Session IV - FinancingSession IV - Financing

Cledan Mandri-PerrottInfrastructure Economics & Finance Department (IEF)Workshop, PPP in Highways, Latvia May 9th 2006c

Mobilizing Private Capital and Mobilizing Private Capital and Management into Infrastructure Management into Infrastructure DevelopmentDevelopment

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Development of Local Capital Markets

Chile and Korea (transport infrastructure bonds)

Using Output Based Aid Mechanisms

Road Maintenance and Rehabilitation

Upcoming Trends and Way Forward

Contents

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Leveraging Public Money : Case of Toll Roads

Case: privately financed firms sells to end users, not the government or SOE, and, to simplify, consider three types of risk.

Construction, operating, and maintenance cost risks: private sector normally has most influence over these costs, so government does not benefit from bearing them.

Price risk: if government controls the toll, it probably benefits from bearing price risk (that is, from agreeing to compensate if it doesn’t increase toll according to concession contract).

Demand risk (given price): appropriate policy is less clear.

Neither firm nor government may have much influence.

Decision needs to consider other aspects of “managing” risk: who can best forecast and anticipate demand to determine whether to build road? Who can best absorb the risk?

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Demand risk in toll road

Whether government should bear demand risk in toll roads is therefore controversial Chile, Colombia, Korea, and Spain, for example, have provided

revenue guarantees (often in return for upside risk sharing). Italy and Turkey gave revenue guarantees for privately financed

railways in the nineteenth century: “PPPs” are not new.) Australia, Canada, United States have not.

Target any guarantee to the real problem: Is total demand risk the issue or is it whether government will build a

competing road or complete a planned complementary road or port? Is risk the problem, or is it just that government doesn’t want to set

tolls high enough to consider costs? If so, a subsidy may be better.

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Valuing revenue guarantees

Step 1. Develop model of traffic revenue that allows for random fluctuation (that is, risk) as well as trend rates of growth.

Step 2. For the trend, take forecasts traffic-revenue growth developed for tendering the toll road.

Step 3. Estimate the expected size of traffic revenue fluctuation (risk), from previous local or international experience.

Step 4. Estimate consequent expected payments by government (see next slides).

Step 5. Discount those expected payments at the risk-free rate to get the value of the guarantee.

(Possible addition to Step 4: adjust expected cash flows for an estimate of risk, using the capital-asset-pricing model).

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0

50

100

150

200

250

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Forecast revenueGuaranteed revenue

Forecast and guaranteed revenue on hypothetical toll road

Estimated Initial Investment: $ 600 MM

$ MM

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A possible good outcome

0

50

100

150

200

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

$ million

Forecast revenue

Actual revenue

Guaranteed revenue

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A possible bad outcome

0

50

100

150

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

$ million

PaymentForecast revenueActual revenueGuaranteed revenue

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0

1000

2000

3000

4000

5000

6000

7000

8000

9000

0 5 10 15 20 25 30 35 40 45 50 More

Payment bins

Fre

qu

en

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Valuation: Frequency distribution of government payments in 2016

Average payment in 2016 is $4.19 millionAssume risk free rate is 5%Approximate value of 2016 component of guarantee is 4.19/(1.05)11 = $2.45 millionRepeat for all years. (illustration purposes = $100.0 million)

This calculation will allow providing a value to theFiscal impact of this option. This is a necessary first stepIn the decision-making process for public sector optionsFor infrastructure development.

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Transport Infrastructure: Developing Local Capital Markets -1

Best solution for foreign exchange risk mitigation = matching currency revenue generation with currency of debt payment services

Financing transport facilities in the foreign debt markets adds substantial risk to the structuring of adequate PPPs creating the need for additional public money support.

Local institutional investors (eg, pension funds, insurance companies, life annuities, etc.) have a natural demand for long-term local currency debt instruments to match their liabilities.

