transport economics - private finance initiative ("PFI")

Private Funding Initiative & Transport

Public Private Partnerships (PPP's) are joint ventures between private sector firms and public sector agencies. The Private Finance Initiative is an example of PPP where:

· Private sector firms
o Design, build and finance new projects eg Chunnel high speed rail link
o Maintain the infrastructure over 25-30 years

· The public sector
o Pays an annual charge for the completed project for 25-30 years
o Operates the network and ensures safety although the government is now proposing private sector management
o Assumes ownership of the asset at the end of the 25-30 year contract.

Decades of under spending on infrastructure, coupled with a rapid increase in demand, means the road and rail network are congested. The scale of investment needed to increase capacity is in excess of £150bn and has serious implications for public sector finances.

Arguments for the Private Finance Initiative

· Finances expensive projects that might otherwise not be undertaken. The government can invest in transport infrastructure, in the current time period, without raising taxes, increase borrowing or diverting expenditure from other priority areas such as education and health.

· Offers better value for money than public funding by encouraging greater control of costs over the project's lifetime. Unlike public sector organisations, the private sector is motivated by the profit motive. There are incentives to be more technically efficient than the public sector resulting in cost savings. Eg:

o Penalty clauses act as an incentive for firms to finish projects on time and within budget
o As contractors are responsible for maintenance costs there is an incentive for initial high quality construction.
o Private sector firms are ‘better managers’ who can improve labour productivity.
o Transfers risk from the government to firms. Profit is the reward for risk taking. All engineering projects face uncertainty. Under PFI firms assume that risk.

Criticisms of the Private Finance Initiative

Critics argue that PFI

· Offers poor value for money. Private sector firms require high profits for assuming high risk Critics argue that increased profit margins exceed the potential savings from greater efficiency. Some private sector firms are demanding rates of return in excess of 30% for investment in London Underground modernisation. This implies a pay back period of 3 years with 22 years of ‘super-normal profit’. The ‘abnormal profit’ received by firms could be reinvested in the service.

· Increase the cost of borrowing. The government can borrow money at lower rates of interest than the private sector because there is less risk of default. PFI means higher interest repayments than if the cash had been borrowed by the Treasury. Eg London Mayor, Ken Livingstone argues that a £13m bond scheme is a cheaper source of finance than PFI.

· Private sector firms seek high profits to cover risk. Engineering uncertainties often result in costly project delays or even failure. Critics argue the risk of over budget run is simply transferred back to the government by increased profit margins demanded by contractors to compensate for high risk

· The government must act as ultimate guarantor. Ultimately the government has to intervene when private sector firms fail in transport. Liability for failure ultimately rests largely with the state. Eg

o NAT's After 11 September a 40% fall in long haul flights meant the government was forced to make a loan of £40m or risk a vital public service becoming insolvent.
o Railtrack: the government has offered £500m to compensate shareholders having place the plc into administration

· London Underground: Banks are only prepared to lend funds to firms bidding for London Underground projects if the government writes ‘letters of comfort’ accepting final liability if the project fails

IMPORTANT

For a complete guide to Transport Economics, we recommend that you purchase our latest Q&A Revision Guide on Transport. Recently extended and updated, the Transport Q&A Guide provides answers to all the questions that can be asked about Transport Economics in your exams. Click here for more detail