PFI indexation, as with other issues affecting affordability, is inextricably linked with the operational side of the contract, so those responsible for PFI contract management must take responsibility for dealing with indexation, and not leave it just to the finance department. Our article on 6 Tips to Keep Control of PFI Affordability explains that if affordability is not managed properly, a deficit of millions of pounds can accumulate over the life of the contract; it highlights indexation as one of the key issues that PFI managers need to keep track of. This article expands on this subject area, providing essential tips to help control costs by keeping track of PFI indexation.
What is PFI Indexation?
A good starting point is to define indexation and related concepts:
Indexation – mechanism in the contract for increasing part of the unitary charge in line with inflation.
Base prices – prices at the base date of the contract, e.g. if the base date of the contract is April 2010, sums of money specified in the contract will be expressed at April 2010 prices.
Current prices – prices at the current time, e.g. if it is now April 2014, we would expect a sum expressed at April 2010 prices to have increased to reflect four years’ inflation.
Out-turn prices – what we expect prices to be in future, e.g. if we’re estimating what something will cost in five years’ time, we normally include an estimate for inflation over the next five years, e.g. 2.5% per year is often used.
Variable or indexed element – part of the unitary charge that increases with inflation.
Fixed or unindexed element – part of the unitary charge that does not increase with inflation.
In PFI projects where there is a contribution from end users, e.g. from a school, this will be indexed too and the indexation mechanism will usually be similar to that in the contract.
Note that terms vary from contract to contract, e.g. the terms ‘base date’ and ‘base prices’ may not be used in your contract. You may need to look at the detail of the indexation provisions in the main contract or payment mechanism to find out what the base date is.
Keeping Track of PFI Indexation – 5 Essential Tips
Tip 1 – Understand what is being indexed
In the contract the unitary charge will be expressed at base prices. The variable element will then be increased with inflation each year, or indexed. The purpose of indexation is to reflect increases in costs (such as wages, supplies and services etc) as a result of general inflation. The other part of the unitary charge remains fixed, mainly because it represents the bank debt used to finance the construction of the PFI asset, which is not affected by inflation. See tip 2 ‘understand PFI costs’ in our article 12 Tips to Control and Reduce Your PFI Costs.
Tip 2 – Understand how indexation works
- The contract will specify:
- The index that is to be used – RPIX is common in PFI contracts
- The base date, e.g. April 2010
- How the increase in the variable element is to be calculated (with a formula often specified).
The calculation may not be quite as straightforward as you would expect, e.g. because RPIX for April is not published until several weeks after the beginning of the financial year. In some contracts indexation is applied to the variable element (e.g. three years’ inflation added if three years have passed since the base date), whereas in others it is applied to the previous year’s figure (in which case only one year’s inflation is added).
Tip 3 – Check the contractor’s invoices
Contractors often make mistakes in how they apply indexation. You, as the client, should therefore carefully check the invoices to make sure it has been applied correctly. Particular things to watch out for include:
- The correct index, e.g. RPIX, has been used
- The correct base and current values of the index have been used
- Indexation has been applied only to the variable element, not to the whole unitary charge
- The correct formula has been used
- There has been no double-counting with increases due to benchmarking and market testing
- There has been no double-counting with increases due to contract variations
- There is no confusion between base, current and out-turn prices.
Tip 4 – Check indexation of end user contributions
End user contributions will usually relate to facilities management services and therefore be fully indexed. The method of calculating indexation may be the same as in the PFI contract, but this cannot be assumed and should therefore be checked. It is obviously important to check that the contributions are increased in accordance with the indexation provisions, otherwise income will be less than it should be, worsening the affordability of the project. On the other hand, as the client, you should avoid any inadvertent over-charging of end users, as this may result in you having to make a substantial refund when the mistake comes to light, which it inevitably will at some point.
Tip 5 – Ensure the contract is clear
If there is any ambiguity in the contract, e.g. in the formula used for calculating indexation, it may be appropriate for the client to propose a change to rectify this. The same principle applies to calculation of indexation for any end user contributions, because – as mentioned above – not indexing these properly can also contribute to an affordability gap.
- Understand what is being indexed
- Understand how indexation works
- Check indexation in the contractor’s invoices
- Check indexation of end user contributions
- Make sure the contract is clear and propose a change if necessary.
For support and advice on PFI indexation and other financial issues in PFI contracts, please do not hesitate to contact us.