According to the CBI, Institute of Directors, and others the world fell apart yesterday because John McDonnell said that he will supply financial markets with what they really want, which is more government debt. Now admittedly, he did so by suggesting he might nationalise some indsutries and buy back PFI contracts in others, but he did not once suggest that when undertaking such activity he would not pay fair value. Indeed, from what I heard, that's exactly what he said would be paid. I accept he suggested parliament could determine that fair value, and without EU law in place it has the right to do that (because that is what taking back control means) but he did not once say that anything but market conditions would be taken into account.
Now let's look at what that means for a minute. What are the market conditions for PFI, for example? I would suggest that the clearest indicator is that when valuing the future net earnings due from these contracts (which is the only reasonable way in which such value might be determined) the appropriate discount rate to be used should be that implicit in the original PFI contract. After all, that would be reasonable; this is what can be called an 'arm's length term' i.e one set by independent contracting parties that was thought fair.
These discount rates (which effectively set the rate of return in the contract) were often quite high because it was supposed that quite large amounts of risk were transferred to the private sector when these contracts were issued (even though this rarely seems to have been the case in practice). This risk transfer was, after all, the whole reason for PFI and formed the supposed justification for the higher returns payable under this scheme than the equivalent government debt would cost. Given that this risk must still exist, because it would be unreasonable to presume they disappear when the contract was signed , then I think this argument can hold true. And it is this risk factor that should equate why, in a rational market, the higher return on PFI produces a yield that is no more attractive, despite that higher sums apparently earned, than is payable on government bonds, with which John McDonnell is proposing that the contracts be bought out.
The result is glaringly obvious. The PFI contracts will, on this basis, be worth considerably less per pound of future potential profit earned (or lost, since the contracts are to be cancelled) at cost to the public purse than the gilts that will replace them are. That means the payment due will not be the profits lost, but the profits lost when discounted heavily for risk taking into account inflation and the fact that right now the net yield on gilts is close to zero. I'm not giving examples: the evidence is that the pedants then pour onto this blog to nitpick figures. I will concentrate on principles. And the principle is that gilts are worth greatly more per pound paid than PFI. And what this means is that firstly buying these contracts in should not be expensive, and secondly that doing so makes economic sense since gilts are so cheap, so that thirdly public funds are bound to benefit whilst fourthly the market should be entirely happy with the rational compensation due.
So why the horror stories fom the CBI, et al? Three reasons. First, dogma. How dare John McDonnell suggest that the state can do anything well? That is the logic that underpins that.
Second, horror at the loss of this income stream that many will know may not be as risky as the contracts represented, and which is a sinecure as a result (not that they can say that).
And thirdly, noisy distraction from the fact that they have been rumbled.
Bring it on, I suggest. And nationalisation of privatised utilities follows much the same logic.
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I agree with your point that under contract law the PFI contractor is entitled to future profits (usually discounted at the equity IRR of the financial close model). It is equally possible that the lower cost of government gilts could cost the tax payer less than private finance.
However, profit is not the only breakage cost payable when a PFI contract is cancelled. Most breakage costs will be unquantifiable in a contract and will include
-redundancy costs
-sub contract breakage costs
-equipment & tooling disposal (some tooling may not be included on a Government owned asset list)
In addition to the breakage costs, cancellation of PFI contracts goes against the basics of procurement project principles that the entity best placed to manage a risk should own the risk.
Since there will be TUPE in most cases I am not sure how big the costs you refer to are
And you last para is baffling
I have previously been involved in schemes where the public sector has tried to “generate a saving” through buying out the PFI debt. Breaking the interest rate swaps also incurs breakage costs. The swap breakage costs are usually expensive and prohibitive.
That’s the contractors problem. No one required them to buy swaps.
Re swaps, in project finance the special purpose vehicle is thinly capitalised and could never sustain the interest rate fluctuation risk. This means that swaps are an integral part of project finance.
Re who bears the cost of breaking swaps, it would not be good value for the public sector if they expected contractors to price in the risk of the public sector terminating at their convenience. The breakage costs in the case of a termination at convenience will have a broad definition and will certainly cover swap breakage.
This makes it a public sector problem.
Only is try public sector plans more PFI
Re: Swaps.
I’ve been through the swaps breakage process in a business I was on the Board of. They’re expensive but that — as far as I could work out at the time — was largely because they’re a method by which the financial sector (swaps are held by banks) profits at the expense of its customers. Any government that’s serious about reducing the level of financialisation in the economy has a vast range of levers it can use to get them to see sense on their swaps margins. (Like, for a start, charging them for some of the state-backed insurance they get against going bust.(
There is nothing wrong with the concept of swaps. As with any contract breaking a swap will require that compensation is due for future profits. In the case of swaps this will be a mark to market valuation of the swaps.
