19.11.3.1 The Contractor will be concerned to protect itself against its costs inflating over the course of the Contract, rendering the Unitary Charge insufficient to meet its operating costs and financing obligations. The payment mechanism should therefore usually include arrangements for indexing the Unitary Charge to this extent. If there is no indexation mechanism, the Contractor is likely to have to build a contingency into its price to cover operating-cost inflation risk and this is unlikely to give the Authority value for money (as the risk is outside the control of the Contractor and, historically, has been difficult to forecast accurately). It is highly unusual for prices to be fixed (i.e. without indexation) throughout the term of any Contract for periods for which PF2 Contracts are typically let. Conversely, it is not usual for the whole Unitary Charge to be indexed, and such "over-indexation" should not be used as a method of artificially reducing the initial Unitary Charge.
19.11.3.2 The Authority should focus on the appropriate method of applying indexation to the payment stream at an early stage in Project development. By the time an ITPD is issued, the Contract should specify the index to be applied and how it applies, however, Authorities should leave the percentage of the Unitary Charge to be indexed to the bidder such that it can be set at a level appropriate to provide a natural hedge against movements in inflation indeces.27 Authorities should not leave the choice of indices to the bidders, given the difficulties in comparing one bidder's price and value for money with that of another bidder where different bidders use different indices. While bidders are free to include proposals with index linked funding (where the finance provider requires index linked cash flows) any index linked funding proposition should be cleared with HMT.
19.11.3.3 In most cases value for money can be achieved through indexation of a proportion of the Unitary Charge which matches the proportion of total costs represented by any elements of the Contractor's underlying costs which are not fixed, using a general price index such as RPI or RPIX.
19.11.3.4 On certain projects, the use of a more focussed index such as a construction index for construction prices, a facilities management index, or a weighted basket of indices, may be preferable. In these cases, the Authority should take care with index selection. Choosing an index that may be short lived, or is not independently produced, is not a sensible approach. It is also not appropriate to have too narrow a focus on a particular industry or sector, as in specific sectors (such as the defence industry), Contractors or their Affiliates are themselves responsible to a significant extent for inflationary costs (that is, they can actually affect the index by increasing their price).28 Required drafting for indexation is as follows:
19.11 Indexation
Reference to amounts expressed to be "indexed" are references to such amounts multiplied by:
Index1
----------
Index2
Where
Index1 is the value of the index or indices selected most recently published prior to the relevant calculation date.
Index2 is the value of the same index or indices published X periods prior to Index1, where X is the period over which the indexation is to be applied.
19.11.3.5 Whilst choosing an index and weighting that reflect the underlying cost exposure of the Contractor has the effect of reducing its cost risk, amended forms of such indexation formulae can incentivise real cost savings over the life of the Contract.
19.11.3.6 For more detailed guidance in this area, please see HMT Supplementary Financing Guidance - Interest-Rate and Inflation Risks in PFI Contracts.
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27 It is open to the Authority, however, in the interests of value for money, to invite bidders to propose alternative indices, provided the choice of such alternates is supported in the bid with appropriate Models demonstrating their financial impact.
28 One such amended indexation formula of X x (1+ RPI ± y) could be used by the Authority in its ITPD, with bidders required to bid values of X and Y. Where future cost reductions are reasonably foreseeable and not reflected in the initial Unitary Charge these can be reflected in the value of Y. The bidder can propose the value of X reflecting the percentage of any elements in its cost structure that are not fixed. The variable X will therefore be a number between 0 and 1.