84. I should like to start where Mr Williams left off with the public sector comparator. On page 24 it breaks it down by category and there is a list there with the base costs, then the risk, presumably at millions of pounds, then the risk as a percentage of the base costs. You will see in the first line it says capital expenditure £208.6 million, risk £61.5 million, risk as percentage of base costs 29.5%. Could you say how you came to 29.5%?
(Sir Kevin Tebbit) There is a range of possibilities. I think the method used is known as the Monte Carlo method. I am not an economist but if any of my colleagues can give us more detail on that.4
85. Do you mean it is like going into a casino and you just throw the dice and see what happens?
(Sir Kevin Tebbit) That is what the economic model is, but it is a way of trying to make sure there is a fair, open and, as far as one can judge, thorough way of looking at risk around these figures.
86. With buildings like this, these sorts of projects, and we looked at the Treasury building only yesterday, the public sector comparator always seems to come out just slightly less competitive so that you go the PFI route. I have just calculated that if you changed that 29.5% to 29% it would swing it the other way. It would go from £61.5 million to £60,494,000, a difference of £1,600,000 the other way, just by changing that from 29.5% to 29%. It is a totally arbitrary figure. I see Mr Trickett nodding. He worked in the building trade. It says capital expenditure, but I am sure you could finesse more than half of 1% without too much difficulty. By just changing your figure from 29.5% to 29% I have suddenly switched more than one million pounds. You only had a difference of £100,000. I have already changed it tenfold the other way by flicking one figure by half of 1%. Do you agree with Mr Colman of the National Audit Office when he said, as was reported in the FT recently, that describing this public sector comparator as a basis for making decisions is really rather spurious?
(Sir Kevin Tebbit) I would not say it was the only basis for making the decision but clearly it is very important to do it.
87. It was an important basis for making the decision.
(Sir Kevin Tebbit) My Department has to abide by the rules which are set down by the Treasury, which we accept and that requires us to do a public sector comparator using these techniques. I have to say that I am slightly surprised. We have here an NAO Report, which is very positive about the way in which the Ministry of Defence has managed this project. It is a project we are proud of. It is going to give extremely good working accommodation for our people and I find myself under rather hostile attack implying that somehow we have cooked the books in order to do it by a route which members find unattractive. I am sorry, but that is just now how it feels.
88. Can I tell you why? I went to a seminar organised by the Chief Secretary quite recently at the Treasury to talk about PFI generally in a building analogous to this, the Treasury building. I asked a question which Mr Gershon, chairing the session, started answering not by talking about finance but by muttering about rats in the basement. It struck me as a little odd. If there were a sound reason related to the method of financing, he would have started with an answer related to finance and not one relating to rats. We went round the Treasury building yesterday. It is a fine building and I am sure your building will be too and will provide excellent accommodation. What we are interested in here, and I am sure this was the basis of Mr Williams's questions as well, is whether this is the best way of doing it. I tell you another reason why I am suspicious. I put down a Parliamentary Question to the Treasury and said: how much cash are you actually going to pay for this building? There is a term we use in PAC, 'COTD', cash out the door. They gave me an answer. I put down exactly the same question to your Department, I worded it the same way, and, as you know because I wrote to you subsequently, I did not get an answer. In fact the answer I got from the Minister, presumably drafted by a civil servant, said, following an explanation of the complexity of the project, that it was impossible to forecast the overall cash sum which would eventually be paid to Modus. If you could not forecast the eventual cash sum which would be paid, how could you come up with £746.1 million as the net present value of that income stream? You could not have done. I thought that was a bit funny. I went back to you and I wrote to Sir John and I pointed this out and lo and behold, yesterday evening I received another letter from the Minister saying "When I wrote to you on 10 June I perhaps failed to make sufficiently clear the many factors which will influence the final cash figure by the end of the contract period". It goes on a bit and then finally says that the total cash sum, other things being equal, will be at or around £2,415,000,000 over the contract period. That was the answer I wanted, but the fact that it was not given to me initially, is one of the reasons why we get suspicious. Then we read in the Report that in December 1998 bond finance was £25 million cheaper and on page 23 that MOD always thought it was close to signing the deal. When you knew that it was £25 million cheaper, what hedging techniques did you buy in December 1998 or January 1999?
(Sir Kevin Tebbit) There are quite a lot of questions there. May I try to take them in the order you asked them?
89. I am sorry, but could you start with the last one.
(Sir Kevin Tebbit) I am sorry, I do not think I can because I am trying to hold in my head the answers to the questions as you went through. If I may answer you in order. First, and it is important to try to reassure the Committee against any charge of an uneven playing field, that the figures we used on the public sector comparator were on the conservative side rather than the reverse. The current Treasury guidance will say that for projects of £100 million and over we should use a 35% figure as the cost overrun risk allowance. We were using figures lower than that, so we were certainly not trying to make things look less favourable to the public sector comparator. We could have loaded higher figures in and still have been within the current Treasury guidance in their Green Book. We could go through this in some detail, but there would be no way of substantiating a charge that we were trying to go for higher figures to make it look less attractive. On the second point, we have already discussed the bond issue: the question of whether there was a point at which there was a bond which was £25 million cheaper is hypothesis based on a different case. On the third point about the reply from the Minister, the problem there was solely that the actual amount of cash that will go out over the whole 30 years of the project is dependent on a large number of different factors, none of which can be precisely identified. Since you pressed for an answer, we gave you an answer which said we will assume inflation is 2.5% over that period. It would gross up very easily and arithmetically to that figure. It has no greater validity than that. One has to make a judgement about what is value for money at a particular point in time. All the time we are facing those sorts of difficulties of forecasting into the future and making a judgement about a project. That is what we did in this case.
