2.39 In December 2000, we reported on the public sector comparator exercise then being used as part of the assessment of the value for money of the bids. When, some 12 months later, the Board of London Regional Transport took the decision to proceed with the PPPs, public sector comparator figures were available to them alongside, as we had recommended, analysis of the wider benefits and risks associated with the deals. But, as in many cases, value for money was difficult to demonstrate objectively and London Underground's and Transport for London's financial advisers made public strongly contrasting assessments of the value for money analysis of the PPP bids.
2.40 The Public Sector Comparators were subject, as we had shown and London Underground acknowledged, to considerable inherent uncertainty and therefore gave only limited assurance about the reasonableness of the prices quoted by the bidders. At the time of Committed Finance Offers, the Secretary of State considered it important that he had his own independent opinion on whether the value for money analysis of PPP bids was robust. In that light, the Department took on Ernst & Young to provide an independent review of the analysis in October 2001.
2.41 Ernst & Young scrutinised and generally approved the public sector comparator methodology finally used by London Underground in reporting to the Board (the Final Assessment Report) - but re-emphasised that the outcome would depend on the performance factors that had been assessed and quantified in terms that did not represent different monetary payments. In particular, Ernst & Young noted that London Underground's social cost adjustments (relating to passenger benefits) increase the cost of the public sector option by 9 per cent and decrease the cost of the private sector option by 5 per cent, giving a net movement of £2,100 million. London Underground updated the analysis in December 2002/January 2003. In the final comparison transaction costs and the financing costs of senior debt formed part (around £1,000 million) of the cost of the PPPs, mostly costs which public sector borrowing would not incur. It is important to quantify wider factors, both positive and negative, and to identify any range of uncertainty. Considering the present value of expected (including non-cash) benefits against a present value of costs is then a standard part of transport investment appraisal.
2.42 Ernst & Young advised the Secretary of State that any potential saving from granting a public sector London Underground access to the bond markets, based on Transport for London's credit rating, would be an arbitrage saving, meaning that it would be a form of subsidy from outside the project. In their view this would distort project selection. Instead they favoured an allowance of £825 million that they considered would represent the potential benefit, in the form of lower costs, to a public sector project given access to stable funding. On this basis the CFO bids, as analysed by London Underground, also offered value for money. Before closing the deal with Tube Lines, the London Transport Board considered an updated overall assessment of the PPP, reflecting changes to the deal since contracts were signed in May 2002. These changes included revised inflation assumptions and the fact that the PPP contracts would now start later than originally assumed. London Underground carried out its analysis on an Infraco basis, with JNP at 31 December 2002 prices, and BCV and SSL at 31 March 2003 prices showing that the bids, as adjusted for expected performance over 30 years, were assessed at lower levels of cost than the levels estimated for the public sector.
2.43 Transport for London updated their estimate of the cost of funding the entire transaction through £5 billion of bonds that they were advised could be issued at a market rate of 5.29 per cent per annum, based on rates in April 20037. This form of financing was not open to London Underground as a policy option (see para 1.17) and this limits its value for benchmarking purposes. This exercise took the composition of the financing of the Metronet transaction as a proxy for all three deals before the Tube Lines refinancing outcome became known. Based on a weighted average cost of total Infraco funding (debt and equity) of 7.15 per cent per annum, their analysis concludes that the annual financing cost of the actual structure is £90 million higher than their preferred structure. About two thirds, or £60 million per year, of this extra cost is variable and would not be payable, or payable in full, in the event of poor performance or repayable in the event of termination. This potential cost specifically rewards some £620 million to £725 million that bears equity risk in the actual structure. A benchmarking exercise in this form also assumes that there would have been bond market capacity for the full amount and this is not necessarily the case, although issuing bonds in phases would have mitigated this risk.
2.44 London Underground's findings depend on the Infracos delivering the expected level of performance with sufficient economy and efficiency to offset at least those higher borrowing costs that are payable regardless of performance. Such higher costs can also be estimated by taking Transport for London's bond cost benchmarking calculation and applying the resulting lower cost of funds only to the senior debt element that does not take material project risk. On this test PPP performance will have to make up for annual costs of £30 million on an amount of senior debt financing of £4,450 million. This annual cost would reduce by about £10 million if no senior standby debt is drawn down. These costs will be covered if the PPP delivers about one third of the performance benefits considered in bid evaluation.
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7 In March 2002, Transport for London made detailed proposals for a public sector bond alternative and this paragraph is not, and is not intended to be, a summary of those proposals. These bond proposals are not analysed in detail here because we find the benchmarking exercise more relevant in looking at the costs of the financing that was actually raised.