3.5.4 Inflation risk

Inflation risk is the risk that inflation will be greater, or less than expected with a resultant impact on the real value of the relevant costs/revenues of the Private Sector party.  Whilst in the context of the Australian economy the Reserve Bank usually forecasts to maintain inflation within a 2-3 per cent range inflation forecasts can sometimes indicate a higher rate is expected and in terms of the specific inflationary pressures affecting construction and engineering projects, there is often a considerable divergence between CPI and other cost indexes such as LPI and BPI.

Most PPP contracts are based on payment structures linked to an index, typically CPI, though other indices, or combinations may be utilised.  At face value increases or decreases in that index are funded by the public sector.  However, where the underlying costs within the private sector cost structure move out of line with the index used to adjust the payments then the private sector is exposed to risk.  For example, if the payment is indexed at CPI, which is say 4 per cent, but the underlying costs of labour and/or life-cycle maintenance is subject to inflation of 6 per cent, then real returns for the private sector will be eroded.

One could argue that the private sector is protected through benchmarking, or market testing provisions, whereby, typically, Soft Services are tested at intervals of five to seven years, at which point the underlying price of delivering a service is adjusted to align to prevailing market rates.  However, even where services are benchmarked, a degree of risk remains with the private sector.  That is, services are typically not benchmarked more frequently than at five to seven year intervals, and costs are typically only adjusted when they move beyond a threshold rate of increase above CPI - for example 10 per cent.  For this reason, a material degree of cost exposure often remains with the private sector.  In addition, there are normally material levels of costs not subject to benchmarking arrangements, in particular life-cycle costs.

Financing also has a significant impact on the degree of inflation risk transfer in a PPP.  For example, many PPP projects have been financed with CPI linked bonds.  Other PPP projects have been financed using fixed rate bank debt.  Fixed rate bank debt includes the market's expectations on long-term inflation and also, importantly, a pricing premium for taking this Systematic Risk.  Therefore, a fixed rate bank debt funded PPP involves a greater transfer of Systematic Risk than a CPI linked bond financed PPP.  This is addressed in Appendix A.

(a) Assessing Relative Importance

To assist practitioners to evaluate the potential effects of inflation risk to assess the relative importance (significance) and its impact on the cash flow of the project, it may be necessary to consider what is the percentage of total costs that may be impacted by inflation, excluding depreciation and amortisation (i.e. cash costs).  It is essential in assessing these factors that all costs subject to inflationary pressure are considered, including:

•  construction and engineering costs;

•  wages and salaries costs; and

•  life-cycle maintenance and building management costs.

A possible quantitative measure of relative importance of inflation risk is provided in the following table (the decision criteria and percentages in the table are indicative only and practitioners will need to apply a degree of judgement to adapt these to the specific project):

If > 70% of total operating costs are operating cash costs	Inflation risk is HIGH
If > 30% and < 70% of total operating costs are operating cash costs	Inflation risk is MEDIUM
If < 30% of total operating costs are operating cash costs	Inflation risk is LOW

(Note - Operating cash costs include wages, overheads, maintenance etc but excludes depreciation & amortisation, or debt service payments)

To complete Table 3 where:

•  Risk is HIGH then place a 5 in the Weighting column (Column 1)

•  Risk is MEDIUM then place a 2.5 in the Weighting column (Column 1)

•  Risk is LOW then place a 1 in the Weighting Column (Column 1)

It would be unlikely to expect that inflation risk would ever be assessed as High.

(b) Assessing Allocation

Having determined the potential importance of inflation on the project, the next stage is to consider how inflation risk is allocated.

Ultimately who bears inflation risk will depend upon whether or not the price variations can be passed onto the Public Sector (or users).

To assist practitioners to evaluate the potential effects of allocation of inflation risk, in order to assess its impact on the cash flow of the project and the party bearing the risk, the following comments are provided:

•  If the PPP payment is fixed the risk is borne by the operator.

•  If the PPP payment varies with a general inflation or specific indices to reflect likely costs of the operator then the pricing risk is likely to be shared.

Under most PPP arrangements the construction price is a fixed element and any unanticipated inflationary pressure is borne by the private sector.  While this risk essentially resides in the short-term of the overall PPP arrangement it is, nevertheless, a potentially significant risk.

In long-term projects, a certain base level of inflation is likely to be assumed.  An alternative way to think of inflation risk is to consider who bears the risk of inflation above or below the assumed base amount.

In assessing this risk it is necessary to consider which party bears the risk and the extent to which a party will be exposed if the actual inflation applied to the underlying cash flows differs to that at which the Service Fee varies.