Supplementary memorandum submitted by
Transport for London
Questions 144-147 (Mr Bacon): Whether Transport
for London had provided advice to the Department of Transport
concerning TfL's recommendations for a public bond financing to
support required capital investment in the Tube?
In fact, beginning in late 2000 TfL had provided
its views and detailed recommendations to LUL and DETR/DfT concerning
what TfL believed to be a cost effective alternative to the PPP
financing scheme. Although some material was formally submitted
only to LUL, at all relevant times LUL was acting under the direction
of DETR/DfT through London Transport. This record is summarized
below, and includes the following attachments:[34]
— Outline of a Programme for the Rehabilitation
and Management of the London Underground; 13 December 2000. Transport
for London, available via the Web at http://www.tfl.gov.uk/tfl/pdfdocs/report02.pdf.
This piece outlines the use of securitisation,
a form of public borrowing, to provide the bulk of the financing
to support an alternative approach to the refurbishment of the
London Underground. The paper also addresses the in-depth involvement
with the private sector, the management of risk between public
and private sectors, the need for a full assessment of asset conditions,
and the likely levels of Government support required for such
a programme.
While the report was not addressed
to DETR, it was provided to DETR and made broadly available to
the public. As the next document attests, it was considered in
detail by DETR.
— Response to Questions Raised by
DETR Concerning TfL's Outline of a Programme for the Rehabilitation
and Management of the London Underground; 29 December 2000.
Confidential correspondence from Robert R. Kiley to Mike Fuhr,
Director, London Underground Task Group.
Regarding TfL's plan of 13 December,
DETR tabled various questions on strategic and technical points
raised by the paper. The note therefore was direct correspondence
from TfL to DETR.
This paper re-emphasised the role the
private sector would play in a TfL plan, the controls that the
public sector would require, and the specifics of the proposed
financing plan and risk allocation by TfL.
— London Underground Public Private
Partnership, Emerging Findings; 17 July 2001. Deloitte & Touche
Corporation. Executive summary available via the Web at http://www.tfl.gov.uk/tfl/pdfdocs/report02.pdf.
This report examines a TfL bond plan
for works within the Public Sector Comparator with regard to the
value for money analysis of the BCV and JNP Infracos. The report
notes that the value of public sector bond financing has been
largely dismissed by LUL's application of a concept termed "reputational
externality". Also, net financing costs for the public alternative
were inflated by an inefficient treasury management plan, which
raised and held for five years large cash balances from bonds,
despite substantially lower investment rates than borrowing costs.
Deloittes notes that these costs could be significantly reduced
by standard treasury management techniques. In LUL's analysis
of VfM, supporting its decision to proceed with preferred bidders,
its presentation of these two factors disadvantaged a viable public
bond case by £900 million. See paragraphs 3.7.2 and 3.7.3.
The Deloitte report also notes that
selection of preferred bidders too early in the process could
lead to a materially adverse impact on VfM. Independent of the
benefit of public financing and highly material adjustments to
the PSC, the 7.5year bid for the JNP line did not show value for
money and the BCV bids show that there was a scenario where the
PSC offers better VfM than the preferred bid.
This report was shared by TfL with
LUL's management.
— Interim Consultation Response
to London Transport on PPP documents provided between 11 February
2002 and 15 March 2002; Chapter VI Value for Money; Transport
for London. Available via the Web at http://www.tfl.gov.uk/tfl/report/pdf—05.pdf.
The chapter describes various criticisms
of the value for money analysis, and describes that a TfL bond-funded
alternative would project present value cash savings of £1.7
billion against mid-point estimates related to works undertaken
in the first contractual period, or £1.2 billion against
the highest estimates of the PSC (see page 44). Even when conceding
for discussion LUL's questionable estimates of social costs that
against the PSC, the savings of the PSC over the bids range from
£1.1 billion (against its central estimates of public costs)
to £500 million (against the 95% high end of estimated public
costs). This chapter notes that TfL's bond plan has never been
accurately represented during any stage in the evaluation of the
PPP, despite the presentation variously to DfT and LUL of the
above materials.
Also in the chapter are criticisms
of the adjustments to the construction of the PSC, in that:
— Its wide risk ranges were never adjusted
to reflect the increasingly narrow risks that ended up being built
into the PPP contracts;
— the VfM ignored contract management costs
of the PPP;
— the 30-year analyses have no substantive
value;
— that the 7.5-year analyses, even when
putting aside the debate regarding public sector financing costs,
do not show value for money (this has now seemingly been echoed
by NAO);
— the "wider factors" did not
include either a full listing of downside risks, or some attempt
to give them financial weight or, failing a full analysis, some
discussion of commercial significance; and
— that there was an overall breakdown in
the chain of verification of the VfM process.
