1.5  The use of CAPM

The methodology provides a framework for determining Discount Rates based on the Capital Asset Pricing Model (CAPM).

The Methodology focuses on capturing differential allocation of Systematic Risk as the driver of different Discount Rates between project options.  To apply the Methodology, each Systematic Risk is identified and analysed and a conclusion must be reached as to who is taking that risk, the Public Sector, or the Private Sector, or a combination of the two (i.e. shared risk). It is this differential allocation of Systematic Risk to the Public Sector and the Private Sector between procurement options and the correlation with the rate of return that is reasonably sought by the Private Sector that is the genesis of the VFM comparison and the determination of the appropriate Discount Rate.

In negotiating a PPP arrangement, the Public Sector will transfer some, or predominantly all of the Systematic Risk it holds under the PSC to the Private Sector1.  This reduction in risk is to the benefit of the Public Sector and will come at a cost to the Public Sector, through a higher price in Private Sector bids.  As more Systematic Risk is transferred to the Private Sector, a higher Rate of Return is justified.  Hence the PPP Discount Rate will exceed the PSC Discount rate where Systematic Risk is transferred.

For context, four Discount Rates are referred to in this Guidance:

•  The Risk Free Rate: This is the theoretical rate of return of an investment with no risk and the estimate for this within this guidance is the long term Public Sector bond rate.

•  The Project Rate: This is the Discount Rate which represents the required return from any project in which all Systematic Risk lies with the Private Sector.

•  The PPP Discount Rate: This is the Discount Rate including Systematic Risk transferred to the Private Sector.

•  The PSC Discount Rate: This is the Risk Free Rate where all the Systematic Risk resides with the Public Sector.

It is this relationship that underpins the Methodology:

•  Where no Systematic Risk is transferred to the Private Sector, the Discount Rate to be used to calculate the NPC should be the Risk Free Rate.

•  If all the Systematic Risk is transferred to the Private Sector then the Discount Rate to be used to calculate the NPC of the Private Sector alternative should be the rate determined based on the CAPM approach outlined in the Methodology.  This rate is referred to in the Methodology as the Project Rate.

•  Where the Systematic Risk is shared between the Public Sector and the Private Sector, then the amount by which the Project Rate exceeds the Risk Free Rate, referred to as the Systematic Risk Premium, and must be allocated between the parties.  The more Systematic Risk transferred to the Private Sector, the higher the Discount Rate should be to evaluate that option.

This relationship between the transfer of Systematic Risk and the Discount Rate is applicable to the evaluation of procurement options in PPP projects and differs to the relationship in traditional project "investment evaluation" where, in deciding whether to proceed with a project at all (irrespective of delivery method), the Discount Rate used reflects the social time preference rate and opportunity cost of capital.  The Methodology is not concerned with whether or not to undertake the project, it is concerned with determining whether Private Sector procurement alternatives provide a measure of the relative VFM for the amount of Systematic Risk transferred to the Private Sector.

This allocation of the Systematic Risk Premium requires the application of judgement on behalf of the practitioner based on an analysis of the proposed contractual arrangements.  The Methodology contains tools that can be used by practitioners to identify the Systematic Risks present in a project, determine their relative importance and correctly apportion these between the parties.  In applying the various tools of the Methodology, the focus is on determining the appropriate Discount Rate for use in the assessment of the PPP option, that is, the PPP Discount Rate.


______________________________________________________________________________________________
1 It should be noted that a core principle of the Value for Money assessment is that risks are allocated to the party best able to manage them.  The principle is for optimal not maximum risk transfer.