E R Yescombe - Impact Media - PPPs

Module 3: Covering Business
Public-Private Partnerships
E.R. Yescombe
YCL Consulting Ltd., London U.K.
www.yescombe.com
2-4 September 2013

(1)
Introduction to PPPs
©YCL Consulting Ltd. September 2013

(2)
Public infrastructure
Why is infrastructure different?

• public goods – available to all but difficult to get users to pay (e.g. street
lighting) ∴ state has to provide
• merit goods – services which should be based on need, rather than ability
to pay (e.g. hospitals, schools) ∴ state has to provide
• externalities – positive and negative – caused by the project but not part
of it: e.g. new road reduces congestion in other roads, but users of those
roads won’t pay for this benefit ∴ state has to provide
But historically state did not provide much infrastructure:

• economic infrastructure (roads, canals, railways) provided by local
communities or private enterprise, e.g. in 19th century England;
• social infrastructure (schools, hospitals) provided by religious
organisations or other charities
State can provide or facilitate provision of public infrastructure

(3)
What is a PPP?
Public-private partnership (PPP, P3)

• American origins – no single meaning – political rather than legal term
• ‘Policy-based’ or ‘programme-based’ PPPs (PPPs against AIDS / malaria)
v. ‘project-based’ or ‘contract based’ PPPs (PPP for a new road)
Private finance for construction of new (or upgraded) public infrastructure

+ long-term service provision (including operation and maintenance)
+ risk transfer to private sector
+ remains in public ownership (or returned at end of contract)
= ‘partnership’

(4)
Development of PPPs
Concessions …the user pays (tolls, fares, water fees, etc.)
• Old concept – 18th century turnpike roads
→ Franchise / affermage – ‘publicans & sinners’, water in France, rail in U.K.)
U.K. development of PFI Model – the public sector pays :

• Underinvestment in public infrastructure in the 1970s, incl. maintenance
• Thatcher government (1979-1990) - ‘New Public Management’:
• the state is an inefficient provider of public services
• where possible, role of state should be to facilitate / regulate provision
of public services rather than always provide them itself
→ privatizations of the 1980s (mainly utilities) → new investment
• But investment in public infrastructure continued to be inadequate:
• development of “self-funding” projects, paid by users (i.e. concessions)
→ Channel Tunnel (1987), plus two major toll bridges and one toll road
• but limited number of possible projects of this type in U.K.
• Continued public budget constraints:
→ Private Finance Initiative (1992), to find other ways of bringing
private finance into public infrastructure investment
PFI model (renamed PF2 in 2012) widely imitated around the world
Also known as the Availability Model because in many cases private sector is
paid when the project is available for use

(5)
‘Boundary lines’ for PPPs

U.S. National Council for PPPs defines a PPP as:
• ‘a contractual agreement between a public agency (federal, state or local)
and a private sector entity. Through this agreement, the skills and assets of
each sector (public and private) are shared in delivering a service or facility
for the use of the general public. In addition to the sharing of resources, each
party shares in the risks and rewards potential in the delivery of the service
and/or facility’
‘Narrow’ versus ‘broad’ definition:
• Narrow– only private finance for new or upgraded infrastructure
• Broad as above covers other kinds of private-sector involvement in
infrastructure, e.g.:
• Design & build contracts (no finance or long-term involvement)
• Management contracts (no finance)
• Franchises / leases (grey area but generally no finance)
• Provision of state property (not public infrastructure)
• Confusing to call them all PPPs – some elements in common, but structures,
especially risk transfer, quite different

(6)
Public procurement / privatisation
PPPs v. standard public-sector procurement:

• Design & build v. design-bid-build
• Contract including operation v. separate and unrelated operation
• Finance from general government budget v. private-sector finance
PPPs v. privatisation:
• No transfer of public ownership
• Public sector remains accountable to users
• Contract-based not regulator-based
• Main overlap with privatisation relates to transfer of staff

(7)
The public → private spectrum

PPPs lie between ‘pure’ public- and private-sector projects:
Public project ←——————————————————————–→ Private project
←—— Public-Private Partnership
Design-Build Build- Build-
Contract Type Public-sector Franchise Finance- Transfer- Operate- Build-Own-
procurement (Affermage) Operate Operate Transfer Operate
(BOO)**
(DBFO) (BTO) (BOT)
Construction Public sector* Public sector Private sector Private sector Private sector Private sector
Operation Public sector Private sector Private sector Private sector Private sector Private sector
Ownership Public sector Public sector Public sector Private sector Private sector Private sector
during during
construction, Contract, then
then public public sector
sector
Who pays? Public sector Users Public sector Public sector Public sector Private-sector
or users or users or users offtaker,
public sector, or
users
Who is paid? n/a Private sector Private sector Private sector Private sector Private sector
* Public sector normally designs the project and engages private-sector contractors to carry
out construction on its behalf (design-bid-build).
** This would be a PPP in the minority of cases where ownership of the project does not revert
to the public sector at the end of the PPP contract (e.g. some waste management contracts)
N.B.: PPP may be Concession or PFI Model

(8)
‘Alphabet Soup’
‘Alphabet soup’:
• BOT build-operate-transfer
• BOOT build-own-operate-transfer
• BTO build-transfer-operate
• BLT build-lease-transfer
• BLOT build-lease-operate-transfer
• BTL build-transfer-lease
• DBFO design-build-finance-operate
• DBFM design-build-finance-maintain (or –manage)
• BOO build-own-operate
etc. etc.
Complex and overlapping terminology is pointless and confusing
The key distinction is between:
• ‘Reverting assets’: At the end of the PPP Contract the assets revert to
public-sector control (unless a new contract, e.g. franchise, is signed);
applies to most PPPs (= all terms above except BOO)
• Non-reverting assets’: Private sector retains ownership & control –
applies only to minority of cases where assets have some non-public use
(= BOO)

