How the rules got fiddled to make sure a public private partnership got pushed through

In 2008 British Columbia’s controversial public private partnership (P3) program was in trouble.

With P3s private companies put up financing for public services and infrastructure and in exchange get to manage the projects with guaranteed profits for decades.  The cost of private finance was always higher than if government borrowed the money itself, but in 2008 things got worse.  The global financial crisis dramatically drove up the cost of borrowing by corporations compared to borrowing by government.

Despite the increased cost of P3 financing BC’s provincial government remained committed to P3s.  The “solution” was to rewrite the rules.  According to information obtained under Freedom of Information, Partnerships BC, (the provincial government privatization agency) dramatically reduced the amount of money private corporations needed to put up to get the contracts.  Transfer of risk to the corporations was reduced.  The P3 schemes were allowed to use accounting practices for the projects that were explicitly forbidden for public projects.  And to make up for the cash the companies were not putting in, the province put up the money and structured it as a “synthetic loan” to the corporate investors.

In other words, despite its fixation on using private money to finance public private partnerships, Partnerships BC turned to public money to reduce costs when the wheels fell off P3s.  Then they rewrote the accounting rules to make sure the P3 looked “affordable.”

Background

BC’s newly elected government introduced P3s in 2002 with the creation of Partnerships BC.  The government press release said “Partnerships British Columbia’s mandate is to promote, enable and help implement P3 projects.”  It was largely based on the British Private Finance Initiative (PFI) model which has run into problems in recent years.

The thinking behind P3s is that while it might be more expensive to have companies  borrow money for projects, government would make up for the extra cost by transferring risk from the government to the private company, by benefiting from innovation and more efficient operations.

The theory is that private companies have an incentive to do things rights because of the money they put in – both their own equity and money that is borrowed from banks or through bonds.  In British Columbia the amount of private money committed to these projects before 2008 varied between 100% for bridges and sewage treatment and 30% for the much more costly Canada Line project. 

The private corporations generally invest something in the order of 10% of the money as equity with the remaining 90% of money borrowed from banks or through bonds.  Partnerships BC calls this an advantage because the lending agencies have an incentive to pressure the private P3 company to perform well.

In 2008 all of this began to fall apart. Due to the financial crisis, banks were reluctant to lend money at all and when they did lend money to private companies they demanded sky high interest rates.  Aside from a mandate to deliver P3s, Partnerships BC also had an “affordability mandate” on its projects which put a ceiling on how high the net present cost of the project could go.  These high private borrowing costs pushed projects like the Fort St. John Hospital over the top.

How Partnerships BC fixed its problem

In April 2008 the Provincial Government issued a press release announcing a new Fort St. John Hospital would be built as a P3 with a private partner, ISL Health.  In July 2009 the government issued another release saying construction was under way.  An attached backgrounder said that because of trouble in the capital markets, this project would be built using a “wide equity” financing model.

The background document said:

In a typical PPP arrangement, the private sector would provide both debt and equity financing for the project; however, the cost of private debt relative to Provincial debt has increased in the current financial markets.  Partnerships BC, the government agency responsible for the delivery of PPPs, explored the use of a variety of temporary credit measures to help manage these impacts and ensure the project remained affordable.

Five months later Partnerships BC and the Northern Health Authority issued a Value for Money (VFM) report on the Fort St. John Hospital shedding a little more light on what “wide equity” meant.  The VFM report said the Fort St. John Hospital would be delivered as a Design/Build/Finance/Maintain P3 with a total project cost of $297.9 million. The capital costs were reported as coming to $249.4 million, which, the backgrounder said, fell within the project’s “Affordability Threshold.”

The VFM report continued explaining the deal with the private partner:

As an innovative interim solution, a wide-equity finance structure was negotiated with ISL Health In this solution, a larger amount of equity, approximately 20 per cent, was invested by ISL Health (typically PPP projects have around 10 per cent equity). The high cost of the proposed bank debt in their proposal was eliminated on account of being unaffordable.

In other words this project had not followed the practice of letting the private partner take the risk of borrowing the money needed.  Instead, the government took on the loans. The private partner in turn boosted its equity investment – reported in the Value for Money report as 20% of costs or double the usual amount.

So the government lost the due diligence that would normally have been performed by the banks. Partnerships BC described it this way in the VFM report:

The senior lenders are also typically responsible to exercise due diligence and fiduciary responsibility over the private partner (ISL Health) under certain conditions. In the wide equity model, Northern Health has assumed the typical due diligence role of senior lenders, which for this project will be applied during construction and the operating period.

 But how much “equity” did ISL health actually put in?  As the Value for Money report said, “The DBFM capital cost components are fixed at $249.4million.”  This might lead people to think that ISL Health was contributing 20% of that figure, or roughly $50 million.  However, an undated memo received from Partnerships BC received in response to an access to information request states:

 ISL will insert $35 million in equity and the remainder of the funding required to complete construction will be supplied by the Regional Hospital district (RHD) and by NH.  NH will obtain the necessary funding via capital grant from the Province.

