In the UK, the head of the National Audit Office (the body scrutinising public spending on behalf of Parliament) has called for a project-by-project review of future private finance initiative contracts, with stricter criteria being employed than in the last two years, to establish the most appropriate funding methods. The “Private Finance Initiative” is the UK’s own version of Public Private Partnerships or PPP and since its inception in the early 1990′s has resulted in over 500 operational projects in England alone with a capital value in excess of £28 billion (according to the National Audit Office Report published 3 November 2009).

Whilst obviously specific to the UK and PFI, the NAO’s report is revealing about the effects of the banking crisis on privately financed projects (PPP) and more interestingly, about the likely prospects for such projects in the future. Its recommendations for how such projects can be more efficient and offer better value for money make interesting reading in light of the UK government plans to put in place “an economic, efficient and effective strategy for financing public services”.

Approval of Treasury response to the credit crisis

The report commends the previous Labour government in its commitment to “reactivating” the financing market at a time when finance became increasingly unavailable, limiting the opportunity for the agreement of sizeable contracts. It also commends the Treasury’s approach at this time and suggests it was successful when establishing the Infrastructure Financing Unit in March 2009 to address the scarcity of debt finance. The Unit was tasked to ensure that 110 privately financed infrastructure projects (exceeding £13billion) would continue by funding any shortfalls in bank finance. For example, this Unit directly assisted the “Greater Manchester Waste Project” in April 2009 providing £120million to the project.

The UK Treasury’s willingness to lend improved market confidence and 35 government infrastructure projects were subsequently agreed without further public lending. However, although banks continued to lend, priority was given to closing deals at prevailing market rates, even if that meant that the public sector was paying more and the private sector was taking on less risk. The total interest cost of bank finance increased by one-fifth to one-third despite the fall in short-term borrowing rates and little change in the risk profile of the projects concerned.

Warning: Change to come

The NAO’s report reveals that higher financing costs added 6-7% to the annual charge of PFI projects. Between £500m and £1billion in higher costs has been built in over 30 years, although this has been partly offset by an increased public sector share in refinancing gains. In October 2008 the Treasury increased the public sector share of such gains from 50% to 70%.

The warning issued by the NAO is that, while the extra finance costs for projects in 2009 were able to provide value for money in the short term and achieve the government’s objective of stimulating the economy, “the Treasury should not presume that continuing the use of private finance at current rates will be value for money”.

Value for Money and Funding Options?

The Report states that the Treasury was justified in not reconsidering the individual business case of projects in 2009 but that in future, there should be “no presumption, based on previous business case analysis, that continuing the use of private finance at current rates will provide value for money”. In addition, the NAO recommends that more exacting and narrower criteria be applied to projects in development than at the height of the crisis. Key recommendations to the Treasury include:

• Analysing the lessons of the last two years with the view to preparing a contingency plan for how government departments should handle future market disruption affecting procurement plans.
• Where there are material changes, such as project costs increasing by 15%, require the department to re-evaluate the project. Such a re-evaluation would “assess all the benefits, and potential loss of benefits, of continuing the project in its current form, compared to other available options, including other forms of procurement”.
The report also highlights a number of alternative funding models for projects that are being developed and that greater emphasis should be placed on assessing the merits of other models when addressing funding issues. These funding models / options have the potential to be key factors in the future implementation and success of PFI projects. Recommendations to the Treasury include:
• During procurement, departments should assess a range of funding options to assess value for money including all public finance or part public and part private finance.
• Government departments should make greater use of sensitivity analysis to inform their decision-making when negotiating small changes in finance rates or considering requests to take on additional project risk.
• Continue to consider how a greater mix of finance sources, with less emphasis on the use of commercial bank loans, can be used to finance infrastructure projects. For example, other options highlighted include the approach of the French government in guaranteeing 80% of debt when a project is operating successfully and loans from the European Investment Bank which is generally able to make funding available on more favourable terms than commercial banks.
• The adoption by the Treasury of a portfolio approach to refinancing, so that individual authorities do not exercise any right to a refinancing on a piecemeal basis. Such an approach would enhance the public sector bargaining position, reduce transaction costs and increase potential gains.

The Future?

