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Project finance deals usually require some form of Governmental support. What Governmental or Legislature actions create better environment for project finance?”
The government plays a vast array of roles in project financing and has potentially impactful role upon project financing. Project financing is a distinct legal entity designed to create cash flows, funds and complete the projects. The government is involved in the form of loan, guarantee, risk participation, and of legal facilitation in return of financial benefits. The problem lies in lack of proactively tapping private financial market and collaborating with private partners or investors by creating a liberal financial framework, This means allowing partners through regulations or law to choose a model or propose a model and appropriate project that is beneficial for them as well as meet policy objectives. Thus, the government must not require for high assurances, highly risky bonds, allowing uninhibited competition, taxing regime, or lack of appropriate support in financing, planning and managing projects. The viable structure must manage development risks, political risks or constructions risks and provide for a structuring plan that mitigates risk, that demands more participation of local authority, and that requires government assurances or undertaking to hold them accountable. Major part is in allocation of risks where role, rights, responsibilities and liabilities of parties are clearly framed. Along with a large size investors, the government can also become equity participants, which enables a better consensus on the purposes of a project. What is required would be a system that is contractually based but subject to legal guidelines, whether through common law or legislation. The appropriate environment would be legislation-based framework that governs project financing contracts between the parties.
Project finance deals usually require some form of Governmental support. What Governmental or Legislature actions create better environment for project finance?”
Project financing means raising funds in order to finance a capital investment project that is economically separable. The fund providers focus on cash flow generated from projects as the source of funds to provide return of and a return on equity invested and service the loans. The cash flow characteristics govern the debt and equity securities terms. The project profitability and collateral value of the assets, such as pipelines, electric generating facilities, refineries, etc. govern the project debt securities. This essay will assess the extent of the support of the government in raising the funds to project financing and how it contributes to framing a structure around the financing. Project financing requires a legal and structural framework that finds its basis on three general sources. First is the project finance legislation and regulations. The second is the standard contractual and financing requirements development by private sector. This UK has standardized contracts to encourage private investments. The third is the project finance standards of the multilateral institutions. This essay will stress on the government support in the form of the first source of project finance legislation and regulations. It will explore the type of government support and the extent of its role in creating a better environment for project financing.
Role of government in private financing
Project financing is a distinct legal entity. It requires an agreement between funds providers to complete the project, make funds available, and make cash flows for meeting expenses and debt service requirements. It requires assurance to make funds available through insurance
Project finance deals usually require some form of Governmental support. What Governmental or Legislature actions create better environment for project finance?”
recoveries or advances against future deliveries. Government support can come in different forms. For example, it can provide a guarantee, whether complete or partial, which determines whether or not a project moves ahead or abandoned. A project is not financed if it is not profitable and cannot be financed without the direct and full government guarantee of the project debt. It is financed by the government on its own behalf in its own general credit. The government will be willing to finance the project in such circumstances. Such form of support is necessary when the project is too large and risky for a single partner to pursue on their own and when the economic benefit will be hard to capture if not all the partners are working together. For example, the Hibernia Oil Field Project was supported with financial support by the Canadian government due to its potential to create employment opportunities and benefit for the public. The government provided grants and loan guarantees, a quarter of the construction costs, guarantees of non-recourse project loan, and forgo most of the sales tax. In return, it would receive certain percentage of the profits and royalties from production at a reduced rate. Thus, the support of the government comes in the form of financial support and other legal facilitation that enable funding and operating the projects. In return, they acquire financial benefits.
