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BA/POCL AUTOMATION
PROGRESS REPORT
16 NOVEMBER 1998
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BA/POCL AUTOMATION: PROGRESS REPORT
Contents
1, Background ..............00%
2. Objectives of the Horizon Project
3. Assessment of the ICL proposal..............
4. Comparison of option 1 with the faltback options .
5. The way forward 6.6... cess este ec eee cece teeeeeeeeeeeenns cee.
Annex A: Implications of ICL proposals for public sector parties
Annex B: Graphical representation of timescales............
Annex C: Risk assessment .
Annex D: Implications for ICL and Fujitsu . .
Annex E: Graph showing the path of discussions a
Annex F: POCL proposals for negotlation strategy ... yan
Annex G: Suggested lines to take for cancellation options ...................
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BA/POCL AUTOMATION: PROGRESS REPORT
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
after a key contractual milestone was missed. The project is now over two years
late. An inter-departmental report to Ministers (July 1988) and an HMT/No.10 Policy
Unit report for the Chief Secretary (September 1998) considered the options for
taking the objectives of the project forward. Following a Ministerial discussion, it was
agreed that the partles to the contract would be given one month to establish
whether a commercial basis acceptable to Government for proceeding with the
contract could be found. At the same time fall-back options were prepared to provide
a basis for judging whether the outcome of the negotiations offered the best value
for money for the public sector as a whole. A report was presented to Ministers on
this work on 23 October.
2. Following receipt of this report, the Chief Secretary wrote to ICL stating that
he and his Ministerial colleagues were prepared to agree to their request for a period
of two weeks for them to make progress in their discussions with the Post Office to
develop a public/private partnership (letter to Keith Todd of 30 October). This was on
condition that:
+ non binding “Heads of Agreement” for the proposal, agreed with the Post
Office, were received no later than Monday 9 November;
. the proposal was based on a realistic business case involving no explicit or
Implicit guarantees or commitments on the part of the public sector for future
additional business;
. that ICL and the PO seriously considered the case for involving a third party
with wider retail experience in the partnership - or otherwise demonstrated
how the necessary skills would be acquired.
3. We have now received ICL/PO's proposal for the partnership, agreed with
Post Office Counters. ICL have also provided 3 additional papers addressing
commercial, contractyal and financing Issues. Ministers’ must now decide:
‘ whether the partnership proposal meets the criteria set out in the CST's letter
Of 30 October;
- whether ICL’'s proposal on this and the wider deal represents sufficient
movement to be a constructive basis for further (time-limited) discussions with
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the public sector;
. whether further discussions are likely to deliver a deal which represents value
for money when compared to the fallback options, taking Into account the
tisks and rewards of each option.
4. However before providing an assessment of ICL’s proposals It Is worth briefly
revisiting the reasons why a decision on a way forward is urgently required.
2. Objectives of the Horizon project
5. Horizon was initiated in 1993 with the aim of:
. Providing a more secure and efficient way of paying benefits;
. providing DSS/BA with the means to account fully for their programme
expenditure;
. automating PO counters, to make current business more efficient and help
them to win new business.
The project also had the indirect effect of helping to maintain the nationwide network
by providing a secure revenue stream from POCL's biggest customer until the
middle of the next decade.
6. Against the background of severe delays to the project (attributed to ICL
Pathway) Ministers became very concerned that there was a serious risk that the
Horizon project would fail to deliver its objectives - or would not do so in a timescale
that would make it worthwhile to proceed.
7. These concerns have prompted a number of inter-departmental reviews of
the project and possible alternative options. These reviews have provided an
opportunity for Ministers to revisit and update the government's policy objectives for
the Horizon project. The key goals 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;
. to support integrated delivery of existing and new government services and
Information more generally taking full advantage of new technology,
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streamlining Government's dealings with citizens:
. 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
8neuring that risks transferred through PFI projects do not end up with the
taxpayer; and
. against these objectives, to secure prudent use of taxpayers money.
8. Decisions an whether to proceed with the contract or to move into an
endgame on the basis of ICL's failure to deliver need to be set In the context of
these objectives.
3. Assessment of the ICL proposal
9. Under cover of Kelth Todd's letter to Chief Secretary of 9 November, ICL
submitted four papers. One meets the Chief Secretary's request for non-binding
heads of agreement on a public/private partnership with POCL for further joint
exploitation of Horizon, and Is also signed by POCL, subject to agreement with ICL
on the wider commercial issues left outstanding. The other three are from ICL alone.
10. The partnership heads of agreement, while giving no guarantees or
commitments about levels of future business, envisage:
. a joint marketing executive to seek out and develop new business to
be transacted over Horizon;
. a single tender arrangement with ICL for certain specified areas of
work, subject to value for money and procurement considerations; and
- the possibility of Invatving a further partner with financial retail
experience (although this has been taken no further at this stage).
11. The heads of agreement are, in the DTI and Post Office's view, a sensible
way forward on which could be built a valuable partnership with ICL. We have no
estimates yet of how much value might be added for either POCL or ICL (but see
below on ICL's preparedness to accept a loss, which gives some indication of what
they believe the partnership could be worth). Subject to HM Goverment consent
and satisfying various legal, requiatory and contractual constraints, POCL and ICL
would wish to work towards a binding agreement by the end of the year.
