WORLD BANK TECHNICAL PAPER NO. 399 X l i,,,,,,,,, /)/'~i/Iu/ht ii{ii// As, 1W./ ,//b,/ ///I //hu//U, /uA/ ,\', /&, i,/ Work in progress V/TP3 9 for public discussion A joint production of the M arch 19 8 World Bank and the Inter-American Development Bank Concessions for Infrastructure .Z(/I /( toJ//zi ) Is irooll t lal .-w to R. I/i)/1L ('d W it/ Ro/w,i R. Iu'i/or /1/h/C f/h' (/t/l ( '// 0 I ill(h'/ A1lvi RECENT WORLD BANK TECHNICAL PAPERS No. 324 Cabraal, Cosgrove-Davies, and Schaeffer, Best Practices for Photovoltaic Household Electrification Programs No. 325 Bacon, Besant-Jones, and Heidarian, Estimating Construction Costs and Schedules: Experience with Power Generation Projects in Developing Countries No. 326 Colletta, Balachander, and Liang, The Condition of Young Children in Sub-Saharan Africa: The Convergence of Health, Nutrition, and Early Education No. 327 Valdes and Schaeffer in collaboration with Martin, Surveillance of Agricultural Price and Trade Policies: A Handbookfor Paraguay No. 328 De Geyndt, Social Development and Absolute Poverty in Asia and Latin America No. 329 Mohan, editor, Bibliography of Publications: Technical Department, Africa Region, July 1987 to April 1996 No. 330 Echeverria, Trigo, and Byerlee, Institutional Change and Effective Financing of Agricultural Research in Latin America No. 331 Sharma, Damhaug, Gilgan-Hunt, Grey, Okaru, and Rothberg, African Water Resources: Challenges and Opportunities for Sustainable Development No. 332 Pohl, Djankov, and Anderson, Restructuring Large Industrial Firms in Central and Eastern Europe: An Empirical Analysis No. 333 Jha, Ranson, and Bobadilla, Measuring the Burden of Disease and the Cost-Effectiveness of Health Interventions: A Case Study in Guinea No. 334 Mosse and Sontheimer, Performance Monitoring Indicators Handbook No. 335 Kirmani and Le Moigne, Fostering Riparian Cooperation in International River Basins: The World Bank at Its Best in Development Diplomacy No. 336 Francis, with Akinwumi, Ngwu, Nkom, Odihi, Olomajeye, Okunmadewa, and Shehu, State, Community, and Local Development in Nigeria No. 337 Kerf and Smith, Privatizing Africa s Infrastructure: Promise and Change No. 338 Young, Measuring Economic Benefitsfor Water Investments and Policies No. 339 Andrews and Rashid, The Financing of Pension Systems in Central and Eastern Europe: An Overview of Major Trends and Their Determinants, 1990-1993 No. 340 Rutkowski, Changes in the Wage Structure during Economic Transition in Central and Eastern Europe No. 341 Goldstein, Preker, Adeyi, and Chellaraj, Trends in Health Status, Services, and Finance: The Transition in Central and Eastern Europe, Volume I No. 342 Webster and Fidler, editors, Le secteur informel et les institutions de microfinancement en Afrique de l'Ouest No. 343 Kottelat and Whitten, Freshwater Biodiversity in Asia, with Special Reference to Fish No. 344 Klugman and Schieber with Heleniak and Hon, A Survey of Health Reform in Central Asia No. 345 Industry and Mining Division, Industry and Energy Department, A Mining Strategyfor Latin America and the Caribbean No. 346 Psacharopoulos and Nguyen, The Role of Government and the Private Sector in Fighting Poverty No. 347 Stock and de Veen, Expanding Labor-based Methodsfor Road Works in Africa No. 348 Goldstein, Preker, Adeyi, and Chellaraj, Trends in Health Status, Services, and Finance: The Transition in Central and Eastern Europe, Volume II, Statistical Annex No. 349 Cummings, Dinar, and Olson, New Evaluation Proceduresfor a New Generation of Water-Related Projects No. 350 Buscaglia and Dakolias, Judicial Reform in Latin American Courts: The Experience in Argentina and Ecuador No. 351 Psacharopoulos, Morley, Fiszbein, Lee, and Wood, Poverty and Income Distribution in Latin America: The Story of the 1980s No. 352 Allison and Ringold, Labor Markets in Transition in Central and Eastern Europe, 1989-1995 No. 353 Ingco, Mitchell, and McCalla, Global Food Supply Prospects, A Background Paper Prepared for the World Food Summit, Rome, November 1996 No. 354 Subramanian, Jagannathan, and Meinzen-Dick, User Organizationsfor Sustainable Water Services No. 355 Lambert, Srivastava, and Vietmeyer, Medicinal Plants: Rescuing a Global Heritage (List continues on the inside back cover) WORLD BANK TECHNICAL PAPER NO. 399 Finance, Private Sector, and Infrastructure Network Concessions for Infrastructure A Guide to Their Design and Award Michel Kerf with R. David Gray limothy Irwin Celine L&vesque Robert R. Taylor under the direction of Michael Klein The World Bank Washington, D.C. Copyright X 1998 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing March 1998 Technical Papers are published to communicate the results of the Bank's work to the development community with the least possible delay. The typescript of this paper therefore has not been prepared in accordance with the proce- dures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data in- cluded in this publication and accepts no responsibility for any consequence of their use. The boundaries, colors, de- nominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encourages dissem- ination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. ISSN: 0253-7494 Michel Kerf is a private sector development specialist in the Private Sector Development and Finance Group of the World Bank's Middle East and North Africa Region. R. David Gray is a consultant, Timothy Irwin is an economist, Celine Levesque is a consultant, and Robert R. Taylor is a principal financial analyst, all in the Private Participation in Infrastructure Group of the World Bank's Private Sector Development Department. Library of Congress Cataloging-in-Publication Data Concessions for infrastructure: a guide to their design and award / Michel Kerf... [et al]. p. cm. - (World Bank technical papers; no. 399) ISBN 0-8213-4165-0 1. Infrastructure (Economics). 2. Privatization. 3. Concessions. I. Kerf, Michel, 1965- . II. World Bank. III. Series. HC79.C3C66 1998 363-dc2l 97-50066 CIP Contents Foreword vii Acknowledgments viii Abstract ix 1 Introduction 1 1.1 Defining Concessions 1 1.2 Early Concessions 1 1.3 The Rationale for Concessions 3 1.3.1 Natural Monopoly 3 1.3.2 Natural Monopoly and Infrastructure 3 1.3.3 Concessions and the Reform of Market Structure 4 1.3.4 Reputation 5 1.3.5 Exclusivity 5 1.4 A Comparison of Different Types of Concessions 6 1.4.1 Types of Concessions 6 1.4.2 Similarities and Differences 7 1.4.3 Differences between Concessions and Other Rights 7 Notes 8 2 The Broad Environment for Concessions 9 2.1 Government Organization 9 2.1.1 Government Responsibilities for Concessions 9 2.1.2 Costs of Government Disorganization and Guiding Principles for Improved Operations 9 2.1.3 Degree of Decentralization in Government Organization 10 2.1.4 The Use of Cross-Sectoral Regulatory Frameworks 14 2.1.5 Government Organization: Illustrations 14 2.2 The Broader Legal and Regulatory Environment 16 2.2.1 Threshold Legal Impediments to Private Participation 16 2.2.2 Property and Land-Use Rights 17 2.2.3 Environmental and Safety Laws 18 . iv Concessionsfor Infrasmructure: A Guide to Their Design and Award 2.2.4 Labor and Immigration Laws 18 2.2.5 Competition Law and Policy 20 2.2.6 Business Operation Provisions 20 2.2.7 Enforcement Provisions 20 Notes 20 3. Concession Design 21 3.1 Introduction 21 3.1.1 StrikingaBalance 21 3.1.2 General Overview of Concession Contracts 21 3.1.3 The Main Principles of Risk Allocation 23 3.1.4 Certainty Versus Flexibility 25 -3.2 Allocation of Responsibilities 28 3.2.1 Main Design Issues 28 3.2.2 Some Lessons of International Experience 28 3.3 Price Setting 29 3.3.1 Main Design Issues 29 3.3.2 The Role of Prices 30 3.3.3 Is Marginal Cost Pricing the Solution? 31 3.3.4 Cost-Covering Tariffs 32 3.3.5 Dealing with Subsidies 34 3.4 Price Adjustment 35 3.4.1 Main Design Issues 35 3.4.2 Basic Principles of Price Adjustment 36 3.4.3 Main Pricing Rules 37 3.5 Specific Performance Targets 43 3.5.1 Main Design Issues 43 3.5.2 Rationales for Imposing Performance Targets 43 3.5.3 Lessons of Experience 44 3.6 Penalties and Bonuses 45 3.6.1 Main Design Issues 45 3.6.2 Lessons of Experience 46 3.7 Public Parties' Security Rights 47 3.7.1 Main Design Issues 47 3.7.2 Performance Bonds and Similar Tools 47 3.7.3 Step-In Rights 48 3.7.4 Insurance 48 3.8 Duration, Termination, and Compensation 49 3.8.1 Main Design Issues 49 3.8.2 Duration and Termination: What Happens in Practice 49 3.8.3 Scheduled and Unscheduled Termination: Rationale and Drawbacks 50 3.8.4 Options 51 3.8.5 Compensation Rules 52 3.9 Force Majeure and Other Unforeseen Changes 53 3.9.1 Main Design Issues 53 3.9.2 Categories of Unforeseen Changes 54 Contents v 3.9.3 Mechanisms to Deal with Unforeseen Changes 55 3.9.4 Who Should Bear the Risks? 56 3.10 Dispute Settlement 57 3.10.1 Main Design Issues 57 3.10.2 Basic Challenges of Dispute Settlement 57 3.10.3 Dispute Settlement Mechanisms 58 3.10.4 Summary 61 3.10.5 Focus on International Arbitration 62 Notes 65 4 Concession Award 67 4.1 Choosing the Method of Award 67 4.1.1 Competitive Bidding 67 4.1.2 Direct Negotiations and Unsolicited Proposals 68 4.1.3 Competitive Negotiations 70 4.2 Prequalification and Shortlisting 72 4.2.1 The Operator's Experience 73 4.2.2 Prequalification Criteria 73 4.2.3 The Operator's Participation 73 4.2.4 The Timing of Prequalification 75 4.2.5 Transfer of the Concession 75 4.3 Bid Structure and Evaluation 75 4.3.1 Technical Proposals 76 4.3.2 Financial Proposals 77 4.3.3 Negotiations 79 4.4 Bidding Rules and Procedures 79 4.4.1 Use of a Reserve Price 80 4.4.2 Sealed Versus Open Bids 80 4.4.3 Simultaneous, Sequential, and Multiple-Round Bidding 81 4.4.4 Bid Bonds 82 4.4.5 Cost-Sharing 82 Notes 82 5 Regulatory Institutions 83 5.1 Introduction 83 5.2 Establishing Independent Regulators 83 5.3 Reconciling Independence with Accountability 85 5.4 Dealing with Constrained Regulatory Capacity 85 5.5 Determining the Functions of Utility Regulators 86 5.5.1 Main Principles 86 5.5.2 Utility Regulators' Roles with Respect to Ministers 87 5.5.3 Utility Regulators' Roles with Respect to Other Regulators 87 5.5.4 The Breadth of Regulators' Authority 88 5.6 Decisionmaking Structure, Procedural Considerations, and Implementation 89 5.6.1 Individual Decisionmaker or Commission 90 vi Concessionsfor Infrastructure: A Guide to Their Design and Award 5.6.2 Opportunities for Participation by Regulated Firms, Users, and Other Interest Groups 90 5.6.3 The Review Process 90 5.6.4 The Timing of Implementation 91 5.7 Finding Alternative Strategies 92 Notes 93 6 Government Support 94 6.1 Types of Government Support 94 6.2 Rationale and Design Issues 94 6.2.1 First Assertion: The Existence of Uninsurable Political Risks 95 6.2.2 Second Assertion: Some Services Should Be Provided Below Costs 98 6.2.3 Third Assertion: The Government Can Bear Risk at Lower Cost 98 6.3 Government Contingent Liabilities 99 6.3.1 Valuation and Budgeting 99 6.3.2 The Institutional Framework 99 6.3.3 Risk Management 100 Notes 101 Annex 1: Choice of Regulatory Instruments 102 Annex 2: A Guide to Power Purchase Agreements 106 Annex 3: Organization of American States Members of IC SID, New York, and Panama Conventions 116 Annex 4: Lenders' Security Rights 117 Annex 5: Investment Insurance Programs 120 References 129 Foreword In recent years countries around the world have government the right to provide a particular ser- met the challenge of developing and maintain- vice. Concessions can be used to create competi- ing critical infrastructure by restructuring pub- tion for the market under conditions in which the lic utilities and expanding private sector service provider has significant market power. participation in the infrastructure sectors. Concession arrangements can take any number of Recognizing the importance of adequate infra- forms involving the shifting of risks and responsi- structure services, such as power, telecommunica- bilities from the public to the private sector. tions, transport, water supply, and sanitation, for Concession arrangements entail a myriad of the development of industry and the quality of life, legal and economic issues, including the organiza- and given the constraints on public budgets to tion of government entities responsible for con- finance these growing infrastructure needs, gov- cession programs and the adequacy of the broader ernments have sought to shift part of the burden legal and regulatory environment. The design and of new infrastructure investment to the private sec- implementation of concession contracts that allo- tor. In addition, private sector involvement can cate risks and responsibilities and the mechanisms bring increased efficiency in investment, manage- for evaluating and awarding projects are also of ment, and operation. And restructuring utilities paramount importance. The government's role as along competitive lines has demonstrated the regulator and as a provider of support for infra- enormous potential benefits to governments and structure concessions must also be assessed. While consumers of unshackling competition for improv- some countries have established extensive conces- ing and expanding infrastructure services. sion programs, others are just beginning to develop Many countries have enlisted private sector these programs. This report provides a guide to the participation in infrastructure through the use of complex range of issues and options involved in concession contracts with private operators and the implementation of concession arrangements, developers. A concession, broadly defined, is a drawing on the experience of both industrial and legal arrangement in which a firm obtains from the developing countries. Nemat Shafik Bernardo Frydman Director Deputy Manager Private Sector Development and Finance Group Private Sector Department Middle East and North Africa Region Inter-American Development Bank vii Acknowledgments T his report was conceived jointly by the Inter- Ezequiel Machado, Terry Powers, and John AmericanDevelopmentBankandtheWorld Cahillane of the Inter-American Development Bank. It was prepared by the Private Bank. Valuable assistance and comments were also Participation in Infrastructure (PPI) Group of the given by Penelope Brook Cowen, Pierre Guislain, World Bank's Private Sector Development Neil Roger, and Warrick Smith. Chapters 5 and 6 of Department and benefited greatly from comments this report draw extensively on previous work by provided at several stages by Bernardo Frydman, Michael Kein and Warrick Smith. vimi Abstract lrhis report is not a step-by-step guide on how petitors helps ensure that direct competition will to negotiate concessions. Nor is it an take place wherever possible and can pressure the attempt to identify model contracts or incumbent to maintain good performance. In clauses. Rather, it aims at helping policymakers addition, many of the objectives pursued through and their advisers to better understand some of the the granting of exclusive rights-such as making most important and difficult issues related to the deals more attractive to private operators or ensur- design, award, implementation, monitoring, and ing that some redistributive social goals are met- modification of concessions. Here, we broadly can often be achieved through other means. define concessions as any arrangements in which a While many aspects of a concession are trans- firm obtains from the government the right to pro- action- or sector-specific, several key principles vide a particular service under conditions of sig- related to the award, design, or monitoring of con- nificant market power. cessions are substantially identical across sectors. While it is impossible to succinctly summarize There will often be important advantages in clearly the muliple issues discussed in the report, and specifying such principles in cross-sectoral laws or while in many cases there is no single "best" answer regulations applicable to private infrastructure to a particular question, some key recommenda- schemes in general. tions emerge. They deserve to be emphasized. The The allocation of risks between the involved following ten recommendations constitute a parties is at the core of concession design. While nonexhaustive list: theoretical principles are well-known-risks The main rationale for concessions is that they should be borne by the party best able to control, can facilitate the regulation of natural monopolies. manage, or hedge against them-their application In markets that are naturally competitive, direct in practice often raises numerous difficulties. A competition between firms can usually work well careful analysis will often be necessary to distin- without recourse to concessions. Before awarding guish between costs that are truly exogenous to the concessions, governments should therefore first operator (that is, those against which the company determine whether competition can be made to cannot protect itself) and those that are not. Only work in the relevant activities, possibly through exogenous costs should be passed on to other par- reforming the market structure. ties such as consumers, suppliers, or the conceding Governments often grant exclusive rights to authority. the concessionaire. But, in many cases, this may Striking an adequate balance between certainty not be desirable. Permitting entry by new com- and flexibility is another main challenge of conces- ix x Concessionsfor Infrastructure: A Guide to Their Design and Award sion design. Performance targets, for example, can people with sufficient technical capabilities. be designed so as to allow for renegotiations under Establishing specialized, cross-sectoral regulatory specific, preestablished procedures. Usually, they bodies that are independent of the government is should focus on the end results to be achieved often advantageous in this respect. When such rather than on the means to be used in order to pre- solutions are politically unacceptable, a range of serve the flexibility of the concessionaire's opera- incremental or alternative approaches can be con- tional arrangements. sidered. Protecting the poorest users is often a major The fact that the financial cost of raising capi- objective of the tariff regime. Cross-subsidies, tal is lower for the government than for private which arewidely used to pursue this objective, tend investors is often presented as an argument in to be distortionary, anticompetitive, and nontrans- favor of government participation in infrastructure parent. International experience demonstrates that projects. But, the argument is flawed for a number there are numerous alternatives, such as financing of reasons. First, the government's lower cost of such subsidies through the budget or through spe- capital reflects its ability to resort to taxation to cial funds, which present fewer drawbacks. repay its debts, not the inherently lower economic Competitive award mechanisms are generally costs of government-funded projects. Second, civil preferred. In some circumstances, however, nego- servants often have less incentive to invest wisely tiated procedures may be more suitable. In such than private project managers. Finally, government cases it will be important that some safeguards, participation in infrastructure projects alongside such as benchmarking or allowing other develop- private investors might distort these investors' ers to better the proposed terms, be built in to incentives to maximize overall project returns. ensure transparency and efficiency Concessioning infrastructure services is always Even when concessions incorporate detailed a complex exercise that raises new sets of questions and specific rules, there is still a need for at least and problems for the administration. It is some degree of regulatory discretion. The chal- absolutely essential for governments to retain qual- lenge, then, is to protect the regulatory process ified and experienced experts who are able to pro- from both industry and short-term political pres- vide sound advice on the range of issues discussed sures and to ensure that the regulator has access to in this report. CHAPTER 1 Introduction T he past 15 years have witnessed a funda- For our purposes the following arrangements mental change in the way governments may be counted as concessions: leases, affermages think about infrastructure. In rich and poor (a form of lease used widely in France), build- countries alike private ownership and operation operate-transfer contracts (BOTs), and divesti- have been replacing public provision, while tures with revocable licenses to operate. When we monopoly has been giving way to competition. refer to concessions in the narrower sense, in which Concessions have played a central role in these the concessionaire has investment responsibilities, changes. The concession documents themselves we use pure concession or concession stricto sensu. At have been used to specify the rights and obliga- the same time there may be arrangements com- tions of the private firms, while the bidding monly called concessions that fall outside the processes that have been used to award conces- scope of this report: concession might be used to sions have brought competitive pressures to bear refer to the rights to operate in a market, even in previously sheltered industries. when those rights are not limited in number and thus confer no market power. 1.1 Defining Concessions 1.2 Early Concessions Throughout the report we use concession broadly to refer to any arrangement in which a firm Concessions have gained in popularity recently, obtains from the government the right to provide but they are an old innovation. The modern theory a particular service under conditions of signifi- dates back at least to the nineteenth century and cant market power. A concession is thus a device Edwin Chadwick's (1859) discussion of competi- that can be used to create competition for a mar- tion for the market. The famous nineteenth cen- ket, when competition in the market is not oper- tury economist Alfred Marshall outlined the case ating. Indeed, for the purposes of this report, for concessions as follows: concessions can be thought of as legal arrange- ments suitable for creating competition for a A public authority may be able to own the market. franchise and, in some cases, part of the fixed According to this definition, concessions need capital of a semi-public undertaking, and to not involve the private sector, since governments lease them for a limited number of years to a can award concessions to public enterprises. Corporation who shall be bound to perform Concessions are typically given to privately owned services, or deliver goods, at a certain price companies, however, and concessions to private and subject to certain other regulations ... the firms are the focus of this report. special point of the proposal is that, where 1 2 Concessions for Infrastructure. A Guide to Their Design and Award possible, the competition for the franchise unregulated, commercially risky environments. They shall turn on the price or the quality, or both, had franchises, but no exclusive rights to serve. of the services or the goods, rather than on Although they were subsequently regulated and the annual sum paid for the lease. (quoted in protected from competition, they remained private. Ekelund and Hebert 1981: 471) In the gas sector in the United Kingdom, to take another example, exclusive franchises were never The practice of concessions dates back even legalized, and by 1850, 14 separate private gas com- further, however, to the middle ages (see panies were operating over the whole London Bezancon 1995). Moreover, in the past two cen- metropolis (Foreman-Peck and Milward 1994). turies infrastructure networks in water, power, The transport sector offers many early exam- gas, and rail were often developed by private ples of private infrastructure construction and firms that, incidentally, bore substantial market operation. In France the king concessioned roads risk with limited protection from competition. and bridges. The concessionaires collected tolls in We mention a few early concessions below with- return for maintaining the routes-often being out trying to be comprehensive or necessarily criticized for doing the former with more zeal than representative. the latter. Canals were also built in France under Private companies developed much of the early concessions as early as the seventeenth century. water infrastructure in France, Britain, and the The concession document established the tariff United States. In 1777, for example, the French that could be charged and the timetable for con- government gave the Perrier brothers a 15-year con- struction; the entrepreneurs building the canal cession to collect and distribute water to households bore market risk. Later, in many Latin American in parts of Paris. They took the water from the Seine countries such as Argentina, Brazil, and Uruguay, using English-made pumps, transported it through private developers from Britain, France, and the pipes of wood and steel, and then delivered it in bar- United States built many of the early railways. The rels-that is, until they ran into financial trouble and history of rail in Mexico illustrates the commnon their firn was nationalized (Benzancon 1995). The cycle of public and private ownership: next century saw the founding of the well-known French firms, Compagnie Generale des Eaux and The Diaz regime undertook initially to pro- Lyonnaise des Eaux. mote railways either directly or through sub- In London there were as many as six private sidies to state governments; but the results water companies operating by the 1820s were slow to appear. So after 1880 policy (Foreman-Peck and Millward 1994). And in the shifted to subsidies to private companies, United States at the dawn of the nineteenth cen- partly in the form of land grants, which tury, 15 of the 16 waterworks that had been con- attracted substantial amounts of British and structed were private. By the end of the century, American capital. Private construction by however, governments had become the dominant numerous companies produced a rather force in water supply, at least in the cities (Jacobson disorganized network with considerable and Tarr 1995:11). duplication of routes. So government grad- Local private firms were responsible for devel- ually attempted to consolidate companies oping most of the electricity utilities in Brazil, Chile, and buy out part of their capital. The even- Costa Rica, and Mexico-Colombia being the only tual result was a national railway system exception among a group of five reviewed in one (Ferrocarriles Nacional de Mexico, formed study of the development of the industry (Cavers in 1909), with majority government owner- and Nelson 1959). The same was true of the United ship but continuing private participation States. The early power companies were privately from the United States and Great Britain owned and they operated in competitive, largely (Reynolds 1985: 99-100). Introduction 3 Later, the Mexican railways were completely down and limit profits. Moreover, the govern- nationalized. Now, they are being privatized again. ment does not need to estimate the lowest prof- In the United States a similar story emerges. Most of itable water price and then regulate to prevent the the public transit systems built in the late nineteenth monopoly supplier from charging a higher price; century were private, as were many roads. According through competitive bidding, the firms reveal to one account, the "heyday of privately owned and that price themselves. Since firms usually have operated roads supported by user fees came during better information than regulators, the price that the early decades of the nineteenth century. Many arises from competitive bidding is probably the roads were built and maintained by state-chartered best available estimate of the appropriate price. turnpike companies. . . [But] partly as a result of Second, a concession encourages firms to pro- competition from canals and railroads by the 1860s, duce water cheaply, since inefficient firms cannot most private toll roads had been turned over to states win the bidding and remain profitable. To win, and counties for operation from general tax rev- firms are forced to offer a price for water not enues" (acobson and Tarr 1995:3).1 much higher than their cost of supplying it. The firm that wins is therefore likely to be one of the 1.3 The Rationale for Concessions most efficient.2 What about industries that are neither natural Concessions should be used in areas where they monopolies nor highly competitive but are most are most likely to aid development. Although they efficiently served by, say, just two firms? If the gov- can be used in any industry and were, for example, emient knew the industry was best served by just used in France to license butchers and bakers in two firms and knew that these firms would charge the Middle Ages, they are most likely to help devel- high markups in the absence of regulation, it opment when they are used to regulate natural might be beneficial to award two concessions for monopolies-that is, services that can be provided the industry. The award of the concession could more cheaply by a single firm than by two or more. then be used to create competition for the market, where competition in the market would operate 1.3.1 Natural Monopoly but not very effectively. This reasoning may under- lie the award of a small number of licenses in When markets can be served efficiently by several mobile telecommunications. Concessioning firms-when they are naturally competitive-ordi- seems less likely to improve on free entry and nary competition usually works well. But when unregulated prices in such cases than in naturally they are naturally monopolistic ordinary, head-to- monopolistic industries, however, since the mar- head competition does not operate. Competitively ket failure is smaller and more likely to be out- auctioned concessions in these industries allow weighed by regulatory failure. some of the benefits of competition to be brought to bear in the absence of direct competition 1.3.2 Natural Monopoly and Infrastructure between firms. That is, they substitute competition for the market for competition in the market. The following infrastructure sectors are usually Take, for example, a water concession considered natural monopolies and are therefore awarded to the bidder offering to supply water at the most suitable candidates for concessioning: the lowest price to consumers. If it is well- designed, it encourages efficiency in two ways * Water distribution. that parallel the effects of competition in the mar- * Power transmission and distribution (as ket. First, it leads firms to offer to sell water at a opposed to power retailing or "supply"). price that covers their costs but not much more- * Gas transmission and distribution (as opposed just as ordinary competitive pressures keep prices to gas retailing). 4 Concessions for Infrastructure: A Guide to Their Design and Award * Railway infrastructure (the tracks and stations, ing to a concession. for example). * Roads. 1.3.3 Concessions and the Reform of Market Structure Other infrastructure businesses, however, are potentially competitive, and concessions may not Since one infrastructure sector may contain poten- be the best solution for them: tially competitive and inherently monopolistic seg- ments, it is sometimes useful to unbundle the * Power generation. segments (see table 1.1 for some examples). Then, * Gas production. competition in the market may work more effec- * The retail supply of both gas and power. tively in the competitive sectors, while competition * Long-distance and mobile telecommunications. for the market is used for the naturally monopolis- * Rail services (as distinct from the tracks). tic sectors. Within the potentially competitive sec- tors an existing company may also be broken up Concessions are not necessarily the wrong into several competing firms. option in these sectors. Although power genera- Before awarding concessions in an infrastructure tion is potentially competitive in most countries, sector, therefore, governments should consider what for example, some electricity markets may be too is the best structure for that industry. Does it make small to support effective competition in the sense to unbundle the industry vertically-separat- market. In those markets, a competitively ing an upstream segment, such as generation, from awarded concession may be the best option. But a downstream segment, such as transmission? Does in the potentially competitive industries listed it make sense to unbundle some of the segments hor- above governments should think carefully about izontally-creating, for example, several generation whether ordinary competition can be made to companies out of one? Only when these questions work by reforming market structure before turn- have been answered should concessioning begin. Table 1.1 Examples of Market Structure Reform Sector Reform Country examples Power Separating generation from transmission Argentina, Australia, Colombia, and creating competition in generation New Zealand, United Kingdom Permitting free entry in generation The countries above plus the United States Gas Separating production and supply Argentina, Colombia, Mexico from transmission and distribution Permitting free entry in gas transmission Chile, Germany, New Zealand Telecommnunications Separating local from long-distance service Argentina, Hong Kong, United States Permitting free entry in basic services Australia, Chile, New Zealand, United Kingdom Rail Separating infrastructure (track) from Sweden, United Kingdom rolling stock Separating railway lines by Argentina, Mexico geographical region Source: World Bank staff. Introduction 5 1.3.4 Reputation the 1930s (Guislain 1997: 210). And there are sev- eral modern instances of firms in naturally monopo- Concessions generally have a limited term, at the listic infrastructure industries that do not enjoy legal end of which they are put out to bid again. When protection from competition. In Germany and Chile the incumbent concessionaire has the opportunity gas transmission companies have no legal monopoly. to compete in the rebidding, it has an extra incen- In New Zealand exclusive legal franchises have now tive to perform well during the term of the original been removed for most infrastructure services, concession, since by performing well, it improves including the transportation of gas and electricity, at its chances of being awarded the concession both the transmission and distribution levels. again.3 If one firm competes for many concessions, it has a further incentive to perform well in order 1.3.5.2 Should governments grant exclusivity? to qualify as a bidder for other concessions. Although it is common for governments to grant Governments can therefore better harness the exclusivity, it is not clear whether governments aid benefits of reputation by awarding several conces- development by doing so.5 The arguments for not sions in a single industry, each for a different granting exclusivity are, on the face of it, strong. region, and permitting international firms to com- Even in natural monopolies the threat of entry can pete for local concessions, since these companies sometimes spur an incumbent monopolist to per- have valuable reputations they want to protect.4 form better. (Technically, the threat of entry will be more valuable the more contestable is the mar- 1.3.5 Exclusivity ket-or the smaller are the sunk costs of entry into the market.) New firms may choose not to enter, Concessions are best suited, we have said, to indus- but their ability to do so if the incumbent offers tries that are natural monopolies. A question that poor value for money keeps the latter on its toes. arises is whether concessions for natural monopo- Similarly, the possibility of entry by other firms can lies should confer a legal monopoly. encourage an incumbent to extend service to unserved areas within the franchise boundary 1.3.5.1 What happens in practice? Most often, more quickly than it would otherwise-to ensure concessions give the winning firm the exclusive right that it does not lose business. to provide the service in question, and this legal Moreover, permitting entry reduces the costs of monopoly typically endures for the length of the mistakenly concessioning an industry that turns concession. There are, however, exceptions. out to have been-or because of technological First, the period of exclusivity sometimes ends change becomes-naturally competitive. If the before the concession. One example is the industry really is naturally monopolistic, exclusiv- Venezuelan telecommunications concession, in ity may make no difference. But if the industry which the holder of a 30-year concession has exclu- turns out to be potentially competitive, exclusivity sive rights for just 9 years. Another is the prevents helpful competition. Abidjan-Ougadougou (C6te d'Ivoire-Burkina Faso) What are the arguments for granting exclusiv- railway concession, which gives the concessionaire ity? At least three can be made. the exdusive right to run trains on the tracks for the first 7 years of the 15-year concession, after which * Sometimes concessionaires are required to other operators must be permitted to enter (Mitchell offer services at low prices to households but and Budin 1995). can charge businesses more. Other times, they Second, some concessions give no legal monop- are required to charge everyone the same price, oly at all. In addition to the early power franchises in even if the costs of service differ-as may hap- the United States, Compafiia de Telefonos in Chile pen when remote rural customers pay the same was awarded a 50-year nonexclusive concession in as city dwellers. At still other times existing cus- 6 Concessionsfor Infrastructure: A Guide to Their Design and Award tomers may subsidize the cost of expanding the 1.4 A Comparison of Different Types of network to reach new customers. In all of these Concessions cases exclusivity prevents new firms from undercutting the prices paid by the over- Concessions in the broad sense used here come in charged customers and thereby depriving the different guises. As well as pure concessions (con- concessionaire of the revenue needed to subsi- cessionsstncto sensu), there are arrangements called dize the others. Using the jargon, it prevents franchises, operating concessions, management cherry-picking or cream-skimming. contracts, leases, affermages, BOTs, and so on. * Because competition tends both to lower firms' The names are not always applied consistently, nor profits and introduce new risks, exclusivity rights are they always helpful. What really matter are the make concessions more attractive to potential incentives and opportunities created by the con- bidders and their financiers. The government can tracts. therefore concession an exclusive business more easily or get more money for it. When other cir- 1.4.1 Types of Concessions cumstances are unfavorable-because of severe political risk, for example-exclusivity might One key difference among various concession make or break a deal. arrangements is the nature and extent of the risk * Finally, exclusivity can prevent second and they transfer from the government to the conces- third firms from inefficiently entering indus- sionaire, and we can classify them accordingly, tries that are naturally monopolistic (that is, most efficiently served by just one firm). Management contracts with incentive payments. Although the threat of entry may be helpful, its When management contracts provide for a per- occurrence may be wasteful. In the nineteenth formance-related payment, part of the operating century, for example, competing companies risk of the business may be transferred from the laid parallel water pipes in the United Kingdom government to the concessionaire, since the con- and parallel railway lines in Germany, which on cessionaire's profits may vary with the operating the face of it seems inefficient.6 performance of the company. But significant operating risk remains with the government as These arguments are correct, as far as they go. Yet long as the government's financial returns still they do not by themselves imply that concessionaires depend on the firm's operating profits. should have exclusive rights to serve. Although Leases. In a lease, as we use the term, the con- exclusivity can resolve certain problems, there may cessionaire is paid no fee by the government. be better solutions. Legal monopolies are only one The concessionaire's profits depend directly on way of permitting one class of customers to subsidize the operating profits of the firn. Operating risk anotherin order to achieve redistributive goals; there is thus fully transferred to the concessionaire. are others that are generally less costly (see section The government still maintains responsibility 3.3.5). Similarly, there may be other ways of increas- for investment and thus bears investment risk. ing the attractiveness of a concession to bidders that * Pure concessions, BOTs, and rehabilitate-operate- are less harmful than exclusivity-such as improving transfers (ROTs). In these arrangements the con- the regulatory regime and eliminating costly invest- cessionaire undertakes investments as well, and ment obligations. And although there may be cases both operating and investment risks are sub- in which inefficient entry would occur without exclu- stantially transferred to the concessionaire.7 sivity, the government needs to weigh this risk against the risk of stifling beneficial competition. Some inef- There is also a distinction between retail and ficient entry and duplication may be a price worth wholesale concessions. In a retail concession the paying for the benefits of competitive pressure. concessionaire sells services to the public. Introduction 7 Distribution concessions- in electricity, water, 10 years' notice, even if the company has done telecommunications, and gas are examples. In a nothing wrong.8 The two systems are thus much wholesale concession the concessionaire sells to more similar than they might seem. another entity (often a government agency or The possible resemblance between divestiture state-owned enterprise), which in turn sells to the and concession raises another issue. Sometimes gov- public. Concessions for independent power pro- ernments believe that the best policy would be to jects and for bulk water supply are examples. The "fully privatize" a given public enterprise, but fear concessionaire's rights and obligations and the that "privatization" would be too unpopular. As a risks it bears tend to vary systematically between result, they may choose to lease or concession the retail and wholesale concessions. business instead. As the previous discussion sug- gests, however, there may be little practical differ- 1.4.2 Similarities and Differences ence between policies described as divestitures and those described as concessions. What both the gov- Because the detailed contractual provisions con- eminent and its critics should be concerned about cerning risk transfer, duration, exclusivity, and so are the details of arrangements. on are what matters, contracts with different Finally, contracts that go under a single name names can have similar effects. A contract called a may have quite different effects. Contracts concession, for example, may closely resemble one described as concessions, for example, typically called a management contract in its incentive effects transfer investment risk to the concessionaire. But if its contractual clauses effectively guarantee the not all operators of concessions have investment concessionaire revenue and compensate it for cost obligations. increases. These possibilities imply that in designing or Further, a divested business needing a license analyzing a concession one must look beyond the to operate may be in much the same position as a arrangement's name and consider the details of its firm with a fixed-term lease. British and French provisions relating to rights, obligations, andthe water policies illustrate the point nicely. Although allocation of risk. It does not imply, however, that the British system is described as a divestiture and the legal instrument used to concession infrastruc- the French as concessioning, the two regimes may ture is irrelevant. A country's laws may treat dif- have similar economic effects. In Britain the gov- ferently two arrangements with seemingly similar emnment sold water-distribution assets to private functions. Some arrangements, for example, may companies, whereas in France local governments be governed by administrative law, others by the remain the legal owners of the assets and lease law of private contracts, with significant implica- them to private water companies for limited peri- tions for the modification or enforcement of the ods of time. When the lease expires, typically contract. In Turkey the government wanted con- after 15 to 30 years, the local government re- tract law to govern its BOT contracts with private awards it, possibly to a different company. On the power producers, but was frustrated by a finding surface, the two policies may thus seem quite of the Turkish courts that the arrangements were different. concessions under the Turkish constitution and Yet in practice the French companies seldom therefore subject to administrative law. lose their concessions when they are rebid, and the British companies have no guarantee of continued 1.4.3 Differences between Concessions and Other operation. The divested British firms need a Rights license to operate, and the licenses they were given at the time of privatization will expire after 25 Concessions must be distinguished from other years, in 2014. After that date the government can rights that business may need in order to oper- revoke a company's license, as long as it has given ate. For example, a power concessionaire must 8 Concessions for Infrastructure: A Gude to Their Design and Award be able to string wires over land that it does not 5. lIf the government expects firms to bid for a con- own, and a water concessionaire must lay pipes cession, it must give them something of value. under other people's land. Similarly, companies Frequently that thing is an existing business. But if the may need town-planning, resource-use, or other government has no existing business to give to the environmental permnits to carry out their business winning bidder, it is hard to see how a concession is possible without exclusivity. A concession to supply efficiently. These permissions may require electricity to a currently unserved town could not be approval from a government agency distinct awarded, for example, unless it conferred exclusive from the conceding authority. They are discussed rights upon the winner. Otherwise, interested firms in section 2.2. would have no need for the concession and instead of bidding for it would simply start up business. The Notes question that arises in this case is whether the govern- ment should award an exclusive concession or instead 1. For a historical perspective of the cycle of public rely on free entry and private ownership in infrastructure see Klein and 6. Economists have shown theoretically that in cer- Roger (1994). tain circumstances more than one firm will be able 2. For more on the rationale for concessions, see profitably to enter a naturally monopolistic industry, Dnes (1995). even though provision by just one firm would be 3. For more on the award and re-award of conces- cheaper. See Train (1991). sions see chapter 4 and section 3.8, respectively. 7. For more on these different types of contracts, 4. For more on reputation and concessions see see Guislain and Kerf (1995). Zupan (1989). 8. See http://wwwopen.gov.uk:80/ofwat/appt.htm. CHAPTER 2 The Broad Enivironment for Concessions T he success of a concession depends not only developers and thus multiply costs or stop projects on the details of the contract or license but from going ahead. For example, unclear assign- also on the adequacy of the broader legal and ment of authority to grant concessions and adopt institutional environment governing the conces- related support measures or overly complicated sion's design, award, and operation. This chapter and undefined approval processes can prevent con- looks first at how governments can best organize cessions from developing smoothly (box 2.2). themselves to manage the process of designing and Governments should try to implement the fol- awarding concessions, and then at laws and regula- lowing principles in order to improve the way they tions that affect the operation of concessions. manage concessions: 2.1 Government Organization * Effective coordination of relevant government policies and approvals. The interface between the government and the * Clarification of roles and responsibilities with private sector is key to the success of private infra- respect to private investors. structure arrangements. Governments need to per- * Acquiring access to the expertise required to form numerous tasks when planning, designing, design and implement complex transactions. implementing, and regulating concessions. And inefficient organization can result in substantial cost The design and implementation of concessions to the government, developers, and consumers. requires the coordination of several governmental actors. Sectoral ministries will usually be responsi- 2.1.1 Government Responsibilities for Concessions ble for developing overall sectoral policy, finance ministries will usually have a close interest in the The functions that governments must perform public revenue or liability implications of particular regarding concessions span a wide range, from the projects, and environmental ministries or authori- establishment of an enabling environment to the ties may have an interest in projects, as may min- award of specific concessions and their regulation istries of justice, competition authorities, and (box 2.1). others. Some coordination will often also be neces- sary between actors at central, provincial, and 2.1.2 Costs of Government Disorganization and municipal governments regarding, for example, Guiding Principles for Improved Operations necessary approvals or the granting of guarantees. When the government does not effectively A lack of definition and transparency in government coordinate all relevant actors, it risks sending mixed processes can increase uncertainty for investors and signals to private investors and causing delays, 9 10 Concessions for Infrastcture: A Guide to Their Deszgn and Award Box 2.1 A Sample of Government Responsibilities for Concessions Framework Determining the form of governrment support * Adopting legal provisions to enable the grant- for the project. ing of concessions. Design of the concession arrangements * Establishing or identfying regulatory authorities. S Choosing legal instruments. * Managing government support to infrastruc- a Alocating responsibilities. ture projects. * Choosing and designing pricing rules and per- * Managing public relations and information. formance targets. Project identification and analysis * Determining bonuses and penalties. * Identifying projects amenable to concessions * Determining duration and termination. (including in-house and unsolicited proposals). * Designing adaptation mechanisms to new or * Prioritizing projects amenable to concessions. unforeseen circumstances. * Hirng advisers. * Choosing and designing a dispute settlement * Performing a preliminary review of the costs mechanism. and benefits of the project (without dupli- cating the analysis to be performed by the Concession award private sector), especially in cases where the * Choosing the method of award. government will be assuming part of the mar- Making decisions regarding prequalification ket risk. and shortlisting. * Reviewing legal and regulatory issues. * Determining bid structure and evaluation me- * Determining preliminary selection criteria. thod. * Granting permission for the project to go ahead * Determining bidding rules and procedures. (for example, for the opening of the bidding * Proceeding with the bidding. process). * Negotiating. * Setting a timetable for the project. Exercise of regulatory function Enabling and supporting measuresfor specific projects * Implementing regulatory rules. * Granting permits and other necessary author- * Supervising and monitoring. izations (such as environmental permits, rights * Enforcing rules (for example, imposing penal- of way). ties). Source. Klein,So,andShin (1996);Fishbein andBabbar(1996);andWorldBankstaff. either of which can deter investors or increase these areas can prevent the establishment of mutually development costs substantially.When several large beneficial and sustainable private infrastructure transactions are envisaged, governments should arrangements. consider establishing an explicit sequencing plan to All countries undertaking major private infra- help in marketing the projects and to avoid over- structure arrangements-industrial and develop- burdening local financial markets. ing countries alike-must hire outside expertise Investors will want to know what entities are from investment bankers, lawyers, and others. responsible for providing what approvals and While detailed technical expertise can be con- against what criteria. This knowledge is essential to tracted out in this way, governrments still require effective coordination within government, but it is staff with relevant expertise to hire and oversee the also important to guide and give confidence to consultants, and to incorporate the lessons of potential investors. In addition, it is a prerequisite experience for future transactions (box 2.3). for transparent approval and bidding procedures. Governments need expertise in a range of new 2.1.3 Degree of Decentralization in Government areas to design and implement concessions. In Organization addition to the technical engineering requirements of particular projects, new skills will be required in In order to manage their concession programs, financing, regulating, and marketing to potential governments may organize themselves in a more or investors and consumers. Inadequate expertise in less decentralized manner. Government activities The Broad Environmentfor Concessions 11 Box 2.2 One Measure of the Cost of Government Disorganization One measure of the effectiveness of government orga- of definition and transparency in government nization in the design and award of concessions is the processes, which increase uncertainty for investors amount of transaction costs incurred by participants in and developers and thus multiply costs. Unclear lines the process. Developing an infrastructure project with of authority between national and local entities and private sector participation is a complex task requiring an onerous approval process can delay projects, firms and governments to prepare proposals, conduct sometimes for years, or even cause them to be aban- bidding, negotiate deals, and arrange funding. These doned. China, for example, is notorious for its tortu- activities may generate high transaction costs, includ- ous bureaucratic processes: any project valued over ing travel costs, staff costs, time delays, and advisory $30 million requires review and approval by the cen- fees for investment bankers, lawyers, and consultants. tral government, in addition to authorization by the In general, the weaker is the policy framework and concemed province, and must pass twice through the institutional capacity of the government, the higher State Planning Council. these transaction costs are likely to be. While the transaction costs incurred in private On average, transaction costs may amount to as projects are often more apparent than in public pro- much as 5 to 10 percent of total project costs. But jects, private projects do not necessarily generate there can be wide variations depending on the stabil- higher overall costs. Greater attention to project ity of the policy environment. Where there is a well- parameters and better monitoring may avoid the time developed policy framework, costs average 3 to 5 and cost overruns that are common in executing pub- percent, whereas they maybe as much as 10 to 12 per- lic sector projects. Also, as governments gain more cent in untested environments. Interestingly, empiri- experience with such projects and clarify the policy cal evidence suggests that transaction costs have little framework-resulting in speedier processes-these to do with project size. Rather, they stem from a lack costs tend to fall. Source: Klein, So, and Shin (1996). regarding the design and award of concessions in decentralization in different ways. For example, a Chile, for example, are much more centralized country's administration of concessions can be ver- than those in Brazil. How does this difference tically decentralized at the same time as being hor- affect the design and implementation of conces- izontally centralized. Take the case of Brazil. sions? There, some responsibilities for concessions First, decentralization is used here in two situ- belong to the state of Rio de Janeiro-meaning ations. The first is vertical decentralization, in that functions are vertically decentralized which the authority to grant and administer con- (although not all the way to the municipal level), cessions has been transferred to local govern- On the other hand, Rio de Janeiro uses a central ments. The second is horizontal decentralization, unit to manage its concessions; which means that in which the functions regarding concessions have its functions are horizontally centralized. Similarly, been dispersed within one level of government. the organization can be vertically centralized but For example, responsibilities for concessions in horizontally decentralized. This is the case in New transport, water, or electricity could be assigned to Zealand, where the central government has the sector departments or ministries within a single tier main responsibility for concessions (vertically cen- or level of government-this would be horizontal tralized), but sectoral departments have the lead decentralization. On the other hand, a single unit (horizontally decentralized). Further, in some or entity (within a single tier or level of govern- countries certain sectors are the responsibility of ment) could be assigned the administration of all vertically decentralized authorities while other sec- concessions in transport, water, and electricity- tors remain vertically centralized. For example, in this would be horizontal centralization. France water is vertically decentralized but Second, one has to keep in mind that organi- telecommunications and electricity are vertically zations for concessions combine centralization and centralized. 