Preliminary Considerations for BOT Schemes
The concept of Build, operate and Transfer (BOT) has been in existence for many years in developed countries. BOTs have gained wide interests among developing countries as a means for implementing large scale infrastructure projects requiring state of the art technologies and sophisticated financial engineering. They shift commercial risks to investors, operators and lenders and thus reduce the burden on the national budgets of delays and associated cost overruns in project execution, and inefficiencies in operation upon completion. In exchange governments provide a guaranteed market for the generation of revenue, which is based on market determined prices to cover interest payments, debt retirement, operation and maintenance costs and provide a competitive return on equity, including compensation for efficiency and assumption of risks.
A growing number of developing countries are presently considering to place major new infrastructure investments into the private rather than public sector. In Lebanon the debate on BOTs is concentrated on the power, telecommunication and water sectors.
Most BOT projects have two distinct phases: a relatively high risk construction period and a relatively low risk operation phase with the first few years of the project being the real period of operating risks. A joint venture company (or consortium) is locally incorporated in the host country with local/ international private sector participation for an agreed concessionary period with the responsibilities for:
Conducting a feasibility study;
Raising the required finance in the capacity of borrower, including public/private, foreign/local equity participation, export credits and commercial bank loans. The sources of finance that can be tapped are very wide and may also include leasing, high yield bonds, subordinated loan stock and multilateral agencies funds;
Construction of the facility, usually on a fixed price turnkey basis;
Operation and maintenance of the facility and the use of the project revenue to cover operating costs, project debt principal and interest and returns on investment;
Ownership of the project facility; and
Marketing of the relevant product, if required.
- Advantage of BOTs
- Reduction in public sector borrowing requirements;
- Promotion of new projects harnessing the drive of the private sector and encouraging market competition and commercial management;
- Independent assessment of the viability of the project and associated investments;
- Encouraging and promoting foreign investments in terms of expertise by means of new, though proven, techniques, operational practices and finance;
- Creating a more efficient environment for the construction and operation of the relevant facilities by giving the contractor a vested interest in the success of the project, leading to lower costs and earlier completion dates;
- Shifting debt from the government to the private sector and raising finance in what are often restricted credit markets;
- Freeing state resources for projects whose financial returns are less easily valued by the market; and
- Privatizing existing assets.
- The role of the host government in BOTs
Typically, the host government would be providing the following assistance and incentives:
A concession agreement:to allow the joint venture company to exploit freely the particular investment for a given period and establishing the limits of the project which should be sufficiently long to offer adequate rewards to investors.
- A feedstock agreement:providing, where necessary, for a guaranteed supply of required raw materials (such as gas and oil) at competitive prices, enabling the facility to complete successfully in the domestic and international markets.
- Defined tax concessions:allowing the joint venture company and project participants to manage the difficult early operating years when financial obligations are greatest.
- Financial undertakings:providing for the government to take over outstanding debt and other financial obligations in the event of identified political risks including political intervention which could adversely affect the well being of the investment at any stage and other circumstances outside the control of the joint venture company including force majeure. This may also include contingent financial support to cover the difficult first few years.
- General commitments:undertaking as to non interference with the construction and smooth operation of the facility and a commitment of sufficient resources to the project and assistance in the provision of all necessary legislation, licenses and authorities.
- Guarantees as to free remittance:enabling the joint venture company to remit freely project revenues including dividends and very importantly, guarantees as to foreign exchange convertibility and availability.
- Equity participation:whose level will depend on the particular requirements of each project.
- Offtake agreements:to purchase the product of the joint venture company on defined terms and price formula.
- Offshore escrow account:arrangements to be established into which project revenues including dividends should be paid.
- The Role of the joint venture company in BOTs
- Pre completion period:
- Commitment to successful construction and completion of the facility usually under a lump sum contract within an agreed time schedule and consistent with the requirement of the host government. This will include the acceptance of a completion guarantee and responsibility for delays arising within the control of the joint venture;
- Arrangement of equity and loan finance on a limited resource basis with the joint venture as the borrower, i.e without the direct and full guarantee of the host government in respect to the repayment of project debt whereby the project lenders under normal circumstances are looking to the viability of the project for the repayment of their loans;
- Standby financing and debt reserve cover to provide for cost overruns and sufficient cover for debt repayment in specified circumstances such as delay arising through construction consortium default;
- Comprehensive insurance arrangements to provide for and establish the normal commercial cover; and
- To act as general sponsors to the project to ensure its efficiency and general well being.
