68346 Pakistan: Contingent Liabilities from Public Private Partnerships July 2010 Final Report Confidential Final Report Pakistan: Contingent Liabilities from PPPs Report to the World Bank and the Ministry of Finance, Government of Pakistan July 2010 Copyright Castalia Limited. All rights reserved. Castalia is not liable for any loss caused by reliance on this document. Castalia is a part of the worldwide Castalia Advisory Group. Confidential Confidential Table of Contents List of Acronyms, Abbreviations and Definitions i Executive Summary ii 1 Introduction 1 1.1 Background on the Assignment 1 1.2 Content of the Report 2 2 Why it is Important to Manage Contingent Liabilities 4 2.1 Exposure to Contingent Liabilities from PPPs 4 2.2 Existing Policies and Processes are Incomplete 5 3 How to Improve the Management of Contingent Liabilities 7 3.1 Structuring Contingent Liabilities 9 3.2 Analyzing Contingent Liabilities 33 3.3 Approving Contingent Liabilities 39 3.4 Accepting Contingent Liabilities 43 3.5 Monitoring Contingent Liabilities 44 3.6 Disclosing Contingent Liabilities 47 3.7 Acting on Emerging Contingent Liability Risks 49 3.8 Budgeting and Paying for Realized Contingent Liabilities 50 4 Who Should be Responsible for Managing Contingent Liabilities 54 4.1 Option 1: Strengthen Existing Institutions 55 4.2 Option 2: Establish an Independent Guarantee Fund 59 5 How to Implement the Recommendations 60 6 Evaluation of International Experience 62 6.1 Colombia 62 6.2 Brazil 65 6.3 Indonesia 67 6.4 Chile 69 6.5 Victoria, Australia 71 6.6 Lessons from the International Examples 73 Confidential Tables Table 0.1: Summary of Recommendations for Contingent Liability (CL) Management in Pakistan iv Table 3.1: Example of a Preferred Risk Allocation Matrix 11 Table 3.2: Analyzing Categories of Contingent Liabilities from PPPs 37 Table 3.3: Possible Rules for Approving Contingent Liabilities 40 Table 3.4: Possible Rules to Limit Overall Fiscal Impact of Contingent Liabilities 42 Table 3.5: Sample Template Monitoring Plan 46 Table 3.6: Example of Disclosure Information 49 Table 3.7: Approaches to Budgeting and Paying for Realized Contingent Liabilities (CLs) 52 Table 4.1: Analysis of Alternatives for Strengthening Existing Institutions 57 Table 6.1: International Approaches to Contingent Liability System Features 74 Figures Figure 3.1: Functional Components of Managing Contingent Liabilities 8 Figure 5.1: Timeline of the Implementation Action Plan 60 Figure 6.1: Colombian Guarantee Management—Institutional Structure 64 Figure 6.2: Brazilian Guarantee Management – Institutional Structure 66 Figure 6.3: Indonesian Guarantee Management – Suggested Institutional Structure 68 Boxes Box 3.1: Policies for How to Structure Contingent Liabilities 32 Box 3.2: Possible Methodologies for Valuing Contingent Liabilities 34 Box 3.3: How Disclosure can Improve a Country’s Credit Ratings 48 Confidential Confidential List of Acronyms, Abbreviations and Definitions Contingent liability A payment obligation whose timing and/or magnitude is dependent on the occurrence of some uncertain future event Contracting authority The government agency, department or state-owned enterprise entering into a public private partnership DPCO Debt Policy Coordination Office FRDLA Fiscal Responsibility and Debt Limitation Act of 2005 Government guarantee A legal or contractual arrangement under which the government agrees to fulfill a financial obligation to a private party or separate government entity IA Implementation Agreement IPDF Infrastructure Project Development Facility IPFF Infrastructure Project Finance Facility IPP Independent power producer MOF Ministry of Finance NHA National Highway Authority NTDC National Transmission and Despatch Company PEPCO Pakistan Electric Power Company PPA Power purchase agreement PPIB Private Power Infrastructure Board PPP Public Private Partnership PPP Task Force A group of senior officials from Ministries and agencies of Federal and provincial governments established to advise on PPP policy Proponent The private party entering into a public private partnership the Government Government of Pakistan/Federal Government of the Islamic Republic of Pakistan VGF Viability Gap Funding WAPDA Water and Power Development Authority Copyright Castalia Limited. All rights reserved. Castalia is not liable for any loss caused by reliance on this document. Castalia is a part of the worldwide Castalia Advisory Group. Confidential Executive Summary This Final Report is the fourth and final deliverable in Castalia’s assignment, funded by the World Bank, to improve how contingent liabilities are managed in Pakistan. The report presents our recommendations on how Pakistan should improve its policies and processes for issuing and managing contingent liabilities associated with public private partnerships (PPPs) in infrastructure. Our recommendations are based on: An assessment of the current exposure to contingent liabilities, including the effectiveness of the existing policies and processes governing PPPs generally, and contingent liabilities specifically (we describe the assessment in a Status Quo Report presented in Appendix A of this report) A comparison of international experience and best practice for managing contingent liabilities. Feedback received from Government stakeholders during a workshop help in Islamabad on July 21, 2010 (information from the workshop is presented in Appendix B of this report) We recommend that the Government: Adopt policies to include eight specific functions for managing contingent liabilities during the PPP development, approval, and implementation process: – Structuring contingent liabilities and designing contractual mechanisms according to good principles for allocating risk – Analyzing the contingent liabilities that will be accepted under a proposed project – Evaluating and approving the contingent liabilities the federal Government will be exposed to when entering into a PPP – Reviewing executed PPP contracts and formally accepting the contingent liabilities to make the contingent liabilities explicit – Monitoring those contingent liabilities while the project is being constructed and implemented – Regularly and publicly disclosing the contingent liability exposure – Taking mitigating action where necessary to reduce the likelihood or cost of the contingent liability becoming real – When necessary, budgeting for and paying for contingent liabilities that have realized. Allocate responsibility for performing the recommended functions to existing institutions—specifically: – The Ministry of Finance (MOF) as key the oversight agency responsible for approving financial commitments to PPPs – The Debt Policy Coordination Office (DPCO) as the division within MOF responsible for providing administrative leadership at the central level ii Confidential – Contracting authorities as the implementing agencies responsible for complying with evaluation, submission and approval requirements, monitoring, reporting to DPCO, and taking action on emerging risk – The Infrastructure Project Development Facility (IPDF) as the agency responsible for supporting contracting authorities and DPCO. Table 0.1 summarizes our recommendation in more detail. We then explain why we arrived at the recommendations and the next steps to finalize our assignment. iii Confidential Table 0.1: Summary of Recommendations for Contingent Liability (CL) Management in Pakistan How it should be Next Steps: What legal and procedural Function Why is it important Who should do it? performed? changes are needed? Structuring CLs and Because it is important that Develop and apply risk Contracting authorities Draft policy (and revise PPP Bill) to designing contractual projects are developed allocation principles when should develop and apply include a check for compliance with mechanisms by which according to sound principles structuring PPPs principles that are approved MOF-approved guidelines when the Government bears for risk allocation and PPP Develop and use draft by MOF reviewing and approving CLs risks under a PPP structuring, which are contractual mechanisms for IPDF should support Provide capacity building support to contract essential to providing value structuring CLs contracting authority, as IPDF and contracting authorities to for money—current needed develop and use structuring guidelines principles and guidance are and contractual mechanisms (beginning incomplete with pilot projects) Analyzing the CLs Because the Government has Use various qualitative and Contracting authorities MOF to develop and issue guidelines for that will be accepted implemented PPPs without quantitative methods to should analyze CLs, analyzing CLs under a proposed making the cost or risk evaluate the potential cost to following valuation Provide capacity building support to project associated with its financial Government of accepting the guidelines developed and IPDF, DPCO, and contracting commitment through CLs CL approved by MOF authorities on how to analyze CLs clear—for example, IPDF should support (beginning with pilot projects) obligations in the energy contracting authority, as sector needed Approving those CLs, Because there is a need to Include CLs evaluation and MOF should provide the final Draft the policy (and revise PPP Bill) to found to be consistent strengthen the centralized approval in the PPP approval approval based on certification include specific submission requirement with structuring process being followed by process: of compliance from DPCO for contracting authorities to follow principles and good which the Government can Check CL structure (with support from IPDF as needed) fiscal management evaluate if the CLs are Assess the results of the Develop evaluation tools for DPCO to consistent with good fiscal analysis of CLs certify compliance management and approve the Ensure DPCO has the resources and Introduce rules to limit financial commitments from capacity to evaluate submissions overall fiscal impact of CLs CLs (such as ceilings or defined budgeting requirements). iv Confidential How it should be Next Steps: What legal and procedural Function Why is it important Who should do it? performed? changes are needed? Formally accepting Because the Government’s Create a distinct legal MOF should sign an Determine legal restrictions for state- the CLs defined in commitment to CLs should agreement acknowledging “agreement letter� after the owned enterprises versus agencies executed PPP be explicit and include a the Government’s CL CLs are analyzed, final PPP Develop and issue a draft “agreement contracts process for checking that commitments and/or contracts are checked, and letter� executed contracts are review final PPP contracts DPCO has certified Include the process for formally consistent with approval before signing compliance with relevant accepting CLs through an “agreement terms policies (FRDLA and PPP letter� in the revised approval process Policy) specified in the PPP policy (and Bill) Monitoring those CLs Because the Government Systematically collect Contracting authority Require reporting requirements to be while the project is does not have a central project and other should include reporting included in PPP contracts and in being constructed and database of what PPPs it has information requirements in draft “agreement letter� implemented implemented, what CLs they Periodically re-evaluate CLs contracts Develop template monitoring plans for contain, and what risks are Maintain a central database Contracting authority executed PPP projects, and include the associated with the CLs; and should develop and follow plan in the submission requirements monitoring this information monitoring plans, gather when approving projects will keep officials informed data for analyzing and re- Provide capacity building support to of exposure and emerging valuing exposure, and IPDF, DPCO, and contracting risks report exposure to DPCO authorities (beginning with pilot IPDF should support projects). contracting authority, as needed. Regularly and publicly Because it will strengthen the Regularly publish information DPCO should include CLs Develop an outline for a section in the disclosing the CL Government’s existing on CLs from PPPs as a part of from PPPs in the annual Debt Debt Policy Statement on CLs from exposure disclosure policies and other public debt and fiscal Policy Statement. Information PPPs following international principles principles and disclosing can policy documents for completing the report for reporting CLs improve accountability and should be collected through Ensure DPCO has the capacity to increase transparency of the the monitoring function (see produce the report Government’s commitments above) Include CL section in next report to third parties (such as credit agencies and lenders) v Confidential How it should be Next Steps: What legal and procedural Function Why is it important Who should do it? performed? changes are needed? Taking mitigating Because the Government Identify risks and take Contracting authority Include identifying risks and taking action where may be able to avoid some coordinated action based on should take any action to mitigating action in the template necessary on emerging costs associated with monitoring information, manage the Government’s monitoring plans (see above) CL risks problems in the past if risks identify—for example, action exposure Assign a “project officer� from the are identified and action was by the contracting authority DPCO should ensure the contracting authority or IPDF to liaise taken to reduce the with support from the Ministry contracting authority is with oversight and regulatory bodies. likelihood or cost of liabilities of Finance or IPDF taking actions where realizing—for example, by necessary, and to provide notifying officials of the costs support when appropriate associated with keeping IPDF should support tariffs low or delaying the contracting authority, as issuance of permits and needed increasing incentives for good decisions When necessary, To ensure resources are Options should be evaluated, Contracting authorities should Evaluate the options (during a pilot-test) budgeting for and available to make payments including have budgetary accountability and determine the preference of MOF to paying for CLs that promptly when required— Setting aside funds in for CLs to provide better budget and pay for CLs have realized improving credibility and advance towards possible incentives to accept the right Include a clause in the Bill stating the clarity as to how costs of CLs future payments CLs, and to manage those CLs policy will be borne, and mitigating Budgeting for expected well Ensure that draft PPP contracts the fiscal impact upcoming payments explicitly comply with the requirements Creating budget flexibility for CLs to accommodate payments when needed. vi Confidential Why enhance the roles of existing institutions? We believe the Government is best served by adopting an institutional framework for managing contingent liability that enhances the roles and responsibilities of existing institutions, as outlined above. This option has the advantages of: Being consistent with the existing mandates of each agency and the basic policy and regulatory framework laid out in the 2010 PPP Policy and draft PPP Bill Being appropriate for the size of the problem—Pakistan has limited experience with PPPs outside of the energy sector, and therefore has limited exposure to contingent liabilities outside of that sector. The main problem the Government needs to address is the weak and unclear policies and processes that are currently in place Not being overly onerous or costly to implement—more complex and sweeping reforms would likely be less flexible, take longer to implement, and the benefits would be more uncertain. Establishing sound policies and practices, and building strong capacity among existing agencies more quickly, is also more likely to create an environment that is attractive to private and multilateral investors. In selecting this preferred institutional option, we also analyzed the option of establishing an independent Guarantee Fund as a Government-owned company that issues and manages financial guarantees to PPPs, which create contingent liabilities. To date, there is limited international experience in developing Guarantee Funds, and the possible advantages have for the most part not been tested. Therefore, the practical benefits of establishing a Guarantee Fund are far from certain. Moreover, the cost of establishing such a complex institution is unlikely to be justified based on the Government’s existing exposure to contingent liabilities, which is concentrated in the energy sector. What are the next steps to implementing the recommendations? The next steps required to begin implementing the recommendations are to: Pilot-test the contingent liability management recommendations on at least one live PPP project that is in the early development or feasibility stage. A pilot-test will provide an opportunity to evaluate and refine the recommendations. It will also offer the opportunity to train staff in contracting authorities, IPDF and DPCO, and provide valuable hands-on experience and guidance in closing a high- priority PPP transaction Evaluate and revise the proposed contingent liability management framework based on the results of pilot-testing Amend and update the PPP Policy (or secondary legislation) and the enabling PPP Bill to enforce and implement the recommendations Revise, if necessary, and adopt the Draft Procedures Manual Castalia prepared for agencies to use when performing their responsibilities Provide ongoing training and capacity building, and ensure each agency— particularly DPCO—has the resources to carry out its role in the contingent liability management framework. vii Confidential 1 Introduction The Government of Pakistan (the Government) wants to strengthen the institutional framework for managing contingent liabilities associated with public private partnerships (PPPs) in infrastructure. Castalia has been asked to make recommendations on how to improve the policies and processes for issuing and managing contingent liabilities associated with public private partnerships in infrastructure—this includes identifying what functions should be adopted to ensure the benefits of good management of contingent liabilities and the appropriate institutional framework for carrying out those functions. This report is the fourth and final deliverable for the assignment, which is funded by the World Bank. The purpose of this report is to answer the following questions: Why is it important to manage contingent liabilities in Pakistan? The answer to this question draws from Castalia’s work assessing the status quo for managing contingent liabilities in Pakistan (see Appendix A), and provides the evidence necessary to develop recommendations that are best suited for Pakistan How can Pakistan improve how contingent liabilities are managed? In answering this question, we recommend the specific functions that Pakistan should adopt. We also explain how the functions we recommend could be performed to provide the most benefit Who should be responsible for managing contingent liabilities? The answer to this question provides the basis for decision makers to determine the best institutional arrangement for carrying out the recommended functions and achieving the benefits of sound management of contingent liabilities within the existing context. The following sections of this report present analysis to answer each of these questions. The remainder of this introduction provides background on the assignment (Section 1.1) and describes the content of the report (Section 1.2). 1.1 Background on the Assignment The Government has identified public private partnerships as an important option for delivering infrastructure services and closing the financing gap in infrastructure investment in Pakistan. PPP contracts have been entered into in the past—particularly, in energy, roads, and ports and shipping sectors—and the Government intends to use PPPs more widely and increase the number of PPPs going forward in infrastructure. A well-designed PPP will often include Government guarantees or will allocate some risks to the Government to make sure the transaction can be completed, and to reduce the total upfront project costs by retaining some risk that it is more practical or more efficient for the public sector to manage. Retaining risk and issuing guarantees create contingent liabilities. The Government has some contingent liabilities from existing PPPs, and as the Government’s stock of PPPs grows, so will its exposure to underlying risk associated with these obligations. However, there are costs associated with the provision of contingent liabilities. 1 Confidential Contingent liabilities create the possibility that the Government may be obligated to make unexpected and substantial payments. These uncertain payment obligations expose the Government to fiscal risk that can create budgetary uncertainty and put the public debt on an unsustainable path. Therefore, effective PPP policy will include a sound framework for deciding when to issue guarantees and managing the fiscal risk arising from guarantees. Improving how contingent liabilities associated with infrastructure PPPs are managed can encourage better decision making, enhance fiscal stability, improve sovereign credit ratings, and lower the cost of borrowing. This assignment aims to develop policies, procedural guidelines, and implementation plans for managing contingent liabilities through four primary tasks: Task 1: Inception—Identify the scope of the assignment and prioritize the objectives of an institutional framework for managing contingent liabilities Task 2: Assess Current Framework and Exposure—Preliminarily assess the Government’s existing exposure to fiscal risk arising from contingent liabilities; identify and assess the current institutional framework governing contingent liabilities in Pakistan; and determine the gaps that should be addressed to strengthen the policies and processes for managing contingent liabilities from PPPs Task 3: Identify and Analyze Options—Identify and analyze options that address the key gaps in the institutional framework from Task 2 will help achieve the benefits of good management of contingent liabilities in Pakistan Task 4: Develop Final Recommendations—Develop a final set of policy recommendations, guidelines, and tools needed to implement the preferred institutional framework for managing contingent liabilities from Task 3. The assignment is a continuation of a previous assignment completed by Castalia in 2008. For that work, Castalia submitted a report on Advice for Fiscal Management of Infrastructure PPPs in Pakistan. Since 2008, the Government has announced an interest in continuing to pursue PPPs to develop new infrastructure and approved a new PPP Policy in January 2010. The Debt Policy Coordination Office (DPCO) in the Ministry of Finance (MOF) is expected to be the key beneficiary of Castalia’s work under this assignment. 1.2 Content of the Report The contents of this report are organized as follows: Section 2 explains why it is important for Pakistan to establish sound policies for managing contingent liabilities, based on the Government’s existing exposure and gaps in the policies and processes that are currently in place. The Status Quo Report presented in Appendix A provides an assessment of the Government’s exposure to contingent liabilities and the existing policies and processes that are in place Section 3 explains how Pakistan can better manage contingent liabilities by presenting our recommendations to eight specific functions that will strengthen existing PPP policies 2 Confidential Section 4 analyzes options for who should perform the functions for managing contingent liabilities, and explains why we recommend empowering existing institutions in the preferred institutional framework Section 5 presents the steps we suggest that the Government follows to implement these recommendations and operationalize an effective contingent liabilities management framework Finally, Section 6 presents our assessment of international experience and good practice in managing contingent liabilities to provide additional context for our recommendations in Pakistan. Appendix A includes the Status Quo Report from the first stage of this assignment Appendix B includes a summary of the stakeholder consultation workshop conducted in Islamabad on July 21 to receive feedback on the draft recommendations for this assignment 3 Confidential 2 Why it is Important to Manage Contingent Liabilities To develop appropriate policies and processes for managing contingent liabilities in Pakistan, it is important first to understand what the current problem is and what benefits can be achieved by improving how contingent liabilities from PPPs are managed. Castalia has worked to identify the existing PPPs and the associated contingent liabilities in Pakistan. We have also assessed the effectiveness of the policies and processes governing PPPs generally, and contingent liabilities specifically, to identify where there are opportunities to improve how contingent liabilities are managed in the future. In our assessment, we found that: The Government is exposed to contingent liabilities in the energy sector— although in practice the liabilities have realized—through its obligations to Independent Power Producers (IPPs) and Rental Power Plants (RPPs) Outside of the energy sector, there is limited exposure to existing contingent liabilities due to the few PPP projects that have been implemented Policies and processes in place are not adequate to facilitate good decision making when structuring PPPs, accepting contingent liabilities, and managing risks. These findings suggest there is an opportunity to adopt an institutional framework that will facilitate the development of better PPPs, create more value for money for the Government when entering into PPPs, and managing the fiscal risk associated with those PPPs once they are operational. In the remainder of this section, we characterize the existing exposure to contingent liabilities from PPPs (Section 2.1) and then describe where there are opportunities to improve existing policies and processes. 2.1 Exposure to Contingent Liabilities from PPPs The definition of PPP has been clarified in Pakistan’s 2010 PPP Policy to include any arrangement involving the financing, development, operation, and maintenance of infrastructure by the private sector which would otherwise have been provided by the public sector. Instead of the public sector procuring a capital asset and providing a public service, the private sector develops the asset and delivers a service in return for payment that is linked to performance. By this definition, the current PPPs in Pakistan that we are aware of include: Thirty IPPs and at least nine RPPs contracted by the Private Power Infrastructure Board (PPIB), totaling approximately 8,500 MW of electricity generation capacity Three concession agreements that the National Highway Authority (NHA) is party to At least 11 concession agreements for terminal facilities contracted by Pakistan’s port authorities and one dry port railway terminal. Pakistan has limited experience developing PPPs in other sectors. The Infrastructure Project Development Facility (IPDF)—created within the Ministry of Finance (MOF) to develop 4 Confidential and implement PPPs—has several projects in various stages of development, but to date IPDF has not completed a transaction. The Government’s stock of contingent liabilities associated with existing PPPs is mainly in the energy sector. Within the energy sector, contingent liabilities arise in the 30 implementation agreements signed between IPPs and PPIB on behalf of the Government, and in at least nine rental power agreements signed with RPPs. These contingent liabilities include primarily the financial obligations of the power purchaser and termination payments in the event of default or force majeure. The contingent liability associated with the guarantee of the power purchaser has effectively been realized—in 2008, for example, the Central Power Purchasing Authority failed to pay about 51 billion Rupees owed to IPPs.1 While the contingent liabilities in the energy sector are known, assessing the full magnitude of the liabilities and the associated fiscal risk is complicated by the current energy crisis in Pakistan, which has created a large, ongoing fiscal burden. In the past, the Government has negotiated solutions to some of these fiscal challenges, and we understand there are current efforts to address the energy crisis that go well beyond the scope of this assignment.2 Outside of this sector, the Government has limited exposure to contingent liabilities. Concession agreements for national highway services include the following obligations that create the primary contingent liabilities for the Government: Termination payment clauses in the event of default by the company or the Government, or a force majeure event A guarantee on the regulated toll rate for Lakpass Tunnel Commercial risk the Government has retained on Shahdara Flyover. In the case of Lakpass Tunnel, the concession includes a toll rate of 13 Rupees per trip; however, the NHA only allowed tolls of 10 Rupees per trip during the first year of operations. Under the terms of the concession agreement, the NHA is obligated to pay the proponent the revenue difference generated by the three Rupee deviation from the contracted toll rate. Concessions on shipping terminals also include termination payment clauses, but there is not enough information available to determine the extent of the contingent liabilities under those agreements. Moreover, it is unclear whether the Government intends to include port authorities in the efforts to strengthen the policies and processes for PPPs and contingent liability management. 2.2 Existing Policies and Processes are Incomplete As explained above, existing exposure contingent liabilities is concentrated in the energy sector. Outside of the energy sector, there are no examples of major problems created by poor management of contingent liabilities. However, our assessment shows that the existing policies and processes are largely incomplete and likely to be ineffective. Failure to improve these policies could exacerbate the problem in the energy sector, create significant problems 1 2009 WAPDA Annual Report. The estimated amount includes only the unmet obligations associated with power purchased 2008, not the cumulative amount in past due. 2 See Appendix A for additional background. 5 Confidential in other sectors and, if left un-addressed, risk derailing Pakistan’s PPP program development efforts. The current lack of effective policies has fostered an environment where decision makers are not well informed of the costs of contingent liabilities and the magnitude of the risks they are accepting when approving PPPs. Moreover, there is no policy in place for the Government to centrally process contingent liabilities, monitor projects, and respond to realized contingent liabilities or take action to mitigate emerging risks. To manage the fiscal risk that the Government is currently exposed to and ensure that contingent liabilities are justified and managed effectively in the future, we think it is important that the Government adopt a series of proven functions for managing contingent liabilities throughout the PPP lifecycle. These functions include: Structuring contingent liabilities and designing contractual mechanisms according to good principles for allocating risk in PPP projects and contract design Analyzing the contingent liabilities to be accepted under a proposed project Evaluating and approving the contingent liabilities the federal Government will be exposed to when entering into a PPP Reviewing executed PPP contracts and formally accepting the contingent liabilities to make the contingent liabilities explicit Monitoring those contingent liabilities while the project is being constructed and implemented Regularly and publicly disclosing the contingent liability exposure Taking mitigating action where necessary to reduce the likelihood or cost of the contingent liability becoming real When necessary, budgeting for and paying for realized contingent liabilities. If effectively implemented, these functions could significantly strengthen Pakistan’s PPP program and help to manage fiscal risk by: Improving incentives to make good decisions, to help ensure: – The Government accepts risks and approves contingent liabilities that provide value for money – Decision makers manage existing risks well. Improving credibility by: – Making the Government’s exposure transparent and signaling a commitment to managing risk, thereby decreasing the likelihood that credit rating agencies and others assessing Pakistan’s sovereign risk overestimate risk exposure – Implementing a systematic process that defines how payments will be made reduces uncertainty, thereby increasing investors’ confidence, attracting greater investment, and lowering the cost of borrowing. 6 Confidential Reducing adverse fiscal impact by implementing a systematic process that reduces the uncertainty of payment obligations, minimizes the cost of realized contingent liabilities, and limits the impact of payments on the fiscal deficit, debt levels, and budget priorities. The next section of this report focuses on explaining why each of the eight functions listed above is needed and how they can be performed in practice. 3 How to Improve the Management of Contingent Liabilities In this section we describe the functions we recommend the Government include in a system for managing contingent liabilities from PPP projects, and describe options for how these functions could be carried out. While the functions described in this section apply specifically to the management of the contingent liabilities, we have developed recommendations that apply generally and can strengthen the entire PPP development process and the process by which the Government prepares and approves the terms of a PPP contracts, and the associated financial commitments, and monitors and manages PPPs once they are implemented. The functions we recommend include: Structuring contingent liabilities (Section 3.1) Analyzing contingent liabilities (Section 3.2) Approving contingent liabilities (Section 3.3) Accepting contingent liabilities (Section 3.4) Monitoring contingent liabilities (Section 3.5) Disclosing contingent liability (Section 3.6) Action on emerging risk (Section 3.7) Budgeting for and paying for realized contingent liabilities (Section 3.8) These functions are shown in Figure 3.1, in the context of the broader PPP project development and implementation process. It is important to note that while these functions are shown alongside the PPP lifecycle, they are an integral part of the PPP project development process and should be embedded within the overarching PPP Policy and related guidelines.) 7 Confidential Figure 3.1: Functional Components of Managing Contingent Liabilities PPP Project Contingent Liability Implementation (CL) Management Process System Identify project Develop project; includes: Identify and allocate Structure CLs project risks (contract clauses) Analyze project Analyze CLs PPP Project Development Stage Approve Approve project CLs Conduct bidding & negotiate contract Execute contract Accept CLs Monitor and manage Monitor CLs project contract Disclose CLs PPP Project Implementation Take action on Stage emerging CL risks Budget and pay for realized CLs In the following sub-sections we discuss each of these functions in more detail, describing: The objective of the function Why the function is important What policies and processes related to the function are in place How the policies and processes should be improved. In some cases there is more than one alternative for how the function could be carried out— for example, what rules will be applied when deciding whether to accept the contingent liabilities under a proposed project. In these cases, we describe the alternatives and recommend the approach we think makes sense for Pakistan. The workshop we will facilitate 8 Confidential with Government officials to discuss this report will help us refine our recommendations and identify the preferred final recommendation. Additionally, in practice, many of these functions are inter-related. For example, the decision on how contingent liabilities will be budgeted for and paid affects the incentives contracting authorities face in structuring proposed projects. The nature of disclosing also affects the information that needs to be collected and maintained to monitor projects. We highlight these relationships at each stage. 3.1 Structuring Contingent Liabilities The most important step in managing contingent liabilities under PPPs is deciding which contingent liabilities to accept in the first place. This can be accomplished by improving how risks are allocated and how contingent liabilities are structured when developing new PPP projects and drafting contracts. The improvements should be made in the context of the entire PPP structuring and risk allocation process. That is, contingent liabilities should be considered along with the range of financial commitments and obligations the Government makes to a PPP. Objective when structuring contingent liabilities: To develop terms that will help complete a transaction, while ensuring that the risks the Government will bear are consistent with good risk allocation principles, borne at the lowest cost and with minimal fiscal impact. 3.1.1 Why is the function important? Contracting authorities lack consistent principles to follow when allocating risks and structuring PPPs. This creates the possibility that projects will be developed that do not adhere to sound principles for risk allocation and PPP structuring, which are essential to providing value for money to the Government. Moreover, contracting authorities have not developed tools and contractual mechanisms—with the exception of PPIB’s template implementation agreements—to ensure PPP contract terms consistently adhere to stated principles. By developing sound principles and policies to follow when structuring contingent liabilities, the Government can have more confidence that it is accepting risks and providing financial support to a PPP project in a way that provides value for money. In turn, this improves the attractiveness of PPPs to the private sector by providing more clarity and certainty on the contractual mechanisms and development procedures that will be followed. 3.1.2 What relevant policies and processes are in place? A broad principle for allocating risk is defined in the 2010 PPP Policy, which states that: “[each] risk will generally be borne by the party best able to manage it at minimum cost.� This principle is in line with international good practice, and provides a basis for managing contingent liabilities. The PPP policy also states that the concession contract will specify how risks have been allocated. However, no further policy or guidance is provided and there is no direction on how contractual mechanisms should be designed to achieve the best risk allocation and to manage fiscal impact. An example of good practice for contracting authorities is the template implementation agreement published by PPIB, which lays out the entirety of the Government’s support to 9 Confidential an IPP, including contingent liabilities like termination payment clauses and the guarantees of the obligation of the power purchaser. Additionally, NHA’s PPP Policy and Regulatory Framework states that NHA will provide “procedures such as time extensions or termination to deal with force majeure risks, and procedures for dealing with changes in costs and losses caused by changes in law�. This guarantee from NHA will create contingent liabilities. NHA has also taken the important step of drafting model concession agreements for BOT contracts. These are important steps in the structuring process and serve as an example that other contracting authorities could follow. NHA could further strengthen its existing policies by better defining and codifying its principles for applying its general policy in practice. 3.1.3 How should the policies and processes be improved? This policies and process for structuring contingent liabilities can be performed by completing two steps: Developing, approving, and applying risk allocation principles when structuring PPPs Developing rules for structuring contingent liabilities and draft contractual mechanisms. Developing, approving, and applying risk allocation principles As part of developing and structuring a PPP project, the contracting authority must identify all the project risks, and decide how these should be allocated. A clear set of principles for allocating risk in PPP projects is an important part of this process, and will determine what contingent liabilities the Government will accept. Pakistan’s PPP Policy 2010 states that risks should be allocated to the party (private or government) best able to manage the risk at the lowest cost. At a minimum, the Government should ensure this broad principle is applied in practice by requiring contracting authorities to develop and follow approved principles when allocating specific risks associated with common types of PPPs. IPDF should provide support to contracting authorities in developing and applying the risk allocation principles, as needed. A central authority, such as DPCO, should review and approve the principles, and check to ensure that the principles are followed before approving individual PPP projects (see Section 3.3). One useful tool that could be used by contracting authorities is a preferred risk allocation matrix for common projects. Table 3.1 below presents an example of a preferred risk allocation matrix that contracting authorities could use as a template. 