12 Concessions for Infrastructure: A Guide to Their Design and Award Box 2.3 Hiring Advisers In hiring advisers, governments must address a num- should use it judiciously and follow a transparent ber of issues: process that stands up to public scrutiny. * On what basis should advisers be remunerated? a What type ofconsultants are needed? Concession Establishing appropriate fee structures for advisory services can require economic and reg- advisers is a complex but important task, as ulatory consultants, legal advisers, technical the fee structure may affect the type of advice consultants and engineers, environmental con- given. For example, investment banks fre- sultants, investment bankers, and others. quently are paid on the basis of a success fee * How should the advisory work he packaged? If for completing a transaction. Thus the advi- a range of advisory services is needed, gov- sory firm will benefit if a public enterprise is ernments have the option of hiring a consor- sold as a legal monopoly (that is, it will fetch a tium (with a lead firm, which can be easier to higher market price), but the sector as a whole manage and can result in more uniform and the economy may suffer as a conse- advice) or hiring separate advisers (which pro- quence. vides access to a range of advice on complex * How should advisers be managed? Governments issues and can promote a more informed can enhance the effectiveness of advisers dur- discussion). ing the assignment by having a strong counter- * How shouldthe advisers be hired? As ageneralprin- part on their side, ensuring that advisers have ciple governments should use competitive bid- access to all pertinent information on a timely ding to select advisory firms, as competition will basis, and making timely decisions throughout generally enhance the quality of proposals, enable the process to provide continued clear direc- governments to choose from a number of pro- tion to the advisers. Otherwise, advisers will posals, and increase transparency in the process. work in a vacuum, with high cost and little Direct hiring may be justifiable, but governments return to the client government. Source: World Bank staff. Third, it is important to remember that much Most systems are not perfectly centralized or depends on the political system and traditions of decentralized. In practice, intermediate solutions the country in question. One should not, however, can be devised in order to strike a more optimum give up trying to tailor or improve the system in balance between the two extremes. For example, place. Even in cases where the jurisdiction and policy determination and implementation can be organization of different tiers of governments, or separated and assigned to different tiers of gov- entities within them, have clearly been defined in ermnent. Different tiers of government can also the constitution, most systems will have room for deal with different policy questions. And different some improvement in the conduct of government levels of government might cooperate on certain business. matters. In a system that emphasizes vertical central- 2.1.3.1 Vertical decentralization. There is no ization one of the main challenges is to take into universally good or bad way of making changes. account specific local conditions. Consultation There are common trade-offs, however, between mechanisms could be useful to achieve this. In a vertical centralization and decentralization system that emphasizes vertical decentralization (table 2.1), as well as between horizontal cen- one of the main challenges is to deal with con- tralization and decentralization (table 2.2). An strained technical capabilities. Expertise can be analysis of such trade-offs shows the strengths enhanced through the use of a central unit staffed and weaknesses of each approach and indicates with skilled individuals that are at the disposal of how an organization can be improved in these local authorities for guidance, advice, and regards. training. The Broad Environmentfor Concessions 13 Table 2.1 Trade-Offs in Vertical Decentralization Centralized Decentralized Criterion approach approach Provides flexibility to adapt to local conditions, priorities, and preferences - + Promotes consistent policies + Promotes experimentation with different approaches + Favors learning between jurisdictions + Helps the development of expertise that is specific to local conditions - + Uses economies of scale to deal with the problem of constrained capacities + Provides decisionmakers with better information + Enables decisionmakers to take into account the effect of local policies on other jurisdictions + Promotes the accountability of decisionmakers + Facilitates the consideration of how decisions regarding concessions can affect trade between jurisdictions (such as standards, subsidies) + Source: World Bank staff. 2.1.3.2 Horizontal decentralization. There are entirely centralized within the finance ministry to similar trade-offs between horizontally centralized ensure control, while sectoral policymaking can be and decentralized approaches (table 2.2). decentralized toward individual sector ministries. Most governments do not take an approach to In a system that emphasizes horizontal central- concessions that is totally centralized or decentral- ization one of the main challenges is to take into ized horizontally. Intermediate solutions can, in account sectoral specifics. The formation of sec- fact, be better. Responsibilities regarding bud- toral departments within a centralized entity can getary commitments may, for example, remain serve this purpose. In a system that emphasizes Table 2.2 Trade-Offs in Horizontal Decentralization Centralized Decentralized Criterion approach approach Enables a focus on sectoral specifics + Promotes consistent policies across sectors (that is, reduces the risk of distortions arising from inconsistent approaches to common issues) + Promotes experimentation with different approaches + Favors learning among sectors + Helps the development of sector-specific expertise + Uses economies of scale to deal with the problem of constrained capacities + Minimizes the impact of sectoral politics + Improves resistance to improper influences from particular industries or political authorities + Decreases the opportunity to inappropriately apply precedents from one sector to other sectors + Improves the ability to deal with blurring industry boundaries + Source: World Bank staff. 14 Concessionsfor Infrastructure. A Guide to Their Design and Award decentralization one of the main challenges is to that they are committed to promoting private sec- maintain coherence among sectors. Establishing tor participation in infrastructure (box 2.4). coordination mechanisms between sectors will be important in this regard. The adoption of cross- 2.1.5 Government Organization: Illustrations sectoral regulatory frameworks can also play a sig- nificant role (see section 2.1.4 below). Governments around the world are working to Most of the new institutional models being improve and reform their organization in order to adopted around the world reflect some balance facilitate the development and execution of private between extreme cases of centralization and infrastructure projects. A few cases are presented decentralization and exhibit different ways of tack- here. These examples demonstrate how some gov- iing the challenges mentioned above. Section 2.1.5 ernments have applied the guiding principles pre- presents some country illustrations. sented in section 2.1.2 and have met some of the challenges presented by centralization and decen- 2.1.4 The Use of Cross-Sectoral Regulatory tralization (section 2.1.3). Frameworks 2.1.5.1 Bolivia. In 1994, to implement its bold All concessions contain many project-specific Capitalization Program, Bolivia created the posi- details. In addition, some issues are unique to a tion of minister for capitalization. The Minister particular industry and hence require attention on was made responsible for all aspects of govern- a sector-specific basis. Examples include technical ment programs covering telecommunications, and safety standards and market structure arrange- electricity, railways, airlines, airports, hydrocar- ments. But many of the issues associated with the bons, and water. Sector-specific working groups awarding of contracts and some other key princi- were formed within the Capitalization Ministry, ples are nearly identical across sectors. For these drawing on relevant expertise from state-owned issues there are a number of potential advantages entities, sector ministries, and the private sector. A to adopting common rules across sectors, includ- central procurement unit was formed and made ing economies of scale, common interpretations, responsible for handling the large number of con- avoidance of the rule-making process being cap- tracts for consultants and advisers. Having accom- tured by industry-specific interest groups, and the plished its objectives, the ministry closed its doors sending of a clear signal by government authorities in the summer of 1997. Box 2.4 The Role of Cross-Sectoral Regulatory Frameworks A growing number of countries are adopting cross- * Contract amendment and termination. sectoral frameworks for private infrastructure, includ- * Competitive bidding, including the scope of ing Brazil, Bulgaria, Chile, China, Colombia, Hungary, exceptions. the Philippines, and Vietnam. a Availability of international arbitration. While details vary among countries, the key elements * Other issues important to private infrastructure of cross-sectoral frameworks include clear rules on: arrangements that are not dealt with adequately in other laws. Examples vary from country to * Which infrastructure sectors are open to pri- country but include the treatment of security vate participation. interests in private projects and rules on liqui- * Which agencies are responsible for approving dated damages (that is rules regarding setting in private projects or contracts. advance of the amount of compensation to be * Tariff adjustment. paid in case of certain breaches of obligations). Source: Kerf and Smith (1996). The Broad Environmentfor Concessions 15 2.1.5.2 Peru. Privatization of state-owned select and award projects under the framework. enterprises was the first stage of the Peruvian gov- The authorities prepare a list of priority projects, emmnent's endeavor to develop private participa- which must be approved by either the Investment tion in infrastructure. Initially, the Private Coordination Committee (ICC) of the National Investment Promotion Commission (COPRI) was Economic Development Authority (NEDA), the responsible for the entire privatization program, NEDA Board, or by local or regional councils, including divestiture of state enterprises. COPRI depending on the conceding jurisdiction and the is an interministerial commission composed of six cost of proposed projects, as specified in the members of the government and assisted by a Implementing Regulations to the Law. Projects small technical secretariat. Various special com- undertaken on a build-own-operate (BOO) basis, mittees were set up to privatize individual state- or through contractual arrangements other than owned enterprises chosen by COPRI (Guislain those defined under the Law, require presidential 1997: 156). approval. With many infrastructure assets now divested As part of its program, the government created to the private sector, Peru is entering the second a BOT Center. The Center has about 14 profes- stage of its strategy, focusing its attention on con- sional staff members and performs the following cessions, including many greenfield projects. The tasks: Private Concessions Promotion Commission (PROMCEPRI) was created in December 1996 * Keeping an updated national inventory of all for this purpose. Modeled after COPRI, PROM- nominated projects that are eligible for devel- CEPRI is meant to be the only agency in charge of opment under the BOT framework. promoting private investment within the area of - Providing general advice to foreign investors public infrastructure and utilities. PROMCEPRI doing business in the Philippines. will also use special committees to implement its * Developing infrastructure projects. concession program. * Providing technical assistance and training to central and local government officials on the 2.1.5.3 Mexico. Mexico uses a relatively design and implementation of projects. decentralized approach to support its infrastruc- * Spearheading promotional activities for the ture privatization program. Sectoral ministries pri- Philippine BOT program and specific projects marily design and implement the projects, while through brochures and roadshows. the cabinet, supported by an interministerial com- mission, does the high-level policy coordination. Initially, the Center was mainly involved in mar- The secretariat to the interministerial commission, keting the BOT concept to private investors. As located in the Ministry of Finance, is not directly the concept has become better known, most mar- involved with specific concessions but is used as a keting and similar tasks have been devolved to the channel for managing concessional loans and BOT units in each sectoral agency The BOT donor support to the program. Center now spends more time training national and local government officials. 2.1.5.4 The Philippines. The government of the Philippines created a novel institutional struc- 2.1.5.5 Australia-State of Victoria. State gov- ture to support the country's large private infra- ernments in Australia have the main responsibility structure program (under the 1989 BOT Law and for most infrastructure sectors. In the State of Regulations). Each sectoral agency has a specialist Victoria individual government departments are "BOT Unit" responsible for coordinating the ultimately responsible for concession design and design and implementation of its projects. award. Project responsibility is assigned to a single National, provincial, and municipal authorities minister in each case. This minister is then respon- 16 Concessions for Infrastructure: A Guide to Their Design and Award sible for facilitating consultation with the other the most important obstacles regarding conces- government departments involved in the project. sions are laws and regulations that prohibit the pri- The minister will also work with the Department vate ownership and operation of public services of Treasury and Finance. In order to provide guid- and foreign investment in infrastructure sectors. ance and promote consistency in analysis and pro- Sometimes, although they do not prohibit the par- cedures, the Victorian government has formulated ticipation of the private sector or foreigners in an "Infrastructure Investment Policy for Victoria," infrastructure, governments impose conditions on a description of whichwas published in June 1994 participation. Investors will want to be aware of by the Department of Treasury and Finance. That these conditions, as they may severely limit the department also acts as a reference center when scope of private involvement. guidance is required by other government entities Tle following questions regarding limitations (see Department of Treasury and Finance 1994, on private participation must be answered: 1996). * Does the law permit the private provision of 2.2 The Broader Legal and Regulatory infrastructure services? In some cases the con- Environment stitution or a law must be amended in order to abolish the legal monopoly of state-owned One of the first things investors will want to check enterprises. before becoming involved in a concession is * Does the law permit the sale of certain infra- whether the country's legal and regulatory envi- structure assets to the private sector? ronment is favorable to concession operations. A * Does a specific law need to be adopted to trans- concession agreement cannot unilaterally modify fer infrastructure assets to the private sector? or override the provisions of a law or the country's This is not necessary in most common-law constitution. Thus one cannot assume that all countries, unless there is specific legislation to issues or problems can be handled within the the contrary, but it is often required in civil-law boundaries of a concession agreement. countries. In order to create a legal environment that is * Are there limits or conditions for participation? conducive to concession arrangements, govern- For example, is the concessionaire obliged to ments may have to amend or repeal some laws and form a joint venture with a public entity or to regulations. They may also have to adopt new legal incorporate itself locally? provisions to permit the granting of certain rights. While the overall legal framework should be Likewise, the following questions on participa- reviewed, it would be pointless in the context of a tion by foreign investors must be addressed: specific concession to document and remedy all the shortcomings that can be found in a country's * Are foreigners legally entitled to hold conces- legal environment. Efforts must be focused on the sions? core part of the legal framework that must be in * Are there limits to the foreign operation of pub- place for the concession program to succeed lic utilities? For example, do foreigners need to (Guislain 1997: 46, 87). This section identifies the partner with local firms? Are foreigners limited main issues that should be tackled. to a maximum number of shares? * Are foreigners excluded from certain sectors? 2.2.1 Threshold Legal Impediments to Private For example, foreigners are sometimes Participation excluded from "strategic" sectors. * Are there other forms of discrimination against Governments must remove impediments that pro- foreigners? For example, are domestic firms hibit private participation in infrastructure. Two of preferred in the bidding terms? The Broad Environmentfor Concessions 17 2.2.2 Property and Land- Use Rights * How do titling and registration function in the host country (or in what ways are they defi- To attract private investment at a reasonable cost, cient)? This information is important for deter- governments must make credible commitments to mining the availability of title, for example. rules that safeguard property rights. Investors ' What enforcement mechanisms protect prop- need adequate protection against unwarranted erty rights? government expropriation and want to know that * What restrictions may be placed on foreigners the land rights they hold can be exercised and with respect to the acquisition and exercise of protected. ownership rights for land or other real estate assets? 2.2.2.1 Legal provisions and restraints on expro- priation. All countries reserve the right to expro- Concessionaires often need to acquire rights of priate property for public purposes. In some way, for example for electricity transmission, fuel countries such powers will be found in the legisla- supply, or roads. They will also want to know: tion on the "eminent domain" right of the state (which describes the government's expropriation * What are the rules applicable to the acquisition powers). Such powers can also be found in the of rights of way? Can titles be secured and Constitution. Many Latin American countries (for transferred in a timely manner? example, Colombia, Brazil, Bolivia, and Peru) * Who has the legal authority to acquire rights of have adopted new constitutions in the 1980s that way? include rights and obligations on expropriation. * If the government has this authority, can the Investors will want to know the conditions for exercise of those rights be delegated? expropriation. For example: * How will the cost be apportioned? • Are investors compensated, and which stan- Building infrastructure often requires that dards apply to compensation? numerous people move to a different location (box * Are the rights to expropriate limited in scope? 2.5). Many people have had to be resettled * Are the rights to expropriate subject to judicial because of hydro dam projects and because of rail- review? way projects (such as in Mexico). Some of the issues concerning resettlement are similar to those 2.2.2.2 Land law. Concession operations raised by expropriation, while others are specific, often require the use and ownership of land. they include:2 Investors are likely to find answers to their ques- tions regarding property rights in the country's * What is the scope of the power of eminent legal system.' domain? a What is the nature of compensation associated * Does the constitution recognize private owner- with it? For example, what valuation method ship (of land, for example)? Many constitutions will be used? What is the timing of payment? had to be amended in Eastern Europe and * Which legal and administrative procedures are countries of the former Soviet Union applicable? For example, which appeal (1989-90) and in some countries like Vietnam processes are available? What is the normal (1992) in order to allow privatization. time frame for such procedures? * How are ownership rights defined, recognized, * What is the legal framework for land titling and and protected in the host country? registration procedures? * What restrictions, if any, are placed on the * Which laws and regulations apply to the agen- transferability of those rights? cies responsible for implementing resettlement? 18 ConcessionsforInfrastructure: AGuidetoTheirDesignandAward Box 2.5 Resettlement Issues in Chile A dam being built on the Bio Bio River in Chile, with Indians living there. Groups opposing the dam have financing from the Intemational Finance claimed that the program to aid and resettle inhabi- Corporation (IFC), has caused resettlement and tants has been inadequate and that the rights of the environmental problems and shows how the breach Pehuenche to remain on the land under a new of an indigenous law can hinder a private infrastruc- Indigenous Law in Chile are being violated. The IFC ture project. withdrew its support from the project amid claims that The dam has caused the river to rise in some areas, the developer had failed to meet the conditions of the flooding the ancestral lands of the native Pehuenche loan with regard to the resettlement of inhabitants. I Source: Inter Press Service (1997). Which laws and regulations apply to the agen- * Wil the concessionaire be liable for past envi- cies responsible for land use, environmetit, ronmental damages? water use, and social welfare? * Wi the concessionaire be liable for future envi- ronmental damages? 2.2.3 Environmental and Safety Laws * What are the standards of environmental com- pliance and reporting? Concessions are often conferred for projects that * What laws and regulations apply to wildlife, can have significant environmental impacts in sec- health, water, and land use? Who is responsible tors such as electricity transmission, ports, for applying them? hydropower, airports, railways, and roads (box * What safety regulations apply to the concession? 2.6). Safety and health standards can also affect the planning and operation of the concession (in, 2.2.4 Labor and Immigration Laws for example, water and power plants). Investors will want to know:3 Labor and immigration laws will present the con- cessionaire with a more or less conducive environ- * Does the law require environmental impact ment for operation: studies, environrmental permits, or licenses? * What procedures are used? For example, does * Does the lawmandate the use oflocal employees? the concessionaire need to'submit a project sum- * Are there restrictions on the use of foreign mary? What assessments must be performed? managers? * Does the law affect the construction and oper- * What are the visa requirements for foreign per- ation of facilities? For example, what condi- sonnel? tions apply to the preservation of the natural environment, to temporary facilities, and to the Issues also arise when the employees of a state- use of pollutants? owned enterprise slated to be privatized are to Box 2.6 Environmental Issues in Malaysia The breach of an environmental law can delay and A breach of the Envirormental Quality Act was the seriously disrupt a project. In Malaysia, for example, basis for the decision. On February 17, 1997, how- local people initially won a court case to stop Erkan, ever, the ruling was overturned on the grounds that the main contractor of the 2,400 megawatt Bakun the Act referred to in the original decision was not hydroelectric dam, from starting work on the project. applicable in Sarawak, where the dam is located. Source: Oxford Analytica (1997). The Broad Environmentfor Concessaos 19 become employees of the concessionaire. These tionship, despite changes in the employer's status, include questions regarding whether the labor be it as a result of succession, sale, merger, split-up, regime applicable to the personnel of state-owned absorption, transformation, or otherwise: "all labor enterprises continues to apply under the concession contracts in effect on the day of such change remain (that is, does the employment relationship con- in force between the new employer and the staff of tinue?). In Morocco, for example, there is a legal the enterprise" (article 754 of the Obligations and presumption of continuity of the employment rela- Contracts Code, quoted in Guislain 1997: 74). Table 2.3 Business Operation Provisions and their Potential Impact on Concessions Accounting rules * Standards applied for purposes of taxation and regulatory oversight * Accounting and auditing procedures (for example, is audit by a public agency mandatory?) Bankruptcy law * Conditions and procedures for liquidation, bankruptcy, and insolvency * Protection afforded to the project company's creditors Contract law * Conditions for the formation of contracts (for example, contractual capacity of key customers and suppliers) Company law * Provisions on the establishment of companies * Limits to ownership forms (for example, with or without limited liability, and joint stock companies) * Ability to "unbundle" control and voting rights from the rights to dividends and income * Provisions for minimum capital requirements, on the conditions of sale or transfer of shares and on the protection of minority shareholders Financial law * Ability to get financing from local banks, pension funds, and other financing sources Foreign exchange rules * Conditions of money convertibility, repatriation of profits, and so on Import/export law * Right to import materials and liabilities for import duties * Submission to export controls Intellectual property * Protection of patent, know-how, and business secrets rights law * Ratification of intemational conventions International law * Ratification of intemational conventions, for example on trade and investment, which affect other areas of the law (such as expropriation and currency convertibility) Public procurement * Conditions of publicity, access, and competition (for example, is there a law preferential treatment for state-owned enterprises?) Securities law * Conditions for the issuance and trading of shares and operation of financial intermediaries * Existence of a securities exchange market and regulatory body * Creation, perfection, and enforcement of collateral interests (see section 6.1.) Tax law * Application of corporate income tax, real estate tax, value-added tax (for example, regarding tax withholding treatment, standards applied to transfer pricing, depreciation norms, tax exemptions, double taxation) * Tax administration procedures Source: Guislain (1997) and World Bank staff 20 Concessionsfor Infrastructure: A Guide to Their Design and Award 2.2.5 Competition Law and Policy * Does the concessionaire have the ability to exchange local currency into foreign Especially in network industries, concessionaires currency? will be concerned with the conditions and terms of * How will the rate be determined? Is the rate their access to the network. If private operators different for foreigners? rely on a state enterprise for access, and if the state * Can project revenues be transferred to offshore enterprise is also a competitor in the market, con- revenue accounts and retention accounts? cerns may arise about the abuse of market power. * Can profits be repatriated? Under what Rules regarding mergers and acquisitions can also conditions? affect a concessionaire's business strategy. * What types of approvals are required? Competition rules can be found in individual agreements, sectoral laws, general competition 2.2.7 Enforcement Provisions laws and regulations, and possibly in all such instruments at once. It is important to know: Finally, investors will want to make sure that all the rights they benefit from under the law can be * Does the country have an economy-wide com- enforced. Investors should be aware of these facts petition law? and assess in each case how the host country's * Do sectoral laws contain competition provi- court system functions. In some cases alternative sions? dispute settlements mechanisms can be consid- * In case of conflict, which law takes precedence? ered. Important questions include: • Which bodies have jurisdiction over competi- tion matters? * How well do courts perform their functions (in e In case of conflict, which body takes prece- terms of delays, costs, expertise, problems of dence, the utility regulatory body or the com- corruption)? petition authorities? * What alternative dispute settlement mecha- * What rules apply to mergers and acquisitions? nisms are available in the country? How do these affect the concessionaire? * Are public parties able to submit disputes to international arbitration? 2.2.6 Business Operation Provisions * Will international arbitral awards be recognized in the country? Many laws and regulations affecting business oper- * Can these awards be enforced in practice? ations can have an important impact on conces- sions (table 2.3). Investors must understand what Dispute settlement mechanisms are discussed benefits can be found in the law (for example tax in more detail in section 3.10. benefits) and what obstacles must be alleviated or how the project can be modified to accommodate Notes obstacles. Some questions will be more important than 1. This list of questions is derived from Guislain others for certain concessions. For example, for- (1997: 47). eign exchange rules might be especially crucial to 2. This list of questions is derived from World Bank (1990). investors when project revenues are in local cur- 3. This list of questions is derived from World Bank rency. A number of questions then arise: (1989) and Guislain (1997: 81-83). CHAPTER 3 Concession Design 3.1 Introduction Clearly, some trade-offs will have to be made among these various objectives. Compromises are 3.1.1 Striking a Balance necessary, for example, between creating incentives for productive efficiency (which increases the risks P z ublic and private parties in concessions borne by the concessionaire) and providing suffi- come to the negotiating table with differing cient comfort to investors to ensure that desirable concerns and objectives. Private operators projects are undertaken. Efforts to promote alloca- and their financiers seek to reap adequate returns tive efficiency might have to be reconciled with the in sufficiently stable environments. In the infra- requirement that some users receive subsidized ser- structure field they are likely to be concerned vices. Assuaging, to the greatest extent, the concerns about the large and immobile nature of required of the parties involved and striking an appropriate investments and about the length of payback peri- balance between the different objectives pursued ods-once in the market, they might be at the are the ultimate goals of concession design. mercy of political authorities. In addition, infra- structure tariffs tend to be subject to political pres- 3.1.2 General Overview of Concession Contracts sures, and risks of nonpayment, especially by public users, can be substantial. In some sectors There are model contracts, such as the model water revenues are raised exclusively in local currency, lease contract, published by Decree in the Official thereby also raising concerns over convertibility Journal of the French Republic in March 1980 and and the transfer of revenues. summnarized in table 3.1.L No two concession Public parties, on the other side, will want to agreements are exactly the same, however. limit possible abuses of monopoly power by the Technical provisions do, of course, vary by sector. private operator. They will seek to maximize pro- The scope of the private operator's responsibilities ductive efficiency (production at lowest possible can also vary with different types of contracts, as was costs) as well as allocative efficiency (the pro- mentioned in section 1.4.1. Substantial differences ducer will supply an extra unit of a good or ser- also appear between contracts of the same type vice to all users willing to pay the costs of (leases, for example, or concessions stricto sensu) producing that extra unit). They will also want to conduded in the same sector, as the parties tailor ensure that appropriate quality, environmental, each agreement to their specific situation and needs. and health standards are maintained. Finally, they Finally, the form of the contractual agreement are likely to impose certain conditions (related to depends on the specific features of the overall legal tariffs, coverage, and so on) in the pursuit of framework. Cross-sectoral concession laws, where social objectives. they exist, may contain provisions that do not have 21 22 Concessionsor lInfrastructure: A Guide to Their Design and Award to be repeated in individual contracts (see section ferred under the concession owned by different 2.1.4). Some countries, such as France, have devel- parties? If so, should two or more parties be oped a wide body of case law on concessions; con- granting the concession? In one proposed Latin sequently, contracts can be kept relatively short, American water concession, assets that were since key provisions and principles have been inter- controlled by the state water company had come preted and defined by the courts. In fact, a range of from a variety of sources. But, the transfer of title legal instruments-including contractual agree- had not been properly registered. In order to ments, as well as constitutions, laws, ministerial ensure that no disputes would arise at a later decrees, and decisions by the courts or by regulatory date regarding the transfer of the assets from the entities-can be used to embody the rules relating state water company granting the concession to to a given private investment scheme (see annex 1 the concessionaire, the parties that had originally on the choice of regulatory instruments). transferred their assets to the state company (in Despite the wide variations found in the con- this case, the government and certain munici- tents of different concession arrangements, there palities) became parties to the concession con- is a set of core issues or topics that must be dealt tract and agreed to waive any claims or rights with in most contracts of this type. It is mainly with they may have had to these transferred assets. these issues or topics that we will be concerned. * Does the identified conceding authority have In the process of designing a concession-type the legal power to grant the concession, enter contract, the government will need to ask and answer into the project documents, and perform its a variety of questions about the best feasible means obligations? of meeting its service objectives. Some of these ques- tions will concern facts; some will require excursions And on the concessionaire's side: into theory. Some will appear routine; others, at least for first-time concessions, may come as a surprise. * What type of entity should be used as the con- Even apparently straightforward issues may require cession vehicle (local companies, partnerships, more careful consideration than is apparent at first, limited partnerships, joint ventures)? as the following two examples show. * If a sponsor is not a party to the concession con- tract, what other kinds of sponsor support may 3.1.2.1 .Identifying the Contracting Parties. be required, such as comfort letters, undertak- Especially in municipal-level projects, it may not be ings, guarantees, letters of credit, or subordi- clear who has the right to grant the concession. nated loans?2 Then, the government needs to ask itself such questions as: 3.1.2.2 The purpose and extent of the concession. The government must have worked out its position * Is the conceding authority the government on the degree of exclusivity (if any) to be conferred itself, a state-controlled body, a government on the concessionaire (see section 1.3.5). The con- ministry, a municipality or a number of munic- tractual arrangements for the concession may have ipalities, an association of municipalities, or to address such questions as: some other body? How many of these bodies should be parties to the contract? For example, * Will exclusivity be granted to the concession- in some Latin American jurisdictions the aire? If not, will the conceding authority under- municipalities will need to form a mancomu- talke not to grant similar concessions or prevent nidad, which is not only an association repre- third parties from acquiring similar rights dur- senting the municipalities, but also an entity ing the lifetime of the concession? with a separate legal personality. W Will the conceding authority undertake not to * Are the relevant assets, or use rights, to be trans- supply services itself? Concession Design 23 * Will exclusivity lapse after a specified period or * It is not always easy to determine unambigu- if specified services are not provided? ously the extent to which a party is in a position * Can the operator unilaterally expand the ser- to adopt appropriate risk mitigation measures. vice area during the lifetime of the concession? To what extent, for example, can a company * What are the rights and obligations of the con- protect itself against the risk of exchange rate cessionaire with respect to other utilities or fluctuations? A company might be unable to community groups engaged in the production control or hedge against those risks, and some of their own services? might argue that the risks should therefore be passed on to consumers. But a company might This brief checklist suggests that even the in fact be able to determine, up to a point, the apparently straightforward entries in table 3.1 can extent of its exposure to exchange rate risks. If be spelled out only after careful thought and study that is the case, the company might more of local legal and physical conditions.3 appropriately bear those risks itself. Indeed, The primary focus of this chapter, however, is on only exogenous costs (that is, costs against some of the more complicated issues that must be which the company cannot protect itself) resolved in order to write a satisfactory concession should normally be passed on in order to pre- contract-how to provide for price adjustments serve the operator's incentives to function effi- over time, for example, or how to credibly provide ciently and reduce excessive risk exposure. for fair compensation in the event of early termina- * In some cases different parties can adopt dif- tion. This discussion will draw on practical experi- ferent risk mitigation measures, and the ques- ence from countries that have already established tion of who is in a better position to deal with concessions and, where necessary, on elements of risk might be complex. It is generally agreed, theory that illuminate the trade-offs implied by dif- for example, that the risk that new laws or reg- ferent policy and contractual choices. ulations might discriminate against the project Two main questions will determine, to a large should be borne by the government because extent, the design of the more complex provisions of the government is in a position to prevent dis- concession agreements: how risks should be shared crimination, while the operator will often be between parties and how rules should be designed unable to protect itself (especially since there so as to leave some flexibility in interpretation. might be very little opposition from the rest of society against measures that affect only the 3.1.3 The Main Principles of Risk Allocation project). But what about the risk of changes in the general legal framework that are unfavor- A variety of risks are inherent to infrastructure pro- able to the project but that affect many differ- jects. The criteria for risk allocation are simple to ent businesses in the same way (a rise in taxes, present in theory. Risks should normally be borne for example)? Again, the government is, to a by the party best able to assess, control, and man- certain extent, in a position to directly control age them or by the party with the best access to that risk (less so than in the previous case, how- hedging instruments, the greatest ability to diver- ever, because the government cannot commit sify the risks, or the lowest cost of the risks bear- to leave the legal framework unchanged for 20 ing. The aim is to ensure that the party with the or 30 years). But this time it can be argued that ability to reduce risks has incentives to do so and the operator should bear the risk because it has that remaining risks are borne by the party for to expect that the general framework will which it is least costly. change over the duration of the contract and In practice, however, it is often very difficult, will be able, in some cases at least, to adopt for a variety of reasons, to determine exactly who commercial decisions that will minimize expo- should bear some types of risks: sure to such risk.4 24 Concessions for Infrastructure: A Guide to Their Design and Award Table 3.1 French Model Contract for a Water Lease Headings Provisions General provisions Introduction Contracting parties General economics of the contract Description of the lease, its duration, and the responsibilities of the lessee Purpose and extent of lease Definition of the service, exclusivity of service, definition of leased area, revision of leased area, utilization of public and private roads Operation of service 'Regulation of service, requests for connection, obligation to connect, user contract, control by the municipality, contracts concluded with third parties Personnel Status of personnel, secondments (elective dause), rights, and obligations of the personnel of the lessee Works General principles, maintenance and large repairs, forced execution of maintenance work, connections, metering, renewals, construction and extensions, extensions requested by users, control of the lessee, and integration of private networks Financing Fees for use of public facilities, surcharge collected on behalf of the municipality, basic tariff, indexation of basic tariff, price reductions for some categories of users, sale price to public users, new works, price indexation for new works, price indexation for maintenance work, verification of financial statements Revision of price and indexation Revision of price and indexation provisions, revision of indexation formulas formula for new works and maintenance, revision procedure Fiscal provisions Taxes, transfer of value-added tax (elective clause) Guarantees, sanctions, and disputes Performance bonds, financial penalties, step-in rights, termination, choice of residence, dispute resolution End of lease Transfer of lease, continuity of service, transfer of assets, acquisition of assets, personnel of the lessee Technicalprovisions Definition of service Inventory of real estate assigned to lessee, transfer of installations at beginning of contract, transfer of new installations during course of contract, import-export transit of water Operation Health provisions, production and conveyance installation, water source, quantity, quality, pressure, meters, verification and reading of meters, individual connections, firefighting, cut-offs Works Quality standards, distinction between maintenance and renewals, pipeworks passing under public roads, works on municipal facilities, role of the lessee in awarding works contracts, control of works undertaken by the lessee Financial and accounting provisions Application of financial provisions Payment of user charges to the lessee, price schedule for works, maintenance of municipal facilities, payment for special extensions, time frame for the settlement of work expenses to be reimbursed by the municipality Production of accounts Annual reports, technical reports, financial statements, operating accounts, verification by the municipality Miscellaneous clauses List of annexes Source: Republique Franqaise (1980) and World Bank staff Concession Design 25 * In addition to the parties' abilities to adopt risk Table 3.2 summarizes the main types of risks mitigation measures, their level of risk aversion encountered in infrastructure projects and the way should also be taken into account. If investors in which they should normally be allocated, not are highly risk averse, for example, some risk- only between public authorities and concession- sharing arrangements with the government aires, but also between other parties, such as con- might be justified, even if, as a result of such an tractors, suppliers, insurers, and users. As agreement, investors are protected against risks mentioned above, appropriate allocation of risk is in situations where they could have reduced very complex and exceptions to the solutions rec- their exposure. The gain from protecting risk- ommended in the table might be justified in some averse investors must be weighed against the cases.7 loss resulting from the fact that investors will have weaker incentives to protect themselves 3.1.4 Certainty Versus Flexibility or that they might adopt other types of uneco- nomic behavior (the incentive properties of Concessions can be designed so as to leave more risk- sharing arrangements are discussed fur- or less discretion to those in charge of interpreting ther in section 6.2.3.2). On the other hand, and implementing them. At one extreme, rules can risk- sharing arrangements might also encour- be very specific and can eliminate almost all scope age more investors to take part in a bidding for discretion. At the other, rules can be designed process, thereby increasing competition for the so as to leave a large degree of discretion to the market. contracting parties themselves or to third parties * Authorities' monitoring capabilities will also responsible for regulating the arrangement. determine how risks should be shared between Three main factors will influence the amount of the parties. If output quality cannot be properly discretion to be retained: monitored, for example, one might choose a price regime that limits the incentives of the * Level of country risk. The more stable a country operator to lower costs by reducing quality, and the greater its reputation for respecting pri- even if it might mean that the operator will be vate property rights and regulatory commit- less vigilant about keeping costs under control.5 ments, the more discretion can be retained * Monitoring capabilities will also vary with the without significantly increasing investors' per- type of investor, and this is also likely to influ- ceptions of risks and, therefore, the cost of cap- ence the optimum risk-sharing arrangement. It ital (figure 3.1). can be argued, for example, that private Reputation of the privatefirm. When an operator investors are often able to monitor project has a reputation to preserve and when bad per- managers more closely than taxpayers can mon- formance would seriously undermine that rep- itor civil servants, and that it might therefore be utation, an argument can be made in favor of advisable to limit the types of risks that the gov- more flexible rules, as there might be less need emnment can bear and the maximum value of to tightly control the operator's behavior. the government's contingent liabilities.6 * Characteristics of the regulated industry. Flexible * Finally, transaction costs must be taken into rules will be more important when rapid tech- account. The risk-sharing arrangement that nological evolution substantially modifies the seems best independent of transaction costs costs of the activity or calls for changing the might not be desirable in practice: indeed, tai- structure of the sector (for example, because loring risk-sharing arrangements to specific sit- the scope for competition is increased). uations might prove to be extremely expensive, and standard solutions might have to be To the extent that discretion is retained on issues adopted in some cases. that are of concern to investors, such as prices, the 26 Concessionsfor Infrastructure: A Guide to Their Design and Award Table 3.2 Identification and Allocation of Risks What ir the risk? How does it arise? How should it be allocated? Design/development risk Design defect Design fault in tender specifications Public sector to bear risk Contractor design fault Liquidated damages to be paid by contractor; once liquidated damages are exhausted, erosion of project company's returns Construction risk Cost overrun Within construction consortium's Contractor to bear risk through fixed-price control (inefficient construction construction contract plus liquidated damages; practices, wastages, and so on) once liquidated damages are exhausted, erosion of project company's returns Outside construction consortium's Insurer risk if insurance is available; once control: changes in the overall legal insurance proceeds are exhausted, erosion of framework (changes of laws, project company's returns increased taxes, and so on) Outside construction consortium's Public sector to bear risk control: actions of government that specifically affect the project (delays in obtaining approvals or permits, and so on) Delay in completion Within construction consortium's Liquidated damages to be paid by constructor; control (lack of coordination of once liquidated damages are exhausted, erosion subcontractors, and so on) of project company's returns Outside construction consortium's Insurer risk, if risk was insured; once insurance control (force majeure, and so on) proceeds are exhausted, erosion of project company's returns Failure of project to Quality shortfall, defects in Liquidated damages to be paid by constructor; meet performance construction, and so on once liquidated damages are exhausted, erosion criteria at completion of project company's returns Operating cost rik Operating cost overruns Change in practice of operator at Project company to bear risk project company's request Operator failure Liquidated damages to be paid by operator to the project company; once liquidated damages are exhausted, erosion of project company's returns Failure or delay in Public sector discretion Public authorities to bear risk obtaining permissions, consents, and approvals Changes in prices of Increased prices Allocation of risk to the party best able to supplies control, manage, or bear it (supplier, project company, or users) Nondelivery of Public sector failure Public authorities to bear risk supplies on the part of public authorities Concession Design 27 Table 3.2 Identification and Allocation of Risks (continued) What is the risk? How does it arise? How should it be allocated? Revenue risk Changes in tariffs In accordance with the terms of Project company to bear risk the contract (for example, indexation of tariffs leads to reduced demand) Government breach of the terms of Public sector to bear risk the contract Changes in demand Decreased demand Project company to bear risk Shortfall in quantity, Operator's fault Liquidated damages to be paid by the operator; or shortfall in quality once liquidated damages are exhausted, erosion leading to reduced of project company's returns demand Project company's fault Liquidated damages to be paid by the project company to public authority Financial risk Exchange rates; Devaluation of local currency; Project company to bear risk (hedging facilities interest rates fluctuations might be put in place) Foreign exchange Nonconvertibility or nontransfer- Public sector to bear risk; in case of contract ability termination, compensation to be paid by government Force majeure risk Acts of God Floods, earthquakes, riots, Insurer risk, if risk was insured; otherwise, risk strikes, and so on to be borne by project company Changes in law Changes in general legal Normally, project company to bear risk (public framework (taxes, environmental sector could bear risk when changes are standards, and so on) fundamental and completely unforeseeable; for example, switch from free market to central planning) Changes in legal or contractual Public sector to bear risk framework directly and specifically affecting the project company Performance risk Political force majeure Breach or cancellation of contract; Insurer's risk, if risk was insured; expropriation, creeping expropriation, otherwise risk to be borne by public failure to obtain or renew approvals sector; in case of contract termination, compensation to be paid by government Environmental risk Environmental incidents Operator's fault Liquidated damages to be paid by the operator; once liquidated damages are exhausted, erosion of project company's returns Pre-existing environmental liability Public sector to bear risk Source: World Bank (1997: 46-50). 28 Concessions for lnfrastructure: A Guide to Their Design and Award Figure 3.1 Regulatory Engineering-A Decision Tree Are domestic institutions capable of credible commitment (adhering to and implementing prespecified rules)? No Yes Regulatory reform Do institutions require very alone may fail. specific substantive rules to be credible? No Yes Regulatory rules can leave Is administrative capability room for discretion. strong? No Yes Regulatory rules should leave Regulatory rules should little scope for discretion and leave little scope for should, in addition, be simple discretion but can be to implement and monitor. relatively complex. Source: Levy and Spiller (1993). challenge is to minimize the risk that the discretion * Is the conceding authority responsible for sup- might be misused. This subject is dealt with in plying some inputs to the private operator? Is chapter 5. such supply guaranteed? * Who is responsible for maintenance? Who is 3.2 Allocation of Responsibilities responsible for renewals? How can the distinc- tion be made between maintenance and 3.2.1 Main Design Issues renewals? * Who is responsible for upgrades? How are In most contracts allocation of responsibilities upgrades defined? between parties will be specified in the provisions * Who is responsible for new investments ?8 defining the service to be provided, conditions of operation of the service, and works to be under- 3.2.2 Some Lessons of International Experience taken (see, for example, table 3.1 and articles 2.1, 2.2 and IV of the IFC Guide to Power Purchase International experience reveals the importance of Agreements in annex 2). the following points: Questions to be addressed while designing these provisions include: Minimizing problems of overlapping or undefined responsibilities. This problem is one of the most * Who is responsible for tariff collection? Who pervasive in concession arrangements. Leases bears the risk of nonpayment? in particular too often suffer from poor dis- Concession Design 29 tinction between maintenance (which is the disconnecting large numbers of small customers responsibility of the lessee) and renewals who were not paying their bills. In many cases (which must be carried out by the public party). disconnecting service to public agencies is Special efforts have been made in the design of explicitly or implicitly forbidden. There are sev- some recently cbncluded agreements to tackle eral possible measures that private operators that problem. For example, the Senegal water can be empowered to adopt to effectively tackle distribution lease, concluded in April 1996, dis- the problem (box 3.1). tinguishes between maintenance and renewals on the basis of the length of the amortizing peri- 3.3 Price Setting ods for each asset, which is defined in the contract. 