2021-06-21

Ten Misunderstandings of the Financial Affordability Assessment

(17-FEB-2017)


Note:English version for reference only,Chinese version shall prevail.

In view of the financial affordability assessment carried out for different PPP projects, some projects have good demonstration reports, but there are misunderstandings of the financial affordability assessment for some other PPP projects. The author has sorted these misunderstandings for reference, correction and discussion.

The first misunderstanding: financial affordability assessment is only necessary for government-funded PPP projects

This misunderstanding is put forward first in this paper, because in practice people knowing nothing are more popular than those knowing something.

Just like learning to write, when the teacher said one stroke represents "one" in Chinese, two strokes represent "two", and three strokes represent "three", then the students would think everything has its law and every word is that simple. They thought they had learnt everything and thus fired the teacher. In PPP projects, some people also consider that financial capacity will be demonstrated only upon funding. And not all PPP projects need funding. For example, those PPP projects requiring user charge or user charge plus viability gap funding do not need funding. Now that no funding is needed, why do we need financial affordability assessment?

This is a typical misunderstanding. But what is the misunderstanding?

Even if the projects require user charge or user charge plus viability gap funding, it does not mean that the government will not provide funding.

Of course, amid such misunderstanding, the following points are right:

Firstly, the PPP projects are correctly divided into: PPP projects requiring government payments, those requiring user charge, those requiring government payments plus viability gap funding, and those requiring user charge plus viability gap funding; secondly, financial affordability assessment is correctly represented as the demonstration as to whether the government has the funding capacity when funding is required. However, we cannot simply consider that projects requiring user charge or those requiring user charge plus viability gap funding do not need to be funded by the government. The reasons are as follows:

Firstly, in this PPP project, does a project company need to be jointly funded by the government and social capital? If the answer is yes, then the money to be invested by the government in the project company shall be provided by the government. Now that the government needs to make payments, then is financial affordability assessment necessary for any type of PPP projects? Project companies are established in some PPP projects with the government funding provided by state-owned enterprises on behalf of the government. When state-owned enterprises provide funding with their self-owned non-financial funds, financial funds are not utilized and financial affordability assessment is not required. Is it right? The answer can be found in the analysis of the second point.

Secondly, does this PPP project require government subsidies in the operation and maintenance phase? If the answer is yes, then even when a project company is established with the government funding provided by a state-owned enterprise with its self-owned non-financial funds on behalf of the government, financial affordability assessment is required. Is it rational? If government subsidies are not needed in the operation and maintenance phase, is financial affordability assessment unnecessary?

Thirdly, does this PPP project need to be provided the relevant supporting facilities by the government? If the answer is yes, when the government is responsible for funding the construction of water, power and road facilities beyond the red line of a PPP project, and the government is required to provide the relevant supporting facilities for the products or output of such project, do these need to be funded by the government? If yes, why not carry out financial affordability assessment? Even in this PPP project that requires no relevant supporting facilities from the government, financial affordability assessment should be carried out. This is also the reason demonstrated in the fourth point.

Fourthly, does the government need to bear the corresponding risks in this PPP project? In any PPP project, it is impossible for the government to bear no risks and transfer all the risks to the party representing the social capital. In this case, such a project cannot be a PPP project. As Article 11 of the Circular of the Ministry of Finance on Issuing the Operational Guidance for Public-Private Partnership Model (for Trial Implementation) (Cai Jin [2014] No.113) provides that " ... In principle, commercial risks of project design, construction, finance, operation maintenance and so on shall be undertaken by social capital; risks of laws, policies, minimal demands and so on shall be undertaken by the government; risks of force majeure shall be reasonably undertaken by government and social capital. ...", once risks occur, especially those that should be undertaken by the government, does the government need to pay for them? In addition, the fifth point below is also the reason for financial affordability assessment for any PPP project.

Fifthly, is there any circumstance under which this PPP project may be terminated early? When a couple get married, they will not say something about divorce. However, when a contract for a PPP project is signed, it must set out the wording about early termination. In this regard, Section 18 [Default, Early Termination, and Disposal Mechanism after Termination] of Chapter II of the Guidelines on Contracts for PPP Projects (for Trial Implementation) issued by the Ministry of Finance particularly prescribes that the government has a repurchase obligation and the responsibility for compensation for repurchase depending on different circumstances when a contract for a PPP project is terminated early. Once repurchase or compensation from the government is needed, does the government need to make payments? Is it necessary to carry out financial affordability assessment?

