Contracting out in defense is an important public and political
issue in the United States. When based on the proper principles,
contracting out allows the government to draw on the skills and
resources of the private sector to deliver services more
efficiently. Although the British and U.S. programs are financed
differently, Britain's experience offers important lessons that
both countries need to learn as they continue, where appropriate,
to contract out in defense.
Between 1997 and 2008, the British government's share of the
national economy expanded from 38.4 percent to 41.9 percent. In
2008-2009, that share will rise to 49 percent. It is time to ask
detailed questions, sector by sector, about the increasing size of
the British state. An official investigation into the British
Ministry of Defence (MoD) would shed useful light on how this
expansion was funded and how efficiently it was administered.
The MoD offers scope for such an investigation because, in
theory, it has returned thousands of workers to the civilian labor
market. However, the MoD has simultaneously expanded use of the
Private Finance Initiative (PFI), which is one way the government
has funded and disguised its spending spree.
The Defence Select Committee of the House of Commons should
investigate the MoD's reliance on PFI and assess whether it has
delivered value for money, produced perverse incentives, become a
way to manufacture private-sector jobs that in reality are paid for
by the public sector, supported ineffective procurement practices,
or been used to conceal inappropriate levels of debt. The U.S.'s
largely successful program of military housing privatization offers
a series of valuable lessons, and its occasional failures offer
other lessons, for the United Kingdom.
The U.S. should also learn from the MoD's use of PFI. One of the
shortcomings of Britain's contracting-out program is a shortage of
government personnel competent to oversee the contracts. The same
issue has been identified in the U.S. In both nations, as a result,
contracting processes have been heavily criticized for their
inefficiency. More broadly, the MoD has extended contracting out
into areas that are unsuitable for it and has not designed PFI
contracts that preserve essential competitive pressures. The U.S.
should take care to avoid both errors.
Contracting out is an important instrument, both in Great
Britain and in the United States, but it needs to be employed
effectively. The British method of financing it has encouraged the
continuing growth of the state and has created a series of risks
and perverse incentives. Each nation should learn from the other's
experience about when to employ contracting out appropriately, how
to fund it, how to design suitable programs, and how to improve its
Britain's Retreat from Economic
The Labour government that took office in 1997 has won an
undeserved reputation as a friend of the private sector because it
supposedly rejected Labour's formerly free-spending ways. The
reality is different. Under Labour, the government's share of
Britain's economy has risen sharply. In 1997, the average
governmental share of gross domestic product (GDP) across the
Organisation for Economic Co-operation and Development (OECD) was
38.8 percent, higher than Britain's 38.4 percent. Key European
competitors, such as Germany (45.7 percent of GDP), had
substantially larger states.
By 2008, the OECD average had nudged downward to 38.5 percent,
but this average concealed important variations. Germany's share
had declined to 43.4 percent, a 2.3 percentage point drop, while
Britain's had increased to 41.9 percent, a 3.5 percentage point
Within a decade, Britain went from being a country that followed
the Anglosphere's model of a limited state and flexible economy to
one that looked more like a continental economy. It did this at a
time when the continental economies were moving haltingly toward
the Anglosphere model. In short, Britain went the wrong way when
many other major industrialized economies were going the right
The same wrong-way trends are evident in the data on Britain's
public debt and the government's annual financial balance. Even the
government's record of fostering economic growth is heavily tainted
by the fact that increased state expenditure accounts for more than
a quarter of economic growth from 1999 to 2006.
Equally startling is the government's record on employment. The
Financial Times has found that two out of three supposedly
private-sector jobs that the government claims to have created are
in areas of the economy dominated by government spending. They are,
therefore, not meaningfully private. Indeed, because they have been
paid for by a massive expansion of state borrowing, much of it in
disguised forms, these jobs constitute a burden that will require
financing for years to come.
This increase in the size of the British state raises vital
questions both for the British people and for supporters of private
enterprise and limited government around the world. Like other
nations, the U.S. should recognize the implications of the failure
of these state-led economic policies. Yet simply describing and
opposing the growth of the state is not enough. It is important to
examine how this growth was funded and the effects and efficiency
of the funding model. PFI is an important part of that story.
Why Labour Relied on PFI
PFI was launched in 1992 under the Conservative government led
by Prime Minister John Major. The Labour Party immediately attacked
it as a disguised form of privatization. Yet after winning the 1997
general election, Labour vastly expanded Britain's use of PFI. As
the junior Health Minister Alan Milburn put it, "When there is a
limited amount of public-sector capital available, as there is,
it's PFI or bust."
Labour's resort to PFI, in spite of its previous objections, was
thus based on its desire to square the circle of wanting to spend
more without having to raise taxes or borrow more. Under PFI, the
government, instead of issuing debt to fund desired expenditure,
makes a long-term contract with private investors to provide goods
or services in return for regular payments.
Because PFI contracts are technically not debt, they allow the
government to provide more services now without having to borrow
more or raise taxes in the near term. However, like debt, PFI
contracts oblige the state to make future payments to the other
contracting party. Thus, while PFI reduces the amount the
government borrows (or raises in taxes) up front, it reduces future
expenditures only if the private-sector contractor is efficient and
if the contract is carefully drawn up and supervised. When used
only to borrow off the balance sheet by committing the state to
future unfunded expenditures, PFI falsifies the national
Contrary to Labour's early criticisms and the left today, PFI is
not simply another word for privatization. The standard complaint
of today's critics is that PFI is privatization and that the
government is manipulating comparisons between the costs of
government-led policies and contracting out to justify contracting
out. Allegedly, these manipulations consummate the unholy alliance
that supposedly exists between New Labour and "the PFI industry."
