Select Committee on Public Accounts Minutes of Evidence

Examination of Witnesses (Questions 1 - 19)




  1. This afternoon we welcome to the Committee Sir David Omand, Accounting Officer of the Home Office and Martin Narey, Director General of the Prison Service to discuss the C&AG's report on the refinancing of the Fazakerley PFI prison contract. We also welcome Mr Robin Herzberg, Concessions Director of Carillion PLC, whom we previously met on Dartford and Gravesham PFI and also Mr David Banks, Managing Director of Group 4 Prison Services Limited. Welcome to all of you gentlemen. We are interested in this report because, although this Committee has now considered reports on the letting of a number of PFI contracts, this is the first example we have seen of a refinancing, so it obviously has implications for future contracts and for others where that might happen. Let me start with the Prison Service and Mr Narey and draw your attention to Figure 7 on page 25 which shows that you have only received £1 million out of the £14.1 million additional benefits which have arisen on this project since the contract was let. Given that you had previously estimated that this contract was only expected to provide marginal savings, why did you not press for more than £1 million from the refinancing?
  (Mr Narey) The reason was that our advice was first of all that there was some doubt as to whether we had any lever to get that additional finance; you no doubt will want to go into that. We argued that we did because of the additional termination liabilities which were forced upon us. We only had a handle on £5.5 million of that sum; that was the sum for which we believed there was some commitment on the part of Group 4 to seek our agreement. Our advisers made a very, very cautious estimate of the likelihood of termination of the contract at ten per cent. I think that is very cautious and the likelihood is considerably lower than that. In fact of the sum of money for which Group 4 were committed to negotiate with us we got about 20 per cent of that money back, we got £1 million of £5.5 million.

  2. I must admit that I would have thought that splitting the difference would have been a more reasonable outcome, but perhaps I have a harder line of the taxpayers' interests than others.

  (Mr Narey) I would say straight away that were we doing this again I would seek more and our contracts now reflect that. For the contracts for the next two brand new prisons at Peterborough and Ashford we intend to put in a clause which will give us half of any refinancing benefits. At the time, with the information available to me last April, I thought we were getting a fair deal.

  3. You implicitly accept the 50:50 rule in future contracts anyway.
  (Mr Narey) I do indeed.

  4. Paragraph 1.20 says that in the event of contract termination the Prison Service could now be exposed to termination liabilities as much as £47 million higher than previously anticipated. That is the maximum of course. Why did you have an arrangement which left you exposed to a higher termination liability if the consortium had the opportunity to benefit from a refinancing? You just pointed out incidentally that you were not sure you even had any legal right to object to that.
  (Mr Narey) That is right. We were aware, after discussions with FPSL, that our termination liabilities were high. You are absolutely right that at the peak those liabilities increased by £47 million or only about £13 million in present value terms. That was the reason and the basis for us negotiating a share of the gains to FPSL through refinancing. We believe that the chance of—and I can be even more confident today than I could be last April frankly—having to terminate the contract was extremely remote and I still believe that. On that basis we were not getting a sum of money to finance a possible termination, we were getting a sum of money in recognition of the probability of the risk which was estimated at ten per cent.

  5. I do not want to disappear into the technicalities of stochastic analysis but on a £1 million for £13 million present value should you not be saying a three per cent probability is the tradeoff?
  (Mr Narey) The probability of termination was calculated, I think very prudently, at ten per cent. My view is that probability of termination is very much lower than that. This is a very, very impressive and successful prison. Ten per cent would have suggested that of the total gains which FPSL were getting ten per cent probability of termination would suggest we should have got about £1 million. In fact, as I have explained, we only believed we had a handle or a lever to negotiate over £5.5 million, so we got about 20 per cent of that.

  6. Paragraph 3.37 says your advisers, Rothschild, were not asked to lead the negotiations, attend any negotiation meetings, or to provide any briefing on how the negotiations should be conducted to achieve the best outcome. Surely a better outcome would have been achieved if the experience of Rothschild had been used in the negotiations.
  (Mr Narey) I should certainly consider doing that in the future. We made it plain that we shall consider incentivising our advisers in future negotiations. That is not to suggest that we were an easy touch on this. The negotiations suggest that, based on advice we were getting from Rothschild we bargained very hard. The original offer from FPSL was for £100,000, then for £300,000 and eventually for £1 million which we accepted. Although there is a great deal of merit in incentivising advisers and using them to negotiate direct, we got a fair deal with their help nevertheless.

