Overview of Investments In and Outcomes Of PPP Investments

Conventional investments are typically driven by country fundamentals. The same holds true for PPP. However, as experiences accumulate, past PPP outcomes become part of a country's fundamentals. Thus, present outcomes will tend to drive future investment patterns.

3.1 World PPP investments

The following figures were constructed using data from the World Bank's PPI database. Figure 1 [ PDF 30.1KB | 1 page ] lists the dollar value of global and regional PPP investments from 1984 to 2006. Global investments peaked in 1997, and then fell sharply following the financial crisis in Asia, and the subsequent crises in Russia, Brazil, and Argentina. PPP investments recovered after 2002, with telecom and transport investments driving the recovery; however, the recent oil price shock and global financial crisis threaten to reverse this trend.

In Asia, the steep decline in PPP investments has not been followed by clear signs of recovery. Only transport investments have rebounded to pre-crisis levels. The rest have remained flat.

In Latin America and the Caribbean, PPP investments peaked following the outbreak of the Asian crisis, suggesting a diversion of investments from Asia. Although PPP investments in the region fell after the Brazilian crisis of 1999, levels have started to pick up since 2002.

PPP investments in Europe and Central Asia have trended upward since 2003. The same is true for the Middle East and North Africa, where investments have increased at an even more rapid pace, reflecting the increasing attractiveness of markets as the price of oil has increased. PPP investments in South Asia have also increased rapidly since 2003, driven primarily by high growth in India. Likewise, PPP investments in Sub-Saharan Africa have risen dramatically in the last few years.

Table 2 [ PDF 26.3KB | 1 page ] shows the sectoral and sub-sectoral breakdown of current PPP projects in the World Bank's PPI database. The energy sector comprises the bulk of PPP projects. Transport projects (mostly seaports, airports, highways, and bridges) account for the second largest share, followed by telecommunications, then water and sewage. This sectoral breakdown reflects two key investment patterns in PPP: sectors with cross-border applications and impact, such as energy and transport, attract the biggest investments, while sectors with more local applications, such as telecoms and water and sewerage, see the least investment.

That water and sewerage investments lag behind other sectors reflects the more politicized nature of water, which continues to be perceived as a public good. It also reflects a widespread reluctance to take water supply and management from national and municipal utilities. Much of this reluctance emanates from concerns about tariff increases. Most people are aware of the typical post-privatization pattern—privatization leads to an immediate increase in tariff, with the corresponding improvements in service efficiency only coming much later, if at all.

Private investors have shown reluctance themselves, having witnessed water privatization conflicts in communities around the world (as well as frequent failures to improve service levels and coverage). Prominent failures in water privatization in places such as Buenos Aires, Argentina; Cocachamba, Bolivia; and the Philippines have not helped matters much. Also, unlike power generation, which provides wholesale bulk supply, privatizing municipal water systems puts concessionaires in direct contact with retail customers—in the front line of privatization.

3.2 World PPP Outcomes

Although PPP failures get tremendous scrutiny from researchers and the media, data would show that an overwhelming number of projects worldwide are neither “canceled” nor “distressed.” Of the roughly 4,000 projects in the World Bank's PPI database, only 57 are listed as distressed, and only 185 are listed as canceled. Thus, although infrastructure projects have suffered the whole extent of country-specific, regional, and global shocks in the last three decades, as a whole, projects appear to have been quite resilient. Given their inherently long gestation periods, it would seem that in general, project developers, firms, investors, governments, and customers have adapted to volatile project cycle environments.

One form of adaptation is renegotiation, and indeed, although experience in Latin America has shown that renegotiations can often be opportunistic (Guasch 2004), the judicious use of renegotiation (by both government and firm) could in fact be responsible for the resiliency of projects.

Divestment can be, and in many instances has been, another response to risk². Many recent PPP divestments have involved the exit of original foreign investors, in favor of new foreign players or emerging domestic private investors. Thus, while most projects have retained private equity investment, the nationality and composition of the private investors have changed.

On the surface, the data on PPP is encouraging. But beneath the veneer of resiliency still lies considerable stress. During the past decade, global macroeconomic shocks and other factors have led to a rash of divestments and renegotiations in Asia and Latin America. Table 3 [ PDF 26.2KB | 1 page ] lists the estimated frequency of renegotiations in East Asia alone. The large number of estimated renegotiations in East Asia has not only been due to volatility experienced during the Asian crisis; uncertainties experienced by investors in the People's Republic of China (PRC) have also been a contributing factor (Woodhouse 2006). The PRC's PPP issues are noteworthy. The government recently established formal regulatory institutions for many utilities, yet the country's planning ministry effectively retains final pricing authority over many infrastructure-related services.

Divestitures due to unfavorable outcomes are a manifestation of another ominous trend—a shortening in the implicit investment horizon for infrastructure, one of the external effects of past PPP experiences in Latin America and Asia. It would not be surprising to find that recent project analyses dwell as much on exit strategies as on investment. While PPP projects are originally conceived by governments with the assumption of a certain amount of stability in terms of investor composition, the opposite has in fact, occurred, with many divestments and buyouts occurring long before the end of the first decade of operations. The frequency of hasty divestments reflects the rise in risk premia, which adds to the cost of subsequent PPP investments.

