NHS infrastructure improvements are being held back by the outdated PDC charge, and this could impede government attempts to "build back better". Howard Davis looks at the state of healthcare infrastructure.
Too often, government policy ignores social infrastructure when setting out investment plans. But the last year has shown the critical importance of the NHS, and therefore, its infrastructure to the economy.
While direct spending on NHS capital has increased, the government has also shut down other methods for the NHS to fund health infrastructure. Reducing capital charges would help the NHS system to invest and boost the economy’s recovery.
Why is NHS infrastructure vital to economic recovery?
Working in social infrastructure often makes you feel like the poor cousin of the heady world of transport, telecoms and energy infrastructure. Government plans usually focus on these industries as 'investment' rather than 'spending' departments.
The government’s first long-term infrastructure plan ignored health and social infrastructure entirely. That’s been fixed now and the UK National Infrastructure Delivery Plan 2016 to 2021 devoted three paragraphs to healthcare on page 79.
Since then, the government has made the welcome announcement to invest in 46 new hospital schemes, although the last six of these are not included in the most-recent budget papers. This shows a commitment to an increased budget for NHS infrastructure.
The capital budget has already increased to between £8.5-9.5 billion pa over the next two years, as part of a broader commitment to invest £600 billion in infrastructure more generally over the next five years. This is a significant commitment and key part of "building back better".
Healthcare represents 10% of the UK economy and the NHS is 78% of that. This is larger than transport, energy or telecommunications. The sector underpins key, government-targeted growth sectors like life sciences, research and education. It's a knowledge industry, with highly qualified people developing new products and innovations every day.
Not to mention, healthcare is a fundamental ingredient and enabler of economic productivity. Put simply, you can’t work if you're ill. Healthcare therefore drives growth, employment and productivity in the broader economy.
This isn't, however, possible without high-quality NHS infrastructure. This requires public sector investment, because the NHS represents 78% of the British healthcare sector.
Why does NHS infrastructure need investment?
The NHS annual depreciation bill is around £3.5 billion. This is based on historical values and probably understates the investment needed to maintain the status quo.
Factoring in the increases in construction costs over the last 10-15 years, just maintaining the status quo could cost £10 billion per annum. This is without bringing NHS infrastructure up to modern standards and implementing NHS plans to improve services.
According to NHS returns, backlog maintenance sits at a further £9 billion. Trusts have reported incidents as alarming as walls caving in and ceilings collapsing in active wards, not to mention leaks in theatres.
These same Trusts are attempting to lure international life sciences companies and renowned academics to come work with them to develop cutting-edge research and treatments, which could drive significant economic growth. That's an immeasurably more difficult task when the estate that those Trusts are demonstrating to investors is not up to world-class standards.
It's clear that supporting the economy and driving life-sciences investment requires significant capital just to bring NHS infrastructure up to an acceptable level.
Will budget boosts increase NHS capital?
The government’s commitment to increased funding is helpful, but it needs to be seen in context, based on three areas:
1 The past
This situation follows a sustained period where:
- demand grew significantly
- the NHS capital budget barely matched its annual depreciation charges, which are probably understated as a measure of what is needed to renew NHS estates
- there has been a huge accumulation of backlog maintenance, which has meant that the overall quality of the NHS estate has deteriorated, impacting staff recruitment and ability to attract international investment
In other words, there's a great deal of catching up to do before the government can say that it's contributing to real improvements.
2 The cost of NHS infrastructure
The cost of NHS infrastructure has substantially increased. We estimate by 2.5 to 3 times per square metre in the last eight to ten years. So, the cost of bringing hospitals up to scratch is significantly greater than before.
3 Non-budgetary funds
Finally, non-budgetary sources of funds have been effectively shut down. This commitment of public sector funding also comes with a virtual ban on any private sector investment or borrowing by the NHS.
Local NHS organisations have worked up a number of innovative development schemes, especially in metropolitan areas, where private land developers are willing to cross subsidise NHS hospital development in exchange for land deals.
These deals would stimulate investment, not only in the NHS, but in life sciences and the broader economy. However, regulators have resisted these deals, because of concerns that they breach the Chancellor’s 2019 commitment to end private finance in healthcare
At the same time, the Independent Trust Financing Facility, which allowed Trusts to borrow for capital development, has also been effectively closed down.