  7. Paragraph 3.17 is my next point of contact. This notes that before the refinancing took place the PFI contract was only projected to deliver savings of £1 million compared with traditional procurement. Now that the project has been refinanced with almost all of the refinancing benefits going to the private sector consortium, what is your current perception of the value for money of the PFI contract you have given to FPSL?
  (Mr Narey) I still believe that Altcourse provides value for money and certainly at the time, relative to the public sector comparator, although the margin was very small, it was certainly there. In any case, my predecessor did not have available to him at that time the capital necessary to build the prison in a conventional manner. Since then, and as I look at Altcourse now—and I visited it as recently as about three weeks ago—its costs bear very reasonable comparison with several prisons in the public sector, with, for example, Woodhill which has a similar architecture. More to the point, in terms of the things I care most about, in terms of decent treatment of prisoners, flourishing education department doing real things to prepare prisoners for release and make them employable, outstanding security and prisoners being treated with dignity throughout, I think Altcourse provides exceptional value for money. It is in fact an outstanding prison.

  8. May I address a question to Mr Herzberg and Mr Banks on paragraph 2.19, the first bullet point? It says that you did not reduce your pricing of initial PFI contracts on the expectation of later refinancing benefits to your shareholders. The refinancing benefits that have arisen on this project, therefore, appear to represent a windfall gain on a deal which only offered the prospect of marginal savings for the Prison Service. Is it fair to say that you have continued to benefit from a deal that is not providing significant value for money for the taxpayer?
  (Mr Herzberg) Certainly my belief is that when we set out to negotiate this contract, refinancing was something which was very speculative. It was a fairly difficult project to finance, to say the least; indeed at the outset we sought to involve UK banks in it. We were singularly unsuccessful in involving UK banks. We nearly had one and at the end of the day we had to finance it entirely through foreign banks. The whole concept of a refinancing at that early stage was very remote indeed.

  9. The outcome has been that you have made quite a lot of money out of it, well over £14 million obviously, and the taxpayer has made about £2 million.
  (Mr Herzberg) We did have to take on board a very high level of risk. You have to remember that this was one of the very first PFI projects. It was certainly the first PFI prison, it preceded the hospitals. There was no certainty at all that these PFI prison projects could be financed, indeed financed to the Prison Service's satisfaction. We took that risk and indeed we did actually manage to complete the construction of the prison five months early. Mr Banks will be able to tell you more about the excellent operations which the prison is now delivering.

  10. Would you like to add anything, Mr Banks?
  (Mr Banks) I would endorse that. The climate for the refinancing was really set by the success of the project: the completion of the build six months ahead of schedule, the making available of prisoner places, similarly six months ahead of schedule, which helped to get some of the additional £14 million to which you referred. An element of that was attributable to the early opening of the prison, which certainly benefited us, due to the success of the project, but also benefited the Prison Service in having access to those places earlier. All of this and the early establishment of a successful and stable regime at Altcourse changed the climate significantly in terms of one where we needed to put in a lot of effort to encourage the finance sector to participate and one where the environment for refinancing was more favourable.

  11. I just say en passant that this Committee is not entirely persuaded of the capital shortage arguments for PFIs. However, I shall put that to one side but perhaps come back to it at the end. Mr Narey, what steps would you now take? You touched on it before when we spoke. What steps would you now take with a new PFI contract to cope with the prospect of refinancing later on? How would you change your PFI contracts?
  (Mr Narey) We intend in future PFI contracts for the two prisons whose planning we have just embarked upon at Peterborough and Ashford to include a clause which will indicate that in the event of any refinancing the Prison Service should receive half of any of the gains which are made by the private contractor.

  12. What advice has been given by Treasury to other departments about this issue?
  (Mr Hull) The advice which has been given to departments is set out in the guidance on standardisation of PFI contracts. It is not specific about whether contracts should contain a provision of that kind. New guidance will be published in the spring. The head of the Office of Government Commerce (OGC) is considering whether mandatory provision of this sort should be included. There are two sides to it and it is important to get it right. It is possibly more likely that such provisions will be higher level, at a more strategic level rather than necessarily at that level of detail.

  13. Is it not a little odd then that we have Treasury saying one thing and part of the department saying another, which is what I think I hear?

  (Sir David Omand) In the Home Office we have drawn up guidance which we are currently discussing with the Treasury to fill the gap until the new Office of Government Commerce guidance is available. What we have emphasised is that where there is third party financing of PFI contracts, then those contracts should include a refinancing clause to ensure that there is no ambiguity as there was in the case of the first contract provisions, the Fazakerley contract, and to make it clear that we would expect to share a proportion of the allocation of risk in any benefit from refinancing. May I just give a word of caution in drawing general lessons from this specific case? It is very important to the whole principle of private finance that the rewards accompany those who carry the risk. If we wish to share in the benefits, the upside of refinancing, we have to accept that we would share in the risks, the downside, of those costs rising. In the case of most of these contracts we would want to maintain that the cost of finance was something for the company to arrange and they would normally do that by bond issue, by some long-term arrangement or insure that themselves. We in Government would not expect to bear that risk. If we do not bear that risk then if those rates go down it does not necessarily follow that the taxpayer would benefit from that. In exactly the same way with other factors of production, land or labour, if the company is smart enough to make a better arrangement, then they make a better arrangement. The best protection for the taxpayer is a really vigorous competition which ensures at the point of competition the soundest arrangements are made and the tightest prices arrived at rather than what could be an artificial clawback mechanism which would require subsequent renegotiation. I just put that as a general caveat on the principle.

