The PPP World
Many countries are now implementing and/or experimenting with private-sector concessions and lease arrangements in order to finance highway construction and other infrastructure requirements. In most cases, the programs require the allocation to private investors of significant project risks throughout the life of the project, including its operation and maintenance phase.
In the U.S., most PPPs have involved the more basic and common design-build (DB) contracting, while full-blown concessions are still a novelty. The significant differences between the U.S. and the rest of the world on the issue of PPPs are largely attributable to historical factors. In this country, at least until recently, we enjoyed a long period when there existed sufficient resources in highway trust funds to finance most of our highway construction requirements. In addition, tax-exempt municipal bonds provided a ready source of long-term financing at relatively low costs to the U.S. taxpayer.
By contrast, in most of the rest of the world, fiscal and budgetary constraints forced governments early on to search for nongovernmental sources of financing to supplement their basic infrastructure requirements. In Spain, Italy and France, publicly owned toll operations established as far back as the beginning of the 20th century were eventually privatized. By the early 1980s and 1990s, the operations of these privatized companies had expanded to the Far East, Eastern Europe and Latin America, and now extend to the U.S.
In the U.S., governments are being forced to change the strategy for financing highway construction primarily because, with increasing fuel costs, governments are reluctant to increase gasoline taxes, one of the principal sources of funds for highway construction. As a result, trust fund balances have been falling. As stated emphatically by the Federal Highway Administration (FHWA): "Projected Federal, State and local highway revenues are insufficient to meet estimates for future highway investment requirements. Investment requirements to cover operating and maintenance costs, and to make capital investments that would maintain current highway conditions and performance, are 40 percent greater than project revenues." It is expected, moreover, that between $85 billion and $120 billion will need to be invested annually in road construction over the next 10 years to meet the nation’s transportation needs. This figure simply cannot be covered with existing public grants or municipal bonds.
Key Issues in the PPP Concession
The most logical place to search for new sources of financing for U.S. highways is to tap the private equity market and collect more toll revenues. As noted in the European Union’s "Guidelines for Successful Public-Private Partnerships," attracting private equity requires a business model that properly allocates risks between the developer, the project company, the lenders and the public authority, while providing a reasonable rate of return to the investor. In PPPs, limited recourse project finance based on toll revenues or availability charges paid by the government (shadow tolls), is the best technique for identifying, allocating and quantifying project risks.
The DB contractors, therefore, must be keenly aware of how this finance structure in a highway concession is likely to impact their risk exposure and consequently the pricing of their services. Moreover, to mitigate some of these risks, especially the completion risks, it will require support from third-party insurers and surety providers.
International experience confirms that there are three main factors that bear heavily on the success or failure of highway concessions: the concession economics; the legal and regulatory structure of the applicable jurisdiction; and the risk analysis and allocation under the PPP agreement.
Concession Economics: Concession economics refers to the basic economic factors that will determine the return to the investor and serves as the basis for its bid for the concession. This model is also the key factor in determining the long-term debt capacity of the project.
In highway toll concessions, the greatest risk outside of the construction risks is always the market risk. Therefore, market projections are critical to securing financing and developing realistic cost estimates. Overly optimistic projections based on faulty assumptions will usually squeeze concession profits, place greater stress on the investment budgets, and force renegotiation of the concession, the construction contract and/or the financing agreements. All parties to the project financing — the sponsors, the lenders, the contractors and operator — will therefore have a stake in ensuring the project is viable both technically and economically. In project finance transactions, it is axiomatic that all of the relevant contracts are interrelated. For that reason, contractors will have to understand how their interests on many vital issues are aligned with those of the lenders and sponsors, and that most issues that arise in the transaction should be resolved in ways that preserve the financial equilibrium of the project while ensuring a reasonable return to all interested parties.
Experience has shown that for new highway projects, governments should review the financial model of the winning bidders before awarding the concession. This will help weed out the opportunistic bid or the overly ambitious financing plan, and ensure that the key parties share a common view of the business plan and projections.
