Contingent Guarantees to Mitigate Regulatory Risk

Contingent Guarantees to Mitigate Regulatory Risk

Outline of Proposed Concept:

Few developing-country infrastructure projects have explicit contractual undertakings from the host country government that are capable of serving as the basis for traditional breach-of-contract political risk insurance coverage. What is proposed here is a project-specific guarantee that could, in turn, be guaranteed by a multilateral agency or other appropriate entity. The host government would promise to abide by certain critical features of the regulatory regime that it established at the time new infrastructure investments were made by private investors (domestic or foreign). These critical features would include items such as the manner and timing of tariff adjustments and other features such as performance standards which could fundamentally affect the amount of revenues earned by the project and, thus, its ability to meet its debt service obligations. The guarantee would not have to freeze all aspects of the regulatory regime: certain performance standards could be changed so long as enforcement were by means of fines that are limited in size or subordinated to payment of the project’s debt service.

The amount payable under the guarantee would be large enough to insure that the host government will take its obligations seriously and to raise the local currency rating of a project covered by the guarantee to investment-grade. The guarantee would be contingent in that it could be called only if the government were to change the pre-established regulatory regime. The host government would, therefore, have no liability under the guarantee so long as it continued to enforce the regulatory regime that it had designed and implemented.

Contingent guarantees should continue to be used (1) until the host-country government is viewed as having a sufficient amount at risk that change of the regulatory regime is no longer viewed as a practical possibility or (2) until the government has established a track record of regulatory stability. In the first case, the measure of success will be the ability of new infrastructure projects to obtain investment-grade local currency ratings without the use of a contingent guarantee. In the second case, the ability of projects subject to such guarantees to obtain investment-grade local currency ratings without them could allow the guarantees to fall away and terminate the contingent guarantee program.

Although this type of guarantee could be used in many infrastructure sectors, the following example illustrates its use in the electric power sector. The project covered by the contingent guarantee is assumed to sell power pursuant to power purchase agreements (“PPAs”) which have been reviewed and approved by the host government. The government will make the following commitment:

• In the event of a payment default under a PPA, the government would require the independent system operator or market settlement agency to:
• Give dispatch priority to the project, and
• Establish a minimum market price equal to the price of power in the defaulted PPA, or
• Subject to a cure period (both for the defaulting purchaser and for the government) make a payment to the project equal to 40%-50% of the project’s senior debt amount. The amount of the guarantee (40%-50% of senior debt) is based on the amount of contingent support which each of the three major rating agencies have indicated is necessary to raise to low investment grade the rating of a transaction which in the absence of support would be several notches below investment grade.

Benefits:

This structure will provide substantial benefits to host-country governments, project sponsors, and lenders:

• Host-country governments would benefit because the structure will promote needed investment at lower cost. (To be effective, contingent guarantees would have to be combined with inconvertibility coverage and foreign exchange liquidity facilities to achieve investment-grade foreign currency transaction ratings.)
• To the extent that multilateral agencies do not reduce the host country’s lending limit dollar-for-dollar with the amount of the contingent guarantee, the host country will make a more efficient use of its borrowing capacity.
• The structure addresses one of the major concerns of project sponsors, which are currently reluctant to make new equity investments in countries that they perceive as posing significant regulatory risk.
• The structure also addresses lenders’ major concerns, which include both regulatory risk and the lessening credibility of partial credit and co-financing schemes involving multilateral agencies.
• If used in conjunction with inconvertibility coverage and a foreign exchange liquidity facility, contingent guarantees could provide a structure in which a project’s debt rating is significantly de-linked from the sovereign’s rating. Emerging markets investors (who choose to take sovereign risk) provide little financing for infrastructure projects; but the “buy-and-hold” investors, who finance highly structured infrastructure projects, do not want to take sovereign risk.
• Contingent guarantees represent the least onerous means of addressing regulatory risk: The host government promises to do what it should want to do anyway, and its guarantor takes little real exposure on a guarantee which is substantially less in both amount and risks covered than a direct debt guarantee capable of mobilizing a similar amount of private capital.

Obstacles to Date:

Although there may be one or more transactions in process which involve this type of guarantee, it represents an approach which, in effect, has not yet been tried. One potential obstacle is the fact that multilateral agencies will account for their exposure under the contingent guarantee as equivalent to a full debt guarantee, rather than taking account of the fact that they are exposed to a narrow segment of risk defined by the prospect of the host government’s breaching its commitment to maintain its regulatory regime for the sector in question. It would clearly be better for all concerned if the accounting used for the transaction were similar to that used by monoline insurance companies, but even in the absence of such an approach, contingent guarantees represent a more efficient use of multilateral resources.

Another obstacle is failure to recognize that this is an issue that must be addressed. In the 1990s, numerous capital markets transactions were executed for projects in low investment-grade countries or, in some cases, in below investment-grade countries. These transactions did not utilize structures to deal with regulatory risk (or devaluation), but these transactions could not get done today. Failure to address regulatory risk is equivalent to abandoning the international capital markets in favor of local currency markets or of deciding to wait until each developing country has achieved an investment-grade rating that is high enough to overcome fixed-income investors’ fears about developing country exposure.

Recommended Next Steps for Implementation:

The most obvious step is that either (1) a multilateral must approach a potential host government and propose a program utilizing contingent guarantees or, alternatively, (2) a government must approach a multilateral.

Assuming that agreement is reached on the concept of contingent guarantees, a major step that must be taken by the host government is the design and implementation of a program to determine which projects will be eligible for guarantees. The most important aspect of any such program is the means by which it insures that projects covered by contingent guarantees will provide service to the public at a competitive cost. The key to political acceptance of a guarantee of regulatory stability is the idea that (without expropriating investors), service could not be provided cheaper under a different regime.

Most infrastructure sectors employ basic technology that tends to have a long useful and economic life. For example, appropriate competitive bidding procedures can insure that electric power generation capacity is acquired at a price which, in hindsight, will not appear to have been above market and will not appear high in relation to current costs for obtaining similar capacity. Similarly, fuel passthrough provisions can be benchmarked to appropriate market standards. A properly-designed program can insure that service is provided to the public at the lowest reasonable cost consistent with market pricing – and with avoidance of post-investment regulatory changes which effectively represent an expropriation of private investors.

The final step required is the selection of one (or, at most, a few) demonstration projects. Required returns for privately-financed electric power generation capacity in the US market fell during the 1980s because early projects were successful and, by demonstrating that the risks involved were not unduly high, drove down the risk premium applied to such projects. To reduce the risk premium for infrastructure projects in a given developing country, there must be a track record of success, where “success” is defined as:

• Successful operation of the project and provision of services to the public at competitive costs
• Generation of returns to project sponsors that are broadly consistent with their original expectations, and
• Demonstrated ability of transactions to avoid being downgraded to below investment grade as a result of downgrade of the sovereign (i.e., a significant de-linkage between the transaction’s rating and the sovereign’s rating).

Bob Sheppard

Co-chair, Experts Group on Public / Private Risk Sharing