Financial black holes: accounting for privately financed roads in the UK

Executive Summary Introduction It is held as axiomatic that citizens, or at least their political representatives, can see how society’s resources are being used. However, the increasing amount of public money now spent outside direct state control raises questions about whether the system of public expenditure reporting and disclosure can deliver accountability for public monies. This report seeks to understand the implications of the turn to private finance for accountability to citizens. It examines empirically the financial reporting and disclosure of expenditure on Public Private Partnerships (PPPs) in the roads sector by both the public and private sector partners and the government, as reflected in national statistics, in order to establish the degree to which the reporting of PPP meets the Treasury (2003a) ideal that it should provide accurate, transparent and credible accounts that allow the public to judge the scope, direction and sustainability of public spending and investments. The roads sector was chosen because PPP takes a significant proportion of the roads budget, and it is the largest and most international of the PPP sectors. The financial viability of roads projects depends upon the ability to generate sufficient traffic to recover the full costs over the life of the contract, including the cost of debt and equity. But should traffic flows be low or lower than predicted, then the roads will operate below capacity, making them difficult to fund. This then necessitates some combination of higher tolls, capital grants and public subsidy, distorting rational capital prioritisation and resource allocation. Consequently, whether government and/or users fund the service, this policy raises questions about how the public sector’s contribution and forms of support are accounted for and disclosed at agency, governmental and national income accounting levels. The public therefore have a legitimate interest in scrutinising their cost and the financial viability of both the projects and their operators. Such scrutiny presupposes the availability of clear, relevant, reliable and timely information about public expenditure and future commitments. In so far as PPPs are replacing the system of public ownership, financing and funding that developed in the nineteenth and twentieth centuries, this may render the system of disclosure and control of public expenditure, developed in a previous era, inappropriate. Traditionally, public sector reporting has been concerned with ex post annual disclosure and reporting for probity, stewardship, control and sustainability purposes. But with no agreed definition of a PPP and such a wide diversity of models, this creates a challenge in developing a consistent reporting and accountability framework. Research Strategy The research strategy is three-fold. First, literature is reviewed to understand the operation of the policy, current reporting practices and the degree to which they deal with the complexities created by PPPs. This review is then used to devise a governance-based reporting framework. Second a case study method is used. Six PPP road projects were investigated, with a combined capital value of £1.3bn, that is, 40% of the total capital value of signed deals for roads and bridges. The cases include large- scale projects, commissioned by different types of public entities and embracing a variety of different financing and funding regimes. A traditional public sector procurement project is used for comparative purposes. Third, the governance-based reporting framework is used to analyse the actual reporting by both the public and private sector partners for each of the cases. The methodology relied on an analysis of documents that are either in the public domain or were requested under the Freedom of Information Act or the Audit Commission Act 1998. The annual report and accounts, ex ante business cases, contract documentation, official and regulatory reports, business plans, ex post facto evaluations and project reviews were sought. In some cases, clarifications from both the public and the private sectors were sought via email, telephone, and face- to- face discussions. Research Questions and Findings The research posed four inter-related questions and the following summary shows the major findings for each question in turn. What additional problems does the PPP policy create? PPPs have become the keystone of the British government’s reform of the public sector, and their scale and scope are both significant and rising, especially in the roads sector, but the problems surrounding them take several forms. Firstly, the context in which PPPs operate and the operation of the policy differ from that set out formally in the law, regulations, concessions, licences and government budgets with the result that the real distribution of risk and costs may fall more on taxpayers and users and less on the financiers than the apparent distribution would suggest. Secondly, PPPs remove public expenditure from the direct control of the public sector and establish contractual relations over very long periods of time that have the effect of committing future governments and taxpayers to expenditures that impact on these and other public services. Thirdly, the institutional arrangements for the financial reporting of PPPs do not provide disclosure that is useful for the public. Accounting for income streams, assets, liabilities and any contingent liabilities is more complex and controversial than accounting for traditionally procured infrastructure and services. Public sector accounting has now become embroiled in issues that have long been problematic in the private sector. These complexities limit the usefulness of the private sector reporting framework for the reporting on and accountability of PPPs. What is the European Union’s role in PPPs? The EU plays a limited direct role in PPP policy or individual projects. As such, PPPs are essentially an issue for each member state, and there is therefore a wide variation in the use of the policy which inevitably gives rise to tensions between political, technical and commercial interests. The EU’s role is nevertheless important for a number of reasons. First, its rules on procurement, competition and competitive dialogue impact on the way that projects are designed, advertised and negotiated. Second, since the EU is broadly in favour of PPPs there are institutional pressures to facilitate this method of procurement