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Public risk bearing in privately financed infrastructure (excerpt)

Timothy Irwin

March 2005

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1. Overview

Public, private, and public–private financing of infrastructure

1. Governments often finance infrastructure themselves. They collect revenue from taxes, borrow to augment their financial resources, and then use the money to pay for the construction of roads, airports, power plants, water distribution networks, and other types of infrastructure. At other times, they encourage private firms to finance and build the infrastructure.1 The firm gets money from its shareholders, borrows to augment its financial resources, and then pays for construction. Governments may prefer this approach because it doesn’t require them to raises taxes or borrow or because they believe the private firm will build and run the infrastructure more cheaply than they could. At still other times, however, governments opt for a mix of public and private financing: the firm helps finances the project, but the government facilitates the financing by making various financial commitments.

2. For example, the government may agree in advance to make payments over the life of the infrastructure in return for the services the infrastructure provides. The British government has used this technique to secure private financing of roads as well

1 For information on the extent of private participation in infrastructure in developing countries, see World Bank (2003x) and the World Bank’s Private Participation in Infrastructure database, available at <http://ppi.worldbank.org/>. Although private participation has recently gained in prominence, it is not new. Indeed, some recently privatized firms began life as private companies and were then nationalized (José Gómez-Ibáñez, 2003, and Michael Klein and Neil Roger, 1993).

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as schools, hospitals, and prisons.2 In the case of the privately financed roads, the users pay no toll, but the government pays a shadow toll. In other projects, a state-owned enterprise rather than the government is the purchaser. A state-owned electricity utility, for example, may enter into a long-term power-purchase agreement with a privately financed generation plant in which the utility agrees to pay make capacity payments related to the plant’s availability to produce power. It makes additional, energy payments if it wants the plant to generate power; it makes the capacity payments even if it doesn’t.

3. When the infrastructure project sells its services to households and private businesses, the government may still protect the firm or its creditors from certain risks. In the nineteenth century, for example, many governments guaranteed investors in private railways a certain return on their investments. Today, governments give similar guarantees to privately financed toll roads and urban rail systems. Even when a government’s financial involvement in the project is quite limited, the government may make guarantee-like commitments to compensate the firm if it refuses to allow a previously agreed tariff to be charged or changes others policies in ways that adversely affect the firm.

4. These mixed public–private arrangements go under many names, sometimes according to the nature of arrangement, sometimes by historical accident. The term “public-private partnership” is often used to refer to arrangements under which a privately financed firm sells its output to the government under a long-term contract, but it is also used more encompassingly to refer to projects selling their services to households and businesses, but benefiting from government guarantees. The term “concession” is most often used to refer to

2 See, for example, Government of the United Kingdom (2003).

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arrangements under which a private firm sells directly to end users, possibly with government guarantees. Privately financed infrastructure assets are often given to the government at the end of a predetermined period, and accordingly some such projects are called build–operate–transfer or BOT projects—or one of a variety of similar names that reflect the nature of the project: build-operate-own-transfer if the company is the legal owner of the assets until they revert to the government; build–lease–transfer if the firm leases the project to the government after its construction; or build–own–operate if the assets never revert to the government. Whether they are called BOTs, concessions, or public–private partnerships, the public sector often provides guarantees or commitments to purchase the output. In this book, all such projects are referred to simply as private infrastructure projects.

5. Private infrastructure projects can work well. Under certain conditions, private firms seem better than governments at building things on time and running them efficiently. So giving a private firm the task of building and running an infrastructure project can lower the project’s costs. At the same time, a government that is no longer in the business of providing infrastructure services may make better policy. Freed from the demands of providing infrastructure, and the interests that go with being a provider, it may make policy decisions that better reflect the public interest. It may be more likely, for example, to permit competition between providers if it is not a provider itself.3

3 For discussions of the rationale for private provision of infrastructure see, for example, Gómez-Ibáñez (2003), Luis Guasch (2004), Clive Harris (2003), Brian Levy and Pablo Spiller (1994), David Newbery (1999), and World Bank (1994, 2004x, and 2004x). William Megginson and Jeffry Netter (2001) survey empirical evidence on the effects of privatization, including the private provision of infrastructure. One particular type of private provision of infrastructure raises additional questions, namely the case in which the private firm sells its output to the public sector.

