10. Under the terms of the London Underground PPP Agreements, Infracos are protected against changes in costs (or loss of performance revenue) subject to three conditions:
- the protection only applies to the extent that the Notional Infraco would also have faced increased costs: cost increases due to inefficiency are therefore borne by the shareholders;
- Infracos have to absorb the first £50 million of additional efficient costs in each Review Period,3 although this risk is reflected in pricing; and
- decisions on what cost increases are allowable are taken by the independent Arbiter, if not agreed with London Underground, which introduces a (limited) measure of "regulatory risk".
11. Where cost changes arise within a 7½ year Review Period, an Infraco can make a reference to me for Extraordinary Review. I then judge how far the cost changes reflect those of the Notional Infraco, and determine the change in the ISC payable by London Underground to cover the allowed cost increase which is in excess of the Materiality Threshold.
12. Although, therefore, the PPP is intended to transfer the risk of inefficient delivery to the private sector, the effectiveness of this transfer depends on the ability of equity holders to absorb this risk. This is turn depends on early identification of inefficiency, enabling the Infraco to take early corrective action. In the case of the two Metronet Infracos, the scale of inefficiency was identified too late to allow for such corrective action, and the interim increase in ISC which I proposed to allow in my draft direction of 16 July 2007 was insufficient to maintain their viability. My decision reflected my assessment that the bulk of the cost increase being experienced by Metronet was the result of inefficiency. As a consequence, the Infracos went into PPP Administration on 18 July 2007. The resulting cost to the taxpayer was identified in a recent NAO report.4
13. One lesson from the failure of Metronet which is relevant to the issue of risk allocation is that Metronet and London Underground appeared to have different views of what risks each party was taking. Given the definition of the Notional Infraco, for example, costs omitted from Metronet's bid were still a risk for London Underground if efficiently incurred, although London Underground originally argued that such omissions were a Metronet risk. This difference of understanding contributed to the delay in addressing cost overruns beyond the point where corrective action could be taken.5
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3 This Materiality Threshold was £200m for Tube Lines in the first Review Period only. A £50 million Materiality Threshold represents about 1% of the contract value.
4 The Department for Transport: The failure of Metronet, 5 June 2009, HC: 512 2008-09
5 "It also seems clear that there have been differences of understanding between Metronet and London Underground about the allocation of different risks under the contract. In particular, the cost consequences of increases in the scope of work required to deliver obligations are mostly borne by London Underground; only the (low) Materiality Threshold and the cost consequences of delivering inefficiently are borne by Metronet. Thus, even where sums were omitted from the original bid, or disputes about contractual requirements have been won by London Underground (such as whether Low Loss Conductor Rail for the Victoria Line was an original obligation or not), London Underground still has to bear the efficient increase in costs." (Extract from my written evidence to the House of Commons Transport Committee, The London Underground and the Public-Private Partnership Agreements, Second Report of Session 2007-08, HC45.)