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.
- In negotiating with the private sector the Department of the Environment, Transport and the Regions achieved its key objectives through a restructured deal in 1998 that is in many respects more robust, with a better allocation of risk, than the original deal signed in 1996.
- However, the complex financial arrangements agreed during the restructuring will require significant and long-term Government support for the project.
- As there is room for debate on the economic case for the Link, the justification for the project is heavily dependent on wider policy benefits envisaged by the Government.
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.
If a deal goes wrong, private sector partners should bear their share of the risk
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.
Substantial risks arise if public sector assets are transferred in advance
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.
The proportion of equity capital in a PFI project should reflect the 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 should monitor the expected benefits from the Link
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.
Government guarantees of project debts are unlikely to be costless
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.
If a project requires public funding, give careful consideration to the most cost-effective route
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.