12. Taking the heads of agreement together with the other three papers, the
Proposal is an attempt by ICL to reduce its risk, making the project more secure and
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hence more attractive to sources of limited recourse finance. ICL have said that they
will underwrite a loss of between £76-103m' NPV on the agreed core case volume
assumptions. It hopes, through the further exploitation of the system with POCL, to
recover some or all of this loss (though we have no figures). POCL believe that, on
reasonable assumptions, ICI_ can expect to recover all of this and perhaps more on
the back of their partnership agreement with POCL. A schematic diagram of the path
of discussions so far (updating a diagram fram Graham Corbett’s report) is attached
at Annex E.
13. Key components of ICL’s proposal are:
e increased prices, and inflation risk transferred back to sponsors
. greater guaranteed volumes across the system
. a contingency fund which they suggest will incentivise the delivery of
the project to timetable
. payments in advance, rather than in arrears
. a revised acceptance process
. revised contract terms which draw on recently published draft PFI
Taskforce guidelines, and
. BA being no longer a party to the ICL contracts after acceptance.
14. A preliminary assessment of their proposal and Its Impact on the sponsors is
attached at Annex A (prepared by POCL with assistance from BA). There Is further
work to be done on the detail of what ICL have suggested. But key concerns, which
would be the agenda for any further negotiation are:
. the commercial terms proposed imply significant price Increases and
increases In guarantees above a level acceptable to the parties;
. the revised pricing proposals together with the proposed contingency fund
would mean that the public sector would have to find an additional
contribution. ICL’s estimate is that this would be £121m NPV, with a
contingency fund (financed by the sponsors) of £80m NPV. If the contingency
is not used the sponsors would receive two thirds of this fund back through
credit notes. If the contingency is used there may be counterveiling
reductions in payments due to delay. Further work fs required to model the
overall Impact on the public sector. Any additional contribution would be over
and above the £116m NPV implied by the Corbett proposal;
e the proposals on acceptance could lock the parties into a system before it
had been fully tried and tested and would result In a significant reduction of
' Range depending on whether or not the proposed contingency Is called
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POCL or BA's rights to termination;
. after acceptance, proposals to enable ICL. to raise limited recourse financing
could mean that the public sector underwriting all of ICL's borrawings; even
after the offer of an additional £100m equity from ICL, this would be a
significant transfer of risk to the public sector - to the extent that this could
result In the project becoming an asset on POCL's balance sheet.
15. I These proposals are clearly unacceptable to the public sector parties.
However there are aspects of the proposal that we feel could be helpful if the project
were to proceed - in particular the suggestion that the contract is restructured so that
POCL take over BA’s contracts with ICL.
16. DTI/POCL are of the view that ICL have moved significantly over the course
of the fortnight''s discussions and show signs being prepared to move further. They
have settled for significantly less than originally stated aspirations of greater control
on POCL's commercial future and single source suppller for all POCL's IT systems.
They believe that there are reasonable grounds to believe that a deal could be
reached through further negotiation. They think the gap could be closed by a
combination of:
. movement by ICL recognising the benefits of the partnership proposal;
. further negotiation about commercial terme, with the possibility of some
further value-added from POCL through an asset purchase (for which POCL
will need a relaxation of their EFL);
. the injection of further direct funding into the project by ICL/Fuljitsu.
17. I DSS/BA do not agree. They do not think that ICL's proposals (particularly
their suggestions on risk transfer) represent a sufficiently significant move on ICL’s
part to suggest that a commercial deal acceptable to Government could be struck.
18. The Treasury's view is that ICL have made a significant move, and are likely
to move further, but a judgement on whether this is significant enough to give
confidence that an acceptable deal could be struck is partly dependent on ICL's
Proposals on funding and underwriting by Government (on which we are seeking
further clarification).
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4. Comparison of option 1 with the fallback options
Recap on the options
19. The impact of each option on the Benefits Agency and the Post Office are
driven by the following key factors:
. the timing of the move to ACT - via the Benefit Payment Card (BPC) in option
1 and direct in options 2 and 3;
. the introduction of simple banking and full banking services at PO Counters;
. the rollout of the technology platform (whether Horizon or an alternative) for
the automation of wider POCL services (for both existing and new PO
clients);
. the end of the minimum floor payment from BA to the POCL.
Annex B sets out in graphical form the timings for each option.
Managing the changes to the PO network
20. The response of the Post Office under each option, and in particular how any
changes to the network would be managed, will be an Important factor In any
decision on the way forward. There are differences of view between the parties on
the ability of the Post Office to manage changes to the network under each scenario.
Key issues will be:
. how to maximise POCL’s existing customer base as benefit payment
switches to ACT;
. how to maintain relations with existing clients who are looking to automation
to Improve services, and to ensure that POCL's credibility in winning new
clients Is not undermined;
. how to ensure that the subpostmasters (private agents who run the majority
of the post office network) perceive that post office business can provide a
viable future and do not voluntarily exit the market (reducing the ability of the
PO to manage network closures and migrate business to other offices).
21. Under all options the Post Office will be seeking to manage a reshaping of the
network, against a background of commitment to a nationwide network of post
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Offices. Their objective Is to retain the current levels of access, especially in rural
areas, but to reduce over-provision In some urban and suburban areas, replacing
some physical offices with electronic access points. Current trends would in any
cage see a reduction in the rural network by some 200 offices each year, and a
gradual shift to ACT-based methads of payment over time (by 2009/10 almost 50%
of claimants are expected to have switched to ACT). Compared to the current
network of 19,000 offices, POCL believe that thelr vision for the future could be
Served by a network consisting of around 11,000 - 13,000 full service offices
supplemented by 5,000-10,000 electronic access points, many of which could
continue to be sited in existing post offices. In practice however we recognise that
any network of the future will be constrained by the same combination of history and
Politics that has shaped today’s network.
