23.2.9.1 Alternatively, either the Authority may elect (for example, for operational reasons)66 not to retender the Project or it may be that there is no Liquid Market, in which case the Authority will instead pay to the Contractor (from its own resources) an assessed value of the amount it would have received through an appropriate retender process (again net of costs) (see Clause 23.2.8 (Retendering Procedure)) that is, if a Liquid Market had existed (the "Estimated Fair Value of the Contract").
23.2.9.2 Estimated Fair Value computations are conducted by forecasting the full Unitary Charge from the date of termination to the expiry of the Contract (ignoring any deductions for performance or availability), from which the estimated costs of delivering the service to the required standard in the output specification (this includes the running costs, lifecycle costs and any rectification costs) are deducted to arrive at the estimated operating cash-flow stream which, had a liquid market existed and the project been re-tendered, a hypothetical bidder would have valued to determine the amount to bid for the project.
23.2.9.3 The first point to consider in making this computation is whether this computation should be conducted in nominal terms (i.e. using current prices) or in real terms (i.e. using constant prices). For contracts with 100% indexation to RPI, it should not normally matter since both methods would return the identical result. However, it is easier and safer to conduct the analysis in nominal terms because:
(a) many elements of a Project (including tax and cost of funds) are always quoted in nominal terms, and it is easy to make errors by ignoring this when conducting 'real' computations, and
(b) the majority of PFI/PF2 Contracts let in the market are partially indexed. For such contracts, the "real" value of the Unitary Charge effectively declines with time. The effect of indexation must therefore be recognised by explicitly including the indexation effects and conducting the analysis in nominal terms.
23.2.9.4 The calculation must also take care to ensure that if the forecast cash flows are expressed in nominal terms (i.e. taking indexation into account), the discount rate used must also be expressed in nominal terms. The discount rate is usually made up of a 'real' rate of return, on top of which an allowance for inflation is added. A methodology for making this adjustment is set out in the drafting below.
23.2.9.5 The Authority and the Contractor will need to agree a forecast rate of inflation to be applied to the indexation formula to make the nominal computations. It is recommended that the agreed assumed rate of inflation should be an easily observable and transparent figure.
23.2.9.6 The next question is whether the Estimated Fair Value analysis should be conducted in pre-or post-tax terms. It is considerably easier and more transparent to conduct the analysis in pre-tax terms because this avoids protracted scrutiny of the assumptions underlying the tax forecasts. Since neither the public sector nor the private sector is actually going to be paying taxes going forwards, it is not necessary to assess taxation in the calculation. Moreover, the risk of changing tax regimes between financial close and termination date lies squarely with the private sector, and this should not be made an occasion to revisit that risk transfer. The analysis should therefore be conducted in pre-tax terms.
23.2.9.7 The forecast cash-flows should be discounted at a discount rate which reflects the risk of the underlying cash-flow. The most transparent measure of the risk of the cashflows is the real pre-tax project IRR reflected in the Base Case. However, since underlying rates in the market such as the real yields on Government Gilts or the London Interbank Offered Rate (LIBOR) can and do vary over time, the Authority must consider carefully whether, in setting a discount rate for the Estimated Fair Value calculation, it should acknowledge the effect of changes to these underlying variables.
23.2.9.8 The main argument in favour of giving effect in the discount rate to changes in underlying risk-free rates is that if a liquid market existed and the Contract were successfully re-tendered, a hypothetical bidder would take into account current market yields on risk-free investments in choosing what discount rate to apply to the Project. If these benchmark rates had moved upwards, for instance, in the time between Financial Close and Date of Termination, an incoming bidder would bid a lower sum for the Project and vice versa. Not recognising this difference could create a discrepancy between the compensation sums arising out of the Retendering procedure and the No Retendering procedure. Therefore an adjustment should be made as set out in the drafting below to reflect the impact on the Estimated Fair Value discount rate of changes to underlying market rates.
23.2.9.9 The adjustment set out below provides the Contractor with a natural hedge against movements in underlying market rates that may cause losses or profits on broken interest rate hedges on Termination. If interest rates move down between Financial Close and Termination Date, the Contractor would find itself having to pay positive breakage costs on the interest rate swap (if one was put in place at Financial Close). Adjusting the Estimate Fair Value discount rate downwards in line with market rate movement would have the effect of generating a larger compensation sum, thereby partially or fully protecting the Contractor against the adverse position on its interest rate swap. Upwards movements in interest rates would likewise have the opposite effect, generating profits on the broken hedge but a smaller compensation sum from the Authority.
