Elena Stuart, Partner
Ilya Osadchenko, Advisor
Moscow, 2014
The theory of mixed economy, developed by American economists J.M. Clark and P. Samuelson in 1939, is the basis of public-private partnerships (PPP), which implies mutually beneficial cooperation between the government and entrepreneurs. What are the benefits for both parties?
Business considers such partnerships in various capacities. Firstly, as an opportunity to participate in resource- and capital-intensive infrastructure projects through organizational and institutional long-term alliances with the government. Secondly, as a way to obtain a guarantee of minimum profitability and return of invested funds in the form of the right to receive income from paid exploitation of the object, as well as partial or full refund of money in case of unsuccessful project implementation. Thirdly, business is interested in direct financial support from the government in the form of financing of costs. This can be expressed in the provision of capital grants, operational subsidies in the form of fixed payments for availability or traffic-dependent payments, and in some cases – the provision of subordinated loans. Within the framework of PPP, the investor also maintains strategic control over the assets created by transferring the management function to a special project company (SPV).
Therefore, the government, by attracting a private partner, receives technological and technical development of infrastructure in the country, competitive markets in the public sector, and accelerated implementation of infrastructure projects.
In addition, the efficiency of budgetary funds usage is increased, some risks are transferred to the private investor, efficient management is attracted, and the pace of socio-economic development of regions is accelerated due to off-budget investments.
In Russia, PPP is used to implement projects in transport infrastructure (roads, pipelines, airports), utilities (water supply, wastewater treatment, hydraulic structures), social sphere (healthcare, sports), and energy projects (heat, gas, and energy supply). It is important to note that recently PPP has become increasingly in demand and relevant both for the government and business.
For the government, the main incentives for partnerships are:
Russia positions itself as a country capable of organizing and conducting virtually any major event in a compressed timeframe. Examples include the 2014 Sochi Olympics, the 2018 World Cup, and the 2012 APEC summit. Events of this level require quality infrastructure, which cannot be created on the necessary scale without the use of PPP mechanisms.
It is caused by macroeconomic and foreign policy factors, which forces the state to reorient budget financing, reduce budget expenditures on infrastructure, and seek off-budget sources of financing.
Russia positions itself as a country capable of organizing and conducting practically any large-scale event in a short period of time. Examples include the Sochi 2014 Olympics, the 2018 World Cup, and the 2012 APEC summit. Events of this level require high-quality infrastructure, which cannot be created on the necessary scale without using mechanisms of public-private partnerships (PPP).
In certain sectors of the Russian economy, it reaches 70%, which requires significant investment volumes to be attracted in the very near future.
In turn, businesses want to cooperate with the government for the following reasons:
Over time, the Russian PPP market ceases to be new for investors, which naturally increases its investment attractiveness and reduces the level of risks.
2. Additional guarantees and rights of investors, as well as the introduction of new, more flexible mechanisms of public-private partnerships at the legislative level. The recent changes to the concessions law and the adoption by the State Duma in the third reading of the law on the fundamentals of PPP are aimed, among other things, at taking into account the interests of financing organizations, which should reduce the cost of borrowed funds attracted by the investor.
3. The desire to establish oneself in the developing PPP market and gain unique experience in implementing such cooperation in Russia in order to participate in future infrastructure projects.
The average implementation period for PPP projects in Russia is 10-15 years. The long-term period is primarily due to the need to return private investments, which determines the complexity of contractual relationships for such projects (unlike projects implemented under the state order model). PPP implies a different financing structure than state orders, as private partner investments are distributed over a longer period of time through the use of debt instruments (debt bonds), which allows solving the problem of financing deficits from the budget.
Before implementing a PPP project, both parties must assess its risks, which is the first step in structuring the task.
Within this evaluation, it is recommended to develop a complete risk matrix, which should be carried out in parallel with the development of the financial model. The latter is based on the forecast of the main economic (such as inflation, exchange rates) and technical (such as traffic forecast) parameters for the entire project period. When it comes to risks in this area, changes in indicators that significantly affect project profitability (internal rate of return (IRR), discounted payback period (DPP)) are primarily understood. Russian and foreign practices of implementing such projects show that the majority of failures are associated with the following mistakes.
The mentioned risk may consist, for example, in the incorrect calculation of construction costs (cost overrun) or in the incorrect calculation of the net present value (NPV).
An example is the construction project of the Orlovsky Tunnel in St. Petersburg. The government of St. Petersburg notified LLC “Nevskaya Concession Company” of the termination of the concession agreement for the design, construction, and operation of the Orlovsky Tunnel under the Neva River in December 2012.
The reason was the concessionaire’s failure to provide documents confirming the financial closure and the violation of the project budget, which resulted in incorrectly calculated capital expenditures (the actual expenses turned out to be 30% higher) and low traffic, which prevented achieving financial efficiency.
An example of hospital construction in Paddington, UK, is indicative in foreign practice.
