2.7 Using private finance brings additional costs over and above conventional funding:
a The cost of the debt, which before the current credit crisis was about 1 percentage point (60-150 basis points)16 above the nominal cost of Government borrowing. Recent increases in the cost are discussed in paragraphs 2.38-2.46 below.
b The cost of the risk capital (equity and subordinate debt), historically a return of about 10-15 per cent at the start of a project.
c Upfront contingency. In theory, the risks of a project will be the same if it is funded conventionally or with private finance. If conventionally funded, it will probably draw down funding to pay any costs associated with risks as they arise. For PPPs, investors and lenders may require the projects to raise contingency funds to cover risks. The PPP will have to pay the finance cost of this contingency funding. The cost of funding contingency depends on the way the finance is structured and drawn down into the project. Bond financed deals, for instance, will tend to draw down all the contingency funding at the start, whereas some bank finance deals will arrange funding to be drawn down as needed.
d Transaction costs, including the cost of arranging finance (e.g. swap fees).
e Complex tendering, using competitive dialogue to allow bidders to propose innovative solutions. Private finance tendering is a long and costly process, but allows more time for due diligence and understanding the true costs and risks of the project.
f Contract administration costs, including the costs of administering a special purpose vehicle to hold the finance and manage the sub-contracts.
2.8 Part of the difference between the cost of private finance and Government borrowing is because the cost of private finance reflects the risks of the project. The cost of Government borrowing does not. To make a proper comparison, public authorities risk adjust their estimate of the cost of a project funded through taxation or Government borrowing. This reflects the way the public purse would bear the cost of any risk that materialised in a publicly funded project. Such risk adjustments have proved controversial for reasons set out in part four, but have a sound theoretical basis. Their weakness has been in their subjective nature.
2.9 Some economic models show that private finance is cost neutral after taking account of risk. Using a subtle variation of this theme, the Treasury has argued "that there is a cost to the Government's use of private finance, involving the extra cost of the private sector securing funds in the market, but a great part of the difference between the cost of public and private finance is caused by [the] different approach to evaluating risk".17
2.10 The NAO view is that achieving a price of private finance that is similar to the price of Government borrowing after risk adjustment should be an ambition to work towards in competitive tendering, rather than an axiomatic assumption. Achieving such competitive finance requires competitive markets. Such competition has not always been achieved (see part five), and appears particularly at risk at present (paragraphs 2.38-2.46 below). Assuming that the additional cost of private finance is accounted for solely by the risks also does not consider the need for contingency funding or the risk of contractors seeking opportunities to pass risk back to the public sector.
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16 That is, 0.6 to 1.5 percentage points.