23.2.9.10 From the point of view of Authorities, it is also beneficial to have adjustments as set out below to the discount rate because, just as the adjustment provides the Contractor with a natural hedge against breakage costs, it provides Authorities with a natural hedge against the cost of funding compensation payments. To illustrate, an upward movement in interest rates would make it more expensive for Authorities to finance a given compensation payment, but the proposed mechanism would adjust the discount rate upward in line with market movement and reduce the amount of compensation to be paid, thereby partly protecting the Authority's position. A downward movement in market rates would have the opposite effect.
23.2.9.11 Any dispute as to the assessed value of the terminated Contract should be dealt with through the dispute resolution procedure (see Section 34 (Dispute Resolution)).
Required drafting (including definitions) is as follows:
"Adjusted Estimated Fair Value of the Contract"
means the Estimated Fair Value of the Contract, less an amount equal to the aggregate of:
(a) where relevant any Post Termination Service Amounts67 paid to the Contractor (if a positive number); 68
(b) the Tender Costs; and
(c) amounts that the Authority is entitled to set off or deduct under Clause 22 (Set-Off and VAT),
plus an amount equal to the aggregate of:
(i) all credit balances on any bank accounts held by or on behalf of the Contractor on the date that the Estimated Fair Value of the Contract is calculated;
(ii) any insurance proceeds and other amounts owing to the Contractor (and which the Contractor is entitled to retain), to the extent not included in (i); and
(iii) the Post Termination Service Amounts (if a negative number) ,69
to the extent that:
(A) (i), (ii) and (iii) have not been directly taken into account in calculating the Estimated Fair Value of the Contract; and
(B) the Authority has received such amounts in accordance with the Contract or such amounts are standing to the credit of the Joint Insurance Account.
means an agreement on the same terms and conditions as this Contract, as at the Termination Date, but with the following amendments:
(a) if this Contract is terminated prior to the Service Commencement Date, then the Service Commencement Date and/or Planned Handover Date shall be extended by a period to allow a New Contractor70 to achieve Service Commencement and/or Handover;
(b) any accrued [performance points] and/or warning notices shall, for the purposes of termination only, and without prejudice to the rights of the Authority to make financial deductions, be cancelled; and
(c) the term of such agreement shall be for a period equal to the term from the Termination Date71to the Expiry Date.
"Estimated Fair Value of the Contract"
means the amount determined in accordance with Clause 23.2.9 (No Retendering Procedure) that a third party would pay to the Authority as the market value of the Deemed New Contract.
"Termination Date Discount Rate"
means a discount rate expressed as [(1+ real base case project IRR + Gilt B - Gilt A)* (1+ i) - 1]
where:
"real base case project IRR" is the real pre-tax Project IRR as set out in the Base Case;72
"i" is the agreed assumed forecast rate of increase in the [here specify the actual index e.g. RPIX] set out in the Base Case for the remaining term of the Contract;
"Gilt A" is the real yield to maturity as at Financial Close on a benchmark government Gilt instrument of the same maturity as the average life as determined from the Base Case as at Financial Close of the Senior Debt; and
"Gilt B" is the real yield to maturity as at the Termination Date on a benchmark government Gilt instrument of the same maturity as the average life as determined from the Base Case as at the date of Termination of the Senior Debt outstanding on that date.
23.2.9 No Retendering Procedure
If either the Authority is not entitled to retender the provision of the Project under Clause 23.2.7 (Retendering election) or the Authority elects to require an expert determination in accordance with this Clause 23.2.9 (No Retendering Procedure) then the following procedure shall apply.
(a) Subject to paragraph (b) below, the Contractor shall not be entitled to receive any Post Termination Service Amount.
(b) If the Authority elects to require an expert determination in accordance with this Clause 23.2.9 (No Retendering Procedure) after it has elected to follow the procedure under Clause 23.2.8 (Retendering Procedure), then the Authority shall continue to pay to the Contractor each Post Termination Service Amount until the Compensation Date, in accordance with Clause 23.2.8 (Retendering Procedure).
