Select Committee on Public Accounts Minutes of Evidence


Supplementary memorandum submitted by the National Audit Office

Questions 142-147 (Mr Bacon) and Question 149 (Mr Williams): Transport for London (TfL) Bond Financing Proposals

INTRODUCTION

  Mr Bacon asked Mr O'Toole for documents, in London Underground, prior to his arrival, containing advice given—by TfL—to the Department on preferences for bond financing. Mr Callaghan (Q 148) referred to London Underground publishing, in 2002, two reports called the Final Assessment Report and the Update to the Final Assessment Report both of which summarised TfL's submissions at some length. Mr Williams asked the NAO to do a brief critique of London Underground's summary for the Committee.

OVERVIEW

  All parties agree that the effective modernisation of London Underground requires:

    —  the assurance of stable funding over many years (and all recognise that such stability cannot be guaranteed with conventional public finance);

    —  effective risk management of the physical upgrading work (which, under all financing options would be carried out by a range of private sector contractors).

  In both TfL's approach and the PPPs', stable funding is provided because the greater part of the money needed is raised at the outset. The direct costs of finance would differ: TfL's approach would be cheaper than in the PPPs.

  The approaches to risk management are radically different. TfL would rely on strong public sector management of the private sector contractors. In the PPP, the private sector would have higher exposure to risk than in a conventional project but greater responsibility for managing those risks. Because private sector money would be at risk, there would be incentives for the private sector to manage the risks effectively.

  If private sector risk management as in the PPPs is more likely to be effective than the public sector contract management proposed by TfL, then the extra cost of the PPP finance might be outweighed by the benefits of superior control of the risks. The Government took that view and ruled out public sector bond options accordingly. The TfL public sector bond option would also have been unique in the field of local government finance in the UK.

  The bond financing proposals run up against two opposing philosophies. TfL proposed lower cost finance within a contract framework controlled by the public sector to counteract private sector self-interest. London Underground (when owned by London Regional Transport) considered that higher cost finance included transfer of sufficient risk and project control to the private sector so that their self-interest would incentivise them to deliver performance that would more than offset the extra financing costs.

TfL's bond financing proposals

  In February 2002, TfL proposed raising £2 billion to £3 billion in part by bonds secured on the London Underground fare box ("Asset Backed Bonds") supplemented by bonds based on TfL's corporate good quality investment rating (which it expected to be rated as AA or high investment quality). These proposals formed part of a different public sector approach to modernising the Tube which was set out in the Mayor's Transport Strategy published in April 2001.

  Several advantages were claimed for this approach to modernising the Tube which TfL claimed had been used to turn around systems in Boston, Philadelphia, New York City and Toronto:

    —  gives local government the financial means and full responsibility;

    —  provides stable funding, largely independent of annual grant negotiations (with capital funding segregated from operating budgets);

    —  management skills, including certain project skills, are retained in house and hold private sector contractors (handling large-scale resource intensive projects) to task; and

    —  lower borrowing cost than PPP, as further described below.

  TfL's advisers recognised that raising the total amount would need five to seven years of Government financial backing for the bonds through grant provisions. In response to the objection that bonds would not lead to the transfer of risk to private sector shareholders, TfL argued that risk transfer could instead be achieved through rigorous contracts with the suppliers of infrastructure improvements and services, without having to pay an equity risk premium across the entire project. TfL also argued that their retained project risk under the PPP was equivalent to the project risk under their preferred structure.

  On this basis TfL estimated that its proposals would lead to a saving in financing costs of £36 million to £84 million per year. About one-third of the saving would arise because of higher PPP borrowing cost (rated at a low investment quality or BBB) and the other two-thirds from saving the cost of remunerating PPP equity at around 20% per year. A further unquantified potential interest cost saving could arise if bonds were only issued in tranches of £500 million as and when funds were needed (but there would be a risk of lack of market interest or of the necessary support from central government at the time).

