Select Committee on Transport, Local Government and the Regions Appendices to the Minutes of Evidence


Memorandum T.M.Blaiklock (LU 16)

LONDON UNDERGROUND

  It is understood from the Press Notice that the Committee wish to consider the following issues:

1.   "the desirability of an independent audit prior to signing the contracts to ensure value for money".

  This question embraces three subsidiary issues:

    —  is an audit required?

    —  should such an audit be independent?

    —  what is "value for money".

  1.1.  "is an audit required?": Government, as owner of LUL, has structured and defined the PPP proposals which the DTLGR/LUL are negotiating with the three Infracos. In these circumstances Government, in whatever form, is the "promoter" of the deal.

  Under normal project financing transactions (oil/gas, power, etc.) the promoter would produce a Project Information Memorandum ("PIM") against which potential investors (ie operators/contractors) and lenders would identify their interest, bid and commitment to support the transaction. Such PIM will include cash-flow projections and, quite often, the underlying computer model. Interested parties are then able to review the PIM upon signing a confidentiality agreement and undertake "due diligence" on the proposal, ie "audit" the deal. [In the case of funding by public bond issue, the prospectus would be available for scrutiny in any event].

  In respect of LUL, which receives a significant proportion of its funding from the Government purse (30-50 per cent?), there is clearly a public interest component to the future operations and development of LUL (and its successor). This is not unusual: every "heavy metro" system in the world requires public subsidy in some form to build, operate and maintain. There is therefore the need to demonstrate some public justification and transparency in relation to the presentation of PPP proposals and for the bidding process to be open, in order to satisfy public interest requirements.

  In the case of the proposals for LUL, I have found it unusual, and indeed incomprehensible, why Government plans and detailed projections for the LUL PPP have not been generally available for public scrutiny, ie "audit".

  The argument that bidders will provide more competitive pricing if such information is not disseminated is weak. The detailed information required to make a sensible bid in this case is the property of LUL. Further, the underlying characteristics of the concession and the bid in this instance are very complex. No other heavy metro has been structured in this way before anywhere. The proposed PPP structure, therefore, is "experimental" with all that that entails in risk terms.

  In the absence of adequate project information bidders will have to guess, ie take higher risks,—which in the event may or may not be manageable,—than might otherwise be the case. As a result, such a Government policy will, if anything, be more than likely to increase the bid prices offered, . . . and the more so because the scope of the underlying concession is complex. From my experience, the more project information is shared with bidders, the finer (and closer) the prices offered.

  1.2.  should such audit be independent?: if the procedures, as mentioned above, are followed and information shared with the bidders/public, the audit(s) will effectively be "independent". The public/market will have had access to the project information (PIM) and opinions expressed accordingly.

  1.3.  "what is "value for money?": This is a subjective, not objective, issue.

  The key requirements of any analysis of PPP proposals should be:

    (a)  an affirmative decision by Government to proceed with an investment in a specific element of public infrastructure in the first place;

    (b)  the acknowledgement that the underlying service provision and investment can in principle be undertaken by the private sector; and

    (c)  confirmation that the (PPP) proposal will cost less, economically and financially, under most, if not all, foreseeable circumstances than if it was funded conventionally (ie the Public Sector Comparator ("PSC")), ie the proposal represents "value for money".

  There are few, if any, publicly available examples of "value for money" ("VFM") calculations undertaken by Government in the analysis of PPP/PFI proposals in recent times. There is, however, much published material describing in general and qualitative terms how it should be done!!

  The main perceived weaknesses in the current analytical procedures are that the discount rate to be used is proscribed by Government and inflexible, and the `time value of money' (and thereby risk) is largely ignored. For example, the LUL/Infraco contracts have a basic life of 30 years, with a review in Year 7. This begs the questions: should the analysis be undertaken over 7 or 30 years' contract period? Should the same discount rate be used for an analysis over 7 years as for 30? Is the cost of money the same? Are the inherent risks the same? I think not!

  It was interesting to note from the recent Deloitte & Touche Report, prepared for TfL on the LUL PPP contracts, that the VFM test showed that the PPP proposals were more expensive than the PSC over 7 years. Not surprising! Further, if the contracts are up for re-negotiation after Year 7, who is not to say that this same result will occur for analysis over Years 7-30? This only emphasises the need for public scrutiny of the LUL PPP plans and projections.