As with a long term fixed rate mortgage, what you are buying is certainty. If ultimately interest rates fall the mortgage looks like a bad deal. It is this that is making PFI look bad.
The PFI contract template also has many advantages to the public sector e.g
1) cashflow, the tax payer doesn’t pay until capital phase complete
2) risk of ownership e.g. maintenance & availability lie with the contractor. If facility is not available you don’t pay
3) more timely completion of projects
4) Gain share mechanisms to ensure that private sector does not make excessive profits
PFI does also have drawbacks e.g can be too rigid and inflexible and the cost of private finance is higher than say through the PWLB (this has never been disputed), however the sweeping generalisation that all PFI is bad is incorrect.
I’m struggling to decide, Martin whether you are playing devil’s advocate here or considering the prospect of somebody standing on your tail.
I am not playing devil’s advocate but I have worked as an accountant and on contract negotiation on large PFI schemes and I recognise that PFI has flaws but at the same time many of the criticisms are unfair.
Historically, an example of the problem with Local Government PFI was the removal of Government “support” for non-PFI borrowing (circa 2006) but the continuation of PFI credits for PFI borrowing. This created an unfair playing field where the decision was not PFI Vs public finance but PFI or nothing. This arguably pushed projects that were not ideal for PFI down a PFI route.
That was a bad idea
But it does not mean PFI was right
Well said Richard.
Entirely agree.
I never doubted that John knew what he was doing here. He’s a wily politician. Timing is of the essence. By not mentioning the possibility of UBI I hope that he is starting to recognise that it is unworkable. However, he is still keen on LVT and didn’t mention that – for good reason politically.
UBI remains key, in my opinion
And it’s decidedly workable. But it would take vision
Met Guy Standing last weekend. His reference to the history of UBI it occurred to me that these were times before the welfare state and later adherents like Friedman abhor public goods and services. We now have a social wage and UBI is distortionary and unnecessary.
You’re not aware of current thinking Carol
No danger of that then.
If UBI causes people to drop out of the workforce or reduce their hours, which is what the aim seems to be, output also falls without doing anything to also lower demand so prices will rise. It’s a lovely ‘what if…’ but it’s inherently inflationary and therefore not a good idea.
A job guarantee scheme is a far better idea.
I think you really need to do a lot more reading
Many thanks for this lucid and ‘voter friendly’ account!
The CBI are just going thought the motions and doing what they think that their members expect them to do. They know that public sentiment does not generally favour privatisation and McDonnell knows that too.
https://yougov.co.uk/news/2017/05/19/nationalisation-vs-privatisation-public-view/
Politically, the details that you are discussing are not centre-stage right now but they will become more important and it is good to see that people such as yourself are ahead of the curve in that regard.
[…] all PFIs is incalculable. There is a finite sample of contracts. It is relatively easy to foresee a methodology for appraisal that parliament might adopt to assess worth. And we can be sure that if it was not worth buying a contract back parliament need not approve […]
Just a thought. If you take the M6 relief road, now owned I think by John Laing Infrastructure fund, the contract would have been signed over 10 years ago when interest rates were much higher than now. Is that rate really the best one to use?
Yes
Because it discounts rates very much faster now
There’s a clue in the headline ,Richard: ‘using the right economics’.
I can see this going to fairly high courts; (assuming it goes anywhere) who/which body will be the final arbiter of ‘fair value?
(Not the FRC I hope on recent showing!)
Given that pensioners and pension investors typically have shares in infrastructure funds such as John Laing because of their reliable income streams, compulsory purchase at a deep discount will put extra strain on the public finances, won’t it?
Why?
Public investment is the basis of sound pensions
PFI cannot deliver that
How will taking PFI back in house affect the original reason for them, that is to make sure no more than no more than 3% of GDP is spent on public services as per the EU Stability and Growth pact? All the time we are in the EU we have to abide by the convergence criteria.
We won’t be in the EU
Maybe you have not noticed
But you were in favour of EU membership not long ago
I still am
But I accept what’s likely
Simon at 3.04.
You just don’t get it do you?
A job guarantee scheme is a seriously bad idea. Seriously bad. Like building pyramids perhaps? In your imagination are you making bricks (with no straw) or wielding a whip? Or perhaps you fancy the pyramid is for your very own final resting place?
I think Richard is right and you should read more, (or even get out more and observe the world around you)
A good starting place would be Rutger Bregman’s ‘Utopia for Realists’. It’s not a difficult read and it’s not full of tables and figures. Read it. I dare you to risk having your complacent prejudices questioned.