As with many liberal criticisms of U.S. wartime contracting,
which assert the existence of a vicious cycle of corruption between
the Bush Administration, the Iraq War, and the contractors, this
concept of an unholy alliance owes more to partisan rancor than to
reality. At its root, PFI is a result of the
government's attempts to buy more public services than it is
willing to finance through higher taxes or more debt. The problem
is ultimately not the comparisons used to justify PFI -- although
there is cause to believe that these are being manipulated -- but the
ideology that drives the demand for the ever-expanding state.
As long as public funds are limited -- as they always will be -- and
public demands are unlimited -- as they will be so long as the left
worships the state -- politicians will look for ways to square the
circle. If the left-wing critics want to reduce the ties between
the state and the private sector, they should advocate reducing the
size and reach of the state.
In reality, contracting out is not the same thing as
privatization. The only true form of privatization is the sale of
government assets to the private sector, which eliminates the
managerial responsibilities of the public sector. Privatization was
central to the achievements of the governments led by Prime
Minister Margaret Thatcher from 1979 to 1990, and it remains a
valuable tool today.
Under PFI, the government, as one of the contracting parties,
does not eliminate its responsibilities. It simply becomes a
manager of contracts instead of a manager of assets. PFI is
supposed both to transfer risk from the public sector to the
private sector by making the private sector responsible for
delivering its contractual requirements and to relieve government
departments of responsibility for handling assets outside their
core competencies. Contracting out has merit, and condemning it
wholesale would be wrong. Yet by its very nature, it places the
responsibility of being a careful contractor on the government.
Questions of PFI Managerial Competence
and Fiscal Honesty
Since 1997, instead of bringing the efficiency of the private
sector to the public sector, PFI has too often brought the
inefficiency of public finance to the private sector. The result is
that PFI is now regularly condemned as a bad bargain for the
taxpayer. In a November 2007 report, the Committee of
Public Accounts found:
[T]he Treasury has done little to apply what it has learned from
the large number of PFI deals that have now been signed. There has
been no improvement in tendering times, significant risks to value
for money continue to be taken when public authorities make late
changes to deals, and there is a continuing lack of skills and
experience in public sector PFI teams. As a result, there are signs
that market interest is weakening, with fewer serious bids for
Concerns about the competence of government contractors were
echoed by the Confederation of British Industry (CBI), the leading
lobbying organization for British business. In a survey of its
members, the CBI found that "49% said they had experienced changed
specifications by the contracting authority after contracts [had]
been signed." Changing requirements after signing a
contract implies, as the committee emphasized, that the contracting
authorities lack the necessary skills and expertise to negotiate
Oversight of signed contracts was also proving problematic. Most
PFI contracts contain provisions to test the value of services
through benchmarking or market testing. In theory, these should
reduce prices. In practice, in more than half of the cases the
committee examined, the supplier had used them to increase prices.
With over 70 percent of recent PFI contracts attracting three or
fewer bidders, and given the limited competitive pressures after a
contract is signed, PFI is in serious danger of becoming a
mechanism for eliminating, not enhancing, competitive bidding.
It is not possible to assess objectively Prime Minster Gordon
Brown's claims that PFI has delivered value for money. The studies
the government cites to back up its claims suffer from serious
errors, and the government refuses to release the underlying data
for PFI contracts, claiming commercial confidentiality.
This does not mean, as critics are wont to imply, that the
conventional state-based approach is superior, but it does
reinforce the suspicion that the government has adopted PFI
primarily to conceal its borrowing.
How Large Are Britain's Obligations
PFI contracts are not a minor entry on the state's account
books. In late 2007, the Treasury estimated the total current value
of all signed PFI contracts at £91 billion through 2032. As
this figure ignores the payments due after 2032, the true value of
the contracts is higher. Nor, of course, can the Treasury know the
value of contracts that either the current government or future
governments will sign in years to come.
Markets worldwide are already alarmed that Britain's
balance-sheet debt (47.5 percent of GDP) is at its highest level
since 1978. Leading politicians are beginning to
speculate that Britain will be forced to turn to the International
Monetary Fund for an emergency loan, as it was in 1976.
Then, the price of IMF assistance was substantial cuts in public
expenditure. If Britain is forced down the IMF route again, the
same remedy will likely be demanded, with the result that many of
the programs on which the government prides itself, and that it has
funded by borrowing, would disappear. This would devastate its
If Britain's liabilities under PFI were acknowledged as claims
on the national income that must be paid by raising taxes or
issuing more traditional debt, Britain's balance sheet would look
substantially worse. On their own, PFI contracts (at 7 percent of
GDP) comprise one-third of Britain's liabilities off the balance
sheet. Taken together, these liabilities raise Britain's public
debt by almost one-third, to 62.8 percent of GDP. Nor will these
liabilities disappear soon. Many PFI contracts have terms of 20
years or more. Taxpayers will be paying for the government's
spending spree for decades.
