Table of Contents

(I)

Theory of PPPs: Why Partner with the Private Sector ......................................................................1

(1) INTRODUCTION ........................................................................................................................1
(2) WHY PPP?...............................................................................................................................2
(3) PPP STRUCTURES ....................................................................................................................5
(a) Traditionally Procured Projects...................................................................................6
(b) Publicly Sponsored BOT Projects ................................................................................9
(c) Partnership Project Development and Investment Opportunities ..............................10
(4) THE SUITABILITY AND EFFECTIVENESS OF ALTERNATIVE PPP STRUCTURES ......................13
(a) Suitability to Transport Projects.................................................................................14
(b) Suitability to Water Projects.......................................................................................17
(c) Suitability to Waste Projects.......................................................................................17
(5) REQUIREMENTS OF PPP PARTNERS .......................................................................................19
(6) ACHIEVING SUCCESSFUL PARTNERSHIPS ..............................................................................20

(II)

PPP Concept Planning and Implementation....................................................................................23

(1) INTRODUCTION ......................................................................................................................23
(2) PRACTICAL CONSIDERATIONS ...............................................................................................23
(3) STAGES IN THE PPP CYCLE ...................................................................................................25
(a) Preliminary Stage .......................................................................................................25
(b) Is a PPP Feasible Identification ..............................................................................28
(c) Private Sector Interest ................................................................................................28
(d) Evaluation: Is PPP the Best Delivery Model?............................................................29
(e) Selecting an Appropriate PPP Structure ....................................................................30
(f)
Choosing the Appropriate Format..............................................................................35

(III)

Ensuring Value for Money in PPP ..................................................................................................38

(1) FACTORS DETERMINING VALUE FOR MONEY .......................................................................38
(2) ASSESSING VALUE FOR MONEY POTENTIAL .........................................................................38
(3) PARAMETERS FOR THE FINAL VFM ASSESSMENT .................................................................39
(a) Financially Free Standing Projects ............................................................................39
(b) Concession Contracts with Public Grants..................................................................39
(c) Projects where the Public Sector is the Main Financial Contributor ........................40
(4) ELEMENTS FOR VFM.............................................................................................................40
(a) Monetary Comparison ................................................................................................40
(b) Non-Monetary Comparison ........................................................................................43
(5) RESULTS OF VALUE FOR MONEYS ASSESSMENT .................................................................43
(6) OPTIMIZING GRANT CONTRIBUTION .....................................................................................44
(7) JUSTIFYING GRANT FINANCING ............................................................................................47
(8) DETERMINING THE FORM OF GRANT ASSISTANCE ................................................................49
(9) BASIS REQUIREMENTS FOR GRANT FINANCING ....................................................................50

(IV)

Risk and Mitigation.........................................................................................................................52

(1) INTRODUCTION ......................................................................................................................52
(2) FINANCIAL IMPLICATIONS OF RISK .......................................................................................52
(a) Revenue Risk...............................................................................................................53
(b) Choice of Private Sector Partner................................................................................53
(c) Construction Risk........................................................................................................54
(d) Foreign Exchange Risk...............................................................................................54
(e) Regulatory / Contractual Risk ....................................................................................55
(f)
Political Risk...............................................................................................................55
(g) Environmental / Archaeological Risk .........................................................................55
(h) Latent Defect Risk.......................................................................................................55
(i)
Public Acceptance Risk...............................................................................................56
(j)
Hidden Protectionism .................................................................................................56
(3) KEY RISK MATRIX ................................................................................................................57
(a) Project Development ..................................................................................................57
(b) Construction ...............................................................................................................59
(c) Operation and Maintenance .......................................................................................61
(d) Revenue.......................................................................................................................63
(e) Financing....................................................................................................................64
(f)
Force Majeure ............................................................................................................65
(g) Premature Termination ..............................................................................................66

(V)

Essentials of a Good Regulatory Framework..................................................................................67

(1) NEED FOR INDEPENDENT ECONOMIC REGULATION ..............................................................67
(2) DEFICIENCIES IN EXISTING REGULATORY APPROACHES IN INDIA ........................................67
(3) ESSENTIAL ATTRIBUTES OF INDEPENDENT REGULATION .....................................................68
(4) CAPACITY BUILDING .............................................................................................................70
(5) INDEPENDENT REGULATION AND USOS ...............................................................................70
(6) REGULATORY EFFICACY AND ACCOUNTABILITY ..................................................................71
(7) CONSUMER INTERESTS VIS--VIS INDEPENDENT REGULATION ............................................71
(8) INTERFACE AND OVERLAPS ...................................................................................................72

(VI)

Preparation of the Concession Agreement ......................................................................................73

(1) INTRODUCTION ......................................................................................................................73
(2) RATIONALE FOR CONCESSIONS .............................................................................................73
(3) GENERAL OVERVIEW OF CONCESSION CONTRACTS .............................................................74
(4) PRICE SETTING ......................................................................................................................76
(5) PRICE ADJUSTMENT ..............................................................................................................77
(6) SPECIFIC PERFORMANCE TARGETS .......................................................................................77
(7) PENALTIES AND BONUSES .....................................................................................................77
(8) PUBLIC PARTIES' SECURITY RIGHTS .....................................................................................78
(9) DURATION, TERMINATION AND COMPENSATION ..................................................................78
(10) FORCE MAJEURE AND OTHER UNFORESEEN CHANGES.........................................................79

(11) DISPUTE SETTLEMENT...........................................................................................................79

(12) GOVERNMENT RESPONSIBILITIES FOR CONCESSIONS ...........................................................79
(13) GUIDING PRINCIPLES FOR IMPROVED OPERATIONS ..............................................................81
(VII)

Approach to Financial Analysis ......................................................................................................83

(1) INTRODUCTION ......................................................................................................................83
(2) KEY INPUTS FOR DETERMINING PROJECT CASH FLOWS ........................................................83
(a) Capital Cost................................................................................................................83
(b) Construction Period....................................................................................................83
(c) Demand.......................................................................................................................84
(d) User Fee .....................................................................................................................84
(e) Operation and Maintenance Costs .............................................................................84
(f)
Applicable Depreciation .............................................................................................84
(g) Applicable Income Tax ...............................................................................................84
(h) Debt Reserves .............................................................................................................84
(i)
Other Assumptions......................................................................................................85
(3) DEVELOPING CASH FLOW PROJECTIONS ...............................................................................85
(4) DISCOUNTED CASH FLOW ANALYSIS ....................................................................................85
(a) Essential Concepts......................................................................................................85
(b) Incremental Cash Flows .............................................................................................86
(c) The Hurdle Rate..........................................................................................................87
(d) The Weighted Average Cost of Capital (WACC)........................................................87
(e) Net Present Value Analysis.........................................................................................89
(f)
Project Internal Rate of Return (IRR).........................................................................89
(5) NPV VS. IRR.........................................................................................................................90
(6) PRIMARY REASONS OF DIFFERENCE BETWEEN NPV AND IRR ANALYSIS ............................91
(a) Size Difference ............................................................................................................91
(b) Reinvestment Rate.......................................................................................................91
(c) Conclusion ..................................................................................................................92

(VIII)

Approach to Financial Structuring ..................................................................................................94

(1) INTRODUCTION ......................................................................................................................94
(2) APPROACH TO STRUCTURING ................................................................................................94
(3) EQUITY ..................................................................................................................................97
(4) GOVERNMENT .......................................................................................................................98
(5) CONSENSUS .........................................................................................................................101
(6) SECURITY ARRANGEMENT ..................................................................................................101
(7) SOURCES OF FINANCE .........................................................................................................102

(I)

Theory of PPPs: Why Partner with the Private Sector

(1)

Introduction
While the assumption that the public sector is responsible for the delivery of basic
services remains deeply entrenched in many countries, the methods by which these
services are created, procured and delivered are changing. This reflects a greater need and
desire for the public sector to work with and harness the benefits of the private sector.
There is a broad range of options for involving the private sector in the financing,
physical development, and operation of transport and environment projects traditionally
the domain of the public sector. As depicted in Figure 1, Public-Private Partnership (PPP)
approaches are arrayed across a spectrum. At one end, the public sector retains all
responsibility for financing, constructing, operating and maintaining assets, together with
the responsibility for assuming all associated risks. At the other end, the private sector
assumes all of these responsibilities. The vast majority of PPP approaches fall in the
middle of spectrum, with risks and responsibilities shared between the public sector and
its private partners according to their strengths and weaknesses.
Figure 1: PPP Options

Public Responsibility

Traditional Public
Sector Structure

Public Owner/
Operator/
Financier

Private Responsibility

Publicly Sponsored
BOT

Public Owner/
Financier

Operator

Contractor

Public Owner

Operator

Public Owner/
Financier

Contractor

Engineer

Operator

Engineer
Engineer

Public Sector

Divesture

Private
Concessionaire
Contractor

Engineer

Concessions

Operator

Contractor

Private Sector

The aim of this section is to provide an overview of the variety of financing and
operational PPP structures that are currently used and which could be matched to the
needs of the Government and the use of Government funding to leverage additional
sources of capital that would not otherwise be available. This all-important phenomenon
allows projects to be built with smaller levels of support from both grant financing
programmes and public resources in recipient nations.

By moving beyond pure grant financing and supporting projects that limit private
participation to simple outsourcing agreements, the potential of PPPs can be demonstrated
in markets that have limited experience with partnerships. By limiting the need for public
investment, PPPs can also help Governments to implement much needed projects sooner
by avoiding the need to wait for future government budget cycles for funding.
(2)

Why PPP?
(a)

Recent years have seen a marked increase in cooperation between the public and
private sectors for the development and operation of infrastructure facilities.
While initial projects have often been in the road sector, with the construction of
toll roads (representing clearly defined financial returns); there is a growing
acceptance that PPP arrangements can be used to meet infrastructure and service
needs in a wide variety of sectors.

(b)

Success of PPP projects, the increasing availability of private sector funds able to
adopt a higher risk profile; and a generalized global trend to privatise utilities has
resulted in attempts to introduce the PPP concept to a wider infrastructure base.
This is due to:

(c)

(i)

Large financing requirements in the infrastructure sector for

upgradation, extending coverage and effective service provision

(ii)

An equally large financial shortfall in available public funds and the

ability of international institutions to cover costs. This requires not only
the identification of additional funding sources but also attention to the
more effective use of public funds and to increasing their impact.

Additionally there is a growing realization that cooperation with the private

sector, in PPP projects, is able to offer a number of advantages, including:
(i)

Acceleration of infrastructure provision

PPPs often allow the public sector to translate upfront capital
expenditure into a flow of ongoing service payments. This enables
projects to proceed when the availability of public capital may be
constrained (either by public spending caps or annual budgeting cycles),
thus bringing forward much needed investment.

(ii)

Faster implementation
The allocation of design and construction responsibility to the private
sector, combined with payments linked to the availability of a service,

provides significant incentives for the private sector to deliver capital

projects within shorter construction timeframes.
(iii)

Reduced whole life costs

PPP projects that require operational and maintenance service provision
provide the private sector with strong incentives to minimise costs over
the whole life of a project, something that is inherently difficult to
achieve within the constraints of traditional public sector budgeting.

(iv)

Better risk allocation

A core principle of any PPP is the allocation of risk to the party best able
to manage it at least cost. The aim is to optimise rather than maximise
risk transfer, to ensure that best value is achieved.

(v)

Better incentives to perform

The allocation of project risk should incentivise a private sector
contractor to improve its management and performance on any given
project. Under most PPP projects, full payment to the private sector
contractor will only occur if the required service standards are being met
on an ongoing basis.

(vi)

Improved quality of service

International experience suggests that the quality of service achieved
under a PPP is often better than that achieved by traditional
procurement. This may reflect the better integration of services with
supporting assets, improved economies of scale, the introduction of
innovation in service delivery, or the performance incentives and
penalties typically included within a PPP contract.

(vii)

Generation of additional revenues

The private sector may be able to generate additional revenues from
third parties, thereby reducing the cost of any public sector subvention
required. Additional revenue may be generated through the use of spare
capacity or the disposal of surplus assets.

(viii)

Enhanced public management

By transferring responsibility for providing public services government
officials will act as regulators and will focus upon service planning and
performance monitoring instead of the management of the day to day

delivery of public services. In addition, by exposing public services to

competition, PPPs enable the cost of public services to be benchmarked
against market standards to ensure that the best value for money is being
achieved.
(d)

International interest in PPPs is attributable generally to three main drivers:

(i)

Investment in infrastructure
Economic growth is highly dependent on the development and
enhancement of infrastructure, particularly in utilities (such as power,
water and telecommunications) and transport systems. Further, in many
countries there is an urgent need for new social infrastructure such as
hospitals and healthcare equipment, prisons, education facilities and
housing. For many governments this is seen as the most pressing area for
private sector involvement.

(ii)

Greater efficiency in the use of resources

The experience of privatisation has shown that many activities, even
those traditionally undertaken by the public sector, can be undertaken
more cost effectively with the application of private sector management
disciplines and competencies.

(iii)

Generating commercial value from public sector assets

Significant amounts of public resources are invested in the development
of assets such as defence technology and leading edge information
systems that are then often used for a narrow range of applications
within the public sector. Engaging private sector expertise to exploit
these assets in a wider range of applications can lead to the realisation of
substantial incremental value for the public sector.
However while certain advantages do exist and can be harnessed, PPP
should not be regarded as representing a miracle cure nor indeed a quick
fix to infrastructure and service development. PPP should be regarded as
an option amongst a range of possible tools to be applied only where the
situation and project characteristics permit it and where clear advantages
and benefits can be demonstrated. Indeed, consideration of PPP should
not preclude other options including the traditional public public
models.

(3)

PPP Structures
The PPP process is extremely dynamic and that the particulars of most arrangements are
tailored to the specific circumstances involved. At the same time, many of the individual
components used to design and structure specific partnerships (i.e. contract terms, in-kind
contributions, financing facilities, or grants) can be used with a number of different PPP
approaches. There can therefore be no one generic or best model of PPP structure
A PPP is a partnership between the public sector and the private sector for the purpose of
delivering a project or a service traditionally provided by the public sector. PPPs
recognise that both parties have certain advantages relative to the other in the
performance of specific tasks. By allowing each sector to do what it does best, public
services and infrastructure can be provided in the most economically efficient manner.
The overall aim of PPPs is therefore to structure the relationship between the parties, so
that risks are borne by those best able to control them and increased value is achieved
through the exploitation of private sector skills and competencies.
In order to work successfully with the private sector, public bodies need to be clear about
the fundamental principles and objectives behind PPP. Under PPP arrangements, private
sector contractors become long term providers of services rather than simply upfront asset
builders, combining the responsibilities of designing, building, operating and possibly
financing assets in order to deliver the services needed by the public sector. As a result,
central and local government agencies become increasingly involved as regulators and
focus resources on service planning, performance monitoring and contract management
rather than on the direct management and delivery of services. The result is that the public
mission is delivered through the private sector.
Designed appropriately, PPPs can generate substantial benefits for consumers and
taxpayers. The scope of potential benefit will, however, depend on the type of project
being undertaken and the exact terms of the contract governing the PPP. It is important to
note that public bodies have a critical role to play in the management and regulation of
PPP during their design, construction and operation. PPPs also require effective contract
monitoring procedures to ensure that contractual obligations continue to be met in terms
of both quality and timing.
It is also essential to recognize that the nomenclature used to describe the partnership
process has not been standardized. There are several terms often used interchangeably
turnkey and build, operate- transfer (BOT), for example. There are also single terms that
are used loosely and can be applied to situations that are fundamentally different. For
example, BOT can be used to describe procurements that involves private financing, as
well as those that do not. As such, it is necessary for PPP practitioners to delve beyond
the terms and concepts and become familiar with the way in which the partnership
process itself works. Indeed the terminology debate surrounding the definition of PPP

categories itself mirrors the evolution of PPP approaches and the evolving regulatory
environment defining PPP in various States.
At present, Law does not have a specific definition of PPP. Each type of arrangement is
defined by individual Legislation governing operational structures and procurement.
However interpretation of Concessions suggests that the principal criteria for
distinguishing concessions from other PPP type structures is the extent of risk transfer to
the private party. This criteria will then also allow each type of PPP to be defined and
related to the relevant legislation and methods for selecting private parties. While the
choice of PPP structures is limitless in terms of financial and legal forms, it is viewed that
all PPPs can be defined in relation to the rules governing the choice of private partners
and the selection and application of public procurement procedures.
While it is not possible at this stage to define all possible types of PPPs according to the
application of public procurement of concession rules, it is extremely important for PPP
sponsors to develop a detailed understanding of the perspective and to correctly
categorise their choice of PPP structure before entering into contractual arrangements.
(a)

Traditionally Procured Projects

Traditionally, most governments have relied on public procurement to develop
their infrastructure systems. With this approach designated government agencies,
such as a ministry or public authority are vested with responsibility for
developing certain types of infrastructure. These agencies typically elaborate
master plans prioritizing needs and then arrange the financing, design, and
construction of individual projects. Once a project is completed it is then
operated and maintained by the agency, together with the other assets under its
care.
Under the traditional public procurement model, government agencies can utilize
the services of the private sector for design and construction, with the award of
individual contracts made on a competitive basis.
However, private sector participation usually does not extend beyond these
functions. There are a number of ways in which greater private sector
participation can be introduced as depicted in figure 2. Three approaches for
outsourcing former public functions to the private sector are described below.
These mechanisms present opportunities for the private sector to participate in
varying degrees in the maintenance, operation and management of infrastructure
improvements.

Figure 2: Private Participation Options with Traditional Public Sector Procurement

Operating Lease
Operating Agreement
Service Contracts

Traditional Public
Sector Procurement
with Outsourcing

Public Owner/
Operator/
Financier

Operator

Engineer

Leasee

Contractor/
Operator

Contractor

Public Sector
Private Sector

(i)

Service Contracts
Public agencies can enter into service contracts with private sector
companies for the completion of specific tasks. Service contracts are
well suited to operational requirements and may often focus on the
procurement, operation and maintenance of new equipment. These tasks
could include areas such as toll collection, the installation, maintenance
and reading of meters in the water sector, waste collection or the
provision and maintenance of vehicles or other technical systems.
Service contracts are generally awarded on a competitive basis and
extend for short periods of time of a few months up to a few years. They
allow public agencies to benefit from the particular technical expertise of
the private sector, manage staffing issues, and achieve potential cost
savings. Nonetheless, with service contracts management and
investment responsibilities remain strictly with the public sector. While
they afford certain benefits, service contracts cannot address underlying
management or cost issues affecting poorly run organizations.

(ii)

Operation and Management Contracts

Public operating agencies utilize management contracts to transfer
responsibility for asset operation and management to the private sector.
These comprehensive agreements transfer involve both service and
management aspects and are often useful in encouraging enhanced
efficiencies and technological sophistication.
Management contracts tend to be short term, but often extend for longer
periods than service agreements. Contractors can be paid either on a
fixed fee basis, or on an incentive basis where they receive premiums for
meeting specified service levels or performance targets.
Management contracts may be used as a means to transfer
responsibilities for a specific plant, facility or service provided by an
infrastructure owner. They may have a more broad reaching scope
involving the management of a series of facilities. Nonetheless,
responsibility for investment decisions remains with the public authority.
Operation and management contracts often provide a good opportunity
to encourage greater private sector involvement in the future. They are
particularly appropriate in sectors undergoing transition from public
ownership where existing regulatory and legal frameworks may not
allow greater private participation. They can be helpful in generating
trust between the public and private sectors in markets where there has
been little experience with PPPs. They also provide a means for private
companies to test the waters in potentially risky markets with limited
risk exposure. While operation and management contracts should be
expected to improve service quality, they cannot be expected to improve
service coverage or encourage tariff reform.