3.3 Determinants of Project Outcomes: Stress and Risk Factors in PPP Investments

3.3.1 The Role of Political Risk

Actions by government executives—political actions—can profoundly influence PPP outcomes. In developing countries, government executives may be responsible for most tariff decisions, or they may make decisions on tariffs even in the presence of formal regulatory bodies. Since the range of possible actions is broad (ranging from tariff interventions to expropriations, to changes in investment rules, regulations, and legislation), a broad definition of political risk is needed in order to capture the impact of executive discretion on projects. For this study, political risk is defined as the possibility that government executives may use their prerogative to make sweeping changes in investment rules or regulations—through measures such as protracted tariff freezing—that undermine a project's market value.³

While broad political risk can pose the biggest threat to project outcomes, it is however usually only realized after other risks—such as currency or demand risks triggered by macroeconomic shocks—have materialized first.

Recent history provides numerous examples of macroeconomic shocks that have been detrimental to PPP. The first macroeconomic shock to privatized infrastructure was the Mexican crisis of 1994, which led to large disparities in forecast and actual traffic on privatized toll roads: a realization of demand risk. The government subsequently bailed out losing projects. This was followed by the Asian crisis of 1997, which triggered the collapse of fixed exchange rates in the worst-hit countries. Overnight, countries that had been pursuing privatization were faced with a political decision—who would bear the cost of currency risk (in addition to demand risk)? In many cases, the burden was shared: governments renegotiated contracts, while taxpayers and consumers of infrastructure services assumed parts of stranded costs. The shock from that crisis reverberates to the present, with Malaysia currently encouraging IPPs to renegotiate.

Recent major macroeconomic shocks to hit PPP investments were the collapse of the Brazilian real in 1999, the breakdown of the currency board in Argentina in 2002, and the banking-related currency collapse in the Dominican Republic in 2003. As with the Asian crisis, these triggered a discrete and simultaneous realization of currency and demand risks. These also triggered renegotiations with private concession operators.

The manner in which governments in Asia and Latin America responded to these crises is a study in contrast. Although the response to such shocks was essentially political, the nature of realized political risk differed across regions. Asia's response primarily consisted of contract renegotiations and partial nationalization or subsidization,⁴ while Latin America's response consisted of tariff freezes and subsequent renegotiations over time.⁵ This was the response of the Argentine government, which froze all utilities tariffs at the height of the peso crisis in 2002 (they remain somewhat rigid and low to this day, even with occasional adjustments).⁶ In addition to imposing a tariff freeze, the government also suspended the indexation of tariffs to the US dollar, leading to the “pesofication” of tariffs. Since then, other governments in the region have used tariff freezes in response to economic shocks (e.g., Nicaragua, and the Dominican Republic after its banking sector-led shock in 2003).

Firms cannot withstand a prolonged period of tariff rigidity. Many of the distressed or canceled projects in Argentina, the Dominican Republic, and Nicaragua are energy projects which have been subjected to protracted tariff freezing. This implies that tariff freezes,⁷ a manifestation of political risk, represent a significant ratcheting up of pressure felt by infrastructure firms. Table 4 [ PDF 27KB | 1 page ] provides a sample of recent tariff freezes.

Many of the projects listed as “distressed” or “canceled” in the World Bank's PPI database are in the sectors and countries listed in Table 4. Sweeping tariff freezes instigated by national executives in response to substantial currency risk are most directly and significantly associated with PPP project cancellations and distress (i.e., political risk manifested in tariff freezes that occur after economic crises raise break-even tariffs for project firms).

There can be other motivations for tariff freezing, such as a large devaluation or persistent price shock in an inflation-averse environment. Since any increase in utilities tariffs feeds into the general price level, the risk of tariff freezing rises when there is a sudden, large devaluation, or when there is a persistent shock to prices, such as the recent increase in global commodities prices. This risk is greater if the country pursues strict inflation targeting (as in the case of the Republic of Korea) or if government executives themselves are highly averse to inflation (as in the case of the PRC).

Protracted tariff rigidity is characteristic of markets where the government routinely intervenes through price controls. In the PRC, such controls are pervasive in wastewater treatment and water utilities.⁸ Because of the localized nature of water projects, tariff approvals for water in the PRC pass through local politicians. Proposals for tariff changes thus become more sensitive after changes in local leadership. The problem is further aggravated when the required rate or level of wastewater treatment is high (and therefore the cost of water treatment to the firm is high, but the rigid tariff allows little or no cost recovery). Due to these and other factors, the timing and extent of net revenues tend to be uncertain. Furthermore, municipal guarantees on prices are prohibited under the law.

Apart from tariff freezing, political risk can manifest in other ways. In Malaysia, threats of contract renegotiation have hounded IPPs after the Asian crisis started to weaken the stateowned power utility, Tenaga. The government recently responded with creeping expropriation. A windfall tax on IPP profits was levied in early 2008. This was followed with an offer of a tax break to any IPP willing to renegotiate. This is a good example of currency risk subsequently triggering political risk.

