by Agnes a Paris
Thu Nov 23rd, 2006 at 06:52:10 PM EST
The construction risks of U.K. public-private partnerships (PPPs; including private finance initiative ie PFI projects, the latter being the legal ancestors of the former) have so far received the bulk of analysts and investors' attention, but this is about to change.
As the initial projects move from the ramp-up phase and into steady-state operations, it is increasingly apparent that the operations, and particularly the lifecycle responsibilities, of project companies (ProjectCos), also carry significant risk.
Many of the operational contracts are determined before construction of the project (including fixed prices), and have yet to be tested under real operating conditions or a period of stress.
The Standard and Poor's rating agency launched mid-2006 a global survey on a portfolio of 30 projects (quite a representative sample) in order to assess the operational risks of PFI projects and the potential consequences for investors, lenders and taxpayers (us).
Quantitative results are still pending, but interesting preliminary conclusions have already been outlined.
The first of them really is groundbreaking news :
Original research undertaken by Standard & Poor's has confirmed our view that the operations of U.K. PPPs are not risk free, and we have identified a number of areas where enhanced analytics are necessary to ensure that appropriate risk-management arrangements have been established.
There are very few projects that have been running long enough to provide quantifiable data on benchmarking and market testing, the interaction between the various players, and the whole life costs of PPP projects, however. The true scale of the likely challenge will only become evident in the next five to 10 years.
God I love these guys' choice of words. Only us investment bankers provide stronger, though less subtle, disclaimers ;-)
The sustainability and cost efficiency of the private finance initiative is an issue we debated over a bunch of diaries earlier this year, so I thought it interesting to convey the information that the common sense comments we then made have been endorsed by the all-times professionals of credit risk.
A number of contract managers have indicated that their FM contracts (or elements of them) were not profitable, and even more indicated that the contract had not been profitable at some point in the past. This suggests that FM contracts may have been routinely mispriced (both under- and overestimated).
Due to the structure of PPP projects, low profits for the operator would not affect the ProjectCo immediately. Certain market players may be willing to support nonprofitable contracts rather than jeopardize their market position by "walking away." Mispriced soft FM contracts may often be corrected by market testing or benchmarking. No such mechanism is usually available for hard FM services, however, which as a result face significant medium- to long-term exposure on these costs. Consequently, the ProjectCo too will find mispricing a significant issue.
The long tenor of hard FM contracts means that it is quite possible-given changes in technology, preferences, and taste, for example-that known risks are underestimated and that there are unknown risks not considered in the assessment of contract costs despite the apparent best practice employed in price estimation by the contractors.
Difficulties affecting FM services have been both project and project counterparty related. Key indicators of potential project difficulties include: deteriorating credit quality of the contractor or its parent; a troubled relationship with the offtaker; disputes about variations; "rescheduling" of major maintenance; and increases in the level of performance deductions.
No ProjectCo wants to replace a contractor unless it absolutely has to, as practicality issues, cost, time taken, and disruption are considered too great. This is partially borne out by market testing exercises where the incumbent provider has generally been reappointed-albeit with a changed (and sometimes reduced) unitary charge.
A noticeable trend during the first 10 years of PPP has been the reducing absolute and relative levels of lifecycle funds, with early funds often 50%-60% higher than at present. The marked decline in the value of funds does not reflect any advance in lifecycle methodology, but a more aggressive costing approach. Given that lifecycle expenditure is only likely to be realized later in the concession, increased risk may be being built into this area from the outset.
As I did in the previous diaries on the topic, more than happy to provide attempts at clarifications if there is too much technical jargon.
Links to diaries in the same PPP-focused vein
PPPs in the transportation sector : enhanced public service ?
The tube Lines project : notorious yet attracting investors