(iii)

Leasing
Leases provide a means for private firms to purchase the income streams
generated by publicly owned assets in exchange for a fixed lease
payment and the obligation to operate and maintain the assets. Lease
transactions are different from operations and management contracts in
that the transfer commercial risk to the private sector partner, as the
lessors ability to derive a profit is linked with its ability to reduce
operating costs, while still meeting designated service levels.
Leases are similar to operations and management contracts in that the
responsibility for capital improvements and network expansion remains
with the public sector owner. However, in certain cases the lessor may
be responsible for specified types of repairs and rehabilitation. Under the

right conditions, private companies entering into lease agreements might

also make targeted capital improvements in order to improve operating
efficiencies and profit levels.
However, responsibility for planning and financing overall investment
and expansion programs remains with the public sector owner. Lease
agreements can be expected to extend for a period of five to fifteen
years. They are suitable only for infrastructure systems that generate
independent revenue streams, and are often used in the public transport
and water sectors.
Traditional procurement can also be used to cover the design and build
functions either bundled or separately. As with the examples above,
ownership of assets remains with the public body and the private sector
is responsible only for well-defined tasks adopting limited responsibility.
(b)

Publicly Sponsored BOT Projects

The functions described above involve instances where limited responsibilities
normally assumed by the public sector are passed to private companies.
However, the functions involved are at once discrete and relatively isolated a
fact that limits the potential benefits that the owner can derive from its
partnership with the private sector.
Integrated partnerships involve transferring responsibility for the
construction, and operation of a single facility or group of assets to a
sector partner. This project delivery approach is practiced by
governments around the world and is known by a number of different
including turnkey procurement.

design,
private
several
names,

The advantage of the publicly sponsored BOT approach is that it combines

responsibility for usually disparate functions design, construction, and
maintenance under one single entity. This allows the partners to take advantage
of a number of efficiencies. First of all, the project design can be tailored to the
construction equipment and materials that will be used. In addition, the
contractor is also required to establish a long-term maintenance program up
front, together with estimates of the associated costs. The contractors detailed
knowledge of the project design and the materials utilized allows it to develop a
tailored maintenance plan over the project life that anticipates and addresses
needs as they occur, thereby reducing the risk that issues will go unnoticed or
unattended and then deteriorate into much more costly problems. The benefits of
this life cycle costing are particularly important as most infrastructure owners
spend more money maintaining the systems than on development. In addition,
the life-cycle approach removes important maintenance issues from the political
vagaries affecting many public maintenance budgets, with owners often not

knowing how much funding will be available to them from year to year. In such
cases they are often forced to spend what money the do have on the most
pressing maintenance needs rather than adopting a more rational and cost
effective preventive approach.
Figure 3: Publicly Sponsored BOT
The public sector awards public
sponsored BOT contracts by
competitive
bid
following
a
transparent tender process. Tenderers
respond to the specifications
provided in the tender documents and
are usually required to provide a
single price for the design,
construction and maintenance of the
facility for whatever period of time is
specified.
Tenderers are also required to submit
documentation
on
their
qualifications, thereby allowing
evaluators to compare the costs of
the different offers as well as ability
of the Tenderers to meet their
specified needs.

Publicly Sponsored
BOT

Public Owner/
Financier

Contractor

Operator

Engineer

Public Sector
Private Sector

While the potential exists to reap

substantial rewards by utilizing the turnkey approach, project sponsors not
accustomed to this approach must take great care to specify all standards to
which they want their facilities designed, constructed, and maintained. With a
turnkey approach the public sector relinquishes much of the control they
typically possess with more traditional project delivery, and unless needs are
identified up front as overall project specifications, they will not generally be
met.
It should also be noted that an public sponsored BOT approach alone does not
relieve public sector owners of the burden of financing the related infrastructure
improvements.
(c)

Partnership Project Development and Investment Opportunities

The structures described above provide new opportunities for the private sector
to perform tasks that would otherwise be undertaken by the public sector.

10

However, PPP arrangements can also involve private sector financing for
projects that would otherwise be fully financed by the state.
These types of PPP arrangements are particularly attractive as they afford all the
implementation and operational efficiencies described early, together with new
sources of capital. Access to additional sources of capital allows owners to
implement important projects sooner by avoiding the need to wait for future
government budget cycles for funding.
Figure 4: Private Participation Options Project Development and Investment
Opportunities
Maintenance Concession
BOOT Concession
BOT

Design Build
Finance Operate
(DBFO) Concession

Divesture

Public Owner

Private
Concessionaire

Private
Concessionaire

Contractor

Contractor

Operator

Operator

Engineer

Engineer

Public Sector
Private Sector

(i)

Concessions
The primary vehicle for PPP opportunities involving direct private sector
investment is the BOT concession agreement. These agreements enable
a private investment partner to finance, construct, and operate a revenue
generating infrastructure improvement in exchange for the right to
collect the associated revenues for a specified period of time.
Concessions can be awarded for the construction of a new asset or for
the modernization, upgrade, or expansion of an existing facility.

11

Concessions can often extend for a period of 25 to 30 years, or even

longer, and are awarded under competitive bidding conditions. Under a
concession approach the ownership of all assets, both existing and new,
remains with the public sector. It is their responsibility to ensure that the
assets are properly used and maintained during the concession period
and that they are returned in good condition when it is over. Concessions
are generally awarded based on following criteria:
(1)
(2)
(3)

The end price offered to users

The level of financial support required from the government and
other grantors
Ability to implement the project

Oversight of the award, implementation, and operation of PPP

concessions is a complex task. As such, it is often common practice for
governments to establish dedicated, stand-alone state agencies or special
purpose vehicles (SPV) with the sole responsibility of overseeing PPP
projects. Implementation agencies are likely to require staff with
sophisticated financial and legal experience that goes beyond that of
many public infrastructure owners.
(ii)

Private Divestiture
Private divestiture involves the sale of assets or shares of a state-owned
entity to the private sector. Divestitures can be approached in many
different ways, and can be either partial or complete. Divestiture is also
often an integral part of the transformation of state-owned enterprises
and can be used as a vehicle to transfer the ownership of assets from the
central government to local governments and / or to private utility
companies. The following discussion on divesture addresses the sale of
assets to private investors only.
(1)

Complete Private Divestiture

In the case of a complete divestiture, the entire assets of a utility
would be sold either to a single investor, a group of investors, or
possibly through a management buyout. In certain cases a
divestiture can also be accomplished by making shares in the
company available for purchase on the national stock market. A
complete divestiture is similar to a concession in certain ways,
as it gives the private investor complete control over investment
in, and the operation and maintenance of whatever assets the
company possesses. However, unlike concessions, divestiture
also gives the private sector ownership of the assets themselves,

12

and that ownership is permanent. As such, the government

relinquishes further control with a divestiture approach,
maintaining only a regulatory role, protecting consumers from
monopolistic pricing and, in some cases, perhaps requiring a
minimum maintenance and investment regimen.
Divestiture is likely to be particularly sensitive when it involves
assets of national significance, such as a water resources or
highway networks. In addition to ideological impediments,
there may well also be constitutional and legislative issues to be
overcome. However, in cases where local managerial
capabilities are strong and where there are local investors who
may be interested in supporting such a venture, divestiture may
provide a way to achieve private sector efficiency gains while
keeping control over the assets and the revenues they generate
within the country.
(2)

Partial Private Divestiture

With a partial private divestiture, the government would retain
ownership of a certain portion of the former public companys
assets. This is often a more attractive alternative to those
governments or authorities that wish to maintain a certain level
of control in the management of the assets. In such cases, the
interplay of responsibilities between the public and private
sectors is blended. A partial divestiture is an excellent way for
the public sector to attract private capital and encouraging
improvements in operational and management efficiency, while
also protecting the public consumers as well as assets of
national significance. The individual arrangements for sharing
responsibility for management and investment decisions depend
on the division of assets, as well as the sharing of costs.
Therefore, they would need to be established on an individual
basis. It is likely that the public sector would transfer as much
of the costs as possible to its private partner.
However, in order for a partial divestiture to be attractive to
private investors there would have to be a reasonable scope for
making a fair profit on its investment.

(4)

The Suitability and Effectiveness of Alternative PPP Structures

Table 1 summarises the advantages and disadvantages of the four main groupings of PPP
relationships. It also provides suggested sectoral applications which are further discussed

13

below. The selection of a suitable PPP arrangement is a complex task and must be based
on individual project characteristics and needs
(a)

Suitability to Transport Projects

Some of the most important issues that will influence the selection of a preferred
form of PPP for projects in the transport sector are the size and scope of the
project, the ability to apply user tolls and the extent of risk transfer required.
Major and minor roads schemes or mass transit systems are well suited to
traditional design and build contracts, as operating costs in a typical scheme are
low when compared to the capital costs of construction.
Traditional procurement contracts are essentially an extension of the existing
conventional approach, endeavouring to transfer design and construction risk to
the private sector through fixed price contracts. In such instances responsibility
for maintaining the infrastructure will remain within the Public sector. In some
instances, the construction of, particularly, a major road scheme may be funded
in part or in whole by user tolls. For example, bridges and tunnels are particularly
suited to user tolling where there is a clear benefit to be gained from choosing the
tolled route over a different alternative route. In such circumstances, the public
sector must decide whether to transfer responsibility for financing the project and
collecting tolls to the private sector contractor.
Toll motorway concession contracts are suitable where the private sector
contractor will finance a major road scheme, collect user tolls and bear the risk
associated with traffic demand. BOT contracts are more suitable where the
private sector will receive user fees paid by the public sector, but the public
sector will finance the project and accept the risk associated with demand.
Shadow toll DBFO contracts are likely to be more suitable where the private
sector contractor will accept some of the risk associated with traffic demand, but
user tolls are not applied.
Projects may be where the private sector contractors are paid on the basis of
Shadow Tolls. However, there are also a range of disadvantages associated with
this approach including the greater level of demand risk retained by the public
sector and the fact that as motorists do not pay for the economic cost of
infrastructure provision, infrastructure investment may not be rationally
allocated.
Minor projects are more suited to traditional design and build contracts and are
not likely to be suitable for other forms of PPP unless bundled together into a
larger contract with a significant operating element.

14

Table 1: Advantages and Disadvantages of PPP Relationships

PPP Type
Contacting

Main Features

Contact with the Private Sector
to design and build Public
Facility

Facility is financed and owned
by Public Sector

Key Driver Transfer of Design
and Construction Risk

Application

Suited to capital projects with
small operating requirement

Suited to capital projects where
the Public Sector wishes to
retain operating responsibility

Strengths

Transfer of Design and
Construction Risk

Potential to accelerate
construction program

Publicly
Financed
BOT

Contract with a private sector

contractor to design, build and
operate a public facility for a
defined period, after which the
facility is handed back to the
public sector
The facility is financed by the
public sector and remains in
public ownership throughout the
contract.
Key Driver - transfer of
operating risk in addition to
design and construction risk

Suited to projects that involve a

significant operating content.
Particularly suited to water and
waste projects.

Transfer of design, construction

and operating risk
Potential to accelerate
construction
Risk transfer provides incentive
for adoption of whole life
costing approach
Promotes private sector
innovation and improved value
for money.
Improved quality of operation
and maintenance.
Contracts can be holistic
Government able to focus on
core public sector
responsibilities.

Weaknesses

Possible conflict between
planning and environmental
considerations

May increase operational risk

Commissioning stage is critical

Limited incentive for whole life
costing approach to design

Does not attract private finance

Possible conflict between
planning and environmental
considerations.

Contracts are more complex and
tendering process can take
longer

Contract management and
performance monitoring
systems required.

Cost of re-entering the business
if operator proves
unsatisfactory.

Does not attract private finance
and commits public sector to
providing long term finance.

15

Concessions

Contract with a private party to

design, build, operate and
finance a facility for defined
period, after which the facility
reverts to the public sector.
The facility is owned by the
private sector for the contract
period and it recovers costs
through public subvention.
Key driver is the utilisation of
private finance and transfer of
design, construction &
operating risk.
Variant forms involve different
combinations of the principle
responsibilities.

Suited to projects that involve a

significant operating content.
Particularly suited to roads,
water and waste projects.

As for Publicly financed BOT

plus:
Attracts private sector finance;
Attracts debt finance discipline;
Delivers more predictable and
consistent cost profile;
Greater potential for accelerated
construction program; and
Increased risk transfer provides
greater incentive for private
sector contractor to adopt a
whole life costing approach to
design.

Possible conflict between

planning and environmental
considerations.
Contracts can be more complex
and tendering process can take a
long period of time
Contract management and
performance monitoring
systems required.
Cost of re-entering the business
if operator proves
unsatisfactory.
Funding guarantees may be
required.
Change management system
required

16

(b)

Suitability to Water Projects

Public Private Partnerships have existed in the international water sector for a
number of years. For example, private sector concessions for the development
and operation of water supply and treatment plants have been common place in
France for at least forty years, leading to the growth of the large and diversified
French private sector utility companies.
The considerations that will shape the selection of a preferred form of PPP for
projects in the water sector are similar to those in the transport sector and include
the size and scope of the project (including its operational content), the ability to
apply user charging and the extent of risk transfer required.
The construction of water supply or waste water networks under PPP
arrangements is likely to be linked to the level of information available on the
extent, composition and performance of existing networks. If information is not
sufficient traditional procurement arrangements may be more suitable. On the
other hand, water supply and waste water facilities are likely to be suited to BOT
and DBFO contracts. They may also be suited to Concession contracts where
there is an opportunity to introduce user charging.
However, water supply and waste water facilities are considered to be less suited
to traditional procurement design and build contracts as the public sector would
retain the risks associated with operating increasingly complex treatment
processes, without having had a role in the design of those processes.

(c)

Suitability to Waste Projects

More recently, the use of PPPs has been stimulated in sectors where there has
been a significant increase in the burden of traditional public sector
responsibilities and this is particularly true with regard to the disposal of
municipal waste. Increasingly, for economic and environmental reasons, public
authorities are reducing their reliance on landfill which has been the traditional
means of disposing of waste. New methods of waste disposal such as waste to
energy schemes and recycling plants require substantial investment and
specialised technical know-how.
The considerations that will shape the selection of a preferred form of PPP are
similar to those for the transport and water sectors and include the size and scope
of the project (including operational content), the ability to apply user charging
and the extent of risk transfer required. Projects in the waste sector are likely to
be suited to the more developed forms of PPP where a significant amount of
operating risk can be transferred to the private sector. In addition, under a
Concession contract, the private sector can be asked to finance the project, collect

17

user charges (in accordance with the Polluter Pays principle) and accept the risk
associated with waste volumes.
Table 2 summarizes the ability of the PPP structures to meet a range of desirable
performance indicators. The various PPP structures are arrayed in increasing
order of private participation from top to bottom on the table. It can be seen that
as private sector participation increases, so too does the potential for achieving a
wide variety of infrastructure goals. However, it also needs to be recognized that
greater private sector participation in infrastructure development also brings with
it increased implementation constraints, particularly when private investment is
involved.
Table 2: The Effectiveness of Alternative PPP structures

Service
Contracts
Management
Contracts
Leasing
Publicly
Sponsored
BOT
Concessions

Improved
Service

Enhanced
Operating
Efficiency

Enhanced
Risk
Sharing

Life
Cycle
Costing

Accelerated
Implementa
tion

Leveraging
Public
Funds

Possible

Yes

No

No

No

No

Implement
ation
Constraint
s
Low

Yes

Yes

No

No

No

No

Moderate

Possible
Yes

Yes
Yes

Some
Some

Possible
Yes

No
Yes

No
Yes

Moderate
High

Yes

Yes

Yes

Yes

Yes

Yes

Very High

As demonstrated, private outsourcing arrangements have the ability to affect service

improvements and gains in operational efficiency. However, their ability to enhance risk
sharing or capture more important life cycle costing efficiencies is limited. These latter
indicators can be somewhat enhanced with certain types of leases, but the extent to which
this is possible depends both upon the required service standards and the duration of the
lease agreement. Given that they do not involve private sector capital investment,
outsourcing partnerships have no ability to accelerate project implementation or leverage
public funds. Therefore these approaches are best suited to situations where
improvements in operational efficiency are desired, but where there is little need for
major capital improvements.
The BOT approach is appropriate when owners need to embark on new capital projects
and hope to achieve greater operational efficiencies. They can also streamline both
implementation costs and the implementation process as a whole.
BOT projects can prove a useful first step in moving towards future partnerships
involving private investment, as they provide the opportunity to demonstrate the types of

18

savings and efficiencies private sector involvement can bring to infrastructure

development.
PPPs involving private investment provide the potential to achieve all the cost and
operational efficiencies associated with the BOT approach. In addition, the benefits
leveraging and accelerated project implementation are also added. As such, investment
partnerships have the potential to deliver maximum benefits to the public sector.
However, these arrangements also introduce legal and regulatory concerns, and require
sophisticated management on the part of the government to insure that its requirements
are met. Therefore, in order to justify the considerable effort involved in resolving such
issues, investment partnerships are often best suited to larger and more costly projects.
(5)

Requirements of PPP Partners

It is important to recognize that the different participants in PPP projects have distinct
goals and requirements that must be met in order for them to be able to participate in an
effective partnership. While certain goals are complimentary; others are not, and as the
number of players increases, so too will the complexity of establishing a fair playing
ground for the various participants.
Table 3 identifies the different players that may be involved in partnership projects and
arrays their likely requirements when operating under the partnership structures discussed
earlier. Predictably, as the level of private sector participation increases, so do the number
of participants and the requirements of all partners, public and private alike.
For private sector participants, the first requirement for any type of involvement is the
potential to derive a reasonable profit. In addition, in return for greater risk exposure, the
private sector will also require the potential for commensurate increases in profit
potential. Similarly, before committing its own capital in the development of projects, it
will require clear legal and regulatory structures, and will want to see the potential for
future economic growth, together with reasonable levels of political support and stability.
While the public sector supports efficiency improvements, the private sectors motivation
for profit introduces conflicts of interest with beneficiary governments, which are
committed to promoting equity and maximizing the well being of their citizens. However,
governments are generally willing to allow their private partners to make a reasonable
profit in exchange for improving service and efficiency, leveraging its own financial
resources, expediting project implementation. Beneficiary governments may also be
concerned about the overall ease of implementation when using outside or donor funds to
support partnership projects.
Partnerships involving private investment are also likely to require loans and guarantees
provided by multilateral institutions and commercial banks. Such institutions will require
rigorous and conservative financial analysis in exchange for their participation. They will
also need clear proof regarding the certainty of outside and State funding, as well any

19

equity contributions to be made by the private sector. Lenders will also need proof of the
technical ability of the private operator, as well as the beneficiary governments ability to
oversee the implementation and operation of the project. In addition, lenders will require
that clear regulatory and legal structures be in place to govern investment partnerships,
and they will also be interested in the general stability of the political environment in the
beneficiary nation. It should be recognized that as regular participants in PPP
infrastructure partnerships, multilateral institutions and commercial banks are well versed
in the potential pitfalls and in turn have developed comprehensive financial modeling and
due diligence practices that will have to be satisfied before their participation can be
assured.
Examples of the different requirements of the parties in various PPP arrangements are set
out in table 3.
(6)

Achieving Successful Partnerships

What are the necessary elements to achieve successful partnerships in the infrastructure
arena? First, it is essential to recognize exactly what a partnership is. A partnership is an
agreement between two or more parties to work together towards a common goal.
Partners share joint rights and joint responsibilities, and when these are not met
partnerships do not work.
Partnerships require the will of all parties involved to work together. They also rely on
clear and carefully crafted agreements defining the rights and obligations of the parties
involved and establish a framework for responding to new situations as they arise.
Concession agreements must also be tailored to the laws and regulations governing the
award. As such, it is essential for governments to develop clear legal and regulatory
formats that identify the various steps in the process, together with rights and obligations
of all involved.
This may well involve the promulgation of new laws. Similarly, effective user fee policies
are also essential components of the partnership process. In certain cases utility fees may
have been subsidized in the past and infrastructure PPPs may be undertaken in
conjunction with the liberalization of tariffs. If this is the case, proposed tariff structures
will require careful review in terms of their overall affordability, their ability to gain
public and political support, and their ability to finance the needed improvements. The
establishment of a reasonable tariff level is a delicate task at best and involves close
interplay between expected utilizations levels, public acceptability, market conditions,
and government support.
Efficient organization and streamlined decision making are also critical to the ability of
beneficiary governments to launch successful PPP projects. One of the most effective
steps beneficiary governments can take to support successful infrastructure partnerships is
the establishment of special-purpose authorities charged with overseeing their
implementation. Such authorities usually work with consultants to organize and execute

20

planning and feasibility studies, conceptual design work, and in many cases establish
financial demand model.
Special purpose authorities can assume responsibility for liaison with all parties, as well
other government departments. Often these agencies also negotiate with development
banks and other potential funders. Once individual projects have been identified, the
authority procures them on behalf of the government and then oversees their construction
and operation. While the presence of a development authority can never guarantee
success, it does streamline and organize government involvement, helps develop
government expertise, and encourage consistent policy.
Successful concessions rely on a series of checks and balances. A well-crafted agreement
uses checks and balances to create co-dependence and transparency, while enabling all
the parties involved achieving their goals. Without the participation of any one of these
actors it would not be possible to develop these projects on a partnership basis. This
reality forces all of the participants to be receptive to the needs of its fellow partners and
to work together towards a joint solution and work through new issues as they arise. This
dynamic may be further reinforced when Multilateral Agencies are involved.
Partnership is achieved by providing credibility for the private partner risking its money
and legitimacy for the government sponsoring the project. Legitimacy is achieved by
ensuring that partnership projects meet the needs of the paying public, produce desired
additionalities, and reinforce wider financing goals. It is also achieved by rewarding for
the successful negotiation of risk and providing the private partner with a reasonable
return on its investment. However, if the rewards are too high then that legitimacy is
undermined. Legitimacy is also undermined when investors are more interested in the
profits derived from lucrative construction contracts rather than the successful operation
of a concession itself once it is built.
Achieving partnership also requires strong political support. Traditionally when there has
consensus that an infrastructure project should be built, governments have allocated the
necessary resources to procure it themselves. When governments look to the private
sector for funding this may be a signal of lackluster support. However, because of the
risks involved, the un-conventionality of the approach and the need to maintain
legitimacy, partnership projects are likely to require stronger political and government
support.
Moreover, as risks and challenges increase, so to must the governments support and
commitment. In addition to providing financial resources, it is important to maintain
critical government support for PPP projects.