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6. The private provision of infrastructure can also protect the government from financial risks, compared with the case of traditional public finance. When the project’s costs rise or its revenues fall, the private firm and not the government may suffer the consequent losses. When governments give guarantees or enter in long-term purchase contracts, however, they continue to bear some financial risks. This need not be undesirable; it may lower the total costs of a project and help the government achieve its objectives. If the government is the sole purchaser, it couldn’t get a good deal unless it committed itself to purchasing the service and therefore to bearing risk related to the demand for the service. And even when the government is not the sole purchaser, it may be difficult or inefficient (for reasons we consider below) to get the firm to finance the project without fiscal commitments.

Potential problems with public–private financing

7. Yet government risk bearing in privately financed infrastructure projects is problematic. Governments are often unfamiliar with the risks they are asked to bear, making it hard for them to decide whether bearing the risks is good policy. If they get the decision wrong, the project may cost the country more than it should. When they assume risk, they may have difficulty monitoring their potential liabilities and may struggle to meet commitments that fall due. If the liabilities are large enough, they can precipitate fiscal crises. At worst, guarantees and long-term purchase contracts may serve merely to disguise

Whether private provision of this type improves outcomes, compared with the case in which the public sector finances the project itself and then separately contracts for construction, on the one hand, and operation and maintenance, on the other, depends in part on the extent and uncertainty of the interdependence of construction and operating-and-maintenance costs (see, for example, John Quiggin 2004).

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the government’s liabilities, allowing it to subsidize projects and take on debt without seeming to do so.

8. Some examples help illustrate the nature of government-backed privately financed infrastructure projects, as well as their possible advantages and disadvantages. (The appendix to this chapter describes further examples of public financial involvement in privately financed infrastructure projects.) To start with an example of a long-term purchase contract, consider the case of the Philippines, where in the 1990s and late 1980s the state-owned power company Napocor signed dozens of power-purchase agreements with private power producers. Most of the agreements were backed by government guarantees to pay in case Napocor didn’t. In one representative case, Keilco, a company majority owned by the Korean electricity company KEPCO, agreed to build a 1200 megawatt gas-fired plant, at a cost of about US$710 million, on the basis of an agreement by Napocor to pay a monthly fee for “capital recovery,” operations, and maintenance of $8.01 a kilowatt, as well as smaller amounts in pesos for energy actually produced.4 The agreement ensures that Napocor pays nothing for the power plant unless it is available to generate power, but also creates an economic liability similar to debt. The amount of this liability can be estimated by making an assumption about the plant’s availability and then discounting the forecast payments corresponding to that level of availability back to the present. If we suppose that Keilco will make available a constant 80 percent of the plant’s nominal capacity of 1200 megawatts, Napocor will have to make monthly payments of $7.7 million (1,200,000 kilowatts × 0.8 × $8.01 per kilowatt). If we discount the payments at 12 percent, we get a present value of US$726

4 The World Bank’s Private Participation in Infrastructure project database and KEPCO’s form 20-F for 2003, available at <<http://ppi.worldbank.org/> and <http://www.kepco.co.kr>.

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million—just slightly more than the reported cost of the plant. The government secures the plant, that is, but only by agreeing in advance to pay its entire cost over time (conditional upon its availability). To see further the similarity of the liability to ordinary debt, as well as its difference, suppose by contrast that Napocor had borrowed US$726 million, to be repaid over 20 years in equal monthly installments at an interest rate of 12 percent a year, and used the money to have the plant built under a turnkey construction contract and then operated by another firm under an operating contract. In this case, the government would also have had to pay $7.7 million a month for twenty years to repay its loan.5 It would have to repay the loan whether the plant was available or not, but it could write the construction and operating contracts so that it received some compensation from the construction or operating firm when the plant wasn’t working properly. A power-purchase agreement may be the cheapest way of securing power if it is difficult to write separate construction and operating contracts that fully protect the purchaser from the risk of power not being available. But for our purposes the important point to note is that a power-purchase agreement creates liabilities similar to debt.

9. Earlier projects like this one quickly brought new generation capacity to the Philippines and ended blackouts and brownouts that were extremely costly to the Philippine economy. But the economic crisis that hit the Philippines in the late 1990s has meant demand has been lower than forecast while costs, denominated in pesos, have been higher. Further, the Philippines electricity regulator has allowed only some of the increased costs to be passed on to electricity consumers. As a

5 This calculation makes use of the formula for calculating the present value V of an annuity: ( )( )1 1 TV A r r −= − + , where A is the annuity, r is the discount rate, and T is

the term of the annuity.