In short, Britain's public debt is higher than the official
figures imply, PFI is an important part of this hidden debt, the
government has used PFI to avoid issuing traditional debt, and PFI
has not demonstrably offered the taxpayers value for their
The MoD's Reliance on PFI
The logic behind the MoD's turn to PFI was set out in the 1998
Strategic Defence Review, which called for developing
"increasingly innovative forms of Public Private Partnerships" as
part of a broader drive to improve contracting efficiency,
especially in areas such as military housing that are not central
to the mission of the MoD. From the start, the MoD recognized that
it was vital to develop "an acquisition stream for both military
and civilian staff which would provide core personnel for the
Integrated Project Teams" and to emphasize getting contacts right
at the start of the acquisition process.
As the review projected, the MoD's use of PFI has expanded
dramatically since 1998, although the MoD still does not rely as
heavily on PFI as do several other departments. By way of
comparison, the Department of Health has 133 projects worth over
£11 billion, and the Department for Transport has 53 projects
worth over £28 billion. The MoD is the
second-largest government contractor by total value of signed PFI
projects and will surpass Health in 2010-2011, when it will make
the largest annual payments on PFI contracts.
In 2007-2008, the MoD made payments of £1.199 billion on
48 separate PFI projects. In total, it has 52 signed or completed
projects with a total capital value of £19.688 billion -- 23.9
percent of the total capital value of all signed projects. It
is important to note that the cost of building capital assets is
only part of the total cost of the MoD's PFI contracts because PFI
contracts require the private-sector contractor to deliver and be
paid for ongoing services.
As Chart 1 illustrates, MoD payments on PFI contracts in
2007-2008 fall into four categories: buildings and infrastructure
(24); communications and information technology (7); provision of
training and training-related equipment (9); and provision of
vehicles and other equipment (9). By value, the largest two
categories are buildings and infrastructure (£435 million)
and communications (£473 million), with the remaining
categories totaling only £291 million.
By 2017-2018, this structure will shift significantly as new
contracts come on stream and old ones end. In that year, annual MoD
payments on the 38 signed contracts will be £1.642 billion.
Communications and information technology will decline to
£252 million, and training will shrink to £70 million.
However, spending on buildings and other infrastructure will jump
by £328 million to £763 million, and spending on
vehicles and other equipment will rise by almost £400 million
to £556.81 million.
Not surprisingly, a few projects account for most of the
expenditure, both now and as projected for 2017-2018. In 2017-2018,
more than £1 billion of the £1.642 billion for PFI
projects will go to four projects: the Allenby/Connaught
accommodations and services project (£271.56 million), which
will provide living and working accommodation for some 18,000
military and civilian personnel; Skynet 5 (£243.23 million),
a system of secure communications satellites; Aquatrine
(£96.74 million), a collection of water and wastewater
projects; and the Future Strategic Tanker Aircraft (FSTA) project
(£390.92 million), which will replace the current air-to-air
refuelling capability and elements of the air transport service.
Assessing the Record and Risks of
PFI's proclaimed goal is to improve efficiency and thus to save
taxpayer money. However, measuring efficiency in government, much
less achieving it, is difficult. Efficiency is a particularly
nebulous goal in the realm of defense, and the MoD's record does
not encourage confidence in the quality of its oversight.
According to the MoD, PFI has been a success. A December 2005
report by the MoD's Private Finance Unit concluded that "PFI
projects in MOD are performing well and are delivering the services
required." Yet this report was based on a survey of
the MoD's PFI teams, who have few incentives to view their own
performance critically, and was produced by a unit that has
everything to lose from uncovering problems in PFI.
Other official investigators do not share the MoD's generous
self-assessment, although some credit it with being more competent
than other ministries. The November 2007 report by the Committee of
Public Accounts found, in addition to other serious flaws, "a
continuing lack of skills and experience in public sector PFI
teams." The head of PFI policy at the Treasury
acknowledged that "the quality of individual public sector project
teams was mixed" but argued that the Private Finance Unit was an
example of the improvement seen in recent years.
Other reputable observers continue to argue that the MoD suffers
from serious managerial shortcomings. In a March 2008 report, the
Defence Select Committee of the House of Commons expressed
astonishment that "the MoD only now acknowledges that it needs to
include in the project management skills of its staff the ability
to examine a contractor's programme schedule and consider whether
it is credible." These managerial weaknesses have
contributed to cost and schedule overruns on many of the MoD's
large procurement programs.
The most recent assessment, in an October 2008 report from the
National Audit Office (NAO), took a middle view. It praised the MoD
for achieving "a good service delivery on a broad and diverse
portfolio of PFI projects" and found that, once a suitable contract
was negotiated, the private sector usually delivered as agreed. The
most significant risks came early, in the contracting stage, when
services desired were not always well specified. The result was
that all eight projects examined by the NAO presented a moderate to
significant risk of failing to deliver value for money.
Regrettably, neither the NAO nor the Defence Select Committee
has conducted a full audit of the MoD's PFI portfolio. The NAO has
not examined Skynet, FSTA, Aquatrine, or any accommodations
project. These contracts will account for the vast majority of PFI
spending by 2017-2018. The Defence Select Committee devotes little
attention to PFI in its annual reports.
The fairest assessment, based on the currently available
evidence, would seem to be that, while PFI has been used to move
borrowing off the books and has not been administered effectively
across the government as a whole, the MoD is one of the more
competent PFI contractors. Yet this assessment should be validated
by a thorough review either by the NAO or, preferably, by the
Defence Select Committee.
