Examination of Witnesses (Questions 60
- 79)
WEDNESDAY 1 NOVEMBER 2000
SIR DAVID
OMAND, MR
MARTIN NAREY,
MR DAVID
KENT, MR
ROBIN HERZBERG
AND MR
ANDREW BANKS
60. I am sorry to press the point but you are
not saying, are you, that the whole of that £10.7 million
is in a cupboard somewhere waiting for the next project to come
along? I understand the point about FPSL. However, you are not
telling us that money has not been available and some of it will
not have been taken by the shareholders of the two parent companies,
are you?
(Mr Herzberg) First of all, that £10.7 million
has to be earned over a period of time. It is not an immediate
windfall and some of it is to do with lower interest rates and
changes in hedges and will only come in over 25 years. I shall
turn to Mr Banks in a moment who can speak for Group 4. Certainly
Carillion's current commitments of equity investment under PFI
is some £32 million. This £5 million is a relatively
small proportion of the cash requirements of our current portfolio.
I suspect the position in Group 4 is very similar.
61. With respect, would it not be the case that
Carillion will go to the marketplace and borrow that money for
future projects and be able to point to Fazakerley and say it
is very successful?
(Mr Banks) That is actually a very good point in terms
of what the success of this project has done in the marketplace.
Mr Steinberg referred to the fact of being remunerated over and
above our expectations for simply delivering the contract. What
this contract did was overdeliver against expectations by virtue
of opening early. That increased the confidence amongst those
capital markets which not only enabled the refinancing to take
place, but I believe fundamentally affected the marketplace in
terms of the appetite of financial institutions. What one has
seen is an increased appetite, increased competitiveness, partly
reflected by these terms, but partly reflected by terms which
are now available and have been available on subsequent PFI projects.
The point I am actually trying to make is that the success of
this project both in terms of the delivery of the project and
the delivery of the regime—and the Chief Inspector of Prisons
commented that it should be a jewel in the crown of the Prison
Service—all of this has actually increased the confidence
which has moved the market forward.
62. Notwithstanding that the point I am getting
at is how much of this £10.7 million windfall will find its
way into the pockets of shareholders. That is the point I am getting
at. I am not disputing anything you have told me about the confidence
this will give in future PFI projects; that is all to be commended.
I am asking where this money will end up.
(Mr Banks) Yes, with the shareholders, that is correct:
£10.7 million less the £1 million which was paid to
the Prison Service by way of compensation for the probability
of the additional risk associated with lender's liabilities.
63. I do not want to put you on the spot but
is it possible for you to calculate how much of that finds it
way to shareholders and in particular to, let us say for the sake
of argument, members of the board who have shares? How much will
people have made?
(Mr Banks) In terms of Fazakerley Prison Services
Limited it is a separate company. The accounts are filed and published
and I am certain we could make a copy available to you.
64. I am interested in where the money ends
up with regard to Group 4 and Carillion. I am not particularly
concerned about FPSL at this particular time. You have spoken
quite rightly about the risks involved in constructing one of
the first PFI projects and indeed the first PFI prison project.
But as Mr Williams said when he was asking you about risk premium,
my understanding is that construction profits for PFI could be
as much as 50 per cent higher than those on conventional building
projects. In other words, the risk is already built in, is that
not right?
(Mr Herzberg) I cannot confirm the 50 per cent; I
am not sure I have the evidence. I would confirm that we would
expect higher construction profits on PFI jobs. If I may answer
the question empirically, across our PFI segment for the first
six months of this year within Carillion, our margin was 2.7 per
cent.
65. Let me take you onto something else which
you said in answer to Mr Williams. He referred to comments you
made in front of this Committee at the end of last year. I want
to take you back to the comparison you made between PFI hospital
projects and PFI prison projects. You said that you expected—correct
me if I am wrong—something like 15 to 17 per cent return
on hospital projects because in your view prisons were less risky.
