Notes from Timothy Irwin’s Government Guarantees – Allocating and Valuing Risk in Privately Financed Infrastructure Projects
Bordeaux Bridge – early template of public-private partnership
– Govt built bridge
– Firm maintained and operated it and contributed capital for construction
– Firm would get the toll for 99 years. If annual revenue < min., govt would pay the min. If >an amount, govt share half surplus
On guaranteeing returns
If firms aren’t convinced by the commercial viability of a project and require guaranteed returns, it’s probably not worth doing!
On exchange rate risk
For free floating currencies
– If a govt agrees to bear the exchange rate risk, the firm will borrow at the lowest interest rates. While this will be cheap in the SR, the difference in local currency (LC) rates and foreign currency rates (FC) is the likely difference by which the LC will depreciate (according to uncovered interest rate parity theory), and the govt will bear the cost
– Indexing prices to FX rate or inflation is similar in the LR. In SR, however, indexing to inflation will protect customers, though it will also limit FC borrowing
Solutions:
– Korean govt bears half the costs of currency depreciation above 20%, and vv
– Govt can limit FC borrowings
Insolvency risk
– Refer to details of Phillipine state-owned power company Napocar, which was to pay slightly more than the cost of a Keilco financed power plant, and which bore the demand and cost risk and hence became bankrupt when an economic crisis resulted in reduced demand and increased costs.
– Explicit guarantees of loans are better than implicit. Govt should choose to do either the latter or make a public announcement that it won’t bail out a firm in case of insolvency, and it won’t be a poor reflection on the govt, b/c the firm and its creditors takes the responsibility for their solvency.
— In the case that the firm goes bankrupt, govt needs to design a mechanism which will allow change of mgt that won’t disrupt service delivery
— Govt can also artificially limit leverage (to the detriment of the “optimal” capital structure wrt to equity sponsors)
— Min. equity as % accounting value of assets (eg in Mexico, 20%)
— Instead of project finance, have equity sponsors put the project on their balance sheet
— Require parent companies of equity sponsors to guarantee the debt
Expropriation risk
– Reduce the concessions demanded by the firm by reducing the probability of this happening in the investor’s eyes (and fundamentally as well, b/c it’ll be less attractive). Do so cheaply by negotiating BITs and assigning investor ability to sue govt in international courts
– But careful about even economy-wide taxes and inflation (Argentina)
– So contracts including a formula, or allowing firm to cover its ‘reasonable costs’ (which should be defined)
Managing decision makers
Ministers for infrastructure projects will be incentivised by the benefits of a project for the prestige and for private benefits. Ministers of finance and heads of state won’t – they’ll be incentivised to keep the costs minimal. Therefore have finance minister on committees that can veto guarantees.
Also consider charging fees to the ministry for the cost of the guarantee.
Allocating risks
Firm should generally bear risks related to
– cost of construction
– cost of operation and maintenance
– demand risk
– exchange rate risk
– availability and terms of financing
Govt should generally bear risks related to
– cost and timing of land acquisition
Sometimes bear
– construction risk
– demand risk
– exchange-rate risk
– liquidity support in times of demand or exchange-rate shocks
– can agree to compensate firm for changes in rules about prices and subsidies
Limited liability fund
So as not to affect govt’s credit-rating, to limit liability and to show commitment to its guarantees, govt can create a limited liability fund, in which case, the budget should be prepared for this and can’t be consolidated for purposes of est. govt budget deficiit. Also, would render some of the next section irrelevant
Power Purchase Agreement accounting standards
– Can be reported as a liability on the govt’s B/S, and the rights as leased assets (see Napocor’s AR for 2002; napocor.gov.ph)
– Cash accounting not optimal. IFRS’ International Public Sector Accounting Standards good, though do not so far treat guarantee-like obligations in the same detail as IFRS do
— IAS 37 treats ‘Provisions, Contingent Liabilities and Contingent Assets’
— Some guarantees may be considered contingent liabilities (defined as ‘a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity; or b) a present obligation that arises from past events but is not recognised because: i) it is not probable that an outflow of resources embodying economic benefits will eb required to settle the obligation; or ii) the amount of the obligation cannot be measured with sufficient reliablity’) and hence not recognised – ie
doesn’t increase govt’s liabilities or its accrual deficit
— Exchange rate and interest rate guarantees might be defined as derivatives by IAS 39 and their cost would be recognised in the deficit and B/S
— Guarantees written on risk factors that are non-financial (as defined in IAS 39) specific to the firm might count as insurance contracts (IFRS 4). Insurance contracts can be recognised at fair value
— IFRS standards would generally require consolidation of the state-owned utility that enters PPAs and might treat PPAs as financial leases (purchase of an asset from the nominal lessor which is also providing finance). See IAS 27 and 17.
—- Alt, could be considered executory, under which both parties have yet to fully peform their obligations and therefore no assets and liabilities would be recognised
— USA: Cost of debt guarantees est as the value of the CF the guarantee is expected to generate, discounted at the risk-free rate.
Actual CF go through a separate financing acct
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Value at risk – The most CF the govt can lose
– For normal distribution, 2 sd away from expected payment gives you the 95% confidence interval. Be sceptical though that the distribution of probabilities is normal!
– Sum of s.d. of risks not the same as as sum of s.d. of portfolio.
s.d. of portfolio = sq rt ( variance of risk a + variance of risk b + 2 * coefficient of correlation of risk a and b * s.d. of risk a * s.d. of risk b)
Further resources
– World Bank Private Participation in Infrastructure Database
– IMF created accrual acconting standards for govt finance statistics
– ‘Private Finance Initiative and Similar Contracts’, Financial
Reporting Standard 5, Reporting the Substance of Transactions, ICAEW
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