The $35 million contribution comes to 14% of the $249.9 million construction cost, not 20%.  And even at that, the memo continues that “The equity contribution is back end loaded and is secured by a letter of credit from a major Canadian Chartered Bank.”

The equity investment and borrowing by the private partner is supposed to guarantee they deliver what they say when they say they will deliver it.  But in the Fort St. John Hospital project, in the terms of Larry Blain of Partnerships BC, the private investor had a lot less “skin in the game.” 

Then there was the question of “risk transfer.”  Another memo obtained under Freedom of Information questioned the return the company was getting for taking on risk.  The Internal Rate of Return (IRR) is the return the company expects to get back on its invested capital.  The government memo said that the IRR the company was demanding was ridiculous given that:

• There is no revenue risk in a hospital project
• Counter-party risk is the province, so as long as the proponent manages the projects minimal equity risk
• Only political risk, which is relatively low.

So it appears that in fact ISL put in less than half the minimum amount of money we have seen go into other P3 projects. Some of it appears to have been guaranteed by a bank instead of being equity investment.  And there was relatively little risk anyway.  But ISL still got a 33 year contract.

It turns out however; that the lack of risk and the apparently relatively low investment by the company were the least complicated parts of this project.  And here things get really tricky.

When Partnerships BC decides whether to deliver a project publicly or to use a P3 they do so by coming up with a comparable Net Present Cost (NPC) figure.  They get this figure by calculating for both the public and private delivery of the project, how much would be spent in each year.  But they do not just add up the numbers.  Instead they “discount” the numbers for each year going forward.

Discounting happens because of the assumption that a dollar today is worth more than a dollar tomorrow. The easiest example of discounting is inflation. A dollar is worth 100 cents today, but with 2% inflation, next year it will be worth 98 cents.  But Partnerships BC does not use inflation as a discount rate. Instead it uses the Internal Rate of return for the private company involved in the public private partnership. Using a discount rate of say, 7.5%, in 35 years the last payment is worth next to nothing.

But when it comes to discounting public and private projects are not treated in the same way. If a project is done publicly, Partnerships BC assumes the capital costs are spent during construction and not borrowed.  That means the amount is discounted very little.  But if the project is done privately, the money is assumed to be borrowed and paid back over the life of the contract. That means that much of the capital costs are heavily discounted. It is one of the accounting tricks that makes P3s look good. 

But with the Fort St. John Hospital, Partnerships BC had a problem. The government, through the Northern Health Authority, was paying most of the cost of construction. Since it was public spending, presumably you would account for it as a public project. That meant very little discounting, and this is turn raised the net present cost of the project. This put the cost of the project over its Affordability Threshold.

But there was a way around this. This was the “Affordability Model.” Under this model, as one FOI document says:

To determine if the Project meets the affordability Ceiling PBC requested ISL to model the NH funding during construction as a loan at the Province’s long term cost of funds 5.05%.

The document goes on to say Provincial Treasury Funding will be:

Structured as a synthetic loan but the Province will not be a lender to the Concessionaire. (emphasis added)

And

The Affordability Model is necessary to demonstrate to Treasury Board that the Affordability Ceiling has been met, however, it does not reflect the deal structure that will be in the Project Agreement.

So, to meet the Affordability Threshold the government creates a “synthetic loan” which pretends to loan the money to the private company. This allows the public spending to be discounted in a way specifically forbidden if the project had been done publicly.

When looking at public projects Partnerships BC accounts for public borrowing in a way that makes it look expensive.  But with this project they accounted for the government’s borrowing to make it look cheap and to make sure the P3 went through.

Now the good news is that Fort St. John gets a needed hospital and by all accounts it is a good one.  By borrowing the lion’s share of the money itself, the government saved a lot of money it would have had to pay if the hospital had been built with expensive private funds. The private company also appears to have done well out of this  putting in much less money than in other P3 projects, carrying little risk, but still getting a 33 year contract to run the place.

But the bad news is that taxpayers will pay a lot more than they would if the government had used only public borrowing.  The private company walks away with what may be a “ridiculous” rate of return on its investment. It appears we paid a lot of money, and according to the FOI memos, got very little risk transfer. The hospital over the life of the contract will pay millions of dollars more than they would have in a public project.

And then there is the problem of a ridiculously complex system of accounting for the costs with “synthetic loans” that can only charitably be called misleading. To make sure the project went through as a P3, the rules were rewritten. The system is both ridiculous and secret. You need to spend years going through Freedom of Information requests to get any details and even then, much of the information is withheld from the release.

The BC government has built hospitals, roads, sewage plants and bridges across the province with public private partnerships. In the UK these chickens are coming home to roost 15 years after the projects were developed with some hospitals having to be bailed out financially from their P3 costs.  Some UK local governments have bitten the bullet and just paid off their P3 contracts.  Pay attention to what is happening there.  It is our future.

Topics: Health care, Privatization, P3s & public services, Transparency & accountability