Other Questions About PFI
Such an assessment is particularly important because, contrary
to the impression conveyed by most evaluations of PFI, the question
of whether PFI is an efficient use of public funds is not the only
one that can and should be asked. At least four others are equally
Does PFI produce perverse incentives? The MoD has shown a
disturbing willingness to rig the bidding processes to ensure that
it achieves its short-term financial goals. Particularly egregious
was the 2003 privatization of QinetiQ, which advises the MoD on the
procurement of equipment. QinetiQ was bought, in part, by the
Carlyle Group. A 2008 investigation by the Public Accounts
Committee found that:
The Department began the competition for a strategic partner
when market conditions were poor and before the terms of QinetiQ's
most significant contract had been agreed. It also eliminated the
only trade bidder at a very early stage. These decisions weakened
the competitive process for selecting a strategic partner....
The Department relied on Carlyle to design the incentive scheme
but did not put safeguards in place to protect its interests....
QinetiQ's management were consequently able to influence the design
of their incentives before Carlyle were appointed preferred
The committee also found that the MoD drove the sale forward
because of an agreement with the Treasury that would credit the
MoD's budget with £250 million if the sale was completed
quickly. Indeed, according to Lord Moonie, then
Dr. Lewis Moonie and a junior MoD minister, the MoD was reluctant
to sell, but "a combination of the Treasury [pressure] and the fact
we needed the money for items in our budget persuaded us to go on
This privatization, which moved 8,000 jobs from the public
sector to the private sector -- and is thus responsible for 18
percent of the MoD's job reductions -- shortchanged the taxpayer by
£90 million and resulted in "QinetiQ senior management
receiv[ing] £200 for each £1 they invested whilst the
taxpayer received just £9."
By itself, the MoD's handling of this sale was scandalous.
However, in the broader picture, it demonstrates that programs that
aim to promote efficiency can have the perverse effect of
encouraging inefficiency if they reward departments for achieving
This is exactly the situation in the MoD today. The ministry is
under pressure to save money because of procurement cost overruns.
Over the past four years, the MoD was required by the Treasury to
make efficiency gains of at least £2.8 billion.
Because PFI both takes debt off the government's balance sheet and
is supposedly more efficient, the MoD has an incentive to use PFI,
whether or not it is appropriate, to claim that it has achieved
Hence, the National Audit Office concluded that PFI "may present
a temptation to public sector bodies...to structure contracts so as
to achieve off balance sheet treatment rather than the best
possible value for money." Bluntly put, this means that the pressure
to use PFI to conceal spending encourages officials to manipulate
data to justify proceeding under PFI instead of through
conventional procurement. The NAO prefers that PFI contracts be put
on the balance sheet, but 62 percent of the MoD's PFI contracts by
capital value are off the balance sheet.
In a previous report, the NAO found that more than half of the
£781 million that the MoD claimed to have saved on
procurement in 2005- 2006 was actually redefinitions.
The same skeptical eye should be applied to the question of whether
the pressure to achieve efficiencies and move expenses off the
balance sheet has encouraged the MoD to use PFI and has affected
the structure of its PFI contracts.
Has the MoD used PFI to move jobs off its books? One of
the MoD's proudest boasts is that it has cut tens of thousands of
jobs. Official total civilian employment in the MoD has fallen from
133,300 in 1997 to 89,500 in 2008, but the MoD also expanded
its reliance on PFI during the same years. Like the government as a
whole, PFI uses public money to pay for nominally private-sector
jobs. The Treasury's efficiency drive has put intense pressure on
the MoD to reduce its civilian staff. This environment is
tailor-made to encourage bureaucracies to produce results,
regardless of how well those results accord with reality.
The MoD's PFI contracts should be scrutinized to determine how
many of the "eliminated" MoD jobs were merely moved into the
nominal private sector. To date, the Defence Select Committee has
done a poor job of holding the MoD to account, both on the size and
cost of its workforce and on PFI as a whole. In its most recent
review of the MoD's annual report, the committee said nothing of
substance about PFI and applauded the MoD for reducing its
It did not ask why, while the MoD's civilian employment has
fallen by 18 percent since 2004, the cost of that smaller workforce
has increased by 15 percent. Nor was it concerned that the MoD's
expenditures on civilian wages increased almost twice as fast as
pay for the forces between 2003- 2004 and 2007-2008. A
thorough investigation of PFI might help to explain that paradox.
It is significant that civilian employment in the upper pay grades
and within the central MoD has expanded since 1997, while the lower
grades have shrunk significantly. Those grades include the
jobs that can most easily be folded into PFI contracts.
The committee conducted a searching evaluation of only one part
of the MoD's employment practices. It expressed its
"disappoint[ment] that the MoD only met two of its nine diversity
targets in relation to civilian personnel." The committee
adduced no evidence that the MoD discriminates against qualified
Achieving an arbitrary ratio of diversity within the MoD is not
relevant to national defense. The committee should perform the
proper role of the House of Commons: examining the effectiveness,
honesty, and efficiency of the government's use of the taxpayer's
money. That includes scrutinizing the MoD's reliance on PFI.
Does PFI reinforce inefficient procurement policies?