Therefore, financial affordability assessment is necessary for any PPP project.

The second misunderstanding: financial affordability assessment may be carried out by PPP project implementing organizations only

This is related to the issue concerning who is the compliant subject that carries out financial affordability assessment for a PPP project. In specific practical work, the financial affordability assessment reports of some PPP projects are prepared by the PPP project implementing organizations. Why? The author neither guesses nor analyzes the reason but states that this is a misunderstanding that should be corrected. The financial affordability assessment for PPP projects should be carried out by compliant subjects.

Then who are the compliant subjects that carry out financial affordability assessment for PPP projects.

The compliance basis is the following two articles of the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects (Cai Jin [2015] No. 21) issued by the Ministry of Finance on April 7, 2015:

Article 6: "The finance departments (or PPP centers) at all levels are responsible for organizing and carrying out the financial affordability assessment for PPP projects within their respective administrative regions. Provincial finance departments are responsible for integrating the financial expenditures of all PPP projects within their administrative regions and supervising and administrating the preparation and implementation of financial budgets."

Article 7: "The finance departments (or PPP centers) shall, in concert with competent departments of industries, carry out the financial affordability assessment for PPP projects. If necessary, professional intermediaries may be engaged by way of government procurement to provide assistance."

Therefore, there are only the following two categories of compliant subjects that carry out financial affordability assessment for PPP projects:

The first category: The financial affordability assessment for a PPP project shall be carried out by the finance department at the corresponding level of the PPP project in concert with the competent department of the industry, or may be carried out with the assistance from a professional intermediary engaged.

The second category: If PPP centers are established, the PPP centers at the corresponding level may, in concert with competent departments of industries, sponsor the projects. Of course, professional intermediaries may be engaged to assist the financial affordability assessment.

It is not of compliance for other subjects than the above two categories to carry out financial affordability assessment for PPP projects.

The third misunderstanding: any third-party professional intermediary may be engaged to assist financial affordability assessment

The subjects carrying out financial affordability assessment for PPP projects are either administrative organs-like finance departments or PPP centers of public institutions. When they, regardless of finance departments or PPP centers, engage third-party professional intermediaries to provide services, it shall fall into the scope of government procurement of services and be subject to the Government Procurement Law of the People's Republic of China. Therefore, the finance departments (or PPP centers) at the corresponding level of PPP projects shall, in concert with competent departments of industries, carry out financial affordability assessment and engage third-party professional intermediaries to provide assistance in accordance with the laws and regulations on government procurement, rather than appointing them arbitrarily.

The fourth misunderstanding: the financial affordability assessment for PPP projects may be carried out at any time

In some PPP projects, financial affordability assessment is carried out at the same time as VFM evaluations with their reports also issued at the same time. Is this acceptable?

According to the Flowchart of Operation of PPP Projects (Figure 1) issued by the Ministry of Finance, we can clearly understand that financial affordability assessment for a PPP project may be carried out only in the project identification stage of such project and after the VFM evaluations for such project are passed.

Of course, the financial affordability assessment for a PPP project cannot be carried out after the PPP project implementation program is applied for approval, as according to Article 5 of the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects, "the conclusions of financial affordability assessment are divided into 'passing demonstration' and 'failing demonstration'. ...It is not suggested to adopt the PPP model for projects failing demonstration."

Therefore, the financial affordability assessment for PPP projects shall not be carried out at any time, but shall be carried out during the prescribed period; otherwise, it would be irregular.

The fifth misunderstanding: the value of non-cash assets invested by the government may be obtained by estimation.

In PPP projects, when project companies are established, the government may fund project companies by such non-cash assets as land, buildings, equipment, and goods rather than cash; when providing government's supporting facilities, the government may also invest supporting land, pipeline networks, and roads. In carrying out financial affordability assessment for this type of PPP projects, the value of such non-cash assets cannot be estimated but shall be evaluated in accordance with the law, as such non-cash assets involve the transfer of ownership (the investment of supporting facilities may not necessarily be related to the transfer of ownership).