This report, as a consultation response,
was of course shared with LUL management.
TfL staff are available to discuss
the above reports and correspondence at the Committee's convenience.
We believe now, as we believed then, that the public bond alternative
would have provided a more prudent and cost-effective approach
to financing the modernisation of the Tube.
Robert R Kiley
Commissioner of Transport
7 July 2004
Questions 36-38 (Jon Trickett), Questions 174-182
(Mr Jenkins) and Questions 182-186 (Mr Williams): Summary of position
on information provision.
INTRODUCTION
Paragraph A3.2 of the NAO Report "London
Underground: Are the Public Partnerships likely to work successfully?
" set forth the position on the exchange of information between
LUL and the Infracos as at the end of the fiscal year, March 2004.
This note summarises the position as at 13 July but the position
is evolving and subject to change.
INFORMATION TO
BE PROVIDED
BY INFRACOS
TO LUL
The PPP contracts span a wide range of complex
activities that are undertaken by Infraco and LUL on the Underground
network. The contract sets down the information to be provided
to LUL that LUL requires to fulfil its functions, for example
to assure itself of the safety of the railway. In some areas,
the contractual information sharing provisions are expressed in
general terms and do not specify the form and content of submittals.
It should be noted that the PPP contracts specifically refer to
the Infracos undertaking their obligations on an open book basis.
Some of these information requirements are set out below:
Capital Projects
LUL has the responsibility to co-ordinate the
execution of capital works across the Underground network by several
different PPP and PFI contractors. This is to ensure both that
proposed works do not over-lap in space and time (with consequent
risk of interference) and that impacts on the operation of the
railway can be managed. To do this, LUL has developed a Master
Projects Database (MPD) into which the Infracos—as well
as LUL itself and its PFI contractors—are required to feed
accurate project plans showing when and where work will be undertaken.
MPD is critical to the management of the unprecedented work programme
being undertaken on the network.
LUL has been planning for many months upon the
basis that MPD would be capable of being used as a management
tool by September 2004. LUL itself is on target to meet this deadline
although its PFI contractors have trailed behind the Infracos,
given that PFI contractors involve some entities related to Infraco
shareholders and discussions did not commence with them until
after the Infracos agreed the principles of what they would provide
in early 2004.
Asset Management
The Infracos have to submit an over-arching
Asset Management Strategy (AMS) that sets out the management regime
they intend to apply to the assets, and an Annual Asset Management
Plan (AAMP) that documents the specific steps they will take under
that regime for each asset class, forecasting out nine years into
the future. Both of these require LUL's approval. These must demonstrate
how the Infraco intends to discharge its PPP obligations including
the adoption of an efficient and economic whole-life cost approach.
Of necessity, this involves the Infraco providing cost information
which should facilitate monitoring progress of Infracos' expenditure
in relation to the baseline forecast in the PPP contracts which
underpinned the level of the Infrastructure Service Charge.
Other Financial Information
The Underground's assets remain on LUL's balance
sheet under the PPP contracts. To accurately account for them,
the Infracos are required to provide LUL with detailed information
on how their work has increased the value of the assets each period.
In addition, the Infracos are required to give
LUL further information about their cash and revenues so as to
allow LUL to monitor the Infracos' overall financial position:
this information includes periodic management accounts. In the
case of Tube Lines, LUL and Tube Lines have agreed that additional
financial information will be provided—this was agreed in
the context of the recent refinancing.
Sub-Contracts
The PPP contracts give LUL "step-in"
rights to take over parts of an Infraco's operation in circumstances
where the Infraco is in breach of contract. Under these circumstances,
LUL would replace the Infraco as the counter-party to the sub-contracts
put in place by the Infraco. Each Infraco therefore has to provide
LUL with information about its Key Sub-Contracts, to allow LUL
to check that the sub-contracts contain the rights LUL may need
in the future and the appropriate terms in areas such as audit.
Thereafter, LUL signs an explicit agreement (termed a "Direct
Agreement") with the sub-contractor formalising the arrangement.
The Direct Agreement also serves the purpose of bringing the sub-contract
and the assets provided under it under the protective provisions
in the Greater London Authority Act 1999 in the event of insolvency
or administration of the Infracos.