21

Table 3: Requirements of PPP Partners under Different PPP Arrangements

Private Sector Requirement
Fair Profit
Reward for Risk Mitigation
Clear Legal/Regulatory Structure
Growth Potential
Political Support
Political Stability
Beneficiary Government Requirements
Leverage Funding
Accelerating Project Implementation
Improving Service Levels
Improving Service Coverage
Efficiency Gains
Ease of Implementation
Maximizing Social Benefits
Transparency/Open Competition
Reasonable Control on Grant Funds
Avoiding Undue Private Profit
Lender Requirements
Rigorous Financial Analysis
Conservative Cost/Revenue Assumptions
Grant/State Funding
Clear Regulatory Structure
Technical Ability of Owner/Operator
Political Stability

Service
Contracts
Required
-

Management
Contracts
Required
-

Yes
Important
Yes
Yes
-

Leases

Concessions

Required
Desirable
Required
Desirable
Desirable
-

Publicly
Funded BOT
Required
Required
Required
Desirable
Desirable

Required
Required
Required
Desirable
Required
Desirable

Partial
Divesture
Required
Required
Required
Desirable
Required
Desirable

Full
Divesture
Required
Automatic
Required
Desirable
Required
Desirable

Yes
Important
Yes
Yes
-

Yes
Important
Desirable
Yes
Yes
-

Yes
Yes
Important
Important
Desirable
Important
Important
Required
Required

Important
Important
Yes
Yes
Important
Desirable
Important
Important
Required
Required

Important
Important
Yes
Yes
Important
Desirable
Important
Important
Required
Required

Important
Important
Yes
Yes
Important
Desirable
Important
Important
Required
Required

Required
Required
Desirable
Required
Required
Desirable

Required
Required
Desirable
Required
Required
Desirable

Required
Required
Desirable
Required
Required
Desirable

22

(II)

PPP Concept Planning and Implementation

(1)

Introduction
It is important to note that there is not one method to analyze PPPs, rather this section will
present a logical progression based on the project cycle with suggested methodologies to
structure thought and analysis for decision making.

(2)

Practical Considerations
The development of a successful PPP requires attention to a large variety of issues. As
PPP is a developing concept, the first stage must be to create a supporting institutional
structure able to develop, guide and manage PPPs on behalf of the public sector. This will
entail the development of supporting national and local legislation and regulations
enabling PPPs, the development of institutional capabilities and importantly the creation
of effective management and oversight structures.
Practical issues associated with PPP development include the following:
(a)

Selection of the most suitable PPP structure for the local setting and project
characteristics

(b)

Developing systems and structures that reduce complexity and wherever possible
standardize the approach

(c)

Ensuring that the structures are manageable both in terms of size and complexity.

(d)

Ensuring that a full understanding of timing is achieved.

(e)

The public sector should be realistic about the skills and experience it has to
develop and implement PPP- integrate private sector expertise if required

(f)

PPPs must demonstrate value for money over and above traditional procurement
programs and must be designed to maximize the benefits of all factions involved
according to their objectives.

(g)

Effective regulatory and institutional frameworks must be developed to manage

and monitor PPPs. Public sector should provide private sector with some control.

(h)

The public who would be paying for the services should be integrated into the
monitoring/ oversight function.

(i)

Trust must be established between all parties if a partnership is created.

23

The following framework can be envisaged for the development of an effective enabling
framework for PPP implementation.

WHAT IS TO BE
PROVIDED

CAN PPP BE
IMPLEMENTED
What are the Objectives

What infrastructure
services are needed

What are the capabilities

and capacities needed

What are the risksWho bears them ?

Is there private sector

interest

What type of PPP

is suitable

ENSURE YOU ARE

READY BEFORE
STARTING

PPP Project Cycle

Project
Identification

Project
Appraisal

Design &
Agreement

Evaluation

Stages

Suitability
Assessment

Procurement

Implementation

Monitoring
PPP Design

Preparation of
National & local
legislative &
Regulatory
structures

ONLY USE A PPP IF

REAL BENEFIR IS
DEMONSTRATED AND
ACHIEVABLE

KEEP IT SIMPLE AND

MATCHED TO REAL
NEEDS

Timeline

Preliminary
Stage

WILL A PPP DELIVER

VALUE FOR MONEY
AND THE BEST USE
OF RESOURCES

Suitability
Assessment

Procurement
Process

Define PPP
Structure

Agreement of
National
Authorities &
Lenders

Construction
Tender

Operation

Evaluation

Monitoring

Negotiation

Contract
Management

Contracting

Requirements
Needs Assessment
Legal Contract
Institutional
Capacity
National Policy

Desired Gains

Risk Allocation

Obstacles &
Constraints

PPP Components

Pvt. Sector Interest

True Cost of
Services

Budgeting
Expectations of a
PPP

Integration of PPP
into Design
Procurement
Procedure

Open &
transparent
Process

Lenders
Requirement

Detailed
recordings

Financial & SocioEconomic

Appraisal

Effective
Implementation
Structures
Effective working
Relationship

24

(3)

Stages in the PPP Cycle

(a)

Preliminary Stage
The broad policy framework needs to be established
before steps are taken to introduce private sector
participation. The basic structure to this decisionmaking process is straightforward. The government:








(i)

Defines policy objectives

Identifies options for meeting them
Appraises the options
Selects its preferred option
Clarity of Objectives

Establishing PPP
Policy
Define Policy
Objectives

Identify Options

Appraise Options

(1)

Successful PPP programs are

Choose Preferred
characterized by a constant referral
Option
back to a clear set of objectives that
have been agreed by all key government officials and their
advisors. Less successful programs fail to ensure that the
reforms are developed in line with the objectives, or they have
vague and undefined objectives, or different objectives
depending on who is consulted.

(2)

Having varied or conflicting objectives will create problems. It

may create problems when bidders submit their tenders. For
example, some government agencies, typically Ministries of
Finance and State Property Funds, may favor awarding a tender
that meets the objective of revenue maximization; other
government agencies, such as line industries or regulators, may
favor a tender that minimizes tariff impacts. Discussion on the
actual objectives should take place well before transaction
documents are prepared. It is essential that objectives are
defined at the start, written down in simple summary, and that
they form the basis of all decisions. Objectives will vary.
However, most PPP programs have two shared objectives:
(a)

(b)

To increase the efficiency of infrastructure industries,

by transferring risk from the public to the private sector
and through the introduction of competition; and
To transfer investment responsibility from the public
sector to the private sector.

25

(3)

Governments may also pursue a range of other objectives

through PPP programs. These include:
(a)
(b)
(c)
(d)
(e)
(f)

(4)

Improving the quality of service delivered

Expanding service provision to certain geographic
areas or to particular sections of the population
Developing emerging capital markets
Redefining the role of the public sector
Focusing on development in a particular part of the
country
Raising revenue

The nature of the governments objectives will have a direct

bearing on the alternative form of PPP and the process pursued.
Unless objectives are clearly defined and prioritized, there will
be no basis for making consistent choices. This will lead to
major difficulties with the selection of advisors and the PPP
process as a whole. The first step is therefore to prepare a
concise written statement of objectives, and to ensure that this
forms the basis of subsequent decisions. One common practice
is to ensure that all documents produced by the team working
on the PPP program start with a short restatement of the agreed
objectives. An indicative Statement of Objectives for a PPP
initiative is presented below.

The government officials responsible for overseeing a PPP program should

articulate a clear set of objectives at the outset of an initiative and ensure that all
affected government agencies are in agreement on the set of objectives. These
objectives should be communicated to advisors at the earliest possible
opportunity and should be referred to throughout the process when alternative
approaches to PPP and processes for implementation are being considered.

26

(ii)

Obstacles & Constraints

Factor
Local and National
government Policy

Extent of Legislative
Authority

Taxation
Framework
Reporting
Accounting
Framework

&

Does the policy environment favour PPP

application and the different applications
required for PPP

Is PPP consistent with other government

policies i.e. land use, social policies etc.

Is there a sufficient legislative authority for

entering into a PPPs

Is there a sufficient legislation to support

the management and supervisory role of
Public Sector in PPP

Are there sufficient authorizations and what

are the limits to enter into debt agreements?

What is the tax status governing PPP

Is there a possibility of offering tax

exemption to the parties entering into PPP.

How are PPPs treated in national authority

accounts
What
are
the
public
disclosure
requirements required

Financial Issues

Technical
Organizational
Issues

Comment

&

Political & Social

Considerations

Ability to integrate
different forms of
funding

Can private sector financing compete with

public sector financing

What is the effective cost of borrowing

Is the project financially self-sufficient or
does it have the capability to become so ?

What financial support mechanisms are

available

Is there sufficient data to allow design and

preparation

Can competitive tendering be assured

What quality control mechanisms exist

Is the national authority creditworthy ?

Is there strong political commitment
towards the PPP approach

Will a PPP be socially acceptable

Will a PPP be acceptable to existing

sources of financing

27

(b)

Is a PPP Feasible Identification

Prior to the decision process of a PPP, a number of pre-conditions must exist
within the national/local authorities as defined in the requirement of the
preliminary stage above. These include:
(i)

Identification of who is responsible for PPP and who has the authority
and responsibility for ultimate decision-making.

(ii)

Developing the necessary expertise to design, tender, evaluate

implement and monitor PPP projects.

(iii)

Establishing policies to guide decision making including ensuring that

the necessary legal and regulatory structures are in place to allow PPP.

(iv)

Developing a policy for PPP in current and future services in order to

introduce a coherent planning process, which encourages early
identification of PPP opportunities.

The objective of this phase is to assess whether a PPP approach is suitable for a
particular project. The responsibility for this assessment and final decision should
lie with the National Authority as project beneficiary and project sponsor (for
convenience in this Part the term National Authority is assumed to imply the
relevant national body responsible for identifying, developing and implementing
PPPs whether this be on a national or local level). However the private sector
will need to be considered in that a basis for viable PPP relationships is that the
private sector finds an interest in the project. Additionally the government as a
promoter of the PPP approach has a valuable role to play in encouraging this
assessment, which is still often neglected in most cases.
The potential for applying PPPs will reflect local authority policy, expectations
and openness to cooperating with the private sector. This in turn will determine
the criteria to be applied and to their respective weightings. This first stage will
assess the desirability and suitability of procuring a project as a PPP. Essential
questions that must be asked are:
(i)
(ii)
(iii)
(c)

What are the potential obstacles and constraints to PPP opportunities?

Would the private sector be interested in the opportunities?
Is PPP the best method to deliver the required services / infrastructure?

Private Sector Interest

The private sector will be interested in some projects more than others based not
only on purely financial considerations. National authorities have a major role to

28

play in adding to the value of a project. Generally the private sector will give
priority to projects, which demonstrate:
(i)
(ii)
(iii)
(iv)
(v)

Sufficient demand
Revenue generating and development potential
Meet internal development criteria
Strong Viability
Strong Political Commitment

A crucial issue that must be addressed by the national authority is the

management of risk. While considering the principal that the party best able to
manage a risk should adopt it, it should also be remembered that the degree of
risk transfer to the private sector will determine the extent of return required by
the private sector. Various market factors will need to be analyzed including
existing and future demand. Various techniques are used to determine financial
viability but at this stage a simple cash flow analysis may be sufficient to
determine whether private interest is possible.
(d)

Evaluation: Is PPP the Best Delivery Model?

Crucial to the selection of any PPP model is whether it would provide value for
money and above all additional value than traditional public procurement
methods. Two considerations are important:
(i)

(ii)

The national authority should establish the true cost of providing a

service with the purpose of benchmarking or shadow biding potential
private costs
The benefits and costs should be systematically analyzed considering
both quantifiable and non quantifiable items

The factors determining value for money will change between projects. A
number of common methods for PPPs to generate better value for money exist
including:
(i)
(ii)
(iii)
(iv)
(v)

Reduced life cycle costs

Better allocation of risk
Faster implementation
Improved service quality
Generation of additional revenue

Other project specific factors will usually be identified by considering the

experience of similar projects and quantifying project specific characteristics. It
should be noted that this, preliminary, value for money assessment can only
provide an understanding of the potential value of using a PPP approach. Final
assessment can only be made at the end of the procurement process.

29

(e)

Selecting an Appropriate PPP Structure

There is no one method for deciding which type of PPP approach will best serve
the needs of a project as this depends on the project characteristics and public
perception of the need for PPP. It is however important that the selection of an
appropriate PPP form be undertaken at an early stage to facilitate effective
project design and achieve early buy-in of the parties. Selection of the
appropriate PPP structure would require assessment of the following factors:
(i)

Needs Assessment
The main focus in a needs assessment is to define the service needs and
to determine the objectives to be achieved through the PPP. These
objectives must be quantifiable, measurable and specific in order to
assist in analysis and the future preparation of the procurement process.
For this purpose and for future monitoring after the completion of the
project, it is extremely important that the national authoritys needs and
objectives are clearly stated.

(ii)

Risk Allocation
The degree of risk transfer will be reflected in the form of the program.
This should be based on analysis of the desirable and feasible level of
risk transfer. The forms of PPP range from, at one extreme, service
contracts, through, at the other extreme, the sale of assets. The main
options are:
(1)

Service contracts
Private companies are employed for certain narrowly defined
and specified tasks (e.g., billing services). The responsibility of
the private company is limited to the specified service. The
service contract is paid for in a fixed fee by the public authority.
The degree of risk transferred to the private sector is limited to
the service task.

(2)

Management contracts
Management contracts extend a service contract to include the
management of the company as a whole, so that management
risk is transferred to the private sector. Payment is usually a
fixed fee, though a portion of the total value may be covered by
a bonus.

30

(3)

Leases
The private sector operates the system for a given period, but
assets remain state-owned. The public sector generally remains
responsible for financing new investment, and the private
company for working capital and maintenance. The private
sector is also responsible for collecting revenue that it uses to
fund its operations, while more risk is allocated to the private
sector.

(4)

Concessions
The private sector both operates the system and is responsible
for new investment for a period of time defined in the
concession agreement. At the end of the contract, the
concessionaire hands over the system and is paid the residual
value of the existing assets. Depending on the existence of
government guarantees, the operational, financial and
investment risk transferred to the private sector may be
commensurate with an asset sale.

(5)

Asset transfer (indefinite) - trade sale or flotation

A full asset transfer, whether sold to individual companies or
floated on the stock exchange, results in the private sector
purchasing the existing facilities. The private sector then has
full control over the ownership and operation of existing assets
and the construction of new assets without any future obligation
to return those assets to the government, or any other party. At
the same time, the assets are freely transferable to other private
sector institutions.

The degree of risk transfer needs to be consistent both with the

objectives and with the overall approach to private sector participation.
Where consumer interests can be protected indefinitely through
competition, solutions with a high degree of risk transfer may be
appropriate. Where the government wants to maintain a loss-making
service, a lower degree of risk transfer will be appropriate because the
service would simply stop if the private sector fully assumed the risks,
unless the operator is subsidized by the public sector.
(iii)

Identification of Broad Options for Meeting the Objectives

(1)

Once a decision has been made to go ahead with PPP, and there
is a clear view of the objectives that can realistically be

31

achieved, the government will have to consider the main options

for PPP. This will be a major and complex decision because the
government will also need to decide on the following issues:
(a)

The degree of risk transfer

(b)

The mechanism for protecting consumer interests

market, contract or regulation

(c)

The structure of the industry

The options for feasible private sector involvement will
also vary among projects. In addition, all elements of
the reform program must be consistent. For example,
an option that seeks to transfer substantial risk to the
private sector should not be combined with a highly
prescriptive contract that limits the ability of the new
owners to manage that risk; and an option that relies on
competition to protect consumer interests should not be
combined with an industry structure that gives too
much market power to one participant.

(iv)

Protection of Consumer Interests

(1)

While government provides infrastructure services, consumers

are protected with varying effectiveness - through the normal
processes of government. Private providers will have a strong
incentive to maximize profits from infrastructure provision. It
needs to be clear how consumer interests will be protected in
this new environment.

(2)

The simplest and most effective way of protecting consumer

interests is through a competitive market. If suppliers fail to
meet consumer needs, they will also fail commercially. Many
governments have withdrawn from direct provision, and now
rely on competition. Where it is feasible, reliance on a
competitive market is by far the best solution.

(3)

Infrastructure services have often been thought of as natural

monopolies. In other words, it is inefficient for several
companies to provide a service because of the high fixed costs.
This makes competition difficult. The transmission and
distribution networks are typically natural monopolies. Both
bulk suppliers and retailers need to access them if they are to
supply final consumers and it is inefficient to have numerous,

32

overlapping networks. Where one source of bulk supply

dominates the main water catchments, a gas field with
substantially lower costs, or a large power station that
dominates the market this also reduces the scope for
competition. In transport, regions that have only enough traffic
to support one highway or one port terminal must contend with
the monopolistic traits of infrastructure, although competition
between modes of transport may still be possible.
(4)

Where private sector participation is sought in areas of natural

monopoly, governments have often relied on regulatory
solutions to prevent an abuse of monopoly power. This allows
the outright sale of these assets, but makes it clear that their
prices will be regulated indefinitely. Typically, the regulators
objectives are set in legislation, but the regulator is given
independence and discretion in meeting them.

(5)

The overall objective from the investors viewpoint is to

maximize profit subject to co4nstraints imposed by the
regulator, consumers and others. Regulatory solutions create
higher risks than competitive solutions. Investors will be
concerned that there will be political pressure on the regulator.
Even if there is no direct pressure, regulators may be concerned
to protect consumer interests and reluctant to recognize the
substantial risks attached to investment. As a result, regulatory
solutions need strong attention to the independence and
competence of the regulators.

(6)

A third option is to protect consumer interests through contract.