 There is a note of optimism in the Report. Infrastructure UK, the new coordinating body established within the Treasury “estimates that the Government needs to continue to encourage substantial investment in new infrastructure, possibly £40-50 billion per annum until 2030″.

Now comes the difficult bit – implementing the recommendations of the Report – and providing structures and funding for PFI projects that secure better value for money. If the private sector’s enthusiasm for PFI was cooling because of high bid costs and lengthy tendering periods, the tendering process will become an even more crucial part of the whole PFI deal, for both the public and private sector. The potential of increased unavailability of government funding will mean that the public sector has few choices outside PFI for the funding of capital projects and a focus and investigation of a variety of alternative funding options will be needed.

Do you have any experience of developments outside the UK for increasing the efficiency of similar projects – and particularly the tender process? If so, your input will be very welcome!

Liquidated Damages in UK PPP transactions

In the UK, the general presumption is that a Project Company will not be liable for delay liquidated damages in the event that the service availability date (or “commercial operation date”) is not achieved by the relevant target service availability date (or “scheduled commercial operation date”). Indeed, English guidance suggests that delay liquidated damages should only be included in exceptional circumstances.

The main reasons for this are three fold:

First, English law prohibits the levying of penalties and liquidated damages must be a genuine pre-estimate of loss. In the majority of PPP projects it is difficult to envisage how a procuring authority will suffer any loss and, accordingly, how liquidated damages will be held to be anything other than a penalty. This is because the procuring authority is unlikely to have made any capital contribution or other payment during the construction phase and the fact that it will not be obliged to pay the service charge until the service availability date is actually achieved. Therefore it is unlikely that the loss that the procuring authority suffers as a result of any delay to commencement of the service will be greater than the service charge it will no longer be obliged to pay in respect of such delay.

Secondly, the way in which PPP projects are structured means that there is already a large incentive on the Project Company (and the Construction Sub-Contractor) to achieve the service availability date on or before the target service availability date. As mentioned above, the procuring authority will not start paying the service charge until the service availability date is achieved. However, the payment profile of senior debt (principal and interest) is likely to require repayment to start on, or soon after, the target service availability date. Where, as a result of delay, the service charge is not being paid to the Project Company on the date that it has to start making debt repayments then the Project Company has a funding gap. This funding gap is filled by the Project Company levying delay liquidated damages on the Construction Sub-Contractor under the Construction Sub-Contract. Accordingly, the Construction Sub-Contractor is incentivised to minimise delay through the operation of a delay liquidated damages mechanism even where no such mechanism exists in the Project Agreement.

Thirdly, best value for money is not likely to be achieved by including a delay liquidated damages mechanism in a Project Agreement. As we have already seen, a PPP Construction Sub-Contract is likely to include a delay liquidated damages mechanism even if the Project Agreement does not. The Construction Contractor will mitigate its exposure to such delay liquidated damages by both including a financial contingency in its price and a time contingency in its construction programme. Both such contingencies will be included in the Project Company’s service charge and construction programme. Should the procuring authority include a delay liquidated damages mechanism in the Project Agreement, then the Project Company will simply pass down in full such mechanism to the Construction Sub-Contractor in addition to the “debt service” liquidated damages that would have be included in any event. Obviously the effect of this is that the financial and time contingencies in the project would be significantly increased and this is unlikely to provide best value for money.

The common position in the Middle East

General market practice in the Middle East is almost entirely the opposite. The inclusion of substantial delay liquidated damages in PPP/BOT Project Agreements is common. Of course, this means that a full pass down of risk from the Project Company will require the Construction Sub-Contractor to assume both the Project Agreement delay liquidated damages and well as the “debt service” delay liquidated damages (referred to above). This is likely to create a significant daily liability for the Construction Sub-Contractor.
The reasons for such a differing approach could be down to the combination of a number of factors:

The law of most Middle Eastern countries does not prohibit penalties in the same way that English law does. Accordingly, there is less of an emphasis on whether the Project Agreement delay liquidated damages are a genuine pre-estimate of loss. However, note that under the Civil Code of many countries in the region, where the amount of compensation payable in respect of a breach has been fixed in advance by the contract (eg. delay liquidated damages) a party may apply to the court and request that such compensation be adjusted to reflect the actual loss suffered by the relevant party. In some jurisdictions that adjustment may be downwards only, in others it may be upwards or downwards. Whether the courts actually exercises that discretion in practice is a different matter and difficult to predict.

