PPP Projects: Discount Rate



Central Guidance Note No. 7

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Discount Rate Principles

for

Public Private Partnership

Capital Investment Projects

February 2006

Contents

1.0 Introduction 3

2.0 Scope 3

3.0 The Purpose of a Discount Rate 4

4.0 Discounting Principles 4

5.0 Setting the Project Specific Discount Rate 5

5.1 Updating the Discount Rate 5

6.0 Discounting Certain and Uncertain Cash Flows 6

6.1 Certain Cash flows 6

6.2 Uncertain Cash Flows 6

7.0 Discount Rates during the Life of the Project 7

8.0 Technical Guidance 8

1.0 Introduction

Public Private Partnership (PPP) projects involve long-term contracts, typically thirty years, with private sector partners for the provision of services and their related assets. A PPP discount rate facilitates comparison for evaluation purposes, in net present value terms, of the cash flows in both the traditional (represented by the Public Sector Benchmark (PSB)) and the PPP bidder’s financial model, for the asset/service to be provided under a PPP arrangement.

2.0 Scope

These guidelines apply only to PPP projects[1] and, in a multi-faceted project, to the portion of a project to be procured as a PPP. The National Development Finance Agency Act, 2002 requires State authorities to “seek the advice of the Agency as soon is practicable before undertaking a public investment project.” The NDFA is also to advise any State authority on the “optimal means of financing the costs of public investment projects in order to achieve value for money” and advise on “all aspects of financing, refinancing and insurance on projects to be undertaken by means of public private partnership arrangements or within the public sector”.

The guidelines relate to the discount rate for discounting whole life PPP cash flows within: (a) the PSB; and, (b) the final stages of the Value for Money Comparison (VfMC) of PPP tenders. This same discount rate (i.e. as applied to the PSB and the VfMC) must also be supplied to the private sector tenderers for use in the compilation of their tenders in order to facilitate a ‘like with like’ comparison when conducting the tender evaluation process.

This differs from an economic discount rate, known as a test discount rate, which may be applied at an earlier stage of the evaluation of capital investment projects (including PPP projects) for conducting a cost-benefit analysis - as indicated under the Guidelines for the Appraisal and Management of Capital Expenditure Proposals in the Public Sector[2].

3.0 The Purpose of a Discount Rate

The ‘time value’ of money must be recognised in decision-making specifically where projected costs are spread over many years. The purpose of using a discount rate is to convert future revenues and costs into their value today (their present value), so that they can be meaningfully used for comparison/evaluation purposes.

4.0 Discounting Principles

In procuring a PPP project to be financed through unitary payments, the State Authority (or the NDFA as appropriate) must compare two procurement approaches, one which involves significant capital expenditure in the early years and ongoing operating and maintenance expenses in the later years (represented by the PSB i.e. the costs under a traditional procurement), and the PPP approach, which usually involves a relatively even spread of expenditure over the entire life of the project (represented by the Unitary Payment stream to the Bidder). In financial modelling, the discount rate is used to help determine/assess which of these two options has the potential to provide the best value for money for the Exchequer over the life of the project.

The following principles/issues apply when setting the discount rate to be used for any PPP project:

• A discount rate has to be advised by the NDFA for each project.

• The discount rate should reflect the relative value of the cash flows from the State Authority’s perspective. The risk and uncertainty of the cash flows to the private partner and the cost of the capital of the private partner have little or no bearing on the relative value of the cash flows to the State Authority and should not be a factor in the selection of the appropriate discount rate.

• The discount rate is based on the risk free cost of debt to the public sector – the yield on the appropriate long term Government Bond.

• The discount rate used in the PSB should not be adjusted for risk. The effect of adding a risk factor in the discount rate would be to double count the impact of those risks which have been accounted for separately in the PSB.

• Where cash flows are to be inflated using a long-term inflation rate the NDFA, having consulted with the Department of Finance, will advise as appropriate. Nominal cash flows[3] should be discounted using nominal discount rates[4].

