long-term financing and risk allocation in … · • eduardo azevedo (secretary of planning and...

Co�ee Break

Day 2 | Case Studies 23/03/17

8h30 – 9h

9h – 10h15

10h15 – 10h30

10h30 – 12h30

12h30 – 13h

Organized by

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Co�ee Break15h30 – 16h

16h – 17h

17h – 18h

• Joisa Dutra (Director, FGV CERI)

• Antonio Barbalho (Practice Manager Energy & Extractive Industries Latin America, World Bank)

• Andrew Haynes (Partner, Norton Rose Fulbright)

• Eduardo Azevedo (Secretary of Planning and Energy Development, Ministry of Mines and Energy)

• José Medaglia Filho (President, Planning and Logistics Company)

FINANCING A GAS FIRED POWER PLANT IN BRAZIL• FGV CERI & Norton Rose Fulbright

FINANCING A RAIL PROJECT IN BRAZIL• FGV CERI & Norton Rose Fulbright

CLOSING REMARKS




OVERVIEW OF INTERNATIONAL BEST PRACTICES• Antonio Barbalho (Practice Manager Energy & Extractive Industries Latin America, World Bank)

• Georges Romano (Managing Director Latin America, Citibank)

• Florence Shoshany (Director, Deutsche Bank)

• Fernanda Custodio (Export Development Canada)

ANTI-BRIBERY AND CORRUPTION

• Maria Cecília Carmona (Head of Compliance, Deutsche Bank)

• Gustavo Kaercher (Partner, Souto Correa)

• Margarida Smith (Head of Compliance, Citibank Brasil)

DISPUTE RESOLUTION

• Moderator: Patricia Sampaio (Professor, FGV)

• Gabriel Costa (Senior Legal Counsel, Shell)

• Flavio Spaccaquerche Barbosa (ICC)

• Solange David (Vice-President, CCEE)


• Ricardo Brandão (Head of Litigation, Attorney General O�ce)

OPENING SESSION: Previous day summary and introducing the second day

LONG-TERM FINANCING AND RISK ALLOCATION IN INFRASTRUCTURE IN BRAZILPOLICY BRIEF

Director of FGV CERIJoisa Campanher Dutra Project Team Members

Project CoordinationJoisa Campanher DutraEdson Daniel Lopes Gonçalves

Researchers Edson Daniel Lopes GonçalvesFernanda Baldim JardimGustavo Timponi CamposLívia Medeiros Amorim Lucas NouraLuiz Gustavo Kaercher LoureiroMariana Reis Paiva MonteiroPatricia Regina Pinheiro SampaioRafael Martins de Souza Renata Motta Café

CollaboratorsCorina Müller MonaghanMariam Tchepurnaya Daychoum

Interns Clarissa Emanuela Leão LimaFernanda Almeida Fernandes de Oliveira

Energy and Extractive Global Practice

Practice Manager for Latin America and the Caribbean Antonio Barbalho Project Team Members Silvia MartinezAlexandre TakahashiLuiz Maurer

The World Bank Disclaimer: The findings, interpretations, and conclusions expressed in this document are those of

the authors and do not necessarily reflect the views of the Executive Directors of the World Bank, the governments

they represent, or the counterparts consulted or engaged with during the study process.

Co�ee Break


8h30 – 9h

9h – 10h15

10h15 – 10h30

10h30 – 12h30

12h30 – 13h

Organized by

Suported by


16h – 17h

17h – 18h








CLOSING REMARKS












DISPUTE RESOLUTION








GLOSSARY

ABGF Brazilian Guarantees Agency (Agência Brasileira Gestora de Fundos e Garantias)

AGU Attorney-General of the Union (Advocacia-Geral da União)

ANEEL Brazilian Electricity Regulatory Agency (Agência Nacional de Energia Elétrica)

ANP Brazilian National Agency of Petroleum, Natural Gas and Biofuels (Agência Nacional do Petróleo, Gás Natural e Biocombustíveis)

ANTAQ Brazilian National Agency for Waterway Transportation (Agência Nacional de Transportes Aquaviários)

ANTT National Land Transport Agency (Agência Nacional de Transportes Terrestres)

BNDES National Bank for Economic and Social Development (Banco Nacional de Desenvolvimento Econômico e Social)

BoFA Bank of America

CCEE Chamber of Electric Energy Commercialization (Câmara de Comercialização de Energia Elétrica)

CCGT Combined Cycle Gas Turbine

CGU Comptroller General of the Union (Controladoria Geral da União)

CL Corporate Lending

CNPE National Energy Policy Council (Conselho Nacional de Política Energética)

CONIT National Council for the Integration of Transport Policies (Conselho Nacional de Integração de Políticas de Transporte)

CPI Consumer Price Index

CVM Securities and Exchange Commission of Brazil (Comissão de Valores Mobiliários)

CVU Variable Cost (Custo Variável Unitário)

DNIT National Transport Infrastructure Department (Departamento Nacional de Infraestrutura de Transportes)

ECA Export Credit Agency

EPL Logistics and Planning Enterprise (Empresa de Planejamento e Logística)

FGIE Infrastructure Guarantee Fund (Fundo Garantidor de Infraestrutura)

FGP Public-Private Partnership Guarantee Fund (Fundo Garantidor das Parcerias Público-Privadas)

FNAC Civil Aviation National Fund (Fundo Nacional de Aviação Civil)

FGV CERI Centre for Regulation and Infrastructure Studies of Getulio Vargas Foundation (Centro de Estudos em Regulação e Infraestrutura-Fundação Getulio Vargas)

ICC International Chamber of Commerce

GIH Global Infrastructure Hub

IPP Independent Power Producer

JKM Japan Korea Marker

JLT Jardine Lloyd Thompson

LC Letter of Credit (Carta de Crédito/Carta de Fiança Bancária)

LRF Limited-Recourse Financing

MAGA Material Adverse Effect Uses in Government Action

MT Minister of Transport

NBP National Balancing Point

NG Natural Gas

O&M Operation and Maintenance

OFI Independent Rail Operator (Operador Ferroviário Independente)

ONS National Electricity System (Operador Nacional do Sistema Elétrico)

PIL Program of Investment in Logistics (Programa de Investimento em Logística)

PPA Power Purchase Agreement

PPI Investment Partnership Program (Programa de Parcerias de Investimentos)

PPP Public-Private Partnership

PPT Thermoelectricity Priority Program (Programa Prioritário de Termelétrica)

PRI Political Risk Insurance

RFFSA Federal Rail Network (Rede Ferroviária Federal, Sociedade Anônima)

SEP/PR Supervision of Secretariat of Ports

TCU Federal Audit Tribunal (Tribunal de Contas da União)

ToP Take or Pay

CERI POLICY DIALOGUE ON LONG-TERM FINANCING AND RISK ALLOCATION — LTFRA

POLICY BRIEF FOR THE LTFRA

CONTENTS

INTRODUCTION 6

BEST PRACTICES IN RISK ASSESSMENT AND RISK ALLOCATION 8

I. DISPUTE RESOLUTION MECHANISM 8

II. INTEGRITY 11

III. CURRENCY RISK AND HEDGING 13

IV. INSURANCES, SURETY AND GUARANTEES: WHY AND HOW TO USE 15 STRUCTURED CREDIT INSURANCE

INTRODUCING A NEW GUARANTEES FRAMEWORK ARCHITECTURE 18

CASE STUDIES 20

I. NATURAL GAS – FINANCING A GAS FIRED POWER PLANT IN BRAZIL 20

II. RAILWAYS – MAJOR RISKS IN RAIL PROJECTS: INSTITUTIONAL 23 ARCHITECTURE, DEMAND AND COMPLETION RISKS

APPENDIX 29

I. EVENT PROGRAM 29

II. PARTICIPANTS 31

6Policy Brief for the LTFRA

INTRODUCTION

FGV CERI POLICY DIALOGUES

On March 15 and 16, 2017, the Centre for Regulation and Infrastructure Studies of Getulio Vargas Foundation (Centro de Estudos em Regulação e Infraestrutura-Fundação Getulio Vargas, FGV CERI) promoted the first Policy Dialogue – Long-Term Financing in Infrastructure and Risk Allocation in Brasilia. The discussion presented in this document is based on preliminary findings from the partnership between FGV and the World Bank. The event also had support from Norton Rose Fullbright. Additional support was granted by the International Chamber of Commerce (ICC).