The private-public collaboration are regulated and governed by negotiated agreements, which provides for public safety, quality of services, profitability, and taxes to the government. Projects like these generate taxes that go to the government. For example, the Toll Road Corporation of Virginia had the toll road project of USD 250 millions in Loudon County, which was expected to pay USD 450 millions of income taxes, federal and state, over the 40 year taxable life and also USD 96 million in property taxes. Moreover, the state and the
local government had their share of profit-sharing payments out of the ground leases to private partners. Support for project financing from the government could, thus, be seen in projects that involve public benefit, that are huge and that require government’s role. Such relationship could be found in projects such as those that adopt: i) the buy-build-operate model where a private partner buys a facility from the government, modernises, expands, and operates the facility as a public facility that generates profits; or ii) the lease-develop-operate model where a private partner leases a publicly owned facility and the land surrounding the facility from the government, expands, develops, and operates the facility under a revenue sharing contract with the government for a fixed period of time. In the form of support as seen above, it could also be observed the framework of support by the government must support public cause. However, it is rather not the government that see potential in the existing facilities or projects, but the private partners. It is the private partners that see profitability in the projects and the plan to address risk involved with the projects. This calls for better support framework that provides for financial and political incentives to support public causes. In this context, is the support of the government in terms of grants and loan or other similar support sufficient without more accountability or stake in the projects? The answer may not be affirmative given the potential risks private partners could be exposed to. It is argued that the role of the government is to reduce the cost of risk-bearing for projects through a stable and efficient policy framework. It cannot perform better through its tax system than the funding in the private financial markets, for example in infrastructure projects. Financial advantages arising from government financing arise from coercive government’s powers. Moreover, governments should not cover commercial risks and should not invest in projects or partners, whether with equity or with debt as the under a
government finance, taxpayers are subject to a contingent liability that if they are properly remunerated it would remove any cost advantage of sovereign borrowing. Private markets tap on low-cost funds and maintain project discipline. They address any trade-offs. In comparison, the government cannot do better by raising funds. However, it can work towards optimal solutions that private markets may not always find, such as better policies of trading risks. It may significantly reduce the cost of risk-bearing, support for securing property rights, reduce regulation, and create a liberal financial market where private partners can avail low-cost funding opportunities. The government must also consider the interest of the taxpayers while off-setting risks. In this regard, the multilateral finance institutions and the government may work together where the institutions may apply their financial instruments in order to support development of better government policies, such as policies that grant guarantees against failures. In this regard, the government needs to come up with a financial framework with better regulation and liberal market allowing more rights to the partners, which along with the government could be held publicly accountable.
Conducive environment for project finance
The government is accountable politically. It does not do so in a managerial sense. This has led to its increasing control over private finance initiative in the UK. With the power and they possess over society, their activities produce a controlling outcome but avoidance of public questions. The government exercises its control and avoid accountability in the form of establishing appropriately separate internal bodies. Similar observation of lack of direct accountability seems to be with the regulatory framework that governs project financing in the UK, which does not have a unified regulatory framework governing project financing. It
has different and various regulatory bodies responsible for different project and the relevant industries. For example, the UK has different energy regulators, such as Office of Gas and Electricity Markets (Ofgem) for downstream gas and electricity; the Office of Communications (Ofcom) for communications; the Office of Rail and Road (ORR) for transport; and the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) for the UK finance and banking sector. Thus, in a project financing a private partner has to deal with multiple government agencies creating a certain level of uncertainties in terms of accountability where they may not have a definite reference point to address issues concerning high stake projects, such as those of national importance. This would be otherwise avoided if there is a direct government representative body to which all the other agencies are answerable. The existence of such direct government representative body would have address the issues arising from the lack of a consolidated project financing law in terms of referring issues to such body arising from non-compliance of the laws. The UK does not have any specific laws governing project finance transactions. It has the common law principles and various UK and EU legislation. For example in respect to legislation, the Planning Act 2008, Part 3 governs nationally significant infrastructure projects, Part 4 governs development consent and Section 239 provides for financing approved by the Parliament for expenditure related to the projects under this Act of 2008. Similarly, the Localism Act 2011 also set out a planning permission framework for approval of major projects where councils and neighbourhoods are given powers and local communities are provided greater control relevant with local decisions like housing and planning. Its Chapter 6 governs nationally significant infrastructure projects. Its Section 120
provides for government’s financial assistance to neighbourhood development plans. Similar to the Planning Act 2008, Section 239 of the Act of 2011 provides for financing approved by the Parliament for expenditure related to the projects. The UK has entered into many bilateral investment treaties related with project financing. The result is bilateral agencies that are linked to government of signing countries. They are created for economic policy purposes and to promote commercial and promotion of the countries. Such agencies could be development agencies that pursue industrial and financial development aims subject to market principles and practices. They are financial investment houses granting loans and investing in equity capital of companies in other countries, especially developing countries. For example, the UK has the Commonwealth Development Corporation, a state-owned corporation, which invests in equity capital and on low-income and lower-middle-income countries. Similarly, the UK has the Export Credit Agencies, which are SPVs based in developing countries and provide political risk coverage, direct loan, or total coverage to exporting companies. They can also provide financial support through interest rate equalisation to commercial banks.
