Private Finance Projects and off-balance sheet debt - Economic Affairs Committee Contents


Examination of Witnesses (Question Numbers 461-479)

Mr Adrian Ewer, Mr David Metter and Mr Paul Davies

8 DECEMBER 2009

  Q461Chairman: Mr Metter, Mr Davies and Mr Ewer welcome to the Economic Affairs Committee. Thank you for coming. I should be grateful, as ever, if you could speak reasonably slowly and clearly for the benefit of the webcast and for the shorthand writer. When we reach questions, if one person has answered and the other two are quite happy with that answer, then we will take that as assent. Of course if you want to add something individually, then feel free to do so. Would you like to make an opening statement or shall we go straight to questions?

  Mr Metter: May I make a brief opening statement?

   Q462Chairman: Yes.

  Mr Metter: I am Chairman of the PPP Forum. I am also Chief Executive of Innisfree. With my PPP Forum hat on, I would like to invite a delegation or some of your lordships to visit some of the projects. We feel that there is a big separation in this world between people discussing PFI and very few people ever actually get to see the projects and to see the transformation which is actually happening on the ground. We would be very happy to arrange for a delegation to visit a number of schools, secondary schools, hospitals and other types of projects so you can actually see how these projects are working on the ground. I did listen to the previous session and may I just make three little points. Innisfree is a channel for institutional investment into the PFI sector. We are the principal equity investors in the sector and some of the questions had an equity slant to them. One of the matters Baroness Hamwee raised was about pension funds. We have over £750 million of UK and offshore pension funds investing through our funds into PFI; these are pension funds like BT, British Rail, British Aerospace, British Steel; we have many local authority pension funds also which are investing in this sector through our funds. Last quarter, we invested over £250 million into the secondary market and this has given the possibility for major contractors and other holders of primary equity stakes to recycle their equity, which has been very useful in the current market where capital is so constrained. I would say that in the primary market business is very quiet in the UK. I know there is a lot of discussion about which procurement method is right, whether PFI is good value for money and we can debate that for as long as anybody would like, but essentially the Government have run out of money and they have not really been investing in big PFI projects for the last three years, well before this credit crunch came. I should say that we are very active in Canada and Sweden where we would expect to be made preferred bidder on some very large super hospitals which demonstrates that this PFI process, which is really an evolution on from traditional procurement, is proving very successful elsewhere in the world. They all have the same problems over there, the same sort of opposition, the same media debate, the same groups of political interest that oppose it but where there is a strong government will and a need for social infrastructure it is being overcome and this method, which is a smart procurement method is being used very successfully.

  Q463  Chairman: Thank you very much. Perhaps I could begin the questions by asking you to give us a brief summary of what you see as the pros and cons of private finance projects? In your written evidence you concentrated fairly heavily on the pros. Perhaps you would like to point out whether you think there as some cons and what those might be.

  Mr Metter: Essentially the major pro is the process itself. It has been able to deliver a substantial infrastructure programme which is probably unmatched, certainly in UK infrastructure procurement, over the last 100 years. The cons are that it is too closely linked to the current Labour Party. This has meant that the media never communicates any of the successes of PFI; they seem to try very hard to find failings and find fault, which is part of the political process where they are trying to hold the Government to account. Equally the Conservative Party: if one read The Observer last Sunday you would have also seen that for them it is important to oppose this policy at the moment. That is a problem because it saps the political will and it causes Government to become less strong about this process. I say that added on to the fact that there is not much money around at present. A lot of the debate which goes on around PFI is not practical debate. Once you unwind it there are certain political positions which are driving opposition to PFI and which are often self-serving. That is the big con. If you look at the NHS hospital estate there are over 1,000 hospitals in the NHS estate. One hundred have been renewed through PFI. There are still many, many hospitals which are pre-1940 which need to be rebuilt, projects like Royal Liverpool Hospital where there is a huge need for that project to be done and actually it will probably be cheaper to do it and run it through PFI than it is costing the NHS at the moment. A lot of the political will has been sapped I believe because of the strong political opposition one sees to it. I have no doubt that when the Conservative Party gets into power they will re-badge PFI, much as has happened in Canada since they will need to use it because it is the procurement tool that is efficient and delivers projects.

  Q464  Chairman: Leaving aside the political environment, do you think there are any inherent cons as well as pros in the PFI approach?

  Mr Metter: Do you mean actually in the practical space?

  Q465  Chairman: Yes.

