§3.5  Inflation-indexed financing or hedging by the Contractor

In cases where a Contractor has an especially high debt:equity ratio, or where the Unitary Charge is highly over-indexed as discussed in §3.2, there may be pressure from lenders (or shareholders) to enter into a hedging arrangement to cover the risk that if inflation runs below the level assumed in their financial model (e.g. 2.5%), it would endanger debt-cover ratios (and equity returns).43

This inflation hedging can be done in one of two ways:

-  Part of the funding can be provided as an index-linked loan, in which the principal and interest payments are indexed against inflation (usually RPI). The pricing of such instruments is at a margin over the yield for index-linked gilts (i.e. rather than a margin over the LIBOR swap rate (for a bank loan) or fixed-rate gilts (for a fixed-rate bond)).

-  Alternatively, an inflation swap can be used: this swaps the amount of Unitary Charge indexed by inflation-and not naturally hedged internally by operating costs etc.-for the same proportion of the Unitary Charge indexed at the fixed inflation swap rate. This swap rate is known as the 'break-even inflation' rate or BEI, because if outturn inflation is consistently at this level the fixed and variable payments under the swap cancel each other out. Thus rather than allowing part of the debt service to become sensitive to inflation, as in the index-linked funding option, instead the over-indexed element of the Unitary Charge is effectively fixed by the inflation swap. The BEI is also derived from index-linked gilts. Because indexed gilts are indexed against RPI, RPI is generally used as the basis for an inflation swap.44

The net underlying financial effect of either method is similar,45 just as there is no inherent difference between the net cost of a fixed-rate loan and a floating-rate loan with an interest-rate swap.

In fact, inflation-linked financing may produce a financial benefit which can be used to reduce the initial Unitary Charge, depending on market conditions. This can arise if the inflation implied in index-linked gilt pricing at that time (for the relevant duration of the funding) is higher than the inflation assumption being used by the bidder to calculate the Unitary Charge (cf. table in §3.3). Or, to put it another way, if the real rate of interest for indexed gilts is lower than for fixed-rate gilts at this inflation assumption. This will make index-linked funding appear 'cheaper' than its conventional equivalent, or make an inflation swap appear to produce a net cash inflow to the project each year. These effects need to be carefully analysed in the value-for-money assessment:

-  Although an inflation-indexed loan or inflation swap hedges the Contractor's cash flow and thus protects the position of investors and lenders, it does not affect the indexation of the Unitary Charge, and thus the Authority remains exposed to movements in inflation as determined by indexation of the Unitary Charge.46 In this respect it is quite different to a fixed-rate loan or interest-rate swap, which both hedges the investors' and lenders' risks and fixes the Unitary Charge such that the Authority is not exposed to movements in interest rates.

-  Thus, the financial benefit discussed above can only be achieved by the Authority taking a greater long-term inflation risk.

-  The other key difference between interest-rate and inflation hedging by the Contractor is that the latter may lead to larger termination liabilities for the Authority, in cases where the Authority is liable for breakage costs on termination. Whilst interest-rate swaps can have significant break costs if rates have fallen, these will decline as time goes on, whereas break costs can be proportionately higher for inflation swaps or index-linked funding (with comparable market movements) because the effect of inflation is cumulative: thus if inflation remains above the level assumed in the pricing of the inflation swap or inflation-indexed loan, the amount payable on early termination of these grows greater over most of the loan life in proportion to the remaining loan outstanding. This may inhibit the Authority's long-term flexibility to terminate the PFI Contract,47 and may also affect the level of any Refinancing Gain to be shared by the Authority.

It is therefore relatively hard for inflation-indexed finance or an inflation swap arranged by the Contractor to demonstrate the best long-term value for money for the Authority, even if there is an apparent initial benefit or affordability advantage.48 Moreover, the requirement for such inflation hedging is mainly likely to arise if the Unitary Charge is over-indexed, and for the reasons set out in §3.2 such over-indexation also has to be justified on value-for-money grounds. In cases where there is a strong value-for-money case for some form of inflation hedging, it may be more appropriate for the Authority itself to provide this via the Unitary Charge indexation regime.

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43  As with interest-rate hedging this question should not arise where the Contractor is using corporate finance (cf. footnote5).

44  In the cases where inflation hedging may be considered appropriate, in the same way as for interest-rate hedging this should be set out in the ITN (cf. §2.4). There are variants on the swap product which need to be considered (cf. §2.5) and the same issues apply in relation to a competitive procurement process and timing of execution (cf. §2.6 / §2.7). It should be noted that it is generally harder to establish value for money through benchmarking of inflation swaps than it is for interest-rate swaps.

45  However, an important difference exists between an indexed linked bond (and indeed most bonds) on the one hand, and fixed-rate bank debt on the other, in circumstances of pre-payment of the two different loan types. Whereas the breakage of a swap on a bank loan can give rise to a loss or a gain for the borrower (depending on prevailing market conditions), with a bond there is generally a par floor on early redemption of the loan (under the Spens clause) which denies the borrower the equivalent of a gain which can arise in certain market conditions Cf. Office of Government Commerce: "Guidance on Certain Financing Issues in PFI Contracts" (July 2002), Section 2: Using the Capital Markets for Finance, §2.12. It should be noted, however, that the market is moving towards greater acceptance of a modified Spens clause with lower termination payments in certain scenarios.

46  A similar point arises in the reverse case of an Authority agreeing to the Unitary Charge (or a portion of it) being indexed each year by a fixed inflationary amount (e.g. 2.5%). In such cases, the Contractor may plan to execute a hedge which swaps the underlying fixed inflation rate into a variable rate. This swap does not affect the indexation of the Unitary Charge but will introduce contingent liabilities for the Authority in the same way as do swaps from variable into fixed inflation rates.

47  Or vary the Contract, or implement changes in service requirements on terms representing value for money.

48  This general principle applies to stable and sustainable long-term market rates. Accordingly, the principle needs to be qualified by the fact that transient market conditions can arise which create windows wherein the real cost of indexed-linked bonds might fall substantially below its long-term sustainable rate. Nothing in this Application Note is designed to deter Authorities from benefiting from such exceptional market conditions, if the opportunity arises. But the transient nature of these market conditions inevitably means that they cannot form a sound basis for a pre-planned value-for-money strategy in the procurement of hedging instruments. Moreover, care must always be taken to distinguish properly between the effect of a higher level of indexation of the Unitary Charge and whether an indexed financing itself offers a lower real cost than fixed-rate finance.