CAPITAL CHARGES AND PRIVATE FINANCE IN A

PUBLIC HOSPITAL SYSTEM

Jon Sussex

Office of Health Economics, England

Agenda• Context

• Capital charges:– objectives and principles– options: pros and cons; UK experience– implementation issues; UK experience

• Private finance versus public– objectives and principles– options: pros and cons; UK experience– implementation issues; UK experience

• Conclusions

UK National Health Service (NHS)

• 100% coverage of UK population (59 million)

• Funding: 98% tax; 2% patient charges

• NHS costs £72 billion = 6.3% of GDP

• [Private health spend = 1.1% of GDP]

• ‘Gatekeeping’ primary care physicians (GPs)

NHS Hospitals

• 2.9 acute (non-psychiatric) beds per 1,000

• Average acute inpatient length of stay 5 days

• NHS hospitals cost £30 billion per year

• Of which capital spend = £2.5 billion

UK Policy on Capital Charges in the National Health Service

• Public investment funds always tight;

• Capital schemes fragmented and delayed

• Capital treated as a “free good”

• From 1984/85 (partial) retention of asset disposal income for new investment

• Capital charges introduced 1991/92:– depreciation– dividend (interest) = cost of capital

Objectives of Capital Charges

1 To make managers aware of costs of capital - capital no longer a ‘free good’

2 Incentive to use capital efficiently

3 Enable cost comparison between hospitals -public and private

4 Basis of fair competition between hospitals: public-public and public-private

Real or Notional Capital Charges?

• Notional => for information only:– either as a memorandum item in the accounts;– or as neutral cash flows (money in = money out)

• Real => capital charges include in prices or benchmarked costs:– more ‘real’ if there is competition between

hospitals

Real versus Notional Capital Charges

Objective Notional Real

Manager awareness ofcosts Efficiency incentive Weak Cost comparability Fair competition

Form of NHS Capital Charges

0

1

2

3

4

5

6

7

8

9

10

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Year

£ m

6% ROCDepreciation

•Straight line depreciation

•Dividend = 6% of assets’ net current replacement cost

NHS Capital Charges: Time Profile

0

1

2

3

4

5

6

7

8

9

10

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Year

£m

NHS Capital Charge

Annuity

NHS Capital Charges: Flow of Funds

• No net increase in NHS funds:– circular for the NHS as a whole: money in = money out– but real for each individual hospital: money in money

out

• Depreciation finances new investment and payment of dividend to government

• 6% return on capital used to pay dividend to government

Valuation / Revaluation

• Current cost preferable to historic cost - closer approximation to economic value

• NHS revalues every 5 years; indexes in other years

• Valuation by government agency (‘District Valuation Service’)

• Lower of: depreciated replacement cost or value in use

UK Experience: Problems

• Cost disadvantage to those with new assets

• Administrative costs (e.g. asset registers, valuation exercises)

• Land values may dominate in special cases - but may proxy for accessibility

• Instability of charges because of revaluations

UK Experience: Benefits

• Disposal of surplus assets

• Capital no longer seen as free good

• Better capital/labour mix

• Resource accounting and budgeting now spread throughout UK government

UK Policy on Private Finance

• Until 1992, private finance discouraged

• Private finance encouraged after 1992

• ‘Private Finance Initiative (PFI)’ => private finance obligatory for major projects after 1994

• NHS (Residual Liabilities) Act 1996

• NHS (Private Finance) Act 1997

• Cash limit on publicly funded investment, but not private, biases in favour of private finance

Objectives of UK Private Finance Initiative (PFI)

• “Through the PFI the private sector is able to bring a wide range of managerial, commercial and creative skills to the provision of public services, offering potentially huge benefits for the Government.” Gordon Brown, 1997

• Appearance of reduced public expenditure in the short run. - The unmentionable objective.

