40912 noTE no. 20 ­ MaY 2007GRIDLINES Sharing knowledge, experiences, and innovations in public-private partnerships in infrastructure Recent trends in risk mitigation instruments for infrastructure finance Innovations by providers opening new possibilities Tomoko Matsukawa and Odo Habeck U sing risk mitigation instruments to support commercial and sustainable financing mechanisms infrastructure finance has attracted grow- for infrastructure development. ing interest among developing country governments, the donor community and the private sector. Official development agencies Main types of instruments and private insurers are exploring new applica- tions, opening new possibilities in raising finance Risk mitigation instruments for infrastructure for infrastructure projects. finance can be defined as guarantees or insurance The importance of infrastructure for economic products. A guarantee contract guarantees the growth and poverty reduction is well established. holder of a debt obligation the timely payment However, raising debt and equity capital for of principal and interest when due. If there is a infrastructure development and service provision default on debt service, the guarantor pays the remains a challenge for developing countries. amount due under the guarantee based on simple guarantee call procedures. An insurance contract Risk mitigation instruments can help mobi- insures payment to the holder of a debt obligation lize commercial debt and private equity when or the equity investor once the insurer evaluates governments or local infrastructure entities lack the claim and determines that it is liable. the creditworthiness or track record to attract finance on their own. They do so by transferring Risk mitigation instruments may benefit debt to third parties--official agencies (multilateral providers (lenders, bond investors) concerned or bilateral) or private institutions--risks that about a borrower's credit risk, covering default on private lenders or investors are unable or unwill- debt service--or equity investors seeking protec- ing to take. tion against investment risk, covering losses on their investment. Some instruments differenti- Risk mitigation instruments are no panacea. ate between the "cause" of the loss as political However, they will help "bridge the gap" while a or commercial risk. Payouts then depend on country establishes a sound legal and policy frame- whether the loss was due to the risk specified. work that will reduce risk--and even afterward Many instruments cover only part of the debt or can support efficient risk sharing. Specifically, the equity investment so that risk is shared between advantages of risk mitigation instruments for the the guarantor or insurer and the lender or equity developing countries include that they: (a) mobi- investor (figure 1). The instruments can be divided lize private capital to supplement limited public according to the type of risk mitigated. resources; (b) enable private lenders and inves- tors to participate when risks beyond their control or perceived excessive are transferred; (c) enable governments to share the risks of public projects Tomoko Matsukawa is senior financial officer, finance and with private sector financiers; (d) upgrade govern- guarantees, of the World Bank, and Odo Habeck is the PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY ments' credit and in turn lower financing costs; (e) managing partner of OGH Advisors. Dianne S. Rudo, a allow official agencies to leverage their financial consultant in project finance, contributed to the editing of resources; and (f) facilitate the development of this note. Helping to eliminate poverty and achieve sustainable development through public-private partnerships in infrastructure PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY Credit guarantees Credit guarantees cover losses in the event of a figurE 1 default on debt service regardless of the cause of Key parameters of risk mitigation instruments the default. Comprehensive risk Partial credit guarantees (PCGs) cover part Full coverage of the debt service payment. Provided by a cred- itworthy guarantor, they improve the credit Partial coverage rating of a borrower's debt issue and thus its market access and the terms of the commercial Debt (Credit risk) Political Commerical debt. Debt transactions using such guarantees risk risk reflect the hybrid credit risk of the guarantor (for Equity the guaranteed part) and of the borrower (for (Investment risk) the rest). The guarantee coverage can be struc- tured flexibly, effectively sharing the credit risk between the lender (or bond investor) and the guarantor. Expropriation--losses from acts by the host govern- ment that may reduce or eliminate ownership of, Full credit guarantees, or wrap guarantees, cover control over, or rights to the insured investment. the entire debt service in the event of a default, normally obtaining debt terms similar to those of War and civil disturbance--losses from damage to, the guarantor. These guarantees are often used by or the destruction or disappearance of, tangible bond issuers to achieve the higher credit rating assets caused by politically motivated acts of war demanded by capital market investors. Wrap or civil disturbance in the host country. guarantees have been widely used for asset- or mortgage-backed securities in the United States. Some political risk insurance policies may cover Companies that provide wrap guarantees are in addition other, less traditional political risks: usually known as monoline insurers. Some official agencies also provide such guarantees. Breach of contract--losses from the host govern- ment's breach or repudiation of a contract. Transferring Export credit guarantees or insurance Export credit guarantees or insurance cover losses Arbitration award default--losses arising from a risks to third for exporters or lenders financing projects. They government's nonpayment when a binding