(9)
Projects suitable for PPPs
What projects are suitable in principle for PPPs?
• the project provides an essential public service;

• not possible / desirable to privatize the project (e.g. road, hospital)
• public sector is directly accountable for the public service;
• the project is self-contained, i.e. it can be built and operated as one or
more units, with a separately identifiable cash flow;
• the project has a long life (if not no point in signing a long-term contract);
• little risk of technological obsolescence (ditto)
• risk-transfer to private sector is possible;
• the project involves significant capital expenditure, and also requires
long-term maintenance;
• the capital cost of the project should be high enough to justify the higher
set-up costs for this more complex type of procurement;
• evidence that similar projects have been procured as PPPs;
• evidence of private-sector interest in providing the project as a PPP.

(10)
Sectors suitable for PPPs

Economic infrastructure
• usually (but not always) user-paid / concession model (may also have
public-sector subsidy)
• Concession Model, e.g.:
• roads / tunnels / bridges (tolled)
• railways / light rail (passenger fares / freight charges)
• water / waste water treatment (or could be PFI Model)
• ‘Quasi-PFI Model’
• ‘availability-based’ process plant / ‘throughput’ contracts:
power generation, power transmission, pipelines, LNG terminals
N.B.: may not be PPPs (e.g. privatized electricity industry)
• PFI Model, e.g.:
• ‘shadow toll’ roads
• ‘availability-based’ economic infrastructure: roads, rail, etc.
• availability-based ‘accommodation’ projects: schools, hospitals
• ‘service-based’, e.g. street lighting
Social infrastructure
• usually (but not always) public sector-paid / PFI model, e.g.:
• ‘availability-based’ ‘accommodation’ projects: hospitals, schools,
prisons, training centres, government offices, etc.
(11)
PPP Contract – key features
Various names: Project Agreement, Concession Agreement, Power Purchase

Agreement, etc.
Parties: Project Company & public-sector entity (= ‘Contracting Authority’)
Objectives:
• Specify required outputs from contract
• Specify payment and performance régime
• Allocate responsibilities and risks
• Accommodate change
• Penalise failure
• Set out termination arrangements
Payment only begins on delivery, i.e. end of construction phase (in most cases)
Pre-agreed payments either by Contracting Authority or by users (or a
combination of the two) calculated to:
• repay bank loans or other debt (usually ‘project finance’-style debt) and give
investors an acceptable rate of return on their equity investment
• cover projected long-term operating costs (allowing for inflation)
• so long as project performs as expected

(12)
Output specification
PPP contract based on output specification – what has to be done but not
how to do it:
• Design and construction:
• PPP school contract: Contracting Authority will specify, say, number of
classrooms of a certain size, but not their layout or how to build them
• Road concession: Contracting Authority will specify, say, that the road
must have two lanes on each side, and meet normal road standards,
but not how the road is to be built to meet these standards.
• Service quality: again specify what is required but not how to do it -
• Key Performance Indicators (KPIs) and performance points (e.g. if the
hospital ward is not cleaned on schedule or to the required standard, or
if accidents are not cleared from the road within a certain time,
deduction for poor service, leading to penalty payments).
• Availability – is the project fully available for use? (e.g. if the roof leaks so
a school classroom can’t be used, deduction for unavailability of the room).
This ensures risk transfer to the private sector, a key aim of a PPP

(13)
Introduction to Project Finance

(14)
What is project finance?

PPP lenders (mainly banks) usually use ‘project-finance’ techniques for PPPs.
Project finance is a specialised form of finance:
• Used for infrastructure with long construction / operation period
• Lenders rely on project cash flow, not corporate balance sheet or past
profit record;
• So lenders carry out detailed due diligence, e.g. examine reality /
viability of cash-flow projections.
• Lenders rely on project contracts not physical assets as security
• Lenders cannot take a mortgage over a school;
• ‘Contract-based financial engineering’.
• High ratio of debt to equity – main reason for using project finance;
• Debt is cheaper than equity, so reduces cost of finance – hence
produces a lower-cost project.
• Project must be ‘ring-fenced’ (i.e., legally and economically self-
contained).
∴ Special-purpose vehicle (‘SPV’) Project Company as the borrower
• No guarantees from investors in Project Company (‘non-recourse’
finance)
• Finite project life, so debt must be fully repaid;
• Cf. corporate loan, where debt may be rolled over indefinitely.
(15)
Why do I need to know about this?

Public-sector viewpoint
• Surely raising the finance is the private sector’s problem?
• Yes but:
• Need to understand what is required to make a planned PPP project
‘bankable’ / financially viable, including whether any public-sector
support (e.g. revenue guarantee) might be needed
• Need to understand how much the project is likely to cost, and whether
this is affordable
• Forced renegotiation to meet lenders’ requirements, or complete
failure to raise finance amongst the commonest reasons for PPPs
failing in developing countries.
∴ Public-sector party needs to understand if a financing plan is credible
before awarding PPP contract.
Private-sector viewpoint
• Can’t propose or bid for a PPP project without knowing what financing is
available, how it should be structured, and how much it will cost
• Non-financial employees (e.g. designers, engineers, maintenance) need to
understand what lenders’ requirements are, and how they differ from a
normal client in a simple construction / operating & maintenance contract.