3.3.1 Main Design Issues Avoiding an allocation of responsibilities that hin- ders operational efficiency. Responsibilities of Provisions determining the price at which services the parties might be clearly defined, but in such can be sold are, of course, central to concessions. a way as to make the provision of the service Concession contracts, or in some cases other legal unnecessarily difficult. This is the case, for instruments such as laws or regulations controlling example, in the lease contract concluded in the prices of infrastructure services, will comprise Guinea in the electricity sector. The renewal of provisions establishing the basic tariff, possibly dif- certain small items, including vehicles, tools, ferentiating between types of services, categories office supplies, computer equipment, and small of consumers, and so on. In addition, special pro- generating sets is the responsibility of the visions might, for example, provide for tariffs ben- lessee. All other renewals must be carried out efiting public entities or poor users. (See, for by the state holding company, which also must, example, table 3.1, and Article 2.2, paragraph 2, in at the beginning of the contract, rehabilitate the Guide to Power Purchase Agreements in annex some of the small items to be later renewed by 2). Provisions dealing with the adjustment of tar- the lessee. The arrangement proves extremely iffs, as opposed to the structure of prices, are difficult to implement in practice, as responsi- examined in section 3.4. bility for maintenance is, in effect, split Some of the main issues related to the price between the state holding company and the structure include: lessee. More generally, the efficient coordina- tion of new investments with operations and * Are the rules for establishing the tariff level and maintenance often proves difficult under lease structure clear? arrangements, since the public party remains * Does the concessionaire have the freedom to the principal financier of works that contribute vary the tariff structure and cost allocation to the operational efficiency of the lessee. across the customers within certain limits? * Allowing the operator to adopt appropriate mea- * Does the concessionaire have the freedom to sures to obtain payment from public and private introduce tariff surcharges in times of high users when the operator bears the risk of tariff col- demand? lection. The problem of nonpayment constitutes * Does the concessionaire have the freedom to one of the biggest obstacles to the implementa- propose contracts to users, according to which tion of private participation in infrastructure service might be interrupted in times of high schemes and one of the main causes of failure demand? in some of the deals that are implemented. The * Should some users benefit from preferential private operator of the water and electricity sys- tariffs? If such tariffs create a shortfall in rev- tem in Gambia, for example, was expropriated enue, how should that shortfall be by the government in early 1995, after it started compensated? -30 Concessions for Infrastructure: A Guide to Their Design and Award Box 3.1 Tackling Nonpayment by Private and Public Users of Infrastructure Services Nonpayment by users of infrastructure services a similar idea, since operators must pay the util- (stemming from refusal to pay bills or from fraudu- ity and are left to collect revenues from individ- lent connections) is a major problem in many coun- ual users whom they presumably know well and tries. The problem is especially prevalent where the on whom they are usually able to exert some services have been heavily subsidized for long periods pressure in case of nonpayment. Concluding of time, thus leading to a perception among the pop- concessions not with one operator but with the ulation that such services should be free. user community itself, as is sometimes done for Many private providers have considered this situa- small water distribution systems, for instance, tion to be an opportunity, seeing a possibility of raising might constitute yet another way of achieving collection rates considerably. But, the opportunity the same objective. exists only to the extent that the service providers are * Public awareness campaigns. In several instances free to adopt a series of measures designed to deal such campaigns have proven effective in reduc- effectivelywith the issue. Such measures might include: ing wasteful consumption and in increasing willingness to pay. With respect to private customers: With respect to public users: * Disconnection in case of nonpayment. This is clearly the most important tool with which to * Disconnection of nonessential services. Ideally, obtain payment. this should be combined with progressively nar- * Installing hard-to-tamper-with and prepayment rower definitions of essential services. meters. This increases the cost of service provi- * Insisting on separate accounts for different govern- sion, but might be justified in some circum- ment departments and parastatals. The objective is stances. to rnake it easier to disconnect individual non- * Promoting self-policing among the user community. payers. One such solution recently adopted in the elec- * Requiring payment from central budget authori- tricitysectorinArgentina involves disconnecting ties. Such authorities are usually in a better neighborhoods where consumption levels indi- position to require and obtain payment from cate large-scale thefts, so as to give incentives to other public users. users in the area to prevent such thefts. * Insisting thatfunding be specifically earmarkedfor Entrusting responsibllity for the operation of utility bills, with prohibition of disbursement for water fountains to private operators is based on any other purpose. Source: Kerf and Srnith (1996). More generally, does the tariff provide incen- the suppliers' direct costs of production, but also tives to the operator to ensure proper mainte- the costs that production might impose on others nance or expansion of the system? And does (through pollution, for example). On the other the tariff enable users to take into account the hand, prices should also reflect demand conditions. economic value of the service, while making Goods or services for which users are willing to pay consumption decisions? a lot should be priced higher than those for which users are willing to pay a little. At any given price 3.3.2 The Role of Prices suppliers are willing to supply a certain quantity of goods or services, and consumers are willing to con- Prices provide signals to suppliers about how much sume a certain quantity as well. When prices rise, to supply and to consumers about how much to suppliers have an incentive to supply more and con- consume. In order to maximize the overall welfare sumers to consume less. The reverse is true when of sodety, the price of a good or service should prices fall. Optimal prices balance demand and reflect the costs incurred in the production of that supply, and consumers and suppliers adjust con- good or service. These costs should include not only sumption and supply decisions accordingly. Concession Design 31 3.3.3 Is Marginal Cost Pricing the Solution? cient use of scarce resources and prevents unnec- essary investments and operational costs. In order to maximize the benefits to society of pro- Marginal cost pricing raises a number of issues, ducing and consuming a given type of good or ser- however. One issue, that is particularly relevant in vice, users should be charged the cost of producing the context of infrastructure is the fact that, in the an extra unit of the good or service when they presence of increasing returns to scale (that is, require it (that is, prices should equal marginal when the marginal cost of providing the service is costs). Therefore, to the extent that location, qual- lower than the average cost-a common situation ity, quantity, and time of day or year affect marginal in some infrastructure industries), marginal cost cost, prices should vary accordingly. pricing will result in losses for the service provider. Time of delivery, in particular, is an important There are ways to compensate the service provider factor in infrastructure sectors, where there is for the fixed costs that are not covered by marginal unused capacity most of the time. For example, cost pricing: to keep the tariff structure unchanged while the marginal cost of supplying additional and compensate the service provider through gov- water at off-peak periods might be very low, in ernment payments or to allow the service provider order to satisfy additional demand during peak to charge tariffs that cover the full cost. periods, a water supplier might have to build costly Whether the first option is advisable or not extra capacity into treatment plants and water depends to a large extent on the efficiency of the pipelines. The cost of doing so should be borne tax system and the credibility of government com- exclusively by those who require water during peak mitments. In many developing countries budget periods. Differentiating between peak and off- constraints are such that the state simply cannot be peak demand can be achieved, with varying relied on to finance the fixed costs of infrastructure degrees of success, through a number of schemes. projects. Adopting the first approach in those con- Note that, in general, compared with a pricing ditions would result in low coverage and insuffi- scheme, in which the cost of increasing capacity is cient maintenance-as is actually the case in many spread across every consumer, marginal cost pric- parts of the world. Some argue, in addition, that it ing is likely to depress demand that is the most is easier to ensure that the service provider does expensive to satisfy. It thereby promotes the effi- not charge excessive prices when full costs have to Box 3.2 Differentiating between Peak and Off-Peak Demand in the Supply of Infrastructure Services Possible schemes aimed at differentiating between utility, PEPCO, offers rebates to those who peak and off-peak demand include: agree to have their air conditioner cycled off for up to six hours on weekday afternoons during • Charging different prices according to the time of the surnmer. service delivery. This is widespread in the elec- Imposing emergency prices. Such prices can be tricity and telecommunications sectors, for imposed in times of unforeseen capacity con- example, where prices often vary between night straints on the system. For example, in Denver, and day, between seasons, and so on. during the drought of 1976, restrictions were * Levying charges on certain types of appliances. The placed on garden watering, limiting it to once use of air conditioning systems, lawn sprinklers, every three days. But people could buy a US$15 and other appliances giving rise to the peaks permit to exceed the quotas. This scheme raised can be discouraged through taxation. enough money to cover its own administrative * Proposing interruptible supply contracts. In costs and it kept water demand during the Washington, D.C., for example, the electricity drought below full capacity (see OECD 1987). Source: OECD (1987) and World Bank staff. 32 Concessions for Infrastructure: A Guide to Their Design and Award be included in the tariff charged to consumers, depart from economic efficiency Departure from because consumers are usually better able than economic efficiency can be reduced somewhat if taxpayers to organize collectively to make sure that the rate is set higher for owners of appliances that the service provider does not artificially inflate its contribute to peak demands. costs. Finally, unless the activity at least breaks Local telephone services, for example, are even, marginal cost pricing does not reveal whether priced according to a flat rate system in the United it is worth it to society to incur the full cost of the States: there is a fixed monthly service charge and service. Indeed, users might be ready to pay the unlimited free local calling. Flat rates are also used marginal cost of supplying the service. They might, in much of Latin America for unmetered water however, prefer to stop consuming it if they have connections. Water charges are based on lot size to pay the full cost of production when that cost is and property value, regardless of the amount of higher than marginal cost. water consumed. Under these conditions water The above arguments means that, for develop- demand may reach 500-600 liters per capita a ing countries especially, the general prescription day-about twice the norm for a metered system. will often be to charge cost-covering tariffs. It is important, then, to select a way of doing so that 3.3.4.2 Fixed per-unit rate. While it provides a minimizes the efficiency loss due to departing from solution to the previous problem, this price marginal cost pricing (see Laffont and Tirole 1993: regime-a per unit charge calculated so as to sat- 19-35). isfy the break-even constraint-is also likely to be economically inefficient since differences in mar- 3.3.4 Cost-Covering Tariffs ginal costs are not taken into account and all con- sumers, at all times, are charged the same price Cost covering tariffs can be designed in several (figure 3.3). ways. Possibilities include the following. 3.3.4.3 Value-of-service pricing. This pricing 3.3.4.1 Flatrate. Consumers are charged fixed scherne takes demand and cost characteristics into prices regardless of the quantity consumed (figure account. It charges higher prices to users who are 3.2). To the extent that the marginal cost is differ- less price-sensitive. As a result, consumers change ent from zero (and that the price elasticity of con- their demand patterns too little, compared with sumption is not zero), such a pricing scheme will what they would do under marginal cost pricing. Figure 3.2 Flat rate Figure 3.3 Fixed Per-Unit Rate Price Price 100 10 80 8 60 6 Total expenses 40 4 Total expenses 20 'C -- - ------ -- ---2 - Unitex-enses Unit expenses ~ ~ ~ ~ ~ ni epese 0 0~ 0 2 4 6 8 10 0 1 2 3 4 5 6 Quantity Quantity Source: Bauer (1996) and World Bank staff. Source: Bauer (1996) and World Bank staff. Concession Design 33 Economic distortion is therefore minimized.9 unit prices are justified as recognizing these cost While elegant in theory, this pricing scheme is differences. When costs do not decline with quan- extremely difficult to implement because of its tity, however, declining block tariffs depart from heavy informational requirements (how demand economic efficiency Declining block tariffs will, in varies with price, in particular, is very difficult to particular, not properly take into account the high evaluate). Also, it may be socially unacceptable investment costs that might be required to add that those needing services most (and who will capacity to the system and deliver larger quantities therefore accept high mark-ups without reducing to some consumers. Some present another argu- consumption) should pay the highest price. ment in favor of declining block tariffs: costs are recovered through the high per-unit price paid on 3.3.4.4 Two-part tariffs. Two-part tariffs com- the first units of consumption rather than through prise a fixed charge (which is usually paid to gain a fixed charge, thereby reducing the risk-men- access to the service) and a per-unit charge. The tioned above-that some users willing to pay mar- per-unit charge can be set equal to marginal cost, ginal but not total costs will prefer to be while the fixed charge is used to make up for the disconnected. In such conditions declining block revenue deficit (figure 3.4). As long as the fixed tariffs remain inefficient, however, as the price charge is not so high that users, who would other- paid on the first few units of consumption is above wise have consumed some of the service prefer to marginal cost. A more efficient way of tackling the be disconnected, consumption patterns will disconnection problem would be to maintain a remain efficient, since the per-unit charge sends two-part tariff but to subsidize those consumers the right economic signals. who are unable to pay the fixed charge (see section 3.3.5). 3.3.4.5 Declining block tariffs Declining block tariffs, of the kind presented in the box below, are 3.3.4.6 Increasing block tariffs. In some cases usually advocated on the basis that larger con- value-of-service pricing, two-part tariffs, or declin- sumers are cheaper to serve than smaller ones (fig- ing block tariffs are seen as unfair because they ure 3.5). In telecommunications, for example, the penalize small users. When such a preoccupation unit labor cost of installing a telephone exchange looms large, one way of protecting small con- with many lines is said to be lower than the cost of sumers is to implement increasing block tariffs. installing one with only a few lines. Declining per- The Cancuin and Cartagena water concessions, for Figure 3.4 Two-Part Tariffs Figure 3.5 Declining Block Tariffs Price Price 100 0.1 80 0.08 Total expenses 60~~~ 0.0 \ Unit expenses 60 -0.06 \______ 40 0.04 20 - 0.02 ~~~~ ~~~Unit expenses 0 0 2 4 6 8 10 0 10 20 30 Quantity Quantity Source: Bauer (1996) and World Bank staff Source: Bauer (1996) and World Bank staff. 34 Concessionsfor Infrastructure: A Guide to Their Design and Award example, have, in addition to a fixed charge, per- where the first priority should be to ensure that suf- unit charges that rise with consumption. If the ficient financing is available to dramatically overall tariff is to raise sufficient revenues in an increase the number of people with access to infra- activity characterized by increasing returns to structure services. scale, however, higher blocks will have to be priced Another argument in favor of pricing some ser- above marginal costs, and the resulting distortions vices below cost is that the poor cannot pay cost- in consumption patterns could be severe. In addi- covering tariffs. In fact, international experience tion, if small users pay less than marginal cost, the clearly demonstrates that in the developing world system generates cross-subsidies, which create subsidizing infrastructure services cannot, nor- additional problems (explained below). Finally, mally, be defended on the basis that it truly helps increasing block tariffs of the kind depicted in fig- the poor, since the poorest typically have no access ure 3.6 do not discriminate between rich and poor to these services. Rather, price subsidization as everyone benefits from the low price charged on schemes often result in lack of revenue to finance the first units. Another type of increasing block the extensions required to link the poorest com- tariff whereby large users pay a high price for all munities to infrastructure networks or lack of units of consumption, while small users pay a lower incentives on the part of service providers to price could constitute an improvement in that extend coverage to those communities. In addi- respect.'0 tion, poor members of society do generally pay very high prices to obtain services either through self 3.3.5 Dealing with Sabsidies provision or from the informal sector.'I When subsidies are nonetheless deemed As argued above, when budgets are tight and absolutely necessary, they should be designed with investment needs are large, the general policy pre- six main interrelated objectives in mind. They scription should be to charge cost-covering tariffs. should be affordable given the current budget; be Some argue that exceptions are justified when the precisely targeted to the most needy; minimize dis- consumption of services generates positive exter- tortions in resource use; maintain incentives for nalities (for example, improvement of health from productive efficiency; allow for the introduction of installing proper sewerage systems). But pricing competition; and be implemented in a transparent such services below costs to encourage their con- manner so that the direction and magnitude of sumption will rarely make sense in poor countries, subsidies can be kept under close scrutiny, Systems of cross-subsidies, whereby some users Figure 3.6 Increasing Block Tariffs pay less than what it costs to provide the service to Price them, while others pay more to compensate, are 0.1 common but have negative consequences. Consumnption patterns will be distorted not only 0.08 r for those who benefit from the subsidies, but also I for those who are net contributors to the scheme. 0.06 I Further, a monopolistic structure has to be main- tained or new entrants have to be forced to con- 0.04 I tribute to the scheme. Otherwise, new entrants I Unit expenses could offer lower prices to the customers paying 0.02 higher prices, thereby eliminating the source of subsidies needed by the incumbent. Finally, cross- 00 10 20 30 subsidy schemes are notoriously nontransparent Quantity since all transfers are made internally by the service Source: Bauer (1996) and World Bank staff. provider. Concession Design 35 International experience illustrates a range of from service providers in proportion to their mar- alternatives for dealing with this issue. One ket share. The rural telephone funds established in approach would be to finance carefully targeted the Unites States and Australia provide illustra- subsidies through the budget and administer them tions of this approach (see Irwin 1997). as part of a cross-sectoral scheme. Subsidies thus become an integral part of the welfare system, 3.4 Price Adjustment rather than the responsibility of infrastructure providers, and are therefore more transparent. 3.4.1 Main Design Issues Distortions are minimized, and the system will allow the introduction of competition. In addition, Over the life of a 20- or 30-year concession much to maintain incentives for the provider to be effi- is likely to change-from the costs of major inputs, cient, budget payments can be made only for each to specific service requirements, to the details of unit of service actually provided. Chile, for exam- the wider legal environment in which the conces- ple, has replaced its cross-subsidy system with such sionaire operates. In practice, many of these a scheme in the water sector (box 3.3). changes cannot be predicted accurately. When the first-best approach is considered Accordingly, concession contracts must allow unfeasible, some countries adopt second-best prices to be adjusted over time, without prior strategies that still enable competition to be intro- knowledge of what those adjustments should be or duced. One approach is to finance carefully tar- what will trigger them. geted subsidies through special funds, which are We can usually distinguish between three types financed from explicit levies on all consumers, of price adjustment rules: indexation rules, rules either directly or indirectly, by collecting the levy for periodic revisions of the basic tariff and of the Box 3.3 Replacing Cross-Subsidies in the Water Sector-Chile's Approach Chile recently replaced its cross-subsidy system with share of the bill have their subsidy suspended. a comprehensive subsidy scheme for low-income Initially, the onus of proving entitlement to the subsi- households, aimed at assisting with the purchase of a dies was laid on households. However, low take-up variety of public services. Every two years the rates prompted water companies to collaborate in Ministry of Planning conducts a detailed national sur- identifying needy customers by examining tariff pay- vey to determine household poverty. On the basis of ment records. It is now believed that all eligible that survey, the Ministry determines how many households in urban areas (about 18 percent of the households require subsidies, as well as the monetary population) are covered by the scheme. volume of subsidies required by the municipalities. In addition, the water company provides loans to The finance ministry reviews this assessment and poor families to help pay for water connections, which requests the necessary budget provision from can cost between US$200 and US$800 (the cost of Congress. Implementation of the subsidy scheme is connection to the system is often the greatest hurdle the direct responsibility of the municipalities. to expanding consumer access to infrastructure ser- In the case of water the subsidy covers 25-85 per- vices in poor neighborhoods). A typical loan would cent of the charges for the first 20 cubic meters of require a 15 percent down payment, with monthly consumption. The municipalities pay it directly to the payments over five years at commercial interest rates. service provider-rather than the households-on While the Chilean model has numerous advan- the basis of services actually provided (that is, on the tages and is being followed by other countries, such basis of the bills actually sent to consumers). The goal as Hungary, it relies on strong local administrative of the scheme is to ensure that water and sanitation capacity coupled with high government commitment. services do not consume more than 5 percent of It might therefore not be easily transferable in coun- household income. Households failing to pay their tries where such assets are lacking. Source: Rivera (1996: 37). 36 Concessions for Infrastructure: A Guide to Their Design and Award indexation rules themselves, and rules for price 3.4.2 Basic Principles of Price Adjustment adjustment in the face of unforeseen events. The first two types of rules are the topic of this section Some basic principles guide the design of_price (examples of such rules can be found in table 3.1 adjustment rules. Broadly, the objective of these and Article 2.2, paragraph 2, of the Guide to Power rules is to ensure that the concessionaire will con- Purchase Agreements in annex 2). Price adjustments tinue to face pressure to seek efficiencies, but will in the face of unforeseen events are discussed in also be able to earn a reasonable-rate of return. In section 3.9. The question of who should be desig- order to arrive at a rule for attaining this objective, nated to apply the price adjustment (and other) we must decide which factors affecting a conces- rules is addressed in chapter 5. sionaire's costs and profitability should be taken Multiple issues arise in the context of price into account in adjusting the price level. We also adjustment provisions. Some of the most impor- must determine when and how to adjust the price tant ones include: level. These decisions hinge importantly on two factors: the proper allocation of risk and manage- * How should indexation rules be designed? ment of the transaction costs of price adjustment. Should specific indexation parameters apply to particular components of the cost structure or 3.4.2.1 Risk allocation. The question of which should a general index be applied to the over- factors a price adjustment mechanism should incor- all tariff? porate is closely related to the question of which e How frequently should prices be changed? risks should be allocated to the concessionaire, * What procedures should be followed to revise which to the government, and which to some other the basic tariff and indexation rules? How party. As mentioned in section 3.1.3, prices and often should these rules be revised? other terms should be adjusted when they reflect i Against which types of cost changes should the events outside the control of the company, but not operator be protected? otherwise. The protection granted to the operator v How can incentives for productive efficiency against price changes should also be devised so as be preserved? not to distort operating, investment, and finance * How do price adjustment rules affect the com- decisions. Protection against exchange rate mercial decisions of the operator? changes, for example, raises that issue (box 3.4). Box 3.4 Protection Against Exchange-Rate Movements and Neutrality of Price Adjustments Price indexation designed to protect against fluctua- water prices that reflects the cost of nontradable tions of the exchange rate can bias an operator's deci- goods (goods not traded outside certain geographical sions. For example, prices may be indexed in the regions, where prices reflect only demand and supply following way: the component reflecting the cost of conditions in the relevant region) with inflation, and domestically purchased equipment is adjusted with the component that reflects the cost of tradable goods inflation, and that of imported equipment with (goods traded across borders, where prices reflect exchange-rate movements. If the company has a world market conditions) with the exchange rate- favorite supplier of equipment abroad, it will be regardless of whether the goods have actually been tempted to use imported equipment because it is imported or produced domestically. Because in open insured against exchange-rate adjustments, even economies prices of all tradable goods would tend to though locally produced equipment may be cheaper. adjust with exchange rate changes, the company It would, therefore, be preferable to use a more neu- would be protected against exogenous price changes tral criterion to adjust prices. but would have no special incentive to purchase For example, one might adjust the component of either imported or domestic goods or services. Source: Klein (1996a). Concession Design 37 3.4.2.2 Transaction costs. The task of price reevaluate the adequacy of existing formulas and adjustment rules is to convert observed changes in more generally accommodate the effects of those costs or profitability into allowable price changes. changes. In this area the emphasis is on establish- This process can be open to considerable dispute ing adequate procedural rules for the reviews and can be very difficult and costly to implement. rather than on devising specific price adjustment Price adjustment rules-and the processes by formulas. which they are applied-must try to economize on transaction costs. An important factor to achieving 3.4.3 Main Pricing Rules this objective is to strike an appropriate balance between rigidity and flexibility when designing The different pricing rules described below (rate of price adjustment mechanisms. This balance, in return regulation and price caps) are too often pre- turn, will depend in large part on the degree of sented as being starkly different from one another. unpredictability of the events requiring price In reality, it is only the degree to which various pric- adjustments. ing rules exhibit advantages or disadvantages that The existence-if not the exact rate-of inflation differs. Besides, as indicated below, multiple vari- is foreseeable and can be taken into account through ants and hybrids are possible. As far as their incen- relatively specific indexation formulas. The general tive properties are concerned, pricing rules can be consumer price index, for example, can be used, at placed on a continuum. To determine those prop- prespecified intervals, to adjust prices (box 3.5). erties with precision and figure out how a particu- Where available, indexes to measure cost lar rule compares with another, we must analyze inflation for specific cost factors can also be used the specifics of the formula. (box 3.6). Over longer periods several factors other than 3.4.3.1 Rate of return. Rate of return regulation inflation are likely to affect costs and profitability ties the revenues of a utility to its costs, measured These might include, for example, major changes in the costs of raw iltputs not picked up by the Box 3.6 An Example of a Price Adjustment index, technological evolution that completely Formula modifies the cost structure of the activity (that is, changes in the weights, a.), or changes in demand If the maximum permitted price at period t- 1 is resulting from shifts in population. Such changes defined as: and their likely impacts are more difficult to pre- t ii, dict than "regular" inflation. It is therefore more The maximum prices at period twill be adjusted in difficult to devise in advance detailed rules that the following way: take such changes into account. Most concessions I provide for a price review about every five years to P < 10iC,, [I (i )J Box 3.5 Price Cap Formula where L o1 p [+ (Ir-X )j The maximum price in period t (Pt) equals the PI< Pt-, 100 weighted sum of cost factors at time t-1 (Ct-I) adjusted for an index of cost inflation for cost fac- Pt: Price at period t tor i between period t and t-1 (Uh) and a factor Pt: Price at period efecintxpctd ffcinc ginfbtwent n It: Measure of inflation between period t and t- 1 reflecting expected efficiency gains between t and X: Measure of expected efficiency gain t- ( -)' Source: World Bank staff. Source: Klein (1996a). Source: World Bank staff£ 38 ConcessionsforInfrastructure: A Guideto TheirDesignandAward as expenses (operating expenses, depreciation, and rate of return regulation for electricity has been taxes) plus the return on the capital committed to linked to a development fund. Surplus profits flow its operations (figure 3.7). The objective is to limit to a fund, which can then be drawn on in years the utility's revenues so that it is able to recover its when profits fall below the agreed level (see Klein expenses and to earn a specified rate of return on and Smith 1994: 39). its invested capital. The rate of return approach is The rate of return system presents one main used in, for example, Canada, Japan, the United advantage: States, and Hong Kong. The first step is to identify the utility's overall * Security to investors and therefore lower capital revenue requirement, which involves determining costs. In the "pure" rate of return system the expenses of the utility, the investments under- described above, the company is assured that taken to provide the services, and the allowed rate its expenses will be reimbursed and the speci- of return on these investments. The level of fied rate of return on its investments achieved. expenses can be obtained from the accounting costs for a test year, which is generally the most But, the system also exhibits some weaknesses: recent year for which audited information is avail- able. The capital dedicated to producing the ser- * W1eak incentives for effciency. The company has vices (which is also called the rate base) can be very little incentive to minimize costs since it valued according to a range of different methods knows that these can be recouped through higher (described later in box 3.15). Finally, the allowable tariffs. In fact, however, in systems with regula- rate of return is typically a weighted average of the tory lags (in which tariffs are not adjusted instan- cost of debt and the cost of equity. taneously or retroactively to reflect changes in In the Unites States the revenue requirement cost conditions), the company does, in effect, of the utility is then translated into consumer have some incentives to control costs, as it might prices. Rate review can be initiated by the com- benefit for a time from lower than expected costs. pany, the regulator, or other intervenors when the This is not the case in a system such as that revenue actually raised is higher or lower than the applied in Hong Kong, however, since any gains revenue requirement or when the revenue require- from cost cutting would eventually have to be ment must be changed (because expenses or the transferred to the development fund. rate base have changed or because the rate of * Overinvestment. To the extent that returns on return is no longer adequate). In Hong Kong the the rate base are more attractive or secure than on investment alternatives, the utility will have Figure 3.7 Rate of Return Regulations incentives to overinvest in capital. This is com- monly called the Averch-Johnson effect. of Assets Allowable 3.4.3.2 Price cap. Over the past decade or so Retum1 - , some countries have started experimenting with a l ofCaiall , . Idifferent approach to economic regulation, in an Revuirements Return effort to overcome the weaknesses of the rate of Requl Return return method. Instead of limiting the operator's revenues in the aim of allowing for a specified rate Dea Prices _of return on its investment, the regulator fixes the price that can be charged for long periods of time Actual according to a formula that takes into account Demand future inflation and future efficiency gains expected Source: Bauer (1996) and World Bank staff. from the utility (this is the RPI-X formnula used in Concession Design 39 the United Kingdom). A stylized example of a price Price caps are becoming increasingly popular. cap formula is provided in box 3.5. In some cases In addition to the United Kingdom, Argentina, additional factors can be inserted into the formula Malaysia, Mexico, New Zealand, Peru, Puerto to take expected variations of future costs into Rico, Singapore, and the United States have account. Such variations could result, for example, adopted them in telecommunications. In addition, from a tightening of quality standards or from the New Zealand uses them for postal services, and implementation of a large expansion program."2 Argentina for gas and electricity. The purpose of consumer price indexation is to Advantages of the price cap system include: compensate the concessionaire for exogenous cost increases. Other indexes that more closely reflect Stronger incentives for efficiency. The provider the exogenous costs of the concessionaire's inputs has incentives to improve efficiency since it may be used instead. These indexes may reduce retains the benefits of lower-than-expected the risks faced by the concessionaire without costs for the period during which prices are blunting incentives. To the extent that they track fixed (which is typically longer than under a rate the operator's actual marginal cost more closely, of return system). Such incentives, however, they may also lead to prices that are allocatively depend on the proper exercise of regulatory more efficient (see section 3.3). Hungary, for powers: at the price review prices can be example, includes a producer price index rather adjusted to reflect the new level of efficiency as than a consumer price index in the price cap for- well as future expected efficiency gains, but mula used in the telecommunications sector. should not be readjusted so as to retroactively Box 3.7 Successive Revisions of the Price Caps in the UK Telecommunications Sector British Telecom was privatized in 1984. The initial cent of British Telecom turnover-the only services general price cap covered slightly more than 50 per- now not regulated by price controls are calls from cent of its sales and was set at the retail price index telephone boxes and priority fault repair services. (RPI) minus 3 percent (X) for a period of five years. The price cap for the general basket of services At each revision, not only was the value of X modi- (exchange lines rentals; local, national, and interna- fied, but the basket of services covered by the general tional call charges; connection charges; and opera- cap was altered. In some cases additional caps were tor-assisted calls) was made more stringent at RPI imposed on services not included in the basket. minus 7.5 percent. Rebalancing within the general At the first price cap review in 1989, the range of basket is also restricted by an RPI minus 0 percent services covered by the cap was extended slightly to for all individual prices other than exchange line include operator-assisted calls, the cap was tightened rentals, where there is an individual price cap of RPI to RPI minus 4.5 percent, and the period before the plus 2 percent, and a maximum connection charge. next review was reduced to four years. Although the These pricing arrangements are intended to remain price caps were not scheduled for review until 1993, fixed until the next scheduled review in 1997. A a number of key revisions were made in 1990-91 in recent consultative document issued by the regula- the context of a review of the regulated duopoly. tor proposes a cap ranging from 5 percent to 9 per- International services were added to the basket of cent below RPI. regulated services, and the price cap was tightened Despite the successive tightenings of the price again to RPI minus 6.25 percent. Other related cap on British Telecom and the other utilities in the changes included a more generous RPI plus 5 percent United Kingdom, a windfall tax on the privatized for most business rentals, low-user rebates, and the companies has been proposed to compensate for the possibility of introducing volume discounts for bulk "excessive" profits they have made. Such a posteriori users, provided British Telecom adhered to RPI modification would of course undermine the ratio- minus 0 for the median residential bill. nale for establishing a price cap regime in the first In the second (official) price cap review in 1993 place and would likely discourage future efforts to the scope of price caps was extended to some 70 per- increase efficiency. Source: Glynn (1992: 90-99). 40 Concessionsfor Infrastructure: A Guide to Tbeir Design and Award eliminate the profits made during the previous elements, or they can be linked to factors driving period (box 3.7). fixed costs, such as the number of consumers. There are, however, several disadvantages, 3.4.3.4 Hybrids between rate of return and price including: cap systems. In practice, most regulatory systems are hybrids of pure rate of return and pure price * Higher risksfor investors and therefore higher costs cap regulation. If price reviews are frequent of capital. With prices fixed for long periods of enough, price cap regulation closely resembles a time, the company benefits from higher than rate of return regime. Further, as mentioned expected efficiency but suffers when costs turn above, regulators might, in practice, be tempted out to be higher-than-expected. Those risks are not only to readjust prices for the future, but also particularly important when many of the costs to claw back some excessive profits made before are exogenous to the company. This is the case, the periodic review. Once again, this reduces for example, when most of a company's costs incentives for efficiency and makes price caps sim- are fixed and when demand can swing inde- ilar to rate of return regulation. pendently of the behavior of the company. In addition, some specific features can be intro- * Weaker incentives to maintain quality. As the com- duced in the regulatory regime, with the explicit pany benefits from cost reductions, it might be aim of striking a balance between rate of return tempted to lower quality in order to keep costs and price cap systems. Essentially, the objective is under control, therefore efficient monitoring is to retain at least some of the incentives for effi- required (see section 3.1.3). In some cases, how- ciency that are present under a price cap regime, ever, such a temptation might not exist. A price- while reducing the risks borne by investors. capped firm might in fact have incentives to raise quality, for example, if the higher costs that it * Review of investments undertaken under rate of incurs are more than compensated by increased return regulation. This system is used in the demand for its products. United States, where investments will be X Difficulty of making correct predictions about the included in the rate base only if they are con- f*ture. Price cap regulation demands a great sidered "used and useful" and if they pass a deal of information as it requires estimating a "prudence test" (see Bauer 1996: 12). This sys- future real price, future efficiency increases, tem increases the incentives of the company to necessary investments and so on . When pre- be prudent in its investment strategy. It of dictions turn out to be wrong, it is often impos- course also increases the risks that it has to bear sible to resist pressure for change, which and might give to long and costly judicial-like reduces incentives for efficiency (see box 3.7). processes to determine whether specific invest- ments should be included in the rate base. 3.4.3.3 Revenue cap. Revenue caps are a vari- ant of price caps, designed primarily to address the Box 3.8 Revenue Cap Formula problems of utilities, most of whose costs are fixed (box 3.8). In addition, a revenue cap eliminates the R cR [1+ (1>X' incentives to maximize sales to consumers, which ' L \ 100 / utilities have under a price cap.13 Both arguments Rt: Revenue at period t were mentioned when Northern Ireland Electricity ,: Measure of inflation between period t and t- 1 was privatized in 1993 with a revenue cap rather X: Measure of expected efficiency gain than a price cap. Several models are possible: maximum rev- Source: World Bank staff enues can be determined without reference to cost Concession Design 41 Box 3.9 Electricity Distribution Pricing in Chile Chile's method of electricity pricing is distinctive, in the average return falls between rates of return on particular because of the innovative approach it takes assets of 6 percent and 14 percent. If the average to rate of return regulation. The price system is made actual return falls outside this range, the rates are up of regulated rates for consumers with peak demand adjusted to reach the upper or lower limit depending of less than 2 megawatts and freely negotiated rates on whether they fall above or below. for the rest. The final price to regulated consumers has The operating costs of the benchmark "efficient two components: a node price at which distribution firm" and the replacement value of assets are based companies buy power from generators and from the on a weighted average of estimates made by the transmission grid, and the value added of distribution. industry and the regulatory agency Although each The value added of distribution is calculated study is intended to be relatively objective and "tech- every four years. The procedure involves determining nocratic", the residual discretion in the system is illus- the costs of an optimally operated firm and setting trated by discrepancies between the regulator's and rates that provide a 10 percent real return over the the investor's calculations of distribution costs and replacement value of assets. These rates are then asset values, which in some cases have diverged by applied to the real companies in order to ensure that more than 50 percent. Source: Bitran and Serra (1994). * Benchmark (yardstick) regulation. This approach tinction between exogenous and endogenous aims at evaluating the various cost components shocks will rarely be perfectly clear. that determine the overall revenue requirement * Sliding scale rules. These rules provide for profit either by comparing the performance of different and loss sharing between the company and the companies or by estimating the costs of a model government. An example is given by the conces- efficient firm. The first approach is used in the sion for the El Melon Tunnel in Chile, which water industry in the United Kingdom (10 com- states that if the concessionaire's rate of return panies provide both water and sewerage services; exceeds 15 percent, its profits above that level more than 20 others only provide water). The must be shared equally with the state. Another second model is used to regulate electricity dis- example is the system governing the New York tribution prices in Chile (box 3.9). Such a system Telephone Company, established in 1986 (table is likely to greatly increase incentives for effi- 3.3). Such systems reduce, to some extent, both ciency without some of the risks associated with incentives for efficiency and risks. Depending on forward-looking price caps. Designing an appro- the design of specific rules, such systems will tend priate model firm might, however, be both diffi- to resemble a price cap or a rate of return regime. cult and contentious. * Pnce caps with cost pass-through. The incentive 3.4.3.5 A hybrid of a price cap and revenue cap. properties of the price cap system are not under- A hybrid price cap-revenue cap system has been mined as long as the cost elements that can be introduced in the United Kingdom for the Regional directly passed on to consumers are truly exoge- Electricity Companies (box 3.10). Allowed changes nous to the utility. In practice, however, the dis- in revenues, between periodic reviews of the over- Table 3.3 An Example of Sliding Scale Regulation: The New York Telephone Company Rate of return Revenue adjustment Over 15 percent Revenues adjusted down by 0.5(return-15) percent Between 13 and 15 percent No adjustment Under 13 percent Revenues adjusted up by 0.5(13-return) percent Source: Laffont and Tirole (1993: 16). 42 Concessionsfor lnfastructure: A Guide to Their Design and Award Box 3.10 Hybrid Price Cap/Revenue Cap ties of the different regulatory regimes studied above Formula with respect to incentives for efficiency and risks. RI< [k(P_1D ) +(l-k)R1_] [1 + i-xt * Incentivesfor efficiency. The variables covered by I 100 regulation and those that are not differ according to the type of regulatory regime. The variables R1: Revenue at period t not covered by regulation are those that the oper- It: Measure of inflation between period t and t- 1 X: Measure of expected efficiency gain ator has incentives to control n order to maxp- PI1: Price at period t-1 nnize its profits. Both price caps and revenue caps D,: Number of units distributed at period t provide large incentives to control costs. Unlike revenue caps, price caps also give the operator incentives to increase the quantity of service pro- vided when prices exceed costs. Rate of return in all formula, depend both on the application of an its pure forn, on the other hand, does not pro- index to factor prices (as under a price cap regime) vide incentives to the operator to control costs or and on the application of the same index to total maximize quantity supplied. revenues (as under a revenue cap regime). The * Riks. The level of risk associated with a given respective weights given to the two indexes depend activity can be measured by the beta values on the balance between fixed and marginal costs (box 3.11). (when marginal costs are high, the price index is given greater weight so that the price regime is As expected, price regimes, such as price caps, closer to a price cap system, and vice versa). that give operators the highest incentives to control costs-that enable operators to keep the benefits of 3.4.3.6 Summary comparison of the different maintaining low costs but penalize them for high options. This section summarizes the main proper- costs-are also those that carry the highest risk for Box 3.11: Beta Values When a stake is held in a particular security, two types rm is the return on the market portfolio. of risks must be considered. Firm-specific risk can be eliminated by portfolio diversification, as changes in The equity beta measures two types of risk: fun- one share price will be offset by opposing movements damental business risk and financial risk. When mak- in others. Market risk, on the other hand, derives ing comparisons across countries; we should look at from economywide factors that affect all securities fundamental risk. This is measured through the asset simultaneously, albeit to varying degrees, and there- beta, calculated as follows: fore cannot be reduced by diversification. The most commonly used measure of the undiversifiable risk BAi BEi (1 - Gi) + Gi BDi associated with a company is its equity beta value. This measures the extent to which the returns on the where R,,. is the asset beta for security i, security move with the market as a whole. It is defined B6, is the equity beta for security i, as follows: GI is the gearing ratio for security i, and B covariance (ri,rm) BD,,i is the debt beta for security i. variance (rm) A general assumption is that B3D = 0, which simplifies where lSi is the equity beta value for security i, the calculation to: B.Ai = BB (1- G). ri is the return on security i, and Source: Alexander, Mayer, and Weeds (1996). Concession Design 43 the utilities. Rate of return regimes, which grant Important questions related to the design of operators complete protection against cost increases, performance targets include: have the lowest risk. Hybrid options, in which risks and rewards are split between operators and other * How necessary are specific performance targets? parties, are somewhere in the middle (table 3.4). * What elements of the operator's performance are best suited to constitute appropriate targets? 3.5 Specific Performance Targets * To what extent does the need for specific perfor- mance targets vary with the type of pricing rule? 3.5.1 Main Design Issues * How does the level of monitoring and regula- tory capacity affect the need for performance Concessions often contain specific performance targets? targets imposed on the operator. Such specifica- tions can relate, for example, to construction time, 3.5.2 Rationales for Imposing Performance Targets coverage ratios, minimum investments, output quality, output quantity, collection ratios, and Often, the objective of imposing specific perfor- safety and health standards. mance targets is to force operators to act differ- Specific coverage ratios, for example, were ently than they would under the original or included in the bidding documents for the Buenos underlying incentive scheme put in place by the Aires water concession as well as for the Cancun general price regime and the sharing of responsi- water concession.14 The Senegal water contract bilities between parties. One example is the impo- requires that specific investments (a minimum sition of quality standards, which operators would number of new connections and minimum length not maintain otherwise, for example, because they of pipes to be renewed) be undertaken every year. operate under a price cap and would be tempted Other contracts, for example, the freight rail con- to lower quality to lower costs (see section cessions and the gas transmission and distribution 3.4.3.2). Another example is the imposition of concessions in Argentina, impose minimum yearly coverage ratios, which operators would not meet investments in dollar terms. The 26-year operation under the current price regime. The coverage and maintenance contract for water in Cartagena, ratios might, for instance, require that service be Colombia imposes higher quality standards, a extended to rural communities at costs higher reduction in unaccounted for water from 52 per- than can be recovered from the irnposed tariff cent to 25 percent, and a rise in the collection rate schedule. from 62 percent to 100 percent in 10 years. The When considering whether or not specific per- French water lease contract (table 3.1) included formance targets should be used to modify the specific performance targets among the technical behavior of operators, the fundamental question is provisions related to operation (health provisions; whether it would be more appropriate to achieve quantity, quality, and pressure; and verification and the same objectives through other means, such as reading of meters) and to works (quality stan- a modification of the basic allocation of responsi- dards). See also Article 2.1 of the Guide to Power bilities or a modification of the pricing rules. The Purchase Agreements in annex 2. answer will depend on two main factors. Table 3.4 Average Asset Beta Values by Regulatory Regime and Sector Regulation Electricity Gas Water Telecom Price Cap 0.57 0.84 0.67 0.77 Rate of Return 0.35 0.20 0.29 0.47 Source: Alexander, Mayer, and Weeds (1996). 44 Concessions for Infrastructure: A Guide to Their Design and Award The first relates to the pros and cons of possible terms of investments, for example) that have been alternatives. For example, adopting a rate of return obtained from the private party. system might decrease operators' temptation to reduce quality (and could therefore alleviate, to a 3.5.3 Lessons of Experience certain extent, the need to impose and monitor quality standards), but it might also lower their Once it has been decided that specific perfor- incentives to control costs. With respect to coverage mance targets should be imposed on the operator, ratios, another approach would be to replace uni- the following lessons of experience should be form tariffs by a price regime that allows for tariff taken into account. variations in order to reflect cost differences among users. As argued above, this option will often be rec- 3.5.3.1 Preserve the autonomy ofthe concessionaire. ommended because it promotes allocative effi- This should be done by specifying end results to be ciency and economic resource use. In addition, in achieved rather than means to be used. Too often, many cases it will eliminate or very much reduce the authorities are tempted to impose some specific tar- need to superimpose specific investment or cover- gets regarding the means to be used by the operator age obligations, since the price regime itself gives the (such as the minimum amount of required invest- operator adequate incentives to expand coverage. ment) in an effort to prevent unrealistic bids and to The second factor to take into account is the ensure that service requirements will be met. To monitoring and enforcement capabilities of author- organize an adequate prequalification process and to ities. Specific performance targets will deliver the require that candidates post sufficient bid and per- expected results only if the behavior of the opera- formance bonds would generally constitute a more tor can be adequately monitored and if the targets appropriate way of eliminating unqualified bidders can be effectively enforced. Overwhelming evi- and unrealistic proposals (see chapter 4). In addi- dence suggests that one should not underestimate tion, to the extent that the type of service required the drawbacks of relying on specific performance can be precisely defined, it is generally much better targets-as opposed to relying on the original shar- to fully tap the private sector's creativity and know- ing of responsibilities and price regime-to reach how, and leave the operator free to decide how to the objectives pursued. Indeed, performance mon- organize the supply of the service. Even if the award- itoring is often difficult, since authorities usually ing authorities themselves do not overly restrict the know less than the firm about the firm's operations. autonomy of the operator, there is a risk that the reg- In fact, in developing countries monitoring and ulator might do so. This risk is particularly important enforcement capabilities are often limited. when the regulator is made up primarily of former Imposing specific performance targets should, in employees of the old public companywho used to be general, be seen as a solution of last resort. in charge of actually providing the service. In such Finally, some arrangements do not add much to cases the temptation for the regulator to micro- the incentive scheme already in place through the manage the concessionaire might prove irresistible. original allocation of responsibilities and overall Some observers argue that this problem arises in the pricing rules. This is, for example, the (not unusual) Buenos Aires water concession, in which the regula- case of investment requirements that operators tor is staffed largely by former employees of the pub- would have met even if the requirements had not lic company (box 3.12). been specifically imposed on them (because it hap- pens to make commercial sense to increase cover- 3.5.3.2 Maintain sufficient flexibility. In many age, for instance). One possible reason for explicitly cases the targets that are set prove ill-adapted and imposing such obligations is that it makes a private difficult to modify in new circumstances. The infrastructure project more politically palatable: Argentine freight rail concessions, for example, promoters can point to the concrete promises (in exhibit this problem (see box 3.13). One possible Concession Design 45 Box 3.12 Control of Means and Results in the Buenos Aires Water Concession-One View "Whereas the concessionaire defends the character results. The key issue is the degree of freedom that of the concession contract as one that specifies Aguas Argentinas should have to fulfill the contract's results rather than means of achieving them, the reg- targets through "investment optimization strate- ulator believes that, as the representative of the gies," in other words, to achieve a given objective owner of the system-the Argentine Government, it with less capital investment and with higher profits. has the obligation to ensure that results are achieved ETOSS, the regulatory agency, is concerned about with adequate procedures and high quality stan- the quality and the sustainability of investments. This dards. Thus the agency emphasizes that the contract problem will tend to become more acute during the must be understood as a contract of means as well as later stages of the concession." Source: Rivera (1996: 65). answer is to identify more suitable targets initially performance targets lose their incentive powers. A (for example, maximum waiting time for connec- recent review of management contracts has shown tion rather than specific investment targets, which that many of these contracts suffer from this could prove to be inadequate if demand projec- defect. For example, the management contract for tions are incorrect). Another solution is to design the Manila Light Rail Transit Authority had a suc- the targets in a more flexible way The investment cess fee linked to profits. But, given the govern- requirements included in the Senegal water lease, ment's pricing policy, it was practically impossible for example, are expressed so as to leave a large for the contractor to make a profit and thus receive degree of discretion to the operator with respect to the success fee (see Shaikh and Minovi 1995). the type of investments to be undertaken.15 Investment obligations could also be regularly 3.6 Penalties and Bonuses reviewed -in line with new demand forecasts.'6 Finally, the parties could devise specific renegotia- 3.6. 