Examination of Witnesses (Questions 120
- 139)
WEDNESDAY 1 NOVEMBER 2000
SIR DAVID
OMAND, MR
MARTIN NAREY,
MR DAVID
KENT, MR
ROBIN HERZBERG
AND MR
ANDREW BANKS
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.
Chairman
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.
Chairman
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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