Q381 Lord Eatwell: Whilst on risk, do you think that extraordinary review clauses in private finance projects are a problem or do they have an important role to play, particularly in large scale projects?
Mr Bolt: My answer to that would be that in a contract with all the features and complexities we have talked about for London Underground you would not have got the deal away without the extraordinary review provisions because of the risks and the fact that things can change even within a relatively short period, the seven and a half year periodic review period. Whether that fits comfortably with a fixed project finance contract structure I think is the more important question and I think if you look at the experience of Metronet clearly there were differences of view about how that extraordinary review mechanism should work which meant that it was left far too late before it was operated and Metronet going into administration was virtually inevitable. It turned out to be a failure because of the way the mechanism worked, not, I think, because of the existence of the mechanism.
Q382 Lord Eatwell: I am very struck by the use of the phrase "we would not have got the project away" in a sense that that suggests this is, if you like, a subsidy to the private sector. Let me explain why. The project is supposed to be transferring risk and what you are effectively doing is capping the risk which will be carried by the private sector and so you are giving them a little sweetener in risk mitigation terms in order for the project to be taken up. Is that right?
Professor Glaister: I think that is right and I think it is a small part of a wider and very poisonous feature of what has happened in some PFIs, namely that a structure is set out which intends to transfer risk as you must-the whole point is to transfer risk, if you do not do that then you are lost-and then at a late stage in the negotiation, because there is a commitment to close a deal but it is turning out to be more expensive or whatever than the original terms, there is a negotiation which reduces the risk to the private sector before the deal is finally signed. That happened, I believe, with the Underground PPPs; it certainly happened with the Northern Line trains deal and a number of other things. So there are things that are negotiated at the last minute that reduce the exposure to risk to the private sector to get the cost of the thing down, but that is another way of saying you hide the cost to the public sector of the risk. If you allow it to be opened up under review contracts later on that is how the thing is dealt with. In view of what we have said it is helpful to have some re-opener, but either it is a 30 year commitment or it is not, and this whole thing depends on there being some kind of solid 30 year commitment to repay the debt which has incurred in building the kit in the first place. I think the re-openers can only be quite a small feature of this. That is a big difference from traditional-if I can call it that-regulated industry where there is not a contract as such and every period of time, typically five years, the regulator can see where we were expecting to be, where are we now, where will we expect to be over the next period of time and what is a reasonable settlement given where we sit now, not what was expected a number of years ago when the contract was signed
Mr Bolt: That is the particular difference between the Underground PPP structure and a typical regulated utility structure where the price review is effectively a fixed price contract for that five year period unless certain specified things happen, so if there is a change of law or a new cost for digging up the road or something those are often allowed as specific adjustments to prices. With the PPP there is a general re-opening; it says that any change in the efficient level of costs is potentially eligible for extraordinary review apart from in the case of the Metronet companies it is the first £50 million which is effectively 1% of the value of the contract, in the case of Tube Lines it was the first £200 million.
Q383 Lord Eatwell: I find your comparison with regulated industries very intriguing because in my field, which is financial regulation, you change it all the time. It is not even a question of waiting for distinct intervals; if something turns up you change the regulations.
Professor Glaister: Yes, and that is always open to a utility regulator. By convention they tend to do things every five years unless something goes horribly wrong, but they can and do vary that interval. If the cost of capital changes very suddenly and a company is no longer able to finance its activities, then the legislation typically requires a regulator to re-open it and to make sure they can finance the activities at the going rate.
Mr Bolt: The statutory duty is about enabling companies to finance their activities. I use the phrase "a fixed five year contract" unless there is something major that changes. In the case of the water companies, one water company recently tried to say that we need that interim emergency price control; it went to the Competition Commission and the Competition Commission basically said that provided you can get through to the end of this pricing review period and things can get picked up in the next pricing, you should not make an adjustment. That is a much more effective transfer of risk to the private sector than a more open-ended mechanism of the sort we have got with the Underground PPP.
Mr Allen: I think the specifics of the extraordinary review mechanism are unique to the London Underground PPP contracts. I am not aware that they feature in any other PPP or PFI contracts. I think that arises from this attempt to create a hybrid between a project finance contract and utility financing. I think that was doomed to failure from the start.
Q384 Lord Griffiths of Fforestfach: If you were going to have, as in the London Underground PPP, reviews every seven and a half years as was intended, what is the benefit of that kind of model as opposed to conventional privatisation/regulation model?