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result, Napocor’s finances have been distressed and the government has had to take over its debts, contributing to a fiscal crisis. It would be simplistic to blame the crisis on the policy of entering into debt-like power-purchase agreements, since the simplest alternative way of securing new power plants would have involved direct borrowing by Napocor. Yet one might wonder whether the difficulty of monitoring the typically off-balance-sheet liabilities created by power-purchase contracts (for Napocor and the public sector as a whole) and the guarantee of the power-purchase agreement (for the government in particular) made it harder to understand the government’s true fiscal position and the risks it was running.

10. The potential problems, as well as the possible advantages, of government risk bearing are also illustrated by railways and toll roads. This book’s focus is on the problems facing present governments, but public financial support for privately financed infrastructure is not new, and some examples from historical railways are instructive. Although a few countries, such as Belgium, early on used public finance to construct railways, most countries used private finance. In Britain, private investors didn’t benefit from any significant public financial support, but in the rest of the world major public support was the norm. Some governments gave land grants or paid for some or all of the construction outright. Many provided guarantees.6

11. For example, Argentina guaranteed investors returns of six or seven percent on capital invested in certain railways. (According to one account, the investors who got the more attractive guarantee did so “not because they necessarily had a better case, but because they were more generous in their dishing out of bribes.”7) The guarantees helped Argentina

6 See Simon Ville (1990, page 131) and the appendix to this chapter. 7 Anthony Burton (1994, page 122).

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attract large-scale investment from London and other foreign capital markets, and perhaps reflected “a recognition on the part of Argentine ruling groups that they were competing for funds in an international market and as such had to apply incentives similar to those being granted by other countries.”8 Yet the government did not always have the money to meet its commitments, in part because of the “difficulty of accurately budgeting for claims”, in part because the “state was usually called upon to make more substantial payments during those periods when it was least in a position to raise additional revenue”.9 And in the end the guarantees caused major fiscal problems:

As the principal official obligation, railway guarantees were undoubtedly a contributory factor to the financial difficulties experienced by the national government, and were largely responsible for the crisis of confidence which brought the whole fragile edifice of the Argentine economic miracle to ruin … Many of the companies formed during this period were committed to long-term dependence upon the guarantee. Indeed ... it might be argued that many were projected merely for the purpose of obtaining a guarantee.10

12. Later in the nineteenth century, Turkey gave some, but not all, private railways a somewhat different type of guarantee.11 Guaranteed lines were promised a fixed level of revenue per kilometer of track, in return for which the government shared in revenue above a certain threshold. The guarantees helped the government secure investment in railways that opened up the country, and some form of subsidy to private railways may have been the best way to achieve the government’s objectives. Yet the design of the guarantees gave investors incentives to

8 Colin Lewis (1983, page 11). 9 Lewis (1983, pages 102, 105, and 122). 10 Lewis (1983, page 86). 11 See appendix for references and details of the Turkish guarantees.

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raise the cost of the railways to the government and country. In the plan to build a railway from Berlin to Baghdad, carried out by a concessionaire sponsored by Deutsche Bank and sometimes implicated in the outbreak of World War I, the Turkish government first awarded a concession from Istanbul to Ankara and then wanted to extend the line from Ankara to Baghdad. The concessionaire, however, proposed to use a more southerly route from Istanbul to Baghdad that would bypass Ankara. According to one contemporary observer, the company reasoned that it already had a guarantee of revenue on the Istanbul–Ankara line and could therefore make more by building an alternative route. Eventually, the Turkish government agreed to its proposal. Others have noted that Turkish lines benefiting from kilometric guarantees don’t proceed directly from city to city, but take a leisurely, unnecessarily winding route, apparently to maximize the value of the guarantee.

