THE
EXTENT
OF
FINANCIAL
SAVINGS
5. When assessing the value for money of a PFI deal
departments are advised to produce public sector comparators (PSCs)
to estimate the cost of an equivalent conventionally procured
project. In this procurement MOD's final PSC showed a central
estimate of £746.2 million. This compared to a deal cost
of £746.1 million.[2]
6. MOD considered that the closeness of the comparison
was due to the fact that in the final negotiations it only agreed
to close the deal when Modus had dropped its price to a level
which was less than the PSC. Modus had not known the PSC cost
estimate and MOD considered it had got the maximum price reduction
that could be negotiated.[3]
Even where there may be valid reasons for a PFI price being marginally
less than a PSC there is still a risk that presenting figures
with a high degree of accuracy, such that minor cost differences
on large value projects appear important, may lead to a misinterpretation
of the financial comparison. The appropriate conclusion is that
the two routes are similar in cost terms. MOD considered that
non quantified factors tipped the balance if favour of the PFI
deal. These were the fixed price of the contract, the risk of
overruns being passed to the contractor, incentives for the project
to come in on time, the fact that the contractors' money is put
at risk, and the incentive scheme for the contractor to perform.[4]
7. The inherent uncertainties in a financial comparison
of this kind are highlighted by this deal. The MOD's central estimate
of the PSC cost of £746.2 million included an adjustment
for risk of £102.9 million or 17.2% (Figure 1). It
is right to take differences in risk into account in these comparisons
since it is not possible to predict conventional procurement costs
with absolute accuracy. The outcome of the financial comparison
was, however, very sensitive to the costing of risk. Figure
2 shows that the decision on the extent of the risk adjustment
for capital expenditure had a significant effect on the financial
comparison. For example, a change in the risk adjustment for capital
expenditure from MOD's assumption of 29.5% to 29% reduces the
PSC by £1 million. MOD's own calculations showed that, depending
on the assumptions that were made for all the various risks, the
costs of conventional procurement could fall anywhere within the
range of £690 million to £807 million.[5]
8. MOD considered that its risk assessments were
not excessive. It noted that its capital expenditure risk adjustment
of 29.5% was lower than the risk factor of 35% that Treasury guidance
at the time suggested should be applied to construction costs
in conventionally procured projects.[6]
A more recent study of public building projects commissioned by
the Treasury estimated a range for construction cost overruns
of between 2 and 24% in standard building projects and between
4 and 51% in those involving non standard buildings.[7]
The extent of these ranges highlights how difficult it is to predict
with certainty what the costs for a conventionally procured project
might have been.[8]
Figure 1: The effect of risk assumptions on the
main components of MOD's PSC
NPV (£ million at 2000 prices) Base costs
|
Base costs
|
Risk |
Risk as % of base costs
|
|
£ million
|
£ million
|
|
Capital Expenditure
|
208.6 |
61.5
|
29.5 |
Capital replacements during contract period
|
95.2 |
22.2
|
23.3 |
Operating costs |
202.4 |
8.0
|
4.0 |
Rent, contribution in lieu of rates, and leasehold risks
|
133.1 |
0.0
|
|
Other |
-2.5
|
17.7 |
|
Total |
639.9 |
109.3
|
17.2 |
Total PSC (base costs and risk adjustments)
|
|
|
|
Source: C&AG's Report (Figure 9, p24)
Figure 2: The financial comparison with different
risk adjustments for capital expenditure
Capital cost risk factor
|
Equivalent PSC cost
|
35% |
£757.7 m
|
29.5% (MOD's central assumption)
|
£746.2 m
|
PFI price |
£746.1 m
|
29% |
£745.2 m
|
25% |
£736.9 m
|
20% |
£726.4 m
|
Source: National Audit Office[9]
9. Given these uncertainties in estimating what a
project might have cost under conventional procurement, a precisely
calculated PSC should not be the main basis for making decisions
on value for money. MOD told us that it had to abide by the rules
set down by the Treasury that required a PSC using these techniques.[10]
We note that the Treasury's guidance specifically warns against
the pursuit of spurious precision, and that it describes the PSC
as an aid to judgement and not a pass or fail test.[11]