Mr Bolt: Can I kick off on that one? As you know, I was in ORR in the period from 1994 to 1999 when the Underground PPP structure was being developed and in the Office of Rail Regulator we said why not set this up and regulate it in the same way as the national rail network and the answer seemed to come back, "Because we are going to do it differently".
Professor Glaister: In my opinion the regulated utilities system-which is now a vast sector of the economy-has worked spectacularly well. There are all sorts of things we could quibble about but fundamentally the system of regulation has done what it was supposed to do whereas the Underground PPP with its fixed reviews is not working as well, if I can put it like that. So I do not recognise the premise of your question.
Q385 Chairman: Given the escalating costs of many of the transport PFI deals and the large optimism bias built into the public sector comparator, are estimates of the efficiency of PFI options like to be overly optimistic? Let me just spice up the question a bit by adding, was the efficiency benchmark set for the London Underground PPPs too stringent?
Mr Allen: If I can start with a specific point on the value for money comparison on the London Underground PPPs, those were 30 year contracts, as you know, with seven and a half year review points. All of the bidders who bid for those contracts effectively priced seven and a half year firm prices knowing that they could re-price at those subsequent review points and yet the value for money comparison was done on a 30 year basis even though you only had firm prices for seven and a half year. If you looked at the value for money comparison over the seven and a half years for which you had a fixed price those contracts were not value for money. I think there was something fundamentally wrong with the way that assessment was done when the contracts were signed.
Professor Glaister: I do not know enough about it but I wonder about the phrasing of your question which says "given the large optimism bias built into the public sector comparator". I do not know that is an established fact.
Q386 Chairman: "Large" being the word you are wondering about.
Professor Glaister: Or any. Plainly, if you are going to make this kind of choice between doing it in-house or doing it with the private sector you need some kind of comparison of the two things. You obviously need that. I do not know whether it has been established independently that the public sector comparator was largely biased.
Lord Moonie: Our witness from the National Audit Office said that in only one case that he could think of where the public sector had been more expensive than the private sector had it not been for optimism bias not being built in.
Chairman: We have heard a lot of optimism bias. Lord Moonie, would you like to take the next question?
Q387 Lord Moonie: An unusual feature of the Metronet contracts was the fact that the bankers recovered 95% of their commitment if the company failed. What, if any, were the economic arguments for this protected status for the banks? What consequences were foreseen? On a personal basis could I just add was this lack of transfer of risk to the banks reflected in the costing of the money provided?
Mr Allen: Since I have already said that I was one of the bank's lenders perhaps I should pick that up. In response to your last question it certainly was not. You might have expected that effectively the pricing of the debt at least was 95% close to a government cost of credit and then perhaps a 5% at a higher risk weighting, and yet the pricing was more like it was a 100% at a high risk weighting. The banks took the benefit of some extremely advantageous pricing there. Again I think it comes back to the point that was made earlier that I think there was a perception at the time that this was what was required, you had three large contracts to design and a limited appetite in the bank market to provide that debt and they wanted some contractual underpinning in order to take on those risks. I am not sure that the economic arguments were very strong; I think it was more a pragmatic argument of what you needed to do in order to sign a contract. I think it is true to say that the banks being 95% guaranteed did blunt some of the incentives that you usually expect to see from private finance and some of the rigour that you look for in terms of their policing of the contracts. Having said that, I think that can be overstated. When we were negotiating with the Metronet banks-I am talking now about when I was at TFL-we found that they did care about losing 5% of their money so the idea that they just walked away and washed their hands of it is not actually the case. I would say that when somebody says that in order to get these contracts away we need to be able to offer this sort of underpinning to the banks that is telling you something about the complexity of the structure that you are trying to let and that should be a very strong warning light that this is not a contract that can be let to the market on a sensible basis.
Professor Glaister: I think that is right. This bank protection was not in the original design; it was drafted in at quite a late stage fundamentally to get the contract away. I think it raises a wider question about the balance of equity and debt in these kinds of arrangements. The theory is that if there are shareholders and their stake is at risk they will be prudent in making sure the company performs efficiently. That is the fundamental thing. There is only 35 million of equity in the Metronet contracts. Mr Bolt: It was £350 million for the two.
Professor Glaister: Thank you. It was a small proportion of the total, that is my point. At the point when the government was deciding whether to close this deal or not I think the advice was that the incentives to perform are so strong that this contract could never fail and in fact those incentives were very substantially blunted by this 95% underwriting of the debt, which was most of the private sector investment.
