[Apologies for the lack of posts last week – business unfortunately intervened – JB]

The PPP Arbiter has made his final direction on pricing for the second period of Tube Lines’ PPP contract – the final figure is £4.46bn.

The figure is broadly inline with that proposed in December’s Draft Decision (the final figure represents an overall increase of £65m on the Draft) and comes after both Tube Lines and TfL’s post-December representations on any other information they felt should be considered.

It appears that both Tube Lines and TfL did indeed take the opportunity to revise their costs further. Perhaps unsurprisingly, it appears that both parties also decided that they had previously been too conservative in their estimates, as the Arbiter’s final report reveals:

The Parties’ representations to the Arbiter set out revised positions on costs in the light of draft directions. In total, Tube Lines’ representations proposed costs of £5.865 bn, a small increase on its original submission to the Arbiter. London Underground considered that the appropriate level of costs was just under £3.7 bn, a reduction of more than £300m from its original submission

The Final Determination

As can probably be guessed from the relatively minor difference in cost determination between the Draft Direction and this final report, the overall conclusions and decisions here differ little from those we covered last year.

In a nutshell, the Arbiter’s decision is based on his assessment of how a “Notional Infraco” – a hypothetical company tasked with carrying out the same work as Tube Lines – would have performed, and his cost estimates are therefore based on both where that company would have been work-wise by the end of the first 7 year period of the PPP contract and what its estimated costs would be going forward.

Here, his determination is that industry best practice indicates that Tube Lines’ contracting and working methods for the Jubilee Line work it has been tasked with carrying out (particularly the signals upgrades) are both flawed. Most importantly Tube Lines, the Arbiter claims, did not sufficiently allow for specification changes in its signalling contract, relying too heavily on an expectation that the Underground’s needs could be met with an “out of the box” solution.

The company, the Arbiter indicates, also did not act sufficiently quickly to manage this oversight with its signals contractor Thales and this – combined with other minor management and works failures – has left Tube Lines incurring greater delivery costs and left it also running behind on the Northern Line upgrade project. The lack of work on the Northern Line in the first 7-year period of PPP thus means Tube Lines will need to spend more money to carry out that work in the second period – which the Arbiter argues is again a cost that the Notional Infraco would not have incurred.

So What’s Different?

Those familiar with last years’ Draft Declaration will see little change in the above. There are several small changes, but nothing major.

Tube Lines had asserted that they felt London Underground, as the client, had contributed to any project failures through bad management and/or communications in certain areas, but the Arbiter now broadly rejects that claim – they were failures, he says, but these should have been dealt with through the contracts’ disputes process and he has already allowed for several instances of this in his Notional Infraco calculations:

The Arbiter has not been persuaded that he should make a specific allowance in Notional Infraco costs, in either RP1 or RP2, to reflect the behaviour of London Underground as client under the contract. That is not to say that its behaviour has not in some cases added to costs, but not in a way or to an extent that would justify as specific allowance, given for example the revised approach to risk described below. Rather, the Arbiter considers that these are matters which are properly the subject of claims. He has based his cost projections on the assumption that the Notional Infraco would, like Tube Lines itself, make claims for additional costs arising from behaviour by London Underground which is not in accordance with the terms of the PPP Agreement.

Tube Lines also contended that the Arbiter could not rule (or base any costs) on anything relating to closures because, the company argued, they felt they had sufficiently demonstrated that it was technically impossible for the work required on the Jubilee Line to have been completed within the number of closures that had been allowed. The Arbiter’s final decision rejects this claim, indicating that whilst it is not possible for him to rule on specific closures, the evidence and data is sufficient to establish that a Notional Infraco could have completed the work within the number of closures that had been initially contracted for.

It appears that the Law Firm Lovells were also asked by Tube Lines to make representations to the Arbiter on whether the entire concept of a Notional Infraco was contractually valid. Lovells, the report reveals, argued that by using the concept of a Notional Infraco as a basis for decisions, the Arbiter (or rather the PPP contracts) were relying on the concept of a “Notional Client” which has no legal and contractual status, and thus should not be used for valid cost analysis without the establishment of a new “Notional Client Status.”

The Arbiter’s final report rejects this assertion, effectively arguing that although the Notional Infraco concept is used, it is based on underlying (and very transparent) data and thus based firmly on realistic (and contestable) legal grounds. London Underground indicated that they supported the Arbiter in this assertion.