This may be an appropriate option under three circumstances:
(a)
(b)

(c)

As an evolutionary stage, before regulatory institutions

are fully formulated and operational.
In sectors characterized by short-term, rather than
indefinite, operation of infrastructure (e.g., solid waste
collection).
For management contracts where the government is
unable to create a suitable regulatory structure

Contractual solutions may appear to create fewer risks than regulatory

solutions because contract law is largely well established, while
regulatory law and practice are relatively untried. However, contracts are
less flexible than regulatory tools. The longer the contract period, the
greater the likelihood that contract management will increasingly adopt
similar features to a regulator. The contracts effectiveness breaks down

33

when it is unable to absorb new information, and use that information to

reset prices and the obligations of providers.
Where contractual solutions are adopted, performance audit will be an
important component of contract management. This will involve
establishing realistic but challenging performance targets for the private
sector operator and then monitoring the operators performance to
ensure these targets are met.
(v)

Compatibility of the Approach to Industry Structure

The success of any PPP process depends on selecting the appropriate
industry structure. For example, solutions based on competition require
that multiple companies supply a service. They also require that the
monopoly networks be separated from potentially competitive parts of
the industry. Creating multiple companies at one level e.g., several
generation companies or individual airports is known as horizontal
separation. Vertical separation refers to the break between levels - e.g.,
separating generation from transmission, or airport terminals from
runways.
Contractual solutions may have fewer requirements for changes to
industry structure. For example, a number of countries have franchised
out operation of the power or water sectors as a whole. Public transport
may be franchised with the network and the services integrated.

(vi)

Appraisal of Options Against Objectives

Once the options have been identified, they need to be assessed against
the objectives. This process is known as appraisal. The form appraisal
takes depends on the objectives. If the governments main objectives are
to improve efficiency and to finance investment, they should seek high
degrees of risk transfer. If their main objective is to maintain control of
the level of provision perhaps for political or national security reasons
they may aim for lower levels of risk transfer.
It is also important that the appraisal takes account of the likely level of
market interest: a reform that appears well designed, but which seeks to
transfer risks the private sector is unwilling to accept, will not be
successful.

(vii)

Transitional Objectives of the Government

(1)

Governments are likely to have transitional, as well as longterm, objectives. They may need to complete a transaction

34

within a particular timetable for example, to fit in with the

electoral cycle. They will need the objectives to fit within a
budget. They are likely to have concerns over regional impacts
and the impact on the labor force, even if these are temporary
rather than long-term concerns. The appraisal should also reflect
these transitional objectives. Reforms need to be politically
acceptable and achievable.

(f)

(2)

The successful implementation of PPP programs will require the

support of a wide range of stakeholders, from employees
through consumers to potential investors.

(3)

The government and/or its financial advisors should fully assess

the degree of investor interest in a project. A large element of
basic infrastructure is unattractive to private investors. This
does not preclude the use of the private sector to improve
efficiency in specific areas. An example in the ports sector is a
container terminal located at a site suitable as a potential hub
port for liner services, but which requires basic infrastructure
that does not exist. Bids are sought from international consortia
in the (mistaken) belief that an efficient container terminal
operation can bear the costs of breakwaters, dredging and
reclamation, to provide a navigable harbor and shipping
channel. The project fails without securing a deal, after much
effort and money have been expended. In such circumstances
some degree of public subsidy will be required.

(4)

Consequently, an important part of the appraisal will entail

assessing the extent to which each of the PPP options will
attract support from investors, from the public, and from the
government. Once this has been assessed, the government will
need to identify those stakeholder groups whose legitimate
interests will be affected by the reform and to establish ways of
resolving related conflicts. The government may also need to
consider how to build a better understanding of the reform
issues (including a willingness to adapt in the face of legitimate
stakeholder concerns) and to build support for each of the
reform options.

Choosing the Appropriate Format

(i)

The appraisal should lead to an approach that meets the governments

objectives. Before starting work on the legal framework and the
transaction, the government needs to decide the preferred option.

35

Each form of PPP is a means to an end and not the end itself. Therefore,
the answer to each of the questions depends on two main factors:
(1)
(2)

(ii)

The governments objectives

The characteristics of the assets and sector in question (i.e., the
constraints)

Basic Conditions Expected in a Partnership

The basic conditions expected in a partnership must be included in the
future tender document. They will form one of the building blocks on
which bidders will build their submissions. The national authority should
consider the following aspects of the proposed PPP and establish their
requirements:
(1)

Preferred length of the partnership

(2)

Ownership of assets during and after the partnership

(3)

Treatment of public employees who may be displaced by the

partnership

(4)

Performance specifications, standards and expectations,

including the roles and responsibilities of both partners

(5)

How both partners performance will be measured a definition

of an adequate rate of return

(6)

Profit and cost

requirements

sharing

provisions

performance

bond

36

Figure __: Choice of Format

At Every Stage Determine:

Asset Sale

The Governments Objective

Local Constraints

Impact of Incentives

N
Must the Govt Own the Asset?

Must Operating Rights

Re-Bid at Present Intervals?

Concession

Concession

Y
N
Concession

Must the Government Retain

Ownership of Assets?

Start

Will Govt. Retain Responsibility

For Next Investment?

N
Will the Govt Maintain
The Asset

N
Must Government Retain
Management Responsibility?

Lease

Y
Management
Contract

Service Contract

Risk to the Private Sector

37

(III)

Ensuring Value for Money in PPP

PPPs should only be adopted as procurement and implementation option if they are reasonably
expected to deliver enhanced value for money over traditional methods. Value for Money
Assessment (VFM) is therefore crucial to deciding the suitability of a PPP, in general, and the
suitability of a particular project design. Given certain restrictions on procurement procedures,
the evaluation stage of a tender becomes crucial in deciding which tenderer is able to offer the
best solution, which is a function of value for money provided.
(1)

Factors Determining Value for Money

(a)
(b)
(c)
(d)
(e)

(2)

Reduced life cycle costs

Better allocation of Risk
Faster Implementation
Improved service quality
Generation of additional revenue

Assessing Value for Money Potential

(a)

Value for money (VFM) generation potential should be investigated with

particular reference to:
(i)
(ii)
(iii)

(b)

The scope of the project including the balance between asset

provision and service delivery.
The potential for cost effective risk transfer particularly with respect
to demand and residual value risk
The scope for user charges, third party revenues and alternative asset
usage that might reduce project costs.

Traditionally this type of information is gathered from market analysis and

reference to previous projects and historical data. However if these sources
prove insufficient or substantial concerns exist it may be necessary to
undertake a shadow bid. This can be done in one of two ways:
(i)

Estimating the cost savings required

This involves adding the additional costs of PPP approach (including
the cost of private finance, profit margins, tendering costs and the
cost of public sector regulation) to a financial comparator (defined as
the comparison of the cost of the preferred PPP tender with the cost
of delivering the project through traditional public sector
procurement methods) and then making a valued judgment on the
potential of the private sector to eliminate these additional costs.

38

(iii)

Actual Bid
This involves developing an actual bid for the PPP project and
comparing it to the estimated cost of traditional public sector
procurement costs.

(3)

Parameters for the final VFM Assessment

The achievement of value for money in Public Private Partnership procurement is, in
part, evidenced through effective competition between potential suppliers and, on
projects that involve public money, through a value for money assessment of the costs
and benefits of the preferred PPP tender. The nature of the value for money
assessment undertaken at the end of the procurement process depends on whether the
PPP project is financially free standing, generates the majority of its revenues from
third parties, or is reliant on public finance. The nature of the value for money
assessment for each type of project is summarized below:
(a)

Financially Free Standing Projects

Financially freestanding projects require the Private Sector to recover all costs
through charges on the final users of the service. The public sector plays a
facilitating role but no public money is involved. It is therefore the
responsibility of the Contractor to determine whether the project is
commercially viable and suitable for investment.
The Contracting Authority should satisfy itself through project appraisal that
a Concession contract is the preferred form of PPP for the project, and that
the application of user charges is appropriate. The Contracting Authority
should determine its preferred approach to the setting of user charges, and
develop a payment mechanism that will deliver government policy, the
objectives of the project and protect the public interest. Value for money is
achieved through the competitive tendering process, which is based on the
economically most advantageous offer principle

(b)

Concession Contracts with Public Grants

The issues set out above for financially free-standing projects also apply to
those projects where the public sector provides grant financing and / or
subventions but the revenues come principally from user charges (i.e. the
public sector is a minority funder).
However, such projects do involve the investment of public money and there
is therefore a need to ensure that the project represents the best use of the
public funds. For this reason the benefit gained from applying the funds to the
PPP project should be compared with the benefit gained from applying them

39

to an alternative project that would otherwise not proceed. Policy priorities

will be an important consideration in this regard. Public subvention could take
a number of forms, including capital grant and revenue support.
(c)

Projects where the Public Sector is the Main Financial Contributor

In the case of projects where the public sector is the sole or main funder a
detailed value for money assessment is recommended at the end of the
procurement. The assessment should compare the costs and benefits (in
monetary and non-monetary terms) of the preferred PPP tender with the costs
and benefits of traditional procurement, or under certain circumstances, with
other comparable measures.

(4)

Elements for VFM

A value for money assessment comprises of the following two key elements:
(a)

Monetary Comparison
Monetary comparison is the comparison of the cost of the preferred PPP
tender, with the cost of traditional public sector procurement, expressed in
terms of discounted cash flows over the life of the PPP contract (the Financial
Comparator). Under certain circumstances other quantifiable measures may
be used as the basis for a Financial Comparator
(i)

Parameters for Required for Monetary Compensation:

The monetary comparison could take one of four forms depending on
the characteristics of the project. The four forms of monetary
comparison can be summarized as follows:
(1)

Financial Comparator
Involving comparison of the cost of the preferred PPP tender
with the cost of delivering the project ( to the standards set
out in the initial output specification) through traditional
public sector procurement.

(2)

Best-Available Alternative
For projects where the cost of traditional public sector
procurement is difficult to determine, the cost of the
preferred PPP tender should be compared with the best
available alternative costing.

40

(3)

Price Benchmarks
Involving the comparison of the preferred PPP tender with
reliable, comparable and independent price benchmarks or
unit costs (e.g. standard cost per volume)

(4)

Comparable PPP Projects

Involving a comparison of the preferred PPP tender with the
cost of the other comparable existing PPP projects.

(ii)

Financial Comparator
The Financial Comparator is a technique employed to assess the
value for money provided by a preferred PPP option and selected
tenderer. It is developed based on the preferred PPP option to provide
a fully costed estimate of delivering the project (to the standards set
out in the initial output specification) through traditional public
sector procurement, presented in terms of a discounted cashflow
analysis. In practice, if the preferred PPP option results in the transfer
to the private sector of all services included in the preferred option
arising from the Project Appraisal, then the differences between the
Financial Comparator and the preferred option will be limited.
The Comparator is based on a hypothetical project contract in which
the public sector undertakes all functions (design, build operate etc)
based on actual costs incurred on similar projects. It should include
all risks and the value of any assets to made available to the project.
Care needs to be taken to avoid double accounting particularly with
respect to public sector costs that would not be part of a PPP
contract.
The costs expressed in the assessment should be presented in real
terms in a discounted cashflow analysis and over a range of
applicable discount rates. The Net Present Value (NPV) of the public
sector project is compared with the NPV of the PPP option. If the
difference in NPVs is positive then the PPP alternative is considered
attractive. A further refinement entails making the cash flow
calculations stochastic through the use of ranges instead of mean
values and the application of Monte Carlo analysis. The result is a
probability distribution of the NPV of the PPP option as compared to
the public procurement option. This distribution would also indicate
the possible spread in the output and again a positive value means the

41

PPP is the more attractive option. A suggested layout of the model is

provided below:
Example of a Financial Comparator
Item/Year
Opportunity Cost

Land
Capital Costs

Construction

Preliminary & Preoperative Costs

Etc.

Residual Values
Recurring Costs

Structural Maintenance

Operational Costs

Etc.
Net Cost Before Risk

N+1

NPV of Capital and Opportunity Cost

NPV of Recurring Cost
NPV of Total Cost (Without Risk)
Equivalent Annual Cost

Risk Analysis

Political Risk

Design Risk

Revenue Risk

Etc.
Net Cost After Risk
NPV of Total Costs
Equivalent Asset Cost
It should be noted that developing a financial comparator is often a
time consuming and expensive task and the results are only as good
as the baseline information provided. While it is undoubtedly a
useful tool a careful assessment needs to be made as to its need given
project scale, available information, cost and the usefulness of
alternative methods.
(iii)

Best Available Alternative

Ideally, the Financial Comparator should be based on the same
services and service levels as the preferred PPP option. However, for
projects where there is no track record of public sector procurement,
the cost of the public sector providing the service levels defined in
the output specification may be difficult to determine and subject to a
high level of uncertainty.
42

In such circumstances, the Financial Comparator should be based on

the best available alternative costing, which will most likely relate to
the provision of services to a lower or alternative standard. The best
available alternative may relate to the cost of current provision.
It is essential that the service levels assumed by the Financial
Comparator are clearly recorded in the PPP Assessment so that, at
the end of the procurement process, the differences between the
preferred private sector tender and the Financial Comparator can be
understood and evaluated.
(iv)

Benchmarking and Comparison

A Financial Comparator may not be required for projects that involve
the provision of services for which there is a well established market.
In such circumstances, the financial comparison could simply involve
a comparison of private sector bids against reliable, comparable and
independent price benchmarks or unit costs (for example, standard
costs per volume). The use of price benchmarks or unit costs is likely
to be most applicable to outsourcing type contracts.

(b)

Non-Monetary Comparison
Comparison of all the factors that are difficult to quantify in monetary terms,
but their value to government and the wider public is significant. Examples
include speed of project delivery, quality of service, and security of supply.
The monetary comparison will not take into considerations all of the factors
that contribute to value for money. Many factors will be difficult to quantify
in monetary terms, but their value to government and the wider public is
significant. Examples include speed of project delivery, quality of service,
security of supply and equity issues such as the accessibility of services.
Consequently, the monetary comparison should not be approached as a pass
fail test, and should be complemented with a value for money assessment of
the costs and benefits of the preferred tender in non-monetary terms.
The costs and benefits of the preferred tender may be usefully compared with
the costs and benefits of traditional procurement in non-monetary terms
through the use of impact statements or a weighting and scoring matrix.

(5)

Results of Value for Moneys Assessment

The results of the value for money assessment that is undertaken at the end of the
procurement process determine whether establishing a PPP with the preferred

43

Contractor will deliver improved value for money compared with traditional
procurement, or indeed other Tenderers. The value for money assessment is therefore
the fundamental tool in deciding whether or not to proceed with a PPP contract.
(6)

Optimizing Grant Contribution

(a)

An inherent characteristic of grant financing is that beneficiaries have little

incentive to optimise the amount they request. This together with
procurement procedures that do not facilitate price negotiations make it
difficult to adapt grants to real requirements unless an effective negotiation
phase is foreseen. Grant financing has two principal impacts, namely:
(i)
(ii)
(iii)

An immediate impact on project financial viability by reducing costs

(or increasing revenues)
An impact on Local Authority (ie Municipal) budgets by reducing
demand on funds and allowing budget transfers to other requirements
An impact on the private sectors perception of project viability

(b)

Assessing the level of required grant financing is complex and must give
regard to the objectives of and impact on each of the parties in a PPP, not
simply the project itself. A basic principle should be to provide grants only
up to that amount which allows the project to be realised and operated in a
sustainable manner. This assumes that a range of financing options are
considered for realisation and that the project is considered over its useful
financial life.

(c)

The overriding consideration must be to match grants to real project needs

thereby avoiding the potential for a Ferrari syndrome in which over
ambitious designs are financed and implemented. A policy could be
developed that bases the calculation of a grant on the revenue generating
capacity of the project with regard to an equitable tariff policy, no
unreasonable profits to the private party and the maximisation of co-financing
opportunities. A Discounted Cashflow Analysis can be used to assess the
projects ability to generate revenue to cover costs without a grant and
specifically what, if any, percentage of capital costs can be covered. The grant
represents the financing gap between forecasted revenue generation and
required revenue generation.

(d)

An alternative has been to calculate the Internal Rate of Return if this is

below an acceptable level then the grant contribution should represent that
amount required to raise the IRR to an acceptable level.

(e)

Both approaches are well known. However both represent a certain number of
difficulties not least of which is the definition of an acceptable IRR and the
level of affordability to sustain required user charges and tariffs.

44

(f)

Alternative methods include:

(i)

A distinction can be made between project types and assigned fixed

rates of grant assistance to each. This obviously provides no
incentive to optimize grants or undertake financial engineering

(ii)

A holistic approach to financing would look at the financial analysis

of the project but also the financial situation and in particular the debt
absorption capacity of the project beneficiary. This would allow a
more precise assumption on the amount of debt that a project can
assume both with respect to the projects viability and the ability of
the project beneficiary to finance debt. As a result grants are set to a
level which allows realisation of the project but assumes that the first
priority of financial engineering will be to assume the maximum
[efficient] level of debt. In this approach soft loan investment funds
have often been successfully used which blend commercial loans and
grants to provide soft loans thereby promoting debt financing but
nevertheless reducing the overall debt burden.

(iii)

Greater emphasis can be placed on determining more accurate

estimations of the IRR and ability to pay. Both, currently, suffer from
a lack of consistent and reliable data that makes benchmarking the
figures very difficult. This is a result both of insufficient availability
of data and inconsistencies in analysis as is often witnessed in project
appraisal work. This situation can be expected to improve with
greater experience of project implementation and application of user
charges, however for the moment greater expenditure on project
financial analysis would seem to be the only alternative.

(iv)

A facility that is not sufficiently exploited at this time, due to

restrictive procurement procedures, is to allow the private sector
Tenderers define the required level of grant assistance. This is a
useful benchmark where flexibility is given to Tenderers to suggest
their optimum approach and where they are encouraged, through the
tender conditions, to minimize their demand for grant financing.

(v)

As long as grant contributions are correctly calculated and only serve

to allow the operator to function and provide the services in a
situation of "economic equilibrium". This would seem to support the
absolute need to ensure both that, no unjustifiable excess profit is
created by grant financing and that the project could not operate
viably without the grant contribution. Additionally any renegotiation
of grant contributions with private operators would need to follow
the same logic.

45

In all cases the prime objective should be the protection of public

interest, optimise the grant allocation in such a manner that the
project is realised, is financially viable, sustainable and generates the
maximum social benefit but which also limits [resulting] private
sector profits to reasonable levels. This can be represented
graphically in the following diagram.
Figure__: Trade Off: Private Sector Profit Social Benefit
Real Impact of New
Operational Asset (With
Grant)

Op.
Profit

Effect of ReNegotiation

Increase
With
Grant
Financing

4
2

Y
5
Impact of
Associating
Private Expertise
/ Capital

Without
Grant
Financing

A
Pure Public
Sector Project

B
Increase with
Private Sector
Participation

C
Project Realisation
and Grant Financing

ReNegotiation

E Social Benefit
(VFM to the
Collectivity )

The graphic can be defined as follows:

On the Vertical - Private Sector Profit axis:
0 Y:

Private sector operating profit without grant contribution

Y X:

Increase in private sector operating profit with grant financing and increased
efficiency of an operative asset (resulting from grant financing)
Reduction from X towards Y = the redistribution of pure operating profit
(resulting from grant financing) to enhanced social benefit and fair private
sector profit margins as a result of re-negotiation

On the Horizontal - Social Benefit axis:

0 A:

Social benefit arising from a purely public sector project

46

A B:

Increase in social benefit arising from private sector participation

B C:

Marginal increase in social benefit from project realisation and grant

financing contribution

C D or E:

Increase in social benefit as a result of re-negotiation of redistribution of pure

profit resulting from grant financing

Point 1:

Represents a project financed purely from public sources

Point 2:

Represents a project financed from private sources with public funds

Point 3:

Represents a project financed under a PPP arrangement with a grant

contribution

Points 4 & 5:

Represent a desired outcome for the grant provider in their objective of

maximising social benefit while limiting the impact on private sector profit
margins resulting from grant financing.

