14 July 2006
The PFI faces a combined attack from national statisticians and influential accountancy bodies. There is a lot at stake, including the chancellor's fiscal rules, reports Don Smith
Opponents of the Private Finance Initiative have long argued that the popularity of this funding method has a great deal to do with its tendency to be off balance sheet and its non-appearance in national debt figures. Well, their analysis is about to get truly tested.
The Office for National Statistics has said that it intends to include some of the money invested through PFI projects in the figures for national debt. Currently, privately financed projects do not score in the main indicator for assessing the UK's public finances – public sector net debt. This is so regardless of whether the borrowing is formally on the balance sheet or off it.
The PSND figure is compiled from annual cash deficits and surpluses, which do not include capital expenditure delivered through private sector financing. The logic is that the PFI 'unitary charge' is paying for services, rather than being debt repayment.
This treatment has been controversial because it provides the Treasury with an accounting-driven incentive to promote the PFI over other forms of procurement regardless of their relative economic merits, as it improves the appearance of the public finances.
This incentive is sharpened by the sustainable investment rule – one of Chancellor Gordon Brown's two main fiscal rules – which states that borrowing should not exceed 40% of gross domestic product.
The use of the PFI has made it easier for the Treasury to meet this rule over recent years.
According to this year's Green Budget from the Institute for Fiscal Studies, PSND would have been 3.4 percentage points higher in 2004 had all the currently operational PFI projects been delivered through public financing. Through using PFI, the Treasury was able to reduce the figure from 36.3% to 32.8%.
The chancellor has much less room for manoeuvre now. The PSND figure stands at 36.8% of GDP, and the Treasury forecasts 38.4% by 2009 (see table).
In addition, the capital value of signed PFI deals increased from £42.7bn at the time of the IFS's calculation to £48.4bn as of March 2006. And there is £10.7bn-worth of schemes at the preferred bidder stage. If we can take these figures at face value, it is clear that adding even a fraction of PFI investment into PSND would place the sustainable investment rule at risk.
But even such supporters of PFI as the Institute for Public Policy Research have suggested that this must be done to reduce the distortionary incentive.
The national statisticians seem to have finally woken up to this issue. Describing PFI commitments as 'debt', the ONS said that 'conceptually' an element of the debt created by PFI must appear in PSND. This element will not, however, be the whole of the 'capital value' of the project that the government uses in most of its calculations.
Instead, the debt's 'imputed financial lease loan' component will be added to the PSND. This is an estimate based on the assumption that PFI assets are 'leased' to the purchaser, and so are a form of non-financial loan by the contractor to the public body.
This will be much less than the capital value, but, given the tiny margin for manoeuvre on PSND by 2010, even a small increase will be problematic, unless other ways of manipulating the figures can be discovered.
It is important to understand that the 40% debt-to-GDP target ratio is little more than a political tool, and, according to economists, has not been derived from economic theory or from experience.
There is no reason, economists argue, why a 40% ceiling is any more desirable than, say, a 30% or 50% one. Indeed, the majority of European Union member states have much higher debt-to-GDP levels.
The IFS also notes that the 40% figure is politically, rather than economically, derived. 'The 40% ratio appears to have been chosen in effect as a commitment not to allow debt to rise again to the levels inherited from the Conservatives,' its 2006 Green Budget states.
So talk of deteriorating public finances or the inevitability of tax rises – two hares that the ONS changes have set coursing in the press – is surely wrong-headed. This is a political problem for the chancellor, rather than a catastrophe facing the nation, and the incentive it generates is, similarly, a political one.
So what is the future for the PFI in the context of this blunted incentive? The answer cannot be provided until we know the outcome of a battle waging between international and domestic accountancy bodies and the Treasury. This is because the ONS changes will apply solely to schemes whose investments are on departmental balance sheets.
For now, these are in a small minority, despite government claims to the contrary. In Meeting the investment challenge, published by the Treasury in 2003, officials said that 57% of PFI schemes were on the balance sheet, implying that the allegations of jiggery-pokery in PFI accounting had been overstated.
But this figure is misleading. Of the £20.2bn (out of £35.5bn) the government recorded as on the balance sheet, £16.1bn is accounted for by the London Underground public-private partnership. Excluding this project, only £4.1bn, or 21% of the PFI programme, is on the government's books.
In addition, the inclusion of the entirety of the London Underground PPP in this calculation is inconsistent with general practice. According to the Treasury's Red Book, the PFI deals for London Underground are coming on to the balance sheet at a rate of about £1.5bn a year, reflecting the incremental and continuing nature of that investment programme.
To place the entire capital value of the deals in this calculation seems like politically driven sleight of hand. With billions of pounds in off-balance-sheet schemes signed since Meeting the investment challenge, it is likely that less than 20% of the total PFI investment is now on the balance sheet.
This is because – just as the Treasury has had an incentive to pursue the PFI to remove borrowing from its national debt figures – departments have an incentive to get PFI projects off their books, on pain of taking a charge against their capital budgets.
In the latest General report of the comptroller and auditor general, the National Audit Office comments: 'Obtaining good quality services at value for money should, of course, be the major incentive of PFI deals. But in addition to that objective, there are also more practical incentives for public sector bodies to structure projects so that the assets (and the corresponding liability to pay for the asset) are not recorded on their balance sheet.'
Having reported its concerns about this since 2001, the NAO expressed its disappointment that 'there seems to have been little visible progress in the revision of the relevant Treasury accounting guidance or the lessening of the incentives that lead public sector bodies to seek off-balance-sheet status for their projects'.
Perhaps the biggest effect of the ONS changes is that the Treasury too has an incentive to try to ensure that projects remain off the balance sheet, structuring projects accordingly, rather than focusing on what makes most economic sense. As long as projects remain off the balance sheet, the PSND will not be affected. Place these on the balance sheet and it will.
The government's comfort zone will soon be eroded, however, as a debate within the accountancy profession starts to heat up. The Financial Reporting Advisory Board, one of the bodies that advises the Treasury on accounting standards, has told officials that it would prefer all projects to be on the balance sheet.
The issue is being looked at by the international financial reporting interpretations committee of the International Accounting Standards Board, but both the NAO and Frab have criticised the body for taking too restrictive an approach.
In its 2006 annual report, Frab comments: 'While the board welcomed Ifric's contribution to the debate on accounting, it believes that the scope is severely limited and that the proposals in this draft are unlikely to meet the stated aim of the draft interpretations of providing guidance on how service concessions should be accounted for.' It has recommended that Ifric works with the International Public Sector Accounting Standards Board to resolve this issue.
With the ONS changes in train, the Treasury is trying to ensure that the off-balance-sheet status of PFI can be preserved, knowing that, with all PFI schemes on the balance sheet, the 40% debt-to-GDP ceiling would be breached. The Treasury has refused to adopt the IASB's latest international financial reporting standards until the matter is resolved to its satisfaction.
But Frab is fighting back. It says: 'It is now clear that in the medium term (under any convergence strategy), most PFI schemes are likely to come on the public sector balance sheet under IFRS.'
Amid these disputes, the central issue has fallen out of view. Whether the sustainable investment rule's prescription is broken is peripheral in economic terms. Yet attempts to meet it continue to create discrepancies in government accounting, and lead to incentives that affect the efficiency of investment policy.
The government says that the PFI should be used only if it brings demonstrable value for money, but it simultaneously uses an economic appraisal system in which, for large schemes at least, it is always the chosen option. It is possible that the accountancy profession itself will provide a resolution. It is certainly high time that this accounting-driven policy was allowed to stand or fall according to its economic merit.
PFjul2006
