Managing in a mixed economy - Essay Example

?Managing in a Mixed Economy Executive Summary This study deals with Private-Public Partnership (PPP) agreement between London Underground and Mertronet. The purpose of the PPP agreement was to acquire funds from the private sector. This paper begins with the background of London Underground and Metronet. Historical facts are also provided to understand the reason for selection of PPP as a means of financing. It also contains literature survey of the problems of London Underground and Metronet also the National Audit Office Report is presented. The paper has been concluded with a few causes and reasons for the London Underground failure and liquidation of Metronet and is followed by the recommendation for the improvement of the PPP agreement. Table of Contents Executive Summary 2 Table of Contents 3 Introduction 4 Public Private Partnership of London Underground 6 National Audit Office Report 7 Financial Incentives 9 Management Expertise 9 Long Term Planning 11 Failure of Consortium Management 11 Poor Corporate Governance and Leadership 11 Financing Issues 13 Contract Incompleteness and Risk Transfer 14 Approvals and Communications 14 Tied Supply Chain 15 Conclusion 16 Recommendations 17 References 18 Bibliography 23 Introduction London Underground has started its operation in the mid-19th century with the help of private venture capital. The Metropolitan line between Farrington and Paddington was the first construction, built by Sub Surface Line (SSL), which was one of the first construction sectors of London Underground (Wolmar, 2002). Due to absence of governing body and corporation, the entire sector started working independently. Therefore, the London Passenger Transport Board (LPTB) was formed in 1933 to control the road and underground transport. In 1948, it was undertaken by the British Commission. The five separate corporations including London Transport Board were restructured by British Commission. In 1970, London Transport Board was renamed as London Transport Executive. From this time onwards, the London Underground was controlled by the local government rather than central government. In 2000, Greater London Authority was formed as a new local government entity. All the transport body was identified as local government. The London Underground Limited was transferred to Transport for London on 15th July 2003 (Butcher, 2010). The tubes were disorganised, chaotic and systematically mismanaged since the early days. Hence, it was necessary to form a PPP. During the year 2002, due to inadequate investment and problem in managing public service and maintaining infrastructure, it was decided that maintenance and renewal of London Underground’s infrastructure would be undertaken through PPPs (Kellaway & Shanks, 2007). In PPP agreement, a contract has been signed for 30 years and the main purpose was to obtain funds from private sector. It was a partnership between two functions of business, i.e. finance and operation. Private sector is well-organised than public sector to complete a project in a cost-effective way. The renewal and maintenance of the tubes by public sector operations and private sector infrastructure were an arrangement that ensured the tubes would provide successful service more efficiently. The stations, train operations, signalling and safety was continued by the public sector, through London Underground Limited. The infrastructure companies such as Infraco BCV, Infraco JNP and Infraco SSL were formed for the purpose to manage station, trains, and signal and track infrastructure. Infra JNP was undertaken by Tube Line on 31st December 2002 and on 4th April 2003 other two companies were undertaken by Metronet. Metronet had invested ?17 billion amount for the PPP contract of 30 years (Finn & Et. Al., 2007). Metronet Rail Group is the group of Metronet Rail BCV Limited and Metronet Rail SSL Limited based in London, UK. Metronet Rail BCV Limited is involved in upgradation, replacement and maintenance of sub-surface deep tube lines that operates in the streets of London (Bloomberg Businessweek, 1999). It was a private partner who was accountable for the facilities related to design, maintenance, construction and operations. The DBFO was responsible for financing the project and was approved for a long-term right to access a project. The service payments are made by the public partner of the project to the private partners, who are based on performance metrics (Williams, 2010). An arbiter is present, who decides the price when any difficulty occurs in the PPP agreement. The London Underground PPP was generally considered as one of the most complex private finance planning in the UK public sector (Mclnnes & Et. Al., 2006). Public Private Partnership of London Underground Public-Private Partnerships (PPPs) are a sort of contractual accord between public sector and private sector organisations for mutual provision and financing of public projects and services. Although the public sector has the duty for delivering infrastructure projects, there might be financial, technical and institutional limitations to a certain extent. The rising adaptation of PPP method is primarily to deliver public infrastructure and services to meet the several needs of existing economies (Perrot & Chatelus, 2000; Broadbent & Et. Al., 2003). The PPPs are designed to provide finance to public project. It is a contract between private and public sector to take the advantages of strength of both the sectors to overcome their limitations. The structure of PPP arrangement should effectively obtain better results compared to the traditional public sector infrastructure financing because PPP approach considers the technical, managerial and commercial skills of private sector which helps in enhancing the cost efficiency, time and quality of the project and leads to a better risk management of public infrastructure project (McKee & Et. Al., 2006). PPP project would be justifiable only if the public infrastructure financing is effective than the traditional financing approach. The effectiveness of PPPs is a measure to find out the operational flexibility to transfer infrastructure risk to the private sector and the ability to enhance cost efficiency, quality and time. The result shows how much they are effective to provide value for money to public sector (HM Treasury, 2003). This paper critically considers literature to study the issues that establish the effectiveness of PPPs in sponsoring public infrastructure projects. There are different types of theories which explain the increasing popularity of using PPPs in financing public