Meeting the Competitive Challenge Competition in a Commissioner-Led NHS

1. Meeting the Competitive ChallengeCompetition in a Commissioner-Led NHS Keith Palmer Senior Associate King’s Fund www.keithpalmer.org palmerk@dial.pipex.com July 5th 2007

2. Introduction • Key elements of NHS ‘market’ are PCT-led commissioning/practice based commissioning (PbC), payment by results and provider diversity eg NHS trusts, Foundation Trusts, independent sector • There are unresolved issues about the way competition and commissioning interact in the NHS • There are also unresolved problems with the current financial regime and adjustment mechanisms to deal with service reconfiguration • This presentation considers the nature of these issues and problems and suggests improvements to the policy framework that would increase the prospects for achieving the government’s desired health outcomes • Although the presentation focuses largely on hospital care, resolution of the problems is necessary if the ‘care closer to home’ and ‘better management of long term conditions’ agendas are to be successfully addressed

3. What are we trying to achieve? Quality • High quality services everywhere • Continuous quality improvement (progression to ‘best practice’) Right services in the right place in right amounts • Location (care networks, hospital/out-of-hospital) • Primary care/public health/acute services/specialist services • Volume of services (waiting times, demand growth) Efficient, least cost provision • Lowest practicable cost of services for specified quality of care

4. The Context: The NHS in 2007 • Now much shorter waiting times • Expanded capacity and improved productivity = sufficient supply of hospital services from 2008 to meet 18 week wait and trend growth in demand for several years thereafter • Demand for acute services will be affected by shift in some acute care closer to patients’ homes • Acute services reconfiguration implied at some locations as new models of care adopted eg Darzi report for London • Focus increasingly on improving quality of care/clinical outcomes and health promotion/management of long term conditions/health inequalities rather than more hospital activity

5. How competitive markets work (I) Pricesare flexible and set by interaction of supply and demand - Demand expressed as purchasing power of many consumers - Supply offers from many diverse suppliers competing on price and quality Over time the market price will tend to equal the long run marginal cost (meaning the operating and capital costs of new capacity) of the most efficient supplier The price mechanism allocates resources according to profitability at market prices - Investment in more capacity where profitable based on expected future volumes and prices - Reductions in capacity where production turns out to be unprofitable – losses, asset write-offs Investment in new capacity - Total amount of capital invested depends on number and size of profitable opportunities given expected future demand - Location and type of new investments depends only on assessments of future profitability and risks

6. How competitive markets work (II) • Quality differentials reflected in differential prices (eg computers, supermarkets) • Investment in innovation incentivised by product/service price premium and expected demand growth for new products or services • Incentives for operating and capital efficiency embedded in prices because price tends to level of costs of most efficient providers • Adjustment mechanisms exist to deal with ‘winners’ and ‘losers’. Adjustment mechanisms include: - Credit lines to finance growth of winners and adjustment/restructuring of losers - Creditor restructuring and asset value adjustments reflect changed future prospects - Acquisitions and mergers often of the losers by the winners - Failure regime well developed – ultimately bankruptcy/ closure or ‘fire sale’ • Network industries often adopt consolidation strategy to minimise transactions costs – relevant for some network services in health?

7. How price controlled monopoly markets work (I) Some industries are natural monopolies and need to be price regulated to protect the public interest eg water, gas and electricity networks, rail network. The price trajectory is set by regulator for 5 year period to incentivise economic and efficient service delivery and achieve prescribed quality standards Funding of cost of capital (debt and equity) given ‘sunk’ and ‘new’ capital investment Funding of depreciation provision relating to ‘sunk’ and ‘new’ capital investment Maximum price per unit £/unit Funding of operating costs after allowing for assumed efficiency improvement Different prices for different providers reflects different capital programmes and different scope for further efficiency improvements

8. How price controlled monopoly markets work (II) Volume and type of capital investments pre-agreed with customers and regulator – conforms to sector strategic investment plans - funding of capital costs in prices based on agreed capital programmes Medium term quality performance improvement framework sets expected standards on quality over 5 year price control period – link between funding and investment in quality improvement Actual performance against targets over last price control period influences price trajectory over next price control period Incentives for operating and capital efficiency Funding of operating costs includes demanding efficiency factor to drive operating efficiency improvements Funding for capital investment set to encourage efficient use of capital Adjustment mechanisms - Credit lines to finance growth of winners and adjustment/restructuring of losers - Creditor restructuring and asset value adjustments reflecting changed future prospects - Acquisitions and ‘mergers’ often of the losers by the winners (if permitted by regulator) - Failure regime = Special Administration regime to protect the public in essential industries

