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Discover the financial implications of Public-Private Partnerships (PPPs) in this insightful article. By focusing on contingent liabilities, uncover the potential fiscal risks and obligations that often accompany PPP projects. From valuation methods to strategic approaches, this article provides practical guidance for policymakers navigating the complexities of PPPs.
This article scrutinizes the fiscal implications of Public-Private Partnerships (PPPs) by examining the concept of contingent liabilities. It underscores how governments often underestimate the potential risks and obligations associated with PPP projects, leading to unforeseen fiscal burdens. Through case studies and global examples, it explains the diverse approaches taken by governments in managing and reporting contingent liabilities. Moreover, the article explores valuation techniques and proposes strategies for prudent fiscal risk management, advocating for centralized control mechanisms to enhance the effectiveness and sustainability of PPP initiatives.
Governments needing infrastructure are often seen turning to PPPs not realising its potential fiscal impact. We know PPPs are off-balance sheet. Is it necessarily be? PPPs often produces contingent risks for government and then may become a fiscal burden which government often ignore or remain unaware of while preparing for a PPP project. Contingent Liability arising from PPP projects can be huge and government can suddenly find itself in situations like Covid 19 where the payment risk which was latent in different contract clauses suddenly clicks in and a substantial fiscal risks comes into picture.
Worldwide PPP has been logically recognized as a major development tools to ensure greater efficiency and possible cost reductions with the involvement of private sector. However for PPP projects, the presence of government as mitigator of risk is very important, as with exchange rate fluctuation, market risk and force majeure the project may not be feasible for private sector. Hence, government has to step in with supports like revenue guarantee, exchange rate guarantees etc. Such liability adopted by the government entails significant future contingent liabilities.
Therefore proper risk analysis and management of these guarantees are important before a project is implemented. The proper structuring of risks and mitigating them are the fundamentals for the success of a PPP.
Generally in PPP, risks are planned to be mitigated through allocation of responsibilities to parties, government vs private sector, that is best situated to handle those risks. However, sharing of risks by the government side create substantial explicit and implicit fiscal liabilities for governments.
Understanding the potential impacts of such contingent liabilities of the government arising from a PPP projects, mostly through the PPP agreement, and quantification of such risks is critical.
European PPP Expertise Centre has set out the range of state guarantees used in PPPs encompassing finance guarantees, and contract provisions such as revenue guarantees, or termination payments.
A government guarantee legally binds a government to take on an obligation if a clearly specified uncertain event should occur. Such obligation for government can be explicit and implicit. Under explicit contingent liabilities, government guarantees payments to the PPP partner by explicitly mentioning specified exogenous events in the contract, e.g. minimum revenue guarantee.
Again such liability can be of explicit liabilities with uncertain amounts and specified amount. Some payment commitment from government cannot be predicted with certainty like land expropriation compensation whereas for specified amount it is possible to include specific provision in the PPP agreement like revenue sharing agreements. The following table provides a brief summaryof contingent liabilities of PPP projects:
Along with explicit contingent liabilities, implicit contingent liabilities for government arise when there is an expectation that the government will take on an obligation despite the absence of a contractual or policy commitment to do so. Such an expectation is usually based on past or common government practices, such as providing relief in the event of uninsured natural disasters and bailing out public utility enterprises, or strategically important private infrastructure firms that get into financial difficulties. Implicit contingent liabilities posses even greater fiscal liability for the government as it is difficult to value these risks and occurrence probabilities of such liabilities are uncertain. As these risks are not inherent to a PPP program, it is difficult for government to properly ensure budgetary allocation for such contingent liability.
In Mexico between 1989 and 1994, government awarded more than 50 concessions for 5,500km of toll roads. The concessions were highly leveraged, debt financing for the projects was on a floating-rate basis and provided by local banks. By 1997, a combination of lower than forecasted traffic volumes and interest rate rises pushed the government to restructure the entire toll road program and bail out the concessions. In total, the government took over 25 concessions and assumed US$7.7 billion in debt. South Korea during 1990s guaranteed 90 percent of forecast revenue for 20 years on a privately financed road linking the capital, Seoul, to a new airport at Incheon. When the road opened, traffic revenue turned out to be less than half the forecast. The government has had to pay tens of millions of dollars every year.
Different governments have taken different initiatives of recognizing the importance of project guarantees along with careful management of associated project liabilities. For example, in Chile the government has guaranteed the revenue of many of infrastructure project including power generation, toll roads and airports. However, such PPP projects get approved by the Minister of Finance based on contingent liability analysis including estimating the cost and risk of the revenue guarantees using a stochastic model.
Along with estimating the risk, the government publishes information on contingent and direct liabilities under PPPs in annual reports on public finance and contingent liabilities. South Africa follows similar kind of approach where the National Treasury must approve projects at major project development stages. National Treasury requires analysis of contingent liabilities as part of project preparation. Contingent liability assessment by National Treasury is also being followed by public reporting by line ministries who include a disclosure note on PPP in their accounts. On the other hand, countries like UK which has extensive previous experience in implementing PPP projects mainly designates most of the project development and contingent liability assessment responsibility to the relevant line ministries. Like Chile, UK also has contingent liability disclose requirement with public reporting of the fiscal implications of PFI projects after every six months.
