Lecture Four

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Lecture Four

FINA 522: Project Finance and Risk Management

Updated: 20th March 2007

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PUBLIC PRIVATE PARTNERSHIPS

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Private Public Partnerships in Infrastructure

• A major new user of project financing techniques• Infrastructure traditionally financed and managed by

governments• Demand for infrastructure has been growing faster than

government funding available, particularly in emerging economies.

• Recent trend has been to involve the private sector in the supply and provision of these services

• For example: Roads, Bridges and Tunnels, Light Rail Networks, Airports and Airport control Systems, Water and Sanitation, Electricity Generation, Hospitals, Schools, Prisons

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Private Public Partnerships in Infrastructure

• For a PPP to be successful, there has to be a clear benefit for both the public and the private partners

• In the spectrum of public sector verses private sector service delivery, PPPs lie somewhere between simply the government contracting –out of a set of service delivery to the private sector and a complete private market to plan, design, build and operate a facility that provides the service

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Private Participation in Infrastructure (PPIs)

• Private sector involvement requires commercial rates of return

• Projects have to lend themselves to generating these returns.

• The public partner typically gains in the sense that a desired project is implemented without any financial strain on the budget

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Private Participation in Infrastructure (PPIs)

• In many instances, the governments receive tax payments from the project, and in certain cases, a share of the profits.

• The structure of the partnership can vary along a spectrum from a leading private sector role to a marginal one.

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Different PPP Models

Degree of Private Sector Involvement

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Design-Build

Government

Operation / Maintenance Service /License

Design-Build-Operate

Lease-Develop-Operate

Build-Lease-Operate-Transfer

Build-Own-Operate-Transfer

Build-Own-Operate

Buy-Build-Operate

Privatisation

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Public-Private Partnership Models

• Design-Build (DB): Under this model, the government contracts with a private partner to design and build a facility in accordance with the requirements set by the government. After completing the facility, the government assumes responsibility for operating and maintaining the facility. This method of procurement is also referred to as Build-Transfer (BT).

• Design-Build-Maintain (DBM): This model is similar to Design-Build except that the private sector also maintains the facility. The public sector retains responsibility for operations.

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Public-Private Partnership Models (Cont.)

• Design-Build-Operate (DBO): Under this model, the private sector designs and builds a facility. Once the facility is completed, the title for the new facility is transferred to the public sector, while the private sector operates the facility for a specified period. This procurement model is also referred to as Build-Transfer-Operate (BTO).

• Design-Build-Operate-Maintain (DBOM): This model combines the responsibilities of design-build procurements with the operations and maintenance of a facility for a specified period by a private sector partner. At the end of that period, the operation of the facility is transferred back to the public sector. This method of procurement is also referred to as Build- Operate-Transfer (BOT).

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Public-Private Partnership Models (Cont.)

• Build-Own-Operate-Transfer (BOOT): The government grants a franchise to a private partner to finance, design, build and operate a facility for a specific period of time. Ownership of the facility is transferred back to the public sector at the end of that period.

• Build-Own-Operate (BOO): The government grants the right to finance, design, build, operate and maintain a project to a private entity, which retains ownership of the project. The private entity is not required to transfer the facility back to the government.

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Public-Private Partnership Models (Cont.)

• Design-Build-Finance-Operate/Maintain (DBFO, DBFM or DBFO/M): Under this model, the private sector designs, builds, finances, operates and/or maintains a new facility under a long-term lease. At the end of the lease term, the facility is transferred to the public sector. In some countries, DBFO/M covers both BOO and BOOT. PPPs can also be used for existing services and facilities in addition to new ones. Some of these models are described below.

• Concession: The government grants a private entity exclusive right to provide operate and maintain an asset over a long period of time in accordance with performance requirements set forth by the government. The public sector retains ownership of the original asset, while the private operator retains ownership over any improvements made during the concession period.

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Public-Private Partnership Models (Cont.)

• Service Contract: The government contracts with a private entity to provide services the government previously performed.

• Management Contract: A management contract differs from a service contract in that the private entity is responsible for all aspects of operations and maintenance of the facility under contract.

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Public-Private Partnership Models (Cont.)

• Lease: The government grants a private entity a leasehold interest in an asset. The private partner operates and maintains the asset in accordance with the terms of the lease.

• Divestiture: The government transfers an asset, either in part or in full, to the private sector. Generally the government will include certain conditions with the sale of the asset to ensure that improvements are made and citizens continue to be served.

