Examination of Witnesses (Questions 1
- 19)
WEDNESDAY 1 NOVEMBER 2000
SIR DAVID
OMAND, MR
MARTIN NAREY,
MR DAVID
KENT, MR
ROBIN HERZBERG
AND MR
ANDREW BANKS
Chairman
1. This afternoon we welcome to the Committee
Sir David Omand, Accounting Officer of the Home Office and Martin
Narey, Director General of the Prison Service to discuss the C&AG's
report on the refinancing of the Fazakerley PFI prison contract.
We also welcome Mr Robin Herzberg, Concessions Director of Carillion
PLC, whom we previously met on Dartford and Gravesham PFI and
also Mr David Banks, Managing Director of Group 4 Prison Services
Limited. Welcome to all of you gentlemen. We are interested in
this report because, although this Committee has now considered
reports on the letting of a number of PFI contracts, this is the
first example we have seen of a refinancing, so it obviously has
implications for future contracts and for others where that might
happen. Let me start with the Prison Service and Mr Narey and
draw your attention to Figure 7 on page 25 which shows that you
have only received £1 million out of the £14.1 million
additional benefits which have arisen on this project since the
contract was let. Given that you had previously estimated that
this contract was only expected to provide marginal savings, why
did you not press for more than £1 million from the refinancing?
(Mr Narey) The reason was that our advice was first
of all that there was some doubt as to whether we had any lever
to get that additional finance; you no doubt will want to go into
that. We argued that we did because of the additional termination
liabilities which were forced upon us. We only had a handle on
£5.5 million of that sum; that was the sum for which we believed
there was some commitment on the part of Group 4 to seek our agreement.
Our advisers made a very, very cautious estimate of the likelihood
of termination of the contract at ten per cent. I think that is
very cautious and the likelihood is considerably lower than that.
In fact of the sum of money for which Group 4 were committed to
negotiate with us we got about 20 per cent of that money back,
we got £1 million of £5.5 million.
2. I must admit that I would have thought that
splitting the difference would have been a more reasonable outcome,
but perhaps I have a harder line of the taxpayers' interests than
others.
(Mr Narey) I would say straight away
that were we doing this again I would seek more and our contracts
now reflect that. For the contracts for the next two brand new
prisons at Peterborough and Ashford we intend to put in a clause
which will give us half of any refinancing benefits. At the time,
with the information available to me last April, I thought we
were getting a fair deal.
3. You implicitly accept the 50:50 rule in future
contracts anyway.
(Mr Narey) I do indeed.
4. Paragraph 1.20 says that in the event of
contract termination the Prison Service could now be exposed to
termination liabilities as much as £47 million higher than
previously anticipated. That is the maximum of course. Why did
you have an arrangement which left you exposed to a higher termination
liability if the consortium had the opportunity to benefit from
a refinancing? You just pointed out incidentally that you were
not sure you even had any legal right to object to that.
(Mr Narey) That is right. We were aware, after discussions
with FPSL, that our termination liabilities were high. You are
absolutely right that at the peak those liabilities increased
by £47 million or only about £13 million in present
value terms. That was the reason and the basis for us negotiating
a share of the gains to FPSL through refinancing. We believe that
the chance of—and I can be even more confident today than
I could be last April frankly—having to terminate the contract
was extremely remote and I still believe that. On that basis we
were not getting a sum of money to finance a possible termination,
we were getting a sum of money in recognition of the probability
of the risk which was estimated at ten per cent.
5. I do not want to disappear into the technicalities
of stochastic analysis but on a £1 million for £13 million
present value should you not be saying a three per cent probability
is the tradeoff?
(Mr Narey) The probability of termination was calculated,
I think very prudently, at ten per cent. My view is that probability
of termination is very much lower than that. This is a very, very
impressive and successful prison. Ten per cent would have suggested
that of the total gains which FPSL were getting ten per cent probability
of termination would suggest we should have got about £1
million. In fact, as I have explained, we only believed we had
a handle or a lever to negotiate over £5.5 million, so we
got about 20 per cent of that.
6. Paragraph 3.37 says your advisers, Rothschild,
were not asked to lead the negotiations, attend any negotiation
meetings, or to provide any briefing on how the negotiations should
be conducted to achieve the best outcome. Surely a better outcome
would have been achieved if the experience of Rothschild had been
used in the negotiations.
(Mr Narey) I should certainly consider doing that
in the future. We made it plain that we shall consider incentivising
our advisers in future negotiations. That is not to suggest that
we were an easy touch on this. The negotiations suggest that,
based on advice we were getting from Rothschild we bargained very
hard. The original offer from FPSL was for £100,000, then
for £300,000 and eventually for £1 million which we
accepted. Although there is a great deal of merit in incentivising
advisers and using them to negotiate direct, we got a fair deal
with their help nevertheless.
