At the Committee of Public Accounts hearing on Wednesday 23rd June, the Committee requested a number of notes which I am pleased to enclose.3
I thought it might also be helpful to the Committee if I set out why I consider the PPP contracts do represent good value for money. As the National Audit Office (NAO) Report notes,4 the Department's objectives for the Public Private Partnership were to obtain private sector investment and expertise to modernise the Tube, while guaranteeing value for money for passengers and taxpayers and safeguarding the public interest, in particular safety.
London Underground's (LU) infrastructure is widely acknowledged to be a large and complex asset base that has suffered from many years of under investment and is in need of modernisation and additional capacity. This is highly challenging in engineering terms as it requires existing services to just under one billion passengers a year to be maintained, while carrying out improved day to day maintenance and the capacity enhancements and upgrades needed, all within very limited engineering hours.
The PPP bidders had to deliver better value for money against the public sector alternatives, as measured by the public sector comparator. These were tested against a bond option, even though it was not available to LU, as well as more conventional funding. The public sector comparator provided a range of prices over the 30 year contract period. LU's conclusions depend on the Infracos delivering the expected level of performance with sufficient economy and efficiency to offset the higher private sector borrowing costs. As the NAO Report explains5 "The costs [of higher borrowing] will be covered if the PPP delivers about one third of the performance benefits considered in bid evaluation.". It should also be noted that the premiums charged by lenders are in line with the rating agencies' independent assessment of correct market rates. Consequently, the lenders' premiums reflect the real levels of risk faced on the non-guaranteed portion of the finance provided.
To provide assurance that the PSC developed by London Transport was fair; the Department commissioned Ernst & Young to review the overall robustness of the value for money assessment. This included reviewing the methodology, the assessment of risk retained by LU in the PPP contracts and that transferred to the private sector, consideration of financial and non-financial factors in the overall value for money assessment, and the overall robustness of the conclusions reached. Ernst and Young concluded that the methodology adopted for assessing value for money "had been robust and appropriate". KPMG, LU's own auditors, also undertook a methodology review of the PSC and confirmed that HM Treasury's guidance had been adhered to, as well as auditing the financial model and related sensitivities.
The bids for the PPP contracts offered higher performance than LU in some areas, as well as additional enhancements. In order to deliver the returns quoted for the shareholders the Infracos will need to have much stronger control over costs and full project planning than LU had previously managed to ensure work is completed to time and budget. The Central Line upgrade of the 1990s was six years late, failed to meet capability targets and was 31% over budget. If just one of these failings were repeated by an Infraco under the PPP contracts for an upgrade, then its rate of return could easily be halved for the full 30 years of the PPP contract. If all three aspects were to be repeated on a line upgrade, then the Infraco would make very low levels of profits for the life of the contract, and these would only be available if the Infraco delivered all its other upgrades successfully. Project and integration risk has genuinely been transferred to the private sector with the Infracos heavily incentivised to manage it well.
Across the 30-year contract, there are periodic reviews and the independent PPP Arbiter provides assurance on value for money by determining at the outset of each review period the economic and efficient price for delivering the services required by London Underground. Only if the Infracos achieve these levels of service and deliver them within the price set by the Arbiter will they achieve their target levels of return on equity.
NAO comment that there is only limited assurance that the price is reasonable, largely because there is uncertainty about what that final price will be. However, detailed analysis showed the PPP to be cheaper than the alternatives in delivering like-for-like outputs, while the Arbiter ensures prices remain reasonable in the long term. Consequently, while there is uncertainty about the long-term price, I am confident that it will offer better value for money than the alternatives. Greater price certainty would have increased the cost because bidders, faced with a fixed and inflexible contract, would have based their cost estimates on a worst case scenario to ensure a return. This would have reduced value for money, as acknowledged by the NAO.6
Finally, although large, the costs of the transactions are not excessive given that they were for 30-year contracts to maintain and upgrade large and complex infrastructure. The negotiations took longer than anticipated as the NAO Report acknowledges and this increased the costs for all parties. Without the PPP, LU would have had to negotiate separately a potentially very large number of other contracts to provide the maintenance, modernisation and capacity enhancements that the PPP will deliver. These would all have had their own transaction costs and it would have left the risk of integrating and co-ordinating all the workstreams entirely with LU.
David Rowlands
Permanent Secretary
9 July 2004
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4 Paragraph 1.1 of NAO Report " London Underground PPP: Were they good deals? "
5 Paragraph 2.44 of NAO Report " London Underground PPP: Were they good deals? "
6 Paragraph 4b of the Executive Summary, NAO Report " London Underground PPP: Were they good deals? " .