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Minimum Revenue Guarantee Creates Value, but It's Not a Free Lunch

Ting Liu
Thursday, April 28, 2016

As an alternative approach to traditional public procurement, Public-Private Partnerships (PPPs) are adopted by governments for a variety of reasons, including to overcome financing constraints by getting private investors involved in large-scale projects, and to transfer project risk to a private partner.1 Despite the advantages of PPPs, challenges remain in their implementation. One of the challenges for revenue-funded infrastructure projects, such as toll roads, is demand or revenue risk - the possibility that a project’s generated funds are insufficient to service the project’s operation and maintenance costs, debt, and the adequate rate of return for investors.2

For many projects, a majority of project revenue, around 80%, will be used in debt and equity service, concession contracts with private financing are sensitive to fluctuations in demand, and many, if not all, renegotiations and cancellations of private participated infrastructure projects take place due to revenue risks.3,4,5 Extensive studies to estimate demand are often completed, but infrastructure networks are still usually characterized with high revenue uncertainties.6 Particularly, in the transportation sector, traffic forecasts are often very inaccurate. 90% of rail projects are overestimated by 106% on average, 50% of road projects end up with forecast errors larger than ±20%, and forecasts have not getting more accurate over time.7

In the face of significant revenue risk in PPPs, a minimum revenue guarantee (MRG) is an instrument that can be used by governments in order to attract private investors. By offering an MRG, the government agrees to compensate a PPP concessionaire if actual project revenue falls below the specified threshold, thus mitigating the revenue risk taken by the private sector. MRG is shown to be more effective than direct subsidies in mitigating the risk of a project sponsor having negative NPVs (net present values)8, and as a result, the default probability of projects with an MRG will be lower.9,10 MRG also provides incentives for private investors to reveal their true cost information and to improve revenue management under information asymmetry.11,12 Experimental studies find that the MRGs worked well in Chile to attract private participation.13 In recent years with the development of real option analysis techniques, a number of researchers have taken a step further to quantify the value created by MRGs and have reached a consensus that MRGs create value for PPPs.

However, there is no such thing as a free lunch. One reason that MRG appeals to governments is its ability to induce more private investment without any immediate increase in reported government spending or debt. That may be true, and MRGs may not be reported in governments’ accounts, but they can expose governments to contingent liabilities which may turn out to be unaffordable. For example, in Columbia, the adverse fiscal impact of MRGs have been very significant, where the total amount of guarantee paid by government during 1995 to 2004 accounts to 70% of the investments of the 11 guaranteed concessions. 10 Likewise, the revenue guarantee offered by Mexican government for the toll road PPP program in the late 80s and early 90s was another case that turned out to be an unanticipated liability of $8.9 billion after the 1994 Mexican economic crises.15

Also, a high level of MRG may lead the private investor to concentrate on minimizing costs in order to obtain more profits, and comprising the infrastructure quality, which may have adverse impacts on social welfare.16 PPP practices indicate that governments are unsure of the thresholds of guarantees that should be offered, which always leads to over-guarantee.17 In summary, MRG is a valuable instrument to enhance private investors’ confidence through government commitment. However, it may give rise to significant challenges to long-term fiscal management. Scholars and governments alike need to make effort in evaluating and designing MRGs, while also improving transparency in accounting, reporting and budgeting of MRGs.

Sources

1) Wang Shouqing, K. Y. (2008) Concession Projcet Financing.

2) Chiara, N., M. J. Garvin & J. Vecer (2007) Valuing simple multiple-exercise real options in infrastructure projects. Journal of Infrastructure Systems, 13, 97-104.

3) Charoenpornpattana, S., T. Minato & S. Nakahama. 2002. Government supports as bundle of real options in built-operate-transfer highways projects. In 7th Annual International Conference on Real Options.

4) Guasch, J. L., J.-J. Laffont & S. Straub. 2003. Renegotiation of concession contracts in Latin America. World Bank Publications.

5) Harris, C., J. Hodges & M. Schur (2003) Infrastructure Projects: A Review of Canceled Private Projects.

6) Cruz, C. O. & R. C. Marques (2013) Flexible contracts to cope with uncertainty in public–private partnerships. International Journal of Project Management, 31, 473-483.

7) Flyvbjerg, B., M. K. Skamris Holm & S. L. Buhl (2005) How (in) accurate are demand forecasts in public works projects?: The case of transportation. Journal of the American Planning Association, 71, 131-146.

8) Wibowo, A. (2004) Valuing guarantees in a BOT infrastructure project. Engineering, Construction and Architectural Management, 11, 395-403.

9) Wibowo, A. (2006) CAPM-based valuation of financial government supports to infeasible and risky private infrastructure projects. Journal of Construction Engineering and Management, 132, 239-248.

10) Carpintero, S., J. M. Vassallo & A. S. Soliño (2013) Dealing with traffic risk in Latin American toll roads. Journal of Management in Engineering, 31, 05014016.

11) Chen, H. & R. Qin (2012) Real options as an incentive scheme for managing revenues in transportation infrastructure projects. International Journal of Revenue Management, 6, 77-101.

12) Shi, S., Y. Yin & X. Guo (2016) Optimal choice of capacity, toll and government guarantee for build-operate-transfer roads under asymmetric cost information. Transportation Research Part B: Methodological, 85, 56-69.

13) Vassallo, J. M. & A. S. Soliño. 2006. Minimum income guarantee in transportation infrastructure concessions in Chile. In Transportation Research Record, 15-22.

14) Martins, J., R. C. Marques & C. O. Cruz (2015) Real options in infrastructure: revisiting the literature. Journal of Infrastructure Systems, 21.

15) Chiara, N. & N. Kokkaew (2013) Alternative to Government revenue guarantees: Dynamic revenue insurance contracts. Journal of Infrastructure Systems.

16) Feng, Z., S.-B. Zhang & Y. Gao (2015) Modeling the impact of government guarantees on toll charge, road quality and capacity for Build-Operate-Transfer (BOT) road projects. Transportation Research Part A: Policy and Practice, 78, 54-67.

17) Xu, Y., J. F. Yeung & S. Jiang (2014) Determining appropriate government guarantees for concession contract: lessons learned from 10 PPP projects in China. International Journal of Strategic Property Management, 18, 356-367.