Value For Money Of Private Finance Initiate Construction Essay

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Private Finance Initiate (PFI) is a scheme devised by the governments for reforming the delivery of state activities that could not be privatized for financial or political reasons. PFI describes the provision of public assets and services through the participation of the government, the private sector and the consumers (ACCA 2004). There is no single definition of a PFI. Depending on the country concerned, the term can cover a variety of transactions where the private sector is given the right to operate, for an extended period, a service traditionally the responsibility of the public sector alone, ranging from relatively short term management contracts, through concession contracts, to joint ventures where there is a sharing of ownership between the public and private sectors. Generally speaking, PFI falls between the traditionally procured government projects and full privatization (Grimsey and Lewis 2005).

PFI falls short of outright privatization as with privatization the government no longer has a direct role in ongoing operations, whereas with a PFI the government retains ultimate responsibility. PFI is more than the traditional the one-off engagement of a private contractor to provide goods or services under a commercial arrangement. Under the PFI, the emphasis is on long-term contracts and strict performance regimes, such as Build-Operate-Transfer (BOT) or Design-Build-Finance-Operate (DBFO) projects (Grimsey and Lewis 2005).

Reasons for Undertaking PFI

There are various reasons as to why governments might undertake PFIs. The main and the most important reason provided by the governments is achieving improved Value for Money (VFM), or improved services for the same amount of money. It is a common notion that publicly procured contracts get delayed and turning out to be more expensive than budgeted. PFI intends on transferring these risks to the private sector by having it bear the cost of design and construction over-runs is another objective, which will provide VFM (Grimsey and Lewis 2005). According to Heald (2003), PFI is the procurement scheme that provides the best VFM compared to all other procurement schemes. Government considers the PFI scheme as the most cost effect means of procuring public infrastructure. The competition generated by the concept, and improved risk management are considered the positive aspects of PFI. Also PFI has certain conceived negative aspects which include the lack of agreed formulae by all stakeholders to benchmark VFM, and an increasing skepticism among the public to the PFI concept in terms of short and long term VFM (Pitt and Collins, 2006).

Components of Value for Money

The value for money assessment is not an exact science, the net result being that opinions on VFM vary from stakeholder to stakeholder. The two ends of the spectrum of interest are the commercial interests of contractors and, the interests of the taxpayer, both choosing different indices to argue their case as to VFM. This immediately raises the question, "VFM for who and what" (Pitt and Collins, 2006).

Construction risk is not the only risk that the government must be concerned about when a PFI is procured. There risks that will have an influence on the Value for Money include risks attached to site use, building standards, operations, revenue, financial conditions, service performance, obsolescence and residual asset value. All these must be taken into account when evaluating whether the PFI route to public procurement constitutes good VFM (Grimsey and Lewis 2005).

Based on the UK PFI experience, public service project managers have come up with six main determinants of value for money (Arthur Andersen, 2000). They are;

risk transfer

long-term nature of contracts

use of an output specification

competition

performance measurement and incentives

private sector management skills

Out of these competition and risk are considered to be most important.

Approaches to Evaluating VFM

There are four main approaches to evaluating VFM. When they are ordered from the most complex to the least, they are:

A full cost-benefit analysis of the most likely public and private sector alternatives

Public Sector Comparator (PSC)-PFI comparison before bids are invited

A UK-style PSC-PFI VFM test after bids

Reliance on a competitive bidding process to determine VFM.

The Public Sector Comparator (PSC) is an analysis conducted prior to the PFI implementation. The PSC is defined as a "hypothetical risk-adjusted costing, by the public sector as a supplier, to an output specification produced as part of a PFI procurement exercise". First, the benchmark cost of providing the specified service under traditional procurement is calculated then the cost of providing the same service under a PFI scheme is computed. Finally the cost of the implementation of the PFI scheme is compared with the benchmark cost calculated. Different countries use different schemes to compute PSC, out of these the UK-style PFI -PSC comparison is the most commonly used scheme for VFM computations.

Principle Factors in Creating VFM

Several factors have been identified as contributing to create VFM in PFI projects. Pitt and Collins (2006) have identified the following as important factors that create VFM in PFI projects.

Risk allocation - optimal allocation and valuation of risk

The rate of return is proportional to the risk borne in a project. In PFI, the party that is more capable of handling and managing the risk takes the responsibility for the risk. The allocation of risk is seen by many as the most crucial element in a PFI being able to achieve VFM. Majority of the PFI projects PFI evaluated show better savings when the cost of transferring the risk is considered.

A focus on outputs rather than inputs - out-put based specification

This is one of the main differences in evaluating PFI projects compared to traditional project procurement. The client specifies the outputs rather than the inputs in a PFI project.

Competition

PFI projects also undergo a bidding process similar to conventional projects. But, the bids are evaluated using different parameters compared to the conventional evaluation where only the cost of implementation is the sole criteria.

Contract duration and scope

The long duration of PFI contracts and the inclusion of the facilities management function allow the bidders to consider properly whole life costing issues in order to minimize the contract period costs. Additionally cost savings are achieved through integrating design, construction and facilities management along with optimizing operational efficiency.

Bidding costs

The barriers to entry of new competitors to PFI procurement are high. The bid costs for a PFI are typically in the order of, approximately, 3 per cent of the contract value (ref NAO).

