Pension Funds and Blair’s PFI Legacy

Part of the “New Labour” program of Great Britain’s former Prime Minister Tony Blair was a Private Finance Initiative. Blair explained the rationale for it in these words in 2002: “Because the government cannot afford to fix the ailing system, it wants private investors to help foot the bill.”

The “ailing system” to which Blair was making reference there was the London Underground (the “subway,” in American English), but the PFI idea is of course broader. It is a relatively new mutation for the older meme of a “public-private partnership,” incorporating many elements of what is sometimes called social infrastructure: hospitals, schools, street lighting, waste management systems, etc. Of course, these have always been constructed by private companies. Under PFI, though, other private concerns lend the money to do the building.

The private investors, unsurprisingly, expect to receive their money back with interest (or profit), so using PFI to finance, for example, a hospital will require a contract that commits the hospital or the National Health Service to specified payments over many years – in the case of the construction of the University College London hospitals, 35 years – thereafter.

Wider Range of Financing Sources

Britain’s PFI has continued through the administrations since Blair’s, and indeed has inspired emulation across the Channel. At the same time, it has stirred up a good deal of criticism, and in November 2011 the Chancellor of the Exchequer announced a plan to reform the PFI. One of the reform proposals is to seek broader participation by pension funds, or in pale bureaucratic jargon, “access a wider range of financing sources.”

Accordingly, new study from EDHEC – Risk Institute asks about Pension Investment in Social Infrastructure. In one sense, writes the author, Frédéric Blanc-Brude, PFI in particular and SI in general looks almost ideal for pension fund investment, as it promises “long-term, stable, inflation-linked cash flows.” It is critical, Blanc-Brude writes, that the public sector authorities involved in such arrangements commit “not to expropriate the rent of the efficient firm” by reneging on the stream of payments. This commitment is what gives rise to inflation indexing – otherwise inflation would itself be a mode of expropriation.

Fig. 1. Distribution of social infrastructure projects by cumulative capital investment and number in Europe, 1995 – 2009

Blanc-Brude, Frederic, Olivia Jensen, and Camille Arnaud. 2010. The Project Finance

Benchmarking Report, 1995-2009. Vol. 1. Stow-on-the-Wold: Infrastructure Economics

The very fact that the government under Prime Minister David Cameron is now intent upon reform, the fact that gave rise to Blanc-Brude’s inquiry, also illustrates his point here. Over periods of decades, government will change hands, political and ideological winds will shift more than once, and officials will adopt different views of how such contracts should be regulated.

The report pours some cold water upon any project managers who might be enthusiastic about PFI. It maintains that for the most part SI in the UK and in Europe generally is “outside the scope of direct infrastructure investment by pension funds because the average investment size is too small.” Transaction costs require that pension funds look for projects of a size that, as the above chart indicates, are rare.

The report’s Fig. 1, reproduced from a study Blanc-Brude and colleagues prepared two years ago, indicates that the number of projects, represented by the green line, drops precipitously as the scale per project, represented by the x axis, increases.

A related consideration is that pension funds that invest in such projects will of necessity be active investors. Passive investment requires “a representative basket of investable [and diversified] infrastructure assets.” This necessarily active role of pension fund management in selection and oversight in turn enhances the transaction costs.

Intermediation and Policy

The report does not pour such cold water over any mutual relations between pension managers and SI projects, only the direct ones. What is needed to make pension funds comfortable with PFI is intermediation.

The report arrives, then, at a policy recommendation: in order to attract the pension funds, the desired new source of investable funds, governments should “take steps to make sure that the benefits of intermediated infrastructure investment are real,” working along with intermediaries, such as specialist funds and funds of funds, as well as with academics and regulators, to create the investment products that will allow pension funds both to seek performance and to hedge risks.

It is unlikely that the obstacles to pension fund participation can be confronted within any one of Europe’s nation states. As a related policy recommendation, then, is PFI is to get a wider range of financing sources it requires “a pipeline of investment projects at the continent level.”

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