13. Now governments are more often concerned about the building of roads than railways. Most roads are purely publicly financed, but privately financed toll roads backed by government guarantees are not uncommon. As in the case of railways, the guarantees help persuade private firms to finance the construction of the roads, but can lead to difficulties for the governments. The Korean government, to take one example, has a policy of guaranteeing investors in roads a certain percentage of the revenue the road is forecast to generate. In one case, it guaranteed a unsolicited, privately financed road linking Seoul to a new airport at Incheon 90 percent of a twenty-year forecast of revenue. In return, the government got to keep any revenue exceeding 110 of the forecast. When the road opened in 2000, traffic revenue turned out to be less than half the forecast, requiring the government to pay millions of dollars. How much the government will have to pay over the life of the guarantee is uncertain, but in present values it may be as much as $1.5

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billion.12 The government’s guarantee policy raises difficult questions: did the government have a reasonable estimate of the guarantee’s cost when it granted it? Was the cost worth bearing? Was the road worth building? If it was, would public provision or a direct subsidy to the private company have been better?

14. Even when guarantees have proved less costly, they still raise difficult questions for public policy. The Chilean government, for example, has given revenue guarantees to at least nineteen privately financed toll roads. In a typical case, the government guarantees the concessionaire revenue equal to 70 percent of the estimated net present value of the concessionaire’s costs, including the costs of investment, operations, and maintenance; the guaranteed revenue might be distributed over twenty years, providing as much as 85 percent of forecast revenue in early years and less in later years. To date, the government has had to make only relatively small payments as a result of its guarantee.13 A recession in Chile, however, would cause traffic levels to grow more slowly than expected, possibly triggering many guarantees at a time when tax revenue would probably also be at a low ebb. How can the government measure and monitor this risk? How serious is the risk? Should the government be planning now for the possibility of future payments?

15. The challenges created by long-term purchase agreements and government guarantees are perhaps greatest in developing countries with precarious fiscal positions, but they are not unique to them. The merits and proper accounting treatment of privately financed infrastructure selling to governments or

12 Irwin (2004). See Junglim Hahm (2003) and the appendix to this chapter on Korean policy generally. 13 Andrés Gómez-Lobo and Sergio Hinojosa (2000, page 30) describe the guarantees and their results up till 2000. See also the appendix to this chapter.

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benefiting from generous government guarantees have been controversial in countries with strong fiscal positions such as Australia and Britain. New South Wales in Australia, for example, gave a revenue guarantee to the Sydney Harbour Tunnel, a project developed in the late 1980s and completed in 1992, as an alternative to the Sydney Harbour Bridge. Toll revenue was expected to be too low to cover the project’s costs, but according to the terms of an “ensured revenue agreement” the government agreed to give the tunnel company a contractually specified amount less receipts from tolls on the tunnel.14 Thus the government, not the company, bore demand risk. The Auditor-General of New South Wales concluded that this and other features of the project meant that, for accounting purposes, the tunnel and associated liabilities really belonged to the government. It issued a qualified audit of the financial statements of the government agency promoting the road, since they did not recognize the Tunnel as a public asset, and, in a subsequent report, offered persuasive evidence that the agency had chosen nominally private (but in substance public) financing partly as a way of circumventing restrictions on public borrowing.15

The difficulty of good decisions about bearing risk

16. It is difficult for governments to make good decisions about bearing risk in privately financed infrastructure projects. To begin with, there is no agreement among experts and advisers on exactly how some important risks should be allocated and therefore on exactly which risks governments should bear. Should they bear demand risk in toll road projects? Should they provide exchange-rate guarantees when investors borrow in

14 Government of New South Wales, Australia, Auditor-General’s Office (1994, page 279). 15 Government of New South Wales, Australia, Auditor-General’s Office (1994).

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foreign currencies? Or should they shield investors from exchange-rate risk in a different way, by increasing tariffs when the local currency depreciates? Should they protect creditors from losses in the event of the project’s being terminated? Should they compensate private investors in infrastructure for changes in government policy? All changes? Some changes but not others? No changes? These are all questions about the appropriate allocation of risks, and though advisers often have strong views about the correct answers the strong views are not all the same.

17. The difficulty of knowing how best to allocate risks is compounded by other problems. First, risk is complex, and psychological research suggests it is difficult to make accurate judgments in its presence. For example, people often overconfidently underestimate the extent of uncertainty surrounding estimates they make. If public decision makers are like other people, they may underestimate the risks they are exposing the government to when they offer guarantees. Ordinary people also make irrational choices about exposure to risk, being affected by superficial aspects of the framing of choices. They can be risk averse about some choices and risk seeking about others; and their susceptibility to the framing of choices means they may switch from being risk seeking to risk averse, without any change in the real nature of the choice. The implications for public policy are not obvious, but it is clear that intuitive judgments and decisions are unreliable. They won’t necessarily help governments meet their goals.