by adopting accounting treatments that encourage the policy. The EU formally approves IFRS for unit level reporting and in terms of national accounting, Eurostat has provided guidance for reporting PPP assets in the European System of Accounts. What reporting and disclosure is needed for public accountability? This study identified three inter-related information flows. First, is the traditional upward flow from public authority to Parliament. The second and newer flow, the downward flow of information to citizens has become increasingly important as a legitimising rhetoric of public service reform. While it includes external scrutiny by Parliament, it is also wider, embracing non-financial information about access to services, service performance, and transparency and equity in resource allocation. PPPs give rise to a third and horizontal flow, from the private sector partner acting as de facto public authority. Information held by private sector companies is also crucial for accountability for public expenditure. Without the horizontal flow both upward and downward accountability has little substantive meaning. In the context of PPPs, the public needs to be able to understand: the basis for and nature of the procurement decision; the costs of contracts; the values of any reported assets and liabilities, including contingent liabilities; any public subventions; the financial viability of both the projects and their operators; and the termination arrangements for completed projects. Thus accountability to the public implies forms of reporting and disclosure over and above the private sector oriented financial statements that enable judgements about VFM and the impact of large projects on budgets. Accountability also implies information that is straightforward to locate and understand. To what extent does current reporting of PPP projects provide public accountability? This study has shown that there is a lack of clear, consistent and complete information, designed for use by the public and provided on a routine basis by all levels of both the public and the private sector. Not only is the routine reporting inadequate, the right to additional information via Freedom of Information and the Audit Commission Act is very limited. More information is forthcoming when the level of popular opposition to a project provides the impetus for press articles and a NAO investigation. The public sector has adopted a framework of reporting intended to meet the needs of shareholders as investors. This means that in the context of DBFOs, information of value to citizens, especially in relation to actual against expected expenditures, estimates of future expenditures, risk transfer, and contingent liabilities, is not reported as part of the annual report and accounts. In the private sector it has long been recognised that the presentation of consolidated accounts for large diversified organisations is problematic for shareholders because it disguises the risk profiles of individual segments. This is now being replicated in public sector consolidations where Departmental accounts made up of numerous public authorities may disguise the risks involved in the turn to private finance. The lack of information provided by the public authorities means that the main source of financial information relating to the cost of an individual project is the SPV’s financial statements, but these too have their limitations. First, while the SPVs and their sub-contractors should be the source of horizontal accountability, their reporting is both limited and opaque. Second, their complex group structure means that there is little disclosure of related party transactions. Thus the web of sub-contracting and the accounting regulations that permit close companies to hide behind the 'corporate veil' makes it impossible to see where public money is going, and difficult to assess the total returns to the private sector. Furthermore, although the public authorities and the NAO have the right to examine the books of account relevant to the contract throughout the extended supply chain, there is as yet no publicly available evidence that either have done so. It is striking that there has been no examination of the additional cost of private finance by the public authorities themselves, yet any additional cost impacts the public authorities’ budget and must create affordability problems. Additional cost is attributed to the cost of risk transfer, but the lack of information about the original bids, the expected and actual traffic flows, the expected and actual payments, any penalty deductions, the cost of operating and maintaining the roads, contractual performance and any contractual changes means that the public cannot assess whether such costs are commensurate with either the benefits to the public sector or the risks to the private sector. Conclusions The researchers recognise the limitations of a case study approach, but believe that these findings, covering almost half the capital value of signed roads deals are robust. These findings are important because other forms of private finance are proliferating, and in connection with projects in local authorities and non-departmental public bodies where reporting is more diffuse, the accountability issues may be even more problematic. Rather than simply call for more disclosure, targeted recommendations are made, in terms of the following arguments: that information that is disclosed by some departments and for some projects but not others should be routinely disclosed by all; secrecy due to commercial sensitivity should only be permitted for finite periods of time; previous public sector accounting norms that co-located expected and actual expenditures should be reinstated; and potential liabilities arising from PPP contracts should be comprehensively collected in one location, valued and disclosed with a risk assessment attached. In conclusion, the lack of consistent, comparable, and understandable financial information in the context of PPP makes it difficult for public sector stakeholders to understand where public money is going, how it is being used, and the extent of future commitments and liabilities. This is not to say that there were ever any ‘good old days’. Rather, the increasing expenditure outside the direct control of the public bodies creates additional reporting problems. In the absence of clear financial information, an informed public debate about public and fiscal policy is impossible, and may also lead to the wrong policy choice.