Select Committee on Public Accounts Minutes of Evidence

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.

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.

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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