56. We are told in the Report that Modus's bid of £647 million increased by £99 million over 16 months. We are told this was mainly due to additional building work and increased financing costs. We know that £37 million of it was additional work. Am I right in assuming that £62 million was additional finance cost?
(Sir Kevin Tebbit) Yes, that is correct.
57. 10% of the total cost of the whole project was the cost of the increase in finance alone. 10% of the total price of the contract of £647 million is the £62 million that the finance increased. It is incredible for one element in the whole project to increase in that short time by 10%. Do you not consider it slightly concerning?
(Sir Kevin Tebbit) I do, but it is a fact of life that you have to take interest rate risk as you go through any project.
58. That would be all right. Explain this then. If the £62 million was 10% of the total cost, what percent was it of the financing cost?
(Sir Kevin Tebbit) I cannot give you a quick answer to that. I will have to give you a written reply to that.
59. A written reply will not do for that because it is rather important for the rest of this hearing.
(Sir Kevin Tebbit) With respect, I am not sure that it is, because the total cost still came within the public sector comparator and is therefore still a valid project.
60. We shall come to the public sector comparator in a moment. All I can say is that I am astonished that you are unable to answer that question, but since you cannot, we have to move on. What it means is that the £62 million increase actually made even more beneficial the possibility of refinancing at a later date, did it not? If it went up 10% and if it came down 10% without having done anything at all, there was a potential £62 million windfall from refinancing, in addition to that which was already built into the contract.
(Sir Kevin Tebbit) It does not work quite as simply as that actually.
61. I am sure it is not quite as simple as that, but it is broadly as simple as that.
(Sir Kevin Tebbit) I do not think so.
(Mr Webber) The cost of interest rates for the project was fixed at financial close. In effect one locks into that cost for all time. The gains that the private sector had prospectively been making from refinancing of some of the early projects was where they took the risk and did not lock into long-term interest rates, they left them floating. That has not happened in this particular case, so there is not such an opportunity to benefit from refinancing.
62. This is one of the most dubious situations I have ever seen. Modus fixed its interest rates on the day the contract was finalised. Then bank rate increased on the rate of the final closure. What difference did this make? Does this account for the £62 million?
(Mr Webber) I believe the £62 million to which you refer is the difference in interest rates on the day we submitted our final bid, which was linked with a particular interest rate and then 16 months later we actually made a financial close of the transaction. At that point we locked into a series of fixed interest rates. That was the movement of the cost of interest in the economy over that time.
63. We have this potential enormous windfall but it was dependent on the bank rate movement, the movement of interest rates over the time of the construction when you were subsequently able to go to people with a cash flow and most of the risk gone.
(Sir Kevin Tebbit) Interest changes over an 18-month period.2
64. Yes, I am sure it does. My recollection is that it has been going down rather than up, but perhaps you do not live in the same world as we all live in.
(Sir Kevin Tebbit) I am just saying that this was nothing to do with this particular project, this was the way in which interest rates were moving.
65. It just happened on the day.
(Sir Kevin Tebbit) No, on the day is much smaller than that. On the day is not the £60-odd million, that is the interest rate movements in the economy over a 16 or 18 month period.
66. There is another coincidence. You had to choose between bonds and bank financing. Let us be clear. Is it not correct that bonds do not offer the possibility of refinancing deals?
(Sir Kevin Tebbit) That is correct.
67. We find that in December 1998 your bond finance bid was £25 million cheaper than the bank financed bid, so bond was better. In June you then pressed for a quick decision on the method of financing. Lo and behold, at that time, bond and bank financing were more or less equal, were they not?
(Sir Kevin Tebbit) At the time we took the decision it is generally accepted that we made the right choice. The bond one you are comparing is the specific GCHQ bond, which would not necessarily, and very unlikely, have been applicable in our case because of all the different factors I have mentioned.
68. In that case why was Modus pressing you to reach a decision on the method of financing? They were forcing you to make a decision between bond and bank financing. Either it mattered or it did not. If it mattered enough to them to press for it, surely it mattered enough to you to get it right.
(Sir Kevin Tebbit) We did get it right, but we got it right at the time of the decision. The reason for being pressed to take a decision was because otherwise they would have to have run, and we would both have had to have borne the cost of, two separate processes of due diligence, one for one route, one for another. That would have carried its own cost. I should clarify this business about what happened on the actual day of closure. That was a movement of a few million, about £4 or £5 million, not the great £60-something million which was the movement of interest rates going on over 18 months.
69. I am still worried about the odd £20 million. We regard the odd £25 million as more than loose change.
(Sir Kevin Tebbit) So do I.
70. We have a situation where bond had been £25 million cheaper; according to the National Audit Office the bond deal had been £25 million cheaper.
(Sir Kevin Tebbit) I am afraid that is not correct.
71. National Audit Office, is that not what it says in paragraph 22 of your supplementary brief?
(Sir Kevin Tebbit) I think it would say it is hypothetical based on GCHQ's own bond which cannot be compared with the very different project we were running. That is the point.