9. The NHS Quasi-market • Commissioner/provider split • Commissioning framework/new contract/PbC • Provider diversity (including GPs and PCT provider arms) • Payment by results (PbR) = average cost prices + efficiency factor + MFF • Patient choice – money follows patients but hospital care only • Providers receive full tariff for all activity provided (except emergency admissions) Not really a market – fixed prices only for some hospital services No currencies or prices for eg community care, integrated patient care etc Many PCTs but in reality a ‘single buyer’ operating with fixed annual cash budgets Provider diversity in theory but not allowed to compete on price and weak quality performance framework/no performance linked payments

10. NHS Financial regime NHS Trusts • I/E balance – now small surplus = ‘must do’ targets • Pay dividend on PDC in full every year = equivalent to interest on senior debt • Interest bearing loans to fund deficits • Main adjustment mechanism is to flex annual expenditure (agency/bank staff etc) • No clear failure regime Foundation Trusts • More flexibility to plan for I/E surplus/deficit • Allowed to keep surpluses and accumulate reserves • Pay dividend on PDC in full every year = interest on senior debt • FTFF borrowing facility = long term loans on attractive terms up to Prudential Borrowing Limit • Theoretical recourse to private sector debt (but not in practice cost effective) • Main adjustment mechanism is use of working capital line of credit • No clear failure regime if licence breach

11. How the NHS quasi-market is intended to work The aim of government health reforms is: • to decentralise decision making and reduce reliance on central command and control and • to rely more on incentives to improve performance and create a health system more responsive to patient needs and preferences Patient choice to strengthen incentives to improve the quality of care Commissioning framework and PbC to allocate spending to meet the priorities of local communities Efficiency factor in tariffs to drive productivity improvement of hospital providers FT regime to empower providers and reward good performance Provider diversity to drive innovation and quality improvement Key issue is whether the way the reform instruments interact with one another delivers the desired policy outcomes

12. Key propositions about the NHS quasi-market in its current form • High quality services and quality improvement cannot be delivered by ‘market forces’ • Right services in right places and in right amounts cannot be delivered by ‘market forces’ • Capital and operating efficiency cannot be achieved with PbR and capital funding regime in current form • Financial regime for NHS trusts and Foundation Trusts needs further development to facilitate and support changes in healthcare to achieve desired health outcomes The analysis from which these propositions are derived is set out in full in ‘NHS Reform: Getting Back on Track’ published by the King’s Fund in 2006. Also available at www.keithpalmer.org

13. Proposition 1: High quality services and continuous quality improvement cannot be delivered by ‘market forces’ in NHS Patient choice – a ‘good thing’ because empowers patients and addresses health inequalities but weak driver of quality improvement - Many services are effective ‘local monopolies’ eg non-elective care, specialist services - Choice decisions rarely based on good information about outcomes - DGHs that lose patients to teaching hospitals are powerless to stem the flow (anyway should they try?) Payment by results • No reward for high quality or quality improvement or good outcomes • No penalty for erosion of service quality (eg caused by efforts to return to financial balance) • No extra funding streams to adopt improved (but more costly) service models • Loss of patients from patient choice/demand management etc has ‘high powered’ adverse effect on finances with risk that patient care will suffer as trusts seek to restore financial balance Funding is a function of volume of activity provided only No payment link to quality of care Result is no incentive to achieve high or improving quality of care Loss of income by DGHs can result in a deterioration in quality of care for remaining patients

14. Proposition 2: Market forces cannot deliver the right services in right places in right amounts Characteristics of system Weak commissioning regime – PCTs must pay full tariff for all activity (including over-performance) but new contract strengthens regime somewhat Fixed average cost prices so no price flexibility - No price signals to indicate which services in which locations should be expanded and by how much - No mechanism to signal excess capacity exists and to remove it from the system (so resources can be allocated to where they will be better used) Incentive effects • Strong incentive on all hospital trusts to maximise hospital activity especially admissions • Strong incentive on all hospital trusts to ‘repatriate’ activity from others and to act to avoid loss of activity to others • Breeds mistrust between PCTs and hospital providers and makes partnership working more difficult • Generates ‘winners’ and ‘losers’ with risk that patients at ‘losers’ will suffer

