Select Committee on Transport, Local Government and the Regions Second Report


Public Sector Comparator

25. The value for money test will examine whether the bidders will offer better value for money than an alternative, publicly funded infrastructure option. To assess value for money, a Public Sector Comparator has been created. A Public Sector Comparator is an estimate of the likely public cost of funding the infrastructure improvement proposed by the bidders under alternative financing scenarios. The PPP bids will be compared against a traditional funding model of a combination of public subsidy and fares revenue and a second option of public subsidy and bond financing with the bonds raised against future fares revenue.[58] Each of the three Infraco contracts will be assessed independently of the others for value for money. Should one or two of the Infraco bids fail the value for money test that will not preclude the other bids from being approved.

26. At the time of our predecessor Committee's inquiry, there were concerns about how the Public Sector Comparator had been created.[59] That Committee recommended that the National Audit Office examined the financial analysis of the PPP at an early stage to ensure that the process was well guided and transparent.[60]

The National Audit Office Report


27. The National Audit Office reported on its findings in December 2000, and noted that this is the largest Public Sector Comparator, by value, developed by any public entity.[61] The National Audit Office found that the Public Sector Comparator had been developed using a clearly documented methodology to estimate the costs of conducting the work in the public sector. It also concluded that the evaluation of the bids submitted by the private sector was thorough and comprehensive. London Underground Limited's auditors, KPMG, found that the methodology for the comparators complied with the relevant Treasury guidance.[62]

28. Although concluding that the methodology used in the development of the Public Sector Comparator was sound, the National Audit Office identified several concerns about the financial analysis:

  • "There is considerable uncertainty in modelling the costs of conducting such a major programme of work over a 30 year period.
  • The financial models alone would provide only limited guidance as to the most likely cost of a public infrastructure operation.
  • There is uncertainty over the most appropriate financing approach for the cost of public infrastructure operation."[63]

Those technical concerns are being considered by London Underground Limited. The National Audit Office told us during this inquiry that " these technical problems will not, in the end, be decisive".[64] Subsequent to the National Audit Office report, Transport for London commissioned work which highlighted "questionable judgemental factors" used in the PSC and claim that the advantages of bond financing have been largely dismissed.[65]


29. The National Audit Office emphasised that too much weight had been given to the financial analysis and that in fact it only had "limited use".[66] Its report stated that:

"There is a wide range of other factors, which are either difficult or impossible to quantify in financial terms, and which could impact directly on the value for money of the different options."[67]

Those wider factors include:

  • the risks and benefits of dividing responsibility for the network;
  • loss of flexibility for managing network upgrade decisions compared to the extra efficiency of private sector management;
  • the risk of a highly contractual and litigious approach to managing the contracts;
  • the ability of the performance specification to avoid perverse incentives and act in the public's interest; and
  •  the transfer of risks between the parties.[68]

Risk allocation

30. The allocation of risk between parties is a major part of the PPP process. For example, asking a private sector company to price for the risk of the Thames flood barrier failing would make the contracts too expensive[69] and the "success lies with allocating risks to those best able to carry them".[70] London Underground Limited told the Committee that the public sector will retain the risk responsibility relating to revenues, changes to health and safety law, legislative changes and some environmental risks.[71]

31. The Government believes risk can successfully be transferred, particularly by giving the private sector consortia responsibility for the condition of the assets over a long period.[72] In contrast, Mr Bob Kiley, Commissioner of Transport for London, told us that less and less risk has been handed to the private sector as the contract has progressed and that "the amount of risk that is really being transferred is barely perceptible".[73] Mr Martin Blaiklock, a specialist in infrastructure private finance deals, described underground metro systems as "second only to nuclear power stations in technical, commercial and financial complexity".[74] He, like other witnesses, doubted whether "London Underground Limited is on top of the risk allocation and mitigation program".[75] The balance of risk transfer is critical to the success of the PPP. If little risk can be transferred to the private sector, due to the cost attached to it, then the rationale for the PPP is seriously undermined.

