The Channel Tunnel Rail Link

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1 Departmet of the Eviromet, Trasport ad the Regios The Chael Tuel Rail Lik REPORT BY THE COMPTROLLER AND AUDITOR GENERAL HC 302 Sessio : 28 March 2001

2 Departmet of the Eviromet, Trasport ad the Regios The Chael Tuel Rail Lik REPORT BY THE COMPTROLLER AND AUDITOR GENERAL HC 302 Sessio : 28 March 2001 LONDON: The Statioery Office 0.00 Ordered by the House of Commos to be prited o 26 March 2001

3 Cotets Executive summary 1 Part 1 To esure completio of the Lik, the 11 Departmet allowed the origial deal to evolve Poorer tha expected performace of Eurostar UK 11 put the origial deal at risk The origial deal came close to collapsig 14 The Departmet wated the Lik completed without 16 a material icrease i the direct grats The restructured deal is i may respects more 17 robust tha the origial This report has bee prepared uder Sectio 6 of the Natioal Audit Act 1983 for presetatio to the House of Commos i accordace with Sectio 9 of the Act. Joh Bour Natioal Audit Office Comptroller ad Auditor Geeral 21 March 2001 The Comptroller ad Auditor Geeral is the head of the Natioal Audit Office employig some 750 staff. He, ad the Natioal Audit Office, are totally idepedet of Govermet. He certifies the accouts of all Govermet departmets ad a wide rage of other public sector bodies; ad he has statutory authority to report to Parliamet o the ecoomy, efficiecy ad effectiveess with which departmets ad other bodies have used their resources. For further iformatio about the Natioal Audit Office please cotact: Part 2 The complex fiacig of the Lik requires 21 log-term Govermet support The Lik will be fiaced from a complex mixture 21 of public ad private fiace ad guaratees The decisio to use Govermet-guarateed bods 24 was fiely balaced The taxpayer faces both ope-eded fiacial risks 26 ad the possibility of returs Part 3 The case for public sector support is heavily 29 depedet o wider beefits Public sector support for the Lik was ievitable 29 The Departmet estimated that the ecoomic ad 31 wider beefits would outweigh the subsidy, so support for the Lik was ecoomically justified The Departmet's ecoomic assessmet of the project 33 is debatable Natioal Audit Office Press Office Buckigham Palace Road Victoria Lodo SW1W 9SP Tel: equiries@ao.gsi.gov.uk Website address:

4 Appedices 1. Chroology of key evets Scope ad methodology of the Natioal Audit 39 Office's examiatio 3. Additioal iformatio o the Lik Advisers for the restructurig of the project Evaluatio of fudig of LCR Pricig of public trasport services with 76 high capital costs 7. Fiacial ad cost-beefit aalysis framework The key beefits ad costs icluded i the value 81 for moey assessmet of the lik

5 Lodo Tuel St. Pacras Waterloo Stratford SECTION 2 N Thames Tuel Ebbsfleet Lik to Waterloo Fawkham Juctio Medway Crossig North Dows Tuel SECTION 1 Tuels Ashford Eurotuel Termial To Chael Tuel

6 executive summary I this sectio Why the Departmet 2 restructured the deal Public expediture impacts 3 The ecoomic justificatio 6 for public sector support Lessos leared 8 1 The cotract uder the Private Fiace Iitiative to build the Chael Tuel Rail Lik (the Lik) ad ru the UK arm of the Eurostar iteratioal trai service (Eurostar UK) was awarded to Lodo & Cotietal Railways Limited (LCR) i February The cotract was i lie with the priciples of the Private Fiace Iitiative: it evisaged that LCR would fiace, build ad operate the Lik drawig reveue primarily from Eurostar UK ad from use of the Lik by domestic trai services. The Departmet of the Eviromet, Trasport ad the Regios (the Departmet) agreed to provide LCR with direct grats totallig 1,730 1 millio for the costructio of the Lik ad its use by domestic trai services. It was expected that costructio would start i 1998 ad that the Lik would ope i At the ed of 1997 it had become clear that overly optimistic forecasts for the operatig performace of Eurostar UK had scuppered LCR's efforts to raise all the moey it eeded from private ivestors to build the Lik. I Jauary 1998, the compay therefore asked for a additioal 1,200 millio 2 i direct grats from the Departmet. Followig egotiatios, the Deputy Prime Miister aouced i Jue 1998 that the Departmet had agreed with LCR o a way forward which would ot ivolve a material icrease i the direct grats to be paid to LCR. However, it did ivolve a radical restructurig of the project ad the role of LCR. A chroology of key evets is at Appedix 1. 3 The restructured deal retais the same route for the Lik but splits costructio ito two sectios: Sectio 1, from the Chael Tuel to ear Ebbsfleet o the outskirts of Lodo ad Sectio 2, from ear Ebbsfleet to St. Pacras. Railtrack has bee brought i both to maage costructio ad, whe it is completed, to purchase Sectio 1. Railtrack also has a optio to purchase Sectio 2 o the same basis. Costructio of Sectio 1 bega i October 1998 ad is o target for completio by 30 September Completio of the etire Lik is ow scheduled for late The fiacig of the restructured project is fudametally differet to that evisaged i 1996, ad so is the distributio of risks amog the various parties ow ivolved with the deal. 1 Future cashflows i the origial deal were evaluated at 1995 prices, discouted at 6 per cet real to To allow compariso with the origial deal, LCR's request for additioal direct grats of 1,200 millio was expressed i 1995 prices, discouted at 6 per cet real to Whe expressed i 1997 prices, discouted at 6 per cet real to 1997, the figure icreases to 1,294 millio. executive summary 1