15. Proposition 2 (cont’d): Market forces cannot deliver the right services in right places in right amounts Results Incentives in current system inhibit collaboration to deliver: • Care networks where roles of providers are differentiated eg urgent care, stroke etc. If change of role results in loss of income to trust (but gain to NHS overall) it is likely to be resisted by trusts • Integrated patient care especially for patients with long term conditions. PCTs fear that hospital clinicians working in the community will (over) refer patients to their hospital trust and increase costs incurred by the PCT • Expanded out-of-hospital care. The logical providers of out of hospital care for many services will often be the hospital trusts. However PCTs will fear that this will result in increased referrals to hospital and increase claims on their fixed budgets • ‘Stranded costs’ arise in hospital trusts that ‘lose activity’ as a result of collaborating in service redesign. Stranded costs arise when the loss of income is greater than the reduction in costs – giving rise to ‘stranded’ fixed costs

16. Proposition 3: Market forces - with PbR as it currently is - cannot deliver capital or operating efficiency What PbR does do • Strong incentive to reduce average total costs below average system costs (after MFF) by 2.5% per annum– induces shorter lengths of stay, higher day case rates, reduced use of agency staff etc What PbR does NOT do • Properly fund differential ‘sunk’ capital costs • Fund full cost of new investment • Fund service innovation where volume of activity remains unchanged • Fund care pathways that extend across more than one provider Result is: • Surpluses and deficits arise at trusts that are ‘over-funded and under-funded, respectively, even if they operate at equivalent efficiency • Recurrent resources available to under-funded hospital trusts are less per patient than at over-funded trusts • Disincentives to invest in service improvement or expansion of services

17. Proposition 4: The current financial regime needs further development if it is to support adoption of new service models • Undue focus on I/E balance or surplus for all NHS trusts regardless of legacy position and/or local implications of restructuring impedes emergence of better models of care • Very inflexible financial regime combined with major income consequences for hospital trusts of changes in the pattern of activity result in ‘gridlock’ and lack of progress • I/E consequences of large planned shifts in activity and income not validated in ‘planned deficits’ and cash funding of them • NHS trusts and Foundation Trusts must pay dividend on PDC in full every year = equivalent to capitalisation 100% with senior debt • NHS trusts have no reserves or ability to borrow. Foundation Trusts have only the reserves they create from surpluses but more ability to run and finance a deficit • No transparent mechanism in NHS to recognise and deal with changes in asset values arising from change in patterns of care

18. How to improve the policy framework • ‘Stronger’ commissioning • Quality improvement/payment regime • Improved capital investment and capital funding regime • Improved financial regime

19. Stronger commissioning The ability of commissioners to more effectively allocate resources to address patient needs and drive desirable service reconfiguration Existing Services • Medium term volume contracts at service level reflecting desired models of care. To increase transparency and predictability about those services commissioners wish to, and expect to be able to afford to, commission • Full tariff for contract volumes of existing services but lower price (50% of tariff?) for over-performance volumes New Services • Tender medium term contracts forall new services • Develop new local currencies and local prices for new service models (polyclinics, integrated patient care) and adopt national currencies and prices when proven to work locally • All new contracts to be based on payment for outputs (or outcomes) and include an efficiency factor • Whenever feasible determine contract prices by competitive process involving diverse providers eg FTs, independent sector etc as partners or competitors

20. Quality improvement/payment regime Existing Services • Progressively incorporate quality framework in PCT contracts – schedule of quality performance targets (national and local) addressing wide range of quality indicators • Continuous quality improvement through locally agreed progression of quality indicators over time • Independent assessment of performance against quality indicators (contracted service from Healthcare Commission?) • Payments by PCT to be linked to actual provider performance against contracted performance indicators – schedule of payment supplements and discounts New Services • All contracts for new services to contain quality framework • Independent assessment of performance against quality indicators (contracted service from Healthcare Commission?) • Payments by PCT to be linked to actual provider performance against contracted performance indicators – schedule of payment supplements and discounts

21. Improved capital investment and funding regime (I) Funding of ‘sunk’ capital costs The Problem Funding to pay capital costs (depreciation and dividend on PDC) in tariffs are sufficient to cover the costs of a trust whose capital employed is equal to the national average capital employed (= about 6% of total income) Actual capital costs relating to ‘sunk’ capital range from 4-13% of income. Therefore tariffs over-fund (slightly) trusts with heavily depreciated capital stock and under-fund (heavily) trusts with new hospitals Capital costs relating to sunk capital investment cannot be managed and rarely avoided Trust 1 Trust 2 Trust 3 Trust 4 Trust 5 Trust 6 Capital costs/total income (%) 4.2 4.8 5.2(8.2) 10.4 11.3 5.8 Under-funding of capital costs gives rise to deficits even if well managed and efficient. Efforts to restore balance risk harm to quality of patient care The Solution Funding of sunk capital costs should reflect actual sunk costs incurred (as in Victoria, Australia) Either incorporate adjustment into MFFs or allow ‘planned deficits’ reflecting unfunded capital costs that relate solely to ‘sunk’ capital expenditure and fund with very long term loans

