THE ‘PRODUCTIVE FINANCE’ AGENDA - IS IT REALLY A ‘WIN-WIN’ FOR PENSION SAVERS AND THE ECONOMY?

SUMMARY?

In this paper, I consider the logic and potential implications of the Government’s policy of relying much more on pension funds and other sources of private finance[1] to fund the UK’s core environmental, physical, and social infrastructure[2] needs. We are seeing the creation of what is, in effect, a new version of the private finance initiative (PFI) regime.[3] I also challenge specific claims by private finance lobbyists that this so called ‘productive finance’ agenda is a ‘win-win’ for pension savers[4] and the economy, environment, and society.

The UK scores badly compared to its major peers on public and private investment.[5] So, there is no question infrastructure investment at scale is needed. The Government’s approach for funding core infrastructure can be summarised as:

• Limiting the use of public investment and significantly increasing the reliance on much more costly private finance. For example, in opposition, Labour had committed to ￡28 billion a year in green public investment with matched funding by private finance implying a total of ￡56 billion a year. In government, that public investment has been slashed to under ￡5 billion a year. Far from being an equal partner in a public/ private finance arrangement, the Government has relegated the state to very much the junior partner. The new National Wealth Fund and GB Energy will operate on the same principle with public money used to attract multiples of private finance.[6] The Government is ceding control of the future financing of critical infrastructure to City and overseas financial institutions.
• Hoping private finance will fill the investment gap. Government is deploying financial deregulation, and corporate welfare such as incentives and ‘de-risking’ investment using public money, to make infrastructure investment even more commercially attractive for financial institutions. The Government, as with the previous administration, is adopting a policy of socialising the risks, privatising the rewards for private finance. Or heads private finance wins, tails we lose.

Government policy has clearly been influenced by various advisory groups almost entirely dominated by representatives of financial institutions which stand to gain from this financialisation agenda.[7] The foxes haven’t sneaked into the chicken coop. Government has opened the gate, invited the foxes in, is offering to catch the chickens, and serve them up on a plate.

Let’s start with the claims that the productive finance agenda is a ‘win-win’ for pension savers[8] and the economy, environment, and society. The theory is that financial institutions (eg. insurers, asset managers, and private equity funds) will invest pension assets in core infrastructure; in doing so, infrastructure gets funded, and pension savers get better returns than if their funds are invested just in safe assets like government bonds (Gilts).

A basic rule of finance is that, if you take a higher risk, you should expect a better reward. So, pension savers might, in theory, get better investment returns if their pensions are invested in higher risk alternative assets such as infrastructure rather than in safe government bonds (Gilts). But, in reality, they are unlikely to gain much once financial institutions and various intermediaries extract fees and charges. Moreover, they will be exposed to greater risk because of financial deregulation and the practices of financial institutions – see below for more detail.[9]

Deliberately limiting the use of low cost public investment, deregulating and using corporate welfare to attract higher cost private finance just seems downright irrational. It might keep costs off the state ‘balance sheet’ and create the illusion of ‘fiscal prudence’. But, households will pay a price to meet the returns, charges, and fees demanded by financial institutions. Using more costly finance pushes up the costs of providing that infrastructure. It imposes a private finance penalty on households. It is a financial conjuring trick to conceal a false economy.

The extraction of high returns, charges, and fees means that less of every potential ￡ of investment would actually be invested in core infrastructure.?Financial institutions invest to generate the best returns and highest fees for shareholders, clients, and executives. They do not prioritise the national interest by allocating investment to where it most needed. That is not a criticism, just the nature of the beast. If we need a warning on the priorities of private finance, look at the previous PFI regime and how City and overseas financial institutions extracted huge value from UK utilities, reducing the amount available for critical long term infrastructure investment.[10]

Looking at the potential wider impacts, financialisation transfers wealth from one group in society to another and, in doing so, can exacerbate inequality. Don’t forget that the state already provides tens of ￡ billions a year in pension tax relief. This disproportionately benefits the better off in society who already have decent pension savings.[11] This tax relief also subsidises a grossly oversupplied and inefficient pensions industry. Moreover, it is hard to see how boosting the financial prospects of London based City institutions supports regeneration and levelling up.?

The UK is already a heavily financialised economy. Financial regulators are now required to promote the growth and competitiveness of the financial sector. The Government’s decision to rely so heavily on more costly private finance, and provide corporate welfare into the bargain, means powerful financial institutions could now have the state ‘over a barrel’ able to dictate the terms on which they provide investment for infrastructure.

So, it’s a win-win-win-win for financial institutions particularly those based in the City of London that have lobbied for this new PFI regime. Higher fees and value extraction, deregulation and more corporate welfare on top of the tens of ￡ billions in pensions tax relief that subsidises the pensions industry, a chance to reputation-wash activities as ‘purpose based’, and ultimately more influence over our lives and government policy as the economy and our social needs are financialised.?

How do we organise the financial system so that sufficient financial resource gets from where it is, to where it is needed, in the most economically and socially useful way? The state is a critical part of the financial system alongside private financial markets. The state can deploy much of the necessary investment at lower cost than private finance institutions, and can allocate investment in the public interest to where it is most needed. Yet, the new Government has chosen to adopt self-imposed fiscal rules which limit more public investment.[12] These rules could be changed to enable more public investment[13] and the Government doesn’t even have to borrow more to fund public investment, it could deploy other progressive policy tools.