7 4 This report examies: a) the Departmet's reasos for restructurig the deal rather tha choosig other optios; b) the likely implicatios of the restructured deal for public expediture; ad c) the justificatio for the direct grats which the Lik will require. Our methodology is summarised at Appedix 2. Why the Departmet restructured the deal 5 The origial deal combied costructio of the Lik with the privatisatio of what was at the time a relatively ew Eurostar UK trai service to Paris ad Brussels. It rested o LCR's forecasts that Eurostar UK would grow quickly eough for the reveues geerated to support the raisig of private fiace to cover the heavy costs of costructig the Lik. Ahead of a mai fiace raisig exercise, the Departmet agreed to support iitial borrowig by LCR of over 400 millio from a sydicate of baks. LCR's origial shareholders put up 60 millio of equity fiace (paragraphs 1.1 to 1.10). 6 I the evet, Eurostar UK performed much less well tha expected ad LCR was uable to cotiue o the origial pla. The Departmet ecouraged LCR to seek other ways of carryig o with the project, ad LCR held iitial discussios with Railtrack i Fidig that it was ot possible to reach agreemet with Railtrack LCR approached the Govermet seekig additioal direct grats, before its fiaces were exhausted (paragraphs 1.11 to 1.26). 7 The Departmet rejected the optio of simply agreeig to pay additioal grats ad made it clear to LCR that it wated the Lik completed without a material icrease i the size of the direct grats. The Departmet was also uwillig to dispese with LCR ad begi the process of selectig a private sector parter all over agai. Such a move would have ivolved a further delay of at least two years ad prologed the plaig blight, which had affected properties ear the route of the Lik (paragraphs 1.27 to 1.32). 8 The Departmet therefore decided to restructure the deal with LCR. The Departmet's key objectives for the restructurig were: a) to esure that the Lik would be built without a material icrease i the level of direct grats agreed i the origial deal; b) to iject ew private sector maagemet ito Eurostar UK; c) to esure that the parties to a restructured deal would be fiacially committed to it ad fiacially strog eough to meet their obligatios; ad d) to achieve a true Public Private Partership with each risk allocated to the party best able to maage it ad with rewards commesurate with the risks. 9 The Departmet achieved its key objectives durig the restructurig ad the restructured deal is i may respects more robust tha the origial: 2executive summary fiacig the costructio of the first Sectio of the Lik is o loger depedet o the performace of Eurostar UK a) Apart from paymets of direct grats, the fiace for Sectio 1 ow comes from two sources: commercial bak borrowig by LCR which has bee guarateed by Railtrack, ad a issue of bods by LCR which carry a Govermet guaratee (paragraph 1.34).

8 costructio risk remais with the private sector b) Because Railtrack will maage the costructio of Sectio 1 ad purchase it at a price liked to the actual cost of costructio, the costructio risk was allocated to a party that was cosidered capable of maagig it ad was strog eough to meet the fiacial obligatios ivolved (paragraphs 1.35 to 1.37). there are improved arragemets for sharig Eurostar UK reveue risk c) Eurostar UK is ow beig maaged by a private sector compay appoited by LCR, Iter Capital ad Regioal Railways Limited (ICRR). The maagemet fee paid to ICRR is a percetage of Eurostar UK turover, adjusted by a sharig of operatig cashflow risk with LCR (paragraphs 1.38 to 1.40). the Departmet has improved its moitorig of the project d) Uder the origial deal, the Departmet decided ot to demad all the iformatio it was etitled to uder the cotract with LCR. This decisio hampered the Departmet's ability to moitor progress ad at the same time deied the exteral fiaciers at the early stages of the project the opportuity to brig private sector fiacial disciplies to the deal. I the restructured deal, the Departmet ow has cosiderable ifluece o the way the whole project is beig maaged. It has a special share i ICRR; it is a co-sigatory to the cotract betwee Railtrack ad LCR ad the Departmet has appoited a director to the board of LCR. I additio, the Departmet is actively moitorig the performace of LCR ad the other parties to the project (paragraphs 1.41 ad 1.42). fiacig for Sectio 2 of the Lik is yet to be secured e) Railtrack has a optio to purchase Sectio 2, but o obligatio to costruct it. LCR is cotractually committed to costruct Sectio 2, but may ot offer the right to acquire Sectio 2 to ayoe other tha Railtrack prior to the expiry of the optio i 2003 or Railtrack's agreemet to surreder it earlier. As a private sector compay reliat o its tradig icome from the Lik, LCR caot guaratee to be able to raise the ecessary fiace for Sectio 2 whe it is required (paragraphs 1.43 to 1.45). f) The Departmet is discussig the arragemets for Sectio 2 of the Lik with LCR, Railtrack ad other parties with the itetio of cocludig a deal very soo. The Natioal Audit Office is moitorig developmets ad may report further if ecessary (paragraph 1.46). Public expediture impacts 10 I restructurig the deal, the Departmet avoided ay material icrease i the et amout of direct grat payable to the project. Nevertheless, the restructured deal ow depeds o the Govermet havig issued various guaratees ad udertakigs to led moey directly to LCR. This meas that the taxpayer is exposed to cosiderable fiacial risk if Eurostar UK does ot perform as well as expected agaist revised forecasts. Set agaist that risk, the Departmet will share i ay log-term profits if the busiess is successful. executive summary 3

