Inflation, when considering not only revenues but also costs, is a two-sided risk: higher inflation affecting costs will result in lower operational margins. However, provided that it is neutralized by a revenue indexation mechanism, it may result in higher nominal cash flows to debt service and to shareholders, increasing the equity internal rate of return (IRR) in nominal terms.
Inflation risk refers to the risk of the value of payments received by the private partner being eroded by inflation. If inflation is not captured in the payments, the real value of the revenues will be significantly eroded when inflation is higher than anticipated, which may be exacerbated by cost inflation resulting in lower operational margin.
Inflation risk should be a shared risk, with the authority providing protection to the private partner by indexing (to some extent) the payments to CPI (or another price benchmark).
The private partner will assume the risk that the indexation mechanism, established in the contract does not effectively protect the private partner’s cash flows. This may be because cost inflation is higher than expected, and therefore not neutralized by the indexation mechanism, or simply because the CPI movement (as captured by the indexation) differs from what was anticipated — also eroding the expected nominal value of the operating cash flows.
This risk is generally borne by the private partner, as the private partner can manage the cost inflation risk by transferring it to the contractors, fixing or limiting the price of the O&M tasks, or linking it to an inflation index correlated to the index applied by the authority in the PPP contract. The potential impact of (lower than expected) inflation in the cash flows available to debt service is also manageable by defining the percentage of debt that will be priced at fixed interest (for example, by Interest Rate Swaps). It is also possible to contract inflation swaps at a cost.
This general rule may have some exceptions described below ("O&M cost risks").
When the project is user-pays, the risk of inflation may be transferred to the user (considering affordability issues and willingness to pay) as long as the private partner has some ability to revise the toll (or tariff). When inflation moves above the limits set out in the contract for indexation of the tariff levels, the risk is borne by the private partner.
Strictly from the standpoint of the authority, inflation risk exists when the payment (in government-pays) is linked to inflation and to the extent it is linked — higher inflation means higher payments in nominal terms.
How to define the indexation mechanism
Any PPP requires a clear set of rules to index the payments to capture the natural movement of inflation in terms of cost and price of services.
Provided it is clear how indexation to the CPI (or a similar benchmark of price) provides Value for Money, the question is to what extent the payments should be linked to inflation to avoid overprotection of the inflation risk. Section 4.10 provides additional information on this issue.