- Post completion period
- Operation, management and maintenance of the facility during the life of the concession period in accordance with the best and most appropriate international practice and technology;
- Acceptance of financial obligations in specified circumstances arising from operator default, including stand by financing and operator penalties;
- Marketing and sale of products; and
- Use of the project revenues to satisfy operating costs, debt service requirements and return on investments.
- Types of risks involved in BOTs
- Construction risk
- Completion delays could likely increase the amount of funds required to complete a project hampering lenders ability to be repaid and equity contributors to recoup their interest.
- Abandonment or non completion resulting from permit problems, financial failure of the sponsors, contractors or suppliers, technical incompetence of the parties constructing the project, uninsured casualty losses or other catastrophic event.
- Cost overruns can result from omissions, price changes, regulatory or other law changes, and even fraudulent expenditures of construction funds. This can increase the project’s debt load and even result in the abandonment of the project.
- Contractor Performance risk that the project will not function t projected levels at the end of the construction period. This risk can result from defects in equipment and design, contractor incompetence or the use of new, or obsolete technology.
- Technology risks due to technical failure or obsolescence.
- Force Majeure risks outside of the immediate parties to the project (like fire, flood, earthquakes, etc.). This risk exists during the construction and operating phases of the project.
- Operating Risk
Once construction of the project is completed and the project is in operation, equity investors and lenders will have to contend with some risks including:
- Technology risk that the project will not perform at levels sufficient to service the project’s debt. Poor design or construction may mean that the project does not perform up to standards.
- Management risk
- Performance risk
- Operation and Maintenance (O&M) cost risk
- Supply risk
Supply risk, or input risk, during the construction and once the project is operational, that raw materials and/or energy used by the project will become unavailable, will increase in cost, or will be of poorer quality than assumed.
Transportation risks: transportation facilities must be reviewed and the potential for blockages, slowdowns or strikes must be analyzed.
- Market risk
The projected demand for the resulting product must be strong enough to ensure sufficient cash flow. Revenue from production must be able to cover the operating costs, debt service and cash needs. Factors to be considered include: demand, competition and pricing.
- Regulatory risk:tax law changes, government acts, environment restrictions/ change in environmental laws.
- Political riskin the form of sovereign actions negatively affecting the operations or profitability of the project. These could affect cash flow, dividend remittance, and debt service. Types of actions include import duties, licensing requirements, expropriation, war.
- Foreign Exchange risk
This risk arises in the case of the currency of revenue being not freely convertible into the currencies of creditors. Also disadvantageous exchange rate fluctuations can effect project capital costs, operating costs, currency of loans, sales contracts, supply contracts.
- Procurement Issues
The normal procedure for awarding BOT projects is through competitive bidding. The host government would define project (s) it considers to do an a BOT basis rather than simply responding to proposals. The government would define the project specifications, the level and nature of government support to be given, the proposed method for calculating tariff rates, the debt equity ratio required as well as other parameters for the transaction. The government would then invite preliminary proposals. A preliminary winner would be selected based on competitive criteria as price, experience and track record of sponsors, side benefits for the host government, etc. A letter of intent would be signed with the preliminary winner, and negotiations would proceed to finalize the financing and the various agreements among the parties involved.
- Escrow accounts
Lenders and investors normally insist on escrow arrangements to cover for debt service and to guard against possible interruptions or ups and downs in cash flow. An escrow agreement is executed among the different parties and the escrow agent providing for the receipt by the latter of payments for purchases from the project company and the relative ranking of lenders and investors by which payments would be disbursed.
- Schedule of actions
Given the complexity of BOT projects, a coherent schedule of actions has to be established to enable all parties to address the important issues. The following is an outline if the main stages involved in most BOT projects:
- Financial planning:
- Undertake financial feasibility study: reviewing the sources of finance, debt and equity, and preliminary cost and revenue estimates. Develop computer model and sensitivity analysis and assess return on equity and cover for debt service;
- Define project structure: formalize revenue source (eg. off take contract). Outline key features of security package, concession agreement, construction contract, overrun pool, insurance, management contract. Examine foreign exchange availability. Specify and evaluate risks. Develop a financing and risk sharing structure within the resources of the promoting/ contracting group. Advise on financing and competitive bidding;
- Seek and evaluate most competitive financing sources like bank debt, export credits and concessionary finance, multilateral agencies, cofinancing possibilities, capital markets, debt equity swaps, and domestic and foreign equity investors; and
- Prepare financing plan: detailed project structure, capital structure, security package, terms of finance, finance sources, timetable. Specify action plan for a structures approach to the financial markets to obtain optimal financing and rapid execution.
