2.38 Since the credit crunch, the cost of private finance has risen significantly. The cost of PFI bank borrowing is normally a fixed interest rate.37 The rate is normally fixed at the time the contract is entered into. In addition, banks charge fees for arranging the finance.
2.39 The rate at which the cost of funding is fixed comprises:
a The long term interest swap rate (swap rate). In the years running up to September 2008, the swap rate followed the Government's cost of borrowing (the Gilt rate), at a premium (known as the swap spread) typically ranging between 20 and 60 basis points above the Gilt rate.38
b The margin above the swap rate, consists of a price representing the risk of conducting the swap (the swap credit margin) and a price representing the risk of lending to the specific borrower (the loan margin). The following analysis combines the two. Many published margins exclude the swap credit margin.
2.40 The margins included in the cost of debt declined from the early years of PFI up to September 2008, so that many deals were closing with a loan margin of (roughly) around 85 to 125 basis points above the swap rate.39 The reduction in margins reflected the amount of liquidity in the financing markets, resulting in competition between lenders and keen pricing on the provision of debt finance.
2.41 By 2009, difficulties in the banking sector had reduced the willingness of banks to lend and it became difficult for projects to find competitive funding. The loan margin for new projects has risen to 180 to 350 basis points (averaging around 250 basis points for a typical building project) above the swap rate and swap credit margin. Some up-front fees charges by banks for arranging finance have also increased.
2.42 At the same time, long term swap rates have fallen, from a high of 5.4 per cent in July 2007 to a low of 3.4 per cent in December 2008,40 although they have since increased to 4.1 per cent.41 As always, the future direction of margins and swaps is unknowable.
2.43 This fall in the swap rate has offset some of the increased margins. The NAO does not hold data on the finance costs of projects it is not auditing. It is thus difficult for us to be precise on what the overall effect has been. However, based on our talks with stakeholders, we estimate that the absolute nominal cost of private finance is (roughly) in the region of 30 to 130 basis points higher in 2009 than it was before 2008. This has decreased the affordability of projects.
2.44 We also estimate that it has increased the cost of private finance to between around 140 to 250 basis points above the government's cost of borrowing (measured as the 25 year gilt rate) for deals closed in 2009, compared to between around 100 to 160 basis points above the government's cost of borrowing before 2008. The estimates in this paragraph and the one above must be taken with a great deal of caution. They are based on reports from market participants and not on our analysis of specific contracts.
2.45 The effect of this increased cost of private finance is complex and depends on the project. We can, however, give an indication of the cost increase public authorities face by using a simplified calculation (Figure 3). There are a number of factors not included in these calculations that may limit the additional costs of using private finance. For example, some departments are using other sources of funding (e.g. capital contributions) to reduce the impact of these costs.
2.46 Sharing in the gains of a future refinancing could also reduce the costs. But a refinancing cannot be guaranteed. An early refinancing, if achievable, is unlikely to recover much more than half of these additional costs, even if favourable terms can be secured. The Treasury has increased the public share of refinancing gains to 70 per cent for all PFI deals that receive final bids after 1 November 2008 or amend their investment terms after that date.
2.47 The current cost of private finance raises issues about the VFM case for the use of private finance. It is possible that using private finance is VFM despite increases of cost, because the benefits continue to outweigh these costs. This requires one or more of the following arguments to be true:
a "The new margins reflect the real risks and should have been higher all along". This argument says that risk margins were too low in the period up to the credit crunch. Thus these risks now priced into private finance, should be considered in estimates of costs of conventionally funded projects. A possible counter argument is that part of the reasons margins are higher may be because of a scarcity of funding available from lenders given the cost of finance comprises both liquidity costs (i.e. a bank's cost of funding itself) as well as compensation for taking on the specific project risks.
Figure 3 | |
Length of financing: | 25 years |
Capital funding requirement: | £100 million |
Current 25 year Gilt rate (as at 21 Sept 2009): | 4.24 per cent |
Current 25 year SWAP rate (as at 21 Sept 2009): | 4.14 per cent |
Current typical margin above SWAP rate: | 260 basis points |
Old 25 year Gilt rate (as at 21 Sept 2007): | 4.35 per cent |
Old 25 year SWAP rate (as at 21 Sept 2007): | 5.08 per cent |
Old typical margin above SWAP rate: | 110 basis points |
Increase in absolute cost |
|
Additional cost compared to terms available in 2007: | £5.4 million |
Increase in unitary charge | £420,000 a year |
Increase in relative cost |
|
Increase in the difference between the cost of private finance and | £6.3 million |
NB: This example excludes refinancing, capital contributions or other mitigating factors. It also excludes stepped increases in margins and other increases in finance costs. Figures should be viewed only as indicative of the effect of changed margins, and are not actual costs of specific contracts. | |
Source: National Audit Office calculations | |
Note | |
b "Using private finance for a particular project brings sufficient benefits and efficiencies compared to conventional borrowing that it is still VFM despite the increase in the cost of funding". This would need to be assessed on a case-by-case basis. In the past, some Public Sector Comparators audited by the NAO have only been marginally in favour of using PFI, whilst others have shown more room for the cost to increase.
c "It is not possible to change procurement routes without restarting tendering, and the opportunity cost of doing so outweighs the higher cost of private finance". The costs of starting tendering again can be considerable. But this argument, however, only applies to those projects that are significantly progressed in their procurement, potentially such as the M25 widening and the Manchester Waste schemes (both of which were signed earlier this year).
2.48 The Treasury has released guidance to departments to remind them to take into account current lending conditions in their VFM analysis.42 The NAO will look to public authorities currently tendering, or about to tender PPPs, to pay particular attention to ensuring the VFM of their projects.
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37 For simplicity's sake, this section ignores bond financed PFI deals, because there have been no bond financed PFI deals since the credit crunch.
38 Based on 25 year swap rates.
39 for simplicity's sake, this analysis assumes a constant swap credit margin of ten basis points. since the credit crunch, swap credit margins have increased (along with loan credit margins) so assuming a constant ten basis points is likely to understate the effect of the recent increases in margins.
40 The long term swap rate briefly fell below the gilt rate, i.e. swap spreads turned negative.
41 Based on 25 year swap rates. Twenty year and 30 year swap rates have followed a similar pattern.
42 Application Note. PPP Projects In Current Market Conditions, HMT (28 August 2009).