(7)

Justifying Grant Financing

Grant financing has traditionally been employed by the public sector to realize
infrastructure requirements that are not financially viable to other sources of financing
(due to risk, viability or scale issues), or which present particular social characteristics
requiring them to remain in the public domain. As a result grants may have different
financing objectives and implementation procedures to classical commercial sources
that in turn creates perceived barriers to successful cooperation between the two.
Due to the decreasing amounts of available public finance there has been considerable
pressure to integrate grants into more commercially orientated forms of financing and
hence PPP relationships. These developments have been augmented by the trend of
privatisation in utility service provision and the increased availability and application
of private finance. These developments have forced a review of how grants are best
used and particularly how the advantages of free funds can best contribute to an
overall financial package.
Deriving the maximum benefit from grant financing requires an identification of their
relative strengths and weaknesses. The following discussion presents a number of
these but it should be borne in mind that, grants usually have conditionalities attached
which do not necessarily relate to market (ie financial) necessities and therefore such
an analysis must go wider than a simple cost benefit analysis of financing
instruments.
The most commonly cited advantage of grants is the ability to finance projects which
would / could not otherwise be financed by commercial sources alone. This is most

47

often the case with social infrastructure that does not usually provide sufficient
financial viability for commercial financing. This argument is valid provided that the
investment costs together with operational and maintenance costs are included and
therefore that the investment is sustainable over its useful (financial) life and provides
a real social benefit.
The use of grants is, arguably, most valuable in co-financing applications where its
objective is to increase the financial viability of a project to a level allowing the
application of commercial financing. This leveraging function entails the use of grants
to reduce the overall cost of the project or to enhance the value of the revenue stream.
It is in this field that grants can be applied most intelligently to derive the maximum
benefit and different methods of doing so are presented later.
The presence of grants, and by association a public or international body, often also
assists in reducing certain types of project risks and therefore project cost. Grants can
be used directly to finance risk coverage or used as a guarantee mechanism. However
the presence of the grant giving body and the willingness to commit public funds,
additionally provides the private sector with a certain assurance regarding the
seriousness of the project and sponsors.
The above two strengths are associated with the leveraging effect of grants meaning
that the availability of grants is usually conditional upon or enhances the availability
of co-financing or is a facilitator to identifying other sources of funding. In this case
grants have an important and complimentary role to play in PPPs as both tools aim to
increase the value and volume of financing.
As stated above, conditionalities are usually attached to grants that are often wider
than financial conditions. This can have the advantage of accounting for or realising
socio-economic externalities particularly if these impinge on project viability and
grants pay for them. However grant financing also has a number of weaknesses that
must be recognised if they are to be successfully integrated into PPPs. Most
importantly grants, in themselves, provide little incentive to efficiency enhancements
usually associated with the pressures of commercial financing. Additionally the
availability of free funds can cause a degree of dependency and crowding out of
alternative sources.
A common complaint has also been the difficulty and cost of implementing grants that
are usually subject to more lengthy and bureaucratic procedures. This has made their
integration into commercial financing packages difficult. However it must be
remembered that grants are usually public funds and therefore imply stringent public
accountability requirements.

48

(8)

Determining the Form of Grant Assistance

Grant financing usually focuses on the provision of services, supplies and works for
the realisation of physical infrastructure. They therefore intervene directly on the
capital costs side of a project by reducing costs and / or enhancing revenue streams.
Grant financing can be used in a number of different ways with the objective of
optimising their impact. This objective is driven in part by the fact that the availability
of grants is often limited, relative to overall financing needs, and that grants should
not be seen as an alternative to other sources of financing but rather as a constituent
part of a financing package. As a result project designers must ask the question
where, and in what form, will a grant have the most impact relative to the needs of
the project and how much funding should the grant provide.
Alternative applications of grants include (but are not limited to) the following:
(a)

Provision of regular, subsidy, payments to operational costs

This can be particularly useful in the first years of operation when cashflow is
still developing but is not sufficient to cover all costs, particularly the cost of
capital.

(b)

Coverage of financial costs

This can include:
(i)

Reducing the cost of borrowing by effectively softening loans

(ii)

Providing loan guarantees

(iii)

Financing risk elements

(iv)

Subsidising taxation payments

(v)

Covering exchange rate losses

(vi)

Subsidising revenue flows

This is particularly useful if a policy objective is to keep user charges
low. However this should not be considered a permanent
arrangement due to the introduction of inefficiencies.

(vii)

Financing the public sectors contribution in-kind

49

(viii)

Assisting the financing of the public sectors financial incentives to

the private sector.

In all cases it is crucial to assess the real need for grants and to optimise the grant
amount relative to this. While grants have many positive contributions, the negative
impacts of grants on a project and public financing should not be forgotten.
(9)

Basis Requirements for Grant Financing

The main requirements, over and above the technical and financial project
characteristics, include the need for a project to enter into a defined list of financing
objectives and priorities. The Government should ensure that certain conditions must
be met in all projects including; transparency in implementation particularly with
respect to procurement, early involvement, clear demonstration of public benefit and
value for money including that grants are not unfairly benefiting the private sector.
(a)

Ensuring Open Market Access

This includes:

(b)

(i)

Fair and open participation of parties receiving equality of treatment

(ii)

Application of transparent public procurement procedures

Adherence to the principles governing State Aid

This includes:
(i)
(ii)

(c)

Ensuring there is no overcompensation for services rendered

Grants matched to real needs

Protection of the publics interest

This includes:
(i)
(ii)
(iii)
(iv)
(v)
(vi)

Ensuring PPPs and grants deliver quality of service

Value for money must be demonstrated
Public participation in the oversight function should be included for
sustainability
Windfall profits to contractors must be avoided
Re-negotiation of contracts should be undertaken where required to
re-balance contracts
Implementation of PPP should not diminish focus on and
responsibility for social consequences including employment and
socio-economic development

50

(d)

Defining the optimal level of grant financing

This includes:
(i)
(ii)
(iii)
(iv)
(v)

Grants to be matched to real needs

Maximise use of limited funds
Do not distort market operation
Maximise leverage potential of grants
PPP are not to be treated as an accounting tool to move public
expenditure of balance sheet.

51

(IV)

Risk and Mitigation

(1)

Introduction
Infrastructure projects involve a number of complex relationships between the
concerned Government, concessionaires and investors (equity and debt) that often
vary over time. Packaging a project from idea to operation is not a simple task.
Successful analysis, allocation and mitigation of risks by the concerned participants at
each stage of the process are the vital features of infrastructure financing, development
and administration. In this context, risks do not disappear, but are borne by the
parties best able to manage (and most interested, given incentives), in managing them.
Final risk allocation and mitigation agreements reflect negotiation and agreements,
generally contractual, between the relevant parties.
The best way to manage or reduce uncertainties and risks associated with a project is
to put in place an appropriate policy. A complementary need is to agree on mutually
acceptable mechanisms, including neutral arbitration procedures for enhancement of
contractual obligations. It is necessary to reduce both, the perception and the reality of
risk, to unbundle the various risks. This is necessary so as to determine which
participant is best placed to manage which risk at the lowest cost and how the cost of
risk mitigation can be shared equitably.
Infrastructure projects are exposed to a wide variety of risks at the various stages of
project evolution. The main risks facing toll road projects include pre-construction,
construction, demand and revenue, currency, force majeure, political and financial
risks. These risks have to be adequately addressed, both at the project development
and implementation stages, through appropriate mechanisms and by allocating risks to
the parties who are capable of managing the same. These risks must be addressed in
the manner satisfactory to the debt and the equity investor before they commit to
project funding.
Identifying the categories of risks, and the range of specific risks within each category,
is a necessary task that precedes selection of risk mitigation strategies or options. Each
potential participant in a project (sponsor, concessionaire, concerned government etc)
will take this exercise, using analytical techniques and sometimes intuition.

(2)

Financial Implications of Risk

A risk is defined as any factor, event or influence that threatens the successful
completion of a project in terms of time, cost or quality. A key principle of PPPs is
that risk should be allocated to the party best able to manage it. The effective
allocation of risk has a direct financial impact on the project as it will result in lower
overall project costs and will therefore provide enhanced value for money if compared
to traditional procurement methods.

52

The direct relationship between risk and financial impact lies also in the fact that the
degree of risk transfer to the private sector will influence the overall cost of the project
to the public sector as all risk will be associated with a price premium. Therefore the
objective must be to achieve cost effective risk transfer not simply risk allocation for
its own sake.
The objectives of risk transfer include:








(a)

To reduce long term cost of a project by allocating risk to the party best able to
manage it in a most cost effective manner.
To provide incentives to the contractor to deliver projects on time, to required
standard and within the budget.
To improve the quality of service and increase revenue through more efficient
operation.
To provide a more consistent and predictable profile of expenditure.
Revenue Risk
Revenue risk is the most fundamental of all unknown factors involved in PPP
projects. Revenues flows are generally determined by two factors: utilization
levels, and tariffs. The availability of reliable historic information
documenting demand and price elasticity levels varies among different
sectors. In the water sector, for instance, a great deal of information is
available. However, the cost of providing water may well have been
subsidized in the past, making it more difficult to determine how consumers
would behave in the face of unsubsidized pricing.
In the case of road projects, even with extensive investigation of past traffic
trends, forecasts of future growth potential, and surveys of peoples
willingness to pay tolls, there is always a significant residual risk on the
traffic levels that projects will actually attract. This risk is only reduced after a
number of years of operation. In order to arrange project financing, certain
assumptions regarding usage and revenue levels must be made. While these
calculations are usually intended to be conservative, overstatements are not
uncommon. Moreover, unforeseen future events can also have dramatic
impacts, such as the oil shocks of the 1970s, which were a major factor in the
failure of the three private concessions in France.

(b)

Choice of Private Sector Partner

Inherent risk is associated with forming a partnership with unknown partners.
This is accentuated through a public procurement process that does not
facilitate extended negotiation periods allowing a degree of knowledge and
confidence to be established. The principle risks are that the private party
proves insufficiently competent and / or is not able to deliver the services to

53

the initial specifications. This can be because of a badly researched tender or

because tenders were designed to win the contract in the hope of recovering
costs at a later stage. In both instances the tender evaluation must aim to
identify such situations.
A common concern of public bodies is that by granting a PPP contract they
may be creating a monopoly situation for a private company or at least
creating a situation of unfair competition or market access. This potentially
impacts both on project costs but also the ability to introduce innovation into
service provision.
(c)

Construction Risk
The capital construction cost of any project is one of the fundamental factors
upon which financing is based, and when cost overruns are incurred; the
financial feasibility of a concession can be jeopardized. Poor project
definition, unknown geological conditions, or loosely defined safety
specifications can have dramatic affects on capital construction costs.
However, these potential problems can be mitigated with the completion of
careful engineering studies before a concession contract is actually signed.
Construction delays also have detrimental effects on capital costs. While
some delays can be minimized through careful construction management,
they still have the potential to arise. Other external factors, such as timely
delivery of right-of way, for example, are more difficult to manage. External
forces such as inflation, economic policy, embargoes, and political conflicts
also have the potential to have dramatic affects on capital costs. Construction
risk is nearly always assigned to the private party, which in turn is likely to
include strong incentives for on-time completion of works in its construction
contract.

(d)

Foreign Exchange Risk

Debt is a defining characteristic of nearly all concessions and, when money is
borrowed abroad, foreign exchange fluctuations can threaten project viability.
This risk can be exacerbated when governments require that concessionaires
obtain a certain portion of their financing from foreign sources. Foreign
exchange risk is greatest when weak currencies are involved, putting projects
in emerging economies at greater risk. In certain cases, foreign currency risk
can be assumed by sovereign governments, export credit agencies, or
international financial institutions in order to make Concession projects more
attractive to private investors.

54

(e)

Regulatory / Contractual Risk

Although governments negotiate contract terms and conditions with their
concessionaires, they are not always successful in maintaining their
commitments. This is particularly true of tolls and other user fees, which tend
to be politically sensitive. These risks are more common than many project
finance proponents like to admit. They can have substantial effects on
existing concession agreements, and also weaken interest in future projects.
Regulatory risk is exacerbated in countries where new and untested laws
govern PPP projects. Such risks can be expected to be greatest in countries
with comparatively little experience in project finance.

(f)

Political Risk
Assessments of the inherent strength and stability of local political institutions
are common in the investment field and are reflected in bond ratings prepared
by recognized rating agencies. As political risk increases, so does the cost of
obtaining financing. The long duration of most concession agreements and
the common aversion to user fee increases, make PPP projects especially
susceptible to political risk. This is exacerbated when new governments
oversee unpopular projects instigated by previous administrations. Host
governments often assume political risks, but such an assignment can prove
less than optimal in the face of lackluster political support for an
infrastructure partnership. Multilateral organizations can use their influence to
help to counter political risk. Bilateral agencies such as export-import banks
have also been known to provide political risk guarantees to private
concessionaires from aligned countries.

(g)

Environmental / Archaeological Risk

Infrastructure projects have the potential to provoke environmental concern,
and governments and citizen groups are becoming increasingly vigilant in
their efforts to mitigate potential impacts. Unforeseen environmental issues
can increase capital costs considerably and result in serious delays. The
private party usually assumes environmental risk. For this reasons, most
would-be investors undertake thorough environmental assessments and
identify likely mitigation programs before entering into a concession
agreement.

(h)

Latent Defect Risk

It is now increasingly common for governments to provide contractors /
concessionaires with the right to preexisting infrastructure systems as a way
to help finance the construction of new infrastructure. In many cases, new
projects may also involve upgrading and expanding existing systems. In

55

exchange, concessionaires usually assume responsibility for the maintenance

of these facilities for the duration of their contracts. While seemingly
attractive, this mechanism can be costly for concessionaires if the facilities
they inherit have unknown structural faults. The risk of encountering
unpleasant surprises can be minimized when thorough and well-documented
inspections of the facilities to be transferred are completed before concession
contracts are formalized.
(i)

Public Acceptance Risk

Infrastructure projects have the potential to provoke vociferous protests
among local communities; a fact that can prove fatal to private concessions.
acceptance risk can pose. Prudent investors need to make careful assessments
of the approvals required for their projects, as well as public sentiment
towards the projects before deciding to invest.

(j)

Hidden Protectionism
Infrastructure provision is generally perceived to be within the domain of the
public sector, and the public can be skeptical when private actors are
involved. Such skepticism can be exacerbated when investors are from an
outside and more affluent country and have the potential to make a profit on
their investment. When such a reaction occurs among the populace, it can also
have repercussions in the political arena, making it more difficult for foreign
investors and their host governments to resolve conflicts. Foreign investors
would be negligent if they ignored this issue, and should investigate the
experiences of other outside investors in the countries where they are
considering doing business. This risk is borne by the concessionaire and it is
best countered by consistent government support. It is however ironic to note
the often inconsistent approach of public bodies to foreign participation.
Particularly there is often less objection to arrangements developed through
direct agreements than when public procurement is involved. It is through the
latter that nationality and foreign participation most often becomes an issue.

56

(3)

Key Risk Matrix

(a)

Project Development
Risk Event

Allocation

Consequences

Mitigation

Non Availability of
Land, Right of Way &
Access to the Project
Site

Concerned
Government

Delay in the commencement

of project construction

Approvals, availability of land, access, RoW,

certification by the concerned government, to
be made a condition precedent to the Project
Implementation

Social unrest due to noncompliance with ESR

SPV

Material adverse effect

Delay in the project

implementation and increase
the project cost

Social Resistance to the

project road

The Environmental and Social Risk

Assessment and Mitigation plan conforming
to guidelines provided by multilateral
lending agencies
Budget for Resettlement Action Plan,
provided by the SPV, as part of the Total
Cost of Project

Unforeseen social risks

Non-performance by the
Independent
Engineer
(IE) and/or Independent
Auditor (IA)

Concerned
Government

Concerned
government & the
project SPV

Monitoring of implementation by SPV

through an NGO

Formation of a project monitoring committee

by the concerned Government through its
local agencies, to ensure public interest

Right of SPV and/or IR to terminate the

services and reappoint a new IE and IA
utilizing the same procedure

Delay in the project

implementation and increase
in project cost

Social Resistance to the

project

Time and cost overrun

Non adherence to quality

and performance standards

57

Auditor (IA)
Non-availability
Construction Power

of

Abandonment of Project
by the EPC Contractor

Concerned
Government

EPC Contractor

Material adverse effect

Project
implementation
delay

Provision for uninterrupted construction

power supply to be the responsibility of the
concerned government.

Increase in inventory cost

Concerned
government
to
provide
connections to the site from two
sources/grids

On continuous unavailability of power on an

extended period, the contractor to be allowed
revision in construction schedule and shall be
paid damages as determined by the
Independent Auditor.

SPV to terminate the contract with the EPC

contractor and hold retention money

SPV
to
demand
security
against
abandonment from the EPC contractor

Cost incurred on project

development to be written
off

Additional cost and time

spent on appointing a new
EPC contractor

58

(b)

Construction
Risk event

Allocation

Design Risk

EPC Contractors

Consequences

Inadequate performance

Additional
repair
modification cost

Increase in Cost during

construction on account
of detailed engineering

Performance
Construction/
Procurement/
Installation

of

EPC Contractors

EPC Contractors

Mitigation

Rigorous performance testing prior to take

over

Defects liability period with a warranty

period for the defects rectified

Design insurance by contractors

Only owner induced changes to have a price

impact

EPC Contractor to absorb all other Cost and

Schedule impact

SPV to award a Lumpsum - Turnkey Time

Certain Contract

and

Additional Operations
Maintenance Costs

&

Increase in the project cost

Inadequate performance of
the project road on account
of inadequate design /
construction quality

Contractors to sign a fixed price turnkey

contract guaranteeing performance, price and
schedule. Price subject to agreed items of
variation

Time overrun
Cost overrun
Additional
repair
modification cost

Qualification of EPC contractor to be based

on exceptional experience and track record
for similar projects

Supervision by SPV representatives

Independent Engineer to be responsible for
monitoring compliance with stated Works
specifications, testing and inspection
Performance security of specified amount
maintained in full force

59

Delays in completion
due to non performance
by the EPC Contractors

Delays due to default of

the
concerned
Government

Delay
defects

in

rectifying

Non
availability
of
material, labour and
plant and machinery
Delay in completion
and/or Construction Cost
overrun

EPC Contractors

Concerned
Government

Time and cost overrun

Time and cost over run

SPV
to
monitor
compliance
with
construction plan and activate early warning
mechanisms

Liquidated damages to account for all time

over runs payable by EPC Contractors to
SPV

Cost over runs to be absorbed by SPV only

when the event leading to delay is owner
induced and other specific events which are
outside the control of the EPC Contractors

Provision of authorized extensions to

concession period or increase in fees/toll
charges to compensate for project time and
cost over runs

Cost increase as a result of subsurface risks,

other than rocks, trees, identified utilities to
be borne by the concerned Government

EPC
Contractor/O&M
Contractor
EPC contractor

Time and cost over run

Performance security of specified amount

maintained in full force

Time and cost over run

Appropriate penalties to be levied for delays

Contractor

Recovery not possible in

Concession
Period
and
Lower Return on Investment.

Risk passed to Contractor through a fixed

price turnkey contract

Appropriate penalties to be levied for delays

60

(c)

Operation and Maintenance

Risk event

Allocation

Non
adherence
to
Performance Standards
and
Technical
Specifications

O&M contractors

Restriction
collection

Concerned
Government

on

toll

Traffic blockages and

disruption on existing
roads/ rail route

O&M Contractor

Insufficient revenue due

to lower demand
SPV unable to transfer
the project road

Concerned
Government

Consequences

Low-quality services

Force Majeure

Accident on the project

road
leading
to
a
temporary loss of revenue

Third party liability and

damages

Project road
unviable

The
Government
termination
discharged
obligations

rendered

concerned
on
has
not
their

Mitigation

Defects as indicated by the IE to be rectified at

the cost of the EPC contractor

Passing of operation risk to O&M Contractor

Concerned Governments obligation to amend

concession

Concessionaires right to collect toll

O&M Contractor to mitigate as far as possible

Insurance and extension of concession period.

