Examination of Witnesses (Questions 60
- 79)
WEDNESDAY 27 FEBRUARY 2002
MR JAMES
NEAL, MR
DOUGALD MIDDLETON,
MR NICK
JOYCE AND
MR MARTIN
BLAIKLOCK
60. So it would not be appropriate for someone
to use that report to say, "This shows PPP will give value
for money over 30 years in real life"? I am not trying to
denigrate the report.
(Mr Blaiklock) I reserve judgment on this in that
sense. One has to perhaps go back to the Terms of Reference which
Ernst & Young were asked to work under in the first place.
From their report, the actual technique which is being used, the
mathematical technique for evaluating bids, is well understood,
and in that sense, fine. But there are, as their report says,
a number of subjective areas which I have a stronger view about
as to whether they should or should not be included, and what
weight you should give to them than perhaps Ernst & Young
have reflected.
61. So, in a sense, you are saying the report
was not asked to deal with the question of, "Is this value
for money over 30 years in real life?" They were asked to
do something else, which they have done, a different question?
(Mr Blaiklock) Yes, I think that is probably true.
Chris Grayling
62. Can I just ask: we have seen since the announcement
by the Secretary of State a couple of weeks ago that the Government
is offering guarantees through London Underground to the banks
of the finance that is being raised for the project. When you
carried out your assessment of the financial details provided
to you by London Underground, did you make any assumptions about
the rate of return that would be required; about the necessity
of providing guarantees in order to deliver a certain level of
interest rate to the banks that finance this?
(Mr Middleton) When we finished our report, the negotiations
between London Underground and the banks on this and on the PPP
bidders was not completed. We understand now that the underpinned
amount, as referred to in the contracts, has been agreed between
London Underground, the banks, and the bidders. The key issue
in value for money terms in considering this issue is to consider
the likelihood that the guarantee will be called ie, what is the
likelihood of one of the Infracos defaulting, and London Underground
having to step in and provide, I think it is 95 per cent guarantee
to the funding banks.
63. Which has just happened with Railtrack.
(Mr Middleton) What we did in our analysis on this
point was look at, effectively, the risk transfer proposals, the
ability of the Infracos to absorb the risk which was being transferred
to them, and you will see in our report the levels of contingencies
etc which are built into the Infraco bids. Based on that analysis,
we asked London Underground to carry out sensitivities, and they
provided us with the sensitivities that were completed on behalf
of the funders by the Infracos. They showed that under most scenarios,
apart from the most extreme banking based case sensitivities,
that the Infracos financially were robust and could handle those
downside scenarios.
64. The reason I ask the question is given what
has happened to Railtrack, and, therefore, the uncertainties that
must exist around infrastructure projects, particularly where
there is uncertainty about the condition of the assets, given
that that has happened, had the Government not been willing to
offer guarantees to London Underground, and, through them, to
the Infracos and to the banks about those debts, would there have
been a significant material change in the financial position of
the project that would have changed the conclusions that you reached?
(Mr Middleton) It is an interesting question, but,
to a large extent, it is a hypothetical question.
65. It is not hypothetical in the sense that
had the Government only been able to manage to demonstrate that
the PPP option is a better option than the public sector comparator
by providing guarantees to the private sector to do it?
(Mr Middleton) No, I think that particular point,
again, is beyond our brief.
66. It might be specifically beyond the brief
of your report, but in the work that you have done, you have made
assumptions about the rate of return that will be required by
the banks in order to provide finance for this project, in order
to come up with the overall costings of the project, or, at the
very least, you have looked at the figures London Underground
has provided to you and evaluated that in the context of the arithmetic
of the project. Have you looked at all at the sensitivities of
that rate of return, and if the guarantees were not there, would
that have materially affected the sums that you were doing?
(Mr Middleton) This is a bit beyond our brief, but
I will answer.
Chairman
67. We are not seeking to put you in a difficult
position. Are you, in effect, saying, "We were not asked
to do this, we did not make that evaluation because it was not
part of our Terms of Reference"?
(Mr Middleton) The assumption and the value for money
analysis is that the project would be funded at the rates which
were implicit within the PPP bids. It is not part of a normal
value for money assessment to delve down into any individual component
which makes up the overall price, because you could check any
one of thousands of input figures and argue that a different result
would be fair. We were not privy to the negotiations and discussions
with the banks, so the importance of this guarantee and the level
of this guarantee is very, very difficult for us to comment on.
Chris Grayling
68. What would your view be, Mr Blaiklock?
(Mr Blaiklock) Well, I think I, like you, have only
read about this in the Financial Times, which perhaps reflects
the rather secretive approach that has been made on a number of
aspects of this PPP negotiation. I certainly have not seen the
contracts, nor been really privy to the Terms and Conditions of
the finance that has been proposed. On the other hand, it does
reflect the fact that the Treasury are very much involved, and
I share your frustration as a Committee that the Treasury have
perhaps not been at some of the discussions you have had. However,
this guarantee must have a cost to it, and to that extent, it
should be included in the PPP value for money assessment. That
is one of the costs which one could say have not been included.
Not only that, but it must have an impact, I assume, on the PSBR,
or possible impact, and that, in itself, has an impact on, "Is
it state aid?", and then you move into territories like,
"Will it have an impact on the European Union and Procurement
rules?", et cetera, et cetera. It opens a Pandora's box,
but unfortunately, at the moment, we cannot actually open the
box to see what is inside it.
