Private finance and "value for money" in NHS hospitals: a policy in search of a rationale?

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Abstract
Background Capital charging regime Until 1991 all major capital expenditure in the NHS was funded by central government from tax or government borrowing. The NHS did not have to pay interest or repay capital, so in effect new equipment and buildings came “free.” The 1990 NHS and Community Care Act established hospitals as independent business units in the public sector and required them to pay for their use of capital through “capital charges.” Capital charges are included in the prices charged to purchasers and comprise depreciation, interest, and “dividends” based on the current replacement value of the assets. To pay their interest charges and dividends to the Treasury, trusts must make a surplus, after paying their operating costs and making a charge for depreciation, equal to 6% of the value of their land, buildings, and equipment. Value for money methodology and risk transfer The government's procedure for demonstrating value for money is based on an economic appraisal that compares the economic costs and benefits of alternative investment decisions. Using it, the annual costs of a scheme financed by the PFI are summed and compared with those of a notional publicly financed scheme, called the public sector comparator. The methods used contain at least two disputable components: discounting and the costing of risk transfer. Discounting —The government's preferred value for money method states that important economic costs arise from public expenditure and its timing. It is argued that unless public expenditure reflects the market cost of capital it could crowd out more beneficial private investment. This is the cost of capital argument. Secondly, it is argued that the timing of payments is economically significant because people value consumption today over consumption in a year's time or later. This is the time preference argument. Both these economic costs, the cost of capital and time preference, are expressed in a single rate known as the discount rate. By applying a discount rate to future payments a net present cost is obtained. Thus net present cost is not the actual cash cost but a way of expressing as a single value the effect of two hypothetical economic costs. 13 14 The net present value or cost is derived by discounting future annual cash costs to reflect the time value of money—the fact that pounds spent in the future are worth less than pounds spent today (see box). This method has implications for the relative costs of the two methods of financing the project. Under conventional public procurement the capital costs are met and accounted for during the construction period, rarely more than three years, and so have relatively higher net “present” value. Under PFI the costs are spread over 30 years and the more distant payments have lower net present value. The discount rate adopted has a crucial impact on whether PFI offers better value than the traditional grant system.2 The Treasury's discount rate is 6% for NHS PFI projects, and welfare economists have repeatedly criticised it as being too high.15 Net present values What is the rate at which future pounds should be discounted? The figure shows the effect on the net present value in today's prices of £1m spent in each of years 1 to 30 using discount rates of 6% and 3% per year. The higher the discount rate the lower the net present value of payments. With a discount rate of 6%, delaying £1m worth of expenditure to year 10 gives it a net present value of £558 395 and to year 30 one of £174 110. A discount rate of 3% gives £1m expenditure a net present value of £744 109 at year 10 and of £411 987 at year 30. Risk transfer —The second element of the value for money methodology is risk transfer. This requires identification of the future pattern of risks and costs over the life of a project for a privately financed hospital compared with a publicly financed hospital. The government claims that the apparently lower cost of publicly financed investment is due to failure to take proper account of the extra costs incurred when things go wrong. Thus a key component of the value for money case is to estimate the cost of the risks transferred to the private sector and to add these costs to the public sector comparator. The next part of this article identifies the extra costs of using private finance and then examines the two central justifications for these extra costs by evaluating the evidence for and the impact of discounting and risk transfer.