Letter to the Committee from Transport
for London
I have been invited to give evidence on 23 June
before the Committee of Public Accounts and I should be obliged
if you would circulate this memorandum to Members of the Committee
prior to the meeting.
I am enclosing a copy of London Underground's
report on the first year of the PPP that gives my perspective
on performance.[21]
It gives a more detailed view than that contained in the NAO Report
and accordingly gives what I believe to be a more balanced view
of performance over the full year. Additionally, there are some
structural problems affecting the chances of success of the PPP
which are not fully addressed in the NAO Report but which are
described below.
As is mentioned in both reports, London Underground
has been experiencing difficulty in obtaining information from
the Infracos. This is now having an impact on our ability to plan
our own resources and discharge our own obligations under the
PPP. We have spent over a year agreeing the principles of what
is to be provided by the Infracos about their capital and maintenance
programmes, but until the information starts flowing comprehensively,
conclusions about the progress being achieved by the Infracos
is largely anecdotal as illustrated by both reports. In order
to demonstrate success, the Infracos need to develop their information
systems as a matter of urgency.
Infraco progress in developing required asset
management plans has been slow and there is not yet evidence of
a strong planning capability within the Infracos. There is also
limited demonstration of a whole-life asset management approach,
and this has led to LUL rejecting or giving qualified approval
to asset management regimes and plans.
The asset performance information referred to
in section 5 of LUL's report was provided to the NAO and I believe
that it provides some useful insights on the underlying performance
of the assets. As yet, it is difficult to observe the type of
improving trends that might be expected over the next few years.
The NAO Report assessed the question of whether
the Infracos are applying private sector innovations to project
management and asset design to ensure early identification of
problems. It concluded that, as might be expected at this stage,
there are no significant examples although the report described
a change in working arrangements implemented by Tube Lines. So
far, there has been limited evidence of the promised innovations
of new plant and equipment and the infusion of external engineering
expertise.
As we all know, the fundamental question about
the PPP is whether it will deliver a better Tube and the promised
improvements. Partnership, although important, cannot of itself
deliver success. The NAO Report places great reliance on partnership
issues in the section on success factors but there are other relevant
success factors that might have been addressed, including:
— a contractual framework and structure
that is sufficiently clear with adequate incentives and contractual
remedies;
— robust contract management by LUL
to ensure that the public gets the full benefits of what we (and
the Government) are paying for;
— effective, state-of-the-art project
management by Infracos (and indeed by LUL) to ensure early identification
of problems, on-time and on-cost delivery and clear visibility
of progress along the way;
— flexible and proactive approach to
problem resolution, rapid escalation/resolution of disputes on
both sides;
— clear prioritisation and management
focus on the most critical projects;
— bringing in expertise from the private
sector to fill gaps in knowledge, including in making the Underground's
assets operate as efficient as possible; and
— balancing a need for processes against
excessive bureaucracy, and learning from early experience to ensure
that process does not replace decision-making and effective, rapid
action.
I am also of the view that the lack of clarity
around PPP/PFI interfaces and LUL's limited change rights and
remedies were deserving of more weight in the NAO Report given
that these issues have a very strong bearing on whether the PPP
is likely to work successfully.
It should be noted that LUL is committed to
procure works from its PFI contractors in circumstances where
it does not necessarily have the rights to procure them through
its PFI contracts. As the PFI contracts were signed at different
times, and prior to PPP, they are not always "back to back"
and this creates opportunities for exploitation by both PPP and
PFI contractors.
The NAO Report recommends that there should
be clarity of interfaces with other contracts and where this does
not occur, remedial action should be taken. Our power to take
remedial action is curtailed by the scope of the change rights
available. Also, more debate should have been afforded to the
issue as to whether LUL had been left with the tools necessary
to meet the management challenges ahead. For example, the power
to require works to be undertaken pending resolution of a dispute
is generally not available to LUL.
LUL has little or no leverage to secure changes
that are required to deliver the Mayor's Transport Strategy and
to improve customer service.
The Report does not fully discuss the most important
success factor of all: adequate and guaranteed funding for the
life of the PPP.
