2.2 The Global Project Finance Market
2.2.2 PPP Development
A large fraction of projectWnance initiative is referred to projects involving the public administration. Such initiatives are run by the private sector on the basis of conces- sion contracts. The goods or services in question are sold to end users (as in the case of toll roads) or to the public administration itself (hospitals or prisons, for example).
One of the most obvious trends in the projectWnance market at a global level is the gradual shift from entirely private initiatives (Cell II) to projects involving the public administration (Cells III and IV in Figure 2-1), as indicated in Table 2-6.
The Wrst key observation is the diVerent level of dissemination of PPPs in the world. While in Europe and Central Asia/Asia PaciWc, PPPs account for more than 25% of total loans granted—in the Americas the percentage is just above 14%. This Wgure is much lower in Japan and in Africa. The second factor to consider is the varying level of distribution of the technique among diVerent sectors. Transportation and infrastructure make up nearly 80% of the total from 2003 to 2006, but sizeable percentages are also found in other sectors as well: water (around 8%), education (around 5%), and health care and hospitals (over 5%). Again, in examining distribution by sector, in Europe we note widespread use of PPPs in all sectors analyzed by Thomson One Banker. In the geographic areas where PPPs are less common, sectors of application are limited almost exclusively to transportation and water. Therefore, it seems that there is additional room for developing this technique in the coming years.
The Global Project Finance Market 27
TABLE 2-5 Development of PPPs in the European Union in Terms of Sector, Institutional Level, and Legislation (2005 data)
Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden UK
Social housing þ þ þþ þþ þþ þ þ þ þ operation
Airports þ þþ þþ þ operation þþ þ þ þ operation
Defense þ þ þ 111 þ þ operation
Health care and hospitals þþ þþ þþ þ þþ 111 þ þþ þþ þ operation
Ports and harbors þþ þþ þþ þ þ operation
Prisons þ þ þþ þþ þ þ þ operation
Light railway þ traditional 111 þþ 111 111 þþ 111 operation
Heavy railway þþ þ þþ þþ 111 111 þ þ
Roads þþ þþ þþ þþ traditional 111 111 1111 1111 111 operation operation þ operation
Education and schools þ þ þþ þþ þ 111 111 þþ þ þ operation
Sports and entertainment þþ 111 þþ þ operation
Water and sewerage þ þþ traditional 1111 þþ 111 111 operation
PPP—Institutional level ooo o oo o oo ooo ooo ooo ooo ooo oo ooo
PPP legislation ** * * ** ** ** *** *** *** * ***
Legend:(þ) under discussion; (þþ) projects under tender auction; (111) many awarded projects, some of them inWnancial close; (1111) many closed projects; (operation) many closed projects, most of them in operating phase; (traditional) many closed projects, most of them in operating phase (traditional concession agreements).
Legend:(o) project task force still missing; some actions taken and sometimes project task forces at regional level; (oo) project task force under way (or existing but only for consulting purposes); (ooo) existing project task forces heavily involved in promoting PPP; (*) proposed regulation; (**) draft regulation already proposed and satisfactory; regulation for speciWc sectors already available; (***) satisfactory regulation already available.
TABLE 2-6 Dissemination of PPPs by Sector and Geographic Area, 2003–2006
Africa and Middle East Americas Central Asia/Asia Pacific Europe Japan
Sector
Amount
(US$ mil.) % Number Amount
(US$ mil.) % Number
Amount
(US$ mil.) % Number
Amount
(US$ mil.) % Number
Amount
(US$ mil.) % Number
Total sector 2003–2006
% of Total
City agency 81.70 0.1% 2 81.70 0.1%
Educational services 116.60 0.6% 2 4,481.00 6.9% 46 460.80 26.2% 14 5,058.40 4.6%
Health care provides services (HMOs)
136.70 0.7% 1 3,216.20 4.9% 45 3,352.90 3.0%
Hospitals 355.60 2.4% 1 2,171.80 3.3% 15 237.20 13.5% 2 2,764.60 2.5%
Motion pictures/
Audiovisual
113.80 0.2% 3 113.80 0.1%
National agency 445.70 0.7% 3 445.70 0.4%
National government 175.00 0.3% 1 122.20 7.0% 1 297.20 0.3%
Public administration 66.10 0.8% 1 7.20 0.0% 1 320.10 1.6% 2 195.00 0.3% 3 40.00 2.3% 1 628.40 0.6%
Regional agency 0.0% 181.70 0.9% 2 1,074.50 1.6% 6 1,256.20 1.1%
Transportation infrastructure
5,347.90 65.1% 18 13,646.30 92.2% 35 18,908.10 93.3% 55 49,470.40 76.0% 111 435.70 24.8% 3 87,808.40 79.7%
Water and waste management
2,799.60 34.1% 8 797.90 5.4% 7 606.20 3.0% 7 3,705.90 5.7% 27 461.90 26.3% 7 8,371.50 7.6%
Total PPPs 8,213.60 100.0% 14,807.00 100.0% 20,269.40 100.0% 65,131.00 100.0% 1,757.80 100.0% 110,178.80 100.0%
Total projectWnance deals
83,621.80 102,973.10 79,812.40 179,028.00 16,065.40
PPP’s/Total project Wnance deals
9.8% 14.4% 25.4% 36.4% 10.9%
Source:Thomson One Banker.
