Note:English version for reference only,Chinese version shall prevail.
Tu Yi, Risk and Performance Department of China Public Private Partnerships Center (CPPPC)
Chen Chuan, Professor at Sichuan University, World Bank PPP consultant, and Chief Adviser of Roca International
Guo Hao, Risk and Performance Department of China Public Private Partnerships Center (CPPPC)
The Public-Private Partnership (PPP) model is a significant innovation in the supply mechanism for the public service sector. It refers to the process that a government selects a nongovernmental investor with the capacity of investment and operation management in a competitive way, conclude a contract with this nongovernmental investor in the principle of equal negotiation to provides services for the social capital, and pay the corresponding consideration to this nongovernmental investor as per performance evaluation results of public services. It has obvious systemic features and complexity, involving multiple aspects such as administration, building, operation and financing. Among those aspects, financing is an essential link in the implementation of a PPP project, as it directly determines the sources of funds for project initiation and subsequent development, affecting the smooth progress and the ultimate success of a project. In China, although it has been repeatedly emphasized in promoting the development of the PPP model that this model is not simply a financing method, whether it is to solve local government debts or to change the investment and financing modes for infrastructure construction to drive the economic development, financing for a PPP project is a topic worthy of attention. The specific financing for a PPP project will undoubtedly be affected by a number of uncertainties including government departments, nongovernmental investors, financial institutions and other financing entities, as well as the economic environment for financing. Among those uncertainties, any changes in the financial market will have direct and significant impacts on financing. To be able to grasp and prevent those uncertainties is an important condition for the successful financing of a PPP project, and the key guarantee for implementation of the entire PPP project.
This paper focuses on studying the risks associated with PPP financing arising from any changes in financial institutions or financial markets and related issues. It first distinguishes project risks and risks of PPP financing, and proposes a risk management framework for PPP projects. In the stage of financing risk identification, conventional means for risk identification are employed to identify and describe the main PPP financing risks. Then, this paper carries out quantitative evaluation of main PPP financing risks by qualitative and quantitative methods, and according to the general principles of risk sharing and the features of financing under the PPP model, obtains the sharing principle, mechanism and framework for financing risks in respect of PPP projects. Finally, on the basis of specifying the responsibilities shared by government departments and nongovernmental investors in respect of each financing risk of PPP projects, this paper sets out specific countermeasures for each particular financing risk.
I. Financing Risks of PPP Projects and Risk Management Framework
The complexity of financing structure of a PPP project, coupled with the features of infrastructure investment such as large investment amount and long term, results in the existence of many uncertainties in different stages during the whole life cycle of the project. Therefore, the financing risks of PPP projects also have their own characteristics: the risks may last a long term, with more complex and diverse types, and there may be higher policy and legal risks; and the government and nongovernmental investors are required to share the PPP project risks.
Because of the complexity and particularity of PPP financing risks, it is especially important to manage such risks in a scientific manner, in order to effectively avoid risks. The general process for management of PPP financing risks covers four stages, i.e., identifying, assessing, allocating and addressing financing risks, as shown in Figure 1.
Figure 1 General process for management of PPP financing risks
According to this process, all the stakeholders identify and assess each financing risks facing the project respectively, which makes the process cumbersome and brings large amount of work, as well as issues such as repeated calculation. Therefore, based on practical experience and theoretical research, the conventional management process for financing risks has been optimized to a certain degree, and the management process for PPP financing risks based on partnership has been set forth, as shown in Figure 2.
Figure 2 Management process for PPP financing risks based on partnership
Under the mode of managing PPP financing risk based on partnership, the core principle for sharing of project financing risks is allocating the risks to the party with the most control and the lowest cost and ensuring the consistency between the risks and the returns. [Ke Yongjian, Wang Shouqing, and Chen Bingquan. Revelation of the Channel Tunnel's Failure to Risk Allocation in Public-Private Partnership Projects [J]. China Civil Engineering Journal, No.12, 2008] Such management framework for financing risks is more practical, as it helps avoid repeated work, respects similarities and differences between PPP projects, and can effectively improve the efficiency in management of PPP financing risks, leading to the agreement between the government and the corporate partners upon a reasonable scheme for allocating PPP financing risks.
