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BA/POCL AUTOMATION
INTERDEPARTMENTAL WORKING GROUP
FURTHER REPORT TO MINISTERS
14,DECEMBER 1998
cv
ps/Secretary of State
PS/ Mr McCartney
Mr Scholar
Mr Macdonald
Mr Baker CGBPS
Dr Hopkins CI
PORT
Mr Sibbick CGBPS
Mr Whitehead CGBPS
Ms Anderson CGBPS
File: KR/69
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CONTENTS
1, Background
2. The ICL offer
3(i). The decision: the case for continuation
3(li). The decision: the case for termination
(I). The way forward: continuation
(ii). The way forward: termination
Annex A: The ICL offer
Annex C: Presentational Strategy
Annex D: letters from Neville Bain and Alistair Darling
Annex E: Cashflows from BA and POCL to ICL
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1. Background
The BA/POCL automation project (known as “ Horizon”) has been under review
since the contractor, ICL Pathway, was placed formally in breach of contract in
November 1997 by both POCL and BA, after a key contractual milestone was missed.
Following the failure of negotiations (the so-called Corbett discussions) to establish a
commercial basis acceptable to Government for proceeding with the contract in
October, ICL were given a further period of two weeks for them to make progress in
their discussions with the Post Office to develop a public/private partnership as a means
of enabling ICL to move further towards the public sector's position. ICL’s proposal for
the partnership was received on 9 November, along with 3 additional papers addressing
commercial, contractual and financing issues. ICL stated they were prepared to accept
a loss of around £100m NPV (although we believe they expect to recover this with the
income earned from the partnership with POCL), but their commercial proposals
involved a risk transfer that would have been entirely unacceptable to the public sector
and would have effectively seen the public sector underwriting the whole deal. Ministers
concluded that ICL’s wider commercial proposals revealed insufficient movement on
their part, and a wide gap remained between the two sides.
2. The Chief Secretary therefore wrote to ICL on 20 November giving them a third
and final period until 9 December to reach heads of agreement with the public sector.
ICL were told that they would have to make an offer which:
” demonstrated that they could secure adequate financing to take the project
forward without the public sector bearing unacceptable risk;
“ provided assurances that Fujitsu were standing behind the project;
“ made an unequivocal move towards the public sector's position as proposed in
the earlier negotiations.
3. Ministers also agreed that they need to be in a position to implement the fallback
options quickly if an acceptable deal could not be struck by 9 December. The Chief
Secretary therefore asked officials to prepare an exit strategy to the same timescale,
building on the work already completed on the fallback options and including
presentational handling. A presentation to Ministers by the public sector parties on the
fallback option was held on 8 December. This demonstrated that there was a do-able
alternative, based on a move to ACT for benefit payments timed to fit the provision of a
banking capability across Post Office Counters.
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5. This report:
“ provides an assessment of ICL's “best and final offer’ of 9 December;
. summarises the case for and against continuation;
. sets out an exit strategy,
should Ministers decide tha! 's offer is unacceptable.
2. The ICL offer
6. Ministers agreed in early September that they would consider continuation with
the project provided an acceptable commercial deal could be struck between the public
sector and ICL, and that the offer provided VFM compared to the alternatives. The key
commercial obstacles to a deal identified in the subsequent negotiations have centred
on the overall NPV gap between the public sector and ICL; the level of risk transfer to
the public sector; and the acceptance testing process.
