Behind the headlines: PFI & schools (Part 1)
Oversimplification of the issues around PFI and PFI contracts continues to lead to misunderstanding
The recent media coverage of schools and maintenance services provided by private providers shows how the oversimplification of the issues around PFI and PFI contracts continues to lead to misunderstanding. Something that has plagued the industry for a number of years. We thought it would be useful to pick five of the key questions that have come out of these conversations and cut through the jargon to look behind the headlines.
The first of these explores the reality behind the concerns about maintenance costs rising.
Why are schools complaining that the costs of maintenance are going up?
In most cases, the fundamental issue is that schools’ budgets are not increasing in line with inflation (i.e. the actual cost of delivering the services).
When these contracts were created, service charges were drafted by the public sector to be subject to annual changes. This was done so they could reflect the inflationary impact, over the multi-decade duration of the contract, of changes in the cost to the supply chain of delivering the services.
Contracts typically apply the Retail Price Index (RPI) to the charges under the contract. RPI is calculated by monitoring the changes in prices of a basket of commonly purchased products. Arguably, given the nature of the costs for the supply chain, the Building Cost Index (BCI) would more closely map the actual changes in the costs being incurred by the supply chain in delivering the services to the public sector. Since 2000, the Building Cost Index has been higher than RPI for each of the last 23 years, the implication being that the cost increases faced by PFI providers have been greater than the indexation in the contracts.
During the period from 2000 - 2009, the gap between BCI and RPI continuously widened, at times as much by +5% in 2002. From 2010 onwards, the gap had started to close, with the difference between BCI and RPI reducing from 28 index points, to 4 from 2010 to 2022 respectively. This is depicted in the graph below:
Local Authority budgets have seen below-inflation increases, particularly over the last 15 years. The Local Government Association (LGA) has calculated that Local Authorities have experienced a 27% real-terms cut in core spending power since 2010. This means that, with this reduction in overall spending power paired with indexed charges under PFIs, proportionately the amount of an allocated budget being spent on maintenance will have increased.
This method of annually adjusting prices applies to many longer-term contracts, both in the public and private sectors. The alternative is for companies bidding for the Project at the outset to try and predict how prices will change over the long contract term. This is very difficult to do, so often results in a significant degree of ‘risk-pricing’ (i.e. adding in contingency to the quoted price, to reduce the risk that the costs of delivering the service exceeds the amount you are being paid to provide it). HM Treasury guidance on standard form PFI Contract provisions (known as Standardisation of PFI Contracts, Version 4 (SoPC4) states ‘if there is no indexation mechanism, the Contractor is likely to have to build a contingency into its price to cover operating-cost inflation risk and this is unlikely to give the Authority value for money (as the risk is outside the control of the Contractor and, historically, has been difficult to forecast accurately)’.