deci- sion or award by an arbitral or judicial forum parties is are normally "tied" to the nationality of the suppliers, project developers, or lenders. These cannot be enforced. one way to instruments cover both political and commercial risk Partial risk guarantees (PRGs). PRG is also used help raise (together, comprehensive risk). Coverage is generally limited to a specified percentage for each risk, but as an abbreviation for similar instruments called commercial can be nearly complete. Comprehensive export "political risk guarantees" which benefit debt providers, and cover a wider range of political and finance and credit guarantees provide the same protection as credit guarantees, guaranteeing debt service in regulatory risks than PRI. They typically cover private equity the event of a default for any reason. government contractual obligations, i.e., losses due to a government's non-payment of its obli- Political risk insurance or guarantees gations under a contractual undertaking, where Political risk insurance and partial risk guarantees the coverage depends on the specific obligations (or political risk guarantees) cover losses caused contractually agreed to for a project by the host by specified political risk events. government. Besides the traditional political risks, they may cover: Political risk insurance (PRI) covers traditional polit- ical risks for equity investors and debt providers: · Government contractual payment obligations (such as termination payments). Currency inconvertibility and transfer restriction-- · Government action or inaction with a material losses arising from an inability to convert local adverse impact on the project (i.e., a change in currency into foreign exchange or to transfer laws, regulations, taxes, or incentives). funds outside the host country. · Contractual performance of public counter- parts. · Frustration of arbitration. Recent trends in risk mitigation instruments for infrastructure finance recent trends in risk mitigation loans to subsovereign governments through or with the guarantee of the sovereign government. Demand for political risk mitigation has been In investment-grade developing countries, and shifting from coverage for traditional political for some subsovereign governments and entities, risks to coverage for risks arising from govern- private monoline insurers and recently estab- ment actions or inactions that adversely affect lished subsovereign units of multilateral banks the operations of a private infrastructure busi- provide loans and guarantee support based on the ness--especially regulatory, devaluation, and borrower's own credit. New sub-sovereign risk. Although these risks do not applications readily fall into an established category of politi- cal risk, some risk mitigation instruments have Who provides what? are opening covered them, at least in part and indirectly. Multilateral development banks offer PCG and ways to raise Regulatory risk refers to the risk of losses result- PRG guarantees for debt providers, while multi- finance for ing from adverse regulatory actions by the host lateral insurance agencies offer PRI for debt and infrastructure government and its regulatory agencies, and from equity. These institutions offer partial coverage so defaulting on contractual clauses when regulated as to share risk with private financiers, and use of by contract. Indeed, regulations for infrastructure their instruments is conditional on meeting their projects are often included in concession or other development objectives. key project contracts between the government (or a public body) and the private company. A Bilateral development agencies have similar PRG or breach of contract coverage of PRI can development objectives to those of multilateral be used to cover related contractual obligations agencies and offer similar guarantees (PCG and of the government. PRG for debt, for example). National export credit agencies (ECAs) include investment insur- Devaluation risk refers to the risk of losses due ance agencies, and offer fairly similar insurance to unfavorable movements of the exchange rate and guarantee programs covering trade trans- (such as the impact of a local currency devalua- actions as well as equity investment or project tion on projects earning revenues in local currency finance debt. Because these agencies are supposed but paying expenses and debt service in foreign to serve their country's national interest, their currency). In countries with sufficiently devel- products are typically tied to the nationality of oped financial and capital markets, devaluation suppliers, project developers, or lenders. risk can be best mitigated through the use of local currency loans, public and private debt issues, or Private monoline insurers guarantee structured cross-currency swaps. debt transactions such as mortgage- and other asset-backed securities and offered wrap guar- In the other countries, devaluation risk has been antees for project finance debt. To maintain a mitigated contractually by allowing for tariff triple-A rating, they normally offer guarantees indexation of foreign currency cost components only to investment-grade countries. Private to foreign exchange rates, although in practice, political risk insurers (and reinsurers) provide this indexation has not always been upheld insurance similar to that offered by multi- and during times of high volatility. A PRG or a breach bilateral insurers. of contract coverage under a PRI can then be used to cover the risk of the government's negating the While private insurers have sophisticated risk enforcement of such a contract, thus indirectly assessment capabilities, multilateral and bilat- covering the devaluation risk. eral agencies have greater leverage with host governments. Also, multilateral institutions Subsovereign risk relates to breach or repudiation enjoy preferred creditor status. Risk mitigation of contracts, non performance or other actions