While the MoD has won praise for reducing the official size of its
workforce, few observers believe that its procurement system is
efficient. The procurement problem is complex, but many of the
difficulties are the result of the fact that procurement decisions
are often made for reasons that have little to do with value for
money or military effectiveness, such as preserving British jobs or
pleasing "partners" in the European Union. With preserving British
jobs comes the need to buy British, which limits competition among
bidders. The result is a backlog of increasingly expensive projects
that has created a budget crisis for British defense.
The Future Strategic Tanker Aircraft project illustrates many of
these shortcomings. It will cost £391 million in 2017-2018,
when it will be the MoD's single largest PFI contract.
Instead of seeking to combine its buying power with that of the
U.S. and other allied states, the MoD decided go it alone by
developing an independent national solution. Even today, the MoD
continues openly to dismiss calls for cooperation on air-to-air
refueling capability. The claim that fast and independent
action was necessary for operational reasons is difficult to accept
given that, although air-to-air refueling was first nominated as a
potential PFI project in 1997, FSTA is not scheduled to deliver its
first plane until 2011 or to complete deliveries until 2016.
The MoD pursued a PFI solution because the limits imposed on its
budget left it unable to purchase the planes outright.
The resulting competition was between only two bidders. It
is not uncommon for large defense procurement projects to attract a
limited number of bids, because only a few companies in the world
have the necessary expertise to compete. However, this implies that
PFI may not be the best solution for large, complex procurement
contracts -- a conclusion that the U.S. reached in 2004 when the U.S.
Air Force abandoned its effort to lease modified Boeing 767s as
In 2004, Britain opted for the bid from AirTanker, a consortium
of companies including the VT Group, European Aeronautic Defense
and Space Company, and Rolls-Royce offering a version of the Airbus
A330-200, over a bid from Tanker Transport Services Consortium
(TTSC), composed principally of Boeing and BAE Systems, offering
converted Boeing 767s. AirTanker will supply aircraft on a lease
basis to the Royal Air Force (RAF) and be free to sell surplus
capacity on the open commercial market. Owing to the complexity of
the contract and turmoil in the global financial markets, the deal
was not finalized until March 2008.
The reasons why the AirTanker bid was chosen are complex. Nor
was the decision in favor of the Airbus necessarily without merit,
as shown by the U.S. Air Force's similar selection of the Airbus
A330-200 in February 2008 after an exceptionally contentious
competition. Yet, as with most large aircraft
contracts, performance was not the only criterion that mattered.
From the start, the contest was perceived as a political
competition between an Anglo-American solution from TTSC and a
European solution from AirTanker.
The British government has been a vocal supporter of both the
European Security and Defence Policy and programs such as the
Eurofighter and the Galileo satellite system, both of which were
launched for essentially political reasons. The AirTanker
decision is open to serious criticism on operational grounds
because it amounts to leasing eight aircraft for day-to-day use and
paying for another six that are guaranteed to be available only
within 30 days after they are requested.
But the deal also fits into Britain's long-standing habit of
subsidizing the European aerospace industry with military contracts
to save British jobs and send signals within the European Union.
This is a poor and expensive basis for procurement decisions.
Then-Secretary of State for Defense Geoffrey Hoon identified the
benefits to British industry as one of the factors that led the MoD
to select AirTanker, which hints at the ways that inappropriate
domestic and European factors influenced these decisions.
The comments of David Ruff, a former PFI team leader at the MoD,
reinforce the impression that PFI -- and defense procurement as a
whole -- is less a means of efficiently acquiring assets than a
disguised, inefficient industrial policy. In June 2004, Mr. Ruff,
after claiming that he was "motivated by the MoD's self-proclaimed
need to derive very best value for money," acknowledged:
We have also seen a shift from the dogma of "PFI is the answer,
now what is the question," to a much more confident approach to
procurement, as much intent on ensuring the UK's defence industrial
base, as securing very best value for money.
Just as serious are the delays that the PFI risk-transfer model
imposes on the procurement process. As the MoD admitted, "industry needs to be very confident that they
understand the requirement and how they are going to deliver it,
and that does take a long time." This implies that PFI is,
as one witness put it to the Defence Select Committee, "a good
business for banks and lawyers" and a poor way of meeting
service requirements because of the expensive delays it
Because its advantages rest in part on competitive tendering,
PFI is most suitable for programs such as construction projects,
where a well-developed civilian market and a large number of firms
are capable of doing the job and, hence, bidding on the contract.
For major procurement projects, the limited number of bidders means
that competitive tension is lacking. This reduces PFI's advantages
in efficiency over conventional procurement while its contractual
complexities remain. These complexities create delays, impose
additional expenses, reinforce the British inclination to go it
alone, and allow further scope for making procurement decisions on
grounds other than cost and effectiveness.
Is PFI foreclosing too many options? Like any debt, PFI
forecloses options in the future. Money that the MoD has committed
to pay for its PFI contracts will not be available for other
purposes. Labour's broader criticisms of PFI before 1997 were
generally incorrect, but Alastair Darling, the current Chancellor
of the Exchequer, was right to warn that the "apparent savings now
could be countered by the formidable commitment on revenue
expenditure in years to come." The Defence Select
Committee echoed that concern in September 2007.
In 2007-2008, the MoD spent slightly over 3 percent (£1.2
billion) of its budget on PFI contracts. This would appear to be a
manageable proportion, but while £1.2 billion is not
"formidable," it is also not negligible. The MoD's 2008 budget
crisis centered on the government's determination to trim £2
billion from the 2009-2010 MoD budget. In today's dangerous
strategic environment, the MoD would be wise to retain as much
budgetary flexibility as possible. To the extent that the MoD
relies on PFI, it loses that flexibility.