10 Confidential Table 3.1: Example of a Preferred Risk Allocation Matrix Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies Pre-contract risks Existing Risk that the procurement Government Government does not Careful preparation Since there is no structure process will experience have a partner yet at this and management of agreement yet signed with (refurbishment any of the following: (a) stage, so it has no option the procurement any other party, there is / extensions) failure to attract sufficient but to bear this risk. process no specific allocation qualified bidders and/or Ensure that the instrument, but the lack of responsive offers; or (b) agency’s procurement recourse to any sort of prolonged and expensive team is experienced compensation. negotiations; or (c) and competent collapse of negotiations. Establish a procurement schedule commensurate with project complexity Site risk Existing Risk that existing Private Private sector can manage Private firm will pass Contract clause requiring structure structures are inadequate cost-effectively if proper to builder which relies private partner to provide (refurbishment to support new due diligence of existing on expert testing and performance bond / extensions) improvements, resulting structure is conducted. due diligence in additional construction Give private firm time and cost enough time to do site studies Site conditions Risk that unanticipated Private – except when Private sector can Private firm will pass Contract clause requiring adverse geological complex geological manage cost-effectively to builder which relies private partner to provide conditions (geotechnical conditions are present if site study effort is on expert testing and performance bond risk) are discovered which AND project is moderate and enough due diligence Contract clause stipulating cause construction costs government-solicited, time is provided to Give private firm the conditions and to increase and/or cause private to absorb only up bidders. enough time to do site mechanism to compensate 11 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies construction delays to a specific cost amount, Complex structures on studies private sector for agreed- after which government linear infrastructure Reimburse part of upon portion of cost assumes (road, rail, pipeline) bidding cost to overruns on technically may require more encourage bidders to complex structures (for thorough and detailed prepare their own site example, tunnel cost geotechnical studies studies overrun guarantee). (for example, long tunnels and long span bridges in unstable terrain), that may not be reasonably completed within the bidding period or may be too expensive for bidders to conduct at the bidding stage without some cost- sharing. Permits and Risk that necessary Private if and when: When Private: Government to obtain in Contract clause stipulating approvals approvals (for example, Permits and approvals Private is better advance of the bidder the schedule to obtain environmental license, have been obtained informed about the proposal submission stage permits and approval and environmental prior to the submission rationale for its the requisite permits and stipulating liquidated management plan, of proposals by request. approvals, which would damages payable to construction permit) may potential bidders, and When Government: allow the private firm to private partner in case of not be obtained or may be later modified at the Government is better achieve a measure of pre- delays obtained only subject to request of successful informed and contractual certainty and unanticipated conditions bidder. positioned to influence an early start to the which have adverse cost Government if and when: the speed of the approval process. consequences or cause Permits and approvals approval process, prolonged delay have not been particularly in obtained prior to situations that are 12 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies bidder proposal complex or sensitive. submission– private is responsible to manage the process, though. Environmental Risk that project site is Private, except when: When Private: Private firm will pass Contract clause liabilities contaminated requiring Project was solicited by Private sector can to builder which relies requiring private existing prior significant remediation the government; and manage cost-effectively on expert testing and partner to provide to project expenses Cost and time required if site study effort is due diligence performance bond to conduct a full due moderate and enough Give private firm Contract clause diligence (site study) time is provided to enough time to do site stipulating the for each bidder are bidders. studies conditions and such that the project When Shared: Reimburse part of mechanism to would be significantly Sites where site study bidding cost to compensate private delayed or would deter effort may not be encourage bidders to sector for agreed-upon potential serious reasonably completed prepare their own site portion of remediation bidders – in such case, within the bidding studies expenses. some risk sharing period or may be too along the lines of expensive for bidders geotechnical site risk to conduct at the could be a solution bidding stage without some cost-sharing. Environmental Risk that the use of the Private, if and when: Private partner is able During procurement Contract clause liabilities project site over the Environmental license to manage the use of private partner must defining what created during contract term has resulted and environmental the asset and attend to demonstrate financial constitutes operation in significant management plan has its maintenance and capacity or support to environmental liability environmental liabilities been approved prior to refurbishment deliver the site in the and the mechanism to (clean up or rehabilitation submission of according to the state required by estimate the private required to make the site proposals environmental government at the end partner’s liability and fit for future anticipated Environmental license requirements known at of the contract pursue payment use) and management plan the proposal stage Government to require Contract clause 13 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies have not been Government is better sinking funds if it is to requiring the approved prior to able to manage resume the site and its establishment of clean- submission of environmental use is liable to result in up/ rehabilitation proposals – liability is requirements not significant clean sinking fund limited to amount known to bidders at up/rehabilitation cost estimated in proposal. the proposal stage. Government, if and when Environmental license and management plan have not been approved prior to submission of proposals – liability for any excess over investor’s proposed estimate. Cultural Risk of costs and delays Government to Government generally has Research cadastral records Contract clause defining heritage associated with assume risk on a better understanding of and obtain expert advice risk and stipulating site archaeological and cultural government preferred procedures, and is usually availability schedule and heritage discoveries site in best position to manage liquidated damages Private partner to this risk payable in case of delays assume risk on private partner preferred site Availability of Risk that tenure/access Government to If government Research cadastral Contract clause site to a selected site which assume risk on preferred site: records and obtain stipulating site is not presently owned government preferred – Government has a expert advice availability schedule by government or site – private partner better If government. and liquidated damages private partner cannot may remain understanding of preferred site: payable in case of be negotiated. responsible for procedures, has – Complete land delays Risk of costs and managing the process special powers of acquisition prior to 14 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies delays in negotiating Private to assume risk acquisition and use proposal stage land acquisition on private partner of land for If private preferred preferred site infrastructure and is site: usually in best – Oblige bidders to position to manage secure access prior – Government is in to contract signing better position to negotiate where policy discourages use of compulsory acquisition power If private preferred site: – Private partner is in control of site selection Design, construction and commissioning risk Design Risk that the design of the Private – private partner Private partner has more Ensure that the Contract clause facility is substandard, will be responsible except experience, knowledge feasibility study is requiring performance unsafe, or incapable of where an express and control over the available well in bond delivering the services at government mandated variables that determine advance of the Contract clause anticipated cost and change has caused the the quality of the design procurement process stipulating liquidated specified level of service design defect (i.e. experience, competent to adequately inform damages (often resulting in long staff, etc.) the design process term increase in recurrent Incorporate strict costs and long term experience and inadequacy of service) competency requirements in the procurement process Private partner may 15 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies transfer risk to builder/architects and other subcontractors while maintaining primary liability; government has the right to abate service charge payments where the risk eventuates and results in a lack of service ­it may ultimately result in termination where the problem cannot be suitably remedied Construction Risk that events occur Private, except when: Private partner has Incorporate strict Contract clause during construction which The event is one for more experience, experience and requiring performance prevent the facility being which relief as to time knowledge and control competency bond delivered on time and on or cost or both is over the variables that requirements in the Contract clause cost specifically granted influence construction procurement process stipulating liquidated under the contract, cost and control over Ensure that feasibility damages contract such as force majeure construction process study is available well clause or government (i.e. schedule, in advance of the Contract clause intervention equipment, materials procurement process providing partial cost In situations where the and technology, etc.) – Private firm generally overrun guarantee for technical or geological this assumes that will enter into a fixed complex structures complexity (for private partner has term, fixed price example, tunnels) enough information to building contract to prevents from having estimate costs and start pass the risk to a sufficient and reliable operations on schedule builder with the information to and as planned. experience and 16 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies measure risk, the A possible exception is resources to construct government may in contractually agreed so as to satisfy the assume part of the risk upon situations that private firm's classify as force obligations under the majeure or contract government intervention. Commissionin Risk that either the Private – although Private partner is in Incorporate strict Contract clause requiring a g physical or the operational government will assume control of the design and experience and performance bond commissioning tests an obligation to cooperate construction process and competency requirements Contract clause stipulating which are required to be and facilitate prompt its inputs, and therefore in the procurement liquidated damages (until completed for the public sector attendance better positioned to process all physical and provision of services to on commissioning tests manage this risk operational commence, cannot be commissioning tests successfully completed passed) Sponsor and financial risk Interest rates Risk that prior to Government Government has more Construction loan interest Contract clause defining pre- completion local currency experience and rate hedging instrument (if mechanism to compensate completion interest rates may move information regarding the and when available) private for interest rate adversely factors influencing local changes during currency interest rates and construction is in better position to manage risk Interest rates Risk that after completion Private Private partner in control Interest rate hedging Contract clause holding post- interest rates may move of selecting and arranging instruments (such as government harmless completion adversely long-term financing interest rate swap from IFC) Arrange financing using a mix of foreign 17 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies and local currency Exchange rate Risk that during Shared Private partner is in Private to partially Contract clause operation, exchange rates Government to control of selecting mitigate by partly requiring establishment may move adversely, assume part of it by and arranging local and financing the project in of a Foreign Exchange affecting the private allowing total or partial foreign currency mix local currency Liquidity Facility partner’s ability to service indexing of payments for long-term Private to establish Tariff or payment foreign denominated debt to exchange rate financing Foreign Exchange adjustment contract and obtain its expected Private to assume Government has more Liquidity Facility to clause profit remainder experience and cover part of the information regarding potential mismatch the factors that between project’s local influence exchange currency revenues and rates foreign currency debt Government to partly transfer risk to users by allowing payment indexing to exchange rate Currency Risk that local currency Government Government has more Purchase partial risk Contract clause stipulating convertibility cannot be converted into experience and guarantee from an that private partner can and profit foreign currency as a information regarding the International Financing benefit from the guarantee repatriation result of government factors that influence Institution to compensate for losses restrictions currency convertibility related to currency convertibility and repatriation of profits Inflation Risk that value of Shared Government has more Government to Contract clause defining payments received during Government to experience and transfer part of it to payment adjustment the term is eroded by assume part of it by information regarding the users by allowing total mechanisms inflation allowing total or partial factors that influence or partial indexing of indexing of payments inflation payments to inflation 18 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies to inflation rate Private to assume Government to ensure remainder risk through its payments do not the methodology overcompensate for adopted to maintain inflation and to avoid value any double payment for after costs adjustments (for example, changes in exchange rate) Financing Risk that when debt Private Private partner is Government requires all Contract clause requiring unavailable and/or equity is required responsible for arranging bids to have fully firm letters of credit from by the private firm for the finance documented financial reputable financial project it is not available commitments with institutions then and in the amounts minimal and easily and on the conditions achievable conditionality anticipated Sponsor risk Risk that the private Government If this risk materializes, Ensure project is Contract clause partner is unable to there is no private partner financially remote requiring a provide the required to transfer the risk to from external financial performance bond and services or becomes liabilities letters of credit insolvent Ensure adequacy of Contract clause Risk that the private finances under loan requiring minimum partner is later found facilities or sponsor liquidity and debt to be an improper commitments ratios person for supported by involvement in the performance bond provision of these Ensure adequacy of services finances through the Risk that financial use of non financial 19 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies demands on the evaluation criteria and private partner exceed due diligence on its financial capacity private partner causing corporate failure Further Risk that by reason of a Government takes risk Government has more Government to satisfy Contract clause of best finance change in law, policy or that private finance is information and is better itself as to likelihood of endeavors obligation required due other event additional unavailable – however, positioned to manage risk need arising, likely by private to fund with to government funding is needed to private partner to assume criticality if it does arise, option on government action rebuild, alter, re­equip etc best endeavors obligation and as to financial capacity to compensate via fee the facility which cannot to fund at agreed rate of of private to finance and increase or capital be obtained by the private return with option on (if appropriate) budget contribution firm (resulting in no government to pay via an allocation if government is Contract clause funding available to increase in fees over the required to fund it providing a buy-out complete further works balance of the term or via (put) option or required by government) a separate capital termination with contribution compensation for private, should finance not be obtained and facility cannot be further operated Change in Risk that a change in Shared If change occurs, the Government Contract clause requiring ownership ownership or control of Government risk as to ability of private requirement for its government consent prior the private firm results in the adverse partner to manage risk consent prior to any to any change in control, a weakening in its consequence of a is diminished change in control. and providing ability to financial standing or change if it occurs; Private partner would Private firm will seek influence or prevent support or other Private firm risk that have to accept to limit this control to change only in specific detriment to the project its commercial requirement to sign circumstances where circumstances objectives may be agreement, hence if substantive issues are inhibited by a condition is not of concern such as 20 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies restrictive requirement acceptable, it could financial capacity and for government walk away from project probity consent to a change Refinancing Risk (upside) that at Private partner to Similar to interest rate risk Government to assure Contract clause spelling benefit completion or other stage benefit; - private partner has itself that likely benefit has out circumstances where in project development Government to share control over its choice of been factored into government is to share the project finances can in limited long term financing – if competitive bids to avoid and at what rate be restructured to circumstances (i.e. downside burden is placed the risk that the private materially reduce the symmetrical risk on private partner, same firm will be allowed to project's finance costs allocation and super principle applies to upside earn super profits from profits) (symmetrical risk the project allocation) Tax changes Risk that before or after Private, if and when: General changes in tax Private partner to Contract clause completion the tax impost Tax increases or new law affect all incorporate in project due providing on the private firm, its taxes arising from businesses in the diligence - financial compensation terms assets or on the project, general changes in tax country returns of the private for discriminatory will change law The government is in partner should be changes in tax law Government, if and when: better position to sufficient to withstand Contract clause Tax increases or new influence specific general tax law changes providing a buy-out taxes arising from discriminatory tax law (put) option or discriminatory changes changes affecting the termination with in tax law project compensation for private partner when no other compensation mechanism is available Operating risk Inputs Risk that required inputs Private, except when: Private partner is in Private partner may Contract clause cost more than Government controls control of the selection of manage through long imposing penalties for anticipated, are of inputs (for example, inputs. term supply contracts breach of specific and 21 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies inadequate quality or are water catchment) where quality/quantity well defined unavailable in required can be assured; performance and quantities Private partner can quality specifications. address to some extent Contract clause on in its facility design compensation to private for issues attributable to government-supplied inputs Maintenance Risk that design and/or Private Private partner is in Private firm to manage Contract clause and construction quality is control of design and through long term imposing penalties Refurbishment inadequate resulting in construction processes subcontracts with suitably (and possible higher than anticipated qualified and resourced termination) for not maintenance and sub-contractors meeting specific and refurbishment costs well defined performance, level of service, and quality specifications Contract clause requiring performance bond from private Changes in Risk that government's Government Government is in better Government to minimize Contract clause of best output output requirements are position to manage and the chance of its endeavors obligation specification changed after contract mitigate the occurrence of specifications changing by private to fund with outside agreed signing whether pre or the risk and, to the extent they option on government specification post commissioning must change, it will ensure to compensate via fee range Change prior to the design is likely to increase or capital commissioning may accommodate it at least contribution require a design change expense; this will involve Contract clause with capital cost considerable time and providing a buy-out 22 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies consequences effort in specifying the (put) option or depending on the outputs up front and termination with significance of the planning likely output compensation for change and its requirements over the private, should finance proximity to term not be obtained and completion; change makes project Change after unviable completion may have a capital cost consequence or a change in recurrent costs only (for example, where an increase in output requirements can be accommodated within existing facility capacity) Operator Risk that a subcontract Private Private partner is fully and Government to carry out Contract clause failure operator may fail primarily liable for all due diligence on principal imposing penalties financially or may fail to obligations to government subcontractors for probity (and possible provide contracted irrespective of whether it and financial capacity and termination) for not services to specification has passed the risk to a commission a legal review meeting specific and (failure may lead to service subcontractor of the major subcontracts well defined unavailability and a need including the guarantees performance, level of to make alternate delivery or other assurances taken service, and quality arrangements with by the private partner; if specifications corresponding cost failure does occur the Contract clause consequences) private partner may requiring performance replace the operator or bond from private government may require 23 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies operator replacement Technical Risk of the contracted Private – except where Private partner is able to Government to Contract clause obsolescence service and its method contingency is anticipated use its expertise and develop detailed, well- imposing penalties or innovation of delivery not keeping and government agrees to know-how to minimize researched output (and possible pace, from a share risk possibly by this risk specifications termination) for not technological funding a reserve Private partner to meeting specific and perspective, with develop detailed, well- well defined competition and/or researched design performance, level of public requirements solution service, and quality – Private partner’s Private partner may specifications revenue may fall have recourse to Contract clause below projections designer, builder or defining the condition either via loss of their insurers required of the facility demand (user pays Private partner to at the end of the term model) payment arrange Contract clause abatement contingency/reserve requiring performance (availability model) fund to meet upgrade bond from private and/or operating costs subject to Contract clause costs increasing; government agreement specifying mechanism – Government may as to funding the to establish a reserve not receive reserve and control of fund (private, public- contracted service reserve funds upon private, public) at appropriate default; quantity/quality Both partners to monitor obligations in the contract Demand risk Demand risk Risk that operating Private, except when: When demand can be Government and Contract clause stipulating revenues falls below Uncertainty in demand estimated with relative private to perform the availability payment or 24 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies forecast as a result of forecast is such that certainty, the private independent market mechanism to establish decrease service volume providing an partner is in a better demand analyses minimum revenue (i.e. traffic volume, water availability payment position to mitigate commensurate with payments or power consumption) element and/or a risk through project scale and attributable to an minimum revenue commercial characteristics economic downturn, tariff guarantee is necessary management practices Where users pay increases or change in to attract private Where government is private partner will consumer habits investment (for the primary off-take it ensure robust financial example, greenfield toll has better information structure and financier road), in which case, to manage risk support the government will – Adequate debt share in the risk coverage through an availability – Adequate reserves payment or a minimum revenue – Credit guarantee. enhancement, insurance Non-technical Risk of a portion of users Private, except when: Private sector has better Private firm to Contract clause giving the losses (tariff or customers not paying There is limited scope access to information incorporate measures ability to private partner avoidance) or evading payment for for private to stop needed to identify non- (technological, business to stop service to non- service, leading to a service or pursue paying users and processes, and otherwise) paying customers and shortfall in cash flows payment (for example, stop/continue service to to identify non-paying stipulating the service delivery or them. customers and prevent mechanisms available to payment collection is and deter non-payment. collect payment. controlled by government) Network and interface risk Withdrawal of Risk that, where the Government, where the Government is in control Government to conduct Contract clause defining support facility relies on a change discriminates of complementary thorough network what constitutes unfair network complementary against the project network management planning process when discrimination against the 25 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies government network, that developing project project and specifying support is withdrawn or concept mechanisms to varied adversely affecting compensate private (for the project example, liquidated damages) Changes in Risk that an existing Private, except when: Government manages Government to Contract clause to provide competitive network is Changes are network allowing it to conduct thorough private partner with non- network extended/changed/re- discriminatory against influence the network planning compete protections and priced so as to increase the project materialization of network when developing compensation competition for the Competition is risk and its consequences project concept mechanisms facility government-subsidized Private firm to review (for example, a likely competition for competing toll-free service and barriers to road on the same entry prior to enter corridor) agreement Private firm will seek compensation against change which unfairly discriminates against the project by government subsidizing competition (existing or new) Interface (1) Risk that the delivery of Private, except when: Government manages Government to Contract clause to core services in a way Changes involve core service activities conduct thorough specify the extent of which is not discriminatory to the allowing it to influence the system planning when core services and the specified/anticipated in project – government materialization of developing project way in which they will the contract adversely to provide interface risk and its concept be delivered so that affects the delivery of compensation consequences Upfront assessment only manifest and 26 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies contracted services (by both government adverse changes and and the private deficiencies can trigger partner) of likely this risk interface issues Contract clause Continuous review and defining compensation monitoring and mechanism for private development of a partner communications strategy in respect of delivery of the two related services Interface (2) Risk that the delivery of Private Private firm manages Upfront assessment Contract clause requiring a contracted services contracted service (by both government performance bond and adversely affects the activities and the private specifying liquidated delivery of core services in partner) of likely damages a manner not interface issues specified/anticipated in Continuous review and the contract monitoring and development of a communications strategy in respect of delivery of the two related services Industrial relations risk Industrial Risk of strikes or Private Private partner is has Private partner (or its sub- Contract clause relations industrial action causing better information about contractors) manage requirement payment of delay and cost to the and control over the project delivery and liquidated damages to project causes of industrial action operations government Legislative and government policy risk 27 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies Approvals Risk that additional Private, except when: Government is in better Private to anticipate Contract clause to specify approvals required during Government has position to manage and requirements private partner the course of the project initiated the change mitigate the occurrence of compensation mechanism cannot be obtained requiring approval the risk (for example, liquidated damages) Changes in Risk of a change in Private, if and when: General changes in law Private partner to Contract clause law/policy law/policy of government Changes occur in affect all businesses in incorporate in project allowing compensation only, which could not be general law and are not the country due diligence - to private in a pre- anticipated at contract project or service Government is in financial returns of the specified signing and which has specific better position to private partner should Contract clause to adverse capital Government, if and when: influence specific be sufficient to allow pass through to expenditure or operating Changes are discriminatory tax law withstand general end users cost consequences for the discriminatory and changes affecting the law/policy changes private firm directed specifically project Government to and exclusively at the monitor and limit project or the services (where possible) changes which may have these effects or consequence on the project Government to require the private firm to effect the change in a way that the financial effect on government is minimized (for example, pay on a progressive scale); Government to pass through to end users 28 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies Regulation Risk that where there is a Private, except when: The private partner has Private firm to assess Contract clause to specify statutory regulator Tariffs or payments are the ability to undertake its regulatory system and may whether payment will be involved there are pricing pre-specified in the own assessment of the make appropriate subject to regulator or not, or other changes imposed contract regulatory system representations and if not, specify on the private firm which mechanism to set and do not reflect its adjust tariffs. investment expectations Force majeure risk Force majeure Risk that inability to meet Private takes risk of Private partner can buy Private to purchase Contract clause to contracted service delivery loss or damage to the insurance from the insurance for insurable expressly define events (pre or post completion) is asset and loss of marketplace— risks that will constitute acts caused by reason of force revenue when risk is commercial If uninsurable, private of God and political majeure events insurable (for example, Government is better firm may self-insure by force majeure events earthquake, floods, positioned to manage establishing reserve Contract clause to fire, and drought) uninsurable risks funding; relieve private from Government takes If uninsurable consequences of some risk of service government to service discontinuity; discontinuity both as establish contingency Contract clause to to contracted service for alternate service require that if and core service when delivery; insurable, private must risks are uninsurable ensure availability of (i.e. terrorism acts, war, insurance proceeds civil unrest, etc.) towards asset repair and service resumption and government is to be given the benefit of insurance for service disruption costs Asset ownership risk 29 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies Default and Risk of 'loss' of the facility Private firm will take the Private firm has more Only serious breaches Contract clause clearly termination or other assets upon the risk of loss of value on knowledge of the by the private firm to establishing specific premature termination of termination underlying causes of lead to termination contract breaches lease or other project default and can identify Private partner to be leading to termination contracts upon breach by risk earlier than given time and Contract clause to the private firm and government opportunity to remedy define options for without adequate payment defaults by the private remediation of default partner which may lead If and when necessary, to termination contract clause to If termination occurs define method to pre completion establish compensation government may (but to private in case of need not to) make termination (pre and payment for value in post-completion) the project on a cost to complete basis; If termination occurs post completion the private partner may receive fair market value less all amounts due to government Government to require step in rights to ensure access and service continuity until ownership/control issues are resolved Residual value Risk that on expiry or Private Private partner can Government to Contract clause on transfer to earlier termination of the incorporate lifecycle impose on the private specifying the 30 Confidential Risk Definition Preferred Allocation Rationale Possible Mitigation Allocation Instrument Strategies government services contract the asset maintenance, maintenance and conditions in which does not have the value refurbishment, and refurbishment assets are to be originally estimated by performance requirements obligations, transferred to the government at which the into the design facility, Government to ensure government at the end private partner agreed to and can manage these an acceptable of the term transfer it to government process during the term of maintenance Contract clauses the contract contractor is stipulating the responsible for the performance indicators work, commission and frequency of regular surveys and monitoring of these inspections; indicators Government may Contract clause require private to requiring the creation establish a dedicated of a sinking fund to sinking fund to cover the cost of accumulate funds bringing the facility up sufficient to bring the to the desired standard asset to agreed condition and/or (if required) obtain performance bonds to ensure the liability is satisfied 31 Confidential Developing rules for structuring contingent liabilities and draft contractual mechanisms The risk allocation principles described above will define what risks the Government is willing or prefers to accept when structuring a PPP. Contacting authorities should then follow established policies for how it accepts those risks. This can be done by developing guidelines and rules for structuring the contingent liabilities, and designing the contractual mechanisms by which the associated risks are accepted. As with the risk allocation principles described above, contracting authorities—with help from IPDF, as needed—should develop the policies for how to structure contingent liabilities, and they should be reviewed and approved by a central authority, such as DPCO. Box 3.1 describes what those policies could be. Box 3.1: Policies for How to Structure Contingent Liabilities The key principle for allocating risk in PPP projects, as defined in the 2010 PPP policy, is that risk should be borne by the party (private or government) best able to manage it at minimum cost. This principle should also apply when structuring contingent liabilities. In particular, the Government should seek to bear the risks it is allocated in a way that minimizes fiscal impact. This has implications for designing the contractual mechanisms for allocating risk, or in other words for structuring contingent liabilities: Where the parties are sharing a risk, in the case where neither party can control it, the Government should accept the minimum level of contingent liability that is consistent with the project having a “bankable� risk profile for the private party3 Contractual mechanisms for risks the Government will bear should reduce the unpredictability of contingent liability payment requirements wherever possible Contingent liabilities should be designed symmetrically, so that the party bearing downside risk also bears upside risk whenever possible. Examples of contractual mechanisms that are consistent with these principles are: Payments for realized contingent liabilities, wherever possible, should be contractually defined to fall due in the fiscal year after the contingent liability realizes (reducing the need for budget flexibility) Demand risk (where relevant and borne by Government) should be borne by extension of contract life to achieve a pre-defined net present value (NPV) of revenue. The guaranteed NPV of revenue should be set to allow the proponent to cover the cost of debt repayments only The Government may bear the risk of a proponent default, but payment will be conditional on re-tendering contract and equal the value received. Contracting authorities should also develop draft contract clauses or detailed model contracts for specific PPPs that are common in each sector. These model contracts serve as tool when contracting authorities are developing new projects to streamline the process and ensure they are following the approved principles for structuring PPPs and contingent liabilities more consistently. The model contracts should be also made public to increase transparency and credibility with the private sector. An example of this in practice, is the template power purchase agreement and implementation agreement published by PPIB. 3 Under these principles, the project may still require viability gap funding (VGF) support to be bankable: accepting more risk than the optimal level in lieu of providing VGF does not provide the best value for money for the Government. 32 Confidential We recommend that these efforts be developed and refined over time, as the Government and contracting authorities begin pursing more projects and gain experience in developing, tendering, and implementing PPPs. For example, some agencies (such as NHA) may take these steps immediately, while the steps will be less urgent for other agencies with a less developed PPP pipeline. IPDF can provide useful support throughout the process, particularly given its recent work developing model tariff and annuity payment contracts. 3.2 Analyzing Contingent Liabilities Once a PPP is structured, decision makers need to evaluate and approve the proposed project. When decision makers are evaluating a proposed PPP project, they should take into account the entire package of support being provided to the project. This includes viability gap funding—such as equity contributions or capital subsides, and operating subsidies or incentives to the private proponent—as well as contingent liabilities. The same is true when officials are making regulatory decisions that impact the financial obligations of the Government once a PPP has been implemented. Decision makers can be provided with the information needed to make good decisions if guidelines for analyzing and reporting exposure to contingent liabilities are developed and followed by contracting authorities. Objective when analyzing contingent liabilities: To inform decision making when the project is structured and approved, and provide a basis for monitoring and budgeting for contingent liabilities. 3.2.1 Why is the function important? In the past, all officials may not have been fully aware of the cost or risk associated with its financial commitment through contingent liabilities from the PPPs it has implemented. For example, it is unlikely that stakeholders were fully aware of the large fiscal burden that would be created by the Government’s obligations to IPPs in the energy sector when retail tariffs were set at a rate that did not allow the power purchaser to fully recover the cost of generation. Similar problems could arise in other sectors, such as highways, if the Government provides toll formula or traffic guarantees without understanding the full implithe expected cost or variability of those guarantees. Analyzing contingent liabilities will help ensure decision makers understand the expected cost and fiscal risk they are accepting when approving a PPP project. It will also improve how PPPs are structured, and provide useful information when monitoring and managing contingent liabilities once a PPP has been executed. Good analysis is also critical when negotiating contract terms with the private sector. 