Policy framework. Project financing in the UK is mostly seen in sectors that are extensively regulated by the government falling in the infrastructure industry, such as the hospitals, schools, power generation, roads, and water and waste projects. Some of the projects wholly fall within the private sector, which will develop, operate and finance through independent companies and private lenders. Projects such as power generation and schools and hospitals are financed through private-public partnerships where the government takes
ownership of the project delivery on the expiry of the concession arrangement that governs the private partners’ developing and developing the specific projects. In this context where private partners play a significant role in projects that benefit the society, the concern question is what kind of government support, including the legislation or regulation which could be extended to such partnership projects to make the environment conducive for project financing. In respect to legislative framework, it is seen that there is no single legislative or regulatory framework governing project financing. In addition, there are legislative provisions that discourage private partners from participating, for example in infrastructure projects. For example, there is the requirement of formal legislative approval of project agreements after being negotiated by the government agencies, which creates an uncertain environment where a private partner is exposed to risk of losing all cost in negotiation. Similarly, private partners are exposed to high costs of private insurance required by the government or high cost in planning, designing and securing project permits. Bonds are also financial risks that could be imposed when they are forfeiture without reasonable cause. Similarly kind of uncertainties is on government’s permission to uninhibited competition imposed by future projects sponsored by the government. Additional risks are in the form of tax regulation that governs toll rates or the rate of return on investment, which were not agreed at the time of negotiation. This is particularly relevant in transportation and other such infrastructure projects, where private partners must be given assurance that their risks of undertaking a project cannot be subject to future public utilities commission. Further, the lack of local government financial support also adds to up to bearing the entire financial crunch of project financing on the private partners. This, thus, calls for more involvement of
the local authorities protecting the project from unfavourable changes in government policies.
The above are some of the legislative or government challenges faced by public-private financing projects. Hence, the private partners are not given more liberty to propose projects that are also driven by their interest and simultaneously serve public good. For example, if they are given liberty to propose projects profitable and financially viable for them rather than they are made to select from a list of projects, such legislative provision will help address high business and regulatory risks faced by them and build better public-private partnerships. For example the Dulles Toll Road Extension built in Virginia is a good case study. The government can help in planning, permits, acquiring lands, and smoothening inter-governmental processes. It can facilitate administratively and financially in environmental impact studies that reduces costs for the private players. The government can acquire stake in a project by granting loan to the projects. It can defer taxes as a form of investment without directly funding a project. It can also provide leases of land or other property related rights such as right of way as a contribution. These provisions could be terms administrative that may facilitate the overall project financing, which may not happen if the appropriate policy measures are not in order. For instance, Moody's in 2017 downgraded the ratings of four UK infrastructure and project finance issuers (Network Rail Infrastructure Finance PLC (NRIF, Aa2); LCR Finance plc (LCR Finance, Aa2); Ineos Grangemouth Plc (Ineos Grangemouth, Aa2); and Merseylink (Issuer) PLC (Merseylink, Aa2)) from Aa1 to Aa2 ratings. Moody’s identified that the key drivers for the downgrades
were the significant weakening of the outlook for the public finances caused by a outlook on the Aa1 rating and by the doubt over the government's fiscal consolidation and increasing debt burden. For example, LCR Finance Plc has the only liabilities in the form of three guaranteed bonds, which are unconditionally and irrevocably guaranteed by the government in regard to their punctual payments. Moody’s stated that LCR Finance has no material credit that is worth outside of. Its claims is based on the government. LCR’s rating is subject to the rating of the government. Thus, any downgrade in the government’s rating will also affect the rating of LCR. Moody’s also gave another driver for the downgrade in rating as being caused by the erosion of the medium-term economic strength that has increased the fiscal pressures manifold due to Brexit and the after-challenges in policy making due to complexity Brexit negotiations and relevant domestic political dynamics.
Risk management. The need for project financing rests in the reason that it abhors uncertainties or risks in a project. The risk structuring process in project financing, thus, occupies an important role in mitigating risks. This process helps identify, analyse, mitigate, quantify and allocate risk so as to prevent any risk threatening the project and prohibiting profitability and revenue. A risk mitigating method is by contracting-out process amongst the stakeholders that allocates the risk. A party that best controls the risk or influences the outcome is allocated risks in return for a compensation proportionate to the risk undertaken. For example, as also seen earlier, the government or the project sponsor could take care of permits, which are development risks as it involves addressing government departments approval, public opposition, etc and in return get a financial stake or reward. Similarly, in terms of construction risks such as price change due to inflation, construction
delays or design changes, the government can give negotiated support and it changes management of allocation of risk, where the government can gain some control over the management of risk. The management of risk allocation is also dependant on the structure of project financing, for instance in case of urban infrastructure, the manner it is funded, financed and governed shapes the risk mitigation. This question occupies a central place in negotiation amongst the national, city-regional and city scales. Such urban infrastructure is sponsored by the financial and state actor. It is then transformed into an asset for international investment. The national state and financial institution coerces local governments to be more entrepreneurial in respect to their infrastructure funding and financing and governance arrangements. This brings in urban infrastructure financialisation and local government practices and governance forms. For instance, the UK City Deals is a new form of urban governance and infrastructure investment where central and local government enter into negotiated agreements with more decentralised powers, responsibilities and resources. However, the national state is highly centralised with more managerial role and has a conservative/risk-averse administrative culture. This poses constraints on financing infrastructure and governance. The governance is, thus, spatial, temporal, political and economic and project financing has a social meaning with variety of and inconsistent processes.
