Lecture Seven

1. Updated: 24 April 2007 FINA 522: Project Finance and Risk Analysis Lecture Seven

2. Managing Contingent Liabilities

3. Contingent Liabilities In Infrastructure: East Asian Experience • Philippines Experience • Indonesian Experience • Malaysian Experience

4. Contingent Liabilities Main Source of Infrastructure Contingent Liabilities, The Philippines

5. Sources of Contingent Liabilities Transportation – Road Projects • Government guaranteed minimum revenues • Problem with overly optimistic demand projections • Cost overruns

6. Malaysia - Transportation • Two Kuala Lumpur light rail projects • Extensive toll road program - 26 projects • Government has provided extensive guarantees of revenues to private investor • Guarantee of loan against default

7. Monte Carlo Estimates of Contingent Exposure to Transport Projects in Malaysia

8. From Contingent to Real Liabilities:Malaysia's North-South Highway (PLUS) Under the 1986 concession agreement for the North-South Highway,automatic toll increases equal to the greater of 6 percent or the annualincrease in the consumer price index. If the eligible toll increase isdenied, the concessionaire must be compensated an equivalent amount by the government. Permitting a formula-driven toll rate increase creates acontingentliability for the government that grows with each additional yearthe eligible increase is denied. Since 1996, the government has deniedthe full increase permitted under the concession agreement. The governmentbudgets for this expense, which for the PLUS concession average 80.5 million for 1996 and 1997 and which increasedsharply to MYR145 million for 1998 (because of the cumulative denialof rate increases for successive years).

9. Electric Power Sector • Contingent liabilities arise through “take-or-pay” contracts • IPP strategy allows for rapid expansion of generation capacity • However, contingent liabilities can be large of demand electricity does not naturalize • Has been disputes in Indonesia, Pakistan and Thailand • No disputes in Philippines

10. Malaysia - Electricity Tenaga – the public utility (largely government owned) • Tenaga signed long term take or pay contracts for IPPs • Exchange rate devalued in 1998 • Ringgit cost of dollar denominated debt of IPPs rise and this is passed on contract to Tenaga in higher power changes

11. Malaysia – Electricity cont’d • Tenaga could not raise electricity rates to customers so much • Tenaga’s financial position worsened • Electricity demand stayed strong • To reduce interest cost of borrowing Tenaga swapped dollar denominated debt for Yen- denominated debt to get lower interest rate • Took on risk of Yen appreciation

12. Indonesia - Electricity • Public electric utility PLN signed 26 long-term take-or-pay contracts with Independent power produces • Cost of power high relative to what it can change its customers • Rupial value of US dollar denominated debt rise rapidly as Rupial depreciated in economic crisis

13. Indonesia – Electricity (cont’d) - Energy demand fell with economic crisis in 1997-1998 hence, excess capacity and revenues did not keep up with growth in costs • Situation got worse for PLN as more IPPs got build and came on stream • PLN not able to meet its obligations • Government stopped negotiations for more capacity • Government had to take over PLN’s obligations

14. How to Manage Risk Contingent Liabilities Better • Should have more competition in power generation sector • Past contracts far too costly • Electricity distribution rates to final customers have to be more flexible not so much price capped

15. Malaysia – Sanitation PPP IWK contract took over sewerage services from local governments • Private firm selected for contract without competitions • Initially yielded a larger improvement in investment and service • Customer’s protested the high rates IWK changed • Contracts signed with people who (IWK) were politically connected. Customers did not think rates changed were fair. • Poor rate of collection of bills for sewerage from customers

16. Malaysia Sanitation • Size of rehabilitation investment underestimated by IWK • Concession agreement not complete • Poor tariff and compensation structure • No interim performance targets • Government had to give MIR 450 million in additional long-term soft loans to IWK • Government eventually had to take over the company

17. Malaysia Sanitation Mistakes: • No competitive bidding • Awarded Single Contract for whole country, hence, government did not have ability to compare performance of different operations • Government guaranteed to a minimum rate of return. Hence, no incentive to contain costs • Should not have separated water utility from sewerage utility • People willing to pay for water sewerage is just a negative externality of water systems • Impossible to disconnect sewerage lines if customer doesn’t not pay.

18. How Much Risk do Malaysian Project Sponsors Really Take? Private participation in Malaysia is less than the value of the “private” projects. Government has provided support through several mechanisms: “soft” loans, equity investments, directed lending through banks and provident funds, and various explicit and implicit guarantees - Government soft loans – carry low interest rates • Equity participation – is carried out through government- owned holding companies • Government guarantees - minimum revenue of traffic volume is guaranteed, the take-or-pay capacity payment arrangements, stands ready to compensate lenders and project equity providers in the event of project termination, a minimum rate of return to the equity holders. • Lending by domestic financial institutions (Including EPF (EMPLOYMENT PROVIDENT FUND (PENSIONS FUND) and other government- directed entities) has been a strength of Malaysia infrastructure development

19. Risk Management • Reducing the risk of source • Transfer risk to parties better able to bear the risk • Monitor and manage any residual risk Actions: • Need to reduce vulnerability of country to shocks • Chile used privatization for less risky sectors - electricity - used more competition to reduce costs - privatization done to reduce costs Malaysia: • Privatized Sectors that were hard to serve- risky- transportation and sewerage • Costs were not controlled were privatized

20. Management of Contingent Liabilities • Macroeconomic stability is very important • A stable growing economy reduces the incidence of contingent liabilities coming due • E.g. exchange rate, market risk • Political Risk • governments need to avoid creating political risks • If greater macroeconomic instability or political risk, then private sector will require greater rate of return. This creates an economic cost to the country because the consumers will have to pay a higher price

21. Market risk is dangerous for contingent liabilities • There should be clear evidence of adequate demand before PPP is implemented • Perhaps better for government to make investment and then let it out as a concession if demand for the project is uncertain

22. Cost Overruns • Usually cost overruns are a function of poor quality of work done at pre-feasibility and feasibility stages and project design. • There needs to be full information shared by all the parties • Surprises are costly • Ability of PPP sponsor and SPV to implement the project is critical

23. Accounting for Contingent Liabilities • There needs to be transparent accountability for all contingent liabilities borne by the government • Surprises cause capital outflows, therefore leading to exchange rate fluctuation and banking crisis that increases the financial and business risks of the project

24. Matching of Life of Project and Terms of financing • PPPs in infrastructure have lives of 15 to 30 years • Often financing can only be obtained with 7 to 10 years term • This forces high tariffs to be charged in early years of the project • If prices higher than quantity demanded will decrease causing a cashflow deficiency