• Value for money and affordability need to be considered by the Authority when determining whether to assume any interest-rate risk through the PFI Contract. • Contingent liabilities associated with some hedging instruments implemented by a Contractor can reduce the flexibility of a PFI Contract and so its value for money. |
Authorities are generally reluctant to provide for adjustments reflecting changes in interest rates in their indexation formula for the Unitary Charge, since their own budgets are normally set by reference to constant or inflation-adjusted base lines and so are without scope to absorb this kind of risk.
The advantage of using a financial institution to absorb interest-rate risks is that they are able to price such risks and distribute them within the wider financial system. The potential disadvantages are the cost of the products, additional negotiations and potential contingent liabilities that may arise for the Authority. Also some market practices can increase the cost to the public sector unnecessarily (cf. §4).
Moreover, assumption of interest-rate risk by an Authority may have accounting implications for the Authority under FRS5 in terms of the risk allocation or 'separability' of the PFI Contract.8
Given that balance-sheet treatment has no bearing on value for money, Authorities may consider whether better value for money might be achieved by passing the interest-rate risk to the private sector for only a part of the term of the Contract and then having it revert to the Authority, notwithstanding the likely balance-sheet implications of such an approach.9 Reasons for adopting this approach might include consideration of the Authority's ability to benefit from a comprehensive refinancing of the project or aggregation of a series of projects, and greater long-term flexibility. However, it must also be noted that there are clear risks for future affordability if this approach is adopted and future interest rates were to be higher than projected. Moreover, to the extent that the capital element of PFI funding for Authorities is fixed, it may not be appropriate for Authorities to leave themselves exposed to future interest-rate changes.
A quite different issue arises in circumstances where the Unitary Charge is fixed for the term of the PFI Contract but the underlying hedges executed by the Contractor are either for a shorter term or lesser amount than the underlying senior debt which is being hedged, or a combination of both. This may arise if the bidder wishes to take the risk on the unhedged portion of debt, so as to benefit from the potential up-side as well as to bear the potential down-side from future movements in interest rates. In such circumstances, the rates at which the hedged portion of the debt is actually hedged should not necessarily be the determinants of the level at which the Unitary Charge is fixed. The fixing of the Unitary Charge is a much more complex process in this case, potentially involving notional debt hedging rates,10 and Authorities should, accordingly, take extra care including using specialist financial advice.
Changes in market interest rates for shareholder-provided subordinated debt (which is generally provided on a fixed-rate basis) at any stage, should not affect the Unitary Charge. Subordinated debt is a form of quasi-equity, which should bear the risk of changes to the opportunity cost of capital.
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8 If the cost of finance is clearly separable in the Unitary Charge, the Unitary Charge itself could be separated into a'lease-style' capital element which could be on-balance sheet with only the remaining service-charge element off-balance sheet. (Cf. Treasury Task Force Technical Note No. 1, "How to Account for PFI Transactions".)
9 For example, an interest-rate swap could be entered into by the Contractor for a period of only 10 years even though the debt has a term of 20-30 years; the Unitary Charge would then be subject to variation in line with prevailing interest rates after 10 years. In this case, the Authority will need to consider whether it is content for interest-rate risk to revert to it in this way (after 10 years), or whether it would wish to agree arrangements with the Contractor by which future interest rate exposure could also be hedged, at some future date, to fix the Unitary Charge levels for the remainder of the term of the PFI Contract according to the then prevailing forecasts of interest rates in the swap market-which may be higher or lower than those prevailing at Financial Close when the original swaps (for years 1-10) were executed by the Contractor.
10 For example, the notional swap rate that would have been achieved had the entire debt amount been hedged to its full term ( cf. SoPC §35.4.4.1).