In the UK, most project financing arrangements prior to the advent of PF2 were carried out under the Government's private finance initiative (PFI) and were part of projects known as Public Private Parnterships (PPPs). PPPs were public services or private business ventures funded and operated through a partnership between the Government and one or more private sector companies. They allowed the Government to contract out the design, building and operation of a facility for the benefit of the public to a private sector company usually for a period of 25 to 30 years.
This Guide briefly explains the allocation of the fundamental risks in a PPP structure. It is not produced by reference to any specific project, instead summarising the position of a typical PPP structure using a 25 year toll road concession as an example. For more information about project finance generally, see our separate Out-Law introduction to project finance documents.
Public Private Partnerships generally
PPPs were created when the Government wanted to procure an infrastructure asset such as a road, bridge or hospital. In order to do this, it invited tenders from private sector contractors who would be able to deliver the asset.
There were two ways the Government could go about this - it could:
- use a standard procurement structure, in which the Government specified what it wanted in terms of an asset and then paid a contractor to build that asset. The Government then took ownership of the asset, and took on the obligation to maintain it, after it was built; or
- use a public private partnership structure, in which the Government specified what it wanted in terms of a service and either pay a service provider to make that service available, or allow the service provider to retain the resulting revenue or share it with the Government.
In a PPP scenario, there were distinct roles to be undertaken by the private sector. Taking our example of a 25 year toll road concession, some of the obvious roles which needed to be undertaken were:
- the road would need to be built to a certain design specification;
- the road would need to be operated over 25 years including providing and manning toll booths, clearing the road, replacing crash barriers, providing road lighting etc;
- the road would need periodic major maintenance over 25 years, for example resurfacing; and
- the cost of building – and then operating – the road would need to be financed.
The Government would want the private sector to perform all these services. As different contractors have different technical capabilities, and these projects tended to be quite large and involve significant risks, private sector companies would usually form a special purpose vehicle (SPV) for the specific purpose of performing all the services required in connection with a particular project.
Looking at the way in which the Government passed these risks on to the private sector, the flow of risk can be broken down in a number of steps.
Step 1: All risks that the Government wanted to pass on to the private sector would be contained in the PPP contract between the Government and an SPV, or assumed by the SPV as a matter of the law as may be applicable to its specific activities - for example, liability for environmental pollution during construction works.
Step 2: An SPV would be set up specifically for the project with no resources of its own. Therefore, any risks and obligations that the SPV assumes would have to be allocated in one way or another. Either these will be passed on to a subcontractor - see below - or left in the SPV with some form of mitigation to cover the financial implications of this risk.
Step 3: Risks relating to the construction of the road would usually be fully passed down by the SPV to a subcontractor through a back-to-back construction contract. This meant that the subcontractor would agree to perform all the services that the SPV agreed to perform to the Government. In practical terms the subcontractor would agree to build the road to the same specification, according to the same or a shorter timetable, and with the same penalties applying for default – for example, if the SPV would be liable to pay damages to the Government then this liability would be matched by the subcontractor's liability to pay damages to the SPV.
The purpose of this pass-down was to leave the SPV neutral. The subcontractor would manage all risks involved in the construction, or upgrade, of the asset.
Step 4: Once the road was complete, the SPV would start to operate the road and, again, these obligations would need to be subcontracted to an operator. While it was usually the case, at least in our road example, that all construction risk is passed on to the subcontractor, it was not always the case that all the operation and maintenance risk would be passed on. There are two common examples of where risk was not passed on to the subcontractor:
- day-to-day operation and maintenance is passed on but the obligation to perform periodic, major maintenance – for example, resurfacing after 10 to 15 years – may not be subcontracted at the start of the arrangement. Instead the risk that this work can be subcontracted remains an SPV risk, and the SPV needed to ensure that it had sufficient funds and resources to provide this major maintenance when it became due; and
- the risk that laws could change over the 25 year operating period is not a risk that can be easily evaluated at the start, and not one that operators are generally willing to price - unlike construction contractors, who will take this risk on over the shorter construction period. Because of this, this risk was often shared between the Government and the SPV, even though this may be a risk that is within the Government's control. In the same way that the SPV needed sufficient funds to pay for its major maintenance obligations above, it also needed sufficient funds and resources to provide any additional works which might become necessary following a change in law.
Step 5: The SPV needed to be able to finance its construction and initial operational activities. The construction of the road would need to be paid for, and the money for this would need to be repaid from revenue generated by the road when it opened for traffic. The funding requirements should exactly match the SPV's liabilities to pay its subcontractors.
Nature of the risks:
At the most basic level, the risks involved in a PPP project could be categorised as follows:
- whether the asset could be built on time and to specification;
- whether the asset could be operated in accordance with the Government's requirements;
- whether the asset would generate the expected level of revenue.
There are numerous risks that featured within each of these basic categories. Using our example of 25 year toll road concession, the main ones were:
Can the road be built on time and to specification?
- Does the SPV have the necessary access to the site?
- What happens if ground conditions are different from expected?
- What happens if the law relating to road construction changes during the construction period?
- What happens if resources that the contractor is expecting to use – for example, labour or materials – are not available?
- Who takes the risk that the road costs more to build than expected?
- What happens if a natural disaster occurs?
Can the road be operated according to the Government's requirements?
- Does the SPV have the required access to the site?
- What happens if the law relating to road operation changes during the operating period?
- What happens if resources that the operator is expecting to use – for example labour or materials – are not available?
- Who takes the risk that the road costs more to operate than expected?
- What happens if a natural disaster occurs?
Will the road generate the expected level of revenue?
- Has the road been built to specification?
- Is the road being operated according to the Government's requirements?
- Demand risk: will cars, lorries etc want to use the road?
- Payment risk: will cars, lorries etc want to pay to use the road?
- Are the operating costs - including the cost of finance - fixed?
These risks were typical for almost any toll road PPP project. The procurement of other types of service via a PPP project would of course involve their own types of risk.