The main purpose of the discussion was to identify the reasons underlying the financing infrastructure gap in Brazil. For this, we considered the experience from the energy sector and new concepts to be discussed with stakeholders. The event is part of a wide range of initiatives targeting a more robust environment for financing, capable of promoting sound long-term investments with private sector participation from Brazil and abroad, and boosting access to alternative sources of capital.

The event program was structured through some selected topics that are part of the research conducted under the partnership between FGV and the World Bank. These topics are the main subject of this Policy Brief and include currency risks and hedging, dispute resolution mechanisms and arbitration, compliance, political risk, and others. In the sections that follow, we summarize the structure adopted for the event.

EVENT STRUCTURE

DAY ONE – General/Cross Themes

Themes were chosen based on their relevance and urgency, from the point of view of CERI and partners involved. Discussions were organized on two-day panels. On the first day, we discussed general issues, applied to all infrastructure industries, with the roundtables divided on the following topics:

1. Introduction – Main Findings 2. Construction, Credit, Forward Exchange and Price Risks3. Insurance, Reinsurance and Surety 4. Capital Markets5. Dispute Resolution6. Integrity – Compliance, Anti-Bribery, Fraud and Corruption7. Risk Allocation and Guarantees Facilities

The themes above have an impact on the Brazilian economy in general; however, they are particularly important to regulated sectors and infrastructures. To this extent, a robust risk analysis and allocation is fundamental in the process for attracting private investors and high caliber competitors, with the capacity and ability to build, operate, and transfer infrastructure projects. Currency risk, for example, is considered as a matter of urgency to improve attractiveness of investments for foreign investors, considering that tariffs/revenues of regulated projects are Brazilian Real-denominated. Concerning insurance and reinsurance products, given the huge evidence that there is a preference for more liquid products like bank guarantees (“fianças bancárias”), which are easier to execute (on demand) although more expensive. There is also the possibility of defining an agenda for credit enhancement of investments, involving stakeholders and regulators both from infrastructure and those two important financial segments; for example deploying a project-based insurance product, which presents room for significant improvements. The question


involving the preference for bank guarantees against insurance products is also related to the ‘Dispute Resolution’ theme. The existence of well-defined arbitration instances for the parties involved and a robust definition of types of claims to be covered is pointed out as another important factor for a country to gain or not access to the international capital markets for infrastructure, with greater impacts depending on the existing institutions for compliance and combating fraud, bribery, and corruption. Finally, access to capital markets is a recurring theme in debates about Brazil’s economic development related to infrastructure bottlenecks, network industries, and regulated firms. There is even greater potential for improvements, if the Brazilian government recent repositioning in relation to public funds and state-owned banks, the main providers of capital in recent years’ long-term projects, is considered.

DAY TWO – Case Studies on Energy and Transportation Assets

The second day was devoted to the process of risk allocation for long-term infrastructure assets. There were two panels focused on relevant experiences for the Energy Sector and Transportation/Logistics. Therefore, discussions were based on two remarkable cases due to their crucial role in the strategy for economic growth in the country and the expressive challenge faced by each sector.

In the case of energy, the panel focused on thermal power plants with natural gas (NG). Since the 1990s, the Brazilian government has been promoting efforts to develop a market for NG, according to Law 9.478/1997. Initiatives in this direction continued to be developed, as can be seen in Gas for Growth Program (Programa Gás para Crescer), sponsored by the Ministry of Mines and Energy (Ministério de Minas e Energia). The program released general directives through a recent publication (December 2016) issued by the National Energy Policy Council (Conselho Nacional de Política Energética, CNPE). Nevertheless, the evolution of the discussions and actions recommended the accomplishment of an event as this one.

Railways investments were also highlighted as the transport and logistics segment is identified as one of the main bottlenecks to the country’s competitiveness. In the 1990s, within the context of network industries, railway concessions were implemented following the restructuring of the Federal Rail Network (Rede Ferroviária Federal, Sociedade Anônima, RFFSA). In spite of the gains from increased volume transported and reduction in the number of accidents, it was not possible to expand the country’s rail network. Consequently, even today the share of the rail mode in the volume of cargo transported is small and substantially lower than comparable economies. Since 2012, the federal government has been attempting to undertake efforts to restructure the sector. However, it has not yet been possible to implement changes capable of facilitating the expansion of investments in railways. The proposed 2012 reform met with resistance even internally and presented a high fiscal cost, and was subsequently abandoned. Contacts with investors in the context of CERI’s research show that this is one of the sectors that face the most difficulty in attracting long-term capital, given the existing regulatory uncertainty. The conflict between the relevance of the theme and the difficulty of making investments in the segment justified its choice as the focus of the discussions to be held on the second day to evaluate how to attract capital to the transportation sector.


BEST PRACTICES IN RISK ASSESSMENT AND RISK ALLOCATION

Dealing with risks is vital to the success of any investment. It becomes even more prominent when it comes to attracting investors in huge projects like the ones in the infrastructure sector. In this sense, best practices to assess and mitigate risks inherent to infrastructure in Brazil should be recommended. The following sections will discuss the significance of a well-established dispute resolution mechanism, integrity concerns, market solutions to protect from currency risk, and the structures in the credit insurance market.

I. DISPUTE RESOLUTION MECHANISM1

Arbitration is a key issue in the context of attracting investments to Brazil. It is regarded as a means of building investors’ confidence, by providing an agile, impartial, confidential, and highly specialized mechanism for dispute resolution. In this sense, the Brazilian government is attempting to increase the role of arbitration in the country as part of a strategy to attract investments to infrastructure sectors.

However, from investors’ perspective, there are relevant risks that need to be addressed. Such risks can be divided into two main issues: (a) uncertainty about what matters may be settled by arbitration; and (b) uncertainty about whether investors will ultimately benefit from an agile and highly specialized forum, with outcomes often threatened by judicialization. Especially in heavily regulated sectors, such as infrastructure, the perception of such risks is magnified. This is mainly because some disputes will involve the participation2 of a public (or quasi-public) entity as a party. Another reason is the dispute will normally involve challenging rules approved by regulatory agencies. The latter creates uncertainty around the possibility of using arbitration for such issues.

Why arbitration?

Regulated in Brazil by Law 9.307/96, arbitration is increasingly adopted and is recognized as a successful way to settle disputes, not only between private parties but also with the public sector. With regards to the public sector, there is no legal rule obliging a public entity to enter arbitration and it can only be used to settle disputes related to strictly alienable interests or property rights.

In 2015, 13.1 percent of the cases arbitrated by the ICC involved a state or public entity. From 2005 to 2015, the ICC Latin America team alone dealt with 136 cases involving 145 public entities and 23 states. Considering all arbitration institutions acting in Brazil, 4 percent of the arbitration cases had a governmental entity as a party. That number is expected to rise in light of the recent amendment3 to the Arbitration Law, which made clear that arbitration can be used to resolve disputes with the public administration.

Several reasons can be put forward for the success of arbitration in Brazil. The Brazilian Courts’ slow decision-making process is often mentioned as a barrier to the enforcement of rights, which further limits the certainty and predictability of the outcome to investors. On the other hand, arbitration being a system with its own methods and specific procedures which are regarded as paramount for succeeding. Moreover, the availability of impartial arbitration contributes to lower the risk perception impacting the minimum required rate of return on investments (the hurdle rate) by investors.

1 The subject of this topic is discussed in more details in an accompanying article “Arbitration in Regulated Sectors in Brazil”, available on http://ceri.fgv.br/sites/ceri.fgv.br/files/arquivos/arbitration-in-regulated-infrastructure-sectors-in-brazil-2017.pdf

2 Expressly allowed by Law 13.129/15.

3 Law n. 13.129/2015.


Generally speaking, three advantages of arbitration are often mentioned: (a) procedural swiftness; (b) confidentiality; and (c) high degree of specialization, since arbitrators are chosen by the parties (reliability). A survey conducted by Queen Mary University of London (2015) pointed out that the enforceability of awards, followed by ‘avoiding specific legal procedures’ and ‘selection of arbitrators’, were the most valuable characteristics of arbitration.

