Letter and supplementary memorandum submitted
by the Department for Transport
At the Committee of Public Accounts hearing
on Wednesday 23rd June, the Committee requested a number of notes
which I am pleased to enclose.[23]
I thought it might also be helpful to the Committee
if I set out why I consider the PPP contracts do represent good
value for money. As the National Audit Office (NAO) Report notes,[24]
the Department's objectives for the Public Private Partnership
were to obtain private sector investment and expertise to modernise
the Tube, while guaranteeing value for money for passengers and
taxpayers and safeguarding the public interest, in particular
safety.
London Underground's (LU) infrastructure is
widely acknowledged to be a large and complex asset base that
has suffered from many years of under investment and is in need
of modernisation and additional capacity. This is highly challenging
in engineering terms as it requires existing services to just
under one billion passengers a year to be maintained, while carrying
out improved day to day maintenance and the capacity enhancements
and upgrades needed, all within very limited engineering hours.
The PPP bidders had to deliver better value
for money against the public sector alternatives, as measured
by the public sector comparator. These were tested against a bond
option, even though it was not available to LU, as well as more
conventional funding. The public sector comparator provided a
range of prices over the 30 year contract period. LU's conclusions
depend on the Infracos delivering the expected level of performance
with sufficient economy and efficiency to offset the higher private
sector borrowing costs. As the NAO Report explains[25]
"The costs [of higher borrowing] will be covered if the PPP
delivers about one third of the performance benefits considered
in bid evaluation.". It should also be noted that the premiums
charged by lenders are in line with the rating agencies' independent
assessment of correct market rates. Consequently, the lenders'
premiums reflect the real levels of risk faced on the non-guaranteed
portion of the finance provided.
To provide assurance that the PSC developed
by London Transport was fair; the Department commissioned Ernst
& Young to review the overall robustness of the value for
money assessment. This included reviewing the methodology, the
assessment of risk retained by LU in the PPP contracts and that
transferred to the private sector, consideration of financial
and non-financial factors in the overall value for money assessment,
and the overall robustness of the conclusions reached. Ernst and
Young concluded that the methodology adopted for assessing value
for money "had been robust and appropriate". KPMG, LU's
own auditors, also undertook a methodology review of the PSC and
confirmed that HM Treasury's guidance had been adhered to, as
well as auditing the financial model and related sensitivities.
The bids for the PPP contracts offered higher
performance than LU in some areas, as well as additional enhancements.
In order to deliver the returns quoted for the shareholders the
Infracos will need to have much stronger control over costs and
full project planning than LU had previously managed to ensure
work is completed to time and budget. The Central Line upgrade
of the 1990s was six years late, failed to meet capability targets
and was 31% over budget. If just one of these failings were repeated
by an Infraco under the PPP contracts for an upgrade, then its
rate of return could easily be halved for the full 30 years of
the PPP contract. If all three aspects were to be repeated on
a line upgrade, then the Infraco would make very low levels of
profits for the life of the contract, and these would only be
available if the Infraco delivered all its other upgrades successfully.
Project and integration risk has genuinely been transferred to
the private sector with the Infracos heavily incentivised to manage
it well.
Across the 30-year contract, there are periodic
reviews and the independent PPP Arbiter provides assurance on
value for money by determining at the outset of each review period
the economic and efficient price for delivering the services required
by London Underground. Only if the Infracos achieve these levels
of service and deliver them within the price set by the Arbiter
will they achieve their target levels of return on equity.
NAO comment that there is only limited assurance
that the price is reasonable, largely because there is uncertainty
about what that final price will be. However, detailed analysis
showed the PPP to be cheaper than the alternatives in delivering
like-for-like outputs, while the Arbiter ensures prices remain
reasonable in the long term. Consequently, while there is uncertainty
about the long-term price, I am confident that it will offer better
value for money than the alternatives. Greater price certainty
would have increased the cost because bidders, faced with a fixed
and inflexible contract, would have based their cost estimates
on a worst case scenario to ensure a return. This would have reduced
value for money, as acknowledged by the NAO.[26]
Finally, although large, the costs of the transactions
are not excessive given that they were for 30-year contracts to
maintain and upgrade large and complex infrastructure. The negotiations
took longer than anticipated as the NAO Report acknowledges and
this increased the costs for all parties. Without the PPP, LU
would have had to negotiate separately a potentially very large
number of other contracts to provide the maintenance, modernisation
and capacity enhancements that the PPP will deliver. These would
all have had their own transaction costs and it would have left
the risk of integrating and co-ordinating all the workstreams
entirely with LU.