Subjectivity of value for money

32. All parties accepted that the wider factors described above are subjective in nature. For example, the determination of risk, the uncertainty that an event might occur, is subjective.[76] Values can be assigned to some risks through assumptions about the probability of such events occurring. London Underground Limited has developed a good understanding of the operational risks to their business through historical performance data. However, whilst estimates can be made of some risks, many of the factors identified by the National Audit Office, such as the risk of significant litigation in managing the contracts, the loss of cohesion from splitting the operation from the maintenance of the network and the likelihood of continued poor public sector management performance, are both highly subjective and critical to determining whether the bids submitted offer better value for money.

33. London Underground Limited accept that many of the factors are subjective and has invested considerable effort in understanding the nature and importance of these wider factors since the National Audit Office report. London Underground Limited told us that it was confident that it could provide an assessment of all of those factors but acknowledged that "it is not a solution to an equation, where you can say is this figure bigger than that figure".[77] The uncertainty over whether the PPP will offer value for money, acknowledged by both London Underground Limited and the Government, shows that "the cost savings [of £4.5 billion] originally promised to Parliament when it endorsed the PPP have proven illusory".[78]


34. In October 2001, the Government appointed Ernst and Young to carry out an independent review of the value for money assessment being undertaken by London Underground. That review, which will cost £400,000, is to include an assessment of both the financial and non-financial factors involved in the decision.[79] Ernst and Young, in its terms of reference for the study, points out that:

 "Due to the subjective nature of the value for money assessment, it is not always possible to conclude decisively on the position of proposed contractual negotiations. The conclusions of the Review are likely to be based on an assessment of a range of factors and hence the overall assessment may be subjective and based on stated assumptions."[80]

The Secretary of State told the Sub-Committee that he would only approve the PPP contracts if they could conclusively demonstrate that they offered value for money over the Public Sector Alternative.[81] The Secretary of State also told us however that "it will not be one of those recommendations which says clearly, yes it is value for money or no it is not".[82]


35. The National Audit Office told us that the decision on whether the PPP contracts would offer value for money depended significantly on the subjective, wider factors. In assessing those wider factors it did not believe that London Underground or the Government "should rely on consultants; those [decisions on the wider factors] are absolutely decisions for the executive, in this case the Board of London Transport and the Department. It is their responsibility to decide what they want to do and how to justify it."[83]

Value for money over seven and a half and 30 years

36. Assets on the Underground network can be in service for 20 to 40 years. The PPP contracts are for a 30-year period to encourage the Infracos to take a "whole life" approach to upgrading the infrastructure. London Underground Limited told us that a contract that was fixed for 30 years would not be practicable and no bidder could offer fixed prices for 30 years in a way that would offer value for money.[84] One of the unsuccessful consortia told us that it would have been willing to sign up to a 30-year price to improve the infrastructure and provide the finance to implement it.[85] London Underground Limited has inserted periodic reviews every seven and a half years to allow itself the flexibility to vary the terms of the PPP so that it can adapt to changes in demand on the network over time.[86] If the two parties cannot agree on the price for the work to be completed at the Periodic Review then an arbiter is appointed by the Secretary of State under the Greater London Authority Act, Section 229. One of the arbiter's roles is to determine the price paid to the Infraco to achieve, if the Infraco acts in an economic and efficient manner, the agreed rate of return.[87] The bids submitted for evaluation under the PPP contain fixed prices for the first seven and a half year period and estimates of 30-year costs. Value for money is being assessed over the seven and a half and 30- year periods.

