The Private Finance Initiative : sixth report, together with the proceedings of the Committee, minutes of evidence and appendices / Treasury Committee.

  • Great Britain. Parliament. House of Commons. Treasury Committee
Date:
1996
Catalogue details

Licence: Open Government Licence

Credit: The Private Finance Initiative : sixth report, together with the proceedings of the Committee, minutes of evidence and appendices / Treasury Committee. Source: Wellcome Collection.

    175/228 (page 139)
    Non-diversifiable risks, such as the increase in the general level of prices, cannot be averaged out by investing in many different PFI projects in the UK, because they are all affected by the risk. This type of risk is allowed for by increasing the discount rate used for calculating the NPV. The approach for deriv- ing this risk adjusted discount rate is to consider the weighted average cost of capital employed in pro- jects with similar levels of non-diversifiable risk. There are no mathematical rules for establishing this. The size of the risk premium (above the risk free rate) should therefore be set after considering the level of diversifiable risk, any single large risks that are fundamental to the success of the project and the rates of return available in the market for projects with similar non-diversifiable risk. The actuarial approach is therefore to address the subjectiveness of the risk/return relationship by breaking down the total project risk into individual or groups of related risks. It is then possible to allow for some risks more specifically than the broad brush approach of simply increasing the discount rate which encourages a short term outlook. THE OPTION PRICING APPROACH The option pricing approach places a value on the availability of options such as that of delaying the start of project. The NPV approach is more limited. For example it compares investing today with never investing at all. The option pricing approach examines a range of possibilities including investing today and delaying the investment by one or more years. Consider for instance a project where the present values of construction costs and net revenues are £80m and £100m respectively, and construction costs are less volatile than the present value of net rev- enues because the latter are dependent on a second PFI project which may or may not be started in the next year. In one year’s time construction costs may therefore either be £75m or £85m and the present value of net revenues either £95m or £110m. Currently the NPV of the project is £20m, whereas in one year’s time it will be either £10m, £20m, £25m or £35m. The average NPV in one year’s time—namely £22.5m—is more attractive than the current NPV of £20m and it may therefore be desirable to delay the project for one year. The same approach can be used to value other options such as combining the public service investment with related commercial investments and the assessment of the opportunities presented by future changes in technology. The option pricing approach is potentially a useful tool for appraising PFI projects but its practical application is at present limited by the lack of mature PFI projects from which to estimate the volatility of returns. In future, as the experience of PFI projects expands, it will be possible to use this approach to complement traditional NPV techniques. 11 January 1996 REFERENCES: 1. C. G. Lewin, S. A. Carne, N.F.C. de Rivaz, R.E.G. Hall, R. J. McKelvery and A. D. Wilkie. Capital Projects. British Actuarial Journal Volume 1, Part II. 2. A. R. Dixit and R. S. Pindyck. The Options Approach to Capital Investment. Harvard Business Review May-June 1995. APPENDIX 11 Memorandum submitted by WS Atkins Ltd. 1 INTRODUCTION WS Atkins Ltd. is the largest engineering based consultancy in the United Kingdom, with a turnover now in excess of £200m and a total staff of some 5,500 people, mainly professionally qualified. A copy of the company’s latest Annual Report and Accounts is attached for information.[Not printed] The Company has been extensively involved in privately financed infrastructure projects for a number of years, including a key role as Maitre d’ Oeuvre to the Channel Tunnel Project. WS Atkins is now fully committed to the Government’s Private Finance Initiative, as indicated on the attached project schedule. We feel therefore that our experience to date makes us well qualified to submit written evidence to the Treasury Select Committee. We confirm that we would be pleased to supplement this with oral evidence at a later date if required. Our evidence is presented under the following headings: