Early termination (including any compensation) risk

Water Desalination Water Desalination

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;

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

(3) Private Partner default - (a) Where the project cannot be retendered (due to political sensitivity or a lack of interested parties) the Private Partner would typically be entitled to an amount equal to the adjusted estimated fair value of future payments, less the costs of providing the services under the project/concession agreement. (b) Where the project can be retendered, the Private Partner would be entitled to the amount that a new private partner would pay for the remaining term of the concession, less any costs incurred by the Contracting Authority during the retendering process.

It is common for the senior debt to be guaranteed as a minimum in every termination scenario (other than Private Partner default) and for rights of set-off below that figure to be restricted.

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.

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 Contracting Authority can face the following risks on expiry or termination of the concession period:

(a) uncertainty about the type and timing of transfer of the plant (either back to the Contracting Authority or to a replacement Private Partner);

(b) re-delivery of poor condition or out-of-specification facilities;

(c) receiving inadequate compensation for non-performance and early termination (if applicable);

(d) inability to obtain the benefit of supply/manufacturer warranties; and

(e) other related political and public relations issues.

The level of compensation payable on early termination will depend on the reasons for termination.

(1) Private Partner right to terminate, such as for (a) non-payment of capacity and output payments for typically between 30-60 days; (b) nationalisation or expropriation of the plant; (c) prolonged events of Government action or inaction / Government/buyer risk events which continue for 365 days (unless the Contracting Authority elects to continue making capacity payments).

The Private Partner will typically receive full repayment of senior debt, and a fixed rate of return on equity contributions and an amount based on future predicted cash flows plus termination costs.

(2) Contracting Authority right to terminate, such as for (a) when commercial operation date is not achieved within a certain period from scheduled commercial operation (generally 200 days); (b) wilful default and material default; (c) failure to remedy defects; (d) failure to pay LDs; (e) reduction of average availability of the plant; (f) termination of desalination licence or land rights; prolonged (typically 365 days) events of Government action or inaction / Government/buyer risk events.

The Private Partner will receive full repayment of senior debt only.

(3) prolonged force majeure

The Private Partner will receive full repayment of senior debt, equity contributions less equity dividends and termination costs. If the relevant force majeure event is 'political', then the Private Partner will also often be entitled to a capped equity return.

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 are therefore not significantly exposed to a project default, they would not typically have the right to call for a termination in these circumstances (ie the Contracting Authority has a discretion as to whether to terminate), 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.

In some emerging markets, the Private Partner is contractually prohibited from terminating in the certain circumstances.

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

The Contracting Authority should ensure that there is no uncertainty about the Private Partner's obligations at the end of the concession period (due to expiry or termination).

These matters can be addressed in the concession agreement and should deal with redelivery obligations, compensation (either on a net book value or present market value basis), access to warranties and guarantees and transfer of operation and maintenance know-how.

A further 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.

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 (eg the Ministry of Finance) 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 Authority's 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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