3.2.2 What relevant policies and processes are in place? There are currently no guidelines in place for analyzing contingent liabilities specifically when considering the level of financial support the Government is providing to a proposed PPP project. The Project Preparation and Feasibility Guidelines prepared by IPDF include broad instructions for analyzing project and non-project related risks; but these instructions have not been developed to the extent that there can be a consistent approach that is understood by decision makers within contracting authorities, IPDF, and ministries like MOF. 33 Confidential 3.2.3 How should the policies and processes be improved? As part of the project analysis when developing a proposed project, the contingent liabilities the Government will bear should be analyzed and, where possible, quantified. The analysis should follow a prescribed methodology set out in guidelines and clearly understood by all parties involved in developing a PPP. Because there is inherent uncertainty in contingent liabilities, the risk analysis required when analyzing contingent liabilities can be complex. Therefore, the prescribed methodology for analyzing contingent liabilities should strike a balance between the cost of complexity and the benefits of creating quality information. Over time, staff performing the analysis will develop the capacity to perform more complex, statistically sound analysis. The guidelines that are developed should be sufficiently flexible to evolve as staff becomes more capable at analyzing contingent liabilities. Options for analyzing contingent liabilities The key objective of good risk analysis is to understand the profile of the underlying risk— or the shape of the distribution. This can be helpful toward understanding both the expected cost and the loss the Government is exposed to in extreme, low-probability scenarios. There are several options to achieve this key objective when analyzing contingent liabilities. In practice, each option offers advantages and disadvantages based on the amount of information that is required, the difficulty in making sound assumptions, and the richness of information that can be produced and analyzed. The main difference in various options is the level of quantitative versus qualitative analysis, and whether a statistically sound probabilistic method or a scenario-based method is optimal. Box 3.2 below describes the possible methodologies. We will use a hybrid approach, which is described in more detail below. Box 3.2: Possible Methodologies for Valuing Contingent Liabilities Exposure to a contingent liability could result in a range of actual cost outcomes— depending on how the underlying risk variables evolve. Different ways of measuring and expressing the value of a contingent liability require different approaches to capturing this variability. These can be broadly grouped into probabilistic- or scenario-based scenario approaches, as described below. Probabilistic approach (fully quantitative) The range of possible cost outcomes from bearing a contingent liability can be expressed in terms of an expected value—that is, the probability-weighted sum of all possible outcomes—and measures of variability such as standard deviations or percentile values. However, the probability and value of payments or costs often depend on a combination of underlying risk variables, each of which can vary independently or in combination, making it difficult or impossible to calculate the expected value directly. Instead, probability distributions for each underlying risk variable can be defined. A risk modeling program, such as Crystal Ball, can then be used to randomly simulate thousands of outcomes and the resulting cost calculated in each case. The average of these calculated cost outcomes gives an estimate of the expected value of the contingent liability and their distribution (expressed using graphs or percentile values) gives an estimate of the degree of variability around that value. 34 Confidential Scenario-based approach (partially quantitative) Rather than attaching probability distributions to underlying risk variables, certain set scenarios—that is, specific combinations of risk variables—can be defined, and the resultant cost determined under each scenario. Scenarios could include “basecase�, “upside�, and “downside� values for variables such as exchange rates, or capture the occurrence of a trigger risk event such as default by the private party. The values calculated using this approach do not take into account the likelihood of each scenario occurring. The approaches described in Box 3.2 differ in the complexity of analysis, the extent of the required inputs and assumptions, and the completeness of the information they provide. In practice, through previous assignments, we have found that a combination of these approaches can work best to achieve a balance between the efficiency of the analysis and richness of information. A combined approach also avoids producing quantitative valuations based on loosely defined assumptions. Taking this approach means the optimal methodology should be tailored to different types of contingent liabilities. For example: Single-variable guarantees such as demand (or minimum revenue) and exchange rate guarantees contain fewer inputs and can be usefully analyzed using a probabilistic approach to produce an expected value, based on the assumed behavior of the underlying variable (demand and exchange rate behavior, respectively) Debt guarantees may be better analyzed semi-quantitatively, by calculating the total cost if a payment was required and analyzing—perhaps including further scenario analysis, for example under different financial structures—and tracking financial robustness to understand the likelihood of a default Guarantees covering damage due to force majeure events may also be better analyzed semi-quantitatively—by calculating the payment required if the trigger event occurs—due to the difficulty of assigning meaningful probabilities to those events. Based on this, a combination of these approaches can be used to analyze the contingent liabilities the Government bears in a PPP. The next section describes how the approaches would apply in practice to different categories of contingent liabilities in Pakistan. Analyzing categories of contingent liabilities in Pakistan Table 3.2 below organizes common contingent liabilities into four categories and describes to what extent the probability and amount of each contingent liability can be analyzed. We also identify the preferred valuation method. The four main categories in Table 3.2 are also described under each of the subheadings below. Termination and Force Majeure payments Analyzing contingent liabilities for the case when a contract is terminated will need to account for the limited information that may be available and ensure the method is practical to implement. For example, it may be impractical to create a financial model for every individual PPP project. 35 Confidential Each contract may define several different types of termination events, each requiring a different payment calculation. These payments are typically defined as some combination of outstanding debt, un-recovered equity, and other amounts that are specific to each contract. Importantly, while the process for analyzing termination and force majeure payment guarantees is similar, the events that trigger payment and therefore the underlying risks are quite different. Demand and regulated price guarantees Demand and revenue guarantees specify a floor at which the government agency will compensate the private proponent if revenue or user-ship should fall below. Regulated price guarantees provide for the difference to the private proponent if tariffs are not adjusted according to the terms of the contract. These guarantees are typically two-variable payments. In these cases, it is relatively straightforward to create a simple model that estimates the expected values and distributions using Crystal Ball and standard input assumptions. The model can be used to estimate a range of scenarios to determine the impact of the regulated price or demand fluctuation over time. While the process for analyzing demand and regulated price guarantees is similar, it is important to not that, in practice, the two guarantees are quite different. Demand guarantees represent genuine commercial risk in the project. By contrast, price guarantees are a regulatory risk that is within the control of regulators or government officials. Other commercial risk bearing In some cases, the Government will have accepted significant commercial risk on a project. This is the case, for example, when the contracting authority makes annuity payments (which themselves are not contingent) to the private proponent, as is the case with the Shadala Flyover implemented by NHA. To the degree that obligations can be associated with specific PPPs, contracting authorities should create financial models to analyze and forecast the financial conditions of the PPP. In other cases, the Government will be exposed to multiple contingent liabilities by guaranteeing the entire set of obligations of a contracting authority that develops PPPs. Often it will be difficult to disentangle the source of the Government’s exposure for each project. It may be more useful to evaluate the exposure to the operating inefficiencies and default of the contracting authority. In these cases, the financial condition of the contracting authority and source of the liabilities based on sector policy will be analyzed. An example of this is the exposure that the Government is exposed to in the energy sector through WAPDA/PEPCO’s power purchase commitments. Miscellaneous guarantees Miscellaneous guarantees that provide compensation for changes in tax law or guarantees exchange rate convertibility are common, but can be difficult to assess. Often it is not practical or useful to analyze them for individual projects; however, it is possible to identify the guarantees and make recommendations about how to evaluate these in the future should these particular risks emerge. 36 Confidential Table 3.2: Analyzing Categories of Contingent Liabilities from PPPs Probability Amount Recommended valuation Guarantee Is the trigger quantifiable? How? Is the amount quantifiable? How? method Termination payments Termination payment in the event Not fully. However, can be quantified Yes, payment inputs include: Measure and report the gross of Proponent default (not due to to some extent by reviewing project Outstanding debt exposure to termination force majeure) performance, financial statements and (other contract-specific Evaluate and report termination forecasts to evaluate: provisions). triggers/ratios and determine if If milestones are being met Often the Government will assume the project is high, medium, or Financial ratios existing assets low risk for termination – Project Loan Coverage Ratio – Debt Service Coverage Ratio – Negative net assets – Un-recovered equity return. Termination payment in the event No, it is not possible to determine the Yes, payment inputs include: Measure and report gross of GOP default or force majeure probability of a force majeure event Outstanding debt exposure causing the proponent to terminate Un-recovered equity Clearly identify the triggers. the contract, or of the Government Discounted cash flow to equity defaulting on its own obligations holders (other contract-specific provisions). Often the Government will assume existing assets Demand and regulated price guarantees Demand or revenue guarantee Yes, by assuming a distribution Yes, with a simple 2-variable payment Construct a simple valuation model function for expected demand and calculation that uses scenario and probabilistic observing actual demand levels Demand shortfall methods to estimate the expected Tariff. value of demand/revenue guarantees 37 Confidential Probability Amount Recommended valuation Guarantee Is the trigger quantifiable? How? Is the amount quantifiable? How? method Regulated price guarantee if tariffs Not fully. It is difficult to determine Yes, with a 2-variable payment Construct a simple valuation model are not set at the level specified in the ex ante probability that tariffs calculation that uses scenario (and the contract won’t be approved according to Demand probabilistic) methods to estimate contract terms. However, it is Tariff shortfall. the expected value of regulated possible to value the guarantee under price guarantees various scenarios Other commercial risk-bearing Other commercial risk bearing: To the degree that obligations are associated with specific PPPs, create a Create a full financial model of Commercial obligations of financial model to analyze and forecast the financial conditions of the PPP project utilities (WAPDA/KESC) PPPs where the contracting authority bears full or significant commercial risk. Miscellaneous guarantees Change in legislation or tax law No, it is not possible to determine No, it is not possible to determine None for existing guarantees what changes in laws may occur, or what adverse impact unidentified Make recommendations on how the probability that they will occur changes in laws may have on a to assess the guarantee if you project. However, guidelines can be know what changes to laws you provided for future scenarios want to evaluate Exchange rate insurance No, it is not possible to determine the Not fully. It is not practical to Make qualified assessments of the probability of NBP default estimate the fx risk or at what point maximum exposure based on the NBP would default. However, a value amount of foreign-denominated of total foreign denominated currency capital that is insured can be estimated Convertibility/remittability No, it is not possible to determine the Not fully. It is not practical to Make qualified assessments on the guarantee likelihood that funds could not be estimate the amount, or at what point maximum exposure based on the converted/remitted the GOP would default amount of locally-denominated funds 38 Confidential 3.3 Approving Contingent Liabilities Once a PPP project has been structured and proposed, and the contingent liabilities have been analyzed, the financial commitments from the Government should be approved. This is particularly the case with contingent liabilities, because the amount of the financial commitment and the associated fiscal risk is not easily knowable, and so it should be subject to additional analysis (as described in Section 3.2) and scrutiny. Objective when approving contingent liabilities: To ensure the use of Government resources in the form of contingent liabilities is focused on policy priorities; represents value for money; and is consistent with good fiscal management. 3.3.1 Why is the function important? Currently, there is no central process being consistently followed by which the Government can evaluate and approve its financial commitments through contingent liabilities to PPPs. This has created a situation where Government officials are sometimes not fully aware of what PPPs, across all sectors, it is party to. Moreover, there is not a consistent process by which the Government can evaluate and approve the fiscal risk and exposure from contingent liabilities for the PPPs that exist. Because accepting contingent liabilities under PPP projects uses Government resources, the contingent liabilities—along with all other forms of financial support—should be centrally approved to ensure the PPP is focused on the Government’s policy priorities, represents value for money, and is consistent with good fiscal management. 3.3.2 What relevant policies and processes are in place? There are no specific requirements or rules for taking the contingent liabilities to be accepted under a proposed project into consideration when approving a PPP project. Although the 2010 PPP Policy specifies that all financial commitments of the Government under PPP projects must be approved by MoF, the requirements and process for PPP project approval in general are not clearly specified. The FRDL Act limits the issue of new guarantees during a fiscal year to two percent of the estimated GDP for that year. This limit does not currently apply to contingent liabilities accepted under PPP projects, but could feasibly be extended to do so (as described in Section 3.1). Checking consistency with that limit would then form part of the process of approving a proposed PPP project. 3.3.3 How should the policies and processes be improved? The PPP Policy 2010 specifies that all financial commitments of the Government under PPP projects must be approved by the MOF. Since contingent liabilities constitute financial commitments, then consideration of these liabilities should be part of that approval. As described in Section 4, where we discuss institutional options for managing contingent liabilities, this aspect of PPP project approval could potentially be delegated by MOF to another entity—or internally—if appropriate. Under the PPP Policy, it is MOF’s responsibility to ensure contingent liabilities are approved. We recommend two aspects of contingent liabilities are checked when evaluating and approving a PPP: 39 Confidential The structure of each proposed contingent liability The overall fiscal impact of the project. Check 1: Have the contingent liabilities been structured well? At a minimum, the agency responsible for evaluating and approving the contingent liabilities under a proposed PPP project should check that those liabilities have been structured according to the principles described in Section 3.1 above. If those principles have been followed, this means that each risk has been allocated to the party able to bear it at lowest cost, and the fiscal impact of each risk the Government bears has been minimized. That is, the total cost of risk-bearing for the project has been minimized, and in that sense the proposed contingent liabilities are cost-benefit justified. When evaluating the structure of contingent liabilities it is also important to take into account the entire package of financial support and obligations provided by the Government. However, particularly in cases where a risk (such as exchange rate, or demand risk) is shared, finding the optimal risk allocation by following the principles may be difficult. In these cases, the Government could consider specifying rules or strategies to avoid accepting too much risk. Two options for doing so, and the potential benefits and disadvantages of each, are described in Table 3.3 below. Table 3.3: Possible Rules for Approving Contingent Liabilities Option Example Potential Benefit Potential Disadvantages 1—define limits The expected cost Helps avoid the Government No clear basis for setting on certain types (or defined bearing more risk than it level of limit—cut-off of risk percentile) of needs to. If the guaranteed point for project approval providing a level level of demand is set too may be somewhat arbitrary of demand high, this is effectively a Requires consistent, guarantee must subsidy to the project and quantitative assessment of not exceed x% of should be considered as such contingent liabilities—only total project cost applicable to risk types that can be quantitatively assessed 2—charge a fee Offer a demand The private investor must Requires consistent and to the private guarantee for a decide whether the guarantee accurate valuation of the investor for fee equal to the is worth the fee. If the private Government’s expected cost certain types of Government’s party actually expects its cost guarantees, and expected cost of of bearing the risk would be make those providing the lower, it will turn down the guarantees guarantee guarantee—this helps make optional sure risks are allocated to the party able to bear them at lowest cost Both the options described in Table 3.3 require consistent, quantitative valuation of the Government’s expected cost of accepting a contingent liability. As described in Section 3.2, valuing contingent liabilities can be a complex and difficult task. Therefore, specific options for setting rules when approving contingent liabilities would be best to fully adopt in the 40 Confidential future, once staff have developed the capability need to analyze contingent liabilities, and the PPP program and contingent liability management framework is fully functioning. Check 2: What is the overall budget and debt impact of the contingent liabilities under the proposed project? The Government should also consider the overall impact of the contingent liabilities under the proposed PPP, and whether this can be accommodated within budget and debt limits. Just as budget limitations mean the Government may not be able to undertake every economically beneficial project, even where the contingent liabilities of a proposed project are well structured, the overall fiscal impact could be considered too high. For most government expenditures, this consideration is addressed through the budget process. The overall budget envelope is defined taking any debt limits into consideration, and this amount is then allocated among departments based on policy and project priorities. However, contingent liabilities are unusual in that they have no budget impact at the point at which the decision is made to accept them. Table 3.4 describes options for taking the overall fiscal impact of the contingent liabilities into account when considering whether to approve a PPP project proposal. As for the first check on the structure of individual liabilities, all of these options would require consistent, quantitative valuation of the Government’s cost of accepting contingent liabilities. Similarly, these rules would be best to fully adopt in the future, once staff have developed the capability need to analyze contingent liabilities, and the PPP program and contingent liability management framework is fully functioning. 41 Table 3.4: Possible Rules to Limit Overall Fiscal Impact of Contingent Liabilities Option Example Potential Benefit Potential Disadvantages 1—define limits Limits could defined by: This approach is simpler than Creates “dual budget�, which may create a bias for total stock of Setting a specific limit on contingent integrating contingent liabilities towards either guarantees or subsidies contingent liabilities from PPPs, or into the overall budget (depending on whether budget or contingent liabilities from Specifying that contingent liabilities from process, while ensuring the liability limit is binding) that does not achieve PPP projects, or PPPs should be included under the limits overall fiscal impact of the value for money—it would be more efficient to on new specified in the Fiscal Responsibility and contingent liabilities under a incorporate into actual budget process (since contingent Debt Limitation (FRDL) Act, namely: proposed project is taken into the overall fiscal envelope should reflect debt liabilities in any account limits) – Overall debt limit of 60% of GDP fiscal year Limits could be defined on – Overall limit on new guarantees in any expected cost, or on another fiscal year of 2% of GDP. measure such as maximum In each case, the nature of the limit would exposure (which may be need to be carefully defined (For example, simpler to calculate). whether on maximum or expected exposure) 2—incorporate Include cost of guarantee when calculating Takes into account the subsidy Subsidy decision rules not yet fully defined contingent total financial support to a project, including element of providing a guarantee or implemented in practice liabilities into VGF, and applying the same decision rules Requires consistent and accurate valuation subsidy (VGF) of the Government’s expected cost. analysis 3—require Contracting authorities must include the Forces contracting authorities to Introduces an opportunity cost of budgeting contracting expected, lifetime cost of the contingent consider cost of guarantee for the contingent liability for which no authorities to liability in their annual budget in the fiscal explicitly when considering expenditure may ever be required budget upfront year in which the liability is accepted. Where affordability of project—that is, Requires consistent and accurate valuation for expected cost the contracting authority is not a consistency with budget priorities of the Government’s expected cost of contingent government department that participates in Requires systems to deal with the budgeted liabilities the budget allocation process, the same amount—for example, setting this aside effect could be achieved by charging a against future payments for realized guarantee fee to the authority liabilities (see Section 3.8 below). 42 Confidential 3.4 Accepting Contingent Liabilities Once contingent liabilities have been approved for a proposed PPP project, the Government should formally accept or issue the contingent liabilities. Formally accepting contingent liabilities through an explicit agreement—to which the Ministry of Finance is typically a signatory—makes the Government’s commitment to its obligations under the PPP contract clear. This may reduce the perceived risk and increase the confidence of private investors. Objective when accepting contingent liabilities: To clarify the Government’s commitment to its contingent liability obligations, and to ensure the executed contract is consistent with earlier analysis and approval. 3.4.1 Why is the function important? Under current policy, the Government’s commitment to contingent liabilities is not explicit and there is not a consistent processes for checking that executed contracts include the approved terms. This creates uncertainty about which contingent liabilities the Government is committed to and which commitments it is likely to uphold. Moreover, during contract negotiations with a preferred bidder, contracting authorities may come under pressure to change the terms of the contract to accept more project risk. As described above, accepting the right contingent liabilities is the most important step in contingent liability management. Having followed the process of structuring, analyzing and approving the contingent liabilities under the proposed or draft contract, it is important that the final contract terms are checked for consistency—and any differences assessed and approved—before the contingent liabilities are formally accepted. 3.4.2 What relevant policies and processes are in place? There is currently no single process in place for a central agency, like MOF, to formally accept contingent liabilities from PPPs across all sectors. PPIB signs implementation agreements on behalf of the Government to contractually define the extent of the Government’s obligations, including contingent liabilities, to independent power producers. In other sectors, however, there is no formal mechanism by which the Government accepts contingent liabilities. The DPCO currently certifies that new debt guarantees are compliant with the FRDL Act and in some cases the Ministry of Finance issues a comfort letter to formally acknowledge the issuance of a guarantee. 3.4.3 How should the policies and processes be improved? Once the project has been tendered and the final contract agreed, the Government should formally accept the contingent liabilities in the project by: Checking the final contract to verify that the contingent liabilities have not materially changed since the project was approved. Signing an “agreement letter� to formally accept the contingent liabilities under the PPP project. Checking the final contract 43 Confidential Once the requirement for issuing an “agreement letter� (see below) has been established, the Government could specify that the agreement will only be provided when the final contract is consistent with the approved draft. A process should be defined for assessing and approving or reconciling any differences (as discussed under the institutional options in Section 4 below). Signing an agreement letter The agreement letter would be similar to the implementation agreements that are signed by the PPIB and independent power producers. That document is effectively a means for the Government to formally acknowledge the contracting authority’s commitments under the PPP. However, these implementation agreements (IA)s are extensive agreements specifying many terms of the contract with IPPs. Following the 2010 PPP Policy, risk allocation for PPPs should be comprehensively specified in the PPP contract itself. Therefore, the “agreement letter� should simply confirm the Ministry of Finance’s commitment to ensuring the contracting authority is able to honor its obligations under the PPP contract. 3.5 Monitoring Contingent Liabilities After a PPP has been executed, the Government should monitor and, when necessary, reevaluate its exposure to contingent liabilities. This will ensure officials have access to updated information on the Government’s portfolio of contingent liabilities and can track, and take action to mitigate, emerging risks. It will also facilitate the budgeting and paying for obligations under realized contingent liabilities Objective when monitoring contingent liabilities: To provide information needed to disclose, act on emerging issues and, if necessary, budget for contingent liabilities. 3.5.1 Why is the function important? The Government does not maintain a central database of what PPPs it has implemented, what contingent liabilities are contain in the PPP contracts, and what risks are associated with the contingent liabilities. Improving the collection and monitoring of information will help the Government track its exposure to fiscal risk from year to year, and improve its ability to take action to reduce the cost or likelihood of an event triggering a payment occurring should risks emerge. Moreover, effective monitoring should be done in way that facilitates the other important functions in managing contingent liabilities, including: Disclosing that exposure at the project and portfolio level (see Section 4.6) Identifying and acting on any emerging issues (see Section 4.7) Budgeting for contingent liabilities, depending on how realized contingent liabilities are paid for (see Section 4.8). 3.5.2 What relevant policies and processes are in place? The 2010 PPP Policy specifies that contracting authorities are responsible for monitoring PPP projects. The PPP Policy also states that the DPCO is responsible for “ultimate management� of any contingent financial obligations, including PPPs, arising from the PPP 44 Confidential program. This follows the FRDL Act (2005), which specifies that the DPCO is responsible for monitoring the Government’s guarantee stock. However, there are no requirements or guidance provided for how monitoring should be done, or for how DPCO and contracting authorities should work together during the project implementation stage 3.5.3 How should the policies and processes be improved? During project implementation (construction and operations), the Government should systematically collect up-to-date information on project performance, and periodically update its evaluation of the contingent liabilities under the project accordingly. This can be effectively carried out by: Including reporting requirements in draft contracts Requiring the use of monitoring plans Maintaining a central database. Including reporting requirements in draft contracts The Government should ensure that requirements for the private proponent to report and provide information to the contracting authority are included in draft contracts for proposed PPP projects. The Government should then check to verify that the reporting requirements are included when approving a project (see Section 3.3). Requirements for the contracting authority to report and provide information to the government agency charged with managing contingent liabilities—DPCO, as specified in the 2010 PPP Policy—should be included in the “agreement letter� used by the Government to formally accept the contingent liabilities (see Section 3.4). Require the use of monitoring plans The Government should also require that contracting authorities prepare monitoring plans that include details of the project and information on the contingent liabilities. The plan should be used to identify potential risk and should lay out an action plan for dealing with problems that may increase the Government’s exposure or cause a contingent liability to trigger. A sample of a monitoring plan that could be used as a template by contracting authorities is shown in Table 3.5. Contracting authorities should be required to submit the monitoring plan as part of the PPP approval process (see Section 3.3). 45 Confidential Table 3.5: Sample Template Monitoring Plan [NAME OF PROJECT] CL Management Plan Timing Contingent Underlying Risk Pre- Sources of Accountable Management Priority Level as Notes, To-Do or Value (state measure) Construction Operations Liability Factors Construction Information Agents Approach at [date] Key Dates [dates] [dates] [dates] Y/N List accountable Classify as high, List sources of agents (inside or - Add brief description of Describe how risk medium or low List key dates or A Show dates if timing differs from overall information by outside payment as defined in contract will be managed priorit and reason to-do points dates (e.g. applies for only first years of risk factor Government) by 1 for classification operations) risk factor - Add quantitative measures of value where possible B C D 2 3 46 Confidential Maintaining a central database Finally, the Government should maintain a central database as part of the process for monitoring contingent liabilities. DPCO is the sensible host of the database given its mandate to manage contingent liabilities in the 2010 PPP Policy. The database should include the monitoring plans submitted by contracting authorities, as well as any other relevant project information. The project information should be collected according to the reporting requirements specified in the draft contracts and “agreement letter�. The analysis of the contingent liabilities reevaluated and the monitoring plans should be updated on at least an annual basis. 3.6 Disclosing Contingent Liabilities Once PPPs are in the implementation stage, the Government should disclose the exposure to contingent liabilities that it has accepted. Doing so improves the accountability of decision makers and the credibility of the Government’s actions. It also gives credit rating agencies and lenders access to accurate information, so they are not overestimating the Government’s creditworthiness. Objective when disclosing contingent liabilities: To improve accountability for decision- makers, and increase transparency of the Government’s commitments to third parties (such as credit agencies and lenders). 3.6.1 Why is the function important? The Government has good practices in place for publicly reporting its fiscal and debt policies and status. Including contingent liabilities from PPPs in these reports would bring the Government further in compliance with its own policies. Further, disclosing contingent liabilities under PPP projects provides real benefits and strengthens the other steps in the contingent liability management framework. Reporting on exposure to contingent liabilities will increase transparency and improve the accuracy and completeness of information available to external parties. This avoids external parties such as lenders and credit agencies, who are likely to take a cautious approach, having to guesstimate the country’s exposure when assessing the country’s creditworthiness, for example, for defining a credit rating (as described in Box 3.3 below). Disclosure also enhances accountability and publicly signals the Government’s commitment to introduce policies to effectively manage fiscal risk, providing stronger incentives to decision-makers throughout the process. 47 Confidential Box 3.3: How Disclosure can Improve a Country’s Credit Ratings Credit rating agencies take into account a country’s contingent liabilities when assessing creditworthiness. There are two primary ways in which contingent liabilities are evaluated and incorporated into ratings: By determining if there is “imminent crystallization of contingent liabilities�, and By checking if the government has adequate funds to cover its contingent liabilities. Disclosure can improve the credit rating of a country by giving an accurate profile of its exposure. This provides auditors with greater confidence that large contingent liabilities are not impending, and that the government has enough funds to cover payments and maintain fiscal stability if high-risk contingent liabilities are realized. Source: Moody’s Sovereign Risk Group. 3.6.2 What relevant policies and processes are in place? The FRDL Act (2005) requires “consistent and authenticated information� on guarantees, including their budgetary impact, to be included in an annual debt policy statement. This is included among the responsibilities of DPCO, who releases the annual Debt Policy Statement. DPCO has also started disclosing the stock of contingent liabilities in the Annual Economic Survey; however, so far, this has only include debt guarantees to financial institutions on behalf of public entities and not contingent liabilities from PPPs. 3.6.3 How should the policies and processes be improved? There are two factors to consider when determining how the Government should disclose its contingent liabilities: Where information on the contingent liability stock from PPP projects should be published What information should be disclosed. Where information should be published Other governments include contingent liability information either within public financial management statements or reports, or as a standalone report. The latter approach is used in Chile, for example, and can make the information more accessible. However, in Pakistan, the annual Debt Policy Statement provides an obvious mechanism for this disclosure: a high- profile and relevant document. This statement already includes a section on “guarantees� (covering loan guarantees only). The guarantee section should be made more generic and cover other types of contingent liability, including those from PPPs, or the report should include a separate section on contingent liabilities to PPPs. What information should be disclosed Any information disclosed about the Government’s CL exposure should be: Accurate and complete, but not excessively burdensome to produce Aligned with, or an improvement on, international standards and practices. At a minimum, a report disclosing contingent liabilities should include information on each project, the nature of each contingent liability, and measures of the exposure and potential cost. The Government should start with a relatively limited set of information, and look to 48 Confidential expand this over time as staff become more capable of analyzing contingent liabilities and the contingent liabilities management system becomes fully functional. Table 3.6 shows a suggested list of information that could be included in the Debt Policy Statement prepared by DPCO. Table 3.6: Example of Disclosure Information Portfolio-level reporting Estimates and a brief description of: – Total exposure to contingent liabilities (annual and net present value) – Total probability-weighted expected value of contingent liabilities (annual and net present value) – Measures of the variability (95th percentile) and distribution of total exposure and expected value. Brief explanations of each measure and how it was calculated. Project-level reporting A comprehensive contingent liabilities table, including: – A description of the nature of the contingent liabilities and the associated project – Key underlying risks – Estimated cost of payment if contingent liabilities are realized (annual and net present value) – Probability-weighted expected value of contingent liabilities (annual and net present value) – Measures of the variability (95th percentile) and distribution of possible payments – A description of the management approach. Brief explanations of each measure and how it was calculated. A summary table listing the projects being monitored during the year and reporting the expected value, estimated cost of payment if contingent liabilities are realized, and measures of variability (95th percentile) 3.7 Acting on Emerging Contingent Liability Risks Beyond simply monitoring exposure to contingent liabilities from BOT projects, the Government should actively manage that exposure where possible, by identifying and taking action on emerging issues. Taking early action can help reduce the cost to Government of bearing contingent liabilities. Acting to mitigate risk can also help to keep decision makers, regulatory bodies, and the private party accountable and, in turn, improve the credibility of the Government’s guarantees. Objective when acting on emerging risks from contingent liabilities: To help reduce the cost to Government of bearing contingent liabilities by reducing the likelihood or cost of those liabilities realizing. 3.7.1 Why is the function important? In some cases, the Government could have avoided costs associated with problems in the past if risks were identified and action was taken to reduce the likelihood or cost of liabilities realizing. For example, with appropriate monitoring policies in place, some stakeholders may have identified earlier what costs would have been incurred by keeping retail tariffs below cost recovery in the energy sector, and acted to either gradually increase tariffs early on or 49 Confidential avoided accepting further obligations. Similarly, the Government and NHA may have chosen to increase the toll on the Lakpass Tunnel and eliminate the need to compensate the private proponent. 3.7.2 What relevant policies and processes are in place? As described in Section 3.5 for monitoring contingent liabilities, the 2010 PPP Policy suggests that responsibility for actively managing those liabilities would be shared between contracting authorities and the DPCO. However, no further guidance is provided. 