9 11 The Lik will be fiaced from a complex mixture of public ad private fiace ad guaratees: a) I the short term, ad begiig durig the re-egotiatios, LCR coducted a sale-ad-leaseback of eleve of its Eurostar trai sets, with the Govermet guarateeig LCR's obligatios amoutig to 230 millio, pedig the arragemet of log-term fiace (paragraph 2.2); b) LCR has raised log-term fiace of 2,650 millio ad expects to raise a further 1,100 millio through the issue of Govermet-guarateed bods. LCR took the view that a issue of equity would ot succeed, ad that it would ot be practicable to borrow such a large sum from baks. Our advisers, RBC Domiio Securities agree that the bods represeted good value i terms of the rates of iterest payable, compared with what was available i the loa markets at the time (paragraphs 2.4 to 2.6). c) Railtrack is obliged to buy Sectio 1 from LCR, ad has guarateed part of LCR's borrowig. Railtrack will pay the actual cost of costructio, icludig a allowace for the iterest costs icurred by LCR, less the direct grats to be paid by the Departmet to LCR. Railtrack has also guarateed up to 700 millio of commercial bak borrowig by LCR for the specific purpose of fiacig the costructio of Sectio 1 (paragraphs 2.7 ad 2.8). d) I additio to direct grats, the Departmet has guarateed paymets from Eurostar UK to Railtrack ad has provided a capped loa facility for LCR to draw o, depedig o how Eurostar UK performs i the future. Direct grats uder the restructured deal of 2,010 millio 3 will be paid towards the costructio ad operatig costs of the Lik. I additio, the Departmet has guarateed the paymets Eurostar UK will be due to pay Railtrack as ower of Sectio 1. These "track access charges" are based o the same priciples as those applyig to the paymets by other trai operatig compaies for the use of Railtrack's ifrastructure elsewhere o the railway system. I this deal, however, they are also the mechaism by which Railtrack will make a commercial retur o its ivestmet i Sectio 1 (paragraphs 2.9 to 2.12). e) The origial shareholders with a cotiued iterest i LCR have coverted most of their equity stake ito preferece shares carryig a fixed rate of iterest. Oe half of these preferece shares will be repaid with accrued iterest o completio of Sectio 1 ad the other half o completio of the etire Lik. LCR's origial shareholders did ot therefore lose their origial ivestmet ad did ot cotribute ay further equity to the project (paragraphs 2.13 to 2.15). 4executive summary

10 12 The decisio to use Govermet-guarateed bods was fiely balaced. The Departmet cosidered that their use had advatages over the alterative of makig voted loas to LCR, fiaced through the issue of covetioal Govermet bods (Gilts): a) the cocept of the Lik as a flagship Public Private Partership would be maitaied; b) it would avoid sigallig to other potetial PPP developers that the Govermet would be willig to take o fiacig risk; ad c) it would keep the project off the public sector balace sheet. This last poit depeded o the guarateed bods ot beig classified as public sector borrowig, which followed from the Office for Natioal Statistics beig satisfied that there was a very low likelihood of the guaratee ever beig called (paragraphs 2.16 to 2.18). 13 The use of Govermet-guarateed bods will, however, lead to extra fudig costs by compariso with Gilts because the iterest rates at which they were issued were higher tha those of directly comparable Gilts. Our advisers cosider that the marketig of the bods appears to have bee hadled most carefully ad attribute this extra cost to techical factors affectig demad from ivestors for the bods. Nevertheless, the advatages over Gilts that the Departmet saw i usig Govermet-guarateed bods were secured at a cost of some 80 millio 4 (paragraphs 2.19 to 2.24). 14 As a result of the fiacig structure ow put i place for the Lik, the taxpayer remais exposed to the fiacial risks of LCR's busiess. If Eurostar UK cotiues to uder-perform, the arragemets made for the Govermet to led LCR the moey to pay Railtrack's access charges would be triggered whe LCR's other cash resources, icludig the moey raised from the Govermet - guarateed bods, are exhausted. Scearios cosidered by the Departmet at the time of the restructurig show that betwee 2010 ad 2021 a shortfall ragig from il to 360 millio might arise. A more recet forecast of Eurostar UK performace suggested a rage of 360 millio to as much as 1,200 millio uder extreme circumstaces. Further, but much smaller, fiacial exposure will arise from ay future Govermet guaratees of LCR's potetial liabilities through a highly complex series of swap trasactios, which were used to hedge LCR's risks from chages i iterest rates (paragraphs 2.25 to 2.32). 15 I restructurig the deal, however, the Departmet esured that the taxpayer stood to beefit i the evet of Eurostar UK beig successful i attractig icreased patroage. LCR is ot permitted to pay divideds to its shareholders util 2021, but if Eurostar UK does well that restrictio could be relaxed before the, provided all accumulated borrowig has bee repaid. After 2021, the Govermet will be etitled to 35 per cet of LCR's pre-tax cashflow ad, if LCR is sold or floated, the Govermet would receive 90 per cet of the proceeds (paragraphs 2.33 ad 2.34). 3 Future cashflows i the restructured deal were evaluated at 1997 prices, discouted at 6 per cet real to Direct grats ( 1,730 millio) agreed uder the origial deal icrease to 2,014 millio whe expressed i 1997 prices, discouted at 6 per cet real to I the rest of this report, future cashflows are quoted at 1997 prices, discouted at 6 per cet real to 1997, uless idicated otherwise. executive summary 4 As at February 1999, the date the Govermet-guarateed bods were issued. 5

11 The ecoomic justificatio for public sector support 16 The Lik could ot be developed without very active support from the Govermet at all stages. The Govermet is ecessarily ivolved through rail regulatio, ad through the UK's iteratioal obligatios, otably those relatig to the Chael Tuel. The Govermet is thereby obliged to provide sufficiet ifrastructure to allow for forecast demad for the Tuel to be met, but there is o obligatio to provide a high-speed rail lik betwee Lodo ad the Tuel, which is what the Lik will be (paragraphs 3.2 to 3.6). 17 It was always evisaged that the Lik would ot be commercially viable without a substatial Govermet fiacial cotributio. Not oly is the Lik oe of the largest ifrastructure projects i Europe, rederig it ulikely that passeger reveues could cover the eormous ivestmet withi a commercially acceptable time, but the Lik competes directly with other modes of trasport, such as airlies, limitig the fares which ca be charged. From the start, the Departmet was clear that it could back the Lik, provided that the estimated beefits could be expected to outweigh the fiacial cotributio made to the project by the Govermet (paragraphs 3.7 to 3.12). 18 Throughout the egotiatio of the origial deal ad the restructurig, the Departmet aalysed the ecoomic justificatio for makig the fiacial cotributio eeded if the Lik was to be built. The Departmet's calculatios cofirmed that the estimated ecoomic beefits of the Lik outweigh the required subsidy. The mai ecoomic beefits comprise reduced jourey times for passegers ad icreased rail capacity, alog with expected regeeratio beefits arisig from the Lik attractig jobs to the areas through which it will ru (paragraphs 3.13 to 3.22). 19 I reegotiatig the origial deal, the Departmet made several chages i its methodology for estimatig the beefits the Lik would geerate. I the fial assessmet the Departmet excluded beefits to o-uk residet passegers but icluded a estimate of regeeratio beefits amoutig to 500 millio. The result, i the Departmet's most likely estimate of future Eurostar UK patroage, showed total beefits of aroud 3,000 millio for a total public sector cotributio of some 2,000 millio (paragraphs 3.24 to 3.26 ad Figure 19). 6executive summary 20 It was a ew step to iclude quatified regeeratio beefits. Previously i cost-beefit aalysis of trasport projects, the Departmet cosidered that regeeratio beefits would be too ucertai to be quatified i moey terms, ad to the extet that they could be quatified some of this would represet double coutig of passeger beefits already icluded i the assessmet. I this case, however, the Departmet decided that the methodology for