The Legal Framework in Brazil

Following international trends, the Brazilian Congress enacted Law 9.307/96 regulating the use of arbitration as a means of resolving disputes. Prior to the Law, there were some legal mentions of dispute settlement, encompassing, among others, the friendly resolution of contractual disputes as an essential clause in concession agreements for public services.4

Today, Law 9.307/96 is the general arbitration law. Only the ports sector has its own regulation for arbitration—Decree 8.465/2015. Regarding renewed concession contracts within the scope of the Investment Partnership Program (Programa de Parcerias de Investimentos, PPI) in roads, rail, and airports, the arbitration rules contained in Provisional Measure5 752/2016 also apply.

A precondition for arbitration is the existence of an arbitration agreement between the parties, which is often a specific clause inserted in the contract or a separate agreement after a conflict arises.6 Arbitration should proceed according to the rules of the arbitral institution chosen by the parties. Nevertheless, modern contracts already contain some procedural rules, such as those related to the implementation of arbitration proceedings, the number and choice of arbitrators, or the timeframe for a decision.

The Arbitration Law itself neither obligates the arbitration to be carried out in Portuguese, nor requires the application of the arbitral rules of arbitration chambers established in Brazil. Nevertheless, Law 8.987/95, which regulates public service concessions, establishes arbitration within the scope of concession agreements must be conducted in Portuguese and takes place in Brazil.7 This obligation is also found in Law 11.079/04, regarding public-private partnerships (PPPs)8 and in the concession agreements’ arbitration clause.

Many questions arise when one looks at the Brazilian legal framework regarding arbitration. The focus here is on problems related to the participation of the public sector in arbitrations, sometimes as a regulatory body, sometimes as an entrepreneur (state-owned companies or public-private companies).

4 Such as Article 23, XV, of Law 8.987/95. It is worth mentioning Articles 851, 852, and 853 of the Civil Code, which allow arbitration and arbitration clauses in contracts, except for matters regarding status, family and personal rights, and others that do not have a strict patrimonial nature.

5 Provisional measures (medidas provisórias) are presidential decrees that take immediate effect with the status of ordinary law, but then subject to congressional approval/rejection/amendment, under a priority regime. They are limited to “relevant and urgent” matters.

6 According to Wording no. 2 of the Council of Federal Justice, even in the absence of an arbitral clause, the Public Administration can sign an arbitration agreement.

7 Art. 23-A, Law 8.987/95.

8 Art. 11, III, Law 11.079/04.


Who Can Agree to Use Arbitration? Some Examples Regarding Regulated Sectors/Infrastructure in Brazil

At first, it was not entirely clear which entities could resort to arbitration to settle disputes. Broadly speaking, Law 9.307/96 originally did not prohibited nor allowed the use of arbitration by public-sector entities. It only mentioned that any person or company able to enter into contracts could make use of it. The main doubt comprised the bodies of the public administration and state-owned enterprises.9 Until the lack of clarity in the Arbitration Law was resolved, some laws made room for arbitration between private companies and public entities in specific sectors. The Superior Tribunal of Justice, in a leading decision from 2005,10 clearly held that a public-private company, engaging in economic activity or performing a state-granted public service, has a legal right to enter into a contract with an arbitration clause. In this case, the dispute was over a power purchase agreement (PPA) related to an alienable right of a public-private company. Finally, Law 13.129/15 clarified the issue, by means of amending the original Arbitration Law to explicitly allow—not to obligate—indirect and direct bodies of the public administration11 to use arbitration to settle disputes regarding alienable rights. While most regulators engage in arbitration, there are some that opt either to leave open the possibility of entering into arbitration or to simply not do so. The following are some examples for regulated sectors in Brazil:

a. Definition of ‘oil field’ as an alienable rightb. Modulating objective arbitrability in telecommunicationsc. Arbitration and Chamber of Electric Energy Commercialization (Câmara de Comercialização de

Energia Elétrica, CCEE)d. Arbitration in the ports sectore. PPI and arbitration

Concluding Remarks

After a first phase marked by tentative contractual and legal provisions regarding alternative dispute resolution in general (conciliation and arbitration in particular), a second phase followed with the enactment of a specific legal instrument for arbitration (Law 9.307/96). Since then, a third phase is in course, related to the possibility for public entities’ entering into arbitration and the definition of ‘alienable rights’ by the regulator rather than the judiciary.

Although the legal possibility is clear and the enforceability of arbitration clauses and awards have been recognized by the Brazilian courts, arbitration still faces some challenges, which are translated into risks for investors. For example, in some infrastructure sectors, there is a grey zone regarding the delimitation of an ‘alienable right’; an arbitral proceeding still takes some time (almost always more than the legally established ‘six months’); there are high costs involved in the process; and finally, praxis has shown that a resort to litigation is often chosen, more in the case for precautionary and urgent measures but also to declare the arbitral award null.

In the context of emerging markets, investors tend to see a concession agreement as having an inherently higher risk or to seek a higher rate of return to compensate for losses, if the right to review an unfair or incorrect decision of a regulatory body by an arbitral institution is denied.

9 Arbitration Law inserted by Law 13.129/15, allowing the public administration to submit to arbitration, TCU now rules for the legality of arbitration clauses.

10 Special Appeal no. 612.439/RS, judged on June 6, 2007. The Superior Tribunal de Justiça is the highest court for non-constitutional matters, entrusted with harmonizing interpretation of federal laws by the state and regional federal courts of appeal.

11 In Brazilian Administrative Law, the Public Administration are divided into direct (ministries, state secretaries, and municipalities) and indirect (agencies, public foundations, public companies, and semipublic companies) bodies.


A legal rule defining how, when, and which bodies of the Public Administration can enter arbitration could provide more legal certainty and therefore less risks to investors. Each concession agreement, depending on the infrastructure sector, brings its own set of rules regarding the time required to settle a dispute, the choice of arbitrators, the arbitral court where the issue should be taken to, cost sharing between the parties, and so on.

It is important for private companies and the public administration to firmly rely on arbitration when there is an arbitration clause in the concession agreement, and not to weaken the gains achieved by the usage of arbitration so far. The formulation of a standardized and well-defined arbitration clause can reduce interpretation risks and offer legal security.

On the other hand, it is necessary for public bodies to define ‘alienable rights’ and to draw a line separating the application of a regulatory measure from its economic effects on particular concessions; only the latter could be submitted to arbitration. The inclusion of such definitions in concession agreements can prevent frivolous arbitration.

Furthermore, arbitration institutions should implement governance mechanisms aimed at reducing costs (such as guidelines related to third-party funding) and to reduce the time needed to settle a dispute (use of mediation and emergency arbitrators, expedited procedures, commitment to a schedule, and sanctions for dilatory conduct).

12 This session follows the discussion that took place at the CERI Policy Dialogue meeting in March, 2017. Subsequently, the arguments were presented in the article “Contratando a Prevenção da Corrupção”, by Gustavo Kaercher Loureiro. April 11th, 2017, available on https://jota.info/artigos/contratando-a-prevencao-da-corrupcao-11042017.

II. INTEGRITY12

The insertion of clauses intended to prevent contractors from committing crimes against the public administration (active corruption, influence peddling, and so on) is becoming more frequent in contracts between private individuals who have some kind of possible interaction with the public power. In general, such clauses provide for reciprocal obligations of (a) abstention from acts that may constitute such offenses (payments, gift offers, promises of advantages, rewards, and so on); (b) constitution and execution of compliance programs; and (c) submission to different types of audits, from part to part, to verify compliance with previous obligations (‘interference clauses’).

Despite the importance of these initiatives, they may bring a risk of criminal liability to the individuals charged with enforcing such clauses, as well as other agents inside the company. The risk arises from the ‘interference clauses’ and is related to the criminal figure of the ‘guarantor’, foreseen in Article 13, § 2, of the Brazilian penal code. By ‘receiving the right’ to supervise the conduct of the other party (and not to perform contentedly), the guarantor may respond for crimes committed by him/her, in compliance with certain conditions that have been attenuating in recent times.

According to the Brazilian penal code, the agent who ‘could and should act to avoid the result’ will be held liable for omission. This duty to act may derive from a law that provides the agent with a duty of care, protection or vigilance (Article 13, § 2, point a); may arise from a contract or some other ‘form’ (point b); or it can still originate from a ‘previous behavior’ of the agent (point c). In the present case, the duty to avoid the result arises from the contract and, more precisely, from the interference clauses, if they are drafted in such a way as to give contractors essentially two capacities: (a) continuous access, on a periodic basis, to the information of the other party that provides evidence and/or evidence of the practice of criminal acts; and (b) powers not only to detect but also to determine the cessation of such practices. If this is the case, certain individuals of the company place themselves in the position of ‘guarantors’ of the other party’s


conduct (Article 13, § 2, point b). There is a voluntary assumption of risk by the behavior of others, different from what happens in situations in which managers and directors respond for acts of their own employees because in this case the relationship occurs within the business structure.