instruments offered by all these institutions are or inactions by a subnational host government complementary and have been used together in and/or contractual counterparties. Subsover- many project financings. Some multilateral agen- eign governments are increasingly responsible cies have "guarantor of record" programs to share for providing infrastructure, acting as borrower, risk with private insurers, which then benefit from concession granter, contractual counterparty, the multilaterals' umbrella. Reinsurance arrange- guarantor of municipal utilities, or local regulator. ments to share and manage risks are common Multilateral banks have traditionally provided among all PRI providers. innovative applications eration provides investment guarantee support for equity acquisitions by Japanese private inves- Providers have tried to expand the use of their tors from the original private investor. instruments through innovative new applications. Complementary guarantees combining PCgs and guarantor of record Prg/Pri To meet the demand for high-quality securities in To support a pipeline project company in West local bond markets, the Inter-American Develop- Africa, the World Bank offered a partial risk ment Bank (IDB) has attracted the participation guarantee while the Multilateral Investment of private monoline insurers by establishing a Guarantee Agency (MIGA) and a private politi- new template that combines a financial guaranty cal risk insurer offered their respective PRGs and and an A/B financing in bond transactions. The PRI, with claims to be allocated on a pro rata resulting guarantor-of-record structure extends basis. A termination payment due but not paid by the IDB's preferred creditor status to the co-guar- the government would be deemed to be a project antor monoline insurer, providing risk protection company loan to the government under the proj- that allows private insurers to enter new markets. ect contract. That allowed the World Bank to offer The IDB has used this approach for wrapping its PRG for a project entirely equity funded. local currency bond issues by Chilean toll road companies, enticing private monoline insurers to Corporate finance with Prg/Pri cover a large share of the credit risk. For the Southern Africa Regional Gas Project, in Mozambique, a South African sponsor provided PCg for pooled finance a corporate guarantee to lenders for all project- In the Indian state of Tamil Nadu the Develop- related commercial risks, except for Mozambique ment Credit Authority (DCA), part of the U.S. political risk. To cover that political risk, over Agency for International Development (USAID), which the sponsor has no control, the World supported a pooled municipal bond issue to Bank provided a PRG and MIGA and the Export finance water and sanitation projects of urban Credit Insurance Corporation of South Africa local bodies (ULB) by providing a PCG covering both provided PRIs. 50 percent of principal repayment. The bond issue was also supported by a credit enhancement of the Pri to facilitate securitization state and the ULBs (escrow accounts funded by MIGA provided PRI coverage (for the risk of the ULB and a debt service reserve fund funded currency inconvertibility, transfer restriction, and by the state government and replenishable by expropriation) for part of the interest payments diverting the ULB's transfer payments). on a mortgage portfolio to support the securitiza- tion of residential mortgage loans in Kazakhstan. Privatization guarantees and brown This was instrumental in achieving a higher rating field project support for the debt issue (A­ by Fitch) than the country Multilateral and bilateral agencies have tradition- ceiling for Kazakhstan (BBB+ by Fitch). ally limited their support to projects making new investments. Some multilaterals now offer PRG/ guarantee facilities PRI for privatization transactions, which may not Multilateral and bilateral agencies have helped involve new investment and so cannot draw countries set up guarantee facilities by providing export credit support. To allow the privati- contingent credit or seed capital to the government. GRIDLINES zation of power distribution companies Both official agencies and private institutions also in Romania, the World Bank provided set up--or are considering setting up--global or Gridlines share emerging knowledge a PRG backstopping the govern- regional guarantee facilities to support infrastruc- on public-private partnership and give an ment's obligations to compensate ture projects in developing countries. overview of a wide selection of projects from the privatized companies for various regions of the world. Past notes can be revenue losses resulting from Note: This note is drawn from Tomoko Matsukawa and Odo found at www.ppiaf.org/gridlines. Gridlines are a Habeck "Review of Risk Mitigation Instruments for Infrastructure publication of PPIAF (Public-Private Infrastructure defined regulatory risks during PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY Advisory Facility), a multidonor technical assistance the initial years of the new Financing and Recent Trends and Developments (World Bank and facility. Through technical assistance and knowledge regulatory regime. The Japan PPIAF, Washington, D.C., 2007), which provides a concise guide dissemination PPIAF supports the efforts of policymakers, Bank for International Coop- and reference information for practitioners. nongovernmental organizations, research institutions, and others in designing and implementing strategies to tap the full potential of private involvement in infrastructure. The c/o The World Bank, 1818 H St., N.W., Washington, DC 20433, USA views are those of the authors and do not necessarily PhoNE(+1) 202 458 5588 fAX(+1) 202 522 7466 reflect the views or the policy of PPIAF, the World Bank, PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY gENErAl EMAilppiaf@ppiaf.org WEb www.ppiaf.org or any other affiliated organization.