Q231 Lord Tugendhat: I think that is a very real world observation. Could I approach it from a different angle. Some of these projects are now so very large and the risks are so very great, do you think that there is actually in reality a great deal of competition for the contracts or is the number of people able to do it very limited? One of the points which came up in the earlier evidence-I do not know if you were here at the time-was that both sides have learned as they go along and that the public sector has learned that the lowest bid is not always the best, and so if one is coming down to who can actually do it, in some cases there must be perhaps only two or even one who are at any given time able to do it.
Mr Morse: That may well be true but of course you have got to deconstruct the contract and think that first of all there is competition for the actual provision and then there might be a party to the contract who is also going to compete for providing maintenance and you have also got the financial competition to conduct, so you are quite often talking about a team who is delivering the PFI contract from the private sector side rather than some super company doing the whole thing. That can lead to a restricted feel. Certainly what I saw, and I will pass to Ed in a minute, was it is important that the competition should be of a qualitative nature and should be very carefully thought out as to what really the drivers of quality are (not just price as you said) in the long run and what are they prepared to agree to in terms of contractual terms, even what I would describe as pre-negotiation of some of those terms. I am sorry, my commercial director bit is showing here. Sometimes you can say, "Look, in addition to the normal competition we expect you to indicate that you would accept certain terms in the contract before we even sit down which will allow us to hold you accountable in rather more tough ways than you might normally expect. Speak now or forever hold your peace. If you do not want to accept let us know and it will be taken into account". There are things like that you can try to apply which may allow you to get the competence. The competence of the organisation who are supplying you and their real ability to deliver is what you need to know. To be honest, the best sort of result is one where the contracting party is really competent to run the contract successfully for you. If you have got a contract that is successful, the thing is constructed or built on cost and on time and the services that come from it are efficiently organised and well delivered, then you may have a bit of a battle about just exactly how much margin they are going to make on it but I do not mind the discussion being around that. When you have really got a problem is when people put in for a contract and they do not have the strength and depth to allow them to resource the contract properly. Then everyone is in desperate trouble and it is all just a question of how much damage all the parties to the contract have to take. So it is worth making certain that the counterparties are really competent and have strength and depth.
Mr Humpherson: Can I just come in and answer the element of the question about the fierceness of the competition and whether that is declining or stable or increasing over time. Perhaps unsurprisingly it is a very dynamic picture. Markets develop; they grow; they shrink. In some sectors we saw in the past quite an illiquid market with not many suppliers and we saw growth. The most dramatic example is in the waste sector and people who build waste facilities for local authorities under a PFI contract. That was a market with very few suppliers as recently as a couple of years ago and as a result of some quite skilled procurement management there are now more suppliers who pitch into the bids. Much the same thing could be said in the schools sector. General construction is pretty much the same as it has always been but there are some areas where you are seeing a trend towards greater concentration. The most striking is in what you might call the after market. Once the asset is built there is a tendency for the original backers of the project on the private sector side to sell their equity to secondary funds who specialise in doing PFI deals and there are fewer of those funds than there were and it is a trend towards concentration. The other aspect where we are seeing some concentration is in financing as a result of financial market problems. We see from the work that we do a general phenomenon that there is less project finance appetite around in the banking sector and as a result it is harder to get these projects funded. There are fewer people putting in less money effectively. That is not to say that deals are not going ahead. It is just much harder and there is less obvious financing competition. So it is a dynamic picture which does not accord to a simple answer I am afraid.
Q232 Lord Eatwell: I would like to turn to the horror stories of IT projects. IT projects seem to go badly wrong whether they are public finance initiative projects or whether they are just public projects and yet IT outsourcing is a really fast-growing part of the private sector and very standardised in the private sector and it seems to work, so what is your view of the relative merits of PFI IT projects and publicly procured IT projects?