As stated above, the requirements for such liability are being mitigated. Two of these trends are relevant here. The first concerns the relativization of intent in crimes of improper omission. It is not uncommon to see the use of figures such as eventual fraud, conscious guilt, or even the import of figures such as ‘deliberate blindness’ or gross negligence. Briefly, if we are not moving toward an absolute responsibility for omission, it is certain that it has become less relevant to ask whether the one who had the duty of vigilance wanted the omission of the crime to occur. The second trend refers to the increase of guarantors. It is often the use of the figures of the ‘primary guarantors’ and ‘secondary guarantors’ to seek to extend the circle of omittance from the one who is directly and immediately responsible for the supervision of the other contractor to ascend the hierarchy (of the delegation, or imputation bottom-up) or extend laterally (that is, toward other agents who, having to collaborate with the primary guarantor, stopped doing so).

Considering this scenario, redoubled attention must be paid to interference clauses. In some situations, surveillance is less problematic. This is the case when contractors are known, in relationships with third parties or when they have the same conditions. In other circumstances, however, the scenario can be quite complex. It is enough to think of contracts involving completely heterogeneous parts, in which one does not dominate the area of performance of the other, behind one of the parties there is a universe of outsourcers, consortiums, consultants, there is a real asymmetry of information and conditions of power. In these cases, paradoxically, surveillance, when more robust on paper, can become a de facto risk. Thus, there is no uniform solution. Some caution is needed to mitigate the risk of a pandemic contractual criminal liability. First, it is worth asking if it is indeed necessary to include such clauses. It is not a matter of questioning the necessity or usefulness of the commitments—which are, moreover, obvious—not to commit crimes or compliance obligations, but to adopt measures to monitor compliance with those obligations. Beyond the commitment to good behaviour, is it necessary to replace the state and also act as a police officer?

Second, with some degree of control being necessary, it is important to leave the standardization aside and size it according to the possibilities and characteristics of the two companies, asking some questions such as, what is the real surveillance capacity that company A has on company B, considering its specificities? What is the most appropriate type of supervision for this contract? What are red flags?

Third, once the clauses are realistically stipulated, a strict execution must follow. Considering that there are those who understand that not implementing a compliance program constitutes a lack of the duty of supervision of the entrepreneur, it is quite possible to understand that constructing an audit clause and not complying with it is worse than not having it. Finally, it is appropriate to establish clearly the powers and attributions related to the enforcement of the interference clauses. This measure may mitigate the risk of vertical and horizontal enlargements of liability discussed above. The guarantor figure in the business sphere was designed to avoid ‘organized irresponsibility’ that ultimately penalized only the subordinate officer who committed the crime materially, leaving the highest spheres of the organization unpunished. Organizing accountability is the best way to prevent ‘disorganized and unbridled accountability’.


III. CURRENCY RISK AND HEDGING13

The outcome of last’s airports concession auction on March 17 were auspicious. The airports of Porto Alegre, Florianopolis, Salvador, and Fortaleza granted a total amount of R$3.72 billion in concession fees (outorga).

The Brazilian effort to develop and design mechanisms to attract foreign investors was recognized by three experienced international airport operators - Vinci Airports SAS, Zurich Airport International AG, and Fraport AG Frankfurt Airport Services. It is important to remember that the profile of investors attracted by the new financial model established at that last auction highly differs from the group of investors that participated in the previous airports’ auction, in which consortia of contractors and/or related parties were awarded winners. Table 1 summarizes the auction results.

Table 1 - Result of the auction of airport concessions – March of 2017

Airport Winner Company Accepted Bid (R$)

Minimum Bid (R$)

Number of competitors

Total number of Bids

Fortaleza Fraport AG Frankfurt Airport Services

425.000.000,00 360 Millions 2 6

Salvador Vinci Airports 660.943.107,00 310 Millions 1 1

Florianópolis Zurich International Airport AG

83.333.333,33 53 Millions 2 11

Porto Alegre Fraport AG Frankfurt Airport Services

290.512.229,00 31 Millions 2 8

Source: FGV CERI.

Evaluating the Inclusion of Market-Based Solutions

One of the innovations of recent the auction was the introduction of a currency risk mitigation mechanism, with optional adhesion. This mechanism enables that changes in the exchange rate in a period of one year that exceed a reference component (variation in the inflation rate and country risk component) be offset by a reduction or increase in the amount to be collected as a grant by the government.

The mechanism establishes two ways for varying the grant to compensate for currency rates changes. On one hand, in case of depreciation of the Brazilian currency, the grant is reduced and can reach up to 100 percent of its total value. Furthermore, for great currency depreciations that lead to a grant’s reduction of more than its total value, the accumulated excesses may be offset in the following year. On the other hand, in case of the Brazilian currency’s appreciation, the grant value increases. However, in this last scenario, the maximum grant increase is limited to 10 percent of its reference value.

In this sense, the Civil Aviation National Fund (Fundo Nacional de Aviação Civil, FNAC) features as an important party in this process, providing collateral to support the proposed mechanism. Managed by the Civil Aviation Secretary (Secretaria Nacional de Aviação Civil), FNAC collects the amounts paid as grant in the aviation sector, acting as a de facto backstop guarantee.

This mechanism works as a de facto hedging mechanism, which can be determined as a two-options combination offered by the government: a Margrabe option, in which one asset is exchanged for another (in this case the currency rate variation is exchanged for the benchmark value); and a cash-or-nothing option, in which the cash flow is an amount strictly positive or zero. In practice, the mechanism created

13 More details in the article “Abertura no mercado de financiamento de longo prazo de projetos de infraestrutura”. Conjuntura Econômica - April, 2017.


by the federal government can be assessed as a derivative box, intended to deal with currency risks. Furthermore, according to this mechanism, the government completely bears the total currency risk variation.14

In analyzing this mechanism as a derivative box, it is possible to compare the instrument offered by the government to those financial derivatives available in the market, which are usually used by companies to mitigate currency risks in other scenarios. In this case, through the introduction of a zero-cost collar15 and a currency swap, it is possible to significantly reduce the compensation amount to be discounted from the grant value or even reduce the contribution amount to FNAC beyond the reference value in case of the appreciation of the Brazilian currency. Table 2 reports the results of the mechanism proposed by the government.

The use of solutions already available in financial markets could even lead to better results. In this case, for values considered in the example presented by the government, it is possible to achieve an expressive reduction of costs. The use of currency derivatives is a safe path for the introduction of a technology already known by investors and foreign banks.

Table 2 - The proposed model by the government

Scenario Mt Margrabe Option (+)

CNt Cash-or-Nothing Option (-)

Total Result Practical Effect

St > Bt St - Bt 0 St - Bt “Grant” at moment t is reduced by the total result

St < Bt 0 Xt = min { Bt - St ; 10% CP} - Xt ‘Grant’ at moment t is increased by the total result

Source: FGV CERI

Figure 1 – Derivatives – Zero Cost Collar Swap

14 An important concern is regarding a sudden exhaustion of the resources destined to FNAC in the occurrence of an adverse and high-level foreign exchange fluctuation. In a scenario of high demand for projects, the available resources could also deplete.

15 The zero cost is a structure that combines two options in a way that the total cost is zero and the cash flow is limited to a maximum value and a minimum value, corresponding to the options’ strikes.


Source: FGV CERI

The Government’s New Challenge: Scaling Up Foreign Exchange Hedging

The government’s solution merit is to combine two fundamental features: a mechanism intended to deal with currency risk (derivatives box) and the use of FNAC’s cash flow as collateral, a de facto financial guarantee. The most relevant question to be answered is whether the proposed mechanism can be replicated and/or extended to other sectors. In this sense, it is important to assess the availability of funds and resources that could be used as guarantee, such as FNAC. The energy sector (electricity and gas) can be assumed as a natural candidates to this kind of proposed mechanism followed by transport and sanitation sectors.

