PROJECT FINANCE SYSTEMS IN TOLL ROAD PROJECTS IN ASIA

Transcription

1 PROJECT FINANCE SYSTEMS IN TOLL ROAD PROJECTS IN ASIA K. A. K. DEVAPRIYA, S. GENZ, and H. W. ALFEN Knowledge Weimar, Bauhaus-Universität Weimar, Marienstr.7A, D-99423, Weimar, Germany. ABSTRACT Project finance (PF) has become a key financial mechanism for mobilization of private capital into road infrastructure projects. The application of PF and related sub-systems, such as BOO/BOT (Built-Operate Own/Built-Operate Transfer) arrangements, for toll roads has demonstrated many dimensions in the recent past. The objective of this research is to examine the role of PF as a financial mechanism to promote BOO/BOT type toll road projects in Asia. While the main focus is on key aspects associated with structuring of PF transactions into toll road projects, attention is also paid to examine how different mechanisms are arranged in response to riskiness of the PF transactions. Following presentation of a framework encompassing aspects of structuring of PF arrangements, case studies on BOO/BOT type PF transactions in toll road projects are conducted. Findings show that the organisation of key aspects, namely the project company (corporate governance), the capital structure, and the contractual structure (transaction governance) are governed by political, regulatory and financial environments. Financial and contractual risk management mechanisms are arranged in the capital structure and transaction governance in response to the risk level of the PF arrangement. Thus, complexity and structure of PF transaction in toll road projects will vary depending on the stability of the external environment. Asia, BOO/BOT arrangements, project finance, risk management, road in- Keywords: frastructure INTRODUCTION The term "Project Finance"(PF) has been used to explain many types of financing of projects. However, according to Nevitt et al (2000) the definition of PF could be summarized as, "A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the sources of funds from which a loan will be repaid and to the assets of the economic unit as collateral (p3). The economic unit in the definition typically refers to a capital investment project incorporated as a single venture company (economic unit) with a set of legally and economically independent assets with a single industrial use [Esty, 2000]. For example, it could refer to oil refineries, mines, highways, pipelines, power plants, and telecommunications systems separately incorporated that rely on cash flows generated by asset use to service debt and

2 910 Devapriya, Genz and Alfen generate equity returns. However, in PF, creditors have recourse only to the project s cash flow and assets since each project is legally independent. Esty (2000) states that due to these reasons PF typically represents a form of off-balance sheet finance, meaning that project liabilities do not appear on the sponsors' balance sheet if certain limitations on shareholdings in subsidiary/ associated companies are observed. It is instead an indication of non-recourse financing of physical assets. In non-recourse finance, the lender has no recourse to the assets of the sponsors beyond those held by them in the PF transaction, in case of default [Nevitt et al., 2000]. PF as an alternative to corporate finance has experienced rapid expansion in infrastructure finance in Asia as well as in Europe in the 1990s. For example, PF as an effective debt instrument has widely been applied to finance Private Infrastructure Projects (PIPs) in developing as well as developed environments. By sectoral distribution, growing PF lending in four consecutive years has been attracted to the infrastructure sectors, while reflecting some decline after 1997 mainly due to the Asian Financial Crisis in 1997 [Esty, 2000, p10]. According to the World Bank (2002), twenty-eight developing countries (DCs) have introduced private activity in toll roads in , awarding 327 projects. Most of these projects are BOO/BOT type arrangements (i.e. concessions and greenfield projects) in Latin America and East Asia. China (US$ 17 billion), the Republic of Korea (US$ 10 billion), and Malaysia (US$ 6 billion) are among the top five countries by investment in toll roads in DCs in [World Bank, 2002]. The BOT model that involves granting of concession to the private sector has gained the widest acceptance in road and other infrastructure sectors. The acronym BOT stands for Build, Operate and Transfer and it functions as a sub set of PF. For the public sector, BOT is an attractive financial mechanism when the private sector offers to build infrastructure at no cost to the government and to some years later return it (within the economic life) back to the public sector [Walker and Smith, 1995]. Table 1 shows variants of BOT model as sub sets of PF. In BOT type projects many contractual arrangements, and with that many expressions, are possible, but often restricted by political/ legal, as well as financial barriers. Table 1: Different BOT model: Project Finance Arrangements in Toll Road Projects BOO Build Operate Own BOT Build Operate Transfer BOOT Build Own Operate Transfer DBFO Design Build Finance Operate BTO Build Transfer Operate BLT Build Lease Transfer (Source: Walker and Smith, 1995) However, the evolution of popular application of PF for PIPs in Asia highlights a number of dimensions. While Lang (1998) reports some of the characteristics of these dimensions in the 1990s, challenges are still associated with structural arrangements in PF in dynamic financial, legal and regulatory environments in Asia. Amidst mix experiences in BOO/BOT type PF transactions, refinancing and restructuring of PF arrangements in toll road projects are gaining grounds in Asia. It is in this background that an investigation is conducted into the application of PF for toll road projects in Asia to understand the underlying factors of sustainability of PF to promote PIPs in emerging economies. While extensive studies have been undertaken on private finance in

