Contingent Guarantees to Mitigate Regulatory Risk
Outline of Proposed Concept:
Few developing-country infrastructure projects have explicit contractual
undertakings from the host country government that are capable of serving as
the basis for traditional breach-of-contract political risk insurance coverage.
What is proposed here is a project-specific guarantee that could, in turn, be
guaranteed by a multilateral agency or other appropriate entity. The host
government would promise to abide by certain critical features of the regulatory
regime that it established at the time new infrastructure investments were made
by private investors (domestic or foreign). These critical features would include
items such as the manner and timing of tariff adjustments and other features
such as performance standards which could fundamentally affect the amount of
revenues earned by the project and, thus, its ability to meet its debt service
obligations. The guarantee would not have to freeze all aspects of the regulatory
regime: certain performance standards could be changed so long as
enforcement were by means of fines that are limited in size or subordinated to
payment of the project’s debt service.
The amount payable under the guarantee would be large enough to insure that
the host government will take its obligations seriously and to raise the local
currency rating of a project covered by the guarantee to investment-grade. The
guarantee would be contingent in that it could be called only if the government
were to change the pre-established regulatory regime. The host government
would, therefore, have no liability under the guarantee so long as it continued to
enforce the regulatory regime that it had designed and implemented.
Contingent guarantees should continue to be used (1) until the host-country
government is viewed as having a sufficient amount at risk that change of the
regulatory regime is no longer viewed as a practical possibility or (2) until the
government has established a track record of regulatory stability. In the first
case, the measure of success will be the ability of new infrastructure projects to
obtain investment-grade local currency ratings without the use of a contingent
guarantee. In the second case, the ability of projects subject to such guarantees
to obtain investment-grade local currency ratings without them could allow the
guarantees to fall away and terminate the contingent guarantee program.
Although this type of guarantee could be used in many infrastructure sectors, the
following example illustrates its use in the electric power sector. The project
covered by the contingent guarantee is assumed to sell power pursuant to power
purchase agreements (“PPAs”) which have been reviewed and approved by the
host government. The government will make the following commitment:
Bob Sheppard
Co-chair, Experts Group on Public / Private Risk Sharing
Projfin@bellsouth.net
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In the event of a payment default under a PPA, the government would require
the independent system operator or market settlement agency to:
 Give dispatch priority to the project, and
 Establish a minimum market price equal to the price of power in the
defaulted PPA, or
Subject to a cure period (both for the defaulting purchaser and for the
government) make a payment to the project equal to 40%-50% of the
project’s senior debt amount. The amount of the guarantee (40%-50% of
senior debt) is based on the amount of contingent support which each of the
three major rating agencies have indicated is necessary to raise to low
investment grade the rating of a transaction which in the absence of support
would be several notches below investment grade.
Benefits:
This structure will provide substantial benefits to host-country governments,
project sponsors, and lenders:
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Host-country governments would benefit because the structure will promote
needed investment at lower cost. (To be effective, contingent guarantees
would have to be combined with inconvertibility coverage and foreign
exchange liquidity facilities to achieve investment-grade foreign currency
transaction ratings.)
To the extent that multilateral agencies do not reduce the host country’s
lending limit dollar-for-dollar with the amount of the contingent guarantee, the
host country will make a more efficient use of its borrowing capacity.
The structure addresses one of the major concerns of project sponsors, which
are currently reluctant to make new equity investments in countries that they
perceive as posing significant regulatory risk.
The structure also addresses lenders’ major concerns, which include both
regulatory risk and the lessening credibility of partial credit and co-financing
schemes involving multilateral agencies.
If used in conjunction with inconvertibility coverage and a foreign exchange
liquidity facility, contingent guarantees could provide a structure in which a
project’s debt rating is significantly de-linked from the sovereign’s rating.
Emerging markets investors (who choose to take sovereign risk) provide little
financing for infrastructure projects; but the “buy-and-hold” investors, who
finance highly structured infrastructure projects, do not want to take sovereign
risk.
Contingent guarantees represent the least onerous means of addressing
regulatory risk: The host government promises to do what it should want to do
anyway, and its guarantor takes little real exposure on a guarantee which is
substantially less in both amount and risks covered than a direct debt
guarantee capable of mobilizing a similar amount of private capital.
Bob Sheppard
Co-chair, Experts Group on Public / Private Risk Sharing
Projfin@bellsouth.net
Obstacles to Date:
Although there may be one or more transactions in process which involve this
type of guarantee, it represents an approach which, in effect, has not yet been
tried. One potential obstacle is the fact that multilateral agencies will account for
their exposure under the contingent guarantee as equivalent to a full debt
guarantee, rather than taking account of the fact that they are exposed to a
narrow segment of risk defined by the prospect of the host government’s
breaching its commitment to maintain its regulatory regime for the sector in
question. It would clearly be better for all concerned if the accounting used for
the transaction were similar to that used by monoline insurance companies, but
even in the absence of such an approach, contingent guarantees represent a
more efficient use of multilateral resources.
Another obstacle is failure to recognize that this is an issue that must be
addressed. In the 1990s, numerous capital markets transactions were executed
for projects in low investment-grade countries or, in some cases, in below
investment-grade countries. These transactions did not utilize structures to deal
with regulatory risk (or devaluation), but these transactions could not get done
today. Failure to address regulatory risk is equivalent to abandoning the
international capital markets in favor of local currency markets or of deciding to
wait until each developing country has achieved an investment-grade rating that
is high enough to overcome fixed-income investors’ fears about developing
country exposure.
Recommended Next Steps for Implementation:
The most obvious step is that either (1) a multilateral must approach a potential
host government and propose a program utilizing contingent guarantees or,
alternatively, (2) a government must approach a multilateral.
Assuming that agreement is reached on the concept of contingent guarantees, a
major step that must be taken by the host government is the design and
implementation of a program to determine which projects will be eligible for
guarantees. The most important aspect of any such program is the means by
which it insures that projects covered by contingent guarantees will provide
service to the public at a competitive cost. The key to political acceptance of a
guarantee of regulatory stability is the idea that (without expropriating investors),
service could not be provided cheaper under a different regime.
Most infrastructure sectors employ basic technology that tends to have a long
useful and economic life.
For example, appropriate competitive bidding
procedures can insure that electric power generation capacity is acquired at a
price which, in hindsight, will not appear to have been above market and will not
appear high in relation to current costs for obtaining similar capacity. Similarly,
fuel passthrough provisions can be benchmarked to appropriate market
Bob Sheppard
Co-chair, Experts Group on Public / Private Risk Sharing
Projfin@bellsouth.net
standards. A properly-designed program can insure that service is provided to
the public at the lowest reasonable cost consistent with market pricing – and with
avoidance of post-investment regulatory changes which effectively represent an
expropriation of private investors.
The final step required is the selection of one (or, at most, a few) demonstration
projects. Required returns for privately-financed electric power generation
capacity in the US market fell during the 1980s because early projects were
successful and, by demonstrating that the risks involved were not unduly high,
drove down the risk premium applied to such projects. To reduce the risk
premium for infrastructure projects in a given developing country, there must be a
track record of success, where “success” is defined as:
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Successful operation of the project and provision of services to the public at
competitive costs
Generation of returns to project sponsors that are broadly consistent with their
original expectations, and
Demonstrated ability of transactions to avoid being downgraded to below
investment grade as a result of downgrade of the sovereign (i.e., a significant
de-linkage between the transaction’s rating and the sovereign’s rating).
Bob Sheppard
Co-chair, Experts Group on Public / Private Risk Sharing
Projfin@bellsouth.net