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Transport Infrastructure: Developing Local Capital Markets -2

Local capital markets:

initiate development via the creation of a sovereign bond market (long-term yield curve)

but investors develop a need to diversify risk profile of their investments and the return mix, providing the incentives for the development of a private bond market

Opportunity for the introduction of infrastructure or utilities bonds (long-term annuities).

Government should stimulate, via adequate securities regulation and institutional investors overseeing, the development of local capital markets as a source of long-term local currency funding for needed PPPs infrastructure projects.

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Developing Local Capital Markets : Chile -1Source: IMF, Fiscal Affairs Dept.,January 2005

By the early 1990s, a sizable infrastructure gap had emerged in Chile, and significant investment was needed to prevent transportation and other bottlenecks from becoming a major obstacle to future growth

Government challenge to close this gap while maintaining fiscal discipline.

Solution: promotion of PPPs

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Developing Local Capital Markets : Chile-2

Concessions program covers 44 contracted projects with a total value of US$5.7 billion (about 6¼ percent of 2004 GDP)– These include: 8 rehabilitation projects with financing from

tolls (US$2 billion); 11 other highway projects (US$1.3 billion); 10 airport projects (US$240 million); 6 urban road projects (US$1.8 billion); and 9 other projects (including prisons, public buildings, a reservoir, for US$360 million).

– Approximately 75% was funded in the local capital markets via local currency infrastructure bonds.

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Developing Local Capital Markets : Chile-3

The government provides guarantees to concession operators:– A minimum revenue guarantee is provided for highway and

airport concessions, – Concession firms are compensated when traffic or traffic

revenue falls below an annual threshold– In return for the minimum revenue guarantee, the

concession firm enters into a revenue sharing agreement in which it shares a percentage of revenue with the government once a threshold is exceeded.

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Developing Local Capital Markets : Korea

0

2000

4000

6000

8000

10000

12000

14000

capi

tal v

alue

(K

RW

bill

ion)

Local

Central

PPP Projects, Investment Value

As of October 2004, 114 concessions awarded for projects in 149 of which 43 have completed construction and now are operating. (See Figure 1) Total investment of about 12 trillion of Korean won capital, predominantly funded in local capital and commercial bank markets, with only a few projects tapping the international capital markets.

Source: Korea PPI Market, M. Dailami, World Bank, November 2004

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Road rehabilitation and maintenance traditionally done through input-based payments to private contractors.

Increasingly, output-based approaches, for example the Performance-based Maintenance and Management in Roads (PMMR), being introduced in Europe, Asia and Africa, and similar KREMA contracts, functional for several years in Latin America (Argentina, Brazil, Uruguay).

Using Performance Based Subsidies in Transport PPPs : Road Asset Management

Output-based aid (OBA) is a strategy for supporting the delivery of infrastructure services that depends –at least in part – on public funding where payment is linked to service delivery.. At the core of the OBA approach is contracting out service provision to a third party – usually the private sector – with payment tied to the actual delivery of services.

Output-based aid (OBA) is a strategy for supporting the delivery of infrastructure services that depends –at least in part – on public funding where payment is linked to service delivery.. At the core of the OBA approach is contracting out service provision to a third party – usually the private sector – with payment tied to the actual delivery of services.

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Expand private sector’s role from simple execution of works to include maintenance, rehabilitation and management of road assets.

Operator paid after outputs delivered and quality standards met (per KM or similar).

Multi-year and consumer-driven out-look, shifting performance risk to operator, and allowing for innovation and efficiency.

Using Performance Based Subsidies in Transport PPPs : Road Asset Management

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Transport Infrastructure : Upcoming trends – 1

Increasing importance of the provision of transport services and regional linkages and interconnectivity as key contributor to economic growth as a key driver of country’s competitiveness.

Broader use of PPP schemes as a way to maximize public money leveraging for infrastructure development.

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Transport Infrastructure : Upcoming trends – 2

Increasing use of smart subsidies as a way to utilize better private sector resources via effective allocation of performance risks.