Mr Humpherson: I will give a view and then maybe Amyas can come in after me. We tend to talk about IT projects as if there was this one thing called "IT projects" but of course in the modern world so many things which do not have IT on the label are IT-related. One thinks about things in the Ministry of Defence sector to do with contracts to train pilots using simulators. There is a big chunk of IT in those things and I do not think we would have a particular view that that IT-enabled kind of project is particularly inappropriate for PFI. If you look at the projects that you are referring to which seem to have problems, they are where it is not the provision of a bit of kit or a generic service but it is the provision of something which is going to transform business. It is using the IT to change ways of working where there is a whole extended nexus of issues beyond just the kit itself. There is the motivation of the staff, there are the business processes, there is a management culture. In those circumstances, it has proven extremely difficult to write down in a contract all of the risks that might arise and therefore the contractor can lay off for in their plans. I think it is in those circumstances of IT-enabled change projects that you see PFI at its least successful. Just as an aside, it is worth adding that it is not really always the case that those projects fail. There is a general view that IT projects fail but we have done work on IT-enabled change done conventionally which shows that these projects can be a success and they can bring significant benefits to the public sector. However, our general view would be IT-enabled change projects where you are trying to transform a business model is probably the least fertile territory in the whole public sector for PFI.
Q233 Baroness Hamwee: Can I go back a bit to pick up some of your answers to Lord Tugendhat and I will explain why I want to ask the question. The local authority witnesses that we had said very bluntly that what they needed was flexibility rather than being driven to particular models of financing. So does it make sense to assess particular categories as being suitable for PFI or not rather than on a case-by-case basis? I suppose in other words what I am saying is is the focus of this inquiry wrong?
Mr Morse: I suppose you could look at it like this: if you say that you do not know how long you are going to need an asset for, then evidently entering into a contract for a long period of time is going to cost you a lot of money, so if you think you might not need an asset for 25 years and you sign a 25-year PFI deal and you break out of it halfway through, drawing up a contract so that you can do that with relatively little cost, all of this expense has been incurred and you will suddenly have to pay it all at the end. If you really want flexibility you need to go to the whole basis. The same effects would be true if you did not have PFI. If you said," I want to use a building but I may not want it in more than 15 years' time," actually you need to think about the sort of building so that it is capable of being used at the end of 15 years and if you have to write it off or sell it you can do so without too much cost. Certainly if it is a real probability you are going to break out early from a contract, you have to take that into account and not get tied into very long commitments, say on services and things of that sort, otherwise, quite understandably, you will find yourself paying penalties.
Q234 Baroness Hamwee: So you are really saying that they should be thinking about the project rather than the structure but if that is the case, then how do they deal with the fact that credits are available for PFI projects but not for other types of capital?
Mr Morse: I think the answer to that is if their judgment is, "I can only get funding for this under PFI and I must have some degree of flexibility in 15 years' time," that you will pay for that in a higher cost rate earlier on. That may be the only way you can get the project done but you are going to have to pay a risk premium of some kind. You can either pay it early or late. If you do not want the scandal of a huge payment at the end you are going to have to pay more to provide that flexibility earlier in the contract. If you set PFI aside, if you want flexibility, it always comes at a cost.
Mr Humpherson: Can I just enhance that observation to say in answer to your question are you asking the right question, yes, you are, definitely, and in answer to your question is it sensible to look on a project-by-project basis or at whole sectors, I am absolutely with the Treasury on this: you have to do both. I would never want to sit here as somebody from the National Audit Office and say it is okay to ignore the value for money of individual contracts, some of which have very significant capital values, and say that does not really matter so long as it is in the right sector. Of course local authorities, agencies and government departments need to assure themselves of the value for money of whatever contract they are signing, but on top of that the programme approach to say there is a programme of private finance deals in the schools sector or the waste sector or in the accommodation sector or the roads sector, that is clearly sensible because it embeds the learning from one project to the next. Exactly the point Amyas was making about the need for the public sector to mimic the sense that in the private sector you have these people who do these things over and over again. It is absolutely deal-by-deal value-for-money assurance but with the learning sector-by-sector.3
Q235 Lord Moonie: You have mentioned risk transfer. Surely the main problem now with major IT projects is the private sector will not accept transfer of risk? Thinking about Connecting for Health and the desperate attempts of the Government and the NHS to find some way of getting some sort of success out of it, some of the payments that have been promised to some of the companies involved in the London area seem fairly extreme.
