Over the past 50 years, the contribution of private finance to direct public sector investment has fallen. The figure above shows that ‘public spending gross investment’ (a measure of capital investment) has decreased by 5.6% as a proportion of gross domestic product (GDP). This reduction is largely due to the privatisations of the water, electricity, gas and telecoms industries in the 1980s and 1990s, which transferred ownership and responsibility for the delivery of national infrastructure to the private sector.

The private finance initiative (PFI) was introduced in the 1990s to bring private sector expertise to public investment. The figure also shows that, in aggregate, the incremental contribution of PFI to public sector investment has been relatively modest. In the past five years, around 90% of the £46bn annual capital investment was publicly funded. Investment last peaked in 2010, boosted by a fiscal stimulus, and since then it has reduced by around one-third.

Decision making and budget process

The National Audit Office (NAO) audits and scrutinises public spending in the UK on behalf of Parliament. The head of the NAO is an officer of the House of
Commons and the NAO is independent of government.

The corporate finance team at the NAO has published reports on infrastructure financing, major capital investments and PFI. It also reviews government transactions, including privatisations and asset sales such as Royal Mail (recording available on CISI TV), and Government interventions in the financial markets during the crisis and its subsequent sales, such as Lloyds Banking Group.

NAO reports are free to download from nao.orgOur review of the budget system explains that central government departments must decide how to finance large capital projects well before cash is drawn down, for example for construction. Departments are not allowed to borrow directly from financial markets, and their capital budgets are set every three to four years. We noted that, if departments did not have enough budget to fund the construction of an asset, their only option for investment was to use private finance. This can provide greater flexibility, although a considerable amount of time may pass between the decision to procure via the private finance route and the process which determines the cost of finance.

There are significant differences between the respective budgetary impacts of using private or public financing. About 90% of privately financed capital investment is not recorded as public spending when the investment takes place and so does not affect departmental capital budgets. In the short term, departments can reduce reported public spending and government debt statistics by using private finance but, in the long term, additional spending would be required via contractual commitments.

Cost of private capital

The future financial commitments for existing PFI projects currently amount to around £232bn. Annual expenditure has increased significantly in recent years in line with contractual commitments, and is currently running at £10bn. Of this, around £3bn a year is needed to service debt. According to the UK’s Whole of Government Accounts (WGA, 2012/13) the average PFI financing cost is 7% to 8%, compared with average costs of government borrowing of 3% to 4%.

Although private finance is more expensive than public finance, it can represent value for money if the benefits, such as risk transfer, outweigh the higher cost. HM Treasury’s PFI database (at March 2014) shows that about two-thirds of all current private finance projects relate to accommodation – such as for hospitals, schools, offices and military barracks – and much of this is generally known as ‘social infrastructure’. We found that information about private finance costs for individual projects is limited. We consider that, if information on the financial terms of the projects were centrally collated and distributed, it could provide more evidence for public authorities about the relationship between project-specific risk and the cost of capital. We have therefore put forward proposals to increase transparency, aid comparisons and improve decision-makers’ confidence that using private finance represents value for money to the taxpayer.

Refinancing, negotiations or buy-outs of private finance deals can achieve cost reductions. For example, when in 2013 we examined savings from operational PFI projects, we found that savings were made by bringing services in-house and replacing private finance. Most private finance deals have used long-term financing agreements (for example, interest rate swaps) to limit exposure to rate rises. The Government introduced gain-sharing agreements to enable taxpayers to benefit from a share of savings achieved, but there are relatively few such examples despite low interest rates and improved financial market conditions. Our analysis shows that the current value of swap liabilities for the 728 PFI special-purpose vehicles in HM Treasury’s database is around £6bn.

Guarantees and the National Infrastructure Plan

	Matthew Rees, Chartered FCSI is the NAO’s Director – Corporate Finance. He moved to the NAO in 2013 from the Competition Commission. This followed a career in investment banking with major international institutions.
	Vasilisa Starodubtseva is an NAO Analyst – Corporate Finance. She joined the NAO in 2014, having previously worked at Preqin, focusing on private equity performance, and at the Bank of England in international finance.

In another recent report, UK Guarantees Scheme for Infrastructure, we examined the Treasury’s £40bn scheme (a sovereign credit substitution arrangement), which was introduced in response to challenging market conditions for infrastructure finance. Our analysis indicates that the value of private finance for new projects halved from £6bn a year prior to the financial crisis to £3bn a year during the crisis, before recovering after 2012. We examined the value for money of the first five such guarantees, with a total value of £1.7bn, each of which involves the UK Government, as opposed to the private sector, taking the project risk for the particular tranche of financing which benefits from the guarantee. Our report recommends a package of measures including: a review of eligibility criteria; improved risk reporting; development of an additional pricing methodology based on an appropriate capital charge; increased use of expert challenge; a review of pricing techniques; and consideration of how to maximise competition and transparency in the allocation of all government-guaranteed debt, to minimise the premium over government-issued debt.

The Government’s National Infrastructure Plan (NIP) contains a pipeline of £327bn of infrastructure investment, both public and private, planned to 2020/21. This anticipates that 79% (averaging £37bn a year over the seven-year period) will involve private financing, whilst the remaining 21% (averaging £9.6bn a year) will consist of direct public investment. In our report, The choice of finance for capital investment, we outline a range of recent developments including the modifications to public–private partnerships through the introduction in December 2012 of Private Finance 2, long-term contracts for renewable energy (contracts for difference), and other forms of government support for private investment (for example, traffic and volume guarantees).

We highlight the wide range of implications for the national accounts and departmental financial statements, and question the extent to which various discrete initiatives represent a comprehensive response to the challenges set out in the NIP.

The original version of this article was published in the June 2015 print edition of the Securities & Investment Review.