(16)
Industries using project finance

Natural resources:
• oil and gas fields
• mining
• LNG export and import plant
• petrochemicals
• pipelines
Process plant:
• power generation (PPAs) & transmission
• industrial, e.g. plastics
Telecommunications (e.g. mobile phone / satellite networks)
Leisure projects (e.g. football stadium)
Public infrastructure:
• PPP Concessions (payment by user)
• PFI-Model PPPs (payment by public sector)
All involve major long-term project investments

Principles / structures similar whatever type of project

(17)
Power-generation project
Electricity
Investors Lenders Gridco / Distributor
Equity Project-Finance Debt

Power-Purchase
Agreement
Project Funding
Project
Company
Sub-Contracts Fuel-Supply
EPC Contract Operation & Maintenance
Contract Contract
EPC Fuel O&M

Contractor Supplier Contractor

(18)
Toll-road concession
Investors Lenders Contracting
Authority

Concession
Agreement
Project Funding
Project Road Users

Tolls
Company
Sub-Contracts Construction Operating Maintenance

Contract Contract Contract
Design & Build Toll-Road Maintenance

Contractor Operator Company

(19)
PFI Model – social infrastructure

Authority

PPP Contract
Project Funding
Project
Company
Sub-Contracts Construction Maintenance Services Contract (e.g. cleaning,

Contract Contract catering, security)
Design & Build Maintenance Services

Contractor Company Company

(20)
Equity and debt

Equity, provided by ‘sponsors’ / passive investors:
• 10-30% of PPP project capital costs
• high risk / high return – high return on investment if project does well, low
return (or loss) if it does not do well
• ‘upside’ and ‘downside’
Project-finance debt, provided by lenders

• 70-90% of PPP project capital costs
• low risk / fixed return = paid before equity / fixed margin over cost of funds
• no ‘upside’ only ‘downside’
• lenders:
• banks = private-sector commercial banks prepared to make long-term
loans to projects; public-sector development banks, et al.
• bonds = public debt issue, usually bought by investors looking for
long-term secure cash flow, e.g. insurance companies, pension funds
• development finance institutions (DFIs): direct (e.g. IFC) or via funds
• export credit agencies (ECAs) – where project imports equipment
• infrastructure / PPP funds - invest mainly in equity, but some debt

(21)
What do lenders expect?

From public sector:
• political commitment
• political consensus (between government and opposition)
• adequate project preparation
• transparent procurement
• appropriate risk transfer
• project pipeline
(& similar requirements from investors)
From sponsors:
• expertise / track record
• arm’s length sub-contracting
• reasonable equity investment
• financial capacity (but not obligation) to provide support to deal with any
financial problems with project
• long-term commitment
From sub-contractors
• Experience in the sector
• Credit standing
• Appropriate penalties / liquidated damages / bonding

(22)
Why investors use project finance
Project finance is complex and slow ∴ expensive, and with a high up-front cost
(on top of complexity of PPPs!)
Benefits for investors:

• Greater leverage, hence higher ROE (return on equity)
• Increased borrowing capacity
• Long-term finance
• Risk spreading / limitation
• Partners with different financial strengths and industry skills can work
together
• Tax benefits (deductibility of loan interest)
• [Off-balance sheet]

(23)
Benefit of PF to the public sector

Project finance for PPP projects is beneficial to a Contracting Authority:
• Lower total funding cost
∴ cheaper projects
• Increases investors’ financial capacity
∴ creating more competition for projects
• Enables public sector to assess and monitor project-specific data
∴ transparency
• Third-party due diligence
• Additional inward investment / skills transfer
• Financial market development
∴ Public sector should ensure that project finance is available for PPP
projects by ensuring ‘bankability’
N.B.: not all PPPs use project finance.
• Alternative is corporate finance (usually with smaller projects)
• Investors use own funds
• Any extra debt is raised by investing company
• Lenders do not rely on project cash flow, but investor’s credit

(24)
PPPs — For and Against

(25)
PPPs vs. public procurement
Main reason governments around the world are adopting PFI is that it helps to
deal with budgetary or borrowing constraints
• But PFI Model provides ‘finance’, not ‘funding’ – public sector has to pay
for it over time and so it has a fiscal effect (→ ‘Affordability’)
• Tariff payments by users of concessions are a form of tax anyway?
Main argument by critics of PFI is that the government can borrow money
more cheaply
• Correct to say that the cost of private-sector equity and loan debt in a PPP
project is greater than the government’s cost of borrowing
• But the government can borrow money more cheaply because the lender is
not taking any risk on the project
• Which means that government is taking the risk – needs to be added to cost
of public procurement
• So value of risk transfer in PPPs needs to be taken into account – but
difficult to assess
• And can the government actually borrow all the extra funds in lieu of a PPP
programme?

(26)
Other arguments for PPPs

Other general arguments in favour of PPPs:
‘Additionality’, or acceleration of investment → economic growth
• Paying for public infrastructure investment through taxes may reduce the
economic growth which the investment is trying to promote?
‘Private capital at risk’ = risk transfer, e.g. construction / maintenance
• Even if the investors lose their investment, the lenders are still at risk
→ Third-party due diligence (banks or bond underwriters)
• If the project gets in trouble, lenders will help it, to protect their loan
Private-sector innovation, and project-management skills (efficiency)
‘On time and on budget’ – but this can be achieved without PPP (and PPP
costs increase during bid stage anyway)
Means that maintenance is actually done
• Transfer of maintenance / lifecycle risk to private sector
• Probably one of the best arguments for PPPs
Public-sector benefits:
• Improves procurement skills – e.g. London Olympics sites
• Forces public-sector into long-term thinking and budgeting
• ‘Contestability’ – comparing efficiency of public and private sector

