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CLYDE AND HEBRIDES LIFELINE FERRY SERVICES - SCOTTISH EXECUTIVE'S CONSIDERATION OF THE REQUIREMENT TO TENDER

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ANNEX B: THE SCOTTISH EXECUTIVE'S CONSIDERATION OF ACADEMIC PAPERS SUBMITTED TO THE LOCAL GOVERNMENT AND TRANSPORT COMMITTEE

1. A number of academic papers have been submitted to the Local Government and Transport Committee and the Executive in relation to the proposals for the tendering of the Clyde and Hebrides ferry services. This section provides a brief summary of each paper and commentary by the Executive on the key issues raised.

2. The papers submitted to the Local Government and Transport Committee and the Scottish Executive were :

  • The Proposed Tendering of Clyde and Hebrides Ferry Services: Problems and an Alternative Proposal (Professor Neil Kay, Emeritus Professor Strathclyde University)
  • Competing for the island lifeline: European Law, state aid and regional public services (Dr Paul Bennett, University of Edinburgh)
  • The Requirements of the European 'Cabotage' Regulation in relation to the General Treaty (Dr Paul Bennett, University of Edinburgh)
  • The Financing of Lifeline Ferry Services to the Clyde and Hebrides (Jeanette Findlay, University of Glasgow)

Overview

3. The academic papers are written from an economic, social and best value perspective. However, they do not take into account the clear legal requirement on the Executive to comply with EU law. Thus, whilst the papers highlight many of the potential issues associated with tendering they do not suggest any alternatives that would satisfy the EU requirements.

4. The Executive's response to these points is set out in more detail in the remainder of this Annex.

PROFESSOR NEIL KAY - THE PROPOSED TENDERING OF CLYDE AND HEBRIDES FERRY SERVICES: PROBLEMS AND AN ALTERNATIVE PROPOSAL - FINAL SUBMISSION TO THE CONSULTATION PROCESS

Summary of Paper

1. Professor Kay's paper was initially written for Edinburgh University's Europa Seminar in March 2005 and a revised version was submitted in March 2005 in response to the Scottish Executive consultation on the service specification for the Clyde and Hebrides ferry services.

2. The key argument in the paper is that the 1992 Regulation does not reflect current thinking post Altmark and that the Regulation would have had different requirements if it had been written today. Following this line of argument Professor Kay considers that, if it can be shown that the payment of subsidy to Caledonian MacBrayne meets the requirements of Article 87 of the Treaty ( i.e. as set out in the Altmark decision), then the underlying policy of EU law will have been met. His proposal (which he considers would meet the Altmark criteria) has 5 parts as follows:

  • ring fence and separately account for leasing of vessels from operational activities.
  • set out Caledonian MacBrayne's obligations on a route by route basis ( e.g. service spec).
  • appoint an independent Regulator to protect and advance interests of ferry users, ensure ferry services delivered efficiently etc.
  • Auditor General to set up procedures to ensure Caledonian MacBrayne is fulfilling its designated responsibilities with specific reference to EC State aid requirements. This might include stripping out profitable routes but would keep most of network together.
  • instruct Caledonian MacBrayne to operate on a least cost, non profit basis with 100% clawback of any profit made.

3. The papers also discusses the Executive's proposals for an Operator of Last Resort; argues that there is a need, more generally, for a Regulator for the services; and considers some of the economic concepts that can arise in competitive tendering.

Scottish Executive Comment

Proposal for an Alternative to Tendering

4. A detailed assessment of Professor Kay's proposals is set out in Annex A, Option F (paragraphs 21 to 25). In summary, his proposal is based on the assumption that the Altmark criteria can be used to satisfy the requirements of the Maritime Cabotage Regulation. However, this is not the case as the Altmark criteria consider whether an operator in receipt of subsidy has an advantage and does not address the requirement of the Maritime Cabotage Regulation that all Community shipowners must be treated on a non-discriminatory basis. Even if the Altmark criteria were relevant Professor Kay's proposal would not avoid tendering. Instead, tendering would occur on a route by route basis which, ultimately, would lead to the break up of the network.

