1. Session IV - Financing Cledan Mandri-Perrott Infrastructure Economics & Finance Department (IEF) Workshop, PPP in Highways, Latvia May 9th 2006c Mobilizing Private Capital and Management into Infrastructure Development

2. 2  Development of Local Capital Markets  Chile and Korea (transport infrastructure bonds)  Using Output Based Aid Mechanisms  Road Maintenance and Rehabilitation  Upcoming Trends and Way Forward Contents

3. 3 Leveraging Public Money : Case of Toll Roads Case: privately financed firms sells to end users, not the government or SOE, and, to simplify, consider three types of risk.  Construction, operating, and maintenance cost risks: private sector normally has most influence over these costs, so government does not benefit from bearing them.  Price risk: if government controls the toll, it probably benefits from bearing price risk (that is, from agreeing to compensate if it doesn’t increase toll according to concession contract).  Demand risk (given price): appropriate policy is less clear.  Neither firm nor government may have much influence.  Decision needs to consider other aspects of “managing” risk: who can best forecast and anticipate demand to determine whether to build road? Who can best absorb the risk?

4. 4 Demand risk in toll road  Whether government should bear demand risk in toll roads is therefore controversial  Chile, Colombia, Korea, and Spain, for example, have provided revenue guarantees (often in return for upside risk sharing).  Italy and Turkey gave revenue guarantees for privately financed railways in the nineteenth century: “PPPs” are not new.)  Australia, Canada, United States have not.  Target any guarantee to the real problem:  Is total demand risk the issue or is it whether government will build a competing road or complete a planned complementary road or port?  Is risk the problem, or is it just that government doesn’t want to set tolls high enough to consider costs? If so, a subsidy may be better.

5. 5 Valuing revenue guarantees  Step 1. Develop model of traffic revenue that allows for random fluctuation (that is, risk) as well as trend rates of growth.  Step 2. For the trend, take forecasts traffic-revenue growth developed for tendering the toll road.  Step 3. Estimate the expected size of traffic revenue fluctuation (risk), from previous local or international experience.  Step 4. Estimate consequent expected payments by government (see next slides).  Step 5. Discount those expected payments at the risk-free rate to get the value of the guarantee.  (Possible addition to Step 4: adjust expected cash flows for an estimate of risk, using the capital-asset-pricing model).

6. 6 Forecast and guaranteed revenue on hypothetical toll road Estimated Initial Investment: $ 600 MM $ MM

7. 7 A possible good outcome

8. 8 A possible bad outcome

9. 9 Valuation: Frequency distribution of government payments in 2016 Average payment in 2016 is $4.19 million Assume risk free rate is 5% Approximate value of 2016 component of guarantee is 4.19/(1.05) 11 = $2.45 million Repeat for all years. (illustration purposes = $100.0 million) This calculation will allow providing a value to the Fiscal impact of this option. This is a necessary first step In the decision-making process for public sector options For infrastructure development.

10. 10 Transport Infrastructure: Developing Local Capital Markets -1  Best solution for foreign exchange risk mitigation = matching currency revenue generation with currency of debt payment services  Financing transport facilities in the foreign debt markets adds substantial risk to the structuring of adequate PPPs creating the need for additional public money support.  Local institutional investors (eg, pension funds, insurance companies, life annuities, etc.) have a natural demand for long-term local currency debt instruments to match their liabilities.

11. 11 Transport Infrastructure: Developing Local Capital Markets -2  Local capital markets:  initiate development via the creation of a sovereign bond market (long-term yield curve)  but investors develop a need to diversify risk profile of their investments and the return mix, providing the incentives for the development of a private bond market  Opportunity for the introduction of infrastructure or utilities bonds (long-term annuities).  Government should stimulate, via adequate securities regulation and institutional investors overseeing, the development of local capital markets as a source of long-term local currency funding for needed PPPs infrastructure projects.

