21.2.9.1 Alternatively, either the Authority may elect (for example, for operational reasons347) not to retender the Project or it may be that there is no Liquid Market, in which case the Authority will instead pay to the Contractor (from its own resources) an assessed value of the amount it would have received through an appropriate retender process (again net of costs) (see Clause 21.2.8 (Retendering Procedure)) that is, if a Liquid Market had existed (the "Estimated Fair Value of the Contract").
21.2.9.2 Estimated Fair Value computations are conducted by forecasting the full Unitary Charge from the date of termination to the expiry of the Contract (ignoring any deductions for performance or availability), from which the estimated costs of delivering the service to the required standard in the output specification (this includes the running costs, lifecycle costs and any rectification costs) are deducted to arrive at the estimated operating cash-flow stream which, had a liquid market existed and the project been re-tendered, a hypothetical bidder would have valued to determine the amount to bid for the project.
21.2.9.3 The first point to consider in making this computation is whether this computation should be conducted in nominal terms (i.e. using current prices) or in real terms (i.e. using constant prices). For contracts with 100% indexation to RPI, it should not normally matter since both methods would return the identical result. However, it is easier and safer to conduct the analysis in nominal terms because:
(a) many elements of a Project (including tax and cost of funds) are always quoted in nominal terms, and it is easy to make errors by ignoring this when conducting "real" computations, and
(b) the majority of PFI Contracts let in the PFI market are partially indexed. For such contracts, the "real" value of the Unitary Charge effectively declines with time. The effect of indexation must therefore be recognised by explicitly including the indexation effects and conducting the analysis in nominal terms.
21.2.9.4 The calculation must also take care to ensure that if the forecast cash flows are expressed in nominal terms (i.e. taking indexation into account), the discount rate used must also be expressed in nominal terms. The discount rate is usually made up of a "real" rate of return, on top of which an allowance for inflation is added. A methodology for making this adjustment is set out in the drafting below.
21.2.9.5 The Authority and the Contractor will need to agree a forecast rate of inflation to be applied to the indexation formula to make the nominal computations. It is recommended that the agreed assumed rate of inflation should be an easily observable and transparent figure.
21.2.9.6 The next question is whether the Estimated Fair Value analysis should be conducted in pre- or post-tax terms. It is considerably easier and more transparent to conduct the analysis in pre-tax terms because this avoids protracted scrutiny of the assumptions underlying the tax forecasts. Since neither the public sector nor the private sector is actually going to be paying taxes going forwards, it is not necessary to assess taxation in the calculation. Moreover, the risk of changing tax regimes between financial close and termination date lies squarely with the private sector, and this should not be made an occasion to revisit that risk transfer. The analysis should therefore be conducted in pre-tax terms.
21.2.9.7 The forecast cash-flows should be discounted at a discount rate which reflects the risk of the underlying cash-flow. The most transparent measure of the risk of the cashflows is the real pre-tax project IRR reflected in the Base Case. However, since underlying rates in the market such as the real yields on Government Gilts or the London Interbank Offered Rate (LIBOR) can and do vary over time, the Authority must consider carefully whether, in setting a discount rate for the Estimated Fair Value calculation, it should acknowledge the effect of changes to these underlying variables.
21.2.9.8 The main argument in favour of giving effect in the discount rate to changes in underlying risk-free rates is that if a liquid market existed and the Contract were successfully re-tendered, a hypothetical bidder would take into account current market yields on risk-free investments in choosing what discount rate to apply to the Project. If these benchmark rates had moved upwards, for instance, in the time between Financial Close and Date of Termination, an incoming bidder would bid a lower sum for the Project and vice versa. Not recognising this difference could create a discrepancy between the compensation sums arising out of the Retendering procedure and the No Retendering procedure. Therefore an adjustment should be made as set out in the drafting below to reflect the impact on the Estimated Fair Value discount rate of changes to underlying market rates.
21.2.9.9 The adjustment set out below provides the Contractor with a natural hedge against movements in underlying market rates that may cause losses or profits on broken interest rate hedges on Termination. If interest rates move down between Financial Close and Termination Date, the Contractor would find itself having to pay positive breakage costs on the interest rate swap (if one was put in place at Financial Close). Adjusting the Estimate Fair Value discount rate downwards in line with market rate movement would have the effect of generating a larger compensation sum, thereby partially or fully protecting the Contractor against the adverse position on its interest rate swap. Upwards movements in interest rates would likewise have the opposite effect, generating profits on the broken hedge but a smaller compensation sum from the Authority.
