Sample Build, Operate, Transfer Contract

					BUILD-OPERATE-TRANSFER
      Some Key Lessons for Future Policy Making

                       Gilberto M. Llanto
 Vice-President, Philippine Institute for Development Studies
      Research Fellow, University of California, Berkeley
                         July 21, 2004



                                                                1
Public-private partnership
• “It is the declared policy of the State to
  recognize the indispensable role of the private
  sector as the main engine of growth for national
  growth and development…for the purpose of
  financing the construction, operation and
  maintenance of infrastructure and development
  projects normally financed and undertaken by
  government.” (BOT Law as amended)


                                                 2
Public-private partnership
• Complex; viability is premised on combining
    social benefit with economic feasibility
•   Public sector- maximize social benefit; private
    sector- maximize financial profit
•   Issue- how to achieve these goals and strike a
    balance
•   Long term association built on incomplete
    contracts


                                                      3
Build-operate-transfer
arrangements
• RA 6957 (BOT Law, 1991), amended by RA 7718
• Major instrument of public-private partnerships
    in infrastructure
•   Basic principle of “users pay”: cost of financing
    the capital investment to the private sector;
    Beneficiaries pay for the benefit. Government’s
    role: regulatory and in some cases, provides
    subsidy, equity or guarantee performance.


                                                        4
Awarded contracts 1999-2003

                          Cost of Awarded Projects (in US$M)


               16,000      14,696.80
               14,000
               12,000
Project Cost




               10,000
                8,000
                                       6,079.90   5,863.90
                6,000                                        4,149.38
                4,000
                2,000                                                     1,740.08
                    0
                        1999      2000        2001       2002           2003
                                              Year                                   5
Questions and a Hypothesis
• Why the decline in investor appetite?
• What can be done to strengthen public-
  private partnership
• Hypothesis: failure to understand the
  nature and requirements of BOT contracts
  and partners’ expectations and to carry
  out commitments sends wrong signals and
  disrupts capital investment flows.

                                           6
Analytical framework

• Long-term contracts: long-term
 obligations are committed ex ante;
 benefits are realizable ex post.

• Incomplete contracts theory

• Bounded rationality

                                      7
Incomplete contracts theory
• Roots:

• - investigation of “hold-up” problem
• - integration instruments: vertical integration
    or contracting
•   - search for optimal contracts -> reasons for
    contractual incompleteness



                                                    8
•   Reasons:
•   unforeseen contingencies
•   writing costs
•   Difficulty of verification of valuations and
    states of nature
•   lack of commitment not to renegotiate.

                                               9
Bounded rationality


•takes into account the cognitive limitations
of the decision-maker in terms of:

• - knowledge
• - computational capacity


                                            10
Bounded rationality


• bounded rationality of all agents:

•    the judges’ rationality is no less
    bounded than the contracting parties’
    rationality


                                            11
Bounded rationality

•   However, there is uncertainty but not
    ‘radical’ uncertainty:

•   Thus, Parties design contracts that
    attempt to approximate future states
    through, for e.g., provisions for
    performance bonds, operation bonds,
    liquidated damages, buy-outs, early
    termination, step-in rights, etc.

                                            12
Contractual relationship
• Optimal allocation of risk based on risk-
  bearing capacities
• Fair and judicious compromise between
  potential economic gain, incumbent costs
  and assigned risks
• Stipulation of arbitration or discussion
  clauses to handle future situations that
  contradict initial hypotheses

                                              13
Contractual relationship

• Need to uphold commitments- written in a
  contract
• Contractual structures evolve.




                                         14
Level of authority conferred to the firm          The Various Types of Contracts
                                           High                                                          Privatization
                                                                                            Concession
                                                                                            BOT


                                                                                 Leasing


                                                                      Contracting out
                                                                      Incentive
                                                                      contracts,
                                                                      management
                                                                      contracts

                                                  Delegated management
                                           Low    Operating & maintenance
                                                     Short-term               Medium-term                Long-term
                                                                       Length of commitment                      15
Need for regulatory framework
• Presence of laws, rules, standards
• Absence of rules leads to incomplete contracts
• Contract can’t address all project parameters,
    especially exogenous parameters
•   Regulator to oversee proper
    implementation/fulfillment of major contractual
    commitments



                                                      16
Regulatory framework

• Performance-based criteria over resource-
  based obligations
• System for evaluating service quality;
  develop appropriate set of measurement
  tools
• Technical and economic regulation
  provided in BOT contract itself (‘regulation
  by contract’)

                                             17
• Technical regulation- pre-agreed set of
  operational standards
• Economic regulation- tariff based on pre-
  determined parametric formula;
  parameters for adjustment in existing
  tariff level are defined.



