NAO analysis of TfL's proposals and London Underground's findings

Part 1 of the NAO Report shows that in discussion of the design of the PPP there was analysis of public operations combined with private funding (paras 1.9-1.10, 1.17). This analysis showed that such an option would only have been possible with Government backing, which the Government was not prepared to offer, in part because the Government wanted private sector direction of the expenditure in the belief that it would thereby be more effective.

Paras 2.41-2.44 discuss the possible savings from TfL's approach (updated in April 2003 to represent £5 billion of bonds at 5.29%) compared with Metronet's actual financing structure. Ernst & Young, as para 2.42 Reports, considered that any such saving should be treated with caution in project selection. In particular if the cost of capital (5.29%) is lower than the discount rate at which TfL make the comparison (8.65%), discounting the cash flows appears to reduce the public sector cost. This would imply that the more money that is borrowed by the public sector, the more value for money would improve. It is partly for this reason that Ernst & Young, correctly in London Underground's view, dismissed the relevance of bond financing comparisons, as they felt that in all circumstances an element of distortion, which they termed arbitrage, would occur.

Arguably the risks to a project under public sector management might outweigh the benefit from cheaper finance-and have certainly done so in previous projects. Instead of letting a lower public sector borrowing cost act as a form of arbitrage or subsidy to a project, Ernst & Young asked how much the public sector might save in the costs of carrying out such a project if annual grant funding were to be replaced by long term stable funding. Ernst & Young then estimated the potential saving from such stable funding at some £825 million. On London Underground's analysis the Committed Finance Offer bids for the PPP remained value for money after reducing the estimated public sector cost by this amount of saving.

Para 2.43 identifies that the debt and equity financing structure agreed under the PPP costs £90 million more annually than the estimated cost for TfL issued bonds, two thirds of which is related to the cost of equity and is dependent on performance under the PPP. Para 2.44 estimates the annual extra cost of the private debt borrowing as £30 million. This debt cost is generally payable regardless of performance. The extra cost has to be considered against an assessment of the benefit of risk transfer and scrutiny of the project by private lenders.

Bond issues were not available to London Underground because the Government attached priority to bringing in private sector responsibility in the manner envisaged by the PPP. The scope for improved value for money compared to the option adopted would depend on public sector efficiency under the bond option compared to private sector efficiency under the PPP option.

Questions 79-85 (Mr Bacon) and Questions 166-168 (Mr Trickett): transaction costs incurred by London Underground and the PPP bidders

The additional information is provided by the National Audit Office in the form of three tables, together with notes and commentary, including the Department for Transport's commentary (where indicated).

1.  The first table18 provides, in one place as requested by Mr Bacon (Question 80), a chart of transaction costs with further breakdown on the composition of bidders' costs. The commentary following the first table describes the scope of work undertaken by the lawyers acting for London Underground and the scope of work undertaken by Price Waterhouse (subsequently PricewaterhouseCoopers) as financial advisers.

2.  The second table19 provides supplementary information on additional firms used by London Underground. The named firms account for some £18 million out of an aggregate expenditure of £26.5 million over six years, during the corporate reorganisation that preceded the PPPs and during the procurement of the three concessions. A further £4.5 million was not identified to specific firms, covering items such as the "Project Office Costs" and "External Contractors", and the balance of£4 million was spread across an additional 50 to 60 organisations and individuals.

3.  The third table20 provides supplementary information on the unsuccessful bidders' costs, naming the principal firms of lawyers and consultants involved.

The supplementary information is cross-referenced to figures in the Comptroller and Auditor General's Report "London Underground PPP: Were they good deals?" (HC 645). In that Report Figure 12 sets out the external advisers' costs and Figures 13 and 13a on pages 30 and 31 chart the progression of London Underground's costs over time.

Question 166 (Mr Trickett): He asked for an explanation of why Tube Lines, bidding for one contract, had been reimbursed more than Metronet which had bid for two contracts. The reasons why Tube Lines incurred greater costs (at £134 million) than Metronet (at £116 million) have been provided by the Department.

Tube Lines' bid was the most advanced during the later stages of the transaction process. As the contracts were negotiated, developed and completed earlier they incurred greater costs in agreeing contract principles than Metronet. This work was incorporated into the two remaining contracts thus reducing transaction costs on the Metronet bids where agreed terms could be incorporated from the Tube Lines deal. Further financial savings were also available from having a single bidder for the two final contracts which avoided some inevitable duplication in costs had separate bidders been selected.

There are two main components within the bids as paid where Tube Lines costs are substantially larger than Metronet. The first of these is the reimbursement of£7 million that Tube Lines received for their unsuccessful bid for the Sub Surface contract. Metronet received no such fees, being successful in both its bids.

The other substantial difference is in pre-contract operational activities and the creation of business plans ("Transition Team resources"). These costs were some £21.5 million for Tube Lines, compared to £2.4 million for Metronet, reflecting the different make-up of the consortia. Tube Lines were required to prepare supply contracts prior to the close of the deals and built up resources capable of letting the necessary contracts to deliver their performance obligations during their negotiations. This required Tube Lines to undertake greater preparation than Metronet to ensure that these arrangements were satisfactory before the PPP deal could be completed. Metronet, on the other hand, included their supply chain within the consortium, and were not required to undertake a similar level of preparation before deal close because contracts had already been arranged with the supply chain.

This does not necessarily mean that the costs for Metronet were less, because the Metronet supply chain will have incurred substantial costs pricing their respective obligations and in particular performing the necessary due diligence to be able to offer fixed prices. But those costs would be included in the overall fixed prices offered to Metronet by their suppliers. In this way those costs are also contained within the Infrastructure Service Charge paid by LUL, although not separately identifiable.

Without the PPPs, as the Accounting Officer told the Committee, London Underground would have had to negotiate separately potentially a very large number of other contracts. In most other contracts bidders' costs are not separately identified but included within the deal price.

Table 1  BREAKDOWN OF TRANSACTION COSTS SUMMARISEDIN"LONDON UNDERGROUND

PPP:WERE THEY GOOD DEALS?" (HC 645)

Source:

London Transport Board approval November 2002 and NAO analysis.

1  The first time period closes with selection of Preferred Bidders (May and September 2001). Detailed break-down over time in Figure 13 of the NAO Report.

2  Fees to Arthur Andersen and PA Consulting principally covered reorganising London Underground into three Infracos and one operating company.

3  Further Metronet bid costs after November 2002 were 50% reimbursable subject to a £3 million cap-applied to the bid team resources line. Final legal fees took Metronet's out-turn to £117.9 million after completing their financing in April 2003.

4  "Transition team" activities include a early operational activities during the extended period before closing the transactions and the creation of Business Plan.

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18 See Ev 36-39

19 See Ev 37-38

20 See Ev 38-39