22 August 2011

The government is increasingly relying on the pricing and transfer of risk to improve public services but their track record on understanding risk is poor.

Today, the Social Market Foundation (SMF) published a damning report on the government’s flagship Work Programme. Last week, the Treasury Select Committee was similarly scathing about the use of Private Finance Initiative (PFI) contracts to pay for public infrastructure. The connection between the two is government’s apparent inability to successfully measure, price and share risk.

Not working

Government is increasingly interested in ‘risk sharing’ contracts. The Work Programme uses a special type of arrangement called payment-by-results (PbR) in which the risk of reducing the number of long-term unemployed is passed to companies like Serco and A4E. The Department for Work and Pensions pays out when someone who was previously ‘long-term’ unemployed finds a job.

The trick for DWP is to pass just enough risk across to the providers to incentivise innovation and improve outcomes. This depends on the price being paid for each outcome and whether any flat-rate fees are included regardless of outcome. If too little risk is passed to the provider, they won’t be motivated to improve performance and the commissioner risks overpaying for any success that is achieved; if too much risk is passed to the providers, they will demand a high price for success or risk being driven out of business.

The SMF argues that a version of the latter has happened in the Work Programme. The providers are on the hook for better outcomes than they are ever likely to achieve, implying the vast majority may be kicked out by DWP or even go bust. DWP meanwhile are expected to be left with a larger welfare bill than anticipated.

Given that a lot of very clever people spent a great deal of effort designing the Welfare Programme contracts, and this is a flagship PbR policy for the government, it goes to show just how tricky it is to assess and price the risks involved. In short, it looks like the balance between risk and reward has not been struck in the right place.

Private finance

The latest criticism of PFI adds a further twist. These are contracts in which the upfront cost of large public construction projects are covered by the private sector. In effect, private contractors borrow money to undertake the work and then charge the government back over a period of several decades. Because the private sector has higher borrowing costs than the government this extra cost gets built into the contract.

To believe that PFI represents value for money you have to believe that the extra efficiency gained from the private contractors being on the hook more than compensates for the additional borrowing costs. Sadly, this is not the case – at least according to the Treasury Select Committee.

This represents a mistaken transfer of risk away from government to private contractors less well positioned to hold it. The lesson here is that different risks are more appropriately held by different parties. The government shouldn’t simply be in the game of transferring risks to others at all costs – because those costs are likely to be high.

There’s a link back to PbR here as some argue PbR is just a new way for government to borrow money, off-balance sheet, and rather expensively. Do PbR proponents really recognise this hidden cost?

The Government looks increasingly tied to procurement processes that rely on government’s ability to successfully price and transfer risk. PFI has a long pedigree but just last month the Department for Education announced a new £2bn PFI for schools. Payment by results is the latest fashion for public service reform featuring not just in the Work Programme but many other areas of social policy. Both require a more solid understanding of risk than the government has demonstrated to date – and that feels pretty risky to me.

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