Concerned Government guarantee

Right to abandon or terminate may not exist

Concerned Government liable for the breach of

contract

61

Concessionaire unable
to transfer the project
road

SPV

SPV on termination have

not
discharged
its
obligation

SPV liable to breach of contract

Failure of the project

road post transfer

SPV

Govt. to undertake repars

SPV to provide a performance bond

Latent defects during

operations

O&M Contractor/
EPC Contractors

Provision of performance security of specified

amount by the EPC contractor

Operating cost over run

O&M Contractor

If O&M costs are beyond the agreed budget, the

operator to bear the cost

Incentive scheme of sharing savings in budgeted

operating cost with the Consortium

In case increase is due to external events beyond

the control of SPV and the Operator, tariff
adjustments permitted to provide additional
operations cost

Buyout or unilateral
termination by the Govt.

Extraordinary
circumstances affecting
financial viability

Concerned
Government

Inability of the project

SPV to discharge its
obligation and achieve
targeted returns

Concerned Government to compensate SPV

SPV unable to continue

as a viable entity

Revision
of
toll
rates
based
on
recommendations of Toll Review Committee

Concerned Government to compensate SPV

62

(d)

Revenue

Risk event
Revenue
Risks

and

Allocation
Traffic

SPV

Consequences

Inefficient Collection
Revenue loss due to
leakage

SPV
O&M Contractor

Poor demand build up

leading to shortfalls in
revenues

Mitigation

The project may not turn

out to be commercially
viable

Revenue loss
Revenue loss

Ongoing toll rate adjustment based on

predetermined formula and indices
Cash Flow control mechanism envisaged.
Security and Hypothecation of Receivables in
the Collection Account envisaged.
Revenue short falls dealt with by extension of
Concession Period

Appropriate mechanism for fee/toll collection

Incentives for improving collection efficiency

Draw down from performance security for noncompliance of obligations by the O&M
Contractor

63

(e)

Financing
Risk Event
Interest Rate Fluctuation

Allocation

Consequences

Mitigation

SPV

Increase in project cost

Could render the project
unviable

Judicious mix of fixed and floating rate

facilities

A) Construction related
inflation

EPC Contractor

Increase in Construction
Cost

EPC contract is inflation protected

Hyper inflation protection in the concession
agreement

B) Operation
inflation

Consumer/O&M
Contractor

Increase in Operation &

Maintenance Costs

Pass through to consumer, as Charges Review

Formula to be inflation indexed
Hyper inflation protection in the concession
agreement

Inflation

related

64

(f)

Force Majeure
Risk Event
Calamities
including
strikes, lock outs etc

Allocation
Insurance
Agencies

Consequences

Impedance
in
project
implementation/ operation

Problems
for
inhabitants/local people
Increase in project cost

Other events

Change in Legislation

Concerned
Government

Concerned
Government

Material adverse effect

Mitigation

Insurance Cover for loss or physical damage as

well as for business interruption

Pre-mature Termination of Concession.

The concerned government shall pay SPV an

amount equal to the sum of: (a) all sums due
and owing to the lenders; (b) total cost of the
project and assured returns

Maintenance of reasonably similar provisions

of Agreements

Timely approvals / certification by the

concerned government to be made a condition
precedent to the Concession Agreement

The concerned government has an obligation to

consult SPV to decide on measures to mitigate
the effect of the same

65

(g)

Premature Termination
Risk event

Allocation

SPV Event of Default

SPV Shareholders

Default by the concerned

government

Concerned
Government

Consequences

Loss of capital invested

Mitigation

If the concerned government terminates the

concession due to an SPV event of default, the
concerned government shall pay the lenders all
sums due to them and bear all costs associated
with transferring the facilities to govt.

The concerned government to pay SPV all

sums due to lenders in case of acceleration of
payments as well as the net block value of the
assets

66

(V)

Essentials of a Good Regulatory Framework

(1)

(2)

Need for Independent Economic Regulation

(a)

An independent and accountable regulatory framework is a specific response

to the general mantra of promoting economic growth. Given the fact that most
of infrastructure services are inherently non-competitive, establishing a
transparent and coherent regulatory regime can attract necessary investments
to meet out the huge demand-supply gap and unlock economic growth
potential.

(b)

A regulators role is vital in establishing transparent systems, especially in

matters such as cross-subsidy and taxes. An Independent regulator is needed
to establish transparency and protect the interests of consumers particularly in
not-so-competitive sectors such as the infrastructure services. Therefore,
transparent regulation is essentially desirable even in case of government
monopolies.

(c)

In addition to tariff setting, the independent regulator has to look at achieving

the other important objectives such as promoting competitiveness and
efficiency, protecting consumer interests, maintaining quality of services,
safety and so on.

Deficiencies in Existing Regulatory Approaches in India

(a)

More than ten years experience of independent regulation in India suggests

that so far the government has not been able to create and follow a cogent and
coherent approach vis--vis independent regulation. Quite often, the policy
objectives that the government wishes to achieve out of independent
regulatory regime are not spelt out clearly in the legislation. At times, the
regulatory mandate falls short to achieve the stated policy objectives. Multistakeholder approach is nearly missing in most of the sectors and given the
rather ambiguous regulatory mandate as well as the limited regulatory
capacity, this evolving form of governance is falling short of the expectations
so far.

(b)

For instance, existing legislation in most transport sectors remain nearly silent
on several important aspects such as Universal Service Obligation (USO),
quality of services, safety etc. Even good practices in one sectoral regulatory
legislation do not find place in others. Appointment and removal of regulators
is practically left with the executive for their discretion, and these
independent bodies are not empowered to even determine the nature and
number of their staff or to appoint consultant without approval of ministry
concerned.

67

(3)

Essential Attributes of Independent Regulation

(a)

Spelling out a regulators role in an unambiguous manner is the precondition

for having effective regulation. Therefore it is necessary that the legislation as
well as the policy, both should specifically set the regulatory agenda in rather
concrete terms. So far, the policy makers in South Asia, and in India as well,
have not tapped the potential of the market to meet out the unmet demand for
these services. Doing that would require a credible and consistent policy
environment and predictable regulation.

(b)

More than anything else, an independent regulator is an instrument by which

the government achieves its policy objectives. Therefore it is necessary for
the government to spell out its policy objectives in a concrete manner and
adequately empower the regulator through legislation, to accomplish the state
policy objectives.

(c)

It appears, separating the policy-making function with that of serviceproviding is one of the major objective that the government wishes to achieve
by establishing an independent regulatory regime, so that equal opportunities
exist for all competing service providers to invest and earn reasonable returns.
Nevertheless, actually doing that would require empowering the regulator
through far more clear legislation and unambiguous policy objectives.

(d)

Regulating the incumbent, especially the government-owned, is a challenging

task not just in India but elsewhere as well. There are several instances across
the sectors when regulators find themselves unable to enforce compliance of
their directives by the state-owned incumbents. Public sector service
providers hardly compete with each other for better economic efficiencies.
Therefore, incumbent regulation is a tricky area in any sector. This is one
major challenge that regulatory authorities are facing across the board. As
long as the regulator remains vulnerable to the discretionary powers given to
the executives of the related ministry to whom normally state-owned
incumbents report, it would be impractical to expect the regulator to
effectively push the state-owned incumbent to a level-playing field with rest
of the service providers. Addressing that would require regulators having
specific strategies to ensure the compliance of their directives and developing
an arms-length and objective relationship with the government.

(e)

This applies to the legislative provisions with regard to functional

independence for regulators, including the provisions regarding their
appointment as well as removal. Several other provisions too undesirably
influence the regulatory process.

(f)

Imparting financial autonomy can substantially enhance functional

independence of regulators. Therefore, it is desirable that the legislation

68

allows a regulator to raise resources on its own, to the extent possible,

through a fee/levy etc.
(g)

Once the independent regulator is assigned with a specific agenda, which is

reasonably challenging in any case, it must be provided with the necessary
wherewithal to perform the job effectively. Since the regulators job is
demanding, it requires adequate skilled staff to attain the effective regulatory
environment. Therefore it should be essentially left for the regulator to
determine the nature and strength of its staff as well as to appoint consultants.
Nevertheless, such decisions should always be subject to public scrutiny and
comparison with standard practices being followed in other sectors and
elsewhere in the world.

(h)

Regulatory powers with regard to dispute resolution are another gray area. It
has been observed that at times market players take the avoidable route of
litigation for seeking judiciary intervention, which costs the sector hugely in
terms of delays. To the extent possible, the regulatory framework should aim
at minimising the chances for judicial intervention. This can effectively be
done by following a rigorous consultation process to reach upon equitable
decisions; and by setting up a specialised appellate body. Anyhow, it needs to
be explicitly examined whether sector specific appellate bodies are required,
or an omnibus Regulatory Appellate Tribunal.

(i)

Further, conflicts between the regulator and the new competition authority are
envisaged due to both immaturity and legislative handicaps. These need to be
sorted out by examining the sector-specific laws, and through a concurrence
party decide on the forum where such cases will fetch the best solution. A
competition authority has an economy-wide remit, while the sectoral
regulator has a subject-wide remit, thus one cannot oust the competition
agencys jurisdiction over competition abuses in any particular sector.

(j)

Attaining a multi-stakeholder approach in regulatory process is highly

recommended to arrive at logical, equitable and enforceable decisions. Active
stakeholder participation offers effective checks and balances that largely
determine the quality of regulation. Yet, so far this is largely missing for
several reasons. Presently, regulators at large are not putting adequate efforts
to proactively reach out and engage different stakeholders in consultations.
Neither the important stakeholders, such as consumers, have the required
capacities to comprehend this evolving form of governance that essentially
involves a complex mix of techno-economic, legal, and polity dimensions.

(k)

Regulation is required because of the fact that a desirable level of competition

does not exist in a market. Still, given the limited resources, the government
must have a clear priority in various sectors to restructure, based upon the
potential net outcome. Similarly, regulatory resources are limited as well.

69

Hence, any regulator must set the priorities for it to work upon. Instead of
exercising its powers on each and every aspect of the market, the regulator
should deal with those areas up front which are intrinsic to promote
competitiveness in the sector. For instance, interconnection should be the
primary priority for telecom regulator, rather than engaging in issues like
numbering patterns to be followed by service providers.
(4)

(5)

Capacity Building
(a)

Presently, capacity building on regulatory aspects is drastically lacking.

Though independent regulation was introduced in India more than ten years
ago, efforts to create necessary facilities to offer training on this subject are
lagging behind. Some multilateral donor agencies such as the World Bank
facilitate short-term training programmes on an ad hoc basis. Other than that,
hardly any effort to create a sustaining facility has been attempted so far.

(b)

Importantly, capacity building on regulatory aspects is highly desirable, not

just for regulators and their staff but for other stakeholders as well. Given the
fact that regulatory decisions are essentially the outcome of stakeholder
consultation, capacity building of other stakeholders is equally crucial to
attain regulatory efficacy. For instance, government officials need to be
adequately trained to negotiate with investors, and meaningful interventions
from consumer groups can only be expected once adequate inputs and skills
are provided with.

(c)

Equally important is incorporating the local context in capacity building and

training modules. While learning from others experiences is desirable, there
are certain local peculiarities which demand application of local wisdom to
find optimal solutions. Therefore, any efforts to train the stakeholders have to
incorporate the local context.

(d)

Nevertheless, for the government to establish such facilities is not

recommended. Instead, the government and industry both should facilitate
and support such efforts that can be initiated by professionally managed
institutions of repute.

Independent Regulation and USOs

(a)

Given the fact that meeting the Universal Service Obligations (USOs) has to
be a major policy objective for any government, it should unambiguously
spell out the regulatory mandate, which often is not the case right now. It is
desirable to incorporate the policy objectives, such as access to services,
providing these services to poor at concessionary rates, and so on, within the
legislation.

70

(6)

(7)

(b)

Cross-subsidies are essentially another form of tax. Therefore it should be the

Parliament which decides the extent to which additional charges should be
imposed on certain consumer classes/sectors to support poor sections.
Currently, such decision making is vested with the related government
department. In fact, excessive taxes on certain consumers are necessary at
times to meet out social obligations. But, this has to be within reasonable
limits.

(c)

Once such limits for cross subsidies are put in place at the highest level, it is
the regulators job to establish transparent and objective-driven procedures so
that public and private utilities both can get indiscriminate allocations to
deliver social obligations, in a transparent manner.

Regulatory Efficacy and Accountability

(a)

As far as accountability is concerned, what is needed is a workable solution

for holding the regulators accountable. Presently, most of independent
regulators in India are supposed to present their annual report before the
Legislature. Unfortunately, this has been followed merely as a token. In
addition to this existing provision, empowered CSOs and consumer groups
working as watchdogs can potentially hold the independent regulators
accountable. This will work as an effective deterrent against possible
regulatory capture by service providers as well. Such arrangement can
potentially offer a workable solution to the accountability concern, provided
these CSOs are appropriately mandated and adequately resourced. Perhaps a
part of the USO Fund in each sector can be set aside to fund consumer
advocacy objectively.

(b)

Regulatory efficacy should be measured against the policy objectives that are
spelt out in the regulatory mandate. To the possible extent, parameters for
judging regulatory efficacy should be defined in quantitative terms in a
transparent manner. Such evaluation criterion should be communicated to the
regulators in advance so that the quality of regulatory decisions is broadly
guided by the evaluation criteria.

(c)

Arranging for independent/peer reviews on periodic basis is another way to

further strengthen the regulatory accountability mechanism. Though, in such
case, the benchmarks should be set bearing in mind the prevailing conditions
around, and increase them gradually.

Consumer Interests vis--vis Independent Regulation

(a)

All stakeholders are supposed to represent themselves before the independent

regulators to raise their voice and put forth their legitimate concerns. Still,
during the evolving days of independent regulation in India, it is apparent that

71

some stakeholders, primarily consumers, are not in a position to represent

their interests appropriately for varied reasons. In such circumstances, the
regulatory framework should have enabling provisions to support these
stakeholders so that their genuine concerns are adequately represented, and
regulators could effectively balance the conflicting interests.

(8)

(b)

The Government offering performance-linked resources to consumer groups

and facilitating the process of addressing their capacity building requirements
are some of the measures that need to be taken up immediately. Unless these
groups are sufficiently resourced to hire professionals and gather other
necessary inputs to make meaningful interventions, the quality of regulations
likely to remain compromised.

(c)

In those sectors where the regulatory bodies are not mandated to take up
individual grievances, it is the responsibility of the regulator to ensure that
some functional and effective mechanism to address such individual
complaints is in place.

Interface and Overlaps

(a)

This can only be addressed through enabling and coordinated legislation for
regulatory bodies. Overlapping mandates of regulatory and competition
authority and that of appellate bodies and/or judiciary can only be avoided if
government ensures that every new regulatory legislation follows certain
essential norms in this regard. Perhaps the Ministry of Law can be entrusted
to ensure such coherence and uniformity across the sectoral regulatory
legislation.

(b)

It is not desirable to have separate regulatory bodies for each sector or subsector. Rather, an attempt should be made to restrict the number of sectoral
regulatory bodies without compromising the quality of regulation. For
instance, there is a strong case for having a regulatory body for the entire
energy sector; rather one each for electricity, coal, gas and petroleum.
Similarly, it is advisable to have one overarching regulatory body for the
entire transportation sector, instead of having separate bodies for different
modes of transport such as road, rail, aviation or marine. Similar logic applies
for the financial sector too.

(c)

Looking at the volume of the work before the economic regulators, it is

strongly recommended to follow the model of having a sector-specific
regulatory body at the central level, which is effectively facilitated and
supported by an omnibus multi-sectoral regulatory and competition authority
in the states.

72

(VI)

Preparation of the Concession Agreement

The famous nineteenth century economist Alfred Marshall outlined the case for concessions as
follows:
A public authority may be able to own the franchise and, in some cases, part of the fixed
capital of a semipublic undertaking, and to lease them for a limited number of years to a
Corporation who shall be bound to perform services, or deliver goods, at a certain price and
subject to certain other regulations the special point of the proposal is that, where possible,
the competition for the franchise shall turn on the price or the quality, or both, of the services
or the goods, rather than on the annual sum paid for the lease.
(1)

Introduction
Public and private parties in concessions come to the negotiating table with differing
concerns and objectives. Private operators and their financiers seek to reap adequate
returns in sufficiently stable environments. In the infrastructure sector, they are likely
to be concerned about the large and immobile nature of required investments and
about the length of payback periodsonce in the market, they might be at the mercy
of political authorities. In addition, infrastructure tariffs tend to be subject to political
pressures, and risks of nonpayment, especially by public users, can be substantial. In
some sectors revenues are raised exclusively in local currency, thereby also raising
concerns over convertibility and the transfer of revenues.
Public parties, on the other side, will want to limit possible abuses of monopoly power
by the private operator. They will seek to maximize productive efficiency (production
at lowest possible costs) as well as allocative efficiency (the producer will supply an
extra unit of a good or service to all users willing to pay the costs of producing that
extra unit). They will also want to ensure that appropriate quality, environmental, and
health standards are maintained. Finally, they are likely to impose certain conditions
(related to tariffs, coverage, and so on) in the pursuit of social objectives.
Some trade-offs will have to be made among these various objectives. Compromises
are necessary, for example, between creating incentives for productive efficiency
(which increases the risks borne by the concessionaire) and providing sufficient
comfort to investors to ensure that desirable projects are undertaken. Efforts to
promote allocative efficiency might have to be reconciled with the requirement that
some users receive subsidized services. Assuaging, to the greatest extent, the concerns
of the parties involved and striking an appropriate balance between the different
objectives pursued are the ultimate goals of concession design.

(2)

Rationale for Concessions

Concessions should be used in areas where they are most likely to aid development.
Although they can be used in any industry, they are most likely to help development

73

when they are used to regulate natural monopoliesthat is, services that can be
provided more cheaply by a single firm than by two or more.
(a)

Natural Monopoly
When markets can be served efficiently by several firmswhen they are
naturally competitiveordinary competition usually works well. But when
they are naturally monopolistic ordinary, head-to-head competition does not
operate. Competitively auctioned concessions in these industries allow some
of the benefits of competition to be brought to bear in the absence of direct
competition between firms. That is, they substitute competition for the market
for competition in the market.

(b)

Concessions and the Reform of Market Structure

Since one infrastructure sector may contain potentially competitive and
inherently monopolistic segments, it is sometimes useful to unbundle the
segments. Then, competition in the market may work more effectively in the
competitive sectors, while competition for the market is used for the naturally
monopolistic sectors. Within the potentially competitive sectors an existing
company may also be broken up into several competing firms.
Before awarding concessions in an infrastructure sector, therefore,
governments should consider what is the best structure for that industry.

(3)

General Overview of Concession Contracts

No two concession agreements are exactly the same. Technical provisions do, of
course, vary by sector. The scope of the private operator's responsibilities can also
vary with different types of contracts
(a)

Identifying the Contracting Parties

In municipal-level projects, it may not be clear who has the right to grant the
concession. Then, the government needs to ask itself such questions as:
(i)

Is the conceding authority the government itself, a state-controlled

body, a government ministry, a municipality or a number of
municipalities, an association of municipalities, or some other body?
How many of these bodies should be parties to the contract?

(ii)

Are the relevant assets, or use rights, to be transferred under the

concession owned by different parties? If so, should two or more
parties be granting the concession?

74

(iii)

Does the identified conceding authority have the legal power to grant
the concession, enter into the project documents, and perform its
obligations?

(iv)

On the concessionaire's side:

(1)

(2)

(b)

What type of entity should be used as the concession vehicle

(local companies, partnerships, limited partnerships, joint
ventures)?
If a sponsor is not a party to the concession contract, what
other kinds of sponsor support may be required, of credit, or
subordinated loans?

The purpose and extent of the concession

The government must have worked out its position on the degree of
exclusivity (if any) to be conferred on the concessionaire. The contractual
arrangements for the concession may have to address such questions as:

(c)

(i)

Will exclusivity be granted to the concessionaire? If not, will the

conceding authority undertake not to grant similar concessions or
prevent third parties from acquiring similar rights during the lifetime
of the concession?

(ii)

Will the conceding authority undertake not to supply services itself?

(iii)

Will exclusivity lapse after a specified period or if specified services

are not provided?

(iv)

Can the operator unilaterally expand the service area during the
lifetime of the concession?

(v)

What are the rights and obligations of the concessionaire with respect
to other utilities or community groups engaged in the production of
their own services?

