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PRIME MINISTER
HORIZON (BA/POCL): MEETING WITH MR NARUTO
Issue
How to handle your meeting with Mr Naruto (Chairman of ICL and Vice Chair of
Fujitsu) on Monday 12 April.
Recommendation
2. While not making any commitments at this stage, I believe you can give a
positive message to Mr Naruto about the progress that has been made over the last
few weeks and the prospects for a final decision by Ministers on the options in
time for the Fujitsu board meeting on 23 April, provided progress can be made in
resolving the key outstanding issues. I attach (Annex A)a speaking note. I also
attach (Annex B) a more detailed note for your information, setting out the
progress that has been made in detailed discussions with ICL, POCL and BA, the
Jatest information on costings, the views of each of the parties, and the issues
which need to be resolved in the next few days. As this note sets out, officials
have successfully developed an alternative approach with ICL, BA and POCL.
This would remove the complexity inherent in the existing contract and provide
better incentives on the parties to deliver the project successfully. It would also
provide a smartcard which would provide the vehicle for developing Modern
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Government services. Costings have fluctuated greatly in recent days, and remain
indicative. Further work is being done to finalise them. However, on. latest
information the alternative approach would be considerably more expensive than
the Benefit Payment Card. You should not therefore give Mr Naruto any assurance
as to what the final decision by Ministers is likely to be.
Progress in developing the alternative option
3. Following Jeremy Heywood's letter of 1 March, officials led by Steve
Robson (HMT) and. involving BA and POCL have been taking forward
negotiations with ICL to develop an alternative way forward for the BA/POCL
project, given ICL’s failure to perform on the existing contracts. Recent work has
focussed on one particular option in which the Benefit Payment Card would be
cancelled and POCL would provide simple benefit accounts into which benefits
are paid via ACT and withdrawn in cash using @ smartcard at post offices. 1cL
would deliver and operate the infrastructure required, making use of much of the
existing Horizon technology, and would contract with a bank to administer the
accounts, POCL's aspirations to become an agent for commercial banks in (e.g.)
rural areas would be developed in parallel.
4. There is still some uncertainty over the allocation of risks between the
parties and the need for POCL to obtain authorisation under the Banking Act.
More particularly, there is great uncertainty over the costs. We are in the process
of firming up the costs. At the moment, the gap between the Benefit Payment Card
Option (Option A) and the preferred alternative (Option B 1) is large and almost
certainly unaffordable. However, the gap is largely based on two elements - the
cost of the smartcard and the cost of managing the benefit accounts - and more
Chae Flow te
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Fefuses SY pare:
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work will be carried out in the next few days to probe whether these costs are
tant to recognise that the costings of this option are indicative
robust. It is impor
uation over recent
at this stage, and indeed have been subject to enormous fluct
days as more detailed work has been undertaken, I will be in a better position to
judge likely costs by the middle of next week, and will provide you with an
updated recommendation then. More details on these issues is set out in Annex B.
Meeting with Fujitsu
5. Inanticipation of your meeting with Mr Naruto on 12 April, the chairman
of Fujitsu, Tadashi Sekizawa, has written to you (7 April) arguing that a firm
decision on the way forward must be made by 23 April when the Fujitsu Board
will meet to approve their consolidated group accounts. Fujitsu’s preference would
be to move ahead with the alternative option being developed by officials. Their
position is that unless a legally binding agreement for the future of the project is
in place by then, their accounts will need to show a provision of around £300m
(the money they have so far spent on the Benefit Payment Card), The letter states
that Fujitsu would not be prepared to make this provision and continue to
underwrite the project, and so work on the project would stop. I judge that this is
a real risk, and not simply a threat to force our hand.
6. Even if the work in the next few days (on costings in particular) shows the
alternative approach to be the best option from the point of view of the public
sector, reaching legally binding heads of agreement with ICL may not be
achievable in the timescale demanded by Fujitsu. However the parties are working
to draft non-binding heads of agreement by Monday 12 April for finalisation by
19 April. Provided it looks then as if we are at least close to converting this into
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a binding agreement, this should give Fujitsu sufficient comfort for their Board
meeting on 23 April.