According to the financial-economic justification, the project cost was supposed to be 300 million pounds sterling. Its completion was planned for 2006, but during the work, the price increased to 894 million pounds sterling, and the completion date was extended until 2013.
Design technical errors
These include risks associated with errors in the design documentation, risks in the field of technological regulation (difficulties in obtaining necessary technical conditions, permits for construction, approval of GPZU, etc.), risks of detecting hidden defects after the facility is put into operation, as well as problems with the construction site.
For example, the problem of complex soil became one of the reasons for the refusal of funding the construction of the Orlovsky Tunnel under the Neva River by the authorities of St. Petersburg.
From foreign practice, we can highlight the project for the construction of a district hospital in Hartford (UK). After completion of the work, it was flooded three times in 18 months, including twice with untreated sewage. And all this as a result of design errors.
2. Unfair risk distribution in a project
This refers to unfavorable participation conditions for businesses. This may be expressed, for example, in high penalty points for investors for violating the terms of the competition documentation or in compressed project implementation timelines. For example, on February 17, 2013, an open competition was announced for the right to conclude a concession agreement for the design, construction, and operation of the Northern Tunnel in Rostov-on-Don. It was planned that the length of the tunnel would be 2.5 km, and the throughput capacity of the four-lane tunnel would be 60 thousand vehicles per day. The total planned costs were determined at 8.5 billion rubles. Two years were planned for design and four years for construction. The competition was recognized as unsuccessful due to the lack of applications.
3. Technical design errors
These are risks associated with errors in the design documentation, risks in the field of technological regulation (difficulties in obtaining necessary technical conditions, permits for construction, approval of project documentation and others), risks of discovering hidden defects after putting the facility into operation, as well as problems with the construction site.
For example, the problem of difficult soil became one of the reasons for the authorities of St. Petersburg to refuse to finance the construction of the Orlovsky Tunnel under the Neva River.
From foreign experience, we can highlight the construction project of a district hospital in Hartford (UK). After completion of the works, the hospital was flooded three times in 18 months, including twice with untreated sewage. And all of this was due to the design errors made by the designers.
4. Social and environmental risks
The environmental risks of a project include the negative impact of the facility on the environment, insufficient level of its technical safety, and harm to human health. Predicting environmental risks should be carried out even before the design stage of the facility through appropriate surveys. In addition, due attention should be paid to insuring environmental risks, but in practice, it is not easy to regulate them with insurers, although environmental insurance has long been used in foreign projects.
Perhaps the most indicative example in this area is the construction of the Moscow-St. Petersburg high-speed highway on the section from 15 to 58 km. Due to the work, it was necessary to partially cut down the Khimki forest, which led to mass protests by the population.
Legislative Risks
It may arise from incorrect application of legal norms that regulate contractual relations by parties or from challenges to concluded agreements by government bodies.
For example, the Department of Road Construction and Transport of the Kirov Region concluded an agreement with KOGP “Vyatskie Avtomobilnye Dorogi” in 2012 within the framework of the regional law on public-private partnerships. The document provided for the repair of roads in the Kirov region for an amount of more than 570 million rubles.
However, the antimonopoly service found that the law “On the participation of the Kirov Region in public-private partnership projects” contradicts Federal Law No. 94-FZ “On the placement of orders for the supply of goods, performance of work, provision of services for state and municipal needs”, which led to a lawsuit to declare the concluded agreement for the repair invalid.
Undoubtedly, public-private partnerships have great prospects as a tool for the development of the Russian economy. However, this will be possible if certain efforts are made in the near future to eliminate the factors that hinder the development of partnership between the state and business. These factors may include an incompletely developed legislative base, insufficiently effective financing mechanisms, and the lack of flexibility on the part of the government towards investors in the form of numerous administrative barriers.
5. Legislative Risks
It may arise from incorrect application of legal norms that regulate contractual relations by parties or from challenges to concluded agreements by government bodies.
For example, the Department of Road Construction and Transport of the Kirov Region concluded an agreement with KOGP “Vyatskie Avtomobilnye Dorogi” in 2012 within the framework of the regional law on public-private partnerships. The document provided for the repair of roads in the Kirov region for an amount of more than 570 million rubles.
However, the antimonopoly service found that the law “On the participation of the Kirov Region in public-private partnership projects” contradicts Federal Law No. 94-FZ “On the placement of orders for the supply of goods, performance of work, provision of services for state and municipal needs”, which led to a lawsuit to declare the concluded agreement for the repair invalid.
Undoubtedly, public-private partnerships have great prospects as a tool for the development of the Russian economy. However, this will be possible if certain efforts are made in the near future to eliminate the factors that hinder the development of partnership between the state and business. These factors may include an incompletely developed legislative base, insufficiently effective financing mechanisms, and the lack of flexibility on the part of the government towards investors in the form of numerous administrative barriers.