3.7.3 How should the policies and processes be improved? Systematically monitoring contingent liabilities under PPP projects, as described under Section 3.5 above, enables the Government to identify contingent liabilities that may be at increased risk of realizing. By identifying this early, the Government can then consider the possible actions that could reduce the likelihood or cost of needing to make a payment. It is difficult to define any specific actions the Government could take, since emerging issues could vary widely. Any action should be analyzed to understand the potential costs and benefits of alternative responses. Appropriate action plans should be included in the monitoring plans as described in Section 3.5. Actions could include: Following up with third-party Government agencies to ensure they are providing required inputs (for example, permits) in a timely manner Informing Government decision makers responsible for policy or regulatory decisions that may adversely affect the project of the potential costs of an adverse decision In certain cases, changing levels of tariffs or charges (and subsidies) to help increased demand keep the financial performance secure In extreme cases, re-negotiating the contract or triggering buyout by the Government. Section 4 describes options for who could be responsible for considering the possible responses and, when appropriate, carrying out any responses found to be justified. 3.8 Budgeting and Paying for Realized Contingent Liabilities While managing contingent liabilities effectively can reduce the cost or likelihood of needing to make payments, some contingent liabilities will be realized and payments will inevitably be required. The Government should implement a systematic process to budget and pay for contingent liabilities when they do realize to strengthen incentives and provide the private proponent with a clear and credible policy for the Government to meet its obligations. Objective of analyzing contingent liabilities: To ensure resources are available to make payments promptly when required—improving credibility and clarity as to how costs of contingent liabilities will be borne, and mitigating the fiscal impact. 3.8.1 Why is the function important? A well-defined system for budgeting and paying for contingent liabilities will ensure the Government has the resources available to meet its obligations and mitigate the fiscal or 50 Confidential budgetary impact of contingent liabilities. By doing so, the Government will also improve the private sector’s confidence in the Government’s guarantee. More specifically, effective policies to budget and pay for contingent liabilities can help to: Incentivize decision-makers to accept the right contingent liabilities, by making it clear who will be responsible for meeting the cost if those contingent liabilities realize Improve the credibility of the Government’s commitments, by making clear the process and timeline with which the private partner will be paid Reduce the adverse fiscal impact of needing to make a payment, by reducing the need for in-year budget cuts or overall expenditure shocks to accommodate the sudden need for an unexpected payment. 3.8.2 What relevant policies and processes are in place? There is no defined policy for budgeting and paying for contingent liabilities from PPP projects. 3.8.3 How should the policies and processes be improved? The challenge in budgeting and paying for realized contingent liabilities is that payment obligations may arise unexpectedly during a fiscal year. This means payment obligations may not be able to be reflected in the annual budget, as for other types of Government expenditures, and resources may not be immediately available. There are several options for budgeting and paying for realized contingent liabilities, as described in Table 3.7. Table 3.7 below describes and evaluates four options, which are not mutually exclusive, for Pakistan: Structuring contingent liabilities to reduce the need for unexpected payments Requiring contracting authorities to set aside funds in advance against possible future payments Budget for payments that may occur in the forthcoming year Create budget flexibility to make unexpected payments when required. Not all of these options will be practical in Pakistan based on existing public financial management legislation. The attractiveness of each option may also depend on the relative importance of the objectives described above. MOF, in collaboration with IPDF, should evaluate the practicality of these options and determine what alternative, or combination of alternatives, is acceptable to private investors and will best achieve the Government’s objectives while aligning Pakistan’s budgeting laws and accounting practices. 51 Confidential Table 3.7: Approaches to Budgeting and Paying for Realized Contingent Liabilities (CLs) Possible Description Relative Advantages and approach Recommendation Approach 1: As described under Section 3.1, well-structured CLs can reduce need for Where possible, this is the simplest solution Structure CLs to unexpected payments. For example: to the challenge of budgeting and paying for reduce need to Defining termination payments as conditional on re-tendering the project and realized CLs, and should be pursued as a make unexpected receiving payment from the new contractor (resulting in both increased priority. However, it may not be possible for payments when income and expenditure in the year in question) all types of CL; depending on the range of contingent Avoiding need for demand-related payments; or if required, define that types of CL the Government faces, they may liabilities do realize payments for particular risk guarantees will be due in the year after the shortfall need to adopt one or both of the other takes place, once the required amount is known and can be budgeted for. approaches Approach 2: Set Setting aside funds in advance can help: (i) create incentives for contracting Setting aside funds could provide strong aside funds in authorities to take on the right risks (although not necessarily to manage them incentives, reduce fiscal shocks, and increase advance against well, if “already paid for�) and (ii) reduce the need for budget flexibility at the time credibility; however, it has a high possible future a CL realizes, since the required payment has effectively already been budgeted for opportunity cost and would requires more payments in advance. In turn, this helps improve credibility, since private parties know the complex valuation Government has funds to make payments. Under this option, contracting authorities would transfer some measure of the cost of the CL (could be expected value or some risk-adjusted expected value) from their budget at the time the CL is accepted, into some kind of fund, which could be: Held as a dedicated Government account that would remain part of the treasury funds Set up as an external institution, to which funds can be paid from the budget and which would not be considered part of treasury funds (see Section 4). Any set-aside funds should be earmarked by contracting authority (or by project). That is, payments for CLs from a given agency can be made up to the amount that the agency has contributed to the fund. 52 Confidential Possible Description Relative Advantages and approach Recommendation Approach 3: The Government could budget for possible CL payments in the forthcoming year, This option reduces the need for in-year Budget for by: budget reallocations or shocks to the fiscal payments that may Including a “reserve� or “contingency� item in the overall budget—this could deficit. However, it has several occur in the be a standard item, or could reflect the most recent understanding of the disadvantages: forthcoming year likelihood of payments being made, based on monitoring information Opportunity cost of not allocating those Requiring contracting authorities to include in their budget for the budgeted funds to some other use forthcoming year any CL that is considered likely to require a payment, even if Difficulty of defining the threshold for the CL has not yet realized. determining what CLs should be In these cases, the relevant budget allocation could be used to make the payment budgeted and getting the budget if it is indeed required; if not, it would be re-absorbed into the general fund at the approved end of the fiscal year Risk of prejudicing outcome, by reducing incentives to mitigate CL or acknowledging a contested CL. Approach 4: Even applying the above approaches, unexpected payments may need to be made. Need to have some kind of system in place Create budget The Government may want to define how such payments will be accommodated. because unexpected payments will always be flexibility to make Any unexpected payment could be accommodated either by cutting expenditure necessary occasionally. The exact unexpected on other budget items, or by increasing the overall fiscal envelope for that year. In arrangement depends heavily on existing payments when the latter case, additional sources of finance must also be found; this could include public financial management legislation required setting up a dedicated contingent credit line, to ensure finance is always available. For example: Payments could be appropriated and made automatically, extending the fiscal envelope and borrowing from a contingent credit line. Repayments could be part of general Government debt, or could be recouped from agency budgets in the future (if debt repayments can be allocated) Payment requirements could lead to a supplementary appropriation from the agency, which the MOF would decide how to handle If an internal “fund� is used, payments could be made by that fund borrowing (subject to automatic Government guarantee) to make payments. 53 Confidential 4 Who Should be Responsible for Managing Contingent Liabilities In Section 3 we described each of the recommended eight functions for managing contingent liabilities and how policies and processes could be improved to ensure these functions are performed successfully. To be effective, these functions must link together as a coherent system, with clearly defined institutional roles and responsibilities. In this section we describe and analyze these institutional roles and responsibilities—that is, who should carry out the functions described in Section 3. The two main options that we consider for allocating the responsibilities to manage contingent liabilities are: Option 1: Strengthening existing institutions—contracting authorities, IPDF, MOF and DPCO—by enhancing their roles and responsibilities Option 2: Establishing an independent guarantee fund to accept the bulk of responsibilities for managing contingent liabilities These two options are described in the sections that follow (Sections 4.1 and 4.2). While there are clear advantages and disadvantages to both options, we recommend Option 1: that Pakistan adopt an institutional framework for managing continent liabilities that strengthens existing institutions and allocates the responsibility for performing the recommended functions to: The Ministry of Finance (MOF) as the oversight agency responsible for approving financial commitments to PPP, including contingent liabilities The Debt Policy Coordination Office (DPCO) as the division within MOF responsible for the central management of contingent liabilities, including evaluating submissions, certifying compliance with policy and law, formally accepting, monitoring, disclosing, and ensuring action is taken to mitigate emerging risk associated with contingent liabilities Contracting authorities as the contracting authorities responsible for appropriately allocating risk and structuring contingent liabilities, complying with submission and approval requirements, monitoring, reporting to DPCO, and taking action on emerging risk The Infrastructure Project Development Facility (IPDF) as the agency responsible for supporting contracting authorities throughout the steps in the PPP development and contingent liability management lifecycle. This incremental option is better suited than Option 2 (establishing an independent guarantee fund) to the size of Pakistan’s current exposure to contingent liabilities and allows for sufficient flexibility and speed in implementation. Option 2 has further disadvantages over the incremental approach. Establishing a Guarantee Fund would certainly need significant investment in further research and institutional design, as well as up-front commitment of Government capital. Because of current exposure to contingent liabilities is heavily concentrated in the energy sector, we do not believe the 54 Confidential exposure justifies setting aside reserves to manage existing fiscal risk in Pakistan. It is important that the energy crisis, which is a large fiscal burden, is addressed; but otherwise resources would be better spent focusing on structuring and completing PPP transactions, so Pakistan can make progress developing capacity and experience in its PPP program. Therefore, we do not recommend the Government establishes an independent Guarantee Fund. In our view, the complexity and cost of this option outweighs the immediate need to address problems with the contingent liability in the Pakistan and has uncertain benefits. 4.1 Option 1: Strengthen Existing Institutions Option 1 is to develop a contingent liabilities management system that relies on strengthening existing institutions by clarify and formalizing existing mandates and adding new responsibilities. This option focuses on making incremental improvements that: Complement the policies and process in place, or currently being developed, for assessing and approving PPP projects Use the resources and capacity in existing institutions with the Government. The primary institutions that could perform the functions we recommend for managing contingent liabilities include: Contracting authorities—the agencies that enter into PPP contracts, such as PPIB and NHA, are typically responsible for developing and assessing PPP projects, and therefore also for structuring and analyzing the associated contingent liabilities. As the agency with the direct relationship with the contractor, the contracting authority also typically plays a key role in monitoring and taking action on emerging contingent liability risks Infrastructure Project Development Facility (IPDF)—IPDF has been established within MOF to support contracting authorities in carrying out their functions in developing PPPs and completing new transactions. IPDF is also intended to have a role in monitoring and managing projects during the implementation stage Debt Policy Coordination Office (DPCO)—DPCO was established in MOF to oversee the Government’s debt policies and manage exposure to debt guarantees and other contingent liabilities. The 2010 PPP Policy explicitly states that DPCO is responsible for the management for contingent liabilities Ministry of Finance (MOF)—MOF is responsible for the Government’s fiscal policy, including the allocation of budgetary resources and the payment of contingent liabilities should they be realized. The 2010 PPP Policy explicitly states that MOF is responsible for approving all financial commitments to PPP projects. There are number of options for how the roles and responsibilities for performing the functions described in Section 3 could be allocated to these institutions. The optimal allocation should comply with 2010 PPP Policy and its enabling legislation, which is currently being drafted. It should also work to create efficiencies with the processes that are in place for moving a project through the PPP lifecycle. This includes both the process followed by contracting authorities with experience developing PPPs—such as PPIB and NHA—and the project preparation and feasibility guidelines developed by IPDF. Finally, 55 Confidential the optimal allocation should take into account the ability of each institution to successfully perform the functions based on the resources and capacity within the institutions. Based on these broad criteria, we have developed a preferred option for allocating responsibilities to manage contingent liabilities. Under the preferred option, contracting authorities have primary responsibility for structuring contingent liabilities and analyzing exposure, as well as having overall responsibility for monitoring and managing that exposure. IPDF is available to provide support to contracting authorities when performing these functions under the same arrangement for preparing and developing PPPs. MOF and DPCO are responsible for evaluating requests, approving, and formally accepting contingent liabilities for particular PPPs. As part of the evaluation process, MOF and DPCO has responsibilities for checking and certifying that approved contingent liabilities are compliant with the structuring principles and guidelines—developed by contracting authorities and approved by MOF—and governing PPP and debt management policies. MOF and DPCO will also have support and oversight role in monitoring and managing emerging risks. Option 1 has the key advantage of making incremental improvements to the status quo, capitalizing on the strengths of the existing system, and avoiding the need for major institutional change. In our view, Option 1 has other specific advantages: Consistency with the mandates of each entity—the 2010 PPP Policy states MOF’s role in approving all financial commitments to PPPs, DPCO’s role in overall management of contingent liabilities, and the role of contracting authorities in structuring and monitoring PPPs Alignment of incentives—the distribution of responsibilities between contracting authorities, which have an interest in developing PPPs, and MOF and DPCO, which have an interest in managing fiscal risk, strikes an appropriate balance between implementation incentives (the desire to execute new contracts) and oversight incentives (the desire to limit exposure to risk) Resource requirements are consistent with exposure—while the contingent liabilities in the energy sector are large and demonstrate the need for good decision making and risk management policies, outside of the energy sector, exposure to contingent liabilities is currently limited. By focusing on strengthening existing institutions, the Government avoids attempting to develop and implement a new, complex entity that requires excessive resources, will require additional time to become operational, and may prove to be unsuccessful More flexible and faster implementation—while there is need for training and capacity building at all levels of Government, this option attempts to best utilize the existing institutional knowledge and organizational capacity in contracting authorities, IPDF, and DPCO. An entirely new entity for managing contingent liabilities would likely take longer to become operational. A more incremental approach also makes it easier to revise and adjust the approach as needed, without requiring major overhauls. Table 4.1 below lists which of these key institutions would perform the functions under the preferred option. We also provide an alternative for allocating each function among the key institutions and explain what the advantages and disadvantages are compared to the preferred allocation that we are recommending. 56 Confidential Table 4.1: Analysis of Alternatives for Strengthening Existing Institutions Function Preferred Option 1 Alternative Option 1 Who should perform the function? Who should perform the function? Structuring The contracting authority, since it is the entity responsible for Alternatively, MOF and IPDF could take a more central role in CLs developing the PPP structure. IPDF can provide support to developing PPP structuring principles and contractual contracting authorities, as needed. mechanisms that would apply to all projects. This approach is Principles and guidelines should be approved by MOF (since more centralized, but does not allow the approach to be tailored MOF will need to approve the set of CLs, as part of the to the specific needs and circumstances in each sector Government’s financial commitment to the project) Analyzing CLs The contracting authority because it is the agency responsible for The agency responsible for approving CLs (such as DPCO) developing the project proposal—following approved guidelines because the analysis could be done as part of project set by MOF. IPDF can provide support, as needed development or project assessment—following approved guidelines set by MOF Approving MOF should provide the final approval based on certification of Alternatively, MOF could give DPCO final authority to approve CLs compliance from DPCO CLs or delegate authority to IPDF This aligns with the 2010 PPP Policy, which states that: MOF should approve all the Government’s financial commitments to PPP projects, including contingent liabilities DPCO is responsible for managing contingent liabilities. Accepting CLs MOF should sign the “agreement letter� after the contingent Alternatively, MOF could give DPCO final authority to sign liabilities are evaluated, final PPP contracts are checked, and “agreement letters� or could delegate authority to contracting DPCO has certified compliance with relevant policies (FRDLA agencies. However, this alternative reduces some of the and PPP Policy) advantages of having the central Government formally issue CLs Monitoring Contracting authorities should be responsible for gathering data Contracting authorities could supply data directly to DPCO or CLs and for analyzing and re-valuing exposure, and required to report IPDF, which could be responsible for analyzing that data, exposure to DPCO, following a prescribed and approved updating the CL valuation, and maintaining monitoring plans monitoring plan According to the Pakistan PPP Policy (2010), the contracting authority is responsible for monitoring the PPP project, while the DPCO is responsible for managing contingent liabilities 57 Confidential IPDF can provide support to contracting agency, as needed— assign “project officer� for projects above a certain value. Disclosing DPCO should include contingent liabilities from PPPs in the Contracting authorities could independently disclose. However, CLs annual Debt Policy Statement. Information for completing the this alternative involves less oversight and is less efficient report should be collected through the monitoring function (see above) Taking action The contracting authority will invariably be central to taking any In some cases, it will be appropriate for MOF, DPCO, or IPDF on emerging action to manage the Government’s exposure, since this agency to take more of a role in responding to emerging risks, but this CL risks has the direct relationship with the private contractor. not a mutually exclusive alternative Involvement of a central agency is important to ensure the contracting authority is taking actions where necessary, and to support the contracting authority in doing so Budgeting and Contracting authorities should have budgetary accountability for No suitable alternative. paying contingent liabilities to provide better incentives to accept the right contingent liabilities, and to manage those contingent liabilities well (in cases where the contracting authority is able to control the risk factor on which the CL depends) 58 Confidential 4.2 Option 2: Establish an Independent Guarantee Fund An emerging idea in the international infrastructure community is for governments to establish independent entities to issue and manage guarantees to private infrastructure operators and investors. These Guarantee Funds are designed to take over the contingent liability management function for PPP projects from the government. Establishing such an entity is a second, and considerably more sweeping option for Pakistan to manage its contingent liabilities. Under this option, the Government would establish and allocate capital to establish an independent Guarantee Corporation as a Government-owned company. The Guarantee Fund would be governed by a board of directors chaired by a representative of MOF. Its day-to-day operations and management would be contracted out to a private financial institution. Besides providing the mechanism by which the Government will make upfront budget commitments to cover contingent liabilities, the Guarantee Fund would manage and oversee the entire process for assessing, approving, and monitoring contingent liabilities, and managing emerging risk. The Board of the Guarantee Fund would approve requests from contracting authorities for guarantees that would create contingent liabilities to PPP projects and enter into guarantee agreements. When issuing a guarantee, the Guarantee Fund would charge a fee to the contracting authorities. The fee would be valued based on assessment and valuation of the expected cost of providing the guarantee. If the guarantee is not approved or the fee is too high, the contracting authority would need to restructure the project to better manage the risk. Under this option, the total value of the Government’s stock of contingent liabilities would not be allowed to exceed the Guarantee Fund’s capital, which would depend on the allocation from MOF and any external funding received by the Guarantee Fund. Outsourcing the management contingent liabilities to an independent Guarantee Fund has a number of advantages over the alternative of maintaining the functions within existing Government institutions. These include: Independence from political influence, in particular the temptation to under- value guarantees to meet budgetary and investment targets Strong technical capacity for valuing and assessing risk if the Guarantee Fund is operated by a private financial institution Potential for the Guarantee Fund to build its own relationships, for example with external financial institutions, and achieve credibility among private investors higher than that of the central government. The main disadvantage of outsourcing these functions, in addition to the increased on-going cost of the private financial institution’s contract fee, is the relative complexity of establishing the Guarantee Fund as an independent entity. There is very little international experience in developing Guarantee Funds, and the possible advantages have for the most part not been tested. The success of the fund also depends on the participation of private investors and insurers or multi-lateral institutions, which may be difficult to secure. The advantages of establishing a Guarantee Corporation in practice are therefore far from certain. 59 Confidential 5 How to Implement the Recommendations This section describes how Pakistan can adopt, test, revise, build capacity, and fully implement the recommendations we described in Sections 3 and 4 of this Report. Following the completion of the current assignment, at least five steps will be required to adopt the recommendations and fully implement the policies and processes for managing contingent liabilities. Figure 5.1 shows the steps and provides an indicative timeline for the completing each one. The structure and timeline we present in the figure draws from our past experience providing training to government agencies for adopting and operationalizing components of a contingent liability management framework. Figure 5.1: Timeline of the Implementation Action Plan 2010 2011 September September November December November December February October October January August August March June Key implementation steps April May July 1A Pilot-test CL management recommendations 1B Simultaneously provide training 2 Revise and further develop recommendations 3 Amend enabling legislation 4 Adopt the Procedures Manual 5 Provide ongoing training and capacity building ONGOING… Specific steps Ongoing implementation efforts The steps illustrated in Figure 5.1 include: Step 1A—Pilot-test the recommendations on one or more live cases. We recommend that the Government pilot-test these contingent liability management recommendations on at least one live PPP project that is in the early development or feasibility stage. A pilot-test will provide an opportunity to evaluate and refine the recommendations and will also help close high priority PPP transactions, which IPDF has struggled with to date. A pilot-test could also be expanded to include other parts of the PPP development and implementation process, such as evaluation and approval of viability gap funding—we describe the potential need for this Appendix A where we provide a summary of the workshop Step 1B—Simultaneously provide training. Training while pilot-testing a PPP project would provide the staff in contracting authorities, IPDF and DPCO, with hands-on experience as well as guidance while implementing for the first time the contingent liability management recommendations Step 2—Revise the contingent liability management framework and develop further guidelines and tools to facilitate the implementation. The pilot-test in Step 1 will provide the opportunity to evaluate the effectiveness of the proposed contingent liability management framework. Following this evaluation any necessary revisions should be made to improve and finalize the recommendations based on lessons learned. Under each function we have also identified tools or guidelines that may be required to implement the function. 60 Confidential These tools and guidelines should be further develop and approved by MOF, when necessary, as indicated in the body of this report Step 3—Amend enabling legislation. Each of the functions we have recommended aligns with the current 2010 PPP Policy, however, the policy should be updated or supplemented to include the specific requirements for contingent liability management. The PPP Bill, which we understand will serve as the legislative vehicle to enforce the PPP Policy and is currently being drafted and finalized, should also be amended to ensure the contingent liability management policy is enforceable Step 4—Adopt the Draft Procedures Manual. As part of this assignment, Castalia has developed a Draft Procedures Manual to help Government agencies in Pakistan fulfill their role in the contingent liability management framework. We recommend that the procedures in the manual be adopted by, for example, MOF issuing a statement to establish the role and responsibility of DPCO as the division within MOF leading contingent liability management and clarifying that project approval will require compliance with the policies and procedures in the Procedures Manual Step5—Provide ongoing capacity building and training—the Government will likely need to provide some ongoing training to staff within DPCO, IPDF and contracting authorities. The training and capacity building needs should be assessed during the pilot-test of the recommendations.. 61 Confidential 6 Evaluation of International Experience There has been a general increase of international interest in managing contingent fiscal liabilities. International standards increasingly require disclosing these liabilities in public accounts, and countries are introducing new approaches to managing and controlling their exposure. However, there is relatively limited international consensus on managing fiscal risk specifically arising from PPP projects in infrastructure. Governments seeking to manage their exposure to risk from guarantees to infrastructure PPPs have done so in a number of ways, reflecting their specific objectives and institutional strengths or limitations. It is nonetheless useful to consider experiences from other countries. Learning from tried- and-tested common features, and considering what drives the differences that exist, may help Pakistan decide on the best options for its own contingent liability management system. There are frameworks in place or under development in other emerging markets that incorporate some or all of the following features: Defining acceptable risks and structuring contingent liabilities Defining a standard approach to valuing contingent liabilities Defining decision rules for assessing and approving contingent liabilities Monitoring and disclosing contingent liabilities Budgeting or setting aside funds to cover expected or actual costs (that is, realized costs, which may exceed expected cost) of contingent liabilities Paying for contingent liabilities when called. The mechanisms used to implement these principles, for example the allocation of responsibilities between different entities within government, differ between countries. In the following sections, we present case studies from a range of countries: Colombia, Brazil, Chile, Indonesia, and the State of Victoria, Australia. We then examine the commonalities and differences between these frameworks, and briefly summarize lessons for Pakistan. 6.1 Colombia During the 1990s, the Government of Colombia issued guarantees for a wide variety of risks in respect of electricity, roads, and telecommunication PPP projects. The value of the contingent liabilities to the Government of Colombia from having issued these guarantees was estimated at around 1.5 percent of the country’s gross domestic product in 1997. At that time, the consensus was that guarantees were issued indiscriminately by implementing government agencies. There were no rules on how to decide whether to issue a guarantee or not, and none on how to cover the Government of Colombia’s exposure from these guarantees. As result, many guarantees were offered to poorly structured projects in which the Government of Colombia was bearing an excessive amount of risk. Between 1998 and 2003, the Government of Colombia defined new rules and procedures for issuing BOT-related guarantees, with a series of laws, decrees, and policy documents. The primary objective of these was to manage the fiscal risks associated with future government guarantees. 62 Confidential Overview The provision of guarantees in Colombia is now controlled by the Risk Management Unit in the Ministry of Finance. This unit is responsible for assessing and approving guarantee requests prepared by implementing institutions, according to well-specified criteria of acceptable risks. Budget provisions against guarantees are made by transfers from the implementing institution to a contingency fund, a special government account which is managed by a private company. The Contingency Fund was established by law in 1998. In 2001, a Decree defined detailed rules and procedures for managing contingent liabilities, supplemented by policy documents defining acceptable types of risk, and how each should be managed. In 2003, a further law required the Ministry of Finance to approve the value of the contingent liability of a proposed guarantee. Projects and risks Risks that the Government was prepared to guarantee were clearly defined, based on the principle that risk should be allocated to the party that is best placed to value and to control the risk, and that had best access to mitigation, protection and diversification instruments. For each sector, the Government defined the specific risks that it was prepared to bear or share, as well as the mechanisms that should be used for mitigation. For example, for a toll road project, the Government is only prepared to bear land acquisition risk. Demand risk is borne by the concessionaire, but shortfalls are dealt with by extending the term of the contract until the concessionaire achieves a pre-agreed level of expected revenue, avoiding a fiscal cost. Institutional structure The institutional structure for managing guarantees in Colombia is summarized in Figure 6.1 below. Responsibilities for setting policy with regard to guarantees, for assessing guarantee proposals and evaluating associated contingent liabilities, and for making the appropriate financial provision, are allocated between the implementing institution, the Ministry of Finance Risk Management Unit, and other government planning authorities: Implementing government institutions identify and prepare projects, estimate the value of contingent liabilities, and make transfers into a Contingency Fund according to their proposed payment plan, once approved by the Ministry of Finance. The implementing institution is also responsible for authorizing claim payments, and for meeting payment costs if these exceed the project provision within the Fund The National Council for Social and Economic Policy defines the risk allocation policy, while the relevant planning department (for example, national or provincial) determines the compliance of a particular proposal with this policy The Risk Management Unit of the Ministry of Finance defines the policy for valuing contingent liabilities. It is responsible for approving guarantees, along with their valuation and associated payment plans. This decision is based on information submitted by the Implementing Institution, as well as a recommendation from the relevant planning office. 63 Confidential The Contingency Fund, a special account administered by a private financial institution under contract to the Ministry of Finance, is essentially a vehicle for making budget provisions against guarantees. There is no direct contractual relationship between the Fund and the private investor. Figure 6.1: Colombian Guarantee Management—Institutional Structure Ministry of Finance National Council for Social and Economic Policy RMU Defines risk allocation policy Applies for guarantee approval National / sub-National Planning Approves/disapproves Authority Implementing Institution Transfers (Government) Determines funds compliance with risk Contingency Fund allocation policy Authorizes payment to private party Manages and PPP Contract Administers Pays claim Private Financial Institution Private Party to PPP Operating policies In preparing and approving claims, and managing the contingency fund, the Government and contracting private financial institution are guided by policies designed to manage the fiscal risk of providing guarantees: Guidelines for calculating the value of the contingent liabilities—that is, the present value of the expected cost of the guarantee to the Government—require the use of risk-pricing modeling methods such as Binomial trees or Monte Carlo simulations Mandating the implementing institutions to make transfers to the Contingency Fund equal to the expected value of the guarantee ensures the expected value of the total stock of guarantees does not exceed the assets of the Fund. These transfers are made up-front, and may be topped up over time if the expected value of the guarantee changes. The Contingency Fund holds a separate account for each project, funded by the transfers from the implementing institution. In the case of a payment claim, any shortfall is met by the government institution that is party to the PPP contract. 