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i. ARR TMUCT ~ PORLCY ¢ ComuNecrtL
: DEPARTMENT OF TRADE AND INDUSTRY I__I GRO
FAX HEADER
FORTHE ATTENTION OF: SrretDran Sven
LOCATION: POL
NUMBER OF PAGES TO FOLLOW: +24 I
pate: ~ [b-fg°4&
FROM: ISABEL ANDERSON
POSTAL SERVICES DIRECTORATE
306 RED ZONE
151 BUCKINGHAM PALACE ROAD
LONDON SWI1W 9SS
TEL NO. FAX NO:
MESSAGE
Honinown
psa dag Working Goup Aeporbs ~
Te Aadoders .
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BA/POCL AUTOMATION PROJECT
INTERDEPARTMENTAL WORKING GROUP
REPORT TO MINISTERS
NOVEMBER 1998
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-BA/POCL AUTOMATION: UPDATE REPORT .
Background
The BA/POCL automation project (known as *Horizon”) has been under
raview alnce 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 Polley
Unit report for the Chiat Secretary (September 1998) considered the options for
taking the objectives of the project forward. Following a Ministarlal discussion, It was
agreed that the parties 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 [udging whether the outcome of the nagotlations offered the best value
for money for the public seclor as a whole. A report was presented to Ministers on
this work on 28 October, :
2. Following receipt of this report the Chlef Secretary wrote to ICL stating that he
and his Minlsterfal colleaques were prepared to agree to thelr request for a perlad of
{wo weeks for them to make progress In thelr discussions with the Post Offica to
develop 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 cage involving no explicit or
implicil guarantees or commitments on the part of the public sactor for future
additional busineas;
. that ICL and the PO serlousty considered the ease for Involving a third party
with wider retail expariance in the partnership - or otherwise damanstrated
how the necessary skills would be acquired.
3. We have now received (CL/PO's proposal far the parinership, agreed with
Post Office Counters. IGL have also providad 3 additional papers addressing
commercial, contractual and financing issues. Ministera' must now decide:
. whether the partnership proposal meeta the criteria sat out In the CST's letter
of 30 October;
-e whether ICL’s proposal on this and the wider deal represants sufficient
mavement to be a constructive basis for further (time-limited) discusatons wilh
the public sector;
° whether further discussions are likely to deliver a deal which represents value
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for money when compared to the fallback options, taking into account the 5
rigks and rewards of each option. .
4. Hawever before providing an assassmant af ICL’s proposals It Is worth briefly
revisiting tha reasons why a decision on a way forward I¢ urgently required.
Objectives of the Horizon project
5. Horizon was initiated In 1983 with the aim of:
. providing a more secure and efficlent way af paying benefits;
, providing DSS/BA with the means to account fully for thelr pragramma
expenditure;
. automating PO counters, to make current business more efficient and help
tham to win new business;
- The projact algo had the Indirect effect af helping ta maintain the nationwido network
by providing a secure ravenue stream fram POCL’s biggest customer until the .
middle of the naxt decade.
6. Against the background of severe delays to the project (attributed to ICL.
Pathway) Ministers becama very concerned that there wae @ serious risk that the.
Harlzon project would fall to deliver its objectives - or wauld not do aa in & timescale —_
that would make it worthwhile to procaed.
7. These concerns have prompted a number of inter-departmental reviews of
the project and possible alternative options, These raviews have provided an
opportunity far Ministera to revisit and update the government's policy objactivas for
the Horizon project, The key goals might be:
» to pay soclal security benefits in a way that Is as cheap, efficient, fraud free
and convenient as possible, consistent with plans for wallare reform:
° to halp to maintaln a nationwide network of post offices In arder to protact the :
accassibllity of government servicas provided across PO counters;
. to support Integrated delivery of existing and naw gavemment services and
information more generally taking full advantage of naw technology,
straamiining Government's dealings with citizens;
. to Improve accasé to basic financlal services, including banking servicoa, for
poorer membera of the community and the socially éxcluded;
. to maintaln a thriving IT sector In the UK, in which ICL is a key player; while
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“enauring that risks transferred through PFI projects do not and up with the
taxpayer;
. against these objectives to secure prudent use of taxpayers money,
8. Decisions on whether to proceed with the contract or to move into an
endgame on the basis of ICL’s failure to deliver need to be gat In the context of
these objectives,
Assessment of the ICL proposal
9. Under cover of Keith Tadd’s letter to GST of 9 Nov, (CL submitted four
papers. One meets the CSTs request for non-binding heads of agreement ona
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
ho transacted over Horizon;
. a single tender arrangement with IGL for certain epacified areas of
work, subject to value for money and procurament conéiderations; and
. the possibility of Involving a further partner with financlal retail
* experience,
11. I The heads of agreement ars, in the DTI and Post Office's view, a sensible
way forward on which could be bullt a valuable partnership with ICL. We have no
eatimates yet of how much value might be added for sither POCL or ICL (but seo -
below on ICL's preparedness to accapt a lass, which givas some Indication of what
they believe the partnership could be worth). Subject to HM Government consent
and satisfying varlous legal, regulatory and contractual constraints, POCL and [Cl
would wish to work towards a binding agreamant by the end of the year.
