Devolution is about to force Scotland into a new PFI

On April 30, 2019, the Scottish Futures Trust (SFT) published a paper looking at how the Scottish Government could get capital expenditure on public infrastructure “off the books” in the light of Eurostat’s developing interpretation of the European System of Accounts rules. In particular, the SFT paper looked at the option of adopting the new Mutual Investment Model. With very little delay, Derek Mackay then announced on May 30 that the Scottish Government would be introducing MIM for some future revenue-funded capital projects – instead of the formerly used non-profit distributing (NPD) and hub models.

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This started with changes in the European System of Accounts – specifically, the introduction of the latest version, ESA10, in 2014. These changes meant that the Office for National Statistics subsequently classified capital expenditure procured under the Scottish Government’s NPD scheme as falling on the government’s books, rather than being off book. It also became clear that the same fate would befall capital expenditure procured under another major Scottish Government scheme, namely revenue-funded hub projects.

This posed a major problem for the Scottish Government, since it threatened its ambitious plan under the National Infrastructure Mission to increase capital investment in Scottish public infrastructure. Without the ability to undertake “off the books” revenue-funded schemes, the Scottish Government would have no chance of meeting its targets. Hence the request to SFT to investigate the MIM model, and the subsequent decision to implement MIM.

The MIM model was recently developed in Wales, specifically to achieve “off the books” status under the new accounting rules. It is a form of public-private partnership, with a typical project life of 25 or 30 years. Under the MIM scheme, the providers of equity capital will be rewarded through the return on the subordinate debt capital they invest, and also through the potential for taking dividends: this is like the original form of private finance initiative (PFI), but unlike the NPD model in Scotland, where the potential for dividends was limited. Unlike the original form of PFI, the public sector client will be able to inject equity capital themselves, up to 15-20% of the total equity raised. Apart from the ability of the public sector client to invest in their own scheme equity, MIM has the main features of old PFI.

READ MORE: PFI: The disaster we should have seen coming

The SFT paper does indeed indicate that there would be extra costs associated with MIM. For example, on the principal interest rate variant considered, the SFT estimates that total costs under MIM would be about 23% greater than funding capital by public sector borrowing. The SFT paper also acknowledges that the move towards MIM in Scotland and Wales, which is dictated by the constraints of the devolution fiscal settlement, is anomalous compared to what is happening in England, and indeed, other European countries, where the movement is away from PFI-like public-private partnerships.

As evidence of this, consider the following two quotations from the SFT report itself: “The Scottish and Welsh governments are proceeding with this type of investment model where borrowing is constrained, and additivity is a key factor. The UK Government which does not have the same constraints on borrowing has decided not to proceed with this type of investment model at present.”

And: “The concept of additionality which is key to Scotland (and was to Wales in developing its Mutual Investment Model) is not typically an issue that other European countries focus on. This is in part due to their ability to access other sources of funding such as borrowing powers where Wales and Scotland cannot beyond their capped borrowing limits.”

While this is bad enough, it turns out that the real situation is actually a good deal worse, because the SFT paper significantly underestimates the actual likely costs of MIM – and the scope under MIM for excessive private sector equity profits. This occurs, for example, because the SFT report does not adequately recognise the extent to which the size and complexity of MIM projects is likely to restrict competition, leading to poor value for money. Because the SFT report considers an artificially restricted range of public sector comparators, hence underestimating the likely excess cost of MIM over public sector borrowing. And because a questionable choice of subordinate debt interest rate in the SFT’s principal variant has a similar effect. Moreover, by choosing to illustrate an unrealistic profile for the likely rewards to equity holders, the SFT paper implicitly understates the likely ability of equity holders to extract excess profits. More detail on these points can be found in a detailed critique of the SFT paper which I have recently published as a Commonweal analysis paper, available via commonweal.scot.

READ MORE: £199bn bill for taxpayers over PFI projects, watchdog warns

The upshot is that the Scottish Government is adopting a model which has the worst features of old PFI. With the likelihood of poor value for money and excess profits on the scale of old PFI.

Partly this poor outcome reflects errors in process. For example, if the SFT paper had been part of a proper consultation, it is likely that the weaknesses in its analysis would have been identified before the final decision was made.

But above all, the decision to implement MIM is a product of the context within which the decision was taken – namely, the straitjacket implied by the flawed devolution fiscal settlement. It is extraordinarily worrying that Scotland (and Wales) are being forced, by the limitations on their capital budgets and borrowing powers within the devolution settlement, down a PFI-type path which has been abandoned by England and by most other countries operating under more rational financial regimes.

What should be done? Principally, the Scottish Government should be much more willing to challenge the status of the current flawed fiscal settlement. An ideal opportunity to do this is likely to present itself soon after the General Election which is clearly imminent. After that election, it is probable that the SNP will in effect hold the balance of power at Westminster. While it will want to use that power primarily to pursue a path to independence, it should also use it to secure the fallback position of a thorough review of the fiscal settlement. These two goals are not inconsistent. If Westminster is reluctant or awkward in negotiations on improving the current fiscal settlement that can only benefit the case for independence.

But the Scottish Government should also be prepared to challenge on other, more technical issues as well. Here are two examples.

First of all, the question of the Scottish National Investment Bank is very relevant here. This is a significant, and worthwhile, SNP initiative. Early aspirations for the SNIB had been that it might provide a cost-effective way of levering finance into investments in public infrastructure – as well as its primary purpose of providing longer-term finance for promising and potentially strategically important private sector companies. However, the rules and regulations surrounding government-supported finance mean that the SNIB will effectively be limited to lending to private companies. The Scottish Government should be prepared to challenge the Treasury on the restrictions surrounding the operation of the investment bank.

Secondly, if the Scottish Government is forced down the MIM route, it should be prepared to challenge Eurostat on the structure of that model. One of the problems with the MIM model as exemplified in the SFT paper is that it assumes an essentially flat profile through time for the stream of finance payments. Since the bank lending component of finance charges is likely to be paid off relatively early in a project’s life, that implies that the returns to the equity investors will, conversely, tend to be weighted towards the later years of a project. It was precisely this type of end weighting which led to some of the grotesque returns to equity in old PFI deals. When I raised this point with SFT, they said that, in their view, the flat overall financing profile is an inescapable requirement for meeting the accounting requirements for getting MIM schemes “off the books”. This is a view that should be challenged – if necessary, forcefully, with Eurostat itself.

The Scottish Government may not win all such challenges but it should certainly win some of them. But the very act of challenging will bring to the forefront the flaws in the current devolution settlement, and the fiscal rules surrounding that settlement. So the blame for the sub-optimal outcomes which will inevitably result under the present settlement will rest where it should belong – primarily with Westminster – rather than on the shoulders of the Scottish Government.