While keen to avoid bearing construction risk, the Department considered the proposed risk transfer expensive but likely to represent best overall value for money

3.19  In 2001, LCR paid £87 million to put the proposal in place. Bechtel received £60 million for arranging the proposal and for carrying a £100 million share of the first £300 million (cash out-turn) of cost overruns in excess of a target construction cost for Section 2, providing overruns were not the consequence of inflation greater than the contractually determined cap of three per cent per annum. The insurers received a £27 million premium for bearing £215 million of overruns for those in the range £300 million to £600 million (cash out-turn) more than the target construction cost.

3.20  Within the 1998 target cost for Section 2 (£2,513 million (1997 prices)), LCR and Rail Link Engineering included a target construction cost for Section 2 that was £2,215 million (1997 prices); a sum their risk analysis predicted had only a 25 per cent chance of being exceeded. This construction target, however, never acquired contractual force. As part of the 2001 Section 2 negotiations, the construction target was increased to £2,714 million (2001 prices). This was a real increase of about £180 million (1997 prices) after allowing for project-related inflation since 1997. This real increase reduced the risk of a cost overrun occurring. Railtrack Group sought a similar increase under its proposal (Figure 16).

3.21  The Department viewed the reward that Bechtel was seeking for arranging the insurance and for increasing its exposure to cost overruns as excessive. The Department was able to negotiate a halving of Bechtel's share of savings below the target cost to 20 per cent, but considered this a small concession.

3.22  The Treasury, however, was, at the time, concerned about the level of railway industry related risk that the Government faced which then included risks associated with Railtrack plc's upgrades of the west and east coast main lines and London Underground Limited's Public Private Partnerships. With these wider risks materialising, the Treasury, therefore, was keen to transfer as much Section 2 construction risk as possible. The Treasury and the Department had concerns that the Department was in a weak negotiating position with Bechtel, but in reviewing the options, the Treasury agreed with the Department that the LCR/Bechtel proposal was likely to represent best overall value for money.

3.23  The Department placed a high value on the increased performance incentives that the LCR/Bechtel proposal imposed on Bechtel and approved LCR's entry into what became known as the Cost Overrun Protection Programme. The programme increased Bechtel's share of over or under-runs against the agreed target. The company benefits financially from any cost saving solutions that it finds and successfully implements (Figure 18) that keeps any overrun below £300 million.