To be clear, I am not suggesting we don't need large scale deployment of private finance. But, if the Government is acting in the public interest, it could and should be using more public investment. The obvious response to those who say we can’t afford more public investment is that, if we can’t afford low cost public investment, we certainly can’t afford more costly private finance.

There is a strong economic and public interest case for more strategic public investment, for new funding models which allow the public to gain a fair share of the rewards from investment rather than allow financial institutions to get the lion’s share while having profits underwritten.?

The Government has published some information on the role of new institutions such as GB Energy and the National Wealth Fund (NWF). But, there appears to be no overarching government strategy for funding core infrastructure. We don’t even have a consolidated assessment of the total funding needed to meet the UK’s core infrastructure needs.[14] Government seems to be hoping that risky deregulation and expensive corporate welfare will ‘encourage’ financial institutions to invest in the UK’s infrastructure priorities, and the market will do the rest.

Despite the compelling case for more public investment, realistically the ‘fiscal prudence’ narrative is probably too well established for civil society to change the direction of travel on this new PFI regime any time soon. But, that shouldn’t stop civil society prioritising making the case for more public investment and for a progressive, public interest infrastructure funding strategy. Of course, large scale private finance is also needed. So, civil society should develop and promote new progressive partnership models that operate in the public interest alongside policy and regulatory tools that ensure financial institutions invest productively not just to extract value.

That will take time. The priority now is to prevent potential abuses. We must prevent a repeat of the worst excesses of the previous PFI regime and huge value extraction from UK utilities. Yet, the Government does not appear to have any concrete plans for preventing financial institutions exploiting this new ‘partnership’ in which the state is now the junior partner. There has been no impact assessment of the costs of using more costly private finance to fund the necessary infrastructure.

Civil society will need to campaign for strict conditions to be applied to ensure fair value for the public. Government should cap the returns, fees, and charges extracted by financial institutions participating in any new public/ private partnerships or when financial institutions take on ventures ‘de-risked’ and made financially viable by the state. Robust governance structures and transparency will be needed to hold private finance to account and ensure any partnerships operate in the public interest, including the new GB Energy and the National Wealth Fund. Civil society will have to persuade Parliament to hold the Government to account for decisions that will have long lasting effects on households including future generations.

Civil society will have its work cut out to mitigate the potential harms caused by this new state/ private finance partnership. The advisory groups that have influenced the new Government on this agenda have been almost entirely dominated by representatives of financial institutions that stand to gain from financialisation. In 30 years campaigning, I don’t think I can recall finance industry lobbies having so much influence over government policy. So, I’m not very optimistic. But, we can’t give up on this. There is too much at stake.

INTRODUCTION AND BACKGROUND?

Finance sector lobbies have been very effective at exploiting claims that the state cannot afford any more public investment to persuade successive governments to utilise pension schemes and other sources of private finance for policy goals. The targets for private finance include core physical infrastructure, social infrastructure (such as affordable housing and new towns, social care, and social services), and greentech/ infrastructure to support the green transition.?

The announcement?from the Chancellor on a ‘big bang for growth’ gives a flavour of the reliance the new Government is placing on private finance.[15] The new government is pursuing the same agenda as the previous government, which promoted initiatives such as the Mansion House Compact.[16] The new Government seems to be planning to use private finance on an even bigger scale. This is part of the so called ‘productive finance’ agenda.

And we mustn’t forget that this private finance agenda is being pushed as a solution to social issues such as poverty, financial exclusion, levelling up, and regeneration under the banners of friendly sounding terms such as ‘social impact’, ‘catalytic’, ‘blended’, ‘purpose based’ finance and ‘inclusive capitalism’.[17]

The UK does score badly compared to its major peers on public and private investment. So, there is no question infrastructure investment at scale is needed. But, the implications of limiting the use of low cost public investment and relying so heavily on more costly private finance have not been properly considered.

Private finance lobbyists are also claiming that this ‘productive finance’ agenda is a ‘win-win’ for pension savers[18]and the economy, environment, and society.?

WHO STANDS TO GAIN, WHO STANDS TO LOSE??

Let’s start with the claims that? the productive finance agenda is indeed a ‘win-win’ for pension savers[19] and the economy, environment, and society. Why do promoters say this is a ‘win-win’? To summarise, the claim is that:

• Public finances are tight and ‘there’s no money left’.?
• Financial institutions (eg. insurers, asset managers, and private equity funds) stand ready to invest pension assets in core infrastructure.
• Government gets the investment it needs to fund its policy priorities and drive the economic growth that so much of the new programme for government seems to depend on.
• In turn, pension savers/ investors could receive better investment returns from alternative assets (rather than government bonds and public listed companies) which would boost the value of their pension in retirement or personal assets.

When you deconstruct what is happening, it doesn't look very productive or a ‘win-win’ for the economy and ordinary households. To understand the issue, we need to identify the different interests involved in this part of the financial system, understand how much more costly private finance is, and the implications of using more costly private finance when lower cost public investment is available.

The different interests

This is fairly high level, simplified systems analysis but there are four main relevant sets of interests:??

