usually at least 30 years.

Proponents of PFI argue that as well as handing over the design and construction of a new hospital, road or school, the taxpayer hands over much of the financial risk, since payment can be withheld if contractual obligations are not met. Taxpayers get improved infrastructure upfront, to be paid for out of the public purse over future decades.

But another – perhaps more persuasive – advantage of PFI in the UK has been the fact that, because the private sector borrows the cash to build the infrastructure rather than the public sector, the vast majority of projects don’t appear as capital spending on departmental balance sheets. With then-Chancellor Gordon Brown promising to stick to Tory spending plans for Labour’s first three years in office, and loudly pronouncing that public sector borrowing should not rise above 40 per cent of GDP, the option of off-balance-sheet capital investment through PFI looked tempting.

Although PFI has become closely linked with the Labour era, it began life under John Major’s Conservative government. In 1989, James Douglas-Hamilton, then a junior minister in the Scottish Office, announced a bidding round for what became the first high-profile PFI scheme: the Skye Bridge, connecting the island to the mainland. The bridge was completed in 1995, having been delivered by a Scottish building company using German engineers and £25m of funding from the Bank of America. The PFI element of the deal was always controversial, due to the high tolls users were charged – at their peak, over £11 for a return – and the bridge was bought back by the Scottish Executive in 2004. Although government clearly had a lot to learn about running PFI projects, it is clear that all the crucial elements were in place by 1997.

In July 1997, two months after Labour took office, a Treasury taskforce was formed to coordinate PFI policy. Responsibility for PFIs was moved to the Office of Government Commerce in 1999, but subsequently returned to the Treasury, reflecting the system’s importance to government spending plans. The use of PFI accelerated to the extent that over 800 deals have now been signed in the UK, committing the public purse to paying back around £215bn in the decades ahead. Deals have ranged in size and profile from the £330m Government Communications Head Quarters in Cheltenham to the provision of street lights in council areas across the country.

Most notably, PFI has been a vital tool in delivering high-profile rises in spending on both health and education infrastructure: in the case of the flagship Building Schools for the Future programme, such arrangements account for over half of the government’s investment. In health – where fears over the privatisation of healthcare have made PFI especially contentious – the government’s early intentions were revealed in a quote from then-health minister Alan Milburn in 1997. When it came to building new hospitals, Milburn said, “it’s PFI or bust”.

David Heald, a professor of accounting at the University of Aberdeen and a public expenditure specialist, says that officials across the public sector felt they had little alternative but to accept private finance. “What tended to happen is that local managers – of local authority health trusts and so on – basically told people the only way they would get the capital investment was by going [down] the PFI route,” Heald says.

Until the economic tumult of the past year, the market for PFI debt boomed, with smaller projects securing direct lending from banks, and the larger schemes able to raise the necessary funds through offering bonds. But as the financial climate darkened, banks and other institutions began to limit the size of their loans, says Elizabeth Fells, head of public service reform at the CBI. This meant bigger deals required ever more lenders, charging increased rates to the PFI contractors. “Whereas before you’d have fewer banks in any one deal, when banks seek to only lend smaller amounts, you need more banks to get enough private finance,” Fells explains. In 2008, the number of PFI deals finalised was barely half the annual average of the previous decade.

Deloitte’s Nick Prior says the threat to PFI from the financial downturn is “often overstated”, but it was significant enough for the Treasury to commit to acting as lender of last resort for schemes in urgent need. Treasury chief secretary Yvette Cooper insisted that committing taxpayer support was necessary to ensure that vital infrastructure investment would go ahead as planned. Notably, the Treasury said that although it would prefer to lend in conjunction with commercial lenders (and at commercial rates), if necessary it would act on its own to support troubled deals. Although bailing-out deals such as the one in Manchester will will further weaken the Treasury’s beleaguered balance sheet, it seems that government is unwilling to countenance either dumping troubled projects completely, or converting them into conventional public procurement schemes.

Gordon McKechnie, who was head of PFI policy at the Treasury until the end of March, insisted that the government intervention was designed to be “temporary and reversible”. As with the government’s acquisition of several high street banks, the Treasury hopes that its venture into PFI lending will be brief, and has pledged to sell any loans on when the market picks up. Officials also believe that intervening now will make that day arrive sooner, encouraging commercial lenders to have more confidence in the stability of PFI.