The Principle of Risk Allocation

A variety of risks are inherent to infrastructure projects. Risks should
normally be borne by the party best able to assess, control, and manage them
or by the party with the best access to hedging instruments, the greatest ability
to diversify the risks, or the lowest cost of the risks bearing. The aim is to
ensure that the party with the ability to reduce risks has incentives to do so
and that remaining risks are borne by the party for which it is least costly.

75

In addition to the parties' abilities to adopt risk mitigation measures, their

level of risk aversion should also be taken into account. If investors are highly
risk averse, for example, some risk-sharing arrangements with the
government might be justified, even if, as a result of such an agreement,
investors are protected against risks in situations where they could have
reduced their exposure.
(d)

Certainty Versus Flexibility

Concessions can be designed so as to leave more or less discretion to those in
charge of interpreting and implementing them. At one extreme, rules can be
very specific and can eliminate almost all scope for discretion. At the other,
rules can be designed so as to leave a large degree of discretion to the
contracting parties themselves or to third parties responsible for regulating the
arrangement.

(e)

Main Design Issues

In most contracts allocation of responsibilities between parties will be
specified in the provisions defining the service to be provided, conditions of
operation of the service, and works to be undertaken. Questions to be
addressed while designing these provisions should include:

(4)

(i)

Who is responsible for tariff collection? Who bears the risk of

nonpayment?

(ii)

Is the conceding authority responsible for supplying some inputs to

the private operator? Is such supply guaranteed?

(iii)

Who is responsible for maintenance? Who is responsible for

renewals? How can the distinction be made between maintenance
and renewals?

(iv)

Who is responsible for upgrades? How are upgrades defined?

(v)

Who is responsible for new investments?

Price Setting
Provisions determining the price at which services can be sold are, central to
concessions. Some of the main issues related to the price structure include:
(a)

Are the rules for establishing the tariff level and structure clear?

76

(b)

Does the concessionaire have the freedom to vary the tariff structure and cost
allocation across the customers within certain limits?

(c)

Does the concessionaire have the freedom to introduce tariff surcharges in

times of high demand?

(d)

Does the concessionaire have the freedom to propose contracts to users,

according to which service might be interrupted in times of high demand?

(e)

Should some users benefit from preferential tariffs? If such tariffs create a
shortfall in revenue, how should that shortfall be compensated?

More generally, does the tariff provide incentives to the operator to ensure proper
maintenance or expansion of the system? And does the tariff enable users to take into
account the economic value of the service, while making consumption decisions?
(5)

Price Adjustment
Concession contracts must allow prices to be adjusted over time, without prior
knowledge of what those adjustments should be or what will trigger them. Broadly,
the objective of is to ensure that the concessionaire will continue to face pressure to
seek efficiencies, but will also be able to earn a reasonable rate of return. In order to
arrive at a rule for attaining this objective, factors affecting a concessionaire's costs
and profitability should be taken into account in adjusting the price level.

(6)

Specific Performance Targets

Concessions should contain specific performance targets imposed on the operator.
Such specifications can relate, for example, to construction time, coverage ratios,
minimum investments, output quality, output quantity, collection ratios, and safety
and health standards.
Often, the objective of imposing specific performance targets is to force operators to
act differently than they would under the original or underlying incentive scheme put
in place by the general price regime and the sharing of responsibilities between
parties.

(7)

Penalties and Bonuses

Concession contracts should contain promises of bonuses and threats of penalties to
enhance operators' incentives to carry out their general responsibilities under the
contract and to meet the imposed performance targets.

77

(8)

Public Parties' Security Rights

Public parties to concession agreements should insist on putting in place some
additional mechanisms aimed at lowering the risk of noncompliance on the part of
private operators (including the risk that operators might not pay the penalties
imposed on them). Instruments that can be used include performance bonds or other
similar tools, step-in rights to the benefit of public authorities (that is, authorities' right
to take over from the private operator and directly carry out the functions that the
operator is failing to perform), and insurance to be taken out by the private operator.

(9)

Duration, Termination and Compensation

Concession contracts should specify that the concession will end at some date in the
future and that, in certain circumstances, it can be terminated before that date.
(a)

Scheduled termination
Concession Agreements generally have a term, after which they terminate.
Usually there is no compensation payable at the end of scheduled termination

(b)

Early termination
Concession contracts can often be terminated before their scheduled end if:

(c)

(i)

Both parties agree

(ii)

The concessionaire has failed to meet its obligations and has not
remedied the problem after notification by the government.

(iii)

The concessionaire becomes bankrupt

(iv)

The service provided under the concession becomes inherently

unprofitable, because, for example, of the introduction of a new
service provided with better technology

Compensation for Termination

To compensate the bidder for his investment and protect the lenders to the
Project, the concessioning authority should provide compensation due to early
termination. The problem here is to design a compensation rule (that is, an
asset-valuation rule) that gives the concessionaire incentives to undertake all
desirable investments without also giving it incentives to over-invest. Paying
too little compensation discourages good investments, while paying too much
encourages investments undertaken solely to get compensation. This

78

compensation should vary with the concessionaires and the concessioning

authoritys events of default
(10)

Force Majeure and Other Unforeseen Changes

These events are primarily changes imposed by public authorities and Acts of God.
Most concessions will include specific provisions to take the possible occurrence of
such events into account.
(a)

Mechanisms to Deal with Unforeseen Changes

Schemes can be devised beforehand specific provisions governing possible
renegotiation processes between the parties. Such as provisions might specify
that the contract must be renegotiated "in good faith," at regular intervals, or
if certain types of events occur, possibly with the support of a predesignated
facilitator

(b)

Who Should Bear the Risks?

Acts of God are part of the unavoidable risks of doing business. However, the
operator may not be able to adequately be able to cover these by taking out
insurance. Therefore, the government must partly take these risks to protect
the lenders

(11)

Dispute Settlement
Few concessions operate in the long run without disagreements arising at some point
between parties to the agreement or with other players. Thus the parties will want to
think in advance about dispute settlement. Concession agreements can include a
number of techniques to help resolve conflicts, including judicial, quasi-judicial,
administrative, arbitral, and non-binding alternative dispute resolution techniques.

(12)

Government Responsibilities for Concessions

The functions that governments must perform regarding concessions span a wide
range, from the establishment of an enabling environment to the award of specific
concessions and their regulation
(a)

Framework
(i)

Adopting legal provisions to enable the granting of concessions

(ii)

Establishing or identfying regulatory authorities

(iii)

Managing government support to infrastructure projects

79

(iv)
(b)

(c)

(d)

Managing public relations and information.

Project identification and analysis

(i)

Identifying projects amenable to concessions (including in-house and

unsolicited proposals)

(ii)

Prioritizing projects amenable to concessions

(iii)

Hiring advisors

(iv)

Performing a preliminary review of the costs and benefits of the

project (without duplicating the analysis to be performed by the
private sector), especially in cases where the government will be
assuming part of the market risk

Reviewing legal and regulatory issues

(i)

Determining preliminary selection criteria

(ii)

Granting permission for the project to go ahead (for example, for the
opening of the bidding process)

(iii)

Setting a timetable for the project

(iv)

Enabling and supporting measures for specific projects

(v)

Granting permits and other necessary authorizations (such as

environmental permits, rights of way)

(vi)

Determining the form of government support for the project

Design of the concession arrangements

(i)

Choosing legal instruments

(ii)

Allocating responsibilities

(iii)

Choosing and designing pricing rules and performance targets

(iv)

Determining bonuses and penalties

(v)

Determining duration and termination

80

(e)

(13)

(vi)

Designing adaptation
circumstances

mechanisms

to

new

or

(vii)

Choosing and designing a dispute settlement mechanism

unforeseen

Concession award
(i)

Choosing the method of award

(ii)

Making decisions regarding prequalification and shortlisting

(iii)

Determining bid structure and evaluation method

(iv)

Determining bidding rules and procedures.

(v)

Proceeding with the bidding

(vi)

Negotiations

(vii)

Exercise of regulatory function

(viii)

Implementing regulatory rules

(ix)

Supervising and monitoring

(x)

Enforcing rules (for example, imposing penalties)

Guiding Principles for Improved Operations

A lack of definition and transparency in government processes can increase
uncertainty for investors and developers and thus multiply costs or stop projects from
going ahead. For example, unclear assignment of authority to grant concessions and
adopt related support measures or overly complicated and undefined approval
processes can prevent concessions from developing smoothly
Governments should try to implement the following principles in order to improve the
way they manage concessions:
(a)

Effective coordination of relevant government policies and approvals.

(b)

Clarification of roles and responsibilities with respect to private investors.

(c)

Acquiring access to the expertise required to design and implement complex

transactions.

81

(d)

The design and implementation of concessions requires the coordination of

several governmental actors. Sectoral ministries will usually be responsible
for developing overall sectoral policy, finance ministries will usually have a
close interest in the public revenue or liability implications of particular
projects, and environmental ministries or authorities may have an interest in
projects, as may ministries of justice, competition authorities, and others.
Some coordination will often also be necessary between actors at central,
provincial, and municipal governments regarding, for example, necessary
approvals or the granting of guarantees.

(e)

When the government does not effectively coordinate all relevant actors, it
risks sending mixed signals to private investors and causing delays, either of
which can deter investors or increase development costs substantially. When
several large transactions are envisaged, governments should consider
establishing an explicit sequencing plan to help in marketing the projects and
to avoid over-burdening local financial markets.

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(VII)

Approach to Financial Analysis

(1)

Introduction
A study of cash flows rather than conventional profitability is often more suited to the
financial analysis of infrastructure project. The principal objective of the Cash Flow
analysis is to determine whether the project is worth more than it costs.
The broad essential steps in cash flow analysis are as follows:
(a)
(b)
(c)
(d)

Determining the expected future cash flows

Assessing project related risks - & therefore the required returns
Determining the Present Value of future cash flows (Project Worth).
Determining whether the Project Worth is greater than the Project Cost

A comprehensive understanding of project cash flows over the concession period is

essential for raising non recourse financing for infrastructure projects
In order to arrive at an accurate estimate of the project cash flows - primary data needs
to be collected and assumptions need to be made regarding the behaviour of the key
variables that will impact the project.
Once project cash flows during the concession have been determined with the required
degree of accuracy key parameters need to be tested to determine financial
viability and subsequently the possible financing structures.
(2)

Key inputs for determining Project Cash flows

(a)

Capital Cost
The EPC cost needs to be estimated very accurately. This is ideally achieved
through entering into a Fixed Price Time Certain Lumpsum Turnkey
(LSTK) contract with a contractor of repute.

(b)

Construction Period
Given the usually significant construction period for such projects, the
Interest to be paid During the Construction period (IDC) becomes a
significant part of the total capital cost. Any increase in the construction
period shall necessarily add to the IDC leading to a cost overrun.

83

(c)

Demand
The projected Chargeable demand on the project over the concession
period needs to be accurately estimated through a comprehensive Demand
Study.

(d)

User Fee
User fee can be either scheduled by the concerned government or can be
determined for the project road by determining User savings as well as their
Willingness to Pay. This exercise is undertaken as part of the demand
study. The user fee should provide for the recovery of costs as well as a
reasonable return on investment

(e)

Operation and Maintenance Costs

Costs relating to the operations of the project, tariff collection, routine
maintenance, major maintenance etc. need to be determined and preferably
frozen through an O&M contract

(f)

Applicable Depreciation
(i)

Book Depreciation
As the project at the end of the concession period is transferred free
of cost and there is no realisable residual value to the asset. It is
therefore increasingly becoming common practice to write off the
entire landed project cost on a straight line basis.

(ii)

Tax Depreciation
Unless otherwise specifically provided for in the Income Tax Act; it
is general practice to apply Tax Depreciation applicable to Plant &
Machinery.

(g)

Applicable Income Tax

The tax regimes in most countries allow for special provisions for
Infrastructure Projects usually by way of a concessional tax rate or a tax
holiday. Such provisions should be well understood and applied.

(h)

Debt Reserves
A debt service reserve may need to be created by the SPV in order to provide
comfort to the lenders. Such a reserve, at any given time, should be

84

maintained at a level equal to the debt servicing requirement for the following
period of a stipulated length. The initial corpus of the reserve is generally
provided by long-term funds as part of the project cost. In case the project
cash flows appear robust such a fund may be built up during operations from
revenues.
(i)

Other Assumptions
(i)
(ii)
(iii)

(3)

Income on Retained Cash

Interest Rates on term loans & working capital
Dividend Payout Policy

Developing Cash flow Projections

In order to determine the feasibility of the project road and assess possible financing;
it is essential to develop detailed cash flow projections during the concession period.
Based on inputs discussed, project cashflows may be accurately estimated and should
include amongst others:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
(m)
(n)

(4)

Cost of the project

Means of Finance
Schedule of Expenditure and Financing during construction
Calculation of Interest During Construction (IDC)
Demand Projections
Revenue Projections
Expense Projections
Debt repayment schedule
Projected Profit & Loss Statement
Income Tax calculations
Depreciation schedule
Projected Cashflow Statement
Projected Balance Sheet
Return on Investment calculation

Discounted Cash Flow Analysis

Before undertaking the analysis it is essential to note the following:
(a)

Essential Concepts
(i)

The cash flow should comprise actual cash and not earnings.

(ii)

Ignore sunk costs

85

(iii)

The cash flow should be measured on an incremental basis.

(iv)

Timings of actual cash flow should be accurately predicted.

(v)

The cash flow should be measured on after tax basis (Take home
pay)

(vi)

Tax
The following key parameters determine the tax liabilities of a
project company:
(1)
(2)
(3)
(4)

(b)

Revenues
Expenses
Depreciation and
Timing

Incremental Cash Flows

The cash flows associated with a capital investment project fall into the
following basic categories:
(i)

Net Initial Investment Outlay

The net initial investment outlay comprises:
(1)
(2)
(3)
(4)

(ii)

Cash expenditures
Changes in net working capital
Net cash flow from the sale of old equipment
Investment Tax Credits

Net Operating Cash Flow

Net operating cash flow for a period is the revenue net of expenses
and tax liabilities for the period.

(iii)

Non operating cash flows

Expensed non operating cash flows are reduced to the extent of the
tax shield they provide. Capitalised non operating cash flows involve
an initial cash flow when they occur, and a series of depreciation
expenses after that.

86

(iv)

Net Salvage Value

The net salvage value is the after tax net cash flow for terminating
the project. This comprises:
(1)
(2)
(3)

(c)

Sale of assets
Cleanup and removal expenses
Release of Net Working Capital

The Hurdle Rate

The Hurdle rate is the minimum return that investors would expect for risking
investment in a particular venture. This may also be thought of as the
opportunity cost of foregoing the closest comparable investment. In the
absence of a comparable opportunity, we treat the Weighted Average Cost of
Capital as the Hurdle rate for the project.

(d)

The Weighted Average Cost of Capital (WACC)

WACC is essentially the weighted average cost of components of a feasible
financing package that will allow the project to be undertaken. For the sake of
simplicity we will assume that the project in question is financed only through
debt and equity. In such a case the WACC can be expressed as the weighted
average of the required rate of return for equity re, and the required rate of
return for debt, rd.
WACC = (1 - @)re + @(1 T)rd
Where T represents the marginal income tax rate on the projects income. The
above equation reduces the task of estimating the WACC to a calculation of
the cost of debt and the cost of equity and an appropriate weighing of these
component costs.
Note that the WACC is expressed as an after tax rate of return. Because the
returns to equity investors are paid after corporate taxes, re is also an aftercorporate-tax rate of return (to equity). The return to debt, rd, is a pre tax rate
of return; it must be multiplied by (1 T) to convert it to an after tax basis.
(i)

Estimating the Cost of Debt

The pre tax cost of debt can be calculated by solving the following
equation for rd:

87

NP =

C1
(1+rd)

C2
(1+rd)2

C3
(1+rd)3

+ .. +

Cn .
(1+rd)n

where NP represents the net proceeds from the debt issue (i.e., gross
proceeds minus flotation expenses, such as underwriting fees, legal
fees, and so on), and Ci represents the pretax cash debt service
requirement payable in period i (i.e., interest plus principal).
Typically, project debt must be repaid in instalments. When this is
so, Ci includes the portion of principal that must be repaid in period i.
The aftertax cost of debt can be calculated in either two ways. The
aftertax payment obligations, rather than the pretax amounts, can be
used in the above equation. This procedure requires adjusting interest
payments for taxes because interest is a tax deductible expense as
well as allowing for the amortisation of new issue expenses. The
amortisation of new issue expenses is treated in the same manner as
the depreciation of capital assets.
Alternatively the aftertax cost of debt can be approximated as:
Aftertax cost of debt = (1 T)rd
The above equation will usually produce a very close approximation
to the true aftertax cost of debt. Differences occur when a project
entity cannot utilise the interest tax deductions on a current basis
for example, when a project entity is organised as a corporation and
construction extends over several periods during which there is no
income to offset the interest deductions for income tax purposes.
(ii)

Estimating the Cost of Equity: The Capital Asset Pricing Model

(CAPM)
A decision to invest in the equity of a project is based on the
expected return on the project. The greater the risk, the higher the
required rate of return. Thee Capital Asset Pricing Model (CAPM)
expresses the required rate of return as the risk free rate plus a risk
premium. It has the following form:

Required rate of return = Risk free rate + Beta x (Expected return on

market portfolio Risk free rate)
The risk premium is a function of two variables. Beta measures the
assets incremental contribution to the riskiness of a diversified
portfolio. As a measure of the assets riskiness, Beta reflects the

88

correlation between an assets returns and those of the market

portfolio. The difference (the expected return on market portfolio
minus the risk free rate), called the market risk premium, can be
thought of as the additional return investors require to compensate
for bearing each additional unit of risk.
(e)

Net Present Value Analysis

The Net Present Value (NPV) is the difference between the present value of
cash inflows and the present value of cash outflows of a project. The Net
Present Value of a project indicates the difference between what the project
costs and what the project is really worth
The NPV of a capital investment project is the present value of all of the
aftertax cashflows (CF) connected with the project all its costs and
revenues, now and in the future:
NPV = CF0 +

CF1 +
(1 + r)

CF2

+ . +
(1 + r)2

CFn
(1 + r)n

The decision rule to follow when applying NPV is: Undertake the capital
investment project if the NPV is positive.
We estimate the value of a project by using discounted cash flow (DCF)
analysis and computing the present value of all the cashflows connected with
ownership. This procedure is similar to discounting the interest payments on a
bond or dividends on a stock, and it is the essence of the net present value
method.
If the NPV of a project is positive then the project should be accepted, but if it
is negative then the project probably should be rejected. Projects with a
positive NPV are expected to increase the value of the firm. Thus, the NPV
decision rule specifies that all independent projects with a positive NPV
should be accepted. When choosing among mutually exclusive projects, the
project with the largest (positive) NPV should be selected.
(f)

Project Internal Rate of Return (IRR)

IRR is a discount rate at which the present value of a series of investments is
equal to the present value of the returns on those investments. In other words,
it is the interest rate that makes net present value of all cash flow equal to
zero.
The IRR for a project is the discount rate that makes the NPV zero:

89

0=

n
t=0

CFt
(1 + IRR)t

CF0 +

n
t=1

CFt
(1 + IRR)t

All independent projects with an IRR greater than Weighted Average Cost of
Capital (WACC) should be accepted. When choosing among mutually
exclusive projects, the project with the highest IRR should be selected (as
long as the IRR is greater than the WACC).
(i)

Modified internal rate of return (MIRR)

Whereas IRR assumes the cash flows from the project are reinvested at the
IRR, Modified IRR assumes that all cash flows are reinvested at the firm's
cost of capital. Thus, MIRR reflects the profitability of a project more
realistically.
(ii)

Dividend IRR
Returns to the equity investors is essentially by way of dividend
payouts, the equity investors are last in the cashflow waterfall and
therefore face the greatest risk and expect the highest return.
The Dividend IRR is the measure of the discount rate at which the
present value of dividend payouts equal the present value of equity
investments.

