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Edinburgh Royal Infirmary: Its first financial review led to a dispute over running costs that looks likely to end up in court

The thinking was always that the risky bit of a PFI project was the construction phase, when asbestos in the walls was likely to come to light, or a World War II bomb unearthed.

The operational phase that followed was supposed to be the safe bit; so safe, in fact, that a contractor that had successfully erected a building could look forward to making a fat profit by selling its stake in it to a secondary market. The buyer is happy to do this because it gains a supposedly risk-free income stream from the operational profits of the project over the remainder of the 30-year contract. For example, two years ago Carillion sold its stake in the country鈥檚 first PFI hospital, Darent Valley in Kent, to Barclays for 拢16.4m 鈥� four times its original investment. But as more schemes become operational and get to their first financial review period, this phase of the PFI is appearing increasingly risky.

This brings us to the following headlines in two Scottish papers: 鈥淧FI flagship cash row鈥� is from The Herald, and 鈥淟egal fight breaks out over ERI鈥檚 bill for an extra 拢30m鈥� is from the Evening 好色先生TV. They refer to the Edinburgh Royal Infirmary, which is fast becoming a demonstration of the problems that can occur in what was supposed to be the safe bit of the PFI:

The ERI is the leading example of this so far. It is one of the few hospital PFI schemes to have reached the three-to-five year review period, having opened in 2002, but many others will reach this stage over the next year or two.

What happens in a review is that the cost of running the facility is benchmarked against similar projects. In the case of the ERI, Consort, the PFI consortium led by Balfour Beatty, benchmark produced figures that showed that its fee of 拢7.5m a year was 拢1.1m less than it should be. It is understood that the health trust found that it was paying roughly the right amount for Consort鈥檚 services.

After nine months of negotiation the two sides failed to reach agreement and went to dispute resolution. It is thought that this granted an extra 拢800,000 to Consort. Believing its case to be strong, the trust has gone to court, and in the meantime, the parties are locked in negotiations. A source close to the project estimates the delays and legal costs have amounted to about 拢500,000 and this has hurt the cash flow of the private sector companies.

Money worries

The PFI has been an easy target for the media, and any rise in costs seem to buttress the argument that the private sector is cashing in. Firms are motivated by profit, of course, but often cost have increased because public sector clients have asked for additional services.

Consort鈥檚 figures showed that at 拢7.5m a year it was being paid 拢1.1m less than it should be for the work it was providing

One big problem is the difference between wage inflation and price inflation. Some schemes have the difference factored into the initial contracts, but those that do not face serious financial problems as the operational element of the contract is staff-heavy.

This inflation inevitably eats into the income stream. Ultimately, this might have the problem of deterring banks and funders from buying secondary stakes from equity-holding contractors. These banks are essentially commodities 鈥� they add little value to schemes 鈥� and so are competing on which can pay the best price. This already lowers their profits, and so with operational problems they could find their returns squeezed, or even wiped out.

Still worse, some of the earlier PFI contracts have 30-year operations contracts, usually at the insistence of the client for security 鈥� as Tim Stone, a director at KPMG, says: 鈥淭he early deals helped to build the market. They weren鈥檛 as stringent as the later deals.鈥� The problem then is that if wage inflation spirals out of control the consortium could easily end up making a loss, as it would not be able to negotiate the necessary increases to its payment. Also, a long-term contract is susceptible to unforeseen problems. For example, a rapid increase in the minimum wage might affect the cost of cleaning.

One funder that has developed a model to erase problems in the secondary market is I2. Michael Ryan, managing director of I2, says that secondary funds like his do not expect the same returns as those that bear the risk at construction phase, but there is still money to be made: 鈥淲e鈥檙e developing much more of a focus on running a business.鈥� This means I2 it is looking to pick up more stakes than a typical bank. It can achieve certain cost savings 鈥� for example, by bundling several stakes it can obtain more cash when refinancing, or get cheaper deals to insure the equity. Using this model means that it will take equity in smaller projects, such as schools, than many of its rivals. To achieve these savings I2 will often take on a more hands-on role than other secondary investors. 鈥淚n some projects we just turn up to board meetings,鈥� Ryan says, 鈥渂ut in others we look at operational performance to drive out financial inefficiencies.鈥� What the public sector client should remember is that the rolling negotiation is an opportunity to manage its private sector partner, not batter it. As one PFI expert puts it: 鈥淭he problem is the private sector ends up looking at things as penalties, not behaviour modification.鈥�

One leading PFI funder says that on one of its schemes it had been charged about 拢2000 a year for failing to meet the target stated in its contract for the number of phone calls it had to answer within a certain number of rings. This could have been solved by employing another receptionist at, say, 拢15,000-a-year. In effect, it saved the consortium 拢13,000 not to meet its target. He says that the renegotiation means that the client can cough up the extra 拢15,000 a year, but can also ensure far heftier fines if the consortium fails to meet the target. The renegotiation period allows the two parties to learn from previous mistakes.

Finally, it must be remembered that much of the criticism against the private sector is unfair, because qualitative assessments of the running of public buildings are not readily available prior to the advent of the PFI 鈥� although anecdotal evidence suggests that standards were not high. Cleaning is an example. It is estimated the public sector spends 拢3/m2 on cleaning, whereas it is 拢15-20/m2 in the private sector. By paying more for cleaning staff is argued that the private sector achieves higher standards.

Gary Sturgess, executive director of the Serco Institute 鈥� the contractor鈥檚 think-tank 鈥� says that PFI prisons, a fairly mature market, show the qualitative advantages of the PFI. 鈥淧risoners have more time out of the cell and more activity 鈥� and this is because of the strict terms of the contract. There is a financial penalty to perform and perform well.鈥�

Ultimately, the operational phase will mean lots of extra problems for the private sector, as well as lengthy disputes with its clients. If the parties are crafty, though, both could end up with what they need 鈥� extra funding, but better performance.