Recent projects have seen NSW more willing to accept some level of interest rate risk where this represents value for money.
Recent NSW social infrastructure projects have heralded a change in the NSW Government's approach to interest rate risk on social infrastructure projects post financial close. While in previous projects NSW has expected the private sector to manage interest rate risk during the term of the project, recent projects have seen NSW more willing to accept some level of interest rate risk where this represents value for money.
No change has occurred to the policy where NSW will not accept the risk of changes in margins bid by proponents.
Why the change?
There are two main reasons for this change.
Firstly the change harmonises NSW's position on interest rate risk on Public Private Partnerships (PPPs) with its debt portfolio. NSW currently has a debt portfolio in excess of $20bn which it uses to fund government and its businesses. NSW currently accepts and manages variability in its interest rate exposure in its long-term debt exposure, yet in the context of previous PPPs, NSW was effectively seeking funding on a fixed rate basis.
Ignoring arguments that the debt in PPPs does not represent government debt but that of the private sector, the recent change in NSW's approach to interest rate risk post financial close seeks to ensure consistency in the manner in which NSW manages its general funding commitments in its debt portfolio with that procured under PPPs.
The second reason for this change is value for money. The concession terms for PPPs are generally longer than is typically funded by the debt markets and accordingly hedging the interest rate risk for long term funding may result in the private sector having to raise funds in niche or less liquid markets.
A paper released by NSW Treasury in February 2004 indicated that historically the cost of borrowing for ten years is on average 40 basis points greater than borrowing for five years. Accordingly, by providing more flexible options for the management of interest rate risk post financial close, NSW encourages the private sector to create financing solutions which may provide greater value for money for NSW over the term of the project, while not exposing NSW to greater risk than is inherent in the management of its existing debt obligations.
The three main options for allocation of interest rate risk
There now appears to be three main options for allocating interest rate risk.
Option 1 - Nominal fixed rate debt
This is the traditional approach adopted in the UK which sees the private sector accepting nominal interest rate risk and providing hedged nominal finance over the term of the project.
Option 2 - CPI linked debt
Under this option the private sector will bear real interest rate risk but NSW will bear full CPI risk through indexation of the service fee. This option recognises the increasing popularity of CPI indexed bonds in recent infrastructure financings in Australia. This approach was adopted on the first New Schools Project.
Option 3 - Floating base rate debt
Under this option NSW will accept interest rate risk against a reference rate, such as the 90 day or the 180 day bank bill swap rate and accordingly to the extent that the 90 day or 180 day bank bill swap rate varies, NSW will bear this risk. However, consistent with NSW Treasury Policy, NSW will not accept this interest rate risk during the construction phase of a project.
NSW will also entertain financing solutions which contemplate the floating rate being set at time periods longer than 90 or 180 days. Some possible funding structures are:
rolling 5 year fixed rates;
rolling 10 year fixed rates; or
combinations of the above.
How will NSW evaluate the three options against one another?
To date NSW has evaluated the three options by converting each of the options to a fixed nominal basis. The following table is a simplified summary of how this would occur:
No specific adjustment required.
Proposal will be adjusted assuming a forecast CPI rate. The assumed forecast CPI rate is generally specified in the call documents.
Proposal will be converted to a fixed nominal basis on the assumption that the reference rate at each reset point will equal the applicable NSW Treasury Corporation bond yield less a forecast term premium.
The NSW Treasury Corporation bond yield will generally be that corresponding to the weighted average of the average loan lives of the debt tranches.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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