by Stephen McPhie, CA
Partner, RSD Solutions Inc.
I call this Part 1, not because I have in mind a continuation of this blog – it stands on its own - but because I know that there is scope for many more parts to this topic. Actually, probably an infinite number of further parts!
Across the United Kingdom, many public sector projects, especially schools and hospitals, have been financed under PFI (Public Finance Initiative). The idea is to transfer risk of building and managing such projects to the private sector. (Taking billions of pounds of public sector debt off balance sheet for a government that appeared addicted to spending, taxing and borrowing may also have been an attractive factor.)
We are gradually finding out that PFI commitments are a potential time bomb for governments and local authorities that are locked into high charges and maintenance costs. It appears that risk transfer in many cases has not occurred to the extent it was thought, and many assumptions underlying future costs and funding that are embedded in contracts were poorly formulated. These contracts are typically for long periods; up to 50 years in some cases.
Public bodies are locked into these contracts just as they are to paying interest on public sector debt. PFI contract costs include not only financing costs (debt interest equivalent) but also management and other costs.
An article in Public Finance Journal[1] reports that maintenance requirements over the lives of many contracts are far in excess of what should be required and at far higher cost than they should be and NPV of cash flows to investors in some contracts studied are as much as 6 times the NPV of their equity investments.
At a time of swingeing cost cutting by governments these fixed cost commitments will make higher cuts elsewhere necessary. Many local councils have, or intend to, raise taxes by significant amounts to fund these commitments.
Also in the journal Public Finance, a report[2] cites a study by economists of PFI in Scotland (the conclusions of which may well be valid for the UK as a whole) that came to similar conclusions about the costs of PFI contracts and inadequacy of embedded assumptions.
Public bodies appear to have been taken to the cleaners by private enterprises in negotiating many PFI contracts. This has resulted in a waste of taxpayers’ money on a vast scale and also a political climate against private sector involvement in public expenditure projects. You might also say that the private sector is shooting itself in the foot by having done this. This may well be true for the sector as a whole but individual companies negotiating contracts do not take a macro view of the sector as a whole. This should be government’s job but politicians’ approaches often appear to be swayed by the easiest way to get votes at the next election. Private sector greed, expensive consultants, public money feeding private profits, etc. are easy rants for politicians. The fact that the public sector only exists because resources have been taken from the private sector does not always figure prominently in the arguments.
In my career in the financial sector in the City of London as well as the United States and Canada, I have seen, and negotiated billions of dollars / euros of contracts and seen all types of mistakes made. The lessons for businesses and anyone else in negotiating contracts is to understand the risks, decide who takes the risk and at what price, and know that unforeseen events will occur and to allow appropriately for that. (I would say also that lawyers are a valuable part of a team and have their role but should not be given roles beyond their own areas of competence. This is not intended as sleight on lawyers; rather just common sense.)
Fro the public sector, more competence and greater vision and imagination are needed in negotiating with private companies.
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