House of Commons - Environment, Transport and Regional Affairs

Select Committee on Environment, Transport and Regional Affairs Fourteenth Report

The case for and the case against the PPP

16. The ability of the public sector to borrow money more cheaply than the private sector is a key assumption underlying the debate about whether the PPP or bond financing is the best option for funding the Underground. This is reflected in the analysis carried out for the Government which acknowledges that the cost of private sector finance is higher, but that it will be more than outweighed by efficiency gains.[56] According to Professor Currie, however, focussing the debate on this issue is "seriously misguided". He argues that the cost of borrowing for the private and public sectors are the same for a given project. By contrast with their counterparts in the private sector, risks are passed to taxpayers without any compensation.[57] A risk premium should, therefore, be put into the cost of capital for the public sector. This is why the test discount rate used by the Treasury is higher than the bond rate.[58]

Efficiency savings

17. The Deputy Prime Minister told us that while the PPP is more complex than the traditional arrangements for funding the Underground, the structure would allow LT to concentrate on providing services, while benefiting from the efficiencies of private sector involvement in the system's infrastructure.[59] The Government believes that PPP deals generally lead to cost savings of between 15 and 20 per cent.[60] This view is shared by Professor Currie. Drawing on experiences of the contracting out of activities and of the Private Finance Initiative (PFI), he thinks that the PPP could produce cost savings of around 20 per cent over and above the savings that would be achieved in the public sector, because the introduction of private capital into the management of previously publicly owned organisations brings considerable benefits as the lines of management, the risks and the incentives are much more prominent.[61] Moreover, incentives to improve efficiency would be blurred in an arrangement where the capital is provided by one source and the management by another as would be the case with bond financing: incentives are much clearer when the management team is answerable to shareholders.[62]

18. Professor Glaister argued that savings under the PFI had been achieved through repeated competitive tendering and greater freedom in labour markets and not, as in the case of the London Underground PPP, "a one-off thing with protection for the transferring employees, which is a different game".[63] This argument is countered by Professor Currie, who said that the privatised utilities had not needed repeated competitive tendering to produce cost savings and that labour market constraints would ease over time.[64] The Government did not in any case claim that cost savings would be found mainly through reductions in labour costs: in its view most savings would result from better project management.[65] That view, too, was challenged by witnesses such as Gaffney, Shaoul and Pollock, who argued that privatisation had not led to improved investment: they argued that, for example, Railtrack's infrastructure investment has not risen in line with need, expectation or commitments, and efficiency savings following the privatisation of the water industry came from lower than anticipated levels of capital investment rather than reductions in operating costs.[66] The railway trades unions pointed out that the Underground's own experience of the PFI had resulted in new rolling stock for the Northern line delivered four years behind schedule.[67] The unions claimed instead that efficiencies would result from an attempt to lower labour costs through "a serious assault" on the jobs and conditions of their members,[68] a fear shared by other witnesses.[69]

19. While Glaister, Scanlon and Travers have little doubt that there are significant cost savings to be made in the delivery of London Underground's services, they find it "difficult to accept" that efficiency gains could not be obtained with better management under a bond-financed regime.[70] It would be "perfectly possible" for money raised by London Underground bond issues to be invested in projects where there is private sector contract management and private sector procurement practices for all new investments.[71] Mrs Susan Kramer also told us that the cheaper financing of revenue bonds could be combined with measures to achieve greater management efficiencies.[72] Similarly, the railway trades unions do not see why the reward and penalty arrangements planned under the PPP have to be linked to the overall funding and financing policy for the network rather than being implemented on a contract-by-contract basis.[73]

20. There is also the prospect of the PPP imposing as yet unquantified, but possibly substantial, additional costs in terms of monitoring.[74] Negotiation and contract administration could become "a significant item" in the case of the PPP because of its complexity and the difficulty in allocating risk between the different parties.[75] LT said that it did not have a definitive figure for the cost of on-going administration, but it believes that it would be "a small number of millions".[76] It should also be noted that the money spent, so far, on consultancy fees in preparation for the PPP is considerable and stood at £60.3 million at 31 March 2000.[77] The Department of the Environment, Transport and the Regions told us that "it has never been the practice to answer questions about future costs of advisers while a project is still under way", but the Government is committed to giving periodic updates on expenditure incurred.[78] Regrettably, it appears likely that LT's earlier hope that the cost of preparing for the PPP would be less than the working estimate it then had of £65 million will prove to have been overly optimistic.[79]

