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Can we assume that the documentation risk is best allocated to the lawyers? PPP deals are legally complex transactions, with multiple...

Can we assume that the documentation risk is best allocated to the lawyers?

PPP deals are legally complex transactions, with multiple (supposedly) interlinking documents covering many hectares of paper.

By M Blaiklock

Posted 29 Sep 2016

Documentation risk in most forms of PPP or project finance transaction sits with counsel insofar as they are responsible for supporting their clients in negotiating a detailed position across all of the risks and the multitude of documentation.

The bigger challenge we face in documentation is the need to standardise.   Evidence suggests that countries that have developed sector specific documentation or detailed guidance, drive the procurement costs down, encouraging more bidders and developing a clearer understanding of the dynamics of the project.

Standardisation is going to be a critical factor in attracting risk weighted capital, whether from insurance companies or pension funds.  Standardisation creates a virtuous circle of improvements, cost reductions, efficiencies and are an effective tool by which governments can convey their preferred risk allocation into the market.

Speaking in respect of our own business, the ‘hectares of paper’ that we all used to wrestle with are largely saved now by smarter working and online documentation.

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Any examples of PPP project failure due to exchange rate risk?...

Any examples of PPP project failure due to exchange rate risk?

Posted 4 Oct 2016

In most PPPs the tariff paid to the private sector (whether by the government or users) is paid in the domestic currency of that country.  Exchange rate risk can arise where either the construction costs of the asset in question, or the debt used to finance construction, is denominated in a currency different to the domestic currency.

The first risk may arise in the construction of an asset that requires equipment that is manufactured overseas (perhaps trains or power generation equipment).  Civil works will typically be costed in the domestic currency.  The second risk will arise in developing markets where there is a constraint on the domestic debt market whereby financing by multilateral or international banks is required.

In modern times lenders will require either a comprehensive hedging programme to be put in place to address the FX risk, or will transfer the FX risk to the host country by requiring that some or all of the tariff is linked to a foreign currency such as USD.  Both of these approaches achieve the same result, which is an ability for the borrower to finance its foreign currency costs even when the domestic currency rates are falling.

I say ‘in modern times’ because the 1997 Asia crisis was largely predicated by an enormous amount of cheap foreign debt being borrowed in South East Asia without hedging.  First the Thai Baht, and then other currencies were substantially devalued causing the cost of repayments to increase in the domestic currencies, and whilst this exposure affected a large part of the economies, there were examples of some projects, that would today be considered PPPs facing substantial trouble.

State electricity company PLN in Indonesia had agreed a number of electricity tariffs in USD and as the rupiah fell from 2,500 to 7,000 against the USD it failed to despatch certain IPPs and subsequently renegotiated some terms of the following decade.  Indonesia’s example demonstrates that there is can be constraints on the government to take hedging risks through the tariff without some form of financial hedging solution being used as well.

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The risk matrices produced by GIH are a great tool for implementing PPP projects in infrastructure, particularly in the transport...

The risk matrices produced by GIH are a great tool for implementing PPP projects in infrastructure, particularly in the transport sector. Nevertheless, I have a few suggestions for possible discussion:

  1. The road PPP project included in the risk matrix is called “Toll Road.” However, it seems that it is meant to include also availability payment PPPs. For example, in the explanation of risks, the following statement is included: “If there is high uncertainty over traffic projections and uncertainty over revenues (due to tariff limitations and/or currency volatility) then the project may need to be structure purely on the basis of an availability fee.” See http://www.gihub.dev.nucleo.com.au/risk-matrices/demand-risk-toll-road-ppp/?re=go. Consequently, I would like to suggest calling it Road Project or Road PPP, which would be more general.
  2. The use of the DBFO acronym as project title for a toll road does not seem appropriate, as originally DBFO involved no tolling (the UK, where the term comes from, adopted, instead, shadow tolls. So far, there is only one toll motorway in the UK). If you open the matrix Excel file, there is no option other than “Toll Road,” when you try to change the title in the matrix; the “arrow” does not seem to work. Furthermore, the description provided on the website seems more applicable to BOT than DBFO. See for example: http://www.gihub.dev.nucleo.com.au/risk_category/port/
  3. Light Rail is classified as DBFOM, with a description similar (in terms of PPP type) to the Toll Road project. No apparent reason to use a different acronym. My suggestion is to call both the Light Rail and the Road Project a BOT, a more common and general term. In summary, it would be simpler and more precise to classify the five transport projects shown in the risk matrices as: (i) BOT (Build, Operate, Transfer): Road, Airport, Light Rail and Port projects; and (ii) ROT (Rehabilitate, Operate, Transfer): Heavy Rail project. The current classification of the PPP projects in the energy sector (i.e., BOO, BOOT and ROT), and water and sanitation sector (i.e., BOOT, ROT and BOT) seems appropriate.
  4. Suggest merging the BOT and DBFO definitions, as given in the Glossary. You may want to add some clarification, for example that DBFO was first used to describe the shadow toll concessions under PFI (now PF2) in the UK.

