Outsourcing Waste Management in the United Kingdom: the good and the bad

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Outsourcing Waste Management in the United Kingdom: the good and the bad

Introduction

Outsourcing through Private Finance Initiatives (PFI) has become a regular occurrence today as compared to when it was first introduced in 1992. Then, many were opposed as it appeared to simply be an alternative form of privatisation. Now, more than 100 PFI hospitals have been built under the last labour government and many other public services are outsourced and financed through PFI. One such public service is household waste management. In recent years, several of the largest waste management companies in the United Kingdom have undergone some form of outsourcing (including PFI). In this paper, we shall study some of these takeovers and examine the consequences, be they positive or negative. We find that the type of firm delivering contracts to these waste management companies could expose them to different risks, and we aim to understand if outsourcing is the best method for governments to provide these services.

Why outsource?

The main motivation behind outsourcing is to attempt to achieve the best Value For Money (VFM), with money, in the government’s case, meaning public funds. Value for money can be defined as, ‘the optimum combination of whole-of-life costs and quality (or fitness for purpose) of the good or service to meet the user’s requirement. VfM is not the choice of goods and services based on the lowest cost bid.’ according to U.K.’s Her Majesty’s Treasury Value for Money Assessment Guide (2006). When defining VFM, it is also common to discuss the ‘three E’s’: economy, efficiency and effectiveness. The definition of these 3 terms approved by the Value for Money Committee is:

Economy: careful use of resources to save expense, time or effort.

Efficiency: delivering the same level of service for less cost, time or effort.

Effectiveness: delivering a better service or getting a better return for the same amount of expense, time or effort.

Assessing whether one is maximising these 3 characteristics obviously varies from stakeholder to stakeholder. For universities, audits are performed. For example, Imperial College obtains public funding and is required to attempt to achieve VFM. To ensure this, ‘an audit committee (according to the Higher Education Funding Council for England – HEFCE - Audit Code of Practice) must state whether or not it is satisfied with the arrangements in place within the college to promote VFM’. From the perspective of the government, VFM is measured using both quantitative and qualitative measures. The quantitative aspect is measured using a Public Sector Comparator (PSC). The PSC attempts to quantify the net present value (NPV) of the project should it be pursued through a traditional procurement. However, one of the biggest factors in attempting to calculate the NPV is what discount factor to use. This is a subjective value which incorporates the level of risk involved. There have been accusations that this value has been manipulated in such calculations in order to present PPP/PFI projects as less costly or more efficient, providing greater VFM (Pollock and Vickers, 2000). The qualitative aspect includes factors which cannot be quantified but should be included, such as the current market state. The government uses the PSC to determine whether a traditional procurement holds more VFM than outsourcing (through Public-Private Partnerships or PFI’s).

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Waste Management Outsourcing: The reasons for it

When PFI’s were first introduced, they were justified by the basis that the private sector was more efficient at delivering services than the public sector; competition forces efficiency and innovation. In a study performed in 2003 by the National Audit Office, it was found that 73% of traditional procurement was delivered over budget and 70% of late. The Confederation of British Industry in 2012 researched 20 discrete service areas and found that opening up certain public services to the private sector would increase productivity by 11% on average, worth approximately £2 billion. Extrapolating this to the entire public service industry would allow savings of £22.6 billion – with an estimate of £190 million identified as potential savings from improved productivity particularly in waste management. Such research suggests that outsourcing would definitely deliver greater VFM. The benefits of outsourcing waste management can be seen in the case of Cornwall waste PFI.

Cornwall is a predominantly rural area, with 71% of municipal waste disposed in landfills and the other 28% recycled/composted. New UK and EU restrictions (the EU Landfill Directive) mandated reduced dependencies on landfills. In order to do so, more complex and new infrastructure would be necessary – requiring large capital injections. Cornwall’s in-house provision, however, would not be sufficient to fund the new projects. The only viable option was to apply to the government for PFI. The non-traditional procurement process began in 2003, with the winning bidder being SITA UK for a 30-year contract. SITA states that in the future, the amount of municipal waste disposed in landfills will fall to 20%. The contract also provided other benefits.

  1. Adhering to the tighter restrictions meant avoiding fines and increasing landfill taxes. It also gave confidence as it would be very certain that the price would not change during the life of the contract.
  2. Planned investment of £177 million in new and upgraded facilities.
  3. Job security for workers; most of the LAWDC (local authority waste disposal company) would be transferred to SITA UK, with increased pay for some.
  4. The movement from landfills to recycling would reduce carbon dioxide emissions by approximately 80 tonnes.