The majority of PPP / BOT projects tendered to date in the region are for process plants and not accommodation based projects. It may be that the price that the procuring authority would pay for the relevant off-take (eg. power or water) under the relevant purchase agreement is significantly less than the price that it is paying, or costs that it is incurring, for its current supply. In such circumstances it is possible to envisage that any delay in achieving the commercial operation date could cause the procuring authority to suffer a loss.

The procuring authorities in the region are not subject to the same obligations to achieve “best value” as their counterparts in the UK. Often, as is typical in the region, the emphasis is more on the speed of delivering the relevant asset than on achieving the absolute best value solution. To an extent, and certainly from a presentational perspective, it is possible to understand why this could lead to including delay liquidated damages in the Project Agreements.

Finally, there other cultural, commercial and structural factors. For example, whilst there have been a number of PPP / BOT projects in the region, some on a staggering scale, the market is still in its relative infancy and is a melting pot of different international contractors and advisors, each with a different idea of the “correct” way of doing things and all with a desire to do business in the region. Arguably, this leads both to the seeking of commercial positions that would not, necessarily, be sustainable in other markets as well as the willingness to accept commercial positions that may be severely resisted in the relevant home market. It remains to be seen whether an economic upturn might lead to a hardening of position on this and other points by the private sector.

Co-authored by Rob Graham, an associate in Pinsent Masons’ Dubai office

The administrative concession is defined in Article 2, paragraph 2 of PPP LAW as a “service agreement in which the government entity is the direct or indirect user, even if such agreement involves performance of works or supply and installation of assets.” This type of concession is governed by PPP LAW, by Articles 21, 23, 25 and 27 through 39, of Law No. 8987, 1995 [FED. LAW 8987], and by Article 31 of Law No. 9074, 1995 [FED. LAW 9074]. An administrative concession contract is that by which government entities delegate performance of a public service to a private company. Such private company will develop the activity for its own account and at its own risk for the period and on the conditions agreed in the respective contract. In administrative concessions, services are directly or indirectly provided to government entities. For instance, the government entity may open competitive bidding procedures for the construction and operation of hospitals and prisons.

The sponsored concession, as defined in Article 2, paragraph 1, is “the concession of public works or services as dealt with in FED. LAW 8987 when it involves, in addition to the fees charged to users, payment of a compensation from the public partner to the private partner.” A sponsored concession is actually an ordinary concession in which the State gives some type of consideration. This type of concession is governed by PPP LAW by FED. LAW 8987 and related legislation. A sponsored concession may be adopted, for instance, in the cases of railways and highways in general.

Article 2, paragraph 3, of PPP LAW expressly stipulates that “the ordinary concession, i.e. the concession of public works or services as dealt with in FED. LAW 8987, will not be considered a public-private partnership when it does not involve payment of compensation from the public partner to the private partner.” Reflecting a general concern about the manner in which PPPs are to be conducted, PPP LAW also lays down the following guidelines:
(a) Efficiency in complying with the State’s missions and in using the company’s funds (due care in the use of the public funds invested in the activity);
(b) Respect to the interests and rights of service users and of the private entities charged with performing the services;
(c) Non-transferability of regulatory and jurisdictional duties, the exercise of police power and other activities inherent to the State;
(d) Fiscal responsibility in the execution and performance of partnerships, as Article 10, I(b) of PPP LAW stipulates that the rules set out in FISCAL RESPONSIBILITY LAW must be observed;
(e) Transparency in procedures and decisions;
(f) Objective sharing of risks between the parties; and
(g) Financial sustainability and socioeconomic advantages of PPP projects.

These guidelines mirror the spirit of care the legislator wishes government entities to adopt when contracting PPPs, reminding them of certain principles and concepts already contemplated by the legislation applicable to contracting of works, services, and other items by government entities with companies of the private sector.

Generally speaking, PPPs operate as an arrangement between the public and private sectors for execution of works originally entrusted to public concerns, which lack funds and/or expertise. As far as this concept is concerned, PPPs and ordinary concessions may seem to be very similar this is not necessarily true.

