Report No: ACS9606 . World Public Private Partnership (PPP) Practice Operational Note Viability Gap Financing Mechanisms for PPPs . June 27, 2014 . Investment Climate Department – Private Participation in Infrastructure and Social Services Business Line (CICIS) World Bank Institute Public Private Partnership Practice (WBIPP) Finance and Private Sector Development Department, Africa Region (AFTFP) . Document of the World Bank OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS . Standard Disclaimer: . This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org. ii CONTENTS ACKNOWLEDGMENTS........................................................................................................................................................... V ACRONYMS AND ABBREVIATIONS ................................................................................................................................. VI I. PUBLIC PRIVATE PARTNERSHIPS AND THE GOVERNMENT FINANCING ROLE ............................... 1 INTRODUCTION ................................................................................................................................................................................................ 1 REVIEW OF THE THEORY ............................................................................................................................................................................... 1 OVERVIEW OF GOVERNMENT FINANCING OPTIONS .................................................................................................................................. 5 II. VIABILITY GAP FINANCING MECHANISMS – ISSUES AND PRACTICES................................................ 24 THE DIFFERENT VGF INSTRUMENTS ........................................................................................................................................................24 DIFFERENT APPROACHES TO DELIVERING VGF ......................................................................................................................................27 INTERNAL STAKEHOLDERS AND INSTITUTIONAL SET-UP AND PROCESSES ........................................................................................29 LESSONS LEARNED TO DATE ON VGF MECHANISMS...............................................................................................................................32 III. KEY MESSAGES FOR TASK TEAM LEADERS .................................................................................................... 35 ANNEX I: RESOURCES REFERENCES ............................................................................................................................ 38 WEBSITES .......................................................................................................................................................................................................38 PUBLICATIONS ...............................................................................................................................................................................................38 OTHER GOVERNMENT SOURCES .................................................................................................................................................................38 TRAINING COURSES ......................................................................................................................................................................................39 ANNEX II: EXAMPLES OF A RISK ALLOCATION MATRIX ..................................................................................... 40 ANNEX III: USE OF GOVERNMENT SUPPORT IN PRACTICE - SUMMARY OF PROJECTS ........................ 42 THE DAKAR-DIAMNIADO TOLL ROAD PROJECT, SENEGAL....................................................................................................................42 THE RUTA DEL SOL PROJECT, COLOMBIA .................................................................................................................................................43 HYDERABAD INTERNATIONAL AIRPORT LIMITED, INDIA ......................................................................................................................44 THE INCHEON EXPRESSWAY PROJECT, REPUBLIC OF KOREA................................................................................................................45 SILO PROJECT, MADHYA PRADESH, INDIA ................................................................................................................................................46 MERSEY GATEWAY BRIDGE, UNITED KINGDOM ......................................................................................................................................47 THE PORT OF MIAMI TUNNEL PROJECT UNITED STATES ......................................................................................................................48 ANNEX IV: INTERNATIONAL EXAMPLES OF GOVERNMENT VGF ARRANGEMENTS .............................. 50 INDIA ...............................................................................................................................................................................................................50 MEXICO ...........................................................................................................................................................................................................51 SOUTH KOREA................................................................................................................................................................................................52 BRAZIL ............................................................................................................................................................................................................53 ANNEX V: GLOSSARY OF TERMS .................................................................................................................................... 54 BOXES BOX 1: KEY QUESTIONS FOR TTLS ON PPP FINANCING ISSUES ..................................................................................................35 BOX 2:FACTORS TO ADDRESS IN SELECTING AND DESIGNING GOVERNMENT FINANCING INSTRUMENTS.............................................37 BOX 3: FACTORS TO ADDRESS FOR EFFECTIVE IMPLEMENTATION: ..............................................................................................37 iii OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS FIGURES FIGURE 1: SOURCES OF DEBT FINANCING IN HIAL ..................................................................................................................44 FIGURE 2: EQUITY FINANCING IN HIAL .................................................................................................................................45 FIGURE 3: FUNDING STRUCTURE OF THE INCHEON EXPRESSWAY PROJECT ...................................................................................46 FIGURE 4: FONADIN SUPPORT PRODUCTS ...........................................................................................................................52 TABLES TABLE 1: PUBLIC POLICY REASONS FOR GOVERNMENT FINANCING TO PPPS ..................................................................................3 TABLE 2: GOVERNMENT SUPPORT INSTRUMENTS IN PUBLIC-PRIVATE PARTNERSHIPS ......................................................................6 TABLE 3: VIABILITY GAP FINANCING INSTRUMENTS .................................................................................................................24 TABLE 4: SUBSIDY FINANCING: FUND STRUCTURE OR ANNUAL BUDGET APPROPRIATIONS ..............................................................29 TABLE 5: KEY STAKEHOLDERS AND FUNCTIONS .......................................................................................................................32 TABLE 6: READINESS CRITERIA AND INDICATORS .....................................................................................................................36 TABLE 7: DAKAR TOLLROAD COST STRUCTURE .......................................................................................................................42 TABLE 8: RUTA DEL SOL PROJECT AT A GLANCE .....................................................................................................................43 iv OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS ACKNOWLEDGMENTS This Operational Note has been co-authored by Peter Mousley from the Finance and Private Sector Development Department of the Africa Region of the World Bank and Shyamala Shukla from the Public Private Partnership (PPP) Practice of the World Bank Institute. This Note is based on World Bank operational and analytical work ongoing in a number of regions as well as the specific country experience that was presented by country practitioners at an International PPP Conference hosted in Kenya by the National Treasury of the Government of Kenya in June, 2013. A particular thanks is extended to the following participants and presenters at this conference who were so forthcoming with their knowledge and practical experience: Stanley Kamau, National Treasury, Government of Kenya; Magdalene Apenteng, Ministry of Finance and Economic Planning, Government of Ghana; Abhilasha Mahapatra, Ministry of Finance, Government of India; Frederick Saragih, Ministry of Finance, Government of Indonesia; Michael Fox, UK Infrastructure, Government of the United Kingdom; Mario Ruiz, Fonadin, Mexico; Heyyoung Kim, Korean Development Institute; James Aiello, National Treasury, Government of South Africa; Rania Zayed, formerly Ministry of Finance, Government of Egypt; William Dachs, formerly National Treasury, Government of South Africa; Helen Martin, World Bank; Solomon Asamoah, Africa Finance Corporation; Andrew Johnstone, Africa Investment Managers; John Ngumi, Stanbic Kenya; Vivienne Yeda, East African Development Bank; Pratyush Prashant and Vivek Kumar, Crisil Infrastructure Advisory. The authors would also like to extend their thanks to the following colleagues who have provided invaluable advice on the preparation of this Operational Note - Clive Harris from the World Bank Institute, Vyjayanti Desai and Katharina Glassner from the World Bank Group Investment Climate Department, Riham Shendy from the Africa Region Finance and Private Sector Development Department and Kalpana Seethepalli from the World Bank Infrastructure Policy Unit. Peer review comments on earlier drafts were provided by the following World Bank Group colleagues - Yira Mascaro, Eric Le Borgne, Jeffrey Delmon, Aijez Ahmed, Lincoln Flor, Particia Sulser and Ian Menzies. Thanks also to Amy Gautem for her editorial work on the final draft of this report. Funding for this output was provided by the World Bank Group Investment Climate Global Practice “Private Participation in Infrastructure and Social Sector” (PPI&SS) Service Line and the World Bank Institute PPP Practice. While the authors have benefited extensively from the generous input and guidance of the aforementioned colleagues and PPP practitioners from the public, private and financial sectors from across the globe, responsibility for any errors or omissions rest solely with the co-authors. v OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS ACRONYMS AND ABBREVIATIONS AfDB African Development Bank ANI National Infrastructure Agency (Columbia) EIRR economic internal rate of return FMV Fair Market Value FONADIN Fondo Nacional de Infraestructura (National Infrastructure Fund) (Mexico) GSM government support mechanism IPP independent power producer IRR internal rate of return MRG minimum revenue guarantee NPV net present value PPA Power Purchasing Agreement PPP public private partnership PV present value SPV Special Purpose Vehicle TIFIA Transportation Infrastructure Finance and Innovation Act (U.S.) TTL task team leader VGF viability gap financing vi I. PUBLIC PRIVATE PARTNERSHIPS AND THE GOVERNMENT FINANCING ROLE Introduction 1. The objective of this Operational Note is to provide an introductory review of a specific form of government financial support to Public Private Partnership (PPP) investments, referred to as “viability gap financing” (VGF). Section II discusses the public policy rationale for government support to PPPs. Section III provides an overview of where VGF fits within the continuum of the different financial support instruments that a government can deploy in support of PPPs and how VGF mechanisms can be structured and implemented to address different objectives, constraints, and opportunities that may exist within the policy, institutional, and market environment for PPP investments. Section IV concludes with some guidance to Task Managers as to the issues to address in providing advice and/or financing support to VGF instruments. 2. The Note is the result of a cooperative effort between the Finance and Private Network Sector Global Practice on PPPs, the World Bank’s Africa Region Finance and Private Sector Department, and the PPP Practice in the World Bank Institute, with input also from parallel work being done out of the Sustainable Development Network Infrastructure Hub, based in Singapore. It is the second of two Operational Notes prepared as an initiative to bring succinctly prepared technical advice to Bank staff and government counterparts on different aspects key to the effective development of PPP programs. The first Operational Note, published in June 2013, focused on the issue of PPP fiscal commitment and contingent liability management and should be viewed as a complement to this Note, as much of its content is immediately applicable to issues addressed herein. 3. This current Operational Note arose out of an increasing engagement with different countries, particularly in Africa and Asia, interested in scoping out options by which governments can efficiently and effectively - with due regard to key “Value for Money” and affordability considerations - address constraints that they face in mobilizing the right mix of financing for PPP investments. The Note is the product of ongoing technical work being carried out in the context of a number of Bank operations, associated analytical studies and presentations, and previous analytical work done in the recent past, as summarized in Annex 1. It has been further enhanced by conferences that have brought together governments with active and embryonic PPP programs that have discussed the diverse financing instruments employed to leverage private sector and donor engagement. The first of these Conferences took place in Washington, DC in June 2012. The most recent, on which much of the content of this Note was generated, was hosted by the Government of Kenya in Nairobi in June 2013. 4. The annexes provide additional key information integral to this Operational Note. Annex II lists some of the principal forms of risks to be mitigated in PPP projects. Annex V contains a glossary of key terms and concepts. Annex III comprises examples of specific existing projects that utilize government financing instruments and Annex IV provides some details on different VGF structures in place in selected countries. Review of the Theory 5. Government support for PPPs can be occasioned for a number of public policy reasons. The overall objective is to augment the supply and quality of public services – in this instance, relating to infrastructure or social service sectors. Infrastructure services are well understood to play a critical role in economic competitiveness and are an essential input to economic growth that generates income and jobs. The mobility and connectivity that infrastructure makes available to a population can generate a wide range of positive economic and social externalities which, combined with a role in fostering growth, constitutes a strong prima facie public good argument for government intervention to augment 1 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS infrastructure investment. In the case of social service provision, there is again a strong public good rationale for accelerated investment – notably in terms of health cost savings, productivity, and labor market efficiencies. There is also a good rationale for social services, insofar as individual choice would result in lower demand for these services with subsequent wider economic and social costs, thus justifying government intervention to increase supply and demand through targeted government support. 6. Table 1 provides further details on public policy rationales that can motivate a government to make financial contributions to PPPs. It can be seen that the fundamental motivations are the same as would apply to any public investment decisions. This is as it should be. The intent is to determine the public interest driver for deploying public funds in support of projects for which there would also be a return to private investment. PPPs are a particular form of solution to the broader government challenge of generating financing and delivering key services required for socioeconomic development that would not otherwise be provided by private actors in the market. These “contributions” can, as will be described later in this Note, come in different forms, via debt, grants, guarantees, equity, and fiscal instruments. Decisions as to which instrument to use will be a function of a number of factors, including, in addition to the public policy objective, the specific requirements of the project to be financed and the political, legal, and institutional context in which the government is operating. 2 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Table 1: Public Policy Reasons for Government Financing to PPPs RATIONALE EXPLANATION Capturing Externalities: Public funding to increase the Where the provision of a service provides utility not just to the direct consumer level of service and/or lower the price to the direct of that service, but generates a positive externality to other members of a consumer. society. For instance, the provision of improved sewage services will not just contribute to the person paying for the service but, by way of a general improvement in sanitary conditions, will also have positive benefits for the wider community. Addressing Social and Political Constraints on Prices Prices that can be charged for infrastructure and/or social services can be kept and Profits: Public funding may be required for a below cost to meet social equity reasons and foster increased levels of demand government to achieve twin policy goals of increasing (i.e., the merit good rationale). It can also be the case that the government is service provision and meeting social or political price-constrained because it is not politically possible to charge at cost- objectives that constrain pricing policy. recovering levels. Redistributing Resources to the Poor: The A pro-poor policy to deliver infrastructure or social services to particularly government may seek to provide funding to target vulnerable or marginalized members of society unable to pay for the service services to particular segments of the society. that often requires use of “smart subsidies,” whereby the provider gets paid to a greater or lesser extent based on performance measures (e.g., number of households reached with water and sewage services, numbers of children enrolled and in class, etc.). Overcoming Market Failures in Providing PPPs are long-term commitments. Financial and capital markets can lack the Infrastructure Financing: Public funding can be longer term maturity instruments or, due to information asymmetries, the deployed by government to address specific risk ability to cost the extended time and risk preferences needed to effectively factors that accompany long-term investments which finance this sort of long-term and information-constrained risk, or channel cannot be adequately priced by the market. sources of funds (e.g., pensions, insurance) towards these sorts of infrastructure assets. This can push financing costs beyond what can be absorbed commercially. Mitigating Political and Regulatory Risk: Government PPP contracts frequently involve a government obligation in the form of a can be required to address a subset of the wider regulatory action (e.g., adjustment of tariffs), off-take and annuity payments, market failure to price certain government-sourced repatriation of profits, currency convertibility and agreement not to risks. It specifically relates to information expropriate. Where the private sector party has uncertainty regarding asymmetries associated with certain government government readiness or capacity to honor these obligations, additional obligations under a PPP contract. coverage is required. Pursuing Strategic Interests: Governments can also, Equity positions may also be taken by government to assure that it shares in for strategic economic reasons, seek a direct any project upside returns1 (namely where project returns exceed the financial shareholder status in a PPP. projections estimated in the original contract). A government may also deem it important to signal a retained ownership to counter electorate perceptions that the private sector is gaining too much control of public assets or where government entities conclude that better project performance can be realized through a shareholder versus a regulator role. Source: from “Public Money for Private Infrastructure,” World Bank (2003). 7. What is the private sector role in the context of this public policy and merit good rationale? The sought-after benefits of involving the private sector in the supply of public services are principally a combination of time preference, financing, and the expertise that the private sector partner can bring to the investment:  In terms of time preference, the government objective is to draw on private sector financing capacity to change the time profile of investments. More specifically, it is to increase the level of investment over the shorter to medium term relative to what could be achieved given existing and near-term public sector budget headroom.  In terms of financing, governments look to reduce the initial public sector cost of the investment by having the private sector – through a combination of equity and debt financing – meet some of the principal capital and downstream operating costs. Based on an agreed rate of return arrangement between private sector and government, the private sector partner would recoup this investment with 1 While such equity positions are often called 'sub-equity' with a kick in returns clause in the case of an upside, sharing in upside return can also be assured through contractual arrangements without an equity investment. Most often a government decision to take an equity position in a PPP is a combination of the strategic, commercial, and political environment as portrayed above. 3 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS profit from revenues obtained over an agreed period of the PPP contract. These revenues can flow from user fees and /or government payments (most generally referred to as annuity or availability payments). There is also the objective by obtaining private investment to achieve a lower all-in lifecycle cost of the infrastructure. A key determinant with respect to this objective will be the relative cost of public versus private sector borrowing costs.  On the expertise side, the government may lack key skills and experience to deliver the service, whereas a preferred private sector provider would have both the track record of performance in the areas required and additional flexibility to recruit expertise as needed. 8. The net outcome sought is faster expansion and delivery of better quality and lower cost service, both in terms of construction/operational performance and cost management/predictability arrived at through an allocation of different risks (an indicative list is provided in Annex II) between the private and public sector parties. Determining the most appropriate government financing instrument - given the case is made that there is a public policy rationale for intervention - depends firstly on whether the underlying project structuring challenge is one of addressing Project Risks or of closing a Viability Gap, as described below:2  Addressing Project Risks: There are a number of circumstances where, while the project would be otherwise commercially viable, there are nevertheless certain risks that the private sector sponsor cannot effectively measure and price due to the higher levels of uncertainty imbedded in the risk.3 This can encompass all the risks listed in Annex II and others. Of particular note in this instance are political and revenue risks. In the case of the former, the commercial viability of a project may depend on certain government policy actions or agency performance – for instance relating to adjustments on a Power Purchasing Agreement (PPA) commitment or timely fulfillment of off-take obligations (which will raise the issue of financial strength and stability of state-owned off-takers or payors). Revenue risk arises in the case of fees charged to the end user (versus a PPA off-take arrangement with a government entity, as would be the case for an independent power producer – IPP), where there is: (i) no track record of user fee charges (i.e., a greenfield road, or where previously no toll was charged); (ii) no historically based traffic forecasts (even when there are thorough and rigorously developed traffic forecast figures and willingness to pay estimates); (iii) wider macro-economic uncertainty that may impact demand. Where robust demand data is lacking a private sector sponsor may seek government guarantees to offset the risk.  Closing a Viability Gap: A “viability” gap can exist where, due to social equity (ability to pay) considerations or social contract (willingness to pay) factors, user fee rates cannot be set at levels that would alone ensure a commercially viable project. In this instance for public and/or merit good reasons (wider economic returns in excess of the financial returns), a government may decide to intervene with support to ensure that the project proceeds. VGF provides government support to eligible, economically important,4 but commercially unviable5 PPP projects to make them commercially viable. The goal is also to leverage private capital (and expertise) for creating public infrastructure, keeping the cost of infrastructure facility at affordable levels for the users. 2 As will be seen in some of the project examples provided, structuring can require attention to both risk and viability gap issues. 3 Uncertainty is an essential element of risk; however, the level of uncertainty may be higher in certain cases, which results in higher costs as the higher risk perception gets factored into projected costs. 4 I.e., projects with suitably high economic rates of return. The most commonly used indicator for economic viability is the project Economic Internal Rate of Return (EIRR). The EIRR includes all the economic costs and benefits - the monetary benefits, as well as positive and negative externalities which are not captured by the financial IRR (FIRR). 5 When the project is not financially viable, the PV of the revenues is not sufficient to cover the PV of all project costs including a reasonable rate of return for the investors. This essentially means that the project is not bankable. Financiers will not lend to it unless the viability gap is closed and equity investors will also be loath to invest. 4 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Overview of Government Financing Options 9. There is a range of different ways that a government may choose to support a PPP project financially to address risk and viability challenges. Broadly speaking, this covers guarantees, equity, debt, grant and fiscal instruments; and other forms of support such as through other contractual clauses pertaining to risk allocation. These are summarized in Table 2, together with some examples of such financing support globally and some of the pros and cons associated with these different instruments. Many of these instruments have been used consistently in PPPs in developing countries since the inception of their PPP programs, given problems in availability, tenure, and cost of financing. However, in the aftermath of the financial crisis of 2008, similar support programs/instruments are being used more commonly in developed countries as well. A more detailed summary of some of the projects referenced in the table is provided in Annex III. 10. Table 2 and the examples referenced reflect a number of considerations about government financing of PPPs, such as: (i) There are many different types of investment – whether in developed, emerging, or developing economies – where private financing and expertise are forthcoming only with the added input of different types of government support; (ii) Political, fiscal, and financial considerations are intertwined in decisions relating to which projects to support, to what extent, and how; (iii) Multiple instruments are being used by governments, including on the same projects. The result is often not the optimal financial structuring, but rather the most feasible one, given the interplay of the above considerations. 5 Table 2: Government Support Instruments in Public-Private Partnerships INSTRUMENT PROS AND CONS EXAMPLES Equity - An equity position can allow the government to share in - United Kingdom: “Private Finance Initiative 2” (PFI2) in the United Kingdom Equity investments can be made benefits (dividends) if the return on the project proves to be equal requires government to hold equity in privately financed projects. The equity can be up through government or better than expected (contractual agreements typically include to 49% but will typically be of the level of 20%. shareholding in a PPP Special return on equity). Purpose Vehicle (SPV), including - India: 26% equity investment by Government of India/Airports Authority of different forms of quasi-equity6 - This can also be important to maintain general public India in PPP airports in Delhi, Bangalore, Mumbai, and Hyderabad. or through investments in equity and political support for the PPP. funds which buy equity stakes in - FONADIN (Mexico) has two equity vehicles: PPP SPVs. - It may facilitate improved interactions of the SPV with o A sub-equity instrument under which it can invest up to 50% in a public entities. project and receive returns when the IRR exceeds the projected level. - More public sector involvement in decision-making and o It participates with up to 20% of market capitalization under its better monitoring and evaluation. Private Equity Funds Program, supporting creation of new funds deployed fully in Mexico with fund managers contributing at least - More information available publicly on the SPV’s 5% with commitment to invest at least two-thirds in sectors performance and financial transactions. covered by FONADIN. - Government equity in a PPP can pose a corporate governance challenge with government on both client and concessionaire sides and this can complicate performance accountability and risk management. It can be managed, but requires an informed government counterpart. - Government shareholding in more strategic and larger PPP assets is more commonplace. - Countries with significant PPP portfolios are likely to be cautious about the complexities that would come with extensive shareholder exposure across a large number of PPPs. Debt Government loan to the PPP SPV - Can provide capital that may not be forthcoming from - United Kingdom: This includes: in the form of senior, mezzanine, other sources. o Co-lending program of UK for debt financing of up to 50% of the or subordinated debt, take-out project debt for pounds sterling 6 billion worth of projects; financing or revenue shortfall - Can potentially provide longer tenor, lower rate local loans, access to land under currency loans than the PPP SPV may be able to obtain from - United States. This includes: lease/rental arrangement, financial markets. o Subordinated debt to projects under the Transportation investments in specialized debt Infrastructure Finance & Innovation Act (TIFIA); e.g. I-495 Capital funds which buy the debt of PPP - Can provide subordinated debt which can enable senior Beltway HOT Lanes project in Washington DC metro area, Port of 6 Quasi-equity includes mezzanine and subordinated debt instruments which we have described under debt to avoid confusion. Under equity, we have included the sub-equity instrument of FONADIN which is a form of quasi-equity. 6 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS SPVs from the original lenders. debt financing from commercial banks at better terms. Miami tunnel, etc. - Government of France’s Fonds Commun de Titrisation: - Can reduce the cost of capital/help in structuring o Issues infrastructure bonds for a project backed by government payments later in the term by providing debt on special terms, such service charge payments to the PPP. as low or no interest rate/long moratorium debt. - India. This includes: o National highway PPP contracts in India provide for revenue - The loan would have a fiscal impact that can be financed shortfall loans to PPP SPVs to tide over temporary downsides; from existing budget revenue sources via public development o India Infrastructure Finance Company Ltd (IIFCL), a 100% finance institutions where they exist, or alternatively from special government-owned and -guaranteed entity has: (i) formed an sovereign or limited recourse bond issues. In some instances, may infrastructure debt fund that will invest in project debt post- specifically require Parliamentary approval. construction in India; and (ii) provided take-out financing to PPPs in India and direct debt up to 20% in PPP SPVs; - In-kind loans can be provided in the form of land o Government of Andhra Pradesh in India provided an interest free, allocations under rental or leasing arrangements. long-term moratorium loan to Hyderabad International Airport Limited. - Moral hazard as to government appetite to insist on repayment, if the project is under financial stress. - Spain has provided Subordinated Public Participation Loans for road PPPs. Grant Via upfront and ongoing grants - The grant would have a fiscal impact that can be financed - Upfront grant financing: such as upfront construction from existing budget revenue sources or alternatively from special o Including, more recently, a combination of upfront and grants or annuity payments or sovereign bond issues. operational grants in Indian PPPs; operational grants, unitary o Grant financing up to 50% of total project costs by FONADIN payments including availability - Parallel public sector investments can serve to improve Mexico, payments, usage based grants/ profitability of a given PPP and thereby have – in effect – a grant o Capital contributions phased during construction in UK’s PFI2. shadow tolls, land right impact. allocations, lease with nominal - Availability payments: common in PPPs in the UK, US, Australia, British payment or parallel public sector. - In some instances, may specifically require Columbia, and South Africa. Parliamentary approval and there may be uncertainty in securing allocations for commitments in the outer years. - Annuity payments: national highway PPP projects in India. - Parallel public sector investments include: (See next section for further details on these issues.) o In Solo-Kertosono Toll Road Project, Indonesia, 60 km of road contiguous to the PPP section fully funded/ constructed by government; o Government construction of Poznan bypass, feeder roads and interchanges and in the A2 Motorway project, Poland; o Government construction of up to $135 million out of a total project cost of $759 million in the Terminal de Contenedores y Carga General de Puerto Cortes in Honduras; o Senegal Dakar-Diamniado Toll-Road. - Land leases: land leased by government or a government entity including: o The National Highway Authority of India (NHAI) to the PPP SPV on nominal payment in Indian PPP road and airport projects; o The PPP SPV of the Hyderabad international airport has been allotted land for the purpose of commercial development to supplement airside revenue. Guarantees 7 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Can cover a range of risks - Can provide key enhancements that ensure project - Government guarantee of a face value of Euro 800 million in an interest and including commercial (guarantee closure with lower outlay than equity, debt, or grant options. principal deferred 17-year debt (equivalent to a zero coupon bond) from the European to lender to project SPV, including Investment Bank in the Poland A2 Motorway project. for bond issuances), payment - Incurs contingent liability that in some instances can be guarantees for potential open-ended (e.g., foreign exchange or interest rate guarantees) and - Political Risk Guarantee of US$45 million by Government of Kenya issued to payments by off-takers / requires close management/oversight to avoid unanticipated fiscal Rift Valley Railways (RVR) in the Kenya Uganda Rail Concession. Termination risk consumers of the services of the impacts. covered by a PRG from MIGA in Kenyan power projects (IPPs). PPP SPV, foreign exchange,7 interest rate, revenue and - Can give rise to conflict of interest issues if the same - UK Guarantee Scheme for projects in aggregate of up to pounds sterling 40 political (refer to Annex II), public authority issues the guarantee and is the contract manager. billion - project promoters apply for a guarantee, a recent example being the Mersey securing loans/bonds through - Gateway Project, which has a government guarantee on 50% of the project’s senior tying up to government service debt. payments are also forms of guarantees. - Guarantees against off-takers include: o Payment guarantees issued to IPPs in Pakistan by the Government of Pakistan against payment by off-taker Central Power Purchasing Agency (CPPA); o Kenyan Government Letter of Comfort in Independent Power Producer (IPP) projects. - Other Guarantees include: o Credit Guarantees from IIFCL, India and under TIFIA in the United States; o Revenue Guarantees in the Incheon Expressway project in South Korea; o Revenue/demand guarantees in toll road projects in Turkey, Grain PPP projects in India. Fiscal Incentives This includes tax holidays, - Often provided through general policy provisions for - India customs, and other duty investors of different types and will benefit all projects uniformly o Exemption from stamp duties, registration tax on purchase of real estate for exemptions and drawback irrespective of financial viability issues. infrastructure; schemes. o Exemption/concessional rate of value added tax; - Reliability dependent on efficient administrative capacity o Duty-free import of road construction equipment in highway PPPs; that can be lacking in ways that materially affect the benefits to the o 100% tax exemption in road sector PPPs in a consecutive 10-year period; investor. o Exemption/concessional taxation including exemption from capital gains tax on bonds issued by project SPVs. - United States o The federal government tax-exempts private-activity bonds issued by the private sector for investment in public infrastructure as part of a PPP arrangement; o Treatment of capital investment as an expense for the purpose of computing corporate taxes. Other key contractual clauses/ - Termination payments are a key component of Almost all countries and contracts use termination payments covering a large part of support instruments government support and can be used in various ways as illustrated. the debt. 7 The Government of Chile established insurance/ guarantees for foreign debt in the 1990s whereby domestic currency depreciation in excess of 10% was covered, but was charged a specific premium. 8 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Termination payments ensuring - Termination payments are credit enhancement Country/ Concessionaire Authority event of Other (such as payment of all or part of the debt, techniques resulting in better financing terms. Project event of default default Force Majeure) as well as equity in many cases. Canada, British Lesser of the FMV8 Greater of In the case of - Have to be carefully constructed to avoid skewing Columbia or outstanding concession FMV force majeure, Variable term contracts tied to incentives, especially private incentives to default. (Sierra Yoyo debt. or outstanding greater of 95% of pre-agreed PV of revenues used Desan Road debt. FMV and as bid variable. Project) outstanding debt. Fixed contract term but with the South Africa The greater of the The payment The sum of debt, flexibility of variation if there is standardized pre-agreed includes debt, subcontractor shortfall in actual revenues at contract percentage of debt equity costs, shareholder contract term completion. provisions and the highest compensation, loans, equity less tender price breakage costs, dividends, received on breakage redundancy retender, or the premium related payments for greater of the pre- to financing employees not agreed percentage agreements, transferring less of debt and the redundancy specified adjusted estimated payments for deductions. project value if the employees not project is not re- transferring, set- tendered. off by amounts payable by the private party and other specified amounts. Indian If occurring prior Debt due, 150% Political event - standardized to “Commercial of the adjusted same as an contract Operations Date” equity.9 authority event of provisions for (COD), no default. national termination highway payment will be Non-political projects. paid. event - termination If after COD, 90% payment equal to of the debt due 90% of debt due less insurance less insurance. cover. Indirect political event - debt due less insurance cover, 110% of the adjusted equity. 8 Fair market value. 9 Adjusted equity is defined in the contract. 9 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS II. VIABILITY GAP FINANCING MECHANISMS – ISSUES AND PRACTICES The Different VGF Instruments 11. The array of different financing instruments that can be deployed by governments, as outlined above, all merit detailed exposition. However, this Operational Note focuses on issues of rationale, design, institutional structures/frameworks, current international practices/frameworks, and overall pros and cons of one particular genre of government support: viability gap financing. This focus derives from the recent growing interest that a number of African, East Asian, and South Asian countries have shown in developing VGF mechanisms as a principal means to support PPP investments, as well as an increasing appetite to finance such mechanisms through World Bank operations. 12. This section begins with a review of the different ways in which VGF can be structured to more efficiently address different project financing requirements. It then details some of the budget approaches that can be taken to its operation and the factors that can determine which approach is adopted in a given country. A summary of the key aspects of the different types of VGF instruments/approaches is detailed in Table 3. In practice, these different forms of VGF can be combined together with other government support mechanisms, as will be seen with the project examples and summary of some of VGF mechanisms currently being used by governments, as provided in Annex III and IV, respectively. Table 3: Viability Gap Financing Instruments FINANCING INSTRUMENTS SOME PROS AND CONS Construction Grant - The construction grant has the effect of reducing debt requirement and The construction grant is a VGF support provided in improving the debt service coverage ratio at the same level of revenues, the form of contribution towards capital expenditure making financiers more willing to lend; i.e., it reduces the credit risk of the PPP project. Construction grant payments are profile of the project; linked to the progress of the project and are commonly - The capital requirement from the private investor is reduced, making the spread over the construction period in accordance project commercially viable at a lower rate of user fee than would with specific verifiable milestones to maximize the otherwise be possible; i.e., it reduces the risk of non-payment of user fees value for money for the public funds. However, there especially in projects where payment by users may be post service (e.g., may be different ways of paying the construction/ water, electricity supply, etc.); upfront grant, including at commencement of service. - Being upfront and fixed, the grant does not create long-term or open- ended commitments for governments; Construction grants may be used singly or in - Risk perception of the private sector about non-payment by government is conjunction with operational grants in a PPP project. lower compared to payments over the longer term; In addition, construction grants may contribute - The construction grant is simpler to administer with lower transaction towards construction costs alone or towards other costs for the public entity as it is paid over a short to medium time horizon initial development costs or towards financing a (i.e., 2-3 years); viability gap based on discounted lifecycle revenues - The upfront grant is usually permanent and is not affected by later and costs. In this last case, the idea is that payment of a changes in projects (although this does not exclude refinancing gains and lump sum amount at the beginning of the project helps revenue upsides being shared); in reducing overall capital costs with the amount going - The upfront grant does not cover later performance risk; this is a towards construction and it proportionately reduces drawback in the instrument vis-à-vis availability or other types of the debt and equity requirements during that period. payments spread over project life. Operational Grant - An operational grant may be better able to cover the performance risk as The operational grant covers a proportion of the it is paid over a longer period; operational expenditure of the PPP project. It has the - It requires a mature long-term budgeting framework to properly manage effect of reducing the operational costs for the private the associated risks; investor in the project, thereby improving commercial - It requires additional government implementation responsibility with viability at lower level of user rate. higher transaction costs for the public entity; - It can create operational risks that the private party would seek to The Operational Grant is provided towards pre- mitigate; specified operational costs (for instance, regular - It may increase project costs overall, as a higher level of debt and equity dredging at a port PPP). Other costs/ risks would from a private party would be required at the outset. remain with the private investor. Operational grant disbursements are a pre-specified amount linked again to specific verifiable performance criteria and are 24 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS capped at a certain level to avoid creating a contingent liability. This instrument can entail a longer-term commitment, depending on the operational cost being covered and terms of coverage. Service Payment (based on service standard) - Availability-based payments can effectively cover performance risk; “Annuity” payments and/or “Unitary” payments are a - Under purely availability-based payments with no usage component, the more general term that can comprise one or all of revenue risk is borne fully by the government; availability, service performance, or usage requirements - It can attract private financing and private participation in areas where for disbursement. the private sector would otherwise be unwilling to invest (e.g., projects with high revenue or credit risk); “The “availability” version entails payment against a - It is more flexible (vis-à-vis upfront grants) in terms of opportunity for supply (e.g., a four lane highway) according to variation during contract term; specified service standards where the availability - It entails a long-term fiscal commitment and requires a mature long-term payment would be adjusted in the event of the service budgeting framework to properly manage the associated risk. not being available (for instance, a lane is closed for maintenance in a way not compliant with terms of the concession contract). Availability payments may or may not be used in conjunction with tolling/user charges. There is the need to differentiate between availability-based payments where: (a) the government is the sole user and buys the services for itself, not on behalf of any end-user, and does not or cannot charge tolls/user fees; and (b) the government pays but the services are utilized by the general public (and not by government directly), on whom government may or may not levy user fees. In practice, however, in many cases the payment mechanism consists of a combination of availability- and usage-based payments, as either of these used singly could result in skewed incentives for the private party. A combination methodology could be used to optimally allocate the demand risk between the public and private entities.10 Demand and Output-Based Payment - This can be used for full transfer of demand risk to the private party; This is a “shadow toll” approach, whereby the - Based on circumstances, it may be difficult to effectively measure output/ government makes payments based on usage (i.e., usage; demand). - This is a less practical instrument that may have limited applicability when used alone. The government pays the provider based on a pre- specified output and rate.11 13. The suitability in a given country of these different approaches will depend on a range of factors. First, the optimal payment mechanism is also largely determined by the economics of the project and how risk can be allocated and translated into the financing structure and the contract. In addition, as will be discussed subsequently, factors such as the nature of a country’s PPP pipeline of projects (some sectors are more suited to VGF approaches than others), political economy factors (including legal authorizing environment, legislative and executive, budgetary framework and processes, as well as inter-ministerial bureaucratic dynamics) play an important defining role, as does the capacity of the public sector to handle different approaches. 10 The Rota Lund PPP Project in Minas Gerais uses a payment mechanism for subsidy whereby the formula for the monthly payment includes the initial availability-based bid amount but varies this amount based on usage (and as a consequence revenues collected by the private party). 11 An example very similar to usage-based payments is the payment mechanism adopted for the solid waste project in Minas Gerais, where payment is based on the amount or tons of solid waste delivered to the landfill by the private party, with the per ton rate being the bid variable. Other performance indicators are effectively factored into the payment formula. 25 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS 14. While grant payment mechanisms may be provided upfront or on an ongoing basis, each of these payment mechanisms has its own distinctive features and associated advantages and disadvantages. While upfront payment during construction is simple as it helps avoid administrative costs related to ongoing payments as well as longer-term commitments that may be prone to political economy issues, it could subject government to an increased private sector performance risk, as the private provider extracts its margin during the first phase, high-expenditure construction period without the incentive to maintain performance at the same level during implementation. This risk can be mitigated through the use of instruments such as performance bonds, upfront equity requirement, performance-based disbursements of the upfront payment, and a strong contract management framework. An upfront payment is fixed and is generally not changeable (i.e., it does not have the provision for conversion to debt at a later point in time should there be an upside in revenues), unlike availability payments which can be calibrated based on changes in variables such as interest rates, inflation, etc. This can, however, be tackled through the use of revenue share beyond a pre-agreed level, conversion to debt, or variation in contract term. Upfront payments would also entail greater fiscal commitments in a shorter stretch of time, and do not defer government expenditure on infrastructure over longer periods of time. This can ultimately mean fewer projects for a country. Longer term payments, on the other hand, expose the private entity to a higher degree of political risk and lead the private sector to factor an additional risk margin into its price. 15. While in some cases, there may be no direct grant financing of the specific PPP project itself, there could be several related public investments which may be linked directly to generation of demand/revenues for the PPP project.12 In such cases, if the publicly invested and privately invested projects are taken up simultaneously, the private entity may be subject to commercial risk arising out of delays in the associated public projects; and there could be inbuilt protections in the contract against failure of the government to successfully complete these projects. In still other projects, to help improve the viability of the project, land is made available at a nominal or low price; or commercial exploitation of land is allowed in order to raise additional revenues as discussed in the case of the Hyderabad Metro and Hyderabad International Airport projects. In almost every case, the ownership of the land remains with the government while the private entity is given the right of use of the land for the specific purpose stated in the contract. However, tying land use revenues and infrastructure PPP projects is a matter fraught with possible implications of windfall profits which the government may not be able to either control or assess. 16. While PPP programs in different countries were seen to initially adopt one or the other of the above instruments predominantly, a distinct change is visible in recent times in countries with larger PPP programs; governments are increasingly realizing the pitfalls of relying on one instrument and trying to adopt a balanced approach to the VGF instruments used based on projects and circumstances, so as to take advantage of the strengths of each while diminishing the magnitude of the associated risks and perverse incentives. The Indian Viability Gap Fund program, while providing in theory for instruments based on needs, used the upfront capital grant in most projects post-2005 after having more or less abandoned the annuity instrument. The PFI in the United Kingdom started out almost solely using availability-based payments and shadow tolls. In recent years, there has been a diversification of grant instruments used. For instance, the UK Mersey Gateway Project has a service commencement lump-sum payment, paid immediately after commissioning of the project, as well as availability payments over project life linked to toll revenues. 12 Examples of this could be PPP port terminals where the road or highway link to the port is being built as a fully publicly funded project, or a silo project where the rail siding and linking rail line are being built through public funding or a highway project where the surrounding road connections are being built through public funding. In these cases, the publicly funded projects contribute directly to the demand for the PPP project. Another example is the Solo-Kertosono Toll Road Project in Indonesia, of which a part of the road of about 60 km length will be built through government funding while a length of 120 km will be built through PPP mode. However, any delay in the public section of the road has the potential to adversely affect the demand on the PPP road. 26 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS 17. In school construction and operations programs in India, the construction grant as well as regular operational grants are being used together. In its proposed health sector pilots, the Government of India is considering a combination of upfront and usage-based payments. In the Miami Port Tunnel in the United States (see Annex III), the two instruments are used together – a construction grant as well as availability payments. Where standardized approaches by governments are desirable for administrative simplicity and due to capacity constraints, the need to incorporate a variety of options based on categorization of risk profiles of projects is increasingly evident. Different Approaches to Delivering VGF 18. VGF can be delivered on an ad hoc project-by-project basis or by way of a more structured programmatic approach. The preferred administrative option will depend upon a combination of factors, including the sector, number and nature of projects, a country’s budget planning framework, and its technical and management capacity. 19. First there is the consideration of administrative cost efficiency. Where there are a large number of similar projects in each sector and the sectors of focus are limited as well, a more structured approach can help package and process projects quickly and can help scale up the project portfolio more rapidly, as in the case of India. Where there are fewer projects and each project is very different from the other, or if there are many projects with different requirements from a wide range of sectors, a structured approach might prove to be more of an impediment, especially if it does not provide adequate flexibility in terms of instruments or entails an administrative cost overhead not justified by the volume of private sector funding that it serves to mobilize. For example, Australia and British Columbia have a fairly mature PPP program but with a very limited number of projects, each of which is very different. The state of Minas Gerais in Brazil is another example where the subsidy arrangements have been developed case by case based on specific project needs, with individual project contracts outlining the mechanisms, levels, and terms and conditions for the provision of government support. These jurisdictions have preferred to develop and support projects in a variety of ways without a specific administrative framework. The case- by-case approach might result in more customized solutions and more innovation, but at the same time it will generally require a more mature, competent, and established government budgetary oversight capacity. A case-by-case approach, which can entail high levels of discretionary decision making can, without this established budget management competence, risk exposing the budget to distortionary and insufficiently assessed fiscal commitments. 20. The second principal consideration is one of budgetary certainty, especially where ongoing payments are made through project life. Governments may use various methods to make grant financing available. The financing can either be earmarked for VGF and allocated to a specialized statutory non- lapsing fund or it can be appropriated through the budget annually or at other appropriate periodicity with unspent amounts reverting back to government at the end of the fiscal year. A dedicated fund minimizes the uncertainty associated with funding, but requires capitalization which, to the extent that this is provided by government, can place a significant upfront fiscal burden on government. 21. The Fund Model: A well-established example of a capital fund for infrastructure subsidy payments is the FONADIN in Mexico.13 The FONADIN (the National Infrastructure Fund) was established in 2008 with a contribution of US$3.3 billion funded by the Farac (the highway re- concessions program14) and the Finfra (the infrastructure investment fund). The fund is managed by the 13 For further information, see Annex IV on international experience. 14 The highway concessions in Mexico were bought off from the private sector when the risk became unbearable for the government and were then restructured and resold to the private sector. The FONADIN was set up from the amount received from the sale. 27 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS National Development Bank of Mexico, the Banobras. It sells multiple products, including guarantees, loans, and subsidy products, with the earnings from loans, guarantees, and other products funding the subsidies. FONADIN is not funded by the national budget and is not subject to the same laws as the budget in terms of disclosure of information, although it is expected to provide regular reports on its performance. The fund structure usually needs a dedicated administrative set-up, but can also be implemented within the existing government set-up, depending upon the level of complexity as well as size. The funds when not in use for funding VGF would need to be used productively and must be invested for the purpose of earning returns, to avoid the opportunity cost of idle, unused funds. However, funds based on a one-time contribution alone either have to close when all funds have been expended as grant financing or must have non-grant products or other forms of investment to generate returns to replenish the fund on a self-sustaining basis. 22. One of the other advantages of such funds over budgetary appropriations is that they can also tap into other sources of funding. One example of this is under the Sindh (Pakistan) VGF Rules 2012 where funds from multiple sources are used to finance the VGF.15 Another example is the Project Facilitation Fund16 proposed to be set up under the Kenya PPP Act 2013, which envisages multiple sources of funding such as budget appropriations, grants and donations, tariffs and levies on projects and success fees paid by companies and is expected to be set up as a statutory fund within the National Treasury. 23. The Budgetary Allocation Model: In a number of countries, including in particular the Indian VGF scheme that has been in operation since 2005, PPP grants are funded through annual budgetary appropriations based on expectations of disbursals of installments to projects in any given year, with unutilized amounts at the end of the fiscal year reverting to government. In this instance, it is not necessary to capitalize a fund at the outset, but rather meet obligations as they fall due through the regular budgetary management process. This implies a lower upfront budgetary outlay and, in principal, a high level of scrutiny is already in place due to the annual reporting requirements associated with the budget appropriations process. On the other hand, the fact that the funds are not earmarked beyond the current fiscal year can constitute a risk to private operators dependent on the VGF cash flow to meet financing obligations on the PPP project. The extent to which this risk is a significant deterrent to private investment will be a function of the overall confidence that the private sector has in the predictability of the country’s budgetary apparatus and its reliability, based on past track record. 24. There can be methods other than using a capitalized fund or annual budget appropriations to address “reliability of funding” concerns. Brazil funds subsidies through a one-time budget appropriation. However, as funding is categorized as interest payments for which annual legislative approval is not required, it is possible to provide a multi-year commitment without giving rise to the uncertainty associated with budget appropriations process. Other ways can be financing through non-recourse bond issues that may be paid back by a public entity through revenues earned from the project either annually through coupon bonds or one time at a later stage in the project term through zero-coupon bonds. The choice of zero-coupon or coupon bonds would be based on the revenue profile of the project. In case the revenue profile of the project does not support the repayment, the payment is guaranteed by the state, in which case it is effectively non-recoverable grant funding by government. 25. Table 4 provides a summary comparison of the pros and cons of funding through a one-time capitalized fund structure as opposed to the annual budgetary process. 15 The VGF in Sindh is funded through budgetary support, gifts, grants, and transfers or in any other way as decided by the Finance Department. 16 Section 68 of the Kenya PPP Act, 2013: The Project Facilitation Fund is expected to fund VGF in addition to payments of contingent liabilities, project development funding, etc. 28 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Table 4: Subsidy Financing: Fund Structure or Annual Budget Appropriations Fund Budget Appropriations Greater certainty of funding with funds available for Less assured funding with requirement for annual or periodic17 investment when needed. appropriations where executive or legislative government branches may decide to curtail future funding. Faster processes as the annual appropriations process is Potentially slower processes associated with annual appropriations eliminated. Less legislative scrutiny unless there is a requirement for Potentially higher level of legislative scrutiny as the program tabling of detailed annual reports. automatically comes before legislature each time funds are appropriated. The extent of scrutiny when part of a much larger budgetary submission is a potential weakness. Separate administrative set-up may be required to manage Existing departmental and administrative processes are commonly fund. used. Higher costs of implementation. Lower costs of implementation. Can be open to substantial investment risk in cases where Essential to appropriate funds in amounts just sufficient to cover the funds are required to generate returns to cover future payments scheduled for disbursals in the particular year for which the funding needs. budget is being appropriated to avoid opportunity costs. Internal Stakeholders and Institutional Set-up and Processes 26. The institutional set-up and processes for VGF play an important role in its implementation. The concession/ subsidy/ payment agreement in PPPs is usually between two parties, but several stakeholders are involved in the VGF process. It is essential to recognize early the need to involve all stakeholders in the development of the VGF mechanism and understand the institutional dynamic between these parties and its implications for VGF operation. While there are differences in the institutional structure and dynamics across these stakeholders in countries, the key players that affect or are affected by the VGF process are commonly observed to be as follows: (i) The Line Ministry or Implementing Agency. The identification and preparation of projects including pre-feasibility, detailed feasibility studies, and project structuring are undertaken by the ministry or agency in charge of the project. For example, in India the line ministry and agency responsible for the identification, preparation and development of national highway projects are the Department of Roads, Transport and Highways (DORTH) and the National Highway Authority of India (NHAI). The line ministries and implementing agencies are also responsible for project procurement and contract management once the project agreement is executed. In Brazil, this phase of the work is done by the implementing agency with support from the PPP Unit. In Mexico, the line ministry will be working closely with FONADIN. In Colombia, the National Infrastructure Agency (ANI) does the work of procurement of projects. In Honduras, Coalianza undertakes project procurement on behalf of the line ministries and agencies while contract management is carried out by the line ministries, with Coalianza evaluating and monitoring project implementation. (ii) The Ministry of Finance. The Ministry of Finance plays a key role in most countries in the review and approval of requests for subsidy, as well as appropriate budgeting for the subsidies. In Colombia, the Ministry of Finance plays a key role in the review of requests for subsidies. In South Africa, the PPP unit is part of the National Treasury, with major functions centralized in the unit. In Mexico, the Investment Unit of the Ministry of Finance must approve a project before it comes to FONADIN for subsidy. In India, the PPP cell that reviews proposals is a part of the Department of Economic Affairs, which is one of the five departments of the Ministry of Finance. In addition, whether the country uses a capitalized fund structure or a periodic budgetary appropriation, the Ministry of Finance is closely involved in the establishment and continued replenishment of the fund/ budget head in most countries. 17 Where the budget cycle is multi-year, funding can be made available for more than a year through budgetary appropriations. 29 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS (iii) PPP Unit. In most countries, the PPP Unit plays the coordinating role by preparing the guidance to ministries on VGF policy, processes, and procedures and templates for use in the preparation of requests for subsidies, and by assisting ministries actively in the preparation of proposals. The PPP Unit also can act as a secretariat to the approving body and manage the VGF processes and monitoring and evaluation of VGF, as is planned in the case of the Kenyan model. The location of the PPP Unit within the government apparatus can vary. The most common option is to house this in Ministries of Finance, although there are stand-alone options reporting to the Head of State, as is the case for the Nigeria Infrastructure Concession Regulatory Commission (ICRC) and the Agence de Promotion de l’investissement et grands travaux (APIX) in Senegal. (iv) National Planning Department/Commission/Council. National Planning Departments in countries are responsible for planning the development process and funding issues. In some countries, these play a key role in the process of reviewing and approving subsidies for infrastructure projects. In Colombia, the National Planning Department is responsible for reviewing the proposals for subsidies jointly with the Ministry of Finance, as is also the case in India, where the Planning Commission is involved in the review of proposals for VGF. (v) Inter-Departmental Committees/PPP Committees. The approval process for subsidies of any kind in countries usually involves a number of departments, such as the Ministry of Finance for the financing, guarantees, and liabilities angle, the Legal Department for the scrutiny of the legal clauses of agreements/contracts, the Planning Department from the programmatic and developmental angle, and the line ministries or implementing agency for preparing and explaining the business case. For the purposes of subsidy approval, countries have found it convenient to work through inter-departmental committees that bring all of the above departments together. In Brazil, an inter-departmental committee approves subsidies; in India, the Empowered Institution and the Empowered Committee, both of which are inter-departmental committees, approve VGF up to a certain pre-specified limit; and in Colombia, the National Council on Fiscal Policy (CONFIS) and National Council on Economic and Social Policy approve subsidies for projects. In Kenya, legislation has given the mandate for approval of subsidies to the PPP Steering Committee. (vi) Technical/Advisory/Financing Body. Specialized technical bodies/institutions separated from the government departments but constituted as public entities could also carry out most of the functions related to the subsidy and project approval processes in PPPs along with the concerned ministry or implementing agency. This is the case in Mexico, where FONADIN, as discussed in an earlier section, has been constituted as a public entity with a specialized set-up consisting of business units, responsible for generating business jointly with the implementing agencies, and other specialized units for reviewing and approving requests for subsidies. In the UK, the PUK and later IUK, now a part of the HM Treasury, played a role in helping ministries and implementing agencies with business development advisory and transaction advisory services. Similarly, there are the Partnerships Victoria in the state of Victoria in Australia and Partnerships British Columbia in the state of British Columbia in Canada. In 2012, the Colombian government set up the National Infrastructure Agency (ANI) for handling transport infrastructure PPPs. The advantage of such specialized bodies is that they bring the substantial technical and financial expertise difficult to achieve or retain in a government department. (vii) Audit Agency. A country’s national audit agency forms a key part of the accountability mechanism in a VGF process. In most cases, there is audit after the fact for VGF. The audit might be confined to the approval process and the appropriateness of the subsidy. Audit may also extend to the implementation of the project accessing VGF. The process of audit is highly evolved in 30 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS some countries such as the United Kingdom. In other countries, such as India, there is less clarity within the VGF scheme regarding audit of the process and projects. While many PPP contracts provide for accountability mechanisms like audit and outline the extent of access to documentation of the Special Purpose Vehicle (SPV) for the purpose of audit, it is much more desirable to outline the framework for audit of projects accessing VGF and the VGF process itself within the rules/guidance relating to VGF for greater clarity, either by directly outlining the details or by reference to such rules/clauses in other related rules/standard contract provisions/specific contract documentation pertaining to individual projects. (viii) Budget Office. The Budget Office examines the requests for budget and fixes ceilings for the VGF, including annual appropriations and indicative amounts for future years given that payment of subsidies is often over a longer term period, ranging anywhere from 3-30 or more years. (ix) Economic Affairs Office. The overall funding availability for various purposes including subsidies is assessed at the macro-level by the Economic Affairs Department based on what the Budget Office/ Department comes up with ceilings for different purposes/budget lines, including for the VGF, which would have its own budget line. (x) Debt Management Office. The Debt Management Office carries out the work of assessing, recording, measuring, and managing the fiscal commitments18 arising out of the payments of subsidies, where these are paid over a long period of time and beyond the normal budgetary cycle, as well as contingent liabilities arising from other forms of government support. While Debt Management Offices are often housed within the Ministry of Finance, they can also be stand-alone entities reporting directly to the President/Prime Minister. (xi) Accountant General. The government needs to ensure proper accounting and accountability systems for the VGF in which the office of the Accountant General is normally involved. The Accountant General’s office is also involved in the opening of fund account and reporting systems associated with funds. (xii) Public Financial Management Information Systems Office. In countries where computerized information systems are well developed, the Information Systems Office involved can help in generating consolidated reports relating to the VGF and fiscal commitments and enable appropriate monitoring of these. 27. Some key lessons in the management of stakeholders in the VGF relate to the following:  Creating clarity in the roles and responsibilities of each stakeholder in the VGF process;  Starting early the process of implementation of the VGF framework to ensure adequate capacity by the time VGF starts disbursing. This capacity building should target all the stakeholders in terms of understanding of PPP as well as the VGF;  Ensuring that the VGF process is embedded in the existing accountability frameworks and processes used by internal stakeholders, where possible;  Ensuring that these frameworks are up to international standards; and  Ensuring that the PPP Unit has a communication strategy with regard to internal stakeholders. 28. Creating appropriate processes for VGF assessment, approvals, disbursals, and monitoring and evaluation, including fiscal commitment management arising from such support, is key to the long-term sustainability of such support to projects. The VGF process can be divided into the following stages. 18 Refer to the Operational Note “Implementing a Framework for Managing Fiscal Commitments from Public Private Partnerships,” World Bank, Washington, DC (2013). 31 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS While the sub-processes in different countries will vary, the main processes required would remain the same. Table 5 summarizes these key stages in the process and where the main stakeholders engage. Table 5: Key Stakeholders and Functions Stage in Process Line Ministry PPP Unit Budget Debt IDC19 Auditor Office Management General Office I. Identifying the project √ II. Preparing the project and testing for √ feasibility a. Assessment of project feasibility - economic, technical, legal, environmental, social, and political feasibility b. Assessment of financial viability c. Assessment of value for money d. Assessment of VGF and other forms of support required III. Preparing and sending the application/ √ business case for VGF approval IV. Review of project for appropriateness of √ VGF, including level of support and instrument V. Review of project for affordability from √ √ budget and FCCL angle VI. Approval of VGF in-principle √ VII. Project procurement √ VIII. Review of bid VGF √ √ √ √ IX. Final approval of VGF √ X. Agreement with private party √ XI. Disbursal of VGF √ √ XII. Contract monitoring and management √ √ and reporting XIII. Annual measurement and management √ √ √ of risk and FCCL and reporting XIV. Audit √ Lessons Learned to Date on VGF mechanisms 28. In assessing the pros and cons of different VGF mechanisms, the following considerations are paramount. Each is considered separately in the subsequent paragraphs. (i) Determining an optimal subsidy level as a percentage of the national budget at the programmatic, sector, and project levels; this may need to be different for different sectors given differing requirements and national priorities; (ii) Designing a VGF framework consistent with the country’s budget framework and PPP project approval processes, including the establishment of accountability frameworks for implementation (i.e., disclosure, accounting, auditing, and monitoring); and (iii) Consideration of affordability issues (i.e., pre-existing financial commitments and contingent liabilities as well as the new financial commitments created by each project).20 19 IDC stands for Inter-Departmental Committee. While the nomenclature might be different in different countries, involvement of various departments in a single approving committee/ team has given good results in terms of coordination and speed of processing of cases. 20 A companion Operational Note, “Implementing a Framework for Managing Fiscal Commitments from Public Private Partnerships,” World Bank, Washington, DC (2013), provides more in-depth consideration of the specifics related to fiscal commitments and contingent liabilities. 32 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS 29. On Optimal Fiscal Commitments: One of the most important lessons learned from looking at VFG mechanisms in different countries is that the level of subsidy should be market determined at the project level, as far as possible. Different sectors and different kinds of projects within sectors may require varying levels of support that need to be determined on a case-by-case basis. Upstream assessment work is essential to arrive at estimates of likely VGF demand for each project and allow the government to address “value for money” and affordability considerations, as well as provide the information essential to effective negotiation with private sector. But the added cost and pricing discipline that comes with the introduction of a competitive process is hard to replicate in technical and financial estimation exercises. This has been evidenced in the case of the Indian program, where private sector bidders have offered “negative” subsidies to win bids for PPP projects that, based on technical and financial feasibility studies, originally indicated that a 20% VGF requirement.21 At the same time, one must underscore the pitfalls of the market assessment method, which may result in an agreement signed on the basis of extremely aggressive bids22 in cases where the public entity has not done its homework properly. Especially in a situation where historical data do not exist, there could be a case for optimal risk sharing so that benefits and costs of risk events are shared optimally between parties. 30. In addition, governments must check if there are other ways to close the gap. For example, in the Dakar-Diamniado toll road project, the government made substantial efforts to find the optimum toll level to maximize revenues and reduce the viability gap. Risk allocations can also be better handled where a project can be separated into phases, as in the case of the Ruta del Sol project, where the project was broken into three projects with different structuring of risk, especially demand risk. In other situations, we find that relatively low levels of equity financing can be used to reduce costs. The use of caps in country frameworks is common to ensure that overall level of support on a single instrument or all instruments together is limited, but there is no single best practice example to draw on. Caps have mostly been ad hoc and applied uniformly across sectors. An exception to this is in South Korea where different caps apply for different sectors based on the government's assessment of generic project characteristics in given sectors. From a conceptual point of view, but always more elusive to determine accurately in practice, is the point at which additional subsidy is judged not to provide value for money. 31. It may help for governments to have caps at overall programmatic and/or sector level to ensure that the government does not commit to more than it can afford from the point of view of fiscal prudence and debt sustainability. Governments often have a level determined from time to time by Parliament of the stock of explicit guarantees or debt they can maintain. It may help to determine from time to time the maximum level of fiscal commitments and contingent liabilities governments can take in the context of PPPs, given that government needs to maintain fiscal space for other purposes. The design of the VGF should preclude budget uncertainty to the extent possible. This is one reason why revenue guarantees, which were popular in the earlier phase of PPPs, are less sought after with greater use of fixed or variable payments where the government's fiscal commitments are known.23 32. On VGF Structures: On the structure of the funding mechanism, a decision on whether budgetary appropriations are used or a separate fund is set up would be based on a number of considerations. First and foremost, it would be determined by a country’s existing fiscal capacity and its pre-disposition to establishing statutory funds and/or ability to operate a VGF scheme within an existing administrative and budgetary framework. The establishment of a statutory fund, for instance, would involve legislative action that may not be desirable or feasible given other legislative priorities and/or 21 In the Indian state of Madhya Pradesh, more than half a dozen projects which the government bid out with 20% in-principle approval of VGF brought in “negative grants” (share paid by the private sector to the government upfront where it perceives a surplus over the contract period after covering costs and making a reasonable return for equity investors). 22 See discussion in paragraph 16. 23 See also Section 4, pp 11-29 of the Operational Note “Implementing a Framework for Managing Fiscal Commitments from Public Private Partnerships,” World Bank, Washington, DC (2013). 33 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS timelines anticipated for the passage of an enabling Act. Another set of considerations would be the pipeline of projects that a VGF mechanism is anticipating and the sectors it is likely to target. Convenience and efficiency will be important criteria, including cost and time implications. If the pipeline is limited and/or the targeted sectors have a relatively modest estimated VGF requirement, then providing subsidies through annual budgetary appropriations may be the more suitable option. 33. On Approval, Oversight, and Accountability Framework: A VGF mechanism needs also to be compliant with a rigorous approval, oversight, and accountability framework. Value for money and affordability assessments would need to be conducted at feasibility stage. Fiscal commitments would need to be accounted for in the budget process through reflection as appropriations in the annual budget and as indicative amounts in a country’s medium- or longer-term budgetary framework. In addition, the contract management framework associated with PPP projects needs to be substantial to ensure value for money through project term. Audit and disclosure mechanisms will further add to the credibility of the process. 34. Meeting these objectives and ensuring that public financing to PPPs is managed through a transparent and accountable system will be key to its credibility within government and with private sector investors and potential international partner contributors. From the private sector perspective, a well-structured VGF mechanism will signal tangible government intent and implementation capacity that can more effectively serve to leverage private investment. For international partners, effective management from appraisal through implementation stages and attention to outcomes and their objective measurement will be principal determinants of any readiness to contribute. And for the government’s own value for money requirements, the VGF should be structured to ensure subsidy disbursements are linked to performance milestones and investors' own equity to mitigate the government's risk/exposure. 34 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS III. KEY MESSAGES FOR TASK TEAM LEADERS 35. This Note has sought to address the following questions to assist TTLs working on PPP financing issues: Box 1: Key Questions for TTLs on PPP Financing Issues What is the rationale for government financial support to PPP projects? What are the instruments available to governments to contribute to the financing of PPPs and what are the factors to consider in determining which instrument to deploy? What have been some of the approaches and experiences internationally in providing public support to PPPs? What are some of the key considerations in selecting, designing, and managing different VGF approaches to PPP financing? 36. In moving forward on design work, project teams should pay close attention to the following upstream “enabling conditions” for government support to PPPs. A checklist of factors to be addressed in preparation and implementation phases is provided below for TTLs’ reference. A bibliography of relevant reports, website references, and training courses is also included as Annex I. 37. On Enabling Conditions for Effective Government Financing: There will need to be evidence of a government technical and administrative capacity to implement given instruments efficiently. In the absence of a track record of transactions successfully reaching financial close and implementation proceeding smoothly with government funds being transferred to the project in a timely and accountable fashion, this evidence will depend on the degree to which the private sector perceives the key government departments: (i) coordinating effectively together; (ii) ensuring a strong prospective pipeline of transactions; (iii) consistently following well-defined and predictable operational arrangements in the deployment of government funds in line with legislative and regulatory guidelines; and (iv) having requisite expertise resident in the principal implementing entities of government. Some of the key indicators by which the government can show its fulfillment of these pre-conditions are detailed in Table 6. 35 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Table 6: Readiness Criteria and Indicators Criteria Issue Indicator Government Coordination Coordination failure is one of the The establishment and successful practice of an inter- principal concerns of the private governmental committee empowered to develop the legal, sector in regard to PPPs.24 regulatory, and operational guidelines to be applied to the Conflicts between central and line selected government finance instruments. This committee agencies over the scope and roles can also be ascribed an ongoing role in decision making and responsibilities of different with regard to government financing allocations. This parties can result in considerable arrangement can augment the degree to which different deadweight in the PPP preparation agencies consult and narrow the space for coordination process. failure. This committee (possibly with somewhat adjusted membership) can also be the same one to develop the fiscal commitment and contingent liability framework.25 Project Pipeline Depending on the readiness of the A strong prospective pipeline of transactions with clear pipeline in terms of project political commitment to them is the first essential development and the recruitment prerequisite. Technically thorough project development - of transactions advisors to accompanied with market soundings - remains the sine qua structure the project for market, non for effective assessment of the different financing the project team can anticipate a options to ensure preferred instruments are responsive to two-year lead time before tenders market demand. are let. Well-Defined and Predictable Oft-times the legal and regulatory This can be mitigated through the preparation of guidelines Operational Guidelines for the instruments do not provide prescribing the specifics of the financing instrument and Selected Government Support sufficient detail for private sector their promulgation through outreach during market Instruments to understand well enough the sounding and roadshow events and by way of websites. eligibility requirements and process by which government financing allocations are made. Requisite Expertise Resident in Limited government capacity – The operation of government financing instruments will Principal Government Entities. both technical and administrative - include financial, budgetary, and PPP technical expertise. can diminish the effectiveness of These are skill areas generally in short supply within the the best designed instruments and traditional civil service. Depending of the size and likely increase their riskiness to private duration of the government PPP program, a specialized sector. cadre of government officials may need to be trained and developed. In the interim, where there are gaps in expertise (most probable in financial and PPP areas) and to respond to existing project priorities, the government can consider recruiting the expertise externally to supplement government staff and assist in the delivery of training programs. 38. On Project Preparation: Box 1 outlines the steps that TTLs should take when selecting and designing the government financing instrument. 24 This challenge was highlighted by private sector participants at the International Practitioner PPP Government Support Mechanism (GSM) Conference that was organized in collaboration with the Government of Kenya in Nairobi in June 2013. 25 Refer to the section of the Operational Note on Fiscal Commitment. 36 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Box 2: Factors to Address in Selecting and Designing Government Financing Instruments  Assessment of the likely portfolio of PPP projects, sector, type of project, principal risks, and revenue sources and levels to determine whether government support is best provided via guarantees, risk-sharing contract clauses, equity, debt or subsidy, or an optimal combination of these.  What are the principal policy drivers from the government’s perspective?  Assessment of the levels and duration of support required; in terms of level of support should there be a cap, should the cap be disclosed to the private sector, and what should be the basis of the cap?  Assessment of whether the chosen instrument/s is/are compatible with sector policy and regulations.  Assessment of whether the chosen instrument/s is/are sufficiently flexible to allow for and manage at least some of the major changes in economic and financial variables over contract term.  Does the PPP pipeline have sufficient volume to justify the establishment of a “facility” – be it for equity investments, guarantees, or subsidies, or do the market conditions merit a more ad hoc project-by-project approach.  Can an approach based on a pre-established framework provide sufficient flexibility to cater to different needs of projects?  Does the government/National PPP Unit have sufficient capacity to handle more complex instruments?  Does the private sector have the capacity to share risks and which risks can it effectively share?  Is the aim to attract domestic or other financiers and do domestic financiers have the required capacity/ appetite to finance projects?  Would the considerations of domestic versus foreign capital investments affect the choice of support instrument and its design?  What is the level of risk perception of financiers towards the different instruments under consideration?  What are the broader legislative and fiscal considerations and implications for different financing options?  What are the institutional processes at preparation stage that can be used to assess these implications ? 39. At the Implementation Stage: Box 3 summarizes the arrangements that should be in place for effective implementation: Box 3: Factors to Address for Effective Implementation:  Clearly defined processes and procedures for implementation.  Robust methodology for assessment of requirement of support at feasibility stage.  Methods to ensure at feasibility stage whether the support is fiscally affordable for the government from the point of view of the fiscal commitments and contingent liabilities that may arise out of such support.  Open and transparent bid procedure with, if possible, a market determination of the support required.  Reliable budget allocation system at program level.  Streamlined disbursement procedures at project level to ensure timely payments.  Disbursement of funds as required against well-defined performance measures.  Clear procedures for performance monitoring of contract.  Clear audit procedures for performance and financial audit of projects and processes.  Ongoing monitoring, measurement, and management of fiscal commitments and contingent liabilities arising out of government support at project and portfolio levels.  Systematic disclosure through (annual) published reports of project progress, fund deployment, projected commitments, and contingent liabilities. 40. The development of PPP financing instruments is a multi-disciplinary task. It requires TTLs to put together teams that combine: (i) sector-specific expertise relevant to the pipeline of actual projects to be funded; (ii) budget and fiduciary know-how of the specific country; and (iii) private sector and transactions and project structuring expertise. 37 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS ANNEX I: RESOURCES REFERENCES There is a wide range of sources of information on different government support mechanisms that can be drawn on for additional guidance. Some of the leading ones are listed below. Websites  United Kingdom: http://www.hm-treasury.gov.uk/infrastructure_public_private_partnerships.htm  India: http://www.pppinindia.com/  Mexico: http://www.fonadin.gob.mx/  South Korea: http://pimac.kdi.re.kr/eng/main/main.jsp  South Africa: http://www.ppp.gov.za/Pages/default.aspx  World Bank: www.worldbank.org/ppp; www.PPIAF.org Publications  European PPP Expertise Centre. (2011). State Guarantees in PPPs, A Guide to Better Evaluation, Design, Implementation and Management.  Farquharson, Torres de Mästle, and Yescombe, with Encinas. (2011). How to Engage with the Private Sector in Public-Private Partnerships in Emerging Markets, PPIAF, World Bank, Pages 61-68, available at https://openknowledge.worldbank.org/bitstram/handle/10986/2262/594610PUB0ID1710Box358282B01PU BLIC1.pdf?sequence=1.  Irwin, T. and T. Mokdad. (2009). “Managing Contingent Liabilities in PPPs: Practice in Australia, Chile, and South Africa,” World Bank and PPIAF Publication.  Irwin, T. (2004). “Public Money for Private Infrastructure – Deciding When To Offer Guarantees, Output-Based Aid and Other Fiscal Support.” World Bank, Washington, DC.  Kerf, Gray, Irwin, Levesque, and Taylor, under the direction of Michael Klein. (1998). “Concessions for Infrastructure: A guide to their design and award.” World Bank Technical Paper No. 399, World Bank and Inter- American Development Bank, Page 143, available at http://rru.worldbank.org/Documents/Toolkits/concessions_fulltoolkit.pdf.  PEI. (May 2012) Infrastructure Investor.  Price Waterhouse Coopers. (2011). Funding Infrastructure: Time for a new approach?  PWC. (2011). Funding Infrastructure, Time for a New Approach.  World Bank Institute (PPIAF). (2012). Public-Private Partnerships Reference Guide (Version 1.0), Pages 161- 167, available at: http://wbi.worldbank.org/wbi/Data/wbi/wbicms/files/drupal- acquia/wbi/WBIPPIAFPPPReferenceGuidev11.0.pdf  Shendy, R.; Martin, H; and Mousley, P. (2013). “An Operational Framework for Managing Fiscal Commitments from Public Private Partnerships.” World Bank, Washington, DC.  Shendy, R. (2013). “Operational Note: Implementing a Framework for Managing Fiscal Commitments from Public Private Partnerships.” World Bank, Washington, DC.  World Bank. (2011). Best Practices in Public-Private Partnerships Financing in Latin America: the role of subsidy mechanisms, available at http://einstitute.worldbank.org/ei/sites/default/files/Upload_Files/BestPracticesPPPFinancingLatinAmericasu bsidies.pdf Other Government Sources  Government of India, Ministry of Finance. (2010). Developing Toolkits for Improving Public Private Partnership Decision Making Processes. User Guide, available at http://toolkit.pppinindia.com/pdf/ppp_toolkit_user_guide.pdf  Government of India. (2005). Scheme for Support to Public Private Partnerships in Infrastructure.  Government of Mexico. (2007). National Infrastructure Plan. 2007-2012.  Government of Mexico. (2008). FONADIN Rules.  HM Treasury. (2012). A New Approach to Public Private Partnerships. 38 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Training Courses  http://www.ip3.org/ip3_site/ppp-project-development-facilities-viability-gap-funding-vgf-development-funds- and-investment-promotion-strategies-october-7-18-2013.html 39 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS ANNEX II: EXAMPLES OF A RISK ALLOCATION MATRIX Risk Definition Commonly Observed Allocation Environmental Risk that project site is contaminated Public especially in cases where Liabilities existing requiring significant remediation  Project was solicited by the government and site was prior to project Expenses provided by government; and  Cost and time required to conduct a full due diligence (site study) for each bidder are such that the project would be significantly delayed or would deter potential serious bidders – in such case, some risk sharing along the lines of geotechnical site risk could be a solution  Where site is procured by private party based on government technical specifications, it is usual for the private party to bear the pre-existing environmental liabilities Design Risk that the design of the facility is Private – private partner will normally be substandard, unsafe, or incapable of responsible except, e.g., where an express delivering the services at anticipated cost government mandated original design or change has and specified level of service caused the design defect or government has supplied (often resulting in long term increase in faulty information on which design is based. recurrent costs and long term inadequacy of service) Construction Risk that an events occur during The private sector will usually bear the risk, except construction that prevent the facility being when: delivered on time and on cost  The event is one for which relief as to time and cost or both is specifically granted under the contract, such as force majeure or government political risk;  In situations where technical or geological complexity (eg. tunnels) prevents having sufficiently reliable information to measure the risk, the government may assume part of the risk. Exchange rate Risk that can occur during construction but Private, public or shared over a longer time frame during operation,  Government to assume part of it by allowing total or exchange rates may move adversely, partial indexing of payments to exchange rate affecting the private partner’s ability to  Private to assume remainder, usually passed on to service users through indexation to user charges foreign denominated debt and obtain its  Catastrophic changes are another consideration for expected profit which there are ongoing efforts by World Bank Group to devise an instrument to mitigate this risk. Inflation Risk that value of payments received Shared between public and private parties during the term is eroded by inflation  Government to assume part of it by allowing total or partial indexing of payments to inflation  Private to assume remainder risk - passing on to users through indexation of tariff to inflation Financing Risk that when debt and/or equity is Private, but increasingly partially or fully taken on by Unavailable required by the private firm for the governments through direct credit guarantees, other project it is not available then and in the contract clauses that back-stop repayments amounts and on the conditions anticipated While there is a theoretical risk that some developers may out equity at risk prior to financial close, most would not risk everything or commit to deliver the project until financial close is secured. Policy, Legal or Tax Any law or regulatory change that is Private, if and when: changes adverse and does not permit pass-through  Tax increases or new taxes arising from general or termination (if prohibitive), including changes in tax law risk that before or after completion the tax Government or users, if and when: impost on the private firm, its assets or on  Tax increases or new taxes arising from the project, will change. discriminatory changes in tax law Demand risk Risk that operating revenues falls below Private where demand history is available, especially 40 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS forecast as a result of decrease service in brownfield projects,; shared or public through volume (i.e., traffic volume, water or power availability payment or a minimum revenue consumption) guarantee where there is unique features and/oir attributable to an economic downturn, uncertainty in demand forecast is such that tariff increases or change in consumer providing an availability payment element and/or a habits minimum revenue guarantee is necessary to attract private investment (for example, Greenfield toll road) Default and Risk of 'loss' of the facility or other assets Private firm will take the risk of loss of value on Termination upon the premature termination of lease or termination other project contracts upon breach by the private firm and without adequate payment Residual value on Risk that on expiry or earlier termination Private partner can incorporate lifecycle transfer to of the services contract the asset does not maintenance, refurbishment, and performance government have the value originally estimated by requirements into the design facility, and can government at which the private partner manage these process during the term of the agreed to transfer it to government contract Source: Based on World Bank & Castalia (2010) 41 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS ANNEX III: USE OF GOVERNMENT SUPPORT IN PRACTICE - SUMMARY OF PROJECTS The Dakar-Diamniado Toll Road Project, Senegal26 The road sector is a priority infrastructure sector for the Government of Senegal due to issues of heavy congestion in and around the demographically and economically fast-growing city of Dakar. The Dakar- Diamniado Toll Road was conceived to reduce congestion and improve access. It is the first PPP toll road in Senegal and is expected to have a substantial economic and social impact for the country. The first section of the road was commissioned in 2011 with commencement of tolling operations. The Dakar- Diamniado Toll Road Project is a Build-Operate-Transfer (BOT) contract with revenues coming partly from user fees. However, the project was found to be financially unviable based on financing from traditional sources of debt and equity and revenues from user charges alone. The solution adopted is detailed below. The gap in project viability has been overcome through subsidy financing by the government. However, this was preceded by other support and structuring mechanisms. A decision was taken to build the highway in two phases, with 100% financing and procurement by the Government of Senegal for the first phase of the project and a 30-year concession with public and private sources of financing for the second phase. The overall cost and financing for the project are summarized in Table 7. Table 7: Dakar Tollroad Cost Structure Component Cost GOS IDA FDA AfDB Private Sector Works Phase 1/Section 1 120 120 Works Phase 1/Section 2 52 52 PPP Works Phase 2 307 78 34 69 126 Right of Ways 139 116 23 Resettlement and Environment 75 11 38 26 Restructuring of PIS 48 28 16 Supervision, Studies, Monitoring 47 24 20 3 TOTAL COST 788 401 109 83 69 126 Source: Consultant Presentation, Nairobi, February 2013. The decision on phasing was based on traffic projections and viability estimates. The total cost of the second phase PPP project is US$307 million with US$181 million (60%) provided by the public entity and US$126 million (40%) provided by the private party. The private financing part of the project, excluding the grant financing, has an approximate debt-equity ratio of 2:1 with 13% equity as a proportion of total PPP project cost. The viability gap for the second phase of the project was reduced through optimum toll levels based on survey results on maximum toll acceptability of users and through careful construction of the risk matrix. In addition, to maximize revenues, a mixed toll design was adopted, with an open length of highway with fixed toll and a closed length with variable tolling but with an alternate freeway available to users. The toll rate caps are fixed by government with a provision for periodic reviews. By limiting the higher return that equity requires relative to debt, the low level of equity also effectively kept the cost of capital lower than it might otherwise have been. The private party mobilized its proportion of financing through a 10-year debt (2014-2024) obligation, as well as in the form of equity. The main bid parameters, among others, were the amount of subsidy required, the guarantee amount required, and the extent of risk sharing acceptable to the bidder, given an internal rate of return (IRR) of 20%. The government provided for sharing the demand upside through profit-sharing clauses applicable 26 A particular thanks to Aminata Ndiaye (previously Director General, Apix, Government of Senegal during the design, negotiation and start-up implementation phase of this PPP) for her generous contribution to this Operational Note. The data and tables presented above are directly from her input. 42 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS beginning the 16th year if revenues exceeded specified levels. Traffic, design, construction, financing, and operation and maintenance risks have been allocated to the private party while the government bears the site risk and any risks arising out of non-payment or delayed payment of grants. Risk of performance by private party was mitigated without driving up costs too much through the requirement of bank guarantee. The Ruta del Sol Project, Colombia The Ruta del Sol project in Colombia is a major road project that links the capital with areas of major economic activity. It is a combined greenfield and brownfield project structured into three contracts. In March 2009, the Government of Columbia approved an approximately US$3.5 billion subsidy contribution to the Ruta del Sol project to help finance construction and part of operation and maintenance costs and to help concessionaires leverage additional resources for construction. The project was structured as three separate smaller projects rather than one large project to minimize project risk in the aftermath of the financial crisis, when private sector appetite for infrastructure investments was expected to be low. The project was awarded in 2009-10 and achieved financial close soon after. A summary of the project is provided in Table 8. Table 8: Ruta Del Sol Project At A Glance Sector 1 Sector 2 Sector 3 Project type Greenfield Brownfield Brownfield Payment mechanism Availability payments User charges + subsidy User charges + subsidy Term 7 years Variable term Variable term Bid Parameter Lowest PV of availability PV of revenues (toll + PV of revenues (toll + payments subsidy) subsidy) Bid Amount $771 million $1047 million $1040 million Pre-Stated Cap $966 million $1120 million $1150 million Demand Risk Public entity Private entity, but Private entity but mitigated by variable term mitigated by variable term Geological risk Public Entity Public Entity Public Entity Performance Risk Private Entity Private Entity Private Entity Site Risk Public Entity Public Entity Public Entity Financing Risk Private Entity Private Entity Private Entity Source: IFC Presentation, Nairobi, February 2013. A unique feature of this project is that the payment mechanism, bid parameter, and risk allocation do not have a uniform structure for all the sectors. Sector 1 is the greenfield part of the project, where traffic estimates were unknown at the time of project development and biding, making the potential demand risk extremely high. Sector 1 was, therefore, structured as an availability payment-based, 7-year concession with separate construction and operation payments. The traffic risk is totally borne by the government for Sector 1, taking into account the private sector’s lack of appetite for taking on demand risk in a secto r with no historical traffic data. The bid parameter used was the lowest present value (PV) of government payment, subject to a pre-stated cap. The site risk and geological risk were retained by the government. While this sector is tolled, the user charges are collected by the concessionaire on behalf of government and handed over to government. Since the demand risk was totally borne by government, this concession had a limited fixed term of 7 years. Sectors 2 and 3 were brownfield projects based on redevelopment and improvement of existing projects. These two sectors had well known traffic numbers and therefore, were structured as toll-based concessions with government subsidies making up for the viability gap. The bid parameter is the lowest PV of toll revenues and government payments, with the concessions having a variable term based on achievement of the revenues by the concessionaire. The demand risk is borne by the private entity, but is mitigated by the variable term, which ensures that the private entity is able to recover its investment. The 43 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS site risk and geological risk have been retained by the government based on prior negative experience of risk allocation to private party. The subsidy for these sectors has the following features:  The concessionaire will receive a subsidy payment based on the construction performance, measured monthly during the construction period of five years;  Performance measures were defined as: (a) at least 10 km of continuous new road; and (b) at least 10 km of existing road with improved geometry. Each stretch of 10 km will give the concessionaire the right to receive a portion of the construction subsidy; and  This subsidy will be paid during the first 10 years only and includes a pre-stated cap on the subsidy amount that Government will pay. Hyderabad International Airport Limited, India The Hyderabad International Airport Limited (HIAL) in India was conceived to cater to increasing demand for international airport services in the state of Andhra Pradesh, which had over the years seen a growing expatriate community from the Middle East as well as the United States. It was also expected that the airport would meet part of the demand from neighboring states due to its convenient location in central India. The new project was conceived as a greenfield international airport project with the existing airport ceasing operations after the commissioning of the new airport. However, pre-feasibility studies showed a significant gap in viability with conventional financing mechanisms and revenues through user charges alone. The government sought to make the project bankable through various support mechanisms in addition to a sponsoring authority/ contracting agency grant. HIAL is a joint venture (JV) between the private parties GMR and Malaysia Airport Holding Behard (MAHB) and the public entities - the Governments of India (Airports Authority of India Limited) and Andhra Pradesh. This is a “Design, Build, Finance, Operate and Transfer” (DBFOT) arrangement and an example of government financing using multiple sources; i.e., equity, interest-free debt, grant financing, and land lease at a nominal cost. The project was commissioned in March 2008. The total project cost at financial close was Rs. 2478 cr (approximately US$490 million). Of this, Rs. 1993 cr (approx. US$398 million) was financed through debt financing by various banks. This includes Rs. 315 cr (approx. US$63 million and 16% of the overall debt financing) coming from the state government as interest-free loan payable in five equal annual installments after a moratorium of 16 years from start date. Figure 1 illustrates the sources of debt financing in HIAL. Figure 1: Sources of Debt Financing in HIAL Source: PPP database, Department of Economic Affairs, available at http://pppinindia.com. 44 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS In addition, VGF of Rs. 107 cr (approx. US$20 million) was provided by the sponsoring authority, the Airports Authority of India Limited, and the Governments of India and Andhra Pradesh contributed equal levels of equity, amounting to a combined 26% of overall investment costs (Figure 2). Total government direct financing support to the project (equity, interest-free loan, and grant) was at Rs. 520.28 cr (approx. US$104 million), approximately 20% of total project cost. Other types of support provided comprised: (a) approximately 5,490 acres of land were provided at Rs. 155 cr (approx. US$30 million); (b) stamp duty and registration fees were waived on the transfer of land; and (c) sales tax was waived on all construction material by the state government and tax was exempted for a period of 10 years on all profits and gains of the project. Figure 2: Equity Financing in HIAL Source: PPP database, Department of Economic Affairs, available at http://pppinindia.com. Sources of revenue for the airport are user charges from airlines and passengers, including a user development fee (UDF) levied on passengers. The concession period of 30 years from commissioning date can be extended for another 30-year period. Risk allocation is of the routine type seen in most Indian PPP projects, with the major risks such as demand, construction, performance, and financial risks, transferred to the private party, but with substantial subsidy and non-subsidy support by the national and provincial governments. The Incheon Expressway Project, Republic of Korea27 The Incheon Expressway Project was built as the sole transportation connection between the Seoul Metropolitan Area and the Incheon International Airport. The successful bidder, the New Airport Highway Co. Ltd. (a consortium of Samsung Corporation and others), was responsible for the construction and then maintenance of the Incheon International Airport Expressway for a total period of 30 years. The project financing was through debt and equity provided by the private party and a construction subsidy provided by the government for a total cost of US$1.4 billion. Government also guarantees a minimum level of revenues to the private party. It was commissioned in 2000. Figure 3 provides a summary of this financing arrangement. 27This is based on Yeo, Hyngkoo, Sigon Kim and Sanghoon Bae, “An Experience of Construction and Operation of the Incheon Airport Exclusive Expressway by Private Capital,” 2003 and work done by Crisil for the Indonesia VGF. 45 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Figure 3: Funding Structure of the Incheon Expressway Project28 The contract provides for extension of term as well as revision of toll rates, should demand fall below the projected traffic by more than 20% in any year of operation. A minimum revenue guarantee operates at 20% below the projected revenues to mitigate the demand risk. However, any losses between 0 and 20% of projected revenues are borne by the private party. The demand risk is, therefore, shared by the two parties. The risk for government is high in the case of revenue guarantees, but when government builds the revenue guarantee into contract period flexibility and provisions for tariff variation, the government's own risk is reduced to an extent. This structure does leave open the possibility of more significant contingent liabilities if revenues fall substantially. In this situation, contract period extension and tariff hikes may not be able to fill the gap and actual payments would have to be made by government. In the case of the Incheon expressway, the actual traffic was approximately half of that projected. The projections in the agreed financial model showed that traffic on the expressway would be around 100,720 vehicles/day. However, the actual average daily traffic as of April 2002 was only 51,597 vehicles/day. As a result, the minimum revenue guarantee (MRG) clause in the contract, which guaranteed up to 80% of projected revenues, was activated. The actual traffic figures have not increased much between 2002 and 2012: 51,815 vehicles/day in 2011 and 52,970 vehicles/day in 2012, a marginal increase. Silo Project, Madhya Pradesh, India29 The Government of Madhya Pradesh has embarked on a series of eight silo projects to increase the state’s grain storage capacity. The state established the Warehousing & Logistics Policy in 2012 to promote the silo projects. The first of these projects, sponsored by the Madhya Pradesh Warehousing & Logistics Corporation, includes the construction and operation of four steel silo complexes to hold 50,000 MT of wheat at Pathari Haweli in the district of Vidisha. The Madhya Pradesh project is being implemented under a DBFOT model with contract duration of 30 years. The concessionaire will be responsible for unloading, debagging, cleaning, drying, storing, bagging, and loading and for vehicle turnaround. The expected cost of each project is Rs. 30 cr. The concessionaire will bring in equity and debt financing. Multiple government support instruments have been used to make this project financially feasible for the private provider such as:  Provision of land: Land of up to eight acres will be provided for each of the projects. The original project also provided for use of a small part of the land up to one acre for agri-related services, such as flour mills and farmers’ convenience stores, to be provided on payment; i.e., to serve as revenue earners for the project. 28 Source: This is based on Yeo, Hyngkoo, Sigon Kim and Sanghoon Bae, “An Experience of Construction and Operation of the Incheon Airport Exclusive Expressway by Private Capital,” 2003 and work done by Crisil for the Indonesia VGF. 29 Source: MP Silo RFQ, RFP and contract documents. 46 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS  Upfront and operational grant: A maximum VGF of 20% of the total project cost is expected to be provided by the state government and an additional 20% under the Government of India ’s scheme for supporting PPPs in infrastructure. The payment of grant will be made after the private provider brings in 100% of his equity. The grant payments will be pari passu with debt installments over the construction period and a part of the grant payment will be paid during the operational phase, with each installment equal to 5% of the total grant support.  Ten-year supply of wheat guarantee: This is provided by the public authority which will have exclusive use over this period. This is a demand guarantee with the government paying the fixed charges whether or not it uses the capacity. After the period of 10 years, the public authority may continue to use the services, or if there is no demand or there is a policy change by the government, the public authority may de-reserve a part of the total capacity. The private provider can then use the de-reserved capacity to provide storage services to anyone in the market and recover revenues. A part of the revenues would then be shared by the private provider with the public authority.  Regular availability payments for the guaranteed quantity for ten years: The payment has three components: (i) a fixed charge equal to Rs. 75.5 multiplied by the availability of storage for the month; (ii) a variable charge for the food grains actually stored at Rs. 0.50 per quintal per month; (iii) a service charge as agreed for unloading and debagging at Rs. 2.25 per quintal to be paid on the weight handled. The demand risk is fully covered for the first 10 years given that the government will pay for all the capacity. Demand risk begins in the 11th year due to the clause on de-reservation, although the risk is moderated given that the private grain businesses are likely to require storage space. These are small projects, but the structuring of the government support keeps open the idea of full or partial use by the private sector as well as a revenue share if usage changes from public to private. Mersey Gateway Bridge, United Kingdom The Mersey Gateway Bridge project is a 1-km, 6-lane toll bridge over the Mersey River, linking the Central Expressway in Runcorn with the Eastern Bypass and Speke Road in Widnes. In addition to the bridge, the project also includes improvements to approach roads along the route of the project. The sponsoring authority for the project is the Halton Borough Council (HBC). While it is a new (greenfield project), it is being built 1.5 km east of the existing Silver Jubilee Bridge, with the objective of relieving the traffic congestion on a bridge designed for 8,000 vehicles/day that is currently carrying an estimated 80,000 vehicles/day. The project30 is contracted under a Design, Build, Finance and Operate (DBFO) arrangement, procured on a fixed price basis. The project term will be 26.5 years from commissioning. According to current estimates, toll revenues will cover about 70%. Government will cover the balance using a combination of various types of support, such as:  Government guarantee: The guarantee will be for 50% of the senior debt of the project up to £270 million31 and is expected to help Merseylink tap the project finance market at better terms. It is part of the UK Guarantee Scheme32 initiated under PF2 to stimulate the project finance market for infrastructure projects. 30 http://www.merseygateway.co.uk/about-the-mersey-gateway-project/funding-of-the-mersey-gateway- projec/#sthash.mvmKk9LJ.dpuf 31 http://www.merseygateway.co.uk/2014/03/chancellor-confirms-270million-guarantee-for-mersey-gateway/ 32 The UK Guarantee Scheme supports nationally significant projects, as identified in the Government’s National Infrastructure Plan 2011, ready to start construction within 12 months from a guarantee being given, financially credible, with equity finance committed and project sponsors willing to accept appropriate restructuring of the project to limit any risk to the taxpayer, 47 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS  Availability Payments: Availability or service payments will be paid after commissioning of the project over the operational period of the contract out of the toll revenues as well as an annual grant to the HBC from the UK Department for Transport that has been capped at £14.55m. This will be a graduated, decreasing resource Availability Support Grant funding over 12 years starting in 2017-18 (following the opening of the bridge) to 2028-29. In addition to the Availability Support Grant committed, the government through the DfT has undertaken to provide Additional Availability Support if required and “to stand behind any shortfall to the level of toll revenue required to meet Halton’s financial obligations,” according to the parliamentary written statement on contingent liabilities delivered on March 10, 2014. 33  Lump Sum Grant: The DfT will provide a grant of £86m to the Halton Borough Council as part of the development budget of the project to cover the costs of land assembly and advance works remediation. The variety of instruments used can be linked to the government’s direct objectives. The guarantee support of up to 50% of the senior debt is expected to enable financial close in what has been a weaker project finance market in the United Kingdom since the global financial crisis and is part of the larger objectives of the UK government to reactivate the project finance market through the UK Guarantee Scheme. This support is considered essential for the project to obtain financing, given that the project continues to have an estimated 30% viability gap in its financial model and, while there is a traffic track record due to the existing Silver Jubilee Bridge, demand risk exists as the project is based on traffic levels that entail a growth beyond trend. To address this, part of the grant is paid upfront at service commencement. But to also take into account the high probability that traffic numbers will take time to develop, availability payments will be made for a certain period, to be assessed through periodic reviews of actual toll revenues so that the government is able to fully utilize the upside in revenues. The Port of Miami Tunnel Project United States The Port of Miami Tunnel project in Florida in the United States includes a tunnel, roadway work, and bridge-widening work. It will link the Port of Miami with the MacArthur Causeway and I-395 on the mainland and has the following objectives: (i) Improving access to the Port; (ii) Improving traffic safety in downtown Miami by routing heavy traffic away from the city; and (iii) Facilitating development plans in and around Miami. The project almost did not happen due to the 2008 financial crisis. Initial equity providers for the project backed out and with the disappearance of the monoline insurance market and the weakening of the private activity bond market, Florida Department of Transportation used the Transportation Infrastructure Finance and Innovation Act (TIFIA) federal loan program for financing the project. The project sponsors are FDOT, Miami City, and Miami-Dade County, all three sharing the capital costs of the project. Miami Access Tunnel, LLC (MAT) is the private partner, which has equity participation by Meridiam Infrastructure Finance, S.a.r.l. and Bouygues Travaux Publics, S.A. The private partner will be responsible for the construction and operation and maintenance of the tunnel. The project achieved financial close in October 2009. The construction is expected to be about 55 months and, thereafter, there will be an operation period of 30 years, with the contract expiring on October 15, 2044. dependent on a guarantee to proceed and not otherwise financeable within a reasonable timeframe; and good value to the taxpayer, assessed by HM Treasury to have acceptable credit quality, not present unacceptable fiscal or economic risks and to make a positive impact on economic growth. (Source: HM Treasury Press Release, July 18, 2012). 33 https://www.gov.uk/government/speeches/mersey-gateway-bridge 48 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS The project uses multiple government support instruments for the project, including fixed payments during construction totaling US$100 million, a final construction completion payment of US$350 million, a TIFIA subordinate loan of US$341.5 million, and annual availability payments of US$32.5 million over a 30-year period. The TIFIA loan repayments are scheduled to begin only after completion of senior debt service in 2015 to the 10 senior lenders for the project - BNP Paribas, Banco Bilbao Bizcaya Argentina, RBS Citizens, Banco Santander, Bayerische Hypo, Calyon, Dexia, ING Capital, Societe Generale, and WestLB. Accrued interest on the TIFIA loan will be repaid out of availability payments from 2016 until 2023, when principal amortization of the TIFIA loan begins, again to be paid from the availability payments. The tunnel will not be tolled. 