12. Taking the Heads of Agreement tagether with the other three papers, the
proposal Is an attempt by ICL to reduce its risk, making the project more secure and
hence more attractiva to sources of limited recourse finance. ICL have sald that they
will underwrite a [oss of between £76-103m' on the agread core case volume
assumptions. It hopes, through the further exploitation of the syatem with POCL, to
recover some ar all of this loss (though we have no figures). POGL believe that, on
reasonable assumptions, ICL can expect to recover all of this and perhaps more on
the back of thelr partnership agreement with POCL. A sohematio diagram of the path
' Range depending an whether or not the proposed contingency Is called
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of discussions so far (updating a diagram trom Graham Corhett’s report) is attached
at Annex E.
13. Key comportents of ICL's proposat are:
e Increased prices, and Inflation risk transferred back to sponsors
. greater guaranteed valumes across the system
. a contingancy fund which they suggest will Incentivise the dalivery of
the project to timetable .
. payments in advance, rather than in arrears
. a taviaed acceptance process
. revised contract tarms which draw on recently published draft PFI
Taskforce guidelines, and
. BA being no longer a party to the ICL contracts after acceptance.
14, Apraliminary 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.
wark to bs done on the detall of what ICL have suggested. But key concerns, which
would be the agenda for any further negotlation are:
“ the commercial terms proposed Imply significant price increases and
inoreases in guarantees above a level acceptable to the parties;
* the revised pricing proposals together with the contingency fund would mean
that the public sector would have to find an additional £121-£148m;
. the proposals on acceptance could lock the partias Into a system before it .
had been fully tried and tested and would result in a significant reduction of
POCL or BA's rights ta termination;
. after acceptance, proposals to enable (CL to ralsa Ilmited recourse financing
could mean that the public sector undarwriting all of [CL’s borrowings; even
after the offer of an addittanal £100m equity front ICL, this would ha a
significant transfer of risk to the public sectar - to the extent that this could
result In the project becoming an asset on POCL’s balance sheet.
15. ‘These proposals are clearly unacceptable to the public sector parties.
However thare are aspects of the proposal tat We feel could be helpful if the projact
were to procaed - in particular the suggestion that the contract Is restructured so that
POCL {ake over BA's contracts with ICL.
16. OTI/POCL are of the view that ICL have moved significantly aver the course
of the fortnight's discussions and‘show signa being prepared to move further. They
have settled for significantly less than originally stated aspirations of greater contro!
on POCL’s commercial future and single source supplier for all POCL's IT systems.
They belleve that there are reasonable grounds to bellave that a deal could be
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feached through further nagotlatlan. They think the gap could be closed by a e
- 17. DSS/BA do not agree. They do not think that ICL’s proposals (particularly
_ further clarification).
combination of;
, movement by ICL recognising the benatiis of the partnership proposal;
. further negotlation about commorelal terms, with the possibility of some
further value-added from POCL through an agsst purchase (for which POCL
will need a relaxation of their EFL);
+. the Injection of further direct funding into the project by ICL/Fujitsu.
their suggestions on risk transfer) represent a sufficiantly significant move on ICL’s
part to suggest that a commercial deal acceptable to Government could be struck.
18, The Treasury's view ie that ICL have made a eignificant move, and ave likely
to move further, but a judgement on whether this Is elgnificant enough to give
confidence that an acceptable deal could be struck Js partly dependent on ICL's
Proposals on funding and underwriting by Government (on which we are soaking
Compariean 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 follawing Key factors:
. the timing of the move to ACT - via the Benefit Payment Card 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 atternattve) for
the automation of wider POCL services (for both existing and new PO
cllents);
« . theend of the minimum floor payment from BA to the POCL.
Annex 8 sets out In graphical form the timings for each option.