18. Second, political struggles can encourage governments to bear risks in private infrastructure projects when it would be better for the country if they did not. Governments are buffeted on all sides by demands for subsidies of one sort or another. Local manufacturers seek tariffs on imported groups, as a way of helping them at the expense of importers and customers. Customers ask governments to keep regulated prices below

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costs, at the expense of the regulated providers. Infrastructure providers seek monopolies at the expense of customers. And so forth. Unless the beneficiaries are widely regarded as deserving, the most transparent strategies for redistributing value tend to fail. Successful strategies therefore tend to come with a rationale that appears to explain how the proposed policy is good for the country as a whole and doesn’t merely redistribute value. In addition, successful strategies tend not to involve obvious financial transfers; as in the case of tariffs on imported goods, the strategies often create costs that are relatively obscure. An infrastructure firm seeking a government subsidy, or a ministry seeking to provide a subsidy to a favored project, may therefore seek a guarantee rather than a cash subsidy. Taxpayers and others are less likely to notice the transfer or understand its costs.

19. There is no simple solution to these problems. But better decisions by governments about bearing risk seem more likely when the following conditions are met:

• The government has a good understanding of when public risk bearing can lower the cost or increase the value of a privately financed infrastructure project.

• The government can estimate the fiscal cost of being exposed to risk.

• The government is constrained by fiscal institutions that encourage careful deliberation of the costs and benefits of bearing risk.

Helping governments meet these three conditions is the aim of this book. The remainder of this overview starts by offering guidelines, orthodox in their underpinnings but controversial in some of their applications, that governments might use in deciding whether to bear a risk. It then sketches an approach to

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estimating the fiscal cost of bearing risk. And it finishes by mentioning some of the fiscal institutions that governments might establish to constrain their decision making.

When should governments bear risks?

20. To consider when governments should bear risk, we need first to define the term. As we use the term, risk is unpredictable variation in value. It includes the possibility of unexpectedly good outcomes as well as unexpectedly bad ones (upside as well as downside risk). It can be considered for a project as a whole—how does the total value of the project vary with, say, demand?—or from the perspective of a particular stakeholder in the project—how does the value of, say, the government’s interest in the project vary with demand?

21. Particular risks, such as demand risk, can be thought of as sources of risk. Demand risk, as we use the term, for example, is unpredictable variation in value arising from unpredictable variation in demand. Construction-cost risk, to take another example, is unpredictable variation in value arising from the unpredictability of construction costs. Demand and construction costs are described here as risk factors.

22. According to a commonly expressed principle, risks should be allocated to those best able to manage them. The principle is right, but to give it traction we need to make it more precise and then use it to frame some more-specific guidelines.

The main principle

23. To make the principle precise, we can express it as saying that risks and related responsibilities should be allocated to maximize total project value. Total project value needs to be understood broadly to include not only value accruing to the

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private infrastructure firm, but also value accruing to the customers of the project and the government.

24. Holding the responsibilities of the parties constant, the principle says: allocate each risk to the party that, given its responsibilities, can maximize the value of the project with respect to unpredictable variation in the risk factor. Consider construction-cost risk: suppose the risk comes partly from uncertainty about the geological conditions that will be encountered during construction and partly from uncertainty about the skill and diligence of the construction company’s workers. To simplify, suppose the construction company alone can influence the skill and diligence of its workers, but no one can predict, let alone influence, the precise nature of the geology. If construction-cost risk is allocated to the construction company, the company has an incentive to ensure its workers are skillful and diligent. Construction-cost risk won’t thereby be eliminated; the construction-company’s profits will be uncertain. But construction costs will tend to be lower, and total project value higher, than if some other party bore the risk.

25. This analysis takes the allocation of responsibilities as given. Often, however, the allocation of responsibilities needs to be determined simultaneously with the allocation of risks: risks and responsibilities need to be matched. Consider demand risk in a toll road and suppose that no party has any control over demand for the road once it is built and that demand is the only risk factor. Once the road is built, that is, nothing can be done to change project value. But suppose also that demand can be forecast—not perfectly but with some effort at least approximately. Allocating demand risk still matters, but since the risk factor cannot be influenced what matters now is to predict and anticipate it. If demand is high enough, let us suppose, total project value is positive, so the road should be built; if not, total project value is negative, so the road should remain unbuilt.

