This article was first published in Ukrainian Journal of Business Law in May 2010
1. Introduction
Private public partnership is a well-known method of cooperation between public authorities (public partner) and investors (private partner), widely used in many countries for developing and maintaining infrastructure facilities. The biggest advantage of PPP for the public partner is that it secures and retains the ownership rights over assets while the private partner undertakes to improve the quality of rendered services. On the other hand, private partners are attracted by a stable income flow.
The effective Ukrainian laws do not foresee such type of cooperation as "private public partnership". However, the Ukrainian Parliament is working on adaptation of the Ukrainian legislation to the European standards in this regard1. There are now several on-going projects in Ukraine that may be classified as PPP projects (e.g. lease of water supply infrastructure in Odessa, concession of water supply infrastructure in Lugansk, concession of centralized heating systems in Artemivsk, concession of the Lviv-Krakovets road, etc). The majority of PPP projects are implemented under the following schemes: lease and operation (the L&O), management and operation (the M&O) and concession of state or municipal property.
As well as any other type of business, private public partnerships imply a lot of risks which should be considered, properly allocated and shared between parties before entering into a project. Careful analysis of specific risks applicable to PPP projects is essential while implementing projects in emerging countries, such as Ukraine, with no developed legislation or established court practice in this sphere.
This article is dedicated to general risks of private partners which are common for all PPP projects in Ukraine, in particular, for L&O, M&O and concession projects. Please note that the level of risks directly depends on the duration of the project and should be carefully considered in long-term contracts.
2. General Risks of the Private PARTNER
Political risk should be understood as a risk of the private partner incurring losses due to political conditions. Unlike other commercial transactions, in PPP projects one of partners (public partner) may use it powers to change the law or to take any other action to prevent successful implementation of PPP project. This is a common risk for emerging countries where governments and their attitude concerning PPP projects frequently change. As a rule, political risks are not foreseeable and are hard to mitigate. We may illustrate one example of such politic risk with the concession of the M1/M15 highway in Hungry2 which commenced with the support of the then ruling government and was terminated due to a changed position of the new one. The new government was not cooperative and refused to modify the agreement to include risk-sharing provisions required in order to save the project. As a result, the concession project was unsuccessful and ended with liquidation of the private partner and nationalisation of the highway. It is worth mentioning that some international organisations, such as the World Bank, provide insurance against this risk3.
Regulatory risks may be regarded from two points of view: (1) effective legislation risk that is caused by outdated rules, loopholes and restrictions which are common for developing countries and (2) risks pertaining to the ever-changing legislation.
Risks pertaining to the effective legislation. The Ukrainian legislation contains many loopholes and inconsistencies which in practice cause problems when selecting the form of the future project as well as during its implementation. For instance, the Ukrainian legislation is rather unclear with regard to implementation of PPP projects under Build-Operate-Transfer (BOT), Rehabilitate-Lease-Operate-Transfer (RLOT) as well L&O schemes. In the neighbouring CIS countries such schemes are implemented under laws applicable to lease.
In Ukraine, the validity of such projects under lease legislation is rather disputable. The Law of Ukraine "On Lease of the State and Municipal Property"4 prohibits lease of "engineering infrastructure". At the same time the law does not give any definition thereof. Upon analysis of other laws it appeared that water, heating and sewage infrastructure may be considered as "engineering infrastructure". Consequently, all BOT, RLOT and L&O schemes are under a big question. Moreover, the position of the Supreme Court of Ukraine with regard to the lease of municipal water supply, sewage and heating infrastructure is not yet defined. However, in practice the validity of the L&O project implemented in Odessa, to the best of our knowledge, was not disputed.
This risk may be identified and mitigated when selecting a scheme for the project's implementation, therefore, the final decision concerning the scheme may be delivered only upon careful analysis of the available legal framework, as well as of the current practice of PPP projects.
