Select Committee on Public Accounts Thirty-Eighth Report

3  Potential exposure of the taxpayer

10. Our 2001 Report on the Link concluded that the level of equity capital was insufficient to reflect the high level of commercial risk in this project, which depended on inherently uncertain forecasts of passenger numbers. If a project involves a high degree of commercial risk, then it needs to be financed with a commensurately high level of risk capital relative to bank debt. LCR only had a total of £60 million in equity and was not, therefore, sufficiently capitalised to bear the risk of a £5.8 billion project.[10]

11. The Department considered that direct public financing for the project would weaken the incentives for the private sector to manage construction to time and budget and to maximise the revenue yield from the Eurostar business. Accordingly, as part of the 1998 restructuring of the deal, Railtrack Group contracted to purchase Section 1 after its completion for a price based on the actual cost of construction, and secured an option to purchase Section 2. Following Railtrack plc's entry into railway administration and Railtrack Group's subsequent withdrawal from the project, the Department looked at whether it should itself take all the risk on cost overrun. Although such an option was the least costly over a range of possible outcomes, the Department concluded that it was not a sensible alternative, as the Department could not manage construction risks. The last time the Department had borne construction risk, on the Jubilee Line extension, the project was completed 21 months late and £1.4 billion over budget. The Department therefore sought to layer the risks so that the project managers would be responsible for a significant amount of the initial overrun.[11]

12. The Department, LCR and Bechtel negotiated the Cost Overrun Protection Programme (COPP), which the Department thought at the time was expensive. Bechtel, a key project manager on the Link and a shareholder in LCR, received £60 million for arranging the proposal. It involved carrying a £100 million share of the first £300 million of potential cost overruns, in excess of a target construction cost for Section 2, providing the overruns were not the consequence of inflation greater than a contractually determined and defined cap of 3% per annum. A group of insurers received a £27 million premium for bearing £215 million of potential cost overruns in the range £300 million to £600 million. Overruns arising from inflation greater than 3% a year were to fall on LCR and ultimately on the Department. LCR was to bear the full cost of any overruns above £600 million (Figure 3).[12]
Figure 3: The sharing of cost overruns between the parties

Source: C&AG's Report

13. The expected cost of Section 2 of the Link has increased. Bechtel will be called upon to cover only a very small part of this increase in costs because the bulk of the increase is due to railway inflation of over 6%, double that of the contractually determined cap of 3%. Railway inflation has been higher than expected because of a greater demand for limited labour and materials after the Hatfield disaster and for the West Coast main line renewal. These events resulted in higher wages and higher materials costs.[13]

14. The Department was confident that there would be no further sizeable increases in the construction costs of Section 2, as work had reached a point where it was over 80% complete. Remaining costs amount to between £100 million to £200 million, against total expenditure of £3 billion.[14]

15. In 1998 the Department granted LCR an access charge loan facility, capped at £360 million at 1997 prices in present value terms, for it to draw down funds to meet Eurostar UK's obligations to pay track access charges. As a result of construction cost increases, LCR is likely to draw on the access charge loan facility earlier than originally expected. The Department and LCR believe, however, that over the remaining 80 years of the franchise, sufficient revenues will be generated to enable LCR to repay the loan.[15]

16. For the future, the Department considers that there will be substantial inflationary pressures on projects in London and the South East, such as the Olympics, widening of the M25, Thameslink 2000 and Thames Gateway. The Department acknowledged the need to phase major infrastructure projects to reduce supply side pressures.[16]

10   22nd Report from the Committee of Public Accounts, The Channel Tunnel Rail Link (HC 630, Session 2001-02); Q 104 Back

11   22nd Report from the Committee of Public Accounts, The Channel Tunnel Rail Link (HC 630, Session 2001-02) para 5 (xii); Qq 12, 15, 104 Back

12   C&AG's Report, para 3.19; Q 12 Back

13   Qq 31-33, 36, 109 Back

14   Qq 36, 39, 72, 109 Back

15   C&AG's Report, para 3.28; Qq 8, 58, 60 Back

16   Q 109 Back

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