Credit guarantee financing (CGF) was introduced in the United Kingdom in 2003 to provide a mechanism for using public debt capital to finance PPP projects. The arrangement requires the participation of credit enhancement agencies to raise the credit rating of the project to AAA status with