Demand Risk for Russian PPP/IPP Projects

20.03.2014

World Finance Review, March 2014

Infrastructure facility output demand is a vital indicator of economic success. Lack of demand can constitute a quite substantial risk, so, to encourage private investment and ensure recoupment, the state (mainly interested in the facility itself) sometimes assumes this risk. Below are certain aspects of this risk in relation to Russian PPP and IPP projects.

DEMAND RISK AND TARIFF REGULATION

Infrastructure facility output (solid domestic waste disposal, electricity supplied to certain consumer categories, electricity transmission services, heat and its transmission, etc.) often has to be sold at regulated prices (tariffs). Therefore, the investment recoupment often depends on rates, established by the relevant authority. The prices (tariffs) shall be: (i) high enough (sufficient to cover the costs) and (ii) cheap enough (affordable for consumers).

Yet the public partner often cannot unconditionally guarantee acceptable tariffs because:

  • Many tariffs envisage a limited list of costs and relevant standards. Fixed asset repair costs for electric power, for instance, proceed from the cost standards approved by the Russian Energy Ministry and Rosatom.
  • Tariff regulation is the domain of various-level state authorities: for solid domestic waste decontamination, tariffs are set by regions, while tariff surcharges for consumers are established by municipalities.
  •  Tariff setting (by regulation sphere and method) is usually governed by profit margin rules not taking full account of the project financing specifics and terms.
  • Tariff setting may not be within the competence of the public partner but may be the responsibility of a different level authority (for heat and water supply, for example, tariffs are usually set by the constituent entity authority, whereas a local government body might exercise public partner powers).
  • Tariffs have a limited term, differing by regulation sphere and method. They are usually set for a year but, even when regulation is based on long-term parameters, are adjusted annually.
  • Even given a fair tariff, the relevant legislation might be amended, as has happened regularly in relation to tariff regulation for engineering/utility organisations.

If the tariff is too high (for covering costs and investments), consumers might not be interested in using the relevant facility (an excessive road toll, for instance, will force drivers to take alternative routes; a too high heat tariff will put consumers off, etc.). Take the GTPP Kolomenskoye project.

In early 2004, the Moscow Government officially predicted connection, by 2010, of additional municipal capacity of 3.9 th MW of electricity and 9.8 th GCal/h of heat and recognised that new generating capacity needed to be built, including using private funds.

In 2006, a public tender resulted in the Moscow Government concluding an investment contract with the privately-owned NaftaSib Energy LLC on the following terms: (i) NaftaSib builds a 136 MW gas turbine power plant and 171 GCal/h of heat capacity using its own and borrowed funds; (ii) NaftaSib holds the title to the GTPP; (iii) NaftaSib pays budget revenues for 20 years (strangely defined as “payment for land plot lease”).

For building the GTPP, the private partner intended to engage the Moscow heat-supply company OAO MOEK, later to become the main heat consumer, but the GTPP was ultimately built without MOEK’s participation.
In 2009, GTPP Kolomenskoye won the competition “Utility infrastructure facility (including utility networks and Moscow Government Economic Complex facilities)”.

Since GTPP Kolomenskoye was built using private and borrowed funds, the tariff was set for recouping credit investments and leasing, topping that of Moscow’s main heat supplier, MOEK The assumption was that MOEK would be the GTPP’s main consumer and would, in turn, sell heat to end consumers (the cost of the higher GTPP tariff being passed on to MOEK consumers).

On 30 November 2011, MOEK cancelled the agreement owing to the excessive tariff and, from January 2012, GTPP Kolomenskoye was disconnected from the MOEK heat network. NaftaSib, which built GTPP Kolomenskoye, is currently undergoing bankruptcy proceedings.

In 2013, two other power plants of outside investors, TETs ZIL and TPP Mezhdunarodnaya, functioned on the Moscow heat-supply market and construction of three new energy sources was nearing completion. According to official sources, in order to ensure sale of MOEK heat, the TPP Mezhdunarodnaya tariff was deliberately set lower than required for covering investments.

MITIGATION OF RISKS AND POSITIVE DEVELOPMENT TRENDS

Guarantee of stable prices (tariffs) and recent legislative amendments

Recent amendments to the Russian legislation establish certain private partner guarantees mitigating these risks with respect to road tolls under PPP concession projects.