10. The PSC was used by MOD as a negotiating tool
to reduce the deal price by £4 million on the day of financial
close. Knowing that the price had become higher than the PSC,
MOD told Modus that MOD could not sign the deal unless the price
was reduced. Modus did not know how much it needed to reduce its
price by in order to offer a price lower than the PSC. MOD had
given Modus certain information on base costs but had not disclosed
the full PSC including risk adjustments. Modus eventually reduced
its bid price to £100,000 below the PSC. MOD would still
have signed the deal had the price been above the PSC because
of the fixed price and other benefits the deal provided. MOD would
be prepared to walk away from a project but would not normally
do so on a PFI project once the initial evaluation and approval
had been completed. It had only once walked away from a PFI project
after it had reached the preferred bidder stage.[12]
11. In all deals there is a risk the price will increase
if the deal is not closed quickly once the preferred bidder has
been appointed following the bidding competition. In this deal
MOD appointed Modus as preferred bidder in January 1999 after
Modus had bid a proposed contract price of £647 million.
It took MOD 16 months to finalise the contract. By the time the
contract was let in May 2000 the deal price had increased by £99
million (15%). This was mainly due to increased financing costs
and additional work required to Main Building that was only discovered
during detailed surveys undertaken after Modus became preferred
bidder. At the time it appointed Modus preferred bidder MOD had
been expecting savings of £25 million compared with its PSC
estimate of the cost of a conventionally procured project. These
savings were not realised. It was only through the final negotiations
on the day of closing the deal that MOD avoided the deal price
being higher than its PSC.[13]
12. £60 million of the £99 million price
increase was due to increases in the cost of financing the project.
These were mainly due to interest rate increases and other movements
in the financial markets (including a loss of income as an initial
assumption that surplus funds could be invested at a profit could
not be realised)[14]
(Figure 3). These factors caused an increase of close to 50% to
the financing costs to £185 million.[15]
As is normal in PFI contracts the financing cost risk remained
with the public sector. MOD was exposed to this risk during the
16 months it took to close the deal with Modus. The increase in
financing costs added 10% to Modus's bid price. Commercial companies
often employ hedging strategies when closing such large deals
to avoid being exposed to such movements in financial markets.
MOD did not hedge against movements in the financing markets as
this is not government policy, but had also been advised that
it would not have been possible to hedge the financing risk as
there was no market in hedging instruments for a deal of this
size at the time.[16]
Figure 3 Reasons for increase in financing costs
|
£m
|
Increase in long term borrowing rates
|
27 |
Assumption that surplus funds could be invested at a profit not realised
|
25 |
Other factors (note 1)
|
8 |
|
60
|
Note 1 : Other factors includes £2 million in respect of debt funding for additional work, £3 million additional equity costs and £3 million additional costs related to working capital and reserves.
|
Source: National Audit Office[17]
13. MOD was exposed to increases in long term borrowing
rates which occurred during the 16 months it took to close the
deal. Part of this increase was due to the fact that MOD remained
committed to a decision taken five months into this period that
the deal should be bank financed. Long term borrowing rates in
the bank financing markets then became relatively more expensive
compared to those in the bond markets during the remaining eleven
months MOD required to close the deal.[18]
14. MOD had asked its final bidders to provide two
bids, one based on bank finance and one based on bond finance.
At this stage, Modus's bond financed solution was expected to
be £25 million cheaper than its bank financed solution (mainly
due to an assumption that surplus funds from a bond issue could
be invested, short term, at a profit). Modus kept the two financing
routes open, but was concerned about the high costs of doing so,
and in June 1999 pressed MOD for a decision on the method of financing.
