Item 2 is a briefing from the Auditor General on his report entitled "Scottish Executive: The NorthLink ferry services contract".
In December 2000, the Scottish Executive awarded a five-year contract to a service operator called NorthLink Orkney and Shetland Ferries to run the lifeline ferry service to the Orkney and Shetland Islands. NorthLink is a joint venture between Caledonian MacBrayne and the Royal Bank of Scotland that started to operate in October 2002. Under the contract, the Scottish Executive was to pay NorthLink a basic subsidy of £45.7 million over five years, adjusted for inflation and supplemented, if necessary, by additional payments under material change provisions in the contract.
I thank the Auditor General for an interesting report. We will discuss our reaction to the report under agenda item 6, but we now have the opportunity to ask any questions or request further information about it.
Where do I start? I could go through the report line by line and ask nit-picking questions at every level, but I will try not to do that.
That is a fundamental question, to which no one has an easy answer. As I remarked in my conclusion, balancing the social objective of service continuity with the objective of achieving best value—which implies a transfer of risk to the operator—is extremely difficult to achieve. That is why the Executive is attempting to ensure that, although the new contract will require the operator to bear some losses if it fails to crystallise the assumptions in its business plan, the contract will also provide the opportunity for additional subsidy to be brought in if it is needed. As I said, I am not in a position to comment on the new contract, but that arrangement is clearly driven by the need to attempt to achieve a balance between those two factors.
There was a risk that the demand for services might not match what was predicted, but the successful bidder won the tender because it offered a bid that was predicated on an increased demand. I do not know much about the tendering process, but I would like to know the extent to which the rules allow for such things to be questioned. You said that the tendering process was robust. Must we simply accept the projections of the lowest tender or can we question them?
As I said at the outset, I have concluded that the contract procedure that the Scottish Executive followed was robust. That is partly because the Executive carried out sensitivity testing of some of the projections. However, at the end of the day, it is not possible to second-guess a service provider and the business risks that the provider is willing to undertake.
You mentioned in your briefing that it was always understood that the Scottish Executive transport group would cover material change. I am not sure how we decide that there was material change as opposed to commercial risk, as in the opposition taking up more of your business than it would otherwise. Perhaps you could explain how that was categorised.
A section of the report describes material change. I wonder whether colleagues could help me to find it.
There are two stages to this practice. First is the tendering process, which defines a specification for the service that is to be provided. In this case, that was determined by the Scottish Executive. Then it is down to the potential bidder to determine how it will provide the service. There is a process of determining whether that bidder is technically competent to deliver the specified service, but it is recognised that there are areas in which there is uncertainty, for example the cost of fuel and certain operating costs that are outside the control of an operator, which will vary and to a certain extent can be taken into account only when the tender is submitted. Such areas, which are beyond the direct control of the potential bidder, are regarded as areas of material change. Other areas, such as possible competition, are down to the potential bidder's judgment, and different bidders will take a different view. In looking at how different bidders determine that, the Scottish Executive is concerned about whether the bidders are taking a reasonable—though not necessarily identical—view of whether competition is likely.
In the context of the report, are you content that the Scottish Executive's transport group was paying additional funding for actual material changes rather than for a misjudgment by the bidder?
There was a combination of factors. As Arwel Roberts has just commented, the contractor should have borne the risks associated with emerging competition. That competition significantly affected the contractor's cash flow, so in part the extra payments that went to NorthLink were to cover elements for which it should have borne the risk. However, it was clearly unable to finance that pressure from its own resources. Undoubtedly, elements of the extra money that was paid were to do with keeping the service going rather than meeting material change clauses.
Paragraph 3.7 of the report lists the items for which the contractor sought additional payment. Information was not available to them when they made their bid.
There is almost a feeling of inevitability about this. Even though the operator carries the risk, in practice there will be subsidies because this is a lifeline service. Paragraph 10 of the summary, on page 4, sets out the situation, which boiled down to a straight choice between NorthLink and P&O: three bids were reduced to two. That situation has now repeated itself in the new contract. NorthLink's costs were higher and its bid succeeded on the basis of assumptions about increased income that, in the event, did not materialise. It bothers me that the assumptions in SETG's sensitivity analysis strengthened the NorthLink case. That leads to the thought that SETG's analysis was wrong and that not enough attention was paid to the overoptimistic income figures rather than to the more inevitable costs. Has SETG improved its analysis procedures?