  Transport for London estimates of financing costs:
Cost of financing (excluding fees) February 2002
(TfL report)
4 April 2003
(Metronet close)
Estimated average cost of PPP debt and equity 6.7% to 8%7.15% per year
Cost of AA rated corporate bond financing 5.2% to 5.5%5.29% per year
Differential in cost of finance1.2% to 2.8% 1.86% per year
Assumed amount of financing£3,000 million £5,000 million
Annual cash differential£36 million
to £84 million
£93 million

Source: Estimates based on publicly available (Bloomberg) market data. The calculation based on the market rates and the terms achieved by Metronet in April 2003 is referenced in the NAO Report "London Underground PPP: Were they good deals?" paragraph 2.43 (page 26).

London Underground's findings

  London Underground generally did not dispute the market-based pricing that TfL put forward, but did not expect Treasury approval "recognising that this is not the way public infrastructure projects have historically been financed in the UK". As a related matter, London Underground advised their Board not to assume, under a radically changed approach, the same level of grant support as that available for a PPP that met policy objectives.

  Of the contract structure, London Underground said that it would not deliver the PPP policy objectives on risk and contract responsibility, noting "Some of the contracting structures proposed by TfL, requiring equity contributions from suppliers or parent company guarantees, are not standard ways of doing business with the UK public sector, and may add to the time needed to put contracts in place." Adding to timing problems, a new procurement competition would have been required.

  Publicly, the advisers to TfL and London Underground showed themselves unable to agree on a common set of assumptions for making undistorted bond financed price comparisons. Little common ground exists, and Ernst & Young, [37]as further discussed below, largely discarded London Underground's bond comparison (see NAO Report "London Underground PPP: Were they good deals?" para 2.42 on page 26).

  London Underground's May 2002 "Update to the Final Assessment Report" gave a high level summary of TfL's objections to London Underground's findings. In addition to maintaining that the PPP was not value for money, TfL challenged the findings about the extent of delay and the availability of grant.

NAO analysis of TfL's proposals and London Underground's findings

  Part 1 of the NAO Report shows that in discussion of the design of the PPP there was analysis of public operations combined with private funding (paras 1.9-1.10, 1.17). This analysis showed that such an option would only have been possible with Government backing, which the Government was not prepared to offer, in part because the Government wanted private sector direction of the expenditure in the belief that it would thereby be more effective.

  Paras 2.41-2.44 discuss the possible savings from TfL's approach (updated in April 2003 to represent £5 billion of bonds at 5.29%) compared with Metronet's actual financing structure. Ernst & Young, as para 2.42 Reports, considered that any such saving should be treated with caution in project selection. In particular if the cost of capital (5.29%) is lower than the discount rate at which TfL make the comparison (8.65%), discounting the cash flows appears to reduce the public sector cost. This would imply that the more money that is borrowed by the public sector, the more value for money would improve. It is partly for this reason that Ernst & Young, correctly in London Underground's view, dismissed the relevance of bond financing comparisons, as they felt that in all circumstances an element of distortion, which they termed arbitrage, would occur.

  Arguably the risks to a project under public sector management might outweigh the benefit from cheaper finance—and have certainly done so in previous projects. Instead of letting a lower public sector borrowing cost act as a form of arbitrage or subsidy to a project, Ernst & Young asked how much the public sector might save in the costs of carrying out such a project if annual grant funding were to be replaced by long term stable funding. Ernst & Young then estimated the potential saving from such stable funding at some £825 million. On London Underground's analysis the Committed Finance Offer bids for the PPP remained value for money after reducing the estimated public sector cost by this amount of saving.

  Para 2.43 identifies that the debt and equity financing structure agreed under the PPP costs £90 million more annually than the estimated cost for TfL issued bonds, two thirds of which is related to the cost of equity and is dependent on performance under the PPP. Para 2.44 estimates the annual extra cost of the private debt borrowing as £30 million. This debt cost is generally payable regardless of performance. The extra cost has to be considered against an assessment of the benefit of risk transfer and scrutiny of the project by private lenders.

  Bond issues were not available to London Underground because the Government attached priority to bringing in private sector responsibility in the manner envisaged by the PPP. The scope for improved value for money compared to the option adopted would depend on public sector efficiency under the bond option compared to private sector efficiency under the PPP option.

Questions 79-85 (Mr Bacon) and Questions 166-168 (Mr Trickett): transaction costs incurred by London Underground and the PPP bidders

  The additional information is provided by the National Audit Office in the form of three tables, together with notes and commentary, including the Department for Transport's commentary (where indicated).

