ࡱ> 352Y :&bjbjWW .2==:"]""""" ."NNNNNNNNXZZZZZZ$I=~NNNNN~NNNNFNNX""NXrXXNB z6""RXThe following are the comments by Partnerships UK, on the paper The Fundamental Flaw in PFI?: The Implications of Inappropriate Indexation of the Element of the Unitary Charge Covering Capital Finance Costs, by Jim Cuthbert. Comments by Partnerships UK:- Issues raised by the paper The papers reasoning can be summarised as follows: (1) Unitary Charges paid by an Authority under a PFI contract increase over time in line with general inflation. (2) The payments made by a PFI contractor to its lenders decrease over time. (3) In consequence of (1) and (2), a PFI contractor has a steadily increasing net cash-flow available to pay returns to it shareholders/equity. (4) The steadily increasing returns on equity in (3) are both: (i) excessive; and (ii) understated because Authorities use Internal Rates of Return (IRRs) in the evaluation of PFI projects. (5) To the extent these equity returns are earned in relation to risks borne by a PFI contractor, there is a timing mismatch between the risks (which may be larger in earlier years of the project) and returns (which may be larger in later years of the project). In connection with the issues raised by the paper, the following facts are relevant: 1. Indexation of Unitary Charges The Unitary Charge is a payment for services and is made conditional on the services being properly delivered to the Authority. The payment is proportional to the time period over which the services are delivered hence monthly payments are made in respect of services delivered during the preceding month. H.M. Treasury guidance on Indexation of Unitary Charges [Ref 1] is accepted in Scotland. It recommends that indexation broadly matches the exposure to inflation of the underlying costs. In many cases where cost elements (e.g. finance) are fixed in nominal terms, the result will be that the whole Unitary Charge is not indexed for general inflation so that prices for services delivered steadily decline in real terms over the life of the PFI contract. However, full indexation of the Unitary Charge is also consistent with value-for-money service delivery, where the real value of the services delivered to the Authority is itself constant. 2. Setting of Unitary Charges Unitary Charges are determined through a competitive procurement process that selects the bid which is most economically advantageous to the Authority. The price element of bid evaluation looks only at Unitary Charges (payments for delivered outputs) and does not concern itself with the underlying component (input) costs by which bidders have derived their Unitary Charge offers. This is because the best value Unitary Charge may not necessarily be delivered by, for example, the use of lowest cost designs of facilities, or the use of the cheapest materials or indeed the lowest cost provision of finance. It is for the winning bidder to assemble the optimum combination of cost inputs to achieve the best overall value service delivery offer (output) to the Authority. Each bidder will assemble its own unique set of proposed inputs. Nevertheless, it is normally the case that there are strong competitive pressures applying to all the underlying cost elements of the bid, and margins on PFI design and construction are correspondingly tight. Certain elements of the service delivery cost (such as facilities management) may of course, also be benchmarked periodically (e.g. at 5-7 year intervals) under the PFI contract. The cost of finance would also be independently benchmarked by the Authoritys financial advisers, prior to contract signature. The strong level of competition for the provision of long-term debt finance in PFI is well illustrated by the interest rates charged by the market, which in recent years have been no more than ~1% higher than the Governments own Public Works Loan Board interest rates, which apply to risk-free lending. 3. Payments to Lenders To offer low Unitary Charges, bidders will generally seek: (i) to maximise the use of senior debt (bank or bond finance) to fund the capital expenditure inherent in their service offer, rather than more expensive equity; and (ii) to deploy senior debt whose costs may be spread evenly over the length of the contract. In consequence, annuity-style debt repayment profiles (similar to domestic mortgages) or other more back-ended repayment profiles are the norm, not straight-line loan repayment profiles of the type illustrated in the paper. Moreover, the competitive pressure on bidders is generally such that, in cases of full indexation of the Unitary Charge, their lenders will be relying on the effects of future inflation on the Unitary Charge to generate sufficient cash flow to enable the PFI contractor to repay their loan within term of the contract. The date of final repayment to the lenders is typically scheduled to be 6-12 months prior to the date of natural expiry of the contract (e.g. 25 years from signature). 