The specific bases of laws and regulations are as follows:

First, Article 47 of the Enterprise State-owned Assets Law of the People's Republic of China provides that: "Where a wholly state-owned enterprise, wholly state-owned company or company controlled by state-owned capital is to be merged with another company, divided into two or more companies or restructured, or where a substantial proportion of its assets are to be transferred, an investment is to be made with any non-monetary property, or the company is to go into liquidation or falls under any other circumstances in which an asset evaluation is required by laws, administrative regulations or its Articles of association, an evaluation of the relevant assets shall be carried out in accordance with the relevant provisions." Evaluation organizations may not be appointed arbitrarily, according to Article 48 which reads: "Wholly state-owned enterprises, wholly state-owned companies and state-controlled companies shall appoint qualified assets evaluation organizations established legally to carry out assets evaluation; where the situation involves any matter to be reported to the relevant organ that performs the duties of an investor for decision, details of the appointment shall be reported to that organ."

Second, Article 15 of the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects provides that: "The expenditure of equity investment shall be reasonably determined according to the capital requirements of the relevant project and the shareholding structure of the project company. Investment in kind such as land or investment of intangible assets within the expenditure responsibility on equity investment shall be evaluated in accordance with the law and its value shall be reasonably determined. ..." And Article 22 provides that: "With respect to the expenditure responsibility on supporting investment, the total costs of other supporting facilities to be invested by the government and the expenses to be paid by the party representing social capital shall be taken into comprehensive consideration. Investment in kind such as land or investment of intangible assets within the expenditure responsibility on investment of supporting facilities shall be evaluated in accordance with the law and its value shall be reasonably determined. ..."

The sixth misunderstanding: the construction and operation costs of PPP projects are calculated according to the methods of calculating business tax

For PPP projects prior to May 1, 2016, it is acceptable to calculate the construction and operation costs of PPP projects according to the methods of calculating business tax. For those after May 1, 2016, the aforesaid calculation method is absolutely not acceptable. For the PPP projects that have not adopted bidding procurement, the financial affordability assessment reports shall be adjusted and demonstrated again, and the implementation programs of the PPP projects shall be re-adjusted. The reasons are as follows:

On March 24, 2016, the Ministry of Finance and the State Administration of Taxation promulgated the Circular on Comprehensively Promoting the Pilot Program of the Collection of Value-added Tax in Lieu of Business Tax (including Appendix I. Implementing Measures for the Pilot Program of the Collection of Value-added Tax in Lieu of Business Tax; Appendix II: Provisions on Matters relating to the Pilot Program of the Collection of Value-added Tax in Lieu of Business Tax; Appendix III: Provisions on Transitional Policies for the Pilot Program of the Collection of Value-added Tax in Lieu of Business Tax; Appendix IV: Provisions on the Application of Zero-rated Value-added Tax and Tax Exemption Policies to Cross-border Taxable Activities). Upon approval of the State Council, the pilot program of the collection of value-added tax (VAT) in lieu of business tax (BT) (hereinafter referred to as the "pilot collection of VAT in lieu of BT") shall be promoted nationwide in a comprehensive manner as of May 1, 2016, and all taxpayers of business tax engaged in the building industry, the real estate industry, the financial industry and the life service industry shall be included in the scope of the pilot program with regard to payment of VAT instead of BT.

The comprehensive implementation of the pilot collection of VAT in lieu of BT will have a major impact on the construction price, operation and maintenance costs, and others of PPP projects. It is reasonable and practicable only if the costs of a whole PPP project are re-calculated based on the new thought on the pilot collection of VAT in lieu of BT when the financial affordability assessment for the PPP project is carried out.