II. Identifying Financing Risks of PPP Projects
As the basis for management of PPP financing risks, identifying financing risks of a PPP project is a continuous and dynamic process running through the whole life cycle of the project. An investment project using the PPP model has some features different from ordinary investment projects in respect of financing, such as huge investment, high leverage ratio, long construction and investment period, high cost of financing, complicated risk sharing and multi-level capital structure. According to the classification of the general financing risks, and considering the characteristics of PPP financing, financing risks of PPP projects are generally divided into the following eight categories, namely risks of capital availability, credit risks of financial institutions, exchange rate risks, interest rate risks, inflation risks, liquidity risks, regulatory risks of financial institutions, and refinancing risks, with the main features as follows:
The risks of capital availability means the uncertainty in raising funds in appropriate scale and duration because of a PPP project's large investment and long term for fund use; and the further difficulty in fund raising for the project due to irrational financing structure, unsound financial markets, blocked financing channels and other factors. This type of risks mainly arises in the project development phase, and the refinancing stage.
The credit risks of financial institutions means that a financial institution providing financing and services for a PPP project by a contract or agreement and helping the PPP project receive financing support timely has any big problem in its credit status and fails to perform corresponding obligations and promises as agreed upon in the contract or agreement, resulting in the possibility of loss to the PPP project.
The exchange rate risks means that in international financial or business activities, economic entities may face uncertainties in future income in respect of receipts and payments, assets and liabilities denominated in foreign currency due to any changes in the exchange rate on the international financial market; such type of risks can be divided into the risk of foreign exchange fluctuations, the risk of unavailability and the risk of non-transfer.
The interest rate risks refer to the uncertainties in loss or income brought to a project because of any change in interest rates during the financing of the project. The interest rate is the price for using the capital, and its change will directly affect the utilization cost of the capital, which results in change in the PPP project costs, and ultimately affects the income of each participant in the PPP project.
In the implementation of a PPP project, the direct impact of inflation is the increase in the costs of raw materials, equipment and labor for the project operation, resulting in increased costs and expenses for project construction and operation as well as difficulties in collecting fees, thereby affecting the returns to the project sponsors.
The liquidity risks generally refers to the risks that the operating income of a project is insufficient for repaying the debt. In respect of a PPP project, as the service and income-obtaining capabilities have not been in play during the project construction, liquidity problems are prone to arise. However, when entering the operation stage, the project shall be able to generate sufficient working capital to service the debts and provide enough funds for project operation and maintenance.
Regulatory risks of financial institutions mean that during the regulatory process, a financial institution may intervene in a project on the strength of direct intervention clauses, resulting in the abuse of regulatory power, which increases the sense of crisis of the project operator and disrupts the project operator's normal arrangements, bring in uncertainties to the normal operation of the project.
Finally, the refinancing risks refer to the uncertainties that where the special-purpose vehicle for a PPP project is strapped for cash or became insolvent, any breach of any provision of the previous contact arises during the refinancing for obtaining funds to transform the project, resulting in the liability for breach of contract.
With respect to the above financing risks, scientific and effective methods for risk identification shall be adopted, such as brainstorming and risk lists. Brainstorming applies when the issue is relatively simple and the objectives are clearer; on the other hand, risk lists apply when there are common risks, and financing risks in previous projects can be identified and listed through searching data and information, so risk identification personnel can predict the risks likely to arise in the project on the basis of the risk list and the actual conditions of the relevant PPP projects.
III. Assessing Financing Risks of PPP Projects
Financing risk assessment refers to measuring and assessing, on the basis of financing risk identification, the possibility of risk occurrence, duration and impact on achieving project objectives (time, costs, scope, quality, etc.). Risk assessment generally comprises two phases: qualitative assessment and quantitative assessment. Qualitative assessment mainly uses descriptive language to express the possibility and impact of risks, and will be affected to a large extent by the practical experience and knowledge of an assessor, so the assessment results are more subjective. Quantitative assessment usually means numerical estimates for the possibility and effects of identified risks based on a large number of available data, and can quantify risks more accurately. However, in practical practice, because of the complexity of the actual project conditions and the data availability, it is usually difficult to achieve accuracy through quantitative analysis; therefore, the complexity of the data is often difficult to achieve the degree of accuracy, so the method of semi-qualitative and semi-quantitative analysis is often used in practice. Results of qualitative assessment are often used as the basis for quantitative assessment, and financing risks are assessed in the principle of "qualitative analysis first and quantitative analysis later".
