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Rent-a-tanker; Private Finance Initiative Print
Using private finance to equip the military. Britain's military looks to private finance

The Economist - April 15, 2006

FOR more than 100 years, the British army's establishment at Aldershot, in Hampshire, has been a hotbed of innovation. From here, expeditionary forces set out for France in two world wars and, in 1904, the first military car was tested on its muddy tracks. Now the innovation is all financial. Last week the Ministry of Defence (MoD) signed its largest ever Private Finance
Initiative (PFI) deal, a 35-year, £8-billion contract under which a private company will finance, build and maintain accommodation for 18,000 soldiers.

The contract does more than underscore the government's ardour for the PFI approach. It also reflects its daring expansion of these contracts from the mundane world of schools and hospitals to the far less predictable realm of defence. Few will quibble with the Aldershot contract, for building a barracks is the kind of thing that PFI contracts should be good for. But the MoD is also negotiating a £13 billion aerial refuelling contract. A private firm will buy 15-20 Airbus jets, fit them out to military specification, train pilots and then lease the planes to the Royal Air Force whenever it needs to top up the fuel tanks of its jet fighters and bombers (usually on their way to the front line). When not needed by the military, some of the
planes and aircrews will be rented out like U-haul trucks.

Are PFI deals the best way to finance such commitments? Many suspect that they are little more than a wheeze to get borrowing off the public balance sheet, allowing the government to spend without (officially) exceeding its public-borrowing targets. The Treasury says they are used only when they provide better value for money than old-style procurement. The evidence is mixed.

PFI contracts have a couple of advantages. First, they compel the contractor to finish on time by tying payments to the provision of service. The incentive seems to work. A 2003 National Audit Office (NAO) study found that 76% of PFI deals delivered projects on time, compared with just 30% of traditional procurements. The second is that they encourage contractors to
consider running costs from the beginning because maintenance is included in their initial contracts. This should lead to buildings that are designed to be cheaper and easier to run. And finally, they limit the government's own flexibility to cut corners. Because maintenance is included in the contract, ministers are unable to dodge repairs when money is tight.

But PFI contracts deliver these benefits at a cost. Private borrowers pay more for money than the government does. Then, too, the state must transfer some risk (for example, that a building will take longer to build than expected) if it is to gain the benefits of private-sector expertise, but that adds to the cost. Better procurement and project management is meant to offset these extra costs, but the evidence that they do remains equivocal.

Fans claim that the growing secondary market for PFI contracts, by broadening demand for them, will help narrow the gap between the government's own borrowing costs and the rate charged to refinance existing contracts. New agreements that let the state share in the gains from refinancing may lead to additional savings.

On balance, PFI deals seem to work best on projects where the government needs something simple and easily measured, says Deloitte, an accounting firm. Asking for a school with a roof that doesn't leak is a good example. But risk is difficult to price, and costs go up as it is added. That is a worry for military PFI deals: pricing the risk of war into a contract would be an impressive feat of economic forecasting.

Another problem is that the government must sacrifice flexibility to persuade the private sector to invest. That may not matter on a simple job such as building a road, where requirements are unlikely to change much. But the opportunity cost grows with the complexity of the contract. Take, for instance, the public-private partnership to maintain and upgrade the London Underground, which, at £15.7 billion over 30 years, is Britain's biggest.
"The tube is a very complicated system. Did we really know what we would want over the next 30 years?" asks Stephen Glaister, a professor of transport economics at Imperial College, London. He points to suggestions from the mayor that trains should run overnight on Fridays and Saturdays as an example. "It's a perfectly good idea, but the contracts don't allow for

The more complicated a contract is, the harder it is to write. The NAO reckons that bidding costs added £455m to the cost of the tube agreements, which run to 28,000 pages. A dizzying system of fines and rewards is meant to align the interests of contractors and passengers. But unless the state can calibrate everything properly in advance (a Solomonic task), its contractors may face perverse or inadequate incentives for the life of the agreement.

The tube experience provides ample warning of some of the hazards facing the military as it tries to wrap up the aerial refuelling contract. But it is unlikely to deter defence chiefs who face a choice of agreeing to a PFI deal or continuing to use tanker aircraft that are older than many of the pilots flying them, given the chancellor's reluctance to add to official public-sector borrowing. "It's great to throw stones at PFI," says Nick Bliss, a solicitor at Freshfields Bruckhaus Deringer, which advises the government on the matter. "But people forget what the alternative is."
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