Financing Sustainable Infrastructure - Assessing the Risks

in Public Private Partnership Models

Palanisamy Saravanan
Associate Professor
Goa Institute of Management
Goa 403006
Email: ps@gim.ac.in
Phone: 0832-2490351 / 300
Fax: 0832 2444136

Electronic copy available at: http://ssrn.com/abstract=1520939

   

Financing Sustainable Infrastructure - Assessing the Risks

in Public Private Partnership Models
What is Infrastructure?

Infrastructure is easier to recognize than define.1 The term infrastructure means and include

Energy (power generation and supply), Transport (roads, rails, tunnels, bridges, ports and

airports), Water (freshwater provision, sewage disposal), Telecommunications and Social

Infrastructure (hospitals, prisons, courts, museums, schools and government accommodations).

Infrastructure is a complex technical system that provides us with a varied range of valuable and

essential services. They have great effects on economy and social relations. Their availability is

an essential tool for geographic and social integration and, consequently, they facilitate the

reduction of poverty.

The operational definition for the term sustainable infrastructure is “infrastructure for sustainable

development”. Further the term “sustainable development” cannot be divided into the two words

that form it but it should be taken as a wide, integrated and unified concept. Some of the recent

conferences held across the world clearly established that “Human beings are the centre of

concern for sustainable development”.2

Financing of Infrastructure:

Traditionally, governments have had the chief responsibility of managing the process of

infrastructure provision, especially funding. But of late governments across the globe are not in a

position to build the needed infrastructure, maintain existing assets and to replace worn-out

assets. Several factors are attributable for this, to name a few, rapid rise in construction cost,

changing economic conditions, tax and expenditure limitations, growth in the size of the

 
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Electronic copy available at: http://ssrn.com/abstract=1520939

   

government workforce and public bureaucracy, governments' budgetary constraints, sectoral

reforms, changes in priorities, technological development, and globalization of financial markets.

So, the traditional role of public sector infrastructure development is undergoing major change as

governments in developing countries seek to bring private sector investment into infrastructure

services. A variety of means are currently used throught the world to finance infrastructure in

new areas and many countries have attempted to apply alternative and innovative methods to

address this issue.

PPP around the Globe:

The Public Private Partnership (PPP) notion is used throughout the world with a range of

meanings. In the United States, PPPs have traditionally been associated with urban renewal and

downtown economic development, while the UK Private Finance Initiative (PFI) was introduced

by the Conservative Government in 1992. Public Private Partnerships have also been viewed as a

tool for providing public services and developing a civil society in countries like Portugal, Italy,

Netherlands, Greece, Ireland, Hungary, Israel, China and India. The PPP definition in Australasia

is that government has a business relationship, long term in nature, with risks and returns being

shared, and that private business becomes involved in financing, designing, constructing, owning

or operating public facilities or services.

PPPs can be explained as agreements where government or public sector undertaking enters into

long-term contractual agreements with private sector entities for the construction or management

of public sector infrastructure facilities or provision of services to the community on behalf of a

public sector entity. PPPs can take many forms and may incorporate some or all of the following

features, although this is not a definitive or complete listing.

 
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™ Design-Build (DB): The private sector designs and builds infrastructure to meet public

sector performance specifications, often for a fixed price.

™ Operation & Maintenance Contract (O & M): A private operator, under contract,

operates a publicly-owned asset for a specified term. Ownership of the asset remains with

the public entity.

™ Design-Build-Finance-Operate (DBFO): The private sector designs, finances and

constructs a new facility under a long-term lease, and operates the facility during the term

of the lease. The private partner transfers the new facility to the public sector at the end of

the lease term.

™ Build-Own-Operate (BOO): The private sector finances, builds, owns and operates a

facility or service in perpetuity. The public constraints are stated in the original

agreement and through on-going regulatory authority.

™ Build-Own-Operate-Transfer (BOOT): A private entity receives a franchise to finance,

design, build and operate a facility (and to charge user fees) for a specified period, after

which ownership is transferred back to the public sector.

™ Buy-Build-Operate (BBO): Transfer of a public asset to a private or quasi-public entity

usually under contract that the assets are to be upgraded and operated for a specified

period of time. Public control is exercised through the contract at the time of transfer.