(27)
Other arguments against PPPs

• Risk transfer?
• Valuation of risk transfer is very subjective
• Real risk transfer?
• Incomplete contract – can’t think of everything in advance
• Over-complex – too difficult for public sector to manage, expensive to
procure
• Contracting Authority has to ensure the public service continues if PPP fails
• ‘Privatising profits while socialising losses’?
• Distorts choice of project (e.g. rebuild v. refurbish)?
• Lack of long-term flexibility?
• PPPs and politics:

• Union / labour issues
• ‘Public service – private profit’

(28)
How not to do it – Mexico in the 1990s

1989-94: Private toll-toad programme awarded 53 concessions for 5,500 km
Investment of ca. $13bn
Miscalculation of costs, revenues, and Mexican currency crisis led to collapse of
programme by 1994 → failure to complete additional planned 6,500 km
Mexican banks left with non-performing loans of ca. $5bn
Large-scale government bail-outs required – only recently have most of these
roads been refinanced in the private sector
Causes:
• Poor tender procedures, mainly for the benefit of local construction
companies, little consideration of long-term viability of projects
• Inadequate bid competition (too many projects at once) → high construction
costs
• Government-owned banks lent with little due diligence
• Lack of institutional capacity in public sector, banks, construction industry
• Cost overruns from inadequate engineering and design work, failures to
secure rights of way, change orders, cost-plus contracts, permit delays
• Inaccurate traffic projections and unwillingness to pay, especially by trucks
• Failure to complete networks / connecting roads
• Poor toll collection procedures and poor control of cash flows
• O&M costs underestimated
• State governments failed to meet financial obligations… etc. etc….

(29)
Process Plant: Offtake Contract

(30)
Power-generation project
Electricity
Investors Lenders Gridco / Distributor

Power-Purchase
Agreement
Project Funding
Project
Company
Sub-Contracts Fuel-Supply
EPC Contract Operation & Maintenance
Contract Contract
EPC Fuel O&M

Contractor Supplier Contractor

(31)
Power Purchase Agreement
Power Purchase Agreement (‘PPA’), developed in the U.S, in 1980s, provides

structure for PPPs in general
Role of the PPA:
• Long-term power sale to a distribution company (public or private sector –

but if public can be considered a PPP)
• Security of revenue for Project Company, enabling it to raise PF debt
• Security of supply for the offtaker (power purchaser)

(32)
PPA tariff structure

Tariff structure / pricing fixed on signature of PPA
Capacity / Availability Charge – set at a level to cover:
• assumed operating costs
• assumed debt service (which follows from assumed construction cost)
• return on equity investment (ditto)
- paid even if plant is not despatched (“despatch risk”)
- provided the plant is capable of producing x MW of power
Energy Charge – set at a level to cover
• assumed quantity of fuel (e.g. gas) used, based on assumed efficiency
• cost of fuel per unit
• other variable O&M costs
Other Costs
• Other ‘one’ off costs which leads, e.g. to greater maintenances costs
• E.g. more than x cold start-ups per annum pay y per start-up
Indexation against inflation / exchange rates
No compensation for inefficiency – higher than expected
• debt caused by construction-cost overruns
• outages (availability)
• fuel consumption
• maintenance costs
→ loss of revenue and / or penalty payments

(33)
PPA - commercial viability
Contracts do not substitute for commercial reality
Does the project make commercial sense?

• Overall supply / demand for power
• Role of the project in the country’s power industry
• PPA price v. price charged to users
• Comparative cost of the power produced
Can the offtaker pay?

• Affordability v. price of power sold to the individual user
• Transmission losses
• General financial condition – may be unstable if power users are subsidised
• Privatisation of state-owned offtaker?
• State guarantee?

(34)
PPA - deductions & penalties

Low initial output
• Supposed to be 150 MW but only capable of 100 MW
• Either cut Availability Payment by 33%
• Or ‘buy-down payment’ – NPV of above; may be covered by penalty from
EPC contractor
High initial heat rate

• Ratio of amount of power generated by x amount of fuel
• High rate means will have to use more fuel to generate same amount of
power
• Either offtaker ignores and Energy Charge is not adjusted
• Or buy-down payment as above
Low availability
• If plant is to be available, say, 325 days a year, but is only available 300 days
(e.g. due to excess maintenance)
• Capacity Charge is adjusted by 300 ÷ 325

(35)
Fuel supply
Fuel supply agreement

• Pricing basis to match power sales
• Can Project Company assume “take or pay” risk?
• Penalties for failure to deliver?
Financing issues:
• Source of fuel:
• If from a dedicated source who takes risk of supply running out?
• If from the market who takes price risk?
• Credit standing of fuel supplier
• Physical connections (pipeline / road / rail)
Is a long term fuel supply needed?
• Supply risk
• Price risk

(36)
O&M Contract
Maintenance may be dome by Project Company

Often covered by Operation & Maintenance (O&M) Contract
Key issue – how much risk can be passed on to O&M Contractor, especially:
• Operating costs other than fuel
• Unavailability = maintenance downtime (planned and unplanned)
• Cost of maintenance (especially replacement parts)
Credit strength of O&M Contractor
Positions quite variable between different contracts

(37)
Transport PPPs

(38)
Toll-road concession
Authority

Concession
Agreement
Project Funding
Project Road Users

Tolls
Company
Sub-Contracts Construction Operating Maintenance

Contract Contract Contract
Design & Build Toll-Road Maintenance

Contractor Operator Company

(39)
Concession Agreement
Parties—Public Authority and Project Company
Term—typically long-term (25-35 years):
• to enable cost + profit recovery
• to transfer long-term risks, e.g. maintenance
Key contract provisions:
• Allocate responsibilities and risks, e.g. land acquisition, connecting roads
• Pre-agreed toll régime, e.g. base tolls + inflation on agreed formula
• Output specification (public sector says what is required not how to do it):
• Penalty régime:
• Service provision / “availability”
• Service quality incl. maintenance standards
• Accommodate change, e.g. extra lanes
• ‘Non-compete’ provisions?
• Termination arrangements
Most risks/obligations passed down to back-to-back sub-contractors
Provides a basis for funding by investors and lenders (equity + debt)

(40)
Should traffic risk be transferred?

