THE COSTS OF THE BRIDGE

Costs for users

31. The terms of the concession agreement between the Department and the operators are that bridge users (and now the Department, as a result of their contribution to the new discounted tolls available from January 1998) must pay tolls to Skye Bridge Limited for a maximum of 27 years or, if sooner, as is expected to be the case, until they have amounted in total to some 24 million (in 1991 prices, discounted). These tolls were determined by the operators' forecast costs after allowing for the Department's forecast contribution of 6 million to meet the expected costs for the approach roads to the bridge.[21]

32. Before signing contracts the Department lost the benefit of competitive tension and negotiated with a single bidder only, who proved to have difficulties finding funders to support the project.[22] In this negotiation the Department accepted an increase in the total tolls to be paid by users of about 2 million (nine per cent), i.e. from some 22 million in the operators' 1990 bid to some 24 million in the final contract in December 1991.[23]

33. We asked the Department about their negotiation particularly of the financing of the project in this period, and why they had accepted the increase in total tolls to be paid by users. The Department said[24] that they done so in order to secure the project. In reply to our further questions they agreed that an alternative arrangement could have been envisaged whereby the total tolls to be paid would have been increased only if traffic did not match the levels expected. But they said that the difficulty with getting funders on board was extreme and they did not perceive at the time that such a deal could have been achieved from their negotiating position.

34. We therefore asked how the Department's confident forecast of a concession lasting less than 20 years could be reconciled to their acceptance in negotiation of a 27 year maximum period. The Department told us[25] that this was to provide comfort for some of the lenders of the project, who were so risk averse that they assumed there would be no traffic growth whatsoever from 1990 onwards.

35. We asked the Department to describe the options they considered at the final negotiation stage to deal with the prospect of a shortfall in traffic. The Department told us[26] that they had examined four options concerning the wider issue of how best to enable finance for the project to be secured. They did not consider separately the option of an agreement with provisions for later changes either in the total tolls to be paid or in the length of the concession.

36. In view of this we asked the National Audit Office to do an analysis of the financial effect of the concessionary period deal in the event that the Department's predicted traffic volumes were met. The National Audit Office told us[27] that since the Department had neither obtained a copy of the bidder's financial model in electronic form nor constructed their own financial model, the data did not now exist to enable such an analysis to be done in full. But if the deal could have been negotiated on terms comparable to those now prevailing in the market a reduction of around 1 million could have been achieved in the allowed total of tolls in the event of traffic in line with the Department's central forecast of traffic growth. Such terms might not have been available in 1991, and a contingent tolling regime might not have yielded net benefits in value for money terms.

37. We further asked the Department why they did not detect at the outset the financing difficulties which the operators encountered, before entering into negotiations with a single bidder under conditions when competitive pressure was absent.

38. The Department told us[28] that they had taken comfort on the projected financing of the project from an assurance from the Bank of America, who were one of the development partners and who were prepared to invest some 8 million of their own funds in the project. They were also the leading financial institution investing in such projects at that time. The Department considered that this institution was the best placed, perhaps the only one then in the business, to have given that assurance, but that the Department would not rely upon them now.

39. We therefore asked the Department what advice they had received from their lawyers concerning the value of the assurance from the Bank of America on the financing arrangements. The Department told us[29] that they had not sought legal advice on this letter because "... its value related to its degree of authority in assessing the relevant matters at the point the judgement was made rather than to its ability to indemnify the Department against changing market conditions".

40. The Department also told us[30] their financial adviser had commented that "... such letters are not intended to create a legal obligation for the writer." He also commented that "... the risk for a financial institution in writing such a letter is in terms of reputation rather than financial; (the) value (of such a letter) lies in demonstrating that the Bank is prepared to put its name behind the project, with a degree of embarrassment if it cannot ultimately deliver finance on the terms indicated".

Financing costs

41. Of the total external capital of 27 million obtained by the successful bidder for the financing for the bridge, 19 million was in the form of loans in line with the market given the degree of risk.[31] Of the remaining 8 million, 7.5 million was loan stock placed with a single investor on a negotiated basis for which it is unlikely competition would have been possible at the time; and the last slice of 500,000 was equity investment (in the form of equity-like index-linked loan stock) by the two construction companies forming the construction consortium responsible for the development of the bridge.