David Rowlands
Permanent Secretary
9 July 2004
Questions 36-38 (Jon Trickett): Supplementary
evidence on inadequate and inconsistent information from the Infracos.
I understand that Transport for London (TfL)
will be providing further information on this issue.[27]
Questions 57-71 (Mr Bacon) and Question 72 (Mr
Williams): Extra costs of private sector borrowing: Breakdown
of total debt costsprivate and estimated public costs and
basis for £450 million difference.
The private sector's cost of borrowing on senior
loans is made up from the addition of the underlying interest
rate and the margin charged by its financiers to reflect their
perception of the credit risk of the borrower. The blended margin
(including fees) of the three Infracos, averaged across their
11 separate finance facilities, is 1.35% a year and the underlying
blended interest rate is 5% a year, giving a total cost of finance
of 6.35% a year.
The total amount of the three Infracos' debt
service (interest, fees and principal repayment) over the 30 years
is £4.3 billion (using Government's 3.5% real discount rate[28])
or £9.7 billion, expressed in nominal or money of the day
terms.
If the PPP had been funded using public sector
finance, raised by way of bonds, then providers of finance will
price their bonds not on the risks inherent in the company, but
the risk of default by the bond guarantor. In the example given
in the National Audit Office (NAO) Report "Were they good
deals? " (paragraph 2.36) the NAO considers the reduced
cost if the bonds were issued directly by central Government,
who attract the highest credit rating; AAA. The underlying interest
rate on these bonds is the gilt rate on which no additional margin
is paid. So the cost of finance would be cheaper by a combination
of the avoided margin and lower interest cost; around 1.6% a year
cheaper overall, giving a total cost of finance of 4.75% a year.
Funding London Underground's (LU) investment
programme in this way (using the Infracos debt profile) would
lead to the cost of funds being lower by around £445 million
over the life of the PPP (at 3.5% real discount rate) (using the
NAO's calculation methodology) ie a total debt service cost of
£3.855 billion or an average of £14.8 million per year
lower than the cost of debt raised by the private sector. The
high level analysis by the NAO estimated a similar discounted
sum of £450 million over the 30 years ie a total debt service
cost of £3.85 billion at an average of £15 million per
year lower.
If the PPP investment programme had been financed
using bonds guaranteed by TfL, then the cost of finance would
have reflected their lower credit rating, ie AA, which trades
at a cost approximately 0.6% a year higher than Government gilts.
Therefore, TfL's total cost of finance would be lower than the
Infracos by about 1.0% per year and total cost of finance would
equal 5.35% per year. Cost of funds would be lower than that achieved
by the private sector by a total of £210 million over the
30 years at an average of £7 million per year (at 3.5% real
discount rate) ie a total debt service cost of £4.09 billion.
The Department's main objectives for carrying
out the PPP were to bring in and incentivise private sector expertise,
achieve clear risk transfer, maintain the infrastructure on a
whole life basis and all with the support of stable funding. Requiring
the private sector to raise its own finance and to have facilities
in place to allow it to invest and absorb risk is a fundamental
part of meeting those objectives.
Therefore, the Department considers that the
key question is whether the higher cost of private sector debtof
which LU were fully aware at the time of the PPP processis
outweighed through the competition, introduction of private sector
management skills and incentives to deliver performance that the
PPP is designed to achieve. Under the PPP the higher cost of finance
will be outweighed if the Infracos deliver the service requirements
and cost controls anticipated under the contracts.
