Early termination (including any compensation) risk

Heavy rail Heavy rail

Description (What is the Risk)

The risk of a project being terminated before the expiry of time and the monetary consequences of such termination.

Risk Allocation (Who typically bears the risk)

Allocation: Public Private Shared
Rationale

In the UK heavy rail sector, the position is less standardised than on typical PPP projects.

A Manufacturer may grant the Owner the right, at its option to elect to take the benefit of work carried out by the Manufacturer prior to termination, at a fair price reflecting instalments of the contract price already paid. Alternatively, the Owner may usually require the Manufacturer to refund the contract price paid, with interest. The Owner may seek to negotiate a right to hand back the entire accepted fleet of rolling stock if the number of rolling stock then accepted is below a specified threshold. On a termination, the Manufacturer will usually be required to indemnify the Owner and Operator against certain costs such as the costs of procuring a replacement contract, less or revenue as a result of owning a smaller fleet and certain other direct losses.

Mitigation Measures (What can be done to minimize the risk)

A key mitigant is to make sure the termination triggers are not hair triggers and that there is scope, where possible, for each party to remedy any alleged default.

Government Support Arrangements (What other government measures may be needed to be taken)

In certain circumstances, the Contracting Authority may require a direct agreement in relation to a maintenance contract. It will invariably require a direct agreement in relation to any rolling stock lease, preventing the Owner from terminating without giving the Contracting Authority certain step in rights, designed to enable the Contracting Authority to perform its statutory duty to provide railway passenger services.

Comparison with Emerging Market

Early termination compensation is reasonably well defined and political risk insurance is not typically.

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Description (What is the Risk)

The risk of a project being terminated before the expiry of time and the monetary consequences of such termination.

Risk Allocation (Who typically bears the risk)

Allocation: Public Private Shared
Rationale

The level of compensation payable on early termination will depend on the reasons for termination and typically for :

(1) Contracting Authority default - the Private Partner would get senior debt (to the extent applicable), equity and a level of equity return;

(2) Non-default termination - the Private Partner would get senior debt (to the extent applicable) and equity; and

(3) Private Partner default - the Private Partner would typically get a payment that is a function of the input cost of the project (construction value / book value) or the outstanding senior debt (if appropriate).

In many emerging markets it is common for the senior debt to be guaranteed as a minimum in every termination scenario, and for rights of set-off below that figure to be restricted but this level of coverage is by no means universal and there are projects where the Private Partner and its lenders will retain the risk of ?a shortfall in asset valuation on an early termination.

While it may seem that project lenders therefore not significantly exposed to a project default, they would not typically have the right to call for a termination in these circumstances, and so they are still motivated to make the project work to recover their loan if the Contracting Authority chooses not to exercise its termination rights.

Mitigation Measures (What can be done to minimize the risk)

A key mitigant is to make sure the termination triggers are not hair triggers and that there are adequate well-defined routes for each party to remedy any alleged default.

The mitigation for the lenders where the level of compensation is less than senior debt is the level of equity in the deal and possibly sponsor guarantees , such as completion guarantees to cover the key risk of default before a steady state service is established.

Government Support Arrangements (What other government measures may be needed to be taken)

The covenant risk of the Contracting Authority may require a guarantee from a higher level of Government to guarantee the level of compensation payable on termination.

The lenders will require direct agreements with the Contracting Authority giving the lenders step-in rights in the case of the Contracting Authority calling a default termination or in the event of the Private Partner being in default under the loan documentation. The lenders would typically be given a grace period to gather information, manage the project company and seek a resolution or ultimately novate the project documents to a suitable substitute concessionaire.

Comparison with Developed Market

In emerging markets, there may also be sovereign guarantees which support the Contracting Authorities payment obligations.

Political risk insurance may be available and is likely to be sought to cover the risk of the Contracting Authority or Government guarantor defaulting on its payment obligation.

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