Note No. 149 August 1998 Risk Management Systems for Contingent Infrastructure Liabilities Applications to improve contract design and monitoring ChristopherM. Government guarantees for private infrastructure projects represent real liabilities, and their Lewis atnd costs can average as much as a third of the amount guaranteed. Most governments do not know Ashoka dcaamde the full extent of these liabilities, because they have made no attempt to systematically estimate them. A companion Note (Viewpoint No. 148) proposes a new framework for identifying government exposures, valuing expected and unexpected risks, and budgeting for expected risks and reserving for unexpected ones. This Note shows how governments can use the valuation process to analyze the distribution of risks, decide which risks they should bear and which should be borne by the private sector, and reduce the frequency and size of calls on guarantees. In what may be the first time that a sophisti- pected loss. In keeping with the lattice of risks cated contingent valuation method was applied outlined in the companion Note, the govern- to government infrastructure projects, the World ment assessed a number of risk exposures: mar- Bank and the Colombian government collabo- ket risk (relating to market volumes and prices), rated to estimate the government's exposure construction risk (from cost and schedule over- in three infrastructure finance projects: runs), counterparty risk (operations risk and * The US$20 million El Cortijo-El Vino toll road risk of failure of participating companies), cur- project, where tlle governmient guarantees iency risk (relaiting to exchainge rates and construction costs and traffic volumes. liquidity), force majeure, termination risk (risk * A joint venture telecommunications project of contract buyout, possibly including penal- between Telecom S.A. and Siemens. where ties), and regulatory risk (the risk of adverse Siemens will supply switching equipment and regulatory changes). cables for more than 80,000 new lines and the government guarantees annual minimum The assessment for the El Cortijo-EI Vino toll cash returns to Siemens in the period after road project showed that the greatest exposures construction. for the government are from the market risk * A US$755 million privately sponsored power associated with traffic volatility and the risk of project to supply a government-owned dis- construction cost overruns. The total expected tribution company, where the government loss to the government under these two guar- provides guarantees for the power purchase antees was estimated at about US$4.2 million agreement (box 1). (table 1). The assessment of the telecommu- nications project identified regulatory and The valuation of the government's exposure market risk and construction risk as the largest in these three projects used a technique called risks. Regulatory and market risk exposure stochastic simulation to identify the net ex- -stemming from Colombia's deregulation of The World Bank Group . Finance, Private Sector, and Infrastructure Network Risk Management Systems for Contingent Infrastructure Liabilities !.i I i1!i F. .2ll Toll roads Toll roads telecommunications, which ended the mono- The government provided a construction cost overrun guarantee and a traffic poly held hy Telecom S.A.-was estimated at volume guarantee once road construction was finished. Under the terms of I§SS 10 million. Construction risk was estimated thecostoverrunguaranteethegovernmentwould coverIODpercentofthe at USS9.8 million, but whether this risk is bome cost of overrun up to 30 percent of the original construction bid, 75 percent of bv Telecom or Siemens is not clear from the the overrun between 30 and 50 percent of the bid, and none of the overrun contracts. In the energy project the govern- above50percentofthebid.Thetrafficvolumeguaranteecommitsthe ment's exposure to CORELCA was estimated : .$ : .n:X: .; d :: 9. ui:. S: AS Xi ufat US$67 million. Most of the exposure relates governmentto reimbursing the Sconcessionaire If traffic volume falls 10 tU$7mlio.Noto h epsr eae govr mntorembrsigte' ncasso"ref4 : :0: wisioto the risk that retail energy prices will be percent below the projections agreed to in the project budget. if traffic insufficient to support CORELCAs operations, volume exceeds projections by more than 10 percent, the additional revenues causing the company to default. are placed in a reserve fund to cover future shortfalls in traffic volume orfor road maintenance. The loss variances for each project were also analyzed, and scenario analyses were run to see Telecommunications how different conditions would affect the risks Thetelecommunications project, a joint venture between Telecom S.A. and of each project. Scenario analysis is an extremely Siemens, has a structure similar to a build-operate-lease arrangement under important tool for governments in reviewing which Siemens will install the switching equipment and cables for more than their exposure to a project finance transaction 80,000 new lines. Under a nrsk sharing agreement Telecom bears 20 percent of in the context of general fiscal policies. In the toll road project, for example. such analysis can the risk/return within a 10 percent band around theexpected revenue of the show how anti-inflationary fiscal policy would project and 100 percent of the risk/return outside this 10 