The more risk transfer to the private sector the greater difficulty in financing
projects
Traffic risk in a PPP toll-road project raises basic risk-assessment issue:
• Can traffic (= toll revenue) risk be transferred to private sector?
• Issues with data collection
• Long-term traffic projections notoriously unreliable
• “Willingness to pay” / value of time saved – difficult to estimate
• Public sector generally (and prudently) overestimates
• “Winner’s curse”
• Traffic growth is a factor of:
• General growth in the economy
• Local development
• The local and national transport network
• Not under control of private sector investors / lenders
• Transferring traffic risk to private sector may inhibit public-sector ability to
manage the network as a whole
• “Non-compete” obligations
Alternatives are: government support [t.b.d.], Availability-Based Contract,
Shadow Tolls

(41)
Availability-based Road Contract

Availability payments (similar system to Capacity Charge in PPA) based on
fixed monthly payments, subject to deductions for:
• Lack of availability: e.g. road closed for accident or maintenance
• Poor service provision: e.g. road not kept free of rubbish
N.B.:
• Does not prevent Contracting Authority charging users tolls for the road
• Tolls can even be collected by the Project Company on behalf of Contracting
Authority
• Retains most of the traffic risk in the public sector – but usage does affect
long-term maintenance costs, for which risk with private sector
This PFI-Model approach deals with the issue of ‘willingness to pay’ by the
users, but not affordability issues for public sector (‘fiscal risk’)
‘Shadow tolls’ are an alternative approach – Contracting Authority pays tolls

instead of users – but still may cause affordability problems

(42)
PFI Model: Availability-based ‘Accommodation’ Projects

(43)
PFI Model – social infrastructure

Authority

PPP Contract
Project Funding
Project
Company
Sub-Contracts Construction Maintenance Services Contract (e.g. cleaning,

Contract Contract catering, security)
Design & Build Maintenance Services

Contractor Company Company

(44)
PFI schools projects

The British PFI programme is the world’s largest PPP programme:
• approx. 700 projects signed, which approx 650 are operational;
• total capital value approx. £55 billion (≈ US$80 billion).
U.K. Department for Education’s projects (mainly schools) have been a major
part of the total PFI programme:
• approx. 170 projects signed;
• total value approx. £8 billion (≈ US$13 billion).
Individual school projects too small to be economic as a PPP:

∴ mostly for ‘grouped’ schools projects: can be 20 or more schools in one
project – so U.K. has more individual school projects than any other type of
PPP.
N.B.: A school is just one type of ‘accommodation’ PPP project in the social
infrastructure sector: same principles can apply to, e.g., hospital, prison, offices.
And same ‘Availability-based’ Contract can be used for other sectors, e.g. roads
(instead of a Concession or ‘Shadow Toll’ contract).

(45)
How to structure a PPP school project?
Two basic types of PPP:

• usage-based, e.g. toll road
• output- and availability-based, e.g. power station.
Private sector could take usage risk for public-sector schools, but:
• usage depends on general public policies (and could restrict changes in
policy; cf. toll roads);
• not acceptable in U.K. for private sector to provide teaching in public
schools, only school buildings.
Or private sector could build a school, hand over to public sector, and then walk
away, with public sector making deferred payment?
• transfers construction risk but otherwise is just a simple loan;
• considered public-sector debt from completion of construction;
• has been used in some European countries but not U.K.

(46)
Output- / availability-based contract?
Typical power-station PPP pays according to:

• output: can the power station generate x MW of power?
• availability: can the power station produce its full output as and when
required (i.e. is it available)?
• throughput: payment for fuel use (not relevant for a school!).
Investors in a PPP power station are not told how to build or maintain it:
• design, construction and operation are at their risk;
• just has to be available to produce the agreed output (x MW).
Output / availability are easy to measure for a power station

• but can they be measured for a school?
• output specification cannot be a single measure (e.g. number of
megawatts);
• availability is not ‘on-off’ like a power station.

(47)
Output specification
Much more complex than a power station:
Construction output – schools must have, e.g.:

• x classrooms of a certain size
• dining room / assembly hall / sports facilities, etc.;
• design is not specified by the public sector (other than requirement to
meet building standards, etc.);
∴ design of school is proposed by bidders (and differs between bidders) to
meet the output requirements.
Service output also needs to be specified:

• maintaining what has been built and ‘lifecycle’ replacement;
• day-to-day services such as cleaning, catering, security:
Equipment may also need to be specified, e.g. desks, IT services.

(48)
Benefit of output specification?
Without output specification cannot transfer risk from public to private sector:
• If public sector designed the school any construction / operation problems
could be blamed on design, and claims made as in conventional ‘design-bid-
build’ procurement.
• Leaves private sector with long-term maintenance and lifecycle risks;
→ choices such as more cost now and less maintenance later, because have to
budget for whole-life cost of the school.
∴ Stimulates innovation by the private sector.
• Risk transfer = off-balance sheet for public sector

• e.g. EUROSTAT requirement that must transfer:
• construction risk plus
• either demand risk
• or availability risk.