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C H A P T E R
u3
Project Characteristics, Risk Analysis, and Risk Management
Introduction
A successful project financing initiative is based on a careful analysis of all the risks the project will bear during its economic life. Such risks can arise either during the construction phase, when the project is not yet able to generate cash, or during the operating phase.
Risk is a crucial factor in project finance since it is responsible for unexpected changes in the ability of the project to repay costs, debt service, and dividends to shareholders. Cash flows can be affected by risk, and if the risk hasn’t been anticipated and properly hedged it can generate a cash shortfall. If cash is not sufficient to pay creditors, the project is technically in default.
Most of the time allocated to designing the deal before it is financed is, in fact, dedicated to analyzing (or mapping) all the possible risks the project could suffer from during its life. Above all, focus lies on identifying all the solutions that can be used to limit the impact of each risk or to eliminate it.
There are three basic strategies the SPV can put in place to mitigate the impact of a risk:
1. Retain the risk.
2. Transfer the risk by allocating it to one of the key counterparties.
3. Transfer the risk to professional agents whose core business is risk man- agement (insurers).
The first strategy is quite common in a corporate finance setting. An industrial firm may retain a given risk because it considers risk allocation to third parties too expensive or the cost of insurance policies excessive compared to the effects 31
determined by that risk. In this case the firm usually tries to implement internal procedures for the control and prevention of the risk. On the other hand, the same risk is likely to have a lower impact compared to a project finance setting. If a firm must close a plant that has caught fire, production can continue in other premises of the firm. Technically speaking, the risk is not idiosyncratic. This is not true for project financing. If the plant burns down, the SPV doesn’t have other premises where production can continue, and the project is technically (and economically) in default.
This explains why Strategy 1 is implemented in SPVs, but it is not enough. Lenders would never accept financing an SPV subject to risks that are completely internalized.
Strategy 2 is the cornerstone of the project finance design, a strategy that is implemented through extensive work performed by the legal advisors of sponsors and lenders. The principle is intuitive. Since the key contracts revolving around the SPV (construction, supply, purchase, O&M) allocate rights and obligations to the SPV and its respective counterparties, such agreements can be used as an effective risk management tool. Every counterparty will bear the cost of the risk it is best able to control and manage. In this way, each player has the incentive to respect the original agreement in order to avoid the negative effects determined by the emergence of the risk in question. If a risk arises and it has been allocated (trans- ferred) to a third party, this same party will bear the cost of the risk without affecting the SPV or its lenders.
Finally, Strategy 3 is implemented as a residual mitigation policy. Some risks are so remote or so difficult to address that any one of the SPV counterparties is open to bear them. Insurers are in the best position to buy them from the SPV against the payment of an insurance premium. These companies can do so because they manage large risk portfolios where the joint probability of emergence of all the risks in the portfolio at the same time is very low.
Figure 3-1 summarizes these concepts and introduces the contents of the chapter.
On the left-hand side, a classification of risks is proposed based on the different phases of the life cycle of the project. On the right-hand side, the most important methods for risk allocation are shown. It is particularly important to stress that the risks common to the pre- and postcompletion phase are hedged by an almost exclusive use of insurance contracts or derivative contracts.
This chapter is dedicated to risk analysis and risk allocation through Strategy 2.
Risk coverage through insurance is dealt within Chapter 4. More precisely, Section 3.1 is dedicated to the process of risk analysis and proposes a classification of project risks based on the project life cycle. Section 3.2 covers the risk allocation phase and explains how risks can be allocated to the SPV counterparties by means of key contracts. Special attention is dedicated to market risk (the risk arising from a drop in sales) given the paramount importance of this risk in determining the future cash flow generation of a project. Mechanisms such as offtake agreements are analyzed, and information is also provided for the use of such contracts in PPPs.