Many of the specific benefits described above apply to general benefits of outsourcing; greater price certainty, all responsibility of risk is transferred to the contractor, innovation allowing for investment etc. Without the option of outsourcing, the new infrastructure would not be a feasible option, forcing cuts to be made in other areas or facing higher taxes/fines. Many politicians also use this as justification for outsourcing, saying that public services (not just waste management) such as hospitals and universities would not be possible without outsourcing. While these consequences of outsourcing may be advantageous in certain situations, it is also possible that they could lead to severe problems within the contractor. We shall examine certain case studies where such is the case.

Waste Management Outsourcing: Problems

  1. Biffa Waste Management

Generally, private financing is more expensive than government financing. In 2002, Audit Scotland found that the cost of financing was between 8-10%- between 2.5-4% higher than if the government had borrowed money on its own account. An example of high interest payments becoming a problem for newly outsourced companies can be seen in the case of the company Biffa Waste Management. Biffa was bought by Montagu Private Equity and GIP (Global Infrastructure Partners) in 2008; a £1.7 billion deal funded through £1 billion of debt. Prior to the takeover, Biffa paid £23 million in interest in 2008; an amount covered by the company’s operating profit of £91 million that year. Post takeover, interest shot up to £176 million in 2009 with operating profit falling to £71 million – a loss of £93.9 million for the year. In 2010, this trend continues; operating profit falls further to just £33.4 million with finance charges becoming £195.1 million and a worrying £118 million for the year. Of the initial £1.7 billion paid by Montagu Private Equity and GIP, £900 million was treated as goodwill – a constant presence on Biffa’s balance sheet. Continued losses led to an impairment review of the amount stated on the balance sheet. Goodwill dropped from £938.2 million in 2010 to £115.7 million in 2012. After failing to find a suitable buyer for the company in 2012, the lenders of Biffa – Angelo Gordon, Avenue Capital Group, Babson Capital Europe and Sankaty Advisors – took over, reducing the company’s debt by 55% to £520 million. What we can learn from Biffa is that outsourcing can have severe consequences; the burden of high interest payments from the takeover led to a decrease in value and eventually the company had to be sold.

  1. Veolia UK
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The main incentive to the private sector of outsourcing is the potential to earn profits. It is this incentive which drives the competitive nature of the private sector which would, in theory, lead to greater efficiency and innovation. However, it also means that the quality of the final product itself is not the top concern of the private company; a company would be more than inclined to accept a fall in product quality if it meant greater profits. This is another worrying aspect of outsourcing. In an article for The Guardian, Lindsay Mackie describes the outsourcing of Biffa as, ‘the hijacking of the real economy by financial pirates’. Such an issue is found in outsourcing waste management to a global entity. Veolia Environnement SA is the parent company of Veolia UK Ltd. Veolia Environnement SA’s growth plan included acquisitions – a plan which accumulated large amounts of debt. To remove this debt, Environnement began a divestment plan, in which Veolia UK Ltd. would sell 90% of its UK water unit for £1.1bn. The purchase allowed Veolia Environnement SA to shift debt from its balance sheet through financing part of the bonds sold through the water unit. Such financial re-engineering can also be found in the subsidiary of Veolia UK Waste Management; the waste management subsidiary is highly leveraged as a result, increasing the risk of insolvency (Johal, Haslam, Tsitsianis & Williams). This case example provides evidence as to the dangers of outsourcing to a global entity.

  1. Greater Manchester Waste Disposal Authority

The Greater Manchester Waste Disposal Authority (GMWDA) in 2005 handled the disposal and recycling of over 1.4 million tonnes of municipal waste in the Greater Manchester area, dealing with approximately 5% of the United Kingdom’s waste. As mentioned before, the EU landfill directive required less usage of landfills and increased recycling or face the consequence of taxes/fines. In April 2009, GMWDA signed a 25 year long contract worth £631 million with Viridor Laing (Greater Manchester) Limited (VLGML), hoping to increase recycling to 50% of all waste by 2015. Mr. Swannick, chairman of GMWDA, stated in 2009 in a press release that the contract would ‘increase costs (at today’s prices) to Greater Manchester householders by £1 per week. However, this compares favourably with the cost of a “do nothing, build nothing” option which would cost an extra £2 a week mostly in Landfill Tax and penalties.’

