1. In May 2000, the Ministry of Defence (MOD) signed a deal costing £746 million over 30 years with the Modus consortium (consisting of Innisfree, Laing Investments, and Amey Ventures Ltd.) for the redevelopment of Main Building, MOD's London headquarters. The deal, procured under the Private Finance Initiative (PFI), is for the redevelopment of Main Building, and maintenance and facilities management thereafter until 2030.
2. On the basis of a Report by the Comptroller and Auditor General1 the Committee took evidence from MOD and Modus on three main issues: the extent of financial savings from this deal; the comparative costs of financing deals under the PFI and conventional procurement; and the risks associated with the long term PFI contract.
3. Our key conclusions are:
• Closer attention to financing costs would have been particularly helpful during the 16 months it took MOD to close the deal. Reducing the length of that period, postponing the choice of finance to the end to get the cheapest form available, and a cannier approach to the financing markets prior to closing the deal all might have helped to secure savings on this project. MOD's last minute negotiations formed the basis of the claim that this £746 million project is expected to yield savings of just £100,000. It would have been more productive for MOD to focus earlier on the pressures that increased the price of the deal by £99 million after Modus became preferred bidder, of which £60 million was attributable to financing costs.
• Financing costs form a significant part of the cost of a long term project, and departments should ascertain how the costs of using private finance compare to other forms of procurement. The Department could not tell us what the extra costs of private finance were in this deal. The value for money case for PFI depends on it bringing benefits that outweigh the extra costs of private finance, and can only be ascertained if those extra costs can be estimated.
• Departments need to think through their future needs to avoid the extra time, and possibly costs, of arranging additional contracts for services excluded from a major PFI contract. MOD had to enter into a separate contract for 500 additional staff when it found, shortly before completing the PFI deal, that these additional staff needed to be accommodated in central London. It also excluded from the PFI contract the provision of IT systems, as it was unable to identify the systems that its staff would require when the new accommodation becomes ready in 2004.
• Where future requirements are genuinely uncertain, departments should assess which will be the more beneficial option for meeting them: paying for flexibility within a long term contract, or using other forms of shorter contractual arrangements. In accommodation projects departments will need to assess the risks of being left with too much or too little accommodation. It may prove more expensive to seek additional accommodation in the market than to pay for this flexibility within a PFI contract.
4. Our detailed conclusions and recommendations are:
(i) The public sector comparator gave a central estimate for the cost of a conventionally financed alternative to the PFI deal as £746.2 million, compared to an expected deal cost of £746.1 million. Such accuracy in long term project costings is spurious, and the small margin in favour of the PFI deal provides no assurance that the deal will deliver value for money.
(ii) About £25 million of the £60 million increase in financing costs arose because Modus had planned when bidding to invest surplus cash from a bond issue at short term rates which would be higher than the long term cost of borrowing. The opportunity to invest cash at a profit will not arise now that the deal has been bank financed and may well not have been realised even if the deal had been bond financed in line with earlier proposals. It is imprudent to base the choice of bidder on essentially speculative aspects of financing proposals.
(iii) MOD appears not to have been alert to the risk that it would be exposed to significant fluctuations in the finance costs during the closing negotiations. In similar circumstances departments should consider options for managing this risk.
(iv) Bond finance may have been as much as £22 million cheaper at the time this bank financed deal was closed. Financing costs are a major component of the contract price and the prices of alternative sources of finance can fluctuate over time. Departments should therefore choose the method of financing as late as possible to ensure they can take advantage of the best sources of finance available.
(v) The financing rates increased in the days leading up to closing this deal as the market knew that this large deal, and other PFI projects, were coming to the market at the same time. In successive sales by the Treasury of debt issued by former nationalised industries and of secondary tranches of shares in privatised companies the Treasury became skilful at reducing the scope for third parties to profit from the knowledge that large Government deals were being finalised. The Treasury should consider if this experience could be applied to PFI procurements.
(vi) In addition, the Office of Government Commerce should consider ways in which the timetable for PFI deals reaching financial close can be better managed to avoid different large deals coming to the market at the same time. This would reduce the risk of increasing financing costs due to an excess demand for available long term funds.
(vii) In this deal the MOD deferred full survey work until after Modus became preferred bidder. As our predecessors recommended, making full surveys available to each of the final bidders may help departments achieve more competitive prices for building work. It will also reduce the subsequent period for closing the deal during which departments are exposed to fluctuating financing costs.
(viii) Modus said that it would be open to sharing some of any future refinancing benefits that may arise. MOD and Modus will need to ensure that a reasonable sharing of any refinancing gains is achieved.
(ix) Transparency of financing costs is essential in comparing bids and in considering the merits of alternative forms of procurement. In this deal the way in which financing costs are made up is not transparent and it is therefore not clear whether the returns being made are reasonable in relation to the risks being borne.
(x) Although relative financing costs are crucial to decisions on PFI projects, the approach to investment appraisal normally used by departments does not enable a comparison to be readily drawn between the financing costs of a PFI deal and conventional procurement. The Treasury's investment appraisal approach does not result in the cost of public finance for conventional procurement being explicitly estimated. There is scope for the Treasury to clarify how the financing costs of alternative procurement approaches might be calculated.
(xi) PFI brings some potential advantages, but, as currently practised, involves the disadvantages of extra financing costs compared to conventional public finance. It is not clear that current financing methods for PFI deals are the most efficient or the cheapest. Neither is it obvious why the improvements in risk allocation and management that are said to flow from PFI need necessarily involve expensive private financing.
(xii) The Treasury should examine whether there are alternative financing methods for PFI projects, either collectively or individually, which would lower the cost of external financing. And the Office of Government Commerce should explore the scope for applying to public sector projects the best of the principles of risk management found in PFI deals to enable the taxpayer to benefit from the advantages of PFI whilst avoiding unnecessarily high financing costs.
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1 C&AG's Report, Ministry of Defence: Redevelopment of MOD Main Building (HC 748, Session 2001-02)