Fitch: UK Infrastructure Projects Well Protected Against Low Inflation
Sensitivity analysis on Fitch's portfolio of 32 UK PFI school and hospital ratings and credit opinions demonstrates that average debt service cover ratios (DSCRs) are generally affected by less than 5 basis points by applying a 1.0% reduction in the inflation level. The OFTO projects are even more robust. Furthermore, the impact of prolonged low inflation on the PFI projects would likely be no more than one notch and would only apply to some projects, all else being equal.
UK RPI inflation has dropped sharply in recent years from 4.8% in 2011 to 1.6% for the 12 months ending in December 2014. The Bank of England has signalled the possibility of further falls in the near term, potentially to below zero.
Low inflation levels are a relevant consideration for UK PFI social infrastructure projects and OFTOs. The revenue streams of these projects are based on availability, through a base unitary charge indexed to inflation (typically RPI) and then adjusted for the availability and performance of the assets compared to target thresholds.
This core exposure to inflation is typically managed in one of three ways: through setting the weighting of inflation indexation in the revenue formula to match the proportion of the project's cost base that is exposed to inflation; achieving the same net result by entering into long-dated inflation swaps (selling inflation exposure in return for fixed rates); or by financing the project's debt requirement through inflation-linked debt.
The long-term operating and maintenance contracts that PFI projects typically use to transfer these risks to a third-party operator tend to use the same inflation index as used in the revenue formula.