  1.  The first table[38] provides, in one place as requested by Mr Bacon (Question 80), a chart of transaction costs with further breakdown on the composition of bidders' costs. The commentary following the first table describes the scope of work undertaken by the lawyers acting for London Underground and the scope of work undertaken by Price Waterhouse (subsequently PricewaterhouseCoopers) as financial advisers.

  2.  The second table[39] provides supplementary information on additional firms used by London Underground. The named firms account for some £18 million out of an aggregate expenditure of £26.5 million over six years, during the corporate reorganisation that preceded the PPPs and during the procurement of the three concessions. A further £4.5 million was not identified to specific firms, covering items such as the "Project Office Costs" and "External Contractors", and the balance of £4 million was spread across an additional 50 to 60 organisations and individuals.

  3.  The third table[40] provides supplementary information on the unsuccessful bidders' costs, naming the principal firms of lawyers and consultants involved.

  The supplementary information is cross-referenced to figures in the Comptroller and Auditor General's Report "London Underground PPP: Were they good deals?" (HC 645). In that Report Figure 12 sets out the external advisers' costs and Figures 13 and 13a on pages 30 and 31 chart the progression of London Underground's costs over time.

  Question 166 (Mr Trickett): He asked for an explanation of why Tube Lines, bidding for one contract, had been reimbursed more than Metronet which had bid for two contracts. The reasons why Tube Lines incurred greater costs (at £134 million) than Metronet (at £116 million) have been provided by the Department.

  Tube Lines' bid was the most advanced during the later stages of the transaction process. As the contracts were negotiated, developed and completed earlier they incurred greater costs in agreeing contract principles than Metronet. This work was incorporated into the two remaining contracts thus reducing transaction costs on the Metronet bids where agreed terms could be incorporated from the Tube Lines deal. Further financial savings were also available from having a single bidder for the two final contracts which avoided some inevitable duplication in costs had separate bidders been selected.

  There are two main components within the bids as paid where Tube Lines costs are substantially larger than Metronet. The first of these is the reimbursement of £7 million that Tube Lines received for their unsuccessful bid for the Sub Surface contract. Metronet received no such fees, being successful in both its bids.

  The other substantial difference is in pre-contract operational activities and the creation of business plans ("Transition Team resources"). These costs were some £21.5 million for Tube Lines, compared to £2.4 million for Metronet, reflecting the different make-up of the consortia. Tube Lines were required to prepare supply contracts prior to the close of the deals and built up resources capable of letting the necessary contracts to deliver their performance obligations during their negotiations. This required Tube Lines to undertake greater preparation than Metronet to ensure that these arrangements were satisfactory before the PPP deal could be completed. Metronet, on the other hand, included their supply chain within the consortium, and were not required to undertake a similar level of preparation before deal close because contracts had already been arranged with the supply chain.

  This does not necessarily mean that the costs for Metronet were less, because the Metronet supply chain will have incurred substantial costs pricing their respective obligations and in particular performing the necessary due diligence to be able to offer fixed prices. But those costs would be included in the overall fixed prices offered to Metronet by their suppliers. In this way those costs are also contained within the Infrastructure Service Charge paid by LUL, although not separately identifiable.

  Without the PPPs, as the Accounting Officer told the Committee, London Underground would have had to negotiate separately potentially a very large number of other contracts. In most other contracts bidders' costs are not separately identified but included within the deal price.

Table 1

BREAKDOWN OF TRANSACTION COSTS SUMMARISED IN "LONDON UNDERGROUND PPP:WERE THEY GOOD DEALS?" (HC 645)
£ millionLUL Tube Lines
(JNP)
Metronet
(BCV
& SSL)
Freshfields legal advice & drafting—just over 50% in period 11
PricewaterhouseCoopers—nearly 70% in period 11
Ove Arup—75% before invitations to bid
PA Consulting & Andersen—over 90% pre bids2
Other firms (see Table 2)
LUL internal costs—60% in period 11
+ add back effect of discounting (see Figure 12 in NAO Report)
29.2
21.4
6.0
26.3
26.5
61.0
10.0
Lawyers for Bidders (Tube Lines Periods 1:2 £1.9 million: £11.7 million)