MOD considered it important to balance the cost of keeping the
two options open against the potential benefit of having financing
alternatives available. It did not, however, calculate what the
costs and benefits might have been of keeping both financing options
open.[19]
15. Movements in the markets meant that the expected
difference in cost terms between bank and bond finance became
marginal. Modus proposed that bank finance should be used to finance
the deal. MOD considered that, in the absence of a clear cost
difference, there were qualitative reasons for choosing bank finance.
These included: greater flexibility to cope with any contract
variations that would require changes to the financing; lower
costs to MOD in the event of an early termination of the contract;
concerns about the security issues attached to the disclosure
levels of a public bond; and that the underwriters of a bond might
not accept Modus being exposed to the same level of penalties
for poor performance as could be applied in a bank financed deal.[20]
16. In the subsequent eleven months up to the deal's
financial close the markets moved so that the cost of bond financing
became again generally favourable compared to bank financing.
MOD stayed with its decision that bank finance should be used,
however, as it could not see a clear case for change. It considered
the movements in the relative costs of bank and bond finance were
volatile, so any cost differential in favour of bond finance could
not be certain to exist at financial close. It did not wish to
delay the deal by changing the financing arrangements and it continued
to prefer bank finance on qualitative grounds. There is evidence
to suggest that when the deal was closed in May 2000 bond finance
may well have been cheaper. Based on other bond financed PFI building
projects signed around the same time, if a bond had been issued
to finance the MOD deal the financing might have been up to £22
million cheaper.[21]
17. Given the fluctuations that can occur in financing
rates it makes sense to make a final decision on financing as
late as possible. MOD told us that, in the same circumstances,
it would in future run a funding competition before closing the
deal, like that used in the Treasury Building project. It considered
that in 2000 it would, however, have been wrong to trial the use
of a funding competition, which had not then been used before,
on the large MOD Building deal. Since the financing markets had
moved in favour of bond finance, and bond finance had been actively
considered by MOD earlier in the procurement, the bond option
might usefully have been reassessed before this deal was closed.[22]
18. In a bond financed project funds are drawn down
from the bond issue at the beginning of the deal and are placed
on deposit to earn interest until they are required. Modus's bid
assumed that, based on interest rates ruling at that time, monies
from a bond issue could be placed on short term deposit at rates
that would be higher than the long term interest rate payable
to bondholders. In the event this benefit was not realised as
short term interest rates decreased and MOD chose bank finance
where funds are drawn down as and when required reducing the likelihood
of there being surplus monies to place on deposit. These factors
accounted for £24 million of the increase in financing costs
after Modus became preferred bidder. At the time Modus was appointed
preferred bidder MOD estimated that Modus's bid would achieve
savings of £25 million compared with MOD's PSC estimate of
the cost of conventional procurement. These estimated savings,
which are not now expected to arise from the deal, were therefore
largely based on the speculative assumption that surplus funds
from a bond issue could be invested at a profit.[23]
19. On the day of financial close, 4 May 2000, bank
rates increased because the market knew that the MOD deal was
coming.[24] MOD raised
all the bank finance for the deal, some £500 million, on
the day of financial close. In addition there had been a number
of other large PFI projects that came to the market around that
time. These factors increased the price that both MOD and other
departments were charged for finance at this time. MOD agreed
it would have been sensible if the large projects had sought finance
at different times. To that end, OGC is now coordinating
the PFI activities of different departments.[25]
20. When MOD chose Modus as the preferred bidder
in December 1998, bidders had only had access to high level surveys
undertaken by MOD into the condition of the building.28 MOD decided
to wait until the preferred bidder stage to allow more detailed
surveys of the building as it considered these would be unacceptably
intrusive on the working environment, and would increase the bid
costs if carried out before the selection of preferred bidder.