12 calculatig regeeratio beefits was sufficietly robust to allow their iclusio i the aalysis. The estimate was that the Govermet would be willig to pay 1,000 millio through covetioal regeeratio fudig to secure beefits equivalet to those likely to arise from the Lik. This figure was the halved to take accout of the double coutig (paragraphs 3.27 to 3.29). 21 I the Departmet's view, the iovatio of quatifyig regeeratio beefits i moey terms as part of this type of aalysis was successful. The Departmet iteds to place more emphasis o quatified regeeratio beefits i future projects ad is udertakig research o guidace as to what form this quatificatio might take (paragraph 3.30). 22 There is room for debate too about the way passeger beefits were take ito accout. At the time, the Departmet did ot have explicit guidace for the appraisal of ew heavy rail schemes to complemet the guidace it had issued for light rail schemes (such as trams). The Departmet's figures were based o a calculatio that the value of time savigs to passegers would, o average, be higher tha the fares beig paid. This would imply that passegers would ot be prepared to pay for the full beefits they would get from usig the Lik (paragraphs 3.31 to 3.34). 23 We examied the other key assumptios made i the Departmet's calculatios. I our view, some of them are questioable. Substitutig more reasoable assumptios, we have estimated that there would be a et beefit from the Lik of uder 500 millio, ad that if moey estimates of regeeratio beefits are excluded, i lie with Departmetal guidace, the the et beefits of the project would oly be margial. To the extet that Eurostar UK does ot achieve the levels of usage assumed i the Departmet's most likely estimate of future Eurostar UK patroage, the the costs of o-goig public subsidy for the project are likely to be icreased ad the quatified et beefits of the project are likely to be reduced still further. O the basis of recet Eurostar UK performace, which has bee below this level, the Lik represets poor value for moey i terms of estimated ecoomic beefits (paragraphs 3.35 to 3.40). 24 What this meas is that the ecoomic justificatio for Govermet support for the project rests heavily o wider policy beefits associated with the Lik. The Govermet saw the project as oe of atioal prestige. It will provide a high speed rail service to Europe. Frace ad Belgium already have such high speed coectios to the Chael Tuel, ad the Lik is oe of a umber of high priority projects for the developmet of high speed rail routes across Europe. This has give the Lik priority status i the Govermet's overall trasport policy. Although such a cosideratio was ot formally icluded i the Departmet's stated objectives, it was a importat cosideratio i Miisterial aoucemets o the project (paragraph 3.23). executive summary 7

13 Lessos leared 25 We caot commet at this stage o whether the Departmet's objective to esure the costructio of the etire Lik will be achieved. Nevertheless, it is apparet from our examiatio that, i difficult circumstaces, a rage of complex issues had to be addressed ad that the Departmet hadled the egotiatios with LCR i a competet maer. Although the project to build the Lik ad privatise Eurostar UK is uique i may respects, the coclusios that ca be draw from it are ot. There are, therefore, a umber of importat lessos to be bore i mid for future Public Private Parterships, alog with some specific poits for the Departmet. Lessos for departmets from the structure of the origial deal: Reveue forecasts for start up busiesses are subject to great ucertaity 1 There have bee several recet examples of high profile start up projects whose busiess plas have depeded o forecasts of usage by members of the public, ad these forecasts have tured out to be highly optimistic. 5 As bidders' forecasts of reveues from the fledglig Eurostar UK busiess were i lie with previous estimates made by the Departmet ad British Rail, the Departmet did ot seek to have them idepedetly validated. Moreover, i the absece of prove demad, it was ot possible for either party to this deal to be sure that forecast reveues would be sufficiet to support LCR's plaed stock market flotatio. Eurostar UK's poor performace weakeed LCR's fiacial stregth to such a extet that its ability to fud the Lik was destroyed. As a result the etire project came close to collapse. Make sure that bidders for a deal are ot ecouraged to be over-optimistic 2 A key elemet of the iitial competitio i to fid a promoter for the Lik was the level of direct grats required by each bidder. As the level of direct grats would deped o the amout of reveue each bidder thought it could secure from operatig Eurostar UK, there was a i-built icetive for bidders to be over-optimistic about the prospects for the busiess. The equity capital to be ivested i a project should reflect the risks of that project 8executive summary 3 Departmets should esure that the capital structure of a proposed deal is cosistet with the risks ivolved i the project. If the proportio of risk or equity capital is too low, the project will ot be fiacially robust i the face of lower tha expected reveues. Moreover, havig a relatively low ivestmet at risk may provide isufficiet icetive for the private sector shareholders to tackle busiess problems with determiatio. Either way, the impact of proceedig with too little risk capital is likely to be a call o the public sector for icreased fiacial support, as happeed i this case. It follows that a departmet should take a close iterest i the private sector's proposals as regards the capital structure of Public Private Parterships. If the market is uwillig to subscribe sufficiet equity capital it is a clear sigal regardig the riskiess of the project, the implicatios of which eed to be thought through by the departmet cocered. 5 The Milleium Dome (HC 936/ ) ad The Re-egotiatio of the PFI-type Deal for the Royal Armouries Museum i Leeds (HC 103/ )