The return from Fazakerley then, if my understanding is correct,
will have turned out to have been 39 per cent. Do you want in
any way to reconsider your view?
(Mr Herzberg) The 39 per cent whilst technically accurate
and correct is distorted because it is calculated on a nominal
amount of share capital.[3]
However, the internal rate of return at the outset on this project
was 12.8 per cent which was very considerably less than I would
expect on hospitals. Even as a result of us performing the construction
extremely well, in two years of successful operations it had gone
up to 16 per cent. I quote a figure from the NAO report (foot
of page 38).
66. Hindsight is a great asset in these matters,
as this Committee finds on a week by week basis. I want to go
back to the original figures for Fazakerley. I do understand that
it was very early days for PFIs but we were talking about marginal
savings of about £1 million which represented somewhere in
the region then of about one per cent. Is it not clear—and
I suppose my question is: why was it not more clear at the time—that
there was really scope for greater improvements than just that
one per cent? For example Bridgend projected savings of somewhere
in the region of 17 per cent. Even without refinancing, with hindsight
really the figures have not turned out to be very realistic, have
they?
(Mr Narey) Certainly relative to subsequent DCMF deals
and relative to the Parc deal which was simultaneous, the cost
of this was certainly greater than that but it was nevertheless
cheaper than the public sector comparator. At the time, and this
is going back some years, there was a cheaper bid and this Committee
have interrogated my predecessor on that basis. My predecessor
did not choose to give the contract to the cheaper bidder at the
time because of concerns about their ability to deliver two prisons
simultaneously because of the very, very high risk involved.
67. I take the point about the public sector
comparator but I was struck by a sense of irony here—and
this is not a party political point, Chairman—that, this
Government having created stability and relatively low interest
rates, it is actually through this refinancing that FPSL have
benefited to a disproportionate extent from that change and the
taxpayer much less so.
(Mr Narey) That is certainly the case, although the
taxpayer has still benefited. We have had a refund of some money
and we do have a key change in the contract in terms of FPSL accepting
that we will only pay for overcrowded places when we use them.
That will save us millions of pounds over this contract.
68. I understand about the good deal for the
taxpayer and that has been borne out by experience. What is my
immediate concern in this report and today is what about the benefits
from refinancing? I am not convinced that they actually compare
to the risk which has been taken.
(Mr Narey) I accept entirely that we did not get the
benefits from refinancing which I would hope to get if we were
in a similar situation today. The reality is that when the contract
was entered into, and indeed when I was discussing Mr Kent's proposals
to me about refinancing, this very helpful document was not available.
We were in the dark. Had it been available, we might have made
some different decisions. We have learned from this and we have
put in hand very different arrangements for future contracts.
At the time, because refinancing had not been foreseen in 1995,
we had very limited leverage on getting a better deal.
69. That worries me. I am not asking you to
predict the future but that worries me. What also worries me,
but I do not have time to explore it, is the advice you were getting
from your then advisers who were effectively telling you that
refinancing was a matter for FPSL to worry about and not you.
I want to just ask a brief question about the future. You have
spoken about the confidence you have in this project and we are
all sincerely gratified to hear that. How do you know that refinancing
in the way that it has been done will not affect the company's
performance at Altcourse? How do you know?
(Mr Narey) The company may want to say something about
that but my understanding is that the rate of return in the early
years of the contract gives them greater confidence in delivering
this. They are making greater money at it. They are much less
likely to get into difficulties. The likelihood of termination
has receded. Added to that, I know from simply spending time there,
I know when I see a prison which is treating prisoners decently
and doing the sort of things which this Government has asked me
to do to try to prepare prisoners for release and try to get them
a second chance upon release. This prison is doing all of that.
This is not just a deal in financial terms. In terms of the quality
I get out of this prison, it is exemplary, and I just wish I could
match it elsewhere.
70. I am gratified to hear that and I understand
that you cannot foresee the circumstances, and no-one can, where
the Prison Service is unlikely to want to terminate this contract.
