Efficient risk sharing for public private partnership with a focus on regulatory and market risk

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University of Amsterdam, Amsterdam Business School

Master in International Finance

Master Thesis

Efficient Risk Sharing for Public Private Partnership With a Focus on

Regulatory and Market Risk.

Narula

Narula,,,, Kunal

Kunal

11352957

Sept

Sept –

–

– 2017

2017

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Introduction

Investments in infrastructure project produce positive externalities that affect the society as a whole and not just a particular section. Externalities occur when the actions of firms or consumers impose costs or confer benefits on third parties who are not originally part of the transaction. In many scenarios the firms or the consumers fail to take into account when choosing their actions [Brealey, Cooper, & Habib, (1997)]. Such externalities play a vital role in determining the success of investments in public goods and services such as infrastructure development in a country. The affect of infrastructural development on the overall health of the economy is well known and documented. According to a report from the McKinsey Global Institute released in 2016, an estimated $57 trillion in infrastructure investment will be required just to keep pace with projected global GDP growth by 2030. That’s nearly 60% more than the $36 trillion spent over the past 18 years. Especially in emerging markets, where lack of infrastructure is directly linked to many socio economic problems, more and more capital needs to be mobilized to the sector to fill the gap between the demand and supply of infrastructure. Through this report, I discuss various sources used to finance infrastructure projects, how PPP helps filling the gap where other sources are not effective individually, common risks faced by infrastructure projects and how can risk sharing between the private party and the government be made more efficient. PPP has been gaining popularity all over the world as a more efficient method of financing infrastructure needs of various countries.

The reason PPP is considered more efficient than private and public sources is because it combines both of them. However, higher efficiency can be achieved only in case the combination leads to higher return from the investment or lower overall risk. In this report, I focus on the risk factors which affect infrastructure projects in general and ways in which these risks can be shared between public and private sources of finance based upon the financiers ability to manage the risk.

I analyze three cases which use the PPP model which help me determine that Market and Regulatory risk require a special attention with respect to determining whether they

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are managed well by the public sector or the private sector. I analyze these two risks in detail, based on observations made in existing literature and research and make observations through case studies. Existing literature too identifies the importance of Demand and Market risk. As per [Yang, Hou, & Wang, (2013)] a healthy market/demand must exist such that PPP projects are viable to be undertaken by the private party. Also, it is important that the financial sector shall be willing to invest in the project based on cost of capital considering that the private investor is immune against the market /demand risk.

In respect of regulatory risk [Zaharioaie (2012)] suggested that, the public-private partnership contract not being under complete control of the commercial law due to the nature of PPP contracts, which can be discretionary and modified by public authorities against the private partner. Hence to make PPP effective, it is important for the state to provide a stable regulatory environment and the government absorb or hedge against these risks on behalf of the private investor. This is because the risks that are supported by the state are in most of the cases ones that the private operators have little control of, such as political, environmental approval or land acquisition risk.

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Various Methods of Financing Infrastructure Projects

Both public and private financing of infrastructure have their advantages and disadvantages. Due to their very nature it is difficult to apply a single source of funding to all infrastructure projects. History of infrastructure financing has taught us that the biggest problem in the single source of funds was that risk was with the party (either government or private) which was not completely equipped to handle that risk in the most efficient way and derive the maximum return from a given level of risk. As the risk exposure of investors in the project increases it becomes essential to develop new approaches for determining the feasibility of projects. Feasibility of project investments is determined for public and private sector differently. While public sector mostly concentrates on the overall development of the society and the population at large, public sector’s focus is on return on investments in economic/financial form [Anthony D. Songer (1997)].

The basic idea of PPP implies that in order to cope with the challenges of development, there is no one organization which can single handedly deal with all the problems or risks present in financing of the project. Hence, private and public organizations need to create institutional arrangements which enable joint participation between them rather than competing with each other. Even though competition creates market efficiency, in

Infrastructure Finance Public Governement Sub national Developement Institutions Private Corporate Finance Institutional Finanace PPP

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the infrastructure sector synergies created through the use of PPP financing create more value as infrastructure projects carry many positive externalities which are usually not considered while calculating the economic efficiencies of investments in such projects. PPP is also plays an important role by changeing the traditional relationship of principal-agent in public sector, which relies on contracting operations or management to the private sector into principal-principal relationship which is a win-win situation for both sectors [Christensen and Legreid (2007)]. The reason PPP is able to be more successful than individual sources of financing is because it divides the risk bearing between the government and the private agency based on their ability to handle it and draw the maximum value out of bearing a particular risk.

Since profit is a reward for bearing risk it is very unlikely that risk can be completely avoided. Parties involved in investments try to manage the risk in the most efficient way rather than trying to completely eliminate it. This ensures that the given reward per unit of risk increases either through return maximization or risk minimization through efficient allocation and mitigation of risk. In the following sections, we first look at each source of funds individually followed by a discussion on PPP and why the appropriate transfer of risk is the most important determinant of the success of PPP as a method of financing infrastructure projects.

Characteristics of Public vs. Private financing

Public financing

Traditionally, the public sector is entrusted upon and is primarily responsible for providing people of the country with a set of public services (such as health, education or welfare) and for building basic infrastructure (roads, bridges, railways, etc.). Both theoretical and empirical evidence have highlighted positive relationship between high-quality public infrastructure and economy-wide productivity [Buffie & others (2012)]. Public investment is an important catalyst for economic growth which indicates a positive relationship between high quality public infrastructure and the productivity of the economy. [Ghazanchyan & Stotsky (2013)].

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Main economic reasons for public interventions.

