18 We found that as a result of the credit crisis, the total interest cost of bank finance increased by one-fifth to one-third. In the 35 projects agreed after the establishment of The Infrastructure Finance Unit, we found that the part of the cost relating to loan margins on PFI deals, which had been 1 per cent or less, widened significantly to around 2.5 per cent on average (Figure 4). Some, for example, the complex Greater Manchester Waste project, will rise to more than 3 per cent in stages over the project life. The increased loan margins resulted in substantial increases to the cost of finance (Figure 4).
19 These increases occurred despite the fall in short-term borrowing rates and little change in the intrinsic risk profile of projects. The fall in the underlying short-term bank lending rate (the base rate) to 0.5 per cent only had a slight impact on PFI deals. This is because the private sector fixes the interest cost on their long-term PFI borrowings. This fixed interest rate, currently around 4 per cent, reflects the risk of future changes in interest rates and is a market factor that is not specific to PFI.
20 In line with policy on acting to stimulate the economy, the Treasury gave priority to closing deals at the prevailing market rates, even if this meant paying more and banks carrying less risk. In addition to charging higher margins, the banks have sought to de-risk their lending to projects following the credit crisis. They renegotiated their lending terms with preferred bidders, through: lowering the proportion of debt in projects; increasing cover ratios (see Glossary); requiring the private sector to inject risk capital earlier; and placing more onerous conditions on when the private investors can withdraw cash from the project.
Figure 4 Comparison of interest costs on PFI projects
NOTES 1 The indicative level of project risk shown above illustrates the fact that the projects are not directly comparable. The change in interest margin percentages partly reflects this. 2 The Future Strategic Tanker Aircraft (FSTA) project raised funding of £2.5 billion. Greater Manchester Waste (GMW) borrowed £582 million. 3 The increase post crisis will rise with stepped increases in the interest rate margin if refinancing (see Glossary) does not take place. Source: KPMG and National Audit Office | ||||||||||||||||||||||||||||||||||||||||||
21 Our analysis shows that the higher financing costs increased the annual charge of typical PFI projects by 6 to 7 per cent (Appendix Two). Riskier PFI projects experienced a larger increase. For example, we estimate that the increase in the financing charges of the Greater Manchester Waste project added 12 per cent to its annual contract price (Figure 11 on page 25). To address this, in October 2008 the Treasury increased the public sector share of any future reductions in debt costs from 50 per cent to 70 per cent.
22 We estimate that between £500 million and £1 billion of higher cost has been locked in, partly offset by the increased public sector share of refinancing gains. The higher end of this range reflects the difference between current PFI bank rates and low rates prior to the credit crisis. Although departments can now press investors to refinance, any refinancing requires careful judgement and will depend on future market conditions. We doubt whether more than half of the current higher financing costs might be recovered.
23 Higher financing costs eroded the value for money advantage that departments attribute to PFI. Departments initially seek assurance on the value for money of PFI procurement by comparing alternative ways of providing the same results. Although we have often expressed concern about these calculations, the typical estimate of the PFI cost advantage lay in the range of 5 to 10 per cent (and some cases we have audited showed smaller savings). We estimate that financing rate changes increased the annual contract charge by around 6 to 7 per cent. This finding suggests an increased risk to value for money resulting from the credit crisis. Given the Government's policy objectives for stimulating the economy, we accept, however, that delays from resubmission of individual business cases might have put the policy at risk.
24 Although the Treasury and departments took steps to assess the impact on the value for money of projects, there were limitations to their assessment. Despite the higher financing costs the Treasury and departments considered that all 35 contracts let in 2009 continued to represent value for money. The Treasury relied on the normal review processes for PFI projects and a review by Partnerships UK of the expected effect of higher bank risk margins on a sample of projects. There were, however, limitations to this approach, as:
• although the Partnerships UK review, commissioned by the Treasury, was useful analysis, it did not cover all projects let or all aspects of financing costs. In addition, the Treasury monitored actual financing terms, but did not have a full analysis of the impact of the higher rates on the cost of projects that closed in 2009;
• some schools projects did not fully reassess their business cases, using out of date guidance which had said an updated quantitative analysis was only necessary if costs increased by 25 per cent; and
• the value for money assessments for the M25 and Greater Manchester Waste projects continued to rely on assumptions, from earlier business cases, that high savings in future whole life costs would not be available under conventional procurement.