All this means that, where NHS providers previously had three avenues for accessing capital, they now have just one: the government capital budget or, in the terminology of the NHS, Public Dividend Capital (PDC), and that comes at a cost.
What is the cost of capital in healthcare?
In order to access capital, NHS organisations need to develop a business case to demonstrate that the new hospital developments are affordable and good value for money. That’s where PDC comes in.
NHS Trusts are expected to make a return on the capital invested by the system each year. This 'PDC charge' of 3.5% pa is basically a cost of capital charged on Trust net assets (more or less) and was conceived when the aspiration was for a free internal market with Trusts having autonomy over investment decisions.
The sense was that a cost of capital was necessary in order for Trusts to consider the long-term costs and benefits of those investments. Now, however, the internal market has waned. Trust autonomy over investments has been effectively eliminated and the business case process gives the centre the ability to scrutinise every major capital investment.
The effect of PDC is that, for every £100 million invested in new NHS infrastructure, Trusts need to find £3.5 million of efficiencies each year. This is over and above the annual efficiency factors imposed on pricing by the centre, and over and above the need to depreciate the new, higher value asset.
Comparing NHS infrastructure to other regulated areas
The narrative around what the PDC charge represents is confused. It's variously referred to as a cost of equity, a loan and a return on investment. At a 3.5% interest rate though, its cost is comparable to the regulated cost of capital on commercially owned, regulated infrastructure such as energy networks and Thames Tideway Tunnel, which vary from 2.69% to 2.85% real weighted average cost of capital (WACC) and 2.5% real bid WACC, respectively.
This is substantially higher, though, than the cost of UK borrowing, with National Loan Fund rates varying from almost zero to 1.5%. The 3.5% cost of capital seemed a reasonable number when it was first developed in the 1990s, when:
- interest rates were between 10 and 15%
- the service was receiving significant additional revenue funding each year and the norm was for Trusts to be in surplus
- efficiencies were easier to find
In the 90s, the service had not been through the repeated productivity challenges of the last ten years. The NHS has been asked to deliver pricing efficiencies of between 1% and 4%, annually. This is an efficiency challenge that accumulates to 35% since 2004.
Now, however, this requirement to pay capital charges has become a deterrent to investment by the NHS, putting up a significant barrier for financially strapped trusts. This undermines the government’s objectives for an infrastructure-led recovery and threatens the NHS’s ability to play its part in stimulating growth in health and life sciences industries.
What does that mean for UK investment in healthcare?
NHS providers have been unable to fully meet the system’s productivity challenges since 2014/15, let alone an additional productivity challenge imposed by investment in capital. That means that the investment, which the government wants to see and will contribute to an infrastructure-led recovery, will be difficult for Trusts to afford.
In 2019, half of NHS providers were in deficit and, even after additional central funding of £2.4 billion, the sector was in deficit by over £800 million. This deficit is after deduction of £647 million of PDC capital charges; a figure that might be lower than you would expect for a service with a total provider income of £85 billion.
That’s because, for the providers in the greatest deficit position, deficits have so eroded net assets that there is no charge to pay because they have negative net assets. Among these Trusts will be many operating dilapidated and expensive buildings, which:
- hinder their ability to attract and retain the most talented clinical and managerial staff. The best people would rather work with up to date, high quality facilities and systems.
- make them unattractive to potential research and commercialisation partners. You don’t take international life sciences investors to see crumbling infrastructure.
- expose them to risks including claims from staff and the public around NHS infrastructure failures
For these Trusts, paying 3.5% pa on new capital is difficult, if not impossible, to fund. This effectively denies them the investment that just might unlock their performance issues and bring them out of a vicious downward spiral.
It could also deny the government an important part of the broader infrastructure boom that it's attempting to unlock. It certainly makes Trusts less competitive in the international market for talent and investment.
What's the solution for NHS infrastructure?
Reducing or eliminating the PDC charge is one way to make investment more achievable for NHS providers. Originally conceived as a way to ration capital and incentivise good decisions around what to fund in an internal market, it has been superseded by a highly structured business case process and virtual total central control of major funding decisions.
Its level was set in a completely different interest rate environment and in an environment where Trusts were significantly more affluent. There is a strong case for change and this will have positive knock-on effects, beyond high quality patient care, into economic performance of the UK economy as a whole.
To discuss these issues further, get in touch with Howard Davis.