Risks of Competitive Tendering

5. Professor Kay considers a number of concepts which are common risks in competitive tendering exercises. In particular he refers to asymmetric information, opportunism, hold up problems, moral hazard and adverse selection. The Executive is aware of these issues and has taken them into account in the design of the service specification, the contract, the grant mechanism, the tender process and, in particular the evaluation of bids, and the proposals for monitoring the contract.

6. Professor Kay appears to predicate arguments on the basis of operators not wanting to win the contract more than once. However, a concept in this area of economics which he does not refer to is "reputations as contract enforcers". This principle suggests that parties would aim to perform well in order to build up a good reputation. If the operator is interested in winning the next or future contracts (as we would assume it is) then it would wish to cultivate a good reputation and relationship with the customer in order to increase its chances of winning another contract.

DR PAUL BENNETT - COMPETING FOR THE ISLAND LIFELINE: EUROPEAN LAW, STATE AID AND REGIONAL PUBLIC SERVICES

Summary of Paper

1. Dr Bennett's paper was originally presented at the Annual Conference of the Regional Studies Association in Angers, France in April 2004. The paper has been updated and this consideration is of the 1 March 2005 version.

2. Dr Bennet's paper considers the underlying EU principles relating to State Aid and the benefits generally assumed to derive from competitive tendering. His paper then discusses potential risks associated with the tendering of the Clyde and Hebrides ferry services. These are discussed further in the section below.

3. Dr Bennet concludes by saying that the "policies that were designed to prevent abuses of state aid in commercial industries and core European regions are inappropriate for essential but unprofitable public services in more peripheral regions."

Scottish Executive Comment

4. Dr Bennett's paper seeks to demonstrate inconsistencies in EU principles and describes some of the risks associated with competitive tendering. However, it does not suggest any alternatives to tendering which would comply with EU rules.

Potential Risks Identified by Dr Bennett

5. Dr Bennet's paper set out a number of potential difficulties and risks associated with competitive tendering as follows:

There may be so little opportunity for an operator to expand the business that the operator's focus would probably be on efficiency savings.

6. The Scottish Executive has made it clear that its consideration of the need to tender the Clyde and Hebrides Ferry Services was not triggered by a desire to secure efficiency savings but because it could be the only way to continue to support the current level of service within EU rules. It is difficult to tell whether any savings would be achieved through tendering. All tenderers would be encouraged in the Invitation to Tender to make efficiency savings and the successful tenderer would be the operator who required the lowest financial compensation (providing other technical and financial criteria had been met) to deliver the quantity and quality of the services specified. However, given the prescriptive approach of the service specification, which was consulted on in 2002 and which was strongly supported by consultees, the possibility of any significant monetary savings could be limited. Nevertheless, tenderers would be encouraged to be innovative during the contract period which may result in efficiency savings. All route and timetable changes proposed by the operator would, however, need to be agreed with the local community concerned and all financial implications agreed with the Executive.

A prescriptive specification will ensure that service requirements are clearly defined in the contract. However, this will prevent the operator acting in an entrepreneurial way and/or the services changing to suit local communities' needs. The Executive will not be able to mandate the operator to provide additional or altered services.

7. As part of the 2002 consultation on the draft service specification the Executive consulted on its proposal for a prescriptive approach. This approach was strongly supported by respondents. This would ensure that the operator was contractually required to provide the services as currently timetabled. However, it was not intended that the services and timetables would be set in stone during the contract period. During this time there would, in principle, be the opportunity for changes to be approved provided that the operator had agreed these with the local communities concerned through the consultative mechanism and that the financial consequences were acceptable to the Scottish Executive. In addition, the Executive would have powers, through the contract, to require the operator to provide additional or altered services. Such a requirement would be made on a No Net Loss/ No Net Gain basis and so any resulting costs or savings to the operator would be reflected in the subsidy arrangements.

It is difficult to build an appropriate 'quality' requirement into contracts. Punctuality and Reliability are not sufficient and do not cover issues such as staff training, staff commitment etc.

8. Punctuality and reliability of services would be key performance targets. However, the service specification would also require that tenderers developed, as part of their bid, a Users' Charter covering such issues as on board facilities, cleanliness, staff conduct, services for disabled people and the complaints procedure. It would also require that tenderers detailed their plans for crewing, training and staff retention which would have to provide adequately for the continuing and long term requirements of the service. Bids would also have to set out the tenderer's proposals for industrial relations and other related polices. Tenderers would be required to demonstrate a commitment to foster constructive relationships and a partnership approach in line with the Executive's objectives. These requirements (and all other aspects of the service specification) would be part of the contract terms and conditions.