64 Confidential 6.2 Brazil Brazil established its current PPP and Risk Management Framework between 2004 and 2006. Brazil was relatively new to the involvement of private finance in infrastructure provision, so the primary objective of the framework was to mobilize private capital to finance extensive infrastructure investment. Overview In Brazil, an independent Guarantee Fund—the Fundo Garantidor de Parcerias Publico-Privadas (FGP)—forms the basis of the institutional structure for managing PPP Guarantees. The decision to approve guarantees proposed by government agencies is controlled by the government as the sole shareholder; all other functions are the responsibility of a management contractor. Provisions against guarantees will be made by allocation of the fund’s assets—hence the stock of guarantees is capped by the size of the fund. The Government nonetheless remains liable for any realized payment obligations that exceed the size of the fund. A PPP Law in 2004 defined the legal framework for PPPs in Brazil, the general guidelines for project contracting, and also authorized the creation of the FGP. The initial capitalization of the FGP, to a limit of US$ 1.5 billion, was authorized by a 2005 Decree. It was formally launched in February 2006, but its operating policies have not been fully published. Selection of risks The FGP provides guarantees to cover the financial obligations of government entities under PPP contracts, which generally constitute direct payments for specified services. Certain risks faced by the private PPP investors are explicitly covered or mitigated by Government through this structure, namely: The risk of the government entity party to the contract facing insolvency, or becoming illiquid—that is, facing a temporarily inability to make a due payment— this includes the risk of lower receipts due to a demand downturn The risk of payment delay due to a protracted legal process, and a long queue of payment claims, in case of dispute. The framework does not have any specific guidelines as to what other risk events guarantees may cover. This is left to the discretion of the FGP. Institutional structure The FGP is a government-owned stock corporation, which was capitalized by the Government with US$ 1.5 billion in shares of publicly traded companies and state-owned enterprises (SOEs). The Government controls company decision-making through the Shareholder Assembly, including approval of guarantee proposals. Funds are thereby kept segregated from the budget process, enabling multi-year payment commitments. The FGP is managed by the government-owned commercial bank Banco de Brasil (BB), which manages its day-to-day financial operations, as well as having the following responsibilities: Establishing the process for project valuation and analysis Designing and preparing potential PPP project guarantee proposals, for approval by the Shareholder Assembly 65 Confidential Drafting guarantee contracts and representing FGP in judicial processes, and Publishing financial statements and information on the stock of guarantees. Guarantees are triggered by non-payment of the implementing institution, if unrelated to performance issues. Disputed claims are subject to a private law process of arbitration. The framework contains a commitment to pay within a certain time frame of either the trigger, or the resolution of a dispute—the FGP’s private entity status exempts it from the constitutional requirement of complying with judicial decisions in chronological order. The guarantee agreement includes a provision for the FGP to recover from the Institution the cost of paying a claim under the guarantee. The World Bank agreed in principle to provide contingent capital to the FGP, most likely in the form of a contingent loan, to ensure funds are available should guarantee calls exceed the capital in the fund. This increases the credibility to the private sector of FGP guarantees. The institutional structure for managing guarantees in Brazil is summarized in Figure 6.2. Figure 6.2: Brazilian Guarantee Management – Institutional Structure Ministry of Finance Notification FGP & collection Implementing Institution Shareholder Assembly Payment Refund of claim Management payment PPP Contract Payment Contractor for services Contingent Loan (proposed) Payment Default notice Private Party to PPP IBRD (Special Purpose Vehicle) Operating policies The operating policies of the FGP have been established by Banco de Brasil, particularly with regard to the criteria and processes by which the eligibility of projects for guarantees will be assessed. Developing these is part of the mandate of the FGP management. Some provisions have been made for how the fiscal risk arising from the contingent liabilities will be managed. The present value of all guarantees provided by the FGP is capped at the level of its assets. A definition on how the “present value of the guarantees� is calculated has not been published. FGP can use various types of guarantee instruments, but each must be covered with assets of similar characteristics, such as liquidity and average life. However, the capitalization of the FGP with shares only may limit the capacity to achieve this. 66 Confidential 6.3 Indonesia In the early to mid 1990s, Indonesia established a large number of PPPs, mainly in the power, road, and telecommunications sectors. In the absence of any defined framework for Government support to PPPs, these deals were opaque, often involving general, ambiguous guarantees such as letters of support to PPAs. When the Asian financial crisis hit Indonesia in the late 1990s, the drop in demand and devaluation of the Indonesian rupiah left many projects unsustainable and subject to forced renegotiations or cancellation. As a result, public private partnership development in Indonesia stopped until 2005–2006. At this time a new focus on PPPs in infrastructure emerged and the Government began to develop a legal and institutional framework for infrastructure PPPs. The key objective of this framework is to mobilize private investment in infrastructure by provision of credible Government guarantees. Overview The Government has recently developed a new risk management framework for PPP projects. As part of that framework, an independent Guarantee Fund, the PT Penjaminan Infrastruktur Indonesia (PII), was formally established in December, 2009. The PII is a fully state-owned corporation, and has been established with an initial capital transfer from the Government of IDR 1 trillion (around USD 107 million). Additional capital is expected to be provided in the coming years. The Government intends PII to be a commercially-run guarantee company, issuing guarantees in its own name and subject to its own policies (to be developed with substantial support, and further capital contribution, from the World Bank). The establishment of this fund supplements and supersedes the previous institutional arrangements for managing risk from PPP projects. Presidential Regulation 67, issued in 2005 (PR67) defined the legal basis for PPPs in Indonesia. This was supplemented by the Ministry of Finance regulation PMK38, issued in 2006, which provided a framework for managing the associated risks (defining acceptable risks and processes to manage their fiscal impact), under the Risk Management Unit of the Ministry of Finance. Both regulations have since been circumvented in practice. Projects and risks The PMK38 regulation established broad categories of risk against which the Government should consider issuing guarantees, based on the principle that that risk should be allocated to the party best able to mitigate or absorb it. These included political risk, demand risk, and certain project performance risks such as land acquisition and contract changes. The regulation also stipulated that projects must be technically and financially feasible, and awarded through competitive tender, to be eligible for guarantee. However, a number of projects that do not appear to fulfill these criteria have since been approved for Government support. The PII has yet to publish any criteria as to specific risks for which it will consider providing a guarantee. Institutional structure Until recently, the Risk Management Unit (RMU) within the Ministry of Finance oversaw the guarantee process. The RMU’s responsibilities—as defined in the PMK38 regulation—were to verify the compliance of the project with the criteria outlined above and to analyze the fiscal costs and risks resulting from proposed support. The decision of the Minister of Finance on whether to provide a guarantee, as proposed by an implementing institution, was 67 Confidential based on the recommendation of the RMU, along with verification by the National Committee for the Acceleration of Infrastructure Provisions (KKPPI) that the project is in line with policy priorities. In order to better manage fiscal risk and improve the credibility of guarantees, the Ministry of Finance has now established the PT Penjaminan Infrastruktur Indonesia (PII), an independent Guarantee Fund, as a state-owned enterprise. The PPI has been capitalized by Government, with an initial transfer of IDR 1 trillion. The PPI will report directly to the Minister of Finance; its internal structure has not been publicly announced. It is intended to operate as a commercially-run guarantee or insurance company—issuing guarantees in its own right for a premium charged to the private contractor, and managing its assets to adequately cover the cost of required payments. The proposed institutional structure for managing guarantees in Indonesia is summarized in Figure 6.3 below. Figure 6.3: Indonesian Guarantee Management – Suggested Institutional Structure Ministry of Finance (Finance Minister) Initial Policy Capital Stipulations Guarantee Proposal PPI Implementing Approval Institution Guarantee PPP Contract Contract Initial Capital Claim Private Party to PPP MDA Payment Operating policies The PMK38 regulation introduced the broad criterion that guarantees would be issued only when the resultant fiscal cost and risk does not “exceed the fiscal capacity of the State to bear.� The new institutional structure will concretize this principle, by limiting PPI to issuing guarantees that can be covered by the value of its assets, thereby both ensuring provision against expected losses, and placing an overall cap on the exposure to guarantees. Detailed policies for PPI have yet to be developed, with substantial support (as well as a further capital injection) from the World Bank. These policies will include the approach to assessing and pricing proposed guarantees. No approach to recovering costs of guarantee payments triggered by Government behavior has yet been defined. 68 Confidential 6.4 Chile Chile began its PPP program in the early 1990s, with highway concessions as a solution for reducing its infrastructure deficit while maintaining fiscal discipline and ensuring that highways were properly maintained once they were built. The Concessions Law was passed in 1991 and the concessions program began in earnest in 1994. Chile’s concession program now includes highways, airports, jails, and other types of public infrastructure (such as stadiums and public transport transfer stations). The Government of Chile offers some guarantees to infrastructure PPPs, mainly focused on traffic levels (the bulk of the projects involve transportation). Its goal is to reduce the risk profile of a given project in which investment decisions made by the Government could lower the project’s cost of capital and thus the total cost of the project. The Government considers that its guarantee program has successfully achieved this goal. The Government is in a strong fiscal position. It has maintained a structural budget surplus of one percent of GDP since 2001. The major risk rating agencies—Fitch Ratings, Moody’s, and Standard & Poor’s—have rated its sovereign bonds as “investment grade� since before 2000. Its sovereign risk, measured in basis points, was the lowest in Latin America for eight years, until creeping just above Mexico’s in September 2007. Chile’s framework for managing the fiscal risk of government guarantees reflects its sound fiscal position, and is geared toward monitoring the fiscal implications of the guarantees. Overview Chile’s framework for managing government guarantees to infrastructure projects centers around structuring and valuing the contingent liabilities that arise from these guarantees. In 2003, the Government instituted a policy for valuing, reporting, and monitoring all of its contingent liabilities. This includes not only guarantees to infrastructure projects, but also to the debt of state-owned companies, financing for higher education, and minimum pensions. Although the policy has been followed continuously since 2003, it was made into law by the Fiscal Responsibility Law (Ley de Responsabilidad Fiscal), approved in 2006. The Concessions Law (Ley de Concesiones) and the Law of Financial Administration of the State (Ley de Administración Financiera del Estado) also underpin Chile’s policies on issuing government guarantees. The Government—through the Ministry of Public Works—is currently party to concessions for 22 inter-city highway projects, seven urban highway projects, 10 airports, two jails and several other public buildings. All but three of the inter-city highway projects, and most of the airports, have a minimum revenue guarantee. Only two urban highways have a minimum revenue guarantee. The value of the contingent liabilities associated with guarantees to infrastructure PPPs has been very low since the policy of valuing and reporting them began in 2003. Their value has fluctuated between 0.15 and 0.25 percent of GDP, or approximately 0.3 to 0.8 percent of the Government’s annual budget. The present value of the future payments under guarantees to infrastructure PPP projects at the end of the 2009 fiscal year was US$342 million. Projects and risks There are no formal rules regarding the types of risks that the Government may accept through guarantees, or the projects that it may provide guarantees to. 69 Confidential All public investment projects—including concessions, are subject to a thorough evaluation involving the Ministry of Public Works, Ministry of Planning and Cooperation, Ministry of Finance, and the Comptroller General. The objectives of this evaluation are to ensure that projects: Are consistent with the Government’s infrastructure plan Pass a social cost-benefit analysis Are undertaken by the public sector or private sector depending on which is best- placed to carry them out, and Are acceptable from a macroeconomic and fiscal sustainability perspective.4 Under the Law of Financial Administration of the State, the Ministry of Finance must also approve the procurement documents of any concession or PPP contract before it goes to bid. The terms of the guarantees are included in these documents. The Contingent Liabilities, Guarantees and Concessions Unit (Unidad de Pasivos Contingentes, Garantías y Concesiones) in the Ministry of Finance is responsible for reviewing and approving the guarantees included in the procurement documents. Types of guarantees the Government has provided include: Minimum revenue guarantees, for projects in which decisions made by the Government have a significant effect on the revenues of a project. Minimum revenue guarantees to highway projects constitute the largest component of Chile’s infrastructure guarantee program. These have more recently been replaced, by introducing variable-length contracts, where the length of the concession varies to allow the concessionaire to achieve a certain minimum level of revenue. This type of guarantee does not create a contingent liability for the Government Guarantees against devaluation of the Chilean peso were provided until 2005 by mutual agreement with concessionaires in which both down-side and up-side risks were shared. Development of the domestic capital market has since allowed concessionaires to raise peso-denominated debt, obviating the need for these guarantees. Companies bidding on a concession may choose whether or not to accept the guarantee offered in the procurement documents. If they choose to accept it and win the concession, they must make a payment to the Government equal to the present value of the expected cost of the guarantee, as measured by the Government. The Government typically also offers a termination payment guarantee, should the project company default on its obligations. However, since the payment is conditional on the government re-tendering the concession and set equal to the price obtained, this creates no contingent liability for the government. Policies for managing guarantees The Chilean Government’s system for managing its exposure to risk from contingent liabilities focuses on structuring its guarantees well to minimize fiscal risk, and on valuing and reporting its exposure. Line ministries bear the cost of guarantees once these have been called. 4 International Monetary Fund, Public-Private Partnerships, Government Guarantees, and Fiscal Risk. Washington, D.C. 2006. 70 Confidential The Contingent Liabilities, Guarantees, and Concessions Unit of the Ministry of Finance is responsible for valuing the exposure. This unit estimates the present value of the government’s contingent liabilities using stochastic analysis through Monte-Carlo simulations to measure the risk associated with the risk factors underlying the guarantees, and Black- Scholes to value the guarantees. The Government began reporting the value of its contingent liabilities in its annual Report on Public Finances (Informe de Finanzas Públicas) in 2003. Since 2007, the Government has issued a more detailed annual report on contingent liabilities. In these reports, the Government also publishes the value of the payments that it knows it will have to make under its guarantees. The obligation to report the value of contingent liabilities was formalized in the Fiscal Responsibility Law of 2006. The minimum revenue guarantees are paid at the end of the fiscal year. Government agencies and ministries that are party to guarantees—including the Ministry of Public Works—subtract the value that must be paid on the guarantees from the next year’s budget to determine the amount of money they may spend in the next year. For example, concessionaires’ revenue shortfall in 2009 determines how much the Government must pay to them under the minimum revenue guarantee. The Government knows what this amount is at the end of the 2009 fiscal year. This amount is subtracted from the Ministry of Public Works’ budget for the 2010 fiscal year. Although payments on Government guarantees come from line ministries, the Government’s net exposure from minimum revenue guarantees is offset by the initial payment made by the concessionaire. However, the Government incorporates the guarantee fee into its consolidated accounts and has not set up accounts to show guarantee claims offsetting the guarantee fee. The Government has considered establishing a guarantee fund for infrastructure PPPs. However, because the value of the contingent liabilities in relation to GDP and the Government’s budget is so small, the Government has determined that the benefit of establishing this fund would be minimal. The Government monitors the value of the contingent liabilities but has not found it necessary to put into place any other mechanisms to cover its exposure from these liabilities. 6.5 Victoria, Australia Under Australia’s federal system of government, most infrastructure development falls within the responsibility of State governments. PPP policies have largely been developed at a State level—the policy of the state of Victoria is a good example. Victoria introduced a PPP program in 2000, since which time twenty projects have been successfully developed. The program’s primary objective is achieving value-for-money in public expenditure on infrastructure. Overview The Victorian State government has very strong finances, and a triple-A credit rating. This means there is little need for explicit fiscal risk mitigation measures to cover government guarantees to PPP projects. Overall project risks do nonetheless need appropriate management. The Victorian Government has therefore introduced a comprehensive management framework for PPPs—“Partnerships Victoria�—to ensure that the risks the 71 Confidential Government undertake through PPP projects are justified and provide good value-for- money. The “Partnerships Victoria� framework was outlined in a policy document and has been periodically updated with the publication of implementation guides5. There is no specific legal framework for the development of PPP projects, although project-specific legislation has been passed for certain major projects, for example when new regulatory authority is necessary. Risk and project selection The main thrust of the Partnerships Victoria policy is the definition of those risks the Government will accept in relation to PPP contracts. The initial policy document laid down the principle that, after pre-supposing that the private party bears all project risks, the Government should “take back� those risks it can manage at lower cost. Two further principles were also established: whoever is allocated risk must have the freedom to choose how to handle and minimize it, and the materiality of the risk should be a consideration in its allocation. The Government set out its initial approach to the allocation of each type of PPP project risk in the Risk Allocation and Contractual Issues Guide, issued in 2001. In 2005, in light of its experience in creating and implementing PPP projects, the government published the Standard Commercial Principles Guide, which acts as a basis for all PPP contracts. This includes an updated set of risk allocation preferences, and defines how these will be reflected in the terms of a PPP contract. The evaluation process for each PPP project is also clearly outlined in the Partnerships Victoria policy. This involves a quantitative cost-benefit analysis of PPP provision, including the cost of the guarantees incorporated in the PPP contract, in comparison with other alternatives such as public sector provision. Concessionaires are selected by way of a rigorous and transparent system of public tendering. Institutional structure and policies for managing contingent liabilities The Victorian Department of Treasury and Finance has overall responsibility for PPP policy. Ministers and department heads are responsible for procuring PPP contracts within their portfolio and departmental responsibility, and have the authority to enter into contracts on behalf of the state government. State Cabinet approval is required, however, at several stages in the planning and procurement process, which is set out in the Partnerships Victoria policy. Any guarantees that form part of a PPP project are contained within the project contract; no independent Government guarantees are issued. Since most Partnerships Victoria projects are paid for by Government departments, rather than users, those payments are known and must be factored into the budget of the relevant department. These kinds of PPP project obligations are reported as part of State debt as “financial leases�. Even for the limited user-pays projects (such as the EastLink toll road), the Government has not borne demand risk. This means that in all cases, the risks retained by the Government are very limited. The State of Victoria budgets for most of these risks, when quantifiable—which are largely during the construction period—by including an estimated value in the relevant department’s budget. This approach is seen as relatively 5 Partnerships Victoria materials are available online, at www.partnerships.vic.gov.au. 72 Confidential inefficient, since the budgeted amount is almost always spent. The State of Victoria reports all contingent liabilities as a note to the balance sheet in its accounts, as required by the Financial Management Act (1994). This includes information on contingent liabilities from PPP projects where applicable: typically, this comprises a paragraph describing the contingent liability. 6.6 Lessons from the International Examples The examples presented in Sections 6.1 to 6.5 illustrate that, despite their largely common principles, there are both similarities and differences between different countries’ systems for managing the provision of guarantees to PPP projects. Learning from tried-and-tested common features, and considering what drives the differences that exist, may help Pakistan decide on the best options for its own contingent liability management system. As a starting point, certain basic institutional features are common to all or most countries: Risk and contingent liability management frameworks are established by law— ensuring policies and responsibilities are mandatory and enforceable, and so credible to the private sector There is a central approval process for PPP projects, including contingent liabilities—since it is the National Government that ultimately bears the risk of PPP project guarantees, and is best placed to weigh up the costs and benefits of competing demands for fiscal resources A specialist unit within the Ministry of Finance oversees the policy with respect to government guarantees to PPPs—since some specialist skills and knowledge are required. Figure 6.3 below summarizes the different countries’ approaches to the risk and contingent liability management functions listed in the introduction to this note. In the remainder of this section, we discuss these functions in turn, analyzing the reasons behind the various international approaches, and drawing lessons for Pakistan. 73 Confidential Table 6.1: International Approaches to Contingent Liability System Features Feature Colombia Brazil Indonesia Chile Victoria Defining Specific risks and mitigation To be developed Principle for risk None, but strong Specific risks and acceptable risks mechanisms defined by allocation defined; precedent in appropriate contract and structuring sector guarantee structures in practice terms defined contingent development liabilities Setting standard Defined—modeled Expected In development In development Defined—modeled Defined—modeled valuation approach Values and range Expected Values Expected Values and and range range Assessing or For all but low-probability In development. In development. Guarantee fee None distinct from approving guarantees, contracting Overall exposure Overall exposure charged to private definition of acceptable contingent authorities must budget up- capped by size of capped by size of contractor and risks liabilities— front: decision thereby guarantee fund guarantee fund guarantee optional defining decision integrated into budget (for revenue and rules process exchange rate guarantees) Monitoring and Exposure monitored to Exposure monitored by Exposure monitored Exposure Exposure monitored by disclosing inform required budget guarantee fund; by guarantee fund; monitored by finance ministry, and contingent transfers to fund (to maintain reporting requirements reporting requirements finance ministry, disclosed annually in liabilities level for each project equal to not yet clear not yet clear and disclosed notes to State balance expected value). No explicit annually in a sheets reporting of contingent detailed annual liabilities from PPP projects report Budgeting or Expected cost covered by Expected cost covered Expected cost covered None Contracting authority setting aside funds transfers to fund. by allocating guarantee by allocating guarantee includes expected value to cover expected If actual value exceeds fund assets—actual cost fund assets—actual of quantifiable liabilities or actual value expected cost, difference met covered by any cost covered by any (typically small) in (above expected from budget of remaining non- remaining non- relevant year’s budget cost) of contingent implementing institution committed guarantee committed guarantee liabilities fund assets fund assets 74 Confidential Feature Colombia Brazil Indonesia Chile Victoria Paying for Contracting authorities Guarantee fund pays Guarantee fund pays Costs of guarantees Contracting authorities contingent transfer expected cost of from its assets from its assets charged back to pay from budgeted liabilities guarantees to fund and must contracting amount (or additional cover any unexpected authorities ex-post appropriation) for additional costs from budget quantifiable liabilities; others paid through mid-year adjustment if required 75 Confidential Defining acceptable risks and structuring contingent liabilities Since providing guarantees constitutes a cost to government, most countries seek to ensure this cost is justified. By defining the risks the government is prepared to bear, countries can attempt to maximize the benefits from provision of guarantees to PPPs. The level of detail to which acceptable risks are defined varies between countries, and broadly increases with the country’s level of experience in planning and implementing PPP projects. In Indonesia, for example, the principles by which risks should be allocated, and some broad categories of risk the government may accept, are outlined, whereas in Colombia, with a longer history of PPP investment, specific acceptable risks are defined for each sector. In Chile, there are no formal rules, but there is strong precedent as to what types of risks and projects the Ministry of Finance has approved guarantees to, and increasing sophistication as to how these guarantees are structured. In Victoria, the acceptable risks, and best methods for allocating these through contract terms, have been laid out in more detail over time in successive policy guides. This trend could occur for a number of reasons: As governments implement more PPP projects, they become more conscious of the necessity to accurately define risks the government is prepared to guarantee, to prevent excessive fiscal exposure (as was the case in Colombia) Governments may prefer to postpone the introduction of constrictive definitions of acceptable risks, while gaining PPP experience (as in Victoria, Australia). In the early stages of a PPP program, the total risk exposure to PPP projects is small relative to the government budget. The government may choose, at this stage, to accept risks beyond those justified by optimal efficient risk allocation, in order to attract private investors and build confidence in the PPP program. That is, the government may rationally accept heightened fiscal risk as part of the cost of developing a culture and understanding of PPP. In Brazil, for example, the selection of risks to guarantee is left to the discretion of the FGP. Setting a standard approach to valuing contingent liabilities Of the possible components of a system to manage the fiscal risk arising from government guarantees mentioned above, the one consistently present across countries is a standard approach to valuing contingent liabilities. Whatever risk management structures are in place, they rest on properly valuing the expected cost of the guarantees. Defining decision rules for acceptable contingent liabilities The extent to which the government sets specific decision rules for acceptable contingent liabilities also varies between countries: In Victoria, there are no specific criteria on contingent liabilities: these will be accepted if the project is overall cost-benefit justified (based on rigorous analysis) and the risks are appropriately allocated In Indonesia and Brazil, the overall size of the guarantee fund provides a cap on the total possible contingent liability exposure, within which any given project must fit. No further decision rules are specified on the acceptable extent of contingent liabilities at the project level, beyond general project eligibility criteria 76 Confidential In Chile and Colombia, different mechanisms of charging for contingent liabilities are used to inform the decision as to whether these should be accepted. In Colombia, contracting authorities must transfer the expected cost of most quantifiable liabilities to the contingency fund: this means the cost of those liabilities must be considered in that agency’s budget decision-making. In Chile, this decision has, in the past, been passed to the private contractor, by offering and charging for “take it or leave it� guarantees on revenues and exchange rates. Monitoring and disclosing contingent liability exposure Monitoring contingent liability exposure is a key part of the system for managing that exposure, in particular in Chile and Colombia. In Colombia, contingent liabilities are re- valued each year, and additional transfers required from the contracting authorities should the amount in the project’s “account� in the contingency fund be lower than the current expected value. In Chile, contingent liabilities are re-valued each year for public reporting. Contingent liability exposure is disclosed in Chile and Australia, following international Government accounting standards. This disclosure takes different forms in the two countries. In Chile, a “contingent liability report� is published annually, and includes quantitative valuations of contingent liabilities (where possible) as well as extensive discussion of this exposure. This report was introduced in 2007, and initially focused on contingent liabilities under PPP projects. Over time, it has been extended to cover other types of contingent liabilities. This disclosure is the central feature of Chile’s approach to managing contingent liabilities from PPP projects. In Victoria, Australia, information on contingent liabilities from PPP projects is published in a note to the balance sheet in the State’s accounts statements, alongside information on all other sources of contingent liability exposure. Since the contingent liabilities that Victoria accepts under PPP projects are limited and generally not quantifiable, the information published is qualitative in nature and typically brief. Setting aside funds towards future payments on contingent liabilities Setting aside funds for expected and unexpected losses helps manage the fiscal impact of bearing contingent liabilities. Again, the approach to these functions differs between sample countries. This may be for a number of reasons: Experience with management of PPP guarantees—in particular whether they have been paid as and when owed Size of the stock of contingent liabilities which must be managed Vulnerability of government finances to fiscal shocks; for example, if a country has a fiscal surplus or low fiscal deficit and relatively easy access to loan financing, it is better able to meet sudden fiscal demands. An important related factor is the degree of credibility of the government’s guarantees. If the private sector perceives that the vulnerability of government finances to the contingent liability arising from government guarantee is low—whether because of the small stock of PPP projects, or lower vulnerability in general—it will have more reason to believe that the government will meet its commitments in case of a claim. Where this is not the case, there is a greater need for a dedicated fiscal risk management for government guarantee provision. 77 Confidential In Victoria, Australia, there is no need for an explicit framework for managing fiscal risk for guarantees. Victoria has an AAA rating, runs a fiscal surplus, and has low financial liabilities. While Victoria is very careful to take on only justified risks from PPP projects, it does not need to incur the expense of earmarking funds against guarantees to achieve credibility, or fiscal stability. The situation is similar in Chile, where the government’s fiscal position is sound (structural surplus of one percent), the stock of contingent liabilities is small, and guarantees are well-structured to limit their fiscal impact. The Governments of Colombia, Brazil and Indonesia, in contrast, have established guarantee funds, to set aside funds for future payments against contingent liabilities from PPP projects. These funds differ in nature: The Colombian fund is essentially a Government account, allowing budget transfers by contracting authorities to be set aside to the value of expected costs (without provision for unexpected losses: that is, cases when actual costs exceed expected costs). Decisions on issuing and paying for guarantees are made by the relevant Government departments The Brazilian and Indonesian funds are independent legal entities, separate from government accounts, privately managed, and capitalized upfront by transfers from central government. Under this approach, responsibility for assessing and valuing guarantee proposals is placed fully in the hands of the private financial institution managing the fund. Any payments required are made from the fund’s resources. Both of these types of system are costly to implement. Direct costs include the up-front cost of establishing the institution and on-going management fees. There is also an opportunity cost of setting aside funds, including the use of credit availabilities from international institutions—this is particularly high when substantial funds are set aside upfront against possible future projects as in Brazil and Indonesia. However, doing so substantially reduces the fiscal risk from realized liabilities and can help improve the credibility of payments (if the fund is well-financed, particularly if supported by an international financial institution). The extent to which this approach is cost-benefit justified will depend on the Government’s objectives for managing contingent liabilities. In Indonesia, for example, the guarantee fund is being considered in part to overcome the lack of credibility of the Government’s guarantees due to its history of reneging on PPP contracts. Paying for realized contingent liabilities—charging contracting authorities In the systems described above in Brazil and Indonesia, there is no requirement for contracting authorities to make budget provisions against guarantees to their own PPP projects. This potentially weakens the incentive for the institution to accept appropriate risks, and accurately value guarantees. Instead, the guarantee financial institution plays a “gatekeeper� role to ensure only properly valued and structured guarantees are issued. In Chile, in contrast, contracting authorities are generally required to pay for the cost of guarantees in the following year, ensuring these agencies do ultimately bear the cost. In Colombia, funds set aside in a contingency fund against expected costs of guarantees to PPP project are provided from the budgets of the proposing institutions, which also bear any cost of a call over and above the contingency amount. While the funds are managed centrally by a private financial institution, and decisions are subject to central oversight, institutions are 78 Confidential essentially responsible for their own budget provisions, resulting in a strong incentive to accurately value and appraise proposed guarantees to PPP projects. The advantage of the latter approach—particularly that of Colombia—is that, since implementing institutions must directly budget for the full cost of PPP projects including guarantees, these projects will be subject to more rigorous scrutiny and prioritization in the course of each institution’s internal budget process. However, it places a high demand on the capacity of the institutions to properly evaluate guarantees. Since individuals within institutions are exposed to political pressures—unless supervision and accountability of the process is strong—perverse incentives to under-value risks may remain. Where the PPP program is young, there may also be a need to build interest among institutions, and so central government may choose to take on more of the risk of projects at this early stage. 79 Confidential Appendix A: Status Quo Report This Appendix presents the Status Quo Report submitted during the first phase of this assignment. Executive Summary This Status Quo Report is the second deliverable in Castalia’s assignment, funded by the World Bank, to improve how contingent liabilities are managed in Pakistan. In the report we identify the existing public private partnerships (PPPs) and their associated contingent liabilities in Pakistan. We also provide an assessment of the effectiveness of the policies and processes governing PPPs generally and contingent liabilities specifically to identify ways of improving how contingent liabilities are managed in the future. We find that: The Government is exposed to contingent liabilities in the energy sector through its obligations to Independent Power Producers (IPPs) and Rental Power Plants (RPPs) Outside of the energy sector, there is limited exposure to existing contingent liabilities due to the few PPP projects that have been implemented Policies and processes in place are not adequate to facilitate good decision making when structuring PPPs, accepting contingent liabilities, and managing risks. This suggests there is an opportunity to adopt an institutional framework that will facilitate the development of PPPs that create more value for money while effectively managing the Government’s fiscal risk associated with those PPPs. What are contingent liabilities and what are they for? For the purpose of this assignment a contingent liability is an explicit, contractually-defined financial obligation associated with an infrastructure PPP, the timing and/or magnitude of which depends on the occurrence of some uncertain future event. A well-designed PPP will often create contingent liabilities for the Government because the value for money of a project can be increased if the Government retains some risks that it is more practical or efficient for the public sector to manage. Contingent liabilities create the possibility that the Government may need to make unexpected, and in some cases substantial, payments to the private proponent in a PPP contract. These unexpected payment obligations expose the Government to fiscal risk that, if severe, can create significant budgetary uncertainty and put the public debt on an unsustainable path. What PPPs have been developed in Pakistan? The definition of PPP has been clarified in Pakistan’s 2010 PPP Policy to include any arrangement involving the financing, development, operation, and maintenance of infrastructure by the private sector which would otherwise have been provided by the public sector. Instead of the public sector procuring a capital asset and providing a public service, the private sector develops the asset and delivers a service in return for payment that is linked to performance. By this definition, the current PPPs in Pakistan that we are aware of include: 80 Confidential Thirty IPPs and at least nine RPPs contracted by the Private Power Infrastructure Board (PPIB), totaling approximately 8,500 MW of electricity generation capacity Three concession agreements that the National Highway Authority (NHA) is party to At least 11 concession agreements for terminal facilities contracted by Pakistan’s port authorities and one dry port railway terminal. Pakistan has limited experience developing PPPs in other sectors. The Infrastructure Project Development Facility (IPDF) was created within the Ministry of Finance (MOF) to develop and implement PPPs, but to date IPDF has not completed a transaction. Where is the Government of Pakistan exposed to contingent liabilities? The Government’s existing stock of contingent liabilities is mainly in the energy sector. Outside of this sector, the Government has limited exposure to contingent liabilities. Concession agreements for national highway services include the following obligations that create contingent liabilities for the Government: Termination payment clauses in the event of default by the company or the Government, or a force majeure event A guarantee on the regulated toll rate for Lakpass Tunnel Commercial risk the Government has retained on Shahdara Flyover. Concessions on shipping terminals also include termination payment clauses, but there is not enough information available to determine the extent of the contingent liabilities under those agreements. Moreover, it is unclear whether the Government intends to include port authorities in the efforts to strengthen the policies and processes for PPPs and contingent liability management. Within the energy sector, contingent liabilities arise in the 30 implementation agreements signed between IPPs and PPIB on behalf of the Government and in at least nine rental power agreements signed with RPPs. These contingent liabilities include primarily the financial obligations of the power purchaser and termination payments in the event of default or force majeure. The contingent liability associated with the guarantee of the power purchaser has effectively realized—in 2008, for example, the Central Power Purchasing Authority failed to pay about 51 billion Rupees owed to IPPs. While the contingent liabilities in the energy sector are known, assessing the full magnitude of the liabilities and the associated fiscal risk is complicated by the current energy crisis in Pakistan, which has created a large, ongoing fiscal burden. In the past, the Government has negotiated solutions to some of these fiscal challenges and we understand there are current efforts to address the energy crisis that go well beyond the scope of this assignment. How can Pakistan better manage contingent liabilities and why is it important? There are currently no clear or consistent policies in place for managing contingent liabilities in Pakistan. Existing PPPs have been developed by contracting authorities, following their own specific processes with limited external approval. However, some elements of the 2010 PPP Policy, and some of the efforts of IPDF to develop and implement PPP guidelines, 81 Confidential provide a basic framework for strengthening how contingent liabilities are dealt with in the future. Our findings suggest that there is an opportunity to improve how Pakistan manages contingent liabilities by adopting policies and guidelines for carrying out a series of proven functions that: Improve how contingent liabilities are structured to increase value for money and help to develop more sound PPPs in the future Create an environment for better decision-making when approving PPPs and accepting contingent liabilities Facilitate central processing and monitoring of contingent liabilities going forward These functions should include: structuring contingent liabilities and contractual mechanisms; analyzing and formally accepting contingent liabilities; monitoring emerging risks and taking mitigating action; disclosing; and budgeting and paying for realized contingent liabilities. To be implemented successfully, the functions should be embedded in an institutional framework that is not overly cumbersome to put into practice and uses the existing resources in Government—in MOF, the Debt Policy Coordination Office, and IPDF, as well as contracting authorities like the NHA and the PPIB. The institutional framework should also work to strengthen the 2010 PPP Policy and build on the parallel guidelines that have been developed to complement that policy. 