Even though both PPPs and ordinary concessions are administrative contracts between the government authorities and a private entity, more specifically concession contracts in a broad sense – concession contracts, in their broad sense, comprise all those in which government entities delegate the provision or performance of services (whether or not preceded by public works) to a private entity, which will perform the activities inherent to the services and assume the business risk under the contractual conditions. Prevalence of the public interest and an assurance of the original economic and financial conditions also constitute essential characteristics of concession contracts – there is a substantial difference between them: while in ordinary concessions, regulated by FED. LAW 8987, the compensation obtained by the contracted concessionaire (private entity) always originates from the service users only, in PPPs the compensation is fully or partially paid by the public partner to the private partner. In sponsored PPPs, the compensation received by the concessionaire from service users is, in principle, supplemented by the compensation paid by the public entity to the private entity, whereas in administrative PPPs all the compensation is paid to the private partner by the contracting public entity itself – Article 2, paragraphs 1 and 2, and Article 6 of PPP LAW.

In other words, PPPs are slated for services and/or public works that do not generate sufficient compensation to the contractor (e.g. expansion and management of highways or railroads with few users) or that do not even involve payment of fees by their users (e.g. construction and management of penitentiaries or public hospitals). Therefore, in addition to dealing with cases requiring investments and/or specialization beyond the possibilities of the public entity, PPPs have another specific characteristic: the venture itself is unable to pay off. These are the basic differences between PPPs and ordinary concessions, and should serve as guiding principles in bidding procedures, analysis of proposals and, particularly, concession contracts regulating PPPs.

Unlike ordinary concession contracts, PPP contracts are subject to more extensive and complex regulations: in addition to traditional clauses such as contractual term (which is considerably longer), PPP contracts must provide for rather specific aspects difficult to be expressed in few general terms. Therefore, PPPs cannot adopt near-standard draft concession contracts, which are mostly adhesion contracts.

The methods of compensation and the guarantees tendered (guarantee fund, insurance, etc.) by the public entity to the contractor, the risk sharing between the parties, the possibility of transferring the special purpose company (a legal entity incorporated to enter into PPPs) to financiers in case of default, the definition of performance evaluation criteria in accordance with the contractual term, among others, will be a matter of concern of those involved in drafting and negotiating PPP contracts. Certainly, this will require a more active involvement of bidders in drafting the contracts, which might result in an ample and detailed document, very probably in similar terms of common law contracts. This obviously strengthens the importance – after the phase of comparative law examination – of studying in advance examples of successful PPP contracts abroad, particularly the pioneering PPP contracts in England.

Having described the fundamental differences between PPPs and ordinary concessions, it is worth dealing once again with their contractual similarities. Both are kinds of administrative concession contracts. For this reason, PPP LAW expressly provides that PPP contracts must meet the general requirements of FED. LAW 8987 for ordinary concession contracts, such as: tariff adjustment mechanisms; methods and standards for service evaluation, expansion and inspection; indemnity calculations; users’ rights and duties; and periodical rendering of accounts by the private party to the public party. As a consequence of this legal provision, the caution taken when drafting PPP contracts must be redoubled, i.e. FED. LAW 8987 must be observed, insofar as applicable, and PPP LAW must be fully observed.

Generally speaking, once this new channel of investments is opened, there are very positive prospects of its use and results. However, it is important to stress the relevant and specific features (which have only been outlined above) of PPPs vis-à-vis ordinary concessions, notably when it comes to the careful drafting of PPP contracts.

Why is it relevant for PPPs?

As most readers of this blog will be aware, PPP projects are usually largely funded by debt borrowed by a Special Purpose Vehicle (SPV). The SPV uses the money to build an asset gets paid by the public sector for the provision of services or utilities connected to that asset over the long term. The payments to the SPV come from the relevant public authority to whom the services/utilities are provided eg the schools authority, or the power offtaker.

So you can see that for the lending banks and the shareholders in the SPV (Sponsors) it is important they are comfortable that the government entity responsible for the payments necessary to repay the debt will make those repayments.

PPPs have been planned in the region for rail projects, road projects, power projects, desalination projects, wastewater projects, schools projects…..The region is looking to PPP to fund urgently needed and critical infrastructure.

Tough times already

PPP projects in the region had already been hit hard by the global economic crisis, with a number of large projects being financed on an expensive short term basis until lending conditions improved.

