Select Committee on Public Accounts Minutes of Evidence

Examination of Witnesses (Questions 120 - 139)



  120. May I ask the Home Office whether this point was considered, that the maximum risk was going to take place just at the time that the company was going to find its profits sinking rather fast? Was that point considered?
  (Mr Narey) No, it was not considered as far as I know.

  121. Should it not have been? It seems to me that adds quite considerably to the risk.
  (Mr Narey) I have never believed and I do not believe now that Group 4 are likely to pull out of a contract in those circumstances. They are clearly committed to this business, they do other work for us in terms of running other prisons and in running escort services; they are a very important partner with us. I find it inconceivable that they would pull out in that way. If they attempted to do so, they would lose very heavily financially because in not providing the service to us we can fine them very heavily. In the early days of this prison, despite it opening very successfully, we have indeed fined them heavily to the tune of about £1.3 million.
  (Sir David Omand) What we would expect to happen then is a competition to find someone else to run the prison on the same basis so that the £47 million only has to be paid if the prison really has to be returned to the public sector.

  122. What worries me is that you did not even consider this point.
  (Mr Kent) The other point to bear in mind on this point is that before the prison returns the banks have the right to step in. If Group 4 are in difficulty banks have the right to step in and find another contractor, which means that the likelihood of not having the prison operating is considerably less. There is little probability that Group 4 will step out, but if that very small probability happened, the banks can find us another operator from what is now a developed market.


  123. One point of clarification, Sir David. I am sure you would not want actively to mislead the Committee. Your comment about the £47 million leading to being in circumstances in which you receive the prison, as it were, is true but £47 million is the difference of course between two circumstances and under both circumstances you receive a prison. I just raise that point so we are clear what we are talking about.
  (Sir David Omand) Correct; yes.

Mr Griffiths

  124. I think running prisons must be a very difficult job for you, for your managers and for their staff. Is this a stunning success story of building and running a prison?
  (Mr Narey) Yes, I believe it is. I know Mr Banks has written to your Clerk inviting you to go to see it and I would urge you to do so. It is not perfect, it did not open without some difficulties but it is an outstanding example of a local prison. I would say without hesitation that it is the best local prison I have and I am very proud of it.

  125. If we looked at the traditional way, the previous way of financing and building a prison, would you expect to have spent the £248 million?
  (Mr Narey) I am quite certain that the cost of a prison built in the conventional way and run in a conventional way would have been greater than the cost of engaging in this contract in 1995 with FPSL, although I acknowledge that now we would expect a more competitive price. At the time it was cheaper. Had we built this conventionally we would have a prison which was costing the public sector more and where, to be honest, I could not guarantee the same quality of return that I have enjoyed from FPSL on this occasion.

  126. You have built prisons before or had major prison refurbishments and other projects. Did they usually come in on budget, below budget or over budget?
  (Mr Narey) We have become much better in recent years at building parts of prisons. We still build house blocks in prisons conventionally. We have become much better in recent years at bringing them in on time and on budget. Previously, I have to say, we had a pretty disastrous record. If Mr Steinberg were here he could have told you the story of the prison in his constituency which was delivered very late and at huge additional cost and after a few months had to be partially closed while major improvements were made to it.

  127. This was on the non-PFI conventional method.
  (Mr Narey) That is right.

  128. Were previous projects like that usually completed on time, early or late?
  (Mr Narey) I could not give you an answer right across the range of projects completed. I can go back and look at them and give you an answer. The occurrence of conventional projects being delivered late was quite significant. Belmarsh prison in London cost 30 per cent more than we had originally anticipated and was opened some months late. I can give you the specific details of that in a note[6].

  129. Just summarise for me how the £47 million liability arose, why you did not say that they should by all means go ahead and refinance but you were not going to take on any of the liability.
  (Mr Narey) The £47 million, which I stress is at present value £13 million, is the worst case. If we have to terminate the contract that is the additional money which we shall have to pay for which we shall get the prison back. Taking account of what we believed then and I believe even more so now to be the remote possibility of that happening, I thought that was not an unreasonable deal to allow FPSL to refinance, it gave them greater confidence, made the possibility of termination significantly more remote and in addition brought some, I accept relatively minor, benefit to the Prison Service but still brought the benefit of £1 million which we would otherwise not have had.

  130. When you talk and look at the risk which does seem to be very small, were you thinking of one in a hundred, one in a thousand, one in ten thousand? How did you evaluate the risk?
  (Mr Narey) Our advisers took a prudent figure of ten per cent as a possibility of termination. If I were to make a guess today I should say the possibility of termination is less than one per cent.

  131. Why was it not then just suggested that if the risks all round seemed to be very small, the share of any benefits from the refinancing would be split 50:50 financially?
  (Mr Narey) Because we had nothing in the contract to allow us to do that. We had to negotiate against a contract which had not addressed refinancing because it was not addressed at the time. At the time of the contract, which was 1995, our advisers told us that refinancing if it were to occur was a matter entirely for FPSL. So we were negotiating on a somewhat difficult basis. Relative to that I thought the deal we got was fair but I accept that today, having learned from this, we would expect a rather greater return.

  132. I noticed that advice was sought from Freshfields, paragraph 1.16 and that they gave advice that consent was not required for refinancing.
  (Mr Narey) That is correct.