  Mr Metter: PFI is a complex trade-off between various stakeholders and various interest groups. It is not perfect for anyone; it is not perfect for Government, not perfect for the private sector, it is not perfect for the users. So you get this envelope, which is a trade-off but it does work very well. You will find people from all those sectors who will have problems with PFI. School masters actually want better schools, they want more money spent on the schools but that is not affordable. The public sector sometimes wants more control without risks being transferred; the private sector finds itself often dealing with public sector partners who are not up to it. We find a lot of the corporate memory gets lost in these projects because people change their jobs. If you look at the Treasury, the people who have been in charge or responsible for procurement change their job every year or two so you lose that continuity. Everybody has their negative slant but overall one has to look at what has been delivered and whether the users, whether the local communities are pleased with the projects.

  Mr Davies: May I add one pro and one con? A pro is because these are long-term contracts being put in place, it really focuses everybody in the public sector in particular on what is important, what they want, what is affordable at the outset. That is the pro because that really focuses that due diligence and that concentration. The con is that means you do have a long-term contract on a particular output specification where, for some types of services, you may want to change that after a period, so it is getting into quite long-term structured contracts but that is in our view a necessary evil, to get the discipline at the outset and to really focus on what you want when you are purchasing as a public sector provider.

  Q466  Lord Lipsey: When assessing what the pros and cons actually are, some people put it that it is the whole-life approach to investment, the fact that it is not just what happens in year one or when you are constructing it but over the whole life. Others think that the greater benefit comes because the projects are more carefully assessed before they are launched and it is a more sophisticated contracting process than traditional contracting. So, developing the Chairman's point about pros and cons, which of those sorts of more detailed pros strike you as the most important in getting the right output from a public point of view?

  Mr Ewer: One of the pros you have just outlined, which is incredibly important in delivering a lot of value which is because it is so detailed and contractual and very long in the gestation period before contract is awarded, is the level of preparation that is done by all parties involved, public sector and private sector, including the whole private sector supply chain, contractors, service providers. When the contract is signed the public sector knows exactly what it is buying and the private sector knows exactly what it has to deliver and that level of preparation is one of the reasons why so many of these are delivered on time and on budget and to very good quality of service; it is so well defined prior to the contracts becoming binding. That is a tremendous benefit of this whole process.

  Q467  Lord Lipsey: At the same time that whole process was much criticised and this was particularly true of the London Underground contracts where the whole process of design disappeared up its own backside, the complexity, lawyers crawling over it and all sorts of things which were damaging to the project.

  Mr Ewer: I was not involved in that London Underground project. As an outside observer, I think that is where the actual procurement was not well organised and managed. I do not actually believe they were projects really which suited PFI because it was very hard to define exactly what was required. I say that as an observer not through any detailed knowledge. It is the one example which is held out as a major failure. It was a very unusual PFI and we all suffer as a result of that one because it is constantly played out as the reason for the failing. There are other projects which have failed which should never have been PFIs and they are ones which are largely experimental because no-one was able to define at the outset exactly how to get to the desired outcome.

  Q468  Lord Best: You have not given us much about the downsides to PFI contracts and you have not touched on the other side of having those long-term commitments, those long-term contracts, which is, we have heard evidence, that you are boxed in then for 20 years or 25 or 30 years and even though you spent all that time in preparation, yes, at the beginning, things come along that you had not thought of when you signed up and to change things later on is going to cost you an arm and a leg. We were hearing how the hospital day surgery becomes much more prevalent, which means you want less space taken up by people who sleep there overnight and more space taken up by places where the surgery can take place in the day. To try to change the contract—oh dear, you have 25 years left on it. Could you just comment on that downside?

  Mr Metter: One has tradeoffs. Having a long-term operating contract connected to these projects gives the public sector a great deal of confidence. Only last week I was up in South Lanarkshire where the regional board is looking at their budget cuts and they cannot touch the PFI project. I have no doubt that over the next five or 10 years the maintenance budgets of many, many traditionally procured projects are going to be cut because that is what has happened in the past. So projects which may have been built new very successfully are not maintained. Under the PFI contract, you cannot do that. We have a contractual relationship with the public sector and it is very difficult for them to change that. On the one hand you can be sure that at the end of 25 years you can get your hospital back and actually, although there is a lot of scaremongering about how much hospitals change, if you look at hospitals over the last 100 years we have some very old hospitals in the UK which are still working very successfully. The question is whether a hospital is going to change so much as to make these projects inefficient. Maybe, but one has to look at that on a probability basis. We have a variation procedure in these contracts which allows variations to be made and for the projects to change their uses, so that comes down to the nature of the partnership and how both sides of it engage to improve or change these facilities. We have projects which have been running for seven years now so we are not at the stage where a whole lot of projects have just been built and nobody really knows how they are going to work in their operating period. We have hospital projects like Dartford Hospital which have been working for seven years; Norfolk and Norwich is a hospital which has been working very successfully. These projects have had variations; they have had a change to the services offered and buildings. So far this has worked very well.