Lessons for Britain from the MHPI
The MoD's turn to PFI after 1997 has no exact parallel in the
U.S. However, the U.S. does have the Military housing Privatization
Initiative (MHPI), which seeks to improve the quality of military
housing by attracting private-sector financing, expertise, and
There is no one-size-fits-all model in contracting out, and the
MHPI is not exactly comparable to most British accommodation
projects for many reasons. One of the most important is that the
MHPI focuses on military family housing, whereas some MoD PFI
accommodation projects are barracks for single servicemembers. In
Britain, most military family housing was privatized on a
lease-back arrangement in 1996. This deal has been heavily
criticized for leaving the MoD responsible for maintenance and for
failing to generate funds to improve other MoD housing.
Nonetheless, the MHPI offers important lessons for British
The problem that the MHPI set out to solve was threefold:
personnel, facilities, and priorities. In its October 1995 report,
the Defense Science Board Task Force on Quality of Life, commonly
known as the Marsh Quality of Life Panel, argued that the quality
of military housing was an important element in recruitment and
retention of the all-volunteer force. The Marsh Panel also found
that military housing was on average 33 years old; that "inadequate
and inconsistent funding [has] resulted in poor maintenance and
repair, and has deferred revitalization and replacement of
unsuitable homes"; and that remedying the problem would cost at
least $20 billion.
Finally, military housing was always the last priority for
funding and the first to be cut, which caused the deferred
maintenance bill to grow to such massive proportions. Fixing
military housing would require balancing the natural -- and to some
extent desirable -- bias in favor of buying weapons against the need
for regular spending on housing.
The Marsh Panel found that "artificial constraints placed on the
military housing delivery system prevent the Defense Department
from taking full advantage of U.S. market efficiencies, run up
costs and seem to serve no rational purpose." It also criticized
the financial rules that precluded using "innovative, creative
methods to encourage or promote private-sector resource
opportunities." The essential problem was that the
Omnibus Budget Reconciliation Act of 1990 enforced the concept of
the unified budget, first devised in 1967 by the President's
Commission on Budget Concepts. The unified budget made it
impossible either to move expenses off budget as Britain does
through PFI or, as the panel pointed out, to access private sources
The panel's recommended changes in this system were accepted,
laying the foundations for creation of the MHPI. The prohibition on
moving expenses off budget remains. All MHPI spending is "scored,"
or accounted for, on budget, although the precise mechanisms for
achieving this are subject to constant debate. Nor is the MHPI a
single program: The Air Force, Army, and Navy work through it in
significantly different ways, with oversight from the Office of the
Secretary of Defense (OSD).
Yet the services' different programs have important elements in
common. The services either make a loan or form a limited
partnership through an equity contribution to a contractor to
support initial construction costs, which are partially financed
through the private sector. housing units are then rented by the
contractor to servicemembers, who receive a housing allowance from
the funds that the services formerly would have spent to maintain
the houses. Servicemembers can rent MHPI housing or use their
allowance to rent outside the program through the private sector.
Five aspects of this program deserve notice:
- The MHPI's primary purpose is not to save money, though
it is forecast to cost about 10 percent less than traditional
methods of military procurement. Rather, it is a way to force the
services to spend money on a dull but necessary commodity -- military
housing -- that they traditionally have preferred to underfund in
deference to more exciting items such as weapons systems. It
produces a better product more quickly today and more reliably over
time for slightly less money. This is an important fact
to bear in mind when evaluating British claims that PFI delivers
value for money.
- The MHPI preserves competition. Because servicemembers
chose their housing, the contractors have an incentive to be good
owners. As conditions in the local housing market change,
servicemembers can benefit from this change.
- The MHPI is accounted for on budget. In British terms,
it is a public-private partnership, not a PFI.
- The MHPI has layers of oversight. Each service has built
a core of experienced contractors, which is overseen by the OSD and
the Office of Management and Budget.
- The average MHPI project has approximately 2,000 units,
which contains the risk if a project goes bad. In Britain, the
Allenby/ Connaught project contains 18,000 units. If it went wrong,
that single failure would taint about 17 percent of the MoD's
2017-2018 spending on PFI.
The MHPI has been a substantial, albeit not perfect, success. At
a scored cost of $2.7 billion, it has produced $24 billion in
capital spending on construction. Of course, this ratio reveals
nothing about the overall cost of the program because the services
will continue to pay into it for decades through the rent allowance
given to servicemembers.
Nonetheless, the MHPI's record is impressive. As of December
2008, the MHPI had 94 projects involving more than 183,000 units.
Almost all substandard military family housing in the U.S. is
currently under improvement through the MHPI. Recognizing these
achievements, Congress made MPHI legislative authorities permanent
in the National Defense Authorization Act of 2004.
The blot on the MHPI's record is the American Eagle fiasco,
which came to light in 2007. American Eagle, a contractor for six
MHPI projects with a total of 8,351 units, did not live up to its
responsibilities, causing significant delays and financial losses.