1 Main Design Issues tion mechanisms (see section 3.9.3). Concession contracts will generally contain 3.5.3.3 Ensure that performance targets are real- promises of bonuses and threats of penalties to istic. Overly ambitious or otherwise unrealistic enhance operators' incentives to carry out their Box 3.13 Unattainable Investment Obligations in Argentine Freight Rail Concessions In 1993 Argentina's national freight rail network was from the regulator. Operators are even abandoning partitioned and concessioned under 30-year con- some lines. tracts. As part of the concession agreements, winning Given the lower-than-expected traffic levels, the bidders agreed to invest about $1.2 billion in the rail investment amounts agreed in the contracts are likely network over 15 years. to be unnecessary and uneconomic, even if the conces- Despite substantial efficiency gains in service, sionaires could afford to finance them. 'With no flexible however, traffic levels have fallen short of expecta- mechanism for contract renegotiation, the government tions, reaching only 60 to 70 percent of projected faces the dilemma of enforcing the contracts to the traffic. Actual revenues are estimated to be only detriment of the operating companies and the national about half of initial projections. Consequently, sev- rail system, or ignoring investment promises on the eral of the concessionaires have failed to make basis of which the concessions were awarded, thus promised investments, thus incurring penalties undermining the credibility of the program. Source: Carbajo and Estache (1996). 46 Concessions for Infrastructure: A Guide to Their Design and Award general responsibilities under the contract and to * Provide for a range of penalties. Relying on the meet the imposed performance targets. Penalties threat of imposing only the most severe penal- and bonuses can take a variety of forms. For exam- ties, such as termination, would risk being ple, AES Corporation built the Lal Pir power plant unduly detrimental to the relationship between in Pakistan under a BOT contract, with an incen- the parties and would, in any case, lack credi- tive for speedy completion of the plant that allowed bility (a contract will not be terminated for them to increase the tariff per kilowatt-hour, origi- minor faults or shortcomings on the part of the nally set under the power purchase agreement at operator). In order to be able to send appro- US 6.5¢, by an additional 0.25¢ if the plant was fin- priately calibrated signals, it is important to ished on schedule. Argentina telephone conces- provide a menu of penalties, including, for sionaires are rewarded by having their initial example, different levels of financial penalties exclusivity period extended by an additional 3 years in addition to the ultimate sanction of contract if they meet certain service and expansion targets. termination. In Argentina's electricity trans- Articles 46 and 48 of the French model lease con- mission sector, for example, there is a detailed tract deal with financial penalties and the threat of schedule of penalties to be paid by the trans- termination (see table 3.1). See also Article 2.5 of mission company in case of outages. These the Guide to Power Purchase Agreements in annex 2. penalties vary according to the relative impor- Some of the main questions relating to the tance of the affected assets and the duration of design of bonuses and penalties include: the outages. Scheduled outages and those resulting from criminal acts of third parties are * When are bonuses and penalties necessary? penalized at lower rates, and total monthly * How can the level of monitoring and regulatory penalties are capped at 50 percent of monthly capacity be taken into account while designing revenues. If the company accumulates exces- bonuses or penalties? sive yearly penalties, the government has the * How can bonuses and penalties be designed to option of terminating the concession. maximize economic efficiency? * Enhance economic efficiency. Penalties and bonuses should ideally reflect the economic 3.6.2 Lessons of Experience costs and benefits of the behaviors that they are trying to prevent or promote. In some cases, for International experience demonstrates the impor- example, instead of seeking to completely elim- tance of the following guidelines: inate a given type of conduct, penalties could be related to the economic loss caused by that * Minimize the regulatory burden. As mentioned conduct (for example, penalties for pollution above with respect to performance targets, pub- could be calibrated to cover society's loss lic authorities' monitoring and regulatory capac- incurred by pollution). Then, the operator ities are often severely limited. Like performance would have proper incentives to adopt eco- targets, specific bonuses and penalties should be nomically efficient behavior (that is, to break imposed onlywhen it has been clearly established the rules when the resulting economic loss for that changes in the overall allocation of responsi- society-covered by the penalty-is smaller bilities and in the general price regime would not than the benefit derived by the operator). constitute a better way to bring about the Liquidated damages are often, in effect, calcu- expected results. Even then, a variety of means lated to cover the economic loss incurred by the can be used to facilitate the monitoring activities beneficiary. For example, liquidated damages of public authorities, such as requiring that penal- payable when a construction contractor fails to ties be paid directly to the users to induce the meet certain milestone dates normally cover users to report breaches of contracts. additional interest costs arising from the delay Concession Design 47 and may compensate equity investors for lost * What are the procedural requirements for the income and fixed costs incurred.17 use of such instruments? 3.7 Public Parties' Security Rights 3.7.2 Performance Bonds and Similar Tools 3.7.1 Main Design Issues Performance bonds can be required from the pri- vate operator to guarantee its obligations under the Public parties to concession agreements will gener- contract, including, for example, the payment of ally insist on putting in place some additional mech- any indemnities or other fees owed to the public anisms aimed at lowering the risk of noncompliance authorities (box 3.14). The risk of losing the bond on the part of private operators (including the risk might also act as a powerful deterrent in prevent- that operators might not pay the penalties imposed ing the operator from "walking away" from a given on them). Instruments that can be used include per- project if disputes arise. There is evidence, for formance bonds or other simnilar tools, step-in rights example, that in the case of the Tucuman water to the benefit of public authorities (that is, authori- project in Argentina, in which conflicts arose ties' right to take over from the private operator and between the private concessionaire and the directly carry out the functions that the operator is authorities on matters of water quality and pricing, failing to perform), and insurance to be taken out by the performance bond posted by the operator did the private operator. Articles 45 and 47 of the have an impact in this respect. Figure 3.8 indicates French lease contract (table 3.1), for example, deal the amount and duration of performance bonds respectively with performance bonds and step-in and guarantees that would typically be required for rights. Perforrnance bonds are also mentioned International construction contracts. under Article IV of the Guide to Power Purchase Agreements in annex 2. * Performance bonds. The purpose of perfor- The design of each of these instruments raises mance bonds is to provide additional funds in certain questions, including: case the contractor fails to perform for any reason. X What is the exact purpose of the instrument? * Advance payment guarantee. Typically, the con- * What risks does it cover (scope, amount, dura- tractor will receive advance payment from the tion)? authorities to assist in purchasing and assembling Box 3.14 Aguas Argentina's Performance Bond Article 10.1 of the concession contract requires the The performance bond must be deposited, either establishment of a US$150 million performance at the Banco de la Naci6n Argentina, or at another bond to guarantee the concessionaire's obligations. main bank, on an account accessible to the "Secretaria These include, among others, liabilities of the con- de Obras Publicas y Comunicaciones." In principle, cessionaire, social security payments owed by the the concessionaire's obligations are payable on request concessionaire, and fines owed by the concession- from the Ente Regulador. But, if the concessionaire aire for a variety of reasons, including delays in fails to pay, payment can be obtained by order of the undertaking investments, termination of contract Secretaria de Obras Publicas y Comunicaciones, because of a fault committed by the concessionaire, through a withdrawal from the performance bond. The costs incurred by public authorities to complete concessionaire must then reconstitute the perfor- works that should have been done by the conces- mance bond no more than days after it has been com- sionaire, and so on. pletely or partially used up. Source: World Bank staff. 48 Concessions for Infrastructure.: A Guide to Their Design and Award Figure 3.8 International Construction that justify direct intervention by the authorities; Contract Performance Bonds they require that the authorities give notice to the and Guarantees private operator; they provide for a cure period, dur- Percentageof contractprice ing which the concessionaire is allowed to take 25 remedial actions; and they specify the maximum Retention duration of the authorities' intervention, as well as 20 bonds Completion of the type of measures they can adopt. If, at the end 15 construction of the intervention, the concessionaire is not in a Advance \ i 1 r - position to resume its activities, the contract can be 10 payment Maintenance terminated with cause by the public party. bonds The C6te d'Ivoire-Burkina Faso rail conces- Maintenance sion, for example, provides a fairly standard exam- oPerforance bonds bonds ple of step-in right provisions. It states that if the 0 12 24 36 48 - 60 concessionaire does not maintain adequate safety Contract Number of months End of award maintenance standards for the maintenance of rail infrastruc- date period ture, the state holding companies, after having Source: Nevitt (1989). organized a hearing for the concessionaire, can force the concessionaire to adopt necessary mea- the materials, equipment, and personnel neces- sures. If such measures are not adopted, notice sary to start construction. The contractor must must be given to the concessionaire. Fifteen days then provide a guarantee to the authorities to later, if the concessionaire has remained inactive, back its obligations. As construction proceeds, the state holding companies can complete the nec- the value of the guarantee can be reduced. essary works with risks and expenses borne by the * Retention bonds. These bonds represent a por- concessionaire. tion of progress payment held back by the authorities in order to provide a fund to cover 3.7.4 Insurance unforeseen expenses caused by a contractor mistake in construction. Public parties to a concession agreement will often * Maintenance bonds. These bonds provide a require the private operator to take out private source of funds for correcting defects in the insurance in order to reduce the risk of bankruptcy construction or performance of the project that and, consequently, of service interruption."8 A pro- are discovered after construction is completed. ject will generally be covered by different types of Typically, the performance bonds and the reten- insurance, including: tion bonds are converted to maintenance bonds upon completion. a Construction all-risk insurance (protection against property damages due to Acts of God 3.7.3 Step-In Rights occurring at any time between procurement and the completion of performance testing). Step-in rights enable authorities to take over the * Advance loss-of-profits insurance (protection operation when the concessionaire does not per- against income losses due to delays resulting form its functions adequately, so that service is inter- from the same risks as those covered under rupted or service quality is seriously deteriorating. construction all-risk insurance). The costs and risks associated with the measures * Adjunct liability coverage (insures against the adopted by the authorities under step-in right pro- obligation to pay compensation for bodily visions are borne by the private operator. These pro- injury or property damage to third parties visions typically identify the breaches of contracts resulting from project work). Concession Design 49 * Property insurance covering business interrup- years. BOTs and concessions stricto sensu frequently tion from property damage due to Acts of Gods have terms of 15 to 30 years. Some last even longer. during the operational phase. The city of Casablanca, for example, gets bulk water * Third-party general liability (which might from a private company under a 50-year concession include coverage for workers' compensation, (Guislain 1997: 205), while the town of Loiret in automobile accidents, and pollution cleanup). France signed a BOT water contract with the Compagnie Generale des Eaux, in 1931, that has a 3.8 Duration, Termination, and term of 99 years. Sometimes, as in the case of the Compensation Chilean power sector, there are concessions with no end date at all (Guislain 1997: 243). 3.8.1 Main Design Issues Occasionally, the concession's duration is determined by bidding. In the Talca-Chillan Concession contracts almost always specify that stretch of route 5 in Chile, for example, it was one the concession will end at some date in the future of the criteria by which bidders' proposals were and that, in certain circumstances, it can be termi- judged. The regulator set a minimum toll and, if nated before that date. In the French water lease two or more firms offered this toll, the winning firm (table 3.1), for example, the duration is specified would be the one that offered the shorter fran- in chapter 1, the "General Economics of chise-term (Engel, Fischer, and Galetovic 1996a). Contract," while early termination and what hap- pens at the end of the lease are discussed in 3.8.2.2 Early termination. Concession con- chapter 9, "Guarantees, Sanctions, and Disputes," tracts can often be terminated before their sched- and chapter 10, "End of Lease." The Guide to uled end if: Power Purchase Agreements in annex 2 refers to these issues in Article 5,'Term and Termination." * Both parties agree. This section focuses on the following questions a The concessionaire has failed to meet its oblig- of concession design: ations and has not remedied the problem after notification by the government. * Should the concession have a scheduled end * The concessionaire becomes bankrupt. date, and, if so, what should the length of the * The service provided under the concession concession be? becomes inherently unprofitable, because, for * Under what conditions should the parties be example, of the introduction of a new service able to terminate the concession before its provided with better technology. scheduled end date? * Should the concessionaire be compensated at French law also permits the conceding author- the end of the concession for the remaining ity to terminate concession contracts in the "gen- value of investments made during the conces- eral interest." The government can do this even if sion, and, if so, how should the compensation the concessionaire is fulfilling its obligations, but it be calculated? must compensate the concessionaire for lost prof- its. Typically, the conceding authority must give the 3.8.2 Duration and Termination: What Happens in concessionaire notice of its intention to terminate Practice the contract some time before termination occurs. The notice period in France is usually about 2 3.8.2.1 Scheduled termination. Concession con- years. British water licenses also provide for termi- tracts come with widely varying terms. Management nation without fault on the part of the licensee but, contracts usually have a duration of 3 to 10 years. by contrast, require the government to give 10 Leases tend to last longer, often between 10 and 15 years' notice."9 50 Concessions for Infrastructure: A Guide to Their Design and Award 3.8.3 Scheduled and Unscheduled Termination: or according to schedule. A water concessionaire, Rationale and Drawbacks for example, would be reluctant to undertake a large-scale expansion of its piped network in the last Concessions need not have an end date. Nor must year of its concession. Similarly, it would have an they provide for early termination. In the United incentive in the last year to skimp on maintenance. States, for example, utility companies have what are But termination provisions can affect the con- effectively, if not in name, unlimited-duration con- cessionaire's incentives even at the beginning of cessions. Although it is conceivable that the firms the concession. The risk of early termination is will lose their licenses and be replaced in the future, always present to some degree and, if significant, the strong expectation is that the authorities will will reduce the benefits to the concessionaire of permit them to remain in business indefinitely any investment with long-term benefits. Further, infrastructure investments with very long lives may 3.8.3.1 The Rationale for Term.ination. What, generate some benefits in the years after the con- then, is the reason for specifying an end date and cession's scheduled end, even if they are made providing for the possibility of early termination? right at its outset. Since the concessionaire is Both scheduled and early termination help the uncertain whether it will reap those benefits, it will government to regulate, by permitting competition discount them more heavily than would be desir- for the market to take place not just at the initial able from the country's perspective. award of the concession but afterward as well. The This problem doesn't afflict investments in all scheduled termination allows the government to assets, however. If its concession is terminated, the stage another competition for the market, even concessionaire could sell, to take one example, any when .the concessionaire has done nothing that is cars it owns for their market value. It would not demonstrably wrong. As section 1.3 argued, such a have taken an enormous risk by purchasing them. competition encourages firms to keep their costs as Similarly, a company with a concession for a bus low as possible and forces them to reveal to the route can afford to buy buses even if it may lose the government the lowest profitable price at which route in the near future, because it can easily sell the service can be provided. The possibility of early the buses or use them to serve another route. The termination, on the other hand, allows the govern- problenm arises with investments that have little ment to replace a concessionaire before the sched- value outside the concession for which they are uled re-award in case of dearly unsatisfactory undertaken-that is, investments that are largely performance-further strengthening the conces- sunk. Roads, bridges, and tunnels, for example, are sionaire's incentives to perform well. for all practical purpose immovable, while water The U.S. style of regulation makes no use of and gas pipes are movable but only at an unrea- this form of competition for the market. Instead, sonable cost. the regulator must examine the performance of the firms it regulates and estimate itself the lowest 3.8.3.3 The trade-off In writing the termination price that permits the firms to turn a profit. provisions of a concession, then, the government has two aims: 3.8.3.2 The cost of termination provisions. The advantages of continuing competition for the mar- - Obtaining the benefits of competition for the ket, however, come at a cost. Because the conces- market. sionaire risks losing the concession in the future, it v Allowing concessionaires to recoup investment may be less willing to make investments in assets that costs. it will benefit from only if it keeps the concession. The effect is most evident in the period just The question is how to write the contract so as before a concession ends-whether the end is early to get the best trade-off between these two goals. Concession Design 51 3.8.4 Options it might be recouped during a 10-year concession. At the end of the 10 years the competition for the next 3.8.4.1 Handling simple cases. In certain simple concession would cause prices to fall to levels not cases the government can achieve good results just much above the costs of operating and maintaining by setting an appropriate duration. the bridge. Short concessions for long-lived assets First, when concessionaires do not need to would thus lead to periods of high prices followed by make long-term sunk investments, the concession periods of low prices. contract should be short, since short concessions One problem with this option is that the initial then permit frequent competitions for the market toll might have to be very high, unnecessarily dis- without jeopardizing investors' returns on socially couraging the use of the bridge during the first con- desirable investments. Concessions for trash col- cession. The second is that, because high tolls lection and bus routes are examples, and the evi- reduce traffic volume, the costs of an economically dence suggests that they work well when they are desirable bridge might not be recoverable at any bid every couple of years (Kwoka 1996). toll over a 10-year period. Some worthwhile Second, if the concession involves a large one- bridges-whose cost would be recovered over 25 off sunk investment and subsequent investment years-would thus remain unbuilt. and maintenance requirements that are relatively unimportant, the government should set the dura- 3.8.4.4 Allowing the concession's length to be tion of the contract equal to an estimate of the eco- determined endogenously. A second option worth nomic life of the initial investment. considering is to let the length of the concession be determined by events rather than being fixed in 3.8.4.2 Handling Difficult Cases. Many conces- advance. In particular, the concession can end sions are not so simple. Often they involve large when the concessionaire has earned a given level of sunk costs and continuing significant investment revenue. The concession for the Queen Elizabeth and maintenance throughout the concession. II Bridge in Dartford, the United Kingdom, for Below, we consider the following options for deal- example, will end when the concessionaire's cumu- ing with these cases: lative revenue has reached the level of outstanding debt or after 20 years, whichever comes first (HM * Combining shorter concessions with higher Treasury 1996). In Chile it has been proposed that prices. toll roads be awarded to the bidder seeking the low- * Allowing the concession's length to be deter- est net present value of revenues, calculated mined endogenously. according to a discount rate set in advance by the * Biasing the rebidding in favor of the government (Engel, Fischer, and Galetovic 1996b). incumbent. An advantage of this approach is that it reduces the * Financially compensating losing incumbents likelihood that the concessionaire will not benefit for their investments. from worthwhile investments when those benefits take longer than expected to materialize. 3.8.4.3 Combining shorter concessions with higher prices. One option for allowing concessionaires to 3.8.4.5 Biasing rebidding in favor of the incum- recover the costs of desirable long-term investments, bent. A third option for encouraging investments while maintaining the advantages of frequent com- whose value will outlive the current concession is to petitions for the market, is to allow concessionaires give the incumbent an advantage in the rebidding. to charge high prices during the term of a short con- Even when the bidding rules do not distinguish tract. Consider, for example, a bridge that will have among firms, the incumbent has one advantage a life of 25 years before major repairs are needed. If over other firms. During the concession it will have the tolls were set high enough, the costs of building developed special knowledge of the demands of 52 Concessions for Infrastructure: A Guide to Their Design and Award local customers, the condition of the assets, and so investments without also giving it incentives to over- on. It therefore knows better than other bidders invest. Paying too little compensation discourages what the concession is worth. It has been argued, good investments, while paying too much encourages however, that the government should actually favor investments undertaken solely to get compensation. the incumbent in the bidding, giving the concession In theory, paying compensation can resolve the prob- to a new firm only if the latter's bid beats the incum- lem at hand, permitting repeated competition for the bent's by more than a specified margin. The advan- market while preserving desirable investment incen- tage of the proposal is that it encourages the tives. In practice, it can be difficult to devise'a com- incumbent to make worthwhile investments, since pensation scheme that gets the incentives right. it has a greater chance of retaining the concession and therefore appropriating the long-term benefits 3.8.5 Compensation Rules of those investments. At the same time, however, the bias in favor of the incumbent reduces the 3.8.5.1 Who should pay the compensation? extent to which other firms put competitive pres- Frequently, concession contracts state that the gov- sure on the incumbent (for more on the theory, see emnment will take over the business at the end of the Laffont and Tirole 1993, chapter 8). concession and will pay any compensation that is due. When the government does not intend to re- 3.8.4.6 Financially compensating losing incum- award the concession in a second round of bidding, bents for their investments. A final option for recon- only the government can be expected to pay com- ciling competition for the market with investment pensation. But when the government plans to put incentives is to give financial compensation to the concession out to bid again, there is no reason incumbent concessionaires who lose their conces- why the compensation should not come from the sion when it is rebid. The winning bidder or the new bidder. In either case the concessionaire will conceding authority can, for example, be required want to be satisfied that someone will pay If the gov- to pay the losing incurnbent a sum of money equal emient is to pay, what guarantee is there that it will to the undepreciated value of the investment. honor its obligations? If the new entrant is to pay, Suppose a bridge cost $25 million to build and was what happens if the government decides not to rebid expected to depreciate in value by $1 million each the concession? What happens if nobody bids? year until, in 25 years, it was fully depreciated. If the incumbent lost the concession after 10 years, it 3.8.5.2 Determining the compensation hy bidding would receive $15 million in compensation. The or administrative rule. It is possible to have firms bid pro-forma French water lease (table 3.1) provides on the amount of compensation they are willing to for compensation in this way: pay the incumbent to take over the business. In the Argentine electricity distribution industry, for The infrastructure that is financed by the example, the concession goes to the bidder offer- lessor and forms an integral part of the lease ing to pay the most compensation to the incum- will be returned to the local government in bent. TChe incumbent can bid, too. If it wins, it return for, if the assets are not fully amortized, keeps the concession and no money changes hands an indemnity calculated, either by mutual (one can think of the incumbent paying its bid to agreement or according to the opinion of an itself). Although the incumbent can afford to bid expert, taking into account, in particular, the any amount of money, it has no reason to bid more amortization conditions of the assets. than it thinks the concession is worth. This arrangement goes some way toward pro- The problem here is to design a compensation tecting the concessionaire's incentives to make rule (that is, an asset-valuation rule) that gives the long-term investments. It should result in the con- concessionaire incentives to undertake all desirable cessionaire's either keeping the concession or Concession Design 53 receiving payment, not from the state whose com- sibility of a takeover. That possibility of a mitment to compensate the concessionaire might takeover-or change of concession operator in the lack credibility when budgets are tight, but from a Argentine case-does something to encourage private bidder. However, the compensation value efficiency, but it does not directly help consumers. that a firm bids depends on its estimate of the price Governments that want to use repeated com- it will be permitted to charge for the service. petitions for the market to help set prices must Therefore, the amount of compensation offered therefore consider administrative rules for deter- will reflect the market value of previous invest- mining compensation. Box 3.15 describes some ments only to the extent that the government does possibilities. not drastically modify the price regime before the rebidding. In addition, the rebidding no longer 3.9 Force Majeure and Other Unforeseen helps the government set the price for the service, Changes and the government therefore has to resort to tra- ditional price regulation. As a result, the rebidding 3. 9.1 Main Design Issues does not help translate efficiency gains into lower prices for consumers. In its effects, the Argentine As mentioned above, concession contracts are system resembles divestiture with the periodic pos- often concluded for long periods of time during Box 3.15 Measures for Determining Compensation at the Termination of a Concession The following are five asset-valuation methods, pre- ment cost. It is the cost of replacing the assetwith sented in order of increasing sophistication, that the cheapest asset that does the same job (the could be used to determine the amount of compen- optimal asset). For example, if a new pipe-mak- sation to be paid to the concessionaire for sunk ing material has been put on the market since the investments at the termination of the concession. pipes in a water concession were laid, the opti- mized replacement cost is the cost of replacing * Historical cost. This is the traditional accounting the pipes using the new, cheaper material. As method of valuation for the purposes of finan- before, the cost of the new pipe must be depre- cial reporting. It takes the cost of the assetwhen ciated to account for its deterioration. ODRC it was purchased and depreciates it over a cer- solves the problem of changing technology, but, tain period of time. As a measure of current like its predecessors, has the effect of compen- value, it can be misleading because it ignores sating concessionaires according to some mea- inflation and thus tends to undervalue assets. sure of the cost of investment. Concessionaires * Inflation-adjusted historical cost. Historical cost could thus be compensated even for making can be adjusted to take inflation into account investments that were economically undesir- by increasing book value according to either a able-that is, investments with benefits that fall measure of the general inflation rate, such as short of their costs, even when the costs are as low the CPI, or a measure more closely related to as possible. the assets involved. Optimized deprival value (ODV)-or market * Depreciated replacement cost. An alternative is to value. The method of optimized deprival value consider what it would cost to buy the equivalent attempts to take into account value as well as asset now-or, since similarly degraded second- cost: the ODV is the minimum of the ODRC hand assets may not be readily available, what it and economic value, where economic value is would cost to replicate the investment now, less the maximum of the net present value (NPV) of an estimate of the asset's depreciation in value future earnings and disposal value, and disposal since investment. A problem with the historical value is the amount the asset could be sold for. cost and depreciated replacement cost is that All together, this implies that: they do not consider changes in the value of assets brought about by changes in technology. ODV = min [ODRC, max (NPV of future * Optimized depreciated replacement cost earnings, disposal value)] (ODRC)-or modern-equivalent-asset (MEA) value. This is a refinement of depreciated replace- (box continues on next page) 54 Concessionsfor Infrastructure: A Guide to Their Design and Award Box 3.15 Measures for Determining Compensation at the Termination of a Concession (continued) To avoid incentive problems, the estimate of aire's expected cash flows, and its cost of capital. The future earnings must be based on an estimated future choice of accounting rule must of course take into tariff that is independent of the bids made when the account the practicality, as well as the theoretical concession is re-awarded. In principle, ODV account- advantages of the options. In addition, it should be ing may generate compensation payments that give noted that ODRC and ODV subject the concession- concessionaires the right incentives. But determining aire to certain risks that do not arise with the simpler the ODV of the concessionaire's assets is difficult, measures of value. As a result, they may raise the cost requiring assessments of technology, the concession- of the concessionaire's capital. Source: World Bank staff. which unforeseen changes are bound to occur. In 3.9.2 Categories of Unforeseen Changes section 3.4 we discussed changes caused, for example, by inflation or technical evolution, which Force majeure and other unforeseen changes can be taken into account through price indexation include various categories of events: formulas or through price revisions at regular inter- vals. Here, we examine events that are too unpre- * Acts of God-natural disasters, wars, civil wars, dictable and whose effects are often too dramatic major economic crises, and so on, which make to be dealt with in that manner. These events are execution of the contract more difficult, more primarily changes imposed by public authorities expensive, or impossible. and Acts of God. Most concessions will include * General policy decisions of the authorities, specific provisions to take the possible occurrence regarding, for example, the tax regime, envi- of such events into account. Some French con- ronmental standards, customs regulations, and tracts (such as that in table 3.1) do not, however, conditions to convert and transfer local cur- deal explicitly with this issue because the French rency, which affect a whole range of operators, Conseil d'Etat has developed a sophisticated body including the concessionaire. of case law on this topic, which is an implicit part * Decisions of the authorities that specifically of any concession arrangement (see box 3.16). On modify the obligations of the concessionaire or the other hand, the Guide to Power Purchase the conditions under which the concessionaire Agreements, in annex 2, contains a whole section operates. Such decisions can, for example, take (Article E) devoted to a discussion of force the form of authorities modifying the obliga- majeure. tions of the concessionaire "in the interest of Questions related to the treatment of unfore- the service" (authorities could require, for seen changes include: instance, that the perimeter of the concession be extended and that service be provided to a * Which categories of events must be dealt new neighborhood). Some laws or regulations with? that affect the concessionaire specifically can * What mechanisms can be used to adapt con- be modified. Or, the structure of the market in tractual arrangements in the face of unforeseen which the concessionaire operates can be fun- changes? damentally altered (for example, opening a pre- * What are the pros and cons of such mechanisms? viously monopolized market to competition). * How does one reconcile the need to take such * Decisions of the authorities that reveal the will changes into account with the need to ensure to terminate the agreement-breach or cancel- sufficient stability of the terms agreed on at lation of contract or regulatory agreements, the time the contract was concluded? expropriation, creeping expropriation, failure to * Who should bear the risk in each case? grant or renew necessary approvals, and so on. Concession Design 55 Box 3.16 Unforeseen Circumstances in French Administrative Law In France an extensive body of case law developed by ognizes the right of public authorities to unilaterally the Conseil d'Etat has progressively distinguished three modify administrative contracts "in the interest of the types of unforeseen circumstances likely to affect private public service"). Public authorities must then com- infrastructure contracts. This case law, which spells out pensate the private operator for its entire financial precise consequences if these circumstances arise, con- loss (that is, the operational deficit, if any, as well as stitutes an integral part of any concession arrangement. foregone profit). The legal basis for the compensation is the right of the private party to maintain the "finan- Force majeure theory applies to events that: are com- cial equilibrium" of the contract. pletely independent of the will of the parties, are unforeseen and unforeseeable, and make the execu- Imprevision theory applies to events that are abnormal tion of the contract completely impossible. Some Acts and unforeseeable, are completely independent of of God, such as wars or natural disasters, fall into this the will of the private party, and lead to a substantial category. The occurrence of force majeure events deterioration of the financial situation of the private enables the private operator to ask the judge to ter- party. Economic crisis, for example, might qualify, as minate the contract and prevents the public party might general measures affecting a whole range of from imposing penalties for nonexecution. operators, such as a change in the tax regime or a cur- rency devaluation. Public authorities must compen- Fait du Prince theory applies to measures adopted by sate the concessionaire. The amount of the the contracting public party that directly affect the sit- compensation has been debated for a long time but uation of the private operator. The most typical case recently the Conseil d'Etat has applied the same rule is when authorities unilaterally modify the obligations as that under the Fait du Prince Theory (compensa- of the concessionaire (the French Conseil d'Etat rec- tion of the operational deficit plus foregone profit). Source: De Laubadere, venezia, and Gaudemet (1995: 731-39). In some countries the notion of force majeure renegotiated "in good faith," at regular inter- will encompass only a very limited subset of the vals, or if certain types of events occur, possibly above categories (for example, onlyActs of God that with the support of a predesignated facilitator make execution of the contract impossible). Some (see Myers 1996: 110-11). countries might maintain a broader definition * Confer the power to modify the agreement to (including, for example, some general policy deci- a third party. In essence, this is the solution sions of the authorities affecting entire categories of adopted by countries that have set up inde- operators). The definition of force majeure matters pendent regulators. Provided they are granted to the extent that the occurrence of events that qual- sufficient discretion, regulators can compen- ify as force majeure will generally excuse nonper- sate operators in case of unfavorable develop- formance on the part of the private party (box 3.17). ments, and sometimes also impose clawbacks in favorable situations. In the UK water indus- 3.9.3 Mechanisms to Deal with Unforeseen try, for example, the regulator sought and Changes obtained, in both 1992-93 and 1993-94, price increases that were lower than those allowed At least four main types of schemes can be devised by the original 1989 formula, because the beforehand to deal with unforeseen changes: recession in Britain had driven construction prices to a level 15 percent below that assumed * Include in the agreement specific provisions in 1989 (see Armstrong, Cowan, and Vickers governing possible renegotiation processes 1994: 347). between the parties. Such provisions might, for * In some countries public authorities reserve the example, specify that the contract must be right to unilaterally modify agreements in 56 Concessionsfor Infrastucture: A Guide to Their Design and Award Box 3.17 Defining Force Majeure Force majeure is a doctrine of contract law that is ters; and epidemics and quarantines. Contracts will invoked to excuse nonperformance of the operator usually also add an additional category of loosely because of unforeseen circumstances. In many legal defined, unforseeable, and unpreventable events that regimes a great deal of uncertainty surrounds the def- cause material interruption, damage, or destruction; inition of force majeure. delay the performance of any obligation under the In France the Conseil d'Etat has, over a long contract; or interfere with its performance and are period, progressively specified the criteria that deem beyond the control of the parties. an occurrence as force majeure. Even though some In some cases the range of force majeure events ambiguity remains (see Antonmattei 1996: 3, 907), it can be quite broad. Given the consequences attached is clear that the concept has received a rather narrow to the qualification of an event as force majeure (that definition, generally excluding, for example, actions is, the fact that it excuses nonperformance on the part by the government (see box 3.16). Elsewhere, force of the private operator), attempts should be made to majeure has to be defined in the transaction docu- limit the number of qualifying events to those that ments, often by listing the specific events that qualify. pose a physical or legal impediment to construction Commonly listed occurrences might include: war or or operation of the project and not merely those that military activity; strikes, lockouts, and other labor dis- make it more expensive or inconvenient. It is also turbances; riots or public disorder; changes in laws, advisable to specifically exclude certain events that rules, or regulations; severe storms and natural disas- the parties agree should not excuse nonperformance. Source: World Bank staff. response to unforeseen changes, but commit to In the absence of provisions to deal with unfore- safeguard the financial interests of the conces- seen circumstances, the bargaining power of the par- sionaire. This is the case in France, under the ties becomes crucial at the time of renegotiation. In "Fait du Prince" theory developed by the some cases a monopolistic operator might be able to French Conseil d'Etat (see box 3.16). "take the authorities hostage" after cQncluding the A variety of insurance schemes will cover the contract, for example, because it is the only party risks associated with the occurrence of unfore- with the capacity to operate the project. In other seen events. Private insurance schemes that cases, when project technology is relatively basic (toll cover losses due to Acts of God were discussed roads, for example), when there are other operators in section 3.7.4. Coverage of risks arising from ready to take over, or when the sunk costs incurred government actions are discussed in box 6.2. bythe operator are particularly high, it is the monop- olist who might be in the weaker position.20 Some of these mechanisms, however, may be of limited practical use in the face of truly unpre- 3.9.4 Who Should Bear the Risks? dictable and unforeseen events that have a great impact on the parties' agreement. The decision to Acts of God are part of the unavoidable risks of introduce competition into previously protected doing business. They should normally be borne by markets provides a good example of such events. the operator, who can obtain some protection by Only a general commitment on the part of the gov- taking out insurance. The argument that such risks ernment to preserve the financial interests of the should be borne by the government because tax- monopolist is likely to provide effective protection payers have a lower cost of risk bearing than in such a case. In the absence of such commitment investors is not really convincing (see discussion of contracts will have to be renegotiated and disputes that issue in section 6.2.3). Risk allocation regard- settled through arbitration or by the courts, if no ing unforeseen events generated by the govern- agreement is reached (box 3.18). ment is discussed in section 6.2.1. Concession Design 57 Box 318 Introducing Competition in Previously Protected Markets: Three Examples SingTel is the sole provider of domestic, interna- independent power producers. NiMo pays out $1 tional, and mobile telephone services in Singapore. billion on some 150 independent power producers Competition in the mobile market was set to begin in contracts every year and pays $0.06 per kilowatt, May 1997. The monopoly on basic services was set to which is substantially higher than market rates. extend until 2007. The telecommunications ministry, NiMo has gone to court and lobbied the state to chal- however, decided to end it seven years ahead of lenge the independent power producers contracts, schedule in order to promote more rapid innovation claiming that it is on the brink of insolvency. In fact, and competition in the sector. Currently, around 1.3 it is in the interest of the independent power pro- million Singaporeans, one-third of the population, ducers to renegotiate rather than watch NiMo go own shares in SingTel. In order to compensate share- bankrupt. They are likely to settle for partial com- holders for the loss of the exclusive right, the govern- pensation of the value of the contracts. ment will pay a lump sum of 1.5 billion Singapore The State of Victoria in Australia has recently had dollars to the company. to manage the transition to competition in power gen- A comparable situation arises for power utilities eFation. The first major private entry into the sector locked into expensive power purchase agreements involved a 33-year take-or-pay power purchase agree- with independent power producers, when changing ment, with the state electricity utility assuming all technology or evolving competition create lower gen- construction risk during completion. Subsequently, eration prices in the market. New York state, for Victoria introduced full competition in generation example, plans to introduce energy competition by and complementary reforms in transmission and dis- 1998 and has asked utilities to submit proposals on tribution. It chose, however, to grandfather the power how they could implement competition. Conse- purchase agreement in order to avoid adverse effects quently, the Niagara Mohawk Power Corporation on the overall business environment, despite poten- (NiMo) is seeking to buy out its contracts with 44 tial efficiency losses. Sources: Mandelker (1996); Oxford Analytica (1996); and Kholi, Mody, and Walton (1996). 3.10 Dispute Settlement Some of the main issues related to dispute set- tlement include: 3.10.1 Main Design Issues i What makes a concession different from other Very few concessions will operate in the long run contracts in terms of dispute resolution? without disagreements arising at some point * What dispute resolution techniques are available? between parties to the agreement or with other * What makes the different techniques more or players. Thus the parties will want to think in less appropriate for concessions? advance about dispute settlement. Concession * What does one need to know about arbitra- agreements can include a number of techniques to tion? Does the host country permit arbitration? help resolve conflicts, including judicial, quasi- What should the arbitration clause in the con- judicial, administrative, arbitral, and nonbinding tract include? What rules and institutions can alternative dispute resolution techniques. The one rely on and refer to in the contract? French model lease contract (table 3.1) includes a provision for conciliation and dispute resolution by 3.10.2 Basic Challenges of Dispute Settlement the administrative tribunal in Article 50. Article XIV of the Guide to Power Purchase Agreements in Concessions often have five characteristics that annex 2 recommends including dispute settlement pose challenges for dispute resolution. provisions comprising negotiations, international arbitration, and possible referral to an expert for * Many occasions for conflicts. Concessions typi- resolution. cally involve many players whose interactions 58 Concessionsfor Infrastructure: A Guide to Their Design and Award can give rise to conflicts. For example, disputes with power purchase agreements concluded can arise between the concessionaire and the between producers and state utilities, the government (conceding authority); a competi- requirement for openness and inclusiveness in tor, when one controls the network and the dispute resolution is not as important. other has a right to use it; the regulator, for * Large investments in immobile assets. Most con- example regarding tariff increases; a state- cessions involve large investments in immobile owned enterprise; its suppliers or workers; its assets (that is, they involve substantial sunk customers; consortium members; and lenders, costs). This type of investment leaves investors shareholders, or insurers. vulnerable to political pressures since they are What does this mean for dispute settlement? not able to pick up and go. Therefore, investors Because of the sheer number of disputes that must be able to enforce the remedies and com- can arise from concessions, and the potentially pensation provided for in the contract. high costs associated with them, and because * Complexity and sophistication of projects. these disputes can involve public and private Concessions generally consist of intricate webs parties, as well as domestic and foreign parties, of legal arrangements for the construction, the concessionaire will want to ensure that it financing, and operation of infrastructure. In has access to reliable, neutral, and noncorrupt terms of dispute resolution, this implies a need forums for dispute resolution. for expertise in dealing with complex commer- - Long-term nature of the concession relationship. cial, legal, and technical issues. Most concessions last a long time and, in the long run, disputes are bound to arise. 3.10.3 Dispute Settlement Mechanisms Notwithstanding current or past disputes, how- ever, the parties will need to maintain a work- There are several techniques to resolving disputes, ing relationship over many years, maybe including judicial, quasi-judicial or admninistrative, decades. The dispute resolution mechanism arbitral, and nonbinding dispute resolution. As a should therefore help the parties stay on good general rule disputes relating to an agreement are terms. subject to the jurisdiction of the courts. The courts l Public nature of concession services. Another involved will usually be those of the jurisdiction in characteristic that sets most concessions apart which the subject matter of the dispute is located. from other types of contracts is the public In the case of a concession agreement, this will nature of many concession services. Often there generally be the jurisdiction in which the infra- is a need to avoid interruptions in the provision structure is located. of public services. If disputes arise regarding When private parties from different countries - disconnection rules (for examnple, in the case of enter into an agreement, they will often choose the nonpayment), or in general if a dispute leads to country or state whose courts will have jurisdic- interruption of service, a decision must be made tion.21 For example, in Latin America project quickly. Also, if concessionaires provide the ser- financing agreements often provide that parties vice directly to private customers, many parties submit their disputes to the jurisdiction of New - may be interested and involved in the dispute York state and federal courts.22 When a govern- and will want a voice in the process. These fac- ment is party to an international agreement with tors require the adoption of dispute resolution foreigners, however, as a matter of sovereignty, it techniques that are able to offer a resolution will typically not consent to grant jurisdiction to the quickly and are open and inclusive. courts of another country (Skadden, Arps, Slate, The public nature of the service is not as Meagher, and Flom 1996: 64). strong when concessionaires do not provide ser- A number of countries have recourse to quasi- vices directly to private customers. For example, judicial or administrative bodies, such as indepen- Concession Desgnz 59 dent regulatory agencies, to resolve some of the dis- can settle their disagreements. Conciliators do putes arising from concessions. In Peru, for example, not make such recommendations (Folsom and the Electrical Concessions Law (DL 25844) holds Minan 1991: 1,060). that the Board of Directors of the Electricity Tariffs In most cases arbitration institutions facili- Commission has the responsibility to "[RIesolve as tate conciliation or mediation procedures the last administrative resort all matters submitted by before formal arbitration in the hope of avoid- interested parties relating to the setting of rates" ing the latter procedure. Also, most courts in (article 15). The public law of the host country will the United States, for example, have court- usually specify mechanisms for appealing decisions annexed mediation programs that aim at reach- of the regulator (see section 5.6.3 on the appeal ing a similar goal, which is to avoid litigation process for regulatory decisions). (Myers 1996: 104). Arbitration is a technique for dispute resolution under which the parties agree to submit some or all 3.10.3.1 Judicial. Parties to concession agree- of their disputes to an arbitral tribunal that is empow- ments often think that courts are inappropriate for ered to render decisions (called "awards") that are resolving their disputes. Some of the concerns that binding on the parties. Arbitration tribunals often arise are that: comprise one, three, or five members. The parties typically choose members based on their expertise * The court system may be too cumbersome, on a particular subject matter. The assistance of local slow, and expensive, courts is also needed in order to enforce arbitral * The adversarial nature of the proceedings may awards. Arbitrations can be domestic (that is, they damage the long-term relationship of the can take place in the host country of the investment) parties. or international (that is, they can take place in a coun- * The courts may lack sufficient technical exper- try other than the host country of the investment). tise for the type of dispute in question. Nonbinding alternative dispute resolution * The courts may not be completely neutral (ADR) includes a wide range of techniques for dis- arbiters of disputes involving private and pub- pute resolution that are nonbinding on the parties lic parties or domestic and foreign parties. (that is, they are designed to be purely advisory).23 * The courts may be corrupt. ADR procedures can be independent of any formal procedure, whether judicial, arbitral, or other, or, Litigation in well-developed court systems can alternatively, it can be used in combinationwith such offer some advantages if many parties are involved procedures. Some examples of ADR schemes in a dispute and if the discovery of evidence is impor- include: tant. This is mainly because traditional courts are equipped with well-developed rules on "joinder of * Informal dispute resolution mechanisms. There parties" (that is, rules that would be used to join con- are many informal mechanisms to resolve dis- tractors, for example, to a dispute arising from a con- putes, ranging from regularly scheduled con- cession contract-to which they are not a sultation meetings between the parties (where party-when they share part of the responsibility for disagreements are brought forward early on so the breach) and on the production of documents and that they can be amicably resolved) to the use witnesses (see McConnaughay 1995; Nelson 1989). of technical advisers with powers to recom- Because concessions operate in many countries mend a settlement.24 where judicial systems are underdeveloped and * Conciliation and mediation. Both conciliation because of the concerns listed above, parties will and mediation involve a third party trying to often want to agree on a dispute resolution mech- help resolve a dispute. Traditionally, only the anism in their concession agreement that will per- mediator recommends to the parties how they mit them to avoid the jurisdiction of the courts as 60 Concessionsfor Infrastucture: A Guide to Their Design and Award much as possible. In some cases, however, the par- * Neutrality: arbitrators can be chosen from ties cannot totally avoid domestic courts. Legal dis- among individuals unrelated to the parties in putes arising from contracts with local employees, dispute. banks, suppliers, and customers generally fall * Integrity: arbitrators can be chosen from among within the exclusive jurisdiction of local courts. individuals of high moral repute. 