Private Finance Projects and off-balance sheet debt - Economic Affairs Committee Contents


Memorandum by Mr Chris Bolt, Arbiter for London Underground PPP Agreements

INTRODUCTION

  1.  The role of statutory Arbiter for the London Underground Public-Private Partnership Agreements was created by the Greater London Authority Act 1999. I was appointed as the first PPP Arbiter in December 2002. Annex 1 gives a brief summary of the PPP Agreements, and Annex 2 outlines my functions and duties.

  2.  The London Underground PPP covers the maintenance, renewal and upgrading of the infrastructure—track, trains, signalling and stations. The PPP Agreements are 30 year commercial contracts, with reviews of scope and pricing every 7½ years. My role is concerned principally with assessing the efficient level of costs and pricing at Periodic Review (and at the Extraordinary Reviews which may take place between Periodic Reviews).

  3.  Based on my experience to date, I set out below my views on some of the questions covered by the call for evidence. I do not respond on questions which are outside the scope of my role as PPP Arbiter.

Q1:   Assessment of value for money

  4.  The PPP deals were subject to a value for money assessment before they were finalised, comparing bids with a public sector comparator. The National Audit Office reported on those assessments[1]. NAO also took the view that creation of the role of Arbiter was important in protecting value for money. Specifically, one of its recommendations was as follows:

    — "Departments should negotiate commercial terms that are broadly neutral in respect of unforeseen and unforeseeable asset condition because seeking to transfer too much risk is likely to over-compensate the private sector on grounds of uncertainty. Steps were taken to think through and reduce such risks in this case. Specifically, the provisions for decision by an independent Arbiter mitigate the risk that thresholds for price review are too easily reached. In larger deals, Departments should consider similar arrangements."

  5.  The PPP Agreements establish the concept of the Notional Infraco as a basis for judging efficient delivery: this is defined as the entity which has the same contractual obligations and financing as the actual Infraco, but which carries out its activities in an "overall efficient and economic manner and in accordance with Good Industry Practice". The contract identifies some characteristics of Good Industry Practice, but it is for me as Arbiter to judge what is efficient and economic and to assess the costs and revenues of the Notional Infraco when disputes about price are referred to me.

  6.  In assessing the characteristics of the Notional Infraco, the approach I have adopted, following consultation with the PPP Parties and others with a relevant interest, has involved a number of elements:

    — review of actual Infraco performance and plans;

    — "internal" benchmarking between the three Infracos;

    — "external;" benchmarking with other relevant metros and railways; and

    — expert technical advice.

  7.  In order to ensure that the Arbiter has adequate access to information, the GLA Act gives me powers to obtain information from the PPP Parties and their associates. I have also published the results of benchmarking work which I have commissioned, although technical advice drawing on actual performance and plans is generally confidential to the Parties.

Q2:   Comparison with traditional procurement

  8.  As indicated above, the London Underground PPP bids were compared with a public sector comparator before the contracts were signed.

  9.  Subsequent performance of the infracos can be assessed against alternative procurement models through the external benchmarking. The Metronet infracos have been transferred back to TfL ownership, following their entering administration in July 2007, and integrated with London Underground. However, it is too early to make a robust assessment of the comparative performance of infracos under the different regimes. There are three main reasons for this:

    — transitional changes designed to remove inefficiencies are still not fully complete;

    — financial systems are being integrated with London Underground in order to produce robust cost information; and

    — Metronet costs have not yet been subject to any detailed independent review.[2]

Q3:   Risk transfer

  10.  Under the terms of the London Underground PPP Agreements, Infracos are protected against changes in costs (or loss of performance revenue) subject to three conditions:

    — the protection only applies to the extent that the Notional Infraco would also have faced increased costs: cost increases due to inefficiency are therefore borne by the shareholders;

    — Infracos have to absorb the first £50 million of additional efficient costs in each Review Period,[3] although this risk is reflected in pricing; and

    — decisions on what cost increases are allowable are taken by the independent Arbiter, if not agreed with London Underground, which introduces a (limited) measure of "regulatory risk".

  11.  Where cost changes arise within a 7½ year Review Period, an Infraco can make a reference to me for Extraordinary Review. I then judge how far the cost changes reflect those of the Notional Infraco, and determine the change in the ISC payable by London Underground to cover the allowed cost increase which is in excess of the Materiality Threshold.