69. Ernst & Young said in their report that
any major enhancements to the network would give rise to the issue
of the possibility of the Infracos taking advantage of what by
then would be a monopoly position. Do you feel that that would
have implications for the long term value for money of the project,
and particularly, if it transpires that there are hidden costs
in this, that, for example, the knowledge of the assets does not
prove to be as great as it was otherwise, but nonetheless the
Infracos are there and in position, and the only people that can
really carry out additional work? Does all that have an implication
of value for money?
(Mr Middleton) Your question mirrors the question
asked by your colleague in terms of the interim revue and relative
negotiating positions. I think we have set out in our report that
there is a logic, and there should be an expectation that the
Infracos will have a reasonably strong position in negotiating
these contracts, and that, not necessarily on the overall contracts,
but in terms of the procurement of those individual pieces of
work, then there is a probability that the value for money of
those individual enhancements might be worse than if you were
in a wholly open and competitive situation. But that is mitigated
by the fact that there are rights to go out to open contract,
and that there are a number of contractual protections built into
the structure, so it is not an unfettered ability to do so.
Chairman: I want to move on. Dr Pugh.
Dr Pugh
70. Can I take you on to using different discount
rates. Your analysis shows no difference in outcome, depending
upon whether you use a discount rate of 3.5 or 6 per cent. The
reason appears to be that you are taking something into account
that is referred to in London Underground's final assessment as
"The social opportunity cost of Exchequer funding".
What exactly is that, and why is it fixed at 30 per cent?
(Mr Middleton) This is a question which you really
have to address to the Treasury. What London Underground did in
their value for money assessment, they used the discount rates
which are set out in the current and published Green Book on Project
Appraisal, and also the 3.5 discount rate with the 30 per cent
social opportunity cost adjustment, which is set out in the draft
Green Book, which is not fully established as Government guidance.
The technical details which sit behind that are extremely complex
and really are one for the Treasury.
71. Without accountants, do you think the figure
of 30 per cent is at all realistic, when the Government can borrow
3.5?
(Mr Middleton) We have no view on that.
72. Do you recognise it puts a significant disadvantage
on any public project because the money can always be spent elsewhere
for any public project?
(Mr Middleton) I think the key thing about the discount
rate which is used in comparing either projects within the public
sector or comparing the public sector against the private sector
alternative is that the discount rate which is used is the same
for the various options which you have before you, and is used
in a consistent manner. The reason that we ran the 3.5 per cent
discount rate as part of our report was to show that actually,
in this case, the project was not that sensitive to varying discount
rates. Depending on the shape of the cashflows you are dealing
with, discounting can create different results, using different
interest rates. All we sought to do in our report was demonstrate
that in this case, the use of different discount rates, that the
project was not that sensitive to it.
73. Mr Blaiklock, it appears to me that it tilts
against the PPP, essentially because you are taking into account
the fact that the Government can spend the money somewhere else,
and they always can, private money can go somewhere else. Can
I ask you to comment on this? Is it a kind of fiddle, or is it
a recognisable, decent accountany practice.
(Mr Blaiklock) A fiddle is your word, but I have not
seen it before, and I did not understand it either. It did seem
to be an unfair imposition against the PSC (Public Sector Comparator)
alternative, because if you use a lower discount rate, which actually
more closely reflects the actual cost of capital, then the public
sector comparator alternative does come out better than the PPP
one on the basis of the data that I managed to glean from the
report.
74. So it has a decisively different result?
(Mr Blaiklock) It improves the position. I think there
is some argument as to whether one actually should be using 6
per cent on every occasion. HM Treasury has used 6 per cent for
years and the world outside has changed. Another issue which I
would raise is that by using real, as opposed to actual, figures,
and including in your assumptions financial issues which they
have, then you are starting to mix apples and oranges, and you
have to be very careful. In a period of low inflation, the differences
are not that great, but over 30 years, and if you look back over
the last 30 years, and use this as the basis, or going forward
30 years, we are going to have higher inflation. When you start
to do this kind of analysis in periods of higher inflation, you
get some significant differences. I think one has to be quite
careful about this issue, and I would always recommend that one
does sensitivity analyses using different rates of discount in
your evaluation and see whether that changes your priorities as
to whom you award a contract, between A and B, by changing the
discount rate. I think on this occasion it actually favours the
public one.
Andrew Bennett
75. You also said that the opportunity costs
should come down, given the guarantees that the Government is
actually giving; is that right?
(Mr Blaiklock) Sorry, this is not a comment I made,
I think.
76. Do you feel, then, that the opportunity
costs should be varied to take into account the greater commitment
in view of, I think you used the words, "the possibility
of State aid"? If that is being put forward, then the Government
is actually committing some money to it, is it not?
(Mr Blaiklock) If it is providing guarantees, yes
it is.
77. Yes, and therefore the opportunity costs
change, do they not?
(Mr Blaiklock) They would do, yes, but I am not an
economist and I could not answer much more than that.
78. Do you think that anybody could come up
with an analysis like this and say, "No, it was not on"?
(Mr Blaiklock) What is not on?
79. That the Public Private Partnership was
not on?
(Mr Blaiklock) If you did this kind of analysis and
you took everything into account, I know what kind of conclusion
I would come up with.
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