Development of local capital markets (local currency debt instruments) as a mechanism for improving effective access to infrastructure financing by transport PPPs.

Need to develop organized and disciplined risk management framework to manage contingent liabilities arising from public money support to PPPs.

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Transport Infrastructure : Way Forward in Latvia -1

PPPs together with the development of and effective use of local currency funding (via capital markets) have a high potential of contributing to needed transport infrastructure development. Importance of involving local stakeholders.

Some important lessons and experience could be drawn from transition economies in similar context (Easter Europe) in the Transport Sector (e.g., motorways in Hungary, Ports in Poland, etc.)

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Transport Infrastructure : Way Forward in Latvia - 2

PPPs are complex and time demanding structures that required full time dedicated resources from the public sector entities responsible transport infrastructure development. Consideration should be given to a Coordinating Transport PPP Unit.

Select a small number of transactions (2 to 3) with the highest potential for success in the short term and focus government resources in taking to fruitful market completion.

Develop a consistent and organized approach to assess, valuate and monitor the contingent liabilities arising from public money support to PPP transport projects. Develop smart and effective risk mitigation products supporting PPPs.

Thanks Thanks

World Bank Group

Infrastructure Economics and Finance

Tuesday, May 09, 2006

Riga, Latvia

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PC (project completion)

InvestmentInvestment

DebtDebt

EquityEquity

Toll Road PPP : Cash Flow Toll Road PPP : Cash Flow FluctuationsFluctuations (Proxy (Proxy for risk)for risk)

Basic StructureBasic Structure : :

Capital Markets:Capital Markets: Long-Term Financing Long-Term Financing

Cash FlowsCash Flows

US$US$

YearsYears

Repayment of Debt is based on project cash-flows (non-recourse to sponsors) Relatively high initial investments Need for longer debt tenors to justify IRR to sponsors

Repayment of Debt is based on project cash-flows (non-recourse to sponsors) Relatively high initial investments Need for longer debt tenors to justify IRR to sponsors

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PC (project completion)

Investment

Debt

Equity

Basic StructureBasic Structure : :

Capital Markets:Capital Markets: Long-Term Financing Long-Term Financing

Cash Flows (e)Cash Flows (e)

US$US$

YearsYears

Cash Flows Cash Flows realreal

Risk Mitigation products : Minimize cash flows Risk Mitigation products : Minimize cash flows downward fluctuations (ability to repay principal + downward fluctuations (ability to repay principal + interest)interest)

Key driver: Cash Flow predictability

Toll Road PPP : Cash Flow Toll Road PPP : Cash Flow FluctuationsFluctuations (Proxy for risk (Proxy for risk))

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Toll Road PPPs : Risk AssessmentToll Road PPPs : Risk Assessment

Completion Risk (engineering & construction cost / time cost control)

Operational Performance Risk (technical & operational know-how)

Environmental Risk (future liabilities, project delays, costs overruns)

Credit Risk (project leverage)

Inflation, interest rate and exchange exchange rate fluctuations rate fluctuations

Political Risk (expropriation, political violence, currency convertibility & transfer)

Regulatory RisksRegulatory Risks. (Government’s default on contractual obligations, i.e., pricing formulas, right of way – land acquisition risk, construction of alternate road, etc. )

Legal Environment (rule of lawrule of law, i.e., judicial system, regulatory procedures and arbitration)

Project Specific Risks (non-Project Specific Risks (non-sovereignsovereign

Country (Economy wide) Risks Country (Economy wide) Risks (sovereign)(sovereign)

Demand (traffic) Risk

Pricing Risk (regulated and non-regulated)

Environmental (past liabilities) Risk

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Key Stakeholders in the Risk Assessment and Risk Allocation of Toll Roads PPP Finance