Concerns raised during the 2002 consultation in relation to responsibility for maintenance, and investment in vessels and piers.

9. Safety and the reliability and continuity of the services are priorities for the Executive and a 3 pronged approach has been devised to ensure that it would be absolutely clear where responsibility for maintenance and investment lay. This approach would utilise the VesCo vessel leasing contracts and harbour management agreement and the contract between the Executive and the operator:

(1) The operator would be required to maintain the ships' condition throughout the contract period and would also be responsible for the operational management of the vessels including repairs, running maintenance, insurance etc for the duration of the contract. The vessel leasing contracts would be based on standard bareboat charters common in the shipping industry. This means that VesCo and the operator's responsibilities would be clear. Key aspects of the contract arrangements would be:

  • that the vessels would be returned to VesCo in at least as good a condition (subject to fair wear and tear) as they were when they were leased out. The terms would include appropriate requirements for a programme of planned and strategic maintenance programmes and annual overhauls. Running maintenance including annual overhauls would be the Operator's responsibility and costs would fall to the Operator. VesCo would also have the right to inspect the vessels as appropriate and at least annually during the annual overhaul so as to enable a below waterline hull inspection.
  • VesCo would be responsible for the cost of statutorily required upgrading of vessels although it would be likely that the operator would manage the work on behalf of VesCo.
  • the Operator would only be permitted to alter/upgrade the vessels with the approval of VesCo and Scottish Ministers. Any costs (other than for statutorily required changes) would ordinarily fall to the Operator. If, however, the proposed improvements would have a beneficial effect beyond the end of the contract VesCo would consider funding some of the costs. The latter would be subject to the approval of Scottish Ministers. The contract would include a procedure whereby the Operator could propose alternations/upgrades and a mechanism for VesCo to contribute if appropriate.
  • The vessels would have to be properly insured. All proposed insurances by the Operator would be subject to VesCo's approval.
  • VesCo vessels could not to be used by the Operator outwith the CHFS service except with the agreement of VesCo and Scottish Ministers.
  • It should also be noted that VesCo would also be responsible for acquiring new vessels, as Caledonian MacBrayne is now, to serve the network through a planned replacement programme. The operator would be bound to use those new vessels as they come into service.

(2) The operator would be required to enter into a harbour management agreement in relation to VesCo owned piers and harbours to carry out some of VesCo's duties as harbour authority. Key aspects of the contracts would be:

  • The Harbour Management contracts would clearly set out VesCo's and the Operator's respective responsibilities in relation to safety, maintenance, insurance, environmental protection and management of the harbours. The Operator would be required to put forward a maintenance plan for approval by VesCo and ad hoc work would be dealt with in consultation with VesCo. The contract would include a definition of the type and upper cost limit of unexpected work that could be carried out immediately without consulting VesCo. This would ensure the operator can respond quickly to unexpected situations.
  • Ordinary capital works would be treated in the same way as maintenance i.e. the Operator would propose works which would be subject to the approval of VesCo and agreed costs would fall to VesCo to meet. However, large scale projects, particularly if they extended beyond the Operator's contract period, would usually fall to be tendered and managed by VesCo.
  • Where the Operator contracted with others for maintenance or capital works ( e.g. the building of a new pier) the contract would include collateral warranties to VesCo. These would ensure that VesCo had the same rights under the contract as the Operator. This would be necessary to ensure that VesCo would have options for recourse if problems arose during the contract period either after the Operator had been replaced or if the Operator refuses to take action.
  • VesCo would continue to be the Harbour Authority, Navigation Authority and have responsibly for harbour safety. Some of these responsibilities could not be delegated and VesCo would continue to carry them out at its own hand. However, where appropriate, the operator would carry out some tasks on behalf of VesCo. Where the Operator was acting as an agent the contract would include comprehensive indemnity provisions to ensure that the Operator was tied into any liability. This means that in the event of a legal action where the Operator was acting as an agent the claim would be against VesCo and VesCo would then have a claim against the Operator. As well as issues specific to VesCo's role as Harbour Authority there are more general issues to consider. For example, VesCo would not be able to delegate responsibility for criminal liability or corporate manslaughter. VesCo would therefore put procedures in place to ensure that it had acted reasonably, employed appropriate personnel (and in some cases that the Operator had employed appropriate personnel) and had appropriate monitoring procedures in place.
  • The Operator would collect harbour dues on behalf of VesCo.