  Q469  Lord Best: You have been listening to the discussion on the secondary market in this field and your views on this would be very welcome too. This business of whether or not the fact that you know you are going to sell the contract on afterwards to somebody else means that the amount of risk that you are accepting is reduced and that risk is undermining some of the many—

  Mr Metter: May I just say something about risk because this risk discussion tends to launch itself into the sort of very low probability outcomes that do not often happen in business life. For the most part 95% of our business activity is involved in building a project on time and on cost and if we do not do that we suffer the losses. We also have to operate to a performance specification which is set by the public sector and if that is not run properly we do not get paid. So 95% of our lives are concerned with building projects on cost and on time and trying to deliver the services so we get paid. If we do not do that, various stakeholders within the project, whether they are service providers, contractors, equity holders, debt holders, suffer the consequences of that. However, if you go to the extraordinary situation where a nuclear bomb falls on a hospital, clearly the Government, if it is a strategic hospital, are going to have to step in and sort that out. So at some point, if you have a strategic social infrastructure asset, the Government are going to have to stand in; it is not like say a business park that they can just let go. But by the time you get to that point, the equity will have lost their money, the debt will have lost their money, the contractors will probably have lost their money, the insurers will probably have lost their money and then you get to the point where the Government stand in. For the most part business risks are transferred very, very successfully. There is always risk argument at the interface. What happens if the Government change the law? Should we take the risk on that? Should we take the risk if there are strikes and these affect our ability to run our project or if the Ministry of Defence does not vet our workers properly should we suffer the losses for that? There is a very fine marginal discussion about where risk should fall. In the broad sense the risk transfer works very well. Equity investors do lose their money. We recently lost our entire equity stake on a Cornwall schools project and it is not clear that Cornwall is going to be any worse off for taking the project themselves. We lose money; we try not to. We try to make sure our contractors and service providers lose money before we do. The banks sit behind us, trying to make sure they do not lose their money. There is a very strong understanding of all of this which has developed over the past 15 years. The model now is very good and the risk transfer works in the way the Government want it to. Clearly the Government could transfer much more risk. For example, in the very early days of PFI they suggested that we should take the risk for the number of prisoners they put into the prison when we had absolutely no control over how many prisoners they were going to send to the prison. They realised very quickly that to make the private sector take that risk was just going to be very expensive for them because sure, you will take that risk but you will just assume for example that the prison is full all the time. As you know, service contracts in PFI projects are benchmarked every five years because to expect the private sector to forecast labour costs for 25 years would not be good value for money for the Government because if you did the private sector would just take the worst assumptions. There is a very, very, very well trodden path on this risk transfer and I certainly believe we have it mostly right.

  Mr Davies: Just to contextualise this, PFI is just one part of a much wider private sector way of procuring. Like Adrian from the last group, when I started in this in the early 1980s in the oil and gas sector the model we used in PFI of having a single purpose company with all the risk passed to the sub-contracts was standard across the industry. We were doing it for project finance generally. To try to limit it in the PFI world of trading in secondary equity rather cuts across what is generally done in international project finance markets in the delivery of projects. Elsewhere we manage the risks well, we make those operate and this would be trying to do something different.

  Q470  Lord MacGregor of Pulham Market: Following up on the point Mr Metter was making, in your written evidence to us you gave a number of examples of private sector losses. Has that led to more institutions being nervous about entering the market? Has it increased the costs or has it not had that effect?

  Mr Metter: What has happened is that in the early days PFI was more experimental in terms of what types of projects were undertaken. For example IT projects turned out not to be a good idea. A lot of projects which are very heavy on service provision are not a good idea. We now see the market pushing a bit towards that. Where PFI works is if banks are lending money and equity investors are investing money and there is a big capital project. Then we are there. If you take us out of the frame, then you start moving perhaps towards a more traditional type of procurement where you have contractors versus the public sector. The types of projects suitable for PFI have evolved over time. The kind of huge losses—Adrian can tell you about the losses on the National Physical Laboratory because his company was involved in that—due to risks being taken that the private sector would probably not take today and perhaps the public sector would not ask the private sector to take.