Major methods of qualitative risk assessment include risk matrix, empirical judgment, and Delphi methods. [Mao Ru. On Risk Management of Engineering Projects [J]. Urban Rapid Rail Transit, 2004, 17 (2): 3-5.] A risk matrix refers to a matrix that is used during risk assessment to define the various levels of risk by probability of occurrence and effect of a risk event, with the probability of occurrence as the line and the effects of a risk as the column to form a table, and the corresponding financing risks indicated at the intersection of each line and column. The empirical judgment method is primarily based on the past experience of financing risk forecasters, who make subjective judgments on the financing risks of a project. Specifically, a forecaster with a perception of each financing risk based on his past experience and the knowledge of each party involved in a project may roughly determine the probability of occurrence of each risk in a specific PPP project. The Delphi method, also known the expert scoring method, is the most popular and simplest analytical method that is easy to use. It includes five steps, i.e., setting up an expert panel for financing risk assessment, conducting appropriateness assessment of financing risks, determining the weight of risk factors, determining the ranking values of risk factors, and calculating the risk level of each risk factor.
The quantitative assessment methods mainly include the methods of sensitivity analysis, fuzzy comprehensive evaluation, Monte Carlo simulation and decision tree. The sensitivity analysis is carried out to identify the risk variable affecting the final indicators; with the remaining risk variables kept unchanged, analysis is made to changes in one or more risk variables to a certain extent to determine the impact level on the final evaluation indicators, so as to determine the factors having greater effect on the results. Under the fuzzy comprehensive evaluation method, the degree of membership of each financing risk is determined based on combining main factors, and a fuzzy subset of the risk assessment set is used to express the possibility of occurrence. This method quantifies qualitative issues, can reflect comprehensively and accurately the judgment information on project risks, and expresses fuzzy attributes of "perceptive risks" of the project. The Monte Carlo simulation technique is a calculation method based on statistical theory, calculating the probability of occurrence of any financing risks or the value of risk damage by using a computer, and obtaining accurate possibility of risk occurrence through several tests; it owns unique advantages. The decision tree method decomposes risk factors level by level to draw a tree-like graph, calculates the probability and expected values item by item, and carries out risk assessment as well as comparison and selection of solutions.
To overcome the disadvantages of qualitative and quantitative analytical methods at the same time, the semi-qualitative and semi-quantitative analysis method is often adopted in practice, as it can assess risks more accurately.
IV. Sharing Financing Risk of PPP Projects
A PPP project generally includes five stages, i.e., identification, preparation, procurement, implementation and transfer. In those stages, the government and corportatepartners concerned are the main financing risk takers of PPP projects.
Normally, the government is the main sponsor of a PPP project, and will often grant a certain amount of the project capital or loan guarantees at the financing stage of a project as support to the project construction, development and financing arrangements. Corporatecapital can also become a sponsor of a PPP project, and establish a special-purpose vehicle through cooperation with the funding institution representing the government. The government can select appropriate socialcapital to participate in a PPP project by way of open biding, invited biding, competitive negotiation, competitive consultation, and single-source procurement. In addition, financial institutions provide most important financial support and credit guarantee for the smooth implementation of PPP projects. Those financial institutions include international financial institutions, commercial banks, trust and investment institutions and relevant industry funds.
In designing a scheme for sharing financing risks, the following guidelines shall be followed generally: the party with most control over financing risks assuming corresponding risks, financing risks return equivalence, and the upper limit for risk assumption [Deng Xiaopeng, Li Qiming, and Wang Wenxiong, et al. Summary and Application of the Principles of Risk Allocation in PPP Model [J]. Construction Economy, 2008 (9): 32-35]. With respect to the PPP financing risks mentioned previously, the sharing scheme may be designed as follows preliminarily: As corporatepartners are more experienced than the government in terms of financing techniques for commercial projects and financial market, and more familiar with the rules of operation of the financial market, the risks of capital availability are normally assumed by corporatepartners. The credit risks of financial institutions should be borne by the corporatepartners in line with industrial practice; however, in the process of financing, the government may take the lead to seek funding support from financial institutions. The occurrence of exchange rate risks is highly contingent, and such risks are usually borne by the corporatepartners, whereas the government provides subsidies or guarantees to moderately share such risks. The interest rate risks are mainly assumed by the private institutions subject to a certain extent, and the risks beyond the said extent shall be shared by the government by subsidies, guarantees and other means. The inflation risks are mainly assumed by the corporatepartners; however, as the government has experience, resources and strength to control and regulate such risks, corporatepartners and the government shares such risks generally. The government and financing guarantee institutions will share certain liquidity risks because financial institutions may request the government or financing guarantee institutions to provide guarantees when financing a project. The existence of regulatory risks of financial institutions will intervene in the optimization and utilization of project funds, affecting the returns on the project; such risks occur quite accidentally, and should be assumed by corporatepartners normally. The occurrence of refinancing risks is mainly associated with the operating and management level of the corporatepartners on the special-purpose vehicles, and thus the refinancing risks are usually assumed by corporatepartners.
