Select Committee on Public Accounts Thirteenth Report


The Committee of Public Accounts has agreed to the following Report:—


Introduction and Summary of Conclusions and Recommendations

1. In December 1995 the Prison Service let a contract under the Private Finance Initiative (PFI) to Fazakerley Prison Services Limited (FPSL), a project company formed by Group 4 Securitas (Group 4) and Tarmac Construction Limited, to design, construct and finance at Fazakerley a new prison with 600 prisoner places and to operate it for 25 years. Tarmac Construction Limited's interest in the project was subsequently taken over by Carillion plc (Carillion).

2. The Fazakerley prison[1] opened in December 1997, five months ahead of schedule. In November 1999 FPSL refinanced the project. The refinancing improved the expected returns to FPSL's shareholders through the early repayment of their original investment and by generating a more favourable flow of dividends. The refinancing created additional benefits for FPSL of £10.7 million.[2] Had the whole of this amount been made available to FPSL's shareholders, their returns from the project, which had been estimated at £17.5 million at the time the contract was awarded, would have increased by 61 per cent.

3. The Prison Service's contract with FPSL did not give the Service any rights to share in refinancing benefits. A consequence of the refinancing, however, was that the Service would be exposed to increased liabilities in the event of the contract being terminated. The Prison Service secured compensation of £1 million from FPSL which was consistent with the cost of these additional risks, but did not receive any further share of the refinancing benefits. The remaining benefits of £9.7 million will be received over time by FPSL's shareholders. This allocation of the refinancing benefits will increase the projected internal rate of return to FPSL's shareholders from 16 per cent to 39 per cent.

4. On the basis of a report by the Comptroller and Auditor General[3] the Committee took evidence from the Home Office, the Prison Service, Carillion and Group 4. This is the first example the Committee has seen of the refinancing of a PFI project. We examined the adequacy of the compensation paid to the Prison Service to reflect the exposure to increased termination liabilities, the balance of risks and rewards in the project to the Prison Service and FPSL and the need for further central guidance.

5. Our key conclusions are:

  • FPSL shareholders secured greatly improved returns and decreased their risk, whereas the Prison Service obtained no more than compensation for taking on increased risk

      The Prison Service has, after negotiation, received £1 million from FPSL as a consequence of the refinancing. But this is compensation for taking on increased termination liabilities. The Prison Service did not gain any share of the remaining £9.7 million refinancing benefits which will accrue to the consortium. By comparison, FPSL has done very well from the refinancing. On a project which was previously estimated to deliver only marginal savings to the Prison Service, FPSL has made £9.7 million from the refinancing, increasing the rate of return to its shareholders from 16 per cent to 39 per cent. In addition, the shareholders' risks have reduced as they have received repayment of all but a nominal amount of their initial investment in the project.
  • Departments should ensure that they are aware of and use the full strength of their negotiating position when dealing with requests to vary the terms of PFI deals

      In settling for a share of the refinancing benefits which no more than compensated the Prison Service for increased risks arising from the refinancing, the Prison Service did not exploit fully the commercial strength of its negotiating position. FPSL could not proceed with a substantial element of the refinancing without Prison Service consent. That fact gave the Prison Service a lever which it did not use to the greatest effect.
  • Departments should share in benefits that will arise through the successful delivery of a PFI project

      Successful projects will create opportunities for better financing terms as financiers will see that project risks have reduced once the service is being delivered satisfactorily. A refinancing can then greatly increase the returns to the private sector and change the balance of risks and rewards. But successful delivery of a PFI project is never a one-sided matter: success will come from the public sector and private sector working effectively together. It is therefore unacceptable for 100 per cent of refinancing benefits to remain with the private sector side. Departments should share in the financing benefits from a successful PFI project, whether through the pricing of the original deal or through a share of any subsequent refinancing gains as they arise.
  • Better guidance is needed to help departments address refinancing issues and how the benefits of refinancing should be shared

