Examination of Witnesses (Question Numbers
Mr Amyas Morse and Mr Ed Humpherson
3 NOVEMBER 2009
Q240 Lord MacGregor of Pulham Market:
But all the contract requirements remain the same?
Mr Humpherson: Absolutely, in every case that
I can think of. It is worth saying just as an additional point
that there are direct benefits to the consolidating firm. They
can extract economies of scale and they can manage their contracts
in a more consistent way, and those are things which are not open
directly to the public sector, which is why we have put so much
emphasis on the public sector exerting whatever information powers
it has to gather information across all of its projects and exert
the counterweight. There is an indirect benefit which is worth
touching on of this transfer of shares which is that it shows
to future projectsa construction firm for example thinking
of investing in a future projectthat there is an on market
for its shares if they want to exit. It gives them some confidence
and that indirect benefit must be good for the public sector.
Q241 Lord MacGregor of Pulham Market:
And could bring additional funds too?
Mr Humpherson: Exactly.
Lord MacGregor of Pulham Market: You
have answered the second question I was going to ask.
Q242 Lord Eatwell: Could I just follow
up on that. The experience in financial services is that this
is disastrous because the initiator of the contract, knowing that
they can exit, is less responsible about the commitments they
make in the contract. That is exactly what happened in the sub-prime
mortgage case. Given these possibilities of exit that you have
described, and a reasonably competitive environment, are you not
then going to get rather less responsible tendering?
Mr Humpherson: I think in the financial sector
what people were worried about was the slicing and dicing of risk
into ever smaller packages such that the originating risk is so
far away from the person who holds it through a very long chain
of bonds, into CDOs, in CDO- squared that you lose sight of it.
Actually the opposite of slicing and dicing is what we are talking
about hereI do not know what the culinary metaphor would
beyou are congealing because you are bringing together
a whole series of separate contracts under one house.
Q243 Lord Eatwell: But the initial person
has an exit possibility so therefore they are no longer responsible
for the terms of the contract which they have negotiated. They
have shifted the responsibility and sold it on.
Mr Humpherson: Yes, but I do not think it was
the shifting of responsibility that has been the concern in the
financial sector; it is the slicing and dicing of the responsibility.
Q244 Lord Eatwell: It certainly has.
Leaving the comparison with the financial sector aside, you used
the term "exit". You have somebody who is tendering
for a contract who can then exit from the responsibility of fulfilling
that contract and therefore it seems to me less obvious that they
would be fully committed to a responsible tender.
Mr Morse: Forgive me, it is not necessarily
so in the way these deals are put together that all the people
who are shareholders are actually involved directly in delivering
it. They are parties to the contract as shareholders but they
are not necessarily the body that is delivering an element in
it, so supposing you were talking about the construction of a
piece of defence equipment, there would be a particular party
that was constructing that defence equipment. A change in the
shareholding will generally not release them from their obligation
to construct that piece of equipment so it is a more complex contractual
Q245 Lord Eatwell: The party taking the
ultimate risk has changed.
Mr Morse: I am not sure that is necessarily
Q246 Chairman: Can I explore what Lord
Eatwell is saying. We have had witnesses who have claimed that
one of the benefits of PFIs has been the detailed scrutiny of
the initial creditors, made not just at the initial tender but
of the contract over time. That has been an additional discipline
that has been of use to the PFIs. That discipline presumably could
be at least watered down if not disappear if you securitise the
PFI things themselves; is that not right?
Mr Morse: Securitisation is a bit different
from somebody succeeding to a shareholding. Just to say though
if that means that somebody is prepared to pay for it, presumably
there will be some conditions as to who then should be a credible
or acceptable shareholder, and in most PFI contracts I have seen
(I have not seen a vast many but I have seen a fair number) there
is some approval process on the part of the customer, which is
let us say the government, as to whether it can be just anyone
or it has to be someone who brings something into the contract.
If that is so, then to take on a contractual liability, unless
there is in front of you a delivery contract or a construction
contract or something like that where that liability sits with
a particular party, this is the discussion we were having before,
in other words, let us say we are talking about constructing a
ship, something I know a bit about, you would have a contractor
who was constructing the ship and then you would have various
parties who would be involved as shareholders, not necessarily
all constructing the ship. The ship construction contract will
be placed separately and these shareholders would be above that,
so I do not think the fact that you might have a change in shareholder
would change the risk of constructing that asset successfully.
Q247 Lord Eatwell: In this case we are
talking about something different. We are talking about PPP portfolio
investor funds. The whole point about such a portfolio is that
you bundle together a series of projects believing that diversification
in projects reduces the risk in investing in the project as a
whole. The experience of those sorts of securitisations is that
the due diligence, if you like, of the buyer portfolio is not
the same as somebody who makes the initial investment and is totally
committed, so in fact diligence disappears or fades, let us say,
or evaporates on two levels: firstly at the initial contract and
secondly on the due diligence of the investor.
