1.28 The process of comparing the different bids was relatively straightforward. Funders had been told that acceptance of the project document, which complied with the Treasury Taskforce standardisation, was one of the evaluation criteria. Bids that proposed amendments to the project document were evaluated adversely. The majority of funders suggested no changes to the project document, thus explicitly accepting the contract terms and conditions. As there were no significant differences in the contract terms, terms of finance and deliverability became the only evaluation criteria. Moreover, as the ability to deliver sufficient funding had been a condition of getting onto the long list, the final evaluation became a straight comparison of impacts on the unitary payments.
1.29 Société Générale and Dresdner Kleinwort Benson evaluated the bids, using a single financial model developed by Société Générale during the negotiations between the Treasury and Exchequer Partnership. The original function of the financial model was to estimate how changes to the bid from Exchequer Partnership would impact on the unitary payment. This meant that it could also be used to calculate the effect on the unitary payment of different funding options. The model could be adapted to analyse both bank and bond financing proposals and ensured that all of the bids were evaluated consistently.
1.30 At an early stage in the competition process it became clear that what is known as a monoline wrapped index-linked bond9 would be likely to provide the cheapest financing solution. This was for three main reasons:
a the project length, at 37 years, some 4 years longer than the longest period for which banks would have been willing to lend, favours bonds. Bonds can be issued for periods of 37 years and would thus reduce the annual debt payment compared to the shorter length bank financing. The lower annual cost meant that the project cover ratios10 could be met with a lower annual unitary payment;
b index-linked finance, in combination with an indexed unitary payment, means that inflation will have a similar impact on both a project's cost of finance and its revenue, out of which these costs will be met. Index-linked finance can be cheaper in real terms than fixed rate finance, as fixed rate finance is considered to include a premium for the risk of uncertain future inflation, which is a real cost; this enabled Exchequer Partnership to offer the Treasury a lower unitary charge (in real terms) than might otherwise have been possible;
c monoline insurance of a bond reduces the interest rate bond investors will require and increases the attraction of wrapped bond finance relative to bank borrowing. If the reduction is large enough and other factors are favourable, as was the case for the Treasury project, it outweighs the cost of the insurance. The financial markets are, however, dynamic. Although bond financing was more competitive than bank financing at the time of the Treasury funding competition this may not always be the case.
1.31 The fact that the unitary payment was index-linked had a direct impact on the competition. Using Exchequer Partnership's financial model, we examined the potential impact on the cost of the project of allowing bidders to offer a partly index-linked and partly fixed payment stream. The result of this work showed that the cost of the unitary payment increased by about 2%. We do not consider that index-linking the whole unitary payment was detrimental to the competition or that financing could have been obtained on better terms if the potential funders had been allowed the opportunity to suggest variant unitary payment options. However, it is clear that the index-linked payment stream effectively meant that it was difficult in this case for banks to offer competitive bids, compared with bond financed solutions available at the time. In future funding competitions, while necessarily fixing the unitary payment for reference purposes, it might be desirable to allow bidders to offer variant payment streams if they were still consistent with the overall risk allocation desired by the public sector. This would avoid the risk of imposing a systematic bias, at the outset of a funding competition, for or against particular forms of finance.
1.32 The bids from the two monoline insurers were very competitive compared to other bids and close to each other. In the final evaluation, Ambac's bid offered the slightly cheaper solution and it was chosen as the monoline insurer. Warburg Dillon Read11 was chosen to act as the bond underwriter. Both of the monoline wrapped bond bids offered much better value for money than the lowest priced bank financed bid (Figure 5).
____________________________________________________________________________________
9 A bond that is insured by a monoline insurer. The fact that the bond is index-linked means that future payments of both interest and the principal will vary according to an agreed price index, in this particular case the retail price index.
10 Cover ratios are used by funders to try and ensure that a project is financially robust and to identify if a project is encountering difficulties. There are many different cover ratios, but at their simplest they are a measure of how much surplus revenue a project will generate over the debt service requirements. A project's cover ratios will be incorporated into the project agreement giving them great importance.
11 Now called UBS Warburg