When projects are built using a Traditional procurement method, the public sector makes progress payments throughout the construction period, and thereafter pays annually for facility maintenance. Depending on which public sector entity procures a project, construction funds are either wholly or in majority provided by the Province. While the Province may not borrow money directly from the market on a project-by-project2 basis to make these payments, it incurs an "opportunity cost" of having to pay earlier than it would under AFP (under AFP, payment for construction is delayed until substantial completion or later). The government could have used the funds used to make these progress payments for other public purposes. A key alternative use for the funds, one that can be used to measure this opportunity cost, is to pay down existing public debt (thus avoiding interest payments on the paid-down debt) or alternatively, to avoid incurring additional borrowing costs to finance government expenses. It is important to note that since this financing cost is not directly linked to project-specific borrowing, this financing cost is an "allocated" or "notional cost." This notional public financing cost is calculated at the current Provincial cost of borrowing (the notional public sector financing rate). The Province's cost of borrowing can be estimated through readily available data. IO uses the simple average of yields on provincial bonds with a term of one year or longer as the estimated current borrowing cost (or weighted average cost of capital).
Though the VFM analysis methodology is consistent across the AFP delivery models described earlier, a key difference is the choice of the point in time (referred to as the base date) at which the PSC and ASB costs are compared. This choice has an important effect on how the public sector financing costs are presented in the VFM analysis, though it does not affect the outcome of the VFM analysis.
Since, in the BF or DBF model, the public sector makes payment at project completion (a future date); this is the date that becomes the base date for comparison of PSC and ASB costs. Thus all BF or DBF PSC costs, such as the multiple construction payments made over the construction term, have to be future-valued at the public sector borrowing rate to the base date. The difference between the future value of each construction payment and the construction payment itself represents the notional cost of financing that the public sector incurs as a result of having made the construction payment. For example, assume that the public sector makes a construction payment of $20 million one year into a three-year construction term. Assume further that the public sector borrowing rate is 5% a year. By making the $20 million construction payment, the public sector does not pay down public debt of $20 million. By construction end, this $20 million debt would have grown to $22.05 million (i.e. the future value at 5% compounded annually for two years). Thus the difference of $2.05 million represents the notional cost of financing associated with the construction payment that the public sector made. This calculation is done for each construction payment made by the public sector to arrive at the total notional public sector financing cost that is added to the PSC in a BF or DBF model. The timing of the construction cash flows is estimated and provided by the external cost consultant.
In a BFM or DBFM model, the public sector makes a series of unitary payments to the private sector, starting from construction completion and stretching over the post-construction period (i.e. typically a maintenance term of 30 years). Since there will be not one but many future-dated payments in the BFM or DBFM model, the date on which the RFP closes3 and all the private-party bids are received is used as the base date for comparison of the costs in the PSC and ASB models. Thus all PSC costs (and ASB costs) have to be present-valued back to the base date using the technique of discounting and using public sector borrowing rate as the appropriate discount rate4. Discounting the payments made by the public sector in the PSC model explicitly accounts for the implied public sector financing cost. To understand why this is so, consider the previous example where a $20 million payment is to be made a year into the future. To finance an expenditure of $20 million in a year's time, the public sector has two equivalent choices. It can either (A) borrow $20 million in a year's time to finance the expenditure occurring then or (B) it can borrow $19.05 million today, invest the borrowed money in an account bearing 5% interest (e.g. buying its own debt that pays 5% interest), earning $0.95 million in interest (= $19.05 x 5%) over the next year so as to have $20 million available just in time to finance the expenditure5.
Since under choice B, the $19.05 million borrowed today would itself accrue interest of $0.95 million (= $19.05 x 5%, recall that we assume that public debt pays interest of 5%) the opportunity cost or public sector financing cost of $0.95 million is reflected in the discount rate used in the discounting technique. By borrowing an equivalent smaller amount (i.e. discounted) earlier ($19.05 million today vs. $20 million in a year), the public sector incurs a financing cost reflected in the discount rate (equal to the public sector financing rate). Thus no separate public sector financing cost line item appears in the discounted PSC model for a BFM or DBFM VFM analysis (i.e. there would be no financing box on the PSC side in the sample VFM figure, when drawn for a BFM or DBFM project). It should be noted that if it were assumed that project-specific
debt were to be raised by the public sector to finance a traditionally-delivered project, then the financing costs associated with that specific debt would be calculated and would appear as a separate line item in the PSC model. However, the net present value of total project costs would be identical unless the project specific debt was issued at a rate different from the public sector financing rate.
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2 Since the current portfolio of AFP projects assigned to IO represent a very small portion of Provincial indebtedness, and since the current AFP projects are themselves individually relatively small in magnitude, it is reasonable to assume that irrespective of the delivery model, Traditional or AFP, no incremental public sector borrowing would occur solely on account of such projects.
3 At the VFM publication stage (stage #3), the base date is the date on which financial close of the project is achieved. Costs are contractually locked down at financial close, making it a good point in time for the comparison.
4 The technique of discounting and why the public sector borrowing rate is the appropriate discount rate are further elaborated in a later section.
5 Thus, today's $19.05 million is the present value of the $20 million a year from now. Stated differently, the borrowing (expenditure) of $20 million in a year's time is equivalent to a borrowing (expenditure) of $19.05 million today (in the regime of a 5% interest rate and 5% discounting rate).