72. Then I do not see why it was relevant to raise this. Was it or was it not £25 million cheaper and did it then not become £25 million cheaper some months after they had struck the deal?
(Mr Colman) We are necessarily in the world of hypothesis because the price of a bond is whatever it is on the day and it is extremely difficult to predict in advance what it will be. So Sir Kevin is quite right in saying that this particular £25 million relates to what this bond would hypothetically have cost if it had been possible to obtain it on exactly the same terms as the GCHQ bond.3
73. That is exactly what it says here and that is just what I said and I was told that it was not true, that it was not £25 million cheaper.
(Mr Colman) It is certainly £25 million on that hypothesis. The doubt and the debate is whether that hypothesis is valid.
74. They then press to get a deal at the one time when it so happens the bank financing is more or less equal to the bond financing and they wanted bank financing because the financial interest offered the opportunity of refinancing and windfall profits. Then having entered into their agreement, a few months later, lo and behold, it was back to virtually the same £25 million differential. This looks a bit suspicious.
(Sir Kevin Tebbit) I am afraid I do not follow your logic.
75. That is all right; other people will. Finally, let us look at the public sector comparator. When Modus became preferred bidder, it was estimated the price would be £25 million less than the public sector comparator.
(Sir Kevin Tebbit) Yes, that is correct.
76. That then converged until they became more or less the same if you take the average of the PSC, which was £746.2 and the final price which the PFI arrived at was £746.1, 0.01% lower than the average public sector comparator. That seems a slight coincidence, does it not?
(Sir Kevin Tebbit) As I have already explained, the reason for that being so precise is because of our own tactics on the last day of closure when we found the spot rate adding to the cost of the project when we were concerned to get the bank finance in place. We negotiated £4 million off the price in order to strike the toughest deal we could. That is why it is as close as you have just described. To all other purposes, it is purely coincidental that they came out close and the PSC comparator is within a very wide range of around £100 million. All one can say about this is that broadly speaking the two routes were about the same in terms of cost.
77. The point is that what we are told is that for negotiation and presentational purposes, MOD placed emphasis on the deal price of £746.1 million being slightly lower.
(Sir Kevin Tebbit) Precisely.
78. For presentational purposes.
(Sir Kevin Tebbit) Negotiation is the first word there.
79. In other words it would have been higher if it had not been that for presentational purposes you persuaded them to reduce it.
(Sir Kevin Tebbit) It would have been higher had we not negotiated that bit off at the end.
80. What comes through at the end of the day is that everything is done to cook the situation where the public sector comparator is never going to be playing on equal ground. We are then told that once you have negotiated for any length of time the public sector comparator becomes virtually irrelevant because it costs you too much to go back and start negotiations again.
(Sir Kevin Tebbit) We do not have a preference for one route or the other. We make judgements on the basis of value for money. We judged that in terms of cost, these were about equal, but we attached importance to those other factors I mentioned at the beginning which give us better value over the project. It is very useful to have a fixed price and know that is what we are going to be paying year on year and not more. You only have to look at this building itself to see what happens when you have cost overruns. We have been so used to cost overruns, so it is very good, I feel very pleased to be able to know that I am not going to be paying more than £55 million a year on this thing. It is also very good to know that it is going to come in on time. If it does not, these people lose a lot of money in payments. There are other qualitative factors which I have seen as I have gone round and these are the things which led us to make the decisive judgement. We have no instinctive affection for PFI as such, it is just that in some circumstances it offers us a better value for delivering the services we need.
81. It just so happens that never have we come across a case which has come before us where the public sector comparator has actually won the argument. This is a difference of 0.01%. I remember another case where the difference was just £1 million out of hundreds of millions of pounds, but in some miraculous way it always turns out that the elements which are quite nebulous which go into the public sector comparator always give an adverse public sector comparator. Can you think of a case where it has not?
(Sir Kevin Tebbit) The preponderant expenditure that the MOD makes is by conventional procurement not by PFI. PFI is a very, very small element in our overall capital and procurement spend. We only do this where it is value for money.
82. I do not suppose you buy a Eurofighter by PFI. It might be a good deal if you could get it there.
(Sir Kevin Tebbit) No, but we might buy a tanker service.
83. In that case what is the point of relating it to the entire Ministry of Defence budget. It does not have anything to do with building which is where most of these arise. I have finished now, Chairman, it is a waste of time.
(Sir Kevin Tebbit) Not in our case actually. We do use PFI for things other than accommodation. We are considering tanker services from aircraft to refuel others in mid air for example. We do look at it for other things as well. It is a small proportion.
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2 Note by witness: As the preferred bidder was selected in January 1999 and the contract was closed in May 2000, it was in fact a period of 16 months.
3 The figure of £25 million referred to is described in para 2.29 of the C&AG’s Report. It is the estimate made by Modus in December 1998 of the potential saving from the use of bond finance.