Risk of cost inflation

37. A number of questions were raised as to how value for money could be assessed over 30 years when the bidders were not committed to the price submitted for that period. The financial advisers to Transport for London, Deloitte and Touche, found "no evidence that there is a valid basis for establishing that the PPP will achieve value for money using commonly accepted techniques for projects of this nature".[88] It believed that assessing value for money over 30 years "is flawed because bidders were not required to submit firm prices for the whole period".[89] Mr Blaiklock also questioned whether it was possible to determine whether the bids are more expensive over the period from seven and a half years to 30 years when prices were unknown.[90] London Underground's advisor, Pricewaterhouse Coopers, strongly disagreed. It pointed out that assessing value for money over 30 years was essential to ensure efficient long term investment and that the seven and a half year year comparison was used to compare committed prices and to protect against bidders attempting to make artificially low bids for the period from seven and a half years to 30 years.[91] Deloitte and Touche told us that subsequent to its report, Pricewaterhouse Coopers had admitted that the seven and a half year comparison was not valid.[92]

38. The National Audit Office told us that the decision to have review periods was a matter for the management of the Underground but that inserting such reviews produced uncertainty about the level of costs for those periods without fixed prices. The National Audit Office also noted that calculating the impact of that uncertainty was "very difficult".[93] Parsons Brinckerhoff stated that the first seven and a half year period would be "a learning curve" for the Infracos and that they would not be able to make a clearly-defined forecast of costs beyond that point.[94]

The Arbiter and cost inflation

  39. There was considerable uncertainty about the likely price of PPP contracts after the first review period. The Sub-Committee received a number of submissions about the role that the arbiter will have in preventing cost escalations. Transport for London questioned the capability of the arbiter to set prices in the public interest. It did not believe that there are sufficient comparable businesses ,except the other Infracos, for the arbiter to assess whether the Infracos are acting in an economic and efficient manner and that the Infracos will control the information required for any such assessment. It concluded that "London Underground's ability to make any informed submissions to the Arbitrator will be limited and the Infracos will be free to exploit their monopoly positions."[95] Both London Underground Limited and the Government are confident that the arbiter will be able to resolve pricing disputes in a manner that protects both the public interest and the interests of the Infracos.[96]

Capital spend profile

40. Mr Kinglsey Manning, an advisor to the National Audit Office, argued that one of the key differences between the Underground PPP and a number of other Private Finance Initiative deals was that the capital spending profile for the PPP continues well beyond the first review period. Mr Manning said that:

"In most PFIs, at least you are able to look at the capital spend over relatively short periods, so your major uncertainty is often to do with the revenue stream beyond the original capital spend; in this case, you have got uncertainties both in the revenue streams and also in the capital spend into the future."[97]

He believed the deal to be "on the very edge of the complex and difficult to analyse".[98]

41. The inclusion of review periods within the contracts has added considerable uncertainty to the final costs of the PPP project. Opinion is divided as to whether it is possible to assess value for money over 30 years when prices are fixed for the first seven and a half years only. That consideration is particularly important as the capital spend for the PPP is not concentrated at the start of the contract period as in many Private Finance Initiatives. There was, however, agreement that any analysis of value for money of the PPP is extremely difficult and highly subjective.

Asset register

42. Experience from the mainline railway has shown that the failure to hold and maintain a complete register of assets and their condition inevitably leads to cost inflation resulting from unforseen problems and insufficient planning information. In his oral evidence to the Transport Sub-Committee on the future of rail franchising and Railtrack, the Secretary of State, acknowledged that "for a company like Railtrack not to know the conditions of its assets is deeply worrying",[99] and that the lack of a well defined asset register was "a fundamental weakness".[100] In its review of the Office of the Rail Regulator, for the mainline railway network, the National Audit Office noted that deficiencies in the information of the condition of Railtrack's assets meant that the Office of the Rail Regulator could not "assess satisfactorily on customers' behalf what is being achieved with this money."[101]

