74. Page 10, paragraph 1.18, there is no need for me to quote the paragraph but if you read the paragraph it is very interesting, is it not, because really this does sum up the whole of the PFI, does it not? In fact it is the whole basis of the PFI, is it not? If the private sector do not get a big enough rate of return they are hardly likely to be interested in the project to begin with. They are only in it for the rate of return, are they not? There are no altruistic reasons why they are in it.
(Mr Gershon) The assumption is they are not charitable organisations and they are there to make a reasonable rate of return, as this report identifies.
75. Right.
(Mr Gershon) On the other hand, they are in the business, not just in terms of what they do for the public sector but with other customers as well, of providing high quality products, goods and services because if they do not do that they will not make reasonable rates of return and they will not prosper as private sector organisations. The rate of return is a consequence of taking business decisions and good management action.
76. For example, the hospital in Durham has just been completed under PFI, my understanding is the contract was based on the fact that there will be returns for shareholders of something like 20 per cent. If you are building into a contract that the shareholders are going to get 20 per cent dividends, somebody has to be paying more money than the project is worth in the first place, if we were in the public sector.
(Mr Gershon) I do not want to get into the deep water we did at the GOGGS hearing about the complexities of some financing issues, about what is the make up of a return and wherever a return is necessarily commensurate with a dividend.
77. Presumably if a contractor is building into a contract the fact that he must get 20 per cent return for his shareholders, it must make the contract more expensive than it would have been if it was built in the public sector. You do not need 20 per cent.
(Mr Gershon) Mr Steinberg, let me try to explain this issue about the cost of finance. I still remember the debate we had here a couple of weeks ago. It is absolutely true that money costs the public sector less than it costs the private sector.
78. Yes.
(Mr Gershon) Typically, if you are a sort of credit worthy private sector organisation, it costs about two and a half, three, four percentage points more than it costs the public sector. You are having to fund the construction cost of a project which is, over the life time, typically around 20 to 25 per cent total project costs. That is making overall about a one per cent difference. If you take that extra to three to four per cent of 20 to 25 per cent it is less than one per cent difference. If that was the only thing then why would you do it but the whole point about having the private sector focussing on not only construction responsibility but having to take whole life responsibility is it should be able to find efficiencies that far outweigh that additional cost of money.
79. At the end of the paragraph it says: "The Office of Government Commerce is reviewing value for money and levels of return the private sector gets on its investments...". Why would it be doing that if it did not think the actual rate of return was too high in the first place?
(Mr Gershon) Because as the market matures and the risks become better understood by the private sector and the market develops, you would expect to see that the rates of return are diminishing over time more towards the sorts of averages the private sector would earn in other market sectors. That is the piece of work that I commissioned, to see whether that is happening in practice. That is what the theory says should happen and I am interested to assess whether it is happening in practice. You would expect on the early contracts that the return the private sector would make, provided the project was successful, would be higher than they would be making in a mature market. We should also bear in mind that some private sector organisations have lost an arm and a leg on PFI contracts. They have not all gone swimmingly well for the private sector.
80. That is probably an argument they should not have been built in the private sector in the first place. They should have been built in the public sector.
(Mr Gershon) No, no, no.
81. I have no great sympathy for that argument.
(Mr Gershon) The private sector have also lost money on conventional procurement as well.
82. I want to come back to that later on, to what happens when that does go wrong. Let me just continue down this track just a little bit more. The PFI and public sector development, I understand over a 60 year period would probably cost about the same but over a 30 year period the PFI is much more expensive than a public sector project, is that right?
(Mr Gershon) Are you making that statement about the particular hospital project in your constituency?
83. No, generally.
(Mr Gershon) No, that is not true. That is not true as a generalisation.
84. It is not true?
(Mr Gershon) No.
85. Is it true about the hospital in Durham, just as a matter of interest? You brought that up, I did not.
(Mr Gershon) I would very much doubt it. I do not know the detail of the public sector comparator but I would doubt it.
86. What happens if you find there is an excessive rate of return, what would you do?
(Mr Gershon) As a result of the study?
87. Yes?
(Mr Gershon) We would need to look at what steps we would need to take to introduce more competition into the market place or what other factors might be driving it. It might be that there are some particular risks we are seeking to transfer which the private sector is putting a very, very high premium on which is not justified and it might be better to advise the public sector client to bring that risk back into the public sector. There could be a variety of reasons. I cannot be specific about it. I just illustrate two of the possibilities that might be taken if the scenario that you have outlined comes to pass.
88. In your review will you be trying to discover if the project is making higher dividends than you thought in the first place and those dividends are cutting services, will you find that out in your survey?