Managing the changes te (he PO network
20. The response of tha Post Office under each option, and in particular how any
changes to the network would be managed, will be an Impartant factor In any
decision on the way forward. Thare ere differences of view botwoort the pariles on
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the ability of ths Past Office to manage changes to the network under each scenarlo. +
Key issues will be: .
. how to maximise POCL's existing customer base as benefit payment
switches to ACT;
«howto maintain relations with existing ellants who are looking to automation
to Improve sarvicas, and to ensure that POCL’s oredibillly in winning new
cliente is not undermined;
. how to ansure that the subpostmasters (private agents wha run the majarity
: of the post office network) parcaive thal 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 af commitment to 2 nationwide network of post
oHices. Thelr objective Is to ratain the currant favels of access, especially in rural
areas, but to reduce over-provision In some urban and suburban areaa, replacing
some physical offices with electronic access points. Current trands would In any
case see a rediiction In the rural network by some 200 offices each year, and a
gradual shift to ACT-based methods of payment over time (by 2009/10 almost 50%
of clalmants are expacted to have switched to ACT). Compared to the current
network of 19,000 offices, POCL belleve that thelr vision for the future could ba -
served by a network consléting 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 axisting post offices, In practice howaver we recognise that
any network of the future will be constrained by the game combination of history and
politics that has shaped today's network,
22, Under option 4 the benefit payment card (BPC) will provide the Post Office
with a more s8cure customer base in the short term since claimants who do nat
choose ACT will continue to use the PO for withdrawal of their benefit. In the
madlum term (by 2004/6) the PO intand to uae the Horizon platform to provide a
range of banking services across His counters, POGL belleve that the banks will see
a commercial casé for paying them to provide these services as they seak to reduce
costs through closures of thelr branch network, Full banking services will be in place
by the time BA will begin to transfer thelr customers to ACT ona compulsory basis,
POGL are of the view that the transition from the BPC to 4 “emarteard" {providing
banking and other services) will ensure that thay maximise the numbar of benefit
customers who continue to use the post office network. However DSS/BA belleve
that the Horizon project will in faci be further delayed, further squeezing the time .
between the Introduction of tha BPC and the switch to ACT; and will distract POCL ;
from intraducing banking services as quickly as possible potentially missing the
emarging banking market.
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23, Under option 2 the PO will need to move more quickly to introduce banking e
services acro$s FO counters In order to be ready for the switch to ACT - go that they
can protect thelr customer base by offering cash withdrawal facilitlas 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 roll-out of banking
services and other systems essential for POCL to sustain thelr busineas. The
consultants are of the view that It would be pogsible to provide banking services by
2001/2 when BA begins the transition to ACT, particularly if a basic cashback facility
is Intraduced early. Howaver the PO belleve there are risks attached to this atrategy
- 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 retail business In ordor not to leave the market. They
aré also concerned that in practice the removal of the card will not allow a re-focus
because the wark on benalits payment products is largely completed,
24. Under optton 3 the PO will also need to move rapidly to Introduce simple
banking services td protact ita customer base. Wa envisage that POCL would Install
simple debit terminats to provide a basic cash withdrawal service before the switch
to compulsory ACT, and wauld follow with full banking services al a later date. The.
conéultants belleve that simple dabit 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
.dabit terminal facilities) to a situation where they were racelving 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
cliants, and to provide It with a means of attracting new business, An announcement
that Horlzon was belng scrapped and the delay to the introduction of an automation
platform (although not to simple banking services) could alga impact on expectations
and lead to unmanaged closures. Again, compensation to retain subpostmasters In
the market Is likely to be raquired. An alternative approach would be to delay the
Introduction of compulsory ACT until the raplacament for Horizon with full banking
facilities was in place. The price for raduaing the risk ta 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 therefare need to work
together to develop a positive and credible stratagy which ensured that BA could
move to a more efficient benefit payment system as soon as possible, whilst
retaining tha confidence of customers, PO clients and subpostmasters In the
gustalnabllity 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
abaut this. .