Developing countries are particularly prone to political risk, because many of them still place the responsibility for tariff decisions on government executives. It may also be the case that executives make decisions on tariffs even in the presence of formal regulatory bodies. The risk of this happening is heightened during crises or some other political event. In countries such as Indonesia (after the Asian crisis) and Pakistan (after a change in government), government authorities set limits on tariffs after IPP contracts were renegotiated.⁹

The pattern of risk-allocation in a project (manifested in the contract) is itself a possible trigger of political risk. The large countries in Southeast Asia all had major difficulties with their IPPs during and after the Asian crisis, due to government-guaranteed off-takes in power purchase agreements (PPAs). All renegotiations of IPP contracts in the wake of the Asian crisis were due to the fact that PPAs passed currency and fuel risks to state-owned utilities (not an undue decision in itself. In many cases, currency risks should be passed onto the state, since the state has best control over the risk. States simply have to manage risks better by pursuing appropriate macroeconomic policies and being more prudent in contracting). The financial fragility of state-owned utilities suggests that government fiscal support, such as government guarantees, may also raise the risk of failure by significantly reducing incentives for stakeholders to conduct more thorough due diligence in projects; raising both moral hazard and adverse selection; and leading to potentially large and fiscally costly contingent liabilities (Reside 2001; Lewis and Mody 1997). The literature on government guarantees identifies a wide array of government fiscal support. This can range from government shouldering demand risk, exchange rate risk (all contractually explicit) or other risks.

Table 5 [ PDF 27.1KB | 1 page ] summarizes the different possible sources of political risk.

3.3.2 The Role of Risk Factors Endogenous to a Country's PPP System

Institutional and Contractual Triggers of Political Risk

Adverse selection and moral hazard contribute to the vulnerability of projects and proponents to macroeconomic shocks (and subsequently, to broad political risk).

Global PPP experience suggests that political risk can be heightened by institutional and contractual weaknesses, such as:

1. The quality and transparency of the system of contracting.
   

   In one case, the Philippine government was compelled to cancel an international airport contract in 2002, due to perceptions that the signed contract was detrimental to the interests of the state.

2. The capacity of government and state-owned enterprises to coordinate projects and bear some risks, especially fiscal risk.
   

   In another case, PPAs signed by state-owned utilities with IPPs featured agreements for guaranteed off-takes, but severe economic downturns led to a drastic deterioration in the utilities' financial positions (by causing the credit risk of the off-taker to decline). With national fiscal balances under severe threat as a result of potentially large debt and contingent liability implications, the governments of Indonesia and the Philippines decided to renegotiate the PPAs in 2002 and 2003, respectively.

Weaknesses in Project Planning, Design and Contracting

Aspects of project planning and design may also heighten political risk, such as:

1. The capacity of off-takers and customers to pay tariffs.
   

   Although retail prices for power had been raised in the Dominican Republic, many industrial and residential users refused to pay tariffs. The government itself missed payments regularly. Poor collection occurred since the tariff was already one of the highest in the region.

2. The political and public acceptability of the project, as well as the extent of public consultation performed for the project.
   

   In some cases, project design is not done through consultation, and is railroaded through the approval process. Customers subsequently lobby government to cancel the project or nationalize it.

The examples above suggest that political events, such as contract cancellations and nationalizations, can also be endogenous with respect to institutional and contractual weaknesses. This implies that political risk can arise from situations or events that can be controlled by either the government or the investor.

In addition, there is sufficient anecdotal evidence to suggest that weaknesses in project planning, design and contracting can contribute directly to project failure. It is well known that excessive demand forecasts, severe risk misallocation in contracts, and underestimation of project risks, can all contribute to failure (Flyvbjerg, Bruzelius, and Rothengatter 2003; Flyvbjerg, Holm, and Buhl 2002; Flyvbjerg, Holm, and Buhl 2005; Mackie and Preston 1998; and MacDonald 2002).

3.3.3 Other Determinants of Projects Outcomes

Apart from the different types of risk described above, a number of other factors can help determine the outcomes of a PPP projects. These include, among others:

1. The nature of institutional arrangements.
   

   Outcomes may vary depending on whether contracting is done with the federal or local governments). The federal government may have some advantages over local governments when contracting infrastructure projects (e.g., greater expertise with large projects, or greater clout when mobilizing national resources and cross-ministry coordination).

2. The nature of regulatory arrangements.
   

   It is well-known that compared to rate of return regulation, price caps create stronger incentives for achieving operational efficiency in projects. If the motivation to enhance efficiency is strong enough, it may have implications on project design and operations, as well as on project outcomes. On the other hand, rate of return regulation may be the modality preferred by private project developers.

3. The country's openness to trade.
   

   It may be the case that infrastructure outcomes in more open economies are superior to others because trade creates a natural demand for infrastructure (roads for access, ports, etc.), thereby reducing demand and other risks.

4. The nature of the sector involved.
   

   Outcomes may differ across primary sectors (energy, water, transport, telecoms), as well as across sub-sectors.

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