Costs for users
31. The terms of the concession agreement between
the Department and the operators are that bridge users (and now
the Department, as a result of their contribution to the new discounted
tolls available from January 1998) must pay tolls to Skye Bridge
Limited for a maximum of 27 years or, if sooner, as is expected
to be the case, until they have amounted in total to some £24 million
(in 1991 prices, discounted). These tolls were determined by the
operators' forecast costs after allowing for the Department's
forecast contribution of £6 million to meet the expected
costs for the approach roads to the bridge.
32. Before signing contracts the Department lost
the benefit of competitive tension and negotiated with a single
bidder only, who proved to have difficulties finding funders to
support the project.
In this negotiation the Department accepted an increase in the
total tolls to be paid by users of about £2 million
(nine per cent), i.e. from some £22 million in the operators'
1990 bid to some £24 million in the final contract in
33. We asked the Department about their negotiation
particularly of the financing of the project in this period, and
why they had accepted the increase in total tolls to be paid by
users. The Department said
that they done so in order to secure the project. In reply to
our further questions they agreed that an alternative arrangement
could have been envisaged whereby the total tolls to be paid would
have been increased only if traffic did not match the levels expected.
But they said that the difficulty with getting funders on board
was extreme and they did not perceive at the time that such a
deal could have been achieved from their negotiating position.
34. We therefore asked how the Department's confident
forecast of a concession lasting less than 20 years could be reconciled
to their acceptance in negotiation of a 27 year maximum period.
The Department told us
that this was to provide comfort for some of the lenders of the
project, who were so risk averse that they assumed there would
be no traffic growth whatsoever from 1990 onwards.
35. We asked the Department to describe the options
they considered at the final negotiation stage to deal with the
prospect of a shortfall in traffic. The Department told us
that they had examined four options concerning the wider issue
of how best to enable finance for the project to be secured. They
did not consider separately the option of an agreement with provisions
for later changes either in the total tolls to be paid or in the
length of the concession.
36. In view of this we asked the National Audit Office
to do an analysis of the financial effect of the concessionary
period deal in the event that the Department's predicted traffic
volumes were met. The National Audit Office told us
that since the Department had neither obtained a copy of the bidder's
financial model in electronic form nor constructed their own financial
model, the data did not now exist to enable such an analysis to
be done in full. But if the deal could have been negotiated on
terms comparable to those now prevailing in the market a reduction
of around £1 million could have been achieved in the
allowed total of tolls in the event of traffic in line with the
Department's central forecast of traffic growth. Such terms might
not have been available in 1991, and a contingent tolling regime
might not have yielded net benefits in value for money terms.
37. We further asked the Department why they did
not detect at the outset the financing difficulties which the
operators encountered, before entering into negotiations with
a single bidder under conditions when competitive pressure was
38. The Department told us
that they had taken comfort on the projected financing of the
project from an assurance from the Bank of America, who were one
of the development partners and who were prepared to invest some
£8 million of their own funds in the project. They were
also the leading financial institution investing in such projects
at that time. The Department considered that this institution
was the best placed, perhaps the only one then in the business,
to have given that assurance, but that the Department would not
rely upon them now.
39. We therefore asked the Department what advice
they had received from their lawyers concerning the value of the
assurance from the Bank of America on the financing arrangements.
The Department told us
that they had not sought legal advice on this letter because "...
its value related to its degree of authority in assessing the
relevant matters at the point the judgement was made rather than
to its ability to indemnify the Department against changing market
40. The Department also told us
their financial adviser had commented that "... such letters
are not intended to create a legal obligation for the writer."
He also commented that "... the risk for a financial institution
in writing such a letter is in terms of reputation rather than
financial; (the) value (of such a letter) lies in demonstrating
that the Bank is prepared to put its name behind the project,
with a degree of embarrassment if it cannot ultimately deliver
finance on the terms indicated".
41. Of the total external capital of £27 million
obtained by the successful bidder for the financing for the bridge,
£19 million was in the form of loans in line with the
market given the degree of risk.
