private finance:

As the private finance initiative unfolds, it is becoming clear that the involvement of the private sector in financing and operating NHS facilities is no simple matter. Fees for contract development under PFI have run into many millions of pounds and attracted adverse comments.1 But to a considerable degree, this may be simply the result of having to negotiate a real contract - that is, one that is legally binding and consistent with commercial practice. Contracting came into the NHS very rapidly as part of the NHS internal market, bringing with it a number of transaction costs.2

But when we look at NHS contracts, both the early ones and many of those still in force, they are far from the commercial correctness that a private sector organisation might expect. It seems likely that the internal market could never have started if it had been obliged to develop full and binding contracts.

A recent survey, for example, suggests that the difficulty of agreeing a contract is a major barrier to collaborative agreements on disease management between the NHS and the pharmaceutical industry.3 Only by purchasing crude volumes of care - for example, orthopaedic operations, undifferentiated - were health authorities able to make a start in the market so rapidly.

Lessons from Australia

Australia has been carrying out a wide range of reforms of public services (for an outline of Australian health services, see box). In a few cases, privatisation of public hospitals has been tried as a way of increasing efficiency.

Experience at Modbury Public Hospital, a small general hospital in Adelaide, after several years of privatised management, highlights strengths and weaknesses of the model and the problems of contracting with the private sector.

Modbury is a 171-bed acute hospital, with accident and emergency, medicine, surgery, orthopaedics, gynaecology, obstetrics and ear, nose and throat departments. It has been operated by a private company since early 1995. The company's general manager reports to a public hospital executive and a small publicly appointed board. The general manager of the hospital, employed by the private hospital company, is responsible for employing staff and meeting activity and financial targets. The public board monitors performance against contract.

There are some positive lessons from the process of privatisation at Modbury. When I visited the hospital for three weeks last year I interviewed senior doctors, nurses and managers. Many of those who had stayed at the hospital as it came to terms with new management and budgets felt that delegation had improved and, in some areas, that historic over-staffing had been rectified. Senior nurse posts were reduced from 34 to 15. Of course, those interviewed were those who had stayed on and so may not be unbiased on the issues of staffing and standards; those who left at the time of privatisation may have thought otherwise.

The new management model comprised heads of service, consultants, unit managers, nursing officers and others responsible for individual areas of the hospital. Although most of the senior medical staff had only a part-time commitment to the hospital, they appreciated the greater degree of local management that privatisation initially introduced. Nursing and other staff noted considerable morale problems during the takeover but those who stayed were broadly positive at the time of my visit.

Profit and loss

But there have been continuing contractual problems. These have emphasised a key concern of the private sector - the need to make a profit. Private companies make mistakes from time to time and will cut their losses when they have to. If a contract is unprofitable, it will be in jeopardy.

But the political consequences of a private sector organisation walking away from a contract are considerable, as is the potential additional cost for the public sector in taking back and operating the facilities. This means that the contract may well have to be re-written if losses start to occur.

This is very much the Modbury experience. In an optimistic mood at the time of the takeover, the private management company agreed to deliver the services of the public hospital for about 20 per cent less than the previous cost. While the first contract was highly detailed, estimates of potential operating costs seem to have been surprisingly crude, reflecting to some extent the speed of the negotiations. It also proved to be inadequate, with the hospital making losses almost from the outset.

A new manager, with an NHS background, was brought in to manage the hospital and re-negotiate the contract. Re-negotiation moved the hospital back towards the kind of contract on which the Australian public sector operates, with a substantial element of funding linked to volume and case-mix, though with a continuing discount at Modbury. This contract offered a period of stability. But before long, that stability was undermined by various difficulties over the detailed contract.

Losses are occurring again as the reimbursement rates for some groups of public patients have changed. This is no doubt damaging to the budgets of both public and private hospitals, as changes in contracts and resource allocation can be in the NHS. But the private hospital company has to make its losses more explicit as shareholders and the stock market need to know where they stand financially.

Problems with strategic changes

Although nominally independent, NHS hospitals are in practice still part of a public system and can be merged and reorganised by district and regional tiers as required, albeit sometimes after a local political fight. From time to time, changes in services have led to facilities being under-used or misused. While the NHS bears some cost for this, since it originally paid for these redundant facilities, there is no continuing cost and little if any publicity of the real costs of change. It is one of those things that happens but can usually be kept within the NHS family.

Involvement of a private contractor changes this radically. The Modbury contract is now threatened by strategic changes similar to those in the NHS. In Adelaide, which has seven public hospitals, there are pressures to merge and consolidate services. One of the most recent service reviews has suggested reducing maternity services to fewer units, threatening a part of Modbury's caseload. If this work is lost, there may be under- used facilities at Modbury. Loss of services also means loss of revenue and of potential profit.

Modbury has stopped plans for a private hospital development, because of the uncertain future it now faces. This situation is an illustration of the risk-bearing issue that has raised so much concern in the debate over PFI.

If the purchaser can simply take 100 per cent of its business away, with no appeal to the patients, the private provider is always at risk. When providing for public hospital systems there is an all-or-nothing basis to the deal that is very threatening for the private provider.

But at the same time, can any private company be given a 30-year contract for healthcare services? Or a guarantee that if services have to change, it will be allowed to recoup its construction costs and expected profits from the remaining caseload? Would the public tolerate enforced closure of other local public facilities in order to help keep the private provider's facilities occupied?

Many of the transitional costs of strategic change may be the same under both private and public management. It may improve the efficiency of the public sector if such costs were made explicit as part of strategic planning. But the pressure to be explicit is likely to be much greater under private management.

It is for this reason that PFI contracts may always be difficult to negotiate and sustain, even after the learning costs have been incurred on the first few projects. It is also the reason why the Modbury contract is likely to continue to pose problems, with shareholders having to make explicit provision for their future losses and reduce services and expenditure.

The loose contracts used by the NHS since Working for Patients have much the same degree of informality as a verbal contract. They are not seen as wholly enforceable and are often broken. Deficits, surpluses and changes of service are all part of the continuing adjustment of the wider NHS to its funding and the demands upon it. This kind of contracting environment has been radically altered by PFI and must continue to adjust to the tighter contractual models of the private sector. When the profits or losses are made public, the real test of private sector involvement will begin.


1 Smith R. PFI: perfidious financial idiocy. Br Med J 1999; 319 (7201): 2-3. Also Gaffney D et al. The private finance initiative: PFI in the NHS - is there an economic case? Br Med J 1999; 319 (7202): 116-9.

2 Croxson B. Organisational costs in the New NHS. Office of Health Economics, London, 1999.

3 Mason A, Towse A, Drummond M.Disease management, the NHS and the pharmaceutical industry. Office of Health Economics, London, 1999.

Peter West is a senior consultant with National Economic Research Associates.

Key points

Privatisation of a public sector general hospital in Adelaide, Australia, five years ago has revealed the strengths of the model and the difficulties of contracting with the private sector.

Managers believe the new model has reduced overstaffingand increased local management.

There have been continual contracting problems and the hospital has made losses, almost fromthe start.

Private finance initiative contracts may always be difficult to negotiate and sustain.