Risk identification and allocation in PPPs

BASIC PRINCIPLES | RI SK ALLOCATION AND BANKABILITY | RI SK MATRIX

ES KOM P P P T R A INI NG
0 1 AUG UST 2 0 1 7

SAUR ABH S UN EJA

This presentation
 Risks in PPP projects – some basics

 Risk identification – a short exercise

 Why risks matter and how to mitigate them?

 Concluding remarks
Risk factors in PPP projects - Basics
Example: Channel Tunnel Project
 1986 - TML (Trans Manche Link), a consortium of construction companies won
50 year concession
 Eurotunnel – created as an SPV late in the process
 TML put little equity in Eurotunnel – main equity through four public offerings
to small shareholders
 Loans financed by consortium of 100 banks
 Safety standards evolved as project progressed affecting design – costs
doubled to £10 billion
Revenue forecasts for Eurotunnel were disastrously optimistic!
Revenues of £287 million vs. forecast of £440 million in 1995

Initial projections Actual

• Capture 67% market share from
ferries
• Premium Pricing over ferries because
of faster crossing time, higher service
frequency, reliability
• Only 30% market share!
Initial technical and operational problems –
erratic services
• Price war – ferry prices fell by 30-
40%

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Example: Ninoy Aquino International's Terminal 3 (Manila, Philippines)

• 25 year concession awarded to PairCargo and Fraport

AG
• Started construction in 1997; was to complete in 2002
• Allegations of Bias in award of contract

In 2003, Philippine Government stopped work & Supreme Court declared the BOT
contract void

Legal Issue Actual

• Opinion in 1999 that anti-dummy law was • $64 m compensation paid by the
violated. Under this Philippine law, Philippines Govt. to PIATCO in 2006
foreigners are prohibited from exercising
any management influence in “public utility
companies”

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Example: El Alto water concession

• Public water system of El Alto concessioned to Aguas

del Illimani S.A. (AISA), a subsidiary of the French Suez
(formerly Lyonnaise des Eaux) in 1997

Concession terminated in 2005

Community groups opposition and demand to terminate because:

• Water prices up by 35% between 1997 and 2004
• The cost for a new water and sewage connection was $445 - more than six months of income
at the national minimum wage
• Failure to expand network (though contractual provisions are not actually violated!)

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Risk Identification – what happened in the various project examples

Projects experienced events that critically affected the profitable

continuation of projects

Channel Tunnel Manila Airport El Alto Water

• Lower traffic • Legal invalidity • Lack of sector reforms
• Lower charges • Expropriation • Alternatives for network
expansion not created
• Higher costs • Termination payment
not as per contract • Lack of public acceptance

In technical parlance,
Not only did ‘risks materialize’
But also their impact could not be contained leading to debilitating effect on
the project outcomes
Relevant risks over the project life cycle
Development Construction Operation

• Land acquisition • Project completion – time • Inputs - availability, quality &

• Rehabilitation and
resettlement
• Permits and
• Project contracts
• Financial closure
• Project completion – cost
• Construction quality
• Performance of design on
commissioning
price (e.g. fuel)
• Plant availability
• Efficiency of process
• Market risk- demand, price,
payment

Risks prevalent throughout the life of the project

• Political risks – Change in Law/Tax/Policy, Expropriation/nationalization of assets
• Regulatory risks
• Environmental risks
• Force majeure risks
• Foreign currency risks – Exchange rate, availability, repatriability
• Inflation

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Risk Mitigation

Any Action to reduce:

• Likelihood of risk materializing, with whomsoever the risk resides
• Consequences to the risk-taking contracting party, if it materializes

Comprises:
• Risk Elimination: If risks are too high, should the project be undertaken?
• Risk Reduction: e.g. clear specifications, high quality feasibility studies
• Risk Transfer through contracts
– Between Government department & private developer
– Between private developer & sub-contractors, suppliers, insurers, users
• Allocating risk to the party best placed to deal with it
– Political Force Majeure / Change in Law - Government
– Land acquisition

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Contracts reflect allocation &
mitigation of risks - Roads Highways
Authority

JV Partners

Concession Agreement
Escrow Bank
State Government

Lenders

SPV O&M Contractor

EPC Contractor O&M Contract
EPC Contract

Concession Agreement SGSA Escrow Agreement Substitution Agreement

• Risk Allocation b/w Govt. & • Major implementation • Risk of misappropriation of Mitigating lender’s risk
Concessionaire risks that State Govts accruals
• Mitigation for risks transferred can address