82 Confidential A.1 Introduction The Government of Pakistan (the Government) wants to strengthen the institutional framework for managing contingent liabilities associated with public private partnerships (PPPs) in infrastructure. Castalia has been asked to evaluate the existing institutional framework for approving and managing contingent liabilities, including an assessment of current contingent liabilities and underlying fiscal risks, and to develop policy recommendations and guidelines to improve how the Government accepts and manages contingent liabilities in the future. This report is the second deliverable for the assignment, which is funded by the World Bank. The purpose of this report is to answer the following questions: Why is it important to manage contingent liabilities from PPPs? Answering this question provides the background needed to assess the existing institutional framework governing contingent liabilities in Pakistan What PPPs exist in Pakistan and where do contingent liabilities arise? Answering this question provides a preliminary assessment of the Government’s existing exposure to fiscal risk from contingent liabilities, and allows us to determine the effectiveness of existing policies and processes and the benefits that could be achieved by improving how contingent liabilities are managed What are the current policies and processes for managing contingent liabilities from PPPs in Pakistan? Answering this question helps determine the specific gaps that should be addressed to achieve the benefits of managing contingent liabilities well. The following sections of this report present analysis to answer each of these questions. The remainder of this introduction provides background on the assignment (Section 1.1) and describes the content of the report (Section 1.2). Background on the Assignment The Government has identified public private partnerships as an important option for delivering infrastructure services and closing the financing gap in infrastructure investment in Pakistan. PPP contracts have been entered into in the past—particularly, in energy, roads, and ports and shipping sectors—and the Government intends to use PPPs more widely and increase the number of PPPs in infrastructure going forward. A well-designed PPP will often include contingent liabilities from the Government to reduce the total upfront project costs by retaining some risk that it is more practical or more efficient for the public sector to manage. The Government has issued some contingent liabilities in existing PPPs and as the Government’s stock of PPPs grows, so will its exposure to underlying risk associated with these obligations. However, there are costs associated with the provision of contingent liabilities. Contingent liabilities create the possibility that the Government may be obligated to make unexpected and substantial payments. These uncertain payment obligations expose the Government to fiscal risk that can create budgetary uncertainty and put the public debt on an unsustainable path. Therefore, effective PPP policy will include a sound framework for deciding when to issue guarantees and managing the fiscal risk arising from guarantees. Improving how contingent liabilities associated with infrastructure PPPs are 83 Confidential managed can encourage better decision making, enhance fiscal stability, improve sovereign credit ratings, and lower the cost of borrowing. This assignment aims to develop policies, procedural guidelines and implementation plans for managing contingent liabilities through four primary tasks: Task 1: Inception—Identify the scope of the assignment and prioritize the objectives of an institutional framework for managing contingent liabilities Task 2: Assess Current Framework and Exposure—Preliminarily assess the Government’s existing exposure to fiscal risk arising from contingent liabilities; identify and assess the current institutional framework governing contingent liabilities in Pakistan; and determine the gaps that should be addressed to strengthen the policies and processes for managing contingent liabilities from PPPs Task 3: Identify and Analyze Options—Identify and analyze options that address the key gaps in the institutional framework from Task 2 and will achieve the benefits of good management of contingent liabilities in Pakistan Task 4: Develop Final Recommendations—Develop a final set of policy recommendations, guidelines, and tools needed to implement the preferred institutional framework for managing contingent liabilities from Task 3. The assignment is a continuation of a previous assignment completed by Castalia in 2008. For that work, Castalia submitted a report on Advice for Fiscal Management of Infrastructure PPPs in Pakistan. Since 2008, the Government has announced an interest in continuing to pursue PPPs to develop new infrastructure and approved a new PPP Policy in January 2010. The Debt Policy Coordination Office (DPCO) in the Ministry of Finance (MOF) is expected to be the key beneficiary of Castalia’s work under this assignment. Content of the Report The purpose of this report is to assess the existing policies and processes for developing and approving PPPs that create contingent liabilities, preliminarily assess the exposure to fiscal risk created by contingent liabilities, and determine why and how the Government should better manage contingent liabilities in the future. Conclusions from this report will then serve as the basis for developing detailed recommendations for strengthening the existing institutional framework in subsequent reports. The contents of this report are organized in three sections after this introduction: Section A.2 lays out the importance of managing contingent liabilities and the key functions of good contingent liability management frameworks Section A.3 provides a list of existing PPP projects in Pakistan and characterizes the associated contingent liabilities Section A.4 assesses the existing policies and processes that are in place to manage contingent liabilities from PPPs in Pakistan. 84 Confidential A.2 Importance of Managing Contingent Liabilities Before assessing the existing institutional framework for contingent liabilities in Pakistan, it is important to understand why it is important to manage contingent liabilities from PPPs. By answering this question, we can start to determine how Pakistan might be able to best manage its existing exposure to contingent liabilities. In turn, this will ensure that we are presenting the right analysis to decision makers when evaluating options for strengthening the policies and processes for managing contingent liabilities—the principle goal of the next task in this assignment. In this section we first explain the purpose of providing contingent liabilities in a PPP contract (Section 0). We then describe what can be achieved by managing contingent liabilities well and outline the key functions of a good contingent liability management framework (Section 0). What Are Contingent Liabilities and What Are They For? Presently, there is considerable disagreement and uncertainty within Pakistan about what comprises a public private partnership and where contingent liabilities may arise. Pakistan is not unique in this respect—there is also no universally agreed definition for PPPs and contingent liabilities internationally. However, it is important to have an agreed definition to create a common language and ensure that policies and processes can be designed to achieve targeted benefits. As such, this section presents the definition of “public private partnership�, which has recently been established in the 2010 PPP Policy to address the lack of clarity (Section 0). We also present our working definition of “contingent liability� (Section 0). These definitions help to clarify the scope of the assignment and the context for Castalia’s recommendations. Based on these definitions we describe the purposes served by accepting these contingent liabilities (Section 0) Definition of public private partnership For the purpose of this assignment we use the following definition of “public private partnership�: A public private partnership (PPP) is any arrangement involving the financing, development, operation and maintenance of infrastructure by the private sector which would otherwise have been provided by the public sector. In a PPP, instead of the public sector procuring a capital asset and providing a public service, the private sector creates the asset through a dedicated standalone business (usually designed, financed, built, maintained and operated by the private sector) and then delivers a service to the public sector entity or consumer in return for payment that is linked to performance.6 This definition was recently established in the new official policy on public private partnerships in Pakistan, which was approved by the Economic Coordination Committee January 2010. The complete text describing what comprises a public private partnership in Pakistan is provided in Box 0.1 below. Based on this definition, the most obvious PPPs that either currently exist or may be developed in the future in Pakistan include: 6 As defined in the Pakistan Policy on Public Private Partnerships: Private Participation in Infrastructure for Better Public Services. Approved by the Economic Coordination Committee of the Cabinet 26 January 2010. (2010 PPP Policy) 85 Confidential Roads and tunnels that have developed by the National Highway Authority (NHA) through concession agreements with private operators Independent Power Producers (IPPs) that have been contracted through the Private Power Infrastructure Board and signed Power Purchase Agreements (PPAs) with Pakistan’s power utilities—the Water and Power Development Authority (WAPDA) and the Karachi Electricity Supply Company (KESC) Projects with similar contractual arrangements in other sectors including, for example: ports and shipping, water supply, sanitation, solid waste, and mass transit. Box 0.1: Definition of Public Private Partnership in Pakistan The following text is used in the 2010 PPP Policy for Pakistan to define what comprises a public private partnership: Public Private Partnerships (PPP) involve the financing, development, operation and maintenance of infrastructure by the private-sector which would otherwise have been provided by the public sector. Instead of the public sector procuring a capital asset and providing a public service, the private sector creates the asset through a dedicated standalone business (usually designed, financed, built, maintained and operated by the private sector) and then delivers a service to the public sector entity/consumer in return for payment that is linked to performance. Therefore the public sector is able to redirect its efforts to serving other urgent social and economic needs. A PPP may include an equity joint venture between GOP and the private sector. The capital and operational expenses incurred by the private investor can be recovered under the PPP modality by charging users for the service provided or via fixed (or partially fixed) periodic payments (annuities) disbursed by the public sector over the concession period, or by a combination of both. PPPs allow each partner to concentrate on activities that best suit their skills. For the public sector this means planning and identifying infrastructure service needs and focusing on developing national, provincial and local sector-specific policies, but also to oversee these and to enforce the PPP agenda. For the private sector, the key is to deliver effectively the needs required by the public sector and consumers at the project level. Some sectors, such as power, have already developed independent and effective regulators, and these will be expanded across other sectors in the future. Meanwhile, in this initial phase, PPP Policy supported by contract will allow PPP to proceed on a project by project basis in most other sectors. Source: Pakistan Policy on Public Private Partnerships: Private Participation in Infrastructure for Better Public Services. Approved by the Economic Coordination Committee of the Cabinet 26 January 2010. Definition of contingent liability The Government may be exposed to a range of contingent liabilities. For this assignment, we use the following definition of “contingent liability�: Explicit contractual financial obligations associated with infrastructure PPPs, whose timing and/or magnitude depending on the occurrence of some uncertain future event.7 7 See for example: Cebotari. “Contingent Liabilities: Issues and Practice�. IMF. 2008 86 Confidential This definition for contingent liabilities covers only part of the Government’s overall contingent liability exposure. The Government may have several other sources of contingent liabilities—such as guarantees on third-party borrowing unrelated to PPP projects, guarantees on savings deposits, or pension guarantees—that are outside the scope of this assignment. While this assignment is designed to achieve the benefits of specifically managing contingent liabilities from PPPs, eventually, the Government may want to expand the recommendations and approach to apply to the full range of exposure from other sources of contingent liability. There may also be contingent liabilities related to PPP projects that fall outside the scope of this definition. For example, the definition does not include implicit guarantees, which are not legally or contractually defined, but are instead based on political or moral obligations of the Government. Implicit guarantees of this nature can include, for example, financial bailouts of failed public enterprises and government relief in response to a natural disaster or environmental cleanup. The optimal approach to managing exposure to implicit liabilities under PPP projects is to establish policies and process to make these liabilities explicit in future projects—for example, by more completely specifying contractual obligations. This is the approach we take in developing our recommendations. Purpose of accepting contingent liabilities in PPP contracts The types of contingent liabilities that this assignment will focus on arise from various financial obligations to the project sponsors of a PPP or from the Government retaining some commercial risk in the project. A well-designed PPP will often include these contingent financial obligations from the Government to reduce the total upfront project costs by retaining some risk that it is more practical or more efficient for the public sector to manage. The private sector may also demand a specific guarantee or prefer not to accept some risks to make a PPP transaction financially bankable. From the Government’s perspective, the purpose of providing contingent liabilities in PPP contracts is to close PPP transactions that have an optimal allocation of risk and provide the greatest value for money. In some cases, the Government may be better able to manage and spread project risks. For example, it may be too costly for the private sector to accept the risks associated with non-insurable force majeure events, such as military conflict or certain natural disasters. By providing a contractual guarantee to repay investors should the force majeure events occur, the Government can structure a project that is financially viable and lower cost. In other cases, the Government may be in a better position to control and mitigate the costs of certain project risks. For example, the private sector is typically unwilling to accept risk associated with regulatory or policy decision and, therefore, requires a guarantee of compensations for changes in laws, such as unexpected changes in regulated fees that are charged to the users of infrastructure. While contingent liabilities are a particular form of financial support to a potential PPP project, they should be economically justified like any other public sector contribution. That is, contingent liabilities, like viability gap funding and public subsidies, should provide economic benefits that exceed the economic costs. What Can Be Achieved By Managing Contingent Liabilities? We understand that a major objective of this assignment is to facilitate the origination of new PPP projects by improving the process by which contingent liabilities are structured in PPP contracts and approved. By improving how contingent liabilities are used, PPPs can be 87 Confidential used more effectively to close Pakistan’s infrastructure deficit. There are also other important benefits to managing contingent liabilities from infrastructure PPPs throughout the lifecycle of a project. This section summarizes the primary benefits of managing contingent liabilities (Section 0) and describes the common components of a contingent liabilities management framework that are used to achieve those benefits. Benefits of good management of contingent liabilities from PPPs There are important benefits that can be achieved by strengthening the process for approving and managing guarantees to infrastructure PPPs. These benefits contribute to Pakistan’s ongoing efforts to enact sound PPP policies and contribute to good fiscal risk and debt management. When assessing the current situation in Pakistan, we have concentrated on identifying to what extent the existing policies and processes that are in place achieve the following benefits: Accepting risks that maximize value for money in provision of infrastructure by choosing good projects, then structuring and implementing those projects well Controlling the cost of accepting risk by minimizing the payments the Government needs to make, and ensuring these payments do not threaten fiscal stability. These benefits can be achieved by strengthening the policies and processes for managing contingent through: Improving incentives to make good decisions, to help ensure: – The Government accepts risks and approves contingent liabilities that provide value for money – Decision makers manage existing risks well Improving credibility by: – Making the Government’s exposure transparent and signaling a commitment to managing risk, thereby decreasing the likelihood that credit rating agencies and others assessing Pakistan’s sovereign risk overestimate risk exposure – Implementing a systematic process that defines how payments will be made and reduces uncertainty, thereby increasing investors’ confidence, attracting greater investment, and lowering the cost of borrowing Reducing adverse fiscal impact by implementing a systematic process that reduces the uncertainty of payment obligations, minimizes the cost of realized contingent liabilities, and limits the impact of payments on the fiscal deficit, debt levels, and budget priorities. Good practice in managing contingent liabilities from PPPs To evaluate the effectiveness of existing policies and process for managing contingent liabilities in Pakistan, it is useful to use international good practice as a benchmark. Elsewhere, contingent liability management frameworks include systematic processes to carry out some or all of the following functions, spanning the lifecycle of a PPP project: 88 Confidential Structuring contingent liabilities and designing contractual mechanisms according to good principles for allocating risk in PPP projects and contract design Analyzing the contingent liabilities that will be accepted under a proposed project Reviewing executed PPP contracts and formally accepting the contingent liabilities to make the contingent liabilities explicit Monitoring those contingent liabilities while the project is being constructed and implemented Regularly and publicly disclosing the contingent liability exposure Taking mitigating action where necessary to reduce the likelihood or cost of the contingent liability becoming real When necessary, budgeting for and paying for contingent liabilities that have realized. Figure 0.1 illustrates where each of these functions fit within the process of developing and implementing a PPP project. In Section A.4 we clarify the purpose of each function, before assessing how effectively the existing framework in Pakistan accomplishes the functions and achieves the benefits of managing contingent liabilities well. 89 Confidential Figure 0.1: Functional Components of Managing Contingent Liabilities PPP Project Contingent Liability Implementation (CL) Management Process System Identify project Develop project; includes: Identify and allocate Structure CLs project risks (contract clauses) Analyze project Analyze CLs PPP Project Development Stage Approve Approve project CLs Conduct bidding & negotiate contract Execute contract Accept CLs Monitor and manage Monitor CLs project contract Disclose CLs PPP Project Implementation Take action on Stage emerging CL risks Budget and pay for realized CLs 90 Confidential A.3 PPPs and Contingent Liabilities in Pakistan After determining why it is important to manage contingent liabilities, we identify and assess the PPPs that exist in Pakistan and the contingent liabilities that arise from those PPPs. This information will be used to complete a preliminary assessment of the Government’s existing exposure to fiscal risk to determine the significance of the benefits that can be achieved by strengthening the policies and processes for managing contingent liabilities and further understand how to best achieve those benefits. Since the early 1990s, Pakistan has recognized the benefits of using public private partnerships to develop and deliver infrastructure services. At that time a policy and regulatory framework was established to facilitate private sector participation in power generation. As a result, over 5,000MW of generating capacity was developed in the 1990’s by independent power producers (IPPs) through power purchase agreements (PPAs) with power utilities in Pakistan. Despite this early success, further development of IPPs has slowed in recent years due to challenges in the energy sector. The inability to expand capacity in recent years has contributed to the current energy crisis in Pakistan. Outside of the energy sector, there has been only limited private sector participation in other areas. For example, the National Highways Authority (NHA) currently has two signed concession agreements—one for an operational tunnel, one for an expressway, and one for a service station. Port authorities have also executed concession agreements on shipping terminals. The Government’s current efforts—particularly the development of the 2010 PPP Policy and the ongoing efforts of the Infrastructure Project Development Facility (IPDF)— are intended to apply the experience in the energy sector and lessons learned from international good practice to develop a comprehensive policy framework—including guidelines for managing contingent liabilities—aimed at encouraging the development of public private partnerships in other critical sectors. With this background, the remainder of this section identifies and assesses the PPPs and contingent liabilities in key sectors, including: the energy sector (Section 0); the roads sector (Section 0); and other infrastructure sectors (Section 0). In each section, we first present an overview of the sector and relevant policy before then listing the PPPs that exist, identifying and characterizing the contingent liabilities, and presenting the pipeline of future PPP projects. PPPs and Contingent Liabilities in the Energy Sector This section presents a preliminary assessment of the contingent liabilities from PPPs in the energy sector. We first present overview of the energy sector and a brief summary of relevant policy (Section 0). Then we list the PPPs that already exist in the energy sector, which include independent power producers and rental power producers (RPPs) (Section 0), and characterize the contingent liabilities that are associated with the PPPs (Section 0). Finally, we list the development pipeline for private energy generation in Pakistan (Section 0). Overview of energy sector and policy This section provides an overview of the energy sector, focusing on the evolution of policies governing private sector development and the status of sector reforms—specifically, the unbundling and planned privatization of the vertically-integrated utility WAPDA (Water and Power Development Authority), and the recent push to develop rental power plants. 91 Confidential Structure of the energy sector Two power utilities—WAPDA and KESC—are the principle entities in Pakistan’s energy sector. WAPDA supplies power to all of Pakistan, except the metropolitan city of Karachi and some of its surrounding areas, which are supplied by KESC. In 1997, the Government adopted a policy to unbundle the vertically-integrated, state-owned utilities and restructure the power sector. The NEPRA Act (1997) and the WAPDA Act (1998) provided the basis for these reforms. Unbundling consists of separating responsibilities for energy sector policy, regulation, and operations. Responsibility for energy sector policy remains with the central Government. Responsibility for regulation has passed to the National Electric Power Regulatory Authority (NEPRA). Responsibility for operations is being divided among generation, transmission, and distribution companies as follows: Four generation companies (GENCOs) The National Transmission and Despatch Company (NTDC) Nine distribution companies (DISCOs). The Government is planning to eventually privatize the generation and distribution companies created from WAPDA. Although KESC has been successfully privatized as an integrated utility, progress on unbundling the operations of WAPDA has been slow. The distribution companies have been created, but they have not yet achieved administrative or financial autonomy from WAPDA. Similarly, NTDC, the power purchasing authority, remains under the control of the Pakistan Electric Power Company (PEPCO), which was established as a management authority to oversee the unbundling of WAPDA. In practice, NTDC has not achieved autonomy or separation of accounts from WAPDA. Figure 0.2 below illustrates the current structure of the energy sector in Pakistan. Private sector participation in the energy sector is contracted through Power Purchase Agreements (PPAs) with IPPs. The Private Power Infrastructure Board (PPIB), created in 1994, is the Government agency with the authority to facilitate private sector investment in energy generation and implement IPPs. Currently there is about 8,500 MW of capacity contracted through PPAs with IPPs. About 6,500 MW of that capacity is commissioned. In Figure 0.2, the role of NTDC is highlighted as the Central Power Purchasing Authority (CPPA) that is purchasing power from IPPs and selling it to distribution companies. 92 Confidential Figure 0.2: Structure of the Energy Sector IPP IPP IPP GENCOs Power Purchase Agreements NTDC is intended to be an independent entity managed by the holding NTDC/CPPA company PEPCO during the unbundling of WAPDA. WAPDA/PEPCO In practice, NTDC has not achieved full financial or administrative autonomy from WAPDA. DISCOs Consumers Evolution of Pakistan’s policy for private sector participation in energy Pakistan’s energy sector is governed under a series of policies promoting private sector participation—most recently, the 2002 Power Policy. Pakistan’s first policy for private sector participation in electricity generation dates from 1986. However, progress on attracting investment under this policy was slow, and a new policy was implemented in 1994. The 1994 policy was called “Policy Framework and Package of Incentives for Private Sector Power Generation Projects in Pakistan.� The 1994 policy aimed to provide a package of incentives to attract foreign investment in private power generation projects. It included the following: Attractive project structure in terms of assured cash flow for debt payment and return on investment A reduction in local currency investment requirements (from what was specified in the 1986 policy) Indicative average tariff of US cents 6.5/kWh for the first 10 years Transfer of inflation and fuel cost risk to the public utility (Power Purchaser), through tariff indexation mechanisms Steps to create and encourage a domestic corporate debt securities market Exemption of IPPs from income, sales, and other taxes Creation of PPIB as a one-window facility to streamline project approval and closure processes, and to facilitate dialogue between the Government and private investors. The 1994 policy allowed investors to make their own proposals regarding the technology and fuel to be used. Under the 1994 policy, 15 power plants with a total capacity of 2,911MW— representing a total investment of approximately US$5.3 billion—were procured by PPIB 93 Confidential and developed by the private sector as IPPs. The IPPs signed long-term PPAs with one of Pakistan’s two utilities—WAPDA and KESC. WAPDA financial difficulties and tariff renegotiations The 1994 policy was initially successful, but the capacity contracted under IPPs grew faster than demand in the mid- to late-1990s. Demand growth slowed further as the Pakistani economy suffered the effects of the Asian financial crisis and the economic sanctions placed on the country after its 1998 nuclear tests. As a result, WAPDA faced difficulties meeting its payments to the IPPs as the cost of purchasing power reached 50 percent of WAPDA’s total operating costs.89 Rather than attempt the politically and socially difficult task of raising electricity tariffs to consumers, the Government attempted to renegotiate the tariffs specified in the PPAs. These attempts were unsuccessful and the IPPs later became a focus of corruption investigations under the Bhutto government. HUBCO—the largest foreign investment project in the country (US$1.6 billion) and the largest IPP—was a principal target of corruption allegations and of the Government’s efforts to reduce tariffs. In 1998, HUBCO and WAPDA entered into a prolonged legal dispute. In December of 2000, the dispute was resolved with a decrease in the tariff paid by WAPDA. In October 2000, KAPCO also agreed to a tariff reduction. Notices of intent from PPIB to terminate other contracts also resulted in tariff re- negotiations. The average decrease in the levelized tariff was approximately 10 percent. In exchange for these tariff reductions, the terms of the PPAs were extended from approximately 20 to 30 years. The renegotiations were carried out under an “Orderly Framework for IPP Negotiations,� drafted with help from the World Bank and adopted in 1998. 1998 and 2002 Power Policy The Government issued a revised power sector policy in 1998, which introduced international competitive bidding and increased the role of the regulatory body, the National Electric Power Regulatory Authority (NEPRA). Due to the ongoing difficulties with existing IPPs at the time, this policy attracted no new investment. By 2002, the tariff renegotiations had been completed and the outlook for foreign investment in Pakistan had recovered. In 2002, the Government announced an updated policy on private sector participation in electricity generation, “Policy for Power Generation Projects, Year 2002.� The 2002 policy was similar to the 1998 policy, but offers additional tax incentives and clarifies the division of responsibility between the federal and the provincial governments. The 2002 policy states that all future investment in power generation is expected to come from the private sector. It also clearly delegates responsibility for all projects over 50MW to the federal government, and responsibility for all smaller projects to provincial governments. 8 A portion of the tariffs paid by WAPDA is indexed to the U.S. dollar/Rupee exchange rate. The Rupee devalued by 45 percent during the economic crisis. 9 Fraser 2005, p. 8 94 Confidential The 2002 policy was designed to provide sufficient capacity for power generation at the least cost. The Government wished to avoid the power shortages that were predicted for the winter of 2003–2004 and keep consumer prices within affordable limits—a key lesson from the crisis of the late 1990s. Under the 1994 policy, the private partners of IPP agreements could specify the technology and fuel to be used. There were no explicit incentives for investors to use least-cost technologies. This resulted in higher payment obligations for WAPDA and contributed to the crisis. To date, 3,000 MW of capacity has been contracted with IPPs under the 2002 policy, but only a small fraction has been commissioned. In contrast to the late 1990s, demand now exceeds supply and a lack of generation capacity is seen as a serious constraint to economic growth. Meeting short-term demand with rental power The Government decided in 2008 to use rental power plants to close the energy supply gap in the short term. In February 2008 the Economic Coordination Council approved the acquisition of 1,200 MW of capacity through rental power agreements (RPAs). An additional 1,050 MW of capacity was approved in 2009. Initially the aim was to have rental power plants producing power by the end of 2009; however progress has been slow and hindered by allegations of corruption. RPAs are essentially short-term power purchase agreements with both fixed and variable payments—capacity and energy payments. The lengths of the RPAs vary from five to six years. Wholesale energy market The Government has had long-term plans to create a competitive wholesale energy market, which was originally intended to begin functioning in 2012, but has not progressed as planned. If successful, this would eliminate the PPAs signed between IPPs and Government- owned utilities. Once a competitive market is created, IPPs would sell their power directly to distribution companies and large industrial consumers. PPAs would be replaced by contracts with individual customers—distribution companies and industrial customers. Therefore, the Government guarantee on the PPAs (established in the IA) would no longer be necessary. The current term of PPAs is approximately 25 years. It is unclear how the Government plans to dismantle these PPAs and the associated IAs if the wholesale market is introduced. What PPPs are in the energy sector? As described above, the energy sector in Pakistan has considerable experience with private sector participation in electricity generation. Currently, there is about 8,500 MW of capacity contracted through PPAs with independent power producers. Roughly 6,500 MW of this capacity is commissioned. Table 0.1 below lists the IPPs that have implemented through PPIB and characterizes the contingent liabilities associated with each. The Government has also signed Rental Power Agreements (RPAs), which are effectively short-term PPAs, to provide a short-term solution to the energy shortage. Nearly 1,500 MW of capacity has been recently contracted with rental power plants, but only one plant has been commissioned. Table 0.2 lists the RPAs that have been signed with the private sector. 95 Confidential Table 0.1: List of Independent Power Producers in Pakistan Contracting Project COD Contingent Liabilities Authority Kot Addu Power Company Limited (KAPCO) - PPIB/WAPDA June 1996 Capacity payment obligation of power purchaser 1,638 MW - listed on Pakistani Stock Exchanges Before 1994 Energy payment obligation of power purchaser Power Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Hub Power Company Limited – RFO - 1,200 MW PPIB/WAPDA March 1997 Capacity payment obligation of power purchaser – 30 years PPA - listed on Pakistani Stock Before 1994 Energy payment obligation of power purchaser Exchanges and GDRs listed on Luxembourg Stock Power Policy Regulatory risk Exchange Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Kohinoor Energy Limited – RFO - 131 MW – 22 PPIB/WAPDA June 1997 Capacity payment obligation of power purchaser years PPA - listed on Pakistan Stock Exchanges 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Tapal Energy (Pvt.) Limited – Furnace Oil - 126 PPIB/WAPDA June 1997 Capacity payment obligation of power purchaser MW – 22 years PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance 96 Confidential Contracting Project COD Contingent Liabilities Authority Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement AES Lal Pir (Pvt.) Limited – RFO - 365 MW PPIB/WAPDA November 1997 Capacity payment obligation of power purchaser capacity – 30 years PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Gul Ahmed Energy – Furnace Oil – 136 MW - 22 PPIB/WAPDA November 1997 Capacity payment obligation of power purchaser years PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement AES Pak Gen (Pvt.) Ltd – RFO - 365 MW – 30 PPIB/WAPDA February 1998 Capacity payment obligation of power purchaser years PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Southern Electric Power Company Limited – RFO PPIB/WAPDA July 1999 Capacity payment obligation of power purchaser - 135 MW – 30 years PPA - listed on Stock 1994 Power Energy payment obligation of power purchaser Exchanges in Pakistan. Policy Regulatory risk 97 Confidential Contracting Project COD Contingent Liabilities Authority Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Habibullah Coastal Power Company (Private) PPIB/WAPDA September 1999 Capacity payment obligation of power purchaser Limited - Gas - 140 MW – 30 year PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Fauji Kabirwala Power Company Limited. – Gas - PPIB/WAPDA October 1999 Capacity payment obligation of power purchaser 157 MW – 30 years PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Rousch (Pakistan) Power Limited (RPPL) – RFO - PPIB/WAPDA December 1999 Capacity payment obligation of power purchaser 412 MW – 30 years PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Saba Power Company Limited – RFO – 114 MW – PPIB/WAPDA December 1999 Capacity payment obligation of power purchaser 30 years PPA 1994 Power Energy payment obligation of power purchaser 98 Confidential Contracting Project COD Contingent Liabilities Authority Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Japan Power Generation Limited - RFO - 120 MW PPIB/WAPDA March 2000 Capacity payment obligation of power purchaser – 30 years PPA - listed on Pakistani Stock 1994 Power Energy payment obligation of power purchaser Exchanges Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Uch Power Limited – Low BTU Gas - 586 MW – PPIB/WAPDA Oct 2000 Capacity payment obligation of power purchaser 30 years PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Altern Energy Limited – Gas – 29 MW – 30 years PPIB/WAPDA June 2001 Capacity payment obligation of power purchaser PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Liberty Power Limited – Gas - 235 MW – 25 years PPIB/WAPDA September 2001 Capacity payment obligation of power purchaser 99 Confidential Contracting Project COD Contingent Liabilities Authority PPA 1994 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Attock Gen Limited – LSFO – 165 MW – 25 years PPIB/WAPDA March 2009 Capacity payment obligation of power purchaser PPA – IA signed in Aug 2007 2002 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination and Force Majeure Guarantee of fuel supply agreement Orient Power Project - 229 MW – IA signed in PPIB/ PEPCO/ Planned April Capacity payment obligation of power purchaser Nov 2006 CPPA 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance Compensation Upon Termination Sapphire Power Project – Gas - 234 MW – IA PPIB/ PEPCO/ Planned May Capacity payment obligation of power purchaser signed in Mar 2007 CPPA 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance Compensation Upon Termination Fauji Mari Power Project – 185 MW – IA signed in PPIB/ PEPCO/ Planned May Capacity payment obligation of power purchaser Aug 2007 CPPA 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy 100 Confidential Contracting Project COD Contingent Liabilities Authority Fx insurance Compensation Upon Termination Saif Power Limited – Gas - 231 MW PPIB/ PEPCO/ Planned April Capacity payment obligation of power purchaser CPPA 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance Compensation Upon Termination Atlas Power Limited – RFO – 219 MW – IA signed PPIB/ PEPCO/ COD unknown Capacity payment obligation of power purchaser in Sept 2007 CPPA 2002 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination Nishat Chunian Power Project - 200 MW – IA PPIB/ PEPCO/ Planned June Capacity payment obligation of power purchaser signed in Sept 2007 CPPA 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance Compensation Upon Termination Nishat Power Limited - 200 MW – IA signed in PPIB/ PEPCO/ Planned May Capacity payment obligation of power purchaser Sept 2007 CPPA 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance Compensation Upon Termination Bhikki (Halmore) Power Project - 225 MW – IA PPIB/ PEPCO/ Planned Capacity payment obligation of power purchaser signed in Oct 2007 CPPA September 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance 101 Confidential Contracting Project COD Contingent Liabilities Authority Compensation Upon Termination Engro Energy Limited - 227 MW – IA signed in PPIB/ PEPCO/ COD unknown Capacity payment obligation of power purchaser Oct 2007 CPPA 2002 Power Energy payment obligation of power purchaser Policy Regulatory risk Fx insurance Compensation Upon Termination Fauji Mari Power Project – 185 MW PPIB/ PEPCO/ Planned May Capacity payment obligation of power purchaser CPPA 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance Compensation Upon Termination Liberty Power Tech Project – 200 MW – IA signed PPIB/ PEPCO/ Planned Capacity payment obligation of power purchaser in June 2008 CPPA September 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance Compensation Upon Termination HUBCO Narowal project. – RFO - 225 MW – IA PPIB/ PEPCO/ Planned Capacity payment obligation of power purchaser signed in Oct 2008 CPPA September 2010 Energy payment obligation of power purchaser 2002 Power Regulatory risk Policy Fx insurance Compensation Upon Termination New Bong Escape Hydropower Project – low head PPIB/ PEPCO/ COD unknown Unknown run-of-the-river - 84 MW – IA signed in Aug 2007 CPPA 1995 Hydel Power Policy 102 Confidential Table 0.2: List of Rental Power Agreements in Pakistan Contracting Project COD Contingent Liabilities Authority Gulf Rental Power Project – 81 MW PPIB/ PEPCO/ April 2010 Capacity payment obligation of power purchaser CPPA 2002 Power Energy payment obligation of power purchaser Policy Karkay Rental Power Project – 249 MW PPIB/ PEPCO/ Planned May Capacity payment obligation of power purchaser CPPA 2010 Energy payment obligation of power purchaser 2002 Power Policy Reshma Rental Power Project – 220 MW PPIB/ PEPCO/ Planned June Capacity payment obligation of power purchaser CPPA 2010 Energy payment obligation of power purchaser 2002 Power Policy Sumandri Road Rental Power Project – 150 MW PPIB/ PEPCO/ Planned Sept Capacity payment obligation of power purchaser CPPA 2010 Energy payment obligation of power purchaser 2002 Power Policy Guddu Rental Power Project – 110 MW PPIB/ PEPCO/ Unknown Capacity payment obligation of power purchaser CPPA 2002 Power Energy payment obligation of power purchaser Policy Sahuwal Sialkot Rental Power Project – 150 MW PPIB/ PEPCO/ Unknown Capacity payment obligation of power purchaser CPPA 2002 Power Energy payment obligation of power purchaser Policy Satiana Road Rental Power Project – 200 MW PPIB/ PEPCO/ Unknown Capacity payment obligation of power purchaser CPPA 2002 Power Energy payment obligation of power purchaser Policy Naudoro Rental Power Project – 51 MW PPIB/ PEPCO/ Unknown Capacity payment obligation of power purchaser 103 Confidential Contracting Project COD Contingent Liabilities Authority CPPA 2002 Power Energy payment obligation of power purchaser Policy Engro Rental Power Project – 227 MW PPIB/ PEPCO/ Unknown Capacity payment obligation of power purchaser CPPA 2002 Power Energy payment obligation of power purchaser Policy 104 Confidential What contingent liabilities exist in the energy sector? Contingent liabilities in the energy sector arise from guarantees contained in the implementation agreement signed between IPPs and PPIB on behalf of the Government. The implementation agreement specifies the entirety of the Government’s responsibility to an IPP. The contingent liabilities created by guarantees provided by the Government in the implementation agreement cover: Financial obligations of the power purchaser—PEPCO through the National Transmission and Despatch Company (NTDC) and Central Power Purchasing Authority (CPPA)10—should the power purchaser default on its payment to IPPs. This specifically includes a guarantee of the capacity payment and energy payment specified in the power purchase agreement Termination payments triggered by the default of the IPP, default of the Government, or a force majeure event Foreign exchange rate insurance provided by the National Bank of Pakistan and provisions for the convertibility and remittability of funds Other guarantees for changes in law and tax status. A guarantee of the obligation of the fuel supplier has also been included in some Implementation Agreements, but PPIB stopped providing this guarantee after the 2002 Power Policy was enacted. Figure 0.3 illustrates where and how these contingent liabilities arise in the energy sector. The main source of contingent liabilities is the commercial risk that the Government is exposed to through its guarantee of the obligation of the power purchaser—PEPCO through NTDC and CPPA. The power purchaser has costs that are defined in the capacity and energy fees in the power purchase agreement, and generates revenue from selling power to distribution utilities at the transfer tariff rate. Distributions utilities then sell power to consumers at the retail tariff rate. Both transfer tariffs and retail tariffs are set by NEPRA. 