Extra costs of private sector borrowing: Breakdown of total debt costs-private and estimated public costs and basis for £450 million difference
The private sector's cost of borrowing on senior loans is made up from the addition of the underlying interest rate and the margin charged by its financiers to reflect their perception of the credit risk of the borrower. The blended margin (including fees) of the three Infracos, averaged across their 11 separate finance facilities, is 1.35% a year and the underlying blended interest rate is 5% a year, giving a total cost of finance of6.35% a year.
The total amount of the three Infracos' debt service (interest, fees and principal repayment) over the 30 years is £4.3 billion (using Government's 3.5% real discount rate8) or £9.7 billion, expressed in nominal or money of the day terms.
If the PPP had been funded using public sector finance, raised by way of bonds, then providers of finance will price their bonds not on the risks inherent in the company, but the risk of default by the bond guarantor. In the example given in the National Audit Office (NAO) Report "Were they good deals?" (paragraph 2.36) the NAO considers the reduced cost if the bonds were issued directly by central Government, who attract the highest credit rating; AAA. The underlying interest rate on these bonds is the gilt rate on which no additional margin is paid. So the cost of finance would be cheaper by a combination of the avoided margin and lower interest cost; around 1.6% a year cheaper overall, giving a total cost of finance of4.75% a year.
Funding London Underground's (LU) investment programme in this way (using the Infracos debt profile) would lead to the cost of funds being lower by around £445 million over the life of the PPP (at 3.5% real discount rate) (using the NAO's calculation methodology) ie a total debt service cost of£3.855 billion or an average of£14.8 million per year lower than the cost of debt raised by the private sector. The high level analysis by the NAO estimated a similar discounted sum of£450 million over the 30 years ie a total debt service cost of£3.85 billion at an average of£15 million per year lower.
If the PPP investment programme had been financed using bonds guaranteed by TfL, then the cost of finance would have reflected their lower credit rating, ie AA, which trades at a cost approximately 0.6% a year higher than Government gilts. Therefore, TfL's total cost of finance would be lower than the Infracos by about 1.0% per year and total cost of finance would equal 5.35% per year. Cost of funds would be lower than that achieved by the private sector by a total of£210 million over the 30 years at an average of£7 million per year (at 3.5% real discount rate) ie a total debt service cost of£4.09 billion.
The Department's main objectives for carrying out the PPP were to bring in and incentivise private sector expertise, achieve clear risk transfer, maintain the infrastructure on a whole life basis and all with the support of stable funding. Requiring the private sector to raise its own finance and to have facilities in place to allow it to invest and absorb risk is a fundamental part of meeting those objectives.
Therefore, the Department considers that the key question is whether the higher cost of private sector debt-of which LU were fully aware at the time of the PPP process-is outweighed through the competition, introduction of private sector management skills and incentives to deliver performance that the PPP is designed to achieve. Under the PPP the higher cost of finance will be outweighed if the Infracos deliver the service requirements and cost controls anticipated under the contracts.
It should be noted that any private sector lender that has not been guaranteed by Government will impose a number of disciplines on its borrower, including requiring repeated technical due diligence, sensitivity analysis, reporting requirements, monitoring and control clauses, and regular reviews of performance. These disciplines are an important factor in ensuring that borrowers meet their expected performance levels and deliver the anticipated efficiencies.
Analysis showed that the benefits of the PPP option over a public sector bond option exceeded the £445 million savings available under gilts. However, any bond finance option would have entailed issuance by TfL. Consequently, there is an even stronger case for the PPP compared to TfL issued bonds which would have been £235 million more expensive than gilts, yet without introducing any new incentives or disciplines to improve performance.
To put this key question in context, the NAO calculates in paragraph 2.44 of the "Were they good deals?" Report that the incremental costs of finance would be mitigated if the PPP delivers about one third of the performance benefits anticipated. As another example, the additional cost of finance of the Infracos of £7.0-£14.8 million per year above the Government or TfL alternatives represents around 0.7-1.48% of the year one Infrastructure Service Charge. If those sorts of levels of efficiencies are delivered by the private sector, then the incremental cost of debt will have been outweighed.
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8 3.5% is the current discount rate that changed from 6% in April 2003.