Investigations by both the Senate and the press strongly suggest
that the firm should never have received a contract and that the
armed services involved were too slow to recognize and remedy its
deficiencies. The fact that American Eagle received its first
contract in 2003, when the MHPI was successfully under way,
demonstrates that the services should never allow contracting out
to become routine. Standardization is desirable, but there is
ultimately no substitute for a well-trained and alert contracting
Both the MHPI's achievements and its failures offer lessons for
First, the primary reason to contract out is not
necessarily to save money. Rather, it can ensure quicker and more
reliable delivery of a superior product for about the same amount
of money. Left-wing critics of PFI, with their enthusiasm for state
spending, ignore the reality that budget processes are political
and that important needs -- including maintenance of existing
infrastructure -- often fall prey to their own demand for exciting
and expensive new programs. On the other hand, British authorities
should be more forthcoming about releasing the underlying data for
PFI contracts and should acknowledge, as U.S. authorities do, that
the advantages of public-private partnerships do not necessarily
revolve around saving money.
Second, the MHPI shows that contracting out does not and
should not depend on off-budget spending.
Third, the MHPI preserves competitive pressures, which
help to ensure that both the Defense Department and servicemembers
receive value for money. This is a significant failing of PFI,
which often locks the MoD into uncompetitive, single-source,
Fourth, the MHPI's failures came about through poor
contracting and inadequate oversight.The same problem of competence
in contracting has also vexed the MoD.
Fifth, the MHPI keeps projects relatively small to make
oversight easier and to spread risk.
How Great Britain Could Contract Out
The next British government should bear these lessons in mind
when it considers the problems and virtues of contracting out in
defense. Specifically, Great Britain should:
- Not contract out when victory on the battlefield is at
stake. Contracting out can and should be applied where
suitable. It is not suitable in cases like the FSTA program in
which the state must make strategically risky decisions to write a
commercially viable contract.
- Not use contracting out to spend off budget. Britain
should follow the NAO's recommendations and place all PFI programs
on budget. This would bring Britain closer to the U.S. system of
unified budgeting. This system will not guarantee less government
spending, but it would make it more difficult to conceal the
financial implications of programmatic decisions.
- Not use contracting out to conceal the growth of the
state. From Labour's point of view, PFI's great advantage is
that it has allowed the state to supply more services than it has
paid for in taxes or borrowing. However, this advantage is
temporary and comes with serious disadvantages in the longer run.
The problem is not contracting out, but that PFI has been used to
expand the power and reach of the state.
- Conduct a full and fair audit of all MoD PFI programs.
To date, no competent authority has fully assessed the value for
money offered by many of the MoD's major PFI programs or how
effectively they have been administered. The next government should
immediately order such an assessment. It should buy out contract
holders if it finds that conventional contracting offers better
value. This assessment should take into account lessons from the
U.S. and consider whether PFI creates financial, procurement, or
strategic problems for the MoD.
- End the practice of providing government financial support
for PFI programs. The fact that the Treasury is now providing
financial support for PFI programs because the private sector is
unable or unwilling to do so means that the government has taken
back the riskiest portion of the financial risk that it had sought
to privatize through PFI. This makes nonsense of the entire PFI
concept. If the private sector is not willing to fund a PFI
program, the program should not be done through PFI.
Principles and Lessons for the United
Similarly, the U.S. can benefit by applying principles and
lessons from Great Britain's successes and failures.
- If the government is involved, risks cannot be wholly
transferred to the private sector.
The justification for placing most PFI projects off the balance
sheet is that they transfer risk from the public sector to the
private sector. In strictly financial terms and in normal times,
this is correct. Yet as the American Eagle failure shows, political
pressures will ultimately force the government to intervene if its
private-sector partner fails.
Similarly, when market turmoil threatens the private sector's
ability to secure the necessary funding, the government will
eventually be forced to reassume the risk it thought it had handed
off. In the worst-case scenario, the
government can be stuck with a PFI contract that privatizes risks
and rewards for which it guarantees the financing and thereby takes
back a substantial share of the risk.
That scenario is unfolding in Britain, as the government has set
up the Infrastructure Finance Unit to enable PFI projects to
proceed in spite of the financial crisis. The bottom line is that,
unless the asset in question is genuinely privatized, the idea that
its associated risk can be transferred to the private sector -- or
that the government can have a hands-off relationship with its
contractual partners -- is a fallacy.
These dangers are particularly pressing when the purpose of the
PFI project is to deliver front-line capabilities. For example, if
the private sector fails to deliver on FSTA, it will lose money,
but the RAF will be grounded. Of course, all spending choices in
defense involve decisions about levels of acceptable risk, but
extreme battlefield risk is ultimately incommensurate with
financial risk to the private sector. The implication is that
contracting out works best when the government has a financial
stake in providing well-defined and essentially civilian assets,
such as housing. It is not appropriate when the nation has a
win-or-lose battlefield stake in the success or failure of the
contract for a one-off military asset.
Congress and the executive branch, while supporting contracting
out where it is suitable, need to resist introducing it where
victory, not profit or loss, is at stake. The risk of defeat should
never be transferred to the private sector.
- The U.S. should take the lead in establishing best practices
for contracting out.
Policy initiatives from one nation often show up, a year or two
later, in the other. In 1997, the U.S. began to privatize
government-owned electric, water, wastewater, and natural gas
utility systems; the U.K. followed in 2003.