infrastructure projects (Oluoch & Wainanina, n.d.). According to Leibenstein (1966), the participation of private sector allows the public sector to become more competent. The government had failed to support the inefficient project. Hence, there was a need to adopt PPPs approach to avoid the failure of inefficient infrastructure projects. PPPs are necessary in infrastructure financing to support the technical and financial efficiency of public project (Sappington & Stiglitz, 1987). National Audit Office Report In July 2007, Metronet BCV and Metronet SSL were unable to meet their obligations. In February 2008, London Underground had to buy 95 per cent debt obligation of Metronet from its private lenders rather than paying back it over the 30 years of the contract. The Department for Transport (DfT) helped London Underground by providing ?1.7 billion. It was accepted that steady investment was needed for PPP construction project as the government was more concerned about London Underground’s track record of completing the replacement and maintenance projects under specific time and budget. Therefore, the Government decided that London Underground should concentrate on executing passenger services. Furthermore, the private sector needs to be used for delivering maintenance and infrastructure improvement. Under the contracts of PPP, Metronet BCV and Metronet SSL were in charge for two-thirds of the work regarding modernisation of Metronet BCV for Waterloo & City lines, Bakerloo, Central, Victoria; and Metronet SSL for Circle, District, East London lines, Hammersmith and City, Metropolitan and. Both companies were referred as Metronet that was owned by a consortium of WS Atkins Plc, Balfour Beatty Plc, EDF SA (formerly Seeboard Group Plc), Bombardier Inc. and Thames Water Plc. The other PPP contract was given to another company that was named Tube Lines (National Audit Office, 2009). In the year 2002, from the overall contract prices the cost of Metronet was estimated to be at least ?6.9 billion for the beginning 7? years. According to the condition, London Underground’s assets were uncertain; hence Metronet was paid for extra work which was necessary for the government. The PPP Arbiter was provided the responsibility to decide for providing extra costs that was incurred reasonably and resourcefully (National Audit Office, 2009). Metronet assets as well as liabilities in May 2008 were relocating to two subsidiaries of Transport for London. For department for Transport and Transport for London a Joint Steering Committee was set up to bring about long term solution for the failure of Metronet. The main reason provided by the British government for the execution of the PPP scheme was the lack of ability of London Underground as a public agency to deliver long term infrastructure (National Audit Office, 2009). Financial Incentives The public sector was unable to provide stable finance and take advantage of business opportunities due to various policy objectives and there was difficulty in describing clear measures of performance. The private sector was more competent to accept challenges and create innovative approaches in renewing and managing London Underground Limited assets. The purpose of the contract was to provide sufficient financial support for Infracos to complete the capital projects on time and within a specified budget and to ensure that underlying assets were properly managed (Pretorius, 2007). Management Expertise The private firms’ projects are difficult as compared to public sector. Hence, the private sector managers are much experienced, knowledgeable and skilled to complete the project on time. Therefore, the government sector prefers to appoint public sector experts. The private management expertise will help to increase the operational efficiency (Pretorius, 2007). Long Term Planning The PPP agreement is for long period of time, which helps to provide sufficient funds for the project. This contract offers private sector to make an investment decision and acquire and manage assets efficiently during the period of 30 years of contract. It also provides the private sector a better chance to recover its investments over the lifetime of the project (Pretorius, 2007). Failure of Consortium Management According to British government report, most of the faults for PPP arrangement failure were due to poor internal management of PPP consortium (UKNAO, 2009). Poor Corporate Governance and Leadership The decision in PPP contract was decided generally by five shareholders. They were represented as the Metronet’s suppliers who had authority to manage and control the scope of project work. Extra amount was paid for extra work undertaken by the suppliers. The executive management was changed regularly as they were not able to measure the cost incurred for extra work performance of its shareholders due to which the cost was increasing simultaneously. There was poor quality of information available to management, particularly while calculating the unit cost of extra work performed by the shareholders. Metronet was not able to supervise the costs and could not get sufficient evidence to support claims that have performed work efficiently. The Metronet was structured a way that it did not provide authority to manage the cost and management data as performed in the rehabilitation projects. The additional problem with Metronet management was the control of government exercised in the PPP agreement. The planning for the London Underground PPP was to transfer power from central to local governments. From the UK Department of Transport, the control of London Underground was transferred to the Mayor of London, an agency named as Transport for London. This agency was in charge of the London Underground. The Department of Transport relied upon the London Underground and Transport for London to control the projects for financial risk. On the other hand, London Underground faced difficulties to obtain information and cost related data which would have allowed it to observe costs more explicitly and identify the results of its interpretation of the contract on increase in project cost (London Transport Report, 2006). London Underground was in need of the information that would have permitted it to take more innovative practices in “partnering” with the Metronet (UKNAO, 2009). It can be concluded that Transport for London and London Underground did not have sufficient information about project performance to supervise and control over the PPP consortiums activities (London Transport Report, 2006). Financing Issues The major objective of PPP agreement was to use private debt for