Session II Public-Private Partnerships (PPPs) and Infrastructure Finance

Project finance The Concept of Project Finance The financing of long-term infrastructure is based upon a non-recourse or limited recourse financial structure where the debt and equity used to finance the project are paid back from the cash flows generated by the project. High gearing requiring less equity Tax benefits Public sector use of revenue Long term debt funding

Creating Distance from Government: Project Finance For private finance, need private assets Project finance involves creating a separate legal and economic entity with the primary role of setting up an organizational structure and obtaining the necessary financial resources to develop and manage a project. The main, and crucial, distinction from conventional corporate or public financial structures is that repayment to debt and equity providers depends solely on the capacity of the project to generate cash flows, with typically no recourse to the balance sheets of the sponsors or the resources of the government.

Typical Project Finance Structure

The public partner may participate as an issuer of debt solely to provide access to tax exempt financing Public partner does not provide any direct financial support (i.e. taxes, revenues other than project revenues) to the project Bond Repayments Project Trustee Investors Government Issuer Trust agreement Bond proceeds Proceeds to pay cost Revenues from project Bonds

Partnership Financing The public partner may participate not only as an issuer, but also with a source of governmental revenues – governmentally imposed Special excise taxes Customer facility charges Incremental tax revenues Utility revenues (special revenues)

Public Private Partnership (PPP) Combination of public and private finance components Is it a partnership? Not in the traditional legal sense More likely a joint venture or in the alternative a lease or franchise arrangement Reliable, long-term commitments Public Private Partnerships (PPPs) involve government engaging the private sector in public service delivery. PPPs are generally characterized by a private sector entity raising finance to construct an asset required by Government, and providing a facility or service in return for a contractual revenue stream from Government or users.

Typical PPP Structure

Contract vis-à-vis Public Private Partnership (PPP) Rather than constituting a separate corporate entity, contracts are widely used as a form of legal governance for PPPs. The private sector enter into a contract with government for the design, delivery, and operation of the facility or infrastructure and the services provided. The private sector finance the capital investment and recover the investment over the course of the contract. The asset transfers back to the public sector at the end of the contract

Principles of PPP Cost measured against conventional procurement. Whole life cost and quality are combined to gauge VFM

Value for Money Contracts awarded based on “value for money,” not lowest bid Government support in the form of credit commitment, concession or other facilitation Flexibility in structuring contractual arrangements to best suit the economic, operational and policy goals of the parties Assets with relatively high residual value A sustainable “win/win” relationship between government and private parties

Contract Theory In economic theory, public–private partnerships have been studied through the lens of contract theory. The Nobel Prize in Economics 2016 was awarded to Oliver D. Hart and Bengt Holmström for their contribution to contract theory. Information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.

Concerns regarding PPPs Agency problems and moral hazard Risk allocation: are transferred risks systematic or idiosyncratic? Service quality standards difficult to ascertain and may be under- or over-estimated at the onset of the contracts: need for renegotiating contracts Inability of the government agency to pay the service charge due to future budgetary constraints Comparing with other alternatives: “Public Sector Comparator” is too difficult to implement Renegotiation in a non-competitive framework may promote opportunistic behaviour

PPP Risks Political, regulatory and change of law risk Additional costs of project oversight, documentation and execution may exceed savings from efficiencies Market projections fail to pan out

Why PPP? Greater regulatory convenience Broadening Financing Channels Enhanced development capacity of the state by leveraging public money Mechanism for tapping into private money and efficiency Greater transparency requirements: usually includes a competitive bidding process Lower financing costs Better risk containment and sharing Better adherence to quality standards which might be hard to measure

Why PPPs (Cont’d) Urgent Need for Critical Infrastructures Balancing public interest and interests of the private investor. The public partner may participate as an issuer of debt solely to provide access to tax exempt financing Public partner does not provide any direct financial support (i.e. taxes, revenues other than project revenues) to the project

Key PPP Objectives Enhance capital sources for creating new and improving existing infrastructure Promote efficiency in infrastructure development and execution Leverage existing assets and future cash flows to facilitate capital formation and respond to pressing infrastructure needs PPP must provide ‘Value for Money’ taking into account cost of PPP, as well as quality of service. Cost and quality of service need to be interpreted in broadest possible terms. For a PPP to be justified, it would need to compare favourably to how public sector provision would have performed on these criteria.

Key Components of An Enabling Institutional Framework for PPPs

Private Participation in Infrastructure Projects in Different Categories of Countries (USD Billion)

PPP: Typical Risk Allocation Public Shared Private Demand and Revenue Risks X Design and Construction Risks Operating and Maintenance Risks Financial risks Legal risks Political risks Environmental risk Force majeure

Mitigate Political and Regulatory Risks Legal/regulation risks, political risks, economic risks and force majeure risk are most frequent risks associated with China’s PPP projects Uncertainty as to dispute resolution The modern PPP law plays a key role in ensuring project quality. A legal and regulatory framework that supports PPPs is meant to facilitate investments in complex and long-term PPP arrangements, reduce transaction costs, ensure appropriate regulatory controls, and provide legal and economic mechanisms to enable the resolution of contract disputes. International Investment Treaties Alternative Dispute Resolution mechanisms for PPPs Investor-State Arbitration

Adequate and Enforceable Legal and Regulatory Framework A legal and regulatory framework providing clarity for government actions and assurance for the private sector that its legitimate right will be adequately protected

Legal Constraints on Public Private Partnerships Legal constraints generally arise as a result of the participation of a “public partner” Why? -- Unlike private enterprise, public agencies are entirely creatures of state law. They have only those powers that are granted by a state constitution and by the state legislature. The power of a state legislature is plenary The state constitution is the citizens’ limitation on the powers of a state legislature As a result, any party dealing with a public agency is required to be aware of the constraints of state and local law. Any exercise of power by a local government beyond its express grant of authority is void. Let the private party beware.

One Size Fits All?

Cross-border issues Choice of law and dispute resolutio

Response to Addis Mandate PPPs should be implemented only in cases where they can be shown to provide value for money in its broadest sense. The implementation of PPPs should be aligned with the Addis Principles. “to holding inclusive, open and transparent discussion when developing and adopting guidelines and documentation for the use of public-private partnerships, and to build a knowledge base and share lessons learned through regional and global forums.” To ensure these conditions, it is necessary to set in place: At national level, an enabling institutional framework; At international level, common standards and guidelines.

Conclusion Establishment of an internationally accepted accounting and reporting standard would be very important in promoting transparency about fiscal consequences of PPPs. Common guidelines are important in areas such as contract structuring, pricing, risk allocation, legal and regulatory frameworks, procurement, project selection and definition and so on. Overall evaluation of consistency with principles on PPPs agreed in Addis and with the SDGs.

Conclusion (Cont’d)