Understanding and Managing the Fiscal Risks of PPPs

Clive HarrisManager, PPPsWorld Bank Institute

Objectives of this session

1. Review the risks inherent in PPPs and understand the reasons why these risks materialize all too often

2. Identify what can be done to better understand and manage these risks– During project selection and procurement– During project implementation

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Governments like PPPs because they don’t have to commit money now to get a project built – so they may ignore future costs

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PPPs by definition impose an obligation on governments• They may be contractually obliged to

make payments under PPPs related to asset availability or service delivery– Obligations to make payments under

PPPs are like debt (though payments usually related to performance of the asset)

• They bear risks under PPP contracts, many of them outside of their control: e.g. demand risk, foreign exchange risk on the costs of inputs, termination liabilities– Risk-bearing by governments under PPPs

produce obligations like guarantees

The existence of these obligations does not mean a PPP is a bad option

• Both types of obligations often are needed for the PPP to proceed and can represent the best way of allocating risks and getting the project done

• But it is important for governments to understand and track the extent of these obligations

• And too often risks materialize and lead to substantial fiscal consequences e.g. toll roads – Mexico (1990s): Spain (1960s-70s); power projects – Dabhol (India), Pakistan, Philippines

Why do these risks arise more often than they should?• Incentives facing government….

– To ignore long-term consequences of projects

– To absorb risks that the private sector could/should bear

• Capacities not adequate….– To analyze possible risks– To manage projects during

implementation= contract management skills are crucial

The government’s incentives• Lack of long-term focus:

– Most governments don’t have long-term budget frameworks, so PPPs involving spending in future years are often not recognized at all.

– Costs of problems likely to be incurred by next Minister/government given lead time for project to be operational

• Lack of process: – Publicly-funded projects at least have a defined

process for approval involving competition against other funding priorities

• Willingness to absorb risk:– Governments very wary of service disruption– Government per se has high ability and willingness to

absorb risk

Evidence that governments absorb risk?• High rates of renegotiation: (100%

contracts in Chile saw post-award adjustment)

• Cancellation rates very low: (Harris & Pratap(2008))

Sector Percentage of Projects With Private Sector Exit1990-2006

Energy 3.6%

Telecoms 4.4%

Transport 4.7%

Water and sewerage 8.8%

Total 4.7%

Capacities for assessing risks• Government agencies often

inexperienced in:– Assessing magnitude of risks– Negotiation…….especially when compared with private

sector and its teams of advisors• PPPs are not part of standard budgetary

process so – there may be no clear process on who

approves projects and associated obligations– or even who is informed of these

Approaches to allocating risk• Mantra is “allocate risks to those best

placed to manage them”• How to apply (following Irwin, 2007):

– Who influences risk factor?• E.g. Construction risk allocated to construction

partner– Who can anticipate or respond to risk

factor?• E.g. Demand – who forecasts (project design)

– Who can best absorb the risk?• Exchange rate movements (who can hedge?)

Managing PPP-related liabilities

• Managing means deciding whether to incur liabilities and monitoring outstanding liabilities with a view to limiting spending or at least getting an early warning of it

• Three key factors:– Who approves PPPs?– What analysis is done before

approval?– Which data is publicly reported?

Chile• The government has guaranteed the revenue

of many of the toll roads and airports• PPPs must be approved by the Minister of

Finance, who gets advice on contingent liabilities from a small Contingent Liabilities and Concessions Unit

• Among other things, the unit estimates the cost and risk of revenue guarantee using a stochastic model

• The government publishes information on contingent and direct liabilities under PPPs in annual reports on public finance and contingent liabilities

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Chile discloses the cost of its PPP obligations(Present values of commitments in US$ million. Note: GDP is about US$110 billion)

Subsidies and annuity-type payments

Commitments made in renegotiations

Maximum guarantee spending

Expected guarantee spending

Route 5 706 62 3,482 224

Other intercity roads 204 63 962 78

… … … … …

Total 2,328 780 5624 335

Chile – annual estimation of concession guarantees

South Africa• Relatively large program of PPPs, including toll roads,

the Gautrain, and several accommodation-related projects

• There are some revenue guarantees and also obligations to make termination payments tied to debt in case of project failure