3 Project finance system 911 toll roads in Asia [ADB (2000), World Bank (1999) and Walker and Smith (1995), for example], the current research focuses on the role of PF as an effective financing mechanism for toll road finance. Thus, the research question is why a PF transaction is structured into a toll road project in a particular manner in the institutional characteristics given. Accordingly, the paper is structured to present a unique framework encompassing the key aspects of structuring of PF transactions and an analysis of BOT-type PF transactions in toll road projects in Hong Kong and China within the above-mentioned framework. FRAMEWORK FOR STRUCTURING OF PROJECT FINANCE TRANSACTION Motives of selection of PF as an alternative to corporate finance reflect in the sponsors' objectives of expanding borrowing capacity and allocation of risks in investment projects such as infrastructures [Brealey et al. (1996) and Esty (2002)]. Foundation of success of PF depends largely on the stability of cash flow and the security structure. A framework is developed in this section to indicate that PF could work to expand borrowing capacity to accommodate asset-specific investments and manage risk associated with investments through specific corporate and transaction governance arrangements at delivering and operation stages of investment projects such as infrastructures. Project Company (Corporate Governance) A project company as a separate legal entity is established to achieve non-recourse/ limited recourse status for PF transactions [Esty, 2000]. The incorporation of a vehicle company isolating the project s assets in a distinct legal entity is important to the sponsors as it allows them to benefit from off-balance sheet financing. The principle interest of sponsors is generally to structure the project in a manner that it does not make them fully extensively liable. In most cases, this requires formation of an independent project company (A Special Vehicle Company-SPV), a subsidiary, which then raises the funds necessary for financing of the project. Sponsors would establish a vehicle company in a form of a corporation, a general partnership, a limited partnership, a joint venture or a trust depending on legal, tax and accounting consideration in the relevant jurisdiction. The choice of a legal form best suitable to meet a project s requirements largely determines the relations between participants, and issues such as the possibility of fund raising, distribution of profits, accounting and taxation. Whereas, the political/ regulatory environment and other institutional arrangements provide the underlying framework and may as mentioned even restrict the choice [Devapriya and Alfen, 2003]. The incorporation of a multi-shareholder project company allows to making profit from skills of the various parties involved to develop, design, build and operate the project. This is also applied to shareholders such as contractors, operators or off-takers, who give indirect credit support, e.g. in the form of guarantees. The incentive effects of such organisational structure lead to increase value of the project. Risks connected with construction and operation is reduced since the incentive effect of shareholding leads to improved performance and prevents actions that could render the project unprofitable. Thus, corporate governance characteristics of the PF arrangement facilitate building, operating and retaining or transferring the infrastructure facility as a separate investment of sponsor s portfolio.