Risk pertaining to the changes in legislation is completely outside control of the private partner and is unforeseeable. It may cause substantial delays in implementing the project and furthermore may become an obstacle in its development. This risk greatly influenced the A1 Toll Motorway Project in Poland which, due to numerous changes in the legislation, was being negotiated for 7 years5. In order to mitigate the risk it is advisable to include provisions into the contract which call for adjustment of the private partner's obligations in case of major changes in legislation.
Risk related to tariffs6 should be also analyzed when entering into a PPP. This risk is common for L&O and concession projects as private partners receive the majority of their revenue from utility fees paid by consumers. However, these tariffs are regulated by public authorities7 and may not be set by the private partner. Moreover, despite the fact that the Ukrainian legislation declares an obligation of a public partner to compensate the difference between the approved tariffs and those which are economical sound8, in the event that they are fixed at the lower level, this obligation is often ignored. Therefore, in order to decrease this risk it is advisable to oblige the public partner directly in the agreement to adjust the tariffs (or at least to assist the private partner with lobbying of adjustment of tariffs), or to allocate "compensation" funds in the annual budget as well as timeframes and means of compensation (direct payments onto the bank account of the private partner or decreasing land tax, lease/concession payments, etc). Some of these provisions were used in the draft concession agreement with LLC Lugansk Voda9 in the water infrastructure concession project. Pursuant to publicly available information the public partner follows these provisions of the concession contract.
Market risk (demand/volume risk) covers a huge range of risks: demand risk, illegal connections, breakdowns, billing, bad debts, etc. This risk has a significant impact on the total cost of the project and, subsequently, on the profits of the private partner. As a rule, this risk is borne by the actual operator of the facility. There are successful projects in many countries when this risk was assumed by the private partner in its entirety (Lugansk projects) or partially borne by the public partner (M5 highway in Hungry)10.
In this article we would like to concentrate on the demand risk as the main element of the market risk. The best illustration of the demand risk is L&O and concession projects with regard to highways. The risk that preliminary toll estimates will be too optimistic and the project will be unprofitable is very high; unsuccessful concession of M1/M15 Hungarian motorway and Thailand Don Muang Tollway11 are the brightest examples. In order to reduce this risk the partners should apply risk sharing provisions, such as revenue subsidies in case of insufficient traffic, or foresee a complete transfer of this risk to the public partner. At least two projects were successfully implemented under these provisions, for instance, highway M5 and M6 in Hungry which were financially supported by EBRD.
Currency risk presents a big problem for investors, even more so in Ukraine where big currency exchange rate swings happened on a few occasions. This risk is especially high in long term projects and is common for L&O and concession projects. Unlike countries with more developed financial markets, Ukraine has little to offer in terms of possibilities to mitigate such currency risks. Usual derivative instruments used to hedge currency risks in foreign jurisdictions cannot be used in Ukraine, therefore, investors are advised to consider possible currency rate fluctuations when committing to the investment.
Financial risk (so-called "bankability" of the project) is closely connected with the possibility of the private partner to involve financial institutions into the project's financing. While stepping into the project these organisations seek additional commitments from the public partner, in particular, for state or municipal guarantees. The previous experience demonstrates that the Ukrainian government is very restrictive in giving guarantees in PPP projects. Last year the Ukrainian government declared its willingness to discuss a possibility of giving state guarantees for concession projects concerning construction and operation of main highways to be used for Euro 201212. However, to the best of our knowledge, no concession of highway under state guarantees was entered into last year. Moreover, the Ukrainian legislation prescribes a rather complicated and ambiguous procedure for applying and receiving such additional commitments from the public partner.
As the practice shows financial institutions are not always eager to provide financing to the projects that have already encountered some problems, especially in case of absence of state guarantees. The impact of this risk may be demonstrated with the concession of the Lviv-Krakovets motor road where the construction stage did not commence due to the lack of the private partner's financing. No financial institutions expressed their will to finance the project. Currently, the parties are discussing possibilities for termination of the agreement13.