• Pension schemes and their members/ policyholders. This includes large employer pension schemes which have their own investment managers or insurance based pension plans managed by insurance companies, people saving for retirement and those in retirement for example living off an annuity. They are the ultimate source of the investment funds even if the actual decisions on where and when to invest, and on what terms, are made by the finance sector.?
• Ordinary households who are not pension?scheme members/ savers. They might be taxpayers, or households that rely on core green, physical, and social infrastructure such as social services and housing. Actually, pension savers wear different ‘hats’. They might have a pension/ annuity, be a taxpayer, and use the infrastructure services that is to be funded by private finance.[20]?
• The interests of the economy/ society ie. that is how does the nation get the investment it needs for infrastructure, green transition, social services, affordable housing, promote sustainable economic growth, levelling up and regeneration, and so on.?
• The private finance sector (financial institutions such as asset managers, insurers, banks, private equity managers, advisers, consultants etc) who invest and manage money on behalf of pension scheme members/ policyholders to generate returns and apply charges and fees for doing so.?These financial institutions determine the allocation of investments and the returns, management charges and fees required before committing that investment. This will be primarily domestic financial institutions based in the City of London but the Government is also keen to attract investment from major global financial institutions. This is where competition and competitiveness could work against the public interest. That is, if the Government wants to attract mobile global investment it will have to offer even more favourable conditions in terms of investment returns and corporate welfare. So, the fiercer the competition, the more costly that private finance could be.

?To be precise, there is a fifth set of interests in this - the Government. It gets to act as if it is being fiscally prudent by keeping policy costs off the state ‘balance sheet’. Yet, the costs are actually transferred from the state balance sheet to households. Just because the state doesn’t fund something, it doesn’t mean it doesn’t cost us. Indeed, as explained below, because private finance is more costly than public investment due to the high returns and fees generated, it costs more to finance the same policy goals. The approach of using private finance rather than low cost public investment is a financial conjuring trick that conceals a false economy. This financial conjuring trick is helped by the way public and private finances are presented and covered by analysts and in the media. Anything that keeps costs off the state balance sheet is presented by the media as prudent and, therefore, good even though households just pay in a different way and pay more.

However, for the purposes of this paper, I will consider the above four sets of interests. Applying this framework, it becomes clear that the big winners are likely to be the same financial institutions promoting this agenda. This is perhaps no great surprise given that the various task forces and advisory councils that have influenced successive government policy on this agenda have been almost totally dominated by finance industry representatives.

How much more costly is private finance??

Limiting the use of low cost public investment to tackle economic, environmental, and public policy goals, and using private finance to fill the gaps, creates new opportunities for financial institutions and intermediaries to extract high returns and fees. As I have covered elsewhere, the productive finance agenda and the establishment of the National Wealth Fund and GB Energy looks suspiciously like the creation of a new huge private finance initiative (PFI) regime.[21]?

Private finance is more costly than public investment. Financial institutions will not invest unless they think they can generate high financial returns and fees. This is not a criticism, financial institutions are not charities. The priority is to generate returns, fees, profits, and bonuses for their clients, shareholders, and executives.

Governments can raise the necessary investment at much lower cost. It can borrow by issuing government bonds, deploy progressive wealth taxes, use the Bank of England, or even NS&I. Whichever approach it uses, the state can raise the necessary investment for policy priorities at significantly lower cost than private finance.

It is difficult to say with certainty until we see more details of which types of project and investors are involved. Further research and analysis is needed. But, we can get an idea of what the additional costs are likely to be from existing data.

To reiterate, if private finance institutions are to provide investment capital for projects they will seek to optimise returns and if projects carry a higher level of financial risk, or where investment returns are not guaranteed, they will expect to generate high returns to compensate. This is a basic risk/ reward rule of investment.

Financial institutions will want to do better than the return they can get from buying government bonds (‘Gilts’), considered to be one of the safest financial assets for financial institutions. The return from Gilts is taken to be the ‘risk free rate of return. So, the return private finance institutions expect to make is usually expressed in the form of the ‘premium above the risk free rate’. At the time of writing, the yield on 10 year Gilts is 3.9%, with 30 year Gilts at 4.5%.[22]?

That gives us an idea of how much it would cost the Government to borrow to fund major green, physical, and social infrastructure projects over various periods of time. Remember, as mentioned above, government doesn’t have to borrow to raise funds. So, the Government could actually fund major green, physical, or social infrastructure priorities at even lower cost than implied by Gilt rates.?

Analysis of previous PFI deals by the National Audit Office (NAO) found that the returns expected by private finance institutions ranged from 2% - 5% above the Gilt rate at the time. Note that PFI carried additional costs in the form of arrangement, management, and administration fees. The NAO report included examples of schools programmes costing 40% more to fund using PFI than if government borrowing had been used, and building of hospitals 70% more. The previous PFI regime was a bad deal for society. We are still paying the price for that policy of keeping costs off the state balance sheet. The Office for Budget Responsibility’s (OBR’s) July 2017 fiscal risks report cited the use of off-balance sheet vehicles like PFI as an example of a ‘fiscal illusion’.[23]?

Promoters of the new PFI regime might argue that new arrangements will not represent such a poor deal for society as the old schemes. Yet, there is no reason to expect that it will be that different. The structure of deals and projects might be different but the core principles will be the same. Private finance institutions will still expect to generate returns above the risk free rate if they are to finance green, physical, and social infrastructure.?

For example, a private finance infrastructure vehicle actually aimed at pension schemes says that it aims to generate an investment return from core infrastructure assets that matches or exceeds UK inflation (measured by the CPI) plus 4%-6% over a rolling ten year period. Note that this is after charges and fees. So, the gross return the private finance vehicle expects to generate from core infrastructure would be even higher.[24]???