                                              18
Risk analysis and sharing
• Common interest to limit all risks that
  constrain project success
• Risks during design-construction
• Risks during the operations phase- volume
  and price-related risks depending on
  elasticity
• Risks of force majeure, macroeconomic
  risks, legal risks

                                            19
Typology and occurrence of primary risks in a public-private
partnership set-up
          INDIRECT RISKS DUE TO THE PROJECT ENVIRONMENT
                                                                Social
     Force       Macroeconomic       Institutional and      acceptability
    majeure           risks             legal risks          of the PPP
                                                              principle



   DESIGN                                                RISKS DURING
CONSTRUCTION            Economic and                     OPERATIONS
    RISKS               financial risks          Operating revenue risks
 Costs
                                                Volume                  Price

 Design                                                     Other
                                                           revenue
                                                           shortfalls
 Execution
                                                 Technical operating risks
 Unpredictable                                     Operating cost overruns20
Case Study: The LTO-IT Project

•   Land Transportation Office -
    Database Infrastructure and
    Information Technology Project
•   customization and operation of IT
    system of LTO, e.g., vehicle
    registration and driver licensing
•   US$75 million total project cost

                                        21
The LTO-IT Project

•   BOO scheme; 10 years
•   solicited mode; winning bidder is
    “AAA” Corporation
•   Phase 1 completed in November
    2001
•   As of February 2004, project is 97%
    complete.

                                          22
Policy framework
•   in 1994, National Information
    Technology Plan 2000
•   one of former Pres. Ramos’ flagship
    projects
•   policy guide during approval: RA 7718
    IRR
•   for future ICT projects: 2003 ICC
    guidelines on ICT

                                            23
First pass

ICC-TB: April 25, 1996

•   PhP28=US$1 exchange rate
•   total project cost = US$44,543,017
•   pass-on fees: as low as PhP150 for
    motor vehicle registration and PhP60
    for licensing of drivers


                                           24
First pass

ICC-CC: February 3, 1997
• performance indices for periodic
   replacement
• fee adjustment formula
• revenue-sharing scheme
• minimal disruption in LTO operations

                                         25
Bidding stage

March to December 1997: preparation of bid
    docs, advertisement, pre-qualification, actual
    bidding, evaluation, award

The losing bidder protested.

Award to AAA Corporation upheld by PBAC.



                                                     26
Second pass
•   fee adjustment formula includes income tax
    as a component of one of the weights to be
    used in the parametric formula

•   February - March 1998: ICC-TB, ICC-CC and
    NEDA Board approval with understanding
    that the LTO will invoke the contract re-
    opener provision in the contract in the event
    that the Supreme Court ruled unfavorably on
    the Meralco case.

                                                    27
Contract review by the OP
March 26, 1998 – contract signing
RA 7718: BOO projects must be approved
    by the Pres.
ES clarified that NEDA Board approval
    carries with it Pres.’s approval.
After elections, former Pres. Estrada called
    for review of all “flagship projects” by
    previous administration -> project delay
    up to November 1998.
                                           28
Sequencing of pre-
implementation activities
What was followed:
First Pass   Bidding   Second Pass

Present practice:
     First Pass   Second Pass   Bidding



                                          29
Salient features of contract
Undertakings of AAA Corp:
- Complete IT Facilities within time frame
- Upon receipt of the first Certificate of
    acceptance of an IT Facility (CAIF),
    commence to operate in accordance with
    schedule
- Performance securities: PhP100 million upon
    contract signing; PhP100 million upon
    issuance of first CAIF


                                                30
Salient features of contract

Undertakings of DOTC/LTO:
 - Collect fees from end-users and remit to
   AAA Corp
 - Open a Trust Fund where payment to
   AAA Corp will be deposited
 - Pay AAA Corp twice a month, based on
   daily transactions.

