Labour extends Tory private finance scheme

If critics of the private finance initiative (PFI) held any hope that the scheme would be abandoned by Labour when it came to power, they were soon dashed.

The initiative for investing in new hospitals, school buildings and equipment was set up by the Tories in 1992. It was seized upon by a government looking for to answer a conundrum that has dogged all Labour governments - how can it appease the City by keeping down public sector borrowing and appeal to its core constituency by investing in new hospitals and schools?

The PFI was introduced by Tory chancellor Norman Lamont in the 1992 Budget. After the UK was forced to pull out of the European exchange rate mechanism earlier that year, the Conservatives needed to stimulate the economy and hold down public spending - and the PFI offered a relatively inexpensive way of boosting a recession-hit construction industry.

The PFI is now the major source of capital funding for local authorities and NHS bodies because ministers will not countenance the borrowing or increased taxes that would be needed if PFI were to be abandoned. Contracts worth more than ?17bn have been signed in all parts of the public sector.

Under PFI, the private sector provides the cash to build, say, a new hospital. This is repaid monthly with interest once the building opens. Bidding companies normally put together a consortium consisting of a construction firm, a bank or equity fund and a provider of support services such as catering and laundry. This provider will also receive a monthly payment.

Contracts are agreed for a set period of time - for large hospital schemes, normally 25-30 years. Deals include a number of penalty clauses, for example, if a classroom becomes unusable because of defective heating or if hygiene standards fall.

The current government often refers to public-private partnerships (PPPs). PFI is an example of a PPP, a term that can also be applied to joint ventures with the private sector where public and private money is invested in a building project.

PFI has been criticised on many levels. One is the slow pace of progress. Work did not begin on a major NHS deal until 1997 and the first PFI hospitals did not open until spring and summer 2000. The lack of progress in the early years was mainly due to the complexity of the deals, and the fact that financiers held out for strong government guarantees to protect their investments.

Labour reversed the Conservatives' "let a thousand flowers bloom" approach - where projects competed with each other to find private sector partners - by limiting the number of PFI applicants to a shortlist of centrally determined "priority" projects. The government has also attempted to streamline the PFI by developing model contracts that cut through bureaucracy and reduce the cost of external advisors.

Public sector unions have criticised PFI as "back-door privatisation" of the NHS. They are concerned that the wages and conditions of support workers who are transferred from the NHS to the private sector consortia will suffer as businesses seek to maximise profits.

Economists point out that the government can borrow money from the markets at cheaper rates than the private sector so the PFI saddles public services with higher interest repayments than if the cash had been borrowed by the Treasury.

The government accepts this but it believes that PFI encourages greater control of costs over the project's lifetime. For example, since the consortium will be penalised if part of the building becomes unusable, it is in its interest to use high quality construction materials, which in turn should keep maintenance costs low.

A seemingly obscure technical detail in the accounting treatment of PFI emerged to threaten its future in 1997. It boiled down to whether the public sector is buying an asset in instalments or paying for the provision of a service. In the former case, the deal or part of the deal would go onto the public sector balance sheet, increasing public sector borrowing and wiping out one of main reasons for introducing the initiative. However, the Treasury is relaxed about the accounting treatment of PFI deals - it believes that under the new rules PFI payments on, say, a hospital building are "off balance sheet" - in other words, treated as fees for providing a service.