It should be noted that any private sector lender
that has not been guaranteed by Government will impose a number
of disciplines on its borrower, including requiring repeated technical
due diligence, sensitivity analysis, reporting requirements, monitoring
and control clauses, and regular reviews of performance. These
disciplines are an important factor in ensuring that borrowers
meet their expected performance levels and deliver the anticipated
efficiencies.
Analysis showed that the benefits of the PPP
option over a public sector bond option exceeded the £445
million savings available under gilts. However, any bond finance
option would have entailed issuance by TfL. Consequently, there
is an even stronger case for the PPP compared to TfL issued bonds
which would have been £235 million more expensive than gilts,
yet without introducing any new incentives or disciplines to improve
performance.
To put this key question in context, the NAO
calculates in paragraph 2.44 of the "Were they good deals?"
Report that the incremental costs of finance would be mitigated
if the PPP delivers about one third of the performance benefits
anticipated. As another example, the additional cost of finance
of the Infracos of £7.0£14.8 million per year
above the Government or TfL alternatives represents around 0.71.48%
of the year one Infrastructure Service Charge. If those sorts
of levels of efficiencies are delivered by the private sector,
then the incremental cost of debt will have been outweighed.
Questions 79-85 (Mr Bacon) and Questions 166-168
(Jon Trickett): Transaction costsDetailed breakdown of
transaction costs, including all consultants paid by London Underground,
difference in legal and engineering consultancy costs, differences
on amounts paid to successful bidders.
We are currently assisting the NAO who are compiling
the additional information requested.[29]
Questions 97-105 (Mr Williams) and Question 168
(Jon Trickett): Convergence of consortia and London Underground's
cost estimates in the public sector comparator.
As a matter of policy, public sector comparators,
which are the public sector's estimate of delivering the same
level of service as the PPP/PFI scheme under consideration, are
not made public during the competition.
This is because the public sector is looking
to obtain best value through competition. There is a justifiable
concern that disclosure of the public sector comparator would
lead to bids only marginally below that value, so that competition
would have been dampened.
The PPP public sector comparator is now fully
disclosed in LU's Final Assessment Report. This report, which
is being provided to the Committee by TfL, analysed the full background
to the transaction, the alternatives available to LU for bringing
investment to the Tube, and TfL's alternative proposals. In reviewing
whether the PPP was value for money, LU considered in depth both
the quantitative analysis, comparing the bids to the relevant
PSC, as well as the qualitative arguments, why the PPP offered
better value over public sector alternatives.
During the PPP procurement, the public sector
comparator was regularly updated to reflect improving asset and
performance data, a better analysis of underlying risks, and LU's
changing performance requirements. Similarly the private sector
bids were being updated on the basis of the same updated data
and its own due diligence.
The chart included by the NAO in Appendix 3,
figure 3.2, which compares movements in the 30 year public sector
comparator with movements in the bidders' Infrastructure Service
Charge in the first seven and a half years, shows that over time
the relative rate of growth of those figures converged, ie that
by the end of the bidding period they had grown by about the same
amount since March 2000. This reflects the fact that they were
responding to the same changes in underlying data and performance
requirements.
While over time the respective costs grew at
the same rate, the private sector bids were growing from a lower
level. Throughout the procurement process, the total bid costs
were at the bottom of, or below, the range of the public sector
comparator. The extensive quantitative analysis conducted by LU
therefore suggested throughout that the deals represented value
for money. This, combined with the qualitative analysis documented
in the Final Assessment Report, led LU to consider that the PPP
represented the best overall value for money from a range of possible
alternatives.
Questions 142-149 (Mr Bacon and Mr Williams):
Transport for London preference for Bond FinancingAdvice/views
provided by TfL to Department for Transport. Summary of this based
on London Underground's Final Assessment Report and Update.
I understand that TfL will be providing to the
Committee and the NAO copies of LU's Final Assessment Report and
the Update to the Final Assessment Report.[30]
The NAO will separately be providing a summary of the issues raised
by TfL on bond finance.[31]
Questions 164-165 (Jon Cruddas): Staff transfer,
new recruits to Infracos & pensions position.