Modem, the other bidder, had already threatened to pull out of
the deal due to the cost of bidding. By deferring the detailed
survey work until the preferred bidder stage, MOD was, however,
exposing itself to the risk that further work would be required
as a result of the surveys, which would be priced without competitive
tension.[26]
21. In the event, the detailed survey programme revealed
that the building was in a worse condition than Modus had assumed
in its bid. The detailed surveys identified problems with the
water supply system, the quality of the roof and asbestos in the
building. Modus asked for an additional £60 million to cover
additional work to deal with these problems. To counter the lack
of competitive tension in the pricing of this additional work
MOD used its advisers, Bernard Williams Associates, to cost each
element of the additional work. MOD then negotiated with Modus
and reduced the price increase Modus was seeking from £60
million to £37 million. MOD considered the £37 million
price increase for the additional work was fair. Nevertheless,
if MOD had arranged these detailed surveys during the final bidding
round the work would have been priced competitively and the period
during which it was exposed to variations in financing costs would
have been reduced.[27]
22. As the deal is funded by bank finance, there
is the possibility that it will be refinanced at some time in
the future. As our predecessors found, refinancing can significantly
increase the contractors' returns from a PFI project.[28]
MOD does not have a specific contractual right in this deal to
share any gain that might arise from a refinancing. However, Modus
agreed with MOD that if Modus wanted to change its financing arrangements
to effect a refinancing it would have to seek MOD's approval,
thus enabling MOD to negotiate a share of the refinancing gains.
THE
COMPARATIVE
COSTS
OF
FINANCE
23. The financing costs are a key element within
the pricing of a PFI deal. The rewards for those providing finance,
as reflected in the finance costs, should be commensurate with
the risks which have borne and successfully managed by the financiers.
Information on the comparative financing costs of PFI deals and
conventional procurement is, therefore, fundamental to assessing
the comparative value for money of these alternative procurement
approaches. The financing costs of this PFI deal were £185
million,[29] representing
25% of the contract price of £746 million.
24. It was not clear what the cost of funding would
have been for a similar project using public finance. If the project
had been financed under conventional procurement the Treasury
would have provided funds raised at the Government borrowing rate,
which is effectively a risk free rate since the lenders know that
their money will be repaid. The methodology which the Treasury
prescribes for a public sector comparator does not explicitly
identify what the public sector borrowing costs would have been.
The National Audit Office subsequently estimated that £100
million was a reasonable indication of the additional cost of
using private sector finance for this project. This represents
the cost associated with transferring risk to the private sector.
The calculation assumes the cost of public borrowing would have
been 6%. By comparison, Modus has entered into arrangements which
fix the interest rates on their bank loans between 7.6 and 8.1%
for either 25 or 27 years. In addition, when the deal was closed,
Modus was forecasting that the rate of return for its equity investors
would be about 20%. Modus told us this rate of return to equity
investors was normal for deals concluded at that time.[30]
25. Whatever the benefits may be of using the PFI
approach, it certainly brings the disbenefits of a higher cost
of finance than in conventional public projects. There is an important
issue as to whether the benefits of the PFI approach could have
been obtained using cheaper public finance. Modus said that, if
one could maintain the disciplines that are generated through
the PFI process, then where the finance comes from would not make
a difference to contractors.
26. Simply substituting public finance for private
finance might not get round the problem. Modus, for example, thought
that separating the capital and ownership from the rest of the
project might weaken the links with risk and reward. MOD doubted
too that a contract could be devised which transferred the building
risks to the contractor in the same way as a PFI deal, but with
financing risks being borne in a different way. In the MOD Building
deal, MOD considered there was risk transfer as the bank loans
are not guaranteed by the Government. The Treasury told us that
this risk transfer explains why the market charges Modus a higher
rate for loans than it charges the Government. The Treasury would
not permit the Government to lend money to private sector firms
at the same rate as the Government was able to borrow, since there
would be risks that the money would not be repaid if the contractor
encountered difficulties.