  12.  Although, therefore, the PPP is intended to transfer the risk of inefficient delivery to the private sector, the effectiveness of this transfer depends on the ability of equity holders to absorb this risk. This is turn depends on early identification of inefficiency, enabling the Infraco to take early corrective action. In the case of the two Metronet Infracos, the scale of inefficiency was identified too late to allow for such corrective action, and the interim increase in ISC which I proposed to allow in my draft direction of 16 July 2007 was insufficient to maintain their viability. My decision reflected my assessment that the bulk of the cost increase being experienced by Metronet was the result of inefficiency. As a consequence, the Infracos went into PPP Administration on 18 July 2007. The resulting cost to the taxpayer was identified in a recent NAO report.[4]

  13.  One lesson from the failure of Metronet which is relevant to the issue of risk allocation is that Metronet and London Underground appeared to have different views of what risks each party was taking. Given the definition of the Notional Infraco, for example, costs omitted from Metronet's bid were still a risk for London Underground if efficiently incurred, although London Underground originally argued that such omissions were a Metronet risk. This difference of understanding contributed to the delay in addressing cost overruns beyond the point where corrective action could be taken.[5]

Q4:   Monitoring performance and quality

  14.  As Arbiter, I have no role in respect of regular monitoring of performance and quality, other than in one respect. The Metronet PPP Agreements provided for an annual reference to me for guidance on whether the infracos had performed its activities in the period since transfer in an overall efficient and economic manner and in accordance with Good Industry Practice or not. In preparation for the 2005 report, which was deferred by agreement between Metronet and its lenders and London Underground, I developed a format for variance analysis which had not previously existed. I have expressed the view[6] that the problems experienced by Metronet could have been addressed earlier had I been allowed to prepare the annual report in 2005.

  15.  In preparing for the Periodic Review of Tube Lines' PPP Agreement, and in particular in developing the framework for internal benchmarking, I was concerned that information from the three infracos was not in a consistent format. I therefore developed, in consultation with Metronet, Tube Lines and London Underground, a Data Breakdown Structure which London Underground and Tube Lines subsequently agreed to adopt for their Periodic Review submissions. Again, this is a matter which would ideally be addressed at the start of a contract rather than having to be developed subsequently.

Q5:   Changing requirements

  16.  The PPP Agreements provide for a Periodic Review to take place every 7½ years (ie there are three reviews during the 30-year contract term). London Underground is only able to make changes to its requirements at Periodic Review (or for affordability reasons at Extraordinary Reviews). As part of the current Periodic Review of Tube Lines' PPP Agreement, London Underground has introduced changes in its requirements, and also proposed modification of other contractual terms (for example in relation to asset management systems). However, Tube Lines has contended that some of these changes go beyond the scope of changes which can be made under the contract.

  17.  The PPP Agreements provide that some of the contentions made in the context of a Periodic Review must be referred to me, and that others must be referred to an adjudicator. This potentially creates unhelpful timing issues, and potentially a conflict of jurisdictions. Similarly, the fact that some cost changes are subject to a contractual claims process and could in principle also be part of an Extraordinary Review highlights the difficulties of running two different change and appeal mechanisms in parallel.

Annex 1

THE LONDON UNDERGROUND PPP

  1.  London Underground Limited entered into three separate Public Private Partnership (PPP) Agreements, with Tube Lines in December 2002 and with Metronet (two separate agreements) in April 2003. Under these Agreements, which cover a 30 year period, three separate companies ("Infracos") are responsible for the maintenance, renewal and upgrading of specific parts of London Underground's infrastructure. London Underground, which is an operating subsidiary of Transport for London, retains responsibility for delivering services to customers.

  2.  Responsibility for the different lines was as follows:

    Metronet Rail BCV Ltd: Bakerloo, Central, Victoria and Waterloo & City

    Metronet Rail SSL Ltd: Metropolitan, Circle, Hammersmith & City and District (the Sub-Surface Lines)

    Tube Lines Ltd: Jubilee, Northern and Piccadilly.

  3.  On 18 July 2007, Metronet Rail BCV Limited and Metronet Rail SSL Limited entered PPP Administration, exiting on 27 May 2008. Ownership was transferred to two new companies within Transport for London. The two Metronet PPP Agreements remain in place pending agreement of a permanent structure for the Metronet Infracos.

  4.  The PPP Agreements provide for a Periodic Review of obligations and pricing every 7½ years. The Periodic Review for Tube Lines' Agreement is now under way. London Underground issued its Restated Terms and Affordability Constraints on 8 December 2008, and Tube Lines submitted its formal Response to Restated Terms on 30 June 2009. Between 1 July 2009 and 30 June 2010, the Parties will seek to negotiate agreement on revised terms, and failing that make a reference to the PPP Arbiter. Any required additional finance will also need to be in place for the start of the second Review Period on 1 July 2010.

Annex 2

THE FUNCTIONS AND DUTIES OF THE PPP ARBITER

  1.  The role of the PPP Arbiter was established by the Greater London Authority Act 1999 (GLA Act). Under the terms of the GLA Act, the Arbiter is independent of Government and of the PPP Parties and can only be dismissed by the Secretary of State on grounds of incapacity or misbehaviour, or for unreasonable delay in the discharge of his functions.

  2.  The Arbiter is a corporation sole. I was appointed as the first Arbiter on 31 December 2002, and my appointment now runs to 30 December 2010. I am supported by a small permanent staff. As I am appointed as an individual, and am personally responsible for the exercise of my statutory functions, I have also appointed an Advisory Board to provide independent and expert challenge to my decisions and procedures. Although I am not required by statute to do so, I have published each year a Business Plan and my Annual Report and Accounts setting out the work programme of my Office and the resources used.

  3.  As PPP Arbiter, I have two principal statutory functions:

    — to give directions on matters specified in the PPP Agreements, when asked to do so by one of the Parties to a PPP Agreement; and

    — to give guidance on any matter relating to a PPP Agreement, when asked to do so by either (or both) of the Parties to a PPP Agreement.

  4.  When the Arbiter is asked for guidance by one Party only, the Act gives me discretion about whether to give guidance. Where I am asked for directions, or am asked for guidance by both Parties to an Agreement, I am required to give directions or such guidance as I consider appropriate.

  5.  Although the Arbiter can be asked for guidance or directions at any time, it was expected that he would exercise formal functions in three main circumstances:

    — in giving an annual "definitive statement" on the performance of the two Metronet infracos;

    — at the Periodic Review of the Agreements which takes place every 7½ years; and

    — at an Extraordinary Review of the terms of a PPP Agreement if there were material changes in costs and revenues within a Review Period.

  6.  In addition, the Act gives the PPP Arbiter further powers "for the purposes of the proper discharge of the functions" conferred on him by the GLA Act. For example the PPP Arbiter may do "all such things as he considers appropriate for or in connection with the giving of a direction or guidance and… do such other things as he considers necessary or expedient… for purposes preparatory or ancillary to the giving of directions or guidance generally… notwithstanding that there is no matter in relation to which a direction or guidance is required".

  7.  The PPP Arbiter's function in respect of directions is limited by the terms of the PPP Agreements: if there is no specific provision in a PPP Agreement for the PPP Arbiter's involvement then disputes are dealt with through contractual dispute resolution. Even on matters within his remit, he is only brought in if one of the Parties seek a direction from him. The PPP Arbiter therefore has no unilateral power to change, or propose to change, provisions in the PPP Agreements. Even where he has made a direction on a disputed matter within his remit, the Parties may, under the provisions of the GLA Act, jointly agree to set it aside.

  8.  In exercising his functions, the Arbiter is under a statutory duty to act in the way he considers is best calculated to achieve four objectives:

    — to ensure that London Underground has the opportunity to revise its requirements under the PPP Agreements if the proper price exceeds the resources available;

    — to promote efficiency and economy in the provision, construction, renewal, or improvement and maintenance of the railway infrastructure;

    — to ensure that if a rate of return is incorporated in a PPP Agreement, and taking into account matters specified in the Agreement, a company which is efficient and economic in its performance of the requirements in that PPP Agreement would earn that return; and

    — to enable the Infracos to plan the future performance of the PPP Agreements with reasonable certainty.

  The Arbiter is also under a duty to take account of any factors which are notified to him by both Parties to an Agreement, or are specified in the relevant PPP Agreement, as ones to which he must have regard.

  9. For the purposes of assessing costs at a Periodic Review or Extraordinary Review, the PPP Agreement establishes the concept of the Notional Infraco. This is defined as the entity which has the same obligations as Infraco, which carries out its activities in an overall efficient and economic manner and in accordance with Good Industry Practice, and has certain other specified characteristics. A key part of the Arbiter's role is therefore to assess what constitutes Good Industry Practice and the level of performance and cost which would be efficient and economic.








1   London Underground PPP: Were they good deals? 17 June 2004, HC: 645 2003-04 Back

2   Although the PPP Agreements remain in place, London Underground has made it clear that it does not intend to refer matters relating to Metronet activities to me for review. However, I intend to ask the independent reporters appointed by me (currently KPMG and Lloyds Register Rail) to review Metronet's Asset Management Plan for the next Review Period when available to assess its robustness as a comparator for Tube Lines. Back

3   This Materiality Threshold was £200m for Tube Lines in the first Review Period only. A £50 million Materiality Threshold represents about 1% of the contract value. Back

4   The Department for Transport: The failure of Metronet, 5 June 2009, HC: 512 2008-09 Back

5   "It also seems clear that there have been differences of understanding between Metronet and London Underground about the allocation of different risks under the contract. In particular, the cost consequences of increases in the scope of work required to deliver obligations are mostly borne by London Underground; only the (low) Materiality Threshold and the cost consequences of delivering inefficiently are borne by Metronet. Thus, even where sums were omitted from the original bid, or disputes about contractual requirements have been won by London Underground (such as whether Low Loss Conductor Rail for the Victoria Line was an original obligation or not), London Underground still has to bear the efficient increase in costs." (Extract from my written evidence to the House of Commons Transport Committee, The London Underground and the Public-Private Partnership Agreements, Second Report of Session 2007-08, HC45.) Back

6   In my evidence to the Transport Select Committee (op cit). Back


 
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