(Mr Gershon) No, no. This is looking at rates of return, it is not an attempt to correlate that with the quality of the service that is being delivered.
89. Do you not think you should? My point is if high levels of rates of returns are being produced then they have to be paid for somehow. The only way I can see them being paid for is a cut in the service.
(Mr Gershon) Let me try to explain. When you bid a fixed price for a contract, irrespective of whether it is PFI, any sort of asset based contract where you have to bid in some way a fixed price, firstly you have to estimate what your costs are then you have to look at the risks you are taking and price those risks. You have to set aside contingency money against those risks occurring.
90. Yes.
(Mr Gershon) Firstly you have to win the contract, you have to put a price on the table, you now win the contract. If you manage those risks very well you do not use all your contingencies which will lead you to a higher than anticipated rate of return. If you have got your estimating wrong, that may erode your contingency, it may consume all your contingency, in which case you are now into a position known as loss.
91. Then you have to pay for that loss. How will you pay for that loss?
(Mr Gershon) You have only got a fixed income coming in.
92. Exactly.
(Mr Gershon) Yes.
93. That is what I am saying.
(Mr Gershon) But the client has remedies against the contractor for failure to deliver the contracted level of service because you get deductions under the contract for poor performance.
94. What you are saying is regardless of the performance of the contractor and regardless of the dividends that are made, this should not affect the service?
(Mr Gershon) The client has the lever to enforce the contractor to perform and deliver the contracted level of service. If he does not his losses just get worse.
95. Perhaps we are not going down the same track here. Let us just take the hospital as an example. If that hospital has to pay the contractor a certain amount of money per year, let us say £12 million a year, what ever it maybe.
(Mr Gershon) For a contracted level of service?
96. Right. That is for the building.
(Mr Gershon) No.
97. Not for the service?
(Mr Gershon) No, no.
98. They do not provide services?
(Mr Gershon) They will provide hard facilities management.
99. Yes, they will provide, perhaps, the car parking and the portering.
(Mr Gershon) No.
100. They do not provide the clinical services?
(Mr Gershon) No, no, no.
101. The point I am trying to make, if you will listen, is if the hospital has a certain budget and they have to take from that budget to pay for the contract, at the end of the day that contract is more than was anticipated because they then have to find extra money to pay the extra payments, where will that money come from?
(Mr Gershon) The extra payments are not triggered by the contractor making losses. I am sorry, although it is true in the hospitals clinical services are not within the scope of PFI, the contractor will probably have an obligation about the maintenance of the ambient temperature inside the building.
102. Right.
(Mr Gershon) He will provide soft FM services like catering, laundering, portering, i.e. the non clinical services.
103. Absolutely.
(Mr Gershon) Right. He contracts. There are key performance indicators in the contract which define the contracted level of service. If the contractor does not achieve that he gets debits off his payments for failing to meet the contracted level of service. If he has already made losses, because he got it wrong on the building, that is tough luck, you do not get extra money, that is one of the great benefits of PFI.
104. I hope that is right. My understanding and information that has perhaps been given to me, it might be biassed information, is that at the end of the day if the hospital, out of its budget, has to increase its payments to the contractors -
(Mr Gershon) Because the contractor has made a loss?
105. Yes. Then they have to find that money from somewhere else and that means cutting services.
(Mr Gershon) Mr Steinberg, if you pass me that information, I am very happy to follow that up and personally come back to you on that.
106. Okay. We will move on. I am almost out of time. That cannot be right. Is it not a fact, the way I look at it, that the track that Jon was going down is absolutely right? Basically you are bound to say, if asked, it is value for money because at the end of the day you have no other option but to say that because there is no other avenue you can go down, therefore you have to justify it. At the end of the day there is only one way that a major capital project can now be built and that is through PFI.
(Mr Gershon) Sorry. It is not the case that is the only way of building capital projects.
107. Can you tell me a hospital that is now being built under a public sector contract?
(Mr Gershon) There are one or two traditionally procured hospitals.
108. Where?
(Mr Ryan) Can I just clarify. I cannot give you the names off the top of my head but I know that very recently on four hospitals in the NHS which had been due to be built under PFI it was concluded that after careful examination it was better to do it through conventional procurement. That is what is being done. That illustrates the fact that the public sector comparator is used properly.
(Mr Gershon) Mr Busby has just mentioned in my ear that he thinks that the one on the Isle of Sheppey is being done through traditional procurement, not PFI.
(Mr Busby) It fits the definition.
Mr Steinberg: I had six pages of questions I wanted to ask you, I have asked one and a half.
Chairman: You can come back at the end if you want to. Mr Rendel, unusually, has now found his reference to the question he was asking Mr Busby so he wants a very brief question to him before he leaves.