      Despite the potentially very significant financial benefits that can arise from refinancing, only 24 per cent of PFI projects reported in answer to recent Parliamentary Questions included arrangements to allow departments to share in refinancing gains. The Treasury's guidance issued in 1999 gave insufficient weight to the reasons why the public sector should be concerned to share in refinancing gains. New guidance is needed urgently. In formulating new guidance, the Office of Government Commerce will need to give very careful thought to the arrangements for sharing refinancing gains. There would be the merit of simplicity in making it the rule in PFI deals that all refinancing gains should be shared in some definite proportion, such as 50:50. Such a step might, however, risk increasing the original prices quoted at the outset of deals, because bidders may well base their prices on an assumption that they will be able to refinance the deals in the event of success. A provision that the windfall element of refinancing gains must be shared would, however, not be open to the same objection.

6. Our detailed conclusions and recommendations are set out below:

On the adequacy of compensation for the Prison Service's higher termination liabilities
(i)There may be a good case for the public sector to make payments to the external financiers on termination of a PFI contract. It is, however, unacceptable that a department should accept without full compensation any risk of having to meet higher termination liabilities as a result of a refinancing which would greatly benefit the private sector shareholders (paragraph 14).
(ii)There was ambiguity over the extent to which the Prison Service's contractual arrangements in respect of termination liabilities required it to consent to this refinancing. That ambiguity complicated the Service's efforts to seek compensation for the increased termination liabilities for which it would be liable as a result of the refinancing (paragraph 15).
(iii)Departments should take early legal advice when developing PFI contracts to limit their exposure to increases in termination liabilities during the contract period. They should develop contracts which unambiguously give them the right to approve any arrangements which might increase those liabilities (paragraph 16).
(iv)It is reasonable for a private sector consortium to see incentive in the prospect of refinancing benefits that may arise as a result of it outperforming the standard of service expected at the time the PFI contract was let. That does not mean that the private sector should reasonably expect to receive 100 per cent of such benefits. In this case, the Prison Service was able to negotiate a share of the benefits, which was no more than compensation for taking on additional termination liabilities as a result of this refinancing, but the compensation represented only about 20 per cent, of the £5.5 million portion of the refinancing gains which were entirely dependent on Prison Service consent (paragraph 17).
(v)No department in a PFI deal can afford to relax its guard against perverse incentives which might tempt the private sector side, in adverse circumstances, to cut and run. In this case, such a risk might theoretically arise because the Prison Service's greatest exposure to additional termination liabilities would occur at a time when the private sector shareholders would have received most of the benefits of the refinancing and their company would be facing additional costs. In such a situation, the shareholders might become less concerned about their company's performance at a time when the costs to the Service of terminating the contract would be at their highest (paragraph 18).
(vi)Departments should assess the risk of contract termination, taking account of changes to a consortium's cashflows which are likely to occur during the contract period. This risk assessment should then be used by departments to devise a pattern of rewards and penalties which continue to incentivise the consortium throughout the period of a PFI contract (paragraph 19).
On the balance of risks and rewards
(vii)When this contract was let in 1995, the Service estimated that it would only deliver marginal savings of £1 million compared with conventional procurement. It was a much less attractive deal in financial terms than the Bridgend prison deal let at the same time to another consortium which was expected to deliver savings of £53 million on a similar sized contract. The refinancing appears, therefore, to give FPSL substantial further benefits on a contract which at the outset did not give the prospect of significant savings to the Prison Service (paragraph 37).
(viii)The prison opened five months ahead of schedule and is considered by the Service to be an outstanding local prison which has paved the way for subsequent PFI contracts. But, given the scale of the improved benefits that have accrued to the consortium from this refinancing, the Service should have sought a more reasonable balance of risk and rewards for both the Service and FPSL. The gains should have been shared more equitably between the consortium and the Service (paragraph 38).