12. 12 Developing Local Capital Markets : Chile -1 Source: IMF, Fiscal Affairs Dept.,January 2005  By the early 1990s, a sizable infrastructure gap had emerged in Chile, and significant investment was needed to prevent transportation and other bottlenecks from becoming a major obstacle to future growth  Government challenge to close this gap while maintaining fiscal discipline.  Solution: promotion of PPPs

13. 13 Developing Local Capital Markets : Chile-2  Concessions program covers 44 contracted projects with a total value of US$5.7 billion (about 6¼ percent of 2004 GDP) –These include: 8 rehabilitation projects with financing from tolls (US$2 billion); 11 other highway projects (US$1.3 billion); 10 airport projects (US$240 million); 6 urban road projects (US$1.8 billion); and 9 other projects (including prisons, public buildings, a reservoir, for US$360 million). –Approximately 75% was funded in the local capital markets via local currency infrastructure bonds. 

14. 14 Developing Local Capital Markets : Chile-3  The government provides guarantees to concession operators: –A minimum revenue guarantee is provided for highway and airport concessions, –Concession firms are compensated when traffic or traffic revenue falls below an annual threshold –In return for the minimum revenue guarantee, the concession firm enters into a revenue sharing agreement in which it shares a percentage of revenue with the government once a threshold is exceeded.

15. 15 Developing Local Capital Markets : Korea PPP Projects, Investment Value As of October 2004, 114 concessions awarded for projects in 149 of which 43 have completed construction and now are operating. (See Figure 1) Total investment of about 12 trillion of Korean won capital, predominantly funded in local capital and commercial bank markets, with only a few projects tapping the international capital markets. Source: Korea PPI Market, M. Dailami, World Bank, November 2004

16. 16  Road rehabilitation and maintenance traditionally done through input-based payments to private contractors.  Increasingly, output-based approaches, for example the Performance-based Maintenance and Management in Roads (PMMR), being introduced in Europe, Asia and Africa, and similar KREMA contracts, functional for several years in Latin America (Argentina, Brazil, Uruguay). Using Performance Based Subsidies in Transport PPPs : Road Asset Management Output-based aid (OBA) is a strategy for supporting the delivery of infrastructure services that depends –at least in part – on public funding where payment is linked to service delivery.. At the core of the OBA approach is contracting out service provision to a third party – usually the private sector – with payment tied to the actual delivery of services.

17. 17  Expand private sector’s role from simple execution of works to include maintenance, rehabilitation and management of road assets.  Operator paid after outputs delivered and quality standards met (per KM or similar).  Multi-year and consumer-driven out-look, shifting performance risk to operator, and allowing for innovation and efficiency. Using Performance Based Subsidies in Transport PPPs : Road Asset Management

18. 18 Transport Infrastructure : Upcoming trends – 1  Increasing importance of the provision of transport services and regional linkages and interconnectivity as key contributor to economic growth as a key driver of country’s competitiveness.  Broader use of PPP schemes as a way to maximize public money leveraging for infrastructure development.

19. 19 Transport Infrastructure : Upcoming trends – 2  Increasing use of smart subsidies as a way to utilize better private sector resources via effective allocation of performance risks.  Development of local capital markets (local currency debt instruments) as a mechanism for improving effective access to infrastructure financing by transport PPPs.  Need to develop organized and disciplined risk management framework to manage contingent liabilities arising from public money support to PPPs.

20. 20 Transport Infrastructure : Way Forward in Latvia -1  PPPs together with the development of and effective use of local currency funding (via capital markets) have a high potential of contributing to needed transport infrastructure development. Importance of involving local stakeholders.  Some important lessons and experience could be drawn from transition economies in similar context (Easter Europe) in the Transport Sector (e.g., motorways in Hungary, Ports in Poland, etc.)

21. 21 Transport Infrastructure : Way Forward in Latvia - 2  PPPs are complex and time demanding structures that required full time dedicated resources from the public sector entities responsible transport infrastructure development. Consideration should be given to a Coordinating Transport PPP Unit.  Select a small number of transactions (2 to 3) with the highest potential for success in the short term and focus government resources in taking to fruitful market completion.  Develop a consistent and organized approach to assess, valuate and monitor the contingent liabilities arising from public money support to PPP transport projects. Develop smart and effective risk mitigation products supporting PPPs.