• Design Risks • Pre-construction risks • Risk of debt not being • Risk to lenders of
• Construction Risks • Clearances serviced concessionaire not
performing
• Traffic & Toll rate Risks • Competing Facility Risk • O&M exp.not paid

• Service Quality Risks • New taxation Risk • Under reporting of revenues 10

Risk identification – Case of ‘Z Port’; risk matrix
Case Example: Z-PORT

Project Background
• Government notifies a port site to kick start economic development
• Obtains long tenure multilateral loan for port construction
• Government decides to transfer the project to private sector on PPP basis
• Government appoints a consultant to manage bid process
• Project is structured as a B/-O-M-S-T (Build-Own-Manage-Share-Transfer)
• Existing assets (berths, equipment, sunk costs – dredging) to be transferred
to SPV on OMST basis
• New assets to be constructed and commissioned – (berth, equipment, etc.)
Case Example: Z-PORT
International competitive bidding was undertaken

Qualified Technical Commercial Preferred

bidders Proposal Proposal Bidder
short-listed evaluated evaluated

RFQ Stage RFP Stage LOI Stage

Comprehensive Selection Criteria was used

Technical Criteria Commercial Criteria

• Traffic Forecast Methodology • Minimum Guaranteed Share of Income (MGA): 50%

• Port master plan and capital cost estimates • Percentage Revenue Share: 30%
• Financial plan and tie ups • Investment Planned in Phase 1: 20%
• Tariff structure
• Organisation set-up; competent project chief;
productivity norms
Case Example: Z-PORT

Key post award issues that came up:

• MGA / Revenue Share not workable

• Unexpected costs came up
• Several other issues
Case Example: Z-PORT

Key post award issues that came up

• MGA / Revenue Share not workable

100 REVENUE SHARING FORMAT At Bid Stage:

90 MGA
Bidder quoted MGA + escalation 8%p.a. & Revenue
80 Share 20%-22%
Amount (Rs. in Crores)

70 DPR Revenue Share

60 At post award review:
50 Independent Consultant’s report highlights that MGA
40 would always be higher than Revenue Share
30
20 Result:
10 Revised Revenue Share Project not bankable at MGA levels.
0 Lenders uneasy. Delays in financial closure.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Concessionaire requests for revision of payment
Year structure to Government.
Case Example: Z-PORT

Key post award issues that came up

• Unexpected costs came up

Additional Dredging Costs:
RFP states – ‘the designed water depths as on dd-mm-yy are adequate for servicing
the ships needing drafts upto zz metres.
However between the RFP and the port hand-over, maintenance dredging was not
carried out as the port was to be handed over to the private sector

Boulder Removal Costs:

During construction of earlier berths, the contractor had used various rock materials.
Contractor had declared that major debris was removed post-construction.
But large size boulders are found when the private entity begins surveys

Cavities in Diaphragm Wall:

Independent experts opined that it is not uncommon and that adequate repair
should be carried out. But it means additional costs!
Case Example: Z-PORT

Key post award issues that came up

• Several Other Issues

Public unrest:
Fear of cannibalisation of nearby anchorage port operations by the new deep
draft port. Local community feared loss of livelihood.
Delay in project milestones:
Unexpected costs, poor state of movable assets, operating losses, lower traffic
realisations, etc. resulted in delays in achieving milestones.
Delays in financial closure:
Initial funds were infused by the promoters. Promoters approach lenders for
funds. Lenders were uncomfortable with the provisions of the concession
agreement due to the MGA issue. As a result financial closure was not being
achieved!
Case Example: Z-PORT

So which project risks can be identified from this case study?

