Supplementary memorandum submitted by
the Department of Health (continued)
Question 126 (Helen Goodman): Example of different
discount rates and the benefits for the public sector
The Code of Conduct recommends that that discount
rate should be equivalent to the base case shareholder internal
rate of return (IRR). In the case of the Norfolk & Norwich
this was 18.94%.
Applying a discount rate of 18.94% per annum
to both the pre and post refinancing equity cash flows, produces
a refinancing gain (ie the difference) of £115.501 million.
The Trust was then entitled to a share of this gain.
Applying a discount rate of 3.5% per annum real
to the two cash flow series, produces a refinancing gain of £47.163
million. Again, the Trust would only have been entitled to take
a share of this gain.
The variation in the refinancing gain can be
explained by looking closely at the profile of the two cash flow
series.
In the pre-refinancing scenario much of the
shareholder return was at the end of the concession. Discounting
these equity cash flows at a high discount rate means that their
present value is relatively low. Using the same high discount
rate to the post refinancing cash flows has a dramatically different
effect. The shareholders have exchanged returns in the future
for up-front returns. The acceleration of shareholder returns
means that these amounts are relatively unaffected by the high
discount rate.
|
| Pre-refinancing
| Post refinancing |
Refinancing gain |
|
| Present value at 18.94% of the distributions occurring after December 2003
| £35.372 million |
£150.873 million | £115.501 million
|
|
Applying a low discount rate (3.5% real) to the pre-refinancing
equity cash flows, and the present value of the back ended returns
is maintained at a high level. In the post refinancing scenario
the accelerated returns paid up front when combined with the ongoing
but lower future returns still exceed the previous level.
|
| Pre-refinancing
| Post refinancing |
Refinancing gain |
|
| Present value at 3.5% real of distributions occurring after December 2003
| £162.473 million |
£209.636 million | £47.163 million
|
|
Question 176 (Mr Ian Davidson): Details of risks for private
companies involved in PFI projects
There are a number of PFI projects where significant risks
have occurred for the private sector counterparties. Whilst there
is no collated information, the following was collected from publicly
recorded sources for the purposes of informing the Committee.
The National Physical Laboratory—A PFI contract awarded
by the DTI in January 1998 was terminated in December 2004 following
difficulties experienced by the private sector consortium in completing
the construction to specification. The National Audit Office is
currently studying how the DTI approached the project, negotiated
the termination and evaluated the contractor's interest.
Press reports, including the Building magazine article of
17 June 2005 "No regrets" recorded that problems with
the temperature in the facility "was the major factor in
the £70 million hit that Laing took on the scheme in 2001".
The Dudley Hospital—A PFI contract was awarded to a
consortium including the construction company Sir Robert McAlpine
in 2000.
The National Audit Office noted in its Report Darent Valley
Hospital: The PFI Contract in Action—HC 209 Session 2004-05
10 February 2005, that "Sir Robert McAlpine reported losses
of £27 million in the two years to 31 October 2003".
Higher figures (up to £71 million) have appeared subsequently
in newspapers.
A contract to build and run an Energy Centre at the Mayday
Healthcare NHS Trust in Croydon, was terminated in 2000, as the
private sector consortium, which included Miller Construction
failed to complete successfully the facility.
The financial problems at Jarvis plc have been widely reported.
The group won up to 25 PFI contracts in the schools, local authority
and smaller health facility sectors. Jarvis encountered problems
with the construction on a number of those projects. In its consolidated
balance sheet as at 30 September 2005, the group recorded accumulated
losses of £710.8 million.
In September 2005 Mowlem announced a £70 million cut
in profit and the contracts were all related to building, infrastructure
and engineering, and that some of were PFI jobs.
Earlier this year it was Reported that Kajima, a Japanese
construction firm was set to make a loss of £80 million because
of problems on its PFI schools contracts.
In late 2003 the contractor Ballast was put into administration,
after the company has lost £14.3 million in eight months
to 31 August. Ballast was involved a number of PFI projects, including
Tower Hamlets Schools.