                                          31
Salient features of contract
Automatic price adjustment formula

Pt = P t-1{ α [ θ (FOREXt /FOREXt-1) +
               λ (ILt /ILt-1) + (1-θ-λ)]
          + β [ γ (CPIt /CPIt-1) +
                δ (PRt /PRt-1) + (1-γ-δ )]
          + [ 1- α - β ] }
- yearly adjustment of fees
                                             32
Salient features of contract
Events of default

AAA Corp’s default:
 - Failure to perform any material covenant
 - Intentional misrepresentation or omission of
    material information
 - Failure to finish the IT facility in accordance
    with scope and specs
 - Repeated non-compliance with terms and
    conditions
 - False representation in any material aspect
                                                     33
Salient features of contract
Events of default

DOTC/LTO’s default:
 - Terminates or cancels BOO Agreement
    without valid cause
 - False representation in any material aspect
 - Failure to perform any material covenant
 - Promulgation of law or regulation which
    adversely affects the interest of the
    proponent in the IT Facility and its financial
    return or otherwise rendering the proponent
    incapable of performing its undertakings         34
Salient features of contract
Remedy for default = Termination

Due to AAA Corp’s default:
 - step-in rights by creditors, or
 - DOTC/LTO to take over facilities and assume
remaining liabilities

In all cases, actual and compensatory damages
 will be charged against performance bonds; if
 insufficient, amount will be set through
 arbitration.
                                                 35
Salient features of contract
Remedy for default = Termination

Due to DOTC/LTO’s default:
 - DOTC/LTO to take over the facilities on “as-is-
  where-is” basis and assume all attendant
  liabilities
   - DOTC/LTO to pay liquidated damages:
      if terminated prior to completion, LD = Value
  of Construction minus attendant liabilities,
   if terminated after completion, LD = Just
  Compensation, i.e., present value of expected
  net income using 15% disc. rate                   36
Analysis of the risk allocation
and incentives system
Preliminary findings:

1. Government shares in completion risk.
   – no provision for liquidated damages
   in case of AAA Corp’s delays in project
   implementation


                                             37
Analysis of the risk allocation
and incentives system
Preliminary findings:

2.   Lack of incentive to finish the project on time.
     - owing to absence of LDs for project delays.
     - LTO viewed the lack of provision for LDs is
     consistent with practice since there is no
     cash outlay from the government and the
     project does not involve any direct
     government support or subsidy

                                                    38
Analysis of the risk allocation
and incentives system
Preliminary findings:

3.   Unclear whether or not the operation risk is
     fully covered.
     - several facilities -> several CAIFs
     - Operation bond, PhP100 million, is valid for
     10 years, beginning “first” In-Service Date.
     - Since the contract distinguished a “first” In-
     Service Date, it can be interpreted that each
     accepted facility has a concession period of
     10 years.                                        39
Analysis of the risk allocation
and incentives system
Preliminary findings:

4. End-user/public bears full depreciation risk.
   - through the parametric formula.
   - usual practice in the Philippines, often
    claimed as requirement of international
    lending partners
   - govt has some form of control through
    macro-policies

                                                   40
Analysis of the risk allocation
and incentives system
Preliminary findings:

5. End-user/public bears full interest rate
    fluctuations risk.
   - through the parametric formula.
   - usual practice in the Philippines, often
    claimed as requirement of international
    lending partners

Both (4) and (5) creates bias towards debt
    financing, specifically $ financing.        41
Analysis of the risk allocation
and incentives system
Preliminary findings:

6. Income tax incorporated in the parametric
    formula, i.e., in β = ave. annual opex as % of
    total revenues, the numerator includes
    taxes.
   - only the VAT, not the income tax, may be
    passed on to the end-users.


                                                 42
Analysis of the risk allocation
and incentives system
Preliminary findings:

7. The setting of weights in parametric formula
    is unclear, e.g.,
     β = ave. annual opex as % of total
    revenues
    – It should be “as % of ave. annual
    revenues” to fix the weights .
    (fixed weights provide incentives for cost
    minimization)
                                                  43
Analysis of the risk allocation
and incentives system
Preliminary findings:
8. The events aside from Early Termination that
   may warrant a call on performance bond
   during operation is unclear.
   - not explicitly specified in the contract
   whether it can be called if the operational
   performance is below standard.
   - unlike performance bond during
   construction, which explicitly states that it
   shall answer for project completion in
   accordance with timetable.
                                                   44
Analysis of the risk allocation
and incentives system
Preliminary findings:
9. Termination as default remedy lacks credibility.
   - absence of calibrated penalties by the
     government for minor faults (e.g., LDs or call
     on operations bond) during operation
   - severest threat (i.e., early termination) as the
     ultimate penalty



                                                    45
Recommendations

• Review BOT law and IRR to identify ways
 to minimize contractual incompleteness,
 e.g., principles for liquidated damages for
 under-performance during operation;
 guidelines on based valuation methods of
 project assets and/or future earnings in
 the event of early termination;


                                               46
Recommendations

• Monitor BOT project companies in fulfilling
  commitments, e.g., investment
  commitments, outreach target.
• Government should develop proficiency in
  contracting, negotiation and risk analysis.




                                            47
Thank you !


              48

				
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