16. The Cost of Capital Debate

Critics of public private partnerships regularly point to the lower borrowing costs of government compared with the private sector. Indeed, at 31 May 2008, AAA rated corporate bonds with maturities of 1-5 years offered yields of 8.52% pa. Australian Government 3 year (AAA rated) bond yields were 6.73% and 5 year bond yields were 6.59% pa (RBA 2008) ¹⁹ The spread between state and corporate bond yields is dynamic and moves on a daily basis. However, the average spread for the 11 months to June 2008 is 1.27% pa.

How does the state capitalise its infrastructure investments? As a general rule, the state can finance investment in one of two ways - by applying taxes or by borrowing. If the state is to draw capital from existing consolidated revenue, it will do so at the expense of alternative projects. Investment decisions and priorities are made by the state on policy rather than investment grounds. The state generally prices its capital on its marginal cost of debt or social time preference - the rate that the state estimates is the price that the community will pay to defer immediate consumption. However, governments use different approaches to calculate social time preference or the social discount rate. Campbell and Brown (2003, p. 221) argue that the state can use the marginal cost of state debt with adjustments for diminishing utility, tax distortions and uncertainty, as the case may be.²⁰ These calculations imply the social discount rate will generally be slightly higher or lower than the marginal cost of state debt. However, the role of intergenerational equity and particularly the user-pays principle that is increasingly embedded in the pricing of infrastructure services suggest that the marginal cost of debt is a reasonable proxy for the social discount rate.

The use of the cost of state debt is not a wholly satisfactory approach. If a state funded project is to fail, taxpayers will be called upon to carry the losses in the form of either further state debt or new taxes. That is, taxpayers are indemnifying the state against loss and carry a contingent liability for that investment (Grimsey and Lewis 2004, p. 133). If taxpayers were to apply a risk-adjusted discount rate equal to the shadow cost of equity, it would be significantly higher than the cost of debt (Klein 1997). Brealey, Cooper and Habib (1997) argue that the social discount rate is the expected rate of return for comparable capital market investments. However, the state does not apply this higher discount rate because it sees itself as essentially a risk-free borrower, ie. As a result of taxpayer indemnity, the risk of default is negligible.²¹ The only break in this circular argument lies with an analysis of the risk attaching to the returns from a particular investment rather than the actual cost of capital (Flemming and Mayer 1997; Anderson, Finn and Peterson 1996). Grimsey and Lewis argue that the risks associated with a given undertaking are the same for either private or public investors - the sources of capital and its relative cost has no bearing on how we calculate the project's risk premium.

The risk premium built into a project has two components - systematic risk which is exogenous and outside the control of investors in the market. Examples of systematic risk include change in government, business cycles, interest and exchange rate movements. The investor's main tool for dealing with systematic risk in listed markets is portfolio theory and careful selection of investments based on the return volatility expressed as the beta of particular stocks, sectors or indexes. Systematic risk is recognised in the discount rates used for Partnership Victoria PPP projects (PV 2003). Unsystematic risk describes the idiosyncratic characteristics of a project; it is generally endogenous in nature and will differ between projects. It can be eliminated by diversification and is recognised in the cash flow forecasts for Partnerships Victoria projects. Both forms of risk are recognised in private investment including PPP bids but neither is recognised in state discount rates used for PPPs in the United Kingdom (HM Treasury, The Green Book, 2003).

Why are discount rates important? The PSC is modelled using discounted cash flow analysis and the discount rate is central to the valuation of future cash flows - positive and negative. ²² The cost of capital is one of many components that constitute the PSC and provide the basis for comparing traditional procurement with private bids. It is the entire procurement option that is measured and if the private bid is lower than the PSC, the cost of capital has clearly not a decisive factor. The other value for money drivers have contributed to the lower private bid. There is no evidence to suggest that the cost of capital is a decisive influence in the PPP selection process and if it was, fewer PPPs would be commissioned.

In the United Kingdom, HM Treasury sought to improve PPP value for money performance by creating a credit guarantee fund (CGF). The fund was created by Treasury capital market borrowings and on-lent to successful PPP consortia with the aim of reducing the cost of capital of the project (Standard and Poor's 2004). The loan takes the form of senior debt guaranteed by consortium bankers and significantly, it is structured in such a way that the incentives attaching to the consortium's lenders, contractors and facility managers remains intact. Variations of the CGF are presently being evaluated in Queensland.

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¹⁹ New South Wales Treasury Corporation bond yields were 7.2% (3 years) and 7.04% (5 years) at 31 May 2008 (RBA 2008).

²⁰ See also Campbell and Bond (1997). The authors employ a labour supply incorporating average and marginal tax rates. The model tests the effect on the supply of labour of a 1% increase in marginal tax rates - the changes in tax revenues and deadweight loss are used to estimate the marginal cost of public funds in Australia.

²¹ The risk of default has a low probability. However, the risks associated with state fiscal management are much greater - an adverse revision of a state's credit rating may increase the cost of servicing all state debt and impose significant current and future burdens on taxpayers and public borrowings.

²² In discounted cash flow forecasts, low discount rates operate to increase the value of deferred cash flows whilst high discount rates have the opposite effect.