§3.2  Proportion of the Unitary Charge to be indexed

When considering the proportion of the Unitary Charge which should be indexed against inflation, there are two balancing factors which should be taken into account:

-  The Authority's resources

The resources available to the Authority are likely to have indexation protection-partial or complete. Where partial, this will be either directly through the Authority's budget, or indirectly as a result of two or more distinct streams of funding being combined for its PFI project-e.g. such as in the case of Revenue Support Grant (an unindexed stream) being made available to a Local Authority to meet part of the cost of its project, with the balance of the cost being covered from the Authority's own (indexed) budget. The relationship between the degree of indexation of the Authority's resources and of the Unitary Charge payment stream is clearly an important issue in the Authority's assessment of affordability over the life of the PFI Contract.

-  The Contractor's costs

Insofar as the Contractor's costs are subject to long-term inflation, it is likely to prove better value for money to index the element of the Unitary Charge which covers these costs against inflation, rather than require the Contractor to build in long-term contingencies into its pricing.32 Contractors' costs can be considered in several categories:

-  Capital costs:

-  The risk of construction-cost inflation is normally taken entirely by the Contractor, which either passes this on to the construction sub-contractor or includes a contingency against this risk. Given the short-term nature of this risk, the construction contractor should generally be willing to provide a fixed price. (The only exception to this may be cases where there would be an especially long gap between Financial Close and completion of construction, or between Financial Close and start of construction, where it may be better value for money for the Authority to take (or share) this risk rather than expect the construction sub-contractor (alone) to price it.)

-  These fixed construction costs are substantially funded with long-term debt,the servicing of which (subject to the issues discussed below) is also a fixed series of payments. In these circumstances, the Unitary Charge element relating to debt service should not be indexed against inflation, unless there is a clear value-for-money case to the contrary.

-  Maintenance and other facilities management ('soft FM') costs: this element of the Unitary Charge is normally suitable for indexation against inflation for the life of the PFI Contract. If there are benchmarking and market-testing provisions for these costs in the Contract, there is an argument that indexation is unnecessary except to cover movements between benchmarking/market-testing dates.33 However, although the difference may be largely one of timing, indexation is likely to play a role in overall value for money.

-  Lifecycle costs: the treatment is the same as for soft FM costs, i.e. indexation of part of the Unitary Charge, but generally without benchmarking / market testing.

-  Other operating costs: these include the Contractor's own direct operating costs (e.g.management and corporate overheads), and costs such as insurance. Operating costs are likely to be subject to inflation. Insurance costs require their own special regime (see SoPC §24 (Insurance) as updated in December 2005).

In summary, therefore, Contractors' costs will be a blend of fixed costs and those subject to price inflation-i.e. variable costs. Depending on the extent to which capital costs dominate, so the proportion of Unitary Charge which is fixed may also be substantial, if debt service has itself been fixed through interest-rate swaps or otherwise (cf. §2). The balancing item of eq-uity return for investors in the Contractor is derived from the excess of income over costs. As such, it will reflect a combination of differential inflation / indexation and fixed income / cost elements.

If the Unitary Charge is 'over-indexed'-i.e. the indexed proportion is larger than the indexed element of the Contractor's costs-this mismatch may enable the Contractor to offer a lower initial Unitary Charge, because the extra Unitary Charge revenue from a higher level of inflation indexation in later years enables there to be a relative 'back-ending' of debt service payments and equity return. The ability to 'profile' the Unitary Charge is normally constrained by the requirement that the Unitary Charge should be level before the application of indexation-hence without over-indexation the scope for back-ended funding is limited.

The principal value-for-money rationale for using a level base Unitary Charge (and so for avoiding profiling) is to ensure a broadly consistent match between the benefits (i.e. the contracted services) being received by the Authority in any time period and the cost of purchasing those benefits (i.e. payment of the Unitary Charge). Level payment streams are a natural feature of output-based PFI Contracts and help ensure that proper incentives are maintained under the Contract payment mechanism over the life of the PFI Contract.34 In fact, there are sound economic reasons-in terms of efficiency and productivity gains over time being captured by an Authority-for the 'level' Unitary Charge, in practice, to reflect a steadily declining real price.

Over-indexation of the Unitary Charge means that:

-  The Authority is paying through the Unitary Charge for a longer average-life loan, which is more expensive over the life of the PFI Contract (as more interest is paid overall).

-  The short-term affordability benefit may be offset by long-term affordability constraints if the indexation of the Unitary Charge is out of line with the mix of the Authority's own resources.

-  Termination liabilities (where the Authority compensates for debt outstanding) will be higher (assuming no change in inflation) because of the higher loan outstandings at any point in time, leading to a potential reduction of long-term contract flexibility (albeit that Unitary Charges will previously have been lower).

-  There may be pressure to enter into inflation hedging (cf. §3.5).

Thus, the value-for-money baseline should be a matching of indexation of the Unitary Charge to the underlying inflation exposure of the Contactor's costs during the service delivery period of the PFI Contract, on the assumption that the Contractor's debt servicing costs are fixed.35 A precise matching may, of course, not be possible, for example because lifecycle costs fluctuate from year to year, but a broad average match should be the aim. This may mean a greater initial affordability constraint, as the initial Unitary Charge may be higher. The adoption of this value-for-money baseline does not, of course, preclude the use of a financing structure in which debt-service elements are also variable, but it does require the incremental costs, risks and benefits of a departure from this baseline to be justified given the drawbacks for an Authority of over-indexation described above. Authority requirements in terms of the proportion of Unitary Charge to be indexed should be specified in the ITN.

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31   See §3.3 for appropriate measures of inflation.

32  This is not to imply that incentives for real efficiency gains and/or continuous improvements in service quality for a constant real price over the life of the PFI Contract should not also be considered and, if value for money, included within the PFI Contract payment mechanism.

33  Not necessarily the case for all benchmarking provisions which sometimes do not operate symmetrically to reflect cost increases and decreases-e.g. downwards-only benchmarking.

34  This section should be read in conjunction with SoPC §10.2 (Features of the payment mechanism), as updated by H.M.Treasury: "Standardisation of PFI Contracts Version 3: Addendum-Further Guidance and Permitted Derogations and Clarifications" (December 2005), p.4.

35  This baseline also reflects the kind of long-term inflation exposure the authority would expect were it implementing the project under conventional procurement. Cf. SoPC §14.2.1, where it is stated that "It is highly unusual for prices to be fixed (i.e. without indexation) throughout the term of any contract for periods for which PFI contracts are typically let or, conversely, for the whole Unitary Charge to be indexed."