22. Under option 1 the benefit payment card (BPC) will provide the Post Office
with a more s@cUre Customer base In the short term since claimants who do not
choose ACT will continue to use the PO for withdrawal of their benefit. In the
medium term (by 2004/5) the PO Intend to use the Horizon platform to provide a
fange of banking services across Its counters. POCL believe that the banks will see
a commercial case for paying them to provide these services as they seek to reduce
costs through closures of thelr branch network. Full banking services will be in Place
by the time BA will begin to transfer their customers to ACT on a compulsory basis.
POCL are of the view that the transition from the BPC to a “smartcard” (providing
banking and other services) will ensure that they maximise the number of benefit
Customers who continue to use the post office network, However DSS/BA believe
that the Horizon project will in fact be further delayed, further squeezing the tine
between the Introduction of the BPC and the switch to ACT; and will distract POCL
from introducing banking services as quickly as possible potentially missing the
emerging banking market.
23. — Under option 2 the PO will need to move more quickly to introduce banking
services acto&s PU Counters in order to be ready for the switch to ACT - so that they
can protect their customer base by offering cash withdrawal facilities across PO
counters. They will have two years to plan this (during which the current levels of
DSS funding will be sustained). The removal of the BPC from the project would in
principle mean that POCL (and ICL) can focus on the early rall-out of banking
services and other systems essential for POCL to sustain their business. The
consultants were of the view that it would be possible to provide banking services by
2001/2 when BA begins the transition to ACT, particularly if a basic cashback facility
is introduced early. However the PO belleve there are risks attached to this strategy
- in particular the impact on the expectations of private agents of an announcement
that the BPC is being scrapped. It is likely that subpostmasters will require
compensation for the loss of retall business In order not to leave the market. They
are also concerned that in practice the removal of the card will not allow a re-focus
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because work on the software development of the BPC is largely completed.
24. — Under option 3 the PO will also need to move rapidly to introduce simple
banking servi@S 10 protect its customer base. We envisage that POCL would Install
simple debit terminals to provide a basic cash withdrawal service before the switch
to compulsory ACT, and would follow with full banking services at a later date. The
Consultants believe that simple debit terminals could be installed relatively quickly,
but have stated that there is a risk around the commercial credibility of this strategy.
POCL would have to move from a situation where they were paying the banks (for
debit terminal facilities) to a situation where they were recelving payments from the
banks to provide full banking services. POCL would also need to commission an
alternative platform to replace Horizon to provide automation of services for Its other
clients, and to provide It with a means of attracting new business, An announcement
that Horizon was being scrapped, and the delay to the introduction of an automation
Platform (although not to simple banking services) could also impact on expectations
and lead to unmanaged closures. Again, compensation to retain subpostmasters in
the market Is likely to be required. An alternative approach would be to delay the
introduction of compulsory ACT until the replacement for Horizon with full banking
facilities was in place. The price for reducing the risk to the network In this way
would be the savings to the Benefits Agency foregone.
25. Under both option 2 and 3 POCL and BA would therefore need to work
together to develop a positive and credible strategy which ensured that BA could
move to a more efficient benefit payment system as soon as possible, whilst
retaining the confidence of customers, PO clients and subpostmasters in the
sustainabillty of the network. A pro-active approach to communicating this strategy
will clearly help to mitigate the risks - although BA are more optimistic than POCL
about this.
Risk analysis
26. Annex C presents an analysis of the risks to the government's key objectives
for the project under each aption. There are, inevitably, differences of view about the
size of the risks and the ability of parties to manage them successfully. DSS/BA
belleve that the risks around deliverability of Horizon in option 1 are very significant
given the history of the project, and that the risks to ail of the objectives in section 2
could be minimised by focussing on getting simple banking technology Into post
offices as early as possible (option 2 or 3). DTVPOCL are of the view that option 1
offers the lowest risks because It offers POCL the earliest date for full automation
and, by retaining benefit recipients In the PO system carries the least risk to the
network and to subpostmaster confidence. Option 1 has been validated by
independent experts who judged It be technically viable, robust and future proof.
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Revised VFM assessment
27. The terms that ICL have offered imply a contribution of between £121m NPV
Plus a contingency of £80m from the public sector. Given that the Working Group
Report (23 October) assumed a contribution of £150m NPV In option 1 and 2 then
the VFM analysis broadly stands: 1.e. that the options are very close, and that the
assessment of risks across the optione ig therefore crucial.
Impacts on ICL
28. A full summary of the impact of all the options on ICL is attached at Annex D.
Under afl options ICL Is likely to face a material write-off. Cancellation would
Jeopardise their plans for flotation.
5, The Way Forward
29. Our assessment of the choice facing Ministers is:
e to continue with the negotiations on the basis that the ICL proposal provides
grounds for believing a commercial deal could be struck with substantial
further movement from ICL and (possibly) more limited movement from the
public sector, taking action to minimise the risk of future problems;
. to decide that the contract is unsustainable in its current form; that the gap
between ICL and the public sector cannot be closed in a way that could be
justified as value for money for the taxpayer (taking into account the wider
risks); and that the balance of advantage lies in opening discussions with ICL
to decide an alternative way forward. This could involve a negotiation around
dropping the benefit payment card (option 2), and if that falled, a negotiated
settlement around ICL’s full withdrawal (option 3).
