9.33 As outlined above, the key role of Government in the private finance raised by PFI projects is to set the terms of the PFI competition. In setting these bid requirements, the public sector sets out its approach to the unitary charges to be paid, and provides a formula for any permitted changes in these charges over the life of the contract. In doing this, the public sector determines in advance some restrictions on the financing options which will be feasible to the PFI contractor. For example:
• if unitary charges are only permitted to increase annually by the rate of inflation, this is likely to lead a PFI contractor to fund its project through an index-linked bond issue, which relates changes in inflation; or
• if unitary charges comprise a mixture of a fixed element, equal to the amount needed to service the finance raised for this project, and a second element which varies with inflation (usually relating to operating costs) this will lead a PFI contractor to fund its PFI project with a fixed rate of interest by way of a bond issue or, if it chooses to use bank finance, the introduction of a hedging instrument to mitigate the interest rate risk normal with such bank financing.
9.34 The key choice for the public sector regards its preferred approach to unitary charges. Guidance has been given on these matters, but the Government believes an alternative approach to interest rate risk is now possible, given the large number of projects now in operation, which could improve value for money futher.
9.35 The Government will review the current approach to managing interest rate risk under a PFI. To date, interest rate risk and its management primarily lies with the PFI contractor, which raises two issues:
• where it is necessary to terminate a PFI contract to ensure flexibility for delivery of public services in the circumstances described above, the cost of breaking the hedging contracts put in place by the PFI contractor are typically passed back to the Government; and
• it is also difficult to ensure that the process of agreeing a fixed interest rate at financial close is sufficiently transparent and cost effective.
9.36 The Government is now in a position to consider its exposure to interest rate risk in PFI contracts in the context of its PFI programme as a whole, securing better value for money than through continuing to require the private sector to put in place such hedging itself.
9.37 The Government therefore plans to review whether its current approach to requiring the private sector to hedge interest rate exposure offers best value for money. It will consult on these issues with both public and private sector participants in PFI on whether an alternative approach can be found which offers better value for money.