  Chairman: We have registered this caveat before of course, as you are probably well aware. To put this at its most general, we are talking about a clawback arrangement here. Most of these clawback arrangements apply to unexpected benefits which come back which the investor or the private company taking part in the exercise are themselves not expecting when they make the initial pricing. We see this in property related matters, we see it in other areas. We have seen it on rolling stock in the railway privatisation. I just say to the Treasury that you do have now at the behest of this Committee some rules on clawback and I think you should consider the extent to which that general rule should apply to financial windfalls as well. I shall leave you to reflect that to your superiors in the Treasury.

Mr Williams

  14. Before you reflect too long, may I follow up on it? We are told by NAO that currently over £17 billion of PFI contracts are signed up. Is it not a bit late in the day for you to be considering these items? Why have you been unaware of these possibilities for so long? Not you personally but you institutionally, Treasury.
  (Mr Hull) In a sense some of the things which the witnesses have said have answered that question in part. PFI is a new innovative process, certain things were not known when this particular project was gone into. When the lessons were learned changes were made and changes are continuing to be made and more changes will be made in the guidance which is promulgated in the spring. I shall certainly draw the Chairman's comments to the attention of the Chief Executive of the OGC.

  15. I should certainly like you to make it clear when you draw the Chairman's words to anyone's attention that to my mind it is rather dilatory that we have gone this far in the process and that you as Treasury still have not confronted the issue. May I take up a point with Sir David? I welcome the more robust attitude the department and the Prison Service are taking now and I commend you for that. That is the good news. As far as your response to the Chairman was concerned, I have to underline what he was saying to you. PFI already includes a risk premium, does it not? That is what you are paying for. That is why the average is 16 to 17 per cent rate of return. That is the risk premium, is it not?
  (Sir David Omand) The difficult cases are those where in the course of negotiation—

  16. No, I am just asking a simple question. Does the negotiating price not include the risk premium? They would not dare enter into it otherwise, would they?
  (Sir David Omand) The Committee has to recognise that if we want a condition in a contract which says, say, a 50:50 split of any benefits from refinancing, we would probably have to pay for that. That is the importance of competition.

  17. Not if you are already getting a 16 or 17 per cent rate of return. It is a windfall return. I realise that none of you was there but was the department or was the Service aware of the possibility of refinancing despite the vagueness of the situation which was described and I recognise it was back in 1995?
  (Sir David Omand) Hindsight is a wonderful thing. At the time this contract started PFI in the Prison Service was novel, contentious and extremely risky. There was no guarantee that a marketplace would emerge at all for private sector prisons. The Prison Service frankly did extremely well in developing that marketplace to a point at which there is now genuine competition. The latest projects which are going forward will have the advantage of a number of toughly competed bids. That is the best answer I can give to your point about how we ensure that the right provisions are in the contract. I do think that it is only with the benefit of hindsight that we can see these points. If I may point to the Committee's last report in 1997 on this prison, this was not an issue which anyone at the time was then identifying. We are all gaining wisdom on this subject. The important thing from where I sit is that I make sure that every single PFI programme with which the Home Office is associated has already picked up on this. I am glad to say that the PFI contract we signed a few weeks ago does indeed include a refinancing clause.

  18. Mr Herzberg, I was interested to read that in fact you regard hospital contracts as more risky than prison contracts. Yet you are entering into hospital arrangements at the same rate you entered into the prison arrangement.
  (Mr Herzberg) Yes, I remember Mr Williams asking me that very question last time I was interviewed.

  19. You have the benefit. I had forgotten I had asked that.
  (Mr Herzberg) I stand by my answer to him then. I still do regard hospital contracts as more risky and the reason I answered it that way that time was because of the complex requirements from the consultants and the need to keep a lot of different clinicians happy. In the case of prisons, you are at least dealing with one clear client, Her Majesty's Prison Service, who at least give some very clear direction as to what they want. To that extent it is a less risky proposition. However, at the outset we did bid a very much lower internal rate of return on this project and I think you will find in the National Audit Office report that the internal rate of return at the outset on this project was only some 13 per cent, which is considerably less than the sort of rates of return I was talking about on hospitals last time I was here.

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