However, the U.K. has usually been in the lead. Britain
privatized much of its military family housing in 1996, and the
U.S. launched the MHPI in the same year. In 2001, the U.S.
considered -- and ultimately rejected -- a leasing plan for air
tankers; Britain began to consider this option in 1997. In 2002,
the U.S. abandoned its Joint Simulation System and started to
consider private-sector training solutions; Britain began to
implement this approach in 1999.
It is important not to exaggerate the similarities between the
U.S. and Britain. The unified U.S. budget model will not allow, and
should not be stretched to allow, PFI. Honestly accounting for
costs of contracting out is essential, and this is a challenge the
next British government must address. But the U.S. and Australia,
which has its own successful program of military housing
privatization run by Defence housing Australia, already consult
regularly on military housing privatization. Just as Anglo-American
information-sharing in recruitment and retention policies should be
expanded, so should both states seek to learn from
each other about contracting out.
The U.S. should take the lead by creating an office under the
Assistant Secretary of Defense for International Security Affairs
that, in consultation with the U.S.'s allies, would produce a
best-practices guide to contracting out in defense and, with due
regard to national circumstances, standardize government policies.
The intent would not be to enforce uniformity, but to create a menu
of recognized options from which states could select. In an era of
international contractors -- the top two MHPI contractors are based
in Australia and London -- this standardization would encourage
competition in bidding and transparency in government.
- Contracts with the private sector require effective
Contracting out is not privatization because it does not reduce
the government's responsibilities: It increases them. The
government must decide what it wants to buy, negotiate the
contract, and then -- like any other buyer -- ensure that the other
party fulfills its side of the bargain. In short, government
contractors need to be as capable as private-sector contractors.
Given generally lower government pay scales, this is a demanding
The U.S. and British experiences with contracting out are not
identical. In the U.S., much of the criticism has focused on
contracting out in times of war, whereas most British contracting
out has been behind the front lines. Yet in both nations, failure
to staff a fully competent contracting force has led to criticism
In Britain, PFI's shortcomings center around the government's
inability to meet the negotiating standard of the private sector.
In the U.S., the Special Inspector General for Iraq Reconstruction
"found that shortage of personnel (and the widespread lack of
required skill and experience among those available) affected all
facets of reconstruction assistance." The American Eagle failure
shows that these shortcomings are not completely restricted to
The U.S. Commission on Wartime Contracting, which is expected to
issue an interim report in 2009, should study both the U.S. and the
British experiences with care. By the same token, as Britain
expands its use of PFI to improve its service accommodations, it
should examine the MHPI, which has won praise from civilian and
military authorities for its successes, despite the failure of
The lesson of these experiences is that both the U.S. and
British armed forces need better contracting forces.
First, each force should have the power and ability to
decide when contracting out would be appropriate.
Second, as the examples of American Eagle and Iraq
suggest, the skills and training of contracting officers should be
Third, the forces need to emphasize continuity of
practical experience and not allow officers to rotate so rapidly
that knowledge is lost and responsibility is blurred, as occurs too
often in Britain.
Fourth, this force needs to be overseen by improved
auditing and be subjected to increased accountability for failures,
both internally and ultimately to appropriate legislative bodies.
It is striking that none of the problems uncovered by even the
inadequate investigations of PFI in Britain have been followed by
public disciplinary action.
- Contracting out should promote efficiency and improved
quality, not hide spending.
The British experience with PFI offers a broader lesson for the
U.S.: The only reason for government to contract out is that it has
good reason to believe that the private sector will deliver a
better service and deliver it reliably.
The British government has contracted out for many reasons that
have little or nothing to do with this logic. Most important has
been its desire to fund additional government spending by borrowing
off the balance sheet. As a result, the British state expanded
considerably. With the British economy now plunging into recession
and less able to pay for the state's growth, the failure of this
state-led economic model is now manifest.
The lesson for the U.S. is clear: Contracting out should be
considered on its merits, case by case. However, it should never be
used to justify spending that increases the size of the state while
simultaneously concealing this growth.
Nor should the state resort to contracting out simply to obtain
use of a defense asset without budgeting fully for it. If the asset
is necessary for national defense, the budget should include it. To
cut budgets and simultaneously demand the acquisition of assets
poses unacceptable risks to national security and financial
The problem with Britain's program of contracting out through
the Private Finance Initiative is not that it involves the private
sector. Nor is PFI a form of privatization, although that term is
often wrongly applied to it. The problem with PFI is that the
British government has used it for reasons unrelated to delivering
value for money. The government wanted to spend more than it
collected in taxes and was willing to borrow. It turned to PFI to
square this circle.
The result is that PFI has financed a hidden and inefficiently
administered expansion of the British state that will be a drag on
British taxpayers for decades to come. While PFI has the potential
to bring welcome improvements in government services, especially in
areas with strong competitive pressures, it has also created a
series of perverse incentives for the ministries that rely on
The solution is not to reject contracting out, but to restrict
it to the areas for which it is best suited. The government should
preserve competition within it, avoid using it for any purpose
other than improving the quality of the services the government
delivers, account for it honestly, and recognize that it requires
strong and effective administration precisely because it involves
the government as a contracting partner. Britain and the U.S.
should each learn from the other's experience, carry out the
necessary investigations, and reform their contracting out
Ted R. Bromund, Ph.D., is Senior Research
Fellow in the Margaret Thatcher Center for Freedom, a division of
the Kathryn and Shelby Cullom Davis Institute for International
Studies, at The Heritage Foundation.