5.0 Setting the Project Specific Discount Rate

The NDFA will identify an appropriate discount rate/comparative Government Bond (to be used as the discount rate) for each large, privately funded PPP project[5]. The NDFA will first need to be provided with the agreed final annual project cash flows for the PSB, signed off by the project manager/board of the relevant State Authority in sufficient time to enable them to conduct the discount rate determination exercise. The discount rate for that project will then be used to finalise the calculations in the PSB. In addition, the private sector tenderers need to be informed of the relevant Government Bond / discount rate that will be used by the public sector, at the latest, approximately two weeks prior to tender submission date.

5.1 Updating the Discount Rate

The discount rate will be used on a number of occasions during the procurement process including:

• the compilation of the PSB;

• the evaluation of the initial tenders;

• at Best and Final Offer (BAFO) stage (where appropriate); and,

• when conducting the later stages of the Value-for-Money Comparison (VfMC) exercise.

In the unlikely event of material changes to the PSB being required, the State Authority/procuring body must immediately inform the relevant parties in the NDFA, who will decide if it is necessary to select a new basis for the discount rate.

6.0 Discounting Certain and Uncertain Cash Flows

All cash flows must be discounted at the same discount rate. There are two types of cash flows in any PPP project – certain and uncertain. It is important to distinguish between: (a) financially underwritten and guaranteed revenues/income; and, (b) un-guaranteed revenues/income. It is also important to consider the risk attached to the source of those cash flows.

6.1 Certain Cash flows

Certain Cash Flows that are financially underwritten and guaranteed should attract a weighting of 100%.

6.2 Uncertain Cash Flows

Uncertain cash flows are typically related to: third party income; user charges; sharing of gains; and, in some circumstances the degree of uncertainty in receiving one form of unitary payment vis-à-vis another[6]. The NDFA will assist the Sponsoring Agency / project manager to determine an appropriate weighting to be used in the compilation of the PSB and the evaluation of tenders which reflect the inherent risk and uncertainty attached to each type of cash flow. Tenderers must be informed (prior to the submission of their tender) that different cash flows will be weighted differently. These weightings, or the approach to the calculation of these weightings[7], must be agreed by the State Authority and the NDFA before tenders are opened.

7.0 Discount Rates during the Life of the Project

The long-term nature of a PPP project requires the State Authority and the NDFA to prepare for eventualities which may arise over the contract term. The discount rate chosen for these eventualities should comply with the discount rate policies as identified in this document and be determined by the NDFA on behalf of the State Authority. Where weightings are to be used, these can be adjusted to reflect any new information that has become available since contract award.

Agreement on the appropriate discount rates may be required with the private sector, prior to contract close, in the following situations:

• Recalculating the Financial Model During the Life of the Project;

• Compensation on Termination;

o Authority Default and Voluntary Termination;

o Force Majeure, Uninsurable Risk and Change in Law;

o Corrupt Gifts, Fraud and breach of the Refinancing provisions;

o PPP Co. / Operator Default;

• Refinancing; and,

• Pre-payment of debt (where applicable).

Irrespective of the situation, care must be taken to ensure that changes to the financial model (part of the project agreement/contract) secure value for money for the Exchequer. Where a change to the unitary payment is contemplated, a comparison must be made between paying the upfront lump sum and amortising the cost over the remaining life of the contract, with the most economical option chosen. Any changes in the financial model (and where applicable in the project agreement/contract) must be conducted in a manner consistent with the approach taken in the calculation of the original unitary payment and maintain the original PPP Co.’s Internal Rate of Return as set out in the initial project agreement/contract.

Technical Guidance

Technical guidance on the determination of a discount rate will be provided as necessary and appropriate by the National Development Finance Agency.

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[1] e.g. where finance is supplied by the private partner or where a stream of future cash flows need to be expressed in today’s terms.

[2] Published by the Department of Finance – February 2005

[3] It is not envisaged that real cash flows would be used in PPP financial models.

[4] Government Bond market yields are nominal yields in this sense.

[5] A separate discount rate may need to be identified for variant bids where the length of term differs from base bid requirements.

[6] Not all uncertain cash flows come from the PPP Co. There is a different level of uncertainty in receiving a unitary payment subject to performance and that of a unitary payment based on availability. The level of uncertainty will also vary depending on the sector (e.g. schools or waste).

[7] Better value for money may be obtained, in some instances, by releasing the weightings methodology to the private sector tenders as part of the tender invitation. This decision will be made by the Project Board following consultation with the Sanctioning Authority and advice from the NDFA for each project.

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