Tim O'Toole
Managing Director
18 June 2004
Note to the Committee from the Commissioner
of Transport
The National Audit Office has submitted to Parliament
an official Report as to whether the London Underground PPPs were
good deals. Transport for London was supplied with several early
drafts of the Report and we provided our views to NAO on a number
of matters addressed in the drafts. Our most recent correspondence
with NAO, which is available to the Committee on request, goes
into some detail as to our remaining concerns. By this written
evidence we hope to bring to the Committee's attention our key
concerns.[22]
We note that while there are numerous points in the Report with
which we agree, there are other points that are quite troubling
and appear to be based on conclusory assertions by the Department
that are not supported by evidence.
Our specific key concerns are as follows:
The Report makes clear that there is no assurance
that the price of the PPPs is reasonable; instead there is ample
reason to conclude that the price is unreasonable.
NAO concludes that "There is only limited
assurance that the price that would be paid to the private sector
is reasonable." This is disturbing to TfL as the agency responsible
for paying the PPP bills, and especially so since Parliament was
specifically led to believe that the Government would not allow
LUL to proceed with the PPPs unless they provided value for money
(Secretary of State 7 February 2002). In fact, NAO's Report does
not identify any basis for assurance that the price is reasonable,
and indeed it identifies a number of reasons for alarm that the
price to be paid by LUL to the private sector is in excess of
a market price:
— The rate of return greatly exceeds
the rate on recent PFI deals. The 18-20 stated range (which applies
to Metronet should they deliver to bid) is described as being
about a third higher than on recent PFI deals. The Tube Lines
rate of return (26%) identified in the Report is far higher still.
— These stated rates of return do not
even take into account the potential upside to the private sector
should they not fully use the £1 billion in contingency that
is included in their pricing for the first 7.5 years. Did the
market really require that all savings on investment in the Underground
should go to enhance already over-market rates of return?
— These rates of return also do not
include the unusual success fees paid to the private sector when
the transactions were closed.
— The price increased dramatically
after selection of preferred bidders, when work was rebid and
contract terms were revised in a non-competitive environment.
— Lenders have "limited downside
risks. . . but are charging rates of interest in line with an
independent credit rating of the companies as `low investment
grade'." Although Lenders have only about £250 million
at risk (5% of £3800 million), they are charging about £450
million more than they would charge for loans with the highest
credit rating.
The Department is reported to explain a number
of these seeming overpayments, as well as the erosion of contractual
terms, as compensation to the private sector for political risk
and controversy. Political risk is a straw man, a deflector of
attention. In fact, the increases in price and the last minute
dilution of key risk allocation provisions reflect inexcusable
failures in the public sector's negotiating strategy. The PPP
procurement process was conducted in a manner that violates fundamental
tenets of effective negotiation tactics. Most importantly, competition
was eliminated from this procurement far too early in the process—competition
from other bidders, and as noted in the next section, competition
from a willingness to consider viable alternatives to the PPP.
The refusal to consider the alternative of
direct government borrowing not only resulted in a waste of public
funds, but provided powerful and unnecessary bargaining leverage
to the private sector.
The significance of the savings that NAO notes
would have been generated by direct government borrowing is diminished
in the Report by noting that such borrowing was against Government
policy. To us, this begs the very question at hand. We understand
that it is not NAO's role to evaluate Government policy. However,
we also believe the decision-making about PPP was skewed precisely
because of this policy and this must be faced should lessons truly
be learned from this procurement. The Underground understood that
it faced a Hobson's choice: the PPP according to the terms demanded
by the private sector or no new investment program. Had a bond
option been taken seriously, the final terms of the PPP would
likely have been far more favourable to the public sector—as
the bond option would have provided another (and quite viable)
form of competition to the private sector. Eliminating alternatives
made the PPP the only game in town, leading to a very weak—and
expensive—PPP.
Important lessons can and should be drawn from
the chronology of this procurement, especially as to the implications
of selecting preferred bidders whilst major issues remain unresolved
and the scope of work remains unsettled.
The Report notes the long and costly delays
in closing the transactions. There were numerous factors, many
of which are noted and quantified in the Report, which delayed
LUL and which should be considered by the Committee as it evaluates
how such delays might be minimised in the future. The prime causes
of delay included unreasonable demands by the prematurely selected
preferred bidders for significant changes in the transaction and
repeated rescoping of the work (primarily for affordability reasons
and incorrect assumptions about power availability).