The strict answer to that is that we will not know until it has awarded the new contract. From placing this contract, it has certainly learned that one cannot make assumptions about levels of use and costs. In so far as the contract has thrown up areas in which the SETG needs to be more careful, the group has acknowledged that it needs to learn lessons, but none of us can guarantee that it has covered all the angles on the contract.
On the Scottish Executive transport group's performance, I refer you to paragraphs 2.28 and 2.29, on page 21 of the report, where we record the fact that NorthLink expected to generate more demand because it was operating new ships and improving the services, was going to reduce fares and was going to market through special offers—one would expect an operator to think about those possibilities—and the fact that its projections were informed by analysis that was carried out by the Scottish Office in the 1980s, which demonstrated traffic growth when new ferries came on to the Clyde and Hebrides routes. We are told that transport economists had validated the projections as reasonable and that the Scottish Executive transport group carried out its own sensitivity analysis on the bids. The key point to mention to the committee is:
However, the assumptions were wrong and NorthLink picked that up quite quickly in the contract. The fundamental starting point was one of overoptimism, and the situation was exacerbated by competition from smaller operators. That was known to NorthLink before it took over. What was the SETG's reaction to NorthLink's concern about its ability to deliver at an agreed price, which came quite early in the process? In other words, how quickly are such matters picked up when the practice shows that the assumptions are wrong?
I am sorry, but we cannot answer that question. It would have to be put to the Scottish Executive.
We are aware of the complexity of the tendering process and of the difficulties that the Scottish Executive transport group had in that it relied solely on the information that was provided by P&O, which was providing the service at the time. However, that leads me to challenge whether the Scottish Executive officials had sufficient knowledge to deal with the contract. It also leads me to challenge the robustness of the financial checks on NorthLink and the other bidders and whether the Scottish Executive officials had the financial competence to make recommendations. We note the excess payments that have been made; those payments certainly call into question the Executive officials' financial competence.
We comment in the report on the skill mix of the people who worked on the procurement process. The transport group established a tender working group for the project, the membership of which included members of the transport group itself and
Was any information gleaned from P&O's bid to determine whether the NorthLink bid represented the best value for money?
The NorthLink bid was significantly cheaper than the P&O bid. The—
It was initially cheaper, but was it cheaper over the term of the contract? Given what we now know, has there been any analysis—
It had a significantly lower cost over the term of the contract. One of the interesting features of the EC rules that apply to such contracts is that there is an obligation to accept the lowest tender if the quality is acceptable.
I have a question about the P&O bid. The fact that two operators came in at a later date and competed against NorthLink raises questions about the bidding process. It is clear that operators believe that they can come in without subsidy and compete against the subsidised operator. Is there any reason to believe that operators would not have come in and competed against P&O if it had been the successful bidder, given that its services would have been more expensive? Do we know whether the fact that the competitors operated separate services rather than services to both sets of islands allowed them to be cheaper—that is, to pick off one route, to have lower costs and therefore to compete?
I am sorry, convener. I cannot help much with your reflections and your implied question. One indubitable fact, however, is that competitors who came in went out again. The market is clearly a difficult one in which to operate successfully. It is not as though the new contract was formed in an environment in which there was a lot of competition. At present, there is little competition apart from a specialised container service that is limited in scope. The fact that operators have not succeeded in the longer term illustrates the challenges that the Scottish Executive faces in achieving a balance between a lifeline service and best value in the contract.
Thank you for that answer. I understood from the start that the question might be an insoluble one.
May I add to what has just been said? It is important to recognise the distinction between passenger services and freight services. Passenger services are subsidised, but freight services are not. It is passenger services that attract the requirement to satisfy the maritime safety regulations. Freight services do not have the same exacting requirements. If, after a joint passenger and freight service has been established, someone can identify a niche in the market, it might be possible to operate a service at a much cheaper level than can be predicted ahead for a joint service.