Is the reality not that at a new price of £47 million to
terminate it, it makes you much, much less likely to go down that
route and therefore that does change, could change in the future,
the nature of the relationship between you and the contractors.
(Mr Narey) I accept that. If that were to occur at
a time when our increased liabilities are at a peak, the £47
million, £13 million in present money, I accept that would
be a disincentive to terminate. I do think the possibility of
termination is so remote. For a start it would have to require
an absolute sea change in the rise in the prison population. The
possibility of us not needing prison places in the North . . .
Well frankly I could get quite delirious about the prospect. I
wish it would occur.
71. I hope you are right.
(Mr Banks) I should like to make a point from a company
point of view and that is that we are firmly committed and are
into the business of working with Government, particularly on
PFI projects and other projects for the long term. In terms of
the contract itself and this particular contract, there are very
many incentives by way of potential penalties for non-performance
ranging from non-performance in terms of the quality of what is
delivered, through more significantly to very significant financial
penalties, in fact non payment to us for the service, if we fail
to make places available, and ultimately to termination of the
contract. There are many steps along the way in terms of this
specific contract to keep us fully incentivised. That is within
the umbrella of a company and a consortium that is fully committed
in this area and in other areas to working with government for
the long term.
Mr Love
72. May I start with Sir David because I have
listened carefully to Mr Narey's acceptance of the benefits of
this contract to the Prison Service but recognising that this
Committee is somewhat sceptical of the capital shortage arguments
which have been used for PFI and having focused very much on the
value for money aspect, do you think as the accounting officer
that the balance of benefit between taxpayers and shareholders
is either reasonable or justifiable in this particular PFI?
(Sir David Omand) May I answer as the departmental
accounting officer? Mr Narey is the vote accounting officer.
73. This Committee would hold you responsible
for the taxpayers' side of that equation. We understand Mr Narey's
responsibility to get the best prison service possible.
(Sir David Omand) The Committee should hold me accountable
for the regime under which the Prison Service is operating its
financial regime but not for the decisions which the vote accounting
officer is actually taking.
Chairman
74. We will not rewrite the constitution at
the moment, just answer the question.
(Sir David Omand) The answer is unequivocal: I think
this is an extremely good deal for the taxpayer and remains a
good deal for the taxpayer and I do worry about the tenor of the
questions which have come to the witnesses in terms of losing
sight of the bigger picture which is that we were in great need
of prison places at a time of rising prison population for a cost
per prison place which is below that of the alternative means
of providing. We have had very high quality prison places. I visited
the prison myself last year, quite coincidentally. Taking up Mr
Williams' earlier points, I cannot see an alternative use of the
resources which could have produced such a good outcome for the
taxpayer at a critical point. Taken to its extreme, the line of
questioning about the negotiation of benefits would take PFI contracts
to the point of extinction. There has to be a balance between
the rewards for risk and the sharing of the benefits mutually
that go with a long-term, 25-year partnership. If in these long-term
private/public sector partnerships the two parties are intent
on scoring off each other for every part of the contract then
these partnerships will not work. The question for me as the accounting
officer is whether the overall balance of advantage still lies
firmly in favour of the taxpayer. If we were to negotiate harder,
would we get an even better deal for the taxpayer? That I suggest
is the question, not whether or not there is a good deal for the
taxpayer. There is. Could we have got an even better deal if we
had negotiated a little harder? I have studied the evidence in
the report very carefully and I am genuinely not sure how much
further this could have been pushed. With hindsight yes, we could
have stuck out a bit longer, but we could in turn have ended up
with longer term liabilities if we had conceded, for example,
on the point which is brought out in the first PAC report on the
ambiguities in the contract over interest rates. If we had conceded
that point and played it into the argument as the NAO report suggests
we might have got a little bit more out in the short term but
that would have exposed the taxpayer to the downside of interest
rate movements over a 25-year period. It is that kind of balance
that the negotiators have to take into account. I am satisfied
as the departmental accounting officer that the negotiators approached
this particular deal professionally and thoroughly. There are
always lessons to learn and as we do more of these we shall get
better at it.