However, at the regional gathering of the International Project Finance Association in Abu Dhabi on Wednesday afternoon, shortly before the Dubai World story broke, and a day after the successful financial close of the USD1 billion Zayed University project by Mubadala, it was generally thought that 2010 would be the start of the upturn. What a difference a day makes…

Or will it?

Can Banks and Sponsors draw a distinction between the Dubai World story and government debt? As the media in this part of the world is emphasising, Dubai World is a government related entity and not the Dubai government. In addition, in PPP transactions in the region it is very common for banks to insist on state guarantees anyway as they very keenly aware of the financial covenant of the ultimate re-payee of their debt. Therefore, perhaps theoretically, it should be business as usual.

However, there is concern already that it might not be that straightforward. Worries about the fragility of the Dubai economy have led to worries about repayment of debt from other countries, and Abu Dhabi may suffer if it doesn’t stand behind Dubai, as it may be argued it allowed investors to believe it would.

A rethink in the air

It may be for this reason that The National, a local newspaper based in Abu Dhabi, yesterday ran a story that actually Dubai World may still pay that Sukuk…..

Firstly introduced in the Anglo-Saxon world as an alternative to privatization and to the former system, under which the government administration was responsible for ownership, maintenance and operation of assets of public interest, PPPs are now a widespread concept in many countries, operate as an arrangement between the public authorities and the private sector for the performance of large-sized works and utility services, by means of sponsored or administrative concessions, sharing the venture risks and primarily counting on private funding.

The bill of the PPP LAW as “an indispensable alternative for economic growth in view of Brazil’s critical needs on the social and economic fronts, to be addressed by a positive cooperation between the public and private sectors” and it was passed by the Congress at a fast pace. This serves as a good measure of the urgency and importance that the Federal Government has attached to this matte, certainly in response to the pressure brought to bear by state governments, notably the States of Minas Gerais and São Paulo, in addition to the private initiative, but may also give a false impression that the issue has not been sufficiently discussed by the Brazilian Legislative.

The driving force behind this expeditious congressional passage of the draft bill into PPP LAW was probably the well-known critical shortage of public funds to sponsor infrastructure works and utility services and to meet the demand resulting from the country’s announced economic growth spurt. This shortage of public funds, coupled with the private sector’s lack of interest in taking over such works and services under the traditional concession system, may help explain why infrastructure investments have come to a near halt.

Contrary to the fears of a supposed lack of in-depth discussions over this issue, justice should be done to the numerous debates among the political forces and civil society concerning the most controversial points underlying the PPPs, notably in relation to:
(a) Bidding procedures; the origin of public funds to make up the Public-Private Partnership Guarantee Fund under Article 16 of PPP LAW;
(b) The priority given to settlement of financial obligations under PPPs;
(c) The role of Special Purpose Companies in the venture;
(d) The limitations imposed by Federal Law No. 101, 2000 [FISCAL RESPONSIBILITY LAW]; and
(e) The possibility of adopting arbitration as an alternative dispute resolution mechanism for PPPs.

The introduction of legal mechanisms of such a magnitude conceivably arouses a number of doubts and questions. However, approval of PPPs has undoubtedly represented a great victory for the Lula da Silva’s Administration, especially by offering a wide array of possibilities for the presence of private concerns in key sectors of the Brazilian economy, the reason why the great expectations and discussions over the role of PPPs in Brazil are far justifiable.

In fact, according to data published by the Ministry of Planning, Budget and Management, based on the Government’s Multiyear Plan, it has been estimated that investments equalling 21.7% of Brazil’s Gross Domestic Product will be required to resume and sustain the country’s economic growth (Source: www.planejamento.gov.br). The studies conducted to prepare the Government’s Multiyear Plan, which is aimed at resuming economic growth and has as its greatest challenge to expand investments and exports without hindering the commitment of increasing domestic consumption, evidence the Government’s need of tools that can help it overcome the obstacles to economic growth.

To achieve its purpose, the Federal Government prepared a portfolio containing projects that should be developed with the participation of the private sector. Investments needs were estimated at approximately hundreds of billions of US Dollars in the transportation (railways, highways and ports), irrigation and water resources areas in the country’s five major regions (www.planejamento.gov.br).