Private finance is being deployed to fund social infrastructure, not just physical infrastructure. In the course of research for a project on ‘social impact’ finance,[25] The Financial Inclusion Centre found examples of financial institutions promoting returns of between 8-13% a year from investing in social housing. It would obviously be much cheaper for the state to provide the financial resources to local authorities to build affordable housing.?

Socialising the risks, privatising the rewards?

Private finance is not only more costly than state finance, it is not aligned with progressive policy goals. Private finance allocates capital to where it can generate the best returns and fees, not to where resources are most needed. So, the private finance lobby wants the state (ie. citizens) to provide corporate welfare to make those investments even more commercially attractive and to encourage apparently anxious financial institutions to commit the (high return generating) finance.

This corporate welfare can take the form of providing incentives to invest, or ‘de-risking’ the investment to subsidise the returns generated or underwrite the financial risks involved. So, if things go wrong with investments, the state (us) protects the providers of finance and if things go well the providers of finance get to bank the returns. This is known as socialising the risks, privatising the rewards. Or heads they win, tails we lose.

The irony is that financial institutions are supposed to be specialists at managing economic and financial risks. Yet, they want the state (us) to underwrite their risks and subsidise their returns. Moreover, pundits claim that the allocation of investments is best left to the market experts. Yet, the essence of concepts like de-risking is that the state is expected to identify and manage high risk ventures to make them viable and profitable for private finance to then extract high returns.

The winners and losers

Let’s consider the four sets of interests in turn.

Pension savers?

Let’s start with pension savers. It might be argued that using pension and investment assets is a zero sum game. As I explain elsewhere, using costly private finance to fund core infrastructure means that households pay a private finance penalty. But, those households who are pension savers and investors will at least receive higher investment returns.

A basic rule of finance is that, if you take a higher risk, you should expect a better reward. So, yes, pension savers might, in theory, get better investment returns if their pensions are invested in higher risk alternative assets such as infrastructure rather than in safe government bonds (Gilts).

Yet, in reality, they are unlikely to gain much once financial institutions and various intermediaries extract fees and charges. Alternative investment funds such as infrastructure funds and private equity funds tend to have higher costs and fees than more conventional investment funds.[26]???

Of course, it all depends on the level of costs and fees. If private finance costs and fees can be controlled, then perhaps pension savers will see some improvement in the returns they receive and the value of their pension pot when they get to retirement.

But, pension savers could be exposed to greater financial risks if their pension schemes invest in alternative assets especially if they have a pension scheme with a life insurer. Note that the additional risk comes not from investing in infrastructure per se but the way insurers will use this investment to reduce the amount of regulatory capital that is supposed to be held against the risk of losses.

Over the years, we have seen a huge transfer of risk in pensions from the state/ employers to individuals. The most obvious is the closure of defined benefit pension schemes and establishment of defined contribution schemes which are more exposed to market risk. Risk has been individualised. Further financial deregulation transfers even more risk to individuals.

Insurance prudential[27] regulation is frankly bizarre. Insurance companies can invest policyholders’ money in higher risk assets that supposedly generate higher returns. This would be fine if the risk is managed well.

Logically, if insurers invest in higher risk assets, you would expect insurers to have to hold more capital against the risk of things going wrong. However, the way the Solvency UK[28] insurance regulation works means that insurance companies can ‘bring forward’ the higher expected returns through a measure called the Matching Adjustment (MA).[29] That is, they can presume these returns have been delivered and reduce the amount of actual capital held against the risk of things going wrong. Experts have described capital created by the banking of future returns not yet earned as artificial capital.[30] And the fact that insurers don’t have to hold as much real capital in reserve, allows insurers to give their shareholders windfalls.

Some of the UK’s major life insurers which manage pension assets and annuities for ordinary people look much stronger than they really are due to the use of this artificial capital.[31] Prudential regulators have already agreed to allow more types of asset to be included within this Matching Adjustment scheme and insurance companies are lobbying for even more to be included.[32]?Investing in infrastructure and similar assets will allow them to make even greater use of this artificial capital mechanism.?

This financial deregulation and the drive to use greater amounts of private finance supported by successive governments works out great for insurance companies. The weakening of the rules means by investing in riskier assets they get to generate higher fees and give shareholders windfalls. The risk of those investments going wrong is transferred to ordinary people who have a pension with the insurer.

It gets even worse. There has been a major growth in the number of defined benefit employer pension schemes being transferred to life insurers who, for a fee, take over responsibility for honouring pension commitments to scheme members. This is known as pension buy outs/ buy ins.[33] The market appears to be dominated by a small number of firms. The top four have between 70%-80% of new business in this market. This concentration risk amplifies concerns about the prudential regulation of this market described above. If problems emerge even in one insurer this could affect large numbers of pension scheme members.[34] And remember, including ‘productive finance’ assets within the Matching Adjustment regime will further undermine the security of peoples’ pensions transferred to insurers through pension buy outs/ buy ins.

So, this productive finance agenda doesn’t have that much to offer pension savers. There may be some prospect of higher investment returns but the high charges and fees extracted by City institutions and intermediaries are likely to significantly reduce the potential benefits. In return for a potentially small upside, pension savers will be exposed to even greater financial risks.?