30. If Ministers decide to allow a further period for negotiation with ICL then next
steps are as follows:
. respond to iCL setting out a period for further discussions - a period of around
one month will be required to reach heads of agreement;
. assuming that further negotiations should be led by POCL, agree quickly a
Negotiating remit for POCL - Including whether POCL should be given an EFL
relaxation to make an offer to ICL;
‘ at the same time ask POCL and BA to reach heads of agreement to enable
POCL to negotiate on a bipartite basis with ICL.
pat
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POCL’s proposals for the negotiation are attached at Annex F.
31. If Ministers decide the contract Is unsustainable then the next steps are:
. to prepare for a negotiated settlement - which may involve option 2;
. to prepare a public announcement/presentation to minimise the impact on
benefit customers and the PO network (see Annex G for an indication of the
questions that are likely to arise which the Government will need to be able to
answer);
. to ask BA/POCL to work up strategy for an early move to ACT consistent with
minimising the impact on PO network.
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ANNEX A
ANNEX - IMPLICATIONS OF ICL PATHWAY PROPOSALS FOR PUBLIC @
SECTOR PARTIES - PRELIMINARY VIEW
1.
a)
»)
Overview
‘This paper represents a preliminary view by BA and POCL of ICL's latest
three proposals on Commercial and Contractual Issues, Acceptance, and
Funding. Legal advice has been obtained, as well as some early
assessment by PO's advisors on corporate finance, and by PO's external
auditors.
Overall, the proposals as they stand would be unacceptable as a complete
package. However, there does appear to have been some movement by
ICL,and POCL (who will have to agree with Government how any
costs/risks beyond the Corbett proposals are treated) believe this is
enough, (c£76 to £103m NPV over the life of the projact depending on
treatment of contingency), prima facia, for talks to continue between the
parties. At the last Treasury Working Group it was confirmed that BA
had already gone beyond their remit and had nothing further to offer.
However there will also need to be some issues discussed between BA
and POCL prior to engaging with ICL in the light of some of ICL’s
proposals - eg restructuring of the contracts for PAS and CMS with the
associated changes in risks, liabilities and obligations that would bring.
There are several key areas of difficulty to take forward and resolve with
ICL. These are summarised below.
Funding Isgues
ICL's proposal effectively requires the public sector to underwrite all of
its borrowings and in some circumstances the equity investment on the
project, including in circumstances where the project falls through ICL’s
default,
There does not appear to be any matching or increased commitments
from ICL Pathway’s parent companies. In addition, there appears to be
extra transfer of existing parent company underwriting to the public
sector either at “acceptance”, or even earlier once contractual agreements
are reached. ICL claim that this approach is in Line with HM Treasury PFI
Task Force Guidelines - but these are draft guidelines, and not necessarily
fully applicable to IT projects.
‘There are also new explicit direct relationships and implicit abilities to
ICL Pathway’s lenders for the public sector being proposed,
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e d) The Post Office's own financial advisors have analysed the funding
proposal and identified a number of areas of significant concern. These
are summarised at Appendix 1.
3. Balance Sheet Issues
POCL’s external auditors have advised that the current terms of the ICL
proposal, in particular the high level of guarantees required and the
intervention rights of their senior lenders, would probably result in the
project having to be inchided as an asset on POCL's balance sheet. This could
result in a net adverse position on POCL's profit and loss, though there will
be offsetting liabilities. This would mean that the project would effectively no
longer be a PFI.
4. Contract Restructuring Proposals
DSS accept the principle of contract restructuring (ie POCL take over the PAS
and CMS contracts in addition to those they already have with ICL) provided
the benefits payment service can be safe guarded, potential legal and policy
issues can be overcome and there is no increased cost to BA and POCL accept
the relevant Habilities and conditions. POCL would need a more detailed
understanding not only of the Habilities it would be expected to take on (on
behalf of ICL) but also its obligations to ICL on behalf of BA. This will need
early discussion and agreement between BA and POCL, to clarify the risk
transfer to POCL and the degree to which this is covered by ICL under the
Corbett proposals, Timing of this, will be critical and POCL would not be
willing to undertake this prior to BA's ‘acceptance’ of the system, including
PAS and CMS.
5. Commercial Terms
a) Pricing
ICLare seeking a significant price rise through changes to discount structure
and through introduction of an RPI-2% pricing formula to replace the
contracted position of no RPI linkage up to 6% and price reductions of 3% per
annum over the steady state period of the contract. This represents c£200m
NPV improvement for ICL, of which £80m would be used to create a
‘contingency fund’. If these contingencies do not have to be used, the public
sector parties would receive 2/3 of this £80m fund back through credit notes
b) Guarantees
ICL are seeking an increase in guarantees to 80% of current business plus 90%
of future POCL banking business, (Current guarantees are 65% of POCL
business and an average of 65% of BA business as forecast in the Invitation to
Tender.) In the discussion facilitated by Graham Corbett, both POCL and DSS
Nia
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indicated that they would be prepared to increase guarantees to 75% of the ®
revenues from currently forecast volumes.
As POCL explained to Graham Corbett, it would not wish to provide a
separate guarantee for banking business but would include banking in Its
overall guarantee, Higher guarantees than 75% of forecast volumes could
also increase the likelihood of having to treat the project as a POCL asset.