Innovation

There is an incentive to innovate in PFI projects as the ability to innovate is directly related to the quality of the output specification and the element of competition during the initial stages.

Borrowing costs - financing of the project

Governments are better capable to borrow more cheaply than the private sector. But private sector would be able manage the capital better hence may borrow lower than the government for the same purpose reducing the cost of capital.

Private sector management skills

Private sector is considered to have better management skills compared to the public sector. The main reason for this is the personal interest towards goals commonly found in the private sector along with the levels of accountability and delegation of authority places the private sector, to achieve things to happen faster.

Client Management skills

This is directly related to the quality of the output specification and the running of the competition, or tender.

Performance measurement and incentives

These do not of themselves materially affect the empirical argument for or against VFM but they increase the confidence of the client when used correctly.

Contract flexibility

When the trend of interest rates over the years comes down reducing the cost of financing a PFI, large amounts of money can be made by refinancing the project. This can be made used in such a manner to increase the gain to the authorities and general public at large.

Evaluation of Projects for VFM

In a major study, the UK Treasury reviewed 50 large public procurement projects in the UK over the last 20 years. Out of the 50 projects reviewed 11 projects had been undertaken under PFI. On the average PFI projects showed better results compared to traditional public procurements. On average PFI projects were delivered on or before the scheduled deadline whereas 17 percent of the time traditional public procurements overshot the deadlines. The PFI projects had resulted only one percent cost overrun on average compared 47 percent overrun by traditional public procurements (MacDonald 2002).

In another study by the UK Treasury in 2003 61 PFI projects were evaluated. In this study, it was found 89 percent of the PFI projects were delivered on time or early and that all PFI projects were within budget (HM Treasury 2003). UK National Audit Office studies show that the PFI projects were largely being delivered on time compared to traditional public procurements. The figures given are 76 percent of PFI projects delivered on time against the 30 percent for conventional procurement. Also 78 percent of the PFI projects were on budget whereas only 27 percent traditional procurements were within budget. Also none of the PFI budget overruns were passed to the public but under conventional procurement, the financial costs of projects that ran into difficulties were absorbed into government budgets (National Audit Office, 2003).

In Australia, it was found that in eight PFI projects examined, the weighted average savings was nine percent across all projects (Fitzgerald, 2004).

In a study by the ACCA in 2004 found certain limitations of PFI and made the following observations (ACCA 2004).

Competition may not be an effective source of VFM because procurers become locked in to projects.

The partnership between the public and private sectors may not deliver good contract management.

Innovation in the design of buildings has been limited.

PFI generates transactions costs that need to be covered before PFI can hope to deliver improved VFM.

The public sector ultimately carries responsibility for service delivery and so risk transfer may not always occur in the ways in which the contract intended.

Based on their evaluation on the high way projects the ACCA researchers have concluded that the road projects appear to be costing more than expected as reflected in net present costs that are higher than those identified by the Highways Agency owing to rising traffic and contract changes. They further state that it was impossible to know at this point whether or not VFM has been or is indeed likely to be achieved because the expensive service contracts for maintenance which would not be required for many years (ACCA 2004).

On the PFI projects carried out on the health sector they conclude that in some cases PFI has turned out to be less economical than expected, and since these are all long term projects, it is impossible to know whether they will deliver VFM over the full term of the contract. In conclusion they say that these projects were costing more than expected and had an impact on the individual trusts and the wider NHS budget that would affect both staff and patients (ACCA 2004).

Khadaroo in his studies on the PFI projects carried out in the secondary schools sector of the Northern Ireland states that the PFI procurement process was dominated by the PFI and PSC comparison while inadequate attention was paid to the consideration of the implication of PFI on: the broader education estate, non-PFI schools, other parts of the public sector, and future generations of users and taxpayers (Khadaroo 2008). He also casts doubts on the degree of objectivity in the VFM assessment process.

Khadaroo further states that there is evidence that the PFI and PSC comparison includes assessment of non-financial criteria, at least in the case of the PFI option. However, the criteria used and the weightings were subjective and arbitrary; changes in the weightings may easily change the choice of the preferred bidder and/or shift the balance in favor of the traditional public sector procurement option (Khadaroo 2008).

Broadbent et.al., have made the following observations on PFI, risk, uncertainty and accounting (Broadbent et.al., 2008);

The PFI pre decisions process is invariably a quantitative analysis, involving costed transferred risks,

Many other risks and uncertainties are considered at the contract formation stage, but none of these are costed or determine decisions.

All the facilities management systems that are in place deal only with transferred risks. However they do not address all these risks.

Conclusions

Through Private Finance Initiate governments involve the private sector for providing public services hitherto provided only by the public sector. The reason for this new initiative was the value for money that can be achieved through the efficient operation of the private sector compared to the public sector. In this paper, the author took a deep look into the literature to see the often claimed VFM is achieved in practice. According to the reports of the HM Treasury and National Audit Office, which are government departments the PFI has provided VFM in terms of completion of projects on time and within budgets. But, independent researchers like the Association of Chartered Certified Accountants (ACCA) and academics have casted their doubt on these conclusions and indicated their reservation about the VFM provided by the PFI projects. They have also pointed out in the short comings in the methods adopted by the government organizations in computing VFM and the lack of transparency in evaluating these projects. In conclusion, it can be stated that the results are mixed as no conclusion could be drawn as there are competing and contradictory conclusions in the literature.

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