™ Operation License: A private operator receives a license or rights to operate a public

service, usually for a specified term. This is often used in IT projects.

™ Finance Only: A private entity, usually a financial services company, funds a project

directly or uses various mechanisms such as a long-term lease or bond issue.  

 
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According to the World Bank’s (Private Participation in Infrastructure) database, among private

investment attracted for 534 projects from 2000-06 in top ten developing countries.3 About £ 100

billion has been committed by the Tony Blair government for 400 Private Finance Initiative

(PFI) contracts in the UK and little over AUD$20 billion of private finance may be channeled

into the public assets over the coming five years.4 In some countries around the world, specific

statutes have been enacted to regulate PPP transactions, the largest of which is China, which

embraced this model to prepare infrastructure for the recently concluded 2008 Olympic Games.

One of the most significant developments in India in the last few years has been the putting in

place of laws to allow private money to be invested in infrastructure through Public Private

Partnership (PPP) franchises. The government set up the India Infrastructure Finance Company

Limited (IIFCL), a Special Purpose Vehicle (SPV) to help facilitate PPP deals and also to

conduct feasibility study. To attract larger investments in infrastructure development, the

government has also set up an Infrastructure panel to look into long term funding for

infrastructure projects. Till 29th October 2008, US$ 13,284 million on 65 different proposals

largely on roads, rails and ports were approved by the Indian government across the different

states of the country and another proposals worth US$2,211 is awaiting for the approval.5

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Exhibit No.1

Different PPP Models and Degree of Risk Transfer and

Private Sector Involvement
D
e Build‐Own‐Operate‐Transfer 
g
r
e Design‐Build‐Finance‐Operate‐Maintain
e

Design‐Build‐Finance‐Operate
O
f P
P
Design‐Build‐Finance‐Maintain
P
P
ri M
v Design‐Build‐Operate
o
a d
t e
e Buy‐Build‐Operate
l

S Build‐Finance‐Maintain
e
c
t Build ‐Finance
o
r
Operation & Maintenance

R
is Design‐Build 
k

Degree of Private Sector Involvement

Models of Public-Private Partnerships:

As stated earlier one can conceive of many models for the PPPs, but the following are some of

the common models. Various other models can also be envisaged.

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FIGURE NO. 1 FIGURE NO. 2

Fixed Pay Off Model Variable Pay Off Model

Run Business
Fixed Pay Off Run Business
  Govt. Vendor (SPV) Business Govt. Vendor (SPV) Business

Revenue Part of Revenue

  Variable Payoff

Administrative Control Capital Investments Administrative Control Capital Investment

The above models (figure nos.1 and 2) are basically relies on the vendor’s ability to fund the

project and run it independently of the public sector partner’s intervention. The public enterprise

authority is vested with the private partner for a limited period of time. An effective monitoring

and evaluation framework is needed for implementing such a model. Invariably the business is

run under strong business related Service Level Agreements (SLA). While the vendor shares the

entire financial risk of the venture, the government shares the risk of loss of administrative

control leading to citizen dissatisfaction. However, given the current low satisfaction levels with

government services amongst the citizens, it is expected that this model will lead to improvement

in these levels rather than deterioration of service levels. Accordingly it is considered appropriate

for the private vendor to have a larger share of the revenue in this model of PPP. This model is

particularly suitable where the capital investment is low and many private vendors can be

attracted to invest in to the venture. Where the revenues can be predicted with certainty, the fixed

pay off variant will be useful. However when revenue figures are completely unpredictable

variable pay off will be more useful and appropriate.

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FIGURE No. 3. FIGURE No. 4

Fixed Pay Off with Capital investment Variable Pay Off Capital investment
by Government by Government
    Fixed Pay Off Run Business Variable Pay Off Run Business

Govt. Vendor (SPV) Busines Govt. Vendor (SPV) Busines

Revenue Revenue

Capital Investments Capital Investments

In these models (figure nos.3 and 4) the capital investment is done by the government and the

business is run by the private partner. This model is especially useful where the government

wishes to utilize the efficiency of the private sector in running important citizen services.