(Metronet both BCV and SSL bids for periods 1:2 £3.3 million: £10.7 million)
13.6

14.0
Advisers (including sums due on completion) 13.116.4
Lawyers for banks and funding bodies 7.86.2
Banks technical advisor, modelling, etc 4.42.5
Other 3rd party advisers' costs to date—tax, audit, VAT 4.23.4
Balance of 3rd party costs forecast for remaining period to close 5.43.0
Bid team resources (Metronet reduced for cap3) 16.614.3
Transition team resources4 21.52.4
Project Office expenses 1.43.2
Tube Lines unsuccessful SSL bid (see Table 3) 7.0 n/a
Payments to sponsors (Metronet both BCV and SSL) 39.050.6
Unsuccessful bidders (see Table 3) 25.0
Total (£455 million)205.4 134116

Source:

London Transport Board approval November 2002 and NAO analysis.

1  The first time period closes with selection of Preferred Bidders (May and September 2001). Detailed break-down over time in Figure 13 of the NAO Report.

2  Fees to Arthur Andersen and PA Consulting principally covered reorganising London Underground into three Infracos and one operating company.

3  Further Metronet bid costs after November 2002 were 50% reimbursable subject to a £3 million cap—applied to the bid team resources line. Final legal fees took Metronet's out-turn to £117.9 million after completing their financing in April 2003.

4  "Transition team" activities include a early operational activities during the extended period before closing the transactions and the creation of Business Plan.

COMMENTS ON TABLE 1

  Legal advice and drafting:

  Work by Freshfields for London Regional Transport and the Department for Transport is further described as follows:

    —  providing input to the overall design of the PPP contracts including evaluation of the options and ensuring the appropriate provisions were included in the GLA Act 1999 eg in relation to tax, protection of railway assets, and the role of the PPP Arbiter;

    —  supporting LUL in reorganising into four separate businesses and the preparation of information to support the bid process;

    —  development of PPP documentation in parallel with design of the Infracos and LUL (and reworking the documentation as elements of the design changed or developed);

    —  supporting negotiations with Railtrack;

    —  restructuring of the Northern Line Train Services Contracts in preparation for transfer to Infraco JNP and supporting protracted negotiations with Alstom;

    —  supporting LUL's negotiations with PFI contractors in relation to transfer of their contracts to TfL;

    —  supporting the tender process and LUL's negotiations with all bidders;

    —  advising on judicial reviews; and

    —  advising on the competition aspects of the transaction including state aid clearance.

  Financial advice and negotiating:

  Work by Price Waterhouse, and subsequently by PricewaterhouseCoopers included the following:

    —  review with London Underground of the procurement options open to London Underground and detailed presentation of alternative models to Government;

    —  providing input to the overall design of the PPP;

    —  development of the PPP structure, including design of the Infracos and LUL interfaces;

    —  supporting LUL in reorganising into four separate businesses and the preparation of information to support the bid process;

    —  development of the London Underground output requirements and performance measurement regime;

    —  continual updates on LUL performance and determining benchmark levels of performance;

    —  review of the PFI arrangements and their interfaces with the PPP;

    —  supporting negotiations with Railtrack;

    —  supporting the tender process and LUL's negotiations with all bidders;

    —  financial review of bids in conjunction with LUL bid evaluation team; and

    —  assisting LUL with financial close and interest rate risk management.

Table 2

OTHER FIRMS USED BY LONDON UNDERGROUND
CompanySpending levels Activity
Up to £100,000


Arnold & Boston
£20,000 Architects
SymondsOver £20,000 Project management—Windsor House
"Mystery shopper"£30,000 Setting up and testing ambience measurement
Cazaley£30,000 Construction work—Windsor House  
Dearle & Henderson£50,000 Cost management (asset knowledge)
AslanOver £50,000 Support on engineering standards work
KvaernerOver £50,000 Engineering support (asset knowledge)
Eurica consulting£60,000 Consulting
Touchstone Renard£60,000 Technical review of asset data
Soil MechanicsOver £80,000 Survey information