6. Acceptance
ICL Pathway’s proposals on Acceptance would mean that the Contracting
Authoritles would be locked into the system before it has been fully tried and
tested. BA and POCL have already made a very significant concession on
Acceptmce as part of the Corbett proposal ie in waiving thelr termination
rights at Acceptance of NR2 which does not deliver the full contracted
requirements. Both parties are not willing to bring forward acceptance before
the end of the Live Trial. Both parties are prepared to consider a modest
increase in the number of allowable faults but not in the magnitude being
proposed by ICL.
ICL have also proposed the appointment of a named expert (Peter Copping
from PA) to help resolve disputes on acceptance between the parties. BA and
POCL are willing in principle to accept expert facilitation (though they do not
necessarily yet accept the nominee proposed by ICL) but cannot agree that the
expert has the right to make binding decisions on behalf of BA and POCL.
Acceptance is a very critical point in the whole programme and under ICL’s
proposals would result in significant reduction of POCL or BA’s rights to
termination thereafter. Acceptance is a serious issue to resolve properly.
7. Other Issues
There are a number of other issues related, for example to dealing with the
“cunning sores” in the project (treated through price rise proposals), extra risk
for BA around delays around the CAPS project, and cash flow and accounting
rules in paying invoices in advance rather than in arrears, as contracted.
8. Future Business Opportunities
ICL have indicated that one enabler for their move has been an improvement
in their perspective of the benefits to them of further exploitation of the
Horizon system, without related public sector guarantees. ‘This has been
embodied in the Heads of Agreement on POCL/ICL Partnership, signed
earlier this week (but which would lapse if agreement on the other issues
detailed above is not reached). ICL reached their view in the light of POCL’s
feedback that in principle ICL has the technical capability to play such a role.
phir]
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ICL's funding proposal seeks to reise non-recourse funding by POCL, in effect
underwriting the funding required and taking on 2 substantial proportion of the
risks of the project. This would release Fujitsu from standing behind the project.
While the conditions purportedly being laid down by lenders arc not unreasonable
from the point of view of lenders, it is still not certain that any lenders would be
interested in funding Pathway.
. ‘Thete is no point in agreeing to any of the changes unless they actually bring about
the funding - i.e. changes should not take effect (if at all) until funding is in place.
It follows that there may be limited uae in agreeing to some but not all of the
Proposals.
\« ‘The major issues of concer on the finding proposals (aside from other concems
on ICL's other commercial proposals) are:
=> Acceptance: the proposal is that we should sign before acceptance, Itis
unlikely that any lender would lend before acceptance and we should not’
sign up to these changes before banks aro on board.
=> Compensation on Pathway default: we have to pay off their lenders even if
they defmult. Although this is not an unusual clause to be required in
circumstances such as this, the likelihood of Pathway default is higher than
typical given their track-record and, therefore, the risk to POCL greater.
= Setoff: we are unable to set-off any liquidated damages owed for :
performance failure against any comtpensation to Pathway and/or their
lenders. This is not normal.
=> Frayd: fraud risk is transferred back to POCL. A primary aim of the PFI
‘was to transfer fraud risk out of the public sector.
=> Changes: all changes would have to be agreed by Pathway and POCL.
would have to pay for them, even if they wore Pathway generated.
6. Secondary issues are:
=> Pathway termination: Pathway can terminete for a minor breach by POCL
and lenders would be repaid, but POCL may not afford to terminate for
material breach by Pathway.
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=> Direct Agreement: it is proposed to have a Direct Agreement between
lenders and POCL. This ts not unusual, but transfers flinding risk to us. As
written there is a risk that lenders could force us to terminate if the funding
agreement between lenders and Pathway are terminated.
= Performance deductions: it is proposed that deductions are capped. This
could leave substantial cost with POCL in coping with persistent poor
performance,
7. Other significant issues include:
for A default, force majeure Yo!
convenience: The to POCL of termination are significant. Although it
is not unusual for the contract to include compensation clauses the
=> Changes inLaw: POCL would take the risk of changes in law. Again, this
is not unusual,
=> Lenders’ security: the lender would have first security over the assets. This
is not unusual, but could cut across our rights to buy (or use) the assets
following termination,
8. The role of BA in standing behind any commitment we take on their behalf has not
been cleared.
9 It needs to be recognised that Pathway already have thitd party lender liability of
£200m.
10, From an accounting perspective, no significant risk has been transferred to ICL, It
is, therefore, probable that the PO will need to recognise this as an asset with
lwo
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Roll out of POCL Introduce
Horizon starts timited banking wee ANNEX B: TIMESCALES
I Roll out of altemative
OPTION 1 Horizon starts (option 3) I e
100% u
80%
b2:LT G6-TT-9T
transactions
&
&
g
JASNISOBAL WH WSL 3d :WOa4
1998/9 199%O 2000/1 2001/2 2007/8 2008/9 2009/10
OPTION 3
transactions
g
1998/9 1998/0
20045 20056 2006/7 20078 20089 2009/10
eee Floor
20001 2001 2002/3 2003/4
:
8
8
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ANNEX C: RISK ASSESSMENT
This annex presents an assessment of the risks surrounding each option against the
key Government objectives:
. Objective A: efficient, secure and accessible benefit payment
. Objective B: maintenance of a nationwide network of post offices to protect
the accessibility af post office services
° Objective C: improved delivery of existing and new services for government
. Objective D: improved access to banking services for the socially excluded
Annex D considers the implications for ICL and therefore the impact on the
government's objectives for the IT sector.