The Treasury move was intended to reassure not just commercial players in the PFI market, but also the various agencies awaiting finalisation of deals still out to tender. The agreement on the Greater Manchester recycling scheme required the department – in the guise of the newly-created Infrastructure Finance Unit – to provide £120m of funding following the decision of Bank of Ireland to row back on its commitments. Andy Rose, the unit’s head, said the move was exactly what the Treasury plan was “set up to do, to get involved where private finance is not available”.

However, there are some who are much less confident about the future for PFI – not least politicians from both opposition parties, who lambasted the government over the decision to step in. “PFI has now largely broken down,” Liberal Democrat Treasury spokesman Vince Cable said last month. “We are in the ludicrous situation where the government is having to provide the funds for the private finance initiative.” Critics argue that in promising assistance for struggling schemes – even on a temporary basis – the government has undermined the most persuasive reason for using PFI: that the private sector takes most of the risk.

Indeed, the government is not only taking on added PFI risk directly through Treasury lending, but also indirectly by taking over banks that have lent to PFI projects. In recent years, Royal Bank of Scotland (RBS), HBOS and Lloyds all financed large PFI deals, with RBS reportedly one of the biggest lenders in the M25-widening scheme. Even if the private finance market recovers, several of its largest lenders may still be in public ownership.

Meanwhile, PFI’s attractiveness may be adversely affected by a longer-term problem: a change in the accounting rules that previously made PFI such an alluring option. Following years of criticism and badgering from organisations including the Financial Reporting Advisory Board and the Accountancy Standards Board, the Treasury has agreed that, at the point of completion, most PFI schemes will now appear on balance sheets as capital investment. David Heald says that, on departments’ balance sheets, PFI schemes will now be treated the same as traditional public capital investment. “The idea is that the new system is neutral between whether a public body uses or doesn’t use PFI,” he says. “Previously, if you used PFI it was off-balance-sheet and didn’t count against your public sector [capital spending] allocation.”

Some think this change could lead to greater hesitancy about exploring PFI investment within departments. “If there are genuine efficiency gains from [using] PFI, changing the accounting rules shouldn’t affect the position,” Heald says. “But if they were doing it because that was the only way they could get capital investment, there may well be less enthusiasm.”

Deloitte’s Nick Prior admits that “consideration” will have to be given to the structure of PFI deals under the new accounting regime, to ensure they don’t weigh down public debt figures, but he insists the rule-change won’t increase pressure for value for money – “That pressure is there already,” he says.

Pressure on the purse strings looks set to dominate the working lives of civil servants and politicians in the coming years. With capital spending due to be frozen from 2011, the future looks less than sunny for Gordon Brown’s favoured method of funding infrastructure.

The private finance initiative in action...

Government Communications Headquarters
New accommodation for the intelligence-gathering agency in Cheltenham was delivered by a consortium led by infrastructure giant Carillion, at a cost of £330m. Nicknamed ‘the doughnut’ in honour of its circular shape, the building’s maintenance, cleaning, catering and telephone services will be provided by contractors over 30 years. Officially opened by the Queen in March 2004.

British Embassy in Berlin
One of very few overseas PFI projects, agreed by the Foreign and Commonwealth Office with German construction company Bilfinger Berger and an American facilities management company. Deal described as “satisfactory” by the National Audit Office.

University College Hospital
New hospital constructed by a consortium led by builders Balfour Beatty and consultants Amec at a cost of £422m. Included construction of a 17-storey tower-block, completed in 2008.

…and in trouble

Skye Bridge
The first high-profile PFI deal, agreed by the Conservative government with a Scottish-German-American consortium, with construction completed in 1995 at a cost of £25m. By 2004, operators were charging users £11.40 for a return journey across the bridge. A campaign of local protests led the Scottish Executive to first subsidise fares, then buy the bridge outright for £27m.

Balmoral High
A secondary school built in Belfast in 2002 under private finance initiative, but closed five years later due to falling pupil numbers, with the Northern Ireland Executive contracted to pay providers until 2027.