Risk analyaia
26. — Annex C presente an analysis of the risks to the government's key objectives
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for the project under each option, There are, inevitably, differences of view abouttha ”
size of the risks and the abillty of parties to manage them successfully. DSS/BA
bellave that the risks around deliverability of Horizon in option 1 are very significant
given the history of the project, and that the riske 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 4 offers the
lowest rlaks because It offers POCL the earllest date for full automation and, by
retaining benefit reciplents in the PO syétem cares the {east risk to the network and
to subpostmaster confidence, Option 1 has bean validated by independent experts
who fudged It be technically viable, robust and future proof. :
Revised VFM aésessment
—— re
27. The terms that ICL have offered Imply a contrlbutlon of up to £148m trom the
public sector. Given that the Warking Group Report (23 October) asaumed a
contribution of £150m In option 1 and 3 then the VFM analysié still stands: Le. that
tha options are very close, and that the assessment of riske aoross the options is
therefore crucial. :
{mpacts on ICL . '
26. A full summary of the Impact on ICL is attached at Annex D. Under all options
ICL’s are likely to face a material write-off. Cancellation would jeopardise thelr plans
for flotation.
The Way Forward
29. Our assessment of the cholce facing Minietars is:
. to continue with the project on the basis that the [CL proposal provides
grounds far belleving a commercial deal could be struck with substantial
further movement from ICL and (possibly) more limited movement from the
pubile sector, taking action to minimise tho risk of future problems;
. to dacido that the contract {s unsustainable in its current form and that the
gap between {CL 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 [CL
to decide an altemative way forward. This could Involve a negotlation around
dropping the benefit payment card (aption 2), and ff that failed, a negotiated
settlement around ICL's full withdrawal (option 3).
80, If Ministers decide to allow a further period for negotlation with ICL then next
ateps are as follows:
. respond to ICL setting aut a period for further dlecussione - a period af around
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one month will be required to reach Heads af Agreement;
assuming that further negotiations should be led by POCL, agree quickly a
negotiating remit for POCL. - including whether POCL should be givan an EFL
relaxation to make an offar to ICL;
at the same time ask POCL and BA to reach Heads of Agreemant fo enable
POGL to nagallate on a bipartite basis with {CL.
POCL's proposals for the negoliation are attached at Annex F.
31.
\t Ministers decide the contract fs unsustalnable then the next steps are:
to prepare for anagotlated settlamant - which may Involve option 2:
to prepare public announcement/prasantation to minimise Impact on benefit
customers/PO network (see Annex @ for an indication of the questions that
are likely to atlas which the Government will need to be able ta anawer);
to ask BA/POCL to work up strategy for early move to ACT conslatent
minimising impact on PO network.
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ANKEX A
ANNEX - IMPLICATIONS OF ICL PATHWAY PROPOSALS FOR PUBLIC
SECTOR PARTIES - PRELIMINARY VIEW
1, Overview
© This paper sepresenta 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 wall as some easly
asresement by PO's advisors on corporate finance, and by PO's external
auditors.
* Overall, the proposala as they stand would be unacceptable as a complete
package. However, there does appear to have been some movermantt by
ICLand POCL (who will have to agree with Government how any
costs/risks beyond the Corbatt proposals are treated) belleve this ix
enough, (c£76 to £103m NFV over the life of tha project depending on
treatment of contingency), ptima facia, for talks to continue between the
parties, At the last Treasury Working Group it was confirmed that BA
had ulrendy gone beyond their remit and had nothing further to offer,
«However thera 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.
2 Funding Iasueq
a) ICL's proposal effectively requires the public sector to underwrite all of
its borrowings and in szomé circumstances the equity investment ar the
project, including in circumstances where the project falls through ICL’s
default,
b) Thare docs 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”, of even earlier ance contractual agreements
ave reached. ICL claim that this approach ia In line with HM Treasury FFL
‘Task Force Guidelines - but these are draft guidelines, and not necessarily
fully applicable to IT projects.
c) There are also new explicit direct relationships and implicit Habilitiés to
TCL Pathway’a lenders for the public aector baing proposed. °
ns
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4) ‘The Post Office's own financial advisors have analysed the funding
proposal and identified a number of areas of significant concern. Thasa
are summurised at Appendix 1, &
3. ncé SI ues
POCL's external auditors hnve advised that the current terms of the [CL
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 included as an asset on POCL’s balance sheet, This could
result In a net adverse ponition on POCL's profitand loss, though there will
be offsetting linbilities, This would mean that the project would effectively no
longer ba a PFI.
4, Con! i
DSS accept the ptinciple of contract reatructuring (le POCL take over the PAS
and CMS contracta in addition to those they already have with ICL) provided
the benefits payment service can be eafe guarded, potential legal and policy
ignues can be overcome and there is no increased coat to DA and POCL accept
the relevant liabilitica aind conditions, POCL would need a more detailed
understanding not only of the liabilities dt 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, t clarify the risk
transfer to POCL and the degree to which this is covered by ICL under the
Corbett proposals. Timing of this, will ba critical and POCL would not be
willing to undertake this prlor to BA's ‘acceptance’ of the system, Including
PAS and CMS.