27. Nevertheless, there is room for doubt as to the
extent of real project risk borne by the banks or bondholders
who currently finance PFI projects, and there is evidence that
even where risks are low external financiers charge a premium
for projectspecific lending as opposed to general government
borrowing. These considerations suggest that it would be worth
exploring the scope for improving the established financing model
for these deals.[31]
28. Further, the potential advantages of the PFI
approach are said to depend on better risk allocation than conventional
projects, better project management, encouragement for innovation
and the use of output specifications. There seems no logical reason
why these features should depend absolutely on the involvement
of private sector financiers, particularly when those financiers
are not themselves exposed to the risks of the projects they finance.
THE
RISKS
OF
BEING
LOCKED
INTO
A
LONG-TERM
PFI CONTRACT
29. The PFI deal that MOD has entered into is for
30 years. Modus must redevelop Main Building and provide maintenance
and facilities management services at Main Building and the Old
War Office until May 2030.[32]
MOD is tied to Modus for this period unless the quality of service
provided by Modus is so poor that MOD would be permitted to terminate
the contract. Departments face potential risks from such long
term arrangements: the contract might not be sufficiently flexible
to allow changes to the department's requirements to be accommodated;
where changes are made it might be difficult in the absence of
competition to demonstrate that the changes are value for money;
or the contractor may perform to below the standard required by
the department but not significantly enough to allow the department
to terminate the contract.
30. MOD considers there are benefits from the long
term deal it has entered into which offset the potential risks
of a long term arrangement:
The contract defines the annual unitary charge payable
by MOD to Modus. MOD expects this to provide greater price certainty
throughout the 30year contract period than would be possible
under alternative arrangements.[33]
- The contract allows flexibility for MOD to reduce
staff numbers in Main Building
If MOD chooses to vacate a whole floor of Main Building
its payments to Modus will be reduced. Modus may then sublet
the vacant floor but for security reasons MOD can veto incoming
tenants. MOD sees its ability to vacate floors and to thereby
reduce its payments any time during the 30year contract
as an important benefit. It is currently planning to reduce its
Head Office staff numbers to 4,300 (Figure 4) but does not consider
this to be a fixed figure. Although it does not expect to be able
to leave London completely it will continue to bear down on Head
Office costs. It therefore believes that it needs downwards flexibility
in its accommodation requirements and has secured this in this
contract.[34]
- Payments linked to services in the long term
MOD's payments to Modus will be linked to the delivery
of services at specified qualities and Modus is required by the
contract to provide the same level of service in the final years
of the 30year contract as in the early years. Modus is also
responsible for the design, build, maintenance, and operation
of Main Building, and MOD expects both factors to incentivise
Modus to provide high quality infrastructure throughout the 30year
period. If the building were not satisfactory Modus would have
to rectify the problem and might face penalty charges.[35]
Figure 4: Planned changes to MOD Head Office staff
numbers in London
|
1 April 1999
|
By 30 Nov 2004
|
% Change |
Main Building |
2,623 |
3,300
|
+26% |
Other buildings (6 at 1 April 1999; 1Old War Officeby 30 November 2004)
|
3,397 |
1,000 |
71%
|
|
6,020
|
4,300 |
29% |
Source: Ministry of Defence
31. Despite MOD's plans to reduce staff numbers it identified
in April 2000, a month before the contract was signed, that a
further 500 non Head Office staff needed to remain in London and
would need accommodation after 2002. In January 2001 MOD approved
a separate contract for the refurbishment of St. George's Court
to accommodate these staff. MOD considers it will be cheaper to
use St George's Court than to accommodate the extra staff in Main
Building, as that would have required additional work with too
much risk and cost. For security reasons MOD also values having
an additional central London building available separate from
Main Building.[36]
32. Modus will provide IT infrastructure in the redeveloped Main
Building, whilst MOD will provide the IT systems. MOD decided
to exclude IT systems from the deal as its systems requirements
evolve continually and could not be predetermined in the same
way as its space requirement. It did not know what configuration
it would require in 2004 on reoccupation of Main Building. The
configuration would need to be linked to MOD's defence information
infrastructure which is being developed separately. In the short
term, MOD has contracted with third party suppliers for the relocation
of systems to the decant buildings being used whilst Main Building
is being redeveloped. When developing the PFI deal MOD had not
known how many systems would need to be moved. There were around
200 different systems which were owned by various MOD agencies.