Table 3 - The Collar as a Hedge of a debt in a foreigner currency

Scenario (S Represents the Currency Rate)

Long Putt (+) Short Callt (-) Debtt (+) Total Result

St > K2 0 St - K2 St K2

St < K1 K1 < St 0 St K1

K1 < St < K2 0 0 St St

Source: FGV CERI.

Note: Rolling zero cost collar: The limits K1 and K2 are obtained for each year horizon and in a way that the combination costs ‘zero’. Then, the effect of extreme exchange rate variations is limited by the instrument. Smaller variations can be protected with a traditional swap (see figure 1).

16 This section is based on the paper “Why and How to Use Structured Credit Insurance, by Corina Monaghan (Jardine Lloyd Thompson [JLT]).

IV. INSURANCES, SURETY AND GUARANTEES: WHY AND HOW TO USE STRUCTURED CREDIT INSURANCE16

Financial institutions started buying Structured Credit Insurance relatively late in the history of the credit and political risk insurance (PRI) market but their use of the product has increased exponentially in the past decade, mainly led by changes in the regulatory environment but also the realization that Structured Credit Insurance can be a powerful instrument for management of credit lines and a valuable source of information. Structured Credit Insurance’s worth as a product was proven in the aftermath of the 2008 financial crisis.

Structured Credit Insurance is a useful instrument of credit risk management and mitigation while also acting as a secondary credit committee and source of information for best practice.

How Banks Started Using the Structured Credit Insurance Market

During the late 1970s, private insurers, initially led by Lloyds’ syndicates before other insurers entered the frame (both Lloyds’ syndicates and insurers being referred to hereafter as ‘Insurers’), had started to offer PRI for investments made in emerging markets, with the underlying rationale being that any loss caused by the actions of a foreign government should ultimately be recoverable through the international courts. Initial demand for PRI came from potential policyholders engaged in business in emerging markets who were looking for a competitive alternative to the offerings of export credit agencies (ECAs) and, to an extent, multilaterals.

It was not long before Lloyds was persuaded that the natural evolution from this starting point would be to allow Lloyds’ syndicates to venture into the previously restricted area of Financial Guarantee Business and insure policyholders against the risk of governments failing to honor contractual obligations. Insurers’


premise was that governments did not default and that losses, if any, would ultimately be recoverable. Thus, the logic which had been applied to insuring investments in emerging markets was carried forward in favor of contractors, suppliers, and off-takers operating in the same territories. Structured Credit Insurance was born with Lloyds granting an exemption from the blanket ban on Financial Guarantee Business. This exemption was later extended to the risk of default of private obligors in 1996.

From a general perspective, the growth of the Structured Credit Insurance Market has shadowed the growth in world trade volumes and values. At the same time, promotion of Structured Credit Insurance as a product has been assisted by both changes in the regulatory environment and support from the regulators themselves which have combined to accelerate this growth and drive improvement of the Structured Credit Insurance product resulting in enhanced credibility among policyholders.

Regulatory and Economic Capital Relief

Regulatory capital relief is the main reason why international banks’ use of the Structured Credit Insurance Market has increased enormously in the last decade. Structured Credit Insurance falls under the definition of a guarantee which is recognized a valid credit risk mitigant under the International Convergence of Capital Measurement and Capital Standards Report (commonly known as Basel II) principles which came into force in the European Union on January 1, 2007. Basel II presented a revised framework of rules meant to ensure that banks are adequately capitalized and to preserve the integrity of capital in international banks with subsidiaries by eliminating double gearing.

According to the Basel II principles, regulatory capital relief is granted where guarantees “are direct, explicit, irrevocable and unconditional, and supervisors are satisfied that banks fulfil certain minimum operational conditions relating to risk management processes” (clause 140 of Basel II). To allow Structured Credit Insurance to be considered a guarantee, the product offering and policy wordings previously used with insurers were adapted to comply with the following operational requirements (clause 189):

• “direct claim on the protection provider”• “explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is

clearly defined and incontrovertible”• “Other than non-payment by a protection purchaser of money due in respect of the credit protection

contract it must be irrevocable”• “no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover”• “no clause in the contract that would increase the effective cost of cover as a result of the deteriorating

credit quality in the hedged exposure”• “it must also be unconditional; there should be no clause in the protection contract outside the direct

control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payments due”

• eligible guarantors must be “rated A- or better”

All of these can be met by insurers and documented in the policy itself. Also worthy of note is that regulatory capital relief may not be the main interest a bank has when purchasing Structured Credit Insurance. In any case, Structured Credit Insurance is also a source of economic capital relief as it contributes to the improvement of the Global Recovery Rate associated with each counterparty and transaction. An insurance policy can therefore be considered as an additional source of security or collateral over and above the security package which might be available under a certain financing agreement.

Management of Internal Credit Lines

If regulatory capital relief probably has been—since the Basel II principles came into force—the most obvious reason why a bank would be interested in buying Structured Credit Insurance, there are other


benefits which should be considered and can be a real enhancement to the bank’s position both internally and among its peers.

Structured Credit Insurance is a powerful instrument for management of credit lines, as it allows banks to mitigate their exposure not only to a counterparty, but also a country, a region, or a sector, therefore freeing up the banks’ capacity to take additional net exposures to these same counterparties, countries, regions, or sectors. This can greatly improve the banks’ ability to offer financing to their clients by pushing the boundaries of the banks’ risk departments’ appetite. At the same time, the use of Structured Credit Insurance can help banks to considerably leverage their position in syndicated deals by allowing them to offer bigger lines than their net appetite would otherwise have dictated without the support of insurers. In certain cases, this can even lead banks to structure deals on their own without having to seek syndication partners for support where their available capacity is limited. This is a crucial aspect to consider for a bank which would be concerned to preserve its bilateral lines and avoid going to the bank syndication market to maintain competitive advantages in a certain sector or country. In such cases, insurers of the Structured Credit Insurance Market represent a valuable and noncompetitive alternative to banking partners.

As a means of adding diversification to a bank’s syndication pool beyond just competitors active in the banking syndication market, the Structured Credit Insurance Market presents the benefit of accessing about 50 partners active within the Structured Credit Insurance Market and potentially through only one channel of communication represented by the broker. The aggregation risk on each insurer can then be reduced by a careful insurer selection strategy. The use of a wide panel of insurers renders the management of waiver requests, amendments, restructurings, and potential claims smoother, as none of the insurers has too much to lose and they are therefore more amenable to finding compromises even in difficult or potential loss situations where the preservation of the bank’s commercial relationship is often a key driver. The good track record for payment of claims and, just as important, the history of restructurings in the Structured Credit Insurance Market are here to confirm this.

Source of Expertise

A major benefit which banks can derive from the use of Structured Credit Insurance, especially when they are entering new territories or activities, is the extraordinary pool of expertise represented by insurers with the most senior underwriters combining decades of experience of supporting trade and investment in emerging markets. This is the result of the continuity of personnel employed by the principal stakeholders within the community of Structured Credit Insurance.

Insurance Market

Some investors may be looking to expand their business in areas outside their traditional area(s) of activity, whether from a geographical or sectorial perspective. The London Structured Credit Insurance Market is a source of deep knowledge across all geographies and most sectors given the diversity of its client base. This experience has been built through the years, on the basis of other banks, commodities traders, and multinational corporates’ activities and information; and it has been tested by difficult loss situations, restructurings, and claims. New entrants in this market which may be nervous about certain countries or sectors can greatly benefit from this expertise and gain confidence with their new ventures where insurers themselves demonstrate a good level of comfort.

All the benefits mentioned above would only remain theoretical if the product had not been able to demonstrate its efficiency. Structured Credit Insurance has now existed for a few decades and with the Basel II principles having been enacted in the European Union in 2006, Structured Credit Insurance, as an instrument underpinning regulatory capital relief, has been put to the test for almost nine years to date with a very satisfactory track record.


INTRODUCING A NEW GUARANTEES FRAMEWORK ARCHITECTURE

Changes in the financing framework conducted by the National Bank for Economic and Social Development (Banco Nacional de Desenvolvimento Econômico e Social, BNDES) combined with evolving regulations have impacted conditions under which investments are made. Those impacts have adversely influenced expectations of investors and the pace of investments in infrastructure business/assets opportunities. A key aspect in this conundrum stems from the need of aligning sustainable projects, regulatory clarity and robustness, market-based financing availability, and adequate business climate to harness the investment potential. The need to evolve the financing framework for infrastructure projects was overlooked while BNDES remained as the key source of lending primarily following corporate lending (CL) discipline.