The Committee asked whether new staff of the
Infracos were able to join the LRT Pension Scheme. There is nothing
in the trust deed and rules that prevents new recruits joining.
But it is for the relevant employers to decide whether membership
should be offered as part of their recruitment packages. Only
ex LRT employees have a statutory entitlement to continued membership
of the LRT Scheme.
We understand that Tube Lines has not offered
membership of the Scheme to new recruits since January 2003, but
instead they are entitled to join the Tube Lines Pensions Scheme.
Metronet is also understood to be considering alternative arrangements.
Questions 169-173 (Jon Trickett): Selection of
preferred bidder, premature end of bidding process and increase
in costsdid bidders estimate their costs after selection
and what were they.
As the NAO Report "Were they good deals"
points out in paragraph 2.19, the policy of maintaining reserve
bidders had drawbacks, but no realistic alternatives were available.
The option of pursuing a full reserve bid would have only doubled
the bid costs with little value for money and would not have been
attractive to those reserve consortia selected. As Figure 14 in
the Report illustrates, the cost increases for Tube Lines are
significant after the selection of preferred bidders in May 2001.
The appointment of preferred bidders was necessary
to ensure that the selected consortium and their backers retained
confidence in the bidding process. The consortium were reluctant
to commit to detailed negotiations and preparation unless selected
as a preferred bidder.
On the issue of recovering costs, successful
bidders in any tendering process have to recoup their costs through
the prices they charge for their services. In the PPP these are
not an upfront cost to the public sector. Instead they are recovered
through a component of the monthly Infrastructure Service Charge.
While the bidders did not provide an exact estimate of their costs
after selection, the scale of these costs was known since they
largely relate to items such as legal and financial transaction
costs which any preferred bidder would have had to incur prior
to concluding the contract. As such, they were part of the cost
that was evaluated as being better value for money than a public
sector alternative. So the £114 million and £134 million
paid to Metronet and Tube Lines respectively were included within
the PPP process and pricing before the contracts were closed.
Questions 174-181 (Mr Jenkins) and Questions 182-186
(Mr Williams): Tube Lines RefinancingScope for further
refinancing and possible gains.
I understand that TfL will be providing further
information on this issue.[32]
Questions 6-11 and Question 186 (Mr Williams):
Arbiterdecisions (binding & contractual position),
penalty for non-compliance.
How are the Arbiter's decisions binding ie
through the contracts or through another mechanism?
Section 229 of the Greater London Authority
Act 1999 gives the parties to a PPP contract the ability to refer
matters specified in the PPP agreement to the Arbiter for a direction.
Where a matter is referred to the Arbiter he is required to make
a determination which shall be final and binding. While there
is no appeal from the Arbiter's decision, his decision would be
susceptible to judicial review.
What is the penalty for non-compliance with
a decision of the Arbiter?
The Arbiter has no sanction to impose any penalty
on the parties to the PPP Agreement for non-compliance with his
decision under the Greater London Authority Act 1999.
However, where the Arbiter's determination takes
effect as a term of the PPP Agreement (see above) it is enforced
in the same manner as any other provision of the agreement. The
matter must initially be dealt with under the Dispute Resolution
procedures contained in the PPP agreements which can result in
the dispute being referred to Adjudicator and ultimately the Courts.
Questions 125-130 (Mr Jenkins) and Question 186
(Mr Williams): Note on fares over 25 years and balance of subsidy
& London Underground income.
I understand that TfL will be providing further
information on this issue.[33]
23 Ev 24¸27 Back
24
Paragraph 1.1 of NAO Report "London Underground PPP:
Were they good deals? " Back
25
Paragraph 2.44 of NAO Report "London Underground PPP:
Were they good deals? " Back
26
Paragraph 4b of the Executive Summary, NAO Report "London
Underground PPP: Were they good deals?". Back
27
Ev 28¸30 Back
28
3.5% is the current discount rate that changed from 6% in April
2003. Back
29
Ev 35 Back
30
Neither report printed. Back
31
Ev 33¸39 Back
32
Ev 28¸30 Back
33
Ev 31 Back
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