If successfully implemented, then each option will contribute to these objectives as
follows:
18
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Without Prejudice
A B ¢c D
option I improves on provides PO provides allows PO to
1 Present system I with technology I platform for offer front end
and eliminates I to retaln existing I delivery of banking
means of and develop existing and services
payment fraud, I new business new government I providing
but delays move I and secures services across I accessibility
to (more customer base I PO Counters through a
efficient) ACT in shorter term I and could trusted brand
through support
migrating to initiatives such
ACT via the as “single
BPC account” and
electronic
government
option I early move to as option 1 but I asoption 1 and I earlier move to
2 ACT delivers reduced security I removal of BPC I ACT brings
significant of customer would enable “unbanked" into
efficiency base due to loss I ICL and POCL I the banking
savings and of BPC and to facus earlier I system In
eliminates earlier move to I on wider advance of
payment fraud I ACT government option 1
services
option I as option 2 asoption2 but I delayed as option 2
a delayed implementation
implementation I of non-banking
of automation technology
for existing and I platform means
new (non-BA) more likely that
cllents other channels
are used for
government
services -
without PO
trusted brand
and reach
However there are risks attached to each option which may threaten the delivery of
these objectives. The following tables attempt to present the potential risks around
each option, how they could impact on these objectives, and how they will be
19
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managed by the relevant parties. There are, inevitably, differences of view about the
size of these risks and the ability of parties to manage them successfully. DSS/BA
believe that the risks around deliverability of Horizon in option 1 are very significant
given the history of the project, and that the risks to all of the objectives above could
be minimised by focussing on getting simple banking technology into post offices as
early as possible (option 2 or 3). DTI/POCL are of the view that option 1 offers the
lowest risks because it offers POCL the earliest date for full automation and carries
the least risk of damaging subpostmaster confidence thereby reducing the threat to
the network.
Option 1
Risk A c Risk management strategy
BPC technology does not v rigorous acceptance process
meet BA's requirements
non-BPC technology does v figorous acceptance process
not meet PO's requirements
Further delay to v Vv active project management;
implementation independent advice; common
incentive structure to deliver to
time
Incomplete roll out v common incentive structure to
ensure no offices remain
outside of Horizon
Lack of ICL commitment v v realistic partnership
arrangement between POCL
and ICL with no fudges
20
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Option 2
Risk A Risk management strategy
non-BPC technology does v rigorous acceptance process
not meet PO's requirements
Further delay to v active project management;
implementation independent advice; common
incentive structure to deliver to
time
Lack of ICL commitment v realistic partnership
arrangement between ICL and
POCL with no fudges
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100% migration to ACT v BA plan changes to
delayed perlodicity; publicity campaign
Delay to implementation of v POCL/ICL refocus efforts on
POCL banking banking requirements
negative reaction of v v presentational strategy for
subpostmasters and exit from announcement; grant regime
postal market to incentivise subpostmasters;
work closely with BA to co-
ordinate timing of mave to
ACT
banks react by chargingBA I ¥ BA work with banks to reduce
customers impact; PO introduce banking
as soon as possible to reduce
impact on bank branches
21
Te-1i-yy ify
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Option 3
Risk A {B IC{D I risk management Strategy
new technology does not ¥ I¥ Iv I rigorous accaptance process
meet PO's requirements
Further delay to ¥ Iv I¥ I active project management;
implementation Independent advice; common
incentive structure to deliver
on time
100% migration to ACT Vv ¥ I BAplans changes to
delayed periodicity; publicity campaign
Delay to implementation of vfv ¥ I POCLACL refocus efforts on
POCL banking banking requirements
negative reaction of Vv Iv Iv Iv I presentational strategy for
subpostmasters and exit from announcement; grant regime
postal market to incentivise subpostmasters;
work closely with BA to co-
ordinate timing of move to
ACT
incompatibility of introducing [¥ I ¥ ¥ I POCL negotiate with banks a
interim banking solution and package including interim
commercial strategy to banking
Introduce full banking solution
banks react by charging BA Iv ¥ I BA work with banks to reduce
customers impact; PO introduce banking
aS Soon as possible to reduce
Impact on bank branches
22
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.
@ Restricted - policy and commercial
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ANNEX D: IMPLICATIONS FOR ICL AND FUJITSU
This Annex reviews the implications of each option for ICL and its parent,
Fulitsu. ICL Pathway have been set up as a subsidiary of ICL which has provided
BA and POCL with parent company guarantees on finance and performance.
2. To recap, the ICL Group balance sheet is not strong. In 1997 It Included net
assets of around £260m. KPMG have confirmed with ICL Pathway that around
£125m of this figure represented capitalisation of the work on this project, some
fixed assets but mainly work in progress. We now think that this figure will have
increased to around £200m. Liquidity had worsened from £105m of net current
assets in 1986 to £42m In 1997. There is a possibility that ICL could strengthen its
balance sheet by writing back some of the £200m goodwill written off according to
existing accounting regulations that have subsequently been revised - but this is not
mandatory. In any event this would do nothing to improve the Group's liquidity and
net current asset position.
3. Profitability Is also weak. On a like for like basis ICL made an operating profit
of around £50m in 1996 compared to @ reduced profit of around £35m in 1997, ona
turnover of £2,477m In 1997. So the group is operating at pretty close to break even.