Mitigating risks depend on the kinds of risk. As such, risk reduction mechanisms cannot reduce all financial and commercial risks as there are third factors beyond partners control
such as inflation, exchange rate movement, business cycles, etc. Political risks are also subject to certain kind of mitigation techniques, including structuring transaction and financing by booth the project sponsors and partners, or non-interference from the government. As an example step, partners can seek government assurances in respect to specific risks, including nationalisation or expropriation, changes in tax regime and any such laws, or transfer of risks. Any such assurances or undertaking from the government give the partner access to remedial rights against the government for its breach of their undertaking or assurances. Such undertaking or assurance is a negotiated agreement, which may be limited as governments are granting fewer broad guarantees restricting remedial rights of the partners and more often transferring the risk to the private partners. Another method is by way involving a large corporation, or financial investors or institutes as investors or lenders to increase the bargaining power of the private partners. They can involve the government as equity participants making them stakeholders in the projects. By doing so, the government is discouraged from taking actions that would be economically detrimental to a project.A more balance of bargaining power would be achieved if there is an international economic interests being derived from a project. For example, if partners could arrange a debt financing through a syndicate of international banks in regard to a construction projects with international constructors involved on a long-term arrangements. This creates a domestic as well as an international pressure on the government and consequently a balance of economic interests is achieved.
Government role in creating a legal and regulatory environment conducive in project financing.
Political will and continuous political support are needed for project finance. A project must not be only financially viable, but also politically viable. For example, if a rate of return is not politically acceptable, the project is exposed to high risk in the form of high rate of return. This is not commercially viable. This also means that the parties have not reached a consensus as to the benefit of the project. The lack of consensus gives rise to practical problems, such as government’s lack of willingness to pay in case of toll roads projects. This gives rise to political problems, which are especially associated with project-financed instruments. One such problem is where a foreign investor has high leverage subjecting a project company to little room to adjust to short-term macro-economic problems in the country, for instance the company has to pay a fixed foreign-currency debt services amount irrespective of the economic difficulties of the country. In case the foreign investor has low leverage, the project company can reduce its dividends and reduce the economic dividends in the country. In either way, a project financed with investment can favour the foreign investors without fair regard to a country’s economy. To avoid such problems, the project must be structured in a manner allowing a country to make future changes, which means that there must a fairly negotiable framework.
One of the ways to structure the project financing is creating a system of legal and contractual relationship between the parties that defines the financial and economic planning needed to develop the project. This system should enable allocation and application of funds in accordance with the financial model adopted in project financing. It will help define liabilities before financing and lenders could establish areas of allocation of cash flow arising from the
investment project. One of the legal structures in regard to project financing is SPVs (special purpose vehicles) where a project company has a single purpose, which is the entire cash flow is entirely attributed to the SPV. The economic, legal or financial management of such project must be protected from third factors so as to align the project and the cash flow coincide in the best possible manner with the firm liable to service debt towards the lenders. Similar legal structure is required particularly with public private partnerships, which is most of the project financing projects. In this regard, there must be a sound and attractive of legal framework. For example, there are sector specific laws that provide for different types of PPPs models, which create problem in selecting the applicable laws. Thus, a specific law applicable to PPPs can remove uncertain interpretation of laws. This is not the case in England. It does not have a specific PPP law. It comes under common law jurisdiction, where written PPP contracts based on a permissive legal system bring certainty and clarity of intention of the parties. Thus, it offers a structured framework in the form of case laws and manuals, for example the Standardisation of PFI Contracts version 4 (SoPC4) contract provisions and commentary. Such framework offers a comprehensive guidance for procuring authorities; offers a reference point for bidders and contractor; prioritises intention of the contracting parties.; offers a contractual-based reference point that allows flexibility in regard to contractual and financial innovation and good practice in the form of standard contractual clauses. Alternatively, enacting a specific PPP law will show political commitment and wider support and bring clear and comprehensive provisions that act as overarching legislative guidance on core issues.
