Public Private Partnerships (PPP) – Global

Experience and Challenges in Russia

Moscow, February 10, 2005
Oddvar Sten Ronsen, Senior Vice President
Nordic Investment Bank

REQUIREMENTS OF SUCCESSFUL PUBLIC PRIVATE PARTNERSHIP

PROJECTS – RISK ALLOCATION BETWEEN THE PRIVATE AND PUBLIC
SECTORS

The whole topic of risk allocation is crucial to our approach to PPPs. It is also a broad
issue, so I shall try to limit it to show the need for a right approach to this aspect of
PPP. Let us remember that the whole reason for PPPs is that there is not enough
room for necessary infrastructure investments over government budgets. As the
previous speeches have shown, and as the Chairman pointed out in his introduction,
PPP solutions may provide an avenue for such necessary investments being
effectuated as the private sector gets involved. However, the private sector is not
prepared to assume all the risks for public utility development projects when the
government still wants, and rightly so, to have a control over, or strongly influence
factors that in a crucial way determine whether the project will be a success or not.

I shall, during the next few minutes, comment on project financing and risk sharing /
risk allocation between the government and the private sponsors. I shall also use
some examples to illustrate the intrinsic difficulties in this respect with one example
from Russia, i.e. the SWWWTP project in St. Petersburg and one example from
Norway, the Norwegian road system. That is what a PPP is: a contract where public
and private organizations undertake to provide services or public works; sharing risks
and with funds obtained by the private sector. Indeed, in the PPP law in Brazil
mentioned by the Chairman, one of the guiding principles is that the private sector
partner is responsible for the financing of the investment and management pursuant
to the following guidelines: Pkt VI” the distribution of risks in accordance with the
conctracting parties’ risk management capabilities”. This is a crucial formulation; “in
accordance with the contracting parties’ risk management capabilities”. What does it
mean? Here we are at the core of the project financing issue in PPP projects. It
means that each party should be willing to share the kind of risks that they may
influence. Let me then state the obvious first; The private investor is normally not
willing to assume a risk that is controlled by the government and that is crucial to the
outcome of the project. E.g the investor in a road project, energy, district heating,
water and waste water, etc would expect the public sector to guarantee a certain
tariff development based on agreed principles as this is crucial to the final success of
the project investment. The private investor is thus normally not willing to assume a
political risk controlled by the government , as e.g future tariff developments, without
a government or municipal undertaking that gives some assurance, and if it should
take such a risk it would only do so at a very high cost as a risk premium.

In any PPP financing of an infrastructure investment it is thus of importance that

there is an understanding of the extent to which a government is willing to support
the project financing structure. This greatly facilitates the completion and risk
allocation work process. From the point of view of a potential investor or lender the
main project risks principally lie in three areas; direct project risks, regulatory and
institutional risks and macro-economic risks. I think it is fundamental for the
development of an optimal financing structure that the risks are best distributed
among and to the parties which have the best possibilities to influence and control
them. Parties who cannot influence explicitly stated risks, e.g tariff developments, in
any significant way will either shy away from those risks altogether, or they will, as I
just said, put a high price on taking them.

This risk allocation principle has two main functions:

Firstly, to reduce the perception of risks and transactions costs, that is, it makes the
project look attractive to the parties, the government and the investors, and none of
them need to compensate for the other parties’ unwillingness to accept the risks they
are less prepared to take. This brings down overall project costs.

And secondly to foster rational and prudent behaviour of the parties involved in the
project during its lifespan. This means that all parties will be able to work effectively
for the success of the project as they are well placed to influence the risks they are
responsible to handle.

Closely related to this is the need for a clear and transparent legal framework to be in
place to ensure successful Public Private Partnership projects. Probably the most
important lesson to be learnt from the Nordic region that has mostly had PPP
transport projects, is that it is necessary to clarify the legal framework for PPP
projects if they are to be successful. In particular it is important to define clearly the
responsibilities of the government regarding the scope for tariff increases, and e.g in
road projects, the extension of a toll-concession period in the event of cost overruns.
The private parties, e.g. the toll operation companies, the government as well as the
financial institutions all have an interest in clarifying the legal framework.