By Cesar Queiroz, Consultant, Inter-American Development Bank

Posted 20 Mar 2017

Different jurisdictions and sectors tend to use different terms (including for historical reasons), and of course the risk allocation on projects has a much wider gradation than the few acronyms that are used, so the choice of acronym can only be so helpful for the reader in ascertaining the underlying project structure.

However I think the main comment here reflects that:

  • each of the “DBFO transactions” we have described could probably equally be described as BOT transactions;
  • “DBFO” itself is not a widely-used generic term. Whilst it was indeed originally used to describe some of the UK road projects it wasn’t our intention for it to be given a very specific meaning like that in this report (i.e. we simply intended to use it generically as any Design-Build-Finance-Operate contract).

I think our choice of DBFO for the infra transactions actually reflects a greater tendency (but not exclusive tendency) to use terms like DBFM/DBFOM in those developed markets where the team drew its examples from, rather than terms like BOT.  In the UK we wouldn’t describe a typical PFI as a BOT, but that doesn’t mean that it isn’t one when viewed from an external or global standpoint.

In most developed market infrastructure projects, if there is a “T=transfer” component, then the “O=own” component is (in my view) relatively unimportant, because the concession agreement tends to impose the full risks of ownership on the concessionaire during the concession period, and the assets are usually fixed assets of national importance and therefore can’t be taken as security by the funders and resold on insolvency. The real security is in the remaining term of the contract and the assignability of that interest. So the distinction between BOT and BOOT isn’t always so relevant. Similarly, in terms of BOO v BO(O)T, there are also quite a few developed market infra PPP projects which have significant residual value components in them (e.g. some healthcare projects and railway asset projects, where ownership of the assets continues post-concession/offtake) and I suppose you could classify these as BOO, but I don’t tend to hear that used in this context, rather they might be called a DBFM with an RV risk.

So, in summary, the BOO/BOOT/BOT terminology hasn’t always been so relevant in certain infra projects, but I think using BOT for the listed projects in this case is not wrong.

In terms of light rail, it can still be very useful to use the term DBFOM to distinguish from DBFM, as there are a number of light rail projects globally where the authority retains the operations of the system (through itself or a separate franchise), and the concessionaire is basically a long-term maintainer, so I think in some circumstances it’s justified to use this type of terminology to talk about project structures at a high level.

Whilst I don’t think that our original approach was wrong, I also don’t see an issue with using the term BOT as a high-level descriptor in our introductions for projects 1,2,3 and 5, as suggested, to add a level of consistency, but in the light rail context it probably does make sense to also retain the term DBFOM in the intro text as a sub-descriptor, clarifying that operation of the system is included in the concession scope.

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In relation to “Land Purchase and Site Risk”, it should be important to include utilities relocation risk as a special...

In relation to “Land Purchase and Site Risk”, it should be important to include utilities relocation risk as a special risk. Clearly the risk depends on the nature of the project, and the general rules for utilities relocations in the respective jurisdiction. Nevertheless, my experience in developing countries in South America (Brazil, Chile, Colombia and Peru) is that there is very poor data regarding primarily the pipes (water, sewage, oil, gas, optical fibre, etc) that interface with the proposed road, so it is difficult to the bidder to properly assess the cost and duration of the required relocations.

The risk is twofold: on the one hand, the cost associated with utilities relocation (this risk is mitigated in some jurisdiction including a cap on the financial exposure of the private sector; or including a share mechanism with the granting authority); and the second is the impact on time available to meet the Commercial Operation Date (either complete or partial COD)

By Sergio Merino, a PPP Practitioner in Chile

Posted 26 Aug 2016

Mr Merino’s experience raises an excellent ‘real life’ issue which Contracting Authorities would do well to take note of. As noted in the Report, the lack of reliable information in developing markets (for example utilities records and land charges) is a very relevant issue to the allocation of land purchase and site risk. In developed markets, the Private Partner is usually in a better position to bear more of this risk as it can mitigate it more effectively through appropriate due diligence.

In the context of a toll road project, in both an emerging and developing market, the position set out in the Report is that land purchase and site risk is ‘shared’ between the Private Partner and the Contracting Authority (for example, as noted by you either through a financial cap or extension of time relief to the date for completion). We agree with your statement that the degree of risk would also depend on the nature of the project and the general rules for utilities in relocation in the respective jurisdiction.

In our view, the Contracting Authority would generally be responsible for providing a “clean” corridor, with no restrictive land title issues, as well as resolving issues with existing utilities and contamination. Existing assets proposed to be used in the project would also need to be fully surveyed and warranted. The Private Partner may take the risk relating to known adverse conditions but other unforeseeable ground risks (e.g. archaeological risks, unknown hazardous materials) will likely be borne by the Contracting Authority.