Toll Road PPP Finance : Risk StructuringToll Road PPP Finance : Risk Structuring

ProjectCompanyProject

Company

ShareholdersShareholders

Lenders /BondholdersLenders /

Bondholders

OperatorOperator

Construction Contractor

Construction Contractor

GrantingAuthorityGrantingAuthority

Services PurchaserServices Purchaser

Shareholder’s Agreement

Concession Agreement

Purchase Agreement (e.g., shadow toll – government entity)

End-users

Traffic Demand

Construction Contracts

Operation & Maintenance Agreement (O&M)

Authority Right of WayAuthority

Right of WayLand acquisition and further transfer to PPP

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Toll Road PPP Finance : Risk StructuringToll Road PPP Finance : Risk Structuring

ProjectCompanyProject

Company

ShareholdersShareholders

Lenders /BondholdersLenders /

Bondholders

OperatorOperator

Construction Contractor

Construction Contractor

GrantingAuthorityGrantingAuthority

Services PurchaserServices Purchaser

Shareholder’s Agreement

Concession Agreement

Purchase Agreement (e.g., shadow toll – government entity)

End-users

Traffic Demand

Construction Contracts

Operation & Maintenance Agreement (O&M)

Regulatory RisksRegulatory Risks

Regulatory & Demand Regulatory & Demand RisksRisks

Completion Completion RisksRisks

Performance Performance RisksRisks

FX Risks and FX Risks and Refinancing Refinancing Risks Risks

Political and Macroeconomic Risks Political and Macroeconomic Risks

Authority Right of WayAuthority

Right of Way

Regulatory RisksRegulatory Risks

Land acquisition and further transfer to PPP

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Toll Road PPP Finance : Risk Mitigation Toll Road PPP Finance : Risk Mitigation

Non-sovereign Sovereign

Completion Risk

Performance Risk

Environmental Risk

Demand Risk

Political Risk

Regulatory Risk (inc.

Land Acquisitio

n Risk)

Macroeconomic Risk

Cost overruns and delays.

Revenue generation and operational costs increase

Hidden liabilities

Revenue generation

Expropriation, transfer, convertibility Cease of revenue generation

Revenue generation. Tariff Adjustment; Right of Way, Termination payment

Revenue generation. Devaluation / inflation impact of cash flows

High Low Low High Low High High

EPC Contract and performance bonds

Performance based contracts

Environmental Assessment

Traffic Minimum Revenue Guarantees / VPN ConcessionPartial Credit Guarantees

Political Risk Insurance

Concession Contract Partial Risk Guarantees

Local currency financing

Private Private Private Private/Public

Private /Public

Public N.D.

Risks

Cash Flow effect

Impact

Risk Mitigation Instrument

Provider

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Demand and Tariff Risk: Rolling GuaranteeDemand and Tariff Risk: Rolling Guarantee

Rolling Guarantee

• A partial credit enhancement product providing a guarantee of a specified number of interest and/or principal payments, on a rolling forward basis – i.e. the guarantee rolls forward to the next installment date automatically (if no claim has taken place) or upon payment by the issuer of a previous claim -- so that the guarantee covers a rising share of remaining debt service.

• For a toll road project where investors perceive a potential risk associated with a variation in the debt service coverage due to slow traffic, delays on tariff adjustments or both at some point within the overall bond tenor, or are uneasy about a period of heavy investments (i.e., rehabilitation), the rolling guarantee will smooth out the repayment profile and reduce investor concerns about potential timing/cash flow issues.

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Debt / Service

Coverage Ratio

1.51.5

1.01.0

Outstanding Principal

Years

N N + I

Rolling Guarantee

DSCRDSCR

Demand and Tariff Risk: Rolling GuaranteeDemand and Tariff Risk: Rolling Guarantee

N + 2

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Demand and Tariff Risk: PCG + MonolinerDemand and Tariff Risk: PCG + Monoliner

Traffic MinimumRevenue Guarantee(Granting Authority)

Traffic MinimumRevenue Guarantee(Granting Authority)

Layer of Lower Credit Risk Quality

(PCG)

Layer of Lower Credit Risk Quality

(PCG)

Partial Credit Partial Credit Guarantee Guarantee MLAMLA

(a portion of the credit loss on the transaction, -- debt service)

Future Flows Securitization of Tolls

Mitigation of the lower credit risk quality and improving the transaction rating attracts participation of Monoline Monoline Insurers to provide a Insurers to provide a “wrap”“wrap” on the whole transaction, improving further the transaction credit rating.