Governments are expected to be the main providers of public goods and services. Governments collect taxes from people of the country and in turn provide goods and services required for survival and economic growth. Major reasons how this model can fail is that government agencies do not focus on profit maximization but on making public goods and services for the betterment of the society as a whole. The society consists of people who do not pay taxes, however need infrastructure to survive. This causes a disruption in the economic model based on revenues and costs through which profit/benefit can be measured and maximized. [Arrow & Lind, (1970)]

Benefit maximization to the society rather than profit maximization is more suited for the public sector rather than the private sector investments. Benefit maximization entail’s rewards such as reduced illiteracy, improved health conditions in the population or fewer accidents. While all this has an economic value (externalities), it may not always be expressed in financial terms and is not always captured as a revenue stream from the project. [Barro, (1988)]. Presence of externalities causes misinterpretation of project risks and how in turn they affect the efficiency of the investments in such projects.

Benefits of Public investments in Infrastructure

On average, an unexpected increase in public investment equal to 1% of GDP boosted GDP by an underwhelming but still beneficial 0.4% in the same year and by more than 1.5% four years later. Contrary to the popular belief, The extra spending did not cause debts to rise to an unsustainable level in fact quite the opposite. Due to the rise in GDP, the debt/GDP ratio fell by 0.9 percent in the first year and 4 percent after four years, although the authors do not set any store by the latter figure because there was so much variation in the results. [IMF report 2016 –Public spending and infrastructure].

The stimulus is even greater in case the investment is financed by borrowed funds. An increase in public investment equivalent to 1% of GDP boosts GDP by 0.9 points in the first year and 2.9 points in the fourth.

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Private investments/Privatization

Privatization means transferring all the control, management and risk of government functions and services to an operator from the private sector which can comprise of private voluntary institutions or private organizations [Hope, (2001)]. The main driver for emergence of privatization is the inefficient performance of the government in running businesses. This inefficiency is mainly due to fact that the government is better suited to be a policy maker and regulator rather than an operator and it gives rise to conflict of interest for the government to fulfill social and commercial goals through the business it is operating. It is also widely believed that public service policies and procedures can significantly limit the operational and decision making capabilities of the management. Also government budgeting processes restrict the autonomy in the investment process. Recognizing the below par performance of government operations in commercial businesses (eg airlines), and private sector’s technical progress, efficiency oriented approach for profit maximization in infrastructure far-reaching reforms have been implemented in terms of privatization. Some economic studies suggest that private infrastructure can provide benefits financially and economically through providing a return on capital and benefiting the society as a whole. A good example can be the privatization of highway network in the USA which has been studied by [Winston and Yan (2011)]. There is no clear evidence that private sector can build and operate infrastructure projects more efficiently if the effect of externalities from these projects is considered while calculating the efficiency.

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Forms of pri

Forms of private finance

vate finance

Similar to public finance, the company’s credit rating and the strength of its balance sheet is of importance to investors. A highly levered balance sheet can restrict the company’s ability to raise further debt.

The company’s entire operations are analyzed by investors, since the debt has to be serviced out of the company’s operating profits.

The loan for the project is a loan on the company’s balance sheet and has to be serviced out of the revenue the company earns.

Corporate finance is the traditional form of non-public infrastructure finance. Companies that are in business to build and operate infrastructure issue shares on the market, or borrow funds through capital markets to finance projects. Companies consist of a diversified portfolio of projects with differing performance and operational risks. Retail and institutional investors may purchase shares of infrastructure companies directly, or hire asset managers to select securities for them. Lenders to a company look at its entire asset portfolio and balance sheet to generate the cash flow necessary to service their loans. Both the government and private companies are starting to avoid the option of balance sheet financing since it strains the company's borrowing capacity and limits its potential participation in future projects.

Institutional investors Independent Asset managers Pure Play Diversified Asset managers Large Banks Investment Banks Commercial Banks Investment arm of Insurance companies Pension Funds Soverign Wealth funds

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We discussed earlier that infrastructure goods are better suited for public finance.

Focus on dividend/income rather than long term growth

Dividends have accounted for over one-third of the total return of the S&P Global Listed Infrastructure Index in the past ten years. High dividend income has been able to attract more investors who prefer constant flow of returns and are not affected adversely by the taxes on dividend income as compared to capital appreciation.

The S&P Global Infrastructure Index is designed to track 75 companies from around the world chosen to represent the listed infrastructure industry while maintaining liquidity and tradability.

Dividends payment might require companies to have a cash flow orientation rather than having a long term investment horizon. Dividend payments can also cause companies to

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choose investments as a portfolio matching dividend payment expectations rather than investments in best projects.

Public Private Partnership (PPP)

A PPP is ‘an agreement where the public sector enters into long-term agreements with the private sector entities for building, operating, managing public sector infrastructure facilities by the private sector entity, or the provision only for services (using infrastructure facilities) by the private sector entity to the community on behalf of a public sector entity’ [Grimsey & Lewis, (2002)].

There are many definitions of a PPP. The differences are present because PPPs are a relatively new concept and governments across the world have taken diverse approaches to PPPs, determined through control, funding, and ownership of the project being financed through PPP.

PPPs are fundamentally varied from complete privatization, and the difference depend on the ownership of risk related to various activities. In a fully private project, all risks are borne by the private sector, whereas some risk from a PPP remain with the public sector. Additionally, contractual arrangements are the main driving force behind the PPP risk sharing model and extend over a defined period of time [Demirag & Khadaroo, (2008)]. PPPs as a group of these varied contractual agreements between the public and the private sector are financing methods that blend the traditional public financing with the privatization. This blend combines the government control and ownership with access to private sector for operational efficiency and some capital. In a PPP financing model, the private sector builds, partially finances, operates and services the project. Despite growing interest and expanding use of the method, it is yet to be determined whether PPPs lead to better and efficient use of public resources. The ever growing ‘infrastructure gap' and the need to mobilize more and more capital towards infrastructure financing means that the long-term global prospects for PPPs remain strong. Understanding government motivation in the use of PPPs and their ability to

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enhance public sector efficiency will play a vital role in the long run success of the financing model.