5. Commercial Terma
a) Pricing
ICL are seeking a significant price rise through changes to discount structure
and through introduction of an RFT-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 rapresents c£2imt
NPV improvement for ICL, af 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 secking 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
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Indicated that thoy would be prepared to increase guarantees te 75% of the
Tavenues from curently forecast volumtes,
Aa 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
‘Authorities would be locked into the ayatem before {t has been fully tiled and
tested. BA and POCL have already made a very algnificant concession on
Acceptance as part of tha Corbett proposal fe in. waiving their termination
rights at Acceptance of NR2 which does not deliver the full contzacted
requirements, Both partes are not willing to bring forward acceptance before
the end of the Live Tyial, Both parties are prepared to conalder a modest
increase in the number of allowable faults but net in the magnitude being
proposed by ICL.
Acceptance ip'a very critical point in the whole programme and under ICL‘s
proposala world result in significant reduction of POCL or BA's rights to
termination thereafter. Acceptance is a scrious issue to resolve properly.
7, Othsr Issues
‘There are a number of other issues related, for example to dealing with the
“running sores” In the project (treated through price tise propasals), extra risk
for BA around delays around the CAPS project, and cash flow and accounting.
roles in paying involees in advance rather than In arrears, 48 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 Porinership, signed
caslier this waek (but which would lapse if agreement on the other issues
detailed above is not reached). ICL reached thelr view in the Light of POCL's
feedback that In principle [CL has the technical capability to play sucha role,
1
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I Comments on Funsling Proposal
! 1. ICL's funding proposal sceks to tales non-recourse finding by POCL, in effect “
underwriting the funding required and taking on a eubstantlal proportion of the
risks of the project. This would releaxe Fujitsu from standing behind the project,
2. While the conditions purportedly being laid down by lenders are nat unreasonable
from the polnt of view of lenders, it is stil! not certain that any lenders would bs
interested in funding Pathway.
3. There is no point in ngreeing to any of the changes unless they actually bring about
the funding - i.e. changes should nat take effect ({fat all) until fimding is in place.
4. Tt follows that there may be limited use in agreeing to some but not all of the
proposals. .
§. The major issues of concert: on tho funding proposals (aside from other concems
on ICL’s other commercial proposals) arc: .
=> Acceptance: the proposal is that we should alga before acceptance. Itis
unlikely that any lender would lend before acceptance and we should not’
sign up to these changes before banks are on board,
=> Compensation on Pathway defhult: we have to pay off thelr lenders even if
they default. Although this {a not an unusual clause to be required in —=
circumstances such as this, the likelihood of Pathway default is higher than
typleal given thelr track-reoord and, therefore, the tisk ta POCL groater,
+> Setepff we are unable to set-off any liquidated damages owed for .
failure against any comperiaation to Pathway and/or their
fenders, This fs not normal.
=> Erud: fraud risk is transferred back to POCL, Aprimary alm of the PFI
was to transfer fravd risk out of the public sector,
= Changes’ all changea would have to bs agreed by Pathway and POCL
would have to pay for them, even if they were Pathway generated.
6.. Secondary issues are:
=> Pathwry termlontion: Pathway cast terminate for a minor breach by POCL
and [euders would be repald, but POCL may not afford to terminate for
matezial breach by Pathway. 2
TWACL
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jC SRE ae PAR GRO * Move
=> Direct Agresmont: it is proposed to have a Direct Agrecment between
lenders and POCL. This is not wusual, but transfers funding risktous, Aa «
_ woitten there is a risk that lenders could force us to terminate if the finding
agreement between lendera ard Pathway are terminated.
=> Performancedeductlons: itis proposed that deductions are capped. This
could leave substantial cost with POCL in coping with persistent poor
performance,
7, Other significant issues include:
OMpars p ia
ponvenlence: The coats to POCL of termination are significant ‘Although it
is not unusual for the contract to includs compensation clauses the
increased, oxposure is aubstantial.
=> Changes in Law; POCL would take the risk of changes in law. Again, this
isnot unusual.
=> Londss security the leader would have first security over the assets, This
is not unusual, but could cut across our rights to buy (or us¢) the assets
following termination.