49 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS ANNEX IV: INTERNATIONAL EXAMPLES OF GOVERNMENT VGF ARRANGEMENTS India The scheme for support to PPPs in infrastructure in India: (i) is administratively simple; (ii) fixes government fiscal commitments upfront; (iii) captures the upside through revenue-sharing mechanisms; and (iv) uses annually appropriated funds. The Government of India pays grants to PPP projects during the construction stage, linking these to construction/performance milestones, debt disbursements, and equity paid-in. The total amount of grant paid is based on the present value of the viability gap presented by the specific project, including a reasonable return to the investor, calculated using lifecycle estimated revenues and costs and a prescribed discount rate. The private party is expected to bring in sufficient equity and debt financing of its own. Financing is made available to PPP projects that are implemented by a Special Purpose Vehicle (SPV) with at least 51% private equity. The project is normally expected to have at least 20% equity to total project cost, although this is not a rigid requirement. The project must provide a service and earn a large proportion (at least 60%) of its revenues from user charges. The concerned Government/statutory entity seeking a VGF allocation for a project is required to certify, with reasons: (i) that the tariff/user charge cannot be increased to eliminate or reduce the viability gap of the PPP; (ii) that the project term cannot be increased for reducing the viability gap; and (iii) that the capital costs are reasonable and based on the standards and specifications normally applicable to such projects and that the capital costs cannot be further restricted for reducing the viability gap.34 Financing under the VGF is limited to 20% of the project cost; however, the public entity sponsoring the project can provide up to a further 20% as additional grant. The 40% cap is not varied under normal circumstances. Upfront grants mitigate the risk of returns to the investor to an extent, while keeping the government's own fiscal risk limited as payments are fixed and known in advance. The PPP contract, in some cases, provides for a sharing of revenues on the upside, so that the private party does not capture the entire windfall should actual revenues exceed estimated revenues. The demand risk of the private party is mitigated in some contracts through clauses allowing term variance35 based on actual user charge revenues (excluding grants) earned. The government is subject to the risk that the private entity will not perform in the case of upfront viability gap financing, which is mitigated in the case of India by requiring 100% equity to be paid in before making the first installment of grant payment available and making grant payments proportionate to debt installment payments made by the lead financier to the SPV. VGF is made available by the Government of India through its budgetary resources. Budget provisions can be made on a year-to-year basis, linked to likely demand for disbursements during the year. There is no pre-specified cap on the amount of subsidy that can be disbursed in any given year. However, fiscal space and pipelines do constitute natural limits to the amount of subsidy that will be drawn down. In the first year of operation of the program, budgetary provision of US$40 million (Rs. 200 cr) was made. The total VGF support during any year is based on the estimated requirement for disbursals during the given year. Grant disbursal processes can add to the risk of delays by their complexity. In India, grant financing agreed to is paid by the Ministry of Finance to the lead financier in installments as required. The lead financial institution in turn disburses these amounts directly to the project rather than going through the procedures within various ministries or levels of government. There are no separate provisions for varying/recovering the VGF should total project costs be below expectations. However, since disbursals are made proportional to debt disbursals, and banks require financial statements and cost incurred 34 Clause 3 (d), Scheme for Support to Public Private Partnerships, 2005 35 As is the case with the South Korean Highway project summarized earlier in the Operational Note. 50 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS statements of private entities before disbursing debt, the VGF payment would essentially get curtailed should costs be lower than stated in the financial model approved as part of the bid package. The VGF program also provides for payment mechanisms other than upfront lifecycle VGF spread over the construction stage, but in practice this does not appear to have been used. India has not used either equity or other forms of support under this program. However, as seen from the airport example provided earlier, the government has provided other forms of support to PPP projects under its other programs. The IIFCL, which is a 100% government-owned and -guaranteed entity, supports PPP projects through financing 20% of the total debt. It is also working on a credit enhancement facility that will provide various kinds of credit enhancement instruments for use in PPP projects. The Government of India has provided up to 26% equity financing in the case of four major airport PPP projects in the country as well as for power distribution companies structured as joint ventures. Equity, debt, and grant financing combined in the same project have so far been used only in specific projects in the transport and other sectors. Mexico36 FONADIN (Fondo Nacional de Infraestructura or the National Infrastructure Fund) is an example of a capital fund formed by combining the assets of two pre-existing infrastructure funds, the FARAC (Fondo de Apoyo para el Rescate de Autopistas Concecionadas) and the FINFRA (Fondo de Inversion en Infraestructura). The initial capitalization of FONADIN was at US$3.3 billion. FONADIN: (i) is administratively more complex than India's VGF as it combines various forms of subsidy and non- subsidy support; (ii) uses performance-based payments; and (iii) is independent of the budget cycle. FONADIN consists of a number of support products through the use of which the viability gap of a PPP project can be effectively narrowed/closed. These products are categorized into recoverable as well as non-recoverable products. Under the “non-recoverable” category, grants are provided that can finance: (i) viability gaps; (ii) studies; and (iii) sub-equity paid into projects. “Recoverable” products include: (i) equity (what is termed as risk equity by FONADIN as opposed to sub-equity); (ii) subordinate debt; (iii) guarantees of different kinds; and (iv) investment into equity funds which in turn invest in infrastructure PPP projects. For each of these, a pre-set cap signifies the maximum payable into any single project. Subsides paid into a project cannot exceed 50% of total project cost (Figure 4). 36 For more details on the subsidy mechanisms in Mexico, Brazil, and South Korea please refer to “Best Practices in Public- Private Partnerships Financing in Latin America: the role of subsidy mechanisms.” World Bank (2011). 51 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Figure 4: FONADIN Support Products Source: Banobras. Projects can be supported when they have significant private sector involvement and generate the remaining proportion of revenues through the levy of user charges. They are required to have a minimum of 20% equity as a proportion of total project costs to mitigate government's risk and ensure private party performance. In addition, the subsidies are disbursed according to timelines prescribed in each contract. Subsidy is determined through an open and transparent system of bidding with the criterion of lowest subsidy required. Grants payments are made by FONADIN to the private entity through the line ministry. While the FONADIN is housed in the Banobras, its operations are completely separated from the other financing operations of the Banobras to prevent conflict of interest issues. South Korea South Korea uses a variety of subsidy payment mechanisms, based on structuring needs of projects. This includes: construction grants, lifecycle cost-based grants, and other types of guarantees. These are financed through regular budgetary appropriations. A unique feature of the construction subsidy support in South Korea is the separate caps provided for different sectors, unlike the practice in other countries where general caps are applicable across sectors. For the roads and ports sectors, with the exception of a few categories of port projects, the applicable cap is 30%, whereas for rail projects a cap of up to 50% is provided. Subsidies are determined through bids as is the case in almost all other countries. Subsidy payment is spread over the period of construction and is linked to achievement of pre-specified milestones. In addition, the government also provides for payments to projects for lifecycle costs, calculated separately as payments linked to capital investments in the project and those linked to operation and maintenance costs. These payments are spread over the contract period. Various types of credit guarantees are also provided to PPP projects to enable them to access financing at lower rates than they would otherwise have been able to, thus helping to reduce the viability gap. South Korea provided minimum revenue guarantees as an instrument of support but discontinued use in 2009, preferring to support PPPs through alternative instruments. 52 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Brazil Brazil provides for subsidy payments to infrastructure in the form of grants invested in the project as VGF, grants for project preparation, and guarantees against non-payment of grants by government. The amount of grants approved in any year cannot exceed 3% of total state or federal revenues. Brazil neither uses simple annual appropriations like India nor has a separate fund as established by Mexico. It follows a system whereby the total subsidies approved for projects in any particular year are appropriated from the annual budget, but are categorized as interest payments and, as such, are a non-discretionary obligation of government. Grants to be paid to projects are determined on the basis of an open and transparent bidding process where the bid criterion is the lowest level of grant required. Grant disbursements are made directly to the concessionaire/private entity by the PPP unit based on request by the line ministry and the receipt of a report on achievement of milestones by the independent verifier concerned. The Brazilian government has also set up a Federal Guarantee Fund with an asset size of US$3.4 billion. This fund guarantees subsidy payments by the public entity to the private entity for federal initiatives. It is not available to sub-national government payments. 53 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS ANNEX V: GLOSSARY OF TERMS Item Description Annuity Payments A stream of fixed annual payments over a specific period of time. Availability Payment Payments for making a service or asset available for use at agreed standards/specifications. Bankable Project A project proposal that has sufficient revenues to cover costs Buy-back Agreement An agreement which provides that the public authority will purchase the assets in the event of natural expiry of contract or termination or other events pre-specified in the contract. Concession A concession gives an operator the long term right to use all utility assets conferred on the operator, including responsibility for all operation and investment.37 Contingent Liability Liabilities assumed by government in a PPP contract where payment is contingent upon the occurrence of a pre- specified future event. Contingent liabilities include, among others, credit, exchange rate, interest rate, inflation, demand/ revenue, force majeure and termination payment guarantees. Credit Enhancement Instrument Instruments such as credit guarantees, risk guarantees, letters of credit, subordinated debt, first loss protection, financial guarantee insurance, credit default swaps, wraps and other risk sharing instruments which enhance the credit profile of an asset, transaction, or security. Cross Subsidization Using revenues from another usually higher priced service/consumer segment to cover the costs of another usually lower priced service/consumer segment. Debt Guarantee A guarantee to make interest and/or principal payments in case of default by the issuer of debt. Discount Rate The rate used for discounting all future cash flows to their present values. It is usually a combination of a risk free rate and a risk premium with different methodologies used for calculation. Exchange Rate Guarantee A contractual arrangement by which a part or all of the risk to the project from exchange rate fluctuations is transferred to government. Financial Model A projection of costs and revenues over the life of a project. Financial models are used for PPP feasibility studies, among other things. Financial Viability A project is financially viable when the discounted revenue streams from the project are sufficient to cover all the discounted costs of the project, including repayment of debt, and a reasonable rate of return for the investors. The Financial Internal Rate of Return (FIRR, as opposed to EIRR) and the Net Present Value (NPV) are the indicators of choice for assessing the financial viability of a project. Independent Verifier An individual or firm experienced in technical/other aspects who provides assessment of design documents, payment claims, technical standards, completion of work, etc. and is sometimes also used for dispute resolution functions in PPPs. Interest Rate Guarantee A guarantee to pay the difference in interest rate should the interest rate change to the disadvantage of the borrowing PPP SPV. Lead Financier The main financier in a syndicated debt financing transaction, who finances a substantial proportion of the total debt, selects co-financiers, and takes key decisions on the transaction. Lease Leases are generally public-private sector arrangements under which the private operator is responsible for operating and maintaining the utility but not for financing the investment.38 37 Source: http://ppp.worldbank.org/public-private-partnership/agreements/concessions-bots-dbos 38 http://ppp.worldbank.org/public-private-partnership/agreements/leases-and-affermage-contracts 54 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Lifecycle Costs Capital and operational costs over project life. Limited Recourse Bond A bond which is partially secured or collateralized and is paid before a non-recourse but after a secured/ collateralized bond. Negative Subsidies Pre-specified payments, usually determined by bid, made by the SPV operator to the public authority from the surplus revenues expected or earned from a user charge-based PPP project. Non-compete Clause A standard contract clause in PPPs by which the government agrees to not build, or allow to be built, competing infrastructure for a part or the entire duration of the contract or till a certain level of demand is achieved. Payment Guarantee This is commonly used in power sector PPPs (IPPs) where the government guarantees the off-taker’s obligation to pay. Performance-based Payment Payment based on the achievement of a pre-specified performance milestone. Performance Bond A bond issued by a financial institution guaranteeing performance at agreed levels by the PPP SPV. A performance bond can be partially or fully forfeited in the event of performance failure. Performance Indicators A pre-agreed set of measures that are used to compare performance to established benchmarks in PPPs. Public Private Partnership PPP refers to arrangements, typically medium- to long-term, between the public and private sectors whereby some of the services that fall under the responsibilities of the public sector are provided by the private sector, with clear agreement on shared objectives for delivery of public infrastructure and/or public services. 39 Revenue Guarantee The government guarantees the PPP SPV a pre-specified level of demand (e.g., tonnes of grain in a PPP grain storage project, traffic in a PPP toll road) or revenues (e.g., when revenues fall below the pre-agreed level, the government pays the difference). Revenue-sharing Mechanism The government and the PPP SPV share the revenues from toll/user charges. In a typical PPP, the revenue share may begin only after total revenues reach a pre-agreed level. However, this may be different based on the revenue profile of projects. Risk An uncertain event which when it happens may affect the cost of a project. Risk Allocation Placing responsibility for a risk with a party through a contract. Shadow Tolling Payments are made per vehicle using a kilometer of the project road, in accordance with the tolling structure and increase over time in accordance with an indexation formula.40 Special Purpose Vehicle A bankruptcy remote entity formed for the purpose of financing and managing specific assets. Sub-equity An equity instrument that gets a return only if the actual realized IRR is higher than the estimated IRR. Subordinate debt Debt that has a lower priority in terms of repayments relative to senior debt. It is paid after claims relating to senior debt have been paid in full. Take Out Financing Take Out financing is used to replace shorter-term loans in infrastructure PPPs, usually after completion of construction, although these could be used at any point of time. These serve to increase loan terms where the financier may be unwilling to lend longer term at the outset but will do so when the risk profile of the project changes with time or achievement of a specific milestone. Unitary Payments A single annual, quarterly, or monthly payment made to the PPP SPV/private entity for the services provided. This includes the capital as well as the operational components. 39 Source: https://ppp.worldbank.org/public-private-partnership/overview/what-are-public-private-partnerships 40 Source: http://www.highways.gov.uk/our-road-network/managing-our-roads/operating-our-network/how-we-manage-our-roads/private-finance-initiatives-design-build-finance- and-operate-dbfo/design-build-finance-and-operate-contract-payment-mechanisms/ 55 OPERATIONAL NOTE: VIABILITY GAP FINANCING MECHANISMS Upfront Equity Requirement A requirement by government/ financial institution that the private entity expend a part of or the full equity before it becomes eligible for grant/debt installments. Usage-based Payment A payment mechanism whereby the government pays the PPP SPV the agreed rate for every unit of service consumed. Variable Payment A payment mechanism which consists of payments that vary based on some specific related variable, such as volumes of service actually provided. Variable Term Contract The contract term is based on a specific variable which is pre-agreed, such as the present value of total revenue earned. In a variant of this, the contract has a fixed term but includes a clause that allows for either reducing or increasing the contract term based on actual revenues vis-à-vis projected revenues. Variable Tolling Tolling that has rates which vary based on time of day or congestion. Grant funding provided by governments to close financing gaps in PPP projects where there is a favorable Economic Rate of Return (ERR) but the Financial Rate of Return is insufficient to attract private financing. This occurs where the present value of the revenue flow from a project does not cover the present value of the costs of Viability Gap Financing the project, including a reasonable rate of return to the investors. A bond which can be redeemed for face value at maturity but does not pay a coupon or regular interest. The Zero-coupon Bond earning from this instrument is based on the extent of discount at purchase. 56