• Comparisons between different measures of inflation to be used within payment mechanisms and between different projections of inflation chosen by bidders are not straightforward. • Great care is required to ensure that such comparisons are done on a like-for-like basis. |
When evaluating bids for the purpose of establishing value for money (as opposed to affordability which is not the subject of this Application Note), four key indexation-related factors influence the calculation of the net present value (NPV) for a given bid:
1) The proportion of the Unitary Charge which is indexed.
2) The inflation index or indices applied to the Unitary Charge e.g. RPI or RPIx.
3) The assumptions made about the value of the index (indices) for the life of the PFI Contract, in order to derive the nominal costs to the Authority.
4) The deflator used to transform that nominal cash flow into a real cash flow, before the application of the public-sector real discount rate of 3.5%.40
The first and second factors have already been discussed in §3.2 and §3.3 respectively.
For the third factor, an Authority should seek suitable specialist advice in preparing assumptions about future values of the index (indices) and not rely on the assumptions proposed by a bidder.41 The sensitivity of the value-for-money analysis to the assumptions used may be greater where different bidders use different indices, and/or propose different proportions of the Unitary Charge to be indexed. As long as the impact of alternative indexation assumptions is well understood and consistently applied in the appraisal, it should not undermine the proper analysis of inflation risks and hedging strategies.
The fourth factor is not project-specific. The deflator currently used in appraising PFI projects is 2.5%.42 As can be seen from the historical figures set out above, this 2.5% deflator figure is mid-way between the averages for RPIx (2.4%) and RPI (2.6%) in recent years.
Particular care needs to be taken when the use of inflation-indexed finance is under consideration (see below), or if a sector-specific index is used (cf. §3.3).
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40 Cf. H.M. Treasury: "The Green Book: Appraisal and Evaluation in Central Government" (2003), paragraph 5.49.
41 Best practice is for the Authority to provide a set of forecasts of values for the index (indices) which bidders must use in preparing their financial projections to help Authorities carry out bid evaluations on a consistent basis.
42 ibid. (paragraph 5.43) refers to the Bank of England's inflation target, currently CPI 2% p.a. Guidance on the most suitable deflator to be used in investment appraisals is updated by H.M. Treasury from time to time.