4 912 Devapriya, Genz and Alfen Contractual Structure (Transaction Governance) The stakeholders in the project company enter into various contracts to form the contractual structure of the project. The contractual structure provides a comprehensive tool for risk allocation and thereby to establish a bankable balance of interests among participants to the project. For this purpose, the particular contracts consist of every right and obligation of the project participants and thus work as a risk management system. The contracts establish relationships to provide inputs and deliver output or service. This is necessitated by the huge sunk investment with highly asset-specific characteristics in investment projects such as infrastructures. The contractual structure functions in principle as a risk management mechanism to manage the lenders' exposure to credit risks in non-recourse/limited recourse financing [Nevitt et al., 2000]. The contractual arrangement is structured to provide the sponsors or lenders with guarantees concerning these factors to stabilize the cash-flow. The main purpose of this risk management system is to find acceptable solutions for managing risks identified by reducing the potential impact during delivering and operation stages of the project. The underlying principle is that the risks should be spread among the parties involved in such a manner that each particular risk is borne by the party most capable of bearing that risk, while the remaining risks are borne by the financing parties. In the BOT type arrangements, this implies that the private sector usually takes on the risks he can manage best, and in areas where potential efficiency gains shall be obtained [Nevitt et al., 2000]. Financial/Capital Structure The sponsors objective of expanding borrowing capacity is achieved by means of various financing instruments. Different financing instruments, primarily long-term finance, and risk management instruments are used to achieve a viable capital structure that resists the risk profile inherent in the PF transaction. The security structure, consisting of contractual bonding, credit support and risk reduction elements functions to manage not only financial risk variables but also risk associated with demand and supply costs of the project [Brealey et al., 1996]. In PF, lenders face a unique risk profile which encompasses risks related to construction, operation, demand and supply besides the classic financial risks. Thus, different debt/equity arrangements are achieved to manage operational and external (legal and regulatory) risks. The debt capacity depends on the extent to which the credit risk can be effectively managed through contractual arrangements and the project s ability to generate a cash-flow sufficient to serve the repayment of debt [Nevitt et al., 2000]. Concerning financial instruments, equity, senior debt and subordinate debt are used to form the capital structure. Equity and subordinate debt assume the risk of cash-flow volatilities and thus provide a buffer for the lenders at simultaneous filling the gap between debt and project costs [Esty, 2002]. The risk reduction elements such as derivative elements, guarantees and incentives function as credit enhancement arrangements [Devapriya and Alfen, 2003]. In particular, derivative elements in PF are used to reduce risks associated with currency, funding costs and price fluctuations of the project s output. In this manner, an appropriate financial structure is derived during delivering, refinancing and restructuring of the project.

5 Project finance system 913 The Regulatory and Policy Framework A credible and stable policy environment that is committed to privately financed infrastructure projects and a well developed legal framework suitable to protect interests of sponsors as well as lenders are pre-requisites for successful PF transactions. Political, legal, financial, administrative and regulatory factors create the external framework in which the transaction is embedded and operated. The structure of PF transaction is derived in relation to the external environment so that project s risk exposure is managed properly. Availability of long-term debt instruments in the capital markets could work to arrange and maintain an effective financial structure of the project. Similarly, specifically-created legal and administrative mechanisms such as BOO/BOT laws could affect derivation and operation of PF arrangements positively [Devapriya and Alfen, 2003]. The above-described aspects of structuring of PF transactions could be summarised into a framework (Fig.1) as follows. Fig.1 Key Dimensions of Structuring of Project Finance Transactions Corporate and Transaction Governances Financial and External Institutional Arrangements (i) Project company (iii) Financial/Capital structure (ii) 1.1 In accordance with legal, tax and accounting considerations the project company is incorporated. 1.2 The aim of non-recourse/ limited recourse is achieved. Contractual structure 2.1 Identification of contractual arrangement. 2.2 Responses to the project s particular risk exposure caused by external and project specific factors. (iv) 3.1 Debt and equity are arranged in relation to the project s risk exposure. 3.2 Responses to the project s risks exposure in order to stabilize the cash flow and reduce lender s credit risk. 3.3 The capital structure may be restructured during the project s life cycle Policy/ regulatory environment 4.1 The regulatory/ policy environment supports the project structure. 4.2 Conditions pertaining to the external environment are reflected in contractual and capital structures. 4.3 Identify measures and institutions dealing with tariff/ toll related aspects. The framework mainly illustrates key aspects of structuring of PF transactions to manage asset-specific investment through appropriate governances including financial structure within legal and regulatory environments given. CASE STUDIES ON STRUCTURING OF PROJECT FINANCE TRANSACTIONS INTO TOLL PROJECTS IN ASIA Within the above framework (Fig.1) this section conducts two case studies, namely Western Harbour Crossing (WHC) in Hong Kong and Guangzhou-Shenzhen-Zhuhai (GSZ) Superhighway in China. According to Yin (1993) a case study is an empirical inquiry that