- Raising finance:
- Prepare information/ placing memoranda: include project description, details of security package, terms of finance and economic projections; for use by bank, export credit and other lenders, contractors and equity investors;
- Make bank and investor presentation to develop interest, confidence and commitment to the project from banks and investors;
- Arrange underwriting group: obtain financing offers, ensure sponsors have a choice of financing, evaluate and compare financing offers. Negotiate term sheet and underwriting agreement to ensure committed finance on most advantage terms;
- Negotiate project document with sponsors, advise on key commercial/ financial terms of project contracts and documents; and
- Incorporate risk reduction techniques: following drawdown, reduce financial risk by choice of currency of borrowing plus currency swaps, forward contracts, etc., and use of interest rate swaps, caps or dollars and fixed rate funding.
- Constraints to BOTs in developing countries
A number of constraints hinder the implementation of BOT projects in developing countries. These are related to (a) the host country and (b) to financial markets. Host countries face difficulties in the establishment of a proper institutional setting, overcoming the absence of long term financing, and safeguarding the interest of those involved in the BOTs. With respect to financial markets constraints they pertain to the access to export credits, commercial loans and equity participation.
- The role of the World Bank Group
The development of BOTs as options to project financing in developing countries requires major institutional reforms which could need substantial assistance and guidance to ensure consistent and permanent changes. The involvement of the World Bank Group in the process has been aimed at addressing these issues by providing technical assistance for institutional and policy reforms, and financial support.
The Bank addresses these constraints through various mechanisms. The bank provides the means for strengthening institutional, legal and regulatory framework involved in the identification, negotiations, and implementation of BOTs. It provides long term financing needed for the implementation of infrastructure projects through financial intermediaries or directly for self standing BOTs. This financing provides for grace periods long enough to allow for projects of long gestation to be completed and revenues to be generated. The financing could cover at least one third of the overall costs of BOTs, provided adequate equity is secured through the international and local investors and possibly multilateral agencies, such as the International Finance Corporation, African Development Bank, Islamic Development Fund, etc. this structure allows the projects financed to cover their interest payments and principal repayments, operating costs, and return on equity from the first year of operation.
The objective of the Bank’s involvement in BOTs is to ensure that projects are self standing from the financial point of view starting the first year of operation. In order to provide the comfort needed by the lenders, the Bank loan, which is provided through a local financial intermediary or directly through the host government, is subordinated to commercial loans and supplier’s credits. In this approach, the supplier’s credits and lenders would be providing less than the total financing required under limited recourse secured against the loans by the Bank and equity contributions.
In addition the Bank assures the financial community that projects selected are dictated by the least cost development plans of the sector under consideration by the host country and that projects financed under BOT arrangements are prepared in accordance with the standards used by the Bank for financing projects implemented by the public sector. Furthermore, the supervision of the implementation of BOTs is supervised by consultants appointed by the Bank to ensure adherence to the agreed timetable and the coordination of the drawdown of loans with the progress of project execution.
The Bank also plays a major role in assisting in structuring and negotiating of security packages needed to safeguard the interests of lenders, investors, and governments. The security package involves a set of interrelated agreements, designed to identify and allocate risks, and provide for provisions for minimizing these risks and compensating those affected by it. While the design of project specific security packages is the responsibility of the financial advisors, the Bank provides the framework and, more importantly, the financial resources needed to finance standby facilities in case of delays, restructuring of projects in case of force majeure by principally concentrating on ensuring resources are available to service the debt to lenders. In other words, the Bank provides the governments the resources to financially backstop BOTs and hence relieve the international financial community of some of the major risks associated with limited recourse financing.
The IFC serves several functions in the implementation of BOTs in developing countries. It provides financing by taking project specific risks, while also serving, in some cases, as financial advisor in the process of preparing BOTs and mobilizing resources for their implementation. Finally, the IFC could syndicate loans with commercial banks to close the financing gaps in BOTs. The Multilateral Investment Guarantee Agency (MIGA) provides guarantees for the equity of foreign investors in developing countries, who are members of MIGA.
January 12, 1993