42. The investors had forecast a rate of return on the equity investment of 500,000 of some 18.4 per cent a year in real terms, 26.4 per cent nominal, resulting in a payment to the equity investors at the end of the project of some 10 million in 1991 prices[32] or 37 million in cash.[33] We therefore asked the Department whether the external financing itself provided value for money.

43. The Department told us[34] that the equity investment was a requirement of some of the secondary investors, who saw it as a way of increasing the security of their own investment, by permitting the company operating the concession to build up cash reserves as a hedge against adverse project developments. While the actual return the equity investors would receive could not be known until the end of the project, the Department's financial advisers had said that they expected the weighted average annual cost of the capital would be lower financing the project with equity (12 .6 per cent a year) than without (13.2 per cent a year). The Department said they would have preferred to have got the interest rates they did for the whole project without the equity slice, they found that they could not sustain this position in negotiation without jeopardising the whole deal.[35] The Department said the estimated equity return was not guaranteed, and that they were reassured that the rate was consistent with or lower than that which appeared to be obtainable for other similar investments.[36]

The Department's costs

44. The Department's own costs in developing, negotiating and supervising the deal were 15 million.[37] Within this sum the Department paid to the operators some 12 million, equivalent to some 9 million in 1988 prices, or 48 per cent more than their original target of 6 million in 1988 prices.

45. The contracts signed in 1991 were conditional upon subsequent satisfactory completion of statutory procedures for the authorisation of the tolls for the bridge, including a public inquiry which recommended modification to the design of the project, while the inquiry process itself necessitated a delayed start to construction, both factors adding to the operators construction costs. These factors were responsible for most of the increase in the Department's contribution to the operators, some 4 million in real terms.[38]

46. Accordingly we asked the Department whether they had managed this process properly, given that it is normal to hold a public inquiry before a project is tendered.

47. The Department said[39] that they had been deliberately experimenting with an approach which sought to maximise innovation and squeeze the very best out of the private sector. They said that in the event it proved to be that the private sector were not willing to take what the Government now consider as an extreme position, namely the acceptance of the risk arising from statutory processes, including a public inquiry. The Department added that, in their view, they would have encountered the same changes in the project leading to increased costs had they promoted the design at the public inquiry and only subsequently put the project to competition.

48. They also said[40] that they had learned lessons about managing risks from this project, though they said that they were not confident that it would have been possible to have improved control of this early private finance project by including costings of the risks involved.

49. The Department told us[41] that the reason they accepted responsibility for the extra costs in this case was that they concluded that the statutory processes were risks that the Department should have carried because they were within their control. They told us[42] that there was careful negotiation with the operators to confirm that these additional costs could be justified. The Department said that, though they firmly believe that every part of a deal should be tendered for, they judged that the overall price of the approach roads was consistent with earlier technical assessments and compared favourably with another similar project.[43]

50. In addition to their 12 million contribution to the operators' construction costs, the Department have paid a further 3 million in developing, negotiating and supervising the contract. We asked the Department why, given that they expected to incur such costs, they set no targets for most of this other expenditure.

51. In response the Department said[44] that they should have established budgets for their other 3 million costs, on advisers and other overheads and would now do so. They said, though, that they did not think that their failure to do so in the Skye case was a serious oversight.

52. We asked the Department why they under-estimated land purchase costs at 300,000 compared to final costs of 784,000. They told us[45] that the initial estimate came from the District Valuer. They said that the District Valuer was responsible for negotiating, and in this case the valuer was persuaded by the wisdom of the seller or his agents that the value of the land was greater than he had initially estimated.

53. In response to a further question, the Department agreed[46] that the purchase had taken place late in the day and it was always to the good if a deal could be closed early. They said, though, that they had to strike a balance between this approach and acquiring in advance of need.