The seventh misunderstanding: no attention is paid to the unreadable investment profits or investment margin of social capital

In the financial affordability assessment for a PPP project, with respect to the total government payments or the identification of the amount of government subsidies, attention is mainly paid to construction costs while little attention is paid to the investment return of socialcapital, or the investment margin of socialcapital is unreasonable, which has a major impact on the improvement to the accuracy of financial affordability assessment and is of great importance to attracting socialcapital to participate in such project. Paying no attention to the investment return of socialcapital is a major misunderstanding. In this regard, Paragraph 1 of Article 16 of the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects expressly provides that: "The expenditure of operation subsidies shall be reasonably determined according to the construction costs, operating costs and profit level of the relevant project, and shall be measured separately according to different payment models."

As to how to determine the reasonable profits or the reasonable profit margin of socialcapital, Article 18 of the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects expressly provides that: "A reasonable profit margin shall, based on the interest rate levels of medium and long-term loans of commercial banks, be determined in combination with risks and other factors by taking into comprehensive consideration the different situations of availability payment, usage payment, and performance payment."

Therefore, in determining a reasonable profit margin, we cannot purely take the interest rate levels of medium and long-term loans of commercial banks as a reference; furthermore, we shall comprehensively consider various factors according to the characteristics of specific PPP projects.

The eight misunderstanding: simply assume that the government has no risk expenditure responsibility for the time being

In a PPP project, to accurately identify the risks and possible expenditure responsibility to be undertaken by the government is not only a major test for carrying out financial affordability assessment for the project, but also a very difficult problem. However, we cannot adopt a simply assume that the government undertakes zero risk expenditure just because of the complexity and difficulty of the identification.

Then, if such a simple method is not adopted, how to handle it? In this regard, according to the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects, we may measure the expenditure of risk exposure by using the ratio method, scenario analysis and probabilistic method and taking into full consideration the probability of various risks and the expenditure responsibility to be brought thereby. The specific meanings of the three methods are as follows:

The first method: the ratio method. In the case that the expenditures of various risks and probability are difficult to be accurately measured, the expenditure of risk exposure can be determined according to a certain proportion of all the construction costs of the relevant project and operating costs during a certain period.

The second method: scenario analysis. In the case that the expenditures of various risks can be measured, while the probability is difficult to be determined, the expenditure of risk exposure brought by each risk can be measured under "basic", "unfavorable" and "worst" scenarios with respect to all events and variables that affect the risk. The formula is:

The third method: the probabilistic method. In the case that the expenditures of various risks and the probability can be measured, the expenditure of risk exposure brought by each risk can be measured by taking all variable risk parameters as variables according to the probability distribution function.

The ninth misunderstanding: that the financial expenditures of an individual PPP project do not exceed 10% of the annual budget is wrong taken as the basis of passing financial affordability assessment

There are many errors in such misunderstanding, which are specifically set out as follows:

Firstly, we should not simply measure the financial capacity of an individual PPP project but shall measure the proportion of all the PPP projects implemented among those funded by the finance department at the corresponding level of the relevant PPP project. If this PPP project is the first PPP project funded by the finance department at the corresponding level of this PPP project, it is acceptable to measure this project only. However, if some PPP projects have been implemented within the administrative region of the finance department at the corresponding level, it is unacceptable to measure this project only. In this regard, Article 23 of the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects expressly provides that: "The finance departments (or PPP centers) shall integrate all the PPP projects implemented and to be implemented in the year for the evaluation of financial capacity, after identifying and measuring the financial expenditure responsibility for individual projects."

Secondly, what we need to measure is not simply that the financial capacity in a year does not exceed the prescribed proportion, but that the financial capacity during all years when the government undertakes payment responsibility does not exceed the prescribed proportion after all the implemented PPP projects are integrated.

