3.6 The new OGC guidance requires new contracts to provide for refinancing gains on qualifying refinancings to be shared 50/50, except in those cases where, at the time of the refinancing, a contractor is projecting a shortfall in returns over the life of the contract compared to expectations at contract letting. In such cases, sharing only applies to those gains that would result in the contractor earning more than the previously expected rate of return. The guidance gives the public sector audit rights over the computation of the refinancing gains.
3.7 The whole subject of measuring refinancing gains, and the impact that sharing refinancing gains may have on the value for money of deals, is complex and will require careful supervision and audit. Risks to be managed include:
■ As with the voluntary code for existing deals, there is a risk of disagreement over how the gains to be shared will be computed. The choice of discount rate to be applied to the private sector cash flows is a key issue. The OGC has issued an application note setting out the most appropriate discount rate to be used.15 But this approach has yet to be widely endorsed by the private sector and it remains an area of concern to them. PUK notes, however, that the OGC's recommended approach on the discount rate has already been used on at least one recent refinancing. In addition, there are uncertainties, within both the public and private sectors, in respect of the effect that proposed changes to the discount rate used to evaluate government investment projects16 might have on the calculation of refinancing gains.
■ Contractors may seek a price increase to offset the contractual obligation to forgo 50 per cent of future refinancing gains.17 PUK says that it has seen examples of contractors seeking such price increases where the requirement to share 50 per cent has been introduced after the issue of the Invitation to Negotiate. Public sector project teams have often successfully resisted the proposed price increase but in some cases have had to make alternative concessions. Project teams will need to ensure that any price increases or other concessions do not more than offset the public sector's share of any refinancing benefit. PUK also notes that contractors have often claimed that their bid price has been reduced to reflect the benefits of future refinancings, but this is inevitably difficult to demonstrate and has generally been rejected by projects teams as ground for not sharing refinancing gains.
■ When bidding for contracts, contractors might submit financial models that show a higher rate of return than they actually expect to earn (the price could be kept competitive by reducing the disclosed level of expected costs when bidding). Then, if they fall short of the model rate, they will be entitled to keep some of the refinancing gains before sharing the rest 50/50. Even if the rate of return quoted when bidding is reasonable, it could reduce the incentive for the contractor to perform well if shortfalls in profits can be made good from a priority claim on refinancing gains. The OGC and PUK consider that there is a low probability of this risk materialising. They consider that financiers' checks before contract letting and the effects of competition should identify unrealistic forecasts and that underperformance by the contractor after contract letting is likely to reduce opportunities for refinancing.
■ The gain will be calculated at the time of the refinancing, based on the contractor's models of "projected returns" before and after the refinancing. If the refinancing is then transacted in some way that actually produces a different benefit than the one projected, it might be difficult for a department to detect this and seek a retrospective adjustment to its share of the refinancing gain. The OGC notes that the new arrangements give departments the right to seek an adjustment if a different refinancing from the one originally notified by the contractor is implemented. However, there will be no adjustment if the benefits from the notified refinancing ultimately prove to be better or worse than those projected at the time of the refinancing.
3.8 The OGC has told us that great effort will be put into managing these risks. This will be achieved through further advice to project teams and monitoring by the OGC (including, where appropriate, as part of its Gateway Reviews), PUK and Treasury expenditure teams.
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15 See paragraph 1.26 and footnote 7, page 10. The OGC's application note states that the most appropriate discount rate to use is the original base case equity internal rate of return (the rate investors expected to earn from capital invested in the project).
16 As set out in the HM Treasury consultation draft "Appraisal and Evaluation in Central Government" July 2002.
17 The PAC noted in its report on the Fazakerley prison refinancing (paragraph 6 (xvii)) that, where benefits are unexpected windfall gains, this should not have affected the pricing of a contract.