We invite other readers to comment on the nature of utilities relocation risk in your jurisdiction. Is it a significant problem? Is information about utilities readily available? And is the risk allocated in the same way?

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In different places in the draft, it appears the concept that the Private Partner will mitigate the risk allocating it...

In different places in the draft, it appears the concept that the Private Partner will mitigate the risk allocating it to appropriate subcontractors.

In my view, the risk allocation within the Private Sector, still maintain the risk in the Private Sector, and my understanding is that the purpose of this document is how to better allocate risks between Public and Private sector.

By Sergio Merino, a PPP Practitioner in Chile

Posted 25 Aug 2016

You are correct in saying that the purpose of the Report is to document the typical PPP risk allocation arrangements between the public and private sector, across different projects/sectors and different markets (i.e. emerging or developed). You will see that the ‘Rationale’ column in each matrix has been used to briefly explain the basis for such typical allocation.

The allocation of the particular risk will be documented as between the Private Partner and the Contracting Authority under the contractual terms of the concession or project agreement. Please refer to the glossary for the definitions of “Private Partner” and Contracting Authority”.

However, we note that a related purpose of the Report is to take this analysis further by providing additional guidance as to how the Private Partner or Contracting Authority (which has been allocated the relevant risk under the concession or project agreement) would then seek to manage and/or mitigate that risk. We see this as a natural extension of the risk allocation issue.

For example, with regards to construction/completion risk allocated to the Private Partner under the concession or project agreement, the Private Partner may seek to pass-through this risk to a D&B Contractor under a lump sum turn-key D&B contract.

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It might be interesting to split between Exchange and Interest Rate risks. Exchange risks are primarily related to foreign currency debt...

It might be interesting to split between Exchange and Interest Rate risks.

Exchange risks are primarily related to foreign currency debt (most of the costs related to construction and operation are local currency related) while interest rate risk are related to long term funding availability and the elapsed time between commercial and financial closing (elapsed time of 1 or more years is the norm rather than the exception).

In the case of Exchange risk, lenders are usually reluctant to allow the debtors to incur this risk, so if there are no mitigating measures, most likely you wouldn’t have foreign debt. Now, if the government wants to attract foreign debt to PPPs, and there is not enough market depth so as to mitigate the risk through coverage instruments (swaps, cross-currency swaps, etc) it shall provide for an exchange risk mitigator (either tariffs are exchange-rate adjusted, or provides for some exchange rate coverage mechanism)

In the case of interest rate risk, interest rate volatility and available funding are the main concern. Concessionaires face these risks because: (1) there is a lack of long term financing (so you finance mid or short term expecting to refinance this debt at maturity); (2) there is no availability of long term fix rate financing (and no market depth to cover this risk); or (3) there is a significant elapsed time between bid submission and financial closing (elapsed time well above 1 year, is the norm rather than the exception in many developing countries)

By Sergio Merino, a PPP Practitioner in Chile

Posted 25 Aug 2016

Thank you for your insightful observations. We agree that there may be merit in more specifically distinguishing between exchange risk and interest rate risk in future editions of the Report so as to further elicit more detail on some of these issues.

In various parts of the Report, you will note that in the context of emerging markets, we have flagged that certain Government support may be required to attract foreign investment to the project (i.e. to appease any ‘bankability’ concerns), not only in the context of exchange and interest rate risks but also issues around repatriation of funds and convertibility of currency. It is for this reason that this risk is typically “shared” in toll road projects as between the Private Partner and the Contracting Authority. In regards to emerging markets, the devaluation of local currency beyond a certain threshold could be addressed by having a trigger for a “cap and collar” subsidy arrangement from the Contracting Authority or leading to non-default termination.

We have also made the observation in the Report that the risk of currency and interest rate fluctuations are generally considered not to be as significant in the context of developed markets, and the Private Partner will seek to address through its own hedging arrangements. However, relevant to your comments, the Report does note that the Contracting Authority may take the risk of a change in the reference interest rate between submission of a bid and financial close.

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In relation to Design Risk, it should be important to emphasize the risk associated with poor basic data. The idea that...

In relation to Design Risk, it should be important to emphasize the risk associated with poor basic data. The idea that any error in the design proposed by the granting authority shall be borne by the private sector, should be waived if there are errors or omissions in the basic data supporting such design. It would be almost impossible for every bidder to collect and process basic data (geological, utilities, natural water flows, etc), so the need that the government shall collect and process these type of data, should be highlighted.

By Sergio Merino, a PPP Practitioner in Chile

Posted 26 Aug 2016

We agree with your view.

It is a good example of how Contracting Authorities can assess and share risk. For a Private Partner to even attempt to bear this risk they would need to introduce substantial contingencies in their pricing which is unlikely to offer value for money for the Contracting Authority. It will also substantially reduce Private Partner interest in the project which will reduce the competitive tension. It also illustrates the need for Contracting Authorities to undertake a vigorous feasibility stage review in which their data can be collected and verified.

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