C4 Typically, the private sector takes account of risk by using higher rates of return to compensate. Whilst the Government accepts that this is a valid approach by the private sector, and fully supports the point that the risks associated with public projects should be properly quantified, its preference is to separately evaluate and quantify such risks. This approach to measuring risk is set out in the Green Book and discussed more fully in Chapter 3. It is therefore inappropriate to compare a "risk free" cost of gilts with the cost of private finance, which is set by the private sector to take account of project risks, without also considering the benefits of the private sector's capacity to absorb risk. Box C1 cites some of the comments in the PwC study which address this issue.
| Box C1: Public versus private sector cost of capital: PwC study "There are two common assertions made to justify the claim that the private sector cost of capital exceeds the public sector cost of capital: 'Governments can borrow at a risk free rate of interest' This is not the case, there is a risk premium either way, it is just explicit in the price of private capital. Where gilts are used, tax-payers effectively underwrite the associated risk and the price reflects this fact. The taxpayer takes on the contigent liability, and where the risk materialises, they carry the cost as a result. If the taxpayer were to be compensated it would be equivalent to paying the risk premium at the point of raising the capital, making the public and private sector's cost of capital equivalent. 'The government are better at diversifying the risk than the private sector' This assertion is based on the Arrow-Lind theorem, an academic theory which assumes that project returns can be treated as wholly independent of National income. In fact this is rarely the case as public investment is not risk free". |