7. ICL wrote to the Chief Secretary on 9 December setting out its “best possible”
offer - on commercial arrangements, project funding and system acceptance (ICL's
letter as supported by 3 detailed papers as before). The headline terms of the offer
include:
« Commercial arrangements
confirmation that fraud risk will, as envisaged in the original contract, be
borne by ICL (up to a limit of £200m over the life of the contract)
* revised pricing, with greater volume risk taken by ICL (if volumes fall by
90% then ICL’s loss falls from -£118m to £204m, whereas if volumes
increase by 10% then their loss reduces to -£32m) and the burden of the
increases largely falling on POCL
* withdrawal of the previous proposal for an £80m “contingency fund” to be
funded by the public sector
. an estimated loss to ICL of £118m NPV (£269m cash)
. Project funding
ICL, with Fujitsu support, funding the whole project, investing £600m (or
whatever is required) - although BA/POCL need to confirm this is a legally
binding guarantee
* an obligation on the public sector, if the contracts were terminated for
Pathway default, to buy the system at its economic value less appropriate
set off costs
” System acceptance
* the sponsors’ giving up termination rights before full functionality for BA is
available and after limited testing of the system in a live environment
- guaranteed payments from the start of National Rollout
* appointment by agreement of an Independent Expert to resolve
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acceptance disputes quickly; the Expert would be empowered to make
binding decisions for implementation without delay (subject to subsequent
arbitration or legal proceedings)
Below this headline level, the ICL offer envisages further discussions on the detail
although the figures in the letter (representing their best offer) depend on the
assumptions about pricing etc. in the supporting papers.
8. An overall NPV gap remains. ICL have moved their position of the 9 November
from a loss of between £75m and £103m (depending on the contingency) to a loss of
£118m on a central case, with no contingency. In terms of the impact on the public
sector, this represents a movement of £36-88m NPV. But ICL have taken on more risk
through the dropping of their request for higher volume guarantees. The public sector
(effectively the PO, since Ministers have already agreed that BA should not make
further concessions) would need to find a further £113m NPV to close the gap, in
addition to the £116m NPV already offered relative to the Corbett base case.
9. On the other hand ICL have met the public sector's requirement that Fujitsu,
tather than the public sector, should stand behind the project as was the intention of the
original PFI contract. ICL have confirmed verbally that the guarantee will be similar to
that provided for DTI for project Elgar and that this can be converted into a legally based
guarantee. Clearly BA and POCL would need to ensure that Fujitsu's support for
Horizon was expressed in legally enforceable terms.
10. The proposals on acceptance testing are still unacceptable to the public sector
parties as they stand. BA is rightly concerned about losing termination rights for a
system which needs to support 15 million claimants before adequate testing in a live
trial. But POCL believe that a way through can be found since, they argue, ICL have
accepted the principle that the system must be seen to work in live operation before it is
accepted.
11. I Acomparison of the 9 December offer with the 9 November offer and the Corbett
proposals is set out in Annex A.
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The parties’ response
12. The PO's view is set out in Neville Bain’s letter to Peter Mandelson of 11
December. Their view (endorsed by DTI) is that:
ICL has made major moves on a number of issues; in particular it has
made clear its acceptance of funding, fraud and performance risks, which
substantially reduces the risk carried by POCL;
the commercial proposals, with no requirement for the public sector to pay
for a contingency fund, represent a move by ICL of £88m NPV;
the system will be seen to work in live operation before it is accepted;
the draft Partnership Heads of Agreement already agreed with ICL would
offer real benefits (if finally signed off) in developing new services; and
overall that
the programme should go ahead with a reaffirmed commitment by all
parties to its delivery.
13. The DSS/BA view (confirmed by Alistair Darling’s letter to the CST of 11
December) is that:
*
*
the commercial proposals make no material change to the November 9
proposal;
acceptance cannot be authorised until there has been a successful live
trial of the system and final responsibility for acceptance cannot be
delegated to an Expert;
Fujitsu’s support of the project must include a legally enforceable
performance guarantee;
Ministers should stand back and weigh the wider issues in the balance -
the justification for continuation of the project against the wider policy
agenda - before reaching a decision;
overall, the proposals should be rejected.
14. The Horizon Programme Director has confirmed that a programme milestone will
be missed in December. This slippage to the programme timetable is likely to add
further delay, complicated by the Millennium, which will mean lost fraud savings and
additional administrative costs to BA.