BBB Credit Rating

AAA Credit Rating

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Financial MarketsFinancial Markets

Risk Mitigation Providers Risk Mitigation Providers

Multilateral Development Banks and Donors (Aid, lending and guarantees) Export Credit Agencies (ECAs) Private Insurance & Guarantors

Political Risk Insurance Financial Guarantee providers (i.e., monoliners, specialized risk support) Derivatives

Cross-border Debt MarketsCross-border Debt Markets Global Financial Markets Driven by risk & return balance Highly sensitive to political –economic

volatility (i.e., financial crisis 1997-2001) Bank markets : have not quite return to

developing countries infrastructure finance Capital markets : depth and liquidity. Risk

& return oriented (new participants). Volatile.

Local Currency Debt MarketsLocal Currency Debt Markets Domestic savings capacities Bank Markets. Short-term nature. Depth

and liquidity dependent upon financial sector reform and competition.

Capital markets. Depth and liquidity dependent upon social and safety net reform (pensions, insurance, etc.) and adequate securities regulatory framework

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WBG: Risk Mitigation Framework

SovereignRisks

Investors / Financial Institutions

Non – SovereignRisks

IFC

• Partial Credit Guarantees

• Hedging Products

• Risk sharing facility

• Securitization

• Investment Guarantee

MIGA IBRD / IDA

• IBRD / IDA Partial Risk Guarantees

• IBRD Enclave Guarantee

• Partial Credit Guarantee

• Policy Based Guarantee

World Bank Risk Mitigation Instruments

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IFC MIGA IBRD/IDA

Products Partial Credit GuaranteesHedges for clients (interest rate, currency and commodity swaps)

Non-commercial political risk insurance

PRG – IBRD & IDAPCG & PBG – IBRD Only

Clients Private sector investors, lenders for private sector projects

Private sector investors, lenders for private projects

Private lenders for public projects

Loans Yes Yes Yes

Equity (Quasi-Equity)

Yes Yes No

Coverage (Risk) Full and timely payment of principal and/or interest up to a specified amount - IFC covers all risks that may result in non-payment of a client’s obligations.

•Currency convertibility and transferability•Expropriation •War and Civil Disturbance (incl. terrorism and sabotage)•Breach of Contract

Government contractualObligations including:• Currency convertibility and

transferability• Expropriation• Political Violence• Breach of Contract • Regulatory • Subsidy payment (e.g. OBA)

Guaranteed Percentage

Determined on a case by case basis (credit risk driven).

Debt: up to 95% Equity: up to 90%

Up to 100% of a tranche

Comparison of World Bank Group Risk Mitigation Instruments

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Comparison of World Bank Group Risk Mitigation Instruments [Contd.]

IFC MIGA IBRD/IDA

Eligibility Must be a member country Must be a member country Must be a member country

Tenors Market based but IFC’s involvement can lengthen tenors

Up to 15 years (20 years in some cases)

Market based

Limits Based on client’s needs Project: up to $110mm (net)Country: up to $420mm (net)

Based on project and country needs and CAS allocation.

Priority Areas of Focus All IFC recipient member countries.Providing long-term local currency financing and development of domestic capital markets.

•  Africa•  IDA eligible countries•  South-South investments•  SMEs

• Infrastructure• IDA eligible countries

Government Counter Guarantee

No No (through the MIGA Convention)

Yes – for IDA in the event borrower is not the sovereign,

a sovereign guarantee may not be required.

Public Sector Projects No No Yes

Areas of Collaboration Joint project preparation, environmental analysis, Board processing, etc.