2.12 In most cases, departments will transfer the risk of future movements in interest rates after contract letting to the private sector. When pricing the contract, the private sector therefore builds into its bid the expected cost of financing the project based on the market's pricing at that time of what future interest rates will be. On signing the contract, the project company will, in most circumstances, then choose to mitigate interest rate risk by locking into a fixed rate of interest for the full term of the funding. This gives it assurance about what its future financing costs will be over the life of the contract so it can be sure that there will be sufficient revenue from the contract to meet these costs. It also relieves the department from concerns that the consortium may seek to pass on costs from rising interest rates even though this is a risk the consortium should bear.
2.13 Alternatively, the project company may, in exceptional circumstances, opt to leave itself exposed to future movements in interest rates so long as the procuring department does not perceive that this would put the company's viability in doubt should interest rates move upwards. If, over the life of the contract interest rates prove to be lower than the private sector had expected when it priced its bid, then its financing costs will also be lower than envisaged leading to higher profits and higher dividends for shareholders. Conversely, however, should interest rates prove to be higher than expected, then the returns to shareholders will be depleted and the project company may even become insolvent.
2.14 In the Fazakerley prison project, FPSL found it difficult to fix the interest rate for the full period of its bank loans on competitive terms because the financing market for PFI deals was in its early stages. FPSL therefore decided to lock into a fixed rate of interest only for the first ten years of its bank loan to 2005. This left the company potentially exposed to adverse movements in interest rates for the remaining ten years of the loan, unless it was able to pass this cost back to the Service through variations in the unitary charge.14 At the time of the refinancing, two things had changed in favour of the company from which the shareholders have been able to derive a significant benefit. They are that:
■ the market's pricing of future interest rates for the remaining term of the loan is lower than that assumed at the time the contract was originally priced; and
■ the market in interest rate hedging instruments for longer periods has become more competitive. The benefit to the shareholders of being able, therefore, to lock into lower interest rates for the remaining term of the original loan is £2.6 million in present value terms.15
2.15 Having left itself open to changes in interest rate movements after 2005, the movement in the market's pricing of future interest rates has worked in FPSL's favour. If the consortium had been able to, and had chosen to, fix its rate of borrowing on competitive terms for the later years of the loans at the start of the contract, the potential for it now to profit from a fall in interest rates would have been reduced or eliminated. This is because the costs of unwinding an existing fixed rate arrangement would normally equate to the benefits of entering into any new arrangement when interest rates change. Although in late 1995, it was generally more difficult and expensive to fix interest rates for longer than ten years because the PFI financing market was not fully developed, the financing arrangements for the Bridgend PFI prison project, which was developed in parallel with Fazakerley prison, did, nevertheless, include fixed interest rates for the full 18 years of the senior debt loan which matures in 2013.16
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14 Although the Prison Service and its legal advisers Freshfields consider FPSL would bear this risk, in our view the PFI contract was ambiguous about this (see paragraph 3.5).
15 FPSL actually chose to fix the interest rate for the full term of the new 26 year loan as part of the refinancing. It is uncertain whether FPSL required the Prison Service's consent for this. The banks were, however, willing to allow FPSL to fix the interest rate for the remaining term of the original 20 year facility without the need for consent.
16 See the National Audit Office report, "The PFI contracts for Bridgend and Fazakerley Prisons" Figure 7, page 42 (HC253 1997-98)