3.10.3.2 Quasz-judicial or administrative. Re- Speed is also usually considered one of the course to quasi-judicial or administrative bodies is main benefits of arbitration. But if the dispute is often seen as appropriate if disputes: technically complex, arbitration is not always quick. Further, increased formality in recent years * Have a strong public policy component. For has also engendered important delays and costs. example, this would be the case for disputes Arbitration, therefore, has lost some of its appeal arising from regulatory decisions that required in that respect. In countries with inefficient court that broad discretion be applied in the public systems, however, the costs and delays of arbitra- interest. We typically see this with the applica- tion can still be minimal compared to the judicial tion of anti-trust rules. alternative. * Require timely resolution and are likely to be Foreign investors often see international arbi- recurrent. For example, an independent regu- tration, as opposed to domestic arbitration, as lator may be best placed to resolve disputes the only mechanism able to provide them with regarding access conditions to a network. some assurance of repair and compensation if • Require technical expertise for their resolution. relations with the government sour. International Infrastructure regulators are often appointed arbitration may also be the most reliable mecha- on the basis of their expertise in areas relevant nism for obtaining enforceable awards. This is to their functions. the main reason why most large infrastructure • Involve many players. An independent regula- projects involving foreigners include an interna- tor can often provide an open and inclusive tional arbitration clause (see section 3.10.5 for forum in which customers, providers, and gov- details). ernmental actors, for example, can interact to Domestic arbitration may be important, if per- resolve disputes. mitted by law, when the transaction does not have an international dimnension allowing the use of Quasi-judicial or administrative bodies can also international arbitration conventions or when the promote the sustainability of the parties' relation- government refuses to submit itself to interna- ship by offering a less confrontational approach to tional arbitration. dispute resolution. The disadvantages of this Some of the disadvantages of international method of dispute resolution are often linked to arbitration in dealing with concessions are its: the independence and accountability of the quasi- judicial or administrative bodies themselves (dis- * Inability to resolve conflicts that require urgent cussed in chapter 5). attention or timely resolution. * Impracticality for the resolution of recurrent 3.10.3.3 Arbitral. The advantages usually daimed issues. in favor of arbitration are: * Difficulty in accommodating the participation of interests other than the disputing parties. * Confidentiality: for example, as it relates to - Inability to resolve disputes arising from regu- commercial secrets. latory decisions that required broad discretion * Expertise: parties can choose arbitrators on the to be applied in the public interest. basis of their technical expertise. * Adversarial nature. Concession Design 61 There may also be constitutional and policy binding, the parties are never assured of a resolu- impediments to arbitration (see section 3.10.5.1). tion (for details, see Paulsson 1996: 210). 3.10.3.4 Nonbinding Alternative Dispute Reso- 3.10.4 Summary lution. ADR mechanisms typically have the fol- lowing benefits (Myers 1996: 105): Table 3.5 looks at four techniques and identifies the cases for which they are appropriate to resolve * Control. the parties control the negotiations concession disputes. A number of techniques and can decide to discontinue them at any time found in some countries have not been included, if they are unproductive. for example, the use of specialist courts or domes- * Flexibility: the third party assists in exploring tic arbitration. alternative and creative solutions in order to The analysis thus far leads us to two broad con- meet the needs of the parties. clusions. First, a number of dispute settlement * Speed. a session can be scheduled quickly and techniques can, and often should, be included in a requires relatively little preparation time. concession agreement. This need stems largely * Economy: some cases can be resolved within a from the particular characteristics of concession few hours. agreements and the inability of any one method to meet all of the parties' goals. Issues will arise as to For certain technical matters, it will often be the interactions of certain techniques, and the par- quicker and more productive for the parties to submit ties will need to give serious thought to how to their disputes to an expert. In the case of a BOT for a avoid inconsistencies. power generation plant, for example, these disputes Second, in order to determine the availability could include those relating to the satisfaction of com- and appropriateness of any particular dispute set- pletion tests and billing (White and Case 1995). tlement mechanism, a close analysis of the relevant The greatest weakness of ADR is a direct con- laws and the contract in question is usually neces- sequence of its strengths. Because the parties are sary. In this context seeking the advice of well- able to withdraw at any time from the process, and qualified advisers, particularly lawyers, will be because the recommendations, if any, are non- important before pursuing any particular options. Table 3.5 Some Dispute Settlement Techniques and their Appropriateness for Concessions Characteristics Goals in dispute Independent Nonbinding International of concessions settlement Courts regulator ADR arbitration Many occasions Access to reliable, neutral, for conflicts and noncorrupt forums = + + Long-term nature Sustainability of the of relationship parties' relationship - + + Public nature Prompt resolution, of services open and inclusive process - + + Large investment in immobile assets Enforceability = - - + Complexity and sophistication of projects Expertise - + + + + Usually appropriate. - Usually inappropriate or presents difficulties. = Appropriateness highly dependent on the independence and accountability of the decisionmnaking body. Source: World Bank staff. 62 Concessionsfor Infrastructure: A Guide to Their Design and Award 3.10.5 Focus on International Arbitration Latin American economies and the widespread acceptance by Latin American states of interna- In most large infrastructure projects involving for- tional arbitration as a means of settling investment eign investors and operators, the legal arrange- disputes.27 ments contain a clause that provides for binding international arbitration. There are two main 3.10.5.2 Submission to international arbitration. forms of international arbitration: institutional and Actual submission to international arbitration ad-hoc arbitration. Institutional arbitration implies requires the consent of the parties concerned. the existence of a permanent institution that There are different ways of giving this consent. The administers arbitration procedures, for example, most common is through an arbitration clause-in by supporting the nomination of arbitrators and a concession contract, for example. These clauses administering the proceedings (Paulsson 1996: give consent to arbitration before a dispute occurs. 214, 217). Ad hoc arbitrations, on the other hand, In order to be workable, an arbitration clause are intended to be self-executing (Paulsson 1996: should include, at a minimum, a clear choice of the 213), that is, the arbitration clause or agreement arbitration mechanism that will apply and a clear itself is intended to provide all the rules for the definition of the scope of the disputes to be arbi- arbitration.25 trated (Paulsson 1996: 222-23). The parties may This section introduces three important issues also wish to include in the clause a choice of: the related to international arbitration:26 law to be applied to the merits of the dispute (that is, the law that applies to the interpretation and * Impediments to international arbitration. application of the contract itself); the place of arbi- * Submission to international arbitration. tration; the number of arbitrators and other * Arbitration rules and institutions. requirements regarding nationalities and qualifica- tions of arbitrators; and mandatory prior recourse 3.10.5.1 Impediments to international arbitra- to conciliation or mediation (Paulsson 1996: tion. Some countries have constitutional and pol- 222-23). icy impediments to international arbitration. For As an illustration, the following is the model example, the constitution may state that the clause used by the International Centre for Supreme Court has exclusive jurisdiction over cer- Settlement of Investment Disputes (ICSID) for tain disputes involving the executive branch. In submitting future disputes to arbitration: addition, there may be explicit constitutional or other legal provisions restricting the state from The [Government]/[name of constituent submitting to international arbitration. In Turkey subdivision or agency] of name of the Constitutional Court determined in March Contracting State (hereinafter the "Host 1996 that concessions were administrative law State") and name of investor (hereinafter the contracts and, as such, were subject to dispute res- "Investor") hereby consent to submit to the olution before Turkish administrative courts exclu- International Centre for Settlement of sively (Wilson, Solsky, and Sarad 1997: 36; Investment Disputes (hereinafter the Cakmak 1996: 8-17). "Centre") any dispute arising out of or relat- Other obstacles may arise from legal traditions ing to this agreement for settlement by [con- that do not favor international arbitration. In Latin ciliationl/[arbitrationl/[conciliationfollowed, America the Calvo doctrine, for example, required if the dispute remains unresolved within time that foreigners be treated the same as nationals limit of the conmmunication of the report of and, as a result, required their submission to local the Conciliation Commission to the parties, jurisdiction. The Calvo doctrine, however, has by arbitration] pursuant to the Convention been largely superseded following liberalization of on the Settlement of Investment Disputes Concession Design 63 between States and Nationals of Other States a dispute would have to constitute a breach of spe- (hereinafter the "Convention"). cific commitments made by the government under the treaty. Second, in the case of investment laws Increasingly, though, governments are giving there is always the risk that the law may be changed consent another way. They are giving their consent, or repealed, and the offer of arbitration may, as a con- in advance, to arbitration for certain types of dis- sequence, be withdrawn before it is accepted by putes in bilateral and multilateral investment investors. In any case the parties may want to be treaties and in an increasing number of national more specific than the law or treaty in providing for investment laws. This is how it works. The provision arbitration (for example, they may want to specify for arbitration in the law or treaty constitutes an the number and nationality of the arbitrators). offer by the government to submit disputes to arbi- Therefore, the parties can still benefit from includ- tration. This offer must be accepted by investors to ing an arbitration clause in the concession contract. make it effective. Investors can generally give their Finally, if the contract, regulatory framework, matching consent at any time-that is, consent may or other laws and treaties do not specify a particu- be given simultaneously with the submission of a lar arbitration procedure, the disputing parties are request for arbitration or conciliation, or even by free at any time to agree to submit their dispute to means of such a request (Parra 1996). binding international arbitration. Parties should be In general, however, investors may not want to cautious about relying on this alternative, however, rely exclusively on such provisions and may wish to as an agreement on such matters is usually more include an arbitration clause in the contract, for two difficult to achieve once a dispute has erupted. reasons. First, a dispute emerging from the operation of the concession may not be covered by the invest- 3.10.5.3 Arbitration rules and institutions. ment treaty. In other words, in order to be covered, Table 3.6 presents the main instruments contain- Table 3.6 Main Instruments and Institutions Related to International Arbitration Instruments Procedural rules Enforcement rules Institutional support International Centre for Settlement of Investment Disputes Convention and Centera , v v Panama Convention and Inter-American Commercial Arbitration Commissionb V v International Chamber of Commerce rules and International Court of Arbitrationc c New York Conventiond V United Nations Commission on International Trade Law Arbitration rules (for ad-hoc arbitrations) v Domestic law based on United Nations Commission on International Trade Law model law on international commercial arbitration v v Notes: See Annex C for a list of member countries of the Organization of American States that indicates which countries are parties to the ICSID, New York, and Panama Conventions. a. ICSID is a public international organization established by the 1965 Convention on the Settlement of Investment Disputes between States and Nationals of Other States (the ICSID Convention). ICSID is part of the World Bank Group. b. The Panama Convention is the 1975 Inter-American Convention on international commercial arbitration. Arbitrations are held under the auspices of IACAC. c. Arbitrations are held under the auspices of the International Court of Arbitration of the ICC. d. The New York Convention is the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, 1958. Source: World Bank staff. 64 Concessionsfor Infrastructure: A Guide to Their Design and Award ing rules for international arbitration and a sam- include enforcement rules that are based on the ple of international arbitration institutions. New York Convention. Procedural rules govern the conduct of arbitra- The ICSID Convention breaks rank with the tions, including the composition of the arbitral New York Convention and other conventions tribunal, the conduct of the proceedings, and the based on the same rules as it limits the role of award. Institutional support refers to the institu- national courts in enforcing arbitral awards. In tions that administer arbitrations by, for exam- fact, the parties to an arbitration cannot challenge ple, helping with the constitution of arbitral ICSID's award before national courts. Only a tribunals. Enforcement rules set the conditions committee appointed by ICSID for this purpose for recognizing and enforcing arbitral awards can review ICSID awards (see Article 54 of the made in the territory of a state other than the ICSID Convention). state in which the recognition and enforcement There are many other institutions that adminis- are sought. ter arbitrations, including many regional arbitration The New York Convention is the main interna- centers. To name a few: the American Arbitration tional treaty dealing with the recognition and Association (AAA); the Stockholm Chamber of enforcement of arbitral awards. According to the Commerce, and the Kuala Lumpur Regional Convention, countries can make certain reserva- Center for Arbitration. The procedural rules they tions to its application (see Article 1). A reservation use are often those of, or simnilar to those of, UNCI- that most member countries have made stipulates TRAL and ICC. The parties will need to decide that a member-once it has made the reservation which forum is best suited to their particular needs. as to reciprocity-will only recognize and enforce One factor that may influence this choice is the awards under the Convention that have been made forum's private or public nature. Some commenta- in the territory of another contracting state. The tors see private institutions like the ICC or the AAA Convention also names a number of grounds that as more appropriate for purely commercial dis- would permit a court to refuse the recognition and putes. In cases that have an important public pol- enforcement of an award, including incapacity, icy component, a forum such as ICSID, which is an denial of a fair hearing, and public policy.28 The intergovernmental organization, may be more Panama Convention and UNCITRAL's model law appropriate. In fact, the argument goes, ICSID was Box 3.19 International Centre for Settlement of Investment Disputes Arbitration under the ICSID Convention is limited ICSID on a voluntary basis is the appointment of arbi- to legal disputes arising directly from an investment trators in ad-hoc arbitration proceedings. ICSID's sec- between an ICSID contracting state (or one of its retary-general has done this for an infrastructure designated agencies or political subdivisions) on the dispute in South America. one hand, and a national of another contracting In early 1997 two concession cases were submitted state on the other. The concept of investment, not to ICSID and are awaiting the constitution of a tri- defined by the Convention, is sufficiently broad to bunal. One case concems a water and sewer service cover infrastructure projects. Membership in ICSID concession in Argentina [Compafiia de Aguas del now stands at 126 of the World Bank's 180 member Aconquija SA and Compagnie Generale des Eaux countries. (CGE) v. Argentine Republic (ARBI97/3)] and the When either the state party to the dispute or the other a waste disposal BOO in Mexico [Metaldad state of the other party (but not both such states) is not Corporation v. United Mexican States (ARB(AF)/ an ICSID contracting state, the dispute may be sub- 97/1)]. The Mexican case has been submitted to ICSID mitted to arbitration under the Centre's Additional under the provisions of the NorthAmerican Free Trade Facility Rules. Also among the functions performed by Agreement (NAFTA). Source: Escobar (1997) and ICSID (1996). Concession Design 65 created for the specific purpose of making deter- 11. For instance, according to 1990 estimates, in minations in disputes involving public and private Guayaquil, Ecuador's largest city, only 45% of urban parties (box 3.19). dwellings have access to indoor drinking water, while On the other hand, a dominant factor in the 36% have no access at all to piped water. In slum choice of aforuisf iaityadex e . I neighborhoods consumers must buy from private ven- choice of a forum iS familiarity and experience. In dors. Private vendors buy water at subsidized prices practice, the ICC is by far the most commonly used and then sell it at a high mark-up. Studies showed that forum for the arbitration of international disputes water bought at 70 sucres per cubic meter was resold and receives more than 300 requests every year. at between 4,000 and 6,000 sucres per cubic meter, a mark up of 5,700-8,500%. In slum neighborhoods consumers spend up to a quarter of family income on Notes water, often of poor quality (Oxford Analytica 1996). A study of five Latin American countries found that 1. Republique Fran,aise (1980). The model con- water and sewerage subsidies to better-off consumers tract is intended to serve as a possible reference to were 1.3 to 2.8 times those to poor customers. Similar municipalities and private water suppliers. results were reported for Algeria and Hungary, where 2. A distinction can be drawn between sponsor the subsidies for services such as electricity, household companies (which are not necessarily parties to the gas, and urban transport to the better-off were 2.5 to contract) and project companies (that is, operating 3.8 times as high as subsides to the poor (Petrei 1987). companies, with legal personality, which are normally 12. It should be noted that if such additional fac- subsidiaries of the sponsors and are established specif- tors reflected the future costs of the operator perfectly, ically for the needs of the project). there would be no need for the X factor (indeed, the 3. See World Bank (1997) for more detailed check- cost factors would capture all efficiency gains). In lists of issues to be dealt with while designing conces- practice, however, it is impossible to devise a formula sion agreements. that would perfectly capture all future changes in the 4. HM Treasury (1995) Paragraph 3.20 discusses magnitude and structure of costs of a well-managed how the risk that the law will be changed should be company. An efficiency factor remains useful, there- allocated. It states that "The key issue is whether the fore, to capture some of the unpredictable ways in change in the law is discriminato-ry in respect of the which a good manager will lower costs. particular project or service. Risk in respect of changes 13. Reducing incentives to maximize sales might be in law and regulations of general application should lie an advantage only to the extent that some market fail- with the private sector. However, where the regulatory ures exist (negative externalities, such as pollution) change is specific to the service provided by the sup- and that the service is consequently priced lower than plier (...), it may amount to a change in the purchas- required to maximize overall welfare. er's requirement." 14. In Buenos Aires the share of the population 5. See, for example, the discussion of the incentives with home water connections was to rise from 70 per- of a price cap regime with respect to quality, in Section cent to 90 percent by year 10, and then to 100 percent 3.4.3.2. by year 30. Similarly, the share of the population with 6. We return to this topic in section 6.3.3. sewerage was to rise from 51 percent to 73 percent by 7. For more on risk sharing and allocation of risks, year 10, and then to 90 percent by year 30. The 30- see Milgrom and Roberts (1992: 206-47) and McAfee year water concession in Cancin, Mexico requires and McMillan (1988: 24-45). that water coverage be increased from 61 percent to 8. On the sharing of responsibilities between the 95 percent and sewerage coverage from 34 percent to public authority and a private operator regarding, in 95 percent within two years. particular, maintenance, renewals, and investments, 15. Article 50.2.1 of the contract states that every see also chapter 1. year the lessee must renew 17 kilometers of pipes of a 9. In fact, in order to minimize the distortion in certain type (wherever it is most needed) or "an equiv- consumers' demand patterns, the mark up that each alent distance of pipes of a different type," according consumer pays above marginal cost should be inverse- to a schedule annexed to the contract (that is longer ly proportional to that consumer's price elasticity of distances for smaller or cheaper pipes and shorter dis- demand. In economic theory, this is known as Ramsey tances for larger or more expensive pipes). pricing. 16. As a result, however, the operator could be 10. For a detailed analysis of different tariff struc- exempted from its investment obligations even if the tures, see Brown and Sibley (1986: 26-97). lower demand forecasts were due to its own bad per- 66 Concessionsfor Infrastructure: A Guide to Their Design and Award formance (such a scheme could therefore give rise to 23. The term alternative dispute resolution (ADR) some moral hazard problems). usually includes arbitration as another alternative to ]it- 17. Contractor liability under liquidated damages igation. For our purposes, we separate arbitration from is almost always capped, however, at some percentage other ADR mechanisms on the basis of the binding of the construction contract price. Liquidated dam- nature of the arbitration award. ages are often 10 to 15 percent of the contract price 24. The parties in Hong Kong's Chek Lap Kok for gas pipelines, for example, while for longer. Airport Project adopted a multitiered dispute resolu- gestation and more technically complicated coal-fired tion mechanism, which is described in McConnaughay power generation projects they may be as high as 35 (1995: 249-50). to 40 percent. 25. Because this is usually very difficult to do, organi- 18. For more detail on risk coverage available zations like the United Nations Commission on from private sources, see American International International Trade Law (UNCITRAL) elaborated rules Underwriters (1997). for use in ad-hoc arbitration procedures in order to 19. See the website of the Office of the Water facilitate matters for the parties. Still missing, though, is Services (OFWAT) at http:/www.open.gov.uk:80/ofwat. a back-up organization that is able to step in and rule 20. For examples of self protection mechanisms on a challenge to arbitrators, for example. For details through which a private party might try to enhance its see Paulsson (1996: 212-14). See also Table 3.6. bargaining position vis-a-vis the government see Kerf 26. For a more detailed treatment of international and Smith (1996:52-56). arbitration see: Redfern and Hunter (1991) and 21. The issue of choice of judicial forum in a con- Fouchard, Gaillard, and Goldman (1996). tract (and its enforcement) raises a number of issues 27. Escobar (1997). For a discussion of the Calvo that are beyond the scope of this paper. National law doctrine and its consequences, see Amador (1992: or case law on the subject should be surveyed as 521-22). See also Peters and Schrijver (1992: 355-83). approaches differ between countries. 28. For details on reservations and grounds for 22. Credit agreements are also generally governed refusals under the New York Convention, see Redfem by New York law. See St.-John-Needham (1994). and Hunter (1991: 457-65). CHAPTER 4 Concession Award T he success of a concession depends not 4.1 Choosing the Method of Award only on getting the provisions of the con- tract right, but also on designing an appro- There are a wide variety of concession bidding and priate method for awarding the concession. The award procedures and a range of options for the issues include: detailed design and implementation of these processes. Essentially, however, the methods can be * Whether to use competitive bidding (or some broadly grouped into three categories: competitive other method) to award the concession. bidding, direct negotiations, and competitive D Whether to have a prequalification process for negotiations. In practice, these methods constitute interested bidders. a continuum, and any award process is likely to * How to structure and evaluate bids. incorporate elements of competition and negotia- * Whether to have sealed or voice bids. tion at various stages. The techniques for selecting D Whether to have single or multiple bidding a private partner or project may be contrasted more rounds. generally with a system of free entry, in which there are no formal selection procedures (see chapter 1). The design of the bidding and award proce- dures can have a significant impact on the eco- 4.1.1 CompetitiveBidding nomic efficiency and transparency of the concession. This chapter describes options for Under a competitive bidding process, tendering approaching these issues and summarizes recent generally involves the following elements: lessons from international experience. It is important to note that the options * Public notification of the government's intent described below do not necessarily conform to to privatize an existing infrastructure service or procurement guidelines required by some multi- award a concession for a new private infra- lateral institutions for projects they finance. structure project or service, generally including Rather, the discussion attempts to address a wide a request for expressions of interest. range of options and their merits and limitations * Distribution of information memoranda, bid- without pointing out how these practices might ding documents, and related draft contracts to deviate from multilateral procurement guidelines. potential bidders. But, it is important for governments to bear these * A formal process for prequalifying potential guidelines in mind when designing a concession bidders. award procedure if they are to preserve the possi- * A formal public process for presenting proposals, bility of donor financing for that project. evaluating proposals, and selecting the winner. 67 68 Concessionsfor Infrastructure: A Guide to Their Design and Award Within this broad framework there may be other methods (such as competitive negotiations important design differences on, for example, or direct negotiations) if the project circumstances whether and how to prequalify bidders, how bids warrant a different approach (see section 4.1.2). will be structured and evaluated, and how offers As mentioned above, donors may require par- will be presented and awarded. These issues will be ticular procurement practices and will typically described in detail later in the chapter. mandate competitive bidding in the projects they Most countries favor competitive bidding. support. The World Bank, for example, has devel- Governments generally cite three reasons for using oped procurement guidelines dealing specifically competitive bidding: it ensures transparency in the with concession contracts (box 4.1). contract award, it provides a market mechanism for selecting the best proposal and typically results 4.1.2 Direct Negotiations and Unsolicited in lower costs, and it stimulates interest among a Proposals broader range of potential investors. Competitive bidding is easiest to design and implement when Under direct negotiations, the project idea gener- the product or service required is fairly standard, ally originates with a private sector sponsor, rather the technical parameters can be defined with rea- than with the government. A developer or opera- sonable certainty in the bidding documents, and tor seeks to negotiate directly with a government there is limited scope for innovation and creativity or government-owned utility on the terms and con- on the part of an operator. ditions for an infrastructure project, whether it be Virtually all governments use competitive bid- a management contract, concession stnicto sensu, ding for privatizing and concessioning existing BOT, BOO, or privatization. There may, in fact, be infrastructure services for these reasons and circumstances in which a full-blown competitive because most countries have public procurement bidding process may not yield the best result for rules in place that mandate public bidding for the consumers. Such instances could include: sale or concession of all government assets. In the case of new infrastructure projects involving some Projects in smaller municipalities, where it may form of monopoly franchise, most governments be too costly to arrange a competitive bidding favor competitive bidding (if a formal process is in process or where it may be difficult to attract place), though some have the flexibility to use developers and operators. Box 4.1 Guidelines for Selecting Concessionaires and Procurement under World Bank Loans In January 1995 the World Bank adopted new rules countries, that is, World Bank-member countries). dealing specifically with private infrastructure or con- When it is not selected competitively, the conces- cession contracts that it finances. The new guidelines sionaire will be expected to procure goods, works, link the way the private developer or operator is and services on an international competitive or lim- selected to the way it will have to procure Bank- ited international bidding basis, in accordance with financed goods, works, and services. standard Bank procurement rules. The main principle is that competitive bidding The World Bank determines whether a specific should be used at one of two stages. If the private selection process meets the criteria set forth in its concessionaire is selected competitively under inter- guidelines. It is therefore prudent to involve Bank national competitive bidding or limited interna- staff from the beginning of the process if the gov- tional bidding, as defined in the Bank Guidelines on ernment or concessionaire wants to hold onto the Procurement, the concessionaire is free to use its own option of letting a competitively selected conces- procedures to procure contracts financed by the sionaire procure goods and services using its own World Bank (as long as these come from eligible procedures. Source: World Bank (1996). Concession Award 69 * Emergencies and natural disasters, in which stimulating innovation may in exceptional cases major projects or repairs must be completed justify alternatives to competitive tendering." rapidly. The U.K. Guidelines further stipulate that direct * Projects involving proprietary or innovative negotiation with a single promoter is possible if: technology. * A private sector promoter identifies an entirely In countries without a track record or a proven new project. legal and regulatory framework for private conces- * A private sector promoter comes forward with sions, governments may choose to enter direct . a project in response to an invitation from a negotiations for some initial projects on a pilot public sector body, based on the delivery of out- basis in order to gain experience and build a record puts that are not specifically defined but that with investors. This approach provides the neces- fall within broad functions, policies, or initia- sary time and experience to properly design the tives. framework for infrastructure concessioning before * A private sector promoter proposes to proceed launching a broad competitive bidding process for with a project already identified by the public other infrastructure projects. sector in a way that is genuinely innovative. There are several examples of direct negotia- tions for private infrastructure projects. Direct Simnilarly, in 1994 the Australian State of negotiations were used for the early independent Victoria issued guidelines pertaining to the power producers (IPPs) in Indonesia and the tendering of private infrastructure projects Philippines, although both countries have subse- (Department of the Treasury 1994). The guidelines quently adopted competitive bidding. Twelve encourage private investment in infrastructure and states in the United States with competitive bid- allow developers to propose new initiatives. The ding procedures in place for procuring power also government's policy is to proceed with open com- allow direct negotiations under certain conditions petitive bidding for awarding the projects, but the and subject to specific rules. In addition, a number guidelines permit direct negotiation in circum- of states require no bidding, and utilities continue stances "where the private sector proponent has to negotiate directly and sign contracts with inde- offered the Government a proposal which embod- pendent power producers. ies a unique and proprietary concept as an essen- The United Kingdom and the Australian State tial component of the proposal and where the of Victoria are recent examples of governments proposal is cost effective when measured against that allow some degree of flexibility in public ten- the Government's benchmarks." dering of private infrastructure projects. In 1994 In general, in cases where governments do not the U.K. government issued guidelines for min- use competitive bidding, they should introduce istries concerning the tendering of privately some degree of competition into the processs, or financed projects (HM Treasury 1994). The guide- otherwise replicate competitive forces, in order to lines emerged from a lengthy public consultative ensure both transparency and economically efficient process in which the government sought views outcomes. Several possible mechanisms could be from developers, financiers, and the public. The used. For example, if innovative designs or technol- guidelines set out the framework for competition, ogy are being proposed, it may be possible to con- competitive negotiation, and direct negotiation. tract the design phase directly and then hold They recognized that, "Competition must keep its competitive bidding for implementation. If it is not central place in public procurement. Its form, how- possible to separate design and implementation, and ever, will vary according to the value and complex- the government proceeds without using competitive ity of individual cases.... In the context of the bidding, safeguards could be built into ensure trans- private finance initiative the advantages in terms of parency and efficiency. These could include: 70 Concessions for Infrastructure: A Guide to Their Design and Award * Using external advisers and consultants to ner competition would be used to narrow the num- assist the government in assessing proposals. ber of potential developers, and negotiations * Benchmarking against the cost of similar pro- would be used to work out detailed terms and con- jects. ditions of the contract. The government would * Announcing the proposed project terms and have failback bidders if negotiations with the pre- conditions, and allowing other developers an ferred bidder failed. opportunity to better the terms within a speci- Alternatively, the government could negotiate fied period-this feature is incorporated in the simultaneously with several developers to further Philippines BOT Law (box 4.2). enhance the competitive aspects of negotiated * Establishing an independent advisory panel to transactions. This is often referred to as competitive review the proposed transaction. negotiations. Under this method governments (or govermnent-owned utilities) specify their objectives Periodic rebidding of the concession would and solicit proposals from private operators through also help ensure longer-term economic efficiency a request for proposals (RFP). The government (or in cases where the initial concession was directly utility) then reviews the proposals, selects those that negotiated. are deemed technically responsive to the RFP, and negotiates the contract terms with the selected bid- 4.1.3 Competitive Negotiations ders. The process may involve simulaneous negoti- ations with several bidders with the objective of It may al~o be possible to combine elements of awarding a single contract. Alternatively, it may competitive bidding with direct negotiation to pro- result in the award of several contracts. mote transparency, while preserving the innovative This competitive negotiation approach is well- or proprietary aspects of developers' proposals. suited to projects in which: For example, governments could initially use a competitive process to solicit proposals in response * There is scope for innovation and different to broad output specifications and then negotiate approaches by developers, and authorities hope directly with one or more developers. In this man- to elicit imaginative proposals for projects. Box 4.2 Philippines Build-Operate-Transfer Bidding-The "Swiss Challenge" Under the Philippines BOT Law, national or local general circulation for at least three weeks. The pub- authorities may accept unsolicited proposals for BOT lished invitation must inform potential bidders where projects on a negotiated basis if: to obtain tender documents, however, proprietary information contained in the original proposal is con- * The project involves a new concept or technol- fidential and may not be disclosed in the tender doc- ogy and is not already listed on the roster of pri- uments. Competitors have 60 days to submit ority projects identified by the government. competitive proposals. If a lower-priced proposal is * No direct government guarantee, subsidy, or received, the original proponent has 30 days to match equity is required. it and win the contract. Otherwise, the award goes to * The project is submitted to a price test or the lower bidder. 'Swiss challenge" from competitors. This challenge has been used, for example, in the case of a New Zealand developer who submitted a The price test works as follows: the agency award- proposal to the National Power Corporation to reha- ing the project must invite comparative proposals to bilitate and maintain a 350 mega-watt hydro plant, any unsolicited proposal it has received. The invita- challenging an unsolicited proposal by an Argentine tion to tender must be published in a newspaper of company. Source: Republic of the Philippines (1994). Concession Award 71 It would be difficult to secure financing on the terms of timing, siting, fuel supply, design, perfor- basis of standardized contract documents. mance, security, and contract-termination provi- sions, once they reach the negotiation stage. In these circumstances simultaneous negotiations Second, it removes the potential incentives that with several prequalified bidders may be the pre- arise under price-based competitive bidding for ferred approach for awarding one or several projects. some bidders to offer unrealistic projects that will Many states and utilities in the United States use do well when evaluated against price criteria, but this approach for procuring new power generation. may never get built. Third, it offers a more rational A 1991 survey of procurement methods undertaken way to screen qualified potential suppliers. by the National Independent Energy Producers (an Another example of the use of competitive nego- association of independent power producers) tiations is the Hong Kong East Harbour Tunnel, demonstrated strong support for this method, citing involving the construction and operation of a tunnel three advantages. First, since the terms are not between Hong Kong and Kowloon. The govern- fixed, it permits developers to be more creative and ment advertised in the Government Gazette for bids tailor projects to the particular needs of the utility in for the construction and operation of the proposed Box 4.3 The United Kingdom Private Finance Initiative-Bidding and Award Procedures Although the guidelines for the United Kingdom a full tender. However, authorities have considerable Private Finance Initiative (PFI) include a presump- flexibility in determining the number of bidders. tion in favor of competitive tendering, they do not Bidders may submit an outline or indicative proposal require it. In fact, the use of a negotiated procedure to serve as the basis for discussions with the tender- involving several bidders at once is "strongly recom- ing authority. Detailed negotiations will then be pur- mended where the conditions for using it are met." sued with the final bidders. The target timetable from In some cases public bodies may also proceed with a publication of the initial notice to contract award is single tender procurement procedure. 12 to 15 months. The reason given for this latitude in methods of Project requirements generally specify a particu- project bidding and award is to encourage private sec- lar output in terms of capacity and availability of ser- tor companies to come forward with innovative ideas. vice. Final bidders are then given an opportunity to By allowing for considerable flexibility in the design comment on requirement specifications before they and procurement of projects, the private sector is are finalized and to suggest alternative solutions for given the greatest scope for influencing project devel- indusion in their tenders. Intellectual property rights opment, while a more restricted procedure might are to be protected, and ideas emanating from dif- dampen innovation and provide inadequate scope for ferent bidders may not be combined in the project negotiation with bidders. design. If an idea submitted by an unsuccessful bid- If competition is used, the first step is the publi- der is used in the project, appropriate compensation cation of a notice of the proposed project in the must be paid. Official Journal of the European Community. The pro- Bid appraisal criteria are chosen and communi- ject is generally loosely defined in this initial notice in cated to bidders as part of an invitation to tender. But order to allow for varied and attractive solutions from the weights given to various elements of cost, quality, bidders. Companies expressing interest must then and deliverability of tenders need not be given to bid- prequalify by providing basic information about their ders. Because the appraisal involves weighing a num- financial standing, commercial and technical capabil- ber of subjective conditions of comparative bids, a ities, and relevant experience. This information is "reasoned, judgmental approach" to evaluating used to assess the capacity of bidders to undertake unquantifiable factors is advocated. The outcome of the project, and thus to compile an initial shortlist. the appraisal may be either the immediate award of a In order to minimize bidding costs, normally no contract or the identification of a preferred bidder more than three or four bidders are invited to provide with which to carry on final negotiations. Source: HM Treasury (1996). See also HM Treasury (1995). 72 Concessions for Infrastructure: A Guide to Their Design and Award tunnel. Bidders were given a very preliminary engi- award it to an operator that offers the best deal on neering design and traffic estimates prepared by the paper but later fails to deliver what was promised. government. Interested bidders were required to One way to reduce this problem is to design the submit technical and financial proposals. The tech- concession contract so that it is attractive only to nical proposal had to specify project details, includ- operators who are confident that they can operate ing whether the bidder would also build a parallel the business successfully. This can be done by writ- tunnel for the metro (bidders had the option of ing a contract that imposes stiff penalties for poor including this in their proposal). The financial pro- future performance and requiring finns to post a posal had to include the proposed toll to be charged bond sufficient to pay the penalties. If poor per- to users during the 30-year life of the concession. formance can be objectively observed, and the bid- Of the nine proposals received, eight passed to ding parties believe that they will indeed forfeit the next stage; one was rejected on the grounds that their bond in case they fail to meet the contract's the consortium did not have sufficient financial performance standards, this system should deter capacity or technical and operational experience. those who lack the requisite technical and financial The government, with the assistance of an external capacity from bidding for the concession. advisor, reviewed the eight proposals for three In practice, however, it may be difficult to months and, based on this review, shortlisted three enforce penalties specified under the contract, and bidders. The government asked them to provide the performance bond may not prevent bidding by additional information on their proposals. Upon overconfident operators. As a result governments receiving this information, the government entered will often go through a process of prequalifying into parallel negotiations with all three. Following prospective bidders to further weed out unsuitable competitive negotiations, bidders were asked to firms. Prequalification may also be used to reduce resubmit their toll proposals. A winner was the number of bidders, thus stimulating qualified selected, and a letter of understanding signed. The firms to prepare good proposals. agreement was then ratified by the Legislature. In addition, governments typically limit the Regardless of the method of award chosen, the total number of prequalified bidders to a shortlist solicitation and evaluation of bids and the negotia- of three or four, because the costs associated with tion of contracts involve complex legal, financial, more bidders often exceed the benefits of addi- and technical issues. It is necessary to stress the tional competition. For bidders there are high costs importance of qualified, professional advisers to associated with preparing bids and negotiating the the success of concession design and implementa- transaction. A large number of bidders reduces the tion. The issues involved in such projects typically chances each has of winning the bid and hence dis- lie outside the scope of traditional civil service courages investment in the preparation of propos- work, and the use of specialized external advisers als. More bidders also raise costs to governments to the government is advocated, especially given since officials and their advisers will usually face that private investors will generally employ their more requests for clarification or additional infor- own teams of experienced advisers on such pro- mation, and more bids will have to be evaluated. jects. For more on the hiring of advisers see box 2.3. There are several issues that must be consid- ered in conducting a prequalification of bidders, 4.2 Prequalification and Shortlisting including: When awarding concessions for the provision of a The type and mninimum degree of experience monopolistic infrastructure service, governments and capacity required of potential operators. usually want to ensure that the winning consortium * The criteria to be used for prequalification and has the technical and financial capacity to operate the quantitative or qualitative method for eval- the concession successfully. They do not want to uating potential bidders against these criteria. Concession Award 73 * The form and extent of involvement by the lead mance criteria to ensure that potential bidders operator in the bidding consortium (for exam- demonstrate a minimum level of efficiency in their ple, minimum equity position, technical assis- relevant operations elsewhere. These may refer to tance contract, and so on). such items as labor productivity (volume of output * The stage in the bidding process at which pre- or service per employee) and cost efficiency (oper- qualifcation should take place (for example, ating costs per unit of service). The challenge is to before bidding documents are distributed or at identify the right parameters by which to judge qual- the time of bidding). ity. Performance criteria should be used judiciously, namely in sectors and services where cross-country 4.2.1 The Operator'sExperience comparisons are meaningful (not subject to wide variations in underlying conditions) and where per- Generally, governments seek bidders with a proven formance data are reliable and verifiable by a third track record in the service being concessioned or party (such as the home-country regulator). privatized. But the degree of experience and Prior to setting the prequalification criteria, gov- capacity required of bidders will depend in part on ernments (with the assistance of their advisers) the size and attractiveness of the market to be often undertake a preliminary "road show" to pro- served, the sector and service being concessioned, mote the transaction and assess the degree of and the number of established firms currently investor interest. By doing this, they can set the cri- operating in the world market in this sector. There teria to ensure that there will be a sufficient number is a good argument for "right-sizing" prequalifica- of bidders, based on their prior knowledge of tion to fit the concession and expected investor investor interest and the technical and financial interest-that is, smaller concessions may set less characteristics of potential bidders. While this pro- rigorous prequalification criteria in order to ensure cedure is by no means essential, it may avoid the a sufficient number of bidders and, hence, real unpleasant surprise of announcing criteria and find- competition in the award process. ing that there are no interested bidders who qualify. Alternatively, some governments have opted for 4.2.2 Prequalification Criteria a less rigid evaluation process without quantitative criteria. Bidders submit information on their expe- In a formal prequalification process governments rience and qualifications, and these submissions are often use quantitative criteria related to technical reviewed by the government to ensure that firms' and financial capacity (table 4.1). These criteria financial and technical capacity is satisfactory, but generally refer to such aspects as: without using explicit quantitative criteria. This process gives the government more flexibility, but it * Operations by the bidder in one or more com- is subject to complaints about lack of transparency parably sized markets (generally expressed in from bidders who do not pass the screening. terms of the customer base in those markets). In assessing a firm's prior experience with sim- * Financial strength of the bidder. ilar operations in other countries, it may be useful * Minimum operating revenues from a compar- to review the company's performance data, regu- able service run by the bidder. lators' reports, and customer surveys or opinion * Minimum required equity of companies in the polls showing the level of public satisfaction with consortium. the service provided. * Quality of service provision in comparable operations. 4.2.3 The Operator's Participation While many of these criteria reflect the size of Once the government has determined that it wishes operations, governments often include perfor- to have a prequalification process, it may also spec- 74 Concessionsfor Infrastructure: A Guide to Their Design and Award Table 4.1 Examples of Prequalification Criteria in Private Infrastructure Transactions Prequalification Technical Sector Country Transaction procedure criteria Financial criteria Electricity Peru Lima electricity Qualification at time Customers Minimum total distribution of bidding; bidders and energy value of assets privatization must exceed a score sales per worker, and net worth of 80 percent against total customers, six weighted quantitative and energy sales technical and financial criteria Argentina Electricity A guarantee to Consortia to include Minimum distribution carry out the qualified operator asset value of concessions bidding process with minimum bidding was required of experience and companies; bidders at the time ownership in proven increase of prequalification consortium of at least 10 percent in asset value in three years prior to bidding Transport Mexico Concessioning Registration through Demonstrated Demonstrated of rail freight written statement legal, technical, and financial lines of interest; authorization administrative capacity of registered parties by capacity the Ministry of Com- munications and Transportation based on uniform criteria Hungary BOT for Invitations for pre- Capacity of bidders Capacity of toll road qualification based on to design, build, bidders to approved preliminary maintain, and finance road design plans evaluated by operate toll road without state aid expert assessment commnittee Water Argentina Buenos Aires $30,000 fee for Minimum Minimum concession prequalification population of largest requirements documents city and aggregate for total annual population served billing and by bidder net share capital; consortium shareholding distribution regime Bolivia La Paz Qualification process Consortia must Minimum net concession to take place at same include water worth and time as economic bids operator with maximum debt- presented minimum experience to-equity ratio and extent of service of operator Natural Mexico Concessioning Registration of Documentation of Documentation gas of distribution interested bidders technical and of financial and meetings between administrative capacity regulator and prospective capacity bidders to clarify information prior to technical bids; small registration fee Source: World Bank staff. Concession Award 75 ify the form that the operator's participation should time and flexibility to form consortia, it also creates take in the bidding consortium. Governments often greater uncertainty among bidders concerning want an experienced operator to have a long-term how many groups are likely to submit bids. The stake in the success of the concession and will insist expectation of a large number of bidders may deter that the operator have a majority (or at least a sig- some investors from incurring the costs involved in nificant) equity stake in the bidding consortium. If preparing a bid. the operator is a large multinational company, this would also enhance the bidding consortium's abil- 4.2.5 Transfer of the Concession ity to raise financing. On the other hand many oper- ators may find this requirement too onerous, While prequalification helps to ensure that bidders particularly for smaller concessions. Rather than have the required technical and financial capacity requiring an equity stake in the consortium, an alter- to undertake a project, it does not ensure satisfac- native is to require that the bidding consortium have tory future performance. As discussed in chapter an operating or technical-assistance contract with a 3, the concession contract should include incen- qualified operator, that is, the operator would man- tives for efficient management and sanctions for age the company (or at least provide specified tech- poor performance. It is also important that regula- nical assistance) but not hold any equity. tory institutions be in place to supervise and enforce contract compliance. 