8, The rolo of BA in standing behind may commitment we take on their behalfhasnot = __
been cleared,
9. Itneeds to be recognised that Pathway already have third party lender liability of
200m.
10. From an accounting perspective, no significant risk hus boen transferred to ICL. It
is, therefore, probable that the FO will need to recognise this as an asset with
+ corresponding liabilities.
SWACL
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Annex C: Risk Assessment
This annex presente an assessment of the rike surrounding each option against (he
key Government objectives: @ :
. Objective A: efficient, sacure and accessible benefit Payment
. Objective B; maintenance of a natlonwide network of post offices to protect
the accessibility of post office services
. Objective C: Improved delivery of existing and new eervices for gavernment
. Objective D: improved access to banking services for the socially excluded
If successfully impfamented, then each option will contribute to these objectives as
follows:
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for existing and I platform
new (nen-BA)
cliants
are used
governm:
services
trusted bi
and reac!
more likely that
other channels
without PO
means
for
ent
rand
h
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A & c D
option I Improves on pravides PO provides allows PO to
1 present system =I with technology I platform for offer front end
and eliminates I to retaln axlating I delivery of banking
means of and develop existing and services
payment fraud, I new business new goverment I providing
but delays move I and secures sarvices across I accessibility
to (more customer basa I PO Counters through a
efficient) ACT inshorterterm I and could trusted brand
through support
migrating to initiatives such
ACT via the as “single
BPG account" and
electronic
government
option I early move to asoption1 but I asoption 1 and I earller move to
2 ACT delivers reduced security I removal af BPC I ACT brings
significant of customer would enable “unbanked" into
éfficlency base dus to loss I 1CLand POCL {the banking
savings and of BFC and to focus earlier I system In
eliminates earller move to I on wider advance of
payment fraud ACT government option 1
sarnices —_
option I as option 2 asoptlon2 but I delayed © as option 2
4 delayed implementation
Implementation I of non-banking
of automation technology
However there are risky altached to each op
these objectives. The fallawing tables attempt to present the potential riske around
each option, how they could impact on these objectives, and haw thay will be
managed by the relevant partiss, There are, inevitably, differences of view about the
size of these risks and the ability of partlas to manage them successfully. DSS/BA
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tlon which may threaten the dolivary of
0191
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believe ihat the riske 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 abave could
be minimised by facussing on getting simple banking technology into post offices as
eatly as possible (option 2 or 3), DTI/POCL are of the view that option 1 offers the
lowest risks because it offers POCL tha earliest date for full automation and carries
the leaat risk of damaging eubpostmaster confidance thereby raducing the threat to
the network, 7
Option 1
Risk - 4 A IB [¢ ID I Risk management strategy
BPC technology does not v tigorous acceptance process
meet BA's requirements
nan-BPC technology does Vo Iv [Vv I tigorous acceptance process
not meet PO's requirements
Further delay to Vv iv Iv I< I active project management;
Implementation independent advice; comman
incentive structure to deliver to
time
Incomplete roll out viv common Incentive structure to
ensure fo officas ramain
outside of Horizon —
Lack of ICL commitment V Iv [v {Vv I realistic partnership
arrangement between POCL
and (CL with no fudges
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Option 2
Rigk A IB [¢ID I Alsk management strategy
non-BPC technology doeos ¥ [Vv [v I rigorous acceptance process
fot meet PO's requirements
I Further delay to Vo [vv I-active projact management;
Implementation independent advice; common
incentive structure to dallvar to
time
Lack of ICL commitnent Voit Iv I realist Partnership
arrangement between ICL and
POCL with no fudges
100% migration to ACT v Vv I BAplan changes to
delayed herladicity; publiolty campaign
Delay to Implementationaf fy {v ¥ I POCLICL refocus efforts on
POCL banking banking requirements.