(3) Responsibility for the day to day harbour operation related to the Clyde and Hebrides services ( i.e. at all network harbours, not just those where VesCo would be Harbour Authority) would lie squarely with the operator as part of the contract with the Scottish Executive. This would include mooring, securing ships, unmooring, marshalling, loading and unloading of passengers, vehicles, freight and livestock.

10. In addition, the contracts would provide for regular meetings between VesCo and the Operator to discuss such matters as capital expenditure requirements, replacement of vessels/additional vessels, harbour management and Operator of Last Resort. The contracts would also set out VesCo's contract monitoring and compliance procedures. A key aspect would be to ensure that all assets were maintained to an appropriate standard. This would include rights of inspection, powers to direct the Operator to take action and dispute resolution procedures.

Tendering often results in reduced terms and conditions for employees, or that employees are replaced.

11. The Executive attaches importance to the future of the staff of the Caledonian MacBrayne workforce should the services be tendered and another operator be successful in its bid. The Executive believes that ensuring the continued employment of the current staff with their strong local roots would be best met through the TUPE Regulations. It should be noted that similar circumstances, in relation to the Northern Isles ferry services, were considered recently by an Employment Tribunal and subsequently by an Employment Appeals Tribunal and it is, therefore, the Executive's view that TUPE would be likely to apply. The Executive would require tenderers to cost their bids as if TUPE applied and, if TUPE was subsequently found (as a matter of law) not to apply there would be a reduction in subsidy throughout the contract equivalent to any reduction in the operator's costs as a consequence of that decision. This should ensure that there would be no financial incentive to the operator to challenge TUPE. Annex C sets out the Executive's detailed proposals in relation to staff.

DR PAUL BENNETT - THE REQUIREMENT OF THE EUROPEAN 'CABOTAGE' REGULATION IN RELATION TO THE GENERAL TREATY

Summary of Paper

1. Dr Bennett's paper recognises that the Altmark decision itself stated that the specific EU rules cannot be avoided by an appeal to the general rules of the Treaty. However he questions why, if Altmark can satisfy the general Treaty rules to prove that a subsidy does not confer an advantage, the same test would not be relevant in relation to Maritime Cabotage, particularly as the Regulation does not specifically refer to tendering. He also argues that Altmark has meant that ordinary State aid rules are now less restrictive than the Maritime Cabotage Regulation and that this was never the intention.

2. Dr Bennet also seeks to break down the Regulation into individual Article sections and to show that they are not applicable to the Clyde and Hebrides services. He argues that Article 4.2 (which limits the requirements Member States can set in relation to Public Service Obligations ( PSOs) and requires that, where compensation is offered, it must be available to all Community shipowners) is not relevant to the Clyde and Hebrides services. He states that the Article was developed to prevent Member States imposing PSOs as a condition of access to a particular route and only compensating their own operators. He further argues that the effect of the Article is that compensation does not have to be paid where no obligations are imposed.

3. Dr Bennet goes on to argue that Article 4.1 (which permits Member States to conclude Public Service Contract ( PSCs) or impose PSOs but requires that where this happens it must be done on a non-discriminatory basis in respect of all Community ship-owners) is the only relevant Article. He then states that the purpose of the Article is to prevent unprofitable PSOs being imposed on shipowners from other Member States whilst leaving the domestic ship-owners free to operate a commercially viable service.

Scottish Executive Comment

4. Dr Bennet's paper recognises that the Altmark decision stated that where sectoral EU rules apply they cannot be avoided by an appeal to the general rules of the Treaty. He also notes that the Maritime Cabotage Regulation requires that all community ship owners are treated on a non-discriminatory basis but that tendering is not mentioned in the Regulation. He then suggests that if Altmark can satisfy the general Treaty rules to prove that a subsidy does not confer an advantage, the same test would be relevant in relation to Maritime Cabotage.