In this new environment, the introduction of international standards/best practices such as limited-recourse financing (LRF) together with other structured approaches highlight the need to uncover and address risks in four major milestones in a project cycle: financial closure, completion, refinancing, and operating risks (figure 2).

Figure 2. Project cycle and risk milestones

Source: FGV CERI.

The figure of a guarantor emerges at each critical milestone to mitigate risks that cannot be adequately managed by private investors. A change of paradigm from CL toward LRF uncovers four components required to enable investments in infrastructure in accordance with best practices:

a. Credit enhancement. Domestic investors may be satisfied with the local A-rated guarantor, that is, the sovereign. However, international lenders and investors requirements may not be met by pricing loans accordingly for a BB-rated guarantor. In addition, those investors may seek a minimum A-rated credit enhancement provider overseas.

b. Conditional and unconditional guarantees for the lifetime of investments. There has been a behavior skew toward completion risk through and disregarding operating/regulatory risks. For completion risks, there has been an overuse of letter of credits (cartas de crédito/carta de fiança bancária, LCs) backstopped by corporate guarantees; this approach overlooks intrinsic counterparties credit risk. Surety products in the tradition of instruments available in US are not part of the financial structures adopted in Brazil.

c. Public versus market instruments. The established frame of mind of investors and lenders requires sovereign guarantees to mitigate risks undermining the implementation of best practices. Inadequate guarantee alternatives and product mispricing do not support the development of a market.


d. Market incompleteness. The lack of effective financial guarantees and PRI (surety) markets curtails alternatives for mitigating risks.

Investing in infrastructure presents a common concern among stakeholders (investors and lenders); the long maturity of contracts involves a reasonable possibility of financial imbalances occurrences caused by Material Adverse Effect Uses in Government Action (MAGA). In such a context, a government authority that acts against the borrower or any of its subsidiaries can reasonably be expected to cause material adverse effect. Investors have responded to MAGA events by requiring and deploying advanced and effective guarantees products; that is, financial guarantees, contingent loans, and insurance (PRI/surety) through a structured framework. These products should be structured to derive maximum benefits to the investment and investors while ensuring sustainability and fairness. Questions have arisen regarding the nature of instruments to be adopted:

a. The country lacks of guarantee products compatible with international standards, for example, surety products.

b. On-demand guarantees are limited to LC and collaterals such as treasury notes and corporate guarantees (whenever liquid).

c. From the insurance markets’ perspective, the products that more closely resemble international standards are those provided by the Brazilian Guarantees Agency (Agência Brasileira Gestora de Fundos e Garantias, ABGF). The managed funds such as Infrastructure Guarantee Fund (Fundo Garantidor de Infraestrutura, FGIE) and Public-Private Partnership Guarantee Fund (Fundo Garantidor das Parcerias Público-Privadas, FGP) face no equivalent in the domestic private insurers market.

Figure 3. The PPI’s facilitator role and the mezzanine guarantor

Source: FGV CERI.

Challenges deriving from this environment could be addressed through the adoption of a two-thread approach. First, by facilitating the convergence of both financial and insurance guarantees products. This task could be performed by the PPI, with the objective of enabling infrastructure investments at project design. Second, the introduction/participation of a guarantor designed according to international standards can bridge potential guarantees gap/midterm supporting needs to enable those investments.


CASE STUDIES

I. NATURAL GAS – FINANCING A GAS-FIRED POWER PLANT IN BRAZIL

Twenty Years in the Pursuit of a Market for Gas

The Brazilian government and other stakeholders involved increasingly acknowledge the relevance of NG for power generation in Brazil, in spite of a common point of view that still associates thermal power generation as a balancing mechanism for the system. There is robust evidence that NG must be considered part of the Brazilian matrix in combination with hydro, other thermal sources, and renewable energy. In the following sections, we discuss the main historical facts regarding the evolution of this market in Brazil.

The 1997 Petroleum Law (9.478) worked mainly in a vertically integrated industry, except distribution. There was lack of a proper regulatory framework and market design for gas. During this time, gas was a secondary resource, related to oil. During this period, there was no NG network expansion.

At the beginning of the year 2000, the Ministry of Mines and Energy created the Thermoelectricity Priority Program (Programa Prioritário de Termelétrica, PPT). The program was implemented to secure electricity supply through thermal power generation plants backed by long-term PPAs. The NG for fueling the plants was contracted under conditions established in the PPT which also hedged the currency risk on fuel prices.

In 2005, the federal regulator, the Brazilian National Agency of Petroleum, Natural Gas and Biofuels (Agência Nacional do Petróleo, Gás Natural e Biocombustíveis, ANP) created two important regulations: 27 and 29. ANP Resolution no. 27 was a tariff regulation and ANP Resolution no. 29 regulated access to the pipeline transport infrastructure.

In 2009, the legislative branch enacted Law 11.909, also known as the Gas Law. The intention of this law was to create proper regulatory framework for the gas sector and to end the lack of regulatory framework for expanding the network. Nevertheless, this law was not enough to achieve its intended goals.

At the beginning of 2016, the government launched the Gas for Growth Program aimed at designing a reform to develop a competitive market for NG.

Project Payments Structure

A thermal power plant’s revenue comprises of (a) fixed revenue related to Take or Pay (ToP), and (b) a variable cost [related to the amount of energy generated whenever dispatched - variable cost [custo variável unitário, (CVU)]. The first element represents the payment for availability. The second element is paid when the Combined Cycle Gas Turbine (CCGT) is dispatched (less the ToP), it is composed of the pass-through of variable costs and operation and maintenance (O&M) and fuel costs.

An indexation formula is introduced in formulation of the NG price. The capacity and O&M payments are not indexed to USD (currency); fuel prices and energy ToP are indexed to the consumer price index (CPI). The main goal is to provide a contractual price indexation to insure the firm against BRL-USD and fuel variations. Current rules also allow for a combination of several international indexes to be used: Japan-Korea Marker (JKM, Japan), National Balancing Point (NBP, UK), Henry Hub (USA) and Brent (UK). Infrastructure contracts such as Regas are not indexed to the U.S. dollar.


Major Risks for Gas-fired Power Plants Projects

Considering both regulated market and free contracting environment, major risks for gas-fired power plants may be identified. Key risks include completion, dispatching, foreign exchange, fuel, and connecting to the grid.

a) Completion Risk

Completion risk could be divided into three groups: licensing (multiple sub-stages and unlimited costs), construction (quality and cost overruns), and commissioning (performance and Grid connection) as shown in figure 4.

Figure 4 – Risks identified and related agents

Source: FGV CERI.

b) Dispatching Gas-Fired IPPs

Dispatch uncertainties caused by demand fluctuation, competition from hydropower and performance are key risks for gas fired-power plants in Brazil. As an example, figure 5 shows the gap between the real dispatch and the dispatch from the Planning Operation Model of the Hydroelectric System in the Short Term (Modelo de Planejamento da Operação de Sistemas Hidrotérmicos Interligados de Curto Prazo, DECOMP) operations research algorithm for the Southeast market.

Figure 5. Forecasted versus real dispatch: Southeast

Source: National Electricity System (Operador Nacional do Sistema Elétrico, ONS), elaborated by FGV CERI.

Ener

gy (M

Wm

)

Thermal Power Plant SE Thermal Power Plant DECOMP SE


The blue line represents the dispatch from DECOMP optimization algorithm, used by the national system operator (ONS) whereas the black line represents the real dispatch. In this situation, the operator may have not followed the optimization model (to avoid or minimize energy rationing in the Brazilian system) and thermal power plants have been dispatched more than the forecasts used when investments were taken. By and large, the forecasted dispatch (in the short term) is underestimated.

The Brazilian electricity auctions favor generators that submit bids associated to lower levels of Energy ToP which effectively means a lower fuel cost for the ToP is desired.17 In addition, the system also contracts NG power plants to operate as backups. However, those plants are often dispatched with greater frequency than planned or expected at the time of the bidding.

Moreover, the domestic gas market cannot provide supply contracting with such flexibility at competitive price – lower prices can only be obtained with larger tenor contracts. Therefore, higher flexibility implies higher costs with uncertain dispatch costs being reimbursed by the CVU which makes gas-fired plants uncompetitive.