Advantages of PPP.

The reason PPP has and is gaining so much popularity and is being adopted by countries around the world is that it addresses the fundamental problems of both public and private sector and tries to maximize value from the project by efficiently leveraging their strengths. Governments expect that private sector management enables a better allocation and a more efficient use of public resources which are scarce.

This efficiency can be reflected in various ways such as faster completion of projects or better operations post completion. It also enables building of projects which might not have been possible due to lack of finances or lack of operational capabilities by either the public or the private sector alone. [Debande (2002)] reasons that PPPs enable mobilization of private capital to build infrastructure, which may not otherwise be possible without private funds.

Because of significant government budget constraints. Another major advantage to PPP is that the government can focus on strategic priorities like defense and tax collection while enabling the private sector to manage operations of infrastructure projects which they are better equipped for. This provides comparative advantage in terms of efficiency (provided the private sector has incentive). The main benefit of PPPs emerges from the ability of the private sector to manage projects more efficiently (from higher quality management) and ability to reduce the construction and operational cost deviations from the desired estimates.

Drawbacks of PPP

Despite their advantages of higher operational and managerial efficiency, PPPs are often criticized to encourage governments to make off balance sheet investments which might not be most efficient (especially when fiscal constraints are binding). PPPs enable governments to make public investments and postpone the expenditures without

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compromising current budget and debt which in that case does not reflect the government’s debt in a true way. This might cause the government to increase infrastructure as a populist measure rather than increasing the overall value derived from the project.

[Bovaird (2004)] argues that PPPs can undermine competition, which is one of the biggest determinants of market efficiency. Whether absence of efficiency because of lack of market competition is related to the way PPP's are structured or the fact that the sectors in which PPPs are set up are low-competition is unclear.

The report [Glaister, (1999)] analysis whether use of PPP rather than public finance does actually lead to increased operational efficiency for infrastructure projects and concludes insignificant evidence to accept the hypothesis.

In PPP projects, a lot of emphasis lies on the contractual agreement between the public and the private sector. These contractual agreements have a significant bearing on the success of the project. Since these contracts are negotiable, it is unclear whether the success of the format of financing lies in the risk sharing or the bargaining power of the parties involved. [Blanc-Brude, Goldsmith, & Valila, (2006)] argues that the terms and conditions of the contract between the government and private sector determines the success of the partnership and efficient execution of the project

Common PPP schemes

1. Design-Build (DB), The government, makes a contract with a private partner to design and build a facility as per the norms or standards required by the government. After the construction is complete, the government holds responsibility for operating and maintain the asset. The ownership of the asset remains with the government throughout. This scheme is also known as Build-Transfer (BT). Design and build is the most basic form of PPP and has very less difference from public financing where the construction process is contracted to a private party. This model of PPP would be most suitable in cases where the government wants to maintain complete control over the asset due to factors as

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mentioned above, however, wants to avail the designing and construction expertise of a private company. This method of PPP might be useful in strategic industries such as defense. Under this method, very little risk is transferred to the private sector. The Private party is paid for its services and carries no demand or other market related risks for the project.

2. Design-Build-Maintain (DBM) In addition to Designing and building, under this method the private sector is also responsible for the maintenance of the facility while the government is responsible for the operation. Asset is owned by government. The important point to note here is the separation of maintenance from operations. The private partner’s job does not end with the completion of the project. It still has to carry out the maintenance while the asset is being operate by the government. For this the private party is paid a fee based on the contract fixed at the initiation of the project. Hence the private party carries no market or regulatory risk. The private party however does carry risk of maintenance expenses increasing significantly. Mostly this risk is hedged with clauses in the contracts which increase maintenance fee on regular intervals or links it to inflation.

3. Design-Build-Operate (DBO) - In addition to Design, Build and Maintain, the task of operating the asset is also transferred to the private party. Under this mechanism the private operator is allowed to recover the maintenance and part of building costs by charging a fee to the customer or the end users of the asset. This is one of the most famous and widely used mechanisms for public infrastructure such as toll roads, airports etc. Whether the market risk is transferred to the private party under this mechanism is not clear. More often than not the fee the operator can charge the end users is fixed at the beginning of the contract with revisions at regular intervals. This puts the risk of lower than expected demand for the asset on the private party. To attract interest from the private participants who otherwise would not be willing to assume this risk as they have no means to manage it, the government often provides a guarantee

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in case there are losses due to shortfall in demand or usage of the asset. The government can also have non-competition clauses in the contract so that the asset does not lose on to competition from other assets operated by the government for lower prices. E.g. in case there is a DBO contract for a toll bridge over a river, the contract can stipulate the government not to construct any other bridge of the river for certain number of years. These projections indicate that the transfer of market risk from the government to the private sector is heavily dependent on the terms of the contract between the two parties. The structure incentivizes the private sector to operate the facility in the most efficient manner to minimize the costs of operations and earn the highest achievable margin on operations. This is better for the society as a whole as it causes an overall increase in the efficiency with which public goods are operated.

4. Design-Build-Operate-Maintain (DBOM) This scheme is a combination of design-build with the responsibility of private partner for the operation and maintenance of a public asset for a certain period. When the period ends, the operation is given back to the government as the owner of the asset. Throughout the process the ownership of the asset remains with the government however the responsibility of the operations and maintenance is with the private sector. This mechanism clearly transfers almost all functions of the asset from the government to the private party. However since the government is owner of the project throughout the process the pricing and market risk also remains with the government. The government decides on the expected usage and prices the private operator can charge the customers. In case of a deviation from the projections, the operator is safeguarded through guarantees or floor prices. Similar to Design Build and Operate, operational efficiency is maximized through this structure. In addition to operational efficiency the mechanism also ensures efficiency with respect to maintenance of the project. This opportunity to the private sector to earn a higher margin due to improved efficiency comes at the cost of higher risk. This mechanism seems suitable for projects in which the

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government has lower operational and maintenance capabilities compared to the private sector. One of the major drawback of this mechanism can be the conflict of interest which arises due to difference in the operator and the owner [Pius Francis Kwaku Agyemang, (2011)]. E.g. for a road project as we will see in the latter case study of NH8 (India), Environmental clearances can cause major delays in the construction of the project with the private sector not possessing the capabilities to manage this risk. Hence the transfer of this risk from the government to the private sector does not always indicate efficiency.