The division of risk between the public and private sectors

21. The extent to which risk is successfully transferred from the public to the private sector will be another important indication of the PPP's success. The Deputy Prime Minister assured us that there will be penalties and incentives in the PPP contracts so that risk will clearly be placed upon the private sector infrastructure companies.[80] There will be "a very few limited risks", however, which will remain in the public sector. Although the exact division of risk had yet to be agreed, the Department of the Environment, Transport and the Regions was confident that private sector bidders for contracts under the PPP knew what would be expected of them in this respect.[81]

22. Gaffney, Shaoul and Pollock argued that the introduction of private finance makes the efficient transfer of risk more difficult in practice because the public sector cannot ignore debt incurred by the infrastructure contractors in the event of any cost overruns. Moreover, as the private sector would not be assuming all risks, there would be many reasons why the public sector might be left paying for cost overruns.[82] They also noted that while it is possible to specify the risks to be transferred, it is a very different matter to transfer them in a legally enforceable contract.[83] This point was echoed by Professor Glaister and his colleagues, who stressed that the allocation of risk must be clearly identified and specified in the contracts. This would be very difficult in view of the complexity of the Underground PPP. He warned that "unless substantial penalty clauses are included in the contract and they are enforceable in practice, all risks fall to the public sector, not the private sector".[84]

The use of long-term contracts

23. Long-term, probably 30-year, contracts for the infrastructure companies would be necessary, according to Professor Currie, to realise the full benefits of the PPP. Efficiencies would be gained from having the same party managing assets over their full life-cycle and thus ensuring that there is an incentive at the design stage to take into account subsequent building and maintenance considerations.[85] Longer-term contracts would also give the private sector certainty in planning for investment, reduce the cost of capital and provide incentive to innovate. Greater stability would also be brought into the financing of the Underground, something which has been lacking for some time.[86]

24. It would, however, be unrealistic to fix the level and pattern of Underground services over the next 30 years at the time when the PPP contracts are signed. Formal reviews would take place, therefore, every 7½ years, when London Underground could change "almost any aspect of its requirements" and the infrastructure companies would be "obliged to deliver those new requirements at a fair price". The contract would provide guidance on what is fair and in the event of a dispute, the matter would be determined by an arbiter.[87] LT expected that as well as redefining its requirements from the infrastructure companies, it would negotiate a new service charge, which should be lower, reflecting increasing efficiency over the first period of the contract, while maintaining the rate of return the companies anticipated in their bid for the contracts.[88]

25. Even with provision for periodic reviews, Professor Glaister argued that there was a "fundamental difficulty" with the inflexibility of the PPP's 30-year contracts.[89] He believed that it would be "very difficult to enforce these contracts rigorously were the contractor to fail to deliver".[90] There would be a risk that a very long-term contract structure will create "a one-sided bet" for the private sector, since although it might become necessary to renegotiate the contract to avoid the company failing in the event of an economic downturn, there would be no renegotiation if profits prove better than expected.[91] The Deputy Prime Minister told us that he was satisfied that there will be sufficient penalties and incentives to ensure that the infrastructure companies perform to the standards that are expected of them,[92] and that poor performance would attract escalating penalties, including the possibility of losing the contract. In the highly unlikely event of an infrastructure company withdrawing from a contract, the Government would, in conjunction with the Mayor, look at the next best value for money option that could be devised.[93] Lord Macdonald, the Minister for Transport, however, pointed to the strength of the consortia bidding for the contracts and the access that this would give to international expertise and project management skills and the consequent innovation this could be expected to bring.[94]

Increasing the number of passenger journeys

26. Over the next 20 years, LT expects that use of the Underground will grow by one per cent per annum at peak periods and by "quite significantly" more than that at off-peak times. The PPP will expand the peak capacity of the existing system by about 15 per cent over twenty years, so the provision of extra capacity will be exceeded slightly by growth.[95] Mr Tunnicliffe warned that although the additional passenger carrying capacity provided by the PPP should prove sufficient until the beginning of the next decade, there were limits to how many passengers the existing system could accommodate.[96]

27. According to Gaffney, Shaoul and Pollock, the financial viability of the PPP hinges on London Underground's estimates of increasing revenue. Its projections assume that fares will increase in line with after 2001-02, but a 40 per cent increase in fare revenue generated by more passenger journeys is anticipated: thus unless extra demand is confined to off-peak times, the revenue projections will depend on increases in network capacity.[97] This view was confirmed by the London Regional Passengers' Committee (LRPC) which commented that with critical parts of the system operating at or close to capacity at peak times, "there is little short-term scope for attracting additional usage except at the cost of worsening travel conditions".[98]