You mentioned that these were complex, one-off contracts that were a first for Scotland. Was any attempt made to compare the services with those in other countries, such as Norway?
As part of the exercise we tried to establish where comparable services might exist. The Norwegian ones are different in that they do not go to and fro, but travel for long distances up and down the coast. I believe that there are similar services in parts of New Zealand and there are certainly such services in British Columbia but, as far as we are aware, they face the same difficulties. They need subsidy.
I wish to ask about the renegotiation of the contract, referring in particular to page 29 of the report. It says:
I agree with the bit about the operator being incentivised. That is true—it is part of the revised arrangements.
I want to go back to an issue that is highlighted at an early point in the report, on the negotiations with the European Commission and the extent of the early delays. Indeed, there was quite a costly extension to the P&O contract. Based on the investigations that Audit Scotland has conducted with respect to this particular contract, do you have any observations about why such delays have occurred, how they might have been avoided, how the negotiation process with the Commission, which is a continuing and critical part of the backdrop to this area of service provision, might be expedited more effectively, and how greater clarity and transparency could be achieved?
One of the key lessons that can certainly be learned through this experience is to recognise the need to allow adequate time to undertake the necessary clearance with the European Commission on such matters. I am not sure whether Audit Scotland can help you with an answer about the nature of the negotiations that were talking place with the Commission at the time.
One of the issues was that new vessels were clearly needed, not just for maritime law reasons, but because of the age of the ships that P&O was operating. From memory, I think that the investment was in the region of £100 million—but I am not absolutely sure about that.
That is right.
Part of the issue was about how to construct a contract that would comply with the five-year time limit while enabling an operator to recover the costs of that level of investment. In the end, the solution was to remove the investment outside the immediate contract process. Effectively, another party invested in the ships, and the vessels were leased back to NorthLink, the idea being that the Executive could still comply with the five-year limit in accordance with the EC regulations without risking vessels being taken away by a contractor when the retendering exercise was rerun in five years' time.
For completeness, the report records that the Executive was successful in getting the new vessels operating by autumn 2002, so that there was no breach of the maritime safety rules.
Leaving aside the details of the substance, can any lessons be drawn about how the actual negotiation process might be improved, particularly with regard to what might be done at the hand of the Scottish Executive? Is the process as you have described it inevitable, given how things operate?
Part of the answer is that, for the immediate future, the vessels exist. There is a company that owns them, which is prepared to lease them to whoever operates the service next. There is not an exact duplicate here of the situation with which the Executive was faced when the contract was initiated. The same problem could arise when those vessels need to be replaced in 25 years, or whatever their lifetime is.
I want to pick up on the point that you made about the obligation under EC regulations to accept the lowest tender. That is a continuing issue that is giving quite a lot of concern elsewhere in Scotland. Presumably there is a get-out clause on that obligation—if the Scottish Executive transport group had believed that the bid was not robust, for example.
Under EC regulations, the process has two stages. At the first stage, a given number of bidders will submit proposals and a judgment is made regardless of cost, because at that stage there is no indication of what the tender cost is. At that first stage, judgments are made about the competence of the bidders to meet the specifications of a contract. That reduces the number of bidders. Those that are taken on to the second stage are regarded as equally competent to deliver the contract and the second decision is made purely on cost. However, the overall decision is not made on cost alone: it is made as a result of having already decided that all those who submit cost tenders are technically competent. Therefore, in theory, from the EC point of view, it makes no technical difference which contractor is appointed, because that decision is made purely on cost.
If I understand you correctly, all the bidders who get through to the second stage are assumed to be equally competent. Once they have got through the first stage, they start on a level playing field in every respect except cost.
Yes.
Therefore, the Scottish Executive cannot weigh any one part of a bid more lightly or more heavily than any other part. At the second stage, the Executive is driven simply by cost.
According to the EC rules, yes.
We seem to have covered all the questions that we had on that subject. I thank Audit Scotland for answering them.
Previous
Items in Private