percent band. The affect the government's exposure under traffic contracts do not clearly specify the allocation of construction risks, volume guarantees. Scenario analysis is also useful in analyzing alternative approaches to Power achieving the government's objective in an in- The government has provided several forms of support to the US$755 million frastructure project. For examplc, in addition to expansion of the 240-megawatt Barranquilla thermal power plant. The 750- underwriting the power purchase agreement, the megawan plant will be constructed by TEBSA to provide power to CORELCA, Colombian government provided a subordinated an undercapitalized state-owned power distributor on Colombia's Atlantic loan to CORELCA. As a result, the evaluation of coast that runs a narrow-margin energy distribution service. TEBSA is a n ction designed to increase the value of the special-purpose vehicle capitalized by the old Barranquilla thermal plant, pactgo thervalue of the in atedcloan to : ~~~~~pact on the value of the subordinated loan to now jointly owned by CORELCA and ABB Distral. The government support CORELCA. consists of a power purchase agreement between CORELCA and TEBSA, three guarantees, and a subordinated loan: Risk sharing between the public and Under the power purchase agreement CORELCA agrees to make capacity private sector payments to TEBSA for the first twenty years of the plant's operation. As long as the plant is operational, CORELCA must pay a schedule of feesthat The valuation process allows governments to start high and decline over time. critic aiiw' assess the distrihution of risks under start high and decliRe overtime. a direct loan, a guarantee, or an insurance The Ministry of Energy guarantees COREECA's ahility to make these program and to design contracts that lead to paymentstoTEBSA,andtheColombiangovernment guaranteesthe fewer and smaller calls on guarantees. For ex- ministry's ability to honor this commitment ample, in soliciting bids for the toll road project, * To prevent CORELCA from failing, the ministry has taken a subordinated the Colombian government asked prospective debtpositioninthecompanytohelp ease anyliquiditycrisis. concessionaires to bid on the basis of a prelimi- Ecopetrol,thesupplierof gastoTEBSA and CWRELCA, guaranteesforce nary set of engineering designs. Recognizing majeure payments. that these designs provided too little detail, the government granted cost overrun guarantees that would compensate the concessionaire for TABLE I EXPECTED GOVERNMENT LOSSES IN COLOMBIAN INFRASTRUCTURE PROJECTS Millions of U.S. dollars El Cortijo-El Vino Telecom SA.-Siemens CORELCA Type of risk toll road project joint venture energy guarantees Market 3.1 2.5 52.0 Constmetion 1.1 9.8a 0 Counterparty 0.3 0.1 5.0 Currency 0 -1.3 2.0 Force majeure 0.2 0.3 7.0 Termination -0.2 0.2 1.0 Regulatory 0 10.1 0 Total 4.5 21.7 67.0 a. It is unoclear from the contracts whetherthis risk is borne by Telecom or Siemens. Soerce: Timothy lrwin, Michael Klein, Guillermo E. Perry, and Mateen Thobani. eds., Dealing with Pufblic Risk in Private Infrastructure (Latin American and Caribbean Studies, Washington, DC.: World Bank. 19981. cost variances within a wide band around the it should consider providing direct credit, tar- submitted bid. While the guarantees served the geting the credit to the area of concern. The purpose of attracting qualified bidders, their government should then determine whether it structure allowed concessionaires to extract a also has the information and skills to most near-certain rent from the government of about effectively monitor and control the risks or 35 percent of the original bid. whether a private servicer should be employed to service the loans. Where the government del- After assessing the risk transfer associated with egates servicing, it must have systems for moni- the toll road project and quantifying the risks in toring tlhe performance of the servicers. the project, the government changed its toll road guarantee program. It now commissions more Even if the government has the best access to detailed engineering studies before it solicits bids information on a risk, it might choose to provide to limit the uncertainty in the bidding process, assistance through a guarantee targeted at a spe- and provides a narrow guarantee. The new cific layer rather than through direct credit. The policy is less expensive than the old one but reason is that a contingent guarantee can be provides the same benefit to the concession- more narrowly focused on the market failure, aires. The change made the Colombian toll road as in the switch from providing a broad guaran- program more efficient-achieving a higher risk- tee to funding engineering reports in the adjusted rate of return by reducing the govern- Colombian toll road concessions. Because guar- ment's risk of delivering a fixed benefit. antees and insurance can be narrowly targeted, they can be used to get the private sector to The valuation process enables a government to absorb as much risk as possible. assess how efficiently risks have been allocated and derive lessons from its findings. To do this Where the private sector is better able to under- the government must first assess which party write and service the underlying risks but some (public or private) has the best access to the government assistance is needed, public-private information needed