Increased cost

2.14  In the second half of 2008, soon after the appointment of Connect Plus as preferred bidder, the credit crisis left Connect Plus attempting to finance the project in a very uncertain banking market. Banks had fewer funds available to lend and, as we have recently reported, the cost of long-term project finance increased signifcantly.10

2.15  The Agency remained keen to award the contract before the end of 2008, and worked with Connect Plus to obtain financing from a club of 16 banks. By December 2008, banks had only offered around half of the financing required. The Department offered to lend up to £500 million to bridge the gap. This offer was beneficial in closing the deal. It demonstrated to banks that the Agency was committed to the deal and had a contingency plan to support the deal. This helped to deliver market confidence for completing the private financing of subsequent projects across government but, as our recent financing report showed, these projects bore much higher financing costs than before the credit crisis.

2.16  The price of the contract increased by £662 million from a present value cost of £2.7 billion when Connect Plus became preferred bidder to £3.4 billion at contract letting (Figure 7). The Agency and Connect Plus worked hard to obtain financing terms broadly in line with market terms following the credit crisis.11 These were, however, much more expensive terms than before the credit crisis and accounted for £444 million (67 per cent) of the price increase. The interest margins for project risk increased from an expected 0.7-0.85 per cent at Preferred Bidder stage to 2.5-3.5 per cent at contract letting.

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Figure 7 Increase in price between Preferred Bidder and contract award

NOTES

1  2007 prices.

2  Using a discount rate of 3.5 per cent.

3  For example, base rate movements, swap margins and reserve requirements, and changes to the ratio of interest to income.

4  In non-discounted cash terms, the contract price increased from £7.4 billion to £9.6 billion.

Source: Highways Agency

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2.17  The remaining price increase of £218 million mainly related to changes made by the banks to reduce their risk. They reduced their risk by requiring:

•  Connect Plus to increase its price to take into account the risk of higher inflation above the retail price index on labour and energy costs over the life of the contract. This had a present value cost to the Agency of around £80 million over the life of the contract.

•  Connect Plus to increase its ratio of income in relation to debt service costs. The Agency is paying Connect Plus more to enable it to meet this requirement, but there is a rebate mechanism which will enable the Agency to recover these additional payments assuming the project performs satisfactorily.

•  Connect Plus's shareholders to increase their investment from £106 million to £200 million with a fall in their internal rate of return on equity from 17.8 per cent to 15.0 per cent.

2.18  The Agency accepted other risks which it had planned to transfer to Connect Plus. It estimated that it is likely to incur a present value cost of £68 million from these risks. This extra cost is not included in the contract price.

2.19  The Agency negotiated a 50-90 per cent share of refinancing gains, depending on the size of the gain. The Agency saw this as an innovative sharing mechanism which gave the potential for a higher government share than the Treasury guidance which, since the credit crisis, has expected a 70 per cent public sector share. There are, however, constraints which make it, in our opinion, improbable that the Agency would achieve more than a 70 per cent share given likely future financing conditions. There is no certainty that refinancing will take place, but if it does, we estimate it may allow the Agency to recover potentially around £100 million through its refinancing gain share. This is lower than the Agency's estimate of £200 million.

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10 Financing PFI projects in the credit crisis and the Treasury's response HC 287, July 2010.

11 Treasury response to the credit crisis, HC 287, July 2010.