Reconsidering PPPs in Developing Countries

COVID-19 will shape our economies and societies for decades to come. As governments consider the opportunity to invest in infrastructure as a way to stimulate domestic economies, it is likely that there will be requests by private sector operators to review existing PPP contracts. How governments approach reviewing existing contracts has the potential to influence the economic, environmental, and social outcomes that infrastructure will deliver in the coming decades.

One of the implications of COVID-19 will be to slash the projections that have been the basis of many private infrastructure investment decisions. Whether it be passengers through airports, goods through ports, commuters on trains and toll roads, or oil and gas through pipelines, it is likely that private infrastructure operators will experience significantly reduced cash flows.

One of the implications of COVID-19 will be to slash the projections that have been the basis of many private infrastructure investment decisions.

The way in which private sector operators respond to reduced cash flow is likely to depend on the degree to which assets have been leveraged. As we are starting to see in other industries, heavily indebted businesses may struggle to survive. The question for investors that do survive the initial impacts of COVID-19 is: how well is the asset equipped to manage the future?

Renegotiating PPPs

Internationally, there has been relatively little attention paid to the renegotiation of PPPs. According to the Global Infrastructure Hub, of the 250 PPP global projects it has examined, 45% of contracts are renegotiated by their 10th year after financial close, with almost 20% experiencing renegotiation by their fourth year. A Global Infrastructure Hub study found that, of 48 instances of renegotiation in 146 projects that were reviewed, the most common cause of renegotiation was found to be increased costs in construction or operations, and the most common outcome of a renegotiation was a change in tariffs.[i] Previous work by the World Bank[ii] had revealed that renegotiation was far more likely when concession contract awards were based on the lowest proposed tariff rather than on the highest transfer fee.

Private infrastructure operators may seek to bring governments to the negotiating table through the use of “force majeure” clauses in contracts. Governments may, in turn, be tempted to try to take control of assets through nationalization, possibly with the risk of investment arbitration. Approaching renegotiation from the basis of conflict, however, is unlikely to result in great outcomes for either party. Having spent so much money stimulating local economies during the pandemic, governments are not in a good position to spend more money acquiring assets. For the private sector, government support will be needed to adapt the asset to manage both the reduction in cash flow and uncertainty about the future.

Adapting Infrastructure

The post-COVID-19 environment presents an opportunity to adapt an infrastructure asset to ensure it is fit for the future. In particular, embedding sustainability into the management of infrastructure is critically important to manage both the short- and long-term impacts of climate change.

One of the challenges with PPP contracts is that a 25 to 30-year contract period does not reflect the changing world we live in. As we know, the world 30 years ago was very different from today. Back in 1990, Tim Berners-Lee was just completing research that resulted in the establishment of the World Wide Web. A government or private operator negotiating an infrastructure contract in 1990 would have had little idea of the changes that would be unlocked over the coming 30 years. Contracts made 30 years ago, based on user expectations in the 1990s, would clearly be not-fit-for purpose today.

This lesson holds true for those renegotiating infrastructure contracts today. Scientific evidence suggests that 2050 is the critical date by which we need to move to net-zero carbon emissions if we are to avoid the catastrophic impacts of climate change and limit global warming to 1.5°C. Reviewing PPP contracts today provides an opportunity to reduce the energy intensity of infrastructure while making investments that will enable the asset to adapt to the impacts of climate change over the next 30 years. Climate change also poses a number of physical threats to infrastructure, with rising sea levels, increased risk of drought in some areas, shifting rainfall patterns, and greater prevalence of temperature extremes, including a change in the intensity and frequency of extreme events.[iii] Adapting infrastructure today has the potential of preventing future losses, with the World Bank estimating that “building back better” after disasters could save up to USD 173 billion per year globally in well-being losses due to natural disasters, compared to business as usual.[iv]

Scientific evidence suggests that 2050 is the critical date by which we need to move to net-zero carbon emissions if we are to avoid the catastrophic impacts of climate change and limit global warming to 1.5°C.

New technology also has the potential to change demands for infrastructure while simultaneously creating new opportunities for the delivery of infrastructure services. Examples of changing technologies include pay-as-you-go systems that are creating the opportunity to deliver off-grid solar systems for communities that are not connected to the grid. The rise in demand for electric vehicles is creating demand for new charging infrastructure while the rapid reduction in the cost of solar is shifting the peak supply of electricity to the middle of the day, with subsequent opportunities for battery storage systems. The combination of changing technology and the need to reduce fossil fuel energy use creates the need for infrastructure to adapt across its user life in order to meet the changing needs of future users in the years ahead.

For governments, a significant question is what mechanisms can be introduced into renegotiations that test whether an infrastructure asset is adapting. In the 1970s, renowned management strategist Peter Drucker proposed a business innovation audit that may be worth revisiting today. Recognizing that the growth of the pension industry in the United States would have fundamental implications for capital formation and the U.S. economy, Drucker argued that, as capital market decisions shifted from entrepreneurs to trustees, the impact would be that, as institutional investors followed the “prudent man rule,” investment behaviour would change. His argument was that there would be a need for new institutional structures that would support pension funds to keep management accountable. He called for a business audit that would be conducted by an independent professional agency every three years that would sit alongside the financial audit. The business audit would go through a “systematic evaluation of business performance; starting with mission and strategy, through marketing, innovation, productivity, people development, community relations, all the way to profitability.”

There is a huge opportunity for governments to use renegotiation to open up opportunities to adapt an asset to meet economic, social, and environmental outcomes that are outside of negotiations on tariffs and costs. Drucker’s idea of a business innovation audit could be introduced into PPP renegotiations as a way of nudging infrastructure operators to constantly adapt their assets. In addition to requiring a regular “sustainability business innovation audit,” governments could embed sustainability into the asset’s strategy by requiring the infrastructure operator to report regularly on the following questions.