4. The Pattern of Cash-flow PFI contractors use of levelised (i.e. annuity) debt service profiles (or similar), substantially eliminates the potential for a growing profile of net cash-flow of the kind suggested in the paper, whether the Unitary Charge is fully indexed for inflation or not. However, this is not to say that there shouldnt be sufficient equity cash-flow provision built into the PFI contractors budget to absorb some of the risks it is bearing. Senior debt also bears risks on the performance of the PFI contractor and the effects of these are, of course, cumulative so that you would expect the majority of cash-flow risk-buffer to be located towards the end of the contract. After contract expiry, the lenders will have no means of recovering any outstanding debt, which explains why they generally require a contract tail of 6-12 months beyond scheduled loan retirement date. One of the strengths of a long-term PFI contract is that a contractor, that has suffered difficulties early-on in the contract, has an opportunity and so an incentive to over-come the difficulties and work towards restoring its profitability through consistently good performance during subsequent years of the contract. Projected cash-flow from later years cannot be brought-forward in times of PFI contractor distress, in the way suggested by the paper, it can only be accessed by sustained good performance, including through a refinancing, that good performance may make possible. 5. Cost of Finance The key measure of private finance cost is the widely recognised weighted average cost of capital (or WACC) in effect the combined cost of all the debt and equity invested in a PFI contractor. To focus solely on the cost of equity is to ignore the greater contribution which debt finance makes to the capitalisation of PFI projects and to introduce problems of adjusting return on equity figures for gearing effects. The WACC of PFI projects has been steadily declining since the mid-1990s and in recent years has been no more than 2-3% above the gilt rate, the UK Governments own cost of borrowing. 6. Contract Evaluation Evaluation of PFI bids is carried out in accordance with prevailing Government guidance [Ref 2 and 3]. In particular, the social time preference rate of 3.5% is used to determine the net present value of an investment in this case, of a PFI contract. The projected rate of return that investors expect to earn from a PFI contract and the capital structure of the PFI contractor do not form part of the price evaluation of bids, nor are Equity IRRs used in bid evaluation, so there is no understating of equity returns. However, a high degree of transparency is required from bidders, including in relation to their finance plans and models, which information is used principally to assess the deliverability of their proposals. Conclusions The principal concern of the paper, that excessive and understated rates of return on equity are being earned by PFI contractors due to interactions between Unitary Charge indexation and debt profiles, especially during later years of their contracts, are unfounded. The concerns expressed result from some misunderstandings about PFI project finance and the approach used by the public sector to evaluate bids. The application of prevailing Government guidance and the effects of a competitive bidding process help Authorities ensure only contracts offering good value-for-money service delivery are awarded. Partnerships UK October 2007 References [1] Application Note Interest-rate & Inflation Risks in PFI Contracts (H.M. Treasury 2006) [2] The Green Book: Appraisal and Evaluation in Central Government (H.M. Treasury 2003) [3] Scottish Government Value for Money Assessment Guidance (SG 2005; revised 2007) @ Vs %&@WX^z{,?@%%% %!%-%9&:&6CJ5CJB*CJCJ 5B*CJB*CJ 6B*CJ6%!VWjkrs %&@X^$$$!VWjkrs %&@X^{,@""%%!%-%%%9&:&*^{,@""%%!%-%%%9&:&$$$,1h. A!"#$%  [8@8 NormalCJ_HaJmH sH tH 6`6 Heading 1$@& 5B*CJ4`4 Heading 2$@&5CJ<A@< Default Paragraph FontNON Default 7$8$H$!B*CJ_HaJmH phsH tH 2B`2 Body Text$B*CJ4P`4 Body Text 2$$CJ:"2!! & :":&^:&:&@Dtx<"\^kt & <"Margaret CuthbertF:\Parnerships UK comments.doccuthbertSC:\DOCUME~1\cuthbert\LOCALS~1\Temp\AutoRecovery save of Parnerships UK comments.asdcuthbertF:\Parnerships UK comments.doc@UUgKKUU:"@@GzTimes New Roman5Symbol3& zArial"qh#F$F8<$>0"EOctober 2007 Analysis of: Margaret CuthbertcuthbertOh+'0  , H T `lt|October 2007 Analysis of: ctoMargaret CuthbertsiargargNormalt cuthbertCut2thMicrosoft Word 8.0i@2~@S6@r`68՜.+,D՜.+,L hp  self <"j October 2007 Analysis of: Title 6> _PID_GUIDAN{A5E8B556-CE5C-4813-A25E-52C29B751E17}  !#$%&'()+,-./014Root Entry F6{661TableWordDocument.2SummaryInformation("DocumentSummaryInformation8*CompObjjObjectPool{6{6  FMicrosoft Word Document MSWordDocWord.Document.89q