(ix)Carillion told the Committee that it would earn a return of 15 to 17 per cent if it performed successfully on hospital projects, and that it deemed these to be more risky than prison projects. Carillion claimed that the investment return of 39 per cent which it now expected to make from the Fazakerley prison project was a misleading figure. In our opinion, however, the 39 per cent figure correctly reflects the increased returns that the FPSL shareholders will receive following the refinancing on an investment which has been reduced to a nominal amount (paragraph 39).
(x)When assessing alternative PFI bids, departments should take into account the various revenues which shareholders of a consortium can earn from a PFI project, the likelihood of a refinancing occurring and how this may affect the balance of risk and reward, for both the procuring department and the service provider (paragraph 40).
(xi)Although this was the first major refinancing of a PFI project, the Service chose not to make greater use of its adviser, NM Rothschild & Sons (Rothschild), in determining a negotiating strategy, and did not ask Rothschild to participate in the negotiations. Given the complexities of PFI refinancing and the potential financial consequences, departments should make appropriate use of experienced advisers in developing, and participating in, refinancing negotiations (paragraph 41).
(xii)The Prison Service assured us that it has learned lessons from the Fazakerley prison refinancing, that it is securing rights to share in refinancing gains on current PFI prison contracts and that it is achieving improvements of up to 30 per cent in its PFI contract prices as a result of establishing a competitive market following the successful opening of the Fazakerley prison (paragraph 42).
On the need for further central guidance
(xiii)Although PFI contracts with a capital value of approximately £17 billion had been let by July 2000, there was no central guidance on refinancing until July 1999, by which time most of those contracts had been let or were under development. The Treasury should aim to anticipate future issues where departments may require guidance rather than simply producing guidance in response to situations which have already developed. It should consult external experts and the National Audit Office about emerging issues where central guidance would be helpful (paragraph 51).
(xiv)Many PFI projects, particularly where contracts were let in the early stages of the development of the PFI, are likely to be refinanced. The National Audit Office's analysis shows, however, that only 24 per cent of PFI projects surveyed included arrangements whereby departments are entitled to share in refinancing gains (paragraph 52).
(xv)The Treasury and the PFI Policy Unit in the Office of Government Commerce (OGC) should therefore complete their planned updating of the central guidance on refinancing as a matter of priority (paragraph 53).
(xvi)The opportunity for refinancing benefits appears, in part, to arise from the successful delivery of a PFI project. PFI deals should therefore reflect the benefit of the improved financing terms that are likely to arise through the successful delivery of the project. The benefit may be secured through the pricing of the deal or through a share of subsequent refinancing gains (paragraph 54).
(xvii)The experience of privatisations shows that in some cases private sector investors have made much higher returns than they ever imagined. We advocated that such unexpected gains should be shared. Windfall refinancing benefits on PFI projects which have not arisen through a higher than expected standard of service from the private sector should similarly be shared between departments and the private sector. Because deals will not have been priced in anticipation of such gains arising, the prospect of sharing the gains between the public and private sectors will have no impact on the original pricing of the deals (paragraph 55).
(xviii)All departments must give careful consideration to refinancing issues when they develop contractual arrangements with PFI consortia, taking account of the lessons from the Fazakerley prison refinancing and further guidance which the Treasury and the OGC may develop (paragraph 56).
(xix)We look to the National Audit Office to carry out a further analysis at the end of 2001 of the extent to which PFI contracts allow departments to share in refinancing gains so that we can monitor progress on these important issues (paragraph 57).

The Prison Service's Negotiations of Compensation for Higher Termination Liabilities

7. During late 1998 and 1999 the Prison Service negotiated with FPSL, the consortium managing the Fazakerley prison PFI contract, over a refinancing proposal from FPSL. This was expected to increase the returns which FPSL's shareholders had anticipated when the contract was let by 61 per cent. The shareholders' expected returns had already increased by a further 20 per cent through the early delivery of the prison and lower costs (Figure 1).[4]

1.  FPSL paid £1 million to the Prison Service as compensation for increased termination liabilities.
2.   FPSL considered that it would not have required Prison Service consent to obtain £5.2 million of these refinancing benefits.
Source: National Audit Office from information supplied by PricewaterhouseCoopers, FPSL's advisers