3. The Decision
15. The key objectives against which a decision should be judged might be:
” to pay social security benefits in a way that is as cheap, efficient, fraud free and
convenient as possible, consistent with plans for welfare reform;
“ to help to maintain a nationwide network of post offices in order to protect the
accessibility of government services provided across PO counters;
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oo to support integrated delivery of existing and new government services and
information more generally taking full advantage of new technology, streamlining
Government's dealings with citizens;
oo to improve access to basic financial services, including banking services, for
poorer members of the community and the socially excluded;
“ to maintain a thriving IT sector in the UK, in which ICL is a key player; while
ensuring that risks transferred through PFI projects do not end up with the
taxpayer; and
° against these objectives, to secure prudent use of taxpayers money.
(i) The case for continuation
16. The case for continuation rests on three points:
“ the acceptability of ICL's offer relative to the alternative option;
” the possible impact on subpostmaster's confidence and therefore the post office
network;
” the impact on ICL and Fujitsu and the knock on consequences for the IT sector
and inward investment in the UK.
Is ICL’s offer acceptable relative to the alternative?
17. In judging whether ICL's offer is acceptable, it is important to consider not only
how far they have moved from 9 November (see above), but also how their proposal
compares to the fallback option.
18. The following table compares the impact of continuation versus termination
(option 3) on the public sector'. Option 1 has been revised to take into account the 9
December ICL offer (which requires a public sector contribution of £113m NPV at 6%
real); and the impact of the additional slippage in the programme on BA. BA estimate
that the slippage of one and half months against the Corbett programme could result in
a delay of six months because of BA’s year 2000 purdah (an additional cost to BA
against the base case of £110m NPV). Option 3 is based on KPMG's modelling, carried
out in October.
' The table does not show figures for option 2 - continuation without the Benefit
Payment card. This option would require ICL’s consent, and is therefore not, strictly
speaking, a choice available to Ministers (although it may be a desirable outcome of a
negotiated settlement).
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DSS admin savings 0.29
DSS programme savings 0.87
Net impact on DSS 1.16
Net impact on POCL 0.31
Subsidy to subpostmasters nia
Horizon refresh costs -0.05 :
additional payment to ICL 0.11 :
Overall NPV 1.31 1.33
19. Cashflows are shown in Annex E. The ICL revised offer would mean £1.7bn cash
over ten years would be paid to ICL (under Corbett the cash payments would have been
£1.5bn).
20. In summary:
” the figures suggest, as before, that the results are very close. The fallback option
now looks marginally better value. But there are still margins of error surrounding
the modelling - and in the case of option 3 these could not be resolved until the
public sector parties were able to enter further discussions with the banks;
” there are significant risks surrounding all of the options which are not factored
into the figures. These would need to be managed carefully.
The impact on the post office network
21. One of the key factors in the decision to try to find a way forward with the project
in September were Ministers' concerns about the impact on the post office network. The
PO's ability to manage change in the network and implement their commercial strategy
depends upon the confidence of both the subpostmasters and the PO’s other clients in
the future viability of the business (of which a key factor is automation). An
announcement that Horizon had failed would adversely affect expectations unless a
clear and deliverable plan was in place for an alternative. An earlier move to ACT would
also see the faster deterioration of POCL’s main source of income (since DSS/BA fund
paper-based methods of paying benefit).
22. There are clearly risks. But we believe that careful presentation, combined with
an agreed BA/POCL strategy for moving to ACT alongside (rather than ahead of) the
introduction of banking services in Post Office would mitigate (to some extent) these
tisks. DSS, BA, POCL and DTI have held productive discussions about how to progress
the fallback option. These discussions, including further work by KPMG, have concluded
that there is a viable way forward. The challenge is to maximise the value for money to
Government through an integrated timetable - but until discussions/negotiations with the
banks are possible then we cannot further develop the costings or get a clearer picture
of the risks. All parties are fully committed to working together pro-actively to maximise
value for money.
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The impact on ICL/Fujitsu, the IT industry and inward investment
23. Loss of the project would be a major blow for ICL. Just how great would depend
primarily on the stance taken by Fujitsu, who have claimed that it could lead to the
collapse of ICL. However, it is possible given ICL’s other work that merely ICL/Pathway
alone will be dissolved. Failure of the project would mean that ICL made a total loss of
£200m in 1998; it would destroy its prospects of flotation in 2000 and might lead Fujitsu
to divest itself of the company. Given the economic climate in Japan, Fujitsu's attitude
may well have hardened. On a least bad scenario, cancellation would damage ICL’s
reputation here and in its export market.