to objectively and most risk sharing is often the best solution. In this accurately evaluate the underlying risks. It must case pro rata guarantees and insurance under then assess which party is in the best position which the private sector and the government to monitor, control, and service the risks once share all losses on a risk equally are often the they are underwritten. If the government is in best form of assistance. Risk sharing gives the the best position to underwrite the risks directly. private entity an incentive to price the coverage Risk Management Systems for Contingent Infrastructure Liabilities appropriately, ensuring that it will not shift thereby aligning the guaranteed party's incen- additional risks to the government. Other risk tives to remain vested in the project wilh the sharing mechanisms within and betw,veen classes government. They can place restrictions on the of risk are also feasible. But they usually require use and investment of reserves held by the guar- more government oversight and more govern- anteed party, to ensure that their value is unim- ment undernvriting expertise. paired during periods in which a loss event is likely. They can structure their support to pro- Managing federal-state partnerships mote pro rata risk sharing, where a private party shares risk equally with the government for some Risk management tools and techniques are also or all types of loss. Since the private party in helpful in analyzing the structure of government this transaction would then bear the same risk programs that share responsibilities between the per dollar of exposure as the government, the federal and state levels. Such programs can government can benefit from the private sector's combine the national government's ability to pricing of risks. Finally, governments can levy redistribute resources across economically risk-based guarantee fees that both reduce the diverse regions with the ability of state and lo- budgetary cost of issuing guarantees and im- cal governments to identify investment needs prove the alignment of incentives between the at the local level. The national government funds guaranteed party and the central government. the program, while state and local governments provide the underwriting and administrative Conclusion forumintended to function. A potentially powerful combination, ancourage dissemina- this type of federal-state partnership is analogous Allocating risks efficiently and limiting the abil- tion of and debate on to a parent company's providing a guaranteed ity of private agents to shift additional losses to ideas, innovations, and beast practicesor as- source of financing to a subsidiary established the government reduces the budgetary costs of panding the private to perform a particular service, issuing guarantees and improves the allocation sector. The views pub- of scarce budgetary resources, But techniques lished are those of the authors and should not Such federal-state partnerships are not without for assessing risk are only as good as the infor- be attributed to tha risks, however. If the federal government does mation on which the models are based, and over World Bank or any of not retain oversight of the underwxriting func- time institutions change, markets evolve, and its affiliated organiza- tions. Nor do any of the tion, the national budget remains at risk. But if new information on risk exposures emerges. A conclusions represent it is overly prescriptive in setting regulations series of loss events can reveal risks that were official policy of the for the program, it reduces the flexibility of previously unknown or unquantifiable, leading ExectWtive Directors the state and local governments to identify to radical changes in risk assessment. Using the or the countries they needs in the local community. The goal is to risk management framework outlined in this and represent. reach the optimal tradeoff between delegation a companion Note, governments can quickly To order additional of project selection and federal oversight of incorporate new information on risk exposures copies please call state underwriting performance. into their pricing of new contingent liabilities 202-458-ll t l or contact and reestimate the expected costs of previously Suzanne Smith, editor, ...X. Room F6P-188, Minimizing the loss shifting issued liabilities. The World Ban<, 1818 H Street, NW, Governments need to implement strong risk This Note is based on a longer paper by the authors in Timothy Irwin, Washington, D.C. 20433, Michael Klcin, Guillerniio F. Ilrrer. aiid Matcn Thc bani. edo., Dealirm or Internet address management programs to limit their contingent witb Public Risk in Prt ate IJbf/astructure (Latin American and (Carib- ssmith7@vworldbank.org. liability exposure to additional loss shifting by hean Studies, Washingnon, D.C.: W\orld Bank, 1998). The series is asl the guaranteed party. The valuation process anailable on-line rstbeWLei,Er, &Yugan wvvvv.orldbank.org/ provides a basis for determining the best strat- Clnstopber Lewis Ernst d Young, and html/fpd/notes/ egy for limiting such exposure. Governments Asboka.oMtody (amod'@worldbank.org), Project notelist.htmll. can require the guaranteed party to hoid a cer- Finance and Guiaraintees Departmnent @ Printed on recycled tain amount of capital or collateral to serve as a paper. first-loss protection barrier for the project,