A.22 A number of respondents suggested alternative approaches to debt finance to address the issue of the increasing cost of debt arising from current market conditions and regulatory requirements of Basel III. These included proposals to access capital markets debt finance although it was generally considered that this would require credit enhancement of the senior debt or separation of the construction and operational phases of the project.
A.23 A number of the respondents highlighted the potential benefits of separating out the construction phase from the operational phase. The primary benefit of this approach would be to reduce the cost of debt finance. It was suggested that banks could provide short term debt to finance the construction period which would allow them to provide lower debt margins as their cost of funding would be lower for shorter term debt. Post construction the debt could be refinanced by institutional investors who would then not be exposed to construction risk and, therefore, expected to price debt competitively. Consequently the cost of debt would be expected to be lower when compared to the current pricing of long term bank debt. However, it was noted that separation of the construction and operational phases of the project could give rise to a number of issues, these included:
• refinancing risk - how future finance and pricing could be committed at the time of financial close;
• due diligence - bank due diligence would be focussed on the construction phase only. Bond investors would also need to undertake due diligence so could result in duplication of costs;
• changes to financing contracts - to take into account moving from a loan to a bond product;
• warranty provisions - Bond investors during the operational phase would require certain protections against problems stemming from the construction phase; and
• some respondents suggested that a portfolio approach to the refinancing of operational projects could yield pricing benefits.
A.24 Most respondents viewed that the public sector should take refinancing risk citing an increase in the price of equity premiums if the private sector was required to take this risk. However, respondents understood that it is difficult to disaggregate the impact of performance risk from market rate risk.
A.25 The majority of respondents did not consider preferred bidder debt funding competitions as being effective, although it was noted that they can yield small price benefits in certain situations. The reasons for this included increased procurement costs, delays to financial close, lack of funder engagement at the bid development phase, the potential for renegotiations of the contract terms post preferred bidder and stifling funder innovation since it is perceived that more credit is given to tried and tested bank debt solutions.
A.26 A number of respondents expressed views that including full indexation (or an inflation floor and cap) of the unitary charge in the payment mechanism could help to attract pension funds and institutional investors. Other respondents preferred that only a proportion of the unitary charge should be linked to inflation to provide a natural hedge against inflation linked and non-inflation linked components of operational and finance costs.
A.27 It was recognised that the provision of long term interest rate swaps can reduce flexibility due to the potential for additional costs known as 'breakage costs' which are borne by the public sector if projects are terminated early. Respondents suggested that a partial interest rate hedging strategy, rolling programme of shorter interest rate swaps or break points could be used to minimise costs. However, central or local government would be required to take the risk of movements in interest rates on unhedged debt.