90. I know it was a very complicated question, but could I go to the last part of it about hedging. In January 1999, when the Report said you thought you were close to signing a deal, what hedging techniques did you employ at that time?
(Sir Kevin Tebbit) As a matter of policy, Government Departments do not hedge. That is the Treasury position.
91. It is Treasury guidance that you do not do it.
(Sir Kevin Tebbit) No.
92. You were basically exposed because you did not hedge. Did anybody advise you to hedge in January 1999?
(Sir Kevin Tebbit) I honestly do not know, but I presume not.
93. Could you find out?
(Sir Kevin Tebbit) I assume not.
94. I should like to know what it would have cost to hedge that risk at that time. It went £60 million the wrong way, which is a huge chunk.
(Sir Kevin Tebbit) This is over a 16 or 18 month period.
95. Yes, but what I want to know is what it would have cost you to take out a 12 or 24 month hedge in January 1999?
(Sir Kevin Tebbit) We are back to the basic point that the Government insures itself. It does not hedge.
96. I should love to know, if it is possible to get a comparator of what it might have cost. Could you also find out whether there was any advice? I should be very grateful.
(Sir Kevin Tebbit) I can tell you that there was no advice.5
97. I should like to ask Mr Webber about the refinancing. You said in an earlier answer that you were sure you would have to talk to the MOD. Is it right that the MOD do not have any rights until year 15? Is that the case?
(Mr Webber) There is no specific clause in this project which says we must share the refinancing gains we make. There is an overarching clause which would catch refinancing gains called a value for money clause which strikes after year 15. Notwithstanding that, if we were to try to replace the existing senior debt in this company, we would still have to go and ask for their approval and indeed make changes to the documentation. It is most likely, as other Departments are doing at the moment, that they will turn round to us and say that in consideration for allowing us to raise more money, they would like to receive some of the gains.
98. Do you have any idea how that share would break down? Fifty/fifty would be good.
(Mr Webber) I think we need to be quite clear.
(Sir Kevin Tebbit) We should like to be bolder than that.
(Mr Webber) That has been under debate for some time between OGC and Treasury and the current market norm is expected to become 30%. Clearly that has not yet been established. I should say that this financing is a fixed rate financing. Just like the bond would have been a fixed rate term of the project, this bank debt is also a fixed rate. I should underline this point, that there is not as much refinancing upside as some people might perceive, because it is bank debt and still fixed so the amounts are not necessarily as significant as might be believed.
99. I want to ask about the fees. You said earlier that 1.2% of the net present value of the contract was typical.
(Sir Kevin Tebbit) Yes.
100. Did you mean by that for the whole gamut of fees across the whole project?
(Sir Kevin Tebbit) Yes, looking across the cost of PFI financed projects.
101. Was that more or less irrespective of the size of the contract, give or take? Or not?
(Sir Kevin Tebbit) No, it was not as precise as that. I would not like to start quoting the others. For these sorts of PFI accommodation projects.
102. I shall give you an example. The Treasury building bond was £140 million and the fees were nearly £10 million, about 4.7% in total. Even as a percentage of the net present value of the contract, which was £169 million, that is still a lot more than 1.2%. Is it possible that you could supply some comparators, small, medium and large, to substantiate that? I am not saying you are wrong.
(Sir Kevin Tebbit) I do not want to comment about any other Departments.
103. Especially not the Treasury. I should be interested to see some comparators across a range of projects, small, medium, large, perhaps public/private.
(Sir Kevin Tebbit) I could give you them for the Ministry of Defence.6 If you wanted them more generally, we should have to ask for the assistance of the NAO.
Mr Bacon: It would be nice to have a good range. Thank you very much. No further questions.
_____________________________________________________________________________________________________
4 Note by witness: The Monte Carlo method is a mathematical technique to calculate the overall risk to the project. It is a tried and tested ‘best practice’ approach to the modelling of multiple risks which uses a statistical approach to combine the probabilities of the various risks to provide a profile of likely risk distribution.
5 Note by witness: During the evidence I was asked by the Committee about hedging, in particular about techniques used in assessing the risk from January 1999 to May 2000 and about the advice, if any, that the department had received. In response, I said that it was not Government policy to hedge and I stand by that statement. I would however add that to have hedged against the financing risk associated with bank versus bond finance would have involved the purchase of an ‘interest rate swap’ option. This was not examined in detail at the time, as it would have been against Government policy because use of such financial instruments does not generally provide value for money. In any case, I understand that there was no market for a deal of this size at the time.
6 Note by witness: Fees vary from one PFI project to another depending on the complexity and the in-house knowledge that has been gained. The average for a sample of MOD projects with a total value (NPV) of less than £25 million was 1.74%; for projects between £25-£50 million was 1.43%; and for projects over £50 million was 1.6%.