31. The capital costs of most projects under conventional procurement are paid in the first few years. In PFPs the costs to the public sector are deferred then spread over many years. In standard business practice, costs due to be paid in future-whether capital or revenue-are "discounted" relative to costs to be paid today. The later a cost falls due, the more it is discounted. When public authorities evaluate the relative merits of procurement routes in accordance with Treasury rules, they add up the discounted costs imputed to each year of a PFP to obtain its whole-life Net Present Value (NPV) (or notional cost), which can then be compared with the NPV imputed to the same project if undertaken by conventional means. The rate of discount applied plays a vital role in the outcome of the comparison: a higher rate makes the private finance NPV seem less.
32. HM Treasury maintain a generic single discount factor, traditionally called the test discount rate, to be used by government departments to appraise policies, programmes and projects. Historically it was mostly used to decide whether or not to undertake public projects and which technique would be best. It has increasingly become important in helping decide between private and public provision. In April 2003 the standard Treasury discount rate was reduced from 6.0% to 3.5%. This was part of a process to achieve greater recognition and transparency of risk by accounting for it in expected cash flows. 12
33. Other things being equal, the reduction of the discount rate might have been expected to increase the NPV (or notional cost) of private finance options relative to conventional procurement and to tilt the balance more towards the traditional path as public authorities weighed their procurement options. But in practice the change seems not to have reduced the use of the private finance procurement route. This was in part because of a new emphasis on risks in traditional procurement, including the attribution of "optimism bias" to expected cash flows in the PSC, so that in many cases the overall appraisal has continued to favour private finance projects.
_________________________________________________________________
12 The reasons for the change in discount rate are outlined in HM Treasury (2002), The Green Book- Consultation Paper, Appraisal and Evaluation in Central Government.