15.2.1 The Contractor will be concerned to protect itself against its costs inflating over the course of the Contract, rendering the Unitary Charge insufficient to meet its operating costs and financing obligations.219 The payment mechanism should therefore usually include arrangements for indexing the Unitary Charge to this extent. If there is no indexation mechanism, the Contractor is likely to have to build a contingency into its price to cover operating cost inflation risk and this is unlikely to give the Authority value for money (as the risk is outside the control of the Contractor and, historically, has been difficult to forecast accurately). It is highly unusual for prices to be fixed (i.e. without indexation) throughout the term of any Contract for periods for which PFI Contracts are typically let. Conversely, it is not usual for the whole Unitary Charge to be indexed, and such over-indexation should not be used as a method of artificially reducing the initial Unitary Charge.
15.2.2 The Authority should focus on the appropriate method of applying indexation to the payment stream at an early stage in Project development. By the time an ITPD is issued, the Contract should specify the index to be applied and how it applies (i.e. how the proportion of the Unitary Charge to be indexed is to be determined). Authorities should not leave the indexation proportion or choice of indices to the bidders, given the difficulties in comparing one bidder's price and value for money with that of another bidder where different bidders use different proportions and methods of indexation.220
15.2.3 Authorities should bear in mind that the use of benchmarking or market testing gives some protection to Contractors for the Services covered by these arrangements. In most cases value for money can be achieved through indexation of a proportion of the Unitary Charge which matches the proportion of total costs represented by any elements of the Contractor's underlying costs which are not fixed, using a general price index such as RPI or RPIX.
15.2.4 On certain projects, the use of a more focussed index such as a construction index for construction prices, a facilities management index, or a weighted basket of indices, may be preferable. In these cases, the Authority should take care with index selection. Choosing an index that may be short lived, or is not independently produced, is not a sensible approach.221 It is also not appropriate to have too narrow a focus on a particular industry or sector, as in specific sectors (such as the defence industry), Contractors or their Affiliates are themselves responsible to a significant extent for inflationary costs (that is, they can actually affect the index by increasing their price).222
15.2.5 Whilst choosing an index and weighting that reflect the underlying cost exposure of the Contractor has the effect of reducing its cost risk, amended forms of such indexation formulae can incentivise real cost savings over the life of the Contract.223
15.2.6 For more detailed guidance in this area, please see HMT Application Note - Interest-Rate and Inflation Risks in PFI Contracts (May 2006).
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219 See HMT's Application Note-Interest-Rate & Inflation Risks in PFI Contracts (May 2006). The possible adjustment to Unitary Charges for movements in interest rates in the periods before or after contract signature are not considered here, but see Section 33.2.1 and HMT's Application Note.
220 It is open to the Authority, however, in the interests of value for money, to invite bidders to propose alternative indices, provided the choice of such alternates is supported in the bid with appropriate Models demonstrating their financial impact and the issues addressed is HMT's Application Note referred to in footnote 219 above are properly addressed.
221 In any event, the Contract should include provisions dealing with circumstances where the specified index (or indices) is not published or the basis upon which it is calculated is changed - see footnote 45.
222 Suggested drafting on indexation can be found in Clause 1.8.2(b).
223 One such amended indexation formula of X x (I + RPI + y) could be used by the Authority in its ITPD with bidders required to bid values of x and y. Where future cost reductions are reasonably foreseeable and not reflected in the initial Unitary Charge these can be reflected in the value of y. The bidder can propose a value of x reflecting the percentage of any elements in its cost structure that are not fixed. The variable x will therefore be a number between 0 and 1.