5. Build-Own-Operate-Transfer (BOOT) - Under this scheme, the government gives a private partner the right to finance, design, build and operate a public facility for a definite period of time. The private sector also owns the assets for such period of time. At the end of the period, control of ownership, operation and maintenance, and capital investment of the facility is given back to the government. During the time the ownership is with the private sector the entire risk also lies with the private sector. Unlike the mechanisms mentioned above this mechanism in which the ownership of the projects remained with the government during the construction and operation of the project. Transfer of ownership means that the private operator has more freedom in deciding the expected usage of the asset and pricing mechanism during the ownership of the project. This freedom is at the cost of protection provided by the government to the private operator. In case the demand for the project is lower than expected the private sector has no recourse like guarantees etc. to recover the shortfall from the government. Since the ownership of the project lies with the private sector during a specific period of time. This method incentivizes the private sector to efficiently and quickly complete construction so that it can start operating and earning revenue from the facility as soon as possible.

6. Design-Build-Finance-Operate/Maintain (DBFO, DBFM or DBFO/M) Through this scheme, government gives a private partner the right to design, build, finance, operate and/or maintain a new public facility under a long-term lease.

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The private sector is allowed to own the asset for a period of time through lease system. When the lease term ends, the facility is given back to the government. As practiced in several countries, DBFO/M covers both BOO and BOOT schemes. The primary difference between DBFO and BOOT is that the ownership tenure of the private sector is the lease period of the project. As compared to BOOT, this mechanism requires the private party to have expertise in the financing mechanism of the project.

Analysis of owner of various risks under each scheme

Capital Investment

Operations &

Maintenance Ownership Demand risk

Design Build Government Government Government Government

Design Build

Maintain Government Government/Private Government Government

Design Build

Operate Private Government/Private Government Government

Design Build

Operate Maintain Private Private Government

Private (Hedged with

government guarantee)

Build Own

Operate Transfer Private Private

Private (till transferred)

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Design Build

Finance Operate Private Private

Private (till transferred)

Are all projects suitable for PPP

Are all projects suitable for PPP?

?

Not all infrastructure projects are suitable for the PPP structure. As we have seen in the above sections, PPP has certain advantages over other methods of financing, however, these advantages are not applicable to each and every project. Large projects which require large upfront financing, very specific operational and maintenance expertise, are in interest of general public rather than one specific group and have not been embarked upon (successfully) in the past by either the private or public sector alone, qualify as good candidates for PPP financing. Since risk transfer is a major component of this financing mechanism it is important that risks in these projects is clearly definable and transferable from one party to another. Also it shall be ensured that the transfer of risk leads to greater efficiency in the construction, operations or financing of the project.

Apart from the suitability factor PPP’s are believed to give rise to monopolistic market conditions as has been concluded by [Bovaird (2004)]. These conditions arise due to the sheer size of the projects, inability of competitors from the private sector to finance the projects or clauses in PPP contracts which prohibit competition as a form of protection to the private sector. Even though a highly competitive market is assumed to be more efficient in providing services, certain services require government participation or control. Following conditions indicate towards the need of public intervention [Pennink,

(2008)] In the following sections we discuss suitability of projects for PPP based on two

conditions i.e. market conditions which require public intervention and risk transferability

Suitability based on market structure considerations

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As discussed earlier there are some specific market structures which suit PPP mechanism. In addition some situations require public intervention as mentioned below -

Natural monopoly in public service. Government needs to ensure minimizing the chance for monopoly by private sector, which can exploit the monopoly for profit maximization rather than improving the infrastructure. Hence PPP enable provides a middle path in sectors where creating a competitive market is unlikely. The middle path enables leveraging private sector efficiency under the watch of the public sector, hence preventing exploitation.

Projects requiring large initial capital investments usually are difficult for the private sector to execute. Hence PPP enables private sector to operate service or maintain the asset with the ownership/primary risk and major investment from the government. Without PPP these projects might not see the light of day due to lack of resources.

Due to (Large) Externalities the government needs to ensure that the negative externalities do not negatively influence society as a whole, in addition that positive externalities (i.e. health benefits from a project) do benefit society as a whole.

Barriers to entry, in the form of laws or regulations can prohibit the private sector from solely participating in the project.

It is also possible that by dividing a certain activity into various segments, can help allocate various parts of those services to parties which can handle them more efficiently. Services can be unbundled horizontally and vertically those parts that are suitable for partnership can be arranged as PPP projects and other parts that are unsuitable for partnership should remain under government’s control.

For example, in toll road, vertical unbundling of toll road development activity can be done with the result of these following components:

Policy preparation

Toll road network planning Feasibility study

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Design Construction

Revenue (toll) collection Operation and maintenance

Based on the characteristics of each component we can decide which activity can be executed more efficiently by the private sector. In this case, those activities include design, construction, toll collection and operation and maintenance. On the contrary, other activities such as policy preparation, toll road network planning and feasibility study should remain with the government. Unbundling activities this way can also enable the risk to lie with the party most equipped to handle it which is discussed as follows

Suitability based on risk considerat

Suitability based on risk considerations

ions

The first step in determining suitability of the project to public or private sector is understanding the risk averseness of the investor. Risk profiling in this manner can enable matching risk appetite of the investor with the riskiness of the project. Risk averseness of the investor enables them to decide required rate of return on their capital. The particular aspect where this makes the difference is the discounting rate that the different parties use for calculating the Net Present Value (NPV) of the projected future cash flows. The risk-adjusted rates of returns for private investors are higher than those set by public investors. However, this difference has been narrowing to almost non-existing in Europe, [The European Journal of Finance 231]

Private investors are risk averse and not risk neutral. This indicates that cost of capital used as a discounting factor for calculating the NPV of the project will be lower for the private sector due to it’s risk averseness. As the contemporary theory on risk-return trade-off suggests, the investors choose their discounting rates according to the risks they perceive in the investment. For this they can apply, the Capital Asset Pricing Model

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[Sharpe (1963)] which is calculated by adding risk adjusted market premium to the risk free rate of return.

