Memorandum T.M.Blaiklock (LU 16)
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:
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
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
2. "How much information about the precise
nature of the contracts should be made public before they are
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:
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
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
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.
Consultant, Infrastructure Project Finance