Select Committee on Public Accounts Minutes of Evidence

Examination of Witnesses (Questions 60 - 79)



  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.


  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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