Of the remaining £8 million, £7.5 million
was loan stock placed with a single investor on a negotiated basis
for which it is unlikely competition would have been possible
at the time; and the last slice of £500,000 was equity investment
(in the form of equity-like index-linked loan stock) by the two
construction companies forming the construction consortium responsible
for the development of the bridge.
42. The investors had forecast a rate of return on
the equity investment of £500,000 of some 18.4 per cent
a year in real terms, 26.4 per cent nominal, resulting in a payment
to the equity investors at the end of the project of some £10 million
in 1991 prices or
£37 million in cash.
We therefore asked the Department whether the external financing
itself provided value for money.
43. The Department told us
that the equity investment was a requirement of some of the secondary
investors, who saw it as a way of increasing the security of their
own investment, by permitting the company operating the concession
to build up cash reserves as a hedge against adverse project developments.
While the actual return the equity investors would receive could
not be known until the end of the project, the Department's financial
advisers had said that they expected the weighted average annual
cost of the capital would be lower financing the project with
equity (12 .6 per cent a year) than without (13.2 per cent a year).
The Department said they would have preferred to have got the
interest rates they did for the whole project without the equity
slice, they found that they could not sustain this position in
negotiation without jeopardising the whole deal.
The Department said the estimated equity return was not guaranteed,
and that they were reassured that the rate was consistent with
or lower than that which appeared to be obtainable for other similar
The Department's costs
44. The Department's own costs in developing, negotiating
and supervising the deal were £15 million.
Within this sum the Department paid to the operators some £12 million,
equivalent to some £9 million in 1988 prices, or 48
per cent more than their original target of £6 million
in 1988 prices.
45. The contracts signed in 1991 were conditional
upon subsequent satisfactory completion of statutory procedures
for the authorisation of the tolls for the bridge, including a
public inquiry which recommended modification to the design of
the project, while the inquiry process itself necessitated a delayed
start to construction, both factors adding to the operators construction
costs. These factors were responsible for most of the increase
in the Department's contribution to the operators, some £4 million
in real terms.
46. Accordingly we asked the Department whether they
had managed this process properly, given that it is normal to
hold a public inquiry before a project is tendered.
47. The Department said
that they had been deliberately experimenting with an approach
which sought to maximise innovation and squeeze the very best
out of the private sector. They said that in the event it proved
to be that the private sector were not willing to take what the
Government now consider as an extreme position, namely the acceptance
of the risk arising from statutory processes, including a public
inquiry. The Department added that, in their view, they would
have encountered the same changes in the project leading to increased
costs had they promoted the design at the public inquiry and only
subsequently put the project to competition.
48. They also said
that they had learned lessons about managing risks from this project,
though they said that they were not confident that it would have
been possible to have improved control of this early private finance
project by including costings of the risks involved.
49. The Department told us
that the reason they accepted responsibility for the extra costs
in this case was that they concluded that the statutory processes
were risks that the Department should have carried because they
were within their control. They told us
that there was careful negotiation with the operators to confirm
that these additional costs could be justified. The Department
said that, though they firmly believe that every part of a deal
should be tendered for, they judged that the overall price of
the approach roads was consistent with earlier technical assessments
and compared favourably with another similar project.
50. In addition to their £12 million contribution
to the operators' construction costs, the Department have paid
a further £3 million in developing, negotiating and
supervising the contract. We asked the Department why, given that
they expected to incur such costs, they set no targets for most
of this other expenditure.
51. In response the Department said
that they should have established budgets for their other £3 million
costs, on advisers and other overheads and would now do so. They
said, though, that they did not think that their failure to do
so in the Skye case was a serious oversight.
52. We asked the Department why they under-estimated
land purchase costs at £300,000 compared to final costs of
£784,000. They told us
that the initial estimate came from the District Valuer. They
said that the District Valuer was responsible for negotiating,
and in this case the valuer was persuaded by the wisdom of the
seller or his agents that the value of the land was greater than
he had initially estimated.