24. The recent approach from Mr Naruto, Vice Chairman of Fujitsu and Chairman of
ICL, to our Ambassador in Tokyo, Sir David Wright, suggests that cancellation could
have a serious effect on our relations with Fujitsu. Fujitsu has been a major inward
investor in the UK, with over £700m invested in the last decade.
(il) The case against continuation
25. The case against continuation rests on the following:
a ICL have not moved sufficiently and there are further delays to the project (the
project is already 3 years late). But the PO (who would have to bear the bulk of
the further payments to ICL) have argued that they have a commercially viable
case under the proposals, and are prepared to bear the additional costs to
secure the deal;
“ the offer no longer appears to be VFM compared to the alternative - although the
Tesults are still close and there are risks which are not reflected in the figures (for
both routes);
“ the delay to a more modern and efficient benefit payment system. Paying
benefits directly into bank accounts which would fit with the Government's
welfare reform agenda, and would provide, in the view of the Social Exclusion
Unit, an extremely influential way of increasing people's access to financial
services and reducing financial exclusion. There is also the fact that we would be
implementing the Benefit Payment Card at a time when alternative, more modern
solutions are available (such as Smartcard - although the PO have plans to
migrate to a Smartcard eventually);
° the public expenditure consequences for BA. It is likely that DSS/BA accounting
officers will require a formal Ministerial direction to continue with the project.
4. The Way Forward
(i) Continuation
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If Ministers decide, on the basis of the above, to continue with the project, then:
BA/POCL will need to resolve their differences on ICL's acceptance proposals,
and agree a way forward with ICL that is acceptable to all the parties;
there may also be a case for pushing for further concessions in the negotiations
to finalise heads of agreement (although this will carry risks, given ICL have said
this is their best possible offer). We would expect POCL to lead these final
negotiations, in close consultation with BA;
we envisage a low key statement to Parliament to end the uncertainty about the
project. A suggested statement is attached at Annex C;
we would need to think carefully about how to minimise the risks of further delay.
One important factor would be a strong renewed commitment from all the parties
concemed to make best endeavours to deliver the project. The parties have also
agreed that a restructuring of the contract with ICL after acceptance to remove
BA (who would become a customer of POCL) would be a useful step;
we also believe there is a case for issuing some form of notice to complete under
this scenario.
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{ii) Termination
27. If Ministers decide that the ICL proposals do_not_ provide a way forward then
uestion arises as to what action to take.
28. The main options are:
a. To serve a 3 month notice terminating the contracts;
To serve notice making time of the essence. This would give ICL/Pathway
b.
the opportunity to complete the contract during the time speci
o
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30. Ministers are therefore invited to decide:
whether they wish to terminate the contract forthwith, by_issuing a_3 month
notice. since this is the quickest route to achieve termination:
whether to issue notice that “time is of the essence’, setting a reasonable period
31. We envisage that the Chief Secretary would write to ICL in parallel, noting that
the public sector could not accept ICL’s offer and that discussions around a
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te-negotiation of the contract had ended.
32. — Our preferred option at this point would be to seek a negotiated settlement. But
this would depend on the reaction of ICL.
33. — Atthis stage, Ministers might also be attracted to the possibility of introducing into
the discussions with ICL option 2 - i.e. continuation without the benefit payment card.
This would offer some of the advantages of the falloack option 3 but would avoid the
adverse impact on Fujitsu and ICL. However, the PO do not favour this option. But
option 2 would require the consent of ICL, so it is not, strictly speaking, a choice
available to Ministers at this stage.
34. — Clearly Ministers would need to be ready once notice had been served to make a
public statement, in the event that ICL either issued writs or went to the press. The
statements would need to provide reassurance to benefit customers, subpostmasters,
Fujitsu and the IT industry. Draft statements are attached at Annex C.
35. BA/POCL will also continue to work up the fallback option, in particular, once
notice has been served, by entering discussions with the banks.
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