financing public project. There was a discussion regarding the cost of private borrowing that was higher compared to the public debt issuing cost. It is contested that PPPs instead of borrowing capital at 4-5% rate, they could have accessed from their shareholders and banks at a rate of 20%. The debt-to-equity ratio of PPP project was high with approximately 88.3% debt to 11.7% equity. The fund in PPP project was mainly in the private debt form which was comparatively small to equity risk borne by the PPP consortium members. The small quantity of equity risk provided less incentive for the PPPs agreement. The government assured 95% of private debt in the case of bankruptcy in the PPPs (Vining & Boardman, 2008). The five participants of Metronet had estimated ?350 million as an equity requirement which was amounted around ?250 million after the calculation of taxes on bankruptcy. This was not a huge write off for them as they were the key suppliers of PPP project. From 2003 to 2007, Metronet for service charges had received ?3 billion, or approximately 60% of the entire capital expenditures (Vining & Boardman, 2008). The PPP consortium was developed in a way so that the high interest rate for private finance has increased project costs. The high amount of interest rates received from the financiers of the consortiums increased the risk and uncertainty for the PPP project. The project financed through the government such as a bond issue might lower the cost of borrowing. The financing risk of PPP consortium has reduced due to assurance of private debt by the Department of Transport. The contract was prepared in such a way that the Department of Transport had little authority to involve in the PPP activities. Contract Incompleteness and Risk Transfer London Underground was aware that the situation of less accessibility of infrastructure facilities would not be identified before the agreement of the contracts. As observed by the National Audit Office, “The uncertainty meant that bidders sought protection from the consequences of adverse conditions exceeding prudent levels of contingency” (UKNAO, 2004a). An example regarding the incompleteness of the contract is related to the renovation of stations. The government had acquired an output based fixed price contract. The private PPP consortium performs as if it has an approval for a series of various cost plus projects. PPP consortium was not successful because the risk allocation was not decided before the contract was signed (Bing & Et. Al., 2005). The PPP contract suggested that the extent station renovations were classified as, refurbishment or improved, modernisation refurbishment, but in PPP contract between Metronet and London Underground, all these terms were not clearly defined. The contracts of PPP may not have transferred enough risk to the private PPPs. Several features of the London Underground PPP contracts reduce the risks for the private sector. Approvals and Communications Several projects had difficulties while developing proper channels of communication in order to get approvals and permissions among the public and the private sector players. In London Underground, single line of communication was designed which had created problems for approvals and permits. They could have implemented different ways of communication, through establishing various communication lines for better relationship between private and government participants. It has been recommended that more attention could have been provided to the relationship between private and public participants in a PPP consortium. Smyth and Edkin recommended shifting from relational contracting to a relationship management approach which could have reduced communications barrier between the partners (Smyth & Edkin, 2007). Tied Supply Chain It is responsibility of PPP consortium to undertake quite a few projects for infrastructure rehabilitation which embrace those of modernisation and refurbishment of several stations. These projects are responsible for having better lighting, elevator access, public address, waiting facilities and closed-circuit television for the improvement in the physical environment along with adherence to the safety measures (Sibley, 2009). The failure of Metronet was blamed for using “Tied Supply Chain”. Poor arrangement of the release of infrastructure contracts was also an issue. In tied supply chain, shareholders were the suppliers for PPP consortium. Conclusion This study relating to the failure of the London Underground PPPs and liquidation of Metronet indicates that there were certain difficult aspects in the partnership that affected its success. There were quite a few factors (classified as primary), responsible for the failure of PPP London Underground, which are as follows: 1. Metronet lacked corporate governance and leadership 2. The Metronet shareholders were treated as suppliers which provided power to the shareholders rather than management of business 3. The London Underground had limited capability for managing the contract. They were not able to reduce the cost arising from the project 4. The PPP Arbiter was unable to initiate an extra review of PPP agreement at the time when Metronet faced difficulties because none of the party took the initiative (Great Britain: Parliament: House of Commons: Transport Committee, 2010) 5. When Metronet had failed, the British Department for Transport had confirmed to pay ?1.7 billion. Thus, it reduced the risks of financial nature to the PPP consortiums. The risk was not transferred to the contractors who were executing the work in tied supply chain. Tube Lines was more successful in the rehabilitation projects by performing as construction manager (National Audit Office, 2009) In 2008, Metronet, the contractor of PPP agreement collapsed after a decision had been made by the arbiter and the contracts was undertaken by London Underground. The same was expected to happen with Tube Lines unless it agreed to reduce the budget (Wolmar, 2009). . Recommendations The London Underground PPP had several problems related to PPPs. Hence, it would have been appropriate if they had used individual infrastructure rehabilitation project rather than large PPP consortiums contract. The project would have been more accurate and timely if they would have initiated the project on time rather than a few years before signing the consortium contracts. In addition, overall financial risk would have reduced since individual projects were included in the PPP arrangements. The study also centers on the failure of Metronet to manage the PPP framework. 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