The Infracos have been engaged with LUL since
the contracts were signed in discussing how they might deliver
their obligations in all these areas. Some information has flowed
from both Tube Lines and from Metronet in each of the four areas
above, but in all four areas significant difficulties have been
encountered. Discussions continue with both companies as to how
the provision of necessary information can be improved. In general,
problems relate both to the Infracos' development of internal
management information systems capable of producing required information
and to the reluctance of the Infracos to provide financial information
already in their possession. The position with Tube Lines is largely
resolved with information flowing or dates for delivery agreed.
There are substantive issues remaining with Metronet and this
is disappointing, given that Metronet was helpful in resolving
an impasse between LUL and Tube Lines/Metronet over the MPD.
CURRENT POSITION
Tube Lines
Capital Projects
Until Tube Lines and LUL agreed the principles
about data to be submitted to the MPD in early 2004, limited capital
projects information was passed to LUL. Since then, Tube Lines
and LUL have been working jointly to configure the necessary automatic
links between Tube Lines' internal project management systems
and the MPD. The MPD is not yet a fully functional management
tool because the required technical integration and data cleansing
has not yet been completed. LUL expects to be provided with a
full set of data by Tube Lines by September 2004.
Asset Management
Tube Lines AAMP for Financial Year 2004 included
a financial review of the costs incurred in the year to date.
LUL was initially unable to reconcile these costs back to Tube
Lines' original bid and the data as initially provided was internally
inconsistent. The problems were due, in part, to the introduction
of new financial systems but a significant reason was the reallocation
of cost and overheads. LUL has given Tube Lines' initial AAMP
a conditional approval, limited to the 2004-05 work programme
(as opposed to the nine year plan anticipated by the contract).
LUL is working with Tube Lines on an improvement programme which
the parties expect will lead to submission of a satisfactory 2005-06
AAMP. If Tube Lines meets the commitments made, then LUL considers
progress will be in the right direction.
Other Financial Information
Tube Lines have delivered the accounting information
required at a high level and have committed to work with LUL in
developing more detailed information.
The management accounting information provided to
date by Tube Lines has been aggregated to a high level, limiting
its usefulness in understanding the evolving position. The additional
information Tube Lines agreed to provide at refinancing is not
due until the Autumn.
Sub-Contracts
LUL has received requests for over twenty Direct
Agreements from Tube Lines and, until recently, copies of the
sub-contracts were not being provided with these requests. In
Spring 2004 LUL exercised audit rights to check compliance with
the PPP contract requirements in this area. Tube Lines has now
agreed to remedy deficiencies identified in the audit by various
dates over the next few months. Since then, Tube Lines have generally
submitted copies of the sub-contracts with requests for Direct
Agreements but no agreement has been reached on the provision
of variations.
Metronet
Capital Projects
Metronet provided only outline information to
LUL about the capital works underway on its lines in 2003. In
February 2004, Metronet agreed principles with LUL governing the
provision of capital project cost and progress data to the MPD
for delivery by late September 2004. Metronet has recently advised
LUL that it only intends to deliver data on live projects in late
October 2004. LUL has not yet been advised when data on the remaining
600 proposed projects will be provided.
Asset Management
Metronet agreed, in principle, to provide (in
the first year AAMP only) broadly similar information to Tube
Lines but this information has not yet been delivered. It is not
possible to make informed judgements as to whether Metronet is
demonstrating a whole-life cost approach upon the basis of the
information submitted. Metronet has recently submitted further
proposals which are under review by LUL.
Other Financial Information
The information being provided by Metronet on
changes in asset value is insufficient to meet LUL's accounting
needs. LUL's external auditors have stated that unless there is
a significant improvement, LUL will not be able to support its
fixed asset accounting records which would place LUL in breach
of its statutory obligations under the Companies Act 1989. Metronet
have subsequently agreed to provide more detailed information
has to enable LUL to fulfil its statutory obligations.
Metronet's management accounts provide more
detail than those provided by Tube Lines to date.
Sub-Contracts
LUL has copies of the initial Metronet sub-contracts
put in place before Metronet took over responsibility for the
Infracos and continues to receive Key Sub-Contracts from Metronet
prior to entering into Direct Agreements. Metronet has recently
agreed to copy material variations to LUL on a non-contractual
basis but there is no agreement yet over what constitutes "material".
Metronet has obligations under the contract
to make sure that sub-contractors undertake their obligations
on an open book basis and contain certain audit rights in favour
of LUL. LUL has been requiring Metronet to insert the same provisions
that it required Metronet to insert in its initial sub-contracts
during the bid process.
Metronet now claims that it is having difficulties
securing these rights from its new sub-contractors and that it
is not obliged to do so.
Metronet has regretfully referred the scope
of these obligations to dispute arguing a narrow interpretation
of the contractual provisions.