The public sector which is perceived to be risk neutral often underestimates the cost of investment due to under estimating for the risk associated with the project and hence ends up making the investment in the project inefficient. [Flyvbjerg, Holm, and Buhl (2002) and Hufschmidt and Gerin (1970)] concluded that public investments’ cost estimates are underestimated almost as a rule.

Risks – PPP

Project-specific risks are defined as those conventionally associated with the construction, operations or financing of the project [Flyvbjerg, (2003)]. The construction risk primarily comes from the delays in completion and cost overruns. The construction risk may be caused by technical difficulties and/or poor management. Delays of completion may be caused by delays of some of the construction elements and doing poorly done work over again. Construction cost overruns may exceed the estimated costs for many reasons which include poor identification of the project, unknown geological conditions, and loosely defined safety specifications, escalation in cost of raw materials and labors and delays in project start-up and so on. In some developing countries, there are also risks of unavailability of construction equipment and lack of construction technologies.

Projects can also be exposed to demand and regulatory risks. There are many interlinks between these risks so before allocation it is absolutely necessary to identify these risks separately and identify features which can be separated for allocation between private and public separately. E. g. construction can involve getting environmental clearances which can also come under the ambit of regulatory risks. As we will see later, regulatory risks are best managed by the government rather than the private sector. Moreover, projects have substantial environment impacts, which will attract risks of strong opposition of public and environmental groups over the issues of pollution and visual

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charm. E.g design of a hydro projects can have substantial bearing on the ESG factors surrounding the project.

The project operation risk may also include project demand risk and operating cost overruns. The demand risk is related to the volumes of demand for the service provided by the completed infrastructure. User demand is very difficult to assess and forecast due to the absence of reliable historic information and data documenting the demand level and even with the extensive investigation of the past trend of demand, there will also be a residual risk on how much users the project could actually attract. For toll road projects in particular, surveys of traffic demand are not reliable considering that there are multiple factors influencing the predicting results, such like expected macro-economic growth, future competition from other transport modes and user behaviors. In addition, some unforeseeable event such as the oil shocks of 1970s also had dramatic impacts on traffic demand. Additionally, actual operation and maintenance costs may exceed those estimated in the project planning phase. If design has been well identified, construction has been adequately performed and start-up testing has been carried out satisfactorily, expected operation costs would be held in control (Yves, 1994). However, a couple of factors may come into play to induce an increase in the operation costs involving disappointing management, underestimation of costs in purchasing raw materials, repairing and renewing facilities, exceptional climate conditions, and incremental costs due to sub-contracting. Box 1b shows an example of negative PPP due to project operation risk.

Case Studies

Expansion of National Highway

Expansion of National Highway –

–

– 8 connecting two cities in Northern India.

8 connecting two cities in Northern India.

8 connecting two cities in Northern India. –

8 connecting two cities in Northern India.

–

BOT

BOT – (

Source – Public private Partnerships in India – Ministry of Finance -

https://www.pppinindia.gov.in/toolkit/highways/module3-rocs-dge1.php?links=dge1)-

The project involved expansion and construction of an existing 4 lane, 27.7 km section of the National Highway connecting the capital city (Delhi) to an industrial town (Gurgaon). The portion of the highway under consideration comprise of 20 intersections,

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experienced high vehicular density (180,000 Passenger Car Units (PCUs)/day in 2000) and non-segregated traffic. These factors led to increase in accidents, acute congestion, wastage of fuel and excessive pollution. The project was decided to be built using the PPP financing model.

The project was awarded to a private consortium which comprised of two companies to design, finance, construct, operate & maintain the facility for a concession period of 20 years. As a BOT highway project, the Concessionaire was allowed to collect toll from the users of the project facility during a fixed tenure of the operational period to recover the investments and costs of operations. At the end of the duration of the concession period the expressway would be transferred back to the Government. Out of the total revenue for the project approximately two thirds were from toll collection.

This was the first BOT project in India to have been awarded on negative grant basis. Negative grant means that the concessionaire offered to pay an upfront fee to the regulator (NHAI) in return of the right to operate the concession and collect fee from it. The negative grant arises in a situation where the project entails extremely attractive cash flows and private companies bid for getting the operational rights by paying to the government. Negative grants are also an indication for minimum or non-existent market risk for the project. As explained later negative grant arises in situations where the demand for the infrastructure is expected to be high so that the concessionaire can recover from the project way more than investments, operating costs and reasonable profit margin. Hence many private companies bid for the project with the negative grant being the bidding price.

The expressway was commissioned after a delay of three years mostly due to delays in acquireing the land and changes to the scope of work.

Financing Information

Following is the financial structure of the deal which was proposed at the time of the inception of the project. As it can be seen that the project is highly leveraged as the Debt to Equity ratio is more than two times. It is also important to understand that this was the financial structure of the SPV formed to Build, Operate and then after having earned sufficient return transfer the infrastructure asset to the Government. The reason the

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project could have been so highly leveraged which enables the increase in IRR of the project was because of the confidence of investors in the high volume of demand the project could have created due to an extreme lack of road facilities between two major cities.

