Setting up the contracts

1.5  The Government announced in March 1998 that it would restructure London Underground's business to create:

■  a publicly owned operating company (London Underground Limited) with responsibility for running trains and stations and setting fares; and

■  three new companies, owned and operated by the private sector, which would be responsible for maintaining and improving infrastructure such as stations, trains, track and signalling under PPP contracts with London Underground.

1.6  The Government believed that stable funding was needed to remedy decades of underinvestment, but was concerned about London Underground's track record in delivering major projects and maintenance to time and budget. There had been substantial cost overruns of over 30 per cent on the Jubilee line extension and the Central line upgrades. Neither project was completed on time or delivered the expected improvements in journey times. The Government therefore sought to transfer risk for delivering the network upgrade to the private sector, with contracts that specified the time, cost and required performance.

1.7  The Government provided funding for the modernisation on the basis that the work would be carried out through PPP contracts. It decided that London Underground should focus on operating passenger services and the private sector should be used to deliver maintenance and major improvements to the infrastructure. DfT, the Treasury and London Regional Transport (LRT) were responsible for the strategy and the design of the contracts. LRT, which then owned London Underground, was controlled by the Secretary of State for Transport. The contracts were for 30 years, with provision for London Underground to re-specify its requirements at 7½ year intervals. There was no provision for voluntary termination of the contract on a no fault basis, as is usually allowed under PFI contracts.

1.8  The procurement competition began in June 1998 when London Underground sought bids for three different groups of lines:

■  Jubilee, Northern and Piccadilly lines (JNP);

■  Bakerloo, Central, Victoria and Waterloo & City lines (BCV); and

■  Sub-surface lines (SSL) comprising the District, Circle, Hammersmith & City and Metropolitan lines, and until its closure the East London line.

1.9  A consortium called Tube Lines won the contract for the JNP lines. The contract was finalised in December 2002. A consortium called Metronet won the two contracts for the BCV and SSL lines and two companies, Metronet BCV and Metronet SSL, were created to carry out the work (Figure 2). Metronet's contracts became operational in April 2003. In 2002 prices, work under these contracts was expected to cost at least £16.9 billion over 30 years, £6.9 billion over the 7½ years to September 2010 (£8.7 billion in cash terms). In July 2003, London Underground was transferred to Transport for London (TfL), a body created by the Greater London Authority Act 1999, which was given responsibility for most aspects of London's transport system.

1.10  Metronet was jointly owned by five shareholders: Balfour Beatty plc, Bombardier Inc., WS Atkins plc, EDF SA (formerly Seeboard Group plc) and Thames Water plc. Metronet guaranteed subcontracts for capital works to its shareholders. This arrangement, known as a tied supply chain (Figure 3 on page 14), aimed to guarantee the availability of resources at a firm price. Tube Lines followed a different 'shopping around' approach based on procuring goods and services through open competition.

1.11  In return for the maintenance, investment and upgrade of the Underground's infrastructure, Tube Lines and Metronet received a four-weekly payment from London Underground called an infrastructure service charge (ISC). These payments varied depending on performance against four key metrics:

■  'availability' measured the reliability of the tube network under Metronet's control;

■  'capability' measured the capacity of the tube network under Metronet's control;

■  'ambience' measured the customer experience of the trains, platforms and station facilities under Metronet's control (as assessed by 'mystery shoppers'); and

■  'service points' measured delivery against a number of varied contractual obligations such as the speed with which service faults were rectified.

1.12  DfT provided grant funding of some £1 billion per annum to TfL, to finance payments by London Underground to Metronet and Tube Lines. This sum was divided broadly into some £600 million for Metronet and £400 million for Tube Lines2.

1.13  Metronet BCV and SSL each had access to £1,325 million of private debt finance alongside £175 million of equity and shareholder loans. TfL was guarantor of 95 per cent of Metronet's borrowing should an act of default occur and DfT had given assurances to Metronet's lenders that the Secretary of State would not stand by should London Underground be unable to meet its financial obligations.

1.14  Metronet's capital works programme (in cash terms) included:

■  £1.2 billion to refurbish, enhance and modernize 150 tube stations to a contractually agreed specification by 2012;

■  £620 million to refurbish assets such as bridges, tunnels and embankments to meet asset condition benchmarks by 2010;

■  £460 million of track upgrade work to be carried out generally by 2010; and

■  £2.8 billion of signalling upgrades and rolling stock including the design and manufacture of over 1,700 railway cars by 2018.

1.15  As the condition of some of the assets transferred to Metronet was unknown, the contracts allowed for £360 million of contingency to cover extra costs.

1.16  During the first 7½ years of the contract, Metronet BCV and SSL both had to absorb the first £50 million of extra costs each (the materiality threshold), with all further economic and efficient costs being met by the public sector. The Tube Lines' PPP contract operates differently. Tube Lines has to absorb the first £200 million of extra costs before the public sector becomes liable for further economic and efficient costs in the first 7½ years of the contract, reducing to £50 million for subsequent periods.

1.17  The Greater London Authority Act 1999 created an independent PPP Arbiter, who could decide, when asked by parties to the contracts, how much Metronet and Tube Lines could be paid for necessary extra work he deemed economic and efficient. This could involve undertaking detailed investigations, and the Arbiter was therefore given the discretion to consult widely and to obtain any relevant information he needed. He could make his determination at either the Periodic Review at the end of every 7½ year period of the contract or between periodic reviews in the following ways:

i  Annual reporting - In the case of the Metronet companies, the Arbiter was expected to report every year from 2004-05 onwards on whether they had performed their activities in an overall efficient and economic manner and in accordance with good industry practice. As part of this process, Metronet had the opportunity to ask the Arbiter for specific direction on the extent to which any extra spending that it had incurred was economic and efficient and therefore liable to be reimbursed by the public sector.

ii  Extraordinary Review - Metronet could request an Extraordinary Review, which would involve the Arbiter determining whether the timing and level of payments to Metronet were appropriate. The Arbiter would do so by deciding what level of costs would be incurred by an economic and efficient company performing the same obligations as Metronet, and comparing this cost estimate to costs actually incurred or forecast to be incurred by Metronet. London Underground also had the ability to call for an Extraordinary Review where there was a substantial shortfall in Metronet's performance. A review requested by London Underground would have, however, been restricted to restating the terms of the contract to address shortfalls in Metronet's performance, or removing contract terms in order to reduce the cost of the work. It would not have extended to determining whether Metronet's extra spending was economic and efficient.

iii  In addition, London Underground and Metronet could also ask the PPP Arbiter for guidance on any matter, and the PPP Arbiter also had further powers under the Greater London Authority Act 1999 to do anything he considered necessary in connection with giving direction or guidance.

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2  Source: London Underground Limited, London Underground and the PPP: the third year 2005/06, July 2006.