• This Application Note is designed to help Authorities and their advisers develop, evaluate and implement cost-effective strategies for managing interest-rate and inflation risks under PFI Con-tracts. • It reflects experience gained across the public sector in implementing PFI projects and should be viewed as a statement of best practice. • Authorities should always seek suitable professional advice in relation to interest rate and infla-tion risk issues. • Boxes are included at certain points throughout the text to highlight key topics and issues. |
PFI Contracts are intended to pass risk to the private sector if this provides good value for money. In many cases the allocation of risk is straightforward-for example the private sector is generally best placed to take the risk of managing construction-but there are a number of areas where detailed analysis is necessary to determine who should manage a particular risk and what the implication is for value for money. One such area concerns interest-rate and inflation risks and their inter-relationship. These subjects are covered in this Application Note in three sections, as follows:
- Interest-rate risk and hedging (cf. §2)
- Inflation-related issues (cf. §3)
- Swap credit premiums (cf. §4).
In undertaking a value-for-money assessment of a PFI Contract, an Authority should always take into account the flexibility which the Contract provides for the Authority to implement future changes in service requirements. Hedging, by its nature, can introduce contingent liabilities for an Authority which may only crystallise in circumstances of contract change (or termination) and so may- depending upon the hedging strategy adopted-adversely affect Contract flexibility. Accordingly, an understanding and assessment of these contingent liabilities forms an important part of the value-for-money analysis.
This Application Note is designed to help Authorities and their financial and other advisers develop, evaluate and implement cost-effective strategies for managing interest-rate and inflation risks under PFI Contracts. It reflects experience gained across the public sector in implementing PFI projects and should be viewed as a statement of best practice. It is not intended as a general introduction to financial hedging issues, nor does it replace the need for Authorities to seek suitable professional advice in relation to these important issues. The Application Note should, nonetheless, always be used by Authorities to form a baseline against which a chosen approach to hedging should be compared and justified-if different from that recommended here.1 If an Authority is in any doubt about how to use this Application Note it should contact H.M. Treasury's Corporate and Private Finance Unit.
H.M. Treasury
May 2006
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1 It should be noted that interest-rate and inflation risk issues are only one element of the overall financial structure of a project which Authorities should consider, and also that this Application Note considers such issues primarily from an Authority's point of view.