Sources of Capital Investment, NHS Hospitals, England (£2000/01)

Sources: Department of Health 1997, 1998, 1999, 2000

0

500

1,000

1,500

2,000

2,500

3,000

3,500

1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 1999/00e 2000/01p 2001/02p 2002/03p 2003/04p

£ m

illi

on

Net government Asset sales PFI

Major* NHS Capital SchemesUK, May 1997 - December 2000

• 85% of capital for major schemes is private

• 23 PFI schemes reached financial close

• £2.2 billion total capital value

• Average capital value = £97 million

• 6 publicly financed schemes approved

• £0.3 billion total capital value

• Average capital value = £53 million

* Capital value £25 million

Reactions to Private Finance in the Health Service

• Ministers and (in public) their civil servants

• Private consortia and their banks

• NHS managers seeking major capital investment

• Other NHS managers and their advisers, in public

• NHS managers and their advisers, in private

• Press and academic commentators

• Doctors• Trade Unions

FAVOURABLE HOSTILE

Types of Benefit and Cost

• Macroeconomic

• [Equity]

• Allocative efficiency

• Productive efficiency

Macroeconomics of Private Finance

• Short-term reduction in measured public expenditure / increased flow of funds for investment

• Depends whether on or off the public sector’s balance sheet - which depends on risk transfer

• But the taxpayer still pays eventually

Allocative Efficiency

• Allocative efficiency depends on the planning and approval system

• But private finance risks doing what the private sector is willing to do rather than what is most socially beneficial

• E.g. Private finance => large and new-build rather than smaller and refurbishment schemes

Possible Sources of Productive Efficiency

• Capturing private sector skills:– managerial– commercial– creative

• Efficiency incentives from allocating (some) risk to the private sector

What the Private Sector Does - Headroom for the PFI?

• Designs• Builds

• Non-clinical services

• Buys surplus assets

• Designs• Builds• Finances• Non-clinical services,

for 25-30 years• Buys surplus assets

PUBLICLY FINANCED‘DESIGN AND BUILD’

PRIVATELY FINANCED ‘DESIGN, BUILD, FINANCE AND OPERATE’

DesignPUBLICLY FINANCED

• Standardisation gave way to innovation

PRIVATELY FINANCED

• Process unchanged - same architects etc. doing the work, still being briefed by hospital staff - but greater emphasis on maintenance after completion

ConstructionPUBLICLY FINANCED

• Private contractors selected by competitive tender

• ‘Design and build’ increasingly common

• Cost and time overruns average 7% and 8% in late 1990s

PRIVATELY FINANCED

• Private contractors selected by competitive tender

• ‘Design, build and operate for 25-40 years’

• Overruns limited by contract terms

Non-Clinical ServicesPUBLICLY FINANCED

• Many non-clinical services in most hospitals competitively tendered for several years

• Laundry, catering, cleaning since mid-1980s

PRIVATELY FINANCED

• Competitively tendered, but as part of bundle and for 25-40 years - particularly important for maintenance

Better Maintained Hospitals?

• Publicly financed hospitals are poorly maintained

• DBFO contracts could lead to fewer shabby hospitals because:– lifetime costs minimised rather than just up-front

capital costs– contract ring-fences money for maintenance

Sale of Surplus Assets

“Including land in PFI deals can only be effective if it passes extra value to the private service provider over and above what would be achieved in an open tender situation. …. in the majority of cases, this criterion cannot be met.”

NHS Estates (2000)

Transaction Costs

• Higher for privately financed than conventionally financed procurement:– external advisers for all parties, including banks– senior health service management time– longer duration of tendering and contract

negotiation

Cost of CapitalPUBLIC FINANCE• Borrow from government• Government’s cost of capital paid• Future taxpayers bear risks

PRIVATE FINANCE• Borrow from banks, bond and equity markets• Private cost of capital paid• Some risks transferred to private consortia

Private versus Public Cost of Capital• ‘Perfect capital markets’ theory => private cost = public cost

properly adjusted for risk

• But government economists found that in the 1980s private bond finance costs up to one percentage point more than public borrowing

• Circumstantial evidence => private cost > public

• Possible reasons are:– lags in procurement process– private sector fear of the health service and its politics– residual fear of private borrower default

Costs and Benefits of Private Finance Finely Balanced Overall

• First 11 major privately financed hospital schemes in England claim average saving of 1.6% (range 0%-4.2%) versus publicly financed alternative

• These figures based on official 6% discount rate

• No cost savings if discount rates 5% or lower

• Social rate of time preference 2%-4%

Privately Financed versus Well-Managed Publicly Financed

Private financing offers:

• ?Slightly lower construction costs?

• ?Possibly fewer construction time overruns?

• Little difference in support services

• ?Better maintained hospitals?

• Higher transactions costs

• Higher costs of borrowing