Mr Humpherson: I feel we could go round this
for several hours. Just to be very clear on our view, we are not
free of concern about these consolidations of ownership, but our
greater concern is that it creates a sort of asymmetry of commercial
power between the atomised public sector on the end of a whole
load of individual contracts and a concentrated private sector.
We have thought a little bit about the risk that you raise and
if there was evidence that there is deterioration in the due diligence
that would indeed be a concern but on the basis of the evidence
we have seen it is not the thing that worries us most.
Q248 Chairman: This is an area of obvious
interest to the Committee. Would it be reasonable to ask if you
could give us a little note on that? We would find that very helpful.
Mr Humpherson: Absolutely, we are happy to do
Q249 Lord Tugendhat: Could I ask a completely
different question. We have had a lot of talk in all the sessions
about capital projects and that is really what it has been about,
but the CBI has raised a question as to whether you could not
use private finance to deliver services. They have thought about
teachers and nurses and that obviously is a very different ballgame,
but what would be your views on that?
Mr Morse: I think the answer is
it is certainly feasible to do it and if you look at some of the
contracts that exist now, let us say the prison contracts, they
are contracts with a large service element, so if you say do they
have to involve the construction of prisons, well, actually that
is not absolutely essential to organising and running a prison
and providing what they probably would provide, which is systems
to support a way of working which were somehow different to those
which were traditionally imposed under prisons, so what you see
if you actually go and look at any PFI prison is that it is organised
somewhat differently to traditional prisons. There is some investment
and then there is a new way of working and possibly rather more
differentiated pay scales, and so I think using people and using
systems differently to deliver is perfectly possible. Because
of the fewer front-end costs element in that I would say it does
not necessarily require the formality of a PFI contract in order
to make that work.
Q250 Lord MacGregor of Pulham Market:
Is that not quite close to outsourcing of the service?
Mr Morse: Yes, it is quite close.
Q251 Lord Tugendhat: But I think it is
different from outsourcing because coming back to the hospital
experience I mentioned earlier it seems to me it is one thing
for a hospital to make use of agency nurses and nurses from different
places because they then have to fit in with the rules and the
spirit of the place where they are working, but like a private
military company, as it were, if you went to Nurses Incorporated
who provided you with a whole batch of nurses on a contract for
a given period or for a given function, they would have a corporate
culture and a set of corporate loyalties and promotion ladders
and so forth which would be different from the place where they
were working which is not the case with outsourcing.
Mr Morse: That is fair but again just to come
back to the prison example, which is quite a concrete example,
what is very clear is the criteria under which it is run. That
is something that is being run by the private sector but under
very strong standards and criteria not set by the private sector.
What you find then is that the public sector is in a detailed
regulatory and standard-setting role, not in the role of directly
providing the management. If you want to go down that road the
public sector does not disappear from the picture. It has to be
very specific about what it wants if it is going to be able to
contract that way and get consistent service.
Q252 Lord Tugendhat: Correct me if I
am wrong but my impression is that you have a private sector prison
and it has all the warders and all the staff and so forth. There
is not within that prison a mix of the private sector employees
and regular prison officers.
Mr Morse: I just do not think I can speak with
certainty about that, to be honest with you.
Mr Humpherson: I think it is a fascinating question,
the supply of labour as opposed to the supply of an asset supported
by labour, and you have mentioned nurses or teachers. One also
perhaps thinks about the social care sector. It is a fascinating
question. To answer it, I think it is probably a good idea to
go back to first principles and say could those contracts be provided
under a PFI-type of arrangement? I suppose our first principle
in PFI is that there is a reasonably predictable fixed and definable
public sector requirement, for the reasons that Amyas has suggested,
and if you think there is going to be any change in the requirement
over the term of the contract it is probably not a good idea to
enter into what is essentially a fixed price arrangement with
commitments for the long term. On top of that PFI can, but does
not always, bring the benefit of innovative management approaches,
a degree of risk transfer and due diligence at the outset so that
the contracting parties look at the risks and very carefully allocate
them between themselves and those taking the risks on the private
sector side and also some kind of whole-life consideration embedded
into the contract at the outset, a credible commitment as we were
talking about earlier. If you think about those principles of
PFI and how many of them might apply to the PFI supply of labour
as opposed to labour embedded with an asset, I am not entirely
sure. Obviously you would have to be sure that the requirement
was fixed for the term of the contract and I guess that is something
the procuring authority would know. Perhaps you can get innovative
management but the benefit of risk transfer and due diligence
and the whole-life maintenance seem to be concepts that do not
quite fit with the scenario. I suppose my answer is by all means
consider some form of medium-term contracting for the provision
of labour services but do not take lock, stock and barrel the
PFI model which has the specific characteristics which are designed
really for the problem it was created to resolve.