(c) In agreeing or determining the Estimated Fair Value of the Contract the parties shall be obliged to follow the principles set out below:
(i) all forecast amounts should be calculated in nominal terms at current prices, and:
(A) for Unitary Charge payment using the indexation formula in Clause 19.11 (Indexation) for indexation in respect of forecast inflation between the date of calculation and the forecast payment date(s) as set out in the Contract; and using the agreed assumed forecast rate of increase in the index [here specify the actual index, e.g. RPIX] (as set out in the Base Case) in applying the formula;
(B) for third party income and for costs, if indexation is appropriate and the appropriate index is the same as is used for the Unitary Charge, the index and the same assumed forecast rates of increase for that index should be used as set out in the Base Case for the Unitary Charge; and
(C) for third party income and costs, if indexation is appropriate but the appropriate index is not the same as for the Unitary Charge the parties shall, subject to the resolving of any disagreement pursuant to clause 23.2.9(d), agree and index for any particular third party income or costs and reasonable forecast rates of increase;
(ii) the total of all future payments of the full Unitary Charge (without deductions) [and any amount to be paid by the Authority under Section 21 (Capital Contributions) forecast to be made shall be calculated and discounted to the Termination Date at the Termination Date Discount Rate;
(iii) the total of all third party income to be received to the Expiry Date (less a reasonable amount to cover bad debts) shall be calculated and discounted to the Termination Date at the Termination Date Discount Rate and added to the payment calculated pursuant to Clause 23.2.9(c)(iii) (No Retendering Procedure);
(iv) the total of all costs forecast to be incurred by the Authority as a result of termination shall be calculated and discounted at the Termination Date Discount Rate and deducted from the payment calculated pursuant to sub-paragraph (ii) above, such costs to include (without double counting):
(A) a reasonable risk assessment of any cost overruns that will arise,73whether or not forecast in the relevant base case;
(B) the costs of the Service forecast to be incurred by the Authority in providing the Project to the standard required,74 and
(C) any rectification costs required to deliver the Project to the standard required (including any costs forecast to be incurred by the Authority to complete construction or development work and additional operating costs required to restore operating services standards),
in each case such costs to be forecast at a level that will deliver the full Unitary Charge referred to in paragraph (ii) above.
(d) If the parties cannot agree on the Adjusted Estimated Fair Value of the Contract on or before the date falling [30] days after the date on which the Authority elected to require an expert determination in accordance with this Clause 23.2.9 (No Retendering Procedure), then the Adjusted Estimated Fair Value of the Contract shall be determined in accordance with Clause 34.2 (Dispute Resolution).
(e) Subject to Clause 24.5 (Method of Payment) the Authority shall pay to the Contractor an amount equal to the Adjusted Estimated Fair Value less an amount equal to the Lifecycle Surplus as at the Termination Date of the Contract on the date falling 60 days after the date on which the Adjusted Estimated Fair Value of the Contract has been agreed or determined in accordance with this Clause 23.2.9 (No Retendering Procedure).
(f) The discharge by the Authority of its obligation in paragraph (e) is in full and final settlement of all the Contractor's claims and rights against the Authority for breaches and/or termination of this Contract or other Project Document75 whether in contract, tort, restitution or otherwise save for any liability that arose prior to the Termination Date (but not from the termination itself) that has not been taken into account in determining the Adjusted Estimated Fair Value of the Contract.
(g) To the extent that the Adjusted Estimated Fair Value of the Contract, less an amount equal to the Lifecycle Surplus as at the Termination Date, is less than zero, then an amount equal to the Adjusted Estimated Fair Value of the Contract, less an amount equal to the Lifecycle Surplus as at the Termination Date, shall be due and payable by the Contractor to the Authority on the Compensation Date.76
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66 There will, in any event (even if a Liquid Market exists), clearly be circumstances in which an Authority will not wish to retender the Project on the original terms - for instance, where its service requirements have radically changed or where the time to retender will give rise to safety or other policy concerns that cannot be addressed adequately in the context of a retender.
67 There will only be any Post Termination Service Amounts here to the extent that the Authority starts the retendering process, but then decides to follow the no retendering approach.
68 These amounts are not deducted to the extent paragraph (c) of the definition of "New contract" is a period from the date of the New Contract to the original Expiry Date (rather than the Termination Date to the original Expiry Date).
69 See footnote 67 above.
70 That is, time to complete is given if termination occurs prior to Service Commencement. Other timing related issues may require a similar treatment depending on the Contract.
71 The Termination Date here is the relevant date as no New Contract is actually being entered into.
72 Parties should not agree a discount rate other than this (this is the discount rate contained in the Base Case (see Clause 28 (Refinancing) for definition).
73 A methodology can be agreed in advance for agreeing what constitutes a reasonable risk assessment.
74 This includes both the every day running of the Hard FM Service and lifecycle maintenance costs. Forecasts by agreement or, in the event of dispute, by an expert.
75 See footnote 68 above.
76 See footnote 65 above.