• The Treasury must approve projects at each of four stages

• The PPP unit is the key adviser in the National Treasury, but other parts of the Treasury are now involved

• Treasury requires analysis of contingent liabilities as part of project preparation

• Departments include a disclosure note on PPP in their accounts

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Britain• Very extensive program of PPPs – many

using PFI approach of unitary payments under long-term contracts

• Britain discloses the fiscal implications of PFI projects

• Formal accounting requirements have caused many PPPs to be recognized on the government’s balance sheet– has helped shift attention from reducing

government expenditure to capturing the real potential benefits of PPPs, such as innovation and efficiency improvements

– Further changes possible depending on Eurostat rule changes

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Britain discloses committed payments to PPPshttp://www.hm-treasury.gov.uk/ppp_pfi_stats.htm

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Implications for other countries

• The biggest contributors to success in these countries is probably the quality of their public sectors

• But all highlight importance of paying attention the following:– Approval– Analysis– Reporting

• Precise solutions depend on the institutional context

Approval• Multistage review of proposed PPPs by ministry of

finance looks like a good idea for any country• But how much of the responsibility for advising on

PPPs should lie with ministry of finance? • In Victoria and South Africa, a PPP group in the

Treasury votes early and often; in Chile, review is later and focuses on contingent liabilities

• Earlier, more intensive involvement by the ministry of finance has advantages—which suggests PPP group in the ministry of finance

• These reviews can help to prevent “gold-plating” or over-specification of projects and ensure good project selection and design

Analysis• Quantifying contingent liabilities is useful when

liabilities are large, not under control of government, and estimates may affect decisions (revenue guarantees in Chile and South Africa)

• But just as important is thinking about whether the allocation of risk creates good incentives

• Often the problem can be simplified by considering the ordinary liabilities of the public sector, instead of the contingent liabilities of the government—as in Australia

Reporting• Financial reporting is surprisingly influential e.g.

adoption of IFRS is helpful in Australia • But adopting modern accrual accounting isn’t a

sensible priority for all developing countries• To try to reduce temptation to disguise debt,

countries with less advanced accounting can disclose information on PPPs and contingent liabilities:

• Simple reporting may be the best approach– list with description of project and liabilities and

quantification of total investment, committed payments, and maximum contingent payments

– Publication of PPP contracts, as in Australia, is easy and helpful

– SOEs or agencies may enter into PPP contracts so important to ensure they reflect these obligations in their accounts

Examples of reporting

• For long-term payment obligations

• For guarantee-like obligationsProject name

Project cost ()

Contingent liability that creates the largest exposure

Estimated payment required if contract had been terminated for that reason on March 31, 2009 ()

… … [e.g., termination payment for contractor default equal to 90% of outstanding debt due to senior lenders]

…

… … … …

Project name

Project cost

Actual unitary and construction-subsidy payments

Forecast unitary and construction-subsidy payments

NPV of forecast payments, 1

January 2009 (at x%)

2006 2007 2008 2009 2010 2011 2012 … ….

… … … … … … … … … … … …

… … … … … … … … … … … …

Managing unanticipated costs during implementationEven in countries with strong institutional

capacity, PPPs can give rise to “unanticipated” costs during implementation

• UK: NAO (2008): “changes to operational PFI deals are often poor value for money” GBP 180mn spent on these changes in 2006 (many changes are actually aspects taken out of contract specification pre-bid to save money!)

• Chile: additional expenditures approx. 39% of original investment, most determined via negotiations and is additional investment requested by the government

Solution: • tighten scrutiny of contract adjustment and

involve Ministry of Finance• Proactive contract management with adequate

resources

Broader sector policies matter• Quality of sector governance and performance

critical in recovering costs are recovered from users not taxpayers

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Thank You and Questions