14 Govermet guaratees of project debts are ulikely to be costless 4 I sigig a direct agreemet with LCR's bakers, the Departmet agreed to support the servicig of all of the 430 millio borrowed durig the early stages of the project. The effect of this was that, if the agreemet with LCR was termiated, the Departmet agreed to take back ot just the assets of the Eurostar UK busiess but also its outstadig liabilities. The Departmet therefore retaied the risk that future Eurostar UK reveues would be isufficiet to service this debt ad attract further ivestmet i the project. If the market is uwillig to provide sufficiet debt capital secured o the project, that is a clear sigal that the project risks go beyod ormal commercial risks. A Govermet guaratee of debt capital trasfers project risks to the departmet, which eeds therefore to cosider thoroughly how to maage those risks. Substatial risks arise if public sector assets are trasferred i advace of exteral fiace raisig 5 I the origial deal, sigificat public sector assets were trasferred to the private sector more tha a year before the plaed completio of the exteral fiacig of the project. The effect of this, whe the fiacig could ot be completed, was that the assets could be recovered by the Departmet oly with the added ecumbrace of the private sector debts which had bee raised by LCR. If a departmet proposes to depart from the ormal practice i Public Private Parterships of trasferrig assets oly whe all fiace has bee raised, the it eeds to thik through its approach to maagig the icreased risks it thereby icurs. Lessos for departmets from the restructurig of the deal: Moitor retaied risks from the start of the project 6 The existece of a direct agreemet may have made LCR's baks less likely to scrutiise the fiaces of the project both before ad after the cotract was siged. For the period that such a risk is retaied, departmets should, i cojuctio with all private sector participats i the deal, esure that robust project moitorig arragemets are put i place. Reallocate risks if ecessary 7 I procurig a PFI deal, risks should be allocated to the parties best able to maage them. If circumstaces chage, however, departmets should ot hesitate to seek a reallocatio of risk which will preserve or ehace value for moey. I the origial deal, the Departmet cosidered that the risks attached to raisig fiace for ad buildig the Lik, alog with the busiess risks associated with ruig a iteratioal trai service, would be hadled better i the private sector. These differet risks were budled together ad haded to a sigle private sector parter. I restructurig the deal, the Departmet quickly realised that risks had to be reallocated if the Lik was to be built. The outcome was a deal that is i may respects more robust tha the origial. executive summary 9

15 If a project requires public fudig, give careful cosideratio to the most cost-effective route 8 LCR could ot have raised all the fiace it eeded without Govermet help. However, the use of bods carryig a Govermet guaratee rather tha a voted loa from the Departmet to fud the Lik, cost the project a additioal 80 millio. The use of such bods reflected the uique circumstaces of this deal ad, i particular, achieved the Govermet's aim of keepig the project off the public balace sheet. Departmets will eed to cosider this cost-beefit balace with great care if similar situatios arise i the future. If a deal goes wrog, private sector parters should bear their share of the risk 9 Uder the PFI, the private sector is paid for takig risk. Resposibility should therefore remai with the private sector should these risks actually occur. I the restructured deal, LCR's shareholders have retaied a ecoomic iterest i the project while avoidig the full fiacial cosequeces of its ear collapse. For the future, departmets should esure that equity risk i PFI deals is real ad that over-optimism i biddig for cotracts will lead to losses if thigs go wrog. Specific poits for the Departmet: The Departmet should cotiue to moitor the deal 10 Uder the terms of the restructured deal, the taxpayer remais exposed to the fiacial cosequeces of Eurostar UK uder-performig agaist forecast passeger volumes but, o the other had, the taxpayer is etitled to sigificat divideds if the busiess is successful. The Departmet is moitorig progress ad has appoited a director to the board of LCR, Eurostar UK's owers. I view of the very log-term ature of these cotiget liabilities ad assets, the Departmet should esure that such active moitorig remais i place ad is adequately resourced. Iovatio i quatifyig regeeratio beefits should be shared with others 11 By attachig a moetary value to the expected regeeratio beefits from the Lik, the ecoomic appraisal of this deal ivolved a radical iovatio i previously accepted practice. The moetary valuatio of expected regeeratio beefits from trasport ad other projects will always be problematical. Nevertheless, the Departmet rightly iteds to share the isights gaied i this project with other public bodies to esure cosistecy i approach. The Departmet should do what it ca to esure that the expected beefits of the Lik are realised executive summary 12 If regeeratio ad passeger beefits are ot as high as expected, the Lik is ulikely to be good value for the taxpayer o ecoomic grouds. To iform future decisio makig, it is essetial therefore that the Departmet should do what it ca to esure that such beefits are realised. This should iclude close moitorig ad evaluatio of the actual value of the regeeratio beefits achieved by the Lik agaist those expected whe the deal was restructured. 10

