In February 2002, TfL proposed raising £2 billion to £3 billion in part by bonds secured on the London Underground fare box ("Asset Backed Bonds") supplemented by bonds based on TfL's corporate good quality investment rating (which it expected to be rated as AA or high investment quality). These proposals formed part of a different public sector approach to modernising the Tube which was set out in the Mayor's Transport Strategy published in April 2001.
Several advantages were claimed for this approach to modernising the Tube which TfL claimed had been used to turn around systems in Boston, Philadelphia, New York City and Toronto:
- gives local government the financial means and full responsibility;
- provides stable funding, largely independent of annual grant negotiations (with capital funding segregated from operating budgets);
- management skills, including certain project skills, are retained in house and hold private sector contractors (handling large-scale resource intensive projects) to task; and
- lower borrowing cost than PPP, as further described below.
TfL's advisers recognised that raising the total amount would need five to seven years of Government financial backing for the bonds through grant provisions. In response to the objection that bonds would not lead to the transfer of risk to private sector shareholders, TfL argued that risk transfer could instead be achieved through rigorous contracts with the suppliers of infrastructure improvements and services, without having to pay an equity risk premium across the entire project. TfL also argued that their retained project risk under the PPP was equivalent to the project risk under their preferred structure.
On this basis TfL estimated that its proposals would lead to a saving in financing costs of£36 million to £84 million per year. About one-third of the saving would arise because of higher PPP borrowing cost (rated at a low investment quality or BBB) and the other two-thirds from saving the cost of remunerating PPP equity at around 20% per year. A further unquantified potential interest cost saving could arise if bonds were only issued in tranches of£500 million as and when funds were needed (but there would be a risk of lack of market interest or of the necessary support from central government at the time).
Transport for London estimates of financing costs:
Cost of financing (excluding fees) | February 2002 | 4 April 2003 |
Estimated average cost of PPP debt and equity | 6.7% to 8% | 7.15% per year |
Cost of AA rated corporate bond financing | 5.2% to 5.5% | 5.29% per year |
Differential in cost of finance | 1.2% to 2.8% | 1.86% per year |
Assumed amount of financing | £3,000 million | £5,000 million |
Annual cash differential | £36 million | £93 million |
Source: Estimates based on publicly available (Bloomberg) market data. The calculation based on the market rates and the terms achieved by Metronet in April 2003 is referenced in the NAO Report "London Underground PPP: Were they good deals?" paragraph 2.43 (page 26).