10 KESC also remains the power purchaser in two power purchase agreements contracted with IPPs. 105 Confidential Figure 0.3: Structure of IPPs and Contingent Liabilities in the Energy Sector Power Purchaser costs are determined by tariffs set in PPA: IPP • Capacity payment Government of • Inflation index Pakistan • Fx index • Foreign/local debt service Implementation Power Purchase component PPIB Agreements Agreements • Energy payment • Fuel cost component • O&M component • Fx index Sovereign guarantee executed by PPIB • Dispatched energy covering: NTDC/CPPA • Supplemental tariff for restoration • Default on Power Purchaser obligation • Tax and withholdings pass-through • Termination event and force majeure payment WAPDA/PEPCO In 2007 and 2008, average cost of • Tariff guarantee power from IPPs was Rs5.19 and • Fx insurance guarantee Rs6.67/kWh • Convertability/remittability • Fuel supply obligation (pre-2002) Power Purchaser revenue generated • Other guarantees for change in law and by transfer tariff set by NEPRA: tax DISCOs • Capacity charge • Capacity portion of generation • Fixed charge for transmission Consumers pay retail tariffs that are set • EEP by NEPRA to DISCOs. • Variable portion of generation Consumers Currently, PEPCO through NTDC and CPPA has been unable to meet some its payment obligations to IPPs because retail tariffs charged to consumers have not allowed the full recovery of generation costs otherwise permitted by National Electricity Power Regulatory Authority. Therefore, the receipts from distribution companies (DISCOs) are insufficient to pay IPPs the contracted cost of generation. While payments to IPPs are given preference over other obligations, the stock of payables has continued accumulate in recent years. For example, in 2008 NTDC/CPPA failed to pay about 51 billion Rupees owed to IPPs for energy purchased in 2008. In the same year, the Government provided over 61 billion Rupees in cash subsidies to WAPDA/PEPCO and the Government reduced the debt service obligation of WAPDA/PEPCO by 52 billion Rupees. While NTDC/CPPA is currently overdue on its payments to IPPs, no IPPs have officially called on the sovereign guarantees provided in Implementation Agreements. In other words, the contingent liability associated with the guarantee of the power purchaser has been realized, but the Government is continuing to handle the outstanding obligations through negotiations, like the circular debt settlements where the Government resolved default payments between the Government-owned fuel supplier (Pakistan State Oil), IPPs, and PEPCO. This situation makes it very difficult to assess the contingent liabilities in the energy sector. For future IPPs, it is possible to estimate the shortfall that would be created by the commercial risk that the Government bears by contracting to purchase IPP-generated power at a higher cost than revenue generated from consumer retail tariffs. Energy sector development pipeline The Private Power Infrastructure Board has an investment plan for private sector generation that includes over 9,000MW of additional capacity with commission dates planned before 2015. This investment plan includes approximately: 106 Confidential 2,442MW of oil power with an estimated capital cost of US$1,800 million 1,919MW of gas power with an estimated capital cost of US$1,510 million 4,874MW of hydro power with an estimated capital cost of US$5,675 million 2,400MW of coal power with and estimated capital cost of US$2,400 million. This additional capacity would be developed by IPPs under the 2002 Power Policy. The contingent liabilities arising from the project would match the description provided in above. Table 0.3 below lists the private sector development pipeline for the energy sector. The list includes planned commission dates published by PPIB, however many projects are behind schedule. Table 0.3: Energy Sector Development Pipeline for IPPs Contracting Project Planned COD Authority Sialkot Rental Power Project, 65.00 MW PPIB / PEPCO / Sep 2010 CPPA Ruba Energy Rental Project, 155.55 MW PPIB / PEPCO / Sep 2010 CPPA Tapal Rental Power Project, 70.00 MW PPIB / PEPCO / Sep 2010 CPPA Walters Power Rental Project, 205.00 MW PPIB / PEPCO / Oct 2010 CPPA Radian Power Project, 150.00 MW PPIB / PEPCO / Jun 2012 CPPA Grange Holdings Power Project, 146.50 MW PPIB / PEPCO / Dec 2012 CPPA Uch II Power Project, 375.20 MW PPIB / PEPCO / Dec 2012 CPPA Green Power Project, 170.95 MW PPIB / PEPCO / Jun 2013 CPPA Star Thermal Power Project, 125.84 MW PPIB / PEPCO / Jun 2013 CPPA Kandra Power Project, 120 MW PPIB / PEPCO / Dec 2013 CPPA New Bong Escape Hydel Project, 84 MW PPIB / PEPCO / Dec 2013 CPPA Rajdhani Hydro Power Project, 132 MW PPIB / PEPCO / Jun 2014 CPPA Gulpur Hydro Power project, 100 MW PPIB / PEPCO / Jun 2014 CPPA Patrind Hydropower Project, 150 MW PPIB / PEPCO / Dec 2014 CPPA 107 Confidential Contracting Project Planned COD Authority Kotli Hydel Project, 100 MW PPIB / PEPCO / Dec 2014 CPPA Sehra Hydel Project, 130 MW PPIB / PEPCO / Dec 2014 CPPA AES Imported Coal Project, 1200 MW PPIB / PEPCO / Jun 2015 CPPA Karot Hydel Project, 720 MW PPIB / PEPCO / Aug 2015 CPPA Madian Hydropower Project, 157 MW PPIB / PEPCO / Dec 2015 CPPA Asrit-Kedam Hydel Project, 215 MW PPIB / PEPCO / Dec 2015 CPPA Azad Pattan Hydel Project, 222 MW PPIB / PEPCO / Aug 2016 CPPA Kalam-Asrit Hydel Project, 197 MW PPIB / PEPCO / Dec 2016 CPPA Chakothi-Hattian Project, 139 MW PPIB / PEPCO / Dec 2016 CPPA Shogosin Hyderopower Project, 127 MW PPIB / PEPCO / Dec 2016 CPPA Shushgai Zhendoli Hydel Project, 102 MW PPIB / PEPCO / Dec 2016 CPPA Gabral-Kalam Hydropower Project, 101 MW PPIB / PEPCO / Dec 2016 CPPA Suki Kinari Hydropower Project, 840 MW PPIB / PEPCO / Jun 2017 CPPA Kohala Hydropower Project, 1100 MW PPIB / PEPCO / Dec 2017 CPPA Kaigah Hydel Project, 548 MW PPIB / PEPCO / Dec 2017 CPPA PPPs and Contingent Liabilities in the Roads Sector This section presents a preliminary assessment of the contingent liabilities from PPPs in the roads sector. We first present background on the energy sector and a brief summary of relevant policy (Section 0). Then we list the PPPs that already exist in the roads sector (Section 0), and characterize the contingent liabilities that are associated with the PPPs (Section 0). Finally, we list the PPP development pipeline for roads (Section 0) 108 Confidential Overview of roads sector and policy The road sector in Pakistan includes national roads, provincial roads and local roads. The National Highway Authority (NHA) in Pakistan has the authority to plan, promote, organize and implement the construction and operations of national highways and strategic roads. This includes service area concessions and tolled motorways and tunnels. Provincial roads are, by default, those roads that are not “national highways or strategic roads�. Following the establishment of the Local Government Ordinances (LGOs) intra- district roads are implemented by local governments while legislative authority remains with the Provincial Assemblies. For the purposes of this assignment only national highways and strategic roads, implemented by NHA, are relevant. National Highway Authority Act The primary legislation for national highways and strategic roads is the National Highway Authority Act (NHA Act). It establishes the NHA as a statutory body to develop and implement road transport projects at the Federal level. In some cases, the NHA Act also enables the execution of projects at the provincial and local levels where such projects are entrusted to NHA by the respective governments. The NHA Act defines an approval process whereby any project above 100 million Rupees requires, in order, the review and approval of the NHA Executive Board, the National Highway Council, the Ministry of Communications and the Central Development Working Party before being implemented by the NHA. According to the NHA Act, the Federal Government can declare a road to be a “national highway or strategic road� by notification in the Official Gazette or by the road being included in the Schedules to the NHA Act. National Highways PPP Policy In May 2009, the Government approved the “PPP Policy and Regulatory Framework for Private Sector Participation in National Highways, Motorways, Tunnels and Bridges� (Highways PPP Policy). The Highways PPP Policy explicitly recognizes that the private sector’s technical, managerial and financial resources can be useful to the NHA’s efforts to develop highways in Pakistan: “The concept of Public Private Partnership (PPP) covers a wide range of situations and is subject to various interpretations. A now well-known definition is: “a PPP is a risk- sharing relationship between the public and private sectors based upon a shared aspiration to bring about a desired public policy outcome,� typically, the provision of new or improved infrastructure to provide a new public service.� The Highways PPP Policy states that PPP should involve investment of private capital to design, financing, construction, operations, and maintenance of a project for public use for specific term during which a private proponent is able to collect revenue from the users of the facility. The Policy further states that for financially viable projects, the tolls charged would be one of the key criteria when evaluating proposals from the private sector. However, for economically viable, but financial unviable projects, the criteria for awarding a concession will be the least subsidy or support required from the NHA. According to the 109 Confidential Policy, the range of support that NHA could provide to a project includes, but is not limited to: traffic guarantees, revenue guarantee, equity stake, annuity payments, and a contribution to project cost. The Highways PPP Policy recognizes that attracting private sector participation is a complex task that requires a dedicated PPP unit in NHA (the Private Sector Cell). The PPP unit is generally responsible for project development and negotiations with the private sector. The Policy lays out some specific components of the PPP project development and procurement process, which include: Development of PPP highway program Development of pre-feasibility reports Dissemination of list of approved PPP Projects Pre-qualification of interested parties Provision of requests for proposals to all pre-qualified bidders Bidding, evaluation and ranking of parties submitting proposals Negotiations with highest ranked bidder and timeframe for achievement of financial close What PPPs are in the roads sector? In 1995, the NHA established its Private Sector Cell with the assistance of the World Bank. The National Highways PPP Policy, as described above, further defined the authority and function of the Private Sector Cell to promote more private sector participation in the roads sector. However, to date, there have been only a few PPPs contracted by the NHA. In 1997 NHA entered into its first concession agreement with Daewoo Corporation for financing, construction, commissioning, management, operations and maintenance of Services Areas on M-2 (the Lahore Islamabad Motorway) for a period of 15 years. Ten Service Areas were to be constructed under the Agreement. In 2005, the Private Sector Cell of NHA was reorganized and in 2006 NHA entered into two concession agreements as follows: A concession agreement with IBEX Construction Limited, a special purpose vehicle wholly owned by Frontier Works Organization (FWO) for design, finance, insurance, construction, commissioning, management, operation, maintenance and tolling of Lakpass Tunnel for a period of twenty five years. The Project comprised of a 180 meter long tunnel along with 4.5 kilometers of approach road and the total Project Cost was estimated to be 679 million Rupees A concession agreement with Standard Construction Company Limited for design, finance, insure, construct, manage, operate, maintain, toll and transfer of M-9 for a period of twenty five years. The project comprised of 136 kilometers of 6-lane closed highway along with several interchanges, service roads, flyover, and pedestrian underpasses. The total project cost was estimated to be 6.32 billion Rupees. The concession for M-2 service areas will expire in two years. The construction of Lakpass Tunnel has been completed and it opened for commercial operations in 2009. However, the 110 Confidential M-9 could not be constructed due to termination of the concession agreement. The NHA alleged that the private proponent was unable to achieve financial close within the stipulated period and therefore the concession agreement lapsed, while the private proponent has claimed that the NHA wrongly terminated the agreement. The dispute is currently under arbitration. Finally, the NHA recently entered into a concession agreement with N. F. Concessions Company Limited—a special purpose vehicle created by Ascent Capital International Limited—for design, finance, constructing, management, operations, maintenance, and tolling of the Shahdara Flyover for a period of 25 years in exchange for availability payments from the NHA. Table 0.4 below lists the three currently executed concession agreements in the roads sector. 111 Confidential Table 0.4: List of Concessions in the Roads Sector Contracting Project COD Contingent Liabilities Authority M-2 Service Areas – BOT – 15 years NHA 1997 Termination Compensation Lakpass Tunnel – BOT – 25 years – PKR 679 NHA 2008 / 2009 Development of Alternate Route million Regulatory Risk – NHA Tariff Approval Subsequent Legislation Termination Compensation Shahdara Flyover - BOT-Annuity Arrangement – NHA 2013 Development of Alternate Route 25 years – PKR 9.66 billion Subsequent Legislation Termination Compensation 112 Confidential What contingent liabilities exist in the roads sector? There is no specific mechanism by which the Government accepts contingent liabilities in the roads sector. However, the Government funds the operations of the NHA and currently highway projects are approved by the National Highways Council and the Executive Board of the NHA, which both include members from the Ministry of Finance and the Ministry of Planning and Investment. Therefore, contingent liabilities in the roads sector are only explicitly defined in the concession agreement signed between the NHA and private proponent. There are generally four types of contingent liabilities that could be included as provisions in the concession agreement: Termination payments triggered by the default of the IPP, default of the Government, or a force majeure event Guarantees specifying a minimum level of traffic or revenue for the project when the private proponent is allocated demand risk for the project11 Regulatory guarantees for any deviation in the contracted toll rate Provisions for the convertibility and remittability of foreign denominated funds Other guarantees for changes in law and tax status. The Highways PPP Policy also recognizes the effect of existing or planned non-tolled or partially tolled competing routes on PPP projects whose financial viability depends on toll revenues. The policy states that NHA will endeavor to ensure that competing routes, especially roads of a similar standard, are tolled appropriately. Provisions to compensate the private proponent should competing routes or subsequent legislation affect the financial performance of the project also give rise to contingent liabilities in road concessions. Figure 0.4 illustrates where these contingent liabilities arise from concession agreements contracted by the NHA. Figure 0.4: Structure of Concession Agreements and Guarantees in the Roads Sector The Government does not explicitly accept the obligations or guarantees Private embedded in the concession Concession Agreement may agreement. However, the Government Concessionaire include provisions funds the operations of NHA and guaranteeing: projects are currently reviewed and • Termination payments in the approved by members of the federal Concession event of default or other force government. Agreement majeure events • Traffic or revenue levels • Changes in the regulated toll rate Government of • Change in law or tax status NHA • Convertibility/remittability Pakistan 11 There are no existing examples of revenue or traffic guarantees, but this is a common contingent liability in PPPs executed in the roads sector in other countries. 113 Confidential The Highways PPP Policy specifically stipulates that escalation of toll rates and toll charges should be permitted, using the formula contained in concession agreement subject to confirmation of mathematical accuracy by the PPP unit with the NHA. The maximum toll escalation factor allowed in any year is directly linked to the annual growth rate in the consumer price index (CPI) as per the Federal Bureau of Statistics. However, the private concessionaire is allowed to apply a lower level of toll escalation, if it considers that it would improve the overall amount of toll revenue. As shown above, this guarantee of the contracted toll rate is one of the key contingent liabilities that arise in road concessions. For example, the Lakpass Tunnel concession includes a toll rate of 13 Rupees per trip; however, the NHA only allowed tolls of 10 Rupees per trip during the first year of operations. Under the terms of the concession agreement, the NHA is obligated to pay the proponent the revenue difference generated by the three Rupee deviation from the contracted toll rate. Roads sector development pipeline The National Highway Authority has an ambitious pipeline of projects that it plans to develop as PPPs. Table 0.5 provides a list of 17 projects that are included in the NHA’s PPP development pipeline. The list includes: An estimated 96 billion Rupee investment in national highways An estimated 1.4 billion Rupee of investment in service areas on national highways Operations and maintenance concessions on four major highways. Table 0.5: Roads Sector PPP Development Pipeline Contracting Project Planned COD Authority Rawalpindi Flyover – N-5 – 14 km length – 4 Lane Flyover – NHA Not known Rs. 18 billion - BOT Karachi Hyderabad Motorway - M-9 – 136 km – Conversion of NHA Not known existing 4 Lane Highway into 6 Land Motorway – Rs. 13 billion - BOT Karachi Northern Bypass - M-10 - 50.2 km – Conversion of NHA Not known existing 2 Lane Highway into 4 Lane divided facility – Rs. 4.2 billion - BOT Muzaffargarh - D.G Khan - N-70 – 53 km – Conversion of NHA Not known existing 2 land highway into 4 lane divided facility including Bridge at Ghazi Ghat – Rs. 5.0 billion - BOT D.G Khan – Rajanpur - N-55 – 106 km - Conversion of existing NHA Not known 2-lane highway into 4-lane divided facility - Rs. 6.5 billion - BOT D.I Khan- Balkasar Interchance - N-120 - 235km – Rs. 11.7 NHA Not known billion Jhang - Chund Bridge – Sargodha – Salam - MB Din –Kharian – NHA Not known 280 km - Upgradation of existing road into 2 lane highway – Rs. 14.0 billion – BOT Realignment of Lahore -Islamabad Motorway at Salt Range - M- NHA Not known 114 Confidential Contracting Project Planned COD Authority 2 - 15km - Realignment of existing 6-lane facility at salt range(15Km) Concession of full M-2 Motorway 350 kms (15 Toll Plazas) with revenue sharing – Rs. 12.7 billion – BOT Link Road Rawat to Thullian - NHA Not known Link between N-5 and M-2 - 28.5 km – New construction of 4 lane divided access controlled Expressway – Rs. 5.15 billion – BOT Kandhkot - Ghotki Bridge at River Indus - Construction of 2- NHA Not known lane concrete Bridge on River Indus - Rs. 6.27 billion – BOT M-1 Service Areas (2 Nos) at River Indus – Rs. 689 million – NHA Not known BOT M-1 Service Areas (2 Nos) at River Haro - Rs. 260 million – NHA Not known BOT N-75 Service Areas (2 Nos) - NHA Not known Rs. 500 million – BOT Peshawar - Lahore - N-5 - 440 km - Operation and Maintenance NHA Not known of 4-lane Highway – Operating Concession – 20 years Lahore-Multan - N-5 - 330 km Operation and Maintenance of NHA Not known 4-lane Highway – Operating Concession – 20 years Multan- Sukkur – N-5 - 455 km - NHA Not known Operation and Maintenance of 4 lane Highway - Operating Concession - 20 Years Faisalabad - Pindi Bhattian Motorway - M-3 & Islamabad - NHA Not known Peshawar Motorway – M-1 - 208 Km - Operation and Maintenance of M-3 (4-lane) & M-1 (6-Lane) Motorway – Operating Concession - 20 Years PPPs and Contingent Liabilities in Other Sectors There are few PPPs that have been implemented in sectors other than energy and roads. However, the Government has ambitions plans for developing PPPs in Pakistan, primarily through the efforts of the Infrastructure Project Development Facility. Currently we know of only a small number of specific PPP projects in other sectors: The Multan Dry Port contracted by the Ministry of Railway At least 11 executed terminal concessions contracted by the port authorities— Port Qasim Authority, Karachi Port Trust, and Gwadar Port Authority—and eight planned terminal concessions. We requested information from the relevant agencies on these and other possible projects but did not receive sufficient information to make a complete assessment of the existing PPPs or associated contingent liabilities. We have included—in Appendix A—a list of the 115 Confidential executed and planned concessions in ports and shipping. However, we can not be certain that the list is comprehensive. Moreover, while the concessions listed in below are PPPs under a strict definition, because port authorities in Pakistan have historically operated autonomously from the federal government and have not presented fiscal risk, it is unclear whether the Government intends to exclude port authorities from the efforts to strengthen PPP and contingent liability management policies and processes. Notably, IPDF is currently assisting port authorities on implementing some projects. This indicates that ports and shipping should be included in the framework. In other sectors we expect that there are no major projects that are currently being processed outside of efforts by Infrastructure Project Development Facility. Table 0.6 lists the projects that are currently under development by IPDF. To date, IPDF has not yet completed any transactions and contracted any new projects since its inception. We do not have draft contracts for the projects being developed to assess the contingent liabilities that may arise from the projects under development. IPDF’s current development efforts presented in Table 0.6 and the priorities outlined in the 2010 PPP Policy provide a good indication of the sectors where PPPs are likely to be developed in the future. Box 0.2 describes the sectors that are highlighted in the 2010 PPP Policy. Box 0.2: Priority Sectors for Developing PPPs in Pakistan The 2010 PPP Policy states that: Regardless of sector or level of government, PPPs will be pursued where they represent priority projects, are affordable to the government and consumers, and represent value for money (i.e. provide a better approach than public procurement. However, the policy identifies the following specific sectors for developing PPPs in Pakistan: Transport and logistics, including federal, provincial and municipal roads, rail, seaports, airports, fishing harbors as well as warehousing, wholesale markets, slaughter houses and cold storage Mass Urban Public Transport, including integrated bus systems as well as intra and inter-city rail systems Local Government Services, including: water supply and sanitation; solid waste management; low cost housing, and healthcare/education and skills development facilities Energy Projects, including hydroelectric and captive power generation projects Tourism Projects, including cultural centers, entertainment and recreational facilities and other tourism related infrastructure Industrial Projects, including industrial parks, special economic zones and related projects Irrigation Projects, some of these combined with power generation Social Infrastructure, which includes education, culture, and health infrastructure. Source: Pakistan Policy on Public Private Partnerships: Private Participation in Infrastructure for Better Public Services. Approved by the Economic Coordination Committee of the Cabinet 26 January 2010. 116 Confidential Table 0.6: List of Projects under Development by IPDF Project Sector Value Status PSEB IT Park Office / Industry 120 million Rupee IPDF assisted Pakistan Software Export Board (the institution) and its transaction Infrastructure advisors in the structuring and implementation of the project. The project is in last stage of the transaction implementation phase with private sector bidder already selected and negotiations are ongoing with selected bidder. At the moment there is also a strong probability that the project may be taken back into the market again given the time it has taken with reference to ongoing negotiations and the rapid change in the business environment Charsadda Solid Municipal Services 20 million Rupee The project is in the last stage of transaction implementation phase and is in the Waste Management process of procuring of a private party. Our earlier floatation of request for proposal Project for the same has not been successful due to security situation in Charsadda. However, another attempt would be made after the security situation issue is resolved Shaheed Benazir Mass Urban Public 50 million Rupee The project is in transaction implementation phase with the request for proposal Bhutto CNG Bus Transport already issued to the pre-qualified CNG Bus Operators asking them to submit their Project technical and financial bids Establishment of Transport & 150 million Rupee The project is in the end of the transaction structuring phase with the feasibility report Cool Chain System Logistics along with the security package for the project already prepared and submitted for along National approval of the report and the security package Trade Corridor Faisalabad Solid Municipal Services 65 million Rupee The “Needs and Options Report� has been finalized and it was decided in a Waste Management stakeholder meeting to proceed on DBFO basis. The draft feasibility has been Project completed for comments. Pre-qualifications have been received from 12 firms Port Qasim Transport & 500 million Rupee IPDF is assisting Karachi Shipyards & Engineering Works (KSEW) in the structuring Shipyard Project Logistics and implementation of the said project as a PPP. The project is in the inception phase of the project development cycle, the RFP has been issued, and transaction advisors are being hired Gwadar Shipyard Transport & 500 million Rupee IPDF is assisting Karachi Shipyards & Engineering Works (KSEW) in the structuring Project Logistics and implementation of the said project as a PPP. The project is in the inception phase of the project development cycle, the RFP has been issued, and transaction advisors 117 Confidential Project Sector Value Status are being hired PTDC Corporate Office / Industry 30 million Rupee IPDF is assisting Pakistan Tourism & Development Corporation (PTDC) in the Complex Infrastructure structuring and implementation of the project as a PPP. The project is in the inception phase and transaction advisors have been short-listed and selected PTDC-Islamabad Hotel / Industry 70 million Rupee IPDF is assisting Pakistan Tourism & Development Corporation (PTDC) in the Tourist Village Infrastructure structuring and implementation of the project as a PPP. The project is in the inception phase and transaction advisors have been short-listed and selected National Institute Heath 7 million Rupee IPDF is assisting Pakistan Institute of Medical Sciences (PIMS – the institution) in the of Dentistry structuring and implementation of the project as a PPP. The project is in the inception phase of the project development cycle, the RFP has been issued, and technical advisors have been short-listed and selected Centre of Liver Heath 6 million Rupee IPDF is assisting Pakistan Institute of Medical Sciences (PIMS) in the structuring and Disease and implementation of the project as a PPP. The project is in the inception phase of the Transplant (CLOT) project development cycle, the RFP has been issued, and technical advisors have been short-listed and selected Faisalabad WASA Municipal Services 10 million Rupee IPDF is assisting Faisalabad WASA in the structuring and implementation of the Metering & Billing project as a PPP. The project is in the inception phase of the project development Project cycle, the RFP has been issued, and transaction advisors have been selected but not approved Karachi Circular Mass Urban Public 1500 million KUTC (Karachi Urban Transport Corporation) has been setup as an overseeing Railway (KCR) Transport Rupee agency for operation & implementation of KCR. To review the financial viability of KCR the CDWP constituted a committee. IPDF was engaged to prepare a financial model in order to assess the financial viability of the project by the committee with reference to its ability to service debt and generate positive cash flows and to finalize for CDWP & ECNEC its recommendations for their consideration Electricity Energy unknown IPDF has been asked by Ministry of Finance to evaluate various options relating to Distribution implementation of power distribution functions via PPP mode. Based upon Companies discussions and exchange of information between IPDF and PEPCO, various options have been evaluated to implement power distribution functions through PPP. PEPCO 118 Confidential Project Sector Value Status proposed the future project of advance metering for LESCO. IPDF has explored basic financial and commercial analysis of LESCO The project is in initial inception stage. Quaid-e-Azam Education 5 million Rupee IPDF is assisting QAU and Higher Education Commission in the structuring and University (QAU) implementation of the project as a PPP. The project is in the inception phase of the Medical College project development cycle. IPDF is planning on issuing an RFP for hiring of a technical consultant. Sheikh Zayed Education 5 million Rupee IPDF is assisting Sheikh Zayed hospital and the cabinet division in the structuring & Hosptal implementation of the project as a PPP. The project is in the inception phase of the project development cycle. IPDF has sent a comprehensive proposal to the cabinet secretary in which IPDF has proposed that a technical advisor be hired to go forward with this project 119 Confidential A.4 Policies and Processes Governing Contingent Liabilities from PPPs Finally, it is important to have a clear understanding of the current policies and processes for managing contingent liabilities from PPPs in Pakistan. By evaluating how effectively Pakistan is currently managing contingent liabilities—and managing PPPs and other forms of guarantees generally—we can identify the gaps that need be addressed to strengthen the existing policies and processes and achieve the benefits of managing contingent liabilities well. There is no single, best practice model for managing contingent liabilities from PPP projects: different countries take different approaches. Nonetheless, as described above, good contingent liability management frameworks typically include a set of similar functions, as well as an institutional framework for carrying out those functions. Comparison with these common functions and proven institutional frameworks is a helpful way to evaluate the effectiveness of the existing policies and processes that apply to contingent liabilities from PPPs in Pakistan. In this section we first describe (in Section 0) common features of good contingent liability management frameworks. We then assess (in Section 0) the extent to which these “good- practice� features are currently apparent in Pakistan. Good Practice in Contingent Liability Management We described above the benefits that can be achieved by effectively managing contingent liabilities. We also identified functions, spanning the lifecycle of a PPP project, which are common in effective contingent liability management frameworks. In this section we first review those functions, and provide some examples how they are carried out in other countries. We then briefly describe and provide examples of institutional frameworks for carrying out these functions. Common contingent liability management functions The common functions that comprise a good contingent liability management system are listed in Table 0.1. The intended purpose of each function is briefly described—that is, how the function can contribute to the overall objectives of managing contingent liabilities well. Examples are also provided for how each function is performed in other countries. Table 0.1: Common Contingent Liability Management Functions What is the purpose of the How can the function be What is the Function? function? performed? Project Development Stage Structuring contingent To ensure that the risks the Define principles for allocating risk liabilities and designing Government will bear are consistent and structuring contingent contractual mechanisms with good risk allocation principles, liabilities, to be applied when by which the borne at the lowest cost and with preparing PPPs and draft contracts Government bears risks minimal fiscal impact Develop tools for practitioners, under a PPP contract such as preferred allocation matrices or model contract clauses Analyzing the To inform how the project is Using qualitative and various 120 Confidential What is the purpose of the How can the function be What is the Function? function? performed? contingent liabilities that structured and approved, and provide quantitative methods to evaluate the will be accepted under a a basis for monitoring and budgeting potential cost to Government of proposed project for contingent liabilities accepting the contingent liability Approving those To ensure the use of Government As part of the overall approval process contingent liabilities, if resources in the form of contingent for PPP projects: found to be consistent liabilities is focused on policy Check contingent liability structure with structuring priorities; represents value for money; Introduce rules to limit overall principles and good and is consistent with good fiscal fiscal impact of contingent fiscal management management. liabilities (such as ceilings or defined budgeting requirements) Formally accepting the To clarify the Government’s Require approval of final PPP contingent liabilities commitment to its contingent liability contracts before signing defined in executed PPP obligations, and to ensure the Provide a distinct legal agreement, contracts executed contract is consistent with typically signed by a finance earlier analysis and approval ministry, acknowledging the Governments’ contractual commitments (subject to checking the final PPP contract) Project Implementation Stage Monitoring those To provide information needed to Systematically collect project and other contingent liabilities disclose, act on emerging issues and, if information; periodically re-evaluate while the project is necessary, budget for contingent contingent liabilities; and make this being constructed and liabilities information centrally available within implemented Government Regularly and publicly To improve accountability for Regularly publish information on disclosing the decision-makers, and increase contingent liabilities from PPPs, either contingent liability transparency of the Government’s as part of other public financial exposure commitments to third parties (such as management documents, or in a stand- credit agencies and lenders) alone report Taking mitigating To help reduce the cost to Based on monitoring information, action where necessary Government of bearing contingent identify and take coordinated action on emerging contingent liabilities by reducing the likelihood or (for example, action by the contracting liability risks cost of those liabilities realizing authority with support from the Finance Ministry) on emerging issues When necessary, To ensure resources are available to Set aside funds in advance towards budgeting for and make payments promptly when possible future payments paying for contingent required—improving credibility and Budget for expected upcoming liabilities that have clarity as to how costs of contingent payments realized liabilities will be borne, and mitigating Create budget flexibility to the fiscal impact accommodate payments when needed As shown Table 0.1, different countries take different approaches to some functions. These approaches depend on the processes for developing PPPs and managing public finances, as 121 Confidential well as on any particular problems the contingent liability management system has been designed to solve. Nonetheless, each function typically serves a common purpose. Above we describe whether and how the existing policies and processes in Pakistan achieve the purposes of these contingent liability management functions. Institutional frameworks for managing contingent liabilities from PPPs Institutional frameworks for managing contingent liabilities from PPP projects vary between countries. As for the approaches to the management functions described above, these variations depend on the institutions in place and the challenges faced when the contingent liability management framework was being developed. Institutions that are typically involved in managing contingent liabilities are: Project contracting authorities—the agencies that enter into PPP contracts are typically responsible for developing and assessing PPP projects, and therefore also for structuring and analyzing the associated contingent liabilities. As the agency with the direct relationship with the contractor, the contracting authority also typically plays a key role in monitoring and taking action on emerging contingent liability risks. Some countries, such as Colombia, have introduced mechanisms to ensure that contracting authorities must also budget and pay for realized contingent liabilities PPP units—several countries have dedicated PPP units that support contracting authorities in carrying out their functions in developing PPPs, as described above. Some also play an oversight role by approving PPP projects or overseeing project performance during the implementation stage. For example, the Partnerships Victoria unit in the State of Victoria, Australia, gives substantial support to agencies in structuring PPP contracts and any associated contingent liabilities Finance ministries and other oversight agencies—PPPs almost always require