Mr Love
75. Let me pick you up. Throughout that reply
you have used the word "partnership". Would you not
concede that there might be some scepticism out there amongst
the general public about the benefits of a partnership which delivers
a 39 per cent return to the private sector but is very marginal
on behalf of the public sector?
(Sir David Omand) I should be very unhappy if we were
continuing to see that rate of return over the range of our contracts.
This was the first through the door, this was the contract which
established the marketplace.
76. I can ask you a slightly different question.
Perhaps it is more appropriate to Mr Narey. Do you think, now
that we know the basis of this new partnership, that it may well
threaten the good partnership which has existed up until now?
(Mr Narey) No, I do not. I think the partnership is
very healthy. I accept all that has been said about the fact that
we had to learn from this. We have got more competitive deals
with FPSL since then, for example a much lower cost per prisoner
place on the prison which is opening next year, dramatically lower.
At the time this was a good deal for the public purse and remains
a good deal. I accept that we can make better deals from now on.
On the capital point, primarily because of the competition, if
not the threat posed by the private sector to the public sector
prison service, we the public sector Prison Service have become
considerably more efficient. I do not think we are quite there
yet but we may be fast approaching the time when we shall be looking,
for example, at the private sector using their expertise to build
prisons but possibly running them ourselves or having a separate
competition for the running of the prison once built.
77. That takes us into some other areas which
I shall resist going to. May I turn to Mr Herzberg? We have talked
a lot about risk premium in relation to both prisons and indeed
hospitals. Would you say that the risk premium of 39 per cent
is a reasonable one?
(Mr Herzberg) No, not at all. I have already said
that 39 per cent is a distortion. It is calculated on a cash flow
showing full repayment of the subordinated debt leaving a nominal
amount of capital and it is misleading.[4]
What I would say is that the returns from the refinancing do actually
represent a change in the profile of the project from the inception
to the period four years later. That is a result of our performance.
I believe that those returns of £10.7 million from the refinancing
are not unreasonable in relation to the way that we have handled
that risk and have performed.
78. May I ask you a theoretical question? If
someone sold me a car with a chauffeur at 39 per cent rate of
return and I went to the Consumers' Association I think they would
be somewhat perturbed about that, especially if it were based
on an HP or a financing agreement which then changed half way
through. Do you think there is any reason why this Committee of
Public Accounts, which is supposed to scrutinise the value for
money of public sector expenditure, should be similarly concerned
about the way this particular PFI contract has gone or do you
think we should just accept that this is a reasonable deal in
that particular set of circumstances which existed in 1995?
(Mr Herzberg) I can only respond and repeat myself
and waste your time on the particular percentage. I do believe
that in the circumstances we have shared a reasonable amount of
money with the public sector on a very arm's-length basis in circumstances
where we took huge risk.
79. Did either of the two partners in FPSL,
Carillion or Group 4 make further profits from the provision of
services to FPSL during the four years that this contract has
existed?
(Mr Banks) The structure of FPSL is that Carillion
and Group 4 are joint shareholders in Fazakerley Prison Services
Limited and Fazakerley Prison Services Limited entered into two
prime contracts, one contract for the design and construction
of the prison, which was a contract that was undertaken by Carillion,
and a contract with Group 4 for the operation of the prison. These
contracts were part of a package which was put in place at the
outset when the contract was negotiated.
3 Note by Witness: To be precise, the 39 per
cent is distorted because it is calculated on a cash flow showing
full repayment of the subordinated debt leaving a nominal amount
of share capital. Back
4
Note by Witness: The calculation is in fact based on a
cash flow showing full repayment of the subordinated debt leaving
a nominal amount of capital. Back
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