Households and wider social impacts?

Financial institutions will expect high returns and fees (and deregulation and corporate welfare into the bargain) before they provide the investment needed for core infrastructure. This makes private finance more costly than public investment. The state can raise the necessary investment at much lower cost.

Someone has to pay a price to fund the required returns and fees. Private finance will only invest if it thinks it can make high enough revenues and profits from the infrastructure to extract the required returns on investment and management fees.

Using a more costly form of finance, by definition, will feed through to higher infrastructure costs. Charges and bills for using green and physical infrastructure, social services, social care, or rents in the case of ‘affordable’ housing, will be higher than they need be. Higher costs will be loaded onto ordinary households who are, in effect, a captive market for private finance institutions.[35] Deliberately using more costly private finance, when lower cost public investment could be deployed, imposes a private finance penalty on households.?

We cannot say with any real degree of certainty yet how much this will cost ordinary households until we get more detail on which green, physical, and social infrastructure will be funded using private finance and on what terms.

As an illustration, Labour while in opposition had said that its green prosperity plan would consist of ￡28 billion a year in public investment, match funded by ￡28 billion from private finance – so a total of ￡56 billion a year. It has since drastically reduced the amount of public investment down to around ￡5 billion a year. This implies that it would need to find ￡51 billion a year from private finance generating the level of returns outlined above. The cumulative additional costs imposed on households could be significant

Moreover, the Government is willing to provide ‘corporate welfare’ to attract this costly private finance. This corporate welfare includes financial incentives or ‘de-risking’ using public money. So, taxpayers will pay for this corporate welfare.

Looking at the potential wider impacts, financialisation transfers wealth from one group in society to another as the returns generated by the charges and fees paid by infrastructure users are transferred to those with pension assets. Don’t forget that the state already provides tens of ￡ billions a year in pension tax relief. This disproportionately benefits the better off in society who already have decent pension savings.[36] This tax relief also subsidises a grossly oversupplied and inefficient pensions industry.

What about the impact on levelling up and regeneration? Financialisation can exacerbate inequality.[37] It is hard to see how an approach which boosts the prospects of City financial institutions and their well paid executives based in London and the South East supports regeneration and levelling up. This effect is likely to be heightened by the secondary growth and competitiveness objective imposed on financial regulators. Financial regulators now have to promote the growth and competitiveness of the UK economy with the emphasis on financial services.

As well as direct financial costs, democratically unaccountable financial institutions will exercise even more control and influence over our lives.

The environment and the economy?

The extraction of high returns, charges, and fees means that less of every potential ￡ of investment would actually be invested in core infrastructure or used to promote economic growth.?As mentioned, not only do financial institutions want to generate high returns and fees, they also want the taxpayer to provide corporate welfare if they are to commit the investment.

Financial institutions invest to generate the best returns and highest fees for shareholders, clients, and executives. They do not prioritise the national interest by allocating investment to where it most needed. That is not a criticism, just the nature of the beast. If we need a warning on the priorities of private finance, look at the excesses of the previous PFI regime and how UK and overseas financial institutions extracted huge value from UK utilities, reducing the amount available for critical long term infrastructure investment.

Private finance lobbies have successfully pushed for deregulation to make infrastructure investments even more commercially attractive for shareholders and also want the state to provide ‘corporate welfare’ in the form of financial incentives or ‘de-risking’ of investments. Socialising the risks, privatising the rewards. Heads they win, tails we lose.

Pundits might argue that the high returns, fees, and charges and corporate welfare are a price worth paying as financial institutions are just better at investment than the state. Financial institutions are supposed to specialise in managing financial risks, and spotting winners. Yet, financial institutions are not actually that good at allocating financial resources to environmentally, economically and socially useful activities.[38] Now they want the state to: underwrite risks and subsidise returns; or identify and manage high risk ventures to make them viable and profitable to hand over to private finance to then extract high future returns.?

If the private finance sector is so good at investing and managing risks, it begs the question of why do they need this corporate welfare? Well, the answer is that it is not that they need it, it is that they are in a position to demand it before committing the investment.

The decision to limit low cost public investment and rely so much on private finance means powerful City and overseas financial institutions could now have the Government (and us) ‘over a barrel’ on infrastructure investment. This is where competition and competitiveness could work against the public interest. The Government wants to attract overseas financial institutions? and will have to compete with other nations to persuade international financial institutions to invest in UK infrastructure. Financial institutions, acting in self-interest, will drive a hard bargain and demand the most favourable terms from competing national governments before committing investment. This could put further upward pressure on the costs of funding UK priority infrastructure.

The financial sector?

So, what about the financial sector itself? Financial institutions, and various intermediaries and advisers obviously stand to gain. It’s win-win-win-win for powerful City institutions – higher fees, deregulation and corporate welfare, reputation-washing, and ultimately more power and influence over our lives and government policy.

Major new opportunities to generate high returns and fees and also have those returns ‘de-risked’, are being created by deliberate government policy. Not only that, the associated deregulation transfers more risk to ordinary pension savers and investors, and provides opportunities for giving shareholders windfalls.

It's not just on Solvency UK where we're seeing deregulation. The charge cap on workplace pensions which prevented rip off investment fees was weakened, again on the grounds that this would encourage pension fund managers to invest in supposedly higher return assets which just so happen to have higher fees attached.[39]?