On completion, the project costed USD 180 million, which is a cost overrun of almost 80%. To fund the shortfall in funding the payments of the EPC contractor were withheld. One of the major reasons for cost overruns was the design being revisited time and again. The design and build format of BOT requires the private party to design and build the project. The reason the Design and Build contract are given to the private contractor together are because building the project without a design is not possible, hence the party responsible for building shall also be responsible for designing. Since the delay was due to improper design it is right to penalize the EPC contractor by withholding his payments. I add a critical analysis of whether this method on three fronts. Who did the risk lie with, was the party which bore the liability rightfully allocated the risk. What were the benefits the deal saw due to allocation of risk this way?

Reasons for failure

Being in a thickly populated region, land acquisition was a major problem. This was in fact one of the core obligations of NHAI under the tripartite State Support Agreement

Particulars Amount Percentage

Debt USD 60 Million 70%

Equity USD 25 million 30%

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entered into with the concessionaire. Before awarding the contract, NHAI had assured the private partner that all requisite land acquisition deals had been obtained. However, there were some portions of land which were difficult to acquire.

Another major reason for the delay in project completion was the redefinition of the scope of work to be carried out. There were many changes to the original design recommended by NHAI and the government keeping in mind future requirements and the convenience of commuters.

Due to the high density of traffic on the road and other technical requirements such as the minimum length for acceleration and de-acceleration, the partial opening of expressway had to be delayed for safety reasons even if completed at certain locations.

Risk Allocation between government and Private

Risk can be better managed if it is accounted for and priced in the cost of capital. Most of the risks as mentioned above are clearly definable and can be accounted for in the contract between the parties. However two particular risks seem to be beyond the contractual scope, i.e. Market/Demand risk, and Regulatory risk. The public sector can contribute to higher efficiency through PPP by insulating the private party from these kind of risks [Zaharioaie, (2012)]. It is advisable that the risks should be shared based on the benefits perceived by each associated part of the project and should be allocated to the party that is best able to manage them [Carbonara, Costantino, & Pellegrino, (2013)]. Since Market and regulatory risks are beyond the reach of the private sector it is unlikely that they can be accurately factored into pricing. Moreover, the accuracy of the presumed transfer of a package of risks to the private sector, together with the identification and valuation of risks are essential to the construction of a meaningful PPP project (Jin, 2009).

Risk Sensitivity Bearer Comments

Regulatory High Not defined Even though this risk has not been addressed in this particular case. It is an

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important risk and shall be borne by the government agency as the private operator will have almost no control over political factors. Political lobbying is an effective risk mitigator used in many countries, however, it is very hard to establish its benefits given the absence of credible data or research. The public party shall insulate or isolate the contractor from political risks as they have little or no control over it [Zaharioaie, (2012)].

Political Low Not Defined Since the asset would have no sources or uses of foreign currency other than INR, this risk is quite insignificant, However in case there are plans of raising foreign currency loans, then this risk becomes very relevant.

Currency High Government Unless the private party is allowed the full authority to deal with any issues related to land acquisition, It is unreasonable to expect them to bear the risk akin to political risk. Mitigation for this risk is highly dependent on the high level of coordination between various government agencies. As we can see in this case that one of the major reasons for the delay in the construction and cost escalation was due to delay in land acquisition, this risk is a very important

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risk, at least in emerging markets where policies can be heavily dependent on political will.

Land acquisition

Significant Private Sector

The market structure can be characterized by the level of demand of the sector and the level of supply which is a function of the level of competition [Carbonara, Costantino, & Pellegrino, (2013)]. Demand risk can be handled by the private sector and public sector with the same efficiency. In this case, it appears that the government is better suited for taking on the demand risk as they can easily alter the demand by developing areas which the highway connects.

Demand and Market risk

This risk which was mostly borne by the private sector however it should have been with the government since this was a Built, Operate, Transfer Project.

Design Low Private

Sector

No indication has been provided regarding the severity or ownership of this risk. However, ideally it should be with the private sector in a Built operate transfer project.

Construction Risk

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* Financial closure is achieved when all financiers are tied into the project, signed the contracts requiring them to provide money to fund the project. Financial closure might not mean that the financing institutions transfer the entire promised capital, it only ensures that there is complete agreement between the investor and the investee

Analysis

One of the major risks which was not factored in for the private sector was the risk of increasing commodity prices. Neither private nor government are equipped to manage this risk especially in case of imported materials or machinery. However, this risk has to be well defined and factored into the pricing of the concession. Setting up a formula based compensation akin to one below can help handle this risk better.

Increase in toll charge = 1 + (Annual increase in commodity price – Consumer Price inflation)/ Actual (not expected) number of units handled by the concession.

One of the reasons that the PPP model makes projects attractive for the private players is because of the magnification of the equity IRR due to increase use of leverage. As we can see in this case, the project was 70% levered because the risk of the project lies with the SPV and the repayment of debt is assured from the cash flows of the project.

Build operate transfer (BOT) model enables the government to continue with the ownership of the asset, while at the same time enabling the private operator to operate and maintain the asset. If the risk of various activities is allocated properly to the parties involved, then both the government and the private company can immensely benefit out of the project.

Toll Road M6

Toll Road M6 –

–

– UK

UK

UK –

–

– DBFO Design, Build, Finance and Operate.

–

DBFO Design, Build, Finance and Operate.

(Source European Commission Directorate-General Regional Policy

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This highway was the UK's first privately funded tolled motorway. A 53-year DBFOM concession contract was originally awarded in 1992. However, opposition from local communities and legal obstacles meant that the PPP process did not restart until early 2000's and the road opened to traffic in 2003. The concession ends in 2054.