(5)

NPV vs. IRR

Another way to look at NPV is to graph it as a function of the discount rate . This
graph, called an NPV Profile, includes both NPV and IRR. It also shows the value of
the project at different possible costs of capital. Therefore, if sponsors are unsure
about a projects cost of capital, the NPV Profile would identify the cost of capital at
which the project would and would not add value.
The NPV Profile in the Figure below shows the general relationship between IRR and
NPV for independent, conventional projects. If the IRR exceeds the cost of capital, the
NPV is positive. If the IRR is less than the cost of capital, the NPV is negative. The
vertical distance from the x axis to the NPV line is the NPV of the project at each
cost of capital, r.

90

NPV Profile

60
50
40
NPV

30
20
10
0
-10 0

10

15

20

25

-20
-30
Cost of Capital (r)

(6)

Primary Reasons of Difference between NPV and IRR Analysis

(a)

Size Difference
When comparing two projects of different sizes the recommendations of
these two analysis might very as the NPV analysis will recommend
investment in the project with the higher NPV even though it might have a
lower IRR.

(b)

Reinvestment Rate
The IRR method assumes that the future cash inflows will earn the IRR
whereas the NPV method assumes that they will earn the cost of capital.
The problem of cashflow timing can arise because of reinvestment rate
assumptions. The question is: what will the cash inflows from the project earn
when they are subsequently reinvested in other projects? The IRR method
assumes that the future cash inflows will earn the IRR. The NPV method
assumes they will earn the cost of capital.
The following example illustrates the reinvestment rate assumption conflict
that results from a difference in cash flow timing. Suppose a company can
invest in only one of two projects, A and B. The cost of capital is 10% and the
projects have expected future cashflows shown in the Table below. Which is
the better project?
Cashflow Streams for Two Projects

91

Year
Project
A
B

-250
-250

100
50

100
50

75
75

75
100

50
100

6 IRR (%) NPV (Rs)

25
125

22.08
20.01

76.29
94.08

Project A has an IRR of 22.08%, and Project B has an IRR of 20.01%. But
Project A has an NPV of Rs. 76.29, and Project B has an NPV of Rs. 94.08.
The IRR method tells us to choose Project A, but the NPV method says to
chose Project B.
A look at the figure below indicates that the Project A will have a higher NPV
than Project B whenever the cost of capital will be higher than 15.40%, the
cross-over point. Both projects would have an NPV of Rs. 37.86 if the cost of
capital were 15.40%. Project B has a steeper NPV profile than Project A
because the present value of cashflows further in the future are more sensitive
to the discount rate. A similar profile occurs for bond market values; the
market value of a long term bond changes more than that of a short term bond
in response to a given interest rate change.
IRR vs. NPV

300
250

NPV

200
150
100
50
0
-50 0

10

20

Cost of Capital(r)
(c)

30
Project A
Project B

Conclusion
Projects require substantial investments in long lived assets, so an analysis of
the profitability of a proposed project before committing funds to it is very
essential

92

The cost of the capital depends on the risk of the investment and not on the
firm that undertakes it.
It is often tempting to make judgemental corrections in the process of
financial analysis this should be avoided in all circumstances

93

(VIII) Approach to Financial Structuring

(1)

Introduction
(a)

The development of financing structure for a project is necessarily a process

of balancing the risk appetites of the various participants - and their
expectations on investments made. It also follows the established logic of
higher reward for higher risk.

(b)

The financing plan also accounts for a number of factors that amongst others
include expected cash flows, acceptable gearing, availability of financing,
terms of such financing and related risk appetite.

(c)

The development of a financing plan is therefore a process of:

(i)
(ii)

(2)

Managing Financial Risk

Building a consensus amongst stakeholders

Approach to Structuring
(a)

Identifying Business Risks

(i)

The factor fundamental to the success of infrastructure Projects is the

realisation of the projected cash flows over the tenure of the
concession period. The cash flows, in turn, depend on the realisation
of demand projections and the ability of the concessionaire to levy
tariff and realise projected revenues

(ii)

Traditionally, infrastructure projects have been funded by the

government, and hence the concept of pay and use is new. The
key business risk is therefore the acceptance of the concept by the
user community and their Willingness to Pay.

(iii)

Due to resource constraints, Infrastructure projects are usually posed

for implementation only when considered critical. The level of
utilisation of such facilities is dependent upon several
macroeconomic factors. e.g: In case of road projects, the extent of
usage will be determined by the location, alternatives available,
industrial & social development in the region etc.

(iv)

Even though an infrastructure facility may be considered critical on

the basis of social and economic requirements of an area its usage
may be far lower than required to justify a prudent investment
decision.

94

(b)

(v)

It is therefore essential to determine accurately the expected

cashflows and therefore the viability of the project on purely
commercial terms. This is an essential first step to ascertain the
extent to which the project can support commercial financing and
the need for budgetary support if any.

(vi)

A detailed financial analysis is also an opportunity to review the

business plan of the project and alter its scope to make the proposal
more efficient.

Examining Cash Flows

(i)

Infrastructure vs. Industry: Unlike industrial facilities where demand

exhibits business cycles over medium to long term, the demand for
infrastructure facilities is determined by long-term economic factors.
Further, the zone of influence of an infrastructure facility is limited to
the immediate geographical area. Therefore unlike industrial
products, there is very little that can be expected beyond the natural
growth in demand.
It is for this reason that it is essential to determine base level data
very accurately.

(ii)

(c)

An infrastructure facility is designed to provide sufficient spare

capacity for the anticipated demand growth over the long term.
Hence, in the initial years, the usage is likely to be substantially
lower than capacity. The resultant impact is relatively low cash flow
in the initial years of project operation. Besides, linking the user
charge revision to the Wholesale Price Index further accentuates the
back-ended profile of the cash flow

Determining Leverage
(i)

Cost of debt is generally lower than the implicit cost of capital even
though it may be in the form of budgetary support. This is especially
true in a developing country where the opportunity cost of
government funds is extremely high. Internationally, it is accepted
practice to leverage infrastructure projects with a large debt
component, which often exceeds what is otherwise considered
"prudent" for industrial projects. This is primarily due to the
considerably lower post construction risk profile of an infrastructure
project. International investors have tended to view returns from
infrastructure projects as steady and relatively risk free. A gearing in
excess of 5:1 is quite acceptable in international markets. There are a

95

number of instances where projects with a debt funding of 90% have

also been implemented
(ii)

As the capital markets in developing countries are still not mature,

the appetite for long-term debt for long-term infrastructure projects is
expected to be limited. It thus becomes necessary to introduce a
larger element of equity or budgetary support than would be the case
in an ideal situation.

(iii)

A high gearing level subjects the project to significant financial risk.

In addition, to achieve high levels of gearing, it is necessary to have
access to long-term debt, of a maturity and repayment profile aligned
with project cash flows - otherwise the cash flows will not meet the
high debt servicing requirements.

(iv)

In order to manage financial risks the proposed financing plan must

determine the prudent level of debt financing for a project in order to
ensure certain debt servicing.
(1)

Debt: Equity Ratio

The Debt Equity ratio is a measure of a company's
financial leverage, calculated by dividing long term debt by
shareholders equity. It indicates what proportion of equity
and debt a company is using to finance its operations.
In order to determine the prudent debt equity ratio the
project cash flows have to be examined at various levels of
debt to arrive at the most efficient mix of financing. The
degree of leverage depends on the ability of the project
cashflows to service debt, the risk perception of lenders and
the prevalent practice
A very high debt equity ratio can result in volatile earnings
as a result of the significant interest expense.

(2)

Debt Service Coverage Ratio

The DSCR is defined as the ratio of the Cash Flow from
Operations in the current year plus the cash balances in the
previous years Debt Service Reserve, to the debt servicing
for the year plus appropriations for the Debt Service
Reserve in the current year. Debt servicing includes interest
payments, redemption premium, principal repayment and
any other payments to the lenders

96

Cash flows from infrastructure projects tend to build up over

time. Therefore the ability of cash flows to meet debtservicing obligations is of primary concern to a lender. The
most commonly used index for measuring debt-servicing
ability of a project cash flow is the Debt Service Coverage
Ratio (DSCR). Whereas the DSCR provides a year on year
measure of debt serviceability, the Cumulative DSCR
provides a broader view of the same across the tenor of debt.
(3)

Cumulative DSCR
The Cumulative DSCR is defined as the ratio of the
cumulative Cash Flow from Operations till the current year
and cash balances in the previous years debt service
account, to the debt servicing cumulated till the current year
plus the appropriations Debt Service Reserve Cumulated till
the current year. Debt servicing includes payment of
interest, redemption premium, principal and any other
changes payable to the lenders

(3)

Equity
(a)

SPV Structure
To avoid recourse by lenders to the promoters/investors in case of insufficient
project cashflows the project is domiciled in a project specific company
often termed the Special Purpose Vehicle. In this case the liabilities of the
promoter/investors is limited to their equity investment in the project
company.

(b)

Return to Equity Investors

(i)

Return
Income to equity investors in a project is essentially by way of
dividends. The return on equity is a function of the difference
between the returns to the project and the weighted cost of borrowed
capital. Therefore, the greater the leverage, the higher the returns.
Since the payments to the equity holders would be from residual cash
flows after meeting all other obligations of the SPV, the unmitigated
residual project risk would essentially be borne by them. An equity
investor will not accept leveraging that will bring his expected return
below the cost of capital.

97

(ii)

Dividend Policy
The dividend payout policy of the project company is largely
determined by the legal and regulatory provisions. Dividend payout
are also determined by covenants stipulated by the lenders. These
may include conditions such as no payment of dividend during debt
repayment moratorium or before requirement for contribution to the
Debt Service Reserve are met etc.

(4)

Government
(a)

Role of the Government

The primary objective of the government on its agencies is to facilitate the
social and economic development of a region through the provisions of
productive public infrastructure.
The government does not see the provision of infrastructure as a business and
does not measure its performance on the basis of return on investment. The
government is more concerned with the incremental socio economic
benefits accruing to a region as a consequence of the project.
The primary measure of benefits to a region is the Economic Rate of Return
(ERR)

(b)

Economic Rate of Return

The economic rate of return (ERR) is the rate of interest that equates the
discounted present value of expected benefits and the present value of costs.
The ERR is calculated using a shadow price reflecting opportunity costs of
resources used by the project or created by it as a result of purchases and
sales. It should include any increases or decreases of quantities of goods in
the economy for third parties if generated by the project and not accounted for
by market transactions or any other form of monetary compensation.
While calculating the ERR the cash flows are modified to represent the
projects impact on national welfare, not corporate welfare. For example, if
project revenues benefit from elevated prices that are a consequence of high
tariff barriers, an adjustment is made to the cash flows to reflect this
distortion. That is, international or border prices are used for tradable
goods.

98

(c)

Benefits from Government Participation

Government participation in a project has several advantages. Amongst others
being the easier availability of land, approvals, clearances etc. More
importantly it sends a strong signal of support to the private sector and the
lender community especially in a countries where privatisation of
infrastructure has only just begun. The greater the support by the government,
the easier the prospects of raising finances and at finer rates.
Government Support vs. Ability to Finance

High

Equity
Guarantee

Debt Repayment
Guarantee

Exchange rate
Guarantee

Grant

Subordinated Loan
Minimum traffic or
revenue guarantee

Shadow Tolls
Impact
on
ability to raise
financing

Low

Revenue
Enhancement

Concession
Extension

Government financial
exposure/support

High

99

Government Guarantees

Counterindemnity

Government

Guarante
e

Political
risk/currency
convertibility
assurances

State-owned
entity

ECAs /
multilateral

Assurance
s

Guarantee

Lenders

Funding
banks /
institutions

Loan
agreement

Off take
agreement

Project
Company

Loan
agreements

100

(5)

Consensus
A workable concession among the various stakeholders is an essential prerequisite to
successful project financing.
Financing Plan - Building a Consensus

Modify Key
Input
Parameters

Structuring

Assessment of key
performance parameters
Project
Company

Lender

IRR, NPV

Debt Coverage
Ratio

Acceptable

Acceptable

Government

Social benefits of project

net of subsidies

Acceptable

Consensus

Transaction

(6)

Security Arrangement
(a)

Through the Concession Agreement, the concerned Government shall

recognise the rights of the Concessionaire to mortgage, charge, assign or
otherwise encumber the project asset and project site and to assign its rights
under the agreement in favour of the lenders

(b)

The Concession Agreement should provide step in rights to the lenders in the
event of Concessionaire defaulting in discharging its obligations to repay the
amount payable to lender or in the event of Concessionaire event of default.
In such an event the representative of the lenders will step in as

101

Concessionaire and assume its obligations for the exclusive and limited
purpose of curing the event of default. In the light of the relatively small cash
flow stream envisaged this will be of little comfort to the lenders

(7)

(c)

The Lenders will also have a right to appoint a Substitute Entity to replace the
Concessionaire in the event of the concerned Government issuing notice for
intention of terminating the Agreement. On appointment of such Substitute
Entity, the Concession Agreement will be novated in its favour

(d)

Till such time that the obligation of the Concessionaire under the financing
agreement remain outstanding, it will not have any right to cancel or
terminate the EPC contract or an O&M contract or cancel or have any
material modification in that without obtaining prior approval from the
lenders

(e)

A detailed compensation structure will need to be put in place in order to

secure the lenders right in the event of force major termination of the
Concession Agreement, event of defaults by the concerned Government
and/or Concessionaire or requisition of the project road by the concerned
government

(f)

A comprehensive insurance package will have to be put in place for the

project road and the insurance policy would be assigned in favour of the
trustee or trustee would be noted as loss payee. In the event of the
termination of the Concession Agreement the insurance proceeds if not used
for repair and restoration of the project road would be distributed first towards
indebtedness to the lenders

Sources of Finance
Considering the substantial investment required and in light of the budgetary
constraints of the Government in developing countries - a substantial part of the
funding needs to be sourced from domestic and international capital markets.
Though for infrastructure projects it is not easy to source equity during the initial
project construction stage, it is possible to successfully tap the market in the post
commissioning phase once the construction risk is over and cash flow streams have
been established.
However, access to capital markets, whether domestic or international, given existing
investor perception of the infrastructure sector in developing countries, requires
creation of an appropriate format, which offers the prospect of a fair return on
investment. Moreover, with the involvement of the Government as one of the project
sponsors with an equity stake, it could be possible to raise commercial funds at finer
rates.

102

(a)

Speciality Funds
Speciality Funds are specifically meant for making equity and equity related
investments primarily in companies and projects focused on infrastructure
projects and related industries. American International Group (AIG), Asian
Infrastructure Development Corporation (AIDC) etc. are examples of funds
primarily meant for investment in infrastructure related companies and
projects.

(b)

Debt Finance
(a)

Long Term Debt

Asian countries, unlike more developed western countries, do not
have a well-developed long-term debt market. Though the domestic
financial institutions and commercial banks offer longer tenors of
debt, large infrastructure projects often require to access international
markets for part financing such projects. The cost of foreign currency
debt is generally lower as compared to the debts in local currency.
However, foreign debt carries the inherent exchange rate risk that to
a large extent obviates the advantages of lower cost. However foreign
debt is beneficial on account of the long tenors that reduce servicing
requirements during the ramp up phase of the project. The
appropriate level of foreign debt has to be determined considering the
guidelines on policies and procedures regarding External
Commercial Borrowings (ECBs).

(b)

Sources of Debt in local currency

The sources of debt in local currency include the Developmental
Financial Institutions, Commercial Banks, Insurance Companies,
long-term loans from multilateral agencies, lease financiers and the
domestic capital market.
(i)

Developmental Financial Institutions (DFIs)

The DFIs are the traditional sources of long-term debt and
Deferred Payment Guarantees for infrastructure projects.
However, a constraint on DFI participation in infrastructure
projects is the prudential exposure norms that restrict each
DFIs exposure to individual projects, companies and
industries.

103

The loans from DFIs may have maturities of 12 -14 years

with a moratorium of about 2 - 4 years and equal repayments
spread over the balance period. DFIs generally extend
limited amount of foreign currency loans for purchases of
imported equipments. Small projects are usually financed
by a single DFI whereas a larger one is generally syndicated
among two or more.
(ii)

Commercial Banks
The Commercial Banks are traditional sources of working
capital finance for projects. The Commercial Banks have
also started offering long-term funds for infrastructure
projects either singly or as a consortium. However, most of
the Commercial Banks in developing countries do not have
in-house capabilities for carrying out appraisal of
infrastructure projects and base their decisions on the
appraisal done by DFIs and/or multilateral agencies lending
to the project
Considering the cash flow profile of the project, working
capital facility can be accessed from banks to fund the short
term deficit in the project cash flow and possibility of short
term credit facility can also be explored to meet the short
term funding requirements that may arise at the project
development and construction stage and in the initial years
of operations.
Development Financial Institutions and Commercial Banks
generally provide a range of value added products for the
development of infrastructure sector:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)

(c)

Credit enhancement
Financial guarantees
Direct lending
Take out financing
Underwriting
Construction period financing
Standby line of credits
Risk sharing arrangement

Offshore Sources of Funds

Foreign currency debt can be tapped from the multilateral institutions
like International Finance Corporation, Asian Development Bank,

104

Commonwealth Development Corporation, Export Credit Agencies

(ECAs), Foreign Commercial Banks and through special lending
facilities of USAID and the World Bank for the development of
public infrastructure.
(1)

Multilateral Institutions
(a)

Multilateral institutions like World Bank, IFC, ADB

and CDC provide funds for the development of
infrastructure projects in Asian countries.
Typically, these institutions lend upto 25 % of the
project cost.

(b)

The World Bank has funded various infrastructure

projects in Asia countries and continues to actively
support privatisation of infrastructure projects. DFIs
can also receive funds from World Bank for lending
to infrastructure projects being developed on a
commercial format

(c)

The lines of credit from the World Bank would be

generally for a period of about 20 years with an
initial moratorium of upto 5 years. The pricing of
such lines is normally based on the banks standard
interest rate linked to LIBOR if it is a single
currency loan. These loans are required to be
guaranteed by the national Government.

(d)

Institutions sourcing loans from the World Bank

would lend these funds for financing part of
infrastructure projects.
Multilateral funding
requires that the project should meet the stringent
financial, social and environmental criteria fixed by
the World Bank.

(e)

Moreover, projects funded by the World Bank line

have to follow its guidelines for procurement of
goods, works and consultancy through International
Competitive Bidding

(f)

Despite obvious benefits such funding often adds

to the project development process both in terms of
time and cost

105

(g)

Generally the terms of equity investment in the

project include entitlement to nominate a Director
on the Board of the Project Company and the
provision of a divestment mechanism at a suitable
time.

(h)

Loans from ADB are available for tenors of upto 15

years with a grace period during construction,
followed by one to two years, depending on the cash
flows of the project. The evaluation criteria of the
ADB are similar to the World Bank in terms of
financial, social and environmental issues

(i)

The ADB loans can be availed of either on a fixed

or a floating rate basis. A front end fee and
commitment charges are payable to ADB for the
loan facility

Structure for Multilateral Agencies Financing

State
Guarantee

Public
Sector

Loan Agreement (with

negative pledge)

Multilateral
Agency

Agent
Project Security (exempt
from negative pledge)

Securit
y
Trustee

Commercial
Banks

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(2)

Export Credit Agencies

(a)

ECAs lend to or guarantee commercial loans to

projects (i.e. within a limited recourse structure).
Generally an ECA guarantee is available for
financing maximum of 85% of the value of the
contract for importing equipment and for services.
The balance 15 % is required to be funded
separately. Certain ECAs also finance equipment
partially sourced outside their country. For example,
Japan EXIM can provide untied financing for
most non Japanese equipment, EDC (Canada) and
USEXIM can provide funds for up to 50% non local
content, and most of the European ECAs can
provide untied funds for up to 30% of the project
cost if the equipment is sourced from elsewhere in
the European Union. Their evaluation process may
take longer than the standard buyer or supplier
credit approval process.

(b)

Pricing for the credit facilities from ECAs will be

based upon a standard fixed interest rate set by the
Berne Union (the CIR Rate), plus a premium for
project and for country risk. The facility is normally
available for a tenor of 5 to 12 years. The
repayment is generally in equal semi-annual
instalments with a grace period given upto project
commissioning

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