High penalties due to underperformance and lack of fuel (supply risk) affect both the generator and the gas supplier, increasing their risks. Moreover, poor performance of generators can lead to revision of contracting conditions and reduction of their capacity payments.

c) Foreign Exchange Risk

As a rule, capacity payments are not indexed to the U.S. dollar. Investors and financiers claim that indexation of capacity payments to the U.S. dollar could lower the capital cost. On the other hand, fuel costs can be indexed to the U.S. dollar and to Gas Prices Indexes (both the Energy ToP and the Energy Payment). Bidders can build a pass-through structure more adherent to its project reality (“Factor i’’ and other costs components). In this context, indexed projects can lose competitiveness due to long-run fuel prices forecasts.

d) Fuel Risk

Contracting of NG thermal power plants in the electricity auctions in Brazil require a long-term flexible gas supply contract (with a length coherent with the PPA’s duration). Since Petrobras is the de facto exclusive supplier of gas in the country, such flexibility comes at a high cost (average 70 percent Gas ToP). Gas ToP cost enhances the availability cost of the plant, increasing the capacity payments accruing to the gas projects. It is important to consider that fuel corresponds to 60 percent to 80 percent of the CVU and financial completion of the project requires the demonstration of fuel availability in the long run.

e) Connection to the Grid

Postponements in transmission lines can hold off generators’ revenues while delays in capacity payments can impact the payment of loans by the project company.

17 The score function in such auctions tend to favor profiles associated with higher variable cost and consequently lower expected generation.


II. RAILWAYS - MAJOR RISKS IN RAIL PROJECTS: INSTITUTIONAL ARCHITECTURE, DEMAND, AND COMPLETION RISKS

Introduction

The Global Competitiveness Index18 for infrastructure, a basic requirement for a country’s competitiveness, puts Brazil at 72 out of 138 countries. Although a good transportation system is essential to ensure a country’s competitiveness and, therefore, its development, the Brazilian logistics matrix is not even close to integrated and relies mostly on highways. This arrangement implies high maintenance costs of the network, expensive freight, and excessive traffic jams. Goods transportation infrastructure has become a first issue to exporters and importers as it hinders their ability to compete. In this context, the expansion of the rail network appears as a suitable alternative.

Looking for a Rail Industry Market - The Last Three Decades

After a long period of inattention, in the 1990s, the Brazilian Government underwent a bundled privatization process, aiming at recovery of the existing physical structure of the railway system. The privatization included concessions to the private sector for providing rail services as well as management and operation of the existing networks, involving, for this purpose, the lease of fixed assets dedicated to the activity.

The first stage of the rail sector privatization resulted in (a) retaining the vertically integrated model; (b) market fragmentation in regions; (c) the dominance of concessions by commodity producers; (d) increased level of efficiency and safety; (e) lack of a (proper) regulatory framework and market design; and (f ) no network expansion (only brownfield projects).

The first wave of privatization attained consistent results of improved efficiency and safety, as shown in figure 6.

Figure 6. Productivity and security in the railway constructions from 1997 to 2012

Source: National Land Transport Agency (Agência Nacional de Transportes Terrestres, ANTT); Railway Transportation National Association (Associação Nacional dos Transportes Ferroviários, ANTF), May 2015.

17 World Economic Forum 2016–2017.


In 2012, the government made a new attempt to develop the transportation sector with the Program for Investment in Logistics I (PIL I). PIL I proposed a broad regulatory reform to encourage intramodal competition, based on the bidding for new branches and unbundling the sector. The proposal involved (a) separating O&M activities from the provision of freight service; (b) participation of the private sector in construction and operation of the lines; (c) introduction of independent rail operator (Operador Ferroviário Independente, OFI); (d) nominating the federal state-owned company, VALEC - Engenharia, Construções, and Ferrovias S.A. as the responsible organization to intermediate the market.

Unfortunately, the market design was inconsistent to meet the expected implementation. Nevertheless, a few legislative advances were made and some projects were analyzed under this model. In most of the projects, as in the case of Açailandia-Barcarena Railway, the public sector would face great financial loss in case of underutilization, since VALEC assumed the role of market monopolist and monopsonist bearing the demand risk.

PIL II marked another phase of the concession process in 2015. PIL II abandoned the content of the reform under PIL I, including the disaggregated model, and established different projects as priority. Later on, the government offered concessions’ renewals in exchange for new investments carried out by incumbents.

For historical reasons, the allocation of demand risk should be vested in concessionaires instead of the public sector in the forthcoming concessions in 2017 under the PPI - Programa Crescer. The government intends to boost three rail projects: the West-East Railroad Integration (Ferrovia de Integração Oeste-Leste, FIOL), Ferrogrão, and North-South.

Major Risks in Rail Investments

Risks increase the level of uncertainty and repel investors. In Brazil, three types of risks stand out as the most critical to rail investments: institutional architecture risk, demand risk, and completion risk. This section will briefly explore them.

Institutional Architecture Risk

Institutional architecture risk refers to the highly fragmented decision-making process that involves the implementation, management, and coordination of infrastructure projects in Brazil. The Brazilian institutions take independent measures culminating in an unarticulated architecture.

The Açailândia-Barcarena Railway is a branch of the North-South Railroad, a 457.29 km network connecting Açailândia (Maranhão) to the Port of Vila do Conde in the city of Barcarena (Pará). The Vila do Conde Port is the main gateway to and from the Amazon and Central Brazil regions. Currently, the port has land access only through highways. It should be expanded to receive the railway in an integrated plan. The expectation was to enable cargo transport and reduce transportation costs, consequently increasing competitiveness of key commodities. The concession granting process had been already in progress when the Brazilian’s Court of Accounts (TCU) contested the viability studies. TCU’s assessment report on both projects advocated a clear failure of projects’ integrated plan. 19

The implementation of those projects strongly depends on careful designed integrated planning due to their synergistic functions. Conversely, the number of entities involved in the institutional architecture raises the potential for lack of convergence. The vast number of institutions involved and unarticulated decision-making process for granting concessions are in part responsible for decelerating and even hindering the project viability, increasing costs and uncertainty.

19 TC 005.342/2014-7.


Figure 7. The fragmented institutional architecture of an integrated logistics project

Source: FGV CERI.

Note: ANTAQ = Brazilian National Agency for Waterway Transportation (Agência Nacional de Transportes Aquaviários); DNIT = National Transport Infrastructure Department (Departamento Nacional de Infraest de Transportes); EPL = Logistics and Planning Enterprise (Empresa de Planejamento e Logística).

Failure on integrated planning has also affected other important infrastructure projects such as the FIOL and Porto Sul complex,20 and the railway corridor between Santa Catarina and the port of Itajaí.21

Demand Risk

Fragmentation and/or lack of consistency in planning can also lead to low robustness in demand forecasting, hence creating a weak environment to invest. Poor market studies harm infrastructure implementation and the economic sustainability of existing ones. The deficiency of demand forecasting can hamper its proper use and main goals, resulting either in bottlenecks or underutilization of infrastructure.

Since the beginning of the Brazilian concession granting process in the 1990s, coordination failures between government agencies have marked the regulatory environment. During the past two decades, successive modifications in regulation affected entities and their roles in the institutional architecture.

In 2001, the government created the National Council for the Integration of Transport Policies (Conselho Nacional de Integração de Políticas de Transporte, CONIT), composed of ministers and representatives of civil society. CONIT’s main goal was to propose national policies for integrating different transportation modals. However, the entity has met only once in 15 years after its creation. Actually, the decision-making process at the Executive Branch was eventually split among the Ministry of Transport (Ministério dos Transportes), the Special Secretariat of Ports, and the National Civil Aviation Secretariat, also contributing to the lack of planning for logistics integration. Both secretariats were extinguished when President Temer took office, and the granting powers were reunified at the Minister of Transport (MT) level. CONIT’s competencies were formally transferred to PPI in 2016.

20 TC 018.153/2010-0.

21 Inventory of extinct Federal Railway Network (Inventariança da extinta Rede Ferroviária Federal S.A. – RFFSA).


The main goal of TCU’s report22 on Açailândia-Barcarena Railway and Vila do Conde Port projects was to analyze the compatibility of market studies assessing projections made by each part due to interdependence and complementarity of both projects. The viability of the railroad is associated with the expansion of the port infrastructure and vice-versa. Therefore, the alignment of projections, especially the expectation of demand, and investment plans are indispensable.