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26. Now the principle suggests that demand risk should be allocated to the party that decides whether the road is built and, if so, what its capacity will be (how many lanes, how strong the pavement). Such a decision is usually at least partly the government’s responsibility. If it were exclusively the government’s responsibility, project value would be maximized (given the assumptions) by allocating the risk to the government—for example by allowing the government to keep the toll revenue. If a private firm was involved, the government could pay it by giving it availability payments independent of traffic.

27. The decision whether to build the road need not be exclusively the government’s, though. It might be made jointly with the firm. The government might make a provisional decision to have the road built, and then ask if any firm was willing to pay for the construction of the road in return for the ability to keep the tolls. If the successful firm bore all demand risk (kept toll revenue and had no revenue guarantee), it would have an incentive to take on the project only if it forecast that demand would be sufficient. If the firm was more responsive to the promise of profit and the threat of loss than the government, this allocation of risks and responsibilities would lead on average to better outcomes than the first, in which the risks and responsibilities lay only with the government.

Distinctions and definitions

28. To be more specific about the application of the main principle for allocating risk, it helps to distinguish four categories of risk. First, risks can be aligned on a spectrum that runs from the project-specific at one end to the economy-wide at the other. Uncertainty about the efficiency with which a power plant operates is an example of a project-specific risk. Inflation risk, interest-rate risk, and exchange-rate risk are examples of

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economy-wide risks. Some risks that are aggregations of other risks may fall in between: construction-cost risk, for example, includes project-specific geological risks and economy-wide wage risks. Second, risks that affect the total value of a project can be distinguished from risks that affect the way that value is distributed among different stakeholders. Construction-cost risk and demand risk are typical examples of total-project-value risks; low construction costs and high demand typically increase project value. Regulated-price risk is an example of a risk that mainly affects the distribution of value; after a project is constructed, the regulated price for its output may have little effect on total project value, but a large effect on the distribution of value between firm and customers. Table 1.1 illustrates the fourfold distinction.

Table 1.1 The fourfold categorization of risk Nature

Total value Distributional

Project-specific

E.g. project-specific causes of variation in construction costs (geology) and demand (service quality)

E.g. project-specific causes in distribution of value (the application of rules for adjusting regulated prices)

Scope

Economy-wide

E.g. economy-wide causes of variation in construction costs (prices) and demand (national income, interest rates)

E.g. economy-wide causes of fluctuations in distribution (unpredictable variation in exchange rates, given foreign-currency debt)

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Table 1.2 Guidelines by category of risk—taking the allocation of responsibilities as given Taking the allocation of responsibilities as given, allocate each risk to the party most able to:

Nature

Total value Distributional

Project-specific

Influence the risk factor

Influence the sensitivity of project value to the risk factor (anticipate or respond to the risk factor)

Absorb the risk

Influence the risk factor

Scope

Economy-wide

Influence the sensitivity of project value to the risk factor (anticipate or respond to the risk factor)

Absorb the risk

Influence the sensitivity of the distribution of value to the risk factor

Guidelines

29. Given these two dimensions on which risks differ, we can offer guidelines for the allocation of each of four categories of risk (Table 1.2). In all cases, the principle of allocating risks and responsibilities to maximize total project value should remain the ultimate arbiter; the guidelines attempt only to specify which allocation is most likely to maximize total project value in each of the four cases. Chapter 2 discusses the guidelines in more detail; here we state them baldly.

30. Project-specific total-project-value risks and accompanying responsibilities should be allocated according to the parties’ ability to

• Influence the risk factor

• Anticipate or respond to the risk factor—that is, to influence the sensitivity of project value to the risk factor

• Absorb the risk.

In some cases, one of these criteria may provide enough guidance. For example, project-specific construction-cost risk

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should generally be allocated to the party that has the most influence over project-specific construction-cost risk factors—typically the construction company. Or, when no party can influence the risk factor, the risk and associated responsibilities should be allocated to the party that can best anticipate or respond to the risk factor. If neither of these guidelines help, the risk should be allocated to the party best able to absorb the risk—that is, bear the unpredictable variation in value without changing the project—by hedging, insuring, diversifying, or just accepting and living with the variation.