In selecting a system that is overall guided by legislative provision and a system that is contractual-based, the question is to choose the one that will bring a fair platform for parties to negotiate, focussed on profitability, and serve public good, which should be the consensus between the parties. If it is contractual-based, there will be situation as seen earlier of one party having higher leverage. This is seen in infrastructure investment, which has not grown as it should have been despite low real long-term interest rates and high potential supply of long-term finance. This does not look aligned with government economic policies as infrastructure is a core determinant of economic growth potential. There is a lack of investable projects. They are not properly designed. They are subject to contractual arrangements where the distribution of risks and returns create the wrong incentives amongst the partners. In order to avoid such situation, project financing must bring in economically rational financing structures with greater involvement of private investors. The projects must be designed so as to create a list of investable projects attracting large investors that could invest a greater share of their financial resources. Further, the structures must consider the untapped capital markets to the finance. If it is legislation-based, political power may favour the government or political interests. The system that is required is a system, whether legislation or common law, which provides a complete and clear procurement procedures for the award of a contract including negotiation and remedies; a guideline on state support and guarantees; a division of parties’ responsibilities in regard to project planning, priority sectors and feasibility exercises; rights and responsibilities of parties; etc. Thus, a change in law and regulation is required to bring a stable environment that allows private ownership or control of the project and protection of private investment; clearer framework that governs project’s operation; consistent policies; transparent procedures; and lenders to take and enforce
security. For example, a change of law may affect the costs of a project. A change of law could be due to adverse decisions of the courts that could impose regulatory risks. The issue is the value of money in the project. Therefore, the legal and regulatory framework must ensure appropriate transfer or allocation of risks, which for example require the contracting authority to absorb any change in cost.
An ideal project financing is it becomes a separate entity that can survive on its own. For this to occur, the agreement between funds providers governing cash flows, fund raising and completing the project must assure appropriate allocation of risks and security of parties’ rights and liabilities. The role of the government comes in different manner. It could be financial support with financial returns. It could be taking part of risks and liabilities in return for public good and economy. Grants, loan guarantees, a quarter of the construction costs, and forgoing most of the sales tax are all forms of government support.
Project financing is regulated and governed by negotiated agreements. However, private partners are exposed to economic and political risks when they have the capability to convert projects into profitable one by accessing low-cost funds. In that regard, they should be given a more liberal market with more rights and choices where they are given more financial and political incentives towards meeting public causes. In that regard, better policies of trading risks must be in order where financial institutions can offer their financial instruments to the government to create better government policies.
The government must be more accountable and managerial along with stake holding in the profitability of the projects financed. The absence of a unified regulatory framework in the
UK governing project financing may be the reason why it is not so. A suggestion would be creation of a direct government representative body that governs all the regulatory bodies. The problem may be also due to the lack of specific laws governing project finance transactions. A specific law and a unified regulatory framework may reduce heavy regulation by the government, which will also be subject to such framework. This is especially necessary where private partners are exposed to high costs of insurance, commercial risks and uncertain political assurances. A unified framework will bring a standard frame of terms and conditions in project financing, for example standard public utilities commission not subject to future changes; a standard percentage of local authority financing, ability of private partners to propose projects that are profitable and financially viable serving public objectives.
The government must participate more in project planning, permits and other such roles to facilitate the project operation and completion administratively and financially. Taking a stake in projects through policy measures by offering tax deference, loans, land rights, etc and structuring the risks appropriately will offer a better risk mitigating method. This is where the government occupies a crucial role in controlling risks and influencing project outcomes. Its role comes in managing development risks, construction risks, and political risks. Risk management depends on the structure of project financing, which considers local government practices and infrastructure financing. In that context, mitigating political risks comes as a form of government support where the government can give assurances in regard to tax regime, remedial rights to partners and allowing larger private financial players brining a balance d negotiation process.
The government must create a legal, regulatory and political framework that creates an environment of consensus in project financing. For example, it should allow a project to adjust to short term macro-economic problems and not allowing higher leverage to foreign investors or managing flexible foreign-currency debt services. The government must create a fairly negotiable framework, which is a blend of legal-based guidelines and contractual-based negotiated terms that clear define all rights, responsibilities, liabilities and remedies. For example, enacting a set of guidelines based on common laws governing project financing whether the projects are categorised as PPPs or any other forms. Alternatively, there could be a law that provides the umbrella provisions that guide the parties in project financing and the judiciaries.
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