22. Thanks World Bank Group Infrastructure Economics and Finance Tuesday, May 09, 2006 Riga, Latvia

23. 23 PC (project completion) Investment Debt Equity Toll Road PPP : Cash Flow Fluctuations (Proxy for risk) Basic Structure : Capital Markets: Long-Term Financing Cash Flows US$ Years ò Repayment of Debt is based on project cash-flows (non-recourse to sponsors) ò Relatively high initial investments ò Need for longer debt tenors to justify IRR to sponsors ò Repayment of Debt is based on project cash-flows (non-recourse to sponsors) ò Relatively high initial investments ò Need for longer debt tenors to justify IRR to sponsors

24. 24 PC (project completion) Investment Debt Equity Basic Structure : Capital Markets: Long-Term Financing Cash Flows (e) US$ Years Cash Flows real Risk Mitigation products : Minimize cash flows downward fluctuations (ability to repay principal + interest) Key driver: Cash Flow predictability Toll Road PPP : Cash Flow Fluctuations (Proxy for risk )

25. 25 Toll Road PPPs : Risk Assessment  Completion Risk (engineering & construction cost / time cost control)  Operational Performance Risk (technical & operational know-how)  Environmental Risk (future liabilities, project delays, costs overruns)  Credit Risk (project leverage) exchange rate fluctuations  Inflation, interest rate and exchange rate fluctuations  Political Risk (expropriation, political violence, currency convertibility & transfer)  Regulatory Risks  Regulatory Risks. (Government’s default on contractual obligations, i.e., pricing formulas, right of way – land acquisition risk, construction of alternate road, etc. ) rule of law  Legal Environment (rule of law, i.e., judicial system, regulatory procedures and arbitration) Project Specific Risks (non-sovereign Country (Economy wide) Risks (sovereign) Demand (traffic) Risk Pricing Risk (regulated and non-regulated) Environmental (past liabilities) Risk

26. 26 Key Stakeholders in the Risk Assessment and Risk Allocation of Toll Roads PPP Finance Toll Road PPP Finance : Risk Structuring Project Company Project Company Shareholders Lenders / Bondholders Lenders / Bondholders Operator Construction Contractor Construction Contractor Granting Authority Granting Authority Services Purchaser Services Purchaser Shareholder’s Agreement Concession Agreement Purchase Agreement (e.g., shadow toll – government entity) End-users Traffic Demand Construction Contracts Operation & Maintenance Agreement (O&M) Authority Right of Way Authority Right of Way Land acquisition and further transfer to PPP

27. 27 Toll Road PPP Finance : Risk Structuring Project Company Project Company Shareholders Lenders / Bondholders Lenders / Bondholders Operator Construction Contractor Construction Contractor Granting Authority Granting Authority Services Purchaser Services Purchaser Shareholder’s Agreement Concession Agreement Purchase Agreement (e.g., shadow toll – government entity) End-users Traffic Demand Construction Contracts Operation & Maintenance Agreement (O&M) Regulatory Risks Regulatory & Demand Risks Completion Risks Performance Risks FX Risks and Refinancing Risks Political and Macroeconomic Risks Authority Right of Way Authority Right of Way Regulatory Risks Land acquisition and further transfer to PPP

28. 28 Toll Road PPP Finance : Risk Mitigation Non-sovereign Sovereign Completion Risk Performance Risk Environment al Risk Demand Risk Political RiskRegulatory Risk (inc. Land Acquisition Risk) Macroecono mic Risk Cost overruns and delays. Revenue generation and operational costs increase Hidden liabilities Revenue generation Expropriation, transfer, convertibility Cease of revenue generation Revenue generation. Tariff Adjustment; Right of Way, Termination payment Revenue generation. Devaluation / inflation impact of cash flows HighLow HighLowHigh EPC Contract and performance bonds Performance based contracts Environment al Assessment Traffic Minimum Revenue Guarantees / VPN Concession Partial Credit Guarantees Political Risk Insurance Concession Contract Partial Risk Guarantees Local currency financing Private Private/Public PublicN.D. Risks Cash Flow effect Impact Risk Mitigation Instrument Provider

29. 29 Demand and Tariff Risk: Rolling Guarantee Rolling Guarantee A partial credit enhancement product providing a guarantee of a specified number of interest and/or principal payments, on a rolling forward basis – i.e. the guarantee rolls forward to the next installment date automatically (if no claim has taken place) or upon payment by the issuer of a previous claim -- so that the guarantee covers a rising share of remaining debt service. For a toll road project where investors perceive a potential risk associated with a variation in the debt service coverage due to slow traffic, delays on tariff adjustments or both at some point within the overall bond tenor, or are uneasy about a period of heavy investments (i.e., rehabilitation), the rolling guarantee will smooth out the repayment profile and reduce investor concerns about potential timing/cash flow issues.

