Have the changes made to a rational PF model to suit public-sector programme sponsors’ needs made it impossible to incorporate relational contracting into PPP structures?
Welcome to part three of our series exploring the use and of relational contracting between Special Purpose Vehicles (SPVs) and Engineering, Procurement and Construction (EPC) contractors in Public Private Partnerships (PPP) programs. In this article, we will discuss the challenges due to the focus on lowest-cost providers in the selection process of PPP consortia, the shift from value-for-money analysis to lowest cost, and the removal of the off-take structure from PPP transactions.
If you missed it, in part one of this series we explored how while many public-sector project owners are moving towards relational contracting for programme delivery, PPPs still rely on non-recourse financing or Project Finance (PF). The challenge lies in the lack of collaboration fostered by PPP contracts, which are bespoke contracts developed by government contracting authorities. The main stumbling block preventing the implementation of relational contracting in PPP structures is the selection of the lowest-cost provider by public-sector major programme sponsors. The hypothesis we test in this paper is if non-recourse financing features of PPP structures can be used with collaborative contracting between Special Purpose Vehicles (SPVs) and Engineering, Procurement, and Construction (EPC) contractors.
Then in part two, our discussion highlighted issues such as biases, loss-leading, competition constraints, and the pressure on PPP project sponsors to prioritize the lowest possible cost of capital. It was emphasized that the PPP delivery model, although designed to create value for stakeholders, is more expensive than traditional delivery models due to the allocation of risk to the private sector. This part concluded by stating that while PPPs can be a useful tool for delivering infrastructure projects, it is essential to consider their limitations and challenges to ensure their effectiveness in meeting public needs.
Now, let’s get to the third section of this four part series…
Risk and Rewards
The main hypothesis that underpins this research aims to understand if the changes made to a rational PF model to suit public-sector programme sponsors’ needs have made it impossible to incorporate relational contracting into PPP structures. The data gathered has already exposed how the value-for-money analysis leads parties to the lowest-cost solution.
Several participants have indicated that as it currently stands, the PPP framework does not allow for the implementation of rational contracting between the SPV and the EPC contractor. SPV cannot use relational contracting with its subcontractors because doing so would render them unable to achieve the lowest cost of financing; risk would remain with the SPV, which in turn would lower the credit rating of the project and increase the debt-to- equity ratio and the cost of debt. Understanding the following commercial premises is particularly important.
Debt is cheaper (4-6%, currently) than equity (12-15%). The more equity is required, the more expensive the weighted average cost of capital will be. A lower credit rating increases the cost of debt 15bps for every credit rating notch. Rating agencies and debt lenders will assign a credit rating score to the SPV depending on the financial resilience of the SPV/programme. The higher the financial resilience, the higher the credit score.
Typical debt-to-equity gearing for a PPP is 90% debt to 10% equity. This is very low compared to traditional PF structures, which see 75% debt to 25% equity and no government contribution to the capital structure.
From the data gathered, it can be concluded that the use of alliance contracting principles between the SPV, and the EPC contractor is ultimately feasible because it is a risk-versus-reward issue where capital providers want to make sure that the risks taken are rewarded in an appropriate fashion (Hellowell & Vecchi, 2012).
One participant stated the following when asked if an SPV could handle more risk (which is equivalent to using relational contracting between an SPV and an EPC contractor): “… I think [if] sufficient equity [is provided] and the gearing ratio [is where] it needs to be, they [SPV] need to have sufficient equity below debt to make sure that those risks are covered. This could be measured either through gearing, DSCR (debt service coverage ratio), or resiliency ratios…”
This conclusion is also backed up by another participant, who states: “… We’ve seen projects where you can establish a different form of security, but I think it takes a lot of persuading of the financing institutions involved in order to demonstrate to them that, ultimately, the protections they see in traditional financing are going to be there for this type of financing…”
In order for relational contracting principles to be adopted by an SPV to manage its subcontracted relationships, two main things would have to occur. First of all, public-sector procuring entities would need to stop awarding contracts to the lowest-cost providers, since a lowest-cost solution is incompatible with these contractual arrangements.
Second of all, capital provider stakeholders such as debt and equity lenders, rating agencies, and other financial advisors would need to structure a new financing product that allows a significant amount of risk to be retained by the SPV. This could be achieved by offering higher returns to capital providers in order to compensate for higher risks, as well as more financial resilience with higher debt-to-equity ratios and no public sector contribution to the financial structure.
The findings of this research are in line with the conclusion drawn by Clifton and Duffield (Clifton et al., 2006): “… Given the issues outlined, it is apparent that there are two key impediments to the application of alliancing to PFI/PPP projects: the availability of suitable projects and the financiers’ willingness to consider open-ended financial exposure…”
In conclusion, the shift from traditional non-recourse financing to PPP-type non-recourse financing has led to unintended consequences that are reflected in both the data gathered and the literature reviewed. These consequences include the transfer of excessive risk to the private sector with not enough upside potential, creating a litigious environment, and a command-and-control approach to programme delivery. These challenges have led some to question the efficacy of PPP in delivering positive outcomes for major programmes.
In the next installment, we will explore in more detail the negative behaviors that excessive risk transfer creates within the project sponsor organization, as well as the loopholes that exist within the PPP structure. We will also examine how a more collaborative model with less risk transfer is proving to be more effective in the delivery of major programmes.