  Mr Ewer: I was in front of the Committee of Public Accounts to explain why we lost so much money. The National Physics Laboratory was a project where the NAO have definitely written a report and gone into it. John Laing, the company I work for, was at that point in its cycle a construction company as well as an equity investor in PFI projects. We lost £60 million on the construction and we basically lost our equity as well and the private sector in total lost over £100 million on that project. The reason why is that it was a project where the definition of what was required in some very complex science laboratories was not clear and there was a misinterpretation from us on the supply side as to what was required and from the client as a purchaser as to what they thought they were getting from us. We could not work it out at the end of the day so the project became an experiment of trying to make laboratories work. At the end of the day that is not for PFI. PFI needs to be for delivery of something which is very, very well defined in terms of what people expect out of it. We kept pouring money into this black hole. At the end of the day also the public sector has an excellent asset which delivers 98% of what the scientists required and paid a lot less for it than it would have paid if we had known what we were trying to build in the first place.

  Q471  Lord Griffiths of Fforestfach: May I ask for clarification? You said it was the National Physics Laboratory. Is it the National Physical Laboratory?

  Mr Ewer: Physical; sorry, my mistake. At Teddington.

  Q472  Lord Forsyth of Drumlean: We have had some evidence that the bidding costs on PFI were very high and that that resulted in there being very few people coming to the party to bid. The CBI said to us that two was enough to tango, that two was enough to have a vigorous competition. I wonder what you think about that.

  Mr Metter: Actually the bidding process in the UK has been very, very expensive and it has meant that for some of the larger projects only the biggest organisations have been known to compete and many big overseas organisations have come in such as Skanska, Bouygues, Vinci, Siemens, big US and European corporations who are able to bear these very high bid costs. It is also true that many of the big UK contractors, Balfour Beatty, Laing, Carillion and other sorts of large contractors have been able to stand the bid costs.

  Q473  Lord Forsyth of Drumlean: Just before you move on, the evidence we have had was that on average there are two or three bidders in any process. Is that correct or not?

  Mr Metter: There are now. There used to be five or six bidders and it was very inefficient. If you were one of five bidders, how much were you going to spend on a bid, especially since, under the UK process, there is a tendency for too much to be required at each stage of the process. Well that is our view. Certainly if one looks at the market in Canada and in Sweden they do these projects at much, much less cost.

  Q474  Lord Forsyth of Drumlean: Does that make it less competitive?

  Mr Metter: I do not think it makes it less competitive, if there are fewer bidding costs.

  Q475  Lord Forsyth of Drumlean: If you only have two firms bidding for a large project rather than six, because, in your own words, the process has become so expensive and cumbersome, to a laddie like me that would suggest there would be less competition. Is that wrong?

  Mr Metter: The thing is that when you get down to two, remember each bidding group is a consortium of a number of contractors, service providers, banks and lenders so it is not one organisation against another. Each of those organisations is going to spend a lot of money. A big hospital bid would cost up to £10 million to bid and in the UK if you lose that you just lose your £10 million. In Canada they actually pay it to you. If you get down to two, they pay the losing bidders bid costs because they are sensitive to these sorts of issues. It does not affect competition. Why should three be better than two when you are getting down to the final stages of a competition? They will always eliminate on the way.

  Mr Davies: Things to avoid. There are two sides to that. I have been in many bids when you are just two and that does not stunt competition at all because you have no idea what the other bidder is doing and you want to win so you are as competitive as you can be. If you are bidding with four or five, you will spend less money until you get to the final knockings and you have been narrowed down because the probability is so much lower. From the public sector angle, if you do too many it is going to detract from the attractiveness of your competition. There is however a risk of only doing it for two bidders and that is particularly if you are doing contracts where there are a number of them around the country because there are not unlimited contractors there and they choose their project. If you are relying at an early stage that some people will stay through the whole of that bidding process, you might be taking an unnecessary risk and end up with one bidder. So on some deals, at an early stage, you will probably have more than two, because you do need two to tango. In the final knockings, if you are down to two, you will get extreme competition. It does not dent it and, for all the reasons David gave, that is fine and you will get strong competition.

