This article first appeared in Forum, The Edge Malaysia Weekly on June 4, 2018 - June 10, 2018

Finance Minister Lim Guan Eng recently announced that public-private partnership (PPP) projects have added RM201.4 billion to the national debt. This large “silent debt”, though shocking, is not unexpected. The UK also had to grapple with this supposedly “off-balance sheet” debt in 2011. There are many lessons Malaysia can learn from the UK’s bad experiences with PPP.

The UK has been one of the most active countries in using PPP for the delivery of public facilities. The PPP model used in the UK is widely known as private finance initiative (PFI). PFI was used in more than 700 projects, amounting to more than £60 billion of capital cost.

What is PFI?

PFI is essentially a design, build, finance and operation (DBFO) method of financing public infrastructure, including hospitals, defence facilities, schools, roads and social housing. It is popular in many developed economies but less so in developing economies for reasons that are explained further below. Under PFI, the private company has to raise the finance to design, build and maintain the public facility for long periods, typically exceeding 20 years. In return, the private company is paid a “regular fee” by the government.

In the UK, the single periodic fee is called the unitary charge and it is linked to performance. Penalties are imposed if the facility is not maintained to agreed standards. Hence, the private company is encouraged to be “clever” in designing and building to ensure future maintenance cost is kept low. The penalties imposed for non-performance can sometimes exceed the maintenance cost of the facility. In Malaysia, a unitary charge is not used. Instead, payments are split into an availability charge and a maintenance charge. This is against the original rationale of PFI.

Criticism of the UK PFI programme

The PFI programme in the UK faced many criticisms. The National Audit Office (NAO) as well as the UK Parliament Treasury Select Committee on PFI issued reports critical of the way the programme was implemented. In a July 2011 report, Andrew Tyrie, the chairman of the multi-party parliament committee on PFI, remarked:

“PFI means getting something now and paying later. Any Whitehall (government) department could be excused for becoming addicted to that. We can’t carry on as we are, expecting the next generation of taxpayers to pick up the tab. PFI should only be used where we can show clear benefits for the taxpayer. We must first acknowledge we’ve got a problem. This will be tough in the short term but it should benefit the economy and public finances in the longer term. PFI should be brought on the balance sheet. The Treasury should remove any perverse incentives unrelated to value for money by ensuring that PFI is not used to circumvent departmental budget limits. It should also ask the OBR (Office of Budget Responsibility) to include PFI liabilities in future assessments of the fiscal rules. We must also impose much more robust criteria on projects that can be eligible for PFI by ensuring that as much as possible of the risk associated with PFI projects is transferred to the private sector and is seen to have been transferred.”

Some even called PFI a “credit card financing” scheme for public infrastructure with its high imputed interest rates. In my previous role as PPP adviser of the Commonwealth Secretariat London, I have come across consultants from international development financing institutions who encouraged developing countries to adopt PFI to finance their public infrastructure, as though PFIs were free money or magic bullets.

Myths and fallacies

The Parliament Select Committee’s Report of 2011 was rather scathing. It debunked many of the myths and fallacies of the UK PFI model. Among these were:

•    PFI projects offer value for money. The committee reported that “the use of PFI has the effect of increasing the cost of finance for public infrastructure relative to what would be available to the government if it borrowed on its own account”. The cost of borrowing by a private company will always be higher than if the government were to borrow the money. It gave an example: if the government were to borrow the money itself, it would have been able to build 1.7 times a project procured through PFI. This is due to the different borrowing rates of the private sector and the government. Other methods could have been used in place of the more-expensive PFI to ensure facilities are maintained properly. For example, the London Borough of Lewisham established a sinking fund to ensure non-PFI schools are maintained properly.

•     Risk allocation. In PFI projects, the construction risk is generally transferred to the private company that is supposedly better able to manage the risk. However, the logic of this is questioned in the report as the cost of construction is then “fossilised” and this cost is charged to the government at a higher interest rate for the next 20 to 30 years, resulting in a loss in value to the government. Other methods such as design-and-build could have been used to achieve the same results at a much lower life cost. Moreover, some of the claimed risk transfer may be illusory — the government ultimately is accountable for the delivery of the services and would therefore not allow the PFI contract to cease.

•    PFI projects create value through innovation. The committee reported that there was no conclusive evidence PFI had created value through innovation. In fact, it was reported that some PFI projects were poor in design and construction. The Royal institute of Architects said “the quality of buildings procured through PFI schemes remained poor in many cases. The poor quality of the building designs lead to a number of issues such as rising maintenance costs over the lifetime of the building”. The NAO commissioned the Building Research Establishment to compare the design quality between a group of PFI buildings and a group of non-PFI buildings and found no “meaningful differences” in build quality.

•    PFI projects are completed on time and within budget. PFI projects are supposedly procured with more certainty regarding price and time. The committee concluded that not only there was no convincing evidence this was true, but PFI projects also took longer to conclude due to the lengthy procurement process, usually two to three years more than traditional procurement methods.

•    Off-balance sheet. For a long time, PFI was the only game in town. It allowed government agencies that did not have the capital budget to complete public facilities using private money. The cost didn’t appear on their balance sheets or liability list. This was allowed under EU public accounting rules. However, under International Public Sector Accounting Standards or IPSAS 32, all PFI debts have to be included in the financial accounts of government departments for financial reporting purposes. This will result in not only the capital cost of the PFI project being included but also all future maintenance cost — a double whammy! At the end of 2010, the government estimated that £40 billion of PFI liabilities had to be re-classified as “on balance sheet”.

•    Inflexibility of PFI. Once a PFI contract is signed, it is cumbersome to amend the terms for the duration of the contract. In the case of schools, designers faced difficulties in trying to predict how the learning environments will evolve, exacerbated by poor levels of participation of key stakeholders, including teachers, pupils and community in the design process. There have also been doubts about the direct relationship between the quality of infrastructure and the quality of pupil education.

•    Weak public sector expertise. It was acknowledged that the public sector lacked the experience and capacities of the private sector in PFI contracts. Evidence was provided about the importance of improving procurement and project management skills in the public sector. According to another expert witness, “In terms of commercial skills and capabilities, the UK public sector has spent the 20-year life of UK PFI attempting to create the necessary capacity. For many years, there seemed to be too little appreciation in the higher civil service ranks of the extent of the difficulties of complex procurements.” In many ways, PFI has exacerbated the problems in this area. Owing to the complexity of PFI, the public sector has become too reliant on expensive external expertise, and the expertise has tilted towards financial skills.

Lack of competition in the market. Competition is generally required to drive cost down and result in value for the government. The committee pointed to a lack of competition in the UK PFI market due to the high cost of bidding. The long, complex and costly procurement process limits the appetite of consortia to bid for projects and also meant that only companies with deep pockets, which can afford to lose millions of pounds in failed bids, can be involved. Smaller companies have often been excluded.

The UK PFI industry has shrunk from its heyday. It has now been replaced with Private Finance 2 (PF2), which is similar to the original PFI. The use of PFI in the UK has been severely curtailed. Many of the debunked myths of the UK’s PFI are similar to those Malaysia is facing now. As I warned governments of Commonwealth member countries, PFI projects, if not properly structured, are ticking time bombs. For Malaysia, RM201 billion is a significant sum.

H K Yong is a development banker in Malaysia. He was PPP adviser of the Commonwealth Secretariat London, where he advised governments of the 53 member-countries on PPP policies and provided capacity building to public servants.

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