2.   "How much information about the precise nature of the contracts should be made public before they are signed?":

  Normally the PIM (see 1(a) above) will include a draft concession contract, which would be subsequently negotiated with the winning bidder(s). Such drafts will, in particular, define the parameters for performance, pricing, force majeure, termination and arbitration conditions. If bidders wish to renegotiate these clauses significantly, this should result in the favoured bid being rejected (with possible the loss of their bid bond) and the second favoured bidder being recalled for negotiations.

  The final contract negotiated and signed with each bidder (i.e Infraco) would not necessarily from my experience be in the public domain, but the public entity signatory (LUL in this case) would have to take public full responsibility for the deal made. Unfortunately, in the case of LUL, possibly through bad planning, one gains the impression that the contracts have not been drafted up in sufficient detail in advance of negotiations. Given that such contracts are reportedly 2-2,500 pages long, this is understandable, but that in turn begs the question: are not these PPP deals too complex for anyone to understand and document, let alone manage??

  This point also raises the question as to what is the position of TfL vis a" vis the PPP contracts signed by LUL, which TfL will have to assume responsibility for at a later date (early 2002?)? When one corporate entity takes over another, it would be normal for the company being taken over to provide an indemnity with respect to any outstanding contractual commitments undertaken. Given the quasi-Governmental nature of LUL and TfL this may be difficult in these specific circumstances.

  TfL does not necessarily enjoy Government support with respect to the funding of any future LUL cost over-runs, etc. arising out of these PPP contracts (negotiated by LUL). Hence, some explicit and binding Government assurances might be in order (particularly after the handling of the recent Railtrack restructuring) to assure TfL and Londoners that they have not adopted a financial 'millstone', which non-Londoners will be able to enjoy at no cost to themselves, and that PPP cost increases outside TfL control will be met by Government. If such assurances are not forthcoming, then TfL (and Londoners) will have grounds for some complaint!!

  In hindsight, it seems incomprehensible to me that TfL have not been fully part of the TfL negotiating team with the power to agree and/or veto input to these contracts.

3.   "The allocation of risk between the public and private sectors":

  This question begs two subsidiary questions:—

    —  what is "risk"; and

    —  is "allocation" appropriate to a "partnership"?

  3.1.  what is "risk": "Risk" is a subjective value (as is "VFM" mentioned earlier). What is a risk to one person, may not be to another, et vice versa. "Risk" is a measure of the uncertainty that a specific event might occur. Values may be assigned to such risks in the form of probabilities (represented by statistical measures of `means' and `standard deviations'), and the impacts of any specific risks can be simulated through sensitivity analysis on the cash-flow projections using a computer model.

  [Comment:. I do not necessarily agree with the NAO comment: "Financial modelling is an inherently uncertain technique" [ref. "The Financial Analysis for the London Underground PPP", Dec 2000, Summary para 11]. Financial modelling is an essential and objective analytical tool. The uncertainty lies in the judgements that may have to be made to provide the input data to such model.]

  It has been a long-standing principle of project financing that success lies with allocating the risks to those best able to carry them. Such `project financing' classically comprises the raising of debt and equity finance against the security (of repayment) provided by future cash-flow projections. Hence, the name: "off balance sheet" financing, synonymous with "non-recourse" financing. To the extent that such cash-flow projections might be supported by contractual undertakings made by third parties or other acceptable security, such financing becomes "limited recourse".

  An ideal `project financing', therefore, comprises a whole series of dovetailing input and output contracts, representing a seamless set of building blocks. To the extent that any uncertainties, or risks, of contractual default might arise, which in turn might threaten the contractual edifice, then these will arise at the interfaces between these contracts. Lawyers will attempt (at great expense and with no responsibility) to define and document the responsibilities and liabilities arising out of such risks, and that is when the complexities arise!!

  It is not surprising, therefore, that the sector where the most successful `project financings' have been arranged is oil, gas and natural resources, where the project risks can be clearly defined, limited and often ring-fenced. Not only that, but the protagonists are invariably major international companies, and the underlying product has an inherent hard currency value, which in itself provides lenders and investors with security in the event of default.

  In infrastructure project financings one is faced invariably with added problems of: (a) non-contracted revenues, or exposure to market risks; (b) government regulation of tariffs and quality of service; and (c) in transport particularly, government subventions for either, or both, construction and operations. All these features remove from the project company, albeit in part, the ability to control risks and thereby their corporate destiny. Hence, the risk profile rises.