7. I suggest, therefore, that you use your meeting with Mr Naruto to provide
him with the reassurance that we are close to a decision. You are of course aware
of the sensitivity surrounding our negotiations with I
CL, given the public sector’s
position that it is ICL who are responsibl
le for the delays to the project, and that we
have been exploring alternative options only because ICL have failed to deliver to
schedule and are in breach of contract.
It will be important that the positive
message given to Fujitsu does not weaken the publ
ic sector’s negotiating position
at this late stage in the process.
8. Tunderstand that you will be accompanied at the meeting by Steve Robson.
Charlie Falconer would also be happy to attend if you thought that would be
helpful.
9. Copies of this minute go to Alistair Darling, Stephen Byers and Charlie
Falconer.
MY ee LALO a
yw
9 April 1999
[append 4 ts thief Sean
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And Sane in Ag ihence
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Annex A
SPEAKING NOTE: MEETING WITH NARUTO, CHAIRMAN OF ICL
Legal preamble:
You will be aware that our conversation takes place in the context of
contractual differences between ICL Pathway and the public sector parties.
° You will understand therefore that:
Our discussion must be without prejudice and confidential.
°
The public sector parties must reserve their rights and remedies under
the existing contracts.
Substantive points:
all parties have worked hard over the last month to develop and cost a more
detailed specification for the alternative option identified during the
discussions between Steve Robson and ICL;
° very grateful to ICL and Fujitsu for their co-operation in trying to find a
way forward;
*
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understand that the parties are working hard to reach draft heads of
agreement on a version of this alternative option (known as Bi). However
there are a number of very important issues still to be resolved, and we have
to be satisfied that the new option is affordable and offers best value for
money for the public sector;
very much hope that these issues can be resolved over the next few days, so
that Ministers will be in a position to take a final decision between the
options, and that if the decision is to proceed with the alternative approach
that it will be possible to reach non-binding heads of agreement on the basis
of this decision, in time for your Board meeting on 23 April.
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Annex B
IN DEVELOPING THE
BA/POCL AUTOMATION: PROGRESS
ALTERNATIVE OPTION
The Prime Minister agreed (Jeremy Heywood’s letter of 1 March) that the public
sector parties - under the chairmanship of Steve Robson HMT - should be asked L
to take forward negotiations on the alternative way forward which emerged from
Steve Robson's discussions with ICL in February (minute from us to you of 24
February).
2. These discussions were conducted on a without prejudice and confidential
basis. ICL accepted that the public sector parties reserve their rights and remedies
with respect to past breaches of contract by ICL Pathway. Both sides agreed that
they would not take pre-emptive legal action against any other party while
discussions are continuing.
What are the options?
3. The Option of continuing with the Benefit Payment Card is Option A. In
the course of the discussions to draw up a technical specification of the alternative
option (option B), two variants have emerged:
Option B1
. the Benefit Payment Card is cancelled;
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° ifnecessary POCL (or probably a specially-formed subsidiary) would seek
authorisation under the Banking Act:
“benefit accounts” into which
. POCL or its subsidiary would provide simple
rtcard at post
benefits were paid via ACT and withdrawn in cash using a sma
offices;
° these accounts would not offer other conventional account services (€.g- a
f credit from another account, withdrawal at ATMs) and would ‘
transfer 0:
he benefit payment card;
appear to the benefit recipient very similar to
. BA would transfer benefits to POCL via the BACs system - in the same way
as is currently done for benefit recipients who receive payment by ACT;
. ICL would deliver and operate the infrastructure required, and would
manage the smartcards, using the existing Horizon infrastructure;
° ICL would contract with a bank (e.g. Girobank) to administer the accounts,
° POCL'’s aspirations to become an agent for the banks (“network banking”)
would be developed in parallel, as under option A.
Option B2
e the Benefit Payment Card is cancelled;
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at least one bank (their preference would
{gation under the
POCL enters into parmership with
be for this to be more). This should not require author!