Thirdly, it is not the annual budget but the general public budget expenditures. The budget includes general public budget, government-managed fund budget, state-owned capital management budget and social insurance fund budget. The general public budget is divided into central general public budget and local general public budget at all levels. Article 6 of the Budget Law of the People's Republic of China provides that: "The general public budget refers to the budget for revenues and expenditures of the fiscal revenue mainly from tax collection that is arranged and used for ensuring and improving people's livelihood, promoting economic and social development, safeguarding national security, maintaining the normal functioning of national institutions and other aspects. The general public budget of the Central Government consists of the budgets of all its government departments (including the entities directly thereunder, hereinafter the same) and the budgets allocated for tax refunds and transfer payments to local governments. Revenues of the general public budget of the Central Government consist of revenues at the level of the Central Government and revenues turned over by the local governments to the Central Government. Expenditures of the general public budget of the Central Government consist of expenditures at the level of the Central Government and the tax refunds and transfer payments by the Central Government to local governments." And Article 7 provides that: "The general public budgets of local governments at all levels consist of the budgets of all departments at their corresponding levels (including the entities directly thereunder, hereinafter the same) and the budgets allocated for tax refunds and transfer payments. Revenues of the general public budgets of local governments at all levels consist of revenues of the governments at corresponding levels, revenues from tax refunds and transfer payments by governments at higher levels and revenues turned over by the governments at lower levels. Expenditures of the general public budgets of local governments at all levels consist of expenditures of the governments, expenditures caused by turning over tax revenues to governments at higher levels, and tax refunds and transfer payments to governments at lower levels." In the financial capacity of a PPP project, the financial expenditures shall not exceed 10% of the general public budget for each year, which shall be borne in mind. Details can be referred to in Article 25 of the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects: "the expenditure responsibility for all PPP projects within the budget each year shall not be more than 10% of the expenditures within the general public budget. Provincial finance departments may determine the specific proportions according to local conditions and report the same to the Ministry of Finance for record filing and make the same public."

The tenth misunderstanding: the PPP projects passing financial affordability assessment are not included in the budget and medium and long-term financial plans or reported for approval and record filing

Those PPP projects failing financial affordability assessment do not have to be included in the mid to long-term financial plans, as the PPP model cannot be implemented if financial affordability assessment fails.

With respect to the PPP projects passing financial affordability assessment, Article 28 of the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects provides that: "Finance departments at all levels shall include the PPP projects passing financial affordability assessment and approved by the people's governments at the same level upon examination in the catalogue of PPP projects and when preparing mid-term financial plans, include the responsibility for financial expenditures of the projects in the overall budget."

In addition, the budget and mid to long-term financial plans shall be subject to approval and record filing. Specific approval organs and the authority to approve as well as record filing organs can be referred to in Article 50 of the Budget Law of the People's Republic of China, which reads: "The government of a township, nationality township or town shall report without delay its budget approved by the people's congress at the corresponding level to the government at the next higher level for the record. A local government at or above the county level shall report without delay its budget approved by the people's congress at the corresponding level and the totalized budget submitted for the record by the government at the next lower level to the government at the next higher level for the record. A local government at or above the county level shall, after totalizing the budgets submitted for the record by the governments at the next lower level in accordance with the provisions of the preceding paragraph, report the totalized budgets to the standing committee of the people's congress at the corresponding level for the record. The State Council shall, after totalizing the budgets submitted for the record by the governments of the provinces, autonomous regions and municipalities directly under the Central Government in accordance with the provisions of the preceding paragraph, submit the totalized budgets to the Standing Committee of the National People's Congress for the record."

Of course, the budget can be adjusted. Where any of the following situations occur in the implementation of the central budget already approved by the National People's Congress or of the local budgets at various levels already approved by the local people's congresses at the corresponding levels, budget adjustment shall be made: 1. the total budgetary expenditures need to be increased or decreased; 2. investing budget stabilization funds is needed; 3. the amount of key expenditures that have been arranged in the budgets needs to be decreased; and 4. the debts to be borrowed need to be increased. Details can be referred to in Article 67 of the Budget Law of the People's Republic of China.

Epilogue

The financial affordability assessment for PPP projects is a necessary process of any PPP project. In carrying out the financial affordability assessment for PPP projects, we shall strictly abide by laws, regulations and policies, particularly the Budget Law of the People's Republic of China, the Regulations for the Implementation of the Budget Law of the People's Republic of China, and the Guidelines for the Demonstration of the Fiscal Capacity of Public-private Partnership Projects, and consult the corresponding regulations and policies when finding anything that is unclear or uncertain, rather than taking things for granted; otherwise, the implementation of PPP projects will be seriously affected.

Note:English version for reference only,Chinese version shall prevail.

FROM: Modern PPP Think Tank

EDITER: VIEW:3024

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