4. lf the whale project was cancelled (option 3) Pathway would suffer a loss of
around £250m. Assuming ICL stand behind Pathway, they will have to bear most of
this. The implications for ICL are:
. it would have to write off a good part of the £200m capitalised assets from the
project unless the work In progress could be deployed on another similar
project;
. it would bear a loss at Pathway of £250m;
. therefore reducing net assets of up to £450m and creating a situation of net
Nabllitles of up to £200m before any write back of goodwill.
5. A write off of anything like this size would clearly be material. There seems
little doubt that it would put at risk for many years any chance of a successful ICL
flotation (planned for 2000).
6. In fact Pathway have not yet signed and filed their latest accounts - missing
the end October deadline - pending the present discussions. A material write-off in
the Pathway accounts could mean the ICL group having to re-file their accounts,
although this is not clear cut. It could be argued that the ICL accounts were prepared
on the basis of information that was true at the time - even though the adjustment Is
23
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large it may not require a “prior year" adjustment. Elther way this would be
embarrassing for ICL's directors and auditors.
7. In these circumstances it might be possible in principle for ICL to simply wind
Pathway up, leaving Pathway’s creditors, rather than ICL, to foot the bill. However
this is unlikely. ICL are more likely to seek guarantees or a significant injection of
new capital for Fujitsu.
8. Cancellation would have limited financial implications for Fujitsu, since ICL
represents only around 5 per cent of group shareholders’ funds and 2 per cent of net
current assets. However Futjitsu has underwritten a £200m loan facility to ICL
Pathway, and Fulitsu Itself had @ bad year in 1997/8, with group profit after Interest
and taxes reducing from £254m In 1996/7 to £26m In 1997/8 due to economic
problems In Japan and South East Asia. Given the current economic climate
Fujitsu's attitude may well have hardened: it may well seek to divest Itself of the
company.
9. The implications of cancellation for employment within ICL will depend on
whether Fujitsu decides to divest itself of the company. It Is estimated that some 270
people at ICL Pathway are working on this project and many more at their
contractors. ICL itself employs 2,700 people In the UK and a further 6,600 in Europe.
However any IT staff released are likely to be quickly re-employed by competitors
given skill shortages In the IT industry.
10. There ig algo a risk that cancellation might prejudice Fujitsu's attitude to future
investment in the UK. Japan accounted for some 9.4 per cent of inward investment
in to the UK In 1996. Despite the closure of their semi-conductor plant, Fujitsu
remain the single largest Japanese Investor in the UK and are highly sensitive to the
outcome on Project Horizon. There is a serious risk that cancellation might prejudice
not only Fujitsu's but other existing and potential investors’ future invesment in the
UK.
11. Under option 1 and 2 ICL could still make large losses. Even a write-off of
£50m would appear to be material (20% of net assets, 100% of annual profits).
24
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WITHOUT PREJUDICE ANNEX E @
_The path of the discussions (to 9 Nov) ©
Impact on ICL - ‘£m NPV over - whole project
— 0 (76-103) (224) (270) (340)
ICL proposal Corbett Initial public Core
inital 9 Nov proposal sector offer case
position et
iti 1201 6 Oct
NB Range of outcomes
depends on release of
contingency provision.
Figures are NPV at 8.5% to 1/1 1999
ICL propose the sponsors would fund the £80m NPV contingency of which they would recover £52m if
it wasn’t required
ICL estimates except (270) and (340) which are HMT estimates extrapolated from Corbett report Page 25
__ hainsyaa WH WAL dad:W0a4d 9 62:1T 85-TT-9T
IGRO}
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ANNEX &
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BA/POCL AUTOMATION PROJECT
PROPOSALS FOR NEGOTIATIONS BETWEEN ICL AND POCL
before negotiations start
. BA and POCL to agree heads of agreament on the future contract terms etc: between the
two parties. The starting point for these will be the proposed agreement reached
between BA and POCL under the Corbett negotiations
* these heads of agreement also to embrace issyes on which Joint agreement is required
in response to the ICL proposals of 9 November. For example, POCL may be prepared
to discuss with BA the early assumption of control of PAS and CMS if suitable terms
could be agreed
* following agreement with BA, clear negotiating remit to be agreed with Government,
The Post Office Board would also want to ensure that POCL’s negotiating brief made
sense commercially and protected its agreed shareholder returns
POCV/ICL negotiations
Process
. the negotiations to be conducted directly and solely between POCL (with Post Office
Executive Board involvement where appropriate) and ICL. The parties, at their sole
discretion, would be free to involve specialist experts
© asenior Treasury official (Adrian Montague) to be available to act as a long-stop
facilitator between the parties, but will not be Part of the actual negotiations.
progress reporting
. POCL to report progress on negotiations to a Progress Tracking Group, the putpose of
which will be:
0 to ensure the outcome of the negotiations is within the remit set by Government
Ministare
© to review progress of the negotiations in order to brief Mi
9 to provide facilitation to the negotiations where requested
© membership of the Progress Tracking Group to be HMT (chair), DTL DSS along with
POCL
timetable
» by 20 November: (assuming Ministerial §0-ahead) heads of agreement reached
between BA and POCL [NB this assumes BA are unable to reach agreement with POCL
before Ministerial decision to continue negotiations]
« by 20 November: Government agrees POCL negotfating remit and announces to ICL
resumption of negotiations
* by 11 December; heads of agreement agreed. These to be turned into fully detailed
and revised contracts as soon as possible thereafter,
16
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P106/700
16-11-98 17:36 — FROM:PEP TEAM HM TREASURY,
+ UG-NOV-1996 MON 14:14 IDF ‘
RESTRICTED - POLICY & COMMERCTAL
LINES TO TAKE IF EITHER ICL OR HMG DECIDE TO TERMINATE
HORIZON PROJECT
ANNEX G
TF ICL TERMINATES
© Regret that ICL has felt unable to continue with the project despite the public
sector partics' best efforts to agree revised terms with them.
