One important aspect of the PSC that has proven to be contentious is the discount rate and this was raised in the report of the Review of Partnerships Victoria Provided Infrastructure. This matter is also discussed in chapter 3.260
The discount rate is defined in the Partnerships Victoria documentation as the rate used to calculate the present value of future cash flows. The rate is usually determined on the basis of the cost of capital used to fund the investment from which the cash flow is expected. This use of a discount rate is a standard part of financial evaluation for any capital public infrastructure project, and reflects the fact that amounts paid out immediately are worth more than the same amounts paid at a later time. The IPPR in the United Kingdom indicated that:261
A payment made later effectively costs less so these future payments have to be discounted, using the Treasury's long established six per cent real pre tax discount rate. A considerable debate has raged over whether this rate is appropriate and the conventional financing route (other things equal); a higher discount rate would favour the PFI. Some economists argue for a higher rate and some for a lower rate and some for using different discount rates for different projects. It should be noted that the private sector tends to use similar 'rough and ready' rules of thumb as the Treasurer's six per cent rate.
The IPPR recommended in 2001 that consideration should be given to reducing the discount rate used by Treasury in the United Kingdom from 6 to 5 per cent. Two years later, the United Kingdom Treasury compared the costs of finance to the private sector and government, and commented that:262
A great part of the difference between the cost of public and private finance is caused by a different approach to evaluating risk. Typically, the private sector takes account of risk by discounting future cash flow at a higher rate … The gilt rate on the other hand does not make any attempt to calculate risks.
The United Kingdom Treasury noted that the expected value of all risks in options should be discounted in future years at 3.5 per cent per year to present value. This would reflect society's preference for consumption now over consumption in the future, rather than discounting the value of expected future cash flows at a higher rate to make a compensation for risk.263 This central point was picked up in the Fitzgerald review:264
The practice of evaluating tenders by discounting the minimum contract payment schedule by a CAPM based discount rate (for example, 6 per cent real or 8.65 per cent nominal) be discontinued. In its place the discounting function presently undertaken would be unbundled into two components - a risk adjustment of estimated costs and an adjustment for the time value of money to be expended. The risk adjustments (including for optimism bias and for potential contractual default or revision) would be treated as additional costs to the Public Sector Comparator and, where appropriate, to the contractual payment stream. The evaluation of tenders would discount the contract payment stream at a discount rate that reflects the time value of money, based on an estimate of the risk free rate such as the Commonwealth Bond Rate that best matches the term of the project - for example, 5.7 per cent nominal for 12 year bonds, or 3.5 per cent real. This rate would not be dissimilar to the discount rate presently used in these circumstance[s] by the UK Government (3.5 per cent real) based on its calculation of the Social Time Preference Rate (STPR) (UK Green Book 2003, Annexe 6).
The government did not support these recommendations made by Fitzgerald and the Partnerships Victoria Guidance Material, Public Sector Comparator, Technical Note suggests for example purposes that a real pre tax discount rate of 6 per cent will be applied.265 Although the real discount rate ranges from 5 to 8 per cent, depending on the type of project, and risk margins.266
Consistent with this, an Australian academic submitted to the Committee that:267
The central principle on which the Partnerships Victoria approach is allocated is that, as far as possible, risks should be explicitly identified and then allocated to the party best able to manage them. This principle is not applied, however, in the selection of discount rates in the evaluation of the public sector comparator.
If all risks have been identified and taken into account, the appropriate procedure for the evaluation of costs and benefits is to compute the present value using a riskless discount rate such as the rate of interest on government bonds, implying a real rate of discount of 3 to 4 per cent.
By contrast, the evaluation procedure proposed by the Partnerships Victoria documents calls for a real rate of discount of around 6 per cent. For a long lived project with returns that are stable in real terms, the effect of using a 6 per cent rather than a 3 per cent real rate of discount is to reduce the present value of benefits by about half.
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260 P Fitzgerald, Review of Partnerships Victoria Provided Infrastructure - Final Report to the Treasurer, January 2004, p.26
261 Institute for Public Policy Research, Building Better Partnerships, The final report from the Commission on Public Private Partnerships, 2001, p.86
262 HM Treasury (UK), PFI: Meeting the Investment Challenge, 2003 July
263 The Report cites The Green Book (2003)
264 P Fitzgerald, Review of Partnerships Victoria Provided Infrastructure - Final Report to the Treasurer, January 2004, p.2
265 Department of Treasury and Finance Partnerships Victoria, Guidance Material, Public Sector Comparator, Technical Note, June 2001, p.16
266 Department of Treasury and Finance, Partnerships Victoria Guidance Material, Use of Discount Rates in the Partnerships Victoria Process, Technical Note, July 2003, p.18
267 Professor J Quiggin, submission no.25, p.36