Questions 142-149 (Mr Bacon and Mr Williams):
Potential refinancings of the PPP Debt
Why refinance? Refinancings generally occur
because the borrower is able to achieve a lower rate of interest
than they currently pay.
Interest payments are split into two components:
the base component and the credit spread. The base component is
the underlying rate of interest that is paid by high quality borrowers.
In the UK for large borrowers, the base component is either Gilts—the
fixed rate at which the UK Government borrows—or LIBOR (the
London Inter-bank Offered Rate)—the floating rate at which
banks borrow from each other. At the time of any debt issuance,
Gilts will be quoted at a fixed rate of interest, whereas LIBOR
will be floating rate interest for short periods (eg three or
six months). Borrowers can enter into interest rate swaps in order
to swap payment of LIBOR for payments of fixed rates of interest.
The credit spread is the premium that the borrower
must pay for being a riskier investment than either the UK Government
or banks and is quoted as basis points[35]
over Gilts or LIBOR.
A borrower can achieve lower interest rates
if either the base component decreases and/or the credit spread
decreases.
However, if the base component is at a fixed rate
of interest (either Gilts or interest rate swaps) and the borrower
wishes to repay the loan in order to refinance, the borrower may
be required to pay a prepayment fee to the investor. [36]Because
the prepayment penalty will be essentially equivalent to any benefit
that the borrower could gain from lower interest rates, the effect
of fixed interest rates is that a borrower will not be able to
achieve any significant benefit from reduced underlying interest
rates.
With credit spreads, a borrower will be able
to achieve a lower rate of interest without prepayment penalty
if the borrower can reduce its credit spread. A borrower's credit
spread can go down for several reasons:
(a) improved credit and therefore becoming
a less risky investment,
(b) market reductions in credit spreads at
that level, and
(c) structural enhancements to the debt which
reduce its riskiness (although the borrower itself does not become
less risky).
Questions 174-181 (Mr Jenkins) and Questions
182-186 (Mr Williams): Can Tube Lines and Metronet refinance?
In theory, both Tube Lines and Metronet could
refinance their debt, as there are no limitations on their ability
to refinance in the PPP Service Contract.
In practice, in the case of Tube Lines, it is
unlikely that they will refinance most, if not all, of their debt.
Metronet, however, has greater potential for refinancing. The
potential for refinancing by both companies is described below.
Tube Lines: Tube Lines original financing
was floating rate bank debt with an interest rate swap, as described
above. When Tube Lines refinanced their debt in May 2004, they
actually borrowed at a higher underlying interest rate than the
original financing, but received payment from the interest rate
swap providers for cancelling the swap, thereby achieving the
net effect of borrowing at the same interest rate as the original
financing.
Tube Lines achieved the refinancing benefit
by being able to reduce the weighted average credit spread on
the refinancing from approximately 1.60% in the original financing
to 0.686% on the refinancing.
Because of the significant reduction in the
credit spread achieved by Tube Lines in the refinancing, for the
majority of the debt, it will be unlikely that Tube Lines will
be able to achieve any material benefit—net of fees and
expenses—from a further refinancing. However, the credit
spread on £172 million of debt will increase significantly
starting in 2010. Therefore, Tube Lines may be able to gain some
benefit by refinancing this debt before the interest rate margins
increase in 2010.
Metronet: There is a possibility that
Metronet could achieve significant refinancing benefit if they
are able to further reduce the credit spread paid on their debt.
A significant portion of Metronet's current debt are in bonds.
Therefore, if Metronet chooses to refinance 100% of the debt,
they may need to pay substantial pre-payment penalties to the
bondholders. For the floating rate bank debt, we expect that for
the majority of this debt, Metronet will enter into interest rate
swaps. Metronet may still need to pay a pre-payment penalty to
unwind the swaps, but this payment should be less than to the
bondholders.
The amount of refinancing benefit for both Metronet
and Tube Lines will only be determinable at the time of refinancing
as it is impossible to predict what structure would be available
at that time, or the underlying interest rates or credit spread.
34 Not printed. Back
35
1 basis point = 0.01%. Back
36
The prepayment fee is paid in order to "make the investor
whole" for the returns that the investor will not be earning
due to the prepayment. It is calculated by comparing the interest
rate on the bond or interest rate swap currently in place against
the current base interest rates at the time of refinancing. If
interest rates at the time of refinancing are lower than the existing
bond or swap, the borrower will need to make a payment to the
lender. With interest rate swaps for bank loans, if interest rates
at the time of the refinancing are higher, the bank will make
a payment to the borrower. With bonds, if interest rates at the
time of refinancing are higher, no additional payments from either
party will be made. Back
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