6 914 Devapriya, Genz and Alfen investigates a contemporary phenomenon within its real-life context, when the boundaries between phenomenon and context are not clearly evident, and in which multiple sources of evidences are used. Accordingly, evidences of BOT type PF transactions in WHC and GSZ Superhighway are collected from case study manuscripts [Lang 1998, for example], sector specific studies [Fishbein and Babbar, 1996, for example]; and country-specific reports from development banks [ADB (2000), World Bank (1999), for example]. While the PF arrangement in WHC has passed many stages including refinancing in 2002, GSZ Superhighway shows many challenging situations including replacement of the guarantor for financial risk in its PF arrangement being one of the top ten toll road projects in DCs in Project Finance Arrangement in Western Harbour Crossing in Hong Kong Figure 2 reveals background information about the WHT project in Hong Kong. The project company of the WHT project was incorporated as a corporation. The SPV, namely Western Harbour Tunnel (WHT) Company Limited, was able to raise debt capital based on its own name, its own assets, and thereby to create a charge over them. Fig.2: Background Information about Western Harbour Crossing The US$966 million Western Harbour Crossing (WHC) is the fourth BOT toll road project, the third harbour crossing in HK, the longest underwater and first dual-3-lane road tunnel in Southeast Asia. Being a fundamental part of the overall road network in Hong Kong the WHC is one of three road links between Hong Kong and Kowloon and a component of the road infrastructure system connecting the new airport with the western parts of Hong Kong. The WHC is a key segment of Route 3 connecting the north-western part of the New Territories between Hong Kong and the Chinese border. Constructed by use of the immersed-tube-technique, the tunnel was opened on 30 April,1997, the year in which Britain handed over the political sovereignty of Hong Kong to China. The sponsors formed a project company to finance, build, operate and transfer the WHC to the Hong Kong government, at no cost, at the end of the 30-year concession period. Until now, the WHC was except for the construction which was completed three month ahead of schedule and within budget not a successful toll road tunnel project. Since its opening in 1997, it has been under-utilized mainly because of toll differences among the three cross-harbour tunnels in HK, as well as the capacity limitation on the approach roads to and from the WHC. The daily throughput of the crossing has improved, although not so far as to cover all costs. (Source: ADB, 2000, Lang, 1998 and World Bank, 1999) Because of this feature, connected with a liability restricted only to the extent of the sponsors particular shares for the project s obligations, the nature of PF was supported very well, and limited recourse financing became possible. The sponsors selected this particular legal form to facilitate a simple BOT-vehicle and to reduce the transaction cost effectively. Simple corporate governance contributed to an effective project structure. It worked effectively as a risk management mechanism concerning the uncertainty connected with the handover of Hong Kong s sovereignty to China. Shareholding position of Chinese stateowned entities pawed way for managing political risks in the formulation of WHT Company Limited.

