• The ITN should ensure that bids can be assessed on a comparable basis as regards interest rates and require transparency of all hedging costs. • The Authority should reserve for itself the right to approve the choice and process of execution of all hedging instruments proposed by the Contractor. |
If interest-rate risk is to be borne by the Authority during the period up to Financial Close, the pricing of financing within bids should be calculated on a comparable basis. Best practice in this respect would entail stipulating to bidders in the ITN documentation a list of sterling swap rates and gilt rates published on a single date,15 from which bidders derive their base financing costs to price their bids. Assumptions for short-term LIBOR rates should also be provided, to take into account credit interest on reserve accounts (bidders may make different assumptions about the spread below LIBOR to be achieved on such deposits).
In order to minimise the impact on affordability of any adverse market movements before Financial Close, bidders should be required to present a Unitary Charge based on interest-rate assumptions which provide a reasonable buffer against current rates. In current market conditions a 0.50% p.a. buffer may be appropriate both for a commercial bank financing with an interest-rate swap or a fixed-rate bond issue.16
Similarly, clear terms should be provided by bidders in respect of MLAs17 or any other additional interest-rate costs, as well as the interest-rate calculation methods used.
The role of the Authority is, therefore: first, to ensure that hedging is considered within each bid and included within the bid evaluation (e.g. where there are differences between bids, or bidder qualifications to any hedging principles specified in the ITN); second to require transparency of hedging costs; and third, to do as much as it can in terms of the design of the ITN and the bidding process to encourage bidders to obtain best value for money. The Authority should reserve the right of approval of all hedging instrument(s) proposed by the Contractor and their execution (cf. §2.7).18
In this context, the choice of a fixed-rate capital market instrument (such as a bond) is as much a decision about interest-rate hedging as is the execution of interest-rate swaps in relation to a LIBOR-based bank loan. However if a bond is being used, the placement of the bond automatically fixes the interest rate-i.e. unlike a LIBOR-based loan, choosing an interest-rate hedging instrument is not a separate exercise for a fixed-rate bond.19 The use of bond finance is discussed in Office of Government Commerce: "Guidance on Certain Financing Issues in PFI Contracts" (July 2002), Section 2: Using the Capital Markets for Finance, and is thus not considered in detail in this Application Note.
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15 In any event well before the bid submission date so as not to disrupt bidder internal approval processes.
16 Unless inflation-indexed financing is used (for which cf. §3.5), since its pricing will be based on a real yield which will be lower in absolute terms and less volatile than the yield on a conventional gilt, in which case the buffer should be correspondingly lower (e.g. 0.25% p.a.).
17 i.e. mandatory liquid asset costs, charged by banks in addition to the credit margin.
18 Cf. footnote 27 to the definition of 'Senior Financing Agreements', SoPC §1.8.1.
19 However there are other issues on execution, discussed in §2.7.