Moreover, the Financial Conduct Authority (FCA) is considering whether to relax the rules on financial advice - what the FCA calls the advice/ guidance boundary. Again, the lobby is claiming that the existing rules prevent investment firms and advisers from recommending that people invest in 'productive' assets which generate higher returns. However, many suspect that the real reason is that this will allow investment firms/ banks/ insurers to sell higher cost/ higher risk products but with reduced liability for paying redress for misselling unsuitable products.

The benefits aren’t just financial. City institutions also get a reputational boost as they are able to rebrand all this value extraction as ‘purpose based’, ‘social impact’, ‘catalytic’, or ‘blended’ finance or ‘inclusive capitalism’.

The expansion of the use of private finance in funding green, physical, and social infrastructure – the financialisation of the economy and society – gives these democratically unaccountable financial institutions even more power and influence over our lives and government policy. This cannot be good.

THE BIG PICTURE?

While this paper assesses the specific ‘win-win’ claims made by finance lobbyists, we cannot lose sight of the big picture - how best to fund critical green, physical, and social infrastructure. The UK scores badly against its peers on public and private investment.[40] So, how do we organise the financial system so that sufficient investment gets from where it is, to where it is needed, in the most economically and socially useful way?

The state is a critical part of the financial system alongside private financial markets. The state can deploy much of the necessary investment at lower cost than private finance institutions and can allocate financial resource to where it is most needed. Private finance is not only more costly than state finance, it allocates capital to where it can generate the best returns and fees, not to where resource is most needed.

Yet, despite the obvious comparative advantages of state finance, the new Government has chosen to adopt a set of self-imposed fiscal rules which limit more public investment, citing the need for ‘fiscal prudence’. These self-imposed rules could be changed to enable more public investment.[41] Government could choose to deploy more public investment.[42] Instead, it is creating major new opportunities for City institutions and intermediaries to generate high returns and fees from investing in green, physical, and social infrastructure.?It does not make economic sense to consciously choose a more costly form of finance for infrastructure priorities when lower cost public investment is available.

Pundits and private finance lobbyists will respond by claiming that the Government has no choice but to turn to private finance as the state cannot afford more public investment enabled by government borrowing. This is misleading for a number of reasons. The impact of the ‘Truss Budget’ is often cited as a warning. But, the financial markets reacted badly to the Truss Budget because of the scale of unfunded tax cuts. Those markets seem fairly relaxed about the idea of more government borrowing if it used for productive purposes.[43]? Moreover, as mentioned above, the Government doesn’t have to borrow more to fund public investment, it can deploy progressive taxes, use NS&I, or get the Bank of England to deploy policy tools to generate the necessary resources.?

The other obvious response to the pro private finance lobby claim we cannot afford more public investment is that if society can’t afford more public investment, by definition, it surely cannot afford more costly private finance.

The new Government talks about a ‘partnership’ with the financial sector to fund core green, physical, and social infrastructure. At this stage, it is not possible to estimate with any degree of accuracy how much of that total infrastructure investment need is expected to be met by the state and how much by the private sector. There doesn’t appear to be a single consolidated list that sets out: i. how much investment the Government estimates is needed for green, physical, and social infrastructure; and ii. how that will be apportioned between public and private finance and the expected costs of that investment. There doesn’t appear to be any impact assessment of the additional costs to households of relying more on costly private finance.

As mentioned, in opposition, Labour’s Green Prosperity Plan envisaged?￡28 billion a year of public investment match funded by private investment (implying a total of ￡56 billion a year). This is still would have involved a lot of costly private finance.

But, at least it was a partnership of sorts. As outlined above, those public investment plans have been slashed. Now the Government talks of an additional ￡23.7 billion over the next parliament or equivalent to under ￡5 billion a year.?Assuming Labour still thinks it needs ￡56 billion a year in public and private finance to green the economy, it looks like the state is being relegated to very much the junior partner with private finance providing the bulk of the identified investment need to green the economy.

Analysts have estimated that the UK needs to increase public investment by ￡26 billion a year (1% of GDP) to make up for years of underinvestment in environmental priorities as part of a total package of public and private investment of ￡77 billion a year. [44] So, based on this assessment of investment need, the state will be even more of a junior partner.

So, not only is the Government planning to use more costly private finance for an even greater share of the total financing need (pushing higher costs onto households), ?as mentioned above, the government (actually using citizens’ money) is willing to ‘de-risk’ investments to make those investments even more commercially attractive for City and overseas financial institutions. If investments go wrong, we pick up the tab. If investments become profitable, financial institutions get to bank the rewards.

New institutions like GB Energy and the National Wealth Fund are set up on this principle – using the state to ‘crowd in’ (much more costly) private investment using concepts like ‘blended’ or ‘catalytic’ finance.?GB Energy will be given ￡8.3 billion over the lifetime of this Parliament to co-invest with private finance in emerging green technologies and scale up investment in mature technologies. For example, it is working with the Crown Estate to attract ￡60 billion of private investment by 2030.[45]? The National Wealth Fund will be capitalised with ￡7.3 billion of public investment over the next Parliament with a view to attracting ￡3 of private investment for each ￡1 of public investment.[46]

To be clear, I am not suggesting that all core infrastructure should be funded through public investment, or that private finance should not be used. We do need large scale private finance. But, I am arguing that there is room for more public investment, that government could and should be using more public investment if it is acting in the public interest. There is surely a strong economic and public interest case for more strategic public investment, for the development of new funding models which allow the public to gain its fair share of the rewards from investment rather than allow financial institutions to get the lion’s share.?