Mr Morse: The first thing to say about risk transfer in connection with PFI is that risk transfer in the PFI context generally does achieve some genuine assumption of risk by the private sector that endures even if there is a failure. What it does not do is to say that they will pay for all the costs of putting the project right beyond a certain amount. That is not going to happen. Generally if a project goes badly wrong the biggest counterparty in the situation ends up picking up the tab and most often that is the government because the government quite often is not well-placed to let the project completely fail for all sorts of reasons I will not go into just now, so you find that in the end, if you take Connecting for Health, to let Connecting for Health go completely would be very damaging for a number of reasons, and therefore you are left with a strong negotiating pressure on either side and generally the most substantial counterparty ends off having to provide financial support or let the project fail, so I think that does occur quite frequently. The other difficulty is that in order to really keep out of risk on an IT project the customer has to be very disciplined and not start modifying the requirements of the system. In my experience that is quite rare. Once the customer in process starts saying, "What if you did this? Could you do that?" and once you start interfering in the design of the system, so to speak, and not doing that in a very disciplined way, you start owning the problem and accepting (not deliberately) risk which can be brought back to you. So if you have a contractual fight, your position has been degraded significantly by all of that. I am afraid this is something that private sector companies, and from my private sector experience I am used to this, find difficult to manage and they are probably much more heavily gunned in terms of protecting their commercial interests than the public sector so it is something that needs to be very, very tightly controlled.
Q236 Chairman: While we are on risk transfer and given that most PFIs involve some risk transfer, should liabilities arising from PFI projects be recorded separately in the accounts to other liabilities?
Mr Humpherson: By and large they are actually. Funnily enough, just before coming here I was looking at HMRC's annual resource account and their PFI liabilities are clearly separated out. Indeed, they also give disclosure of the buildings that they occupy which are not on their balance sheet because the risk has been transferred to their private sector partner. In terms of the financial statement of individual entities of government departments, there is reasonably clear separation and disclosure in the vast majority of cases of which I am aware. I think there is a separate point which is how they appear in the national statistics, what are called the National Accounts, which are used to determine figures about GDP for example and public sector net debt and of course that is obviously a question for the statistician. We are an organisation at the National Audit Office which likes disclosure and transparency so I think the more that can be disclosed and the more transparent things are we would support that.
Q237 Lord Moonie: So it is outside your vires but your personal opinion would be that it should be disclosed?
Mr Humpherson: I think it must help the user of whatever set of statements to have that information separately identified. Just to be clear, in most of the financial statements that we audit there is fairly thorough disclosure which separates out the relevant bits.
Q238 Lord MacGregor of Pulham Market: There are a number of specialist PPP portfolio investor funds. Do they bring benefit to the public sector and bring additional funding to the market, even indirectly? Mr Morse: I think the answer to that is they can be a good thing for the market but the risk that you have is that they will use their group capability to extract better terms for themselves and so far we have not seen that involving better terms being passed on to the public sector. So I think they are definitely realising benefits by being there but we have not yet managed to see really effective extraction of a share of those benefits back into the public sector. There are risks as well because when you find yourself with a strong consolidating counterparty they begin to be able to drive more consistently the deals that they will accept and they begin to dictate terms rather more so we could find ourselves facing tougher and more savvy counterparties as a result.
Q239 Lord MacGregor of Pulham Market: Are there any problems about the risk having been transferred from the original provider to these funds and therefore there are difficulties in the acceptance of private sector risk?
Mr Humpherson: I cannot think of a situation where that has been an issue. I think the short answer is no. It could be that there maybe some examples of which I am unaware but I do not think the equity transfer of the shares is really perceptible at the project level. Maybe a letterhead changes perhaps but-
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 projects-a construction firm for example thinking of investing in a future project-that 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.
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3 Having reviewed the evidence provided by the local authority witnesses referred to by Baroness Hamwee in Q233, we would like to add the following additional evidence: We believe that the decision as to which procurement route to use should be made at both a local level, case by case, and on a programme level. It can be important to achieve VFM across a programme to use a standardised approach, and it is sometimes not appropriate to give Local Authorities complete freedom to adopt any approach they choose for a programme that is centrally funded and managed. For example, in our recent report on Building Schools for the Future we set out the argument the Department for Children, Schools and Families used for strongly encouraging Local Authorities to adopt a Local Strategic Partnership (Building Schools for the Future: renewing the secondary school estate, HC 65, 2008-09). But on the other hand, it is possible to provide Local Authorities with a limited menu of choices, which would still achieve synergies and economies of scale across a programme. In part 3 of our written evidence to the committee we set out the way funding and budgeting incentives encourage the choice of off-balance sheet PFI. Again using the example of the Building Schools for the Future programme, the Department is funded on the assumption that 41% of secondary school renewal by capital value across England will use PFI (ibid). If it allows a Local Authority not to use PFI, it will normally seek to ensure another uses more PFI to make up the numbers.