  The key to success for investors and lenders, therefore, is to minimise the interfaces and thereby the risks. The more the interfaces, the higher the risks will be.

  In the context of the LUL PPP, not only is the LUL system to be split into three parts, which have interdependent interfaces, but there is also the interface with LUL for operations. Secondly, underground metro systems are second only to nuclear power stations in technical, commercial and financial complexity. Metros have to interface with most other public utilities, eg power, gas, water, drains, telecoms, roads, etc., which increases the risk opportunities. These interfaces all have to be documented, defining the relationships, force majeure events, etc., and it is no surprise that the proposed PPP contracts are some 2-2,500 pages long.

  The LUL PPP is certainly one of the most complex, if not the most complex, infrastructure concessions of all time. One has to question, however, whether LUL is on top of the risk definition and mitigation program. Furthermore, one needs to ask who understands the underlying documentation relating to the transaction in all its parts (apart from a team of expensive lawyers)? That in itself represents a significant risk to the PPP over the life of the contract(s).

  In conclusion, the proposed LUL PPP is conceptually ambitious and arguably flawed. The cost of failure will be very high, and it is questionable that London can afford such risks.

  3.2.  is "allocation" appropriate to a "partnership": PPP stands for "public-private partnership". Yet in a partnership the partners agree to share the fruits of success and the burdens of failure in proportion to their participation. I do not see such an underlying principle in the LUL PPP. Indeed, the PPP principle seems a misnomer. PPP is a creation of the current propensity for spin and political correctness. In reality, PPP is all about risk transfer and allocation. It is confrontational in nature and, in name, a misrepresentation.

  Previous deals of this nature have been undertaken as PFIs (Private Finance Initiatives), sometimes called PSPs (Private Sector Participation) in other countries, which do not raise such expectations of trust and sharing.

  3.3.  Finally, in the context of risk allocation comment needs to be made with regard to the proposed corporate structure for the LUL PPP.

  Notwithstanding the proposed three-way structure for the Infracos in relation to LUL, there is much to be said, in my view, for structuring all LUL infrastructure components, ie track, stations, train control, electro-mechanical equipment, etc,, (but not the rolling stock or the workshops which could remain private), into one not-for-profit company along the lines of NavCanada.

  One over-riding advantage of the not-for-profit company is that, whatever anyone might say, there is an inherent conflict between profitability and safety, if the railway/LUL infrastructure is owned and managed by the private sector (c.f. recent Railtrack experience with Paddington, Hatfield, etc..). This is avoided through the not-for-profit structure. For this reason alone, the not-for-profit structure, whatever the precise legal make-up it possesses under English law, is to be preferred.

  Such company would be allowed to securitise future revenues and be largely free of government interference. However, such an enterprise could only be commercially and financially successful if Government was prepared to make a long term (and flexible) commitment in relation to future annual subventions. Unfortunately, Governments have to date felt unable to allow the running of the Capital's transport system such freedom. Hence, the rejection of Mr Kiley's proposals for raising bond issues for the Underground. Given recent Railtrack events, such long-term commitment by Government is even more essential.

  In conclusion, it should be said that the not-for-profit concept is not suitable for all PPPs. However, in those cases where public safety might be at the forefront of the service to be provided and the service is of a wholesale nature and not direct to the public, eg as for NATS, Railtrack, LUL, etc., the concept has merits, deserving closer study and development.

4.   "The opportunities to adjust the contracts after they have been signed; and the role of arbitration in the event of dispute over the contracts":

  In short, the answer is that no re-negotiation of items of contractual principle should be allowed. LUL should also be aware that any re-negotiation of one PPP contract will set precedents for the other two.

  With respect to arbitration, it is recommended that an internal disputes resolution panel made up of recognised industry specialists is set up for each Infraco PPP contract to nip in the bud any disputes before outside assistance is required.

  With respect to the second series of (five) discussion points raised by the Committee, I feel I am not best placed to comment. In any event, detailed comment would be constrained by the lack of access to the LUL PPP plans and specific contract terms and conditions being negotiated.

  However, I would add that, unlike what was allowed for CTRL, it is essential to ensure that, whichever Infraco is awarded a PPP concession, it has to be able to show that they can without question acquire the finance needed to fund future investments. Some form of bonding mechanism might provide sufficient incentive. That might, on the other hand, prove rather expensive to the PPP bids, which could tilt the balance back in favour of the PSC option.

T.M. Blaiklock

Consultant, Infrastructure Project Finance

October 2001


 
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