21.2.9.10 From the point of view of Authorities, it is also beneficial to have adjustments as set out below to the discount rate because, just as the adjustment provides the Contractor with a natural hedge against breakage costs, it provides Authorities with a natural hedge against the cost of funding compensation payments. To illustrate, an upward movement in interest rates would make it more expensive for Authorities to finance a given compensation payment, but the proposed mechanism would adjust the discount rate upward in line with market movement and reduce the amount of compensation to be paid, thereby partly protecting the Authority's position. A downward movement in market rates would have the opposite effect.
21.2.9.11 Any dispute as to the assessed value of the terminated Contract should be dealt with through the dispute resolution procedure (see Section 28 (Dispute Resolution)).
Required drafting (including definitions) is as follows:
"Adjusted Estimated Fair Value of the Contract"
means the Estimated Fair Value of the Contract, less an amount equal to the aggregate of:
(a) [where relevant any Post Termination Service Amounts348 paid to the Contractor (if a positive number);]349
(b) the Tender Costs; and
(c) amounts that the Authority is entitled to set off or deduct under Clause 12 (Set-Off),
plus an amount equal to the aggregate of:
(i) all credit balances on any bank accounts held by or on behalf of the Contractor on the date that the Estimated Fair Value of the Contract is calculated;
(ii) any insurance proceeds and other amounts owing to the Contractor (and which the Contractor is entitled to retain), to the extent not included in (i); and
(iii) the Post Termination Service Amounts (if a negative number),350
to the extent that:
(1) (i), (ii) and (iii) have not been directly taken into account in calculating the Estimated Fair Value of the Contract; and
(2) the Authority has received such amounts in accordance with the Contract or such amounts are standing to the credit of the Joint Insurance Account.
means an agreement on the same terms and conditions as this Contract, as at the Termination Date, but with the following amendments:
(a) if this Contract is terminated prior to the Service Commencement Date, then the Service Commencement Date shall be extended by a period to allow a New Contractor351 to achieve Service Commencement;
(b) any accrued [performance points] and/or warning notices shall, for the purposes of termination only, and without prejudice to the rights of the Authority to make financial deductions, be cancelled; and
(c) the term of such agreement shall be for a period equal to the term from the Termination Date352 to the Expiry Date.
"Estimated Fair Value of the Contract"
means the amount determined in accordance with Clause 21.2.9 (No Retendering Procedure) that a third party would pay to the Authority as the market value of the Deemed New Contract.
"Termination Date Discount Rate"
means a discount rate expressed as [(1 + real base case project IRR + Gilt B - Gilt A)* (1+i)-1]
where:
"real base case project IRR" is the real pre-tax Project IRR as set out in the Base Case;353
"i" is the agreed assumed forecast rate of increase in the [indexation formula] set out in the Contract for the remaining term of the Contract;
"Gilt A" is the real yield to maturity on a benchmark government Gilt instrument of the same maturity as the average life of the outstanding Senior Debt as shown in the Base Case at Financial Close; and
"Gilt B" is the real yield to maturity on a benchmark government Gilt instrument of the same maturity as the average life of the outstanding Senior Debt as shown in the Base Case as on the date of Termination.
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347 There will, in any event (even if a Liquid Market exists), clearly be circumstances in which an Authority will not wish to retender the Project on the original terms - for instance, where its service requirements have radically changed or where the time to retender will give rise to safety or other policy concerns that cannot be addressed adequately in the context of a retender.
348 There will only be any Post Termination Service Amounts here to the extent that the Authority starts the retendering process but then decides to follow the no retendering approach.
349 These amounts are not deducted to the extent paragraph (c) of the definition of "New Contract" is a period from the date of the New Contract to the original Expiry Date (rather than the Termination Date to the original Expiry Date).
350 See footnote 337 above.
351 That is, time to complete is given if termination occurs prior to Service Commencement. Other timing related issues may require a similar treatment depending on the Contract.
352 The Termination Date here is the relevant date as no New Contract is actually being entered into.
353 Parties should not agree a discount rate other than this (this is the discount rate contained in the Base Case (see Clause 34 (Refinancing) for definition).