The chronology of events should be closely reviewed
when considering how this procurement might have been better managed
and certainly before the two judicial reviews and the state aid
contest are flagged as any significant cause of delay. Commercial
close—the initialing of contract terms subject to a long
list of still open items for each of the PPPs—did not occur
until 8 May 2002, a year after preferred bidders were selected
for the two deep tube Infracos (and almost 10 months after the
first judicial review was concluded in July 2001). Most commercial
concessions occurred in this lengthy run-up to commercial close
(and most specifically, in the period from September 2001 through
February 2002, when the committed finance offers were approved
by LUL). The second judicial review followed commercial close
and was complete within two months—a two month period that
formed but a small part of another long period during which LUL
was receiving and reviewing draft finance documents (initially
with terms to which LUL took significant objection) and the bidders
were revising and finalising their financial models and the parties
were endeavouring to resolve the very long list of items left
open at commercial close (including the very complex restructuring
of the Northern Line Train Services Contracts.) These LUL activities
continued well after TfL and the Mayor withdrew their request
for a second judicial review.
As for state aid proceedings, it should be remembered
that the Government-initiated state aid proceedings were required
not only as a matter of prudence but also as a matter of contractual
obligation under the Share Purchase Agreements between LUL and
the private sector. The Commission's state aid decision was not
rendered until early October 2002. The Commission's ability to
give state aid clearance was greatly compromised and complicated
by a very material fact about the transaction that is prominently
noted by the NAO in its Summary: "The terms of the deals
changed markedly during prolonged negotiations with the eventual
winning bidders." The Government's own submission to the
Commission indicated that the price of the contracts had increased
by £590 million in the non-competitive period of the procurement—a
complex fact that the Commission had to address in making its
decision. It was not the fact of the contest that caused the delay—it
was the problematic procurement.
Measured against the original objectives
for the PPPs—including comprehensive risk transfer and value
for money—the PPPs do not constitute a good deal for the
public sector.
Most fundamentally the question of whether the
PPPs represent good deals for the public depends on the measuring
stick. To what are the PPPs to be compared? To what the market
might have offered if the transactions were negotiated effectively—ie,
if the bidders thought that there was a viable alternative to
their proposals? It is clear from the NAO Report that much was
left on the table. By way of example, the Report identifies that
the refinancing gains enjoyed by the Tube Lines sponsors could
have been 100% available to the public sector; also the rates
of return exceed market rates even before any portion of contingency
is made available to enhance those rates; and the success fees
are significantly out of line with market.
Or are the PPPs to be considered in light of
whether they will achieve the Government's objectives? In that
case, one must identify those objectives. The Report at one point
defines those objectives as a transfer of comprehensive risk and
responsibility to the private sector. Yet the Report does not
explicitly consider whether this was achieved—except to
note (in what we consider to be a significant understatement)
that the negotiations "led to London Underground accepting
more risk sharing than it had originally hoped to negotiate."
Instead the NAO reframes the objectives as limited
to "bringing in the private sector expertise to manage the
upgrade projects and to maintain the infrastructure on a whole
life basis supported by stable funding." This is a low bar
to success, and could have been achieved in quite a number of
ways, each of which would have been compatible with use of the
much cheaper bond alternative for stable finance. In our view,
whether the PPPs were a good deal should be considered in light
of the reasonableness of the price—was there value for money—and
their effectiveness at transferring real risk and responsibility.
As noted above, the Report confirms that there is no comfort to
be had that the price is reasonable (and indeed there is reason
to be concerned that the opposite is in fact true.) As for comprehensive
risk transfer, that key objective and rationale for giving up
unified public sector control of the Underground fell entirely
by the wayside. There is not a single example of significant risk
transfer offered by the Report—unless one considers the
private sector's responsibility for its own persistent uneconomic
and inefficient behaviour to constitute acceptable and comprehensive
risk transfer. It is our view that the private sector would have
borne that risk even in a traditional contract structure.
Robert R. Kiley
Commissioner of Transport for London
21 June 2004
21 Not printed. Back
22
This written evidence is based on the final draft report provided
to us by NAO on 27 May 2004 and a further e-mail dated 9 June
2004 attaching correspondence from Patricia Leahy to Jay Walder
describing additional changes to the Report. Back
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