Banking Act:
the banks would provide accounts into which benefits were paid via ACT
and withdrawn in cash using 2 smartcard at post offices, and which would
be capable of providing other simple services, ¢S other payments could be
made into the accounts;
ts via the BACs system;
BA would transfer benefits to these account
the infrastructure and could deliver the
ICL would deliver and operate
nt of the banks, would
banking hub required, but given the involveme!
probably not manage the smartcards unless appropriate risk transfer
arrangements are in place;
gent for the banks (“network banking”)
POCL’s aspirations to become an a:
would be developed in parallel, as under option A.
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£m NPV option A
BA 1,123
payment toICL I 0
(to deliver a loss
of £126m NPV)
I POCL 246
total NPV to 1,369
[te sector
The overall NPV shown in the last row of the table assumes that ICL is
recycled some of the savings in order to ensure that they would earn -£126m NPV
over the life of the project under all options, as set out in their December 18 offer.
A is the highest, followed by Bl
The results show that the NPV of option
(incremental cost relative to option A of £340m) and then B2 (incremental cost
relative to option A of £680m).
The main reasons for the differences in costs are as follows:
4,
the specification of option B1 includes a smartcard rather than a magnetic
stripe card as under option A. This accounts for around £75m;
B1 and B2 include banking operation costs of some £250m (a large eleme
of these costs will be subject to competitive tender).
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eaay 19%
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ivity testing against the following:
In addition, KPMG are carrying out sensiti
that a bank would charge for
uncertainties about costs - ¢.8 the price
the costs of smarteards:
administration of the accounts;
anking comes on stream, and about the
3” to conventional bank accounts
worsen the financials
d vice versa);
uncertainties about when network bi
speed of migration from “benefit account:
operated by POCL as an agent (a faster migration will
for ICL but improve the financials for the public sector an
ecent difficulties with testing procedures in the current programme ~ which
in BA’s view may lead to a further delay to option A of 6 months;
failure by ICL and POCL to deliver option B1 to the timetable envisaged.
s move to ACT, delaying administration savings;
could delay BA’
There are also risks, some of which have not been quantified:
additional assumed universal banking fraud costs of up to £100m for both
BI and B2;
the figures assume that ICL bear the same NPV loss in both option A and
option B - i.e. the loss they stated they were prepared to bear in their
December 18 1998 offer (-£126m NPV). Although ICL have indicated they
are content with this approach, this will require careful negotiation over the
next week to make this stick;
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gration from
al commercial difficulties for POCL of the mi
* the potenti :
i yr banks under option BL.
provider of benefit accounts to agent fo
the options?
would prefer BI, since it would give them the same NPV loss as option A,
but they would benefit from the reduced complexity of the contractual
arrangements with the removal of BA from the contract.
are not prepared to wait for B2 - would require some commitment before
POCL signed agreements with the banks;
are concerned about how the contractual boundaries would be drawn
between themselves and the banking partners;
POCL
prefer option A to either of the alternatives (B1 or B2). They are concerned
at the higher costs, longer timetable and extra risks which Option B1 would
bring them compared to Option A;
. In particular, POCL are concerned about taking on potential fraud risks
associated with the benefit accounts, and would prefer to engage banking
Partners to bear this risk (i.e. a preference for Option B2 over B1);
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Which alternative option. should be developed?
8 In view of the costings, the views of the parties and also the advice of the
that option BIL would be less
Government's advisers (PA Consulting and KPMG)
BI should be the
officials agreed that option
In any case, all parties have agreed
costly and less risky than B2,
n B2 in sufficient detail to be ina
preferred alternative option on which to build.
that it would not be possible to work up optio
position to sign heads of agreement by the end of April.
option A. There is
9, Therefore the choice should focus on option BI versus
of course, also the option of termination.
What other issues need to be resolved?
Allocation and management of fraud risks
BA insist that fraud risks be transferred to POCL, in the same way that
currently fraud risks associated with their benefit recipients who are paid by
ACT is borne by the banks.
further work is required to establish who will be bearing which fraud risks,
and how they are managed.
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° in particular there is a difference of view between BA and ICL/POCL on the
use of PINpads. ICL argue that this will be necessary if they are to bear
card management risks, and the modelling assumes PINpads are installed.