The previous PFI regime was used to keep costs off the state balance sheet by governments also trying to appear ‘fiscally prudent’. It was a financial conjuring trick to conceal a false economy. Now, a new version of PFI is being deployed for the same reasons with the same attendant risks and potential harms for society.?

THE NEED FOR A PROGRESSIVE INFRASTRUCTURE FUNDING STRATEGY AND DAMAGE LIMITATION MEASURES?

The Government has published some information on the role of new institutions such as GB Energy and the National Wealth Fund (NWF).[47] But, there appears to be no overarching government strategy for funding core infrastructure. We don’t even have a consolidated assessment of the total funding needed to meet the UK’s core infrastructure needs.[48] Government seems to be hoping that risky deregulation and expensive corporate welfare will ‘encourage’ financial institutions to invest in the UK’s infrastructure priorities, and the market will do the rest.

Despite the evidence from history, the Government does not appear to have any concrete plans for preventing financial institutions exploiting this new ‘partnership’ in which the state is now the junior partner. No framework or criteria for determining: how, where, and when to deploy public and private investment; or how risk and rewards should be shared in any partnerships between the state and private finance. No sign of strategic policy and regulatory tools to ensure financial institutions invest productively rather than to extract value.

Despite the compelling case for more public investment, realistically the ‘fiscal prudence’ narrative is probably too well established for civil society to change the direction of travel on this new PFI regime any time soon.

Nevertheless, that shouldn’t stop civil society prioritising making the case for more public investment and for a progressive, public interest infrastructure funding strategy. Of course, large scale private finance is also needed. So, civil society should develop and promote new progressive partnership models that operate in the public interest alongside policy and regulatory tools that ensure financial institutions invest productively not just to extract value.

That will take time. The immediate priority is to mitigate potential misuses and abuses, and prevent a repeat of the worst excesses of the previous PFI regime. The way UK and overseas financial institutions extracted huge value from UK utilities, reducing long term critical infrastructure investment, provides another painful lesson from history.

Civil society will need to campaign for strict conditions to be applied to the deployment of private finance to ensure that any new public-private ‘partnership models’ share risk and returns in a way that is fair, equitable, and economically and socially useful. How do we ensure fair value for the public? Government should cap the returns, fees, and charges extracted by financial institutions.

Robust governance structures and full transparency will be needed to hold private finance institutions to account and ensure any partnerships operate in the public interest. The governance and operations of new institutions such as GB Energy and the National Wealth Fund will be critical. Civil society will have to persuade Parliament to hold the Government to account for decisions that will have long lasting effects on households including future generations. Civil society should also campaign for reform of the self-harming presentation of government finances which penalises the use of public spending and investment and makes the use of private finance seem beneficial.

Civil society will have its work cut out to mitigate the potential harms caused by this new partnership between government and financial sector. The task forces and advisory groups that have advised the new Government on this agenda have been almost entirely dominated by representatives of financial institutions that stand to gain from this financialisation.

In 30 years campaigning, I don’t think I can recall finance industry lobbies having so much influence over government policy. So, I’m not very optimistic. But, we can’t give up on this. There is too much at stake.

Mick McAteer?

August 2024?

[1] Private finance for the purposes of this article includes pension funds, insurance funds, investment funds, and private equity/ venture capital and so on.

[2] Core infrastructure includes: green infrastructure/ ‘greentech’ to green the economy and make the economy and society more resilient to climate change; physical infrastructure such as transport, buildings, and utilities; digital connectivity and communications infrastructure; and ‘social’ infrastructure such as affordable housing and social care, levelling up, regeneration, and services to tackle poverty and exclusion and social injustice. Some of these overlap eg. greening physical infrastructure helps green the economy.

[3] We are seeing the implementation of what is in effect a huge new private finance initiative (PFI) regime across a range of policy areas. See: (1) A new PFI regime, corporate welfare, and financial deregulation-private finance lobbies are winning big and ordinary people will pay the price | LinkedIn

[4] This includes those currently contributing to a pension and those taking an income from retirement eg. through an annuity. It also includes savers and investors, not just people saving inside a pension scheme. But, for the purposes of this article I focus on pension savers.

[5]? Public investment: what you need to know | Institute for Fiscal Studies (ifs.org.uk)

[6] We have yet to see details of how these new institutions will work in practice. But, from what we can see, a key role for both will be to ‘de-risk’ and attract private finance https://assets.publishing.service.gov.uk/media/66a235daab418ab055592d27/great-british-energy-founding-statement.pdf Boost for new National Wealth Fund to unlock private investment - GOV.UK (www.gov.uk)

[7] This includes The Productive Finance Working Group, British Infrastructure Council, and National Wealth Fund Task Force

[8] This includes those currently contributing to a pension and those taking an income from retirement eg. through an annuity. It also includes savers and investors, not just people saving inside a pension scheme. But, for the purposes of this article I focus on pension savers.

[9] Note that the additional risk comes not from investing in infrastructure per se but the way insurers will use this investment to reduce the amount of regulatory capital that is supposed to be held against the risk of losses.