The other biggest fear of the investors is the enforcement of public partners' obligations. It should be noted that any financial obligation may be enforced only if it was included into the state/municipal budget. The risk is caused by fact that the period of time for which state/municipal budgets are approved is usually shorter than the term of PPP projects. Hence, there is a risk that the private partner will need to seek having the relevant financial obligations included into the relevant budget.
3. Lessons Learned
The private partner should take into consideration all risks mentioned above before entering into a PPP project, especially in emerging countries. The level of each risk depends on the duration of the project, and its likelihood is higher for long term projects.
Upon analysis of previous successful and unsuccessful projects we may conclude that private partners may try to mitigate the risks at the beginning of a project. Except for general recommendation such as follow-up and careful consideration of political situation, legislation framework and proposal of the public partner, the private partner should realistically estimate the outcome of the project and prepare an effective risk sharing concept.
Unsuccessful examples of PPP project confirm that private partners are often too optimistic in forecasting future revenues. Due to such very positive approach business decisions are taken without proper assessment and allocation of the market risk. Afterwards, it may put the whole project under a question unless the PPP contract is re-negotiated.
Another important issue to be negotiated is a risk sharing concept of the project. As the previous experience proves only an effective risk sharing concept may make the project successful (e.g. concession of the highway M5 in Hungry). At the same time it is clear that often private partners refuse to revise PPP contracts' conditions when the project already experienced some problems (e.g M1/M15 highway in Hungry). Therefore, it is advisable to foresee risk-sharing provisions from the very beginning. Often such initiative is supported by governmental and local municipal authorities (e.g. Lugansk water supply concession).
Finally, it should be noted that the Ukrainian Parliament adopted in the first reading a few of draft laws which considerably mitigate both components of the regulatory risk, tariffs risk as well as provide a non-exhaustive list of state guarantees. It is expected that these draft laws will facilitate implementation of existing projects and attract investors for new ones.14
Footnotes
1. The Draft Law "On General Basis of Cooperation between the State and Private Partners" was already considered and adopted in the first reading
2. EBRD sector factsheet www.ebrd.com/pub/factsh/themes/infrppp.pdf
3. Nevertheless, such insurance is possible only to certain extent and it does not apply to wide range of global risks such as war, crisis, revolution, etc. Still, we are not aware of any project in Ukraine where political risk was insured.
4. The Law of Ukraine "On Lease of the State and Municipal Property" makes references to Article 5 of the Law of Ukraine "On Privatisation of State and Communal Property" No. 2269, dated April 10, 1992 which explicitly prohibits privatizing and, thus, leasing engineering infrastructure.
5. Vickhram Cuttaree Successes and Failures of PPP Projects, Warsaw – June 17, 2008
6. This risk will be significantly mitigated should the Draft Law "On General Basics of Cooperation between the State and Private Partners" be adopted
7. Article 9 of the Law of Ukraine "On Prices and Pricing" No. 507, dated December 3, 1990
8. For instance, for water supply business it is foreseen in the Regulation of the Cabinet of Ministers of Ukraine No.959 dated July, 12 2006 "On the Procedure of Tariff Formation for the Services of Central Water Supply and Sewage"
9. http://www.klv.lg.ua/about/aplication_1/
10. In M5 project the public partner provided for subsidies (so-called "availability payment") for the fist 5 years of concession when tolls were lower than it was expected
11. The concession started in 1989, however, due to the fact that traffic volume and, as a result, revenues were less than it was originally forecasted, partners implemented a risk-sharing provision whereas the public partner partially assumed the risk of insufficient volume risk and provided subsidies.
12. http://webtest.mtu.gov.ua/uk/news/5924.html
13. http://www.epravda.com.ua/news/4aee955c2d00d/
14. The Draft Law "On General Basis of Cooperation between the State and Private Partners" and the Draft Law "On Amending Certain Legislative Act" http://gska2.rada.gov.ua/pls/zweb_n/webproc4_1?id=&pf3511=35553
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