16 Part 1 To esure completio of the Lik, the Departmet allowed the origial deal to evolve This part of the report examies the reasos why the Departmet chose to restructure the deal for the Lik whe the origial deal with LCR came close to collapse i Jauary The cause of that ear collapse was disappoitig performace by the Eurostar UK busiess. Optios cosidered by the Departmet icluded abadoig the project, puttig i additioal direct grats as LCR had requested ad a restructurig. The Departmet chose the latter optio as beig oe which offered the prospect of completig the Lik without udue delay. The restructured deal which followed is i may respects more robust tha the origial. Sectio 1 of the Lik is uder costructio ad will be purchased o completio by Railtrack. LCR is required to costruct Sectio 2 ad Railtrack has a icetive to purchase it, but has ot yet exercised its optio to do so. Poorer tha expected performace of Eurostar UK put the origial deal at risk 1.1 LCR wo the Departmet's competitio to build the Lik ad operate Eurostar UK uder a 999 year cocessio because its bid required the lowest level of direct grats ad, i the Departmet's view, had a more favourable distributio of risk tha proposed by the other shortlisted bidder for the project, Eurorail CTRL Ltd. LCR's shareholders are listed i Figure 1. The amout of direct grats icluded i LCR's bid was related to its forecast of Eurostar UK reveues, which were higher tha its competitor. Whe actual Eurostar UK reveues grew cosiderably less rapidly tha forecast, the project was o loger see as a good ivestmet by private sector ivestors ad LCR realised that it could o loger raise the fiace eeded to costruct the Lik ad operate Eurostar UK. 1 Shareholders i LCR as at August 1996 Members Percetage shareholdig Bechtel Limited 19 SG Warburg & Compay Limited 19 Virgi Group Limited 18 Natioal Express Group Plc 17.5 Société Natioale des Chemis de Fer Fraçais (SNCF) 8.5 Lodo Electricity Plc 8.5 Ove Arup & Parters 3.5 Sir William Halcrow & Parters Limited 3 Systra Sofuetu Sofrerail 3 Source: The origial deal combied costructio of the Lik with the privatisatio of Eurostar UK 1.2 The deal with LCR was more tha just a very large privately fiaced ifrastructure project, it also ivolved the privatisatio of two Govermet-owed compaies (Figure 2): The Departmet Uio Railways Limited (URL), resposible for the plaig ad desig of the Lik; ad Europea Passeger Services Limited (ow Eurostar (UK) Limited or Eurostar UK), the operator of the UK part of the Eurostar iteratioal trai service. Assets trasferred to the private sector o privatisatio icluded the iteratioal rail termial at Waterloo i Lodo ad eleve Eurostar trai sets. Aother seve trai sets had previously bee sold ad leased back by the compay. The deal also icluded the trasfer to LCR of various lad ad buildigs at Kig's Cross, Stratford ad elsewhere i Lodo ad Ket. Further iformatio o the Lik is at Appedix 3. part oe 11

17 2 The origial cotractual structure of the deal Baks Facility agreemets Direct agreemets Developmet agreemet 430m Debt Eurostar (UK) HMG LCR 100% Direct grats Equity agreemets Shareholders 60m Equity 100% URL Costructio cotracts Cotractors Maagemet agreemet Rail Lik Egieerig The Departmet retaied the busiess risk i Eurostar UK 1.4 I 1994, after the pre-qualificatio roud of the competitio, the Departmet iformed the bidders that there were two pricipal criteria for evaluatig bids. The cotract would be awarded to the bidder that had sought the lowest level of direct grats, provided this was ot offset by the amout of risk the bidder wated the Departmet to bear. 1.5 At the coclusio of the last roud of biddig i December 1995, LCR's bid for direct grats was valued at 1,733 millio (Figure 3), approximately 400 millio less tha that sought by Eurorail CTRL Limited. The assessmet of the risks that the bidders wated the Departmet to bear did ot reveal a great disparity betwee them, although o balace the Departmet cocluded that the terms offered by LCR were more favourable. Note: Source: Rail Lik Egieerig (RLE), is a uicorporated associatio comprisig Bechtel Limited, Ove Arup & Parters, Sir William Halcrow & Parters Limited ad Systra Sofuetu Sofrerail. RLE has bee cotracted to desig ad project maage Sectio 1 of the Lik. LCR 1.3 The Departmet privatised Europea Passeger Services Limited for policy ad commercial reasos. O policy grouds, the privatisatio was compatible with the Govermet's plas to privatise British Rail. The commercial reasos for the privatisatio stemmed from the view that Eurostar UK would geerate substatial reveues over time. The Departmet cosidered that the busiess was such a attractive propositio that, if trasferred free of log-term debt, there would be a lower requiremet for public support of the project. 1.6 To reduce the risk that the direct grats would be paid too early durig the costructio of the Lik, the Departmet ad LCR agreed that paymets would ot commece util costructio was 68 per cet complete. This precautio, however, did ot elimiate the Departmet's fiacial risk i the early stages of the project. 3 Breakdow of the direct grats to LCR uder the origial deal Grats Preset value Dates whe paymets would have bee due of grats ( millios at 1995 prices) Capital Grat 796 This grat would have bee paid i 12 quarterly istalmets, the first beig millio ad the remaiig eleve each beig 100 millio. The first paymet would have bee due o the later of either the third aiversary of Fiacial Close or whe costructio of the Lik was 68 per cet complete. Deferred Grat 603 This grat would have bee paid i four equal quarterly istalmets of 270 millio. The first paymet would have bee due 78 moths after Fiacial Close, provided the fial permit to use had bee issued. Domestic Capacity 334 This grat would have bee paid i 34 equal half-yearly istalmets of millio. The first paymet would have bee due 78 moths after Fiacial Close, provided the fial permit to use had bee issued. TOTAL 1,733 Notes: 1. Fiacial Close was to have bee the later of the date upo which the fudig agreemets for the secod stage of fiacig were executed or the date the leders' aget certified to the Departmet that all coditios precedet to draw dow the secod stage fiacig had bee complied with or waived. part oe 2. Rebasig the grats to 1997 prices produces a preset value of 2,014 millio. 3. The Domestic Capacity Charge would have bee paid to LCR for providig capacity o the Lik for other trai operatig compaies to ru services betwee Lodo ad orth ad east Ket. 12 Source: The Departmet