negative raactlon of Viv ov Iv I presentational strategy for
subpostmasters and exit from announcement; grant regime
postal market to incentlvise subpostmastera; _
work clogely with BA ta co-
ordinate timing of move to
ACT
banks react by charging BA [¥ ¥ I BA work with banks to reduce
customers = - Impact; PO introduce banking
as S00Nn a8 possible to reduce
Impact on bank branches
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Option 3
Risk A_}B [CID I risk management Strategy
new technology doos nat Vo tv tv I rigorous acceptance process
meat PO's requirements
Further delay to Voit lv I active Project management;
implementation Independent advice; common
incentive structure to deliver
on time
100% migration ta ACT v Vv I BAplans changes to
delayed periodicity; publicity campaign
Delay to Implementation of viv ¥ I POGL/IGL refocus efforte on
POCL banking banking requirements
Negalive reaction of ¥ Iv Jv [Vv I presentational strategy for
subpostmasters and exit fram announcement; grant regime
postal market fo Incentivise subpostmasters;
work closely with BA to co-
ordinate timing af mova to
ACT
incompatibility of introducing I¥ }v ¥ 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 S00N as possible to reduce
(mpact on bank branches
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ANNEX D: IMPLICATIONS FOR ICL AND FUJITSU
This Annex reviews the implications of each option for (CL and its parent,
Fujitsu. (CL Pathway have bean set up as a eubeldlary of ICL which has provided
BA and POCL with parent company guarantees on finarice and performance,
2. Torecap, the {GL Group batance shaat [s not strong. In 1997 It included net
aagets of around £260m. KPMG have confirmed with ICL Pathway that around
£125m of this figure represented capkalleation 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 currant
assets In 1986 to £42m In 1997. There isa Possibility that (CL could strengthen its
balance sheet by wilting back some of the £200m goodwill written aff according to"
existing accounting regulations that have subsequently baen revised - but this [s not
mandatory. In any event this would do nothing to improve the Group's liquidity and
net current aaset position. .
3, Profitability Is also weak, On a like for lke basis (CL made an operating profit
of around £50m in 1996 compared to ATEGUCET profit af around £35m In 1997, ona
turnover of £2,477m in 1997, So the group Ie operating at pratty cloge to break even.
4, If the whole 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 asrate 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 eltuation of net
abilities 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 [CL
flotation (planned for 2000), .
8, in fact Pathway have not yet signed and filed thelr latest accounts - missing
the end October deadline - pending the present discussions. A material write-off In
the Pathway accaunts could mean the ICL group having ta re-flle thelr accounta,
although this is not olear cut, {t could be argued that the ICL accounte were prepared
on the basis of Information that was true at the time - even though the adjustment is
i large it may not require a “prior year" adjustment, Elthor way this would be
embarrassing for (CL’s directors and auditors.
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7. In these ciroumstances it might bo posaible in principle for ICL to simply wind =“
Pathway up, leaving Pathway's oraditors, rather than ICL, to foot the bill. However
this Is unlikely. [CL are more likely ta seek guarantees or a significant injection of
new capital for Fujitsu.
8. Cancellation would have limited financial implications tor Fujitsu, since (CL
tapresents only around 5 per cant of graup shareholders' funds and 2 per cent of net
current assets. Howevor Futjitsu has underwritten a £200m {oan facility to ICL
Pathway, and Fuliteu itself had a bad yaar In 1997/8, with group profit alter interest
And taxes raducig from £264m In 1886/7 to £26m in 1897/8 due ta economic
Problems in Japan and South East Aala, Given the currant economio ollmate
. Fujitsu's attitude may woll have hardaned: it may well seek to divest itself of the
company. :
2. The Implications of cancellation for employment within ICL will depend on
"whether Fujitsu decides ta divest Itsalt of the company. it ié estimated that same 270
People at ICL Pathway are working on this project and many more al thelr
contractors. ICL Itself employs 2,700 people in the UK and a further 4,600 In Europe.
Howaver any IT staff released are Ilkely to bo quickly re-employed by competitors
given skill shortages In the IT Industry. -
10, There Is algo a risk that cancellation might prejudice Foujiteu's attitude to future
inveatment in the UK. Japan accounted for come 9.4 per cant of Inward investment
In to the UK In 1988. Despite the closure of thelr semi-conductor plant, Fujitsu
remain the single targast Japanese Investor in the UK and are highly sensitive to the
outcome on Project Horizon. Thera is a serious risk that cancellation might prejudice =_
not only Fulitsu's but other existing and potential investors’ future Invesment In the
14. 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 aeeets, 100% of annual profits).
