Case Study: The London Underground (UK) (Part I)

The bidding process

The PPP project to rehabilitate and upgrade the London tube was offered to private-sector companies (the so called Infracos) through different contracts involving different parts of the underground network. The responsibility for providing the transportation service to final users, instead, was retained by a public-sector company, the London Underground Ltd. (LUL).

In a first stage, contracts were tendered and the preferred bidders, the Tube Lines and Metronet consortiums (Infracos), were chosen in May 2001.

The PPP was highly criticized, by the Mayor of London among others, in terms of incompleteness of the contract and unclear value for money. Some argued a PPP contract would not be the best way to upgrade the tube system and made a case for the LUL undertaking works by itself. Besides, despite PPP advocates arguing the contracts contained strong incentives to improve safety standards, some critics raised concerns about the effect on safety of the decentralized nature of the London tube PPP project.

The legal and political challenges to the PPP agreement led to large costs for the public sector arising from consultancy services and advisory fees, and to delays in the award of contracts. The uncertainty on contract negotiation and award delays even led bidders to threaten suing the government for the high bidding costs if the PPP contracts were dramatically modified.

In fact, according to the House of Commons' report (2005), the costs incurred by the winning bidders were eventually included in the service charge at the taxpayers' expense. As bidding costs reimbursement, Tube Lines received £134 million and Metronet £116 million. LUL even reimbursed the unsuccessful bidders for their bidding costs by £25 million. In addition, LUL paid £109 million in advisory fees. Still, the poor outcome for all parties of the PPP suggests serious flows at the contract drafting stage.

The PPP contract for Tube Lines was completed in December 2002 and for Metronet in April 2003. Therefore, for at least 19 months the winning bidders were able to negotiate the contract terms. The Tube Lines consortium was awarded the concession for the Jubilee, Northern, and Piccadilly lines. Instead, the Metronet consortium was awarded one concession for the Bakerloo, Central, and Victoria lines, and another one for the District, Circle, Hammersmith & City, and East London lines. Thus, Metronet signed over two out of the three PPP contracts.

The type of PPP contract

The London tube PPP contract was more complex than a typical operation PFI deal. Further, in the London tube PPP there was not a construction phase followed by an operation phase since the contract involved a continuum of work to improve the assets over the contract life. That is, the PPP agreement was similar to a DBFO model with respect to the whole-life cost approach, but building and operation activities were not bundled: the concessionaries would upgrade the existing infrastructure while LUL continued to provide the transportation service.

Risk allocation

LUL kept the responsibility for delivering the transportation service and charging user fees, so that demand risk was borne by LUL.

The risk of cost overruns arising during the contract was shared between LUL and the Infracos. The amount of cost overruns to be borne by the Infracos was capped provided that the Infracos performed in an economic and efficient manner (and it is not easy to prove that a firm does not perform efficiently). The maximum amount of cost overruns to be borne by Metronet was £50 million for the first seven-and-a-half years of the contract; for Tube Line, the amount was £200 million.

The contracts imposed weak constraints on the Infracos' subcontracting arrangements, and this led to incentive distortions in the Metronet case. In Metronet, the shareholders were also the suppliers of the consortium, so they were less concerned about cutting costs down as an increase in Metronet's costs translated into a higher revenue for the supplier companies, leaving shareholders financially unaffected. In fact, large cost overruns were eventually incurred, as it is discussed below.

It was expected that the private financing involved in the PPP contracts would give incentives for the Infracos to efficiently manage the project's risks. However, substantial risk was also borne by the public sector through a debt guarantee granted to the lenders entitling them to receive 95% of their invested funds in case of early contract termination. Moreover, despite the fact that the private financing was publicly guaranteed, the cost of capital turned out to be £450 million above the cost of capital that would have been observed had the project be financed by the government.

Cost overruns

One of the Infracos, Metronet, failed in controlling the costs resulting from the pledged works. It was estimated that the Metronet costs in the first seven-and-a-half-year period of the contract would be four times what had been expected initially when signing the contract. Such cost overruns led to an Arbiter intervention, and the Arbitrer warned Metronet would have to pay £750 million in cost overruns unless significant improvements were made by the consortium. If Metronet were to pay for the cost overruns, the profits earned in the first years of the contract would vanish and heavy losses would arise.

Under this circumstance, Metronet sought to be compensated for the cost overruns arguing it had not signed a fixed-price contract and therefore it should not fully bear the unexpected costs of the project. In addition, the consortium blamed LUL exercising its 'specified rights' to request additional works for the cost overruns incurred. Metronet eventually proposed either to share costs with LUL or to have the scale of pledged works reduced.

In reaction, the consortium was highly criticized for not undertaking the pledged works in an economic and efficient manner, i.e. for not making cost-reducing efforts, thus having no reasonable argument to support its compensation claims. In this regard, a strong criticism arose out of the fact that Metronet implemented a supply chain arrangement whereby most of the pledged works were carried out by supplier companies linked to the consortium's shareholders. According to the critics, this arrangement may have played a role in explaining the Metronet cost overruns since the consortium's shareholders were making profits through the supplier companies and so they had weak incentives to control the Metronet costs. Hence, the supply chain arrangement lacked transparency and was vulnerable to outright corporate abuse. In support of this view, the critics pointed out that no cost overruns were incurred by the Tube Lines consortium, which had implemented an outsourcing arrangement based on competitive tendering and used to stand up to the additional work requirements of LUL.

