63. Note that the allocation of risk to the private sector in order to confer optimal incentives to control costs, to maintain service delivery and to improve outcomes will usually involve the private sector raising finance at rates in excess of the public sector's costs of capital. This is generally unavoidable. The benefits of better management arise precisely from the transfer of risk to private managers: the contract puts their capital at risk throughout the length of the contract, and thereby gives them an incentive not only to control costs but also to maintain service quality. These incentives are weakened to the extent that the public sector retains financial risk.
64. Consider, for example, a proposal that involves sale of a property portfolio to a private contractor, who then contracts to provide office services to the public sector using the assets. An apparent saving may be secured by allowing the initial transfer of the ownership of the assets to go through for a peppercorn payment in return for a reduction in the unitary fee charged for provision of the office services. Such an arrangement involves an implicit loan of the value of the properties to be repaid over the course of the service contract. The arrangement may appear attractive to both parties because the contractor's cost of funds may exceed by a significant margin the Treasury Discount Rate. However, in such a case it is important to appraise:
∙ The implicit risk that remains in the public sector as a consequence (e.g. the default risk on the implicit loan should the contractor sell assets and then fail, or should the public sector charge on the assets prove inadequate);
∙ The fact that the private contractor's incentive to deliver good service is weakened precisely to the extent that they have effectively received payment in advance.
65. Proposals to transfer assets to the private sector for a nominal sum must be subjected to an investment appraisal to demonstrate that the terms offered represent value for money to MOD.