28. Although increasing the capacity of the existing Underground network could be achieved by improving its performance, it is generally accepted that capacity constraints must be addressed through the construction of additional lines and extensions to existing lines. However, the Government has said that it would not be appropriate to include major lines or extensions in the PPP,[99] although relatively small-scale, but nonetheless valuable extensions, such as the those of the East London line[100] and the Croxley link on the Metropolitan line[101] could be taken forward under the PPP. For example, the Government may decide that bidders for the sub-surface lines PPP contract should be asked to provide a separate price for linking the East London line to the national rail network.[102] If the Mayor decides to build the Croxley link, provisions would be included in the PPP contracts to increase capacity at stations and to provide for line extensions.[103] Decisions about major projects, such as CrossRail and the Chelsea-Hackney line, are, the Deputy Prime Minister told us, the responsibility of the Mayor. He commented that there would be difficulties in raising the large sums of money that will be required for these schemes and he thought that some contribution from central government would be necessary.[104]

29. Concerns have been raised about the complexity of the legal arrangements if contracts for new lines or major developments of the current network are not awarded to the existing infrastructure companies. Conversely, if the incumbent companies are given preferred bidder status, they may have London Underground "over a barrel" because of their very strong negotiating position.[105] While the Government told us that it expects that the infrastructure company responsible for a particular station or line would be in the best position to offer good value for a major enhancement project, an alternative contractor could be selected if its price proved uncompetitive. The incumbent company would, however, have to be paid for providing any work which could not be undertaken by a third party.[106]

The restructuring of London Underground

30. The reorganisation of London Underground through the separation of operations and infrastructure and the creation of the three infrastructure companies has implications for, amongst other matters, safety. The Government told us that the safety regime has been designed to avoid fragmentation and to retain responsibility for the statutory Railway Safety Case for the whole network in the hands of public sector London Underground.[107] LT believes that safety will be enhanced by the implementation of the PPP.[108]

31. Dr Jean Shaoul told us, however, that she was extremely concerned about the division of the Underground into four units would make planning, coordination and, above all, ensuring safety "extremely difficult".[109] Other witnesses drew parallels with the fragmentation of responsibility for safety following the privatisation of the national rail network. The Transport and General Workers' Union, for example, argued that "a similarly fragmented structure runs the risk of reducing safety standards below their present levels".[110] Moreover, it said that experience and expertise in safety matters might be lost as a consequence of the organisational restructuring introduced by the PPP. In addition, there might be problems with coordinating the approaches of the different organisations towards safety matters, the use of sub-contractors by the infrastructure companies may increase the complexity of 'the chain of command', and financial considerations may place pressure on the infrastructure companies to look for savings which could affect safety adversely.[111] The Mayor of London, Mr Livingstone, said that "inevitably there is the risk to safety if [the] PPP proceeds".[112] Despite these comments, we received no convincing evidence that safety on London Underground would in reality be compromised by its restructuring. It could, indeed, be argued that safety would be enhanced, by the extra capital investment which we all hope will result from it.

The Public Sector Comparator

32. The Government stressed that its preference for the PPP is based "not on dogmatic adherence to any particular structure, but on a determination to deliver best value for the Tube, its passengers and the taxpayer". A public sector comparator will be used to test for best value and will act as the 'yardstick' against which private sector bids will be judged.[113] Contracts will be awarded only if the bidders can demonstrate that they can provide better value than the public sector.[114] As we have said, the design, construction and use of the comparator will be open to examination by the NAO.[115] The Government has stated, however, that the timing of the NAO's scrutiny and the publication of its opinion is a matter for the Office itself. The NAO has in turn made clear that it cannot involve itself in the decision-making process, although it has already provided the Department of the Environment, Transport and the Regions with guidance on the preparation of the comparator.[116]

33. A number of our witnesses stressed the importance of having the comparator checked independently by a body like the NAO.[117] Mr Livingstone said that he would be prepared to support the PPP if is found to be the best option and if the comparator evaluation is "fairly done".[118] There was also much support for ensuring that the NAO's evaluation is completed before the PPP contracts are signed, rather than following the Office's usual practice of examining matters retrospectively.[119] Glaister, Scanlon and Travers in any case believe that the test using the comparator should be carried out in the public domain so that the process is open to scrutiny.[120] The Government, however, intends to publish the full results of the comparator only once the contracts have been awarded. In its opinion, to do so earlier would "give away our negotiating position and prevent us from achieving best value for money".[121]