WHAT WENT WRONG? (IF (CL TERMINATES)
© This large and complex IT project became subject to extensive delays and
cost-overruns, and the contracting parties were unable to agree an acceptable
commercial basis for continuing with it,
IF GOVERNMENT TERMINATES
e Despite the public soctor's best efforts it has unfortunately not proved possible to
reach agreement with ICL on commercial terms for continuing with the project.
WAY FORWARD NOW?
© The Government remains fully committed to the objectives of the Horizon project
to provide:
- the automation of the post office counters network, to match the ambitions we
have for it to become a world beating model service; and
- asimple safe way of delivoring the £billions of taxpayers’ money wo pay out
each year in benefit payments
» But the plans we inherited from our predecessors are not now the beat way to
achievo these objectives, given the delays that have now occurred in the project
they devised.
¢ We believe there is now a better way forward, exploiting the best technology and
expertise available to meet the ambitions this Government has to handle its
dealings with people in a modern, convenient and streamlined way.
« In particular, we want to he able to take advantage of the best modern technology
and look to sohutiona for the future.
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© Our vision for the future is that :
- every post office will be automated, and will offor on-line banking servicea in
association with the commercial banks as well its current range of rervices;
- people will be able to collect thoir benefits in cash from post offices/shops /
banks and a number of other outlets - whichever is the most convenient;
+ they will be able to do this because of the banking facilities that the Post
Office will install on its counters; and because we will work with the banks to
provide evoryone with a bank account, if they do not already have one.
© We will be achioving this massive change, moving us away from an antiquated
system of paying benefita which has been around since the 1940’s, by building a
partnership with the banks, the commercial world, the Post Office, Government
and people,
‘This approuch will open up the prospects of the kind of Single Government
Account signalled by the Prime Minister at the Labour Party Conferonce, to bring
togother in a simpler way the many transactions Government has with cach
individual citizen.
EFFECT ON POST OFFICES ?
© Post Office Counters will now need to consider urgently the options for securing
a replacemont for Horizon, [incorporating banking facilities] but in the meantime
it will be businoss as usual! for post offices up and down the country.
© The Government remains fully committed to the maintenance of a nationwide
network of post offices providing good local access.
© Fully recognise importance of post offices to communities they serve and ;
rocognise the especially valuable role played by post offices in rural communities.
IMMEDIATE CONSEQUENCES FOR BENEFIT CUSTOMERS?
© Those customers who prosontly use payment card will see tio interruption of their
payments,
© Vast majority of 18 million benefit customera will be unaffected.
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COMPULSORY ACT?
© DSS will take steps to ensure that it gets the secure, convenient and cost effective
method of paying bencfits which its customers need.
© Bonefit recipients ure increasingly opting to receive their benefits through their
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bank accounts, but the Govornment will ensure that all benofit recipients who wish
to do so can continue to collect their benefits in cash at past offices.
REP].ACEMENT FOR HORIZON?
e Government remains committed to offering benefit customers a secure,
convenient and cost effective method of benefits payment and automation of the
post office countors network,
© Government accepts it is important to future of Post Office Counters that network
has modern, automated on-line platform for handling present and future business.
© Disappointing to lose Horizon, but Post Office Counters will now need to quickly
consider altemative options which will help it to provide the services which its
clients and customers want.
RURAL NETWORK
© The vast majority of post offices are run by private individuals who operate the
facility alongside a rotail outlet.
© Managoment of the nctwork is the reaponsibility of Post Office management who
seek to cnaure that services continue to be provided where possible, However,
when a subpostmaster resigns or retires it is unfortunately not always possible to
recruit a replacement.
© Tho Post Office must also be sensitive to changes in shopping habits and
demographio trends.
© When the Post Office are unable to retain a full time facility in such areas they
will seek to establish a part-time facility where possible.
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POST OFFICE REVIEW?
e We are committed to granting the Post Office greater commercial freedom within
the public sector.
© Expect to announce conclusions of Review shortly.
© Post Office Counters has extended its product range into a number of new arcas in
recent years, which has proved popular with customers. Important that they
continue to develop in ways which wil] help underpin the network which is valued
by many people,
1S THIS ANOTHER PFI FAILURE?
© No. The Private Finance Initiative will continue to provide succcssful basis for
public/private sector partnerships.
© Risks transferred ynder PFI to the private sector must not come back to public
sector,
WHAT DORS FALLURE MEAN FOR ICL’S PLANNED FLOTATION/ITS
FUTURE?
© Decisions conceming the future of ICL are a matter for ICL and its parent
company, Fujitsu,
WHAT ARE IMPLICATIONS FOR INWARD INVESTMENT BY ICL'S
PARENT COMPANY, FUJITSU?
Each project neads to be considered on its own merits. The Government greatly
values Fujitsu's investment in the UK,
DI l/Postal Services Directorate
16 November 1998
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