Between £100,000 and £1 million


Harris & Porter
Over £100,000 Project management—accommodation
HaswellOver £100,000 Bid evaluation—technical support
Kennedy & DonkinOver £100,000 Engineering support (asset knowledge)
Mellish & LynchOver £100,000 Quantity Surveyor—support on cost databases
OspreyOver £100,000 Project management
Steer Davies GleaveOver £100,000 Customer survey
TFPL Ltd.Over £100,000 Reorganisation of deeds room, etc
William Dick PartnershipOver £100,000 Commercial managers—Windsor House
WS AtkinsOver £100,000 Eng support (asset knowledge)
Bacon & Woodrow£150,000 Pensions services and advice
Nigel Rose and PartnersOver £150,000 Bid evaluation—quantity surveyors
Decision FocusOver £170,000 Modelling early PPP structural options
Slaughter and MayOver £200,000 Legal services
Royal Bank of Canada/
Ernst & Young
Over £200,000Advice on interest rate hedging strategy
OpteamaOver £200,000 Engineering consultants (process mapping)
Metro ConsultingOver £250,000 Bid evaluation—train operations
Computercenter LimitedOver £300,000 Computers and accessories
ITNETOver £400,000 IT services
Cap GeminiOver £400,000 Information technology services
AEA (and Risk Solutions)Over £500,000 Design/test safety management structure
Marsh (formerly Sedgwick)£520,000 Insurance services and advice
Hobley NesbitOver £570,000 Commercial/management support to H&H
PML Ltd.Over £700,000 Bid preparation and checking
Field, Fisher, Waterhouse£750,000 Legal advice to LRT on transfer to TfL


Over £1 million


Bank and legal fees
Over £1 million PPP interface with Northern Line PFI deal
Richard EllisOver £1 million Property services and advice
ICL (and others)Over £1 million IT services
OverburyOver £1.2 million Office refurbishment
Pugh Roberts
(to end March 2001)
£2,200,000Dynamic Simulation Modelling
KPMG£2,400,000 Audit and review of Public Sector Comparator methodology
Hornagold & HillsOver £2.5 million Project management and related services

Source:

Project records provided to the NAO support the stated estimates. Precise figures could be compiled, but only after confirming the amounts with each individual firm to eliminate errors in data interpretation, such as possible double counting.

Table 3

UNSUCCESSFUL BIDDERS COSTS

£ million
Tuberail (JNP)

LINC (BCV and SSL)
Tube Lines SSL Group
(SSL)
Internal costs4.910.9 5.4
External costs—legal3.7 2.01.2
External costs—other2.4 6.91.5
Total Bid11 19.88.1
Total Paid11 14 7


Internal Costs for all bidders

  Staff Costs, including accommodation, clerical support, expenses and printing.

Tuberail

External Costs

  Includes Asset Management, Financial, Legal, Technical, Public Relations, Human Resources, Risk Assessment and other Due Diligence.

  Lead firms include Linklaters, Allen & Overy, Arthur Anderson, S&P and Moody's.

Amount Paid

  Following a claim by Tuberail in September 2002, the London Transport Board agreed to full payment of the £11 million requested. This was based on accepting that Tuberail had diligently followed London Underground's instructions during a prolonged bidding process.

LINC

External Costs

  Lead firms include Schroder Salomon Smith Barney (part of Citigroup), Slaughter and May, Clifford Chance, Ernst & Young, Symonds Group, Steer Davis Gleave and CJ Associates.

Amount Paid

  £7 million was paid for each unsuccessful bid making a total of £14 million.

Sub Surface Lines (Tube Lines Group)

External Costs

  Includes LSA (public relations), AON (insurance advice), APM Ltd (asset management consultancy), Capita (technical advice), Chapman & Company (Property advice), Claire Howard Consultancies (Property), KPMG (Tax), Lovells (legal advice), Norton Rose (lenders' legal advice), PKF (audit of financial model), Scott Wilson Kirkpatrick (lenders' technical advisor), VST Comeco Rail Ltd (technical advice).

Amount Paid

  As Tube Lines owed Tuberail £7 million for their unsuccessful bid for Infraco JNP, Metronet paid the £7 million they owed Tube Lines direct to Tuberail.









37   The Department retained Ernst & Young to provide independent advice to the Secretary of State. Back

38   See Ev 36-39 Back

39   See Ev 37-38 Back

40   20 See Ev 38-39 Back


 
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