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Public Private Partnerships (PPPs)

Main characteristics of PPPs are: 1. Private sector is given responsibilities for one or

more of the following tasks: i. Defining and designing the project ii. Financing the capital costs of the projectiii. Building the capital physical assets (road, bridge)iv. Operating and maintaining the assets in order to deliver the

product/servicev. Significant risks is transferred from the government to private

sector

2. Bundling of responsibilities or the allocation of two or more tasks to a unique partner(s)

3. Allocation of the financing task, private financing.

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Public Private Partnerships (PPPs)Why PPPs have become an alternative to traditional methods for the provision

of public services? 1. Ex ante Competition (Private sector firms compete to do project) Marshaling the pro-efficiency forces of competition lowers

costs. Competition at the bidding stage, ex ante. Less likely that tax payers will get value for money their if

such ex-ante competition does not exist 2. Scarce Skills Private sector has skills not available in the public sector Allocate certain tasks to a private partner who has the skills and also the incentive to reform at a high level 3. Poor Labor Relations Private sector through the forces of competition may offer a skilled, efficient and flexible labor force. The public sector

labor management may be inflexible due to tradition, civil service laws, and political protection of certain groups of workers

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Public Private Partnerships (PPPs) 4. Innovation Some parts of the project may need new approaches and innovative thinking The extend of PPPs will depend on the complementarities

between the tasks 5. Risk Major risk can be managed better by private sector (ex. construction-delay risk, being contractor and operator give incentive to minimize such risk) Political risk is better managed by public sector 6. Economies of scale Private sector is taking advantage of economies of scale from the operation of similar project in other jurisdictions, the PPP option becomes more attractive

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Public Private Partnerships (PPPs)

7. Observability and measurability of quality Concerns about the quality of services The partnership agreement should specify the required quality, provide the measurement of verification of quality and provide for enforcement of the contracts’ requirement. 8. Constrains on public sector borrowing Being in depth and further borrowing risk on deteriorating of government, credit rating cost of borrowing increases Allocating the financial tasks to the private sector

PPPs should be embraced only when they allow government to provide services of an acceptable quality at lower cost to taxpayers (consumers)

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Risk Analysis

• PPPs involve a range of risks:– Construction risks: relate to deign problems, building

cost overrun and project delays– Financial risks: variability in interest rates, exchange

rate and other factors affecting financing costs– Availability risks: relate to continuity and quality of

service provided and in turn depend on “availability” of an asset

– Demand risks: relate to ongoing need for the service– Residual value risk: relate to future market price of

assets

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Risk Analysis• It is necessary to achieve significant risk transfer in order

to derive the full benefits from the capital inflows from the private sector and the management change

• Financing costs of risk transfer and pricing of risk are important in efficient allocation of risks

• Risk Transfer and Financing Costs– With complete market in risk bearing, project risk is not affected

by the particular source of financing (finance theory)– Incomplete markets in risk bearing affect project risk as sources

of financing defines the risk of project– Various sources of financing will determine how this risk will be

allocated– Private sector transfers risk to financial markets– Governments transfer it to taxpayers in general

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Risk Analysis

• Pricing of Risk– To use PPPs, government must compare cost of

public investment and provision of service with using PPPs to provide the service

– PPPs sometimes are an efficient way for government to relieve its risks

– Government has to pay for the risks that it transfers to the private sector

– Project-specific risk (e.g. interruption of supply of building materials, labor problems, unfavorable weather, etc) can be diversified across a number of government or private sector projects and need not be priced by the government

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Risk Analysis

– Market risk reflects the economic developments that affect all projects and cannot be diversified and should be priced properly

– private sector demands a discount rate that includes a risk premium on the risk free discount rate that typically government uses

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Competition and Regulation in PPPs• Private sector efficiency is main reason for PPPs• Competition is the important source of efficiency

in both the private and public sector• Competition in award of construction and service

contracts necessary to foster competition, managerial improvement and spur innovation

• In the case where private sector sells to public sector, there is little scope for competition after the contract is awarded and government usually regulate prices

• Price regulation and incentive based regulations are used to increase output, hold down prices, limit monopoly profits

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Prerequisites for PPPs Success

• Political commitment

• Good governance

• Government expertise

• Effective Project Appraisal and Selection

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Risk Transfer• Need for Risk Transfer to the Private Sector

– Determines whether PPPs is a better option than to have public investment and government provision of service

– Influences the appropriateness of accounting and reporting treatment of PPPs

• Risk Transfer and Ownership– PPPs are legally owned by private and are legally

mandated to bear the risks of the project– If government bears ownership related risks, it is in effect

the owner of the asset, and in that case the PPPs will be indistinguishable from traditional methods of financing

– Different risks are associated with owning and operating an asset and risk transfer can be assessed by reference to these rights and obligations

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Risk Transfer• In the case where ownership related risks are not specified

by PPP contracts, risk transfer can be assessed by reference to the overall risk characteristics of the PPPs

• In the Non-separable contracts (ownership and service elements cannot be distinguished) the balance between demand risks and residual value risk borne by government is used in the UK

• Demand risk is borne by government if service payments to a private operator are independent of future need for the service

• Residual value risk is borne by the government if the asset is transferred to the government at more or less than its residual value

• Other factors such as government guarantees, extent of government influence over asset design and operation can be used to assess the degree of risk that has been transferred away from the government