7. Paragraph 3.17 is my next point of contact.
This notes that before the refinancing took place the PFI contract
was only projected to deliver savings of £1 million compared
with traditional procurement. Now that the project has been refinanced
with almost all of the refinancing benefits going to the private
sector consortium, what is your current perception of the value
for money of the PFI contract you have given to FPSL?
(Mr Narey) I still believe that Altcourse provides
value for money and certainly at the time, relative to the public
sector comparator, although the margin was very small, it was
certainly there. In any case, my predecessor did not have available
to him at that time the capital necessary to build the prison
in a conventional manner. Since then, and as I look at Altcourse
now—and I visited it as recently as about three weeks ago—its
costs bear very reasonable comparison with several prisons in
the public sector, with, for example, Woodhill which has a similar
architecture. More to the point, in terms of the things I care
most about, in terms of decent treatment of prisoners, flourishing
education department doing real things to prepare prisoners for
release and make them employable, outstanding security and prisoners
being treated with dignity throughout, I think Altcourse provides
exceptional value for money. It is in fact an outstanding prison.
8. May I address a question to Mr Herzberg and
Mr Banks on paragraph 2.19, the first bullet point? It says that
you did not reduce your pricing of initial PFI contracts on the
expectation of later refinancing benefits to your shareholders.
The refinancing benefits that have arisen on this project, therefore,
appear to represent a windfall gain on a deal which only offered
the prospect of marginal savings for the Prison Service. Is it
fair to say that you have continued to benefit from a deal that
is not providing significant value for money for the taxpayer?
(Mr Herzberg) Certainly my belief is that when we
set out to negotiate this contract, refinancing was something
which was very speculative. It was a fairly difficult project
to finance, to say the least; indeed at the outset we sought to
involve UK banks in it. We were singularly unsuccessful in involving
UK banks. We nearly had one and at the end of the day we had to
finance it entirely through foreign banks. The whole concept of
a refinancing at that early stage was very remote indeed.
9. The outcome has been that you have made quite
a lot of money out of it, well over £14 million obviously,
and the taxpayer has made about £2 million.
(Mr Herzberg) We did have to take on board a very
high level of risk. You have to remember that this was one of
the very first PFI projects. It was certainly the first PFI prison,
it preceded the hospitals. There was no certainty at all that
these PFI prison projects could be financed, indeed financed to
the Prison Service's satisfaction. We took that risk and indeed
we did actually manage to complete the construction of the prison
five months early. Mr Banks will be able to tell you more about
the excellent operations which the prison is now delivering.
10. Would you like to add anything, Mr Banks?
(Mr Banks) I would endorse that. The climate for the
refinancing was really set by the success of the project: the
completion of the build six months ahead of schedule, the making
available of prisoner places, similarly six months ahead of schedule,
which helped to get some of the additional £14 million to
which you referred. An element of that was attributable to the
early opening of the prison, which certainly benefited us, due
to the success of the project, but also benefited the Prison Service
in having access to those places earlier. All of this and the
early establishment of a successful and stable regime at Altcourse
changed the climate significantly in terms of one where we needed
to put in a lot of effort to encourage the finance sector to participate
and one where the environment for refinancing was more favourable.
11. I just say en passant that this Committee
is not entirely persuaded of the capital shortage arguments for
PFIs. However, I shall put that to one side but perhaps come back
to it at the end. Mr Narey, what steps would you now take? You
touched on it before when we spoke. What steps would you now take
with a new PFI contract to cope with the prospect of refinancing
later on? How would you change your PFI contracts?
(Mr Narey) We intend in future PFI contracts for the
two prisons whose planning we have just embarked upon at Peterborough
and Ashford to include a clause which will indicate that in the
event of any refinancing the Prison Service should receive half
of any of the gains which are made by the private contractor.
12. What advice has been given by Treasury to
other departments about this issue?
(Mr Hull) The advice which has been given to departments
is set out in the guidance on standardisation of PFI contracts.
It is not specific about whether contracts should contain a provision
of that kind. New guidance will be published in the spring. The
head of the Office of Government Commerce (OGC) is considering
whether mandatory provision of this sort should be included. There
are two sides to it and it is important to get it right. It is
possibly more likely that such provisions will be higher level,
at a more strategic level rather than necessarily at that level
of detail.
13. Is it not a little odd then that we have
Treasury saying one thing and part of the department saying another,
which is what I think I hear?
(Sir David Omand) In the Home Office
we have drawn up guidance which we are currently discussing with
the Treasury to fill the gap until the new Office of Government
Commerce guidance is available. What we have emphasised is that
where there is third party financing of PFI contracts, then those
contracts should include a refinancing clause to ensure that there
is no ambiguity as there was in the case of the first contract
provisions, the Fazakerley contract, and to make it clear that
we would expect to share a proportion of the allocation of risk
in any benefit from refinancing. May I just give a word of caution
in drawing general lessons from this specific case? It is very
important to the whole principle of private finance that the rewards
accompany those who carry the risk. If we wish to share in the
benefits, the upside of refinancing, we have to accept that we
would share in the risks, the downside, of those costs rising.