central approval from finance ministries and other oversight agencies such as planning ministries or agencies. This approval typically covers a combination of consistency with policy priorities and budget resources, and for value for money. In some cases, specific units within the Finance Ministry are responsible for assessing financial commitments under PPP projects, including contingent liabilities. For example, in Chile the contingent liabilities under a proposed project are analyzed by a contingent liabilities management unit under the Budget department. That unit is also responsible for publishing an annual report on the government’s contingent liability exposure. Guarantee fund managers—some countries have established guarantee or contingency funds from which obligations arising from realized contingent liabilities from PPP projects will be paid. These can be government “accounts� in which budgeted funds are set aside—and which may be managed by a private financial institution—as in Colombia, or legally independent (typically partly or fully government-owned) guarantee companies that assess and issue guarantees to PPP projects in their own right, as is under development in Indonesia. While the specific roles and responsibilities of different institutions vary, all contingent liability management frameworks require close coordination between different entities, both within and outside government. This means that a common feature of all successful 122 Confidential frameworks is that respective responsibilities, and processes and requirements at each stage—that is, the way those institutions will work together—are clearly defined. How Pakistan Manages Contingent Liabilities Pakistan has no specific framework for managing contingent liabilities from PPP projects. However, other policies and processes currently in place may achieve some of the same functions and institutional features as listed above. In this section we first briefly describe the policy areas that are relevant to managing contingent liabilities from PPP projects in Pakistan. We then assess in turn whether these policies adequately define the functions and institutional framework for managing these contingent liabilities, and identify the gaps that an improved system should address. What policies are relevant for managing contingent liabilities in Pakistan? In Pakistan, the key relevant policy areas for managing contingent liabilities from PPP projects are those for: Developing and implementing PPP projects in general Managing similar types of contingent liability. We describe each of these briefly in turn. Policies and processes for developing and implementing PPP projects As described in Table 0.1 and illustrated in Figure 0.1 above, the contingent liability management functions are usually integrated into the overall policies and processes for developing and implementing PPP projects. In Pakistan, PPPs have in the past been developed by contracting authorities, following their own processes, which are specific to each authority and include limited external approval. An updated PPP Policy—briefly described in Box 0.1 below—was introduced in January, 2010. This replaces the 2007 PPP policy, which was the first attempt to adopt formal processes for developing PPP projects across infrastructure sectors, and includes some provisions that are relevant for contingent liability management. Box 0.1: Content of the PPP Policy (2010) The current PPP Policy was approved by the Economic Coordination Committee (ECC) of the Cabinet in January, 2010. This policy includes descriptions of : The background, objectives and scope of PPP in Pakistan, including the types of support the Government may provide to PPP projects Institutional roles and responsibilities for developing and implementing projects, which comprise roles for the contracting authorities (which may be federal or local Government departments, or state-owned enterprises), the Planning Commission, and several entities under the Ministry of Finance (MOF) The (forthcoming) legal framework for PPPs Principles for allocating and managing risks through PPP agreements Processes for developing and implementing PPPs, including recommended steps in the PPP development process, the Government’s approach to unsolicited proposals, and some information on project approval requirements. Source: PPP Policy (2010) 123 Confidential A PPP Bill, intended to set these policies in law, is yet to be finalized and enacted. We understand the draft PPP Bill is undergoing a third-party legal review before it will be approved within the Ministry of Finance and ratified through the parliamentary process. Policies and processes for managing similar types of contingent liability A second policy area that may have implications for managing contingent liabilities from PPP projects is the policy and processes for managing similar types of contingent liability. These include the policies defined in the Fiscal Responsibility and Debt Limitation (FRDL) Act (2005) with regard to the provision of debt guarantees to private parties, and the processes set in place by the Debt Policy Coordination Office (DPCO) to implement those policies. As explained in Box 0.2, while the provisions of the FRDL Act do not currently apply to obligations under PPP projects, they could reasonably be extended to do so. Box 0.2: The Implications of the FRDL Act (2005) for PPP Contingent Liabilities The implications of the Fiscal Responsibility and Debt Limitation (FRDL) Act (2005) for management of contingent liabilities under PPP projects depends on the interpretation of “guarantee�, as defined in the Act. Under the FRDL Act, “guarantee� is defined as follows: “Guarantee� includes any obligation undertaken to make payments in the event of the profit of an undertaking falling short of a specified amount A later clause, setting a cap on new guarantees, elaborates on this definition, specifying that the cap applies to “guarantees, including those for Rupee lending, bonds, rates of return, output purchase agreements�. Good practice in structuring PPP projects in general would avoid providing explicit rate of return or debt guarantees. However, some types of contract clause—such as termination payments in the case of contractor default, or minimum demand guarantees—do achieve a similar result. The FRDL Act is not currently understood to apply to these types of contingent liabilities, but a new contingent liability management system could draw on these provisions of the FRDL Act. Source: Fiscal Responsibility and Debt Limitation (FRDL) Act (2005) Chapter 1, clause 2 (definitions) and Chapter 2, clause 3(d) Do these policies achieve the contingent liability management functions? Table 0.2 describes the extent to which these policies and processes address each of the contingent liability management functions described in above. Since the current policies make limited explicit reference to managing contingent liabilities, there are several gaps in Pakistan’s current contingent liability management framework with respect to these common functions. Table 0.2: Contingent Liability Functions in Pakistan Function Relevant Policies in Pakistan Project Development Stage Structuring contingent A principle for allocating risk is defined in the PPP Policy 2010: that liabilities “[each] risk will generally be borne by the party best able to manage it at minimum cost�. This principle is in line with international good practice, and provides a basis for managing contingent liabilities. The PPP policy also states that the 124 Confidential Function Relevant Policies in Pakistan concession contract will specify how risks have been allocated. However, no further policy or guidance is provided on how these contractual mechanisms should be designed, to achieve the best risk allocation and to manage fiscal impact Analyzing contingent No requirement or approach to analyzing contingent liabilities is defined liabilities Approving contingent There are no specific requirements or rules for taking the contingent liabilities liabilities to be accepted under a proposed project into consideration when approving a PPP project. The requirements and process for PPP project approval in general are not clearly specified, as described below. The FRDL Act limits the issue of new guarantees during a fiscal year to two percent of the estimated GDP for that year. As described in Box 0.2 above, this limit does not currently apply to contingent liabilities accepted under PPP projects, but could feasibly be extended to do so. Checking consistency with that limit would then form part of the process of approving a proposed PPP project. Formally accepting PPIB signs Implementation Agreements to contractually define the extent contingent liabilities of the Government’s obligations, including contingent liabilities, to Independent Power Producers. In other sectors, there is no formal mechanism by which the Government Accepts Contingent Liabilities. The Debt Policy Coordination Office currently certifies that new debt guarantees are compliant with the FRDL Act and in some cases the Ministry of Finance issues a comfort letter to formally acknowledge the issuance of a guarantee. Project Implementation Stage Monitoring contingent The PPP Policy (2010) specifies that contracting authorities are responsible liabilities for monitoring PPP projects. The PPP Policy also states that the DPCO is responsible for “ultimate management� of any contingent financial obligations, including PPPs, arising from the PPP program. This follows the FRDL Act (2005), which specifies that the DPCO is responsible for monitoring the Government’s guarantee stock. No requirements or guidance are provided for the nature of this monitoring, or for how DPCO and contracting authorities should work together during the project implementation stage Disclosing contingent The FRDL Act (2005) requires “consistent and authenticated information� liability exposure on guarantees, including their budgetary impact, to be included in an annual debt policy statement. This is included among the responsibilities of the DPCO Taking mitigating As described above for monitoring contingent liabilities, the PPP Policy action on emerging (2010) suggests that responsibility for actively managing those liabilities contingent liability risks would be shared between contracting authorities and the DPCO. No further guidance is provided. Budgeting and paying No approach to budgeting and paying for contingent liabilities from PPP for realized contingent projects is defined liabilities 125 Confidential Is the institutional framework for managing contingent liabilities well-defined? To date, responsibilities and processes for developing PPP projects in Pakistan have been fragmented, with agencies following their own processes, and without well-defined or centralized approval requirements. Both PPIB and NHA—two agencies with experience with private sector participation in Pakistan—follow internal approval processes. For example, the final approval of a new IPP is made by the PPIB Board, which includes the Secretary of Finance and Secretary of Planning, and PPIB has authority to sign Implementation Agreements codifying the Government’s obligations to an IPP. The Ministry of Finance and IPDF are actively developing policies and guidelines to develop PPPs in sectors that have had limited experience with PPPs to date. This assignment draws from and supports those efforts, particularly the new PPP Policy approved in January 2010. The PPP Policy clarifies responsibilities for managing contingent liabilities The PPP Policy (2010) is part of the Government’s efforts to rationalize and strengthen the institutional framework for developing PPPs in general. The PPP Policy defines responsibilities for various aspects of developing and implementing PPP projects, and provides a basis for an institutional framework for managing contingent liabilities. For example, it is clearly stated that the DPCO is responsible for managing all contingent liabilities of the Government, including those from PPP agreements. The policy also requires the Ministry of Finance to approve any financial commitments under PPP projects. However, in some cases (and reflecting the relatively unclear processes, as described below) the interactions between entities are not clearly defined. For example, the relative responsibilities of the contracting authority and the DPCO for managing contingent liabilities during the project implementation stage would need to be more clearly defined under an improved contingent liability management framework. The applicability of the PPP policy’s requirements to entities such as the PPIB and port authorities, which have developed their own processes as described above, has also not been clearly defined. Processes for developing and approving PPPs remain unclear under the PPP Policy The main shortcoming of the 2010 PPP policy is that the processes for developing PPPs are not clearly and fully specified. The PPP Policy describes an eight-step process for developing PPPs—the “PPP Lifecycle�: from project identification (needs and options analysis) to tendering, closing and monitoring a PPP contract. The component steps of developing PPPs are broadly in line with international good practice and some guidelines have been issued by IPDF to carryout specific functions. However, the requirements for project assessment— including the process by which projects are evaluated and approved at each stage—are not clearly specified. Figure 0.1 shows the PPP project development process as currently specified in the 2010 PPP Policy, including the eight-step PPP Lifecycle. As highlighted in Figure 0.1, the PPP policy does not specify clearly how the required project approvals fit among the project development steps12, or the kind of analysis and assessment that is required at every stage. 12 The exception is the “approval of viability gap funding�, which is specified as following the completion of the bidding process. Requiring this formal approval only at this late stage, however, risks undermining competition in the bidding process: private contractors may be discouraged from bidding if the project may ultimately not be approved. 126 Confidential Many countries strengthen their contingent liability management frameworks by integrating the contingent liability management functions (particularly at the project development stage) into the overall process for developing and approving PPPs. In Pakistan, to do so successfully would first require that overall process to be clarified and strengthened by addressing the gaps highlighted in Figure 0.1. 127 Confidential Figure 0.1: Map of PPP Project Development Process in 2010 PPP Policy Transaction Contracting IPDF MOF DPCO Planning Advisors Authority Commission (CA) CDWP Policy does not Analysis required at this Assess potential for state who in 1. Project needs Submission stage not clearly PPP and MOF has options analysis requirement s and specified recommend authority at each timing of this approval stage? (“project preparation�) 2. Initial viability not clearly specified; not analysis included in list of steps Approve project Approve project Hire TA Oversee due 3. Carry out due diligence (set TOR, diligence approve report) Draft PPP Law describes a “feasibility study� as 4. Risk, affordability Support CA MOF approval required Planning Commission including output of and VFM test throughout process if project financial ensure consistency with both these steps. obligations are involved GOP infrastructure Analysis required at policy/strategy 5 (a). Carry out Oversee market this stage not market sounding sounding clearly specified. 5 (b). Structure PPP and prepare tender documents Approval not included in list of steps Approve Approve structure and structure and docs docs 6. Tendering / Bidding 7. Approve In some places defined as Recommend on MOF responsibility; for VGF, financial VGF amount may be responsibility of VGF commitments 8. Sign PPP management? agreement 128 Confidential Processes for approving and issuing other forms of guarantee are also unclear In some countries, contingent liabilities under PPP projects are formally accepted through a legal agreement (sometimes called a guarantee or comfort letter), distinct from the PPP contract, and typically signed by the Ministry of Finance. This allows a distinct approval process for obtaining that agreement letter can be put in place—this is often comparable to the process for issuing other forms of guarantee such as debt guarantees, and could be an alternative approach in Pakistan to integrating contingent liability approval into the overall PPP approval process. However, as with the development of PPPs, the process that is in place for issuing or managing debt guarantees in Pakistan is also not clearly defined or consistently followed. Figure 0.2 illustrates the general process that we understand is generally followed to review and approve a request for a debt guarantee. Most significantly, DPCO is tasked with reviewing the request for a debt guarantee and certifying that it is compliant with the Fiscal Responsibility and Debt Limitation Act after it has been approved by the Economic Coordination Committee (ECC). Once DPCO has certified the request, MOF issues the guarantee. In most cases the guarantee is formally issued with a comfort letter from MOF. Figure 0.2: General Process for Approving Debt Guarantees Implementing MOF DPCO ECC Agency (Finance) Review and Prepare request Approve request elevate request Certify Issue guarantee compliance with FRDL Act The process illustrated above has not been consistently followed in the past, however. As a result, data on what guarantees had been issued were not compiled or systematically monitored and manage. In 2009, DPCO responded to this lack of information by collecting and collating information on debt guarantees for the first time. DPCO identified a total of 994.7 billion Rupee of outstanding guarantees, including US$2,799 million in foreign denominated loan guarantees. 129 Confidential Appendix B: Stakeholder Workshop This Appendix provides information on the one-day stakeholder workshop held in Islamabad on 21 July, 2010. The objectives of the workshop were to: Identify and understand the benefits that can be achieved by managing contingent liabilities Present Castalia’s specific recommendations on how to manage contingent liabilities and how roles and responsibilities should be allocated Collect feedback on the recommendations Discuss how the recommendations could be adopted and implemented. Given the limited engagement of the Ministry of Finance and other stakeholders during the early stages of this assignment—due in part to the departure of the Director of DPCO—and the diversity of participants, much of the time during the workshop was spent clarifying the purpose and benefits of managing contingent liabilities and providing background on the assignment. This prevented detailed discussion on the specific components of the recommendations. Nevertheless, there was open dialog among the participants and many constructive comments were given. In general, participants expressed enthusiasm about the proposed contingent liability management framework. However, there was notably some question as to how all of the ongoing PPP related initiatives fit together (including contingent liability management, viability gap funding, the 2010 PPP Policy, the project development process, and the development of a financing facility) and whether contingent liabilities is a high priority or if other efforts might be more important. Based on this observation, we believe that it would be a worthwhile effort to undertake a project that aims to: (1) clearly show how all ongoing initiatives should be integrated, (2) prioritize and create a timeline and milestones for moving the integrated initiatives forward, and (3) identify any additional gaps or capacity building constraints, would be very fruitful and well-received by the Government. This need aligns with our suggestion that pilot-testing a project would be an effective way to carry out an assessment of Pakistan’s PPP program while simultaneously providing training and guidance moving a project toward closing a transaction. B.1 Workshop Attendance Table 0.3 below lists the individuals that attended and participated in the workshop. Table 0.3: List of Workshop Participants Sr. Name Designation Organization No. 1 Ms. Sumaira K. Aslam Joint Secretary (Investment) Ministry of Finance Joint Secretary (Budget 2 Mr. Haq Nawaz Ministry of Finance Implementation) Deputy Secretary 3 Mr. Momin Khan Ministry of Finance (Investment) 130 Confidential 4 Mr. Mahmood Ahmed Section Officer (Investment) Ministry of Finance 5 Ms. Mehwish Ashraf Financial Analyst (DPCO) Ministry of Finance Mr. Raghuveer Y. Lead Pakistan Energy and 6 The World Bank Sharma PPP Program Senior Energy and PPP 7 Mr. Anjum Ahmad The World Bank Specialist 8 Dr. Rashid Aziz Senior Energy Specialist The World Bank 9 Ms. Saadia Rafaqat Economist The World Bank 10 Tasneem Alam Economist IMF Ministry of Deputy Chief (Physical 11 Chaudhary M Anwar Planning and Planning and Housing) Development Ministry of 12 Mr. M. Hussain Malik Deputy Chief (Transport) Planning and Development Additional Director (Banking State Bank of 13 Mr. Irfan Ismail Surveillance Department) Pakistan Deputy Director State Bank of 14 Mr. Usman Shaukat (Infrastructure and Housing) Pakistan Privatisation 15 Mr. Abdul Karim Nayani Consultant Commission 16 Mr. Shah Jahan Mirza Director (Finance & Policy) PPIB 17 Mr. Sabir Ali Khan Director General (CPCC) PEPCO 18 Mr. Najam Javid Director Finance (IESCO) PEPCO 19 Mr. Anwar ul Haq Director Finance (PESCO) PEPCO Mr. Muhammad Jawad 20 Dy. Director (CPCC) PEPCO Anwar National 21 Mr. Afzal Masood Manager (Finance) Transmission and Despatch Company Mr. Muhammad Sohail Ministry of Ports 22 Section Officer (Coord) Nomani and Shipping 131 Confidential Syed Mohammad Ali Port Qasim 23 XEN (Civil) Shah Lakiary Authority Port Qasim 24 Mr. Mumtaz Alam D.M. (Finance) Authority 25 Brig. Syed Jamshed Zaid General Manager (P&D) Karachi Port Trust Mr. Muhammad Hanif 26 Project Manager (East) Karachi Port Trust Abdullah Ministry of 27 Mr. Khizer Javed Deputy Director Communications National Highway 28 Mr. Arshad Chaudhry G.M. (BOT) Authority National Highway 29 Mr. Azeem Tahir Director (BOT) Authority National Highway 30 Ms. Sehrish Jamil Assistant Director (Planning) Authority Mr. Mir Muhammad Ministry of 31 Director Planning Khaskheli Railways Mr. Khizar Saleem Ministry of 32 Section Officer (Works) Khokhar Housing and Works Ministry of 33 Mr. Fayyaz ul Haq Section Officer (Policy) Housing and Works Mr. Shahnawaz 34 Head Projects IPDF Mehmood 35 Mr. Ali Malik Advisor Projects IPDF 36 Ms. Saadia Hassan Advisor Projects IPDF Castalia - Strategic 37 Mr. Kevin Richards Project Manager Advisors PanGro - 38 Mr. Ahmad Waqar Chairman Development Advisors PanGro - 39 Mr. Aamir Qawi Chief Executive Officer Development Advisors PanGro - 40 Mr. Arsalan S. Vardag Chief Financial Officer Development Advisors PanGro - 41 Mr. Junaid Jadoon Senior Associate Development 132 Confidential Advisors Ministry of 42 Mr. Majid Baig Deputy Chief (Planning) Railways 43 Mr. M. Ikram Assistant Economist Ministry of Finance 44 Mr. Tariq Farooq Procurement Specialist Ministry of Finance Alternate Energy 45 Mr. Aamir Butt Assistant Director Development Board B.2 Workshop Presentation The following pages include the presentation that was delivered by Castalia during the stakeholder workshop following an introduction by Mr. Raghuveer Y. Sharma form the World Bank and Castalia team member Ahmad Waqar, former Secretary of Finance. 133 T +1 (202) 466 6790 F +1 (202) 466 6797 1700 K Street NW Suite 410 WASHINGTON DC 20006 United States of America Managing Contingent Liabilities T +61 (2) 9231 6862 F +61 (2) 9231 3847 and Fiscal Risk from Infrastructure 36 – 38 Young Street SYDNEY, NSW 2001 Australia PPPs in Pakistan T +64 (4) 913 2800 F +64 (4) 913 2808 Level 2, 88 The Terrace Funded by the World Bank PO Box 10-225 WELLINGTON New Zealand T: +33 (1) 45 27 24 55 July 2010 F: +33 (1) 45 20 17 69 7 Rue Claude Chahu PARIS 75116 France --- www.castalia-advisors.com Copyright Castalia Limited. All rights reserved. Castalia is not liable for any loss caused by reliance on this document. Castalia is a part of the worldwide Castalia Advisory Group. Outline Introduction and Objectives Session 1: What are “contingent liabilities� and where do they occur in Pakistan? Session 2: How can managing contingent liabilities improve Pakistan’s infrastructure and fiscal management? Session 3: What should Pakistan do to manage contingent liabilities? Session 4: Who should manage contingent liabilities in Pakistan? Session 5: How can Pakistan implement a contingent liabilities management system? 1 Introduction and Objectives The Government of Pakistan and the World Bank has asked Castalia to recommend how the management of contingent liabilities (CLs) from PPP projects can be improved So far we have: - Evaluated the existing policies and institutional processes governing contingent liabilities in Pakistan - Assessed some of Pakistan’s existing contingent liabilities - Developed recommendations and options to strengthen the institutional framework in Pakistan The objective of this workshop is to: - Identify and understand the benefits that can be achieved by managing contingent liabilities - Present Castalia’s specific recommendations on how to manage contingent liabilities and how roles and responsibilities should be allocated - Collect feedback on the recommendations - Discuss how the recommendations could be adopted and implemented 2 kevin.richards@castalia-advisors.com arsalan.vardag@pangro.com 3 Session 1: What are “contingent liabilities� and where do they occur in Pakistan? 4 First, what do we mean by a “public private partnership�? Pakistan’s 2010 PPP Policy defines “public private partnership� as follows: - A public private partnership (PPP) is any arrangement involving the financing, development, operation and maintenance of infrastructure by the private sector which would otherwise have been provided by the public sector. In a PPP, instead of the public sector procuring a capital asset and providing a public service, the private sector creates the asset through a dedicated standalone business (usually designed, financed, built, maintained and operated by the private sector) and then delivers a service to the public sector entity or consumer in return for payment that is linked to performance. PPPs exist in the following sectors: - Energy - National roads - Ports and rail - Others? - The 2010 PPP Policy also renews Pakistan’s commitment to developing PPPs 5 What are “contingent liabilities�? A contingent liability is a payment All contingent liabilities obligation whose occurrence, timing -PPP projects and/or amount depend on some uncertain -Pension guarantees future event or circumstance -Other loan guarantees This project focuses primarily contingent liabilities arising from explicit guarantees to PPP projects Contingent liabilities under PPPs only An explicit guarantee is a contractual or legal commitment from the government to make a payment to a private party, incur an expense, or forego revenue if a certain event occurs Contingent Liabilities arising from explicit guarantees to PPPs 6 Contingent liabilities in Pakistan—direct guarantees Example: NHA has signed concession agreements for road and tunnel projects which include contingent liabilities The Government does not explicitly accept the obligations or guarantees Private embedded in the concession Concession Agreement may agreement. However, the Government Concessionaire include provisions guaranteeing: funds the operations of NHA and • Termination payments in the projects are currently reviewed and event of default or other force approved by members of the federal Concession majeure events government. Agreement • Traffic or revenue levels • Changes in the regulated toll rate • Change in law or tax status • Convertibility / remittability of Government of funds NHA Pakistan 7 Contingent liabilities in Pakistan—3rd-Party Guarantees Example: PPIB has been given the authority to sign Implementation Agreements on behalf of the Government, which include guarantees to Independent Power Producers Power Purchaser costs are determined by tariffs set in PPA: IPP • Capacity payment Government of • Inflation index Pakistan • Fx index • Foreign/local debt service Implementation Power Purchase component PPIB Agreements Agreements • Energy payment • Fuel cost component • O&M component • Fx index Sovereign guarantee executed by PPIB • Dispatched energy covering: NTDC/CPPA • Supplemental tariff for restoration • Default on Power Purchaser obligation • Tax and withholdings pass-through • Termination event and force majeure payment WAPDA/PEPCO In 2007 and 2008, average cost of • Tariff guarantee power from IPPs was Rs5.19 and • Fx insurance guarantee Rs6.67/kWh • Convertability/remittability • Fuel supply obligation (pre-2002) Power Purchaser revenue generated • Other guarantees for change in law and by transfer tariff set by NEPRA: tax DISCOs • Capacity charge • Capacity portion of generation • Fixed charge for transmission Consumers pay retail tariffs that are set • EEP by NEPRA to DISCOs. • Variable portion of generation Consumers 8 Why are contingent liabilities necessary? By providing guarantees, the government is exposed to the possibility of sudden and substantial unexpected payment obligations, which could lead to fiscal instability But, guarantees are needed to mobilize private investment in infrastructure And structured appropriately, they can maximize value for money This creates a need to establishing a systematic process for managing contingent liabilities Lower Payment Risk Higher Government or Provide site, some Make up revenue Provide part of project agency behavior, force majeure shortfalls, cost over runs structure at gov’t most force majeure expense 9 What general types of contingent liabilities are common in infrastructure PPPs? Guarantees on particular variables that affect project performance: - Demand guarantees (specifying a minimum •What triggers each of these level of demand) contingent liabilities? What are the underlying risks? - Exchange rate guarantees Termination payments or arrangements •What information is available for - If the private party defaults each: - If the Government defaults •During project development? •Once a project has been Compensation or termination arrangements implemented? covering damage due to some force majeure events •What are the implications on: Guarantees on Government behavior •The justification for the - Guarantee of regulator decision-making Government accepting risk? - Guarantee of availability of land, permits •The ability to manage risk? Government bearing project commercial risk 10 Session 2: How can managing contingent liabilities improve Pakistan’s infrastructure and fiscal management? 11 What benefits can be achieved by managing contingent liabilities well? Objective of managing CLs How it can be achieved Benefit Improve the ability to By establishing a systematic process that: Better infrastructure: close PPP transactions • Helps the contracting agencies identify, • More projects closed based on sound risk structure and implement transactions well • Greater value for money allocation and • Gives investors confidence in project achieved on closed management structuring and the provision of guarantees transactions By ensuring decision makers : More value created with • Accept risks and approve projects that limited resources through: Improve accountability maximize value for money • Better project screening and decision making • Make regulatory and policy decisions that • Good regulatory and policy reduce risk and improve value for money decisions By controlling the fiscal cost of accepting risk: • Better fiscal and budgetary • Reducing the uncertainty of payment planning Reduce fiscal risk and obligations • Lower burden on instability • Minimizing the cost of payments on realized Government’s balance contingent liabilities sheet and budget • By making the Government’s exposure • Improved sovereign credit transparent and signaling a commitment to rating Increase credibility manage risks • By increasing investors’ confidence in how • Lower borrowing costs payment obligations will be met over time 12 What are other countries doing to manage contingent liabilities? There is limited experience, but growing interest internationally in managing contingent liabilities See handout on International Approaches to Managing Contingent Liabilities Countries have focused on establishing frameworks that: - Define acceptable risks and structures for contingent liabilities - Establish a standard approach to valuing contingent liabilities - Define decision rules for assessing and approving contingent liabilities - Monitor and disclose contingent liabilities routinely - Budget or set aside funds to cover expected or actual costs (that is, realized costs, which may exceed expected cost) of contingent liabilities - Establish a systematic process to meet payment obligations. International experience also suggests it is important to: - Clearly assign roles and establish mandate to centrally administer the policies - Develop specialized knowledge on risk management principles. 13 Session 3: What should Pakistan do to manage contingent liabilities? 14 What should Pakistan do to manage contingent liabilities? PPP Project CL Management Process System Pakistan should adopt policies and processes for performing eight key Identify project functions: Develop project, - Structuring contingent liabilities and including: designing contractual mechanisms Structure CLs Identify and allocate (contract clauses or according to good principles for risk project risks guarantees) allocation Analyze project Analyze CLs - Analyzing contingent liabilities that will be accepted under a proposed project Approve project Approve CLs - Establishing a central process for approving contingent liabilities Conduct bidding & negotiate contract - Formally accepting contingent liabilities Execute contract Accept CLs - Monitoring contingent liabilities while a (execute “IA�) project is being implemented - Regularly and publicly disclosing Monitor and manage project contract Monitor CLs contingent liabilities Disclose CLs - Taking mitigating action on emerging risk Take action on emerging CL risks - Budgeting and paying for realized contingent liabilities Budget and pay for realized CLs 15 Contingent liability management functions—project development stage What? How? Why? Structure CLs Develop and apply risk allocation principles Because it is important Structure CLs (having when structuring PPPs that projects are (contract clauses or allocated risks) Develop and use draft contractual mechanisms developed according to guarantees) for structuring CLs. sound principles for risk allocation and PPP Analyze CLs structuring, which are essential to providing value for money Approve Analyze CLs Analyze and where possible quantify the cost To help inform decision CLs of CLs (likelihood of payment, expected cost, makers of the fiscal and variability) impact of accepting risk Define methodology for analysis Review DRAFT Procedures Manual for Managing Contingent Liabilities 16 Contingent liability management functions—project approval stage What? How? Why? Approve CLs Include CLs evaluation and approval in the To establish a central Approve (as part of PPP approval process: approval process before CLs project approval accepting any financial -Check CL structure process) commitment from the -Assess the results of the analysis of CLs Government -(Maybe) Introduce rules to limit overall Accept CLs (execute fiscal impact of CLs (such as ceilings or “IA�) defined budgeting requirements) Accept CLs Check CLs in final contract are consistent with To deal with any approved terms changes during Create a distinct legal agreement project negotiations acknowledging the Government’s CL and facilitate central commitments and/or review final PPP oversight and formal contracts before signing acceptance of CL Review DRAFT Procedures Manual for Managing Contingent Liabilities 17 Contingent liability management functions—project implementation stage What? How? Why? Monitor CLs Systematically collect project and other To keep officials informed and information because it is necessary to Periodically re-evaluate CLs disclose CL stock and identify Monitor CLs and act on any emerging risks Maintain a central database Disclose CLs Regularly publish information on CLs from To promote transparency and Disclose CLs PPPs as a part of other public debt and fiscal accountability policy documents Take action on emerging CL risks Take action Identify risks (e.g. deteriorating financial Because proactive on emerging performance; failure of Government management can reduce the CL risks agencies to provide necessary inputs) and cost to Government of take coordinated action based on monitoring accepting CLs information Review DRAFT Procedures Manual for Managing Contingent Liabilities 18 Contingent liability management functions—project implementation stage cont… What? How? Why? Budget and Pay for realized CLs promptly and according Can help: pay for to well-defined process Incentivize decision-makers Budget and pay for realized CLs Options: to manage risks well realized CLs -Set aside funds in advance towards Improve credibility of the possible future payments Government’s commitments -Budget for expected upcoming Reduce fiscal impact of need payments to make a payment -Create budget flexibility to accommodate payments when needed Discuss preferred approach to budget and pay for contingent liabilities 19 Session 4: Who should manage contingent liabilities in Pakistan? 20 Who should manage contingent liabilities in Pakistan? Two options… Option 1: Integrate contingent liability management Option 2: Create an independent Guarantee Fund into existing institutions Contingent liability management functions carried out Government could create a legally-distinct Guarantee by a combination of: Fund to issue guarantees in its own name, in place of the Government (as in development in Indonesia, Brazil) - Contracting Authority—as the agencies with the responsibility for developing and implementing projects Guarantee Fund could operate as a commercial - DPCO—as the division within MOF responsible for guarantee fund / insurance company, charging for providing administrative leadership at the central level guarantees based on fund capital provided upfront by (defined as CL manager in 2010 PPP Policy Government—could attract capital from other sources - IPDF—as support to contracting authorities in all Guarantee Fund would be responsible for: aspects of PPP development and contract monitoring/ management - Structuring CLs (by defining what types of guarantees it will offer—possibly following Government-specified - MOF—as the oversight agency responsible for restrictions or policies) approving financial commitments to PPPs - Analyzing and approving CLs (defining a price and Allocation of functions should consider capacity of offering guarantee at that price for decision by private different agencies contractor) - Accepting CLs in its own name - Monitoring, disclosing, taking action on and paying Possibly use a contingency fund or account within for CLs when realized Government to set aside funds towards future payments; could involve charging guarantee fee (as in Government would effectively budget for CLs at the Colombia) point of the initial transfer to the Fund; a mechanism should be defined for recovering the cost ex-post of any adverse Government behavior 21 Why it is better to strengthen existing institutions Is the solution consistent with the existing mandates of each agency and the basic policy and regulatory framework laid out in the 2010 PPP Policy and draft PPP Bill? Is the solution appropriate for the size of the problem? - Pakistan has limited experience with PPPs outside of the energy sector (and roads to some degree), and therefore limited exposure to contingent liabilities - The main problem the Government needs to address is strengthening the incomplete and unclear policies and processes that are currently in place Will the solution produce results? - Complex and sweeping reforms would likely be less flexible, take longer to implement, and the benefits would be more uncertain - Establishing sound policies and practices, and building strong capacity among existing agencies more quickly, is also more likely to create an environment that is attractive to private and multilateral investors - Incremental reform also facilitates learning by doing 22 How can CL management be integrated into PPP development process? Transaction Contracting IPDF MOF DPCO Planning Advisors Authority Commission (CA) CDWP Assess potential for 1. Project needs PPP and options analysis recommend 2. Initial viability analysis Approve project Approve project Hire TA Oversee due 3. Carry out due diligence (set TOR, diligence approve report) 4. Risk, affordability Support CA and VFM test and throughout CL analysis process— including CL 5 (a). Carry out Oversee market analysis market sounding sounding Include additional submission 5 (b). Structure requirements PPP and prepare tender documents Iterative, rather than a (=structure CLs) linear process Approve Approve structure, Check CLs structure and docs and CLs docs 6. Tendering / Bidding 7. Approve Recommend on financial Re-check CLs VGF amount commitments 8. Sign PPP Sign support letter agreement (accept CLs) 23 How will CL management work during project implementation? Private Party Contracting IPDF MOF DPCO Authority (CA) Submit monitoring information Monitor CL exposure Compile Periodically re- Support CA information on evaluate CL throughout process overall portfolio and exposure publish Prompt or support Take action on Take action on action on emerging emerging risks emerging risks risks Elevate intractable problems to oversight body (MOF) 24 Session 5: How can Pakistan implement a contingent liabilities management system? 25 What steps are needed to adopt and implement these recommendations? Adopt the Draft Procedures Manual Pilot-test the recommendations on one or more live case Simultaneously provide training Develop further guidelines … and tools Revise/amend enabling legislation Ongoing training and capacity building 26 Questions and Closing Comments 27