Mr Allen: Stephen's point about the capitalisation of PFI and PPP companies is very important and not limited to the experience with Metronet. Croydon Tramlink is another example that we have managed where effectively because the shareholders have a very limited amount of equity in the company there comes a point when actually they would rather let the company fail than continue to support an investor. The risk you transfer effectively to the company is limited by the amount of equity that the shareholders put in in the first place, and if the risks that the company is trying to bear are larger than that it may be that shareholders walk away from it. That is certainly what happened with Metronet, they said, "Fine, we'll just face losing our equity; we've effectively had profitable sub-contracts, we can lose our equity and not be too concerned about that".
Q388 Lord Tugendhat: Can I jump a little bit and ask whether you believe that investment in transport infrastructure has been greater as a result of the use of PPP than it would otherwise would have been?
Mr Bolt: I think a factor which has probably led to some increase in expenditure has been the longer term framework that has been established to enable, in the case of TFL, the longer term TFL financial settlements, so a commitment from government to programmes of investment which are similar to the experience on the national rail network with the five year commitment that it reflected in the 2005 Railways Act. I think you could get some of that without a PPP structure as, in a sense, the heavy rail example demonstrates.
Q389 Lord Tugendhat: What about in other spheres? Do you think that we have more new hospitals than we would have had if it were not for the PPP? There is a suggestion that Chelsea and Westminster might not have been built if it had not been for PPP.
Professor Glaister: I think that was entirely a matter of choice of the government of the day. It was always open to them to have borrowed the money in the way that governments borrow money normally, separately from the contract for the provision of the buildings and the provision of the service. For all sorts of reasons the government of the day chose to do it that way rather than this way. The ultimate cost to the tax payer is about the same-you could argue it could be higher or lower-it is just the timing that is different and the transparency is different. It was a fact that for a long period authorities could not get their hospitals or their roads unless they had a PFI deal of a particular kind; the Treasury just did not allow it. That was a choice the Treasury made; there was nothing fundamental that said they had to do it that way. There were issues to do with the public balance sheet which I rather think was spurious but was an issue at the time. There were advantages to do with whole life costings but, as I said, you could have got that in any case. It was just a particular way of doing things which the government chose and there were alternatives. After all, when the PPP for the Underground was signed, Steve Allen and his colleagues were allowed to borrow £3.1 billion on the markets of public debt in the normal way to fund all sorts of other things, proving there was that alternative there.
Mr Allen: I think things have moved on. At the time the London Underground PPP contracts were signed it is quite clear the Treasury would not have committed that level of funding to the underground under anything other than a PPP structure and that is partly because of the experience of things like the Jubilee Line extension where there was a concern that public sector was not good at managing large capital projects. Since then we have developed long term funding agreements with government and prudential borrowing has come in for local authorities who have the ability to borrow on their own account and the long term nature of those agreements allows you to plan your activities and finance them in that way. I think we have moved on, but at the time I think you had not had the PPP structure investment would have been at a lower level.
Q390 Baroness Hamwee: Mr Allen used a phrase-I might not have got this absolutely right in-in the context of the Underground PPP "all of the bidders". I wanted to ask whether, in the transport field there is real competition or is the pool of bidders really rather limited bidders really rather limited?
Mr Allen: I think it depends on the particular assets you are looking to procure and also related to the complexity of the contracts. If you are looking for something relatively straightforward in terms of road construction or maybe track laying on the railway, there is probably quite a depth of the market there. Some things are more specialised: train manufacture, signalling and equipment. I think one of the potential problems of PPP and PFI structures is that you bundle together a disparate group of services and people have to form consortia and therefore you do not necessarily get the best bidder for each particular class of asset, but again I think if you break them down into smaller more sensible groupings then you can generally get sufficient depth of competition. I would say there is another warning light as to how you structure the contract: if there is not sufficient interest from the market then the market is probably telling you something about the way you have structured the contract.
Professor Glaister: It is an international market. The capital markets are very international; the management market is very international. We have several train operating franchises essentially owned by German and Hong Kong professionals. The equipment is entirely international so I do not think there is any difficulty about getting competition as long as, as Steve has indicated, what is offered for competition makes sense.
Chairman: We are out of time, but thank you, all three of you, very much indeed for a stimulating session.