However the capital costs are high enough for private enterprises to be in a position to invest in

to the project. The governments’ ability to invest high capital and the private vendors’ ability to

run the business efficiently is combined to provide a best of breed solution. The entire financial

risk in this model is taken by the government. The government also incurs the administrative risk

of project failure and subsequent loss of credibility amongst the citizens. Thus these models need

to be run under strong Service Level Agreement. Government needs to exercise close control

over the vendor in this model. Government also becomes the major beneficiary of the revenue

generated through this model. Large facilities like Hotels and hospitals may be run using this

model. These models can be used for running of large airports, rail stations and ports. When

revenue generation is not linked to the services provided by the private vendor, the fixed pay off

model will be used. However when the services provided by the private vendor directly impact

the revenue generation process, the variable pay off model should be used.

 
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FIGURE NO. 6
               FIGURE NO. 5
Capital Investment by both and Capital Investment by both and
Fixed Pay Off Model Variable Pay Off Model

Fixed Pay Off Run Business Variable Pay off Run Business

  Govt. Vendor (SPV) Business Govt. Vendor (SPV) Business

Revenue Revenue
 

Administrative Control Capital Investments Administrative Control Capital Investments

The above two models (figure nos.5 and 6) tries to divide the risk and return between the PPP

partners equally or in an agreed ratio. Both partners invest capital in to the project. Returns are8 4

shared as per the original capital investment ratio or may be on the risk perception of the

partners. Projects requiring large capital like oil refining etc may fall under above category. This

model tries to distribute the risk and return between the PPP partners. Invariably the vendor will

also have a large stake in the success of the project. Thus these models are likely to work with
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fair degree of autonomy to the vendor. Government may make initial investments and then

accrue annual revenue for their investments. Where the revenues can be predicted with certainty,

the fixed pay off variant will be useful. However when revenue figures are completely

unpredictable variable pay off will be more useful and appropriate.

Assessment of Risks:

The nature of the risks changes over a period of time of the project. Most of the risk of a PPPs

comes from the mere complexity of the arrangement itself in terms of documentation, financing,

taxation, design, process, sub-agreements and the like. At least ten risks face by PPPs involving

infrastructure project:

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(i) Technical risk, owing to engineering and design failures;

(ii) Construction risk, may occur because of faulty construction techniques, cost

escalation and delays in construction;

(iii) Operating risk, because of higher operating and maintenance costs;

(iv) Revenue risk, due to volatility of prices and demand for products and services which

leads to revenue deficiency;

(v) Financial risk, owing to variability of interest, exchange rates, inadequate hedging

for the same and all factors that can influence the cost of financing the project;

(vi) Fore majure risk, involving war and other natural calamities and disasters;

(vii) Political risk, because of change changes in law, unstable government and policies;

(viii) Environmental risk, owing to adverse impact on environment and hazards;

(ix) Residual value risk is related to the future market price of the asset. This is important

if property of the assets needs to be transferred back the government at the end of a

certain period of time.

(x) Project default risk, because of failure of the project from the combination of any of

the above.

Most of the above cited risks are common to any PPP, in some PPPs agreements, revenue risk

might be very low and indeed insignificant. For instance, the projected revenue from a toll bridge

might be more assured than that of an oilfield. In principle, the risks of PPPs can be evaluated by

 
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using the some of the basic techniques available in the project finance space. The important

questions in assessing the risks are as below.

(a) Whether the projected cash flows can cover up the operating costs?

(b) Whether the projected cash flows can service the debt funds?

(c) Whether the projected cash flows can provide adequate return to the risky capital?

Consider the case of an infrastructure in the form of a toll road / bridge. Sponsors of the

project (private sector) borrow funds to build the same. The sponsors estimated that the

toll revenues will be sufficient to service the debt and generate profits. But the risks are

plenty. Will the road / bridge can actually be built up on time? Can the toll rates be fixed

to the utility’s costs for providing services?

The uncertainties regarding the project cash flows can fall into any of the two categories:

(1) Moderate deviation from the estimated cash flow projections due to fluctuating

prices, costs, timing delays, minor technical problem and the like.

(2) Disasters to a project, due to major cost escalations, slow economy, change in legal

rulings, alternative to the political climate, environmental disasters etc. which might

lead to project failure and bankruptcy.