31. Project-specific distributional risks should be allocated to the party that influences or controls them. For example, consider the (project-specific distributional) risk arising from unpredictability in the price the government will allow the firm to charge (Chapter 7). The government controls the risk and according to the guideline should bear it. It can do this by entering into a contract with the firm that fixes the price of the service (or fixes a formula that in turn fixes the price) and requires the government to compensate the firm if it fails to allow the promised price. The same arguments apply of course to unpredictable distribution in value arising from unpredictability in whether the firm will keep its promises to meet quality standards or extend services to new customers: the firm should bear the risk.

32. In practice, it is often not feasible to fully allocate risk to the party that influences or controls the risk factor. In other words, it is often not feasible to fully protect others from the risk. When a government compensates a firm for a reduction in the regulated price, it does not tax customers in exact proportion to their gains; some people lose or gain with the change in price. And the biggest challenge is sometimes not to determine the right allocation in principle, but to make a roughly appropriate allocation stick. For example, when the government can control the courts, how can the firm ensure that the government keeps

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its promise about the tariff or else compensates? And how can the government and customers ensure that the firm keeps its promises about quality and service extension?

33. Sometimes two parties jointly control or influence a project-specific distributional risk. Insolvency risk, as we use the term, is a mainly project-specific distributional risk arising from the firm’s leverage and random variation in its value. The risk is jointly controlled by the firm (ultimately its shareholders) and its creditors, because they jointly determine leverage: without leverage, there is no insolvency risk. The guideline suggests therefore that shareholders and creditors should jointly bear insolvency risk. In practice, this means creditors should expect neither customers nor the government to bail them out. Again, however, it can be a challenge to make such an allocation of risk stick in practice. Governments struggle not to intervene to stave off a private infrastructure firm’s insolvency. If a government believes it will bail out the firm, the matching of risks and responsibilities suggests its should also limit the firm’s leverage. (Chapter 6 looks in more depth at insolvency risk.)

34. Economy-wide risks are different in that project participants cannot usually influence the risk factor. Or, as may be the case for the government, if they can influence the risk factor, it is unlikely that their decisions should be made by reference to the particular project.

35. Economy-wide total-project-value risks should be allocated according to the same principles as project-specific total-project-value risks, except that the first guideline drops out: they should be allocated according to the parties’ ability to anticipate or respond to the risk or simply to absorb it. Inflation risk is often allocated largely to customers by means of tariff-adjustment formulas that increase prices according to inflation. On average—though of course not in every case—customers have a natural hedge against such changes since their income tends to

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vary with inflation. The allocation makes sense, then, because customers are well placed to absorb the risk.

36. Economy-wide distributional risks should be allocated to the party that can most control the sensitivity of the distribution of project value to the risk factor. Consider an example: in developing countries, infrastructure projects are often financed with loans in foreign currency, which creates uncertainty about the distribution of value between project participants (Chapter 5). If the local currency falls (and nothing else changes) shareholders lose because they must pay more in local currency to their creditors. Shareholders and creditors together control the sensitivity of the distribution of value to the exchange rate, by choosing the amount of foreign-currency debt. So according to the guideline governments should seek to avoid bearing this sort of exchange-rate risk. If they choose to bear it, the matching of risks and responsibilities suggests they should also be involved in decisions about the firm’s foreign-currency borrowing. Likewise, if customers bear exchange-rate risk, the government or regulator should be involved in such decisions.

Valuation

37. Good guidelines for public risk bearing are unlikely to be enough to lead to good decisions. Problems of politics and psychology both create reasons for governments to estimate the fiscal cost of bearing the risks they are thinking of bearing—or, to use a different term, to value the exposure to risk. Valuation allows policymakers to supplement their own susceptible intuition with quantitative estimates, possibly reducing the temptation to bear risk when it doesn’t increase total project value. While the details of valuation of risk are technical (and relegated to Chapter 4 and the second halves of Chapters 5, 6, and 7), the basic ideas are simple.

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38. The first step is to identify the risks the government is thinking of bearing in a private infrastructure project. What are the legal, contractual, or other rights and obligations that would cause the government to make or receive payments? And, given those obligations, what are the risk factors that would determine payments (demand, construction costs, and so on)?

39. Given a model of the evolution of those risk factors, the next step is to measure the government’s possible exposure; that is, to answer questions such as the following:

• What is the most the government might gain or lose?

• What is the amount it can expect to gain or lose?

• What is the probability of particularly large losses?