[10] For example, see: Thames Water Users Left to Pick Up Bill For Former Owner Macquarie - Bloomberg

[11] The net cost of pension income tax and National Insurance Contributions (NICs) relief was estimated to be ￡48.2 billion in 2022. Fifty eight percentage of that relief went to people in the 40% and 45% income tax bracket. CBP-7505.pdf (parliament.uk)

[12] The chancellor has tied her own hands with her fiscal rules – here’s why she should change them ? City, University of London

[13] Scrap fiscal rules and stop subsidising banks to fix our broken economy | New Economics Foundation

[14] To be fair the National Infrastructure Commission has produced an assessment covering some of those core areas. But, it is a partial assessment. Final-NIA-2-Full-Document.pdf (nic.org.uk)

[15] Chancellor vows 'big bang on growth' to boost investment and savings - GOV.UK (www.gov.uk)

[16] Chancellor’s Mansion House Reforms to boost typical pension by over ￡1,000 a year - GOV.UK (www.gov.uk)

[17] Social Impact Finance | The Financial Inclusion Centre

[18] This includes those currently contributing to a pension and those taking an income from retirement eg. through an annuity. It also includes savers and investors, not just people saving inside a pension scheme. But, for the purposes of this article I focus on pension savers.

[19] This includes those currently contributing to a pension and those taking an income from retirement eg. through an annuity. It also includes savers and investors, not just people saving inside a pension scheme. But, for the purposes of this article I focus on pension savers.

[20] So, they could actually be in a position where they pay higher costs to use services funded by private finance and those higher costs are funding the returns they get from their pension saving. Not so much a question of robbing Peter to pay Paul, but Peter robbing himself to pay himself.

[21] (6) A new PFI regime, corporate welfare, and financial deregulation-private finance lobbies are winning big and ordinary people will pay the price | LinkedIn

[22] United Kingdom Rates & Bonds - Bloomberg

[23] PFI-and-PF2.pdf (nao.org.uk)

[24] GLIL Infrastructure (localpensionspartnership.org.uk)

[25] Social Impact Finance | The Financial Inclusion Centre

[26] See Table 2: analysing-the-impact-of-private-pension-measures-on-member-outcomes.pdf (publishing.service.gov.uk) Analysis produced by the Government Actuary’s Department considered the potential effect of pension schemes investing more in private equity funds. It was assumed that the private equity funds would produce a higher investment return than conventional assets. But, once the high charging structures common in private equity were factored in, investing in private equity could actually reduce the size of the pension savers pot.

[27] Prudential regulation is intended to ensure life insurers who manage pension schemes for policyholders have enough assets to honour commitments, to protect against future financial shocks. This is similar to the concept of bank prudential regulation which aims to ensure that banks have enough capital to withstand losses on loans and other financial activities.

[28] The main prudential regulation covering insurers. Previously known as Solvency II.

[29] The technique in question is called the Matching Adjustment. For more detail of how risky this is see: Submission to HM Treasury Review of Solvency II consultation | The Financial Inclusion Centre Former FCA board member criticises Solvency II reforms (ft.com)?

[30] Capital created by matching adjustment is entirely artificial (ft.com)

[31] Regulation is masking the true condition of insurers (ft.com)

[32] Solvency II: the case for introducing a Matching Adjustment sandbox - Financial Times - Partner Content by Phoenix Group (ft.com)

[33] The pension deal bonanza remaking the UK’s retirement sector (ft.com)

[34] Pension buyouts-a ticking time bomb? (8) Post | LinkedIn

[35] When it comes to critical infrastructure, households are more or less a captive market for private finance. Households don’t really have the option of shopping around for better deals. This makes it even easier for private finance institutions to extract returns and fees.

[36] The net cost of pension income tax and National Insurance Contributions (NICs) relief was estimated to be ￡48.2 billion in 2022. Fifty eight percentage of that relief went to people in the 40% and 45% income tax bracket. CBP-7505.pdf (parliament.uk)

[37] Inequality and financialisation | New Economics Foundation, ?How household debt influences inequality | British Politics and Policy at LSE

[38] For examples, see: An Economic and Social Audit of the City | The Financial Inclusion Centre

[39] Investing in higher charging infrastructure funds, private equity and other alternative assets could take schemes over the charge cap.

[40]? Public investment: what you need to know | Institute for Fiscal Studies (ifs.org.uk)

[41] Scrap fiscal rules and stop subsidising banks to fix our broken economy | New Economics Foundation

[42] The chancellor has tied her own hands with her fiscal rules – here’s why she should change them ? City, University of London

[43] Labour could borrow more without UK bond market backlash, say investors (ft.com)

[44] New analysis by leading economists concludes that UK government should increase sustainable public investment by ￡26 billion a year to boost growth and productivity - Grantham Research Institute on climate change and the environment (lse.ac.uk)

[45] Great British Energy: what we know so far - Energy Saving Trust

[46] Boost for new National Wealth Fund to unlock private investment - GOV.UK (www.gov.uk)

[47] We have yet to see details of how these new institutions will work in practice. But, from what we can see, a key role for both will be to ‘de-risk’ private finance https://assets.publishing.service.gov.uk/media/66a235daab418ab055592d27/great-british-energy-founding-statement.pdf Boost for new National Wealth Fund to unlock private investment - GOV.UK (www.gov.uk)

[48] To be fair the National Infrastructure Commission has produced an assessment covering some of those core areas. But, it is a partial assessment. Final-NIA-2-Full-Document.pdf (nic.org.uk)