5. The requirement to tender is not mentioned in the Regulation. However, as Dr Bennet notes, the requirement is to act on a 'non-discriminatory basis' is. This is a common principle of EU law and the effect of this requirement is that Member States must treat all Community shipowners in the same way. If subsidy is to be made available, that subsidy must be available to all Community ship-owners on the same basis. If the subsidy is to be made available to only one ship-owner (as in the case of the Clyde and Hebrides) then all ship-owners must be given the opportunity to qualify for this subsidy and the only feasible way of providing this opportunity is through a bidding process. This is a different issue from the Altmark consideration as to whether a subsidy would confer an advantage on one operator over another.

6. It should also be noted that guidance issued by the European Commission in relation to the Maritime Cabotage Regulation (the December 2003 Communication on the Interpretation of the Regulation ( COM (2003) 595)) states at 5.4:

"The Commission takes the view that, in general, the awarding of public service contracts risks to discriminate between operators, as normally only one operator of a given route is concerned. It therefore considers that launching an open Community-wide invitation to tender is in principle the best way to ensure non-discrimination."

7. Dr Bennet also suggests that the effect of Altmark is that ordinary State aid rules are now less restrictive than the Maritime Cabotage Regulation and that this was never the intention. However, the view among expert commentators is that, if anything, Altmark represents a tightening of the general State aid rules (see Annex D) The criteria set out in Altmark are extremely difficult to meet without tendering. In particular, the 4th test (ie the 'typical undertaking' test), means that an arrangement with a provider is always vulnerable to challenge from another operator who consider that the service could be provided for less subsidy.

8. Dr Bennet seeks to break down the Regulation into individual Article sections and to show that they are not applicable to the Clyde and Hebrides services. The purpose of the Regulation is to liberalise maritime markets. However, it is recognised in the Regulation that the market would not provide certain services that would otherwise be deemed necessary by Member States and therefore it provided an exception to the blanket liberalisation. The preamble states that,

"the introduction of public services entailing certain rights and obligations for the shipowners concerned may be justified in order to ensure the adequacy of regular transport services to, from and between islands, provided that there is no distinction on the grounds of nationality and residence."

9. Thus, under the Regulation the only purpose for which Member States may impose public service obligations and/or conclude public service contracts is, therefore, to ensure 'adequacy of regular transport services'.

10. The effect of Article 4's provisions would, as suggested by Dr Bennet, prevent a Member State imposing PSO's (Public Service Obligations) on a route on only foreign shipowners. However, it also has the effect that where subsidy is available (either under a PSO or PSC (Public Service Contract) arrangement) that it must be made available to all Community shipowners on a non-discriminatory basis. It is this latter effect which is relevant to the Clyde and Hebrides ferry services.

MS JEANETTE FINDLAY - THE FINANCING OF LIFELINE FERRY SERVICES TO THE CLYDE AND HEBRIDES

Summary of Paper

1. The STUC commissioned Ms Findlay to look at:

'a comparison of the cost of continuing to run lifeline ferry services through the existing integrated structure, compared with the revised structure as now proposed by the Scottish Executive, but incorporating the costs associated with tendering'

and that

'the report should also consider the EC definition in tendering these lifeline services and state whether it is achievable that services can be improved with lower costs to the taxpayer. The report should also identify costs associated with redundancy in different scenarios where TUPE might apply or not'

2. The paper discusses some of the risks generally associated with contracts/competitive tendering and compares the status quo with additional costs which may arise when the Clyde and Hebrides Ferry Services are tendered.

Scottish Executive Comment

General

3. The underlying basis of the report, as stated at the outset, is "it is possible that a tender would not go ahead if it can be shown that the cost to the public would be less by continuing the present arrangements than by going through a competitive tendering process". This is a misunderstanding of the position. There is a clear requirement in the Maritime Cabotage Regulation that, where compensation is to be offered, it must be made available to all community ship owners on a non-discriminatory basis. If tendering were deemed necessary, the costs which might arise from a tendering process and/or the Scottish Executive's preparations for that process (such as the restructuring of Caledonian MacBrayne) cannot be taken into account in considering whether or not the Regulation applies.

Additional Costs arising from Tendering

4. The report focuses on the likely additional costs that would arise if the Clyde and Hebrides Ferry Services are tendered compared to the status quo.