30. 30 Debt / Service Coverage Ratio 1.5 1.0 Outstanding Principal Years NN + I Rolling Guarantee DSCR Demand and Tariff Risk: Rolling Guarantee N + 2

31. 31 Demand and Tariff Risk: PCG + Monoliner Traffic Minimum Revenue Guarantee (Granting Authority) Traffic Minimum Revenue Guarantee (Granting Authority) Layer of Lower Credit Risk Quality (PCG) Layer of Lower Credit Risk Quality (PCG) Partial Credit Guarantee MLA (a portion of the credit loss on the transaction, -- debt service) Future Flows Securitization of Tolls Monoline Insurers to provide a “wrap” Mitigation of the lower credit risk quality and improving the transaction rating attracts participation of Monoline Insurers to provide a “wrap” on the whole transaction, improving further the transaction credit rating. BBB Credit Rating AAA Credit Rating

32. 32 Financial Markets Risk Mitigation Providers  Multilateral Development Banks and Donors (Aid, lending and guarantees)  Export Credit Agencies (ECAs)  Private Insurance & Guarantors  Political Risk Insurance  Financial Guarantee providers (i.e., monoliners, specialized risk support)  Derivatives Cross-border Debt Markets  Global Financial Markets  Driven by risk & return balance  Highly sensitive to political –economic volatility (i.e., financial crisis 1997-2001)  Bank markets : have not quite return to developing countries infrastructure finance  Capital markets : depth and liquidity. Risk & return oriented (new participants). Volatile. Local Currency Debt Markets  Domestic savings capacities  Bank Markets. Short-term nature. Depth and liquidity dependent upon financial sector reform and competition.  Capital markets. Depth and liquidity dependent upon social and safety net reform (pensions, insurance, etc.) and adequate securities regulatory framework

33. 33 WBG: Risk Mitigation Framework Sovereign Risks Investors / Financial Institutions Non – Sovereign Risks IFC Partial Credit Guarantees Hedging Products Risk sharing facility Securitization Investment Guarantee MIGAIBRD / IDA IBRD / IDA Partial Risk Guarantees IBRD Enclave Guarantee Partial Credit Guarantee Policy Based Guarantee World Bank Risk Mitigation Instruments

34. 34 IFCMIGAIBRD/IDA ProductsPartial Credit Guarantees Hedges for clients (interest rate, currency and commodity swaps) Non-commercial political risk insurance PRG – IBRD & IDA PCG & PBG – IBRD Only ClientsPrivate sector investors, lenders for private sector projects Private sector investors, lenders for private projects Private lenders for public projects LoansYes Equity (Quasi-Equity) Yes No Coverage (Risk)Full and timely payment of principal and/or interest up to a specified amount - IFC covers all risks that may result in non- payment of a client’s obligations. Currency convertibility and transferability Expropriation War and Civil Disturbance (incl. terrorism and sabotage) Breach of Contract Government contractual Obligations including: Currency convertibility and transferability Expropriation Political Violence Breach of Contract Regulatory Subsidy payment (e.g. OBA) Guaranteed Percentage Determined on a case by case basis (credit risk driven). Debt: up to 95% Equity: up to 90% Up to 100% of a tranche Comparison of World Bank Group Risk Mitigation Instruments

35. 35 Comparison of World Bank Group Risk Mitigation Instruments [Contd.] IFCMIGAIBRD/IDA EligibilityMust be a member country TenorsMarket based but IFC’s involvement can lengthen tenors Up to 15 years (20 years in some cases) Market based LimitsBased on client’s needsProject: up to $110mm (net) Country: up to $420mm (net) Based on project and country needs and CAS allocation. Priority Areas of FocusAll IFC recipient member countries. Providing long-term local currency financing and development of domestic capital markets. Africa IDA eligible countries South-South investments SMEs Infrastructure IDA eligible countries Government Counter Guarantee NoNo (through the MIGA Convention) Yes – for IDA in the event borrower is not the sovereign, a sovereign guarantee may not be required. Public Sector ProjectsNo Yes Areas of CollaborationJoint project preparation, environmental analysis, Board processing, etc.