THE incoming Labour Government’s intention to utilise private finance to unlock infrastructure investment has certainly rung alarm bells. So, let’s look at some of the lessons from past attempts to use private finance which need to be taken on board if any future implementation is to be successful.

Private Finance Initiatives (PFIs) were introduced by the Conservatives, but enthusiastically taken up by the Blair/Brown Labour administrations. The problems with PFI are too well known to rehearse in detail – but it turned out that PFIs were very expensive (“one hospital for the price of two”), resulted in the provision of assets which were often poor quality and inflexible, often gave rise to grotesquely inflated profits for the private sector equity investors, and, if things went wrong, it was quite clear that risk had not actually been transferred to the private sector.

Fixing the flaws in PFIs for any new implementation would be difficult, but there are some obvious things which could and should be done in any redesign – and which would be a relatively straightforward way of avoiding some of the past mistakes.

For example:

  • With PFI, the government relied heavily on revolving door recruits from the financial sector itself when designing and implementing the system. Repeating the over-reliance on the private sector to provide the design “expertise” will just repeat old mistakes.
  • Make sure those risks for which the private sector is being compensated are actually borne by the private sector.
  • Don’t overestimate the level of return required to attract private sector investment.
  • Put relevant clauses in contracts to ensure ownership is not subsequently transferred to offshore tax havens.
  • Don’t go for schemes which are so large and complex that there are few bidders, and hence over-pricing.

Improvements like this are essential, but will not be enough on their own.

What has also to be addressed is what is, in many ways, the fundamental flaw in private finance schemes like PFI – or Regulatory Asset Based (RAB) pricing. (RAB is the scheme used in funding utility infrastructure investment, with whose effects on the water industry down South we are now all too familiar. It is also proposed to be used in new nuclear schemes).

The fundamental flaw relates to what happens if there is a mismatch between the profiles of risk and reward. What do I mean by this?

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This is best explained by way of an example. Consider a typical PFI scheme for the provision of, say, a hospital. Under such a scheme, a private sector consortium will borrow from the banks, and put in some equity capital of its own, to fund the construction of the hospital over, say, a four-year period.

Once the hospital is operational, the consortium will typically receive a regular unitary charge payment over the next 30 or so years to cover the original financing costs, the maintenance of the asset, the provision of some services, and also to cover the risk elements the private sector has agreed to take on.

By common consent, however, the bulk of the risk in such a scheme attaches to the initial construction period, whereas the payments the consortium will receive will be spread fairly evenly over the next thirty years. Once the construction phase is successfully over, the consortium owners will be looking forward to receiving a low risk set of returns to compensate them for their original equity investment.

This set of returns will be an ideal investment for something like a pension fund, which is looking for a low risk, guaranteed investment. So the equity owners will, in effect, be able to sell off their future returns to a pension fund or similar body, for perhaps multiple times the amount of equity capital originally invested. By doing this, they will be able to recover their investment after four years, plus an annual return over this period substantially in excess of the originally projected return to equity.

READ MORE: Bankrupt hospitals, collapsed schools and billions in debt: The biggest PFI disasters

This is what happened with PFIs. Research by academic Dexter Whitfield indicated that original investors in PFI schemes who sold their stakes received on average an annual 28% return on their investments.

The other side to this coin of grossly high returns to equity investors is poor value for money for the public sector client – and yet this state of affairs is virtually guaranteed by the mismatch between the profiles of risk and reward implicit in private finance schemes.

What are the chances of avoiding this state of affairs in Labour’s proposed new incarnation of private financing? Well, that depends on what Labour are hoping to achieve. But if it is their hope to use private finance to get the creation of new infrastructure assets off the government’s books, and hence not counting against government debt, then the chances of avoiding the problem are very limited.

This is because, under the international accounting rules which govern the decision as to whether a new asset is on or off the government’s books, effectively what you have to do the achieve “off book” status is to indulge in the charade that you are not buying an asset, but are purchasing a stream of services – namely, the use of a serviced asset over an extended period.

That charade involves paying for the use of the asset by a stream of service payments extending far into the future, (like the unitary charge payments under PFI). This virtually guarantees the kind of mismatch problem identified here.

Accounting systems are meant to provide sets of rules designed to keep us operating prudently and safely. But when blind adherence to such rules pushes one into a course of action which is clearly wasteful and unsustainable – then the wise thing to do is to ditch the rules, and the course of action they dictate.

If Labour want their new private finance initiative to be a success, this is a lesson they will have to take on board. If all they are going to do is to get public infrastructure investment off the books by adherence to the present accounting rules – then we are just going to have a rerun of the old PFI and RAB disasters.

Jim Cuthbert is a former chief statistician at the Scotland Office, taking an early retirement in 1997. He previously worked at the Treasury and was seconded at the Organisation for Economic Co-operation and Development.