Some had become time expired and MOD did not know if they would
need to be replaced. In the event only 90 systems had to moved
into the decant buildings.
33. MOD did not consider that committing itself to deals which
ran for 30 years would constrain its ability to be flexible in
managing the defence budget in future. Commitments involving £2
billion of private finance had been entered into with a further
£12 billion of private finance commitments being considered.
If all these projects went forward, 8% of the defence budget would
be committed to private finance arrangements. MOD considers the
PFI arrangements it has entered into represent best value for
money for delivering the services it needs to run the Armed Forces
world wide and to execute defence policy.[37]
1
C&AG's Report, Ministry of Defence: Redevelopment of MOD
Main Building (HC 748, Session 2001-02) Back
2
C&AG's Report, para 2.48. The total cash cost of the PFI
deal is around £2.4 billion (Qq 88-89) Back
3
Ibid, paras 2.59-2.60; Qq 16-18, 75-81, 159, 162-163 Back
4
C&AG's Report, para 15, Table 1, p 7; Q 2 Back
5
C&AG's Report, para 2.47; Q 76 Back
6
Qq 86-87, 124; Ev 22, para 13 Back
7
Ev 22, para 13 Back
8
C&AG's Report, paras 2.49-2.50; Qq 123-125 Back
9
Ev 22, para 13 Back
10
Qq 86-87 Back
11
Treasury Task Force Private Finance, Technical Note No 5, How
to construct a Public Sector Comparator, para 2.2.3 and p
67 Back
12
C&AG's Report, paras 2.58-2.60; Qq 77-80, 144-145, 160-161
(and footnote), 176-181 Back
13
C&AG's Report, paras 2.24, 2.58, Figure 12, p 27; Qq 5-6,
75-79 Back
14
C&AG's Report, para 2.24; Ev 22, paras 9-12 Back
15
discounted at the Treasury discount rate of 6% real (Q 109) Back
16
Qq 57, 88-96 (and footnote) Back
17
Ev 22, paras 9-12 Back
18
C&AG's Report, paras 2.31-2.39; Ev 22, para 10 Back
19
Qq 33-35, 68 Back
20
C&AG's Report, para 2.32; Qq 66-67, 69-70, 74, 88-89 Back
21
C&AG's Report, paras 2.40, 2.42, 2.44. The possible savings
are based on the bonds used to finance the GCHQ and Treasury Building
deals in June and May 2000 respectively. Back
22
Qq 9, 27-32 Back
23
Ev 22; para 11; Q 126 Back
24
C&AG's Report, para 2.39 Back
25
C&AG's Report, Figure 8, p 22; Qq 19-23, 44, 122 Back
26
Qq 126, 166 Back
27
C&AG's Report, para 2.2.5; Qq 167-175 Back
28
13th Report from the Committee of Public Accounts,
The refinancing of the Fazakerley PFI prison contract (HC
995-I, Session 1999-2000) Back
29
Q 109 (footnote). The finance costs are calculated relative to
the Treasury discount rate of 6% in real terms when the deal was
closed. Back
30
C&AG's Report, Figure 8, p 22; Ev 21-22, paras 1-8; Qq 104-119,
137-138. The forecast rate of return to Modus's equity investors
of 17.6% in real terms reflects their forecast returns on equity
and subordinated debt taken together. Back
31
Qq 186-203, 208-211 Back
32
C&AG's Report, para 3 Back
33
Q 2 Back
34
C&AG's Report, para 1.16; Qq 4, 129, 133-137, 151-157, 204-207 Back
35
Q 2 Back
36
C&AG's Report, paras 1.21-1.22; Qq 4, 41-43, 130, 135, 212-213 Back
37
Qq 13-14, 81-83 Back