Financial and accounting problems at Amey, a PFI and outsourcing
company, led to a £55 million pre-tax profit in 2001 being
restated as an £18 million loss.
The Internal Rate of Return (IRR) is the rate that when used
to calculate the net present value of future cash flows gives
an answer of zero.
The shareholder's IRR of 18.7% was the return that the shareholders
expected to generate as a result of the competitive process for
the entire PFI contract. The Octagon consortium was selected because
their bid overall was the best for the Trust.
The calculation of the shareholder's IRR is sensitive to
the timing of the receipts. The graph shown on the attached sheet
shows what the shareholder IRR would be if the refinancing was
delayed.
The IRR is a product of the timing of the refinancing and
as a result of the refinancing being completed in December 2003
the IRR for the shareholders is 60%. The graph attached shows
that the IRR changes dramatically dependent on the timing of the
refinancing.
Supplementary question from Mr Richard Bacon
Have annual "smoothing payments" in the region of
£3.4 million per year have been made to the Norfolk and Norwich
University Hospital NHS Trust in recognition of the accelerated
rate of depreciation-equivalent incurred by the Trust in purchasing
the buildings from Octagon Healthcare over a shorter period than
60 years? Please supply details, including the value and frequency
of such payments and stating for how much longer these payments
will be made.
Payments to the Norfolk and Norwich University Hospitals
NHS Trust under the "smoothing monies" initiative started
in financial year 2003-04. The amount was £3,778 million,
a fixed annual amount, never inflated, which was paid in full
up to 2005-06 (see the attached spreadsheet). The initiative was
introduced for a number of the early PFI projects due to the effect
on affordability which arises from the difference between the
length of the primary contract period, which was typically 25
to 30 years, and the expected life of the asset generated under
the project, which is usually 60 years.
In PFI deals the private sector partner will plan to recover
the full capital cost during the primary concession period whereas
an equivalent public sector scheme would depreciate the asset
over 60 years (ie pay the money back through capital charges to
the Department). The support, paid when the unitary charge starts
as the new hospital opens, therefore created a level playing field
between privately financed and public capital projects by spreading
capital cost across 60 years rather than the primary concession
period.
The spreadsheet also shows that from 2002-03 the trust has
received support for the capital charges on the land it contributed
to the deal as "bullet payments" to offset the annual
charges; these are prepayments (that will reduce over the contract
period) and attract capital charges at the appropriate rate. The
background to this is that prior to the publication of the guidance
"Land and Buildings in PFI schemes" in February 1999,
there was uncertainty amongst accountants about whether there
would be a requirement to fund the 6% capital charges on land
and buildings transferred to the private sector as part of PFI
projects. Work for the land and buildings guidance confirmed this
was required so it was decided that schemes which had not previously
funded this charge should be reimbursed via direct funding from
the centre. The capital charge rate changed to 3.5% for financial
year 2003-04, which reduced the capital charges payable.
These were two of the reported revenue and resource pressures
which emerged from the use of PFI in the NHS. However, at the
end of 2003 the Department's Finance and Investment Sub-Committee
(FISC) advised that central revenue support mechanisms for PFI
schemes could not be justified in the long term and, in principle,
should stop immediately. They were not compatible with the changes
in the way funds are now allocated to the NHS (ie directly to
local health bodies), nor consistent with the way Trusts' income
would be determined in future, ie through the amount of activity
they deliver under a national tariff rather than simply pricing
services to cover costs (Payment by Results). The decision was
taken of course in the context of the largest ever sustained increase
in NHS Funding—an average of 7.3% over and above inflation
each year from 2003-04 to 2007-08.
However, to prevent sudden falls in income for Trusts, we
agreed with Strategic Health Authority Directors of Finance that
this funding should be phased out over a number of years to give
local NHS bodies time to adjust. Funding was due to cease in 2006-07
but the tapering arrangement was actually extended to 5 years
from 2003-04 (ie to 2007-08) in line with the tapering proposed
under the Payment by Results tariff supplement.
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