Should the state be involved in the financing of PPP projects?

In PPP projects, risk should be borne by the party best able to manage the project and minimize its costs.

However, there are situations where the standard allocation of risk does not deliver the optimal outcome for the contracting authority (so-called "value for money"), which creates scope for the use of various forms of government support. When should government support PPP projects and what options are available?

PPP projects are expected to bring innovative approaches to design, shorter construction times and, above all, long-term responsibility of the private partner for the quality of construction and operation of the infrastructure. These benefits must outweigh the higher cost of financing. Private investors borrow on less favorable terms than the government, and these higher costs are reflected in the prices offered in tenders. Since the first PPP contract for the D4 motorway project was signed in 2021, financial market conditions have changed significantly. Base interest rates and the margins that banks and other lenders add to them have increased. In addition, the PPP projects currently in the pipeline are many times larger than the first project, which may make it more challenging for investors to raise the necessary amount of financing at market conditions. These factors raise the question of whether and how the state should support the implementation of the nine approved PPP projects in order to confirm its will to actually implement them, complete as many of them as possible and at the same time obtain the most favorable terms.

Grants

Investment grants from the government should be considered for PPP projects whose size exceeds the debt financing capacity of the financial markets and for which the bidder may have difficulty in obtaining financing at market rates. Investment grants can be paid to the concessionaire during or at the end of construction. They reduce the need for debt financing as well as the amount of affordability fees required. In determining the optimal level of investment subsidy, it is important not to significantly alter the risk allocation of the PPP project. Even if it is provided, the concessionaire must bear most of the responsibility for the risks of constructing and operating the infrastructure to be built. If the contracting authority wishes to classify the PPP project as off-balance sheet, the amount of the grant is limited by Eurostat rules (ESA 2010), according to which it may not exceed 50% of the investment cost and may be significantly lower if the allocation of other project risks is suboptimal.

Guarantees

Providing guarantees for PPP projects can help to obtain cheaper sources of financing from commercial banks and other financial institutions, reduce the cost of capital, increase the availability of financing in local currency countries (such as the Czech Republic) and make projects more attractive to investors in volatile financial markets. These guarantees can cover different parts of the projects being implemented and typically include:

Loan guarantees - This is the most common form of security and provides lenders with the assurance that the sponsor of the PPP project will meet its obligations in the event of default by the concessionaire. It usually covers only the lenders' senior debt and is usually limited to a certain percentage (e.g. 80%).

Revenue guarantees - The sponsor guarantees that the availability payment it has agreed to pay to the concessionaire will not fall below a specified minimum threshold over the life of the contract, regardless of the performance of the PPP project.

Currency risk guarantees - If the project is financed in a currency other than the local currency, the government will compensate the concessionaire for exchange rate differences in the event of a change in the exchange rate. This type of guarantee was also provided by the MoF to the concessionaire in the Czech pilot PPP project of the D4 motorway, where the concessionaire financed its investment costs partly in CZK and partly in EUR due to the limited liquidity of the koruna market.

Contractual terms - The above-standard security of contractual terms most often relates to compensation mechanisms, e.g. in the event of changes in the legal environment or a materially adverse change (see again the D4 motorway PPP project), indexation of availability payments to inflation in the operational or construction part of the project, or refinancing of the project where the state takes the risk if the concessionaire fails to renew contracts with lenders during the concession period.

Guarantees for subordinate organizations - Guarantees for the obligations of state or regional institutions involved in PPP projects (see again the D4 pilot project, where bidders required guarantees from the Ministry of Finance for the payment obligations of SFDI).

Staple financing

Staple financing is a pre-arranged package of finance made available to all bidders by the procuring entity, in conjunction with selected banks, to cover part of their investment requirements. It is intended to facilitate the financing of large projects where it may be difficult for individual bidders to secure the full amount of financing on the financial markets on their own. For upcoming Czech PPP projects, the consideration of stapled financing is particularly relevant for the extremely financially demanding high-speed rail projects, but also, for example, for the upcoming D35 motorway project, which may be up to four times larger in investment than the first PPP project, the D4 motorway. By standardizing part of the financing structure, governments can facilitate faster financial close and potentially reduce the resulting interest rate and currency risk.

Tax benefits

PPP projects are supported by various tax incentives in different countries, including income tax reliefs, tax deductions, real estate tax exemptions, accelerated depreciation, VAT exemptions, etc. Not all of these are relevant to Czech conditions. However, it would be worth considering, for example, allowing the concessionaire to defer a large VAT payment after the completion of construction to the operation phase in order to ease the pressure on cash flow and reduce the overall financing requirements.

Other options

The government can further support PPP projects by providing other forms of financing, such as subordinated debt or mezzanine financing, which improve the credit profile of the project and reduce the risk margins of senior lenders. A systemic solution for the implementation of the overall PPP program may be the establishment of public or semi-public infrastructure funds to co-finance PPP projects and provide additional financial resources.

Conclusion

Each type of government support has its own specific use and purpose and can be combined with other forms of support according to the needs of a particular project. By using these mechanisms, government can make PPP projects more financially viable and attractive to private investors, which can both speed up and make cheaper the construction of the necessary infrastructure. To ensure that there is no loss of value for money as a result of this government support, it is crucial to maintain a similar level of risk-sharing as with full private funding. In other words, the private funding component must always cover most of the project risks, while the public support component should address sub-optimal market situations. The optimal combination of private sources and public support ensures sufficient incentives for concessionaires and reduces the overall cost of PPP projects for the government, thereby providing additional value for money.