7 Project finance system 915 The construction risk was successfully hedged using a turnkey contract involving a completion guarantee and adequate incentives to manage risk associated with the application advanced technology in construction and completion of the tunnel. Evidences were reported concerning reduction in construction time and costs. This also applies to the rightsof-way (ROW) acquisition problem. The ROW acquisition was completely assigned to the government in order to eliminate the corresponding pre-construction risk. Among other contractual arrangements, the concession agreement included a toll adjustment mechanism, set up in the project agreement. The HK government s first compromise and standardized toll adjustment mechanisms aimed at managing revenue risk and flexible and independent approvals concerning toll adjustments. It calibrated the project s ability to generate revenues, to not only cover the cost, but to also ensure a reasonable return, and was therefore regarded an effective security system for the project s lenders. The traffic risk was unhedged because of the government s unwillingness to provide corresponding guarantees. This still possesses a danger to the project. As a result WHT Company Ltd had to increase tolls in February, The capital structure, too, consisted of measures to reduce the riskiness of the transaction. The debt to equity ratio amounted to 68:32 to meet the requirements of the Western Harbour Crossing Ordinance. The project company used different financing instruments, to balance debt and equity, to assemble the capital in order to expand the borrowing capacity. In particular, multiple-layer of guarantees and currency and interest rate hedging mechanisms have worked to minimize financial risk in the capital structure. The financial risk was effectively minimized by adequate structuring of the capital structure with longterm debts under Hong Kong Inter Bank Offered Rate (HIBOR). Three factors are important in this context, i.e. the proper structuring of the long-term loan facility connected with a special drawdown mechanism, the hedging of the interest rate of 50% of the outstanding debt for a period of five years of operation, and the borrowing in local currency. However, the project capital structure was refinanced through loan syndications in July, 2002 and only three foreign banks (out of 18 banks) participated in over-subscribed HK $ 3.5 billion facility. Lesser number of foreign banks participated in loan syndication due to risk associated with the PF transaction in the WHC Company Ltd. The political, legal and regulatory environment of the WHT project can be described as stable, transparent with comparatively high certainty for sponsors, investors and lenders. It allowed to set up the project company in a flexible manner, adjusted to the needs of the project, and to structure it without being restricted massively by legal barriers. Project Finance Arrangement in Guangzhou-Shenzhen-Zhuhai Superhighway in China Figure 3 shows background information about GSZ Superhighway project in China. The project company of the GSZ Superhighway project took the legal form of a corporative joint venture (JV) with two sponsors, a PRC utility and a foreign investor, namely Hopewell Holdings. Because of the legal requirements, Hopewell had to provide the necessary debt at the early stage of the project. Fig.3 Background Information about GSZ Superhighway

8 916 Devapriya, Genz and Alfen The US$1,922 million GSZ Superhighway was the first project financing in the PRC. The road was planned to connect Hong Kong and Guangzhou, one of China s largest industrial regions. The project was initiated at a time indicated by booming economical growth in Southern China and relaxation of PRC policy towards foreign investment projects. The GSZ Superhighway should shorten the time for travelling between the two regions from 6 hours, caused by heavily congested roads, to approx. 75 minutes. The project was not immediately successful, at the projects outset it suffered several set-backs related to the late completion, to huge cost-overruns largely due to design changes and additional land acquisition costs, and to traffic levels being far below expectations. However, the present traffic levels are above expectations and continue to increase. (Source: Fishbein and Babbar, 1996, Lang, 1998) This made a web of contracts necessary in order to provide the private sponsor with the necessary guarantees or securities to raise PF loans on a limited recourse basis. The JV arrangement in GSZ Superhighway project was not necessarily chosen by Hopewell in order to establish a separate legal entity to raise PF loans. But, it was a legal requirement for foreign investments in China. The construction contract took the form of a turnkey contract in order to manage the risks related to construction by shifting them to the contractor consortium or their parents. The turnkey contract therefore involved specific features including a completion guarantee, an early completion bonus, performance and retention bonds. This was strengthened by 50% of the completion guarantee provided by Slipform, a subsidiary of Hopewell. Thus, Hopewell s commitment in the project has become a strong incentive for meeting the performance standard to the expectation of lenders. However, time schedule and budget could not be regarded credible since there was a good chance for unforeseen circumstances due to incomplete ROW acquisition at construction start. The capital structure shows a relatively high equity share due to legal and administrative requirements associated with the JV arrangement in China. The initial debt to equity ratio of 40/60 represented comparatively high equity contribution of PRC utility. The security structure embedded in the different contracts supported the different PF structure in GSZ Superhighway project. Guangdong International Trust & Investment Corporation (GITIC) provided a cash-flow deficiency guarantee ensuring repayment at operation stage. The GSZ project was initially funded with a combination of several financing instruments involving equity, shareholder loans, third party US$ debt from a 34-bank-syndicate of foreign commercial banks, and third-party RMB debt (subordinated to bank facility) from Chinese banks. The political/ regulatory environment contained large uncertainties over the project. At project development stage, the legal environment consisted of very few specific instruments to promote PF projects effectively. To lower the political risk, investment insurance was arranged with the People s Insurance Company of China (PICC) by the borrowing party. It worked to manage commercial lenders risks during construction. Finally, and perhaps most important, the cash-flow deficiency guarantee from GITIC was aimed at managing the financial risk at the operation stage. However, during the operation of the project, this cash-flow deficiency guarantee of the repayment of the bank facility was rearranged due to the bankruptcy of GITIC. Since the demand is expected to remain strong in