 Lets do a small exercise…

Prominent risks that can impact an infrastructure project
RISK CATEGORY DIRECT CONSEQUENCE
Construction risk Additional raw materials and labour costs, cost of maintaining existing infrastructure
Demand risk Reduced revenue based on lower throughput
Design risk Cost of modification, redesign costs
Environmental risk Additional costs incurred to rectify an adverse environmental impact on the project.
Financial risk Additional funding costs or unexpected refinancing costs
Force majeure risk Additional costs to rectify
Industrial relations risk Increased employee costs, lost revenue or additional expenditure during delay in
construction or service provision
Latent defect risk Cost of new equipment or modification to existing infrastructure
Performance risk Cost of failing to comply with performance standards
Change in law risk Cost of complying with new regulations
Residual value risk Lower realisable value for underlying assets at end of project term
Technology Cost of replacement technology
obsolescence risk
Case Example: Z-PORT …
Key project risks can be identified from Z PORT case:
Construction risk More than expected construction cost due to additional dredging requirement and
requirement for boulder removal
Latent defect risk Cavities detected in diaphragm wall – repair expenses with respect to existing
infrastructure
Demand / traffic Traffic levels were less than the assessment that formed the basis of financial bid –
risk unfavourable project economics
Optimistic traffic assessment by both government and developer at the bidding stage

Financing risk Delay in financial closure due to less robust project viability
Maintenance risk Greater than expected maintenance costs due to poor state of movable assets
Mechanical equipment had significantly depreciated as a result of being unused for several
years

Social risk Feared loss of livelihood by local community

Proposed development in competition to existing port that provides employment to locals
Preparing a risk matrix – Key steps
 Qualitative analysis of risk : sources, consequences, mitigation strategies
 Risk allocation: risk allocation between public and private stakeholders
 Cost to government: maximum, expected (likely)
 Likelihood of event occurrence: qualitative/ subjective
 Identify critical risks, enabling government actions and follow up
Risk Matrix
An Illustration

Govt. Impact Likelihood Severity

Risk Consequence Allocation / Mitigation
Liability Grade Grade Grade
Site conditions Increase in Time, Concessionaire Nil Low Low Irrelevant
Cost in turn passed on to EPC
contractor
Market risk Low revenues Concessionaire / MRG Max:$100mn High Med High
b/w 60%-80%, revenue share
>125%
Force Majeure Compensate, Shared Max:$300mn High Low Medium
Terminate Insurance by concessionaire, Exp: N.A.
govt. compensates for
uninsurable and exceptional
event
High Low Medium
Termination
Compensate, Shared Max:$300mn
Terminate Equity & Debt not fully covered. Exp: N.A.
Developing bankable PPPs – risk management matters
Private investment in infrastructure cannot be taken for granted
Government’s reluctance towards PPPs… Developers may face substantial risks…
 Infrastructure regarded as vital national asset • Demand risk: less than expected traffic & underutilized
 Infra projects have extensive external effects capacity
and linkages – govt.’s involved role in • Tariff risk: tight regulation typical for aeronautical revenues -
planning revenue risk
 Many Infrastructure developments operate • Development stage risks: issues in obtaining statuary approvals
as natural monopolies, risk of abuse of • Financing risk: Inability to raise finances / delay in financial
dominant position closure / increase in financing costs

Key to-dos to make projects bankable & attractive for pvt. Sector
 Adequate project preparation – for high private interest, getting
competitive bids
 Sensible risk allocation between government & private developer
 Transparent & balanced framework for tariff setting (including trajectory)
 Viability enhancement measures if required
 Measures to enhance lender comfort
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Logical risk allocation is at the heart of PPPs (and bankability)
Risks typically allocated to private sector:
- Design, technology and construction risk
- Demand / traffic risk (PPAs mitigate this in power projs.)
- Operating / performance risk
- Financing risk

Shared risks
- Force majeure
- Demand risk (in some
cases)

Binding government to obligations:

- ‘Implementation agreements’ or ‘state support
agreements’ may be signed in addition to CAs that
record committed government responsibilities
- Default on key obligations may trigger
compensation or force majeure
Risks typically allocated to government:
- Ensuring land acquisition
- Key statutory approvals
- Ensuring connecting infrastructure
- Change in law / other regulatory risks