5. The report suggests that the restructuring of Caledonian MacBrayne would lead to cessation of trade with tax debt of £5-10m. The arrangements for restructuring are still to be finalised but it is likely that there would be a tax liability broadly on the scale suggested in the report. Capital allowances are available for ships and the capital allowances held by Caledonian MacBrayne should be available to VesCo. Going forward, the capital allowances are available to be claimed by VesCo, the extent to which VesCo can take advantage of this and the timing will depend on the level of future taxable profits. The proposed restructuring would ensure that the substantial and publicly funded assets which Caledonian MacBrayne currently holds remained in public ownership whichever operator ran the services. This would ensure efficient utilisation of the existing fleet and other assets, offer service reliability through a period of change and guarantee the availability of vessels and ports for subsequent operating contracts. VesCo would also have a role in strategic planning including vessel procurement to meet service delivery needs and the capital investment programme for its piers and harbours.

6. It should be noted that, should tendering proceed, the fleet could not simply be left with Caledonian MacBrayne. The geography and climatic conditions of the Clyde and Hebrides network require unique purpose built vessels. It would, therefore, clearly be discriminatory to give only one bidder access to those vessels, given that its provision has largely been funded by grants from Scottish Ministers. It would be discriminatory for only one of the bidders to have assets funded in this way.

7. Under a tendering approach, the alternative to the VesCo option would, therefore, be to sell the vessels to the successful bidder with a requirement that he would then sell them on to the next operator of the services. However, that approach would mean that Scottish Ministers would have less control over the maintenance and investment in the vessels, or the condition in which they were transferred to subsequent operators.

8. The Report suggests that, if TUPE were not to apply, redundancy costs would be in excess of £20m, if Caledonian MacBrayne did not win a tendered contract. If all staff were to be made redundant Caledonian MacBrayne estimates that the cost would be in the region of £30m. However, the Executive is of the view that TUPE would be likely to apply and a recent decision by the Employment Appeal Tribunal on the transfer of staff working on the Northern Isles ferry service lends considerable weight to that assessment.

9. The Report suggests that if the Caledonian MacBrayne pension scheme were to be closed it would require an injection of £10m to ensure that it had sufficient funds to cover future pension entitlements. A range of options for future pension arrangements would have to be considered should tendering proceed and it is not necessarily the case that the Caledonian MacBrayne scheme would have to be closed. It should be noted that the Executive would require the successful tenderer to ensure that transferring staff had access to an actuarially equivalent scheme. The report suggests that bidders would not wish to provide such a pension scheme. However, it would be a requirement of the tender specification and refusal to provide it would result in failure of the bid.

10. The Report notes that other new costs arise from a tendering process, such as a requirement for additional monitoring by the Scottish Executive. It also notes that the restructuring of Caledonian MacBrayne into 2 companies would result in additional management and a greater need for coordination and monitoring. These would be additional costs. However, it would be essential that a contract of this nature was monitored rigorously and robustly. And, whilst there would be some additional costs involved in the creation of a separate vessel owning company, this structure would ensure that Caledonian MacBrayne's vessels remained in public ownership with the associated benefits as set out at paragraph 5 of this section

Protection of the Existing Caledonian MacBrayne Workforce

11. The report states that tendering does not necessarily mean lower costs for the same quality, and that lower costs have often been achieved at the expense of wages and the terms and conditions of the workforce. The Executive is committed to doing everything it can within EU rules to protect the existing Caledonian MacBrayne workforce, their terms and conditions and access to an actuarially equivalent pension scheme should tendering proceed. The Executive's proposals in relation to the protection of the workforce are set out in detail at Annex C.

Risks Generally Associated with Tendering

12. The Report discusses risks often associated with contract/competitive tendering arrangements including principal agent and moral hazard issues. Similar issues are addressed in the commentary on Professor Kay and Dr Bennet's papers and the points made there are not repeated here. However, it should be noted that should tendering proceed then bidders would be closely scrutinised to ensure that their proposals complied with the requirements of the service specification and that bidders had made realistic assumptions about costs and revenues. Appropriate monitoring and enforcement arrangements would be developed to ensure that the Executive had detailed information about the operation of the services (including costs). The terms of vessel leases and harbour management arrangements combined with regular inspections would ensure that vessels and other assets were well-maintained and that the operator was incentivised to appropriately maintain the assets.