Examination of Witnesses (Questions 20
- 39)
WEDNESDAY 1 NOVEMBER 2000
SIR DAVID
OMAND, MR
MARTIN NAREY,
MR DAVID
KENT, MR
ROBIN HERZBERG
AND MR
ANDREW BANKS
20. The Prison Service managed to get a £53
million advantage over a conventional option in the case of Bridgend,
which was negotiated at much the same time. Why was it that much
more advantageous there, £53 million on a small contract,
when Fazakerley was only £1 million?
(Mr Narey) The prisons are different. It is fair to
say that Securicor who developed Bridgend used a rather different
design than the build of what is now Altcourse, Fazakerley, which
is largely conventional. There are prisons with different purposes;
Altcourse holds category A prisoners for example. I accept that
at the time there was a very large gulf between the advantage
over the public sector but there was still an advantage against
the public sector comparator in the Altcourse project.
21. You do not mind if I say that one looks
with a slight suspicion when one finds a contract for £247
million and it so happens that it fine tunes down to the point
where you can specify that there is an advantage of just £1
million between going the conventional route and going the PFI
route. One is left with a very clear impression that it did not
matter what the outcome was. You were going to go this route anyhow.
You were going to go PFI. You just did the comparator as a sop
to say you had done it.
(Mr Narey) I do not believe that to be the case, although
as you know I was not around.
22. No-one was, as far as I can gather.
(Mr Narey) I firmly believe that my predecessor would
not have done that. I will offer the view that one of the consequences
of the involvement of the private sector in the Prison Service
is that it has made the public sector part of the Prison Service
considerably more competitive. One of the things I am looking
at at the moment is whether or not there is a case for looking
more closely at conventional build. Hitherto to the work done
by my predecessor and work commissioned by me when I became Director
General 20 months ago suggested that we could not compete competitively.
That may now be changing, as demonstrated by the fact that on
a rather different contract, a contract for the running of Buckley
Hall prison, run very successfully by Group 4, in a market test
of that prison last year I took that back into the public sector
because the public sector bid was both better on quality and more
competitive on price.
23. I suspect many of us here can well understand
why you prefer to go the PFI route and I intimated last time that
it could give you an escape route from certain national agreements
and so on and manpower commitments which we went into in detail
at that time. I do not wish to pursue that further because we
dealt with it at the time and probably the less said the better
on that particular issue. May I come now to the rate of return?
It has increased from 16 per cent to 39 per cent, so we are told
by NAO. You agreed that. Does that mean, or is it me not understanding
these matters, that in that case you have full payback in two
and a half years?
(Mr Herzberg) The 39 per cent is calculated on a nominal
amount of capital still in the company. It is £100 or something
now. It is not surprising that you get a statistically very high
internal rate of return.
Chairman
24. One hundred pounds cannot be right.
(Mr Herzberg) The share capital of the company which
is very small, so that is how you get a very high internal rate
of return.[1]
Mr Williams
25. When did it actually come into operation,
I have forgotten?
(Mr Herzberg) In December 1997.
26. That is virtually it, is it not? That explains
it. In two years we have had payback and you now only just have
notional capital. So over a period of 25 years you are going to
get ten times payback for this contract. Someone is. We are paying
ten times payback. Is that not correct?
(Mr Herzberg) It is correct that the payback is over
that period of time.
27. We could have had ten prisons for this one
in that case.
(Mr Herzberg) That belies the risks which were actually
undertaken on the project at the outset. This is private finance.
The banks and Group 4 and Carillion put this equity at risk at
the outset and it was only at the end of the construction period
that we were receiving any monies back at all.
28. I have been generous to you. I first of
all said it was two and a half years to payback and you have already
had payback in less than that. That underestimates anyhow because
you and Carillion had a premium rate on this. I understand that
the 39 per cent does not include your profits on the construction
nor does it include the profits which the shareholder businesses
stand to make on their trading operations with the prison. Is
that correct?
(Mr Herzberg) That is correct.
29. This is a bonanza, is it not? You go into
business on this one alone and make a profit. This is like coming
up with the lottery several times a year just about, is it not?
I think we should put you in charge of the lottery.
(Mr Narey) The reality is that whatever the additional
income which Group 4 generated, we have not paid any more money
for this. We are paying the price we contracted at the beginning
of this contract, less the amount which was returned for refinancing.
The cost per prisoner place of this establishment, which I described
as being outstanding—
30. I understand that but are you disagreeing
with Mr Herzberg, who has agreed with me, I think, that they have
had payback?