Governments should also avoid awarding the highway concession based on the lowest toll in order to curry favor with voters, or based on an attractive concession fee to balance the state budget. Historically, these concessions have limited shelf lives and usually are either canceled or renegotiated, sometimes even before the ink is dry on the financing documents. On the other hand, concessions that are awarded based on a careful appraisal of the long-range economic benefits to the public from the PPP financing and its execution will avoid these pitfalls.
But to achieve a solid concession, state authorities will need to be free to apply innovative techniques adjusted to the characteristics of their highways and their respective social and economic conditions. In Chile, a country with over 25 years of experience with privately financed toll roads, the government has used many different concession procurement techniques over the years to develop a viable PPP program. Chilean highway concessions have evolved from early concessions awarded based on the lowest tolls, to concessions awarded under very sophisticated criteria using present value calculations of projected revenues where the developers essentially offer competing financial models. Recent reports suggest that these projects are financially stable and profitable.
Contractual flexibility is also critical in the economic viability of concessions. No agreement lasting over 20 years could ever expect to be drafted to address every conceivable contingency. The so-called "incomplete" contract theory, assumes that in all long-term contracts, the parties will need to be able to make timely and necessary adjustments to accommodate unforeseeable events. Accordingly, most successful PPP programs contain mechanisms either in the contracts or relevant regulations for introducing needed changes. The challenge in such instances is to achieve this flexibility without opening the door to difficult renegotiations of the entire agreement, which would possibly invalidate the competitive gains achieved through the bidding process. Well-drafted concession contracts with appropriate adjustment provisions are no longer a novelty, as many countries have benefited from the seminal work of the British government in its fully annotated standard-form PPP agreements.
Legal and Regulatory Structure: When one discusses the shortcomings in most PPP programs, not just in the U.S., but also in most countries of the world, one factor usually stands out: the absence of a suitable legal and regulatory framework for PPPs. In Brazil, in the early 1990s, its highway concession program floundered due to a long list of basic flaws. However, the main problem was the failure of the concession law to provide sufficient comfort to lenders and investors, which increased the overall cost of the financing. As a result, to satisfy the lenders, the PPP sponsors and shareholders were forced to provide higher levels of equity in the financing and to offer substantial financial guarantees. Finally, although several highway toll projects were successfully completed in the mid 1990s, by 2000, the Brazilian PPP program had all but ended. The new PPP Law enacted in 2004 in that country has addressed many of the earlier deficiencies, and it is hoped that with a new concession regime and improved standard contracts, the state and federal PPP highway programs will be rebooted to attract national and international investors.
In the U.S., there are 23 states that have a statutory framework for PPPs, but only a handful have implemented Design-Build, Finance and Operate (DBFOs) under the federal government’s PPP initiatives. States considering PPPs for highways are carefully revising their statutes to determine which laws may have to be amended to accommodate PPPs. The FHWA and the U.S. Department of Transportation (DOT) have also published Model PPP legislation to assist the states in this effort, which is now gaining ground, but more work still remains to be done to create the appropriate framework for PPPs. It is clear, however, that without a solid statutory framework for PPPs, states will encounter difficulties attracting private developers to implement highway concessions.
Disputer Resolution in the Concession
Legal risks must be mitigated in cession contracts through an efficient procedure for managing disputes, which invariably arise in long-term contracts for basic services. This is why it is vital to include alternative dispute resolution procedures, including mediation, which anticipate conflicts and provide a technically competent forum for addressing foreseeable controversies and disputes between the state authorities and the developers. These procedures should be adapted to the technical and financial characteristics of the PPP highway concession and should provide reasonable access to all interested parties, including the contractors.
In Chile, the concession laws and regulations established a very effective and stable mechanism for handling disputes. The law requires that in each concession, the government and the private company appoint a standing three-person Conciliation Commission (CC) (one appointed by each party and the third by the two members) to which all disputes are referred. The CC does not issue binding decisions, but its now viewed favorably by investors, the public and the government as a fair and reasonable mechanism for resolving PPP controversies, and has been replicated in other countries with similar programs.