Lovells also indicated that Tube Lines felt that they had not been given all the information they needed from the Arbiter’s office to be able to reply to his decisions. Again, the Arbiter rejected this claim, indicating that only commercially sensitive data from those parties he had asked for advice (such as on signalling costs from alternative manufacturers) was held back from Tube Lines and London Underground, and that both parties were given sufficient data to respond to his numbers. Again, London Underground agreed with the Arbiter’s assertion.

Finally, the Arbiter’s report sheds some light on the recent spat over Victoria Line upgrade costs. London Underground had provided these to the Arbiter so they could be factored into “best practice” calculations, but Tube Lines had argued that the figures provided by London Underground underestimated the cost, and pointed to documents they had obtained via an FOI request to prove this.

The report reveals that in response to this claim, the Arbiter undertook a special review of the Victoria Line figures given to him by London Underground. He was able to establish that the figures given to him initially were incorrect, and that the new figures pointed to by the FOI request should be used instead. Ultimately, however, this appears to have had little effect on the final price.

Financing The Difference

The Arbiter’s draft report, along with his appearance before the London Assembly Transport Committee, had foreshadowed another suggestion that now appears in the the Final Report – one that certainly hasn’t found favour with London Underground or TfL. This is the suggestion that, should the cost of the work prove more expensive than TfL or Tube Lines can budget for, one of two eventualities would likely be the best approach to take:

1) That London Underground should look to descope work down to a level which it could indeed afford to pay.

2) That TfL should consider taking on the responsibility of raising any additional loan finance required on Tube Lines’ behalf, as it would be able to secure better rates from the market than Tube Lines – particularly considering the currently precarious nature of Tube Lines’finances.

So What Happens Next?

The Arbiter has indicated that although he considers this report to be his Final decision, as the PPP contract stipulates, he is prepared to reopen and reassess his estimates if one of three things happens:

1) London Underground change their requirements further (if, for example, they decide to rescope further to reduce cost)

2) If the current negotiations between Tube Lines and TfL on leasing arrangements for the new Piccadilly Line Rolling Stock change significantly, or if no leasing arrangement is agreed at all (in which case the cost of buying the Piccadilly Rolling Stock will need to be factored in)

3) If a dispute Tube Lines currently has open, which argues that London Underground’s restated terms aren’t consistent with the PPP contract, rules in favour of Tube Lines.

If any of the above is to happen, however, then the parties would need to notify the Arbiter of any changes to by 21 May 2010, with the Final Determination becoming binding on the 30th June.

As it stands, therefore, the final battle lines appear now to have been drawn. Tube Lines’ press release post-decision is decidedly ambiguous – it welcomes the Arbiter’s final report but is tight-lipped on the subject of further appeals either to the Arbiter or the Courts, indicating that time is required to evaluate the Arbiter’s final report closely.

Meanwhile, TfL’s own reaction is rather more aggresive. Their post-report press release takes a decidedly dim view of the assertion that it should take on any responsibility for financing what it regards as Tube Lines’ failures. More, that for TfL to have any responsibility for raising the required finance would clearly be in direct opposition to the very concept of the Public Private Partnership system. Thus were they required to do so, then TfL feels it would be a clear indication that the PPP itself was flawed and consequently that any additional costs required should be met by the Government:

While the Arbiter’s Final Directions are a welcome endorsement of LU’s evaluation of the costs, rather than Tube Lines’, they nevertheless confirm a price around £400m more than LU’s £4bn budgeted cost.

However, rather than demanding that Tube Lines raise the finance required to complete the Tube upgrades in full, as the PPP was created to ensure, the Arbiter suggests that TfL should either cut back on the Tube improvements promised to Londoners or simply provide more public funds without any effective scrutiny of Tube Lines’ future plans.

As the Government has made clear it will not provide an additional finance to TfL, this clearly demonstrates the PPP is not delivering for Londoners and taxpayers.

While it is clearly the case that TfL could raise finance more cheaply than Tube Lines, the Mayor and TfL made clear that all PPP finance necessary must be raised by Tube Lines and its shareholders.