4.2.4 The Timing of Prequalification Often governments design concessions to pre- clude operators from transferring their shares (or The timing of prequalification is also important. operational management responsibility) in the Some governments have opted to hold prequalifica- concession company during the life of the conces- tion early in the bidding process, that is, prior to the sion. This restriction is designed to ensure that distribution of any draft bidding documents. Early there will always be an experienced operator man- prequalification formalizes discussions with poten- aging the concession. But it may make financing tial bidders, since only prequalified bidders receive difficult to obtain, because lenders generally seek the draft bidding documents for comrnment, under- transferability rights in the event that operators take due diligence, and participate in the bidding. default on their loans. The possibility of a takeover This formnalization enhances the transparency of the by another operator also gives the government a process. One drawback of early prequalification is means of exerting pressure on an inefficient oper- that it forces potential investors to form consortia ator. A possible solution is to allow transferability early in the process and reduces their flexibility to to another operator, with the approval of the gov- change consortium partners during the preparatory ernment, and provided that the new operator sat- phase. This problem can be mitigated to some extent isfies the original prequalification criteria. by allowing the reorganization or merging of consor- tia prior to the actual bidding. However, govern- 4.3 Bid Structure and Evaluation ments may want to limit the merging of competing consortia in order to avoid collusion between bidders Given the complexity of many infrastructure pri- and to maintain a sufficient number of bidders. vatizations and new investment projects, it is often Another option is to defer qualification until difficult for governments to evaluate and compare the actual bidding. With this approach bidders proposals from different bidders. In designing the must prove that they meet qualification criteria bid evaluation process, governments must decide: established by the government at the time of bid submission. If they do not meet these criteria, they Whether to have a two-stage process involving will be disqualified from the bidding. While defer- the sequential evaluation of technical and ring prequalifcation provides bidders with extra financial proposals. 76 Concessions for Infrastructure: A Guide to Their Design and Award * Which specifications to include for the techni- (25), maintenance plan (8), concession fee to be cal and financial proposals. paid (12), payment required by the passenger trains * How to assess whether a technical proposal is for trackage rights (5), and number of personnel to fully responsive to the specified requirements. be retained from the public company (15). * How offers should be evaluated and compared. A process involving a technical evaluation of proposed business plans has important drawbacks, 4.3.1 Technical Proposals however. It often involves considerable discretion and judgment on the part of the evaluation com- Many governments have adopted a two-stage mittee, which reduces the overall transparency and process (either in the place of or in addition to a automaticity of the award process. Experience has prequalification round) whereby bidders present also shown that changing market conditions after separate technical proposals containing business contract award often require operators to make and investment plans. These proposals are evalu- significant (and justifiable) modifications in their ated before proceeding to the financial offers. business plans and investment programs. These Often the evaluation is conducted on a pass/no- changes reduce the meaningfulness of the evalua- pass basis-that is, only those bidders that pass the tion process to the extent that it relied heavily on technical evaluation proceed to the financial eval- the assessment of the proposed business plans. uation. The winning bidder is then selected on the Given these drawbacks, many governments basis of the best financial proposal from among have opted for a process whereby all bidders bid those who passed the technical evaluation. on the same technical specifications or service This approach was used in the Buenos Aires requirements, and the evaluation is based solely on water privatization. Four prequalified bidders sub- financial proposals. To ensure that the technical mitted technical proposals setting out their busi- specifications and service requirements are viable, ness plan, including investments, financing, and so governments will generally issue a preliminary ver- on. These plans were then evaluated by the gov- sion to bidders for comment and discussion prior ernment to assess their adequacy with respect to to finalizing project plans. After consultation and the service requirements in the concession con- receiving bidders' written comments, the govern- tract. The committee concluded that three of the ment finalizes the bidding package, and all bidders four plans were technically responsive; the fourth bid on the same technical specifications and was deemed nonresponsive, principally because it requirements. -included an innovative proposal for a sewage treat- Although the technical specifications are stan- ment plant that was considered by the committee dardized for all bidders, there may still be a two- to be nonviable. After the technical evaluation, the stage procedure. In this case the technical proposal three bidders that passed proceeded to the finan- may simply involve providing legal documentation cial proposal stage. The concession was awarded to to meet standard bidding requirements. the bidder with the best financial proposal (in this Alternatively, it may be used to qualify bidders (if case the lowest average tariff to consumers). a prequalification process was not used earlier) or An alternative is to weight the technical and reduce the number of prequalified bidders that financial evaluations. This method was used to advance to the financial evaluation. In this case the select the new private concessionaires for the technical proposal would contain information on Argentine freight rail privatization. Bidders sub- the bidder's technical and financial capacity and mitted detailed business plans with technical and experience in order to assess these against certain financial information. The proposals were evalu- specified thresholds. This procedure is, however, ated on the basis of the following weighted criteria: quite different from a two-stage bidding process proposed investment plan (30 points), promised whereby bidders submit proposed business and additional investments (5), organizational plan investment plans for evaluation. Concession Award 77 4.3.2 Financial Proposals amount of risk and ownership to be transferred to the private operator, and the government's objec- There are many different options for structuring tives for the transaction. If the transaction involves financial proposals (table 4.2). Some of the more privatizing existing assets or shares, a common common options include bidding on: practice is to have bidders bid the amount of cash (or debt retirement) they would pay the govern- * The highest price, in cash or debt retirement, ment for the assets or shares being privatized to be paid for the assets or shares of the enter- (assuming that the pricing regime is specified in the prise being privatized or highest concession fee concession contract).' In this case the winner is (one-time or annual) paid to the government. simply the highest bidder. This method is used by * The lowest cost to the government for con- most governments to divest existing enterprises. structing or operating facilities or services. Peru, for example, privatized its electricity dis- * The largest amount of new investment to be tribution assets in Lima and received $389 million undertaken by the operator. in cash payments for 60 percent of the shares. * The lowest tariff to be charged to consumers. However, basing awards on the highest fee can * The lowest net present value of the future rev- encourage concession designs that limit competi- enue stream to the developer from the service tion in the sector in order to attract a higher price or project. for the concession. While conferring exclusivity * The lowest subsidy that the government must rights on the concessionaire may indeed raise more provide to the winning bidder to operate a loss- revenue for the government, it results in higher making service. prices to consumers for infrastructure services. In some privatizations governments may In addition, there are other criteria on which decide that short-term revenue needs are less projects may be bid, such as the maximum extent important than private investment in the company of new service coverage promised or the minimum being privatized. In such cases they may structure length of the concession period. While not strictly the privatization to include the issuance of new "financial" criteria, these bear directly on the level shares, rather than (or in addition to) the sale of of investment to be undertaken or on the con- existing shares. Where new shares are issued, the sumer tariffs required by the developer. proceeds will remain with the privatized company The choice of which method to use will depend (for future investment), whereas proceeds from on several factors, such as: whether the transaction the sale of existing shares will go to the govern- involves an existing service or a new project, the ment. For example, Peru's telecommunications Table 4.2 Examples of Financial Proposals Infrastructure transaction Structure offinancial proposal Peru: Lima electricity distribution privatization Highest dollar value offered for assets Argentina: Buenos Aires water concession Maximum discount to existing tariffs Philippines: power-generation BOTs Lowest price (cents per kilowatt-hour) of power to be supplied Chile: south access to Concepci6n toll road Minimum toll and minimum one-time subsidy Turkey: electricity distribution concession for Minimum margin on distribution required by the Istanbul operator Venezuela: cellular concession Highest concession fee paid to government Source: World Bank staff. 78 Concessionsfor Infrastructure: A Guide to Their Design and Award privatization combined the sale of existing shares sold), involves bidding on the basis of the tariff to (with the proceeds going to the government) and be charged to consumers. This was the method used the issuance of new shares (with the proceeds for concessioning the water and sanitation services in remaining in the privatized company). Similarly, in Buenos Aires and Manila, where concessions were Bolivia's capitalization program bidders bid on the awarded to the bidder proposing the largest discount value of new shares issued by the capitalized enter- from the existing tariff structure. This method has prises; proceeds remain with the company to also been used for awarding new toll road conces- finance future investment, while the winning bid- sions and power generation plants. der acquires a 50 percent stake in and manage- Some innovative bidding schemes have been ment control of the company. developed in the past three years for private infra- Where privatization of infrastructure involves a structure projects that involve considerable market full concession but no sale of assets, governments risk. In the case of new toll roads, for example, frequently base the bidding on the highest pro- experience has shown that it is very difficult to posed concession fee to be paid by the conces- forecast traffic flows, thus generating high risk for sionaire. This fee may take the form of a one-time the operator (or the government in the event that upfront payment or an annual payment for the life it has provided traffic or revenue guarantees). To of the concession. If the fee is to be spread over the address this problem, Chile is now considering bid- life of the concession, the bidding procedures gen- ding on the basis of the net present value of the erally specify the discount rate for translating bids future revenue stream from the collection of tolls, from future to present value. with the concession awarded to the operator who When a government's objective is to increase bids the lowest net present value. Under this bid- investment in the privatized company, it may ding method the concession would not be fixed in choose to hold the bidding on the basis of new length. It would terminate when the revenue investment commitments. This method of bidding stream (in net present value terms) reaches the is commonly used when a government is con- original bid. Thus the concession length would cerned that the market value of a company being automatically adjust to fluctuations in demand, privatized is much lower than the book value thereby reducing market risk for the operator and (reflecting the government's historical investment) eliminating the need for traffic or revenue guaran- *and that it will therefore be accused of giving away tees from the government. This method is some- public assets. In such cases governments will often what similar to that used in the private base the bidding on proposed investment commit- construction and operation of the QEII Bridge ments to demonstrate to the public that the new (Dartford-Thurrock River Crossing) in the United owners will invest in the privatized company. Kingdom, where the concession period is set at a Bidding on the basis of investment commit- maximum of 20 years or until the company has ments has three important drawbacks. First, by accumulated revenue equal to the project debt. locking in future investment levels, it prevents the For more on variable-length concessions, see also operator from adjusting investments and opera- section 3.8.4.4. tions to reflect changing market circumstances. In summary, there are many ways to structure Second, it has often proven difficult to enforce the financial bid, and the choice can have impor- these commitments, thereby undermining the tant effects on the award and operation of the pro- basis for the original bidding and contract award. ject and, ultimately, on consumers. In designing Third, it may encourage excessive, economically the financial bid, governments should seek to fol- unjustifiable investment, low some basic principles, such as: Another bidding option, which is commonly used for either new infrastructure projects or concession- * Structuring the financial bid as simply and ing of an existing service (where assets are not being transparently as possible so that the bid award Concession Award 79 is automatic (that is, avoid complex formulas While negotiations on matters such as the pro- requiring subjective judgments or qualitative posed tariff, concession period, and risk allocation evaluations on the part of the government). are not uncommon in many concession awards, they Structuring the financial bid to promote eco- are clearly contrary to the spirit of transparent com- nomic efficiency, in terms of efficient con- petitive bidding and are barred by many interna- sumption by users and efficient operation and tionally recognized procurement rules and investment by the concessionaire. For example, guidelines. For example, Article 31 of the UNCI- bidding on investment commitments may not TRAL Model Law on Procurement states that "no promote efficiency if it leads to overinvestment negotiation shall take place between the procuring or the uneconomic allocation of resources. entity and a supplier or contractor with respect to a tender submitted by the supplier or contractor." As Similarly, bidding on tariff levels will not pro- much as possible, technical discussions and negoti- mote efficiency if the tariff structure is itself dis- ations should be addressed in the technical proposal torted or if it precludes improvements in the stage of the bidding. Postbid negotiation of non- structure or level of tariffs during concession substantial terms of the contract should be limited implementation. in order to avoid delay in the procurement process. Measures aimed at reducing these risks 4.3.3 Negotiations include: Once the contract has been awarded, several steps Requiring detailed, firm evidence at the bid- typically remain in finalizing the project. There is ding stage that financial closure can be reached often a negotiation stage between the winning bid- within a specified period. Investors' concerns der and the government to clarify some issues that should be taken into account early on to avoid arise as a result of gaps or lack of clarity in the draft delaying the process after bidding. contract documents. Additional issues may arise as * Preparing draft contracts to minimize the scope the winning bidder seeks to negotiate and sign con- for change as a result of postbid negotiations tracts with other project participants in order to (this requires clarity and consistency in draft- bring the project to financial closure. ing). Bidders should be given the opportunity These postbid procedures can be lengthy and to comment on draft documents at an early may sometimes lead to changes in contract condi- stage. tions, which can have important implications for * Keeping the runner-up in the wings as a fall- the bidding process. Extensive opportunities for back option during postbid negotiations. This postbid negotiations can cast doubt on the trans- option, however, should not be used by gov- parency of the process, as bidders may submit ernments to try to squeeze a more favorable overly optimistic proposals to win the bidding if offer out of the winning bidder with the threat they are confident that they can secure changes in of re-opening the bidding. their commitments during subsequent contract negotiations. This concern is especially grave in 4.4 Bidding Rules and Procedures cases where ex post negotiations result in changes in the very criteria on which the bid itself was Apart from the structure of the bid, bidding rules and awarded. For example, if the winner of the com- procedures should also be designed to ensure trans- petitive bidding for a concession awarded on the parency and economically efficient outcomes. There basis of the lowest tariff is able to revise the tariff are a number of important design issues, including: in subsequent negotiations, the validity and trans- parency of the bidding process itself is put into * Whether to use a reserve price and whether to question. announce it. 80 Concessionsfor Infrastructure: A Guide to Their Design and Award * Whether and when to use sealed bids rather 4.4.2 Sealed Versus Open Bids than open bids. * Whether to have a single round or multiple Another important design issue is whether to have rounds of bidding. sealed or open (voice auction) financial bids. Most * Whether to have simultaneous or sequential governments use a sealed bid procedure, whereby bidding (in cases where several concessions bidders present single sealed bids that are opened with interdependent values are being in a public forum. Often, there is a significant awarded). spread between bids, which has led governments * Whether to require bid bonds and activity to conclude that sealed bids will produce the best rules. results in terms of highest revenue or lowest * Whether bidders should be remunerated for a tariff.2 portion of their bid costs. Many game theorists, on the other hand, argue that open auctions-whereby bids escalate until all 4.4.1 Use of a Reserve Price but the winner have dropped out-induce more aggressive bidding and yield higher prices under An important design issue is whether to use (and most circumstances (see McMillan 1992: 133-49, announce) a reserve price, whereby bids are 1994: 145-62). While open auctions are fairly rare rejected if they fall below a specified level (or in infrastructure concessions, they have been used above a specified tariff if bidding is based on low- in the award of radio spectrum for mobile tele- est average tariff). While a well-designed compet- phony in the United States. Proponents of auc- itive bidding process will yield the true market tions argue that, under sealed bids, bidders have value without the need for a reserve price, govern- less information on other bidders' estimates of ments may still feel that a reserve price is necessary project value. Thus there is greater likelihood as a safeguard against collusion (and hence, below- under sealed bidding that the "winner's curse" will market bids) and also for public credibility. occur-that the winning bidder is the unfortunate The concept of a reserve price is often misun- one who, out of ignorance, overestimates the value derstood by the public. Frequently, when the of what is being auctioned. In order to avoid pay- actual bid far exceeds the announced base price, ing too much, experienced bidders will adjust their there is criticism that the reserve price was set too actual sealed bids downward to compensate in low. But the reserve price should not be the gov- advance for the winner's curse. As a result of this ernment's best estimate of the market value (that compensation, sealed bids may actually yield a is, the government should not be trying to guess lower price than a voice auction (assuming bidders the winning bid). Rather, it should be set at the are experienced). minimal justifiable level in order to spur as many Despite these arguments, there may be good bids as possible-and hence a market outcome. reasons to opt for a sealed-bid procedure. First, Experience demonstrates that the more bidders collusion between bidders is generally considered there are, the higher the sales price and the more to be less likely with sealed bids than voice auc- advantageous the outcome is likely to be for the tions; under a sealed-bid procedure, bidders' government. defections from collusive agreements (that is, the Announcing a reserve price tends to enhance submission of bids above the colluded price) are both the transparency of the process and the infor- harder for others to prevent than under voice auc- mation available to all bidders. But, in deciding tions. Second, if bidders are inexperienced, they whether to announce the reserve price, govern- may be less likely to correct for the winner's curse ments should also assess whether there is likely be under a sealed-bid with the result that the sealed- only a single bidder for the project; if so, it may be bid procedure may actually yield a higher price preferable to keep the reserve price confidential. under these circumstances. Concession Award 81 In summary, the issue of whether to have sealed rationale was that the concessions were not of or open bidding is an important design considera- equal market value and, hence, it would be better tion that could significantly affect the behavior of to bid the most attractive first in order to reduce bidders and, hence, the bidding outcome. In decid- bidders' uncertainty. ing which method to use, governments should It is also possible to run simultaneous auctions assess such factors as the expected number of bid- over multiple rounds. This bidding process was ders, the possibility of collusion among bidders, used for the auctioning of radio spectrum licenses and bidders' experience with similar projects. by the U.S. Federal Communications Commiss- ion (FCC) and has since been replicated by 4.4.3 Simultaneous, Sequential, and Multiple- Mexico in its spectrum auctions. In the FCC auc- Round Bidding tions bidders submitted computerized bids for spectrum licenses being offered in any number of If a series of similar concessions is being auctioned markets. Their bids were then posted for all bid- (for example, rail lines and electricity distribution ders to see, and rebidding took place over several franchises), governments must decide whether to rounds. Bidding continued until no new bids were auction these simultaneously or sequentially. If the received (though the FCC had the discretion to government is placing restrictions on the degree of keep the bidding open or to close it after a speci- concentration (such as preventing an operator fied number of rounds). from winning more than one concession), the bid- A simultaneous multiple-round auction allows ding rules must specify how the winner will be bidders to continuously reassess their strategy and determined in a simultaneous auction should the preferences in light of their competitors' bids. For same company have the highest bid for more than example, a firm can assess how it is doing with one concession. respect to its competitors in several markets at For example, in privatizing electricity distribu- once (for example, Chicago versus New York) and tion in Lima, the Peruvian government split the ser- adjust its bidding strategy for the subsequent vice area into two separate concessions to round. Simultaneous multiple-round auctions may facilitate benchmark regulation.3 The two conces- be particularly useful when awarding several simi- sions were roughly equal in size and customer base. lar concessions with interdependent values. They were awarded simultaneously in a single- In its spectrum auctions the FCC employed round sealed bid procedure. Prequalified firms were activity rules and penalties to ensure that the auc- allowed to submit separate bids for each concession, tions closed within a reasonable period of time and with the restriction that the same firm could not be that bids were serious. In each round the FCC awarded both concessions. The bidding rules spec- established minimum bids (or bid increments from ified that if the same firm had made the highest bids the previous round) . To discourage bidders from for both concessions, the government would select waiting until the end of the auction to participate, the winners on the basis of the bid combination that the FCC imposed activity rules specifying the fre- provided it with the highest revenue. quency of bids required to maintain eligibility. Mexico, in concessioning its rail lines, consid- Bidders were granted five activity waivers that ered whether to have simultaneous or sequential could be used during the course of the auction. bidding for the three main lines. The government They were also required to pay upfront fees related stipulated that no firm could be awarded more to the size of the markets they wished to bid on. than one concession in order to ensure competi- Penalties were imposed for defaulting on payments tion among rail lines. In this case the government after the bidding concluded. opted for sequential single-round bidding (com- The choice of bidding mechanism and the mencing with the Northeast line), rather than design of bidding rules are crucial. Governments simultaneous bidding of all three concessions. The should assess carefully the circumstances-the cost 82 Concessions-for Infrastructure: A Guide to Their Design and Award of bidding and expected strategic behavior of bid- established. Prequalification and shortlisting of ders-before deciding on the mechanism. It may potential bidders may encourage firms to partici- be, for example, that in smaller transactions the pate by limiting the number of bidders and, hence, cost to bidders and the government of a multiple- increasing the chances of winning. But these will round auction will outweigh the expected benefits. not lower the costs of preparing a bid. Some governments have adopted cost-sharing 4.4.4 Bid Bonds mechanisms to defray bidders' costs in preparing and submitting bids. The U.K. Private Finance Governments frequently use bid bonds to ensure Initiative may offer such arrangements in projects that bids are serious and remain valid until contract where high bidding costs might otherwise limit the award and signature. Bid bonds can be significant number of potential bidders. The decision to do for large privatizations or concessions. For exam- this is left to the authorities carrying out the bid- ple, the bid bond was $10 million for Lima's ding and award process.5 Reimbursement of all or electricity distribution concession, a transaction part of the bidding costs may be considered par- valued at roughly $200 million.4 In Manila's recent ticularly if a project is withdrawn after an invitation water and sanitation concession, the bid bond was to negotiate has already been issued. $5 million. Not all governments, however, require bid bonds. The U.K. Private Finance Initiative dis- Notes courages the use of bid bonds, arguing that "bid bonds are expensive and should not be sought 1. While the assets are sold, the operator is general- other than in exceptional circumstances." ly granted a concession to provide a specified service for a fixed period of time. 2. For example, the spread between the winning and 4.4.5 Cost Sharing second bids in Peru's telecom privatization exceeded $1.1 billion ($2.0 billion versus $850 million). Preparing bids and proposals for infrastructure 3. Each concession would exclusively serve one-half concessions can be costly for developers and oper- of Lima. In setting retail prices, the regulator would be ators. The transaction costs of preparing bids may able to compare the performance of the two operators. easily amount to 5 to 10 percent of the project's 4. The Lima electricity distribution concession was total costs. Investors may thus be reluctant to pre- split into two concessions. The bid bond was $10 mil- tton for each concession. The winning bids were $212 pare and submit proposals if the costs of doing so million and $176 million. are high and their chances of winning are slim. This 5. For example, bidding costs were refunded in the may be particularly true for entrants that are less competition for the Channel Tunnel Rail Link. CHAPTER 5 Regulatory Institutions 5.1 Introduction parties. Second, some regulatory functions call for particularly sophisticated technical skills, and it is A s discussed in previous chapters, conces- therefore especially important to endow the regu- sion contractswith detailed regulatory rules lator with such capabilities. This chapter addresses 'l Lreduce the need for regulatory discretion. the following questions: Evenwith very specific rules, however, multiple reg- ulatory tasks still must be performed: competing What can be done to help the regulator resist bids must be evaluated; pricing rules must be undue pressures? applied (the impact of inflation on prices must be * How can protection against undue pressures calculated in accordance with indexation formulas, be combined with adequate accountability of for example); firms' behavior must be monitored to the regulator? ensure compliance with pricing, quality, and other * How can the regulator acquire necessary tech- obligations; and decisions must be made on the nical capabilities? application of sanctions for noncompliance. * Which functions should be performed by the Furthermore, rigid rules have costs and, in some regulator? cases, some flexibility will be desirable. The appli- * How should the regulatory entity be struc- cation of rules governing access to bottleneck facil- tured, which procedures should it follow, and ities or anticompetitive behavior, for example, will when should it start to operate? often call for judgments. Also, over long periods, * When the recommended solutions are politi- pricing rules will eventually have to be reviewed. cally unacceptable, what alternative strategies The character of the entity or entities in charge could be considered? of performing these tasks will have an important impact on both the technical quality of the work 5.2 Establishing Independent Regulators done and the confidence in the integrity of the reg- ulatory system as a whole. These factors, in turn, It is widely accepted that the regulator should will determine whether private operators will be maintain an arm's length relationship with willing to provide infrastructure services and under regulated firms, consumers, and other private which conditions. interests. The idea that the regulator should also Whatever the nature of the regulatory entity, maintain an arm's length relationship with political two important issues arise. First, the regulator authorities, on the other hand, still remains an must be able to balance the interests of the opera- object of debate. tor, the users, and the government without suc- The rationale for giving the regulator indepen- cumbing to pressures by one or more of these dence in this second sense is strong, however. It 83 84 Concessionsfor Infrastrcture: A Guide to Their Design and Award stems from three related considerations. First, tive provisions specifying particular qualifica- because consumers constitute a large proportion tions (and disqualifications) for appointment, of voters and utility services are often perceived to and sometimes also requiring the legislature to be essential, governments face pressures to use participate in the appointment process. regulation to advance short-term political objec- Terms of appointment. Regulators are usually tives. There are numerous examples of justified appointed for a fixed period, which maybe sub- price increases being withheld at the expense of ject to renewal. When a regulatory board or investors, economic efficiency, and the longer-term commission is made up of several individuals, interests of consumers. their terms may be staggered to reduce the Second, investors are aware of these pressures influence of any one government over the over- and of the vulnerability of their usually large, long- all composition of the entity. term, and immobile investments. Unless a govern- Security of tenure. Appointees can be removed ment has made a credible commitment to rules only in restrictively defined cases. Protection that enable reasonable returns, private investment from arbitrary removal is essential for resis- will not flow. Weaknesses in the credibility of that tance to improper political pressures. commitment will be reflected in higher costs of Agency funding. Regulators can be given access capital and, hence, higher tariffs. to independent sources of funds, such as user Third, credible commitments are difficult to fees or levies on the regulated industry. In order make because of the long-term nature of most to prevent levies from growing too burden- investments. Highly specific rules can increase the some, the law establishing the agency often sets comfort level of investors in some cases, but, as a cap on levies, usually defined by reference to mentioned above, such rules might not be sustain- industry turnover.' The cap sets the maximum able and are not appropriate in all cases. levy, and actual levies are set annually to cover In these conditions entrusting regulatory a budget approved by the legislature. When an authority to government ministers presents serious agency is responsible for more than one indus- drawbacks, as short-term political considerations try, levies usually differ among industries, so are likely to weigh heavily on regulatory decision- that each industry covers the costs of its own making. The situation is worsened when the state regulation and contributes to costs shared remains the owner of utility enterprises, as there is across industries (see Smith and Shin 1995b). then no arm's length relationship between the reg- ulator and the firms. Independent regulators have a long history in In order to provide a satisfactory solution to the United States and are being adopted by several this problem, a number of countries have estab- OECD countries, including Australia, Canada, lished independent regulators with real autonomy and the United Kingdom. The trend toward infra- from political authorities. Although generally a structure privatization and reform has seen this part of government, the regulator can be estab- model emulated in a growing number of develop- lished so as to enjoy some protection against polit- ing and emerging economies. Recent examples ical pressures. Some of the concrete measures that include Argentina, Bolivia, Hungary, Jamaica, can be adopted in that respect are: Malaysia, Mexico, Peru, the Philippines, Russia, and Venezuela. Even countries without indepen- * Mandate. An independent regulator will typically dent infrastructure regulators have often adopted have its mandate dearly defined by law and will this model for other regulators with technically not be subject to direction by political authorities. demanding and politically sensitive roles, such as * Appointments. While the executive branch is antitrust regulators. usually.responsible for making appointments, Proposals to establish such agencies, however, its discretion might be constrained by legisla- often remain controversial. In particular, there is Regulatory Institutions 85 often skepticism of independent regulation in * Review of budgets. Agency budgets should be countries with a long legacy of strong executive subject to scrutiny by the legislature and exec- dominance and pervasive corruption. There are utive as part of the budget process. several possible answers to this concern. First, * Annual report. The regulator is typically independence is not achieved overnight in any required to publish an annual report on its society. With time, as the regulator builds a con- activities. stituency among consumers and investors, it can be * Other scrutiny arrangements. The regulator's expected to develop greater resistance to political actions may be subject to scrutiny by other arms pressures. Second, independence is a relative, not of government, including legislative commit- an absolute, concept, and progress must be mea- tees and specialized audit or oversight institu- sured at the margin. Any departure from direct tions. In some countries, for example, an political control can be expected to somewhat independent audit office or controller-general reduce the concerns of investors and, therefore, may have jurisdiction to review the conduct the costs of capital. and performance of regulatory agencies. 5.3 Reconciling Independence with 5.4 Dealing with Constrained Regulatory Accountability Capacity Independence must be reconciled with measures In order to ensure that the regulator has the req- to ensure that the regulator is accountable for its uisite capacity to carry out its tasks, measures actions. Checks and balances are required to might be adopted to facilitate the recruitment of ensure that the regulator does not stray from its qualified personnel. Regulators should, for exam- mandate, engage in corrupt practices, or become ple, meet strict professional qualification require- grossly inefficient. Striking the proper balance ments. Making sure that the regulatory entity has between independence and accountability is noto- access to sufficient financial resources is also riously difficult. A number of measures can be important if the entity is to attract qualified per- adopted to help achieve these objectives: sonnel. Such positions should, in addition, be exempted from civil service salary rules if such * Mandate and review. Decisions of the regulator rules make it difficult to recruit and retain highly should be subjected to an appeal process (this trained and experienced professionals. topic is further discussed in section 5.6.3). Training regulators is also crucial. Training usu- * Removal for misbehavior While security of ally must cover relevant concepts from traditional tenure is an essential safeguard of indepen- disciplines in econornics, law, and finance, but dence, that protection should not extend to should also include broader training in negotiation cases in which there is evidence of incompe- analysis, media relations, and so on. No less impor- tence or misbehavior. To reduce concerns over tant, newly appointed regulators can benefit con- removal provisions being misused for political siderably from contacts and exchanges with more purposes, causes for removal will have to be experienced regulators from other countries. In carefully defined. In addition, the legislature some cases this is done through bilateral "twin- could be involved in the decision, with super- ning" arrangements between the nascent regulator vision by the courts. and a more experienced foreign regulator. These * Transparent decisionmaking. This will typically arrangements may provide a basis for exchanging include mechanisms for interested parties to staff and materials or for providing other forms of make submissions on matters under consider- support and advice. There has also been a recent ation and for the regulator to publish decisions trend toward the creation of networks among reg- and the reasons for those decisions. ulators. Recent examples include the Hemispheric 86 Concessions for Infrastructure: A Guide to Their Design and Award Energy Regulators Conference being developed in 5.5 Determining the Functions of Utility the Americas and the International Forum for Regulators Utility Regulation supported by the World Bank. Finally, when in-house capacity is in short sup- 5.5.1 Main Principles ply, one option is to contract out some regulatory responsibilities to an independent group or con- There is a wide range of regulatory tasks that can sulting firm. This might prove to be a very efficient be assigned to utility regulators. These include: way to overcome capacity constraints. For exam- ple, Chile contracts out the technical monitoring of * Award of licenses or concessions. water standards. Another task that could be under- * Administration of rules included in licenses or taken by outside experts is the auditing of regu- concessions (for example on tariff matters). lated firms' financial accounts. * Settlement of disputes between government There may be some limits to this approach, how- and operators, between consumers and opera- ever. First, contracting out regulatory functions tors, and between different operators (on must be seen as legitimate; contracting out an entire access matters, for example). system (including decisionmaking responsibilities) * Monitoring of firms' compliance with regula- will usually be politically unacceptable. Specific reg- tory norms. ulatory tasks or functions may be more amenable to * Prosecution of firms for noncompliance, contracting out (examples were mentioned in the including the imposition of penalties. previous paragraph). Independent consultants can be given responsibility for conducting bidding Several factors will determine whether, and to processes, and dispute settlement is regularly han- what extent, any of the above tasks should be con- dled by external arbitral bodies. Providing for the ferred on a utility regulator: transfer of know-how from outside experts to in- house staff might also minimize resistance to the * Whether the activities in question are consid- idea of contracting out some regulatory functions. ered to be political or technical matters. Second, to the extent that outside experts are Judgments of this kind vary among systems and entrusted with regulatory responsibility, it is essen- over time. For example, political control over tial to make sure that they are protected from undue tariffs was once considered the norm. But there pressures. Third, such outside experts must be kept is now growing recognition that once the general accountable for their work. This means, for exam- policy principles are determined, society's inter- ple, that it might be difficult, if profits or prices are ests will be better served by delegating responsi- controlled by reference to a very complex model bility for tariff administration to an independent (such as in the Chilean electricity sector), to contract agency. Tax and other distributional issues, in out analytical work while retaining a sufficient base contrast, are still widely regarded as the exclu- of information in-house to allow the consultants' sive province of elected bodies. findings to be checked on an informed basis. * Whether locating particular functions within a One should note, in addition, that enhancing single agency has the potential to create signif- the expertise of the regulatory entity is not only a icant conflicts of interest or dilute the agency's way of resolving technical capacity constraints but focus. For instance, giving a regulatory agency also of fostering the independence of the regula- responsibility for actively promoting invest- tor. Highly qualified and well paid staff may be less ment in a sector will often conflict with its role likely to give in to political pressures or succumb to as an impartial arbitrator of investor and con- bribes or other inducements from industry (in sumer interests. Argentina, for example, regulators are more highly * Whether, by contrast, locating particular func- paid than the president). tions within one agency has the potential to fos- Regulatory Institutions 87 ter the development of expertise, coherent regulators. There is no general answer as to which policies, and economies of scale. Especially in approach is best. While ministerial control might countries where there is a shortage of appro- expose the process to short-term political influ- priate skills, there are benefits to limiting the ences, some countries are concerned about delegat- number of different agencies and assigning ing this sensitive task to a regulator. The Jamaican related tasks to the same body. approach might represent a reasonable compromise Whether the regulator enjoys the confidence of in that respect. In any case the identity of the deci- users and political authorities. New agencies sionmaker will matter less when detailed criteria for may have their role limited initially and be given the award of a license or concession are specified greater responsibility once they have proved and the decision is subject to effective review. their competence and reliability. The agency's role in imposing sanctions on util- ities for noncompliance with norms also varies 5.5.2 Utility Regulators' Roles with Respect to among systems. In some legal systems the power to Ministers impose sanctions is reserved for the courts. In Colombia enforcement powers in the energy sec- There is a general consensus that ministers should tor are not conferred on the regulator but on a sep- retain responsibility for broad sector policy, includ- arate Public Services Commission. In most cases, ing public investment, privatization, sector restruc- however, the regulator has the power to impose turing, taxation, subsidies, intergovernmental sanctions, although major sanctions-such as the relations, and maintenance of the legislative frame- cancellation of licenses or concessions-may work. Even in these areas, however, agencies may require ministerial decisions. be given formal or informal advisory roles. And gray areas remain. For example, many agencies are 5.5.3 Utility Regulators' Roles with Respect to responsible for defining tariff structures, induding Other Regulators those that include some degree of cross- subsidization between different classes of users. Utility regulators' main focus is on the control of When subsidies are made more explicit, however, firms with monopoly power. But utilities, like other judgments on these questions will usually be seen firms, are subject to regulation on a variety of mat- as more appropriately made by elected bodies. ters, including environmental and safety standards On the other hand, most independent regulators and restrictions on anticompetitive practices. In will be responsible for administering rules, settling some cases existing agencies may exercise regulatory disputes, and monitoring firms, although in some responsibilities of this kind. In the United Kingdom, cases regulators might have only advisory functions for example, responsibility for regulating the water with respect to the administration of certain rules. sector is divided between the Director General of There is less agreement over responsibility for Water Supply (economic regulation, incduding granting licenses or concessions. In the United prices) and the Department of Environment (pollu- States regulators grant Certificates of Public tion and, hence, quality standards). Then, the issue Convenience and Necessity, which are functionally of coordinating the actions of the utility regulator equivalent to licenses or concessions. In the United and the other involved agencies becomes crucial. Kingdom the power to grant licenses is formally Quality standards have a direct impact on util- vested with the relevant minister, who can, however, ities' costs and, hence, on prices and the afford- delegate this task to regulators. In Jamaica the reg- ability of services. They should therefore be ulator must make recommendations on the award coordinated with economic regulation. If the util- of licenses, but the minister makes the final deci- ity regulator is not responsible for regulating qual- sion. And in Argentina and Peru concessions are ity parameters, it can, for example, advise the granted by ministers without involvement by the agency responsible for setting standards. Tariff 88 Concessionsfor Infrastructure: A Guide to Their Design and Award rules can be designed in such a way as to permit and in a centralized or decentralized manner have certain cost increases to be passed on automati- already been discussed in chapter 2. This section cally, or to allow tariffs to be reviewed if there are will therefore highlight only a few points that are significant changes in quality standards. of particular relevance in the regulatory context. In many countries a specialist agency with econ- omywide jurisdiction is responsible for antitrust 5.5.4.1 Sectoralcoverage. Therearethreebasic regulation. Once again, it is important to clearly dis- models around the world. Regulatory institutions tinguish between the responsibilities and roles of can be: the antitrust agency and utility regulators. Antitrust regulation and utility regulation may overlap in sev- 0 Industry-specific: separate agencies are estab- eral areas. For instance, industry-specific regimes lished for electricity, gas, telecommunications, governing access to networks may overlap with gen- and so on (such as in Argentina and the United eral rules governing the misuse of market power, Kingdom). and some arrangements endorsed by the utility reg- * Sector-specific: separate agencies are estab- ulator may involve at least prima facie contraven- lished for energy, transport, and communica- tion of antitrust rules. It will usually be appropriate tions (such as energy regulators in Colombia to give priority to industry-specific rules. In the and Hungary). United States and Canada the question of jurisdic- * Multisectoral: a single agency is established for tion was left largely for the courts to resolve, lead- all or most utilities (such as state-level agencies ingto manydecades of uncertainty and much costly in the United States, Canada, and Australia, litigation. The preferable approach is to establish and national agencies in Jamaica, Costa Rica, clear rules governing the interaction of the two and Panama). regimes from the outset. On the other hand, both antitrust agencies and Multisectoral agencies present some particu- agencies in charge of regulating infrastructure ser- larly important advantages. They generally report to vices can usually contribute expertise to utility reg- a central ministry or directly to the head of state, ulation-and this complementarity should expand which tends to enhance their independence with as competition comes to play a greater role in util- respect to specific sectoral ministries. They also fos- ity industries. For this reason both agencies may be ter the development of technical capacity by con- involved in reviewing proposed mergers, restrictive centrating available resources in one agency and by agreements, or anticompetitive conduct within util- enabling staff to learn across sectors. Finally, they ity industries. In some cases a member of the make it easier for the regulator to deal with blurring antitrust agency is made a member of the utility industry boundaries, a particularly important point agency (as in Australia), or one agency makes for- in the utility sector, where technological evolution mal submissions to proceedings conducted by the drastically changes how some services are provided other. Antitrust agencies may also be given special (witness the new telecommunications law enacted roles in utility regulation, such as determining in February 1996 in the United States, which whether the conditions of effective competition are removes the regulatory barriers that separated the sufficiently absent to warrant price regulation (as in telephone, cable, and broadcasting industries). Mexico) or acting as an appeal body from the util- On the other hand, political resistance often ity regulator (as in the United Kingdom). has to be overcome in order to set up an indepen- dent regulatory agency Such resistance might be 5.5.4 The Breadth of Regulators'Authority more virulent when the agency is to be entrusted with cross-sectoral competencies, as several line The pros and cons of organizing governmental ministries might jointly protest against a decision entities on a sector-specific or cross-sectoral basis perceived as depriving them of some of their Regulatory Institutions 89 responsibilities. Another concern is that a cross- common regulatory framework, which may sectoral agency might be unable to develop suffi- increase costs and weaken the credibility and cient sector-specific expertise. Usually, though, this effectiveness of the regulatory regime.2 issue can be adequately dealt with through the cre- On the other hand, decentralization can reduce ation of sector-specific departments within the the information asymmetry between regulators institution (figure 5.1). and firms by bringing the regulatory authority closer to the regulated enterprise. In addition, it 5.5.4.2 Degree of centralization. Some coun- can foster experimentation with innovative tries have established countrywide regulators (for approaches to regulatory problems. According to example, the United Kingdom). Others have set some commentators, such regulatory competition up regulatory entities at the state, provincial, or creates incentives for governments to improve the municipal level. In France and Canada, for exam- quality of their regulation and to emulate the most ple, primary responsibility for regulating water util- successful approaches (see, for example, Siebert ities falls to municipal authorities. Other countries and Koop 1993: 15-30). have adopted a multi-tier structure. In Germany, for example, the granting of concessions in the 5.6 Decisionmaking Structure, Procedural electricity sector is the responsibility of the munic- Considerations, and Implementation ipalities, while the Lander (or states) determine rates. In the United States some national agencies Some countries entrust decisionmaking authority are responsible for interstate regulatory issues, to a single individual (for example, the United while commissions established at the state level Kingdom and Malaysia), while others use a com- deal with other regulatory matters. mission or board (such as Argentina, Chile, the A centralized approach, like a cross-sectoral Philippines, and the United States). A commis- one, may be an appropriate response to sion will often be preferable, especially when shortages of technical capacity, since such short- there are concerns about improper influences on ages tend to be more acute at lower levels of the regulator from industry or government (table government. In addition, some infrastructure 5.1). activities exhibit significant scale economies. Decentralized regulatory institutions might there- 5.6.1 Individual Decisionmaker or Commission fore have jurisdictions that are smaller than the minimum efficient size for particular activities. In If a commission is chosen, decisionmaking will be such cases several regulatory entities may need to facilitated by establishing an odd number of mem- collaborate in elaborating and administering a bers and by limiting the total number of members. Figure 5.1 Possible Structure of a Regulatory Commission Commission (3-5 persons) Rai I Telecommunications Poic supot Cop - Standards -Standards -Standards -Standards - Legal - Finance -Trfs-Tariffs -Tariffs -Tariffs -Economic studies - Human resources LCompliance -Compliance Compliance Compliance -Financial analysis -Information systems External relations Regional offices Source: World Bank staff 90 Concessionsfor Infrastructure: A Guide to Their Design and Award Table 5.1 Individual Regulators Versus a Commission Criteria Individual Commission Speed of decisionmaking + Accountability for decisions + Vulnerability to individual preoccupations - + Vulnerability to improper influences by industry - + Potential to stagger the terms of commission members in order to weaken links with particular government - + Potential to reflect multiple perspectives - + Source: World Bank staff. As a rule, the more commissioners there are, the uncertainty for investors. Compromise decisions slower the decisionmaking process and the weaker may also lack vigor and clarity, to the detriment of the direct accountability of individual members. the community's long-term interests. Commissions with three members are found in Italy For these reasons it is generally preferable to andthe Indian state of Otissa;Argentina andMexico adopt alternative participation models. At a mini- have established commissions with five members; in mum individuals or groups with a significant inter- the United States, regulatory commissions are typi- est in a regulatory decision should be permitted to cally made up of three or five individuals. present their views to the agency before a decision is made. In the United States, the process for doing 5.6.2 Opportunities for Participation by Regulated so usually involves formal hearings, which are often Firms, Users, and Other Interest Groups criticized for their legalistic nature, costs, and delays. Regulators in the United Kingdom initially For the regulatory agency to make well-informed adopted much more informal processes, although decisions and for its decisions to be accepted as fair there is a trend toward greater formality. Some and legitimate, it is important that affected inter- countries, including Argentina and Bolivia, are ests have the opportunity to present their views. It experimenting with ways of developing regulatory is sometimes suggested that such interests should processes that more closely reflect local adminis- be represented on the regulatory commnission itself trative traditions and resource constraints. In addi- This approach may offer a number of benefits. For tion, representative bodies can be given advisory, example, it might improve the credibility of the gov- rather than decisionmaking, responsibilities. Such ernment's arm's length relationship with investors, bodies may be created at the initiative of the inter- reduce the risk of capture by any one interest, and ests themselves or with the encouragement and ensure that decisions reflect multiple perspectives. support of the regulatory agency or government. Such an approach is not without risks, however. The creation of special consumer councils may be Great care is required in designing the body to especially important in countries that lack econo- ensure that representation is balanced and thus mywicle consumer rights organizations. minimize the risk that decisionmaking will be cap- tured by a particular interest group. Wide repre- 5.63 The Review Process sentation might also mean large numbers, thereby reducing individual accountability for decisions Irrespective of whether the primary decisionmaker and often leading to longer delays in regulatory is a government minister or an independent regu- decisionmaking. Compromise decisions in a body lator, effective review procedures are necessary to with shifting alliances may make regulatory deci- ensure that decisions are made in accordance with sionmaking more difficult to predict, increasing the regulatory commitments expressed in the law. Regulatory institutions 91 To be credible, the review must be undertaken by Argentina adopted an alternative approach. an entity that stands at arm's length from the orig- There, sales took place first, driven by the acute inal decisionmaker, the political authorities, and economic, financial, and political constraints the the regulated firms. As with the whole of the regu- country was facing. In telecommunications, for latory process, a high degree of transparency is example, privatization occurred in 1990, but the essential. final structure of the telecommunications regula- In most countries appeals from the regulatory tor has not yet been approved, and funding is lack- agency go straight to the courts. If the courts have ing to enable the regulatory body to perform its a reputation for independence, they can play a duties. In this environment there has been some critical role in supporting the credibility of regula- instability in the basic regulatory framework and tory commitment. But, if there are concerns over concern that monitoring and enforcement are the independence of the judiciary, delays in the inadequate. judicial system, or the capacity of the courts to While Argentina's experience supports the make judgments on complex economic issues, it view that creating a working regulatory framework may be more appropriate for review functions to and related institutions is not absolutely essential be given to another forum, at least as an interme- for privatization to proceed, there are clearly risks diate step. In the United Kingdom, for example, in this approach that may translate into higher the Monopolies and Mergers Commission acts as costs of capital and a greater risk of consumer an appellate body with respect to license amend- backlash. Other things being equal, there are per- ments. In Chile certain appeals are heard by an ad suasive grounds for establishing effective regula- hoc tribunal led by a supreme court judge and tory arrangements before or, at the latest, as part comprising a law school dean and the dean of an of the privatization process. economics faculty. In Bolivia appeals from sec- When the objective is to establish cross-sectoral toral regulators go to a superintendent general, institutions, an additional sequencing issue arises: whose mandate includes promoting consistency should the regulatory institutions exhibit cross- across sectors. sectoral features from the outset or should they Grounds for appeal are usually limited to first be organized on an industry or sector-specific alleged errors of fact or of law, including failure to basis? There are three broad options. First, a mul- follow a required process. Appellate bodies are tisectoral entity can be established at the outset, generally not permitted to reconsider the merits of with each industry brought within the regime at the the decision and substitute their own judgment. time of or before privatization. This will often be Some lirnited exceptions may be appropriate for the preferred approach. It has been adopted in appeals to specialist appellate bodies. Bolivia, for example. Second, when only some industries or sectors are being reformed, an agency 5.6.4 The Timing of Implementation could be set up with regulatory responsibility for only those industries or sectors. The competencies Infrastructure privatization in countries such as of the agency can then be expanded as new indus- Chile and the United Kingdom involved establish- tries or sectors undergo reform. This approach is ing detailed regulatory arrangements prior to pri- currently being considered in Uganda. Also, if an vatization. This mandate permits the regulator to industry or sector-specific regulator already exists, supervise restructuring and pricing reform and new industries or sectors may be brought within its offers consumers assurance that their interests will jurisdiction, thereby avoiding the creation of addi- be protected, thus reducing possible resistance to tional entities. Some states in the United States privatization. It also allows investors an opportu- proceeded in that way. In general, the feasibility of nity to develop a better sense of how the regulatory progressively expanding the competencies of a reg- framework operates. ulatory agency will depend on how easily the struc- 92 Concessions for Infrastructure: A Guide to Their Design and Award ture and operation of the initial institution can be * State holding companies with regulatory powers. modified to meet a broader mandate. Some countries have conferred regulatory Third, regulators can be established initially authority on commercial companies set up to on an industry-specific basis, but consolidated manage the sector's assets. Such companies over time through mergers. This also happened in have usually been established in the context some U.S. states, and this solution is being envis- of lease arrangements. They are given respon- aged for the United Kingdom (see Helm 1994: sibility for ownership, planning, and some- 17-39) and Chile (see Bitran and Serra 1994). times financing of infrastructure assets, as This strategy has a number of weaknesses, how- well as for regulating the lessee. Guinea and ever, including the likelihood that existing entities Senegal, for example, decided to establish will resist merger and that the benefits of cross- such companies when lease contracts were sectoral regulation will not be available during the concluded in the water sector. Although often critical early phases of a new regulatory system. fully owned by the state, those companies can be granted a certain degree of autonomy with 5.7 Finding Alternative Strategies respect to the responsible line ministry, and they can be exempted from civil service salary As already mentioned, some of the measures pro- rules. They are not without drawbacks, how- posed above are likely to meet substantial political ever. For example, they tend to be staffed resistance. Delegating regulatory responsibility to a with ex-employees of the old public monop- fully independent agency, in particular, might prove oly, who often have good operational skills very controversial, and some political authorities but no expertise in regulatory matters, and may refuse to take that step. Such refusal is likely who might be tempted to micromanage the to translate into higher costs of capital. It might also private operator. State holding companies lead to the adoption of overly rigid, specific pricing also tend to be organized on a sector-specific and other rules in an attempt to reduce concems basis. that the regulatory process will be captured by some * Dedicated unit within ministries. While interests. There are nevertheless some solutions decisionmaking remains with the minister, that may partly compensate for the lack of an inde- bringing staff together in a dedicated unit pendent regulator and that may constitute steps may facilitate the development of expertise toward the ultimate adoption of such a model. and may contribute to the development of professional norms that could strengthen Independent agency with an advisory role. This resistance to ministerial direction. If civil solution was adopted in the United States dur- service salary rules make it difficult to attract ing the early phases of the development of its highly qualified professionals, it is essential to regulatory framework (U.S. regulators with provide adequate funding for the outside advisory powers date from 1839 in Rhode consultants. Island, but it was not until the early 1870s that * Use of courts. If a country has an independent commissions with mandatory rate-setting and judiciary, it may be possible to expand its role other powers were established in Illinois, Iowa, in regulatory decisionmaking. Limitations to Minnesota, and Wisconsin). A more recent this approach include the low level of techni- example is that of Hungary's Energy Office. cal expertise of most courts, the delays and Where such agencies are established, their expense usually associated with litigation, authority can be enhanced by requiring that and limitations in the remedies that courts their recommendations be published and that can order and effectively supervise. the final decisionmaker give reasons for deviat- * Use of arbitration. As mentioned in section ing from the recomrnmendations. 