Finer points key to PPP success

By Martin Preston

Traditionally, governments have procured infrastructure by entering into a contract for the construction of the relevant asset such as a road, school, hospital, etc and taking over the operation and maintenance of the asset when it is completed.

An alternative means of procurement is for a government to enter into a public-private partnership (PPP) with a private sector entity (the project company) to finance and construct the relevant asset and then to provide the associated services under a concession agreement for a fixed period, typically 20 to 25 years.

The advantage to a government of this approach is that it is not required to fund the upfront capital expenditure required to build the asset. Instead, the private sector will fund the construction costs, typically through a mixture of debt and equity, and the income received by the private sector over the term of the concession agreement is used to repay the debt and to provide a return on equity.

Other advantages of a PPP approach may include lower overall costs (as the construction will factor in whole-of-life costs so that operational factors and reduced maintenance are given a higher priority than they may have been had a project been tendered on an engineering, procurement and construction – EPC – basis) and greater efficiencies as private sector expertise is brought in to operate and manage the project.

One of the concerns that governments sometimes have about PPP is that it means losing control of an asset and/or service that would traditionally come under the control of the government. However, such concerns can be allayed as a well-drafted concession agreement should enable the government to step in and/or terminate the concession agreement in the event of poor performance by the project company.

The concession agreement is the key document under which the government grants the project company the right to construct and operate the asset. The services to be provided under the concession agreement should be in terms of an output specification. In other words, the concession agreement should set out the services that the project company has to provide but should not be too prescriptive about how those services are provided. It is then the project company’s responsibility to design, finance, build and operate the asset in order to meet the output specification.

There are two ways in which the project company may be paid for the services it is providing under the concession: by way of payment from the end-users (so, in the case of a toll road, the users of that road) or on the basis of availability payments from the government itself.

If payment for the services is by way of a charge on end-users, this will result in the project company taking demand and collection risk for the services with no guaranteed payments from the government. If this approach is to be adopted, it will be necessary to ensure that enabling legislation is in place to allow the project company to charge end-users directly as this may not otherwise be permitted by law notwithstanding the project company’s contractual right to levy such charges.

The project company will also want to ensure that the government does not build a competing asset that affects the demand for the project company’s services (such as, for example, a new road that diverts traffic from the road that the project company is responsible for). It is not usually possible to fetter a government’s discretion to build competing infrastructure, so this is generally addressed in the concession agreement, with the project company either being entitled to relief (payment by the government of the shortfall in revenue or an extension to the term of the concession agreement to give the project company more time to make a return on its investment) or to terminate the concession agreement for government default.

If a project company (and its lenders) are to accept a concession agreement under which the project company is to take end-user demand and collection risk, they will need to be satisfied both that the demand is there and that it is politically acceptable to levy charges on the public for the services provided. This was graphically illustrated by the Skye Bridge PPP project in Scotland, which was vehemently opposed by locals (many of whom refused to pay the toll) and was ultimately taken over by the government.

The alternative to direct tolls is for payment to be made by the government on the basis of availability. What constitutes availability will depend on the type of asset and will need to be reviewed on a project-by-project basis. What is important is to ensure that availability is sufficiently accurately defined as it is against this definition that the project company will be paid and/or suffer payment deductions for poor performance. Additionally, consideration should be given to the concept of deemed availability, where the project is deemed to meet the availability requirements if the reason for any availability shortfall is due to a government default or the occurrence of a risk for which the government is responsible.

Typical risks that would be borne by the government include delayed access to the site (if the government is providing the site, as is usually the case), the obtaining and maintaining of permits that have to be obtained by the government, political force majeure and changes in law. How these are addressed will depend on the particular jurisdiction so that in relation to, for example, change in law, the government may provide relief for any change in law, or just for those that result in the project company incurring costs above an agreed threshold or only for those that affect the project (or the sector it is in) but not for general changes in law, which may be seen as part of the risk of doing business in that country and not impacting on the project company any more than any other company operating in that country.

Most other risks will – bar any special circumstances affecting the particular project – typically be assumed by the project company, who will seek to pass these risks onto its subcontractors or, in the case of natural force majeure, its insurers.

Termination of the concession agreement and the compensation that may be payable on compensation are of critical importance to the project company and the lenders as they are each entering into the project on the basis that they will be repaid (in the case of the banks) or receive a return on their equity (in the case of the shareholders in the project company) from the long-term provision of the services under the concession agreement by the project company. They will be concerned that an early termination of the concession agreement will mean that the debt is not repaid and/or that there is no return on equity.

Given the long-term nature of the concession agreement, the events allowing the government to terminate the agreement should not be “hair triggers” but should result from poor performance over a reasonable duration of time and allow the project company the opportunity to cure the default before the government is permitted to terminate the agreement.

Typical events enabling the government to terminate for project company default include insolvency of the project company, penalty points or deductions for poor performance exceeding a threshold level, abandonment, failure to complete construction of the underlying asset by the longstop date and assignment of the project agreement without consent.

Should the government have a right to terminate the concession agreement for project company default, the lenders will be able to step in under their direct agreement and seek to cure the default prior to the government terminating the concession agreement. The government’s right to terminate the concession agreement will be suspended for an agreed period while the lenders seek to cure the default in question.

Linked to the issue of termination is the question of what compensation is paid to the project company on a termination for project company default. The lenders will seek to have their debt repaid in full on the basis that this has been used to construct the underlying asset (such as the road, hospital, etc) which the government now has control of and which it is able to operate either itself or through a new third-party operator.

Gulf Construction

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