18 1.7 The Departmet aticipated that there would be two stages to the wiig bidder's fiacig of the project. The first stage fiacig would fud the first two years of the project while the wiig bidder secured, through a secod stage fiacig, the bulk of the fuds it would require to fulfil its obligatios. The competitio required the bidders to set out the details of their plas for fiacig the project. LCR adopted the Departmet's two-stage approach, proposig to raise the secod stage fiace through the proceeds of a flotatio i October 1997 ad log-term bak debt. LCR's first stage fiacig pla comprised 430 millio of short- to medium-term bak debt (Figure 4) ad 60 millio of equity from its shareholders. I May 1996, LCR's baks agreed to provide loas for the first stage fiacig, secured agaist Eurostar UK. 1.8 As LCR did ot have the commercial stregth to raise such substatial loas o its ow, the Departmet decided to support the basis o which the loas would be repaid. I a Direct Agreemet with LCR's baks the Departmet agreed that, if the cotract with LCR was termiated, the Departmet would take over ad cotiue operatig Eurostar UK as a goig cocer. I the evet of reversio, Eurostar UK would have to service the debt but the Departmet agreed to pay the operatig costs of the busiess if reveues were isufficiet to meet both debt servicig ad operatig costs. I the ulikely circumstaces 4 Loas for the first stage of fiacig uder the origial deal Amouts Bak Loas: ( millio) Commercial Baks Facility 1,2,3 Uited Bak of Switzerlad 66 2 /3 Dai-Icho Kagyo Bak 66 2 /3 Dresder Bak (Luxembourg) 66 2 /3 Citibak 55 Credit Focier Europea Ivestmet Bak (EIB) 4,5 100 Kreditatstalt für Wiederaufbau (KfW) 4,5 30 TOTAL Eurostar UK turover, costs ad operatioal losses millio * Turover Costs (257) (243) (235) (248) Operatioal Loss (before depreciatio) * Budgeted figure Source: The Departmet ad LCR (see Figure 5) that Eurostar UK's reveues were isufficiet to service the outstadig debt, the term over which the debt was to be repaid would be exteded. If the deal with LCR was termiated, the Departmet would therefore get back ot just the assets of Eurostar UK but also the liabilities. The Departmet was cofidet that Eurostar UK reveues would grow i lie with LCR's forecast 1.9 While there was a risk that Eurostar UK could revert back to public owership with 430 millio of bak debt, the Departmet cosidered that the risk was offset by the likely profitability of the busiess. At the start of the competitio to build the Lik ad before the Eurostar service was operatioal, trasport idustry experts expected Eurostar UK to gai a large share of the existig market for travel betwee Lodo, Paris ad Brussels. It was estimated that Eurostar UK would carry over 12.5 millio passegers (sigle joureys) i ad that umbers would exceed 15 millio joureys by the ed of the decade. As LCR had similar expectatios for future Eurostar UK patroage, the Departmet did ot challege the forecasts Nevertheless, the Departmet foresaw potetial risks, particularly because the award of the cotract would be well i advace of the secod stage fiacig. If the forecast growth was ot achieved, the Departmet was cocered that LCR or its baks might seek to reegotiate the terms of the deal if a secod stage fiacig could ot be completed i the market o acceptable terms. Allayig this cocer were three factors: Notes: 1. Bak Facility Aget was the Uited Bak of Switzerlad. 2. The Commercial Baks Facility could be used to fud Eurostar UK operatios, for desigig ad developig the Lik ad for the purchase of lad ecessary for its costructio. 3. The term of the Commercial Baks Facility was 90 moths from 31 May The EIB ad the KfW Facilities could oly be used to fud the desig ad developmet of the Lik ad the purchase of lad ecessary for costructio. LCR could ot use these fuds for Eurostar UK. SG Warburg & Compay Limited, LCR's pricipal fiacial adviser, cosidered that LCR could achieve the secod stage fiacig eve if Eurostar UK reveues were 15 per cet lower tha forecast; i the mid stages of the competitio, LCR had the most strogly led ad best developed marketig strategies for Eurostar UK; ad part oe Source: 5. The term of the EIB ad KfW Facilities was 120 moths from 31 May The Departmet 13

19 part oe the Departmet's view that LCR's shareholders would ot risk losig their 60 millio equity ivestmet without beig cofidet that secod stage fiacig was achievable. I the light of lower tha expected growth i Eurostar UK reveues the project was ot see as a good ivestmet 1.11 LCR forecast that i , Eurostar UK's secod full year of operatio, 9.5 millio passegers would use the trai service. The actual umber of passegers usig the service i that year was 5.1 millio (Figure 6). As the actual performace of Eurostar UK was sigificatly lower tha that forecast ad with expected growth for beig less tha forecast, LCR realised that the Lik would ot be viewed as a good ivestmet Whe the Departmet was evaluatig bids, much depeded o the bidders' forecasts. As the evaluatio would favour the bidder demadig the lowest level of direct grats there was a i-built icetive to take a optimistic view of future demad for the Eurostar UK service. Although the iclusio of private fiace i a project ca be see as a meas of temperig udue optimism, at the first stage fiacig of this project there were two structural features that checked the eed for detailed scrutiy of passeger forecasts by ivestors. The first was the Departmet's support for debt repaymets i the Direct Agreemet. Although such support was eeded if LCR was to raise debt, it also effectively elimiated the eed for the ledig baks to satisfy themselves that the project could repay the loa. The secod cocered the level of equity ivested by LCR's shareholders. LCR's shareholders subscribed 60 millio, just over 12 per cet of the total stage 1 fiace. This equity comprised 30 millio of capitalised teder costs ad 30 millio i cash. Sice all the shareholders were also suppliers to LCR, there is some doubt as to whether the value of the equity at risk was sufficiet to balace the shareholders' iterest i 6 LCR's origial forecast of Eurostar UK passeger umbers Passeger umbers (millios) Source: LCR LCR forecast passeger umbers Actual passeger umbers 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 04/05 becomig major cotractors to the project. LCR expected that project developmet costs amoutig to 92 millio would be paid to its ow shareholders i the period leadig up to the plaed flotatio i October The reliace o optimistic forecasts was ot the oly factor that udermied LCR's attempts to covice potetial ivestors that the project was a soud ivestmet opportuity. LCR experieced difficulties marketig Eurostar UK to the widest audiece of potetial passegers. These difficulties stemmed from the operatio of the trai service beig the resposibility of three differet compaies, each oe resposible for the service withi the atioal boudaries of the three coutries served by the busiess. SNCF ad SNCB, the State-owed compaies resposible for domestic rail services i Frace ad Belgium respectively, are the two other compaies that ru the Eurostar iteratioal trai service. Eurostar UK, by cotrast a private compay whose sole busiess is the operatio of the UK arm of the iteratioal passeger trai service, experieced difficulties covicig SNCF ad SNCB to adopt vigorous ad co-ordiated marketig strategies Eurostar UK also ecoutered competitio that LCR ad the Departmet did ot foresee. All the forecasts aticipated that demad o the Lodo to Paris route would cotiue to grow at historic rates ad that Eurostar UK would draw a cosiderable umber of passegers from the airlies. The rate of growth i demad for Eurostar UK has slowed cosiderably because the growth of low-cost airlies, competig o cost but also offerig more choice of destiatios, has draw leisure travellers away from the traditioal Lodo to Paris route. Moreover, the adverse impact of low cost airlies has goe beyod suppressig growth i passeger umbers, it has also restricted the ability of Eurostar UK to icrease fares for leisure travellers The Chael Tuel fire i November 1996, just over five moths after LCR took over Eurostar UK severely disrupted Eurostar services for two moths ad cotiued to impact upo the efficiecy of the service for a further five moths. The Departmet cosidered that the fire would delay LCR's proposed flotatio by the amout of time eeded for passeger demad to pick up, followig the resumptio of full operatios. The origial deal came close to collapsig 1.16 I Jauary 1998 LCR publicly approached the Departmet with a request for 1,200 millio 6 of additioal direct grat. At this time LCR was at the poit prices