3.10, arbitration can be used to deal with a Regulatoty Institutions 93 certain number of regulatory issues, but it has Notes some limitations: it may be a slow process, supervision for the implementation of deci- 1. Examples include 0.5 percent for telecommuni- sions is limited, and it might raise issues of cations regulators in Argentina, Peru, and Venezuela, legitimacy when broad discretion hs to be ,1.0 percent for the energy regulator in Colombia, and 2.0 percent for the water regulator in Peru. exercised or when multiple interests should 2. On sectoral coverage and degree of centralization be given the opportunity to intervene. of regulatory institutions, see Smith and Shin (1995a). CHAPTER 6 Government Support 6.1 Types of Government Support technical and financial capacity to complete or oper- ate the project. Such support is often critical to make G overnment support to infrastructure pro- projects bankable and therefore feasible. Lenders' jects can take a variety of forms. Key provi- security rights are discussed further in annex 4. sions can be divided into two categories. First, the government can provide direct or indirect 6.2 Rationale and Design Issues financial support to the project. This form of support is discussed in this chapter (see box 6.1 for examples Governvment financial support can be provided of common financial support mechanisms). Second, through three basic types of instruments: subsi- government support might be needed with respect dies, financial investment (debt or equity), or guar- to the securities and remedies required by lenders. antees.I This section aims to identify the different Lenders might, for example, require that the gov- cases in which government support is justified and, ernment give them the right to step in and cure any in each case, which of those three instruments is alleged breaches before the concession is terminated most appropriate. or substitute a new company to take over the con- Three distinct justifications are commonly pre- cession, provided the substitute has the required sented in favor of government support: Box 6.1 Key Provisions for Government Support of Infrastructure Projects The main provisions for government support com- * Exemptions from restrictions on the import and monly sought by project sponsors include: export of all necessary plants and equipment. A guarantee of convertibility and transferability * Direct financial contributions, such as grants, of local currency earnings. loans, equity participations, and asset transfers. * The right to keep foreign currency sale pro- * Exemption from, or reduction of, taxes, royal- ceeds offshore. ties and other levies and duties. * Compensation if new planning or environmen- * Complementary investments. tal laws detrimental to the profitability of the * A period of exdusivity. project are adopted. * The adoption of necessary legislation and the * A guarantee that the project development and issuance of appropriate approvals and consents operation plan will not be changed without for the implementation and operation of the prior consent of the sponsors, except in some project. narrowly specified circumstances (for example, * Guarantees of supply or off-take agreements. on the grounds of national security). Source: Freshfields (1995). 94 Government Support 95 * The existence of uninsurable political risks. (war, civil war, terrorism, sabotage, and so on); * The assertion that some services should be pro- convertibility and transfer risk (the conversion of vided below cost. local currency into foreign exchange may be * The assertion that the government has a lower impossible because of exchange controls; transfer cost of risk bearing than private investors. of foreign currency out of the country may be blocked by the central bank). Such risks-when they are relatively severe-will not be accepted by 6.2.1 First Assertion: The Existence of Uninsurable private investors and are not easily insured in pri- Political Risks vate markets (box 6.2). It is generally accepted that such risks should be borne by the government that 6.2.1.1 Rationale. Traditional political risks directly causes them and is in a better position to include: the risk of expropriation (nationalization control them. without "just compensation," either by a single act The definition of political risks can, however, or by a series of measures that amount to "creep- extend beyond the traditional political risks ing expropriation"); the risk of political violence described in the paragraph above. Modifications of Box 6.2 Political Risk Insurance Investment insurance for political risk is available income. EID/MITI and Treuarbeit have no restric- from a number of national public agencies, multilat- tions on eligible countries, although Treuarbeit does eral institutions, and the private sector. The first pub- require the availability of adequate legal protection, lic plan offering inconvertibility coverage to such as a bilateral investment treaty with Germany. companies investing abroad was established in the MIGA coverage is available in the 128 countries that United States in 1948. In 1971 the function of pro- are MIGA members. The maximum term offered by viding political risk insurance in the United States the national agencies and MIGA is about 15-20 years. was taken over by the Overseas Private Investment Exposure limits vary as well: OPIC offers maximum Corporation (OPIC). Other national programs coverage of $200 million per project, while MIGA's include EID/MITI in Japan and Treuarbeit in limit is $50 million per project. These two public insur- Germany The Multilateral Investment Guarantee ers make up the bulk of the market. Investment cover Agency (MIGA), a member of the World Bank by members of the Berne Union, an association of Group, began offering political risk insurance in national credit and investment insurers (which 1988, and other multilateral institutions, including includes the agencies mentioned above and about 40 the International Bank for Reconstruction and others representing 34 countries), totaled more than Development and the Inter-American Development $15 bilion in 1996, with an outstanding portfolio of Bank, now offer political risk guarantees with a gov- $44 billion. erinent counter-guarantee. In recent years the private market for political risk MIGA and most national systems cover risks aris- coverage has grown rapidly. The major players in the ing from expropriation, war, civil strife, and currency industry include the American Insurance Group inconvertibility and nontransferability. In order to be (AIG) and Lloyds of London. While these insurers eligible for coverage by a national agency, investors can offer a broad range of coverage for different risks, must generally be citizens of that country or a corpo- including expropriation and, to a more limited extent, ration established under that nation's laws. Rules on inconvertibility and political violence, the terms and what types of investments can be covered and the exposures available are usually more limited, and fees countries for which coverage will be extended vary can be substantially higher than those of public agen- among agencies. OPIC currently offers coverage in cies. Most private insurance coverage is only for one about 140 countries that are judged to observe human to three years, although AIG now offers a facility with rights and workers' rights and have a low per capita a coverage of ten years. Note: For more details on the forms of political risk coverage avadable from American, German, and Japanese public insur- ers and MIGA see annex 5. Source: Beme Union and World Bank staff. 96 Concessions for Infrastructure: A Guide to Their Design and Award the legal framework, unfavorable regulatory deci- risks should normally be borne by the operator sions, and failure by publicly owned enterprises to (and in some cases transferred to subcontractors uphold their obligations to the project can, at least or users if the subcontractors are in a better posi- in some cases, also be classified as political risks. tion to bear those risks). The case of the C6te The extent to which the government should pro- d'Ivoire water lease, concluded before 1987, tect private investors against those risks is, how- clearly illustrates the dangers of leaving commer- ever, a rather difficult issue to settle. cial risks with the government (box 6.3). On the other hand, public enterprises that lack any type of 6.2.1.2 Modifications of the legal framework. autonomy are much more likely to default because Whether the government should compensate of political interference in their management. operators for changes in legislation that adversely Therefore, the more pervasive the government's affect their activities is a question that has been control of the enterprise, the greater is the case for examined above. As mentioned in section 3.1.3, considering performance risks as political risks. much will depend either on whether these changes Whether the government should then bear those specifically affect the operator or on whether a risks is an issue we discuss in the next section. wide range of businesses are affected in the same general way 6.2.1.5 Appropriate instrument. Governments must determine the most appropriate mechanism 6.2.1.3 Regulatory risk. As far as regulatory risk for mitigating these political risks. A government is concerned, an important issue is the degree of guarantee designed to protect investors against discretion that is granted to regulatory authorities: specifically identified (political) risks is more the issue of government compensation will nor- appropriate than subsidies or financial investments mally not arise as long as the regulator exercises that do not distinguish between different types of only the discretion that it has been granted. Only risks. The use of such guarantees is not without its when regulatory rules are specific enough can it be costs, limitations, and trade-offs, however. ascertained that a breach-possibly justifying gov- First, as it is extremely difficult to determine pre- ernment intervention-has taken place. Another cisely whether some risks are truly beyond the con- important point is that breaches of regulatory rules trol of the service provider, sovereign guarantees by the regulator might have to be dealt with differ- might end up blunting the operator's incentives. ently according to the identity of the regulator. If Second, sovereign guarantees can raise acute regulatory responsibilities have been conferred on problems of moral hazard and adverse selection: an autonomous entity at arm's length from the gov- ernment, it might be preferable, in order to safe- * Since the government knows that if a guaran- guard the autonomy and authority of that entity, to tee is called it can finance the liability through rely on appeal mechanisms before an independent taxation, it might be tempted to adopt too lax body (such as a superior court or another ad hoc an attitude in the granting of such instruments group of experts) rather than on intervention by the (moral hazard). Therefore, unless it is generally government to compensate private operators. assumed that risks should be borne by taxpay- ers (we return to this topic in section 6.2.3), 6.2.1.4 Breach of contract by public enteiprises. guarantees should be granted only if the gov- Much will depend in this case on the degree of ernment is willing and able to deal with the effective separation between the government and source of risk. This means that political risk the publicly owned enterprise. For corporatized guarantees should be granted only when they entities with true cornmercial autonomy, supply or are complemented by genuine efforts to con- purchase risks are in fact commercial risks, akin to trol risks and attempts to reform the underly- the risks of dealing with a private firm. Commercial ing causes that give rise to risks, and only with Government Support 97 Box 6.3 Government Exposure to Commercial Risk in the Pre-1987 C6te d'Ivoire Water Lease SODECI is an Ivorian company that is 46 percent sions by its contract. When the forecasts failed to owned by SAUR, a French water distributor, and 50 materialize, SODECI was compensated for the short- percent by private Ivorian investors and employees of fall in actual water demand. Between 1982 and 1987 SODECI. Another 3 percent is held by the govern- SODECI received some $10 million in compensation ment and 1 percent by private French interests. Since taken from the sums that should have been allocated 1974 it has been responsible for supplying water to to the construction fund. In 1986 the financial crisis Abidjan and other urban and rural centers in the was such that no investment could be made. To make country and for operating the sanitation system in up for this shortfall, the government more than dou- Abidjan. Tariffs collected by SODECI were used to bled tariffs for industrial water supply, thus causing pay revenues to SODECI and to finance two publicly industrial consumption to fall even further. By 1987 administered funds set up to cover debt service pay- the sector had $330 million of cumulative debts from ments and investments in water system infrastruc- its ambitious public expenditure program. By 1988 it ture. SODECI was obliged to maintain and operate had arrears to SODECI amounting to $24 million. any additions made to the existing system by the A new contract was negotiated in 1987 for a 20- Water Directorate and the Ministry of Public Works year concession under which SODECI's remunera- and Transports. SODECI was not consulted on tion was reduced and its revenue guarantee canceled. investment decisions but was guaranteed compensa- In addition to operation and maintenance, SODECI tion if the amount of water actually consumed was is now responsible for projecting demand and plan- less than forecast, thus shifting most of the commer- ning and executing investments in the urban water cial risks of the project to the government. supply sector. A portion of the tariffs collected by While coverage and efficiency of service improved SODECI are assigned to a development fund for substantially under the lease, the financial situation of social connections, renewal, and extension works to the sector progressively deteriorated during the eco- be executed by SODECI, in accordance with a price nomic crisis that struck the country in the 1980s. schedule set out in the contract and with the approval Government investment decisions were based on of the Water Directorate. SODECI also has respon- extremely optimistic consumption forecasts and sibility for submitting plans for new investments to be required extensive borrowing. A continued active financed by the government and is responsible for the investment program in the face of the economic execution of works totaling less than 80 million CFA downturn led to a large accumulation of public debt Francs. For larger works SODECI is permitted to and a low capacityutilization rate. SODECIwas insu- participate in a competitive bidding process for the lated against the government's poor investment deci- construction contract. Source: Kerf and Smith (1996) and World Bank staff. respect to the behavior of entities that the gov- Finally, while the central government can pro- emnment is in a position to influence. vide guarantees against risks related to the behavior * In addition, there is a risk that the party whose of other entities (decentralized political authorities, behavior is being insured against might actually for example), it cannot meaningfully guarantee its behave worse knowing that its contracting part- own behavior. To add credibility to the govern- ner benefits from government protection ment's original commitment, other instruments are (moral hazard). Thus guaranteeing the behavior needed, such as governmental performance bonds of publicly owned enterprises might conflict or guarantees by multilateral institutions counter- with efforts aimed at increasing the autonomy guaranteed by the government. Once again, how- and commercial orientation of such enterprises. ever, as the government can rely on its taxation * Also, investors who benefit from the protection powers to replenish the performance bond or to ful- conferred by a guarantee might seek out exces- fill its counter-guarantee obligations, it is necessary sively risky projects (adverse selection). For to ensure that such instruments support genuine that reason, guarantees should leave beneficia- efforts on the part of the government to limit the risk ries somewhat exposed. of breach of contract. 98 Concessions for Infrastructure: A Guide to Their Design and Award 6.2.2 Second Assertion: Some Services Should Be a government portfolio will be more attractive to Provided Below Costs risk-averse investors. In addition, by spreading risk over a large number of people (the taxpayers), the 6.2.2.1 Rationale. There are three main reasons governtment is able to substantially reduce the risk for pricing infrastructure services below costs. First, borne by each individual. This is not only because a the provision of some services might create positive given amount of risk is divided among many indi- externalities, thereby justifying higher levels of con- viduals. It can be demonstrated, in fact, that the sum sumption than those that would exist if users had of the risks borne by all investors will be smaller to pay the full cost of services. Second, authorities when the total number of investors is greater (see might want to keep prices equal to marginal costs Arrow and Lind 1970). Once again, such a result will in an industry characterized by increasing returns to appeal to risk-averse investors. scale (which requires that the firm obtain additional It is not entirely clear, however, that the gov- sources of revenues to cover its fixed costs). Third, ermnent can in fact pool and spread risks better it might be considered desirable to provide public than the private sector.2 In addition, the above subsidies to some users. As argued in section 3.3, argument overlooks one dimension of the prob- however, exceptions to the principle of cost-cover- lem: the government has weaker incentives to ing tariffs should be rare and narrowly defined, invest wisely than do private investors. One reason especially in developing countries. is that, unlike private parties, the government can rely on its taxation powers to raise more capital if 6.2.2.2 Appropriate instrument. In cases where its investment decisions prove unwise. Another services are indeed priced below cost, government reason, already mentioned in section 3.1.3, is the support should take the form of subsidies supple- fact that civil servants' use of taxpayers' money is menting the price that users are willing to pay for usually not as closely and efficiently monitored as the service. Subsidies should be provided only for the investment decisions of managers of private services actually delivered (as in the scheme devel- infrastructure projects. oped in the Chilean water sector-see box 3.3). Such subsidies directly address the discrepancy 6.2.3.2 Appropriate instrument. It is therefore between the price that users are ready to pay and very doubtful that, in terms of investment risks, the "socially desirable" price. In addition, they fully taxpayers are in a better position than private preserve the incentives for the service provider to investors and that they should therefore be satis- perform efficiently. fied with lower returns. If that were the case, how- ever, it would justify paying lower risk-adjusted 6.2.3 Third Assertion: The Government Can Bear returns to the government than to private investors Risk at Lower Cost for its loans or equity participation in projects. The difference between public and private returns 6.2.3.1 Rationale. The argument that the cost of would, of course, make projects in which the gov- bearing risks is lower for the government (that is, for ernment participates more attractive to private taxpayers) than for private investors is based, first, investors and lenders. Indeed, with the govern- on the fact that individuals tend to be risk-averse ment requiring low returns, a larger share of total and, second, on government's supposedly superior returns would be available to private parties. ability to pool and to spread risk. By investing in a Even if justified on the basis of taxpayers' lower wide range of different projects with mutually inde- cost of risk bearing, risk-sharing arrangements pendent outcomes (pooling risks), the government through loans or equity participations by the gov- can reduce the overall risk of its portfolio: under- ernment are not without drawbacks, as pointed out performing projects will tend to be compensated by in section 3.1.3. With equity contributions, the gov- overperforming ones. The lower risks represented in enment shares in losses and profits. The fact that Government Support 99 it shares in losses will make the project more attrac- ing offsetting receipts when they are cashed in. As tive to risk-averse investors. The fact that those for guarantees, they are simply not recorded as investors also have to share profits might, on the expenses, unless a claim is made in the future. other hand, reduce their incentives to maximize the Consequently, the subsidy elements of government performance of the company and induce them to loans and guarantees never appear as such. Also, the exaggerate their costs (thereby reducing the total different forms of government support are treated amount of profits to be shared). With loans, the differently. Policymakers have an incentive to pro- government shares downside risks without the vide guarantees rather than cash subsidies, as they upside potential (indeed, the returns on debt are let the fiscal position of the governmnent appear bet- fixed; any returns in excess of what is necessary to ter than it actually is (see Mody and Patro 1995). reimburse lenders goes to equity holders). Private Recognizing these problems, the United States equity holders can therefore limit their risks with- changed its budgeting and accounting systems for out limiting potential profits, which might induce grants, loans, and guarantees in 1990 in order to them to pursue excessively risky projects.3 record the actual costs of these instruments (see box 6.5). Other countries, such as Canada and New 6.3 Government Contingent Liabilities Zealand, have also introduced policies to ensure that guarantees appear in government accounts. Correct valuation of the different types of govern- New Zealand's Fiscal ResponsibilityAct of 1994, for ment support to infrastructure projects is an essen- example, mandates that the Treasury regularly pub- tial prerequisite to sound management of lish any contingent liabilities of the Crown. government exposure. Valuing direct cash subsi- dies is straightforward. Valuing the subsidy ele- 6.3.2 The Institutional Framework ment of a government loan can be done by comparing the price of government loans with the Issues of technical capacity and the ability to resist market price of similar loans. improper pressure, similar to those discussed in chapter 5, are also relevant here. Indeed, issuing 6.3.1 Valuation and Budgeting guarantees calls for difficult and technical judg- ments regarding, for example, the extent of cover- The subsidy element of a guarantee can be esti- age. Also, political authorities and investors mated in the following way: the value of a full promoting specific projects might attempt to credit guarantee (as opposed to a partial risk guar- unduly influence the process. antee covering only certain risks) can be calculated based on the difference between the interest rate Box 6.4 Value of a Full Credit Guarantee- of a risk-free loan and that of a normal market loan. A Numerical Example The subsidy element equals that difference minus The loan amount, or government contingent the guarantee fees (box 6.4). liability (that is, amount covered by guarantee), is Most governments, however, fail to treat these $100,000. types of subsidies coherently in their budgets. * The interest rate on a risk-free loan is 5 per- Indeed, under a cash-based system of budgeting- cent. which is the most common-only cash outlays are * The interest rate on a normal market loan is recorded. Therefore, while direct cash subsidies are 10 percent. recorded when they are issued, as they should be, * Guarantee fees are $1,000. the subsidy elements of loans and guarantees are not The value of the guarantee = 10%($100,000) properly taken into account. The disbursement of a - 5%($100,000) - $1,000 = $4,000. loan is recorded as a cost equal to the full amount Source: World Bank staff. of the loan with subsequent repayments represent- 100 Concessionsfor Infrastructure. A Guide to Their Design and Award Box 6.5 The United States Federal Credit Reform Act of 1990 Prompted by an explosion of loan guarantees issued ment. If guaranteed loan defaults (or interest subsi- during the 1980s and a recognition of biases created dies) are larger than the fees that borrowers pay to by the simple cash-based system of budgeting, the the government, that shortfall is also a cost. These United States introduced a new system of budget- costs, or "subsidies," must compete for budgetary ing for loans and guarantees, established by the resources on the same basis as other government 1990 Credit Reform Act. Under this new method of allocations. budgeting each form of credit is valued using a The Credit Reform Act significantly improved the financially equivalent metric-the expected present budgeting process in the United States. The issuance value of future costs. The budgetary cost of credit is of direct loans, guarantees, or grants has the same fis- defined as the present value of the expected cash cal implications and requires the same budget disci- outflows from the government minus the expected pline. As a result policymakers are able to decide on cash inflows to the government. If borrower fees, the form of financial support by looking at the under- repayments, and interest are not sufficient to cover lying needs of the targeted population rather than on the principal of a direct loan and the Treasury's cost the specific budgetary treatment of alternative finan- of borrowing, the shortfall is a cost to the govern- cial structures. Source: Lewis and Mody (1997). There might be substantial advantages, there- lihood that a given entity might default on its fore, to adopting solutions similar to those men- obligations might vary over time, and this tioned in chapter 5. Political authorities would retain would of course modify the value of govern- the responsibility of determining the budget to be ment guarantees related to those obligations. aRlocated to a central guarantee authority. They could * The government should charge a fee as com- also define the types of projects that could benefit pensation for the risks it takes and to cover the from guarantees. But the central guarantee author- costs of administering the guarantees. Such ity, set up at arm's length from sources of improper fees could rise according to prespecified crite- pressures, would be responsible for issuing guaran- ria (such as the downgrading of the guaranteed tees in each case. The members of the authority entity by a rating agency) when the likelihood could be exempted from civil service salary rules in of default increases. order to attract and retain high-quality staff. A cross- * If fees are not paid, the government could sectoral mandate might further protect staff against arrange to seize collateral as compensation. pressures from any single investor or sectoral minis- * Efforts can be made to diversify the overall ter with a stake in a particular project. It might also guarantee portfolio in order to reduce the vari- promote the learning and implementation of coher- ance of expected liabilities. ent solutions across sectors. Finally, it would make * When the overall portfolio remains correlated maximum use of scarce human resources. with particular variables (the interest rate, for example), the government can purchase appro- 6.3.3 Risk Management priate derivatives (such as interest rate deriva- tives) to hedge its exposure. The government can use a variety of tools to ensure * Guarantees should be structured so as to leave that its exposure does not grow excessively or that the beneficiary with some exposure in order to it supports the wrong project: limit problems of moral hazard. In addition to capping the budget of the guar- In order to keep track of the extent of govern- antee authority, the political authorities should ment exposure, the exact value of the subsidies put monetary ceilings on total government provided should be revised regularly. The like- exposure. Some restrictions might also be put Government Support 101 on the use of instruments that severely expose private corporations can also spread risks over a large the taxpayer. The types of risks that the gov- number of individuals. Those who believe that the ermnent is willing to cover could also be specif- government is in a better position to spread risks ically limited. Such rules are often advisable, argue, however, that in order to control a large corpo- ration, some shareholder may hold a large block of given the fact that, as discussed in section 3.1.3, stock, which is a significant component of his wealth. government officials decide on the use of tax Thus from the point of view of such a shareholder, the money rather than their own and might there- costs of risk bearing are not negligible, while those foreeasilyabusethediscretionarypowersgiven costs are negligible for other stockholders. to them. Consequently, in considering prospective investments, the shareholder who controls the company might dis- count for risk when it is not in the interest of the other Notes stockholders to do so. This problem, the argument goes, would be avoided in government-controlled 1. Apparently distinct types of support can, in fact, companies. This line of reasoning is not completely be considered as particular examples of one of these convincing, however. One can point, for example, to three forms. Complementary investments, such as the the fact that the major shareholder could be an equity rehabilitation of a road leading to a privately conces- fund itself, consisting of a large number of sharehold- sioned bridge, can be thought of as an in-kind subsidy, ers, thus spreading the costs of risk bearing over an for example. even greater number of individuals. Also, it is far from 2. The private sector also can pool risks. If the state clear that bureaucratic managers will be less risk retains an advantage in this respect because it controls averse than corporate managers. a larger number of diverse projects, that advantage 3. For a detailed discussion of whether governments can be transferred to the private sector by privatizing have a lower cost of risk bearing than investors, see the projects in question. By the same token, large Klein (1996c). ANNEX 1 Choice of Regulatory Instruments Basic Options ties give their consent. There are some exceptions to that principle, however. In France, for example, X variety of instruments can be used to define concession-type arrangements can be unilaterally ^ and regulate concession-type arrange- amended by public authorities, under certain con- 1 ents. Theyinclude public law instruments ditions, provided that appropriate compensation is (which form a hierarchy of norms ranging from con- given to the operator (see box 3.16). Finally, when stitutions to laws and secondary legislation, such as a separate entity has been entrusted with regulatory decrees), licenses (unilateral and nonnegotiable responsibilities, much will depend on the degree of acts of the administration that take effect when a insulation it enjoys from political pressures. private party agrees to their terms), private con- tracts (negotiated by both parties), and decisions by Flexibility to tailor commitments to specific investors regulatory authorities. The table below illustrates the range of possible options. General legislation that applies to whole categories of service providers is usually unsuitable when adap- Choosing an Instrument tation to specific circumstances is required. Even if there is only one firm (and if a law would apply The choice of instruments will be dictated, in large therefore to only one service provider), contractual part, by the legal traditions of the country. Norms agreements can usually be negotiated in a more flex- of a certain rank might also have to be adopted to ible environment. As to the ability of regulators to modify provisions that would hinder the adoption tailor decisions to specific investors, that will or implementation of concession arrangements. In depend on the degree of discretion that they enjoy. addition, the different options can be evaluated In the United States, for example, the constitution against the following criteria: has been interpreted as requiring that investors get a fair rate of return, compared with other industries Ease with which the government can unilaterally of similar risk. This leaves the regulators with enor- change the rules mous latitude to make rules and set prices. Laws require the cooperation of the executive and Adaptability to changing circumstances the legislature to effect a change. Decrees or subor- dinate legislation provide less protection against Laws are generally relatively difficult to modify, unilateral modifications, since they can generally be while decrees can be changed more easily since, as modified by the executive alone. Contracts, for their mentioned above, the executive alone can effect a part, cannot normnally be modified unless both par- modification. Contracts can be renegotiated by the 102 Annex 1 Choice of Regulatory Instruments 103 parties. Regulators' power to modify contracts will they are interpreted by a single forum, such as a depend on the degree of discretion that they enjoy cross-sectoral regulator. Use of standard con- and on the procedural rules that they must follow tracts or licenses might promote consistency. in that regard. For example, the terms of British Licenses in the U.K. water industry, for example, Telecom's license can be modified by the regulator are fairly standardized. Among the standard with the agreement of the company. Moreover, the provisions are formulas for calculating price lim- regulator can undertake unilateral modifications, its for service. Each company is required to pro- against the company's will, but must first seek a duce an annual statement for the regulator recommendation from the Monopolies and demonstrating its adherence to the specified lim- Mergers Commission and approval by the secre- its. The licenses also provide for regular price tary of state for trade and industry. reviews and adjustments. Standard conditions include service quality requirements and cus- Consistency tomer relations rules, as well as requirements for the provision of reports and accounting informa- General norms, such as laws and decrees, can tion to the regulator, and the levying of license enhance certainty for investors, especially when fees. Annex Table 1.1 Examples of Instruments Embodying Regulatory Norms Constitution The Constitution of Colombia provides for proper indemnification for the expropriation of private property (Art. 58). It also specifically gives the state control of the electromagnetic spectrum and the mandate of combating monopolistic practices in the use of the spectrum (Art. 75). Parliamentary laws In Chile the 1982 Mining, Electric Power Services Law (DFL-1) provided the basis for the regulation of electricity generation, transmission, and distribution and sets out the provisions for rate setting. Decree-laws In Peru the 1992 Decree-Law of Electric Concessions (Decree-Law 25.844) was adopted by the government (president and cabinet ministers), acting under emergency powers, and replaced previous electricity laws. Presidential decree In Argentina the creation of the Comisi6n Nacional de Telecommunicaci6nes, the telecommunications regulator, came in a presidential decree (Decreto 1185/90). In addition to the structure of the agency, it described procedures for the award of licenses, control of prices, and interconnection rules. Ministerial decree In some cases a decree may be issued by a sector ministry, such as Costa Rica's decree by the Ministry of Natural Resources, Energy and Mines in 1989 (Decree No. 18.947), which established parameters for private investor participation in some power projects. Licenses In Jamaica the license for the national telecommunications operator includes provisions fixing the rate of return to be earned by the company. Contractual arrangements A concession contract for the operation and maintenance of the water and wastewater systems in Cancin, Mexico sets out service efficiency standards and the tariff regime. Decisions by regulatory agencies In Colombia the Comisi6n de Regulaci6n de Energia y Gas, a specialist regulatory agency, plays an active role in implementing competition regulation in the sector. The Comisi6n imposed a system of free access to the electricity network and issued decisions requiring the state oil company to divest its gas transportation assets. Source: World Bank staff. 104 Concessionsfor Infrastructure: A Guide to Their Design and Award Annex Box 1.1 Transparency of the Policy Framework for the Electricity Sector-Contrasting Indian and Pakistani Approaches Enron's Dhabol power project in Maharashtra State, In Pakistan, on the other hand, the government India-one of a series of "fast-track projects"-was approved and published, in March 1994, a Policy concluded between Enron and the state government Framework and Package of Incentives for Private in 1993. The original deal provided for the construc- Sector Power Generation Projects. The power pol- tion and operation of a 2,015 megawatt, $2.8 billion icy framework, considered overly generous by gas-fired plant. The nationalist Hindu party which iyfaeok osdrdoel eeosb won-hed suseu. enatsta eion, cpaign e many, promised investors an average tariff of 6.5 won the subsequent state election, campaigned Scnsprklwt-oradeepinfo against the Dhabol project and canceled the agree- US cents per kilowatt hour and exemption from ment when it took power. corporate income tax and import duties on equip- The party daimed that the award process lacked ment. The policy was successful in attracting almost transparency and had resulted in a project that was too 2,100 megawatts of new power development. expensive and a power tariff that was too high. The deal Subsequently, the government moved to tighten its was eventually renegotiated, and the tariff was cut by policy and negotiate lower rates, but expressly more than 20 percent, the capital cost reduced by $300 stated that existing commitments would remain rnillion, and capacity increased to 2,450 megawatts. intact. Source: World Bank staff Sustainability eration will generally reduce the risk of backlash from the legislature or from consumers. The leg- The sustainability of concession arrangements islative process, for example, usually involves depends on a variety of factors. One important ele- greater transparency than contractual agreements, ment is the degree of transparency with which such especially when such contracts are not competi- arrangements are devised. Public debate or delib- tively bid (see annex box 1.1). Concessions might Annex Box 1.2 Regulatory Instruments Used in the Telecommunications Sector in Peru Multiple instruments of different ranks are used to telecommunications services, it lists the func- set up the regulatory framework for telecommunica- tions of the Ministry of Transport and tions in Peru: laws are relied on to ensure stability and Communication with respect to telecommuni- consistency of the main principles concerning private cations, and it establishes a separate regulatory participation, market structure, and regulatory insti- entity-El Organismo Supervisor de Inversi6n tutions, while more technical rules are embedded in Privada en Telecomunicaci6nes (OSIPTEL). decrees (or Reglamentos), which also apply to all par- Ley Disponen la Demonopolizacion Progresiva de ties but are easier to modify. Concession contracts los Servicios Publicos de Telecomunicaci6nes, and regulatory decisions specify the particular rights adopted by congress on January 12, 1994. This and obligations of individual parties. The most law outlines the progressive demonopolization of important of these instruments are listed below: local and long distance telecommunications ser- vices in the country. It also provides for the award Decreto Supremo-Ley de Telecomunicaci6nes of of telecommunications concessions and identi- April 28, 1993 (decree with rank of law adopted fies the main types of information (duration, by the president and the minister of transport types of services, coverage, and price regime) that and communications). The Decreto identifies must be provided by such contracts. Finally, it the different types of telecommunications ser- states that OSIPTEL must be autonomous from vices, it defines the different instruments that an "administrative, functional, technical, eco- can be used to promote the private provision of nomic and financial" point of view. (box continues on next page) Annex l Choice of Regulatory Instruments 105 Annex Box 1.2 Regulatory Instruments Used in the Telecommunications Sector in Peru (continued) • Reglamento de la Ley de Telecomunicaci6nes legal status, objectives, functions, powers, and adopted by the president and by the minister of organizational structure of OSIPTEL. transport and communications on February 18, * Concession Contracts with Companiid Peruana de 1994. The Reglamento identifies the different Telefonos S.A. and with ENTEL S.A. These con- telecommunications services, establishes inter- tracts define the scope of the delegated services, connection rules, and defines the various the rights and obligations of the concessionaire licenses, permits, or contractual arrangements and the ministry, the price and interconnection enabling the private provision of telecommuni- regimes, and the rules pertaining to contract cations services. modifications and dispute settlement. * Reglamento de OSIPTEL, adopted by the pres- * Various decisions of OSIPTEL, fixing, for exam- ident and by the prime minister on August 5, ple, maximum prices for various types of 1994. The Reglamento defines, in detail, the telecommunications services. Source: World Bank staff. also be unsustainable when legal requirements to ing a presidential decree with the force of law. devise and conclude such arrangements are Ultimately, however, it is impossible to make unclear. This could be the case, for example, when absolutely sure that a given project will not come procedural requirements are undefined, or when under attack after conclusion of the agreements. questions of competency are unresolved. In such This only underlines the importance of establish- situations high-level instruments, such as laws or ing a clear overall legal framework for private par- presidential decrees, might constitute a "safer" ticipation in infrastructure. option. In Guinea, for instance, the president rat- In many cases different rules will be embodied ified several privatization agreements, including in different types of instruments. This approach the water lease. It was not clear, at the time, who can help set up a framework exhibiting more was authorized to sign the concessions or, indeed, advantages and less disadvantages than any single whether the law allowed concessions of this kind. instrument (see the example of telecommunica- In effect, the president settled the question byissu- tions in Peru, annex box 1.2). ANNEX 2 A Guide to Power Purchase Agreements T his annex provides an overview of issues Article fl-Sale Of Capacity And Energy that should be addressed in a Power Purchase Agreement (PPA) between a 2.1 Obligations to Provide Contract Capacity Purchaser (often a state-owned electricity utility) and Electrical Output. Specifies that the Company and a privately owned power supplier (the must make available to the Purchaser, not later "Company") constructing a power plant.' It than the specified commercial operation date emphasizes issues that might be of concern to (COD), the contracted capacity of each unit and lenders. The paper does not address all issues that deliver energy to the Purchaser in accordance with might arise in negotiating a PPA, but provides the PPA.2 The Company will commit to making examples of ways in which they were addressed in each unit available by the COD to ensure that each existing power projects. In this example, the pro- unit meets specified operating characteristics, to ject is assumed to be a base load thermal plant operate and maintain the plant over the term of the financed partly with foreign loans and equity (it PPA, and to comply with the Purchaser's dispatch could be modified to accommodate mid-range or instructions (see section 8.2). peaking thermal or hydro plants). This example does not cover credit enhancements that might be 2.2 Obligation to Pay forAvailable Capacity and required if the power purchaser is not creditwor- Electrical Output. The Purchaser will be required thy. The discussion is organized by the section to pay a monthly tariff for the available capacity headings that might be found in a typical PPA. and the electrical output generated by the plant. Much of the detail of a PPA is often contained in The most common approach is a "two-part" tariff, annexes; a list of those commonly found is also separated into capacity and energy components. provided. The capacity charge is designed to recover the plant's fixed costs and the energy charge covers Article I-Definitions fuel costs.3'4 Energy costs are usually incurred only if the plant is dispatched by the Purchaser, whereas Defines all the capitalized terms used in the PPA fixed charges are payable if the capacity is available and annexes, or cross-references to the section in but not dispatched and, under specified force the PPA where the term is defined. Often, com- majeure events, even where capacity is not avail- plex terms (for example, force majeure, monthly able. The detailed tariff provisions are often con- tariff) are defined in the text of the PPA. tained in an annex. 106 Annex 2 A Guide to Power Purchase Agreements 107 The tariff methodology should satisfy several ally determined on the basis of a specified deemed objectives if the PPAis to be bankable: (1) be suffi- availability. The PPA should set out the point at ciently dear to allow potential investors to calculate which deemed commissioning occurs and at which the project's likely cash flows; (2) generate sufficient it ceases. These provisions often require an inde- revenues to cover the fixed and variable costs of the pendent engineer to certify when a unit would have project, including debt service; and (3) generate suf- passed the relevant test, but for the occurrence of ficient revenue to yield a minimum ratio of earnings specified events.6 In addition, PPAs often include to payments of principal and interest to satisfy a "deemed generation" provision whereby the lenders' criteria. The tariff methodology should also Purchaser makes capacity payments to the meet the country's regulatory requirements and Company for capacity that would have been avail- result in an economically satisfactory and politically able, but for specified force majeure events, gen- acceptable price of electricity. erally political events. 