Jim Cuthbert, a former chief statistician for the Scottish Office, is the author of a new Common Weal report on PFI

TWO of the main downsides of PFI, and other forms of public private partnership (PPP), have become increasingly apparent in the years since the use of these forms of partnership became widespread in the UK.

On the one hand, in many schemes, the equity investors are able to extract eye-watering and clearly excessive profits by selling their equity stakes soon after the construction phase of the project is completed. But on the other hand, it is depressingly common for other PFI schemes to fail, or hit major problems. What the evidence shows is that these two features were actually inevitable, given the way PFI was set up.

The whole point of PFI was to enable the public sector to procure capital assets – such as new schools, hospitals, roads – without this expenditure appearing ‘on the books’ of the government. In other words, the relevant expenditure had to be counted as current expenditure, rather than public sector capital expenditure, according to the rules of national accounting.

To achieve this, two main features had to be built into the design of PFI and other PPPs. First of all, the provision of the capital asset had to be bundled in with the provision of services. So, for example, the Government was not buying a hospital, but contracting to receive the services of a fully maintained facility for a 30-year period.

Secondly, it had to appear that a substantial amount of risk was being transferred to the private sector providers of the bundled service. If these two requirements could be seen to be met, then the national accountants would classify the unitary charge – which the public sector would pay for 30-years to get provision of the serviced asset – as current expenditure by the government. Therefore, the building of the asset would not appear on the government’s books.

READ: PFI - The disaster we should have seen coming

These two features, bundling and risk transfer, inevitably meant that a substantial risk premium will be paid to the equity owners of the company delivering the project, over the 25 or 30-year life of the project. It is this feature, the payment of a substantial risk premium over an extended period, which makes the twin downsides of PFI/PPP inevitable.

The reasons for this are technical and are explained in the paper. But, effectively, if the equity owners of a PFI/PPP project come to the secondary PFI market to sell their equity stake, what they will receive will be what is known as the net present value of the projected stream of equity returns, calculated at a particular discount rate – where the discount rate in question is the rate of return the secondary market buyer is seeking on their investment.

So what is critical in determining secondary market behaviour is the slope of the net present value function at different discount rates. What the paper shows is how paying a substantial risk premium over an extended period implies a steeply sloping net present value function.

This generates huge returns in the secondary market if things appear to be going well with the project – but a sudden collapse in value if problems appear. This accounts for both of the observed features with PFI: excessive profits in some schemes, and failure in others.

These problems should have been apparent when PFI was being set up, but were missed.

More importantly, solving the problems involves a fundamental re-design, which takes out of the system the long-term payment of a substantial risk premium to equity holders. Neither the English redesign of PFI, PFI2, nor Scottish initiatives – like the non-profit distributing scheme and the hub approach – have achieved this.