On 10 January 2014, a Federal Law came into force stipulating that a toll road concession agreement include the maximum toll (not exceeding the limit set by the competent authority)and indexation of it. The parties may agree to change this condition only proceeding from a decision of the Russian government, Russian Federation constituent entity or local government body (depending on the level of the project) and only if rules substantially against the concessionaire’s interests are introduced.

The public partner bears the lack-of-demand risk

Construction of the M11 Moscow-St Petersburg Highway from 334 to 543 Km, structured as a long-term investment agreement, provides another example. This road sector is characterised by both a relatively high construction cost and the risk of a high toll meaning demand fails to cover costs.

As a mitigation method, the state was to bear the lack-of-demand risk. Project payback is guaranteed by payments from the public partner (not road tolls) as follows.

During investment: (i) prepayment of 30% of the stage against a bank guarantee; (ii) work performed and confirmed by relevant certificates (less the prepayment and the private partner’s investment element). The finance sources consist of construction subsidies and bond issues, while obligations to place and maintain bond issues are borne by Avtodor.

During operation: (i) quarterly operational payments; (ii) annual repair payments against a bank guarantee; (iii) annual investment payments consisting of: (a) an irreducible amount, including the nonindexed sum for paying back the borrowed funds, and the indexed sum for paying a return on borrowed funds; and (b) a reducible amount, paid provided the facility complies with transport and operational parameters, including a non-indexed amount - to pay back own funds and the indexed amount - return on own funds.

The toll is paid directly to the budget rather than the private partner.

Specific of lack-of-demand risk in concession projects

By federal law, a concession agreement public partner may also assume some of the PPP facility creation and use costs. However, this relates to particular concession projects only (highways, highway sectors, auxiliary structures and road service facilities) and provided the concessionaire does not receive other
creation and use payments and that the given payment constitutes a tender condition. Possibility of public partner payment is not envisaged for other facilities, so sometimes such projects are not structured as concession agreements.

In some cases (tariff regulation or payment by the concessor), the private partner may be released from making a concession payment (i.e., traditionally contributed to the budget during PPP facility use). Only in July 2010 did it become possible to structure concession projects without a concession payment.

One concession project where the public partner bore the lack-of-demand risk was the Km 543-684 sector of the Moscow-St Petersburg Highway, for which the federal budget finance consisted of: (i) partial financing of the road-building costs (capital grant); (ii) payment by the concessor, including: (a) operating payment (for road maintenance costs); (b) investment payment (for road-building costs in consideration of returns on invested capital; (c) additional payment (only if more tolls are collected than anticipated).

However, public partner financial obligations also entail other problems.

Budget limitations

Russian budget outlays are specified for the relevant budgets’ expenditure obligations for each financial year (and planning period). The draft federal budget is approved for three years: the financial year and planning period, whereas Russian constituent entity or local budgets are set for one or three years (as above).

Recent positive amendments to the budget legislation (law of 2 July 2013) permit concession agreements to last longer than the approved budget limit term.

It is also possible to approve budget allocations for long-term target (sub) programmes but, on the basis of the annual programme appraisal, the competent authority may cut or terminate such allocations early.

Most PPP projects involving state financial obligations thus entail a risk of them not being fulfilled.

Russia also has special regulations on use of budget funds to create publicly useful facilities, such as those on placement of state or municipal orders regulating facility creation out of budget funds, which stipulate a special tender procedure and model for contracts and co-operation. The legislation on state and municipal orders may thus potentially apply to PPP projects involving payments from the budget.

Construction of the M11 Moscow-St Petersburg Highway from 334 to 543Km, structured as a long-term investment agreement, provides another example. This road sector is characterised by both a relatively high construction cost and the risk of a high toll meaning demand fails to cover costs.

There have been recent court decisions confirming the possibility of reclassifying and invalidating PPP agreements, though they are few in number and relate to obvious violations or attempts to bypass legislative restrictions.

The given legislative contradictions and gaps may be resolved by the draft law “On the Fundamentals of PPP in Russia”, currently being considered by the State Duma. On 26 April 2013, the Draft PPP Law passed its first reading out of three. To become law in Russia, it should also be approved by the Federation Council, signed by the President and promulgated. Particular attention should be paid to preparation of a PPP project, including the choice of form, in order to foresee potential risks and preclude unfavourable consequences, if possible.

Russian budget outlays are specified for the relevant budgets’ expenditure obligations for each financial year (and planning period). The draft federal budget is approved for three years: the financial year and planning period, whereas Russian constituent entity or local budgets are set for one or three years (as above).

http://www.worldfinancereview.com/issue/pp_14_15.pdf

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