However, International Financial Reporting Standards require the value of the assets and liabilities of the contract to be accounted for in the authority’s balance sheet. The sharp increase in capitalisation in GMWDA’s balance sheet immediately increased financial instability. This is not only due to having to report the value of the assets of the PFI contract but face the risk of impairments of asset valuations as they are marked-to-market – a significant source of financial risk. These impairments did negatively affect GMWDA. From 2011 to 2014, impairments to assets amounted to £244 million. Communities minister Eric Pickles described the contract as a ‘botched PFI deal’, blaming the ‘cost of rubbish disposal being well over the market rates’. The asset impairments left GMWDA with a net worth of negative £123 million by the end of March 2014. As a result, the authority increased levy’s through council taxes to raise funds. From 2012 to 2013, the levy was increased by 14.15% to £166.1 million, a significant increase (2.6% in resident’s council tax bills). Such is the risk attached to outsourcing using large contracts.

Conclusion

This paper has analysed the various benefits of outsourcing; the alleged increase in efficiency and innovation can be seen in certain examples such as Cornwall Waste PFI. However, we have also seen the various risks attached to different types of firms being involved in these contracts. Biffa’s takeover by Montagu Private Equity and GIP lead to large amounts of debt and hence crippling interest payments which led to large goodwill impairments. Outsourcing to subsidiaries of global entities such as Veolia Environnement SA opens the risk of the parent company loading large amounts of debt on its subsidiary. In the case of GMWDA, we can see the financial instability inherent with a sharp increase in capitalisation of the balance sheet along with potential asset impairments, leading to increased levys.

While these issues expose the risks attached to outsourcing, they do not necessarily suggest that outsourcing should not be undertaken. During the PSC, these risks should be quantified and will contribute to the discount factors used during NPV calculations. These risks may negatively affect the taxpayer (such as is the case in 2013/2014 for taxpayers in Greater Manchester) but they may only do so on a temporary basis. GMWDA has announced in its budget for 2014/2015 to have a levy increase of 0% and hopefully a reduction in the levy in the next year. The PSC will also have accounted for the current struggles of the waste management market. The current economic crisis has led to a decrease in consumption and thus less waste. The European Union’s new regulations requiring landfill volumes to be reduced by 25% has also forced companies to adapt. Compounding such problems are large retailers such as Tesco deciding to deal with its own waste instead of using waste management companies.

It is important to understand the risks attached to outsourcing to different types of firms in order for more accurate evaluations through the PSC. Doing so will allow for more effective project appraisal and thus maximise value for money.

References

Pitt, M., Collins, N. & Walls, A. (2006). The private finance initiative and value for money. Journal of Property Investment & Finance, Vol.24 No.4, 2006, 363-373.

Lonsdale, J. (2000). Developments in value-for-money audit methods: impacts and implications. International Review of Administrative Sciences, Vol. 66 (2000), 73–89.

National Audit Office (2010). The performance and management of hospital PFI contracts. Report by the Comptroller and auditor General, June 2010.

Morallos, D. and Amekudzi, A. (2008). The State of the Practice of Value for Money Analysis in Comparing Public Private Partnerships to Traditional Procurements. Public Works Management & Policy Volume 13 Number 2 October 2008 114-125.

Imperial College London (2015). Value for Money Policy. Available at http://www3.imperial.ac.uk/purchasing/externalvalueformoney

Pollock AM, Vickers N. Private pie in the sky. Public Finance 2000 Apr 14:22-23.

HM Treasury (2003), PFI: Meeting the Investment Challenge (HM Treasury, London).

CBI (2012). Open Access Report. Available at http://www.cbi.org.uk/media/1768027/open_access_report.pdf

Biffa Group Limited (2009). Annual Report and Accounts. Available at http://www.biffa.co.uk/assets/files/Publications/BGL_2009_ACCOUNTS_signed.pdf

Mackie, L. (2012). Don’t let Biffa go to waste. Available at http://www.theguardian.com/commentisfree/2012/oct/04/dont-let-biffa-go-to-waste-disposal?INTCMP=SRCH

Eduljie, G., van Eijk, F. & Perianu, F. (2012). A Model For The Efficient Delivery Of Waste Management Services. Available at http://www.iswa.org/uploads/tx_iswaknowledgebase/598299_Paper.pdf

Johal, S., Haslam, C., Tsitsianis, N. & Williams, K. (2014). Capitalising on contracting out:

Accounting for firms managing UK household waste.

National Audit Office (2003). PFI: Construction Performance. Available at

http://www.nao.org.uk/wp-content/uploads/2003/02/0203371es.pdf

GMWDA Press Release (2009) Available at

http://www.gmwda.gov.uk/news-media/press-releases?action=view&newsID=5