2.3. Third-party sales. Generally, the ability to 2.5 Liquidated Damages make third-party sales, particularly where the Purchaser's creditworthiness is questionable, 2.5.1 Damages for delays. If a unit fails to pass enhances the financeability of a project.5 It may ben- its performance tests by the commercial operation efit both the Purchaser and the Company if the date, the Company may be required to pay the Company were permitted (but not obligated) to sell Purchaser liquidated damages of an agreed excess capacity and energy not dispatched by the amount per day up to a cap.7 Sometimes the dam- Purchaser. Because the PPA generally constitutes a ages increase after a specified number of days of take-or-pay obligation of the Purchaser, the proceeds delay. Lenders will examine the impact of liqui- of third-party sales can reduce the Purchaser's dated damages on debt coverage ratios. The monthly tariff payments. Alternatively, the Company, Company should not be required to pay damages as agent for the Purchaser, might sell available capac- if the delay results from events beyond the control ity and energy to a third party in return for a negoti- of the Company, such as certain force majeure ated agency fee from the Purchaser. events or failure by the Purchaser to comply with Another approach would be to allow the specified obligations. Company, after it has delivered a notice of termi- Another approach is to provide that inordinate nation to the Purchaser based on the failure of the delay by the Company, that if not excused, should Purchaser to complywith payment or other obliga- allow the Purchaser to terminate the PPA. From tions under the PPA, to sell part of the plant's con- the independent power developer's point of view, tracted capacity and energy to any third party. The however, the power seller should receive and be revenue would be set off against amounts due to required to apply liquidated damages from the the Company from the Purchaser under the PPA. contractor to either complete the units or to redeem project debt in order to adjust fixed 2.4 Deemed commissioning deemed generation. charges payable thereafter under the PPA. Developers and lenders expect a mechanism in a PPA that enables a deemed commissioning to 2.5.2 Damages for underperformance. Liqui- occur where a unit is ready but cannot be commis- dated damages are often payable when a plant fails sioned because of specified events. These events to meet specifications, particularly contracted are typically breaches by the Purchaser of its oblig- capacity tests. The relationship between liquidated ations (for example, failure to complete intercon- damages and provisions allowing the Purchaser to nection or transmission facilities or to provide terminate the agreement for failure to meet such energy for commissioning) and certain force tests needs to be carefully considered. The parties majeure events. The capacity payments are gener- may wish to consider, for example, whether the 108 Concessionsfor Infrastructure: A Guide to Their Design and Award Company's failure to meet a contracted capacity (2) receipt of certain governmental authorizations test could lead the Company to terminate the tests and clearances; (3) obtaining comfort regarding and pay liquidated damages to the Purchaser. The the receipt of approvals not received as of the date liquidated damages could be measured by the dif- of execution of the PPA; (4) if applicable, govern- ference between contracted capacity and the ment assurances relating to currency convertibility, actual percentage of contracted capacity demon- the availability of fuel and the like (5) if applicable, strated in testing. The Purchaser might prefer an receipt of government guarantee of the payment underperforming unit to a termination right, which performance of the Purchaser; and (6) execution would require the Purchaser to buy out the project of the construction contract and certain other pro- (see section 5.3). ject agreements. Conditions precedent to the Purchaser's obligations may include receipt by the 2.6 Testing performance. Testing should be Purchaser of (1) corporate documents (for exam- objective and designed to confirm levels of con- ple, articles of association and board resolutions) tracted capacity, reliability, and fuel efficiency or and (2) evidence of the Company's receipt of nec- heat rate. Testing should be certified by an inde- essary governmental approvals. pendent engineer. Receipt of the engineer's cer- The Company will usually wish to make finan- tificate should become the trigger for the cial closing a condition precedent to its obligations, commencement of capacity payments unless an whereas the Purchaser will expect that any condi- earlier "deemed" commissioning has occurred (see tions precedent to the Company's obligations be section 2.4). The PPA should specify the conse- satisfied within a certain period or the Purchaser quences of any inability to complete testing due to shall have the ability to terminate the PPA without unavailability of testing power or transmission liability. Lenders will require that the PPA specify facilities. when the obligations of the parties commence. There should be no ambiguity as to whether any 2.7 Company's purchase of power; pre- provision in the PPA is effective and enforceable. commissioning power. These provisions oblige the Accordingly, lenders will prefer to make all obliga- Purchaser to provide to the Company energy tions effective as of the date of execution of the required for construction, commissioning, mainte- PPA. Open-ended commitments for either party nance, and start-up. Often the tariff for electricity can be avoided by including provisions allowing ter- supplied to generating companies for such pur- mination if, after specified dates, certain key events poses is the applicable tariff for industrial compa- have not occurred (such as financial closing). nies. In addition, the Company would look to the Purchaser to purchase "pre-commissioning Article IV-Pre-operation Period power"-power generated by a unit during testing after-its synchronization-generally at a price that Pre-operation obligations frequently include a "rea- would cover the Company's fuel cost associated sonable efforts" obligation by the Company to with producing such pre-commissioning power. obtain necessary consents and approvals, and by the Purchaser to provide reasonable assistance to the Article IH-Conditions Precedent Company in obtaining the consents and approvals. The Company's other pre-operation obligations PPAs often set out conditions precedent to the may include (1) appointing the construction con- effectiveness of each party's obligations under the tractor and an operator; and (2) providing copies of PPA (and certain other obligations may not be con- the construction and O&M contracts to the ditional).8 Conditions to the Company's obliga- Purchaser. The Purchaser may be required to pro- tions under the PPA may include (1) receipt of vide the Company with title to the site and con- good, enforceable leasehold interest to the site; struction, water, power and other services. Annex 2 A Guide to Power Purchase Agreements 109 Some advisers have recommended that a lenders and other limitations, to terminate the Purchaser should have the right, under a PPA, to agreement and exercise certain other rights.9 In approve project contracts. Developers and lenders addition, continuation of force majeure events will prefer to avoid this, as the Purchaser may not beyond a specified period (see Article XI) could have sufficient resources to review these agree- also trigger a right of either the Company or the ments in detail. The Purchaser is perhaps better Purchaser to terminate the PPA. Lenders will gen- served by clear construction and operational per- erally prefer to limit the number of the termination formance criteria in the PPA for the Company to events. adhere to; the PPA could also include appropriate Events giving rise to a termination and/or buy- incentives. It will be the obligation of the Company out right for the Company typically include (1) dis- to contract with construction contractors and solution of the Purchaser; (2) failures by the operators to see that these criteria are met. The Purchaser to observe payment obligations and Purchaser's concerns about the enforceability of maintain letters of credit or other security; the Company's obligations can also be addressed (3) breaches of other obligations by the Purchaser through requirements for performance bonds under the PPA; (4) government guarantees (if any) under the PPA in favor of the Purchaser. The pre- or implementation agreements ceasing to remain operations provisions generally also provide the in force; and (5) repudiation by the Purchaser of Purchaser with the right to observe the construc- the PPA. The Purchaser typically has the right to tion progress of the project. terminate the PPA and/or exercise its buyout rights A PPA will often provide, as part of the pre- if: (1) the Company fails to achieve financial clos- operating obligations, for the Purchaser and the ing by a specified date; (2) the Company fails to Company to agree on operating procedures. These achieve commercial operations of the units by include methods of day-to-day communication, key specified deadlines (generally subject to extensions personnel lists, clearances and switching practices, for certain events); (3) the Company abandons the outage scheduling, and capacity energy reporting. If project; (4) the Company breaches its obligations the parties are able to agree on such operating pro- under the PPA; and (5) the Company is dissolved. cedures before the execution of the PPA, they could Termination provisions generally include be included in a schedule to the PPA. requirements for notice by the party wishing to invoke termination and/or buyout, followed by a Article V-Term and Termination consultation period between the parties and a period during which the defaulting party may 5.1 Term. Defines the date on which the agree- attempt to cure the default. Such a cure right is ment becomes effective and the period after which usually accompanied by a cure period (in addition it will terminate. The provision will also provide to the cure period provided to the nondefaulting extensions for specified force majeure events and party) in favor of the lenders if the Company may also include procedures for a request by either defaults. party for an extension (in which case tariff calcula- tions should be defined for the extended term). 5.3 Buyout price. Generally, the termination Lenders will insist that the PPA's term be a few provisions lead to a buyout by the Purchaser which years beyond the period, permitting the Company can be triggered by either party depending on the to generate sufficient cash flow to retire the pro- termination event. Lenders will wish to ascertain ject's debt. that all outstanding debt be included in the buyout price. However, where the Purchaser's credit is in 5.2 Termination. In the event of default, the question, buyout will be considered of limited nondefaulting party will have the right, subject to value by developers and lenders, unless supported certain cure rights for the defaulting party and by government guarantees. 110 Concessionsfor Infrastructure: A Guide to Their Design and Award The PPA should provide a methodology for cal- ing for the project; (2) use reasonable efforts to culating the buyout price. In some PPAs this is negotiate fuel supply agreements, a construction specified as a combination of: (1) a discounted contract and financing documents;'0 (3) use rea- cash flowvaluation based on the estimated net pre- sonable efforts to obtain government authoriza- sent value of the Company's expected cash flows tions; and (4) operate the plant in accordance with over the remainder of the PPA plus a specified the Purchaser's dispatch instructions and prudent residual value of the plant; (2) a construction utility practices. Typical covenants of the Purchaser period evaluation consisting of a specified per- include (1) to provide, by or before a specified centage of equity subscriptions paid into the commercial operation date, interconnection and Company plus an allowed return on the equity at transmission facilities; (2) to assist in identifying a specified rate; (3) a termninal evaluation set at a and preparing applications for government autho- specified percentage of the plant's depreciated rizations; (3) to assist the Company in negotiating replacement cost; (4) the Company's outstanding and executing the financing documents; and (4) to long- and short-term loans and any accrued inter- cooperate with the Company with respect to the est and financing fees; and (5) transfer costs. Each Company's obligations and rights under the PPA. component is scaled according to the reason for The PIPA should set forth the consequences of a termination, with the highest buyout price follow- failure to comply with any such obligations. ing a Purchaser default and generally none in the event of expiry of the PPA. Intermediate buyout Article VIII-Project Operation prices can be negotiated for terminations caused by different force majeure events. An appraiser Issues typically include scheduled outages and may be appointed by the parties to calculate the maintenance outages, operations and mainte- buyout price. nance, emergencies and record keeping. Article VI-Representations and 8.1 Scheduled outages and maintenance outages. Warranties Prior to the commercial operation date (COD), the Company will be required to submit its desired The representations and warranties in a PPA typi- schedule of scheduled outage periods for the first cally include the organization and valid existence full maintenance year after commissioning. The of the Purchaser and the Company, the legal and PPA should also provide for a date by which the binding nature of the obligations constituted by Company must submit its desired schedule of out- the PPA, the absence of certain legal proceedings age periods for each subsequent year. Generally, that rnight adversely affect the ability of the parties longer notice is required for years subsequent to to meet their obligations, and the due authoriza- the COD. The PPA may also set parameters within tion of the PPA by the parties. Sometimes a pro- which the scheduled outage periods should occur. ject might require additional representations and The PPA will generally provide for a period dur- warranties, frequently covering environmental ing which the Purchaser may object in writing to a issues, or on land owned by the Purchaser, for requested schedule and propose an alternative example. schedule. The Company will often insist that scheduled outages should occur only at times Article VII-Undertakings determined in accordance with this procedure and that the Purchaser should not require the A PPA generally contains additional Company to schedule outages in a manner or time undertakings/covenants from each party. The outside the technical limits of the plant, or incon- Company's undertakings might include obliga- sistent with prudent utility practices or manufac- tions to: (1) use reasonable efforts to obtain financ- turer recommendations, or which would pose risk Annex 2 A Guide to Power Purchase Agreements 111 of damage to the plant. The Purchaser's mainte- 8.3 Emergency plans; supply of power and emer- nance program for interconnection facilities and gency. The PPA will generally call for each party to transmission facilities should also be coordinated establish plans for an emergency, such as local or with the approved scheduled outages for the plant. widespread electric blackout and voltage reduc- Frequently, the Purchaser will also be prohibited tion to effect load curtailment. During an emer- from discriminating against the Company in favor gency the Company may be required, as soon as of other plants when the Purchaser schedules and possible after a request from the Purchaser, to sup- reschedules outages. ply such power as the plant is able to generate, con- The PPA will also address "maintenance out- sistent with prudent utility practices and specified ages," defined as an interruption or reduction of technical limits of the plant, and, at the Purchaser's generating capability (excluding scheduled out- expense, make reasonable efforts to reschedule ages) that cannot be postponed until the next any outages or to complete work during the outage scheduled outage. An abbreviated set of proce- to restore power as soon as possible. Other limita- dures requiring oral notice within 24 hours (or a tions and parameters on the ability of the similar period) to the Purchaser usually is provided Purchaser to direct the Company to perform emer- for maintenance outages. gency-related operations (such as cold starts and emergency maximum loading or deloading) may 8.2 Operation; dispatch. This sets out procedures be included. for issuance by the Purchaser of dispatch instruc- tions to the Company and for the degree of dis- 8.4 Record maintenance. Each party will be patchability allowed to the Purchaser, if any. These required to keep the records necessary to adminis- provisions usually provide that the plant's dispatch ter the PPA, including an accurate and up-to-date procedures shall be in accordance with dispatch operation log, at the plant. The provisions will gen- procedures for similar plants on the Purchaser sys- erally require maintenance of such records for an tem. Typically the dispatch instructions should take agreed period after their creation. into account the characteristics of the plant, the overall system condition and requirements, and the 8.5 Interconnection, metering standards, and conditions and characteristics of other power testing.The PPA should contain provisions pro- sources available to the purchaser, in setting out viding for exchanges of information concerning appropriate and equitable dispatch instructions. the plant's design, the interconnection and trans- The PPA can also provide the Purchaser with the mission facilities, the allocation of responsibility right to request that the plant be shut down. In turn, for construction, and interconnection, ease- the Company will expect limitations on this right as ments and rights-of-way, protective devices and well as indemnification for costs incurred in shutting the testing of interconnection and transmission down and restarting the plant and any increased facilities. Specifications for the meters to be used costs incurred in connection with the shut down. for the project should be set forth, as well as The Company will also reasonably ask for a lead responsibility for maintaining the meters, pro- time in which to restart the plant, in accordance with viding regular metering results, checking meter the relevant unit specifications. accuracy, and so on. These provisions may also provide that the Company shall not be required to operate the plant Article IX-Payment other than in accordance with prudent utility prac- tices and specified technical limits. The Company This specifies procedures for invoicing, the may also be asked to use best efforts to employ method and amount of payment, resolving dis- qualified personnel from the country and to insti- putes relating to invoices, security for payment, tute training programs for such personnel. and rights to set off. 112 Concessions for Infrastructure: A Guide to Their Design and Award 9.1 Invoicing. This section should establish a such a letter of credit if the due date for an invoice payment date by which the Purchaser must pay has passed without payment or if a replacement the Company the monthly tariff payment for a letter of credit has not been delivered to replace an given month. It should also specify the manner in expiring or partially drawn letter of credit.'2 Failure which invoices are to be provided by the to replace a letter of credit fully could result in Company. Generally, commencing with a month addition of interest to the invoice until such time following the date on which synchronization for as the letter of credit is fully restored. the first unit occurs, the Company will be required to submit to the Purchaser by a specified date an Article X-Liability And Indemnification invoice stating the available capacity, the energy delivered to the Purchaser, the aggregate variable These provisions state that neither party shall be charges, and the total monthly tariff payment. The liable to the other for damages, except as specified. invoice should include reasonably detailed calcu- The Article also requires for each party to indem- lations, in accordance with the PPA; an example nify the other for losses resulting from negligent of a tariff calculation in a schedule to the PPA is acts of the indemnifying party, except to the extent often helpful. Other charges, fees, and reim- that (1) such losses are caused by any act of the bursements payable by the Purchaser to the indemnified party and (2) the indemnified parties Company are generally billed separately. If the tar- are compensated by insurance or specified agree- iff calculation procedures call for an annual ment. The parties may also agree not to assert adjustment, such as for fluctuations in foreign claims for indemnification until the aggregate exchange rates, the provisions will generally pro- amount of all claims exceed a minimum amount. vide for invoicing at a specified time(s) each year The indemnity provisions will generally provide the for such amounts. indemnifying party with the option to assume and The agreement will provide for the form of pay- control the defense of claims for which the indem- ment, such as direct payment or wire transfer to an nifying party acknowledges its obligation to pro- account designated by the Company to the vide indemnification. Purchaser.'I Any delayed payment charges should also be specified. Notice of disputes relating to an Article XI-Force Majeure invoice should be given promptly. Lenders often expect the agreement to provide that the Treatment of force majeure in PPAs is highly con- Purchaser pay the invoice when due, though it may tentious and many approaches have been used. A be entitled to a repayment after any invoice dispute PPA should clearly classify force majeure events, is resolved. The waiver of set off rights may also be specifying the impact of each event on the obliga- included. tions of the parties, in particular on the paymnent obligations of the Purchaser and the construction, 9.2 Securityforpayment. The PPA may require completion, and operational obligations of the the Purchaser to cause a bank acceptable to the Company. The parties might consider the follow- Company to issue to the Company one or more ing approach: irrevocable, unconditional standby letters of credit to ensure short-term liquidity. The PPA will gener- 11.1 Categories. An event of force majeure is ally provide that the letter of credit shall at all times any event that prevents any party in the perfor- be in a specified amount, usually tied to projected mance of its obligations under the PPA, but only tariff payments for a specified period, using certain to the extent that the events are not within the rea- assumptions regarding load factors and other ele- sonable control of the affected party and could not ments of the tariff calculation to calculate the have been avoided with reasonable care. A nonex- amount. Typically, the Company may draw upon haustive list includes: Annex 2 A Guide to Power Purchase Agreements 113 (1) Specified nonpolitical events: such as natural Article XII-Taxes disasters, labor difficulties, and contractor failure;13 (2) Domestic political events, including war, Taxes are generally passed through to the revolution, terrorism, political sabotage, changes Purchaser under the tariff. In addition, there in the law affecting the project, expropriation, should be provisions addressing administrative unjustified denials of governmental authorization, matters relating to taxes, including requirements and certain interruptions in fuel supply (if fuel risk for the Purchaser to support all applications by the is borne by the utility);14 Company for exemptions from domestic taxes (3) Foreign political events, including generally and an obligation on the part of the Company to the same events in category (2) but occurring out- take reasonable steps to ensure that its liability on side the country concerned. taxes is minimized, and procedures for resolving Generally, the following conditions shall not any dispute of claims by the Company for a pay- constitute an event of force majeure unless the ment in respect of taxes under the tariff existence of such condition is the result of an event provisions.16 of force majeure: a. late delivery of plant, machinery, equipment, Article MH-Change In Law materials, spare parts or consumables for the pro- j,ect, or The PPA should address the impact on the tariff in b. a delay in the performance of any contractor. the event of a change in applicable law or its inter- pretation that affects the Company. 'Applicable 11.2 Notices/duty to mitigate. This provides pro- law" is frequently defined to include any act, cedures for notification by the party claiming force decree, regulation, notification, or order having majeure to the other party and imposes a duty on the the force of law. "Change in law" is defined to party affected by the force majeure to use reasonable include any new enactment, amendment, modifi- efforts to mitigate the effects of the force majeure. cation, or repeal of any applicable law as well as any change in the interpretation of the applicable law 11.3 Effect on obligations. The Article provides (either through decisions by courts or by govern- that neither party shall be liable for any failures in ment). Some PPAs in such circumstances have complying with its obligations under the PPA required an automatic adjustment of the tariff, (though the obligation to make payments which subject to the approval of the regulatory agencies; are payable should be excluded) if the failure was other PPAs may require that the parties meet to caused by force majeure events.15 The period attempt to amend the PPA to pass on the impact allowed for performance by the affected party of in the tariff payment. In the absence of agreement, its obligations under the PPA is extended day-for- the dispute resolution procedures in the PPA day (plus additional periods to compensate for would apply. While various approaches to the allo- demobilization and remobilization). cation of risk of change in law are taken in PPAs, lenders will require that the cash flows of a project 11.4 Buyout consequences of force majeure required for debt service be protected against such events. If the construction or operation of the plant changes through tariff modifications. is adversely affected, for a certain continuous period, due to the occurrence of a domestic polit- Article XIV-Dispute Resolution ical event, either party can deliver a notice to the other party and, subject to dispute resolution pro- Dispute resolution provisions should generally cedures and time limits, terminate the PPA. Upon provide for good faith negotiations followed by termination, the Purchaser will be obligated to buy arbitration under internationally accepted rules in out the project (see Article V). a third country.17 The provision should specify the 114 Concessionsfor Infrastructure: A Guide to Their Design and Award applicable rules, the number of arbitrators, the Determination of availability place of arbitration, the language of the arbitration Outages and emergencies proceedings, the nature and enforceability of the Tariff calculations award, and the appointing and administrating authority. In addition to arbitration, the PPA may Notes also allow referral of technical matters to an expert for quicker resolution. 1. International Finance Corporation. 1996. Financing Private Infrastructure. Washington, D.C., Article XV-Notices pp. 118-26. 2. The commercial operation date is often based on the financial closing date and should be extended by This Article sets forth the details for providing delays caused by the Purchaser's breach of obligations notices under the PPA, as well as provisions for and certain force majeure events. changing notice addresses for the parties. 3. Fixed charges in a two-part tariff usually include all fixed costs associated with the project, including Article XVI-Miscellaneous fixed O&M costs, insurance costs, administrative costs, financial costs, taxes, and return on equity. (The fixed component of fuel transport charges may also be These may include an assignment provision included.) It could be expressed in local currency restricting assignment by either party to the PPA. and/or foreign currency. Lenders will generally require that the Company 4. The energy charge is also known as the "variable assign its rights under the PPA to lenders and that charge" and may include variable operating and main- the Prchaer ener ito a irec agrementwith tenance costs. the Purchaser enter into a direct agreement wth 5. Third-party sales also promote the interchange of the lenders relating to such assignment and certain power, the expansion of transmission systems, and other issues. The Purchaser or the regulatory agen- improve overall system efficiency. All such direct sales cies may wish to provide for an assignment of the could be interruptable by the Purchaser, unless the PPA to an entity that results from future privatiza- Purchaser notifies the Company of a reduction in the tion of the Purchaser. Because of concerns for the Purchaser's system demand for an extended duration. privatized entity's operational c a ad c . In such a case, the Company could contract to make its privatized entity's operational criteria and credit- excess capacity available for the corresponding duration. worthiness, lenders often attempt to spell out the 6. Lenders often require the Company to engage an operational and financial parameters of the priva- independent engineer to report on construction tized entity in hopes of ensuring that the progress and to provide certification on construction, Purchaser's payment obligations under the PPA testing (usually a condition of loan disbursement), and Will be properly assumed and performed. The mis- operations. Sometimes the independent engineer also mediates technical disputes between the parties. cellaneous provisions should also address the gov- 7. If liquidated damages are imposed, they should erning law of the agreement, a severability clause, reflect the actual damages expected to be suffered by a waiver of immunity by the Purchaser, and confi- the Purchaser (for example, in respect of its outlay on dentiality provisions. the interconnection and transmission facilities). 8. Such obligations indude, for the Company, using Sample Annexes/Schedules its best efforts to achieve financial closing, to obtain consents and approvals, to conduct preliminary stud- ies and the like, and, for the Purchaser, the transfer of Permiits and authorizations title to the site, obtaining consents and approvals and Technical limits and parameters assisting the Company in doing the same. Interconnection 9. The lenders will expect to enter into a direct con- Commissioning and testing specifications tractual relationship with the Purchaser, wvhereby the Metering standards and testing Purchaser agrees (i) to make payments to the Company directly into an account designated by the Buyout price lenders without right of credit or right of set-off; (ii) to Insurance provide to the lenders reasonable notice and cure Annex 2 A Guide to Power Purchase Agreements 115 rights; (iii) to accept in the event of a default, as a sub- 13. To the extent that insurance is available at a rea- stitute for the Company under the PPA, any reason- sonable cost to cover the occurrence of any of the nat- able agent for the lenders or any reasonable Purchaser ural events, the Company will be asked to undertake of the Company upon a foreclosure sale, provided that to insure against such risks. such person shall assume all of the Company's obliga- 14. Lenders will also examine whether the force tions under the PPA; and (iv) to afford the lenders an majeure arrangement under the fuel supply agreement opportunity to remedy the event giving rise to a termi- is properly reflected in the force majeure section of nation notice prior to termination of the PPA. Also, it the PPA, in order to leave no gap in the allocation of may be necessary to negotiate with the Purchaser fur- fuel risks. If, for example, the fuel supplier will be ther provisions to address issues of concern to the excused from its obligation to supply fuel under the lenders arising after the PPA is signed. fuel supply agreement due to government actions, the 10. Lenders will focus on fuel supply risks and how lenders are likely to require that the unavailability of such risks should be managed and mitigated. They will fuel be a political force majeure event for the consider the reliability and credit of the fuel supplier, Company in the PPA. the adequacy of the fuel source, the existence of an 15. Although the occurrence of a force majeure altemative fuel supplier, the consequences of non-sup- event may prevent a payment obligation from arising, ply (for example, whether this should be a force once a sum does become payable, the payment obliga- majeure event under the PPA), and also transportation, tion will not be excused by force majeure. storage, and disposal risks. The liquidated damages 16. The developers will also be considering the tax payable under the fuel supply agreement will also be implications under their home tax regime. relevant. Finally, lenders may investigate whether fuel or 17. The most often used arbitration rules are those altemate fuel could be imported into the country. of the International Chamber of Commerce (ICC) 11. Lenders will generally require that payments of and the United Nations Commission on Intemational invoices be made directly to an account controlled by Trade Law (UNCITRAL). Depending on the parties a trustee or security agent or over which the lenders involved in a dispute, the arbitration rules under the hold some form of security. Convention on the Settlement of Investment 12. Some PPAs look to the establishment of escrow Disputes between States and Nationals of Other accounts funded by the Purchaser's receivables (or States (through the International Centre for liens over such receivables) from specified customers Settlement of Investment Disputes-ICSID) may for additional liquidity security. also be suitable. ANNEX 3 Organization of American States Members of ICSID, New York, and Panama Conventions Country ICSID Convention New York Convention Panama Convention Antigua & Barbuda X Argentina X X X Bahamas, The X Barbados X X Belize * Bolivia X X * Brazil X Canada X Chile X X X Colombia * X X Costa Rica X X X Cuba X Dominica X Dominican Republic * Ecuador X X X El Salvador X * X Grenada X Guatemala * X X Guyana X Haiti * X Honduras X X Jamaica X Mexico X X Nicaragua x Panama X X X Paraguay X X Peru X X X St. Kitts & Nevis X St. Lucia St. Vmcent & the Grenadines X Suriname Trinidad & Tobago X X United States X X X Uruguay X X Venezuela X X X Totalparties/members OAS (35) 21 20 16 Global 126 108 16 X denotes parties/members of conventions. * denotes signatories. Note: Members of the ICSID and New York Conventions as of April 1, 1997, and of the Panama Convention as of December 19,1996. Source: World Bank staff. 116 ANNEX 4 Lenders' Security Rights L imited or nonrecourse transactions are typi- swap parties. However, depending on the project's cally characterized by the establishment of a financial structure, some lenders/investors may be special-purpose entity, whereby lenders look subordinated to others regarding security interests in to the cash flow and assets of the project company project cash flow and/or assets. Likewise, it is not to secure repayment of their loans. A lender's secu- uncommon for offtake parties, which provide fixed rity package consists of a variety of collateral rights or front-end loaded payments (payments that are pertaining to these assets and cash flow. The vari- expected to be above market), or input providers, ous elements commonly included in such packages which provide their goods at below-market prices, to are listed in the box below. receive a second lien on project assets. Under such As defined in the intercreditor agreement, the circumstances senior debt providers will have prior- security package is typically shared pro rata between ity with respect to subordinate lenders or third-party senior lenders of each individual debt tranche as well contractual participants over project cash flow as with any currency, interest rate, or commodity and/or any proceeds from the liquidation or transfer Annex Box 4.1 Lenders' Security Packages A lender's security package quite often consists of the reserve, and major overhaul account. following components: * A pledge of the borrower's interest in the major * A first security interest in the borrower's inter- project agreements (for example, partnership/ est on project assets, including a mortgage or shareholder/joint venture, offtake, construc- fixed charges (that is, charges relating to specific tion, input supply, operation and management, assets without the possibility of substitution) technical assistance), including, but not limited over land, buildings, and other fixed assets. to, entitlement to payments, liquidated dam- * Floating charges over moveable assets, includ- ages, indemnities, retainage accounts, perfor- ing project inventory and receivables, produc- mance bonds, insurance and brokerage tion/work in progress, intangibles, and other undertakings, and warranty provisions speci- personal property and interests. fied under such agreements. * A pledge of the shareholders' equity participa- * Assignment of rights underlying major project tion in the borrower, including charge over div- authorizations, including licenses (such as idend rights. environmental), permits (such as construc- * Escrow accounts to control and, when neces- tion), notices, consents, acknowledgments, and sary, retain cash flow relating to the project, endorsements. including all monies owing or pending under, * Specification of the lenders as loss payees on all for example, the operating, debt service insurance policies relating to the project. Source: World Bank staff. 117 118 Concessionsfor Infrastructure: A Guide to Their Design and Award of any assets until their loans, pending interest and tract without their consent, and lenders rights to fee payments and any other costs (such as legal), are transfer the contract rights to new purchasers (sub- paid in full. Also, senior lenders will not allow sub- ject to appropriate restrictions as to the qualification ordinate lenders to accelerate their loans without and financial capability of the purchasers). their prior written consent. Often, governmental counterparts are unwilling Lenders will generally require a full collateral or unable, because of legal restrictions, to grant assignment of all rights of the borrower. In other lenders full collateral rights and seek to limit the words, they will want the right to "step into the rights of lenders to project cash flows. But a collat- shoes" of the borrower in a default situation and eral assignment limited to the borrower's rights to have the ability to perform the obligations of the receive payment under a project agreement does not borrower (including curing defaults) and enforce adequately protect the lenders' interests. Indeed, if the right of the borrower to transfer the project the borrower is unable or unwilling to perform as agreements, in their entirety, to a new company that stipulated under the project agreement, its right to intends to acquire the project from the borrower. receive payment will quickly cease through early ter- Lenders seek a full collateral assignment in order to mination clauses. In a financing situation in which bring in a new borrower who assumes the respon- lenders are providing the majority of the capital for sibilities and obligations as outlined in the conces- a project on a limited-recourse basis, lenders insist sion agreement without assuming prior liabilities on the right "to become the borrower" in every (tax, environment, labor), as would be the case with respect and to operate the project directly or through an assignment of the shares of the borrower. This a transferee without further action. Solutions that effectively increases the net value of the concession have been devised to give satisfaction to lenders have as transferred/sold to a third party included defining certain quantifiable criteria based As such, lenders will require the parties to the pro- on net worth, number of projects of similar size and ject contracts other than the borrower to execute con- technology, and so on, against which new "borrow- sents to the collateral assignments. This is required to ers" would be evaluated or, in certain cases, formu- establish between the lenders and these third-party lation of lists of automatically approved third-party contractual participants certain rights of the lenders substitutes. It is in any case essential that lenders be with respect to the contract. This often includes the sufficiently comfortable with the security package obligation of the contracted party to notify lenders in they are being offered and with the overall legal and the case of a borrower breach/default under the con- regulatory environment in which the project com- tractual arrangements, lenders' rights (not obliga- pany has to operate. Otherwise, projects will simply tion) to cure defaults by the borrower, lenders' ability not be "bankable" and will not come to financial clo- to object to amendments or termination of the con- sure (annex box 4.2). Annex Box 4.2 "Bankability" of Mexican Power Projects Under the Carbon II power project a BOT contract under a Build-Lease-Transfer (BLT) contract. A BOT for a multiunit, coal-fired plant was awarded to contract for the Merida m project was awarded in Mission Energy. However, the govermnent refused to January 1997. In addition to the passage of a new give commercial lenders step-in rights and other secu- electricity law and creation of an energy regulator, rity interests in the project, which was thus unable to Mexico has actively sought to encourage private secure financing. The deal eventually fell through financing for independent power projects by improv- over these issues and other disputed matters. ing the environment for project lenders, including Since then, financing has been closed on the first through changes in the Civil Code that facilitate privately built power plant in Mexico, Samalayuca II, bankruptcy procedures. Source: World Bank staff. Annex 4 Lenders'Security Rights 119 In addition to payment defaults and remedies required ratio for an extended period of time (for allowed for under such circumstances, lenders will example, two consecutive quarters), "trapped" also seek to further protect repayment of their loans cash flow may be applied to prepay debt in through: inverse order of maturity. * Lenders will also have certain approval rights, as * The imposition of covenants, both positive related, for example, to operating and capital (maintaining certain debt-equity and working expenditure budgets (approval could be auto- capital ratios and reporting requirements) and matic if not above the expected rate of inflation), negative (not incurring any additional indebted- construction change orders above certain ness above certain amounts, or not amending or amounts, and the sale or transfer of borrower terminating any major project agreement with- equity to third parties. out prior lender consent). Should the borrower * Likewise, lenders will look to secure their ability not comply with the stated covenants beyond a to sell off or assign participations in their loans pre-established cure period (which can vary to other debt providers. Issues related to per- from 0 to 5 days for payment defaults to more mitted timing of such sale or assignment, mini- than 180 days for technical problems arising mum amounts to be held by the originating from force majeure events), then, as with a pay- lenders, participating bank voting rights with ment default, lenders have the right to declare respect to the borrower, and so on will be out- an event of default, accelerate in full their loans, lined in the credit agreement. and exercise any and all of their collateral rights. i Inclusion of contingent restrictions on dividend Finally, quite often because of problems with distributions should, for example, the borrower registration, perfection, and enforcement of collat- not achieve certain debt service coverage ratios. eral rights, many projects never make it to financial In certain cases, if the borrower falls below the closing (annex box 4.3). Annex Box 4.3 Legal and Regulatory Issues in Securing Transactions While collateral is of key importance in enabling pri- exist on the offered collateral. However, lenders vate lenders to offer loans and reduce interest rates, often encounter difficulties in checking which liens legal and regulatory impediments in some countries may be outstanding on project collateral because of make it difficult for the lenders to acquire collateral the state of disarray of many public registries. In interests. These obstacles are related to the creation, Bolivia, for example, pledges are filed chronologically, perfection, and enforcement of lenders' security inter- rather than under the name of the borrower or a ests in a project. description of the pledged asset, so that the entire In order to create a security interest, the collateral registry must be searched to discover a prior pledge. pledged must be identified. In some systems, for In addition, there may be unclear procedures for reg- example in Uruguay, the law requires that the physical istering government pledges or support agreements property be specifically enumerated and determined, to projects. These conditions can result in high trans- and no substitution is permissible. This creates diffi- action costs, including notary costs, relating to the culties and expense in monitoring the loan to ensure perfection of the lenders' rights. that the specified property has not been exchanged or Enforcement of a security interest involves the sold. In the United States, by contrast, lenders can ability of the lender to repossess and sell the collat- obtain a floating security interest for the value of the eral. In some systems, where private parties and gov- property rather than identified physical assets and can ernment officials cannot contract to repossess automatically get a continuing security interest in the property, this requires a lengthy legal process. In addi- proceeds of any sale of the property. tion, the lenders may not be permitted to attach other The perfection of a security interest involves property of the borrower, such as proceeds from the obtaining an assurance that no prior superior claims sale of collateral. Source: Fleisig (1995). ANNEX 5 Investment Insurance Programs Germany (C&L Deutsche Japan United States MIGA Revision AG) (EID/MITI) (OPIC) Eligible investments New (induding New (including New (including New (including expansion, expansion and expansion and privatization, modernization, modernization of modernization expansion, and financial restructuring existing projects). of existing projects). modernization of existing projects). of existing projects). Must promote Must be sufficiently Must demonstrate economic growth and legally protected, for a potential for development in the example, under a positive effects on host country, be bilateral protection U.S. employment financially, agreement, intensify and economy, be economically, and foster the environmentally and environmentally relationship with the sound, promise sound. host country. significant benefits to the social and economic develop- ment of the host country; must not contribute to violations of internationally recognized worker rights. Types/Forms of Equity, shareholder Equity investment Equity, loans, Equity, loans to Investment loans, shareholder (shares in foreign property rights, unrelated borrowers, guarantees of enterprises). Loan of surety obligations. third-party loan third-party loans; an investment type guarantees; loans to unrelated (long-term loan)- construction and borrowers (project shareholder loans service contracts, lending); leases, or loans to unrelated production-sharing contractual arrange- borrowers (project agreements, leases, ments (licensing, lending). Capital contractual franchising, technical provided to an arrangements (licensing, assistance, and overseas branch. franchising, technical management agree- assistance agreements)- ments)-minimum minimum 3 years. 3 years. 120 Annex 5: Investment Insurance Programs 121 Germany (C&L Deutsche Japan United States MIGA Revision AG) (EID/MITI) (OPIC) Cash, machinery and Cash, machinery and Cash, machinery and equipment, consigned equipment, services, equipment, consigned inventory, debt-equity licenses, debt-equity inventory, debt-equity swaps, reinvested swaps, reinvested swaps. earnings. earnings. Eligible Investors Natural or juridical German citizens and Japanese citizens Citizens of the United person who is a corporations and corporations States, corporations, national of a MIGA established under or other institutions partnerships, other member country German law and established under associations created other than host domiciled in Japanese law. under U.S. law and country, or juridical Germany. Domestic investor owned more than 50 person not could be majority- percent by U.S. citizens, incorporated or owned by foreign foreign corporations domiciled in a individuals. owned at least 95 member country percent by U.S. citizens, but majority-owned corporations, and the by nationals of like. MIGA member countries. Eligible Countries Developing member Host country that Host country's With some exceptions, countries as host ensures the legal legal system must no insurance if host countries and protection of the adequately provide country's income per industrialized and investment, for for foreign invest- capita exceeds developing countries example, by means ment inflows US$4,269 (1986); as countries of a bilateral (existence of bilateral agreements of investor. investment protection bilateral agreements must exist. agreement. not required). Host country's Some bilateral Host country's A Foreign approval for the investment protection approval for the Government issuance of a MIGA agreements require issuance of a Approval (FGA) guarantee contract the host country's guarantee contract process is required, is required. approval on the is required. which varies, investment to be depending on the guaranteed as a host country. prerequisite for the applicability of the bilateral agreement, some require a simple notification (or not (table continues on next page) 122 Concessions for Infrastructure: A Guide to Their Design and Award Investment Insurance Programs (continued) Germany (C&L Deutsche Japan United States MIGA Revision AG) (EID/MITI) (OPIC) even this) to the host country. Risks covered Political risks only. Political risks only. Political and Political risks only. commercial risks. a) Inconvertibility/ Acts that restrict Acts that restrict the Acts that restrict the Acts such as new nontransfer the investor's or investor's ability investor's or currency restrictions lender's ability to to convert amounts lender's ability to or failure by exchange convert local currency paid into a bank repatriate funds for control authorities to returns into foreign account and/or the more than 60 days. act on an application exchange for transfer transfer of such for hard currency for outside the host amount to Germany more than 60 days (in country for more for more than 60 days. some cases more than than 90 days. In addition: payment 90 days). prohibition or moratorium. b) Political violence Damage to, or Total loss of whole of Occurrences Two types of loss destruction or the investment due to such as: compensation disappearance of, actions such as civil * Inability to coverage are available: tangible assets caused disturbance, war, continue business * Business income by politically domestic armed * Bankruptcy or coverage motivated acts of war conflicts, revolution, some other reason * Assets coverage or civil disturbance, or riots. of similar nature due to war, revolution, including revolution, * Suspension of insurrection, or insurrection, coups transaction by the politically motivated d'etat, sabotage, bank or some other civil strife, terrorism, and terrorism. reason of similar and sabotage. nature a Suspension of Actions undertaken business for a period to achieve labor or exceeding 6 months student objectives are attributable to war, not covered. revolution, civil war, riot, or civil disturbance. c) Expropriation Partial or total loss of Total loss of parts Total loss of insured Total loss of the insured investment as or whole of the investment as a result investment due to a result of acts by host investment due to of acts that deprive acts that i) are attrib- government (outright nationalization, the investor of the utable to the foreign nationalization and expropriation, or investment by the governing authority, confiscation) causing other events of host government. ii) violate reduction or interventions or Creeping expro- international law, elimination of noninterventions by priation is covered iii) deprive the Annex 5: Investment Insurance Programs 123 Germany (C&L Deutsche Japan United States MIGA Revision AG) (EID/MITI) (OPIC) ownership of, or the host government where the insured investor of control over, rights to whose effects are has objectively fundamental rights, the insured similar to an expro- assessed an infringe- iv) continue for 6 investment and priation. Creeping ex- ment by the host months. Actions that continuing for 1 year. propriation covered if government. lead to creeping Creeping expropria- the series of events expropriation such as tion is covered if a have the same effect outright national- series of acts, over of an expropriation ization arising from time, have an expro- (and lead to a total decrees or a series of priatory effect. loss of the investment). events that have the same effect of an expropriation are covered. Lawful actions by the Coverage excludes host government losses due to lawful (exercise of regulatory or revenue regulatory authority) actions by the host are not covered. governments. d) Breach of Protects against Breach of commitments Breach by the In some cases OPIC contract losses arising from the by the host government host government may cover the breach host government's or government- of a contractual by the host govern- breach or repudiation controlled entities of a obligation is ment of a contractual of a contract with the contractual (bilateral) covered. obligation if it meets investor. In the event or noncontractual Suspension of the the requirements for of an alleged breach (unilateral) obligation insured business expropriation (total or repudiation, the is covered if it is operations has to loss) and either i) the investor must be able politically motivated. occur for more than insured must have to invoke an The bi- or unilateral 6 months. successfully demon- arbitration clause in "commitments" must strated that the actions the underlying be stated in the could not have been contract and obtain guarantee document. justified under the an award for damages. terms of the under- If the investor has lying commercial not received arrangement, or ii) the payment, MIGA failure to perform will compensate. must be the subject of an arbitral award in favor of the investor that remains unpaid for a period of 3 months. Commercial Bankruptcy of the party insolvency in which the insured investment was made and which (table continues on next page) 124 Concessionsfor Infrastructure: A Guide to Their Design and Award Investment Insurance Programs (continued) Germany (C&L Deutsche Japan United States MIGA Revision AG) (EID/MITI) (OPIC) cannot be imputed to the insured. Scope of Coverage a) Duration Minimum 3 years and Up to 15 years, with Minimum 3 years Maximum 20 years maximum 15 years for gradual roll-overs and up to 15 years, (equity). For loans, equity (20 years of 5 years. with possible leases, and transactions under certain extension for the term is generally circumstances). For projects with long equal to the duration of loans, leases, and construction periods. the underlying contract transactions the term is or agreement. generally equal to the duration of the under- lying contract or agreement. b) Limits/ Maximum amount of No written limits Per-project limit Maximum amount of ceilings coverage for a of coverage or is 50 billion Yen. political risk insurance single project is country ceiling No country ceilings. for a single project is US$50 million. restrictions (case- US$200 million. Maximum coverage by-case). No country ceiling but ratio of debt (to per-country exposure unrelated borrowers) is limited to 15 percent to shareholder invest- of global portfolio. ment in the same project is 6:1. Country ceiling US$225 million per country. c) Maximum Although to date Ninety-five percent. Ninety-five percent Ninety percent percentage of MIGA has maintained Earnings are eligible for political and of eligible invest- coverage a 90 percent limit, it up to 10 percent per 40 percent for ment. Loans and leases can insure up to 95 year, but limited to commercial risks. from financial percent of the invest- a maximum of 50 Ninety percent of institutions to ment. For equity percent on the value earnings up to 10 unrelated third parties investments: up to of the equity/capital percent of invested may be insured for 95 percent of invest- investment and 100 amount up to 100 100 percent of principal ment and up to percent of the percent of principal and interest. an additional 450 shareholder loans; in total are insured. percent to cover future if reserves are earnings. For loans transferred into shares, and loan guarantees: the coverage can be up to 95 percent of increased to 300 principal and up to an percent of original additional 150 percent investment. of the principal for interest to accrue over the term of the loan. For technical assistance Annex 5: Investment Insurance Programs 125 Germany (C&L Deutsche Japan United States MIGA Revision AG) (EID/MITI) (OPIC) contracts, and the like: 95 percent of the total value of payments due. Risk premium Premiums are For all types of Combined premium Premiums are determined on coverage 0.5 percent rate of 0.55 percent- determined based on predefined "base per year on total 1.75 percent per year the characteristics of rates" in relation to insured amount. (depending on the coverage provided, the type of industry Handling fee 0.1 host country)is charged the project, the host such as: percent flat investment for all risks. country, and the type 1) Manufacturing < DM10 million plus of industry period. and Services 2) Natural 0.05 percent flat for Base rates are defined Resources (including amounts exceeding in relation to the type agribusiness and DM10 million of industry such as: forestry) 3) Oil and (capped to 1) Manufacturing and Gas/Infrastructure DM20,000). Services and the type of 2) Institutional Loans coverage (currency and Leases transfer, expropriation, 3) Oil and Gas breach of contract, war 4) Natural Resources and civil disturbance) 5) Contractors and and range from 0.25 Exporters, and the percent to 1.25 percent type of coverage per year. No differentiation (inconvertibility, between equity and debt. expropriation, Base rates may be adjusted political violence) depending on project's and range from 0.20 risk profile (economic percent to 1.50 percent and political conditions per year. Base rates can of host country). be adjusted up or down Application fee: by 30 percent, US$5,000 investment< depending on the risk US$25million, profile of the project. US$10,000 investment >US$25million (fee is credited against first year's premium). Optional processing fee of US$25,000 depending on com- plexity of the project and/or the environ- mental sensitivity to cover unusual MIGA underwriting costs. Unused portion of the processing fee (table continues on next page) 126 Concessionsfor Infrastucture:A Guide to Their Design and Award Investment Insurance Programs (continued) Germany (C&L Deutsche Japan United States MIGA Revision AG) (EID/MITI) (OPIC) will be deducted from the first-year premium. Indeminification/ recovery: Inconvertibility/ Compensation paid Compensation is Compensation is Compensation is paid nontransfer upon receipt of based on the gross paid up to the on the basis of the blocked local amount of the loss insured amount prevailing rate of currency and in the of an investment. The limit (actual-loss) exchange for the currency stated in the gross amount of the and based on the blocked local currency, guarantee contract. loss on an investment following formula: is with respect to a loss x 95 percent participation or, in the (political)