(Mr Narey) No, I am not. It is not for me to disagree.
I am just trying to make the point that we have not paid additional
monies from the beginning of the contract.
31. In terms of value for money, looked at from
where I am sitting—I am not saying it did not achieve what
you intended to achieve, what I am saying is what you achieved
has turned out to be a very bad deal as far as the public is concerned
and an unbelievably good deal as far as the shareholders are concerned.
(Mr Narey) How I am trying to respond is that in terms
of value for money for prisons in the public sector with which
I can compare it, this still provides value for money. I accept
entirely that we needed to get the price down and in future DCMF
prisons, including one being opened by Group 4 next year, we have
a significantly lower contract price.
32. How significantly? Bear in mind that we
are talking about ten times payback here. Is it one tenth?
(Mr Narey) In terms of cost per prisoner place about
30 per cent.
Mr Williams: That is not necessarily the appropriate
criterion, is it? Perhaps you would let us have a note on that.[2]
Chairman
33. Forgive me for asking this question but
it is just for clarification because of my poor memory on it.
The numbers we are talking about, the internal rates of return,
are they pre or post inflation? Are they real?
(Mr Herzberg) After tax real.
Mr Steinberg
34. I should like to ask you some questions
on risk taking but after the questions Mr Williams has just asked
it seems to me that there was very little risk at all, so I am
not going to bother asking them. You could not really lose, could
you?
(Mr Herzberg) May I continue the line of the previous
discussion? This was the first prison project actually to be built
under a private finance initiative, but it was also one of the
first PFI projects absolutely. We were uncertain as to whether
we could actually complete the construction during the programme
we set out. There had never previously been a privately financed
prison. We also had all the problems of—
35. How do you mean you could not guarantee
the construction? Whether it is the private sector or the public
sector it is the same fellows doing it.
(Mr Herzberg) There was still a very demanding programme,
two and a half years. Prisons, hospitals, five ten years ago were
taking double that length of time. We have halved the period of
time under the private finance initiative as a result of the adverse
incentives which are actually on us, the liquidated damages etcetera
which are imposed upon us by the banks if we fail to complete
on time. Just dealing with this risk point, it was extremely difficult
at the outset to finance both prisons and hospitals because a
number of banks talked about the reputational risk, the political
risk, they would not do it. Indeed on this particular project
we were actually turned down by the Chief Credit Officer of one
of the clearing banks after we had been speaking to them for some
time. We could not actually persuade the other clearing banks
to get involved in the first place.
36. I hear what you are saying but basically
what you are telling me is irrelevant. The fact of the matter
is that you were quite confident that a PFI scheme was very profitable,
you went out of your way to raise the finances. Okay, you had
difficulty in raising it but you raised it. The fact of the matter
was that the rewards are quite significant and at the end of the
day, if you failed, the public sector would have picked it up
anyway. So you could not lose, could you?
(Mr Narey) Risk was certainly there during the construction
phase. Risk is still there. Last weekend at Feltham I lost 65
places when there was a mini riot on a wing. I shall lose them
for four months. If Altcourse were to lose 65 places for four
months, and that could happen, that does happen not infrequently
in prisons, it would cost them £1 million in payments which
we would not give them, in addition to the rectification costs
to put that right.
37. What happens if they go bust?
(Mr Narey) If they go bust we get a prison back with
a life of about 56 years.
38. Maybe it would be a good idea if they went
bust then.
(Mr Narey) I do not think so. I am trying to say that
the risk is still there now. At the time this prison opened, we
had only previously used the private sector in prisons we built
ourselves; the history was that those prisons opened with great
difficulty. You might remember some of the controversy about both
Doncaster and the Wolds. They opened with immense difficulty.
There was a significantly reduced confidence relative to today
in the private sector being successful in opening prisons and
running them calmly.
39. You have just verified that it is true to
say that if they are successful they reap huge rewards, as Mr
Williams has actually got out of Mr Herzberg. If they fail, the
penalties are minimal and at the end of the day you pick it up
anyway or the taxpayer does.
(Mr Narey) No, we would not pick it up. The penalties
are very, very significant. Even for the loss of places on a temporary
basis the loss of income for Group 4 is very significant at about
£120 per prisoner place per night. There are very significant
penalties for Group 4 in potential loss of income if they do not
on every single day continue to provide us with the places for
which they contracted.
1 Note by Witness: In fact, the cash flow shows
full repayment of the subordinated debt, leaving only the share
capital of the company, which is very small. Back
2
Note by Witness: See Appendix 1, page 17 (PAC/293). Back
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