  Mr Metter: It is important to recognise that in these projects price is not the only major variable. Design is an important variable and so is quality. In the early stages of PFI where there was too much emphasis on price we ended up getting a lot of schools that were built like sheds. They were not good civic amenities and there was a lot of unhappiness about that. In the bidding process, people often tend to think price, price, price, but it is certainly not that. Once you are building big landmark buildings like, for example, our project at Barts, the design is hugely important because these projects are going to be there for 100 years or so. The ability to design these projects well is also very important and also attracts a high level of competition.

  Q476  Lord Griffiths of Fforestfach: May I ask what you think are the pros and cons of using a ring-fenced special purpose vehicle to finance, little equity, large debt and so on, as opposed to some other model?

  Mr Metter: A special purpose vehicle means that that project and its risks are ring-fenced from other projects. If you put everything in a pool, if one of them goes badly wrong, it is going to taint all the others. The way the finance will come in will mean it will be more corporate in nature than project. That has certain problems with it, especially if you want contractors to take a stake in the project and you want to have different stakeholders in different projects. It is much better to keep these projects separate from each other. That is our view.

  Mr Davies: You can transfer ownership, there is a focus on due diligence by the lenders on the project risks; there is a focus directly on that one project, it is not lost in a morass; you can maximise the amount of debt, which is a cheaper form of capital because the markets are used to it, they are used to it in project finance worldwide. You can very focusedly pass risk out to sub-contractors. In the earlier session you were saying that equity means not much risk transfer, but that is not true: it is just passed through under that structure to a number of sub-contractors and it is a model which has been proven outside PFI for 15 years before we even started PFI.

  Q477  Baroness Hamwee: May I go back to two points which we have been covering? The first is on competition. We are all used to the concept of a preferred bidder, but can you just continue the explanation of whether competition remains and whether the bidder is actually in a very advantageous position because by the time—I cannot think of the term for the person who wants the project—the procurer is with a preferred bidder it seems to me that there is very little negotiating scope left on the procurer's side. Is the preferred bidder not in a hugely advantageous position?

  Mr Davies: Two points there. First, under what is now known as the competitive dialogue, a lot of the competition and the definition of what is required and the pricing, is done with more than one bidder. It is not just the preferred bidder. The new directive means that it is taken far longer down the line which has on the one side the adverse effect on bid costs but on the other side is removing the risk you have described. In theory, when you select that preferred bidder, so much has been bottomed out. In practice there can still be quite a lengthy time with that preferred bidder then delivering the project. The key negotiation strategy you have is that they have given you your bid, they have given you your price and you are trying to deliver within that price. To the extent that there is any change from that price thereafter, it is normally only for reasons which are outwith their control. For instance, if the debt market price has increased, which I have had on some projects, their price goes up and it is a straight pass through. It is something you can observe; you know that it has been imposed on them. So your negotiating power is holding them true to the bid that you agreed when you made them preferred bidder and that tends to be tied down pretty tightly.

  Q478  Chairman: In your experience, have you ever seen the price come down when these external factors vary?

  Mr Davies: Interest rates falling, absolutely. Indexation of bids; sometimes the actual price we agree with a preferred bidder has an indexation to RPI or consumer index or whatever which can go in either direction. Yes, it can come down. Recently, because of what has happened in the price of funding, it has gone in the opposite direction because that has been pushing it from a funding point.

  Mr Ewer: There have been examples in the past as well where the price has come down because a preferred bidder has been appointed, even though their price is unaffordable and then there has been what you call a value engineering exercise to descope the project post preferred bidder and if you take scope out the price does come down.

  Q479  Baroness Hamwee: We have heard from a number of witnesses that innovation is a benefit of private finance projects. We have heard this afternoon that they are best suited to the sort of projects where there is experience and one knows what the project is about really. I do not know whether there is a conflict between those two and whether you can provide examples of significant innovation.

  Mr Metter: I think that significant innovation, certainly at the practical level, is not apparent very much any more. This has to do with risk transfer issues because when projects and delivery become very innovative the price attached to that is often beyond the Government's affordability. When PFI started there was this innovation dimension to it, but it very quickly walked away. I am sure there is innovation down at very, very technical levels. There are hospitals where there are innovations on ward design but it is at a very, very detailed technical level. If you took people round and they were not experts in hospitals, they would not really notice that. Certainly the main innovation is the PFI process itself and its development and the financing and contractual nature that has been built up over the last 10 or 15 years.


 
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