Risk Analysis and Risk Allocation:
DBFO/concession PPPs are structured around financing provided to special project concession companies. The project finance business model is premised on the efficient allocation of the project’s risks to that party in the transaction most capable of managing and assuming that risk. As applied to PPPs, this means that the construction risks must be fully assigned to the DB contractor and indirectly to third-party insurers and sureties. In Greenfield highway construction projects, PPP lenders will normally insist that there be a fixed-price lump-sum turnkey of pricing the construction a very risky undertaking with potentially disastrous consequences for the unwary DB contractor.
Risk Mismatch
The task of risk analysis does not end with the DB contract. In a DBFO, the contracts are all interconnected. For instance, liquidated damages payable by the contractor or operator should at least match any payment obligations of the concession company to the state under the PPP or concession agreement. Similarly, the force majeure provisions in the two agreements should be back-to-back to ensure that there is no risk mismatch that would unfairly favor one party over the other.
Although it is easy to state these general principles in PPP highway projects, in practice, it is often difficult to achieve a seamless allocation and alignment of the risks. For instance, in highway concession contracts in Brazil, the government had agreed to allow for an extension of the concession upon the occurrences of a force majeure, unless such a force majeure event was "insurable," a concept that was not clearly defined in the concession agreement. Clarification on this point was needed to allow the financing and construction contracts to close.
The Concession and the DB Contract Risks
It is virtually impossible in these tractions to achieve a perfect allocation of risks especially during the construction period. For instance, even if the contractor is in full compliance with the DB construction contract, there is always a risk that the lenders will cut off funding for the project triggered by some event extraneous to the construction, such as a termination for convenience of the concession by the conceding authority. In such circumstances, the contractor might be exposed for a brief period to substantial losses for unpaid invoices and would only have a claim against the concession company which has no hard assets and limited revenues until project completion. In the better crafted concession agreements, the concession will provide a formula for early termination for convenience, which fully compensates the concession company, the lenders and the contractors.
For instance, in a port concession in Chile, the following formula applied in the concession contract to compensate the project company in the event that prior to completion of construction there was a unilateral termination of the concession by the conceding authority:
…the aggregate of the Outstanding Debt under the Funding Agreements at the date of termination and the net present value of the dividends that Port Co. is forecast to issue to its ordinary shareholders over the next 15 years from the date of termination using a real discount rate of 10 percent.
This formula would generate enough funds for the project company to cover unpaid invoices of the contractor and effectively mitigates the credit exposure of the contractors even though they are not parties to the PPP agreement. In the U.K., a similar formula is applied which is designed to compensate the project company so that the investors are "no worse off because of the government’s default than if the contract had proceeded as contemplated." Surprisingly, there are many concessions where this risk is not addressed, and where the affected parties are forced to seek guarantees or insurance to cover the gap.
Conclusion
Most transportation experts agree that a new paradigm for PPPs that transfers more of the operational and financing risks to the private sector is needed in the U.S. With the recent large highway PPP projects in Illinois (Chicago Skyway Toll Bridge) Texas (I-35 Corridor, SH-121), Virginia (Dulles Greenway, I-895/Pocahontas Parkway) and California (SR-125), we are now seeing the emergence of European-style concession/DBFOs, and more ambitious financing initiatives for highway construction. These projects have involved structured project finance with substantial changes in the risk allocation between the public and private sectors. But public acceptance of these projects and their endorsement by the political leadership in many of these states is still ambivalent. We are confident that in spite of these reservations, the PPP model of project financing will gain wider use and acceptance. We believe also that we can gain much from studying the experiences of other countries’ PPP programs to avoid some of their earlier mistakes and to take advantage of the valuable research many have already carried out in developing these innovative procurement techniques.
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