BA would like to be able to decide whether or not PINpads are used for
customer service reasons. ICL argue that the removal of PINpads would
require an additional payment to them of £50m p.a. (around £450m NPV -
although this figure looks very large compared to the current levels of {
benefit fraud associated with paper-based systems of around £150m p.a.)
ced
° POCL are concerned about taking on the risk of the small percentage of
people who are “unbankable”, and who pose a particularly high risk because
they are proven or highly suspected of defrauding banks or other financial
bodies.
BA have accepted that this would be their responsibility, They have agreed
to look at alternative means of paying them benefit (which may or may not
involve POCL bank, but this would be at BA’s risk).
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Guarantees
the current cont
ract provides ICL with guaranteed transactions volumes.
The modelling for this exercise has assumed that
L will seek guaranteed volumes in the re-
there are no guarantees.
However it is likely that IC)
negotiation of the contract.
isation of POC
Aut
on under the Banking
option B1 may require POCL to obtain an authorisati
Act 1987
° authorisation raises difficult commercial issues for POCL, who do not view
becoming a bank as part of their commercial strategy. However this will in
part depend how POCL place the “benefit account” product in the market.
° there may be an issue for the Treasury about the establishment of a state
owned bank. However we believe this can be addressed by limiting the use
to which POCL puts its authorisation - i.e. making it clear that this is solely
for the purpose of providing simple benefit accounts.
Funding of POCL.
e given that the cost to the public sector of option B1 will be borne largely by
POCL (whereas under option A it is borne by BA), POCL are seeking
reassurance about funding, in order to confirm they have a business case.
* transitional funding for POCL (financed from the savings to DSS - there is
no scope for DSS to provide transitional funding over and above this) is an
important but somewhat separate issue from the overall NPV to the public
sector, and this will need to be worked through. Transitional funding will
need to be structured to incentivise ICL and POCL to deliver option BI on
time.
usiness case for Smartcards
. smartcard technology is more expensive than magnetic stripe technology.
This adds around £75m NPV to the costs of option B1 relative to option A.
. However use of a smartcard relative to the magnetic stripe benefit payment
card will simplify the user authentication and fraud management approach
of BI relative to option A, and will open up the possibility for POCL (with
ICL) to develop new applications for electronic government.
° There are risks to consider when assessing the additional costs of smartcards
are justified:
° smartcard technology is still at an early stage and there is uncertainty
over what technology to use and the standard to adopt. The other side
of the coin is that the launch of a nationwide system of the scale for
BI could set the standard for smartcards for the future
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P i 5
the useful life of the smartcard is suggested to be a maximum of 5
years. The use of smartcards for benefit payment alone will be
insufficient for recovery of the investment in this timescale. ‘The
question is then whether POCL will be able to exploit the wider
{ potential quickly enough. and the timescale for electronic
government services.
P nt ri
° if we move to option B1 there is arisk of challenge under EU procurement
law, but this risk is not thought to be a show stopper.
Conclusion
10. Further work will be required to assess these risks and resolve the
outstanding issues. But on the basis of the cost information we currently have, the
Government will be faced at the end of next week with a difficult decision between
continuing with the Benefit Payment Card (option A), moving to the alternative
approach (option B1) or cancellation:
the Benefit Payment Card (option A) remains the cheapest way of bringing
automation to post office counters. However, the Benefits Agency continue
to be firmly opposed to it, and the complex tripartite contractual
arrangement would remain. There has already been a further 3 month delay
since November, and further delays are a possibility with knock on effects
on costs to the public sector;
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the alternative option (B1), introduces new contractual relationships which
provide better incentives for the parties to act together. POCL would
contract directly with ICL, and BA will no longer be a party. This will
simplify the decision-making process and therefore the project is more
likely to be delivered successfully. It introduces a smartcard, which could
provide the vehicle for developing Modern Government services (although
we would need to decide whether the additional costs of the smartcard
would be justified). And by providing simple accounts to all benefit
recipients, Option BI could provide a stepping stone towards the
Government’s social exclusion agenda. However, the additional cost is
significant, and it would delay the introduction of automation in post
ii
offices. And POCL would prefer option A over option B1;
the final option is to terminate the project altogether, and to find an
alternative means of providing electronic payment of benefits and of
automating post office counters. However, this is bound to lead to messy
litigation with ICL and provide uncertainty for the post office network.