• What are the likely future demands that will be placed on the infrastructure asset?
• In what ways can the asset be adapted to better serve economic, social, and environmental needs?
• What are the impediments to adapting the asset, and how could these be addressed?

The purpose of these three questions is to create an understanding among the contract parties of the new possibilities that may not be otherwise be considered in a traditional negotiation. There are no right or wrong answers to these questions. The intention of the questions is to unearth the potential for adaptation of the asset. The answers that are provided can then be used as the foundation for subsequent negotiations.

Enhancing Transparency

A second area of focus for the renegotiation of PPP contracts is to enhance transparency. One of the criticisms levelled at PPPs is the lack of visibility of contract terms. There is an opportunity to use the renegotiation of PPPs to require infrastructure operators to publicly report information on their sustainability performance. Existing disclosure frameworks, such as the Global Reporting Initiative, provide a platform for reporting sustainability performance. Five global reporting frameworks, CDP, the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC) and the Sustainability Accounting Standards Board (SASB), issued a statement in September 2020 committing to work together to establish a shared vision of the elements necessary for more comprehensive transparent measurement and disclosure of sustainability performance.[vi]

Using Renegotiation to Propose New Models

A broader question is whether governments can use the opportunity of renegotiating a PPP to completely review the structure of an asset. In this regard, governments need to understand institutional investors’ appetites to own infrastructure assets.

With global interest rates at record low levels, institutional investors have been increasingly allocating to infrastructure as an asset class.

According to industry analyst Preqin, in 2019, USD 98 billion was raised from investors, with assets under management standing at USD 582 billion. The increased allocation to infrastructure has included the emergence of mega-private capital funds, with half of all capital raising in 2019 going to just five funds.

Rising institutional investment in infrastructure has led to rising prices for infrastructure, which has incentivized governments to consider private investment. In Australia, “asset recycling” emerged as a new term that sought to make privatization palatable to the Australian community.

The use of the term was first given traction in Australia by the premier of New South Wales, Mike Baird, who stood for re-election in March 2015 on a platform of privatizing 49% of Ausgrid, an electricity distribution company that owns, maintains, and operates the electrical networks supplying Sydney and parts of regional New South Wales. Baird argued that proceeds from the sale of Ausgrid would be used to invest in new road construction projects to relieve growing city congestion.

After being successfully re-elected, Premier Baird’s first attempt to sell 50.4% of Ausgrid to the State Grid Corporation of China and Cheung Kong Infrastructure Holdings was formally rejected on August 11, 2016, by the Australian Treasurer, based on national interest grounds. Subsequently, a consortium consisting of major Australian superannuation funds acquired Ausgrid for AUD 16 billion.

The Victorian Government in Australia also used asset recycling as a justification for the sale of the Port of Melbourne in September 2016 for AUD 9.7 billion. Proceeds were used to remove level crossings across Melbourne’s rail network and to invest in a significant Metro upgrade and regional infrastructure.

Despite being able to successfully sell assets at a peak in the market, asset recycling has not been all smooth sailing in Australia. As part of employment guarantees under the terms of its partial privatization, Ausgrid has been criticized for being slow to restore power in recent intense storm events and bushfires that impacted Sydney and its regions. Ausgrid has maintained that its employment is above the levels required as part of privatization. In Victoria, the state’s economic regulator, the Essential Services Commission, is currently investigating if the Port of Melbourne is charging tenants rents above market rates, as well as examining if the efficiency of tenants’ operations has been reduced since privatization.

For developing countries, there are two core challenges with “asset recycling.” The first is that developing countries may not have the mature infrastructure assets that institutional investors are seeking and willing to pay a premium for. The second is that institutional investors may not pay a premium price for an asset in a developing country that they have been prepared to pay in developed markets.

There is, however, one element from the asset recycling debate that developing countries should consider. In a renegotiation situation, there is a question as to whether the PPP structure should be thrown away and a new structure introduced. The experience of asset recycling has illustrated that institutional investors are prepared to pay a premium to control an asset and are also content to have government as a co-shareholder.

The reason that an investor is willing to pay a premium to control an asset is the same as with a corporate merger. Investors anticipate that, by having control, they can make changes to an asset that will improve their long-term returns. The appetite for control reflects the understanding by institutional investors that infrastructure is a business, not an asset. Re-establishing infrastructure as a business rather than a contract addresses one of the key challenges with PPP structures, which is the underlying assumption that the asset won’t change over the length of the concession. Having government as a co-shareholder is also a way to ensure that the interests of communities are prioritized.

Conclusion

It is arguable that PPPs were never fit for purpose for developing countries. Defining long-term key performance indicators in PPPs is difficult due to rapid changes in technology and society. For PPPs to work efficiently, there is a need for competitive tension among competing teams that may not always be present in developing countries. Where contracts are negotiated, it makes little sense for the project and finance expertise to then disperse.

There is an opportunity to use a PPP renegotiation, or a negotiation to establish a new PPP, to establish an infrastructure business. Through the regular business review process, an infrastructure business provides a better platform to adapt to future challenges. As we have seen with asset recycling in Australia, an infrastructure business also offers the ability for a government to hold equity. The importance of equity ownership in the context of a developing country is that it provides a mechanism where the benefits from the continual adaption of an asset, including new investments as the infrastructure business matures, are shared among government and institutional investors. This provides a foundation for trust, unlike the PPP structure, which, it is argued, institutionalizes conflict.

COVID-19 is likely to place financial stress on many infrastructure contracts. With the potential for a disruption in established business, infrastructure operators will not be immune. Reconsidering PPPs provides an opportunity for a reset that can align the infrastructure asset with the future needs of the city in which it resides.