8. The Prison Service's PFI contract with FPSL required the Prison Service to approve any arrangements which resulted either in an increase in the aggregate loan principal of FPSL's borrowings, or which had the primary intention of increasing the Service's termination liabilities. The Prison Service's advisers, Rothschild, identified that the refinancing proposed by FPSL would increase the Prison Service's termination liabilities by up to £47 million in cash terms (£13.5 million in present values) (Figure 2).[5]

    This figure shows that the maximum termination liabilities, in cash terms, vary depending on what point in the contract period termination takes place. As a result of the refinancing, termination liabilities have increased. The point at which this increase is at its maximum occurs in 2013 when there is an additional £47 million of liabilities.

    Source:National Audit Office from information supplied by Rothschilds

9. We asked the Prison Service why it had an arrangement which left it exposed to a higher termination liability in a situation where FPSL had the opportunity to benefit from a refinancing. The Service said it believed that the chance of having to terminate the contract was extremely remote and that the refinancing would give Group 4 more confidence in running the prison which made the likelihood of a termination much less than it had been previously.[6]

10. The Prison Service acknowledged that there had been ambiguity over the extent to which the refinancing, and the resulting increase in its termination liabilities, required its consent under the contractual provisions. FPSL's lenders decided, nevertheless, that it would be prudent for FPSL to seek the consent of the Prison Service to the refinancing in view of the uncertainty as to whether or not such consent was actually required. The Service sought compensation from FPSL for taking on the increased termination liabilities.[7]

11. After rejecting lower offers, the Prison Service accepted compensation of £1 million for the risk of higher termination liabilities. The Service accepted the offer of £1 million on the basis of advice from Rothschild. This showed that the aggregate present value of the increase in FPSL's outstanding bank debt during the contract period was £9.28 million. Based on a 10 per cent probability of the contract being terminated during the contract period the cost to the Prison Service of bearing the related risk that its termination liabilities would increase was £928,000.[8] The £1 million compensation exceeded this amount and the Service told us that it was a very prudent estimate that there would be a 10 per cent chance of the contract being terminated over its 25 year period. The Service now judged the possibility of termination during the contract period as less than one per cent.[9] In accepting the £1 million compensation the Service noted that this was ten times FPSL's opening offer. It told us that it believed that it only had a lever to negotiate over £5.5 million of the refinancing benefits so it had secured about 20 per cent of these benefits.[10]

12. The refinancing increases, and brings forward, the returns to FPSL's shareholders (Figure 3).[11] The profile of these cashflows concerned us as it appears that, under the new financing arrangements, the shareholder returns go down quite sharply after 2012, just when operating costs are beginning to rise and at the same time as the increase to the Prison Service's termination liabilities is at a maximum. There is also the prospect of further debt payments after 2015 because the debt repayment period has been extended. This could give an incentive to FPSL to under-perform so that the Prison Service might wish to terminate the contract at a time when it would face maximum financial risk from so doing.

1  The prison is now known as HMP Altcourse Back

2  Unless otherwise stated, all figures shown in this report relating to the value of benefits to FPSL's shareholders are quoted in present value terms as at 30 November 1999, the date of the refinancing, using a real discount rate of 6 per cent Back

3  C&AG's report "The refinancing of the Fazakerley PFI prison contract" (HC 584, session 1999-2000) Back

4  C&AG's report, paras 2-3, 1.15, 1.21-1.22 and Figure 2, p4 Back

5  ibid, paras 1.13, 1.20 and Figure 3, p15. Termination liabilities are payments which  the Prison Service would be required to make to FPSL in the event that the contract is terminated prematurely by either party. Back

6  Evidence, Qs 4, 55, 129 Back

7  Evidence, Qs 113-114, 133 Back

8  Evidence, Appendix 1, pp 17-18 Back

9  Evidence, Qs 1, 4-5, 92-100,130 Back

10  Evidence, Qs 5, 85 Back

11  C&AG's report, Figure 1, p2 Back

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