Frank Knight clearly documented the differences between “risk” and “uncertainty”.6 In both the

cases, the actual future outcome is not predictable with certainty. But in the case of risk, the

probabilities of the various future outcomes are known (either exactly mathematically, or from

the past experience of similar scenarios). In the case of uncertainty, the probabilities of the

 
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various future outcomes are merely “wild guesses”. Risks can be insured, diversified, computed

with different probabilities whereas true uncertainty or disaster scenarios are different.

Exhibit No. 2

Analytical Approach Towards Risk Assessment

 
Entity    Risk Perspectives         Key Variables  Major Risks              Risk Analysis 

  Value-for- Expected
Capability of
Govern- Money NPV of Cost
  SPV and
ment Project
Interest
Contingent Sensitivity
  rates
risk of risks
  Demand
Factors,
 
Special Impact on IRR on Price Monte –
Purpose return Equity sensitivity, Carlo
  Life of the
Vehicle simulation
Project,
  Performance

  Interest
Lender / Default/ coverage Demand
Factors Downside
Banker/
  Delays on ratios,
Price Sensitivity
Bond interest Debt
  sensitivity analysis
holders and Equity Life of the
principal ratios project,
 
Performance

Note: Basic Framework is adopted from Grimsey and Lewis 2002

Can a Public Infrastructure need best be met through a partnership with a Private Sector?

The answer to the above question yes because PPPs are a win-win-win partnership. From the

governments’ point of view, it takes care of the infrastructure backlog, stimulate economic

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growth, create jobs, transfers costs and risks from public sector. Basically, government seeks to

utilise private sector finance in the provision of public sector infrastructure and services and

thereby achieve value for money. Value for money is defined as the effective use of public funds

on a capital project, can come from private sector innovation and skills in asset design,

construction techniques and operational practices and also from transferring key risks in design,

construction delays, costs overruns to private entities for them to manage.

From the project sponsor point of view PPPs or PFI is essentially a variation in project financing

characterised by the creation of a SPV for the project with the objective of making direct

revenues to pay for operating costs, interests costs on debt and providing the desired return on

the risky capital. From the users perspective they are getting the infrastructure / services

delivered on time and budget and better value for money.

Conclusion:

Though PPPs have evolved from the project finance space, they are quite different in terms of

complex contractual agreements, governance and accountability measures. The empirical

evidences across the globe indicate that PPPs have the potential to provide infrastructure at more

reasonable prices than comparative delivery through the public sector.4 In PPPs governments

shifts the risk to the private sector that is best known to manage risk. Moreover, the basic

objective for the governments is to achieve value for money in the services provided at the same

time makes sure that the private sector entities meet their contractual obligations properly and

efficiently. Value for money and risk sharing are the two building blocks on which the PPPs are

built with the support of robust, long term revenue stream and over the period of time. In order to

guarantee value for money, the relative strengths and weaknesses of each PPP scheme should be

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considered. Depending on the sector of application, some models are better suited than others in

delivering targeted outputs and in ensuring accurate risk management. Choosing the wrong

model or inaccurately evaluating the risk management capacities of each party may have

extremely costly consequences and a negative impact on public accounts. This paper only

touches the surface of different financial models perceived in structuring a PPP deal as well

assessing the risks associated with them in an infrastructure framework. Each of these models

can be investigated further for risk return patterns and advantages gained to government and the

private enterprise to arrive at well structured PPP contracts.

 
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References:

1. Canadian Council for Public Private Partnerships, Position Paper, Retrieved on 21st

August 2008 from www.pppcouncil.ca

2. Conrado Bauer, Investing in sustainable Infrastructure Worldwide – Role of the

Engineering Community – retrieved on 20th August 2008 from www.worldbank.org

3. Devapriya and F. Pretorius (2002). The Economic Implication of Project Finance

Arrangements for BOO / BOT Power Projects in Asia, Journal of Construction Research,

Vol 3. No.2, 285-309

4. Grimsey, Darrin and Lewis K. Merwyn (2002), Evaluating the risks of public private

partnerships for infrastructure projects, International Journal of Project Management,

107-188

5. Hodge A Greame (2004), The Risky Business of Public Private Partnerships, Australian

Journal of Public Administration, 63 (4):37-49, December

6. Knight Frank. Risk, uncertainty and profit. Boston: Houghton Mifflin, 1921

7. Private Participation in Infrastructure Database retrieved on 21st August 2008 from

http:\\ppp.worldbank.org

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