Risk Mitigation – Irrigation PPP Example

Purpose of Document and Target Audience

This digital artefact concentrates on risk mitigation, in particular for a typical irrigation PPP in Africa. The target audience is any African Government that wishes to develop an irrigation project as a PPP.

The infrastructure problem that this kind of PPP would solve is the creation of an irrigation scheme that is sustainable technically and economically.

The services that would be provided are water and agricultural know-how that become affordable by farmers as they increase and diversify their cropping as a result of the irrigation scheme.

The private sector would want to participate because it would be remunerated for the provision of water and would leverage its profits by means of new agricultural marketing opportunities resulting from improved farmers’ output.

As repeatedly emphasised throughout the PPP MOOC Course, comprehensive risk identification, mitigation and allocation are critical to the success of a PPP transaction, and in particular, of the kind of irrigation PPP targeted by this document.

The Issuu app is used to produce the website, and the link will be supplied separately as per the PPP MOOC instructions.

Background

There are many examples of problematic PPPs in Africa and the world. One of the main causes of problem PPPs is inadequate risk management. There is understandable concern that a Government might not be able to cope with the risks it assumes under a PPP. Or, in other words, how can problem PPPs be avoided.

Risk mitigation measures are not only possible, but they are necessary to protect governments from entering into PPPs that become problematical because of poor risk management.

Every PPP has its own distinct risk profile. In each case PPP partners can mitigate common risks by introducing safeguard measures in a transaction before they are allocated under the final PPP structure. It is worth examining these measures in detail so as to help convince stakeholders, especially Governments, that the benefits of PPP are attainable without excessive danger of projects collapsing as long as risk is well managed.

Some of the general problems encountered and mitigation measures are as follows (source: Uganda PPP Unit):

Complex nature of transactions –use of transaction advisors if local capacity not sufficient

Political acceptance weak at some levels – sensitization of relevant ministers

Limited response from private sector –intensify investor promotion Excessive public expectation – improve stakeholder consultations

The primary transactional risks to be mitigated generally are (source – author):

Demand System planning Construction Operational Commercial Foreign exchange Financing Regulatory

The role of independent regulation is crucial to ensure performance standards are met. This in turn sets the stage for appropriate risk mitigation.

Structuring PPPs with Regard to Risk Mitigation

Risk mitigation measures and appropriate risk allocation are becoming essential in structuring PPP agreements. With the uncertainty surrounding global credit markets since 2008, the ability to raise long-term debt in emerging markets will be affected in the future by risk mitigation instruments provided by private and public institutions, including development banks. Risk mitigation instruments may allow for the transfer of certain defined risks towards entities that are more creditworthy than a PPP sponsor or operator. It is furthermore possible to cover both equity and debt through such instruments. Risk coverage is geared towards provision for losses against commercial or political risks, and may be applied to protect (i) sovereign debt, when lending to a government or its agencies, (ii) corporate debt, in the case of limited recourse project financing, or (iii) equity investments, normally associated with equity investment into a private entity. In the case of debt, risk coverage may reach up to 100% on both the principal and interest payments.

There are various types of financial guarantees in use by financial institutions and multilateral agencies as credit enhancements, and for which private firms have shown interest in light of difficult market conditions (source – African Development Bank, Ethiopia Country Office):

Partial Credit Guarantees (PCG), which are flexible instruments traditionally used in emerging economies to tap the international banking markets or to support a local bond offering in international markets. PCGs only cover a specific portion of the obligation, in proportion to the credit enhancement sought by the user. PCG instruments have recently been extended to support municipal bonds, and for private companies to borrow from local commercial banks. PCGs have mostly been utilized in Latin America or Asia.

Full Wrap Guarantees covers the entire amount of the debt service obligation in the event of a default. FWGs have demonstrated an ability to open access to the capital markets in Latin America, by attracting large institutional investors keen on accessing long-term instruments.

Other useful Guarantee instruments include: o Political Risk Guarantees/ Partial Risk Guarantees, which cover

losses against specified political events, and o Export Credit Guarantees that insure against a portion of both

political and commercial risk in a project.

Risk Mitigation Specific to Irrigation PPPs

Taking an irrigation PPP as an example, transactional risks can be mitigated as demonstrated below (source – Ethiopian Ministry of Water Resources).

Mitigation of Demand Risk:

Surveys on willingness to connect Fixed water allocation on first come first served basis Connect agreements signed by farmers Flat minimum fee to recover capital costs Security deposits Connection incentives Expanding boundaries Differential tariffs by sector.

Mitigation of System Planning Risk:

Surveys on willingness to connect Final subscription before final design and construction Flexible construction scheduling Direct financial accountability for over-planning and excess capacity Preference towards pipeline option.

Mitigation of Construction Risk:

Right-of-way access indicated by surveys on willingness to connect Safeguard policies in place; i.e. arrangements for environmental and

cultural heritage monitoring and evaluation and consideration of international water issues

Financial accountability with private operator.

Mitigation of Operational and Commercial Risk:

Metered volumetric tariffs Closed system Security staff Disconnection and reconnection policy Fines for past due accounts Price adjustment mechanisms for cost increases.

Mitigation of Foreign Exchange Risk:

Government would charge lenders an interest risk premium to offset possible foreign exchange losses in local currencies.

Mitigation of Financing Risk:

IFI loans Defined regulatory function and rules Bid for equity Security deposits

Mitigation of Regulatory Risk:

Partial risk guarantees and breach of contract guarantees on changes in government policies

Defined regulatory function and rules Setting up water user council to oversee arrangements amongst farmers.

Attached is a PowerPoint file showing the above transactional risk mitigation measures with respect to a typical irrigation PPP – this can be used for presentational purposes (source – author).

As noted above, the role of independent regulation is crucial. Taking an irrigation PPP example, appropriate regulation:

Ensures service standards and equitable tariff adjustments Ensures proper water allocation and irrigation scheduling Deals with new entrants and exits Regulates temporary water transfers between farmers.

Modelling of Risk Factors

Again taking an irrigation PPP as an example, the factors driving the eventual transaction should be modelled in order to determine the interoperability of the factors and how to make appropriate adjustments to them in advance to improve risk mitigation for the transaction.

A simulation model (source – World Bank, Ethiopia Country Office) is available as an Excel file (unfortunately the Issuu website will not accept Excel files). The factors are analysed in terms of who controls them: farmers, private operator, and

government. Peer reviewers are invited to request this model by email and then to try operating it to see how the various factors affect the sustainability of the proposed transaction.