In the case of most of these contracts we would want to maintain
that the cost of finance was something for the company to arrange
and they would normally do that by bond issue, by some long-term
arrangement or insure that themselves. We in Government would
not expect to bear that risk. If we do not bear that risk then
if those rates go down it does not necessarily follow that the
taxpayer would benefit from that. In exactly the same way with
other factors of production, land or labour, if the company is
smart enough to make a better arrangement, then they make a better
arrangement. The best protection for the taxpayer is a really
vigorous competition which ensures at the point of competition
the soundest arrangements are made and the tightest prices arrived
at rather than what could be an artificial clawback mechanism
which would require subsequent renegotiation. I just put that
as a general caveat on the principle.
Chairman: We have registered this caveat before
of course, as you are probably well aware. To put this at its
most general, we are talking about a clawback arrangement here.
Most of these clawback arrangements apply to unexpected benefits
which come back which the investor or the private company taking
part in the exercise are themselves not expecting when they make
the initial pricing. We see this in property related matters,
we see it in other areas. We have seen it on rolling stock in
the railway privatisation. I just say to the Treasury that you
do have now at the behest of this Committee some rules on clawback
and I think you should consider the extent to which that general
rule should apply to financial windfalls as well. I shall leave
you to reflect that to your superiors in the Treasury.
Mr Williams
14. Before you reflect too long, may I follow
up on it? We are told by NAO that currently over £17 billion
of PFI contracts are signed up. Is it not a bit late in the day
for you to be considering these items? Why have you been unaware
of these possibilities for so long? Not you personally but you
institutionally, Treasury.
(Mr Hull) In a sense some of the things which the
witnesses have said have answered that question in part. PFI is
a new innovative process, certain things were not known when this
particular project was gone into. When the lessons were learned
changes were made and changes are continuing to be made and more
changes will be made in the guidance which is promulgated in the
spring. I shall certainly draw the Chairman's comments to the
attention of the Chief Executive of the OGC.
15. I should certainly like you to make it clear
when you draw the Chairman's words to anyone's attention that
to my mind it is rather dilatory that we have gone this far in
the process and that you as Treasury still have not confronted
the issue. May I take up a point with Sir David? I welcome the
more robust attitude the department and the Prison Service are
taking now and I commend you for that. That is the good news.
As far as your response to the Chairman was concerned, I have
to underline what he was saying to you. PFI already includes a
risk premium, does it not? That is what you are paying for. That
is why the average is 16 to 17 per cent rate of return. That is
the risk premium, is it not?
(Sir David Omand) The difficult cases are those where
in the course of negotiation—
16. No, I am just asking a simple question.
Does the negotiating price not include the risk premium? They
would not dare enter into it otherwise, would they?
(Sir David Omand) The Committee has to recognise that
if we want a condition in a contract which says, say, a 50:50
split of any benefits from refinancing, we would probably have
to pay for that. That is the importance of competition.
17. Not if you are already getting a 16 or 17
per cent rate of return. It is a windfall return. I realise that
none of you was there but was the department or was the Service
aware of the possibility of refinancing despite the vagueness
of the situation which was described and I recognise it was back
in 1995?
(Sir David Omand) Hindsight is a wonderful thing.
At the time this contract started PFI in the Prison Service was
novel, contentious and extremely risky. There was no guarantee
that a marketplace would emerge at all for private sector prisons.
The Prison Service frankly did extremely well in developing that
marketplace to a point at which there is now genuine competition.
The latest projects which are going forward will have the advantage
of a number of toughly competed bids. That is the best answer
I can give to your point about how we ensure that the right provisions
are in the contract. I do think that it is only with the benefit
of hindsight that we can see these points. If I may point to the
Committee's last report in 1997 on this prison, this was not an
issue which anyone at the time was then identifying. We are all
gaining wisdom on this subject. The important thing from where
I sit is that I make sure that every single PFI programme with
which the Home Office is associated has already picked up on this.
I am glad to say that the PFI contract we signed a few weeks ago
does indeed include a refinancing clause.
18. Mr Herzberg, I was interested to read that
in fact you regard hospital contracts as more risky than prison
contracts. Yet you are entering into hospital arrangements at
the same rate you entered into the prison arrangement.
(Mr Herzberg) Yes, I remember Mr Williams asking me
that very question last time I was interviewed.
19. You have the benefit. I had forgotten I
had asked that.
(Mr Herzberg) I stand by my answer to him then. I
still do regard hospital contracts as more risky and the reason
I answered it that way that time was because of the complex requirements
from the consultants and the need to keep a lot of different clinicians
happy. In the case of prisons, you are at least dealing with one
clear client, Her Majesty's Prison Service, who at least give
some very clear direction as to what they want. To that extent
it is a less risky proposition. However, at the outset we did
bid a very much lower internal rate of return on this project
and I think you will find in the National Audit Office report
that the internal rate of return at the outset on this project
was only some 13 per cent, which is considerably less than the
sort of rates of return I was talking about on hospitals last
time I was here.
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