(49)
Payment mechanism
Payment begins on completion – construction is funded by private sector.
Fixed constant monthly payments – ‘Unitary Charge’ (= service fee: not split as
for PPA)
• Calculated by bidders to cover:
• Operating costs
• Debt service
• Equity return
• Partially indexed for inflation
Payment deductions for:

• Unavailability
• Poor service quality

(50)
The PPP schools experience in U.K.
An enormous increase in school building.

• Difficult to imagine it could have been achieved in another way.
Lengthy procurement periods.
Projects generally completed on-time and on-budget.
• Exceptions relate to solvency of construction sub-contractors, but problems
have been absorbed by investors / lenders, not public sector.
• However → delays in delivery of completed schools.
∴ Public sector needs to pay more attention to credit quality of major
sub-contractors.
Design quality is adequate, but little evidence of major innovation.
Good level of performance on availability (very limited deductions)
Some concerns on quality of services, e.g. cleaning.
Concerns on long-term flexibility and the cost of change.
Much adverse publicity in newspapers and TV – poor Government
communication of the benefits of the PFI programme.

(51)
Risk Analysis, Allocation and Mitigation

(52)
Risk allocation
Theory:
• Project risks should be allocated to the party
• best able to manage them, and
• best able to bear the financial consequences
Dealing with commercial risks in PPP projects:

• PPP contract allocates project risks between the Contracting Authority and
the Project Company
• Sub-contracts move risks from the Project Company to sub-contractors
• Insurance ‘plugs holes’, where no party can take the risk

(53)
Contracting Authority and risk

Allocation of risk is a VfM (‘value for money’) question:
• Key element of the Public Sector Comparator (PSC) [t.b.d.]
• Specifically, is it more cost effective for the Authority to retain a risk or pass
it to the private sector, i.e. does the private sector price the risk higher (=
retain risk) or lower (= transfer risk) than the Authority would?
Contracting Authority’s primary objective is delivery of the service
∴ biggest risk is non-delivery
Contract penalties / deductions are a crude instrument for ensuring service
delivery
Contracting Authority does not normally get any financial guarantees / bonding
Contracting Authority’s main risk protections are
• due diligence before signature
• effective contract monitoring
• ultimate ownership of project

(54)
Optimism Bias
‘Optimism bias’
• key issue when considering risk assessment for the public sector
= tendency to underestimate costs in a public procurement:
• Underestimation of construction / operation costs, time to construct,
etc.
• Optimism may be needed to get approval for project
• Little career sanction if the public-sector official gets it wrong
• ‘Gold plating’ is further issue with costs of public procurement
Much of the risk of optimism bias → private sector in PPP contract (but some
risks will be retained by public sector)
And PPP procurement itself is not without optimism bias!

(55)
Investors and risk

Investors have:
• a relatively small equity investment;
• with a relatively high return.
Ultimately their equity investment is an ‘option payment’:
• payment of a lump sum;
• gives a right to future profits;
• limits their risk; and
• gives them the option to walk away from a failed project and lose no more
money.
Often willing to leave more risk in the Project Company, but constrained by
lenders’ requirements
Not in investors’ interests to give guarantees to Contracting Authority or lenders
as it destroys the value of their option – loses a main benefit of the project-
finance structure

(56)
Lenders and risk
Debt is cheaper than equity, so

• High gearing (ratio of debt to equity) produces a lower total cost of funding,
but
• High gearing creates greater risk for the lender
Lenders’ return is limited – fixed return over cost of funds – and has downside
but no upside
∴ Project risks must be limited – ‘A banker is a man who lends you an
umbrella when it’s not raining.’
Lenders want the Project Company to be an ‘empty box’, with risks transferred
to other parties, e.g.:
• sub-contractors (construction / operation / maintenance)
• insurance
• Sponsors
• Contracting Authority
As lenders are most conservative, their attitude to risks is the lowest common
denominator and so determines what goes in the PPP Contract

(57)
Risk matrix
Risk analysis (by all parties) based on:
• Identifying all possible project risks (however remote)
• Measuring effect of these risks on project’s ability to service debt
• Looking at what mitigations exist in the project’s contractual structure: e.g.
are risks passed through to sub-contractors?
• Considering whether residual risks are acceptable
N.B.: Lenders concerned about low probability / high impact risks:
• may require a disproportionate amount of negotiation / evaluation
Analysis in blocks, e.g.:
• Site risks
• Construction risks
• Revenue risks
• Operating risks
• Legal / regulatory risks
• Residual-value risks
• Macro-economic risks (interest rates and inflation)
• Political risks (other than legal/regulatory) [t.b.d.]
• Private (debt) finance (can it be obtained, on expected terms?)
The role of insurance also has to be considered:
• Insurance for physical damage and consequential loss of revenue
• Political risk insurance [t.b.d.]

(58)
Risk-transfer - outline framework

Risk transfer under most PPP contracts follows similar general principles:
• Site risks to Contracting Authority
• So if the Contracting Authority does not make the site available on time
it will have to pay compensation for the delay
• Design / construction risks to Project Company
• So if the school is completed late or over budget no payments are made
and the revenue is therefore lost.
• Construction sub-contractor will pay penalties to compensate.
• Most operating risks to Project Company:
• High opex / maintenance / lifecycle, or payment deductions, reduce
net revenues
• Usage / revenue risk transfer depends on type of project
• Some risks / deductions may be passed down to services sub-
contractor and O&M / building maintenance sub-contractor.
• Macro-economic risks may be shared:
• High interest rates reduce revenues (unless fixed or hedged).
• Payment mechanism may hedge against opex inflation.
• Currency exchange-rate risk depends on revenue currency.
• Political risks – legal / regulatory or wider political problems
• Mainly to Contracting Authority
Insurance covers most force majeure (Acts of God).