Q253 Lord Eatwell: Coming back to a bit
of an old chestnut here which is that several people have commented
on the way in which the development of PFI contracts has had an
impact on traditional procurement and traditional procurement
techniques have improved side-by-side. If that is so, is the optimism
bias added to public procurement now outdated?
Mr Morse: I think we have always been professionally
sceptical about it, and I heard some of the remarks that were
made earlier and saying let us assume there is a bias and just
put it in. No, we would look at every project on its merits and
look at the quality of evidence and, as I said at the beginning,
insist on rigorous evidence and evaluation rather than saying
let us assume that there is optimism there. So (i) we do not think
that it was appropriate in the first place and (ii) yes, I think
things have been learned, but you are still left with the point
that you do not have the degree of protection from summary decision-making.
I have seen PFI contracts being put in place alongside non-PFI
contracts for the same amount and value and, generally speaking,
there is a much more deliberate approach to evaluating risk in
PFI than in non-PFI. It cannot possibly be because people do not
realise what is happening with PFI contracts because they have
quite often been working on them so it is more that you just do
not have a shortcut option when you are doing PFI because you
have to convince the outside financing counterparties that all
the risks have been understood and nailed down tightly. It is
very difficult to reproduce that degree of discipline and not
be bounced by impatience in the public sector without contractual
protection. I think that while it has improved the degree of deliberate
due diligence and discipline that is associated with it, it is
always going to be a bit more difficult to sustain.
Q254 Lord Moonie: Just a slight variant
on that as a cynic. Surely optimism bias is something that has
been introduced to the figures to ensure the public sector do
not win the business?
Mr Morse: I could not possibly comment!
Q255 Chairman: Can I put the question
slightly differently. Have you had a chance to look at how many
PFI projects would have failed to come forward had the optimism
bias not been there?
Mr Humpherson: Could you take me through the
question again please.
Q256 Chairman: I will repeat it in slightly
different words. If you took the optimism bias out of the calculations
how many projects which essentially became PFIs would not have
got over the hurdle?
Mr Humpherson: Optimism bias has been a crucial
contributor to the PFI net present value being lower than the
public sector comparator net present value in a very large number
of cases we have looked at. Indeed, what we have tended to see
as a general rule is two numbers clustering quite close together
so if you took the optimism bias out of one of them it would make
the public sector comparator lower.
Q257 Lord Eatwell: Higher not lower.
Mr Humpherson: The PFI NPV would be higher,
you are quite right, thank you for that correction. Does that
mean we believe that those deals would therefore have failed the
value-for-money test? No, because we have always felt quite consistently
probably from the first report we ever wrote on this back in the
1990s, that you should never regard the public sector comparator
as a pure pass/fail test and the only arbiter of value for money
because there are so many more aspects to value for money than
simply comparing a deal in front of you to sign with your hypothetical
estimate of what it might cost. You need to be sure that the costs
being proposed by your private sector contracting party are reasonable
costs on their own terms. You also need to be sure that you have
a long-term need for the asset. All of those sorts of things are
absolutely crucial. The direct answer to your question is that
the optimism bias does shift the numbers.
Q258 Chairman: I want to be absolutely
sure. Had there been no optimism bias then there would probably
have been far fewer PFI projects? Is that right? Is that what
you are saying?
Mr Humpherson: That is a counter factual that
I cannot answer. What I can say is if you took the optimism bias
out of the number the PFI net present value would be higher than
the public sector comparator so it would look as though PFI was
more expensive, if I can put it bluntly. However, I am not going
to say that would have meant fewer PFI deals would have been signed
because I think the reasons for signing PFI deals, whether they
are value for money or not, is more than just a contract versus
Q259 Chairman: So other reasons would
have been brought to bear to make sure these were PFIs rather
than ordinary public procurement?
Mr Humpherson: I think the procuring authority
would look at a wide range of sources of assurance. At least that
is what we would expect them to do. One thing is this public sector
comparator: how much would it cost us to do it conventionally.
Another would be are we sure that we need this service for the
amount of time and we are not tying ourselves into something which
we are going to then regret as we need to unwind it? That is valuing
flexibility. Another is looking at the costs proposed in the model
put forward by the contractor. The contractor is saying we will
provide you the hospital or the prison or the school or whatever
for a fixed price, and you have to be absolutely sure that those
fixed prices are fair and reasonable and, just as you do in any
contract, you would say is this what it should cost.