16/11 '98 14:00 TX/RX NO. 0191 P24
00:PT 86, TT/9T
“ON XU/XL
T6TO
Std
fnex &
WITHOUT ses iis
_The path of the discussions (to 5 Nov) -
Impact on ICL ~ £m NPV over whole project
small
me «(0 (76-103) (224) (270) (340)
ICL . ICL proposal Corbett Initial public Core
initial 9 Nov proposal sector offer case
position 12 Oct 6 Oct
NB Range of outcomes *
depends on release of
contingency provision
Figures are NPV at 8.5% to Ll 1999"
ICL estimates except (270) and (340) which are EMT estimates extrapolated from Corbett report
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, . Annex &
RESTRICTED - POLICY AND COMMERCIAL
BA/POCL AUTOMATION PROJECT
PROPOSALS FOR NEGOTIATIONS BETWEEN ICL AND POCL,
e
before negotiations atart
* BA and POCL to agree heads of Sgreament on the future contract torma etc between the °
two parties. The starting point for these will be the Proposed agreement reached
between BA and POCL ander the Corbett negotiations
* these heads of agreement alao ta embrace issues on which fotntagreement is required
in reaponee to the ICL Praposals of 9 November. For example; POCL may be prepared
to discuss with BA the early assumption of contro] of PAS and CMS if auitable terms
could be agrecd
* following agreement with BA, clear nogotiating remit to be agreed with Government.
The Fost Office Board would ulso want to ensure that POCL’a Negotiating brief made
sence commercially and protected its agreed shareholder returns .
POCH/ICL negotiations
discration, would be free te involve specialist e:
* a senior Treasury official (Adrian Montague) to be available to act ag a Jong-stop -
facilitator batween the partes, but will not be part of the actual negotfations, _
progress reporting
© POCL to report progress on Negotiations to a Progress Tracking Group, the purpase of
which will be:
© to ensure the outcome of the negoHiationa is within the remut set by Government
© to review progress uf the negoHations in order to brief Ministers
0 to provide facilitation to the negoHations where requestad
« membership of the Progress Tracking Group to be HMT (chair), DTI, DSs along with
metable
© by 20 November: (assuming Ministerial go-ahead) heads of agreement reached
between BA and POCL (NB this assumes BA are wnable to reach agreement with POCL,
before Ministerial decision to continue negotiations]
® by 20 November: Government agrees POCL negotiating remit and announces to cL
resumption of negotiations
« by 11 December: heads of agreement agreed. These to be turned into fully detailed
and revised contracts ne soon as possible thereafter.
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DRAFT - NOT YET AGREED BETWEEN DEPARTMEN TS ANNEX G
LINES TO TAKE IF EITHER ICL OR HMG DECIDE TO TERMINATE
HORIZON PROJECT
IF ICL TERMINATES
Regret that ICL has felt unable to continue with the project despite the public
sector parties' best efforts to agree revised terms with them.
IF GOVERNMENT TERMINATES
« Despite the publio sector's best efforts it has not proved possible to reach
agreement with ICL on commercial terms for continuing with tho project.
WHAT WENT WRONG?
® 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.
EFFECT ON POST OFFICES ?
+ Post Office Counters will now need to consider urgently the options for securing
a replacement for Horizon, but in the meantime it will be business 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. :
¢ Fully recognise importanco of post offices to communities they serve and : -
recognise the especially valuable role played by post offices in rural communities.
EFFECT ON BENEFIT CUSTOMERS?
© Those customers who presently use payment card will see no interruption of their
payments,
* Vast majority of 18 million benefit customers 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 benefits which its customers need.
¢ Benefit recipients are increasingly opting to receive their benefits through their
bank accounts, but the Government will ensure that all benefit recipients who wish
to do so can continue to collect their benefits in cash at post offices.
REPLACEMENT FOR BENEFIT PAYMENT CARD?
¢ DSS will need to look at the options for ensuring that it can offer its customers a
secure, convenient and cost effective method of benefits payment.
REPLACEMENT FOR HORIZON?
© Government accepts it is important to future of Post Office Counters that network
has modem, 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 retail outlet.
© Management of the network is the responsibility of Post Office management who
seek to ensure 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.
1
© The Post Office must also be sensitive to changes in shopping habits and
demographic trends, :
¢ When the Post Office are unable to retain a full time facility in such areas they
will seck to establish a part-time facility where possible. .
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POST OFFICE REVIEW?
‘
* 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 areas in
recent years, which has proved popular with customers. Important that they
continue to develop in ways which will help underpin the network which is valued
by many people.
IS THIS ANOTHER PFI FAILURE?
* No. The Private Finance Initiative will continue to provide succesful basis for
public/private sector partnerships.
Risks transferred under PFI to the private sector must not come back to the public
sector.
WHAT DOES FAILURE MEAN FOR ICL’S PLANNED FLOTATION/TS
FUTURE? : —
¢ Decisions concerniing 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 needs to be considered on its own merits. The Government greatly
values Fujitsu’s investment in the UK.
DTI/Postal Services Directorate
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13 November 1998
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