(59)
Political risks
PPPs need strong political support – important that this is from government and
opposition, so if there is a change of government, policy does not change.
PPPs also very difficult to negotiate if the Contracting Authority’s staff don’t
want to enter into the PPP – unless there is firm political direction.
Sub-sovereign risk – further issue if Contracting Authority is not central govt.
Investors / lenders may want political-risk guarantees – provided by DFIs, ECAs

Political risks originally defined as:
• currency convertibility and transfer
• expropriation of the project by the state
• political violence
Newer category of ‘creeping expropriation’ – powers of the state are used against
the Project Company. So typical political risk guarantee also covers, e.g.:
• contractual payment obligations (including termination payments).
• Government action or inaction with a material adverse impact on the project
• frustration of arbitration (refusal to recognise award).

(60)
Why do projects fail?

Triggers for failure:
• Sponsors fail to comply with contractual obligations, e.g. further
investment;
• Sponsors’ inability to raise finance
• Construction sub-contractor underestimating costs / relying too much on
income from equity share / misunderstanding D&B obligations
• Underestimation of operating costs / over-estimation of revenues from
concessions
• ‘Winner’s curse’ / PPP contract renegotiation
• Political interference
• Abandonment of project by Project Company and Sponsors
Causes
• Inexperienced Contracting Authority – poorly drafted contracts
• Aggressive ‘low ball’ tendering, with the aim of renegotiation
• Inexperienced Sponsors – misunderstanding of what they are taking on
• Government / opposition turning PPP into political football

(61)
Public-Sector Support for PPPs

(62)
Reasons for public-sector support
PFI-Model / process-plant projects with a Contracting Authority has support

simply because payments are coming from public sector
Even Concessions create contingent liabilities, e.g. retained risks and
termination payments
Otherwise public-sector support may be provided for a variety of reasons:
• For financial-market reasons: e.g. lack of long-term finance without some
support
• For financial-viability reasons: support needed because project would not
be financially viable if all its finance were raised on market terms.
• For cost reasons: i.e. to reduce the cost of private finance and hence reduce
payments by Contracting Authority, or by users.
• To reduce political risk: need for clear government cover for political risks

(63)
Types of public-sector support
Viability-Gap Finance
Subsidy
Minimum revenue guarantee (MRG)
Debt guarantee
Mezzanine debt
DFI finance

(64)
The Procurement Process

(65)
PPP Project Cycle
PPP project cycle can be divided into 7 main stages from Contracting Authority
point of view:
Inception: set up project governance; appoint advisers
Feasibility Study: needs and options analysis, evaluation, procurement plan
Preparation for market: prepare request for proposals; draft PPP Contract
Procurement: pre-qualification; negotiation → preferred bidder; signing
Construction: monitor; deal with any changes*
Operation: ditto
Handback: ensure handback condition
PPP procurement is far more complex than standard public-sector procurement:

• Has to consider long-term operation phase, not just construction
• Has to take private finance into account
• Needs strong governance to get it right

(66)
Feasibility study
Benefits:
• information about project costs, and whether these can be met from within
the Contracting Authority’s budget or by user fees;
• identification, quantification, mitigation and allocation of risks;
• a basis for considering how the project will be structured;
• identification of constraints which may cause the project to be halted; and
• ensuring that the project is developed around a proper business plan.
Some typical errors:

• gaps in the evidence supporting the argument;
• insufficient investigation of demand risks;
• excessive risk transfer to the private sector;
• costings not derived from market-based information;
• proposed financial structure is not viable
Initial market soundings (including talking to DFIs) are important

(67)
Feasibility study: contents
Key topics:
• Needs and options analysis

• Project scope
• Output specifications and performance requirements
• Socio-economic assessment
• Technical viability
• Risk identification and analysis
• Costings
• Payment mechanism
• Financial modelling and sensitivities
• Value for Money
• Affordability

(68)
Value for Money
UK Treasury:
‘…PFI should only be pursued where it delivers value for money (VfM), where
VfM is the optimum combination of whole life cost and quality (or fitness for
purpose) to meet the user’s requirement, and does not always mean choosing
the lowest cost bid. (Value for Money Assessment Guidance, 2004)
How can VfM be achieved?

• Programme level = Qualitative evaluation
• Is this project inherently suitable as a PPP (see slide 9)?
• Project level = Is it VfM to procure this particular project as a PPP?
• Can this be demonstrated in quantitative terms (i.e. PPP is ‘cheaper’)?
→ ‘Public-Sector Comparator’ (PSC)
• Procurement level
• Is this PPP project procurement being run in a way which will produce
best VfM?
• Primarily achieved by competitive pressure
But even if the project stands up in VfM terms, is it ‘Affordable’?

(69)
Quantitative VfM evaluation

A PPP appears to be inherently more expensive than a direct public
procurement because its cost of finance will usually be lower because:
• Government can borrow more cheaply than the private sector
• But Government borrowing does not take risk into account
• Risk on Government projects is borne by taxpayers, not lenders
∴ To show that a PPP is better VfM than public procurement in quantitative

terms, we need to
• compare cost of public-sector procurement v. cost of PPP procurement =
‘Public-Sector Comparator’ (PSC).
• N.B.: whole-life comparison – construction and operation costs
• to show that, when you allow for risk transfer, the PPP route is better VfM
• i.e. the ‘true’ net cost of public procurement is greater than the PFI route
Issues:
• How to value risk transfer?
• When should you do the calculations?