34. Other concerns were also raised about the comparator. The most significant related to the level of interest rate that will be assumed for the public sector bond as this will have a significant impact on the value for money judgement. Dr Shaoul and Mr Gaffney told us that they were alarmed at the prospect of the standard discount rate being used as, based on London Underground's figures, it could be 2.5 per cent higher than the bond interest rate. They said that any appraisal which did not use a bond interest rate would "deservedly be taken as evading the central issue".[122] In addition, the case for using the standard discount rate to reflect the full financing costs of a public sector bond is "quite irrelevant" in these circumstances. They argued that the cost of project risks would already be taken into account by raising the comparator's values to reflect the risks that are being retained.[123]

Accountability

35. Responsibility for the Underground will not be transferred to the Mayor and Transport for London until the PPP contracts have been signed, which could be many months after he has taken office. The Government has, however, rejected transferring control before the negotiations have been completed because it would "create uncertainty for the bidders" and could interrupt the completion of the agreements.[124] The Deputy Prime Minister said that it would be better and quicker to continue with the PPP, providing that it is shown to offer best value, rather than waiting another three or four years for the matter to be renegotiated.[125] The Government has made clear that it wants to work closely with the Mayor in the interim in a way consistent with the rapid implementation of the PPP.[126] After all, the Mayor is already responsible for setting fares on all former LT services and will be able to review the PPP contracts periodically once they are in place.[127]

36. The Underground will play a key role in any transport strategy for London. Consequently there is view that Greater London Authority should be directly involved in decisions that are made about the PPP.[128] Instead the PPP's long-term contracts are felt to give the Authority little say in the overall funding and strategic decisions for the network.[129] Indeed, the Mayor's control of all the Underground's assets have been described as being "fettered for up to 30 years" by the PPP.[130] There is also unease about the lack of transparency surrounding the PPP arrangements due to the desire to maintain commercial confidentiality.[131] Mr Livingstone described it as being "outrageous" that the PPP deal should be "done over the heads of the Mayor and Assembly", when they will be responsible for paying any loans that the infrastructure companies may have taken, in the event of those companies defaulting.[132] Following his election as Mayor, Mr Livingstone announced the establishment of an independent panel of experts "to scrutinise the various options for financing the modernisation of the London Underground".[133]

The requirement for external funding

37. Although it was originally hoped that the PPP would remove the need for continuing Government subsidy,[134] it has become increasing apparent that this is unlikely to be the case. As we have said, there is likely to be a gap between the Underground's revenue and the financing charges regardless of whether the PPP or the revenue bonds option is chosen. Mr Tunnicliffe told us that under the PPP there was likely to be "a modest" requirement for continuing subsidy,[135] although LT believes that the PPP will be the option that requires the lowest public subsidy.[136]

38. Whatever option for funding London Underground is adopted, it seems clear that there will be an on-going need for external funding, most likely in the form of direct grant from central Government. Indeed, Mr Livingstone argued that it would be unacceptable for the Treasury to withdraw public subsidy, and was particularly concerned at the prospect of congestion charging having to be introduced in London, not to create a new source of funds for transport expenditure, but to bridge the gap between the Underground's revenue and the PPP's infrastructure charges.[137] There was also concern that the provision of grants should be guaranteed for every year of the PPP, rather than being the subject of annual negotiations, to ensure that the Underground benefits from stable and long-term funding.[138] The Minister for Transport said that the Government has "never ruled out subsidy, but we believe it is pointless to speculate about the level...until the bids have been scrutinised".[139]

56 London Underground: Bond Financing vs the PPP. Back

57 Funding the London Underground, pp. 14 and 15. Back

58 Q 229. Back

59 Q 268. Back

60 Q 256. Back

61 Q 210. Back

62 Q 224. Back

63 QQ 119 and 124. The PPP will involve the transfer of approximately 5,200 employees (around one-third of London Underground's staff) to the successful bidders for the infrastructure contracts. The Deputy Prime Minister has given assurances to staff in respect of pension rights, concessionary travel and contractual rights covering pay, hours, leave, collective agreements and union representation (FLU 12). Back

64 Q 209. Back

65 Q 262. Back

66 FLU 6, para. 60. Back

67 FLU 9. Back