In the Metronet case, the debate over who should have borne the cost overruns suggests the original PPP contract was poorly designed. In particular, the Metronet's setup by which the interests of shareholders and suppliers overlapped was an unsatisfactory arrangement from the point of view of providing incentives to cost-reducing efforts.

Negotiations between LUL, Metronet, and its lenders

LUL, Metronet, and its lenders have been recently involved in complex negotiations to determine the responsibility over the cost overruns incurred and the implications on the financing of the project. Cost overruns estimations made by Metronet exceed £1 billion, a figure much higher than the Arbiter's £750 million. On the basis of its own estimations, Metronet has demanded LUL for £992 million to cover the past and projected overspending during the first seven-and-a-half-year period of the contract. The Arbiter, however, has rejected such a demand and awarded Metronet only £121 million to cover overspending over the next year.

Metronet is also negotiating with its lenders who have blocked any injection of new financing. Lenders fear the consortium may walk away from the contract if it is obliged to bear the cost overruns incurred. This is because, since the shareholders are liable only for their initial investment (£350 million), they may prefer to let Metronet go bankrupt rather than to bear heavy losses.

Nevertheless, Metronet going bankrupt would be a big problem for the public sector as it guaranteed 95% of the £2 billion debt due to lenders. According to the financial agreements, Transport for London is liable for the debt guarantees if it cannot sell the contract to another company within one year after exercising step-in rights. If it can sell the contract, but the amount collected is less than the guarantees, it has to pay for the difference.

Sources: see London Underground (Part VII).

Transparency of risk allocation

[Brazil: Lei 11.079, Art. 5]

Art. 5. The clauses of public-private partnership contracts shall be in accordance with the provisions of art. 23 of Act 8987, dated February 13th, 1995, as applicable, and shall also state:

III - the sharing of risks among the parties, including those that refer to acts of God, force majeure, acts of State and unforeseeable events;

[Mexico: Acuerdo Secretaria de Hacienda Diario Oficial 9 Abril 2004]

20.  Las dependencias y entidades deberán presentar las solicitudes de autorización de proyectos para prestación de servicios ante la Secretaría, a través de las Direcciones Generales de Programación y Presupuesto sectoriales. En el caso de entidades sectorizadas, la solicitud deberá ser presentada por la dependencia coordinadora de sector y, en el caso de las entidades no sectorizadas, la solicitud deberá presentarse por la entidad, directamente a las citadas Direcciones Generales.

21.  Las solicitudes a que se refiere el numeral anterior deberán acompañarse de la siguiente información:

VI.  Los elementos principales que contendrá el contrato de servicios de largo plazo que se celebraría entre la dependencia o entidad contratante y el inversionista proveedor, incluyendo: d) Los riesgos que asumirán tanto la dependencia o entidad contratante como el inversionista proveedor.

Transparency of the liabilities, undertakings, commitments, guarantees, and contingent liability

[Mexico: Acuerdo Secretaria de Hacienda Diario Oficial 9 Abril 2004]

32.  Las dependencias y entidades deberán enviar a la Secretaría, por conducto de la Dirección General de Programación y Presupuesto sectorial que corresponda, a más tardar el último día hábil de septiembre, la actualización de los montos correspondientes a obligaciones de pago para ejercicios fiscales subsecuentes que se hayan asumido en los contratos de servicios de largo plazo. La Secretaría incluirá dicha información en el proyecto de Presupuesto de Egresos de la Federación del siguiente ejercicio fiscal.

[Brazil: Lei 11.079, Art. 5]

The clauses of public-private partnership contracts shall be in accordance with the provisions of art. 23 of Act 8987, dated February 13th, 1995, as applicable, and shall also state:

II - the penalties applicable to the Public Administration and to the private partner in case of non-compliance with contractual obligations, which shall always be determined proportionately to the magnitude of the offence committed and to the obligations assumed;

VI - the facts that trigger public sector payment default, the means and terms for reestablishing the payment stream and, if applicable, the form by which guarantees are enforced;

Efficient Risk allocation

[Brazil: Lei 11.079, Art. 4]

The following guidelines shall be observed when contracting public-private partnerships:

VI - objective risk sharing among the parties;

[Peru - Decreto Legislativo n. 1012 Art. 5]

Asignación adecuada de riesgos. Debería existir una adecuada distribución de riesgos entre los sectores público y privado. Es decir que los riesgos deben ser asignados a aquel con mayores capacidades para administrarlos a un menor costo, teniendo en consideración el interés público y el perfil del proyecto

Inefficient risk allocation

[Mexico: Acuerdo Secretaria de Hacienda Diario Oficial 9 Abril 2004 - Considerando]

Que una forma de incrementar la eficiencia en el uso de los recursos del sector público es transferir a los sectores social y privado la mayor cantidad de riesgos y contingencias relacionados con los costos financieros y de ejecución de obras, mediante la utilización de esquemas para la realización de proyectos para prestación de servicios con base a los cuales se celebran contratos de servicios de largo plazo, a fin de que el gasto de cada ejercicio fiscal se concentre en los aspectos más importantes de la función pública,