Early termination (including any compensation) risk

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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, junior debt, equity and a level of equity return; the compensation of equity might be limited to an amount calculated as net capitalised earnings at the time of termination.

(2) Non-default termination - the Private Partner would get senior debt and equity return; Senior debt might participate in the risk by being not compensated in full and equity compensation might be limited to an amount calculated as net capitalised earnings at the time of termination; and

(3) Private Partner default - the Private Partner would typically be entitled to an amount equal to a pre-set percentage (around 70- 85%) of the scheduled outstanding debt, minus damage claims of the Contracting Authority, with no equity compensation. Alternatively, the (assumed) price for the concession from a (deemed) retendering of the concession minus any damages and costs for early termination and retendering might be paid.

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.

While project lenders are therefore exposed to a project default, they are secured by step-in rights which entitle them to step into the contract with the Contracting Authority. Further, in the event of a termination due to no parties' default the equity compensation serves as a buffer.

The Private Partner will also mitigate risks by appropriately allocating such risks to appropriate subcontractors.

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

The lenders will require direct agreements/tri-partite 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 Emerging Market

Early termination compensation is well defined and political risk insurance is not typically obtained due to a lesser risk of the Contracting Authority defaulting on its payment obligations.

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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, equity and a level of equity return;

(2) Non-default termination - the Private Partner would get senior debt 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.

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. 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 Private Partner will mitigate risks by appropriately allocating such risks to appropriate subcontractors.

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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