“And I did it my way…” Frank Sinatra
FACED WITH AN alarmingly crumbling infrastructure, Russian authorities are pushing forward with a $ 1 trillion construction programme to upgrade existing Soviet-era assets and create new ones.
This became intrinsically easier to do as a result of the responsibilities assumed in connection with such high-profile events as the Sochi Winter Olympic Games, the Kazan Olympiad, the Soccer World Cup as well as the World Hockey Cup recently brought onto the agenda. Having taken on the obligation to renovate existing airport networks, roads, railways and other infrastructure assets, the Russian government will need to look into the potential for new forms of financing, including public-private partnerships (PPPs).
It is remarkable that a majority of the PPPs already announced in Russia imply significant state control with corresponding assumption of risks and therefore strong state obligations in favour of investors.
This is particularly true for the projects being launched through a concession mechanism (BTO under the provisions of the Russian Concession Law) where the property created and/or modernized belongs to the state.
As per the figure below, Russian PPPs do tend to lean towards state ownership. This is also due to the fact that a majority of the projects being implemented are realised under regional PPP laws (around 33 regions have adopted their own PPP law in Russia) which differ in some respects from Federal Concession Law, particularly with respect to property. Despite the fact that property under a regional PPP may belong to the private partner (there are different contractual structures possible including DBFO, BOO and BOT) some restrictions apply that prevent senior lenders from implementing proper security packages on a true non-recourse basis.
These include, notably, the question of the pledge of assets and land plots which is rather difficult especially in the water/waste/heat sectors. This results from the fact that these sectors may have strategic meaning for the state and may be protected from any type of encumbrances by different legislative acts.
In addition to the tendency of the state to control as much as it can, the disparity described above leads to uneven risk distribution and, as a consequence, to additional direct and indirect state guarantees required by lenders on the whole project cycle – from construction to operation.
Sometimes, it may therefore appear that there is not much of a difference in the risk allocation for a given project whether it is implemented as a PPP or through good old state procurement methods.
It should be noted that at the time the Russian Federal Concession Law was adopted in 2005 it was usual practice for most experts in Russia to look at projects through the prism of only one criterion: the price (for the total capital expenditures proposed by bidder) as is inherent in state procurement culture. Today we see an evolution with emphasis now placed on the qualitative tender requirements (technical and legal) together with financial robustness criteria.
Uneven risk distribution between the state and private partners has its logic. Among other reasons for this situation, there is the overriding characteristic of the Russian economy, i.e. monopolism. Another reason for having redundant state control is the impact of Russia’s existing obligations toward third parties e.g. in relation to high-level sports events in the near future.
The perception of PPP as the replacement for regular procurement is a peculiarity of the prevailing approach to launching investment projects in Russia today, especially at municipal level.
As budgets suffer from a lack of resources in the face of vast investment programmes, the proposal to move to a PPP approach becomes irresistible.
Hence, substituting state procurement with PPP implies the adoption of unusual commercial structures on the projects that used to be financed through other techniques. It should be stressed that, precisely for this reason, the most popular structure for doing PPPs in the Russian regions is the availability model. This allows the state to create deferred payment mechanisms which are attractive as local budgets lack the necessary resources today.
An obstacle to the implementation of availability structures, however, is that the economy of the region where the infrastructure project is implemented may not show sufficient growth to ensure the necessary payback on the investment. Furthermore, the rating of the majority of the regions is not sufficient for senior lenders (commercial banks as well as international financial institutions) to accept recourse to municipality when the risk associated with such recourse is not fully covered contractually by sponsors, EPC-contractors and operators.
One possible way to deal with this problem is to obtain additional guarantees from the federal Ministry of Finance. This has been used in many cases e.g. for toll road projects to cover bond issues (M1, M10, Western-High-Speed-Diameter). Another way is to involve Vnesheconombank (VEB, Development Bank of Russia) in different roles – as the senior lender (debt and pension funds provider) as well as the sub-sovereign institute which provides special guarantees for refinancing (if the average tenor provided today in the market is not enough to cover the project maturity) and insurance mechanisms.
It should be noted that when comparing the funding mechanisms the state usually uses to finance the budget deficit (municipal bonds, federal subsidies and loans, etc.), state procurement or deferred payment PPP solutions turn out to be wholly inefficient for the state turn out to be wholly inefficient for the state not only from the risk allocation point of view (since the state still covers the risks which it cannot efficiently manage) but also from that of the average-weighted-cost-of-capital.
The Russian PPP experience in toll road projects as well as in the housing and communal services sector shows that project WACC usually exceeds 18 percent in RUR-denominated cash flows. As senior lenders end up requiring the state to cover specific risks with government compensation for any default event in both the construction and operation stages, the risk-reward profile looks more attractive for private partners. Even taking into account the RUR inflation rates, it is still attractive. For example, with a classic 20/80 leveraged transaction with long-term and cheap RUR financing, sponsors’ (equity) IRR can easily reach 25 to 30 percent or even higher.
In order to make PPP an efficient approach for the Russian state, it is crucial to develop a stable legal environment confirmed by a positive track record which means, of course, defining stable and clear rules of the game to attract investments. Having that in place, the disparity described above would disappear, allowing the private partner to control more risks (hopefully more efficiently than the state) resulting in the ability to satisfy the bankability requirements of the lenders.
NO IMMEDIATE TRANSITION
The urgent need to build new roads, ports, airports etc. within the next five to seven years does not allow the immediate transition to properly elaborated techniques, however. As deadlines for completion are very strict (and taking into consideration the astronomical amounts to be spent in the near future) the distortion will simply have to stay in place for now.
However, this creates a unique opportunity for private partners with relevant experience to get involved in Russian PPPs with favourable sub-sovereign and sovereign guarantee profiles as well as with attractive risk-reward positions.
We expect PPP projects in Russia to be more marketable in future with significant weakening of state control and gradual repudiation of extensive direct and indirect guarantees as a consequence. At the same time, risk-reward positions for private partners will evolve towards the more modest returns that are common in other parts of the world for PPPs.
Pavel A. Brusser, PhD is an executive director and head of infrastructure, project & structured finance at Gazprombank email@example.com.