20 of exhaustig the fuds it had raised through the first stage fiacig ad there was little if ay prospect that it would be able to raise further fuds from private sector sources. The Departmet did ot obtai all the iformatio to which it was etitled from LCR 1.17 The Departmet kew before the award of the cotract that reveues from Eurostar UK were crucial to the success of the project. I August 1996, the Departmet's fiacial advisers, (J Hery Schroder & Co Ltd ad Deloitte ad Touche) set out detailed proposals for moitorig LCR's fiacial health. The Departmet did ot, however, isist that LCR comply fully with its obligatios to supply fiacial iformatio Util the fire i the Chael Tuel i November 1996, the Departmet istructed its advisers ot to press LCR for iformatio about Eurostar UK reveues. The Departmet's reasos were: a) that LCR, havig take over Eurostar UK o 31 May 1996, required time to covert the busiess culture withi the compay from a public sector railway operator to a market drive busiess; b) that the implemetatio of LCR's marketig strategies required time to become effective; ad c) that a rigorous aalysis of LCR's performace, shortly after it had take cotrol of Eurostar UK, could have impacted adversely o the cotractual relatioship The Departmet's stace cotributed to the decisio ot to implemet a proposal, made i August 1996, for a idepedet review of LCR's reveue projectios. Whe the Departmet did sactio this work i December 1996, LCR had already commissioed L.E.K. Cosultig (LEK), a trasport cosultacy, to aalyse the demad for the Eurostar UK service. The Departmet therefore decided to await LEK's report before cosiderig what actio, if ay, eeded to be take The Departmet did ot istitute formal ad regular fiace progress meetigs with LCR util April At the iaugural meetig the Departmet, after takig advice from its legal advisers (CMS Camero McKea), agreed that rather tha receive detailed mothly reports o progress towards the secod stage fiacig, it would receive outlie reports that LCR would expad upo at subsequet progress meetigs. LCR had iformed the Departmet that the secod stage fiacig was still possible but, followig the disruptio caused by the Chael Tuel fire, LCR's positio would be precarious if the Departmet isisted o receivig detailed reports ad, i compliace with its obligatios, forwarded these reports to LCR's bakers. LCR was cocered that its bakers would call i the loas despite the Departmet's support for repaymet of the bak debt i the Direct Agreemet. The Departmet cosidered that this would have bee likely as oly 192 millio of the 430 millio loas package had bee draw dow ad the baks would have bee able to cap their exposure. By allowig LCR to cotiue to operate Eurostar UK, extra time was secured to tur the busiess aroud. The Departmet reasoed that with the debt fully draw dow, there would be a icetive o the baks to support a restructurig of the deal which would result i earlier repaymets of the outstadig loas tha would be likely if they had to deped o reveues from a publicly ru Eurostar UK. The Departmet wated LCR to exhaust other aveues of fudig before exposig the taxpayer to icreased fiacial risk 1.21 I February 1997 LCR iformed the Departmet that to covice ivestors of the soudess of the Eurostar UK busiess followig the Chael Tuel fire there was a eed to collect more Eurostar UK reveue data. As a result, LCR had to postpoe the flotatio from October 1997 to March This meat that LCR would exhaust its stage 1 fiaces i Jauary To bridge this fudig gap, LCR proposed to raise fiace by sellig the eleve Eurostar trai sets it still owed ad leasig them back from the ew ower. LCR's access to these fuds was, however, preveted uder the cotract util after completio of the secod stage fiacig. I May 1997 LCR approached the Departmet to obtai a relaxatio of the cotract The request effectively asked the Departmet to icrease its fiacial risk i the project by 230 millio. If Eurostar UK reverted to the public sector, the Departmet would become liable for the leasig paymets. The Departmet cosidered that it was the oly party beig asked to icrease its fiacial exposure, as LCR had ot proposed either raisig further debt or obtaiig a further ijectio of equity from its shareholders. I July 1997, Miisters met LCR ad suggested that LCR should seek additioal fiacial support from its shareholders ad leders. LCR's respose was that its shareholders were ot prepared to icrease their ivestmet ad its baks would oly led more if the Govermet provided additioal fiacial support I August 1997 the Departmet iformed LCR of the detailed terms o which it would be grated access to the leasig proceeds. The Departmet cosidered that LCR would fid the terms so ufavourable that it would be compelled to go back to its shareholders. LCR sought a alterative solutio before it ra out of moey 1.24 While LCR was cosiderig how to bridge the fudig gap, it received LEK's report o future passeger demad for the Eurostar UK service. The aalysis revealed that demad was strog but at levels lower part oe 15