9 Project finance system 917 the long-term the main operation risk of the GSZ Superhighway is regulatory risk. Toll adjustments require an approval from the Guangdong Province Price Bureau. However, there is no contingency plan to address possible delays in the approval of price increments. This can affect the cash-flow negatively. In fact, the toll setting (adjustment) methodology of the government department remains unclear. A failure in getting permission for periodic toll adjustments can cause a considerable downturn of performance of the PF arrangement in the GSZ Superhighway. SUMMARY AND CONCLUSIONS The BOT type PF arrangements in the WHC Company Ltd and the GSZ Superhighway projects indicate that each key dimension consists of unique characteristics to manage credit risk in the legal, political and administrative environments given in Hong Kong and China. Legal form of the project companies and contractual arrangements facilitate structuring particular financial structures for non-recourse/limited recourse financing in toll road projects. While the WHC Company Ltd functions as a corporation to manage credit risk of a highly leverage capital structure in a matured market, risk in equity based PF transaction in the GSZ Superhighway is addressed through a JV arrangement in developing environment. Contractual bonding and financial instruments, namely guarantees and incentives and hedging instruments in the contractual and capital structures have paved way for managing credit risks effectively in PF arrangements in the WHC Company Ltd and the GSZ Superhighway. Therefore, derivation of appropriate corporate governance, transaction governance, and the capital structure is largely governed by project-specific requirements, as well as the characteristics of the external environment represented by political, legal, and administrative factors. Riskiness of the PF transaction in the particular environment is reflected in the corporate governance, the transaction governance, and the capital structure. Financial and contractual bonding mechanisms are arranged in the capital structure and the transaction governance in response to the risk level of the PF arrangement. Thus, complexity and structure of PF transactions in toll road projects will vary depending on the stability of the external environment. Unlike most PF studies that focused on how a particular PF arrangement worked, this research attempted to examine why a PF transaction was structured in a particular manner to suite the conditions given. Thus, findings of this research indicate how replications of PF transactions in other infrastructure sectors could be achieved effectively based on a country s unique characteristics. The research therefore offers initial insights to understand underlying factors of sustainability of PF in infrastructure development. Acknowledgement: This research paper arises from the EU-Asia Public-Private Partnerships Network (EAP³N) sponsored by the European Commission under Asia-Link Programme, REFERENCES Asian Development Bank ;(2000); Developing best practices for promoting private sector investment in infrastructure-road; ADB, Manila, The Philippines.

10 918 Devapriya, Genz and Alfen Brealey Richard A., Cooper Ian A. and Habib Michel A.; (1996); Using project finance to fund infrastructure projects; Journal of applied corporate finance, Volume 9, Number 3, p Devapriya K.A.K. and Alfen H.W.; (2003); "Role of Institutional Arrangements in Financing Project Companies in Asia; proceedings"; 2nd Workshop on Applied Infrastructure Research; Berlin, 11 October Esty B.C.; (2000); An overview of the project finance market; Harvard Business School Case , Harvard Business School, MA. Esty B.C.; (2002); Returns on project-financed investments: Evolution and managerial implication; Journal of Applied Corporate Finance,15.; No.1. Fishbein G and Babbar S; (1996); Private Financing of Toll Roads; RMC Discussion Paper Series, No.17; Project Finance and Guarantees Group, the World Bank. Lang L.H.P. (1998); Project finance in Asia; Elsevier Science B.V.; London. Nevitt Peter K. and Fabozzi Frank J.; (2000); Project financing - seventh edition; Euromoney Books; London Walker C and Smith, A.J.; (1995); Privatized infrastructure the BOT approach; Thomas Telford; London. World Bank and Ministry of Construction of Japan; (1999); Asian toll road development programme: Review of recent toll road experience in selected countries and preliminary tool kit for toll road development; Draft final report; May; Washington; D.C. World Bank; (2002); Private participation in infrastructure: Trends in developing countries in , The World Bank. Yin R.K.; (1993); Case study research design and methods; Sage Publications; Newbury Park, California.