Highways Agency - Safe roads, Reliable journeys, Informed travellers

Discount rate explanation

Introduction

Under DBFO contracts, the private sector assumes substantial risks, including those relating to designing, building and operating the roads. Generally, the private sector is expected to be able to manage these risks better than the public sector, thereby providing better value for money.

A highly competitive procurement process helps ensure that the agreed terms are the best on the market at the time.

Cost-benefit analysis: general

1. Cost-benefit analysis is an appraisal technique for assessing the value for money of planned investment. It is used where the yardstick of profitability is inappropriate because the product to be delivered is not something that can be bought or sold. Roads are an example of a non-tradeable product because users do not pay directly for using them and there is no revenue from improvements to roads to be set against the costs of these improvements.
2. Almost any capital investment project (including roads) results in a sequence of costs followed by a stream of benefits. These costs and benefits need to be compared to arrive at a view of the overall worth of the project. These costs and benefits cannot simply be added together as if they had all occurred simultaneously because, both individually and corporately, we place different values on the same cost or benefit according to when it occurs. In overly simplistic terms, a pound today is worth more than a pound in a year's time even if there is no inflation.
3. To deal with this issue in economic and project appraisal terms, the costs and benefits in different years are transformed to their "present values" by the process of discounting to a common year. Discounting involves the notion of charging interest against a project, rather than paying interest to an investor who would earn compound interest on a sum invested over a period of time. Any sum, whether it is a cost at the start or benefit years later, can be reduced to its present value by multiplying it by a discount factor. The Net Present Value (NPV) of a project is the difference between the discounted benefits and costs. Where the net return is positive this represents a sound economic case for investment or, where several options are being considered, that with the highest net return represents the best investment option.
4. Cost-benefit analysis has been applied to the appraisal of trunk road investments since the 1960's to ascertain whether the planned investment represents good value for money.

Discount rate

5. The basis of DBFO contracts is that the Highways Agency pays for an all-inclusive road service over a long period, typically 30 years. To evaluate the private sector bids against each other, and also against the public sector comparator (see below), it is necessary to calculate the Net Present Value of these payments.
6. On advice from Her Majesty's Treasury (HMT) book entitled "Appraisal and Evaluation in Central Government" (The Green Book) between 1989 and 1997, the former Department of Transport and the Highways Agency used 8 per cent a year in real terms as the discount rate for investment appraisal of publicly financed roads. HMT also decided that a real discount rate of 8 per cent a year should be used to appraise private sector bids for DBFO road projects, and in preparing the pubic sector comparator.
7. The main criticism in the Public Accounts Committee (PAC) report into the first four DBFO road projects was the use of a discount rate of 8 per cent rather than 6 per cent to appraise the projects. In their view this led to the savings from delivering the projects as a public- private partnership (PPP) being overstated by about £69 million.
8. In February 1997, a year before the NAO and PAC reports were published, HMT issued new guidance on the choice of discount rate for appraising both conventionally funded and DBFO road projects. This recommended the use of a 6 per cent real discount rate and that is the rate, which was used in preparing the public sector comparator and assessing the bids for the A13 Thames Gateway DBFO.
9. The advice in the HMT "Green Book" has now been revised and the discount rate reduced to 3.5%.

Public-sector comparator

10. To ensure the bids satisfy the twin tests of delivering value for money and optimal risk transfer, the Agency prepares a public sector comparator before deciding whether to invite bids for DBFO projects. It is prepared by costing what the Agency estimates it would have had to pay to procure the construction of the relevant road schemes and all the operation and maintenance of the project road over 30 years by traditional means.
11. The process is detailed in the NAO report into the first four DBFO projects (The Private Finance Initiative: The First Four Design, Build, Finance and Operate Roads Contracts). In summary, the Agency prepares an assessment of the Net Present Value of the public sector comparator, and compares this with the Net Present Value of the projected payment under the DBFO contract.