For Public Private Partnerships to be successful for infrastructure investments the

risk structure must be explicitly documented and shared in a transparent way. The
PPP concept involves the sharing of a wide range of risks and obligations between
the government, the concession holder and the financing institutions. The general
business principle is, as previously stated, that the risks are best distributed to the
parties having the best possibilities to control or influence them.

A government providing some kind of undertaking in this respect to attract private

capital and long term financing from financing institutions may rightly be reluctant to
assume project risks along with the project sponsors. The government will, however,
be in a better position to assess total project risks than any other domestic or foreign
investor or lender. Being the executive arm of the state, the government is able to
influence the regulatory and institutional framework as well as economic policy and
other mechanisms impacting the project. The government, for its own part, would
probably want to be provided with adequate counter commitments to ensure that the
government undertaking, in case of future project failure not due to the actions of the
government, will not be a burden to the national government and the tax payers, but
to the project sponsors. Such risk allocation would also foster due diligence for

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development and execution of investment projects and maximum commitment of all
the parties in the projects to their successful operations.

Let me try to exemplify this: The first example is the Norwegian PPP models for road,
tunnel and bridge financing, which have been used with much success during a 30
year period. They are user-based and have become a commonly accepted form of
finance for such infrastructure in the transport sector. Initially there was some
resistance from the public, but today it is commonly accepted that the users have to
pay. The projects vary considerably in size but they entail the same kind of problems
with regard to investments, traffic forecasts, pricing and risk assessment. The models
may be described as successful. They have been tested and accepted as a useful
financing mechanism by the Norwegian government, the financing institutions and
the public. One of the most unique tollroads is the Oslo Ringroad system, to the
financing of which NIB contributed with a loan of USD 66 million. But let me say that
initially there were problems to get the Norwegian PPP projects up and standing
because the risk allocation among the stakeholders was unclear. What changed the
picture? Basically that the rules for risk sharing were taken into a law that was
debated and passed by the Norwegian parliament. So now, if the traffic volume is too
low compared to forecast, or the costs have turned out higher than previously
estimated, it is possible within certain limits to increase the tariff or extend the
concession period or a combination of the two in order to salvage the project. Thus
the basic terms of the concession contract such as the concession period, method of
computerized toll, expiry of contract etc. are clearly documented. The public today
want these projects to be self-financing. By using a PPP structure with toll based
financing it is possible to initiate projects in heavy traffic areas earlier than otherwise
would have been possible.

The second example is from the PPP project in St. Petersburg, the South West
Wastewater Treatment Plant, a milestone USD 220 million project that cleans the
wastewater from nearly one million inhabitants in the City of St. Petersburg. NIB, as
lead bank for the financing of this important NDEP project, worked closely with
Vodokanal of St. Petersburg and the City of St. Petersburg to find an adequate
structure for the project. The challenge we faced in structuring the project was to
manage it without placing any direct burden on the finances of the City of St.
Petersburg, neither its budgets nor its guaranteeing capacity. The core issue turned
out to be a matter of risk allocation; which party should carry which risks? And I am
very pleased to say that only through a very close cooperation with the City and
Vodokanal and the sponsors was it possible for NIB to present to the other
participants in the financing a package that was acceptable to all the parties. A PPP
structure was worked out which makes use of the basically strong financial situation
of St. Petersburg without burdening the City with direct financial guarantee
obligations. In addition, the structure enjoys the support of the Russian Federation.
And at this juncture I would like to thank the Ministry of Finance for its active support
in the process of getting the project in place. The key was to agree on the risk
allocation. The investors carry all the direct construction and operational risks,
wheras the City has committed itself to a tariff development structure and various
other undertakings that ensure a reduced risk with respect to the future revenue flow.
But let me also say this: the legal expenses were very high in this transaction and a
clearer legal framework would make such a structure more easily available. As long

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as the legal framework is not in place the high transaction costs are interesting to the
legal firms, but are a deterrent the would-be investors.

It should be a worthy objective to work for – a simplification and clarification of the

legal structures. (The total legal costs for this project were approx. EUR 2 million
which is far to high. The costs were paid by Swedish and Finnish government
contributions to the project. )

I have tried to illustrate the importance of achieving a risk allocation that has the
support of the stakeholders, and a risk allocation that the parties accept as fair and
realistic. A legal framework that takes care of the basic principles is quite essential
for success in the development of PPP structures in any country, and I look forward
to follow the future development of this concept in Russia.

Thank you for your attention.