Conclusions

54. The 39 million cost of the bridge fall directly both on the toll payers and on the taxpayer. Together they will pay the amount the winning private sector bidder estimated as necessary to cover the cost of construction, the cost of operating the bridge over the lifetime of the concession, and the cost of financing the concession. It follows that to minimise the costs to toll payers and to the taxpayer, it would have been necessary for the Department to have persuaded the winning bidder to accept lower estimates of likely costs.

55. In the event the estimated costs rose rather than fell during a period of exclusive negotiations with the winning bidder. The Department accepted the bidder's argument that traffic flows might not increase over the concession period in line with the Department's own expectations. The effect of this and other concessions made during exclusive negotiations is that the target toll revenue figure rose to 24 million from 22 million increasing the burden on toll payers by some 2 million. It also means that the operator will get the benefit of this additional income if, as now seems likely, their own more pessimistic traffic forecasts are exceeded.

56. This upward pressure on the costs of the bridge arose because the Department were negotiating this aspect with a single bidder as a result of financing difficulties encountered by that bidder. The Department did not detect the risk of such difficulties before entering into exclusive negotiations because they relied on an assurance from the Bank of America, who were the financial adviser to the bidder, that the proposed method of finance was achievable. In the event it was not and we criticise the Department for relying on an assurance, which provided no real security

57. Following objections to the preferred design on environmental and aesthetic grounds, the Department agreed with the operator to pay an additional 4 million in real terms to cover costs arising from the delay caused by the need for a public inquiry and from the recommended changes which resulted. The Department were unable to persuade the private sector to accept the risk of such additional costs. We note that subsequent Treasury guidance is that such risks should be retained in the public sector as being best able to handle them. This guidance casts doubt on the practicality of awarding contracts for privately financed projects before statutory planning procedures have been concluded.

58. The Department believe they would have encountered the same level of construction costs had they promoted the bridge at a public inquiry before, not after, proceeding with a competition. But if the competition had followed the public inquiry then the additional costs would have been subject to competitive pressure. We note the Department's assurance that lessons have been learned from this project, though they have not said what these are.

59. The Department consider that the financing terms on which the bridge has been provided are not out of line with other private sector projects concluded at the time. But neither the real rate of return to equity investors of 18.4 per cent a year nor the terms of the index-linked bonds which formed the next tier of financing were determined competitively. The terms of neither of these forms of finance were readily capable of being benchmarked against the market. There was, moreover, clear evidence of market imperfections, such as the fact that at the time of the deal there was only one potential provider of the index-linked bonds. This calls into question the validity of such benchmarking as may have been possible.

60. The experience of privatisation has shown that Departments are able to learn from experience and put pressure on the market to deliver increasingly good value for money in successive deals. We therefore look to Departments and their financial advisers to secure improved terms, as the financial market for PFI deals develops.

61. In those cases in which negotiation cannot be avoided, Departments should protect themselves from making unnecessary concessions to the bidder by developing a clear negotiating limit and by taking steps to avoid unwelcome surprises, for example by seeking independent confirmation of the likely viability of bidders' financing proposals.

21   C&AG's Report Paras 4, 23 Back

22   Q111 Back

23   C&AG's Report para 1.47 Back

24   Q15-19 Back

25   Q90 Back

26   Evidence, Appendix 1, pp 20-24 Back

27   Evidence, Appendix 3, p26 Back

28   Q50, Q111 Back

29   Evidence, Appendices 1-2, pp 20-26 Back

30   Evidence, Appendix 1, pp 20-25 Back

31   C&AG's Report paras 23-24 Back

32   C&AG's Report para 25 Back

33   Q26 Back

34   Q49, Q114 Back

35   Q114 Back

36   Q25-27 Back

37   C&AG's Report paras 4-5, 19 and Figure 2 Back

38   C&AG's Report para 3.12 and Figure 9 Back

39   Q101, Q93-95, Q100 Back

40   Q5, Q103-104 Back

41   Q4 Back

42   Q115 Back

43   Q106-107 Back

44   Q8-9 Back

45   Q28-31, Q120-122 Back

46   Q29, Q32 Back


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