22. Improved capital investment and funding regime (II) Funding of capital invested in new capacity and service innovation The Problem Many desirable capital investments in new capacity, service innovation and service improvement have higher marginal capital costs than the average capital costs funded in tariffs. Important disincentive to invest – note little investment by trusts in recent years The Solution • Need for income supplements in tariffs to fund ‘gap’ between marginal costs of efficient provider and average costs funded in tariffs • All major capital schemes are claim on public sector capital budget and claim on future PCT resources (out of which capital costs must be paid). Need for all NHS trusts and FTs to secure sign-off from PCTs (and DH?) about conformity with strategy and affordability • Need mechanism to secure capital efficiency eg bid value of annual income supplement? • Need robust mechanism to deal with provider trust failure Funding for capital costs in tariffs Income supplement to fund capital cost ‘gap’ Bar height reflects capital costs of new investment by efficient provider

23. Improving the financial regime (I) The Problem • Major service reconfiguration will result in major shifts in income and costs, in net I/E and cash flow positions (creating winners and losers) and cause changes in values of assets and liabilities. The current financial regime is too inflexible to accommodate and support desired adjustments. • This is true for Foundation Trusts as well as NHS trusts The Solution • Need to allow ‘planned deficits’ for net ‘losers’ during transition period and capture share of surpluses of ‘winners’ to fund deficits of losers and fund restructuring costs • Service reconfiguration may reduce asset values at some sites – need to recognise as changes in asset and liability balance sheet values and related recurrent capital costs • Legacy debt will need to be ‘dealt with’ – for NHS trusts by SHAs, by whom for FTs? • Some restructurings will require issue of very long term debt to some trusts • Need for a robust failure regime to deal with trust failure to meet its financial obligations. ‘Consequences’ must impact on entire trust, not just Board/CEO eg forced takeover by another trust.

24. Improving the financial regime (II) The Problem • Mergers and acquisitions are an important mechanism for dealing with ‘failed trusts’ and for facilitating service reconfiguration. Currently organisational change involving NHS trusts and/or FTs is very difficult either for statutory reasons and/or because the ‘system management’ rules remain to be clarified • In the absence of clear rules about the criteria for approval of mergers/acquisitions, about how legacy debt and asset value changes will be dealt with and about how restructuring costs and transitional deficits will be financed, few trusts are likely to be interested in exploring mergers and acquisitions especially with deficit trusts and trusts that are expected to be ‘losers’ from service redesign The Solution • Urgent clarification of system rules relating to organisational change • To include clarity about criteria for approval of mergers and who is responsible (for NHS trusts and FTs) • To include clarity about how legacy debt and balance sheet adjustments will be dealt with and how restructuring costs and transitional deficits are to be financed

25. Foundation Trusts There is unfinished business relating to the role and responsibilities of FTs in the ‘new’ NHS • Should the clinical and service strategies of FTs be subject to review and approval by PCTs (and/or SHAs and/or some central agency)? If not, how are national and regional service development strategies (such as Healthcare for London) to be implemented? • Should the major capital programmes of FTs be subject to approval by PCTs (and/or SHAs and/or some central agency)? As noted earlier, the consequential future annual capital costs are a claim on future PCT income. • Bad investment decisions are likely to be a future claim on the taxpayer (deficits have to be financed if the hospital is not to close). How can FTs retain appropriate autonomy while also remaining accountable to taxpayers?

26. What is the role of competition in a commissioner-led NHS? Patient choice between alternative providers remains – but in a commissioner-led NHS the number, type and location of providers is result of commissioning decisions by PCTs. Not all hospitals provide exactly the same range of services Competition focuses primarily on contracts for new services - Responding to tenders issued by PCTs (or groups of PCTs) - All providers (incl FTs and independent sector) may respond alone or in partnership with others - Competition based on quality, price and responsiveness to tenders - Needs clearer rules to ensure reasonably ‘level playing field’