Risk management systems for contingent infrastructure liabilities ; applications to improve contract design and monitoring

Privatesector P U B L I C P O L I C Y F O R T H E Note No. 149 August 1998 Risk Management Systems for Contingent Infrastructure Liabilities Applications to improve contract design and monitoring Christopher M. Government guarantees for private infrastructure projects represent real liabilities, and their Lewis and costs can average as much as a third of the amount guaranteed. Most governments do not know Ashoka Mody the full extent of these liabilities, because they have made no attempt to systematically estimate them. A companion Note (Viewpoint No. 148) proposes a new framework for identifying government exposures, valuing expected and unexpected risks, and budgeting for expected risks and reserving for unexpected ones. This Note shows how governments can use the valuation process to analyze the distribution of risks, decide which risks they should bear and which should be borne by the private sector, and reduce the frequency and size of calls on guarantees. In what may be the first time that a sophisti- pected loss. In keeping with the lattice of risks cated contingent valuation method was applied outlined in the companion Note, the govern- to government infrastructure projects, the World ment assessed a number of risk exposures: mar- Bank and the Colombian government collabo- ket risk (relating to market volumes and prices), rated to estimate the government’s exposure construction risk (from cost and schedule over- in three infrastructure finance projects: runs), counterparty risk (operations risk and ▪ The US$20 million El Cortijo–El Vino toll road risk of failure of participating companies), cur- project, where the government guarantees rency risk (relating to exchange rates and construction costs and traffic volumes. liquidity), force majeure, termination risk (risk ▪ A joint venture telecommunications project of contract buyout, possibly including penal- between Telecom S.A. and Siemens, where ties), and regulatory risk (the risk of adverse Siemens will supply switching equipment and regulatory changes). cables for more than 80,000 new lines and the government guarantees annual minimum The assessment for the El Cortijo–El Vino toll cash returns to Siemens in the period after road project showed that the greatest exposures construction. for the government are from the market risk ▪ A US$755 million privately sponsored power associated with traffic volatility and the risk of project to supply a government-owned dis- construction cost overruns. The total expected tribution company, where the government loss to the government under these two guar- provides guarantees for the power purchase antees was estimated at about US$4.2 million agreement (box␣ 1). (table 1). The assessment of the telecommu- nications project identified regulatory and The valuation of the government’s exposure market risk and construction risk as the largest in these three projects used a technique called risks. Regulatory and market risk exposure stochastic simulation to identify the net ex- —stemming from Colombia’s deregulation of The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network  Risk Management Systems for Contingent Infrastructure Liabilities BOX 1 CONTINGENT LIABILITIES FOR THREE COLOMBIAN PROJECTS Toll roads telecommunications, which ended the mono- The government provided a construction cost overrun guarantee and a traffic poly held by Telecom S.A.—was estimated at volume guarantee once road construction was finished. Under the terms of US$10 million. Construction risk was estimated the cost overrun guarantee the government would cover 100 percent of the at US$9.8 million, but whether this risk is borne cost of overrun up to 30 percent of the original construction bid, 75 percent of by Telecom or Siemens is not clear from the the overrun between 30 and 50 percent of the bid, and none of the overrun contracts. In the energy project the govern- above 50 percent of the bid. The traffic volume guarantee commits the ment’s exposure to CORELCA was estimated government to reimbursing the concessionaire if traffic volume falls 10 at US$67 million. Most of the exposure relates to the risk that retail energy prices will be percent below the projections agreed to in the project budget. If traffic insufficient to support CORELCA’s operations, volume exceeds projections by more than 10 percent, the additional revenues causing the company to default. are placed in a reserve fund to cover future shortfalls in traffic volume or for road maintenance. The loss variances for each project were also analyzed, and scenario analyses were run to see Telecommunications how different conditions would affect the risks The telecommunications project, a joint venture between Telecom S.A. and of each project. Scenario analysis is an extremely Siemens, has a structure similar to a build-operate-lease arrangement under important tool for governments in reviewing which Siemens will install the switching equipment and cables for more than their exposure to a project finance transaction in the context of general fiscal policies. In the 80,000 new lines. Under a risk sharing agreement Telecom bears 20 percent of toll road project, for example, such analysis can the risk/return within a 10 percent band around the expected revenue of the show how anti-inflationary fiscal policy would project and 100 percent of the risk/return outside this 10 percent band. The affect the government’s exposure under traffic contracts do not clearly specify the allocation of construction risks. volume guarantees. Scenario analysis is also useful in analyzing alternative approaches to Power achieving the government’s objective in an in- The government has provided several forms of support to the US$755 million frastructure project. For example, in addition to expansion of the 240-megawatt Barranquilla thermal power plant. The 750- underwriting the power purchase agreement, the megawatt plant will be constructed by TEBSA to provide power to CORELCA, Colombian government provided a subordinated an undercapitalized state-owned power distributor on Colombia’s Atlantic loan to CORELCA. As a result, the evaluation of any action designed to increase the value of the coast that runs a narrow-margin energy distribution service. TEBSA is a energy guarantee must take into account its im- special-purpose vehicle capitalized by the old Barranquilla thermal plant, pact on the value of the subordinated loan to now jointly owned by CORELCA and ABB Distral. The government support CORELCA. consists of a power purchase agreement between CORELCA and TEBSA, three guarantees, and a subordinated loan: Risk sharing between the public and ▪ Under the power purchase agreement CORELCA agrees to make capacity private sector payments to TEBSA for the first twenty years of the plant’s operation. As long as the plant is operational, CORELCA must pay a schedule of fees that The valuation process allows governments to critically assess the distribution of risks under start high and decline over time. a direct loan, a guarantee, or an insurance ▪ The Ministry of Energy guarantees CORELCA’s ability to make these program and to design contracts that lead to payments to TEBSA, and the Colombian government guarantees the fewer and smaller calls on guarantees. For ex- ministry’s ability to honor this commitment. ample, in soliciting bids for the toll road project, ▪ To prevent CORELCA from failing, the ministry has taken a subordinated the Colombian government asked prospective debt position in the company to help ease any liquidity crisis. concessionaires to bid on the basis of a prelimi- ▪ Ecopetrol, the supplier of gas to TEBSA and CORELCA, guarantees force nary set of engineering designs. Recognizing majeure payments. that these designs provided too little detail, the government granted cost overrun guarantees that would compensate the concessionaire for  TABLE 1 EXPECTED GOVERNMENT LOSSES IN COLOMBIAN INFRASTRUCTURE PROJECTS Millions of U.S. dollars El Cortijo–El Vino Telecom S.A.–Siemens CORELCA Type of risk toll road project joint venture energy guarantees Market 3.1 2.5 52.0 a Construction 1.1 9.8 0 Counterparty 0.3 0.1 5.0 Currency 0 –1.3 2.0 Force majeure 0.2 0.3 7.0 Termination –0.2 0.2 1.0 Regulatory 0 10.1 0 Total 4.5 21.7 67.0 a. It is unclear from the contracts whether this risk is borne by Telecom or Siemens. Source: Timothy Irwin, Michael Klein, Guillermo E. Perry, and Mateen Thobani, eds., Dealing with Public Risk in Private Infrastructure (Latin American and Caribbean Studies, Washington, D.C.: World Bank, 1998). cost variances within a wide band around the it should consider providing direct credit, tar- submitted bid. While the guarantees served the geting the credit to the area of concern. The purpose of attracting qualified bidders, their government should then determine whether it structure allowed concessionaires to extract a also has the information and skills to most near-certain rent from the government of about effectively monitor and control the risks or 35 percent of the original bid. whether a private servicer should be employed to service the loans. Where the government del- After assessing the risk transfer associated with egates servicing, it must have systems for moni- the toll road project and quantifying the risks in toring the performance of the servicers. the project, the government changed its toll road guarantee program. It now commissions more Even if the government has the best access to detailed engineering studies before it solicits bids information on a risk, it might choose to provide to limit the uncertainty in the bidding process, assistance through a guarantee targeted at a spe- and provides a narrow guarantee. The new cific layer rather than through direct credit. The policy is less expensive than the old one but reason is that a contingent guarantee can be provides the same benefit to the concession- more narrowly focused on the market failure, aires. The change made the Colombian toll road as in the switch from providing a broad guaran- program more efficient—achieving a higher risk- tee to funding engineering reports in the adjusted rate of return by reducing the govern- Colombian toll road concessions. Because guar- ment’s risk of delivering a fixed benefit. antees and insurance can be narrowly targeted, they can be used to get the private sector to The valuation process enables a government to absorb as much risk as possible. assess how efficiently risks have been allocated and derive lessons from its findings. To do this Where the private sector is better able to under- the government must first assess which party write and service the underlying risks but some (public or private) has the best access to the government assistance is needed, public-private information needed to objectively and most risk sharing is often the best solution. In this accurately evaluate the underlying risks. It must case pro rata guarantees and insurance under then assess which party is in the best position which the private sector and the government to monitor, control, and service the risks once share all losses on a risk equally are often the they are underwritten. If the government is in best form of assistance. Risk sharing gives the the best position to underwrite the risks directly, private entity an incentive to price the coverage  Risk Management Systems for Contingent Infrastructure Liabilities appropriately, ensuring that it will not shift thereby aligning the guaranteed party’s incen- additional risks to the government. Other risk tives to remain vested in the project with the sharing mechanisms within and between classes government. They can place restrictions on the of risk are also feasible. But they usually require use and investment of reserves held by the guar- more government oversight and more govern- anteed party, to ensure that their value is unim- ment underwriting expertise. paired during periods in which a loss event is likely. They can structure their support to pro- Managing federal-state partnerships mote pro rata risk sharing, where a private party shares risk equally with the government for some Risk management tools and techniques are also or all types of loss. Since the private party in helpful in analyzing the structure of government this transaction would then bear the same risk programs that share responsibilities between the per dollar of exposure as the government, the federal and state levels. Such programs can government can benefit from the private sector’s combine the national government’s ability to pricing of risks. Finally, governments can levy redistribute resources across economically risk-based guarantee fees that both reduce the diverse regions with the ability of state and lo- budgetary cost of issuing guarantees and im- cal governments to identify investment needs prove the alignment of incentives between the at the local level. The national government funds guaranteed party and the central government. the program, while state and local governments provide the underwriting and administrative Conclusion Viewpoint is an open forum intended to function. A potentially powerful combination, encourage dissemina- this type of federal-state partnership is analogous Allocating risks efficiently and limiting the abil- tion of and debate on to a parent company’s providing a guaranteed ity of private agents to shift additional losses to ideas, innovations, and best practices for ex- source of financing to a subsidiary established the government reduces the budgetary costs of panding the private to perform a particular service. issuing guarantees and improves the allocation sector. The views pub- of scarce budgetary resources. But techniques lished are those of the authors and should not Such federal-state partnerships are not without for assessing risk are only as good as the infor- be attributed to the risks, however. If the federal government does mation on which the models are based, and over World Bank or any of not retain oversight of the underwriting func- time institutions change, markets evolve, and its affiliated organiza- tions. Nor do any of the tion, the national budget remains at risk. But if new information on risk exposures emerges. A conclusions represent it is overly prescriptive in setting regulations series of loss events can reveal risks that were official policy of the for the program, it reduces the flexibility of previously unknown or unquantifiable, leading World Bank or of its Executive Directors the state and local governments to identify to radical changes in risk assessment. Using the or the countries they needs in the local community. The goal is to risk management framework outlined in this and represent. reach the optimal tradeoff between delegation a companion Note, governments can quickly To order additional of project selection and federal oversight of incorporate new information on risk exposures copies please call state underwriting performance. into their pricing of new contingent liabilities 202-458-1111 or contact and reestimate the expected costs of previously Suzanne Smith, editor, Room F6P-188, Minimizing the loss shifting issued liabilities. The World Bank, 1818 H Street, NW, This Note is based on a longer paper by the authors in Timothy Irwin, Governments need to implement strong risk Michael Klein, Guillermo E. Perry, and Mateen Thobani, eds., Dealing Washington, D.C. 20433, or Internet address management programs to limit their contingent with Public Risk in Private Infrastructure (Latin American and Carib- ssmith7@worldbank.org. liability exposure to additional loss shifting by bean Studies, Washington, D.C.: World Bank, 1998). The series is also the guaranteed party. The valuation process available on-line Christopher M. Lewis, Ernst & Young, and (www.worldbank.org/ provides a basis for determining the best strat- html/fpd/notes/ egy for limiting such exposure. Governments Ashoka Mody (amody@worldbank.org), Project notelist.html). can require the guaranteed party to hold a cer- Finance and Guarantees Department Printed on recycled tain amount of capital or collateral to serve as a paper. first-loss protection barrier for the project,