  133. Was that the only advice which was sought from Freshfields?
  (Mr Kent) The initial refinancing proposals—and Group 4 can probably go into them in more detail—were somewhat different from the final ones. On those initial proposals, the advice from Freshfields was that our consent was not required. Then we got further details and further proposals from Group 4 and went back to Freshfields. At that time they indicated that there were parts of the refinancing which were likely to require our approval although the contract was not completely clear on it. We continued to take advice from Freshfields throughout this whole programme. The report refers to Group 4 picking up the bill for Rothschild; they also picked up the bill for Freshfields though the report does not mention that.

  134. You have extensive experience of procurement in the private sector, which I think is commendable.
  (Mr Kent) Yes, I have.

  135. What is the key lesson you have learned from this PFI and the consequential refinancing?
  (Mr Kent) Most of the lessons are set out in the report and they include the ones which when you are entering into an area in which you have no experience, and this was one because there had never been a refinancing of a PFI before, it is very important as early as possible to get the best legal and financial advice you can and that is what we did and I am very grateful we did because we could have made a mess of this if we had not.

  136. Do you think there was some naivety when the original contracts were being drawn up in 1995 in not looking at even the possibility of refinancing?
  (Mr Narey) It is difficult to say. My view, if we ignore the benefit of hindsight, is that there was not, that this was an entirely novel project, it was groundbreaking, described by the Finance Panel as an entirely ground breaking operation and at the time it was not unreasonable for those then responsible not to anticipate the possibilities which might come from refinancing. We did take advice on it. The professional advice which my predecessors were given at that time was that if refinancing were to occur it was a matter entirely for the contractor and not something which should concern us.
  (Sir David Omand) May I develop that answer as it is rather an important point? At the time when this contract was being negotiated the assumption was that the cost of capital was a matter for the contractor and that the question of refinancing as part of the contract would not come up because it was the clear understanding that the risks of interest rate movements for example would be borne by the contractor. If rates went up they would pay, if rates went down they would benefit but the public sector was isolated from those risks. That was the mindset when these contracts were drawn up. By 1999 the Treasury guidance was beginning to shift that slightly, although they did say that such profit sharing was likely to be appropriate only in strictly limited circumstances. We are now in this session almost at the point where the Committee is suggesting to us that as a rule of thumb refinancing benefit should be split 50:50. So there has been a huge shift in thinking on this subject over the lifetime of this contract.

  137. Do you think in terms of speed of delivery, quality, cost effectiveness, PFI beats traditional financing hands down?
  (Mr Narey) The average speed of completion of a PFI prison has been about 40 months. The speed of completion of a public sector prison traditionally built was 75 months.


  138. I want to raise a couple of points. One for Sir David on this question of the liability of the taxpayer getting a clawback benefit. When this was discussed in other cases, particularly on privatisation, it was clear that the theoretical economist line which ruled in the Treasury at the time was that you would pay for whatever you got back. In other words, if you got a clawback arrangement you would pay for that in the original price. What became apparent to this Committee over a number of privatisations was that the crystallisation of value was often much greater than had been expected by anybody, either party to the exercise. This was most clear with the rolling stock companies with railways where individuals made in one case £35 million on a £100,000 investment in two years. That man sitting in front of us said he had no concept he was going to make that; he was perhaps hoping for £2 million. The doctrine we ended up at was really the doctrine of sharing in the unexpected gain, the gain which was beyond the expectation of either side, either party. It is very hard to establish that sometimes and this is a rather good case of not just the size of the gain but the nature of the gain being unexpected. One can understand that since you were breaking ground here that was not allowed for in the original calculation. The point which has to be clear is that sure, clawing back gains will change the pricing mechanism in the early part of a contract, but if you are looking at gains which are beyond the normal expectation range that probably will not have any effect on the pricing range. It also has an effect on acceptability of privatisations. The public see their money being lost by millions or even billions made by people in the private sector on the back of a public sector contract. This is something which has to be borne in mind. I know it is not strictly an accounting officer consideration, but it is something which comes up. I just raise that point to put the witnesses in the context of what we have seen before.
  (Sir David Omand) May I say that that thought process is very much one we share. The guidance which we are currently discussing with the National Audit Office to go round the Home Office on this matter picks up these points. I have to add to them the other consideration about not taking on risks of downside movements.

  139. You neither want to take on the risk, nor do you want to strangle the golden goose but both are important and we understand that. If we see clawback arrangements which give the first benefit to the contractor we do not particularly object to that; it is when you get beyond initial benefits that we start to argue the case. The other issue is really a question to Mr Herzberg in particular. It would be helpful for the Committee—and forgive me for asking for this, it is what we typically ask the department—if you could let us have a brief note on what you see to be the risk factors in prisons these days. You have said yourself that the prisons are lower risk than hospitals but where are the risks? We have heard from Mr Narey about the possibility of you losing a wing for a quarter or something like that. It would be interesting for the Committee to know what you think the risk factors are.
  (Mr Herzberg) I should be very happy to respond in writing and list both the construction risks, and the operating risks with the help of Mr Banks, but also the financing risks.[7]

6   Note: See Evidence, Appendix 1, page 17 (PAC/293). Back

7   Note: See Appendix 2, pages 18-22 (PAC/297). Back

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