However the process of reporting contingent liability from PPP projects varies across countries. For example, in New Zealand PPP contingent liabilities are recognized in Government's balance sheet. Other countries tend to follow more conservative approach of mentioning about contingent liability in notes to balance sheet, e.g. USA, Canada and often through separate statement, e.g. Australia, Japan. In addition, there exists significant divergence regarding the type of contingent liability reported. Countries like New Zealand and USA reports all the contingent liability whereas Hungary report only the explicit liabilities.
Along with quantitative valuation and reporting process, several governments have created qualitative guideline for fiscal risk management of PPP projects.
Among the above mentioned countries, both Brazil and Indonesia have chosen to establish an independent guarantee fund, which is separate from government accounts, privately managed, and capitalized upfront by transfers from government. Several countries have established specific rules for controlling total fiscal exposure to PPPs. In Hungary, the public finance law limits the total nominal value of multi-year commitments in PPPs to 3 percent of government revenue. On the other hand, Brazil's Federal PPP Law limits total financial commitments undertaken in PPP contracts to a maximum of 1 percent of annual net revenue.
Contingent obligation proposals may need to be considered alongside competing instruments, and ceilings on total issuance of guarantees may need to be subjected to treasury approval during the budget process.
In principle, the centralized management of contingent liabilities at the government level should involve the overall policy for approving projects; the identification, classification and recording of risk exposure; provision of funds to meet potential liabilities and subsequent implementing systems for monitoring government risk exposure. Designating the responsibility to the Ministry of Finance with close coordination with other important stakeholders like Central Bank will ensure selection of most feasible PPPs. Especially for exchange rate and interest rate guarantee the Central Bank can provide prior insights regarding the potential future contingent liability.
Along with explicit liabilities, it is equally important to control implicit contingent liabilities. Such liabilities can have sizable financial implications, especially when the government backstops public enterprises, public financial institutions, subnational governments, and private firms. One of the most difficult aspects of implicit contingent liability management is that occurrence of such support requirement is counter cyclical and often it is difficult for government to provide support during recession or economic slowdown. The UK National Air Traffic Services (NATS), under a PPP arrangement, was to be paid a fee based on airline traffic volumes. However, the PPP Company took on considerable debt for its investments and operations. After the September 11th attacks, airline traffic fell below forecasts and the company was in danger of not meeting its debt obligations. To reduce the perceived risk of a disruption in service, the UK Government had to step forward and inject GBP 100 million of equity into the project company.
Moreover, for fiscal risks to be properly incorporated in decision making, suitable procedures are required in the budget and PPP approval process. Depending on country context and stages of PPP program development, the ideal process of contingent fiscal risk management process may vary across countries. Multistage review of proposed PPPs projects by authorities who have expertise in fiscal management; quantification of certain contingent liabilities will lead to better value for money assessment of PPPs.
Depending on the individual country, this centralized control process may involve requiring the prior approval of the minister of finance, the cabinet, or the legislature, under guidance provided by a well-articulated policy framework that covers the justification, design, analysis, and approval of guarantees.
Currently Canada, Colombia, Chile, the Netherlands, Sweden, Turkey and USA carry out valuation of government guarantees for infrastructure projects. However, the valuation method across countries differs like New Zealand carries out valuation of maximum possible loss where in Columbia the practice is to analyze the probability of default for infrastructure projects. A defining characteristic of guarantees and other contingent liabilities is uncertainty about whether the government will have to pay and, if so, about the timing and amount of spending.
A number of analytical techniques are available to value guarantees including for PPP projects including Monte Carlo simulation analysis and the Black-Scholes options pricing formula. Both the approaches can be used for modeling project guarantees such as toll revenue in the case of a minimum revenue guarantee. However, the ultimate choice of valuation technique depends on the structure of the guarantee and the information that is available about the determinants of guarantee payments.
In Monte Carlo simulation the value of the underlying risky variable at any time is assumed to depend on its initial value, the mean and variance of its growth rate. The probability distribution of guarantee payments and the expected guarantee payment can be generated by taking a large sample of outcomes for the random variable and calculating the guarantee payment in each case. The value of the government guarantee will be the discounted present value of expected risk-adjusted guarantee payments over the life of the project guarantee. On the other hand, for Black-Scholes options pricing formula guarantees are valued like financial options. Such valuation methodology is consistent in the sense that that a guarantee provides the beneficiary with the option to make a claim against the government if any contract specific event occurs during the contract period. The Black-Scholes formula produces a precise valuation but can only be used for fairly simple guarantees.
Whereas, Monte Carlo simulation analysis can be applied to more complex guarantees, but the result is only an approximation.
Development and maintaining a PPP contingent liability fund preferably with treasury department or central bank is a good way forward. Provisions could be included in the PPP agreement for private sector’s contribution in the PPP contingent liability fund. For example, for a road PPP, if toll traffic exceeds the expected traffic by more than a certain percentage or waterfall traffic the private sector may need to share a certain percent of the increased toll revenue. The government can keep that amount for future contingent liability management for that specific project or other PPP projects. This fund can be managed by Central Bank, private party or financial institution to avoid spending for other purposes.
Indonesia has taken such initiatives through creating Indonesia Infrastructure Guarantee Fund, or IIGF. Under the Ministry of Finance. For initial development of such fund, assessment of the potential contingent risk exposure for the country arising from all the PPP contracts for a particular fiscal year and subsequent allocation of funds can be determined through using appropriate tools, Monte Carlo/Black-Scholes/other. Review of the annual usage of the fund can suggest for further allocation and management. However, independent PPP bodies like WAPPP could be used as a gate keeper to balance the risk intake by the government as opposed to allocation of contingent liability fund for each PPP project.
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