(70)
Affordability
PPPs provide finance but not funding
Someone – either the public sector or the user – has got to pay over time
Public object to paying for something ‘the government should provide’ (e.g. a
road) or is ‘provided by God’ (e.g. water supply)
If payment for existing infrastructure – e.g. toll roads – has not kept pace with
costs → difficult to price new infrastructure properly
Social infrastructure likely to rely on public-sector payment (PFI model)

→ fiscal problems: i.e. cannot be properly afforded within overall budget

(71)
Procurement procedure
Typical procurement / review stages:
• Pre-qualification (pre-qualify say 4)
• Request for proposals (cut down to 2)
• Negotiation on proposals
• Best & final offer (BAFO) from remaining 2 bidders
• Bid evaluation
• Preferred bidder
• Commercial Close / Financial Close
• No substantive negotiation after appointment of PB
Bid evaluation: Simple price evaluation not appropriate:

• “Two envelope” system: bidders have to pass minimum hurdles e.g.:
• technical feasibility
• deliverability (including finance)
• adherence to risk transfer and other aspects of proposed PPP contract;
then open second envelope and the best price bid wins
• Single evaluation: Different factors are given a percentage, e.g. cost 40%,
technical and deliverability 30%, legal (= risk transfer) 20%, design 10%;
bidders scored against each factor and the best score wins
• Problems of transparency if negotiations take place after contract award

(72)
Relationship with lenders
Important to ensure that bidders have appropriate levels of lender support at

each stage of procurement process:
• Feasibility study: should include evidence that the project is likely to be
“bankable”. Direct discussions with potential lenders, including DFIs, is one
way to help establish this.
• Pre-qualification: Initial letters of support from potential lenders (other
than multilateral DFIs, which cannot support any particular bidder): not
legal commitment on the lenders’ part, but lenders usually take such letters
seriously.
• Initial bid: Evidence of bank support, including a term sheet, but subject
to further due diligence and final credit approval
• Negotiations: Contracting Authority ideally does not deal with lenders but
leaves this to bidder, but realistically some negotiation with lenders may be
needed to ensure that project remains bankable
• Final bid (BAFO): At this stage lenders should confirm that the terms of
their loan are agreed, provide a final draft loan agreement, and confirm that
they have received the necessary credit approvals.

(73)
Unsolicited bids
World Bank (PPP Reference Guide):
…there is a place for genuine and innovative [unsolicited] proposals, but these are the
exceptional case. The private sector must put up strong independently analyzed cases
for unsolicited proposals at an early stage, before governments are sucked in to
supporting projects that are financially weak, high risk, will take up significant
human resources of the government, and will likely take a longer than normal time to
implement because of these difficulties.
Undesirable in early stages of a PPP programme
Often fail to produce expected benefits / raise finance / keep to schedule
Tie up limited public-sector PPP expertise, so hamper programme development
Go for ‘low-hanging fruit’ – the obvious easy deals, no added value
Private sector feasibility study is not a substitute for public-sector work –
seldom saves money or time
Difficult to fit within proper competitive procurement procedure:
• Can be done by BAFO prequalification, payment of development fee, bid
bonus for evaluation, Swiss challenge (= right to match) – but none are ideal
Often linked to corruption

(74)
Published 2002 Published 2007
Further information:
www.yescombe.com

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Module 3: Covering Business

2-4 September 2013

©YCL Consulting Ltd. September 2013

Why is infrastructure different?

But historically state did not provide much infrastructure:

State can provide or facilitate provision of public infrastructure

©YCL Consulting Ltd. September 2013

Public-private partnership (PPP, P3)

Private finance for construction of new (or upgraded) public infrastructure

©YCL Consulting Ltd. September 2013

U.K. development of PFI Model – the public sector pays :

©YCL Consulting Ltd. September 2013

‘Boundary lines’ for PPPs

©YCL Consulting Ltd. September 2013

Public procurement / privatisation

PPPs v. standard public-sector procurement:

©YCL Consulting Ltd. September 2013

The public → private spectrum

©YCL Consulting Ltd. September 2013

©YCL Consulting Ltd. September 2013

Projects suitable for PPPs

What projects are suitable in principle for PPPs?

• the project provides an essential public service;

©YCL Consulting Ltd. September 2013

Sectors suitable for PPPs

PPP Contract – key features

Various names: Project Agreement, Concession Agreement, Power Purchase

©YCL Consulting Ltd. September 2013

©YCL Consulting Ltd. September 2013

Introduction to Project Finance

©YCL Consulting Ltd. September 2013

What is project finance?

Why do I need to know about this?

©YCL Consulting Ltd. September 2013

Industries using project finance

All involve major long-term project investments

©YCL Consulting Ltd. September 2013

Equity Project-Finance Debt

EPC Fuel O&M

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Equity Project-Finance Debt

Project Road Users

Sub-Contracts Construction Operating Maintenance

Design & Build Toll-Road Maintenance

©YCL Consulting Ltd. September 2013

PFI Model – social infrastructure

Equity Project-Finance Debt

Sub-Contracts Construction Maintenance Services Contract (e.g. cleaning,

Design & Build Maintenance Services

©YCL Consulting Ltd. September 2013

Equity and debt

Project-finance debt, provided by lenders

©YCL Consulting Ltd. September 2013

What do lenders expect?

©YCL Consulting Ltd. September 2013

Why investors use project finance

Benefits for investors:

©YCL Consulting Ltd. September 2013

Benefit of PF to the public sector

©YCL Consulting Ltd. September 2013

PPPs — For and Against

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PPPs vs. public procurement

©YCL Consulting Ltd. September 2013