23. The financing costs are a key element within the pricing of a PFI deal. The rewards for those providing finance, as reflected in the finance costs, should be commensurate with the risks which have borne and successfully managed by the financiers. Information on the comparative financing costs of PFI deals and conventional procurement is, therefore, fundamental to assessing the comparative value for money of these alternative procurement approaches. The financing costs of this PFI deal were £185 million,29 representing 25% of the contract price of £746 million.
24. It was not clear what the cost of funding would have been for a similar project using public finance. If the project had been financed under conventional procurement the Treasury would have provided funds raised at the Government borrowing rate, which is effectively a risk free rate since the lenders know that their money will be repaid. The methodology which the Treasury prescribes for a public sector comparator does not explicitly identify what the public sector borrowing costs would have been. The National Audit Office subsequently estimated that £100 million was a reasonable indication of the additional cost of using private sector finance for this project. This represents the cost associated with transferring risk to the private sector. The calculation assumes the cost of public borrowing would have been 6%. By comparison, Modus has entered into arrangements which fix the interest rates on their bank loans between 7.6 and 8.1% for either 25 or 27 years. In addition, when the deal was closed, Modus was forecasting that the rate of return for its equity investors would be about 20%. Modus told us this rate of return to equity investors was normal for deals concluded at that time.30
25. Whatever the benefits may be of using the PFI approach, it certainly brings the disbenefits of a higher cost of finance than in conventional public projects. There is an important issue as to whether the benefits of the PFI approach could have been obtained using cheaper public finance. Modus said that, if one could maintain the disciplines that are generated through the PFI process, then where the finance comes from would not make a difference to contractors.
26. Simply substituting public finance for private finance might not get round the problem. Modus, for example, thought that separating the capital and ownership from the rest of the project might weaken the links with risk and reward. MOD doubted too that a contract could be devised which transferred the building risks to the contractor in the same way as a PFI deal, but with financing risks being borne in a different way. In the MOD Building deal, MOD considered there was risk transfer as the bank loans are not guaranteed by the Government. The Treasury told us that this risk transfer explains why the market charges Modus a higher rate for loans than it charges the Government. The Treasury would not permit the Government to lend money to private sector firms at the same rate as the Government was able to borrow, since there would be risks that the money would not be repaid if the contractor encountered difficulties.
27. Nevertheless, there is room for doubt as to the extent of real project risk borne by the banks or bondholders who currently finance PFI projects, and there is evidence that even where risks are low external financiers charge a premium for project-specific lending as opposed to general government borrowing. These considerations suggest that it would be worth exploring the scope for improving the established financing model for these deals.31
28. Further, the potential advantages of the PFI approach are said to depend on better risk allocation than conventional projects, better project management, encouragement for innovation and the use of output specifications. There seems no logical reason why these features should depend absolutely on the involvement of private sector financiers, particularly when those financiers are not themselves exposed to the risks of the projects they finance.
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29 Q 109 (footnote). The finance costs are calculated relative to the Treasury discount rate of 6% in real terms when the deal was closed.
30 C&AG's Report, Figure 8, p 22; Ev 21-22, paras 1-8; Qq 104-119, 137-138. The forecast rate of return to Modus's equity investors of 17.6% in real terms reflects their forecast returns on equity and subordinated debt taken together.
31 Qq 186-203, 208-211