43. London Underground Limited told us that an up to date asset register exists for most of the Underground's assets including track, tunnels, signals and trains because they are all accessible for inspection. There was a classification of assets, known as 'grey assets', about which less information was available because they cannot be inspected easily.[102] However, the National Audit Office report of December 2000 found that "past knowledge about asset conditions means that margins for uncertainty (in estimating the capital spend programme) are inevitably substantial",[103] a finding that London Underground Limited did not dispute. Transport for London estimates that the bidding consortia have a "solid understanding of the nature and cost of the capital expenditures over the first two years of the PPP. Thereafter the priorities are not as well defined."[104] Mr Kiley told us that the first priority, if Transport for London were awarded control of the system, would be a "stem to stern" assessment of the physical condition of the assets.[105]

44. The Infracos take the risk for cost inflations due to poor knowledge about asset conditions over the first seven and a half years. Both of the preferred bidders have undertaken significant investigations to check on London Underground Limited's assessment of asset conditions. Tube Lines have conducted over one million man hours of 'due diligence' assessments.[106] Transport for London claim that the Infracos liability for cost overruns is limited to £30 million per year over the first seven and a half years[107] although this was denied by London Underground Limited.[108]

45. If the Infracos faced increased costs over the first seven and a half years, they would be allowed to request an increase in the Infrastructure Service Charge for the following seven and a half years. If the Infracos and London Underground Limited do not agree, the arbiter will have to determine whether any price rises are due to Infraco inefficiency or due to circumstances beyond their control, such as worse than anticipated asset conditions. The arbiter has a duty to ensure that the rate of return specified in the contracts with the Infracos would be earned if the Infraco acts economically and efficiently. Transport for London argued that a lack of knowledge about asset condition would contribute significantly to the inability of the arbiter to prevent price rises.[109]

46. A register of assets exists and is maintained by London Underground. However, the register is incomplete and worse than anticipated conditions in the "grey assets" could have very significant cost implications for the PPP. Even with the asset register, London Underground Limited has acknowledged that there is considerable uncertainty in estimating the costs of the investment programme over 30 years.

58   HC (2001-02) 373-IV, Q766. Back

59   Funding of London UndergroundBack

60   IbidBack

61   The financial analysis for the London Underground Public Private Partnerships (2000-01) National Audit Office, HC54. Back

62   IbidBack

63   Ibid Back

64   Q309. Back

65   LU3. Back

66   The financial analysis for the London Underground Public Private Partnerships (2000-01) National Audit Office, HC54. Back

67   IbidBack

68   IbidBack

69   Q512. Back

70   LU16. Back

71   LU11A. Back

72   LU12. Back

73   Q270. Back

74   LU16. Back

75   IbidBack

76   LU16. Back

77   Q41. Back

78   LU3. Back

79   LU12A. Back

80   IbidBack

81   Q555. Back

82   Q611. Back

83   Q328. Back

84   LU11A. Back

85   Q395. Back

86   LU11A. Back

87   LU12C. Back

88   London Underground Public Private Partnership - Emerging Findings, 17 July 2001, Deloitte and Touche Back

89   IbidBack

90   LU16. Back

91   Commentary on Deloitte and Touche Report, (redacted Version), 24 August 2001.Pricewaterhouse Coopers. Back

92   Q344. Back

93   Q520. Back

94   Q218. Back

95   LU3. Back

96   LU11A, LU12B. Back

97   Q338. Back

98   Q338. Back

99   First Report of the Transport, Local Government and the Regions Select Committee, HC (2001-02) 239-II, Q915. Back

100   Ibid, Q913. Back

101   Ensuring that Railtrack maintain and renew the railway network. (1999-2000) National Audit Office Report, HC397, p9. Back

102   Grey assets include tunnel surrounds, bridges and station structures behind cladding. Back

103   The financial analysis for the London Underground Public Private Partnerships (2000-01) National Audit Office, HC54, p5. Back

104   LU3 Annex E. Back

105   Q236. Back

106   LU13. Back

107   LU3. Back

108   Q184. Back

109   Q260. Back

previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2002
Prepared 5 February 2002