A simple example can illustrate this. Suppose you toss a coin four times and offer to pay someone one dollar for every time the coin lands head up. The most you could lose is $4, and the least is nothing. The amount you can expect to lose—the amount you would lose on average if you played the game many times—is $2. And the probability of losing, say, $4 is one in sixteen (½ × ½ × ½× ½).

40. The third step is to estimate the cost of bearing the risk. The amount the government can expect to pay is often a reasonable first approximation of the cost of the exposure. But in principle the expected payment needs to be adjusted to take account of the timing and risk of the possible payments.

41. Adjustments for the timing of payments are relatively straightforward. A payment (possibly) made in the future is less expensive than a payment (possibly) made now. So the future payment needs to be discounted at the riskless rate of interest.

42. Adjustments for the cost of being exposed to risk are more difficult, but exposure to risk does matter. For example, a

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guarantee that exposes the government to, and protects the firm from, demand risk might reasonably be valued by both the government and the firm at more than its expected value discounted at the riskless rate of interest. Estimating the appropriate adjustment for risk is not always straightforward; in some case making no adjustment may be justified in practice even if it isn’t conceptually ideal. Often, though, there are, methods—widely used in financial markets—that can generate a reasonable estimate of the cost of being exposed to risk (see Chapter 4).

Fiscal institutions

43. Improvements in decisions about bearing risks can be sought case by case. With better knowledge of the principles that should govern the allocation of risk and the ability to value exposure, governments can seek to make better decisions in each case they encounter. In addition, however, improvements can be sought at the level of the fiscal institutions that shape governments’ case-by-case decisions on whether to bear risk. That is, governments can try to design fiscal institutions that impose useful disciplines on their decision making. Broadly speaking, good fiscal institutions ensure that decision makers have relevant information and face strong incentives to take account of the public interest.

44. Government-accounting standards are a crucial fiscal institution. Primitive cash-based accounting is part of the problem, because it encourages governments to ignore the costs of decisions that do not require the disbursement of cash in the short term. Accordingly, part of the solution is for governments to adopt modern accrual accounting standards. Such standards generally require the recognition of noncash as well as cash costs and of assets as well as debts. The best of the standards require recognition of at least some guarantees and nonstandard

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liabilities such as long-term purchase commitments. And when they don’t require recognition, they usually required disclosure in footnotes. One possible set of standards is International Public Sector Accounting Standards, which are based on the International Accounting Standards Board’s International Financial Reporting Standards.

45. Budgeting rules are also critical. In part the solutions are similar to those for accounting; budgets should give approval to incur noncash costs, not just to disburse cash. Good budget procedures require governments to consider spending proposals simultaneously and therefore to confront the tradeoffs involved in expenditure. Decisions about exposure to risk should be made in the same context. A dollar of cost incurred by issuing a guarantee should count equally with a dollar spent in cash. Budgeting on the basis of good accounting helps achieve this goal; but even the best accounting standards do not capture the cost of every form of exposure to risk, and most governments are still some way from reporting according even to reasonable modern standards.

46. Thus stopgap measures that force the counting of guarantees may help. Several governments have used special funds both to help manage the cash-flow risks of guarantees and to make up for weak accounting. When a ministry issues a guarantee, the government can require it to make a cash contribution to the fund equal to an estimate of the cost of the guarantee. To make the contribution, the ministry gets a budgetary appropriation that shows up in the accounts and counts against the deficit (so long as the fund is kept off balance sheet, something that may be difficult with good accounting). The fund can also be used to meet, or contribute toward, payments if the guarantee is called. Another option is to institute a purely paper transaction: money going to the ministry issuing the guarantee and then back to the government’s consolidated fund. The government continues to

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manage cash as before, but an estimate of cost of guarantees shows up in the ministry’s budget.

47. Governments can also enlist the help of outsiders. Charging for guarantees effectively makes the guarantee’s beneficiary part of the group deciding whether the guarantee will be issued and may reduce the chance of its being granted when its costs exceed its benefits. Disclosing contracts and policy decisions to the public—either routinely or after requests made according to freedom-of-information laws—gives members of the public the opportunity to comment on and criticize government decision making. Irritating as it may sometimes be for governments, external comments and criticism probably improve the quality of the average decision. These and other ways of improving fiscal institutions are considered in Chapter 8.

48. The next chapter considers in more detail the principles that should govern governments’ decisions about bearing risk in private infrastructure projects.

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