Such a step is vital to ensure the rigorous scrutiny of Tube Lines’ future plans by the financial markets and protect London’s taxpayers and farepayers by transferring risk from the public to the private sector, which the PPP was intended to enshrine.

Similarly, the Mayor has also provided a customarily hyperbolic response:

In other countries this would be called looting, here it is called the PPP

The Guardian also claim that the Mayor has indicated to them that he is considering suing Arbiter Chris Bolt for saying that TfL should raise the money – something that, it is probably fair to say, is a less than helpful suggestion.

Both the Mayor and TfL have also highlighted the fact that Tube Lines, a Joint Venture between Ferrovial and Bechtel had spent over £400m effectively subcontracting staff from its parent companies – a cost that they feel is unacceptable and which they feel the Arbiter has unfairly overlooked.

This is a line of argument that both the Mayor and TfL have been pushing since the appearance of all three parties (TfL, Tube Lines and the Arbiter) in front of the London Assembly, and an argument that one suspects they feel may gain some traction in the press.

Whilst on the surface it seems a relatively clear area of overspend, however, it is worth realising that it is likely not as white/black a situation as it appears on first glance.

It may well be, as TfL and the Mayor seem keen to imply, that Tube Lines may not have worked overly hard to ensure that the contracting rates for those staff were best value, but its still a figure that includes all the necessary wage and HR costs associated with those roles. Thus whether inflated or not, its tricky to see how a significant amount of that expense would not have been incurred anyway, and its therefore probably not the “instant saving” figure that they imply.

Final Conclusions

Overall, it will be interesting to see what the next month or so brings. Descoping somewhere would seem to be the most likely outcome were London Underground to give way on financing, but descoping a PPP contract that has already been extensively restated would prove incredibly difficult. Doing so would mean making cuts somewhere – most likely to the Piccadilly Line Upgrade – that, put simply, London’s transport infrastructure cannot really afford to make.

As the tone in TfL’s press release clearly indicates, this is something of which they are most definitely aware, and it seems unlikely that they would go quietly down this path.

It also seems likely that we will see further remonstrations between TfL and the government over the issue of the PPP contract itself, something the Government will be keen to avoid in the run-up to the coming election – with the suggestion being that if TfL cannot afford to fund the shortfall, the Government should step in. Sadly, TfL’s political capital here, it could be argued, is rather compromised by some of the decisions taken in the last year by the current Mayoral administration.

This was most obviously evidenced recently by the Mayor’s last effort to take a high line on the subject of finance with the DfT – an effort that resulted in a rather pointed rebuke from Secretary of State for Transport, Lord Adonis:

Under devolution, it is for the Mayor and TfL to deliver the Tube upgrades within their generous budget – not for me to bail them out if they fail to do so.

If Boris wants me to take charge of TfL then he should say, and I would start with more sensible priorities like not cancelling the Western congestion charge zone and not replacing a modern bus fleet needlessly – both of which are costing Londoners hundreds of millions of pounds which could be spent on upgrading the Tube.

If TfL did find themselves faced with the need to raise further funding, then it would be equally interesting to see whether they considered it better value to attempt to remove Tube Lines from the calculations completely – a buyout of the company is something that they have acknowledged has been discussed internally in the not too distant past.

On the other side of the coin, Tube Lines themselves remain in a precarious financial position. The determination, whilst certainly higher than TfL wanted, is significantly lower than the £5.8bn Tube Lines had declared was their absolute minimum requirement.

The company are not in the position to easily (or more importanly cheaply) raise capital and have been on “Ratings Watch Negative” status with ratings agency Fitch since the middle of February. This effectively means that their finances are being watched closely, and baring a suddenly positive improvement in their future prospects (something that a more favourable Arbiter’s report might have foreshadowed) they may find themselves downgraded as an investment proposition at the end of April when they publish their next Business Plan.

By April, therefore, the question may not be whether Tube Lines should raise capital if TfL refuse to do so, but whether they can do so at all. Were that situation to arise then it seems difficult to see how, with the end of RP1 representing a break-point in the PPP contract, Bechtel and Ferrovial would not consider the possibility of simply walking away from the PPP completely.

As indicated above, the next month or so should prove very interesting indeed…

Written by John Bull
John Bull is the Editor of London Reconnections. A transport journalist and historian, his writing often focuses on the political or strategic challenges facing London's transport network and beyond.