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Logical allocation of risks matters for attracting private investments
Lessons from oil field auctions in Mexico (July and Sept 2015)
 2 rounds of oil fled development auctions in Mexico
◦ July’15 auction managed to find buyers for only 2 of
the 14 blocks; Sept’15 round faired better – 3 of 5
blocks on offer found buyers despite lower prices (9
bids received)
 Improved response credited to lower risk
perception and rationalized bidding rules
◦ Advance information on minimum production share (below
which bids would be rejected)
◦ Reduced bid guarantee requirements
◦ Clarification on circumstances under which the regulator, the
National Hydrocarbons Commission, could rescind a contract
 77-year monopoly of Pemex, the state oil firm, ended in
2015
Managing demand risk
 Demand / traffic is a prominent risk faced by private developers – given high investment requirements, returns
are very sensitive to lower than expected demand
Discussion on some measures to manage demand risk
Balancing capex. expectations vs. viability
Projects often conceptualized with expensive
specifications or high capacities; need to manage
capex:
- Cost effective / less prescriptive architectural
designs
- Modular expansion in line with demand (as
the case with airport terminals, highway lanes,
additional trains in desalination plants)
- Partial safeguards in cases of low traffic
common in infra concessions
Exclusivity / Restriction on developing competing
facilities
Need for balance between interests of developer
and users (competition / adequate
infrastructure); examples
- In India, restriction on developing a competing
airport within 150 KM; but allowed in case
expansion not possible at existing airport
- Typical measures in PPPs: no competing facility
till time / capacity utilization threshold; first
right of refusal to incumbent
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Measures to enhance lender comfort
In addition to structuring viable projects and mitigating risks – some specific mechanisms
enhance lender comfort:
 Taking reasonable securities
◦ Finance guarantees provided by govt. – loan guarantees (govt. guarantees debt in case the project company
fails) and re-financing guarantees [e.g. Loan Guarantee Instrument for Trans-European Transport Network
Projects set up in 2008 to backstop senior debt servicing during initial ‘ramp-up’ periods of transport PPPs]
◦ Possibility to take over movable assets in case of default
◦ Clear procedures for appointment of liquidators

 Lender step-in rights

◦ Many concession agreements allow lenders to take control of the infrastructure project or to replace
concessionaire where the project company is not performing / cases of financial default
◦ Supported by ‘substitution agreement’ executed at the time of concession

 Other provisions where needed

◦ E.g. Amman (Jordan) Airport – traffic risk taken by developer, but protection to lenders in cases of traffic loss
due to unforeseen catastrophic event
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Contingent liability risks to the government sector in
case of PPPs
Contingent liabilities and relevance to governments - context
 All PPP arrangements lead to some contingent liabilities (CLs)
◦ While in most PPP arrangements government does not need to provide an upfront financial contribution,
contingent liabilities are created (government default – like not payment, termination due to government
action)
◦ The PPP legislation already insists on recognition, treasury approval and reporting of contingent liabilities
 The capital values of several of the planned PPP projects are substantial, these PPP Agreements shall
thus create large contingent liabilities
◦ One of the likely PPP projects in the energy space: solar CSP is expected to have a development cost of NAD 11.5 BN

 Contingent liabilities matter: accumulation of CLs can have a tangible impact on sovereign ratings
 The present fiscal policy environment (in Namibia) not geared up to accommodate PPPsZ
◦ CLs in the case of PPP projects are seen as ‘unlikely’ risks (assuming good contracting), therefore are different from
government guarantees
Impact of CLs on sovereign ratings
 Excessive CLs can lead to
adverse impact on sovereign
credit ratings
 As per a guidance from S&P
CLs below 30% of GDP are
considered as ‘limited’ / low

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The work in front of us…
 Task definition:
◦ Review of the present mechanism for recognition, accounting and reporting of guarantees / CLs
◦ Recommend an update to the framework for accounting of CLs that is suitable for PPP projects
(high value but low probability CLs)

 Goal posts (what a solution should satisfy)

◦ Credible system for recognition, accounting, reporting and updating the CLs (with sufficient project /
public entity related details; suitable for internal and external information needs)
◦ Identifying a well studied acceptable threshold for PPPs related CLs (if different from existing
buckets)
◦ The proposed system to be compatible to the expectations and requirements of external
stakeholders: credit ratings, bond investors, IMF

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Conclusion
 Risks are an integral part of any infrastructure project
 It is important to upfront identify all possible risks that would impact the progress of the
project
 The consequence and impact of each risk needs to be assessed
 Risks then need to be allocated to the entity that is best suited to manage such risks –
through project concession and associated contracts
 The objective is not to maximise risk transfer but optimise risk allocation!
 Risk allocation is the key step that is used for developing contracts
Thank You Contact: Saurabh Suneja
Director, Public Private Partnerships
Ministry of Finance, Republic of Namibia.
Tel: +264 61 2092083/2557 (O) +264 856331146 (M)
Email: saurabh.suneja@mof.gov.na