53. In response to a further question, the Department
agreed that the purchase
had taken place late in the day and it was always to the good
if a deal could be closed early. They said, though, that they
had to strike a balance between this approach and acquiring in
advance of need.
54. The £39 million cost of the bridge fall
directly both on the toll payers and on the taxpayer. Together
they will pay the amount the winning private sector bidder estimated
as necessary to cover the cost of construction, the cost of operating
the bridge over the lifetime of the concession, and the cost of
financing the concession. It follows that to minimise the costs
to toll payers and to the taxpayer, it would have been necessary
for the Department to have persuaded the winning bidder to accept
lower estimates of likely costs.
55. In the event the estimated costs rose rather
than fell during a period of exclusive negotiations with the winning
bidder. The Department accepted the bidder's argument that traffic
flows might not increase over the concession period in line with
the Department's own expectations. The effect of this and other
concessions made during exclusive negotiations is that the target
toll revenue figure rose to £24 million from £22 million
increasing the burden on toll payers by some £2 million.
It also means that the operator will get the benefit of this additional
income if, as now seems likely, their own more pessimistic traffic
forecasts are exceeded.
56. This upward pressure on the costs of the bridge
arose because the Department were negotiating this aspect with
a single bidder as a result of financing difficulties encountered
by that bidder. The Department did not detect the risk of such
difficulties before entering into exclusive negotiations because
they relied on an assurance from the Bank of America, who were
the financial adviser to the bidder, that the proposed method
of finance was achievable. In the event it was not and we criticise
the Department for relying on an assurance, which provided no
57. Following objections to the preferred design
on environmental and aesthetic grounds, the Department agreed
with the operator to pay an additional £4 million in
real terms to cover costs arising from the delay caused by the
need for a public inquiry and from the recommended changes which
resulted. The Department were unable to persuade the private sector
to accept the risk of such additional costs. We note that subsequent
Treasury guidance is that such risks should be retained in the
public sector as being best able to handle them. This guidance
casts doubt on the practicality of awarding contracts for privately
financed projects before statutory planning procedures have been
58. The Department believe they would have encountered
the same level of construction costs had they promoted the bridge
at a public inquiry before, not after, proceeding with a competition.
But if the competition had followed the public inquiry then the
additional costs would have been subject to competitive pressure.
We note the Department's assurance that lessons have been learned
from this project, though they have not said what these are.
59. The Department consider that the financing terms
on which the bridge has been provided are not out of line with
other private sector projects concluded at the time. But neither
the real rate of return to equity investors of 18.4 per cent a
year nor the terms of the index-linked bonds which formed the
next tier of financing were determined competitively. The terms
of neither of these forms of finance were readily capable of being
benchmarked against the market. There was, moreover, clear evidence
of market imperfections, such as the fact that at the time of
the deal there was only one potential provider of the index-linked
bonds. This calls into question the validity of such benchmarking
as may have been possible.
60. The experience of privatisation has shown that
Departments are able to learn from experience and put pressure
on the market to deliver increasingly good value for money in
successive deals. We therefore look to Departments and their financial
advisers to secure improved terms, as the financial market for
PFI deals develops.
61. In those cases in which negotiation cannot be
avoided, Departments should protect themselves from making unnecessary
concessions to the bidder by developing a clear negotiating limit
and by taking steps to avoid unwelcome surprises, for example
by seeking independent confirmation of the likely viability of
bidders' financing proposals.
21 C&AG's Report Paras 4, 23 Back
C&AG's Report para 1.47 Back
Evidence, Appendix 1, pp 20-24 Back
Evidence, Appendix 3, p26 Back
Q50, Q111 Back
Evidence, Appendices 1-2, pp 20-26 Back
Evidence, Appendix 1, pp 20-25 Back
C&AG's Report paras 23-24 Back
C&AG's Report para 25 Back
Q49, Q114 Back
C&AG's Report paras 4-5, 19 and Figure 2 Back
C&AG's Report para 3.12 and Figure 9 Back
Q101, Q93-95, Q100 Back
Q5, Q103-104 Back
Q28-31, Q120-122 Back
Q29, Q32 Back