Nevertheless, although the demand projection provided by the port was based on technical studies elaborated under the Supervision of Secretariat of Ports (SEP/PR), the one used by the railway came from projections requested by ANTT and MT. These projections show enormous discrepancies creating huge uncertainty concern on demand forecast that affects the reliability of economic feasibility appraisal.

Figure 8. Demand forecasts until 2045.

Source: ANTT, MT, and the port, elaborated by FGV CERI.

The studies also identified the most important products in the cargo handling in both projects: alumina, soybean and corn. They represent, in value added, more than 75 percent of the volume of cargo to be transported by the railway section.

Moreover, the fact that ANTT and MT produced completely different set of forecasts for the same logistic modal put into question the technical capacity of Brazilian public institutions for transport. A previous analysis of the viability by TCU,23 pointed out uncertainties in ANTT’s demand projections, which led to a new one carried out by MT during the concession. TCU claimed that the ANTT study did not demonstrate the critical assessment required for a model whose demand risk belonged to the granting authority and also lacked calculation records. In addition, the railroad demand appeared insufficient to cover the construction costs. 24 Unfortunately, the new studies by MT are also subject to criticism. It was claimed that all that MT wanted was to prove the project’s financial viability. The demand projected seemed quite inflated; it would exceed the highway operational capacity in the 11th year of operation.

TCU’s report highlights the contribution of other expansions in multimodal land access to the expectation of demand, especially for grains. Thus, the fact that these concessions may not be granted aggravates the capacity scarcity conditions and increases risks inherent to investments due the different demand projections.

22 TC 005.342/2014-7.

23 TC 019.582/2013-7.

24 Items 51, 87 and 356 of TC 019.582 / 2013-7.


The court concludes that in any of the cargo demand scenarios, there is evidence of a significant capacity deficit of alumina, soybean, and corn in the port complex, which may lead to a bottleneck in the cargo flow. The port expansion project would not be enough to meet the projected growth in demand by the railroad.

Completion Risk

Completion risk derives from complications within the three stages of the infrastructure undertaking: licensing, construction, and commissioning. The licensing process is fragmented and bureaucratic, with multiple phases that can seriously delay the process. The issue of environmental licensing is one of the main reasons for delays in construction. Besides, during the construction stage, it is not rare to face cost overruns, bad quality of civil works, and safety issues. Finally, the connection with other channels can hamper the successful completion of the project.

The lagging development of the North-South Rail illustrates the inefficiency of concession contracts designing to attract committed concessionaires. The North-South Rail was meant to connect the Amazon to the Rio Grande Port, in the south of Brazil, across 4,155 km. However, after three decades of slow construction, some of the branches were not even auctioned. Currently, there are 682 km under delayed construction and 30 percent of the construction have not even started. Furthermore, somebranches already constructed and in high demand for transporting commodities have never been used because of lack of technical adequacy to operate. There were complaints of illegalities, such as bribes and overbillings.

Another case of delays in construction is the Transnordestina Railway, started in 2006. There was a promise to construct a 1,728 km railroad connecting Pecém Port (Ceará) to Suape Port (Pernambuco). After 10 years, the invested value exceeds R$6 billion and remains far from completion. The part built has turned into a “ghost” railroad located in the middle of the route. The construction was stopped by TCU due to a mismatch between the values already received and the physical execution. 25 The Transnordestina Railway is under investigation and mechanisms to terminate the contract with the concessionaire are been discussed.

International Experience - Relevance of Rail and Risk Allocation Matrix

In this decade, the government has made efforts to attract investors and expand the logistics network. Infrastructure investments in Brazil are risky which leads to a debate among stakeholders about how risks are allocated and who will bear the risks: the granting authority or the concessionaire. According to Law no. 8.987/95 (concession contracts), risks related to the concession are usually private. Nevertheless, in accordance with international recommendations, the government has been making different contractual arrangements to bear some of the risks involved in infrastructure investment and attract more investors. Table 4 describes the most adequate risk allocation among stakeholders, according to the Global Infrastructure Hub (GIH).

25 TC 012.179/2016-7.


Table 4. Risk allocation according to GIH

Source: FGV CERI.

Agenda Toward Investments Attraction

Some issues must be addressed in the infrastructure debate to attract qualified investors. First, it is necessary to improve the articulation of government entities in the institutional architecture, as well as achieve convergence in the decision-making process. Then, the demand projection is ought to consider the integrated nature of different transportation modes involved. It is also indispensable to manage completion risks by improving rationality of the environmental licensing process. Finally, the establishment of a suitable Guarantees Framework is vital to attract investments in the sector.


APPENDIX I

EVENT PROGRAM

Co�ee Break

Day 1 22/03/17 9h – 9h30

9h30 – 10h30

10h30 – 11h30

11h30 – 12h

12h – 13h

13h – 14h30

Hotel Brasília Palace (SHTN Trecho 1, lote 1 - Asa Norte - Brasília, DF)

AGENDAFGV CERI Policy Dialogues

Long-term �nancing of projects & infrastructure in Brazil

14h30 – 15h30

MARKET FINDINGS, MAIN CHALLENGES AND ENABLING FRAMEWORK


• Edson Gonçalves (Senior Researcher, FGV CERI)

• Andrew Haynes (VP, Norton Rose Fulbright)


CURRENCY RISK MANAGEMENT

• Thomas Berkes (Executive Director of Structured Solutions, Santander)

• Luiz Figueiredo (BNP Paribas)

• Marcelo Guaranys (Deputy Minister for Public Policies, Executive Office of the President of Brazil)

FINANCING APPROACH, CONSTRUCTION RISKS AND RISK MITIGATION

• Moderator: Joisa Dutra (Director, FGV CERI)


• Henrique Pinto (Secretary of Public Policy Coordination, Brazilian Investiment Partnerships Program)

• Luciene Machado (Deputy Managing Director, BNDES)

INSURANCE AND GUARANTEES


• Corina Monaghan (Senior Vice President, JLT)

• Marcelo Pinheiro Franco (Executive Director, ABGF)

• João di Girolano (Head of Surety Brazil, Swiss Re)

OPENING SESSION

• Paulo Pedrosa (Deputy Minister, Ministry of Mines and Energy)

• Mansuetto de Almeida (Secretary of Economic Monitoring, Ministry of Finance)

• Marcelo Allain (Secretary of Investments, Brazilian Investiment Partnerships Program)

• Paul Procee (Head of Infrastructure Brazil, World Bank)

LUNCHEON GUEST SPEAKER

• Robert Peterman (VP of Global Business Development, Toronto Stock Exchange)


Co�ee Break


8h30 – 9h

9h – 10h15

10h15 – 10h30

10h30 – 12h30

12h30 – 13h

Organized by

Suported by


16h – 17h

17h – 18h








CLOSING REMARKS












DISPUTE RESOLUTION









II. PARTICIPANTS

Organization: FGV CERI

Support: • World Bank • Norton Rose Fulbright • ICC

Government:• Ministry of Finance (Ministério da Fazenda)• Ministry of Planning (Ministério do Planejamento, Orçamento e Gestão)• Ministry of Mines and Energy (Ministério de Minas e Energia)• Minstry of Transport (Ministério dos Transportes)• Casa Civil • PPI• ABGF• Brazilian Electricity Regulatory Agency (Agência Nacional de Energia Elétrica, ANEEL) • ANP• ANTT• Attorney-General of the Union (Advocacia-Geral da União, AGU)• CCEE• Power Research Company (Empresa de Pesquisa Energética, EPE)• EPL• TCU• BNDES• Bank of Brazil (Banco do Brasil)• Securities and Exchange Commission of Brazil (Comissão de Valores Mobiliários, CVM)• Securities, Commodities and Futures Exchange (BM&FBOVESPA)• Comptroller General of the Union (Ministry of Acting Transparency, CGU)

Financial Institutions and Others:• Citibank • JP Morgan• Deutsche Bank• Santander• BNP Paribas• Bank of America (BofA) Merrill Lynch• Pátria Investimentos - Blackstone• JLT • Itaú BBA• Souto Correa• AES Eletropaulo• Shell• Swiss Re Corporate Solutions• Bolt Energias• HSBC• Faveret Advogados

APPENDIX II

long-term financing and risk allocation in … · • eduardo azevedo (secretary of planning and...

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