Due to the special nature of a project, there are differences between risk-sharing preferences and actual allocation of project risks. The aforementioned suggestions on financing risk allocationmay not necessarily be suitable for all PPP projects in practice. Therefore, the framework for risk allocation may be adjusted based on the factors actually affecting risk allocation, so as to establish good risk-allocation adjustment mechanism. See Figure 3:
Figure 3 Risk-allocation adjustment mechanism
V. Addressing Financing Risks of PPP Projects
With respect to the eight types of financing risks mentioned above, we put forward countermeasures on the basis of the characteristics of PPP financing.
In respect of the risks of capital availability, we can control such risks by optimizing the project programs, preventing government influence and policy changes, and eliminating frauds and corruptive activities.
With respect to credit risks of financial institutions, a PPP project may select a bank partner with good credit standing according to the bank credit ratings of authoritative institutions, and establish a good relationship with the government to reduce such risks. Legally, it shall specify in the relevant agreement the rights, responsibilities and interests of the borrower and the lender, the scope of the bank's regulatory power, and clear provisions on breaches.
To guard against the exchange rate risks of PPP projects, overall consideration shall be giving to the timing and conditions, so as to select the appropriate timing and currency for exchange; when it is predicted that the currency of the host country will appreciate, then the currency of the host country can be selected as the one for future income, to gain more value from the income through changes in the exchange rate. Risks can also be hedged by using the clauses on forward foreign exchange trading, foreign exchange options trading and foreign exchange hedging. In addition, the method of balanced allocation of risk can be adopted; that is, the parties negotiate and agree on a basic exchange rate and determine a neutral range in which the parties bear foreign exchange risks and interests on their own.
The best way to avoid interest rate risks is to fix the interest rate of loans, that is, to sign a contract with a bank at a fixed interest rate; regardless of any changes in interest rates on the market in the future, the loan interest shall be calculated at the agreed interest rate. In addition, the risks may be minimized by signing interest rate swap agreements and using financial derivative instruments such as interest rate futures and interest rate options to improve the returns on investment of the project.
In order to guard against the inflation risks, the parties to a PPP project shall, in the PPP agreement, link the price of the project products or services with the inflation rate as well as the exchange rates of local currency and loans at the place where the project is located, use the price adjustment formula containing the inflation rate, exchange rate and interest rate, and provide for specific provisions on the appropriate compensation mechanism, the increase in the corresponding charges on products or services, or extension of the franchising period, in order to ensure that the cash flows of the project are sufficient for debt repayment and investment recovery.
To avoid withdrawal of investment from a project midway, it is advised to use the mode of guarantees from the government and financial institutions and specify in the PPP contract a clear timetable for payments and the liability for any delay in payment. A risk warning model for fund liquidity may also be set up to track the status of the capital for the project at any time. Then, the parties concerned may, according to the specific circumstances of the PPP project, arrange the time and amount that each financial institution invests in the project and find the best choice for liquidity supporters.
To guard against the regulatory risks of financial institutions, it is advised to select an experienced construction, operation, maintenance contractors to ensure that the income from the project is sufficient for debt repayment and the investors can make a profit. The relevant parties shall try their best to avoid a circumstance where the direct intervention agreements or terms under a contract become effective, and prevent occurrence of any major accident or financial crisis, to ensure that the project maintains a good financial position. Moreover, a corporate partner or special-purpose vehicle may communicate with the financial institution about the specific conditions of a project, and they agree on the specific operating, management and other modes for the project, to limit the regulatory power of the financial institution.
With respect to refinancing risks, a special-purpose vehicle shall keep a close eye on the operation status of the relevant project, including project proceeds, project outputs, equipment operations, market conditions and other information. In addition, to improve liquidity and utilization efficiency of funds, the government may, on the premise of strengthening regulation, consider releasing a number of financial instruments suitable for refinancing PPP projects, such as convertible bonds and corporate bonds; corporate partners should choose an initial financing mode that is helpful to the carrying out of refinancing, and consult the government on the relevant financing terms, so as to create favorable conditions for refinancing.
Note:English version for reference only,Chinese version shall prevail.