The PPP partners include Public Sponsor: Highways Agency (HA). Private Concessionaire: Midland Expressway Ltd (MEL) which consists of the following two partners: Macquarie Infrastructure Group (75%) and Autostrade (25%)

Risk Sensitivity Bearer Comments Regulatory Not

significant

Private sector

The Concession agreement provisioned for the private company (MEL) to carry out the design, construction, financing, operation, and maintenance (DBFOM) of the M6 Toll at their own cost and risk, without recourse to government funds or Government Guarantees. The absence of any sort of support indicates that all the risk has been transferred to the private sector. Even though not very significant in this case as the project is in a developed country and the risk appears to be non-significant, there is clear reasoning that regulatory risk maximizes

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The number of cars on the road was on expected lines however commercial vehicles did not use the highway as expected due to wrong toll pricing schemes. This led to cash flows being lower than expected which resulted in nonservicing of debt and eventually the restructuring of debt. Debt worth USD 1.1 billion was restructured so that the cash flows from the project were able to cover debt payments over the 54 years of the concession life.

Design Significant Private Sector

This risk which was mostly borne by the private sector and rightly so it has been transferred by the government to the private sector, through DBOFM contract.

Construction Risk

Low Private Sector

No indication has been provided regarding the severity or ownership of this risk. However ideally it should be with the private sector in a Built operate transfer project.

One of the key features which emerges out of the situation is that the market risk which clearly lied with the private part was shifted to the lenders of the project. The restructuring of the loan enabled the private party to reap benefits which were not shared with the government and hence can be seen as a loss of utility to the taxpayers of the nation. The motivation for the private party reaping all the benefits of the restructuring was that, they bore all the market risk and any benefit arising out of it

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(restructuring of debt) shall solely be with the private participant of the project. However, the ability to restructure indicates that the risk did not completely lie with the private participant.

This is no longer considered to be a good practice and most PPP contracts worldwide are expected to include sharing of benefits in some way. Therefore, even though not legally obligated, MIG agreed to reinvest 30 percent of its refinancing gains to fund several neighboring public projects of great interest to the Highways Agency. These include a toll-free extension of M54 to the M6 Tollway plus expansion of an interchange at the southern end of the M6 Tollway. Both projects will improve accessibility to the facility. MIG also agreed to operate and maintain these additional facilities during the concession period.

Analysis

As the first toll road in England to charge motorists a direct charge for using a highway, the M6 Toll represented a move to use different financing arrangements to the traditional UK shadow/availability tolling approach in order to

PPP model was used to enhance the funding for surface transport construction in the country, minimize the project risk to the sponsoring Highways Agency - While traffic continues

PPP with fixed, periodic availability payments—increasingly used for surface transportation projects – is essentially equivalent to a bond from a budgetary perspective, since it commits future funding resources from the government to this project.

The case of the Channel Tunnel

(Source European Commission Directorate-General Regional Policy

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Connecting the United Kingdom to rest of Europe, the Channel Tunnel rail link is one of the largest transport projects in the history. Crossing the English Channel through the tunnel, which links the United Kingdom to Europe through France takes only 35 minutes as compared to the 75 minutes-crossing by ferry.

Issues which led to the failure of the project

One year before construction started in 1988, the Channel Tunnel construction and equipment costs were estimated to be approximately 2.7 billion GBP. In June 1993, the funding requirements were re estimated to be 4.9 billion GBP, which as in excess of the initial budget by more than 80%. In May 1994, funding requirements reached 10.1 billion GBP. The Project was mostly financed through bank loans from a consortium of over 100 European and Japanese banks.

Overestimation of usage with risk on the Private Sector

The traffic across the Channel as a whole was overestimated. Initially, 16.3 million passengers were forecast for the Eurostar trains in the opening year. In the first year of operations, 2.7 million passengers used the facility. The volume of goods passing through the tunnel were sporadic, and they substantially fell in 1997 due to the closing caused due to a fire. The total volume of goods eventually stabalized. The commercial traffic through the tunnel reached and exceeded the market share forecasts made in 1980 for the transportation of goods through Eurotunnel, but the forecasts for 1990 and 1994 were overestimated.

Risk Sensitivity Bearer Comments Regulatory Significant Private

sector

English and French government authorities established an institution: the Independent Safety Authority, The institution put many environmental restrictions on the project. This was

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unmanageable risk for the private sector and one of the major reasons for the failure/delay. In this case too like all other cases,

As mentioned earlier demand was sporadic and significantly below the estimated levels before the opening of the facility. Though this risk was borne by the private sector, it had less or almost no control for managing this risk in a better manner. Competition from other methods of crossing the channel was not curtailed by the government for better utilization of the channel.

Design Significant Private Sector

This risk which was mostly borne by the private sector and rightly, so it has been transferred by the government to the private sector, through DBOFM contract The private sector executed the designing in a much efficient manner.

Construction Risk

Low Private Sector

Major cost overruns required fresh financing. This was also impaired due to the delay in completion due to regulatory problems. Even though it can be argued that the cost overruns should be a risk that the private sector should bear since it is responsible for building the asset. However it can be argued that delays in projects due to regulatory factors beyond

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the private sectors control should not result in the private sector being penalized.

The decision to use Government-guaranteed bonds transferred most of the risk back to the government. The contract does not clearly layout the events which would have to cause the guarantee to be activated. The government considered that their use had advantages over the alternative of making voted loans to the private constructor, financed through the issue of conventional Government bonds (Gilts).

Political and regulatory risk

The Link could not be developed without very active support from the Government at all stages. The Government is necessarily involved through rail regulation, and through the UK's international obligations, notably those relating to the Channel Tunnel. The Government plays an important role in providing sufficient infrastructure to allow for forecast demand for the Tunnel to be met,

After years of loss-making and the fears of the facility being shut down, the government renegotiated the original deal. The government made several changes in its methodology for estimating benefits the Link would generate. In the final assessment, the government excluded benefits to non-UK resident passengers but included an estimate of regeneration benefits amounting to £500 million. The result, in the government’s most likely estimate of future Eurostar UK patronage, showed total benefits of around £3,000 million for a total public sector contribution of some £2,000 million

Especially for PPP projects the government should ensure that the capital structure of a proposed deal is consistent with the risks involved in the project. If the proportion of risk or equity capital is too low, the project will not be financially robust in the face of lower than expected revenues. Moreover, having a relatively low investment at risk may provide insufficient incentive for the private sector shareholders to tackle business

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problems with determination. Either way, the impact of proceeding with too little risk capital is likely to be a call on the public sector for increased financial support, as happened in this case. It follows that a department should take a close interest in the private sector's proposals as regards the capital structure of Public Private Partnerships. If the market is unwilling to subscribe sufficient equity capital it is a clear signal regarding the riskiness of the project, the implications of which need to be thought through by the department concerned.

Conclusions

We analyzed various factors which can have a bearing on the efficiency of PPP as a model for financing infrastructure projects. The uncertainty regarding various factors contributing, positively or negatively gives rise to risks to the project, which have to be factored into the cost of capital. Most of these risks are easily definable and can be contracted by both parties based on the knowledge about who is better equipped to manage the risk. However, as we saw that market and regulatory risk are two risks which are not clearly definable and there is not much evidence that transferring them from the public sector to the private sector can efficient results. Few concepts which seem to have the maximum bearing on the success of PPP projects in making construction and operation of Infrastructure projects more efficient are as follows-

Dealing with political and regulatory risk

Private partners would always require some sort of immunity from unnecessary political interference in the construction and operations of the infrastructure projects. Infrastructure projects are long term in nature and perform best in a stable political and regulatory environment. [Zaharioaie (2012)] opined that, the public-private partnership contract not being under the auspices of the commercial law, can be discretionary modified by the public authorities against the private partner. The private investors therefore, will be more attracted by investments in stable states from a political point of view. What we have observed in literature and through the case studies is that

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political and regulatory risk are best managed by the public sector and add no additional value by being transferred from the public sector to the private sector.

Dealing with market and demand risk

Availability of a stable market for PPP products is essential for the successful execution of PPP projects. In order to develop an effective PPP, a market must exist such that PPP projects are profitable to undertake, the private party is willing to participate, and the financial market is willing to invest [Yang, Hou, & Wang, (2013)]. A strong market structure or demand for the product is necessary for profit maximization from the project which is the main objective of the private sector. The market structure can be characterized by the level of demand of the sector and the level of supply which is a function of the level of competition. Through a demand-side analysis the public sector can examine characteristics of the client base such as providers, sources of funding and pricing strategies and the technology adopted in service or asset delivery while the supply-side analysis assesses the market through willingness-to-pay studies that give information on consumers’ preference, household sources of income, and public sector’s current target population among others. By combining both demand- and supply-side analysis, service delivery strategies can be developed to address inefficiencies and create opportunities for greater private sector participation Even though PPP appears to be well suited for efficiently mobilizing more capital to infrastructure projects, it heavily relies on efficient risk transfer from the public to the private sector. Risk transfer which is at the core of the success of these projects is defined by the contractual agreements which can vary from project to project. Contrary to the common perception of transferring all risk to the private sector, In consultation with supporting literature, I suggest that market risk and regulatory risk shall be with the government as the private sector has very little or no capability of handling these risks. I have provided evidence from other studies and research papers which suggest risk sharing mechanisms which point in the same direction.

PPP projects are mostly used on projects which require huge capital investments and incorporate modern and innovative ideas. Due to their scale and technicalities involved, such projects tend to have high costs and have a higher risk associated. Without the

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resources and expertise of the private sector, the success of such projects might never be accomplished.

There is also a strong political support for PPP. The strong political support is due to additional job creation required for the execution of projects financed under the PPP scheme, which would have not been financed by the government otherwise. Even those governments which have sufficient finances would use PPP to partner with the private sector for technical or operational expertise.

Efficient risk sharing for public private partnership with a focus on regulatory and market risk

University of Amsterdam, Amsterdam Business School

University of Amsterdam, Amsterdam Business School

University of Amsterdam, Amsterdam Business School

University of Amsterdam, Amsterdam Business School

Master in International Finance

Master in International Finance

Master in International Finance

Master in International Finance

Master Thesis

Master Thesis

Master Thesis

Master Thesis

Efficient Risk Sharing for Public Private Partnership With a Focus on

Efficient Risk Sharing for Public Private Partnership With a Focus on

Efficient Risk Sharing for Public Private Partnership With a Focus on

Efficient Risk Sharing for Public Private Partnership With a Focus on

Regulatory and Market Risk.

Regulatory and Market Risk.

Regulatory and Market Risk.

Regulatory and Market Risk.

Narula

Narula

Narula

Narula,,,, Kunal

Kunal

Kunal

Kunal

11352957

11352957

11352957

11352957

Sept

Sept

Sept

Sept –

–

–

– 2017

2017

2017

2017

Contents

Introduction

Various Methods of Financing Infrastructure Projects

Characteristics of Public vs. Private financing

Public financing

Public financing

Public financing

Public financing

Main economic reasons for public interventions.

Main economic reasons for public interventions.

Main economic reasons for public interventions.

Main economic reasons for public interventions.

Benefits of Public investments in Infrastructure

Benefits of Public investments in Infrastructure

Benefits of Public investments in Infrastructure

Benefits of Public investments in Infrastructure

Private investments/Privatization

Private investments/Privatization

Private investments/Privatization

Private investments/Privatization

Forms of pri

Forms of pri

Forms of pri

Forms of private finance

vate finance

vate finance

vate finance

Focus on dividend/income rather than long term growth

Focus on dividend/income rather than long term growth

Focus on dividend/income rather than long term growth

Focus on dividend/income rather than long term growth

Public Private Partnership (PPP)

Public Private Partnership (PPP)

Public Private Partnership (PPP)

Public Private Partnership (PPP)

Advantages of PPP.

Advantages of PPP.

Advantages of PPP.