28 March 2001
Sir John Bourn, Head of the National Audit Office, told Parliament today that although the Private Finance Initiative deal for the construction of the Channel Tunnel Rail Link was in many respects unique, the lessons to be learned from the project’s near collapse are not. The report makes three key points.
The report notes that, in difficult circumstances, a range of complex issues had to be addressed and that the Department handled the negotiations with LCR in a competent manner. It also sets out a number of lessons for future Public Private Partnerships, including:
Make sure that bidders for a PFI deal are not encouraged to be over-optimistic
Poor performance by Eurostar (UK) Limited (the UK arm of the international train service transferred to the private sector in 1996 as part of the PFI deal) weakened London & Continental Railways (Eurostar UK’s owner and contractor for the construction of the Link) to such an extent that its ability to fund construction of the Link was destroyed and the entire project came close to collapse. There have been recent examples (such as the Millennium Dome and the Royal Armouries Museum) of high profile projects whose business plans have depended on forecasts of usage that turned out to be highly optimistic. As bidders’ forecasts in 1996 for the fledgling Eurostar UK business were in line with previous estimates made by the Department and British Rail, the Department did not have them independently reviewed.
The private sector is paid for taking risk. Responsibility should therefore remain with the private sector should these risks actually occur. In the restructured deal, LCR’s shareholders retained an economic interest in the project while avoiding the full financial consequences of its near collapse. On the other hand, the taxpayer could be exposed to further financial risk of £360 million on current forecasts if Eurostar UK revenues are badly affected by poor passenger numbers. Departments should ensure that over-optimism in bidding for contracts will lead to losses if things go wrong.
The risk of running a relatively new international train service was bundled together with the risk that the private sector contractor would be unable to raise sufficient finance to build the Link. Significant public assets were transferred to the private sector more than a year before the planned completion of the external financing for the project. If a department proposes to depart from the normal practice in Public Private Partnerships of transferring assets only when all finance has been raised, then it needs to think through its approach to managing the increased risks involved.
Departments should ensure that the capital structure of a deal is consistent with the risks involved in the project. If the proportion of risk capital is too low, the project will not be financially robust in the face of lower than expected revenues. Moreover, having a relatively low investment at risk may provide insufficient incentive for the private sector shareholders to tackle business problems with determination. Either way, the impact of proceeding with too little risk capital is likely to be a call on the public sector for increased financial support, as happened in this case. It follows that a department should take a close interest in private sector proposals for the capital structure of Public Private Partnerships.
The Department calculated benefits of some £3,000 million from a public sector subsidy of £2,000 million. Reworking the calculation, adjusting some of the Department’s assumptions, the report shows that the economic case for the Link is debatable and that the justification for public sector support is heavily dependent on wider policy benefits. If regeneration and passenger benefits are not as high as expected, the Link is unlikely to be good value for the taxpayer on economic grounds. It is essential therefore that the Department should do what it can to ensure that such benefits are realised.
The Department retained the risk that future Eurostar UK revenues would be insufficient to service £430 million of debt taken on by LCR and attract further investment in the project. If the market is unwilling to provide sufficient debt capital secured on the project, that is a clear signal that the project risks go beyond normal commercial risks. Such guarantees transfer project risks to the department, which needs therefore to consider thoroughly how to manage those risks.
LCR could not have raised all the finance it needed without Government help. However, the use of bonds carrying a Government guarantee rather than a voted loan from the Department to fund the project, cost the taxpayer an additional £80 million. The use of such bonds reflected the unique circumstances of this deal and achieved the Government’s objectives for risk allocation and accounting treatment in this Public Private Partnership. Departments will need to consider this cost-benefit balance with great care if similar situations arise in the future.
"It is apparent that, faced with a range of complex issues, the Department handled negotiations with LCR in a competent manner. The financing of the restructured project is fundamentally different to that envisaged in 1996, and so is the distribution of risks between the various parties now involved. There are a number of important lessons here for future PPPs, along with some specific points for the Department".
Sir John, 28 March 2001
In February 1996 the Department of the Environment, Transport and the Regions awarded London & Continental Railways the Channel Tunnel Rail Link contract. LCR would finance, build and operate the Link drawing revenue primarily from Eurostar UK while the Department would provide LCR with subsidies of £2 billion for the construction of the Link and its use by domestic train services. However, LCR could not raise all the money it needed from private investors and in January 1998 the company asked for an additional £1.2 billion in public subsidy. Following negotiations, the Deputy Prime Minister announced that the deal had been restructured without a material increase in the level of public subsidy.
The restructured deal retains the same route for the Link but splits construction into two sections: Section 1, from the Channel Tunnel to near Ebbsfleet on the outskirts of London, and Section 2 from near Ebbsfleet to St Pancras. Railtrack has been brought in both to manage construction and, when it is completed, to purchase Section 1. Construction of Section 1 began in October 1998 and is on target for completion by 30 September 2003. Completion of the entire Link is now scheduled for late 2006. The Department is discussing the arrangements for Section 2 of the Link with LCR, Railtrack and other parties with the intention of concluding a deal very soon.
Press notices and reports are available from the date of publication on the NAO website at http://www.nao.org.uk/ Hard copies can be obtained from The Stationery Office on 0845 702 3474.
The Comptroller and Auditor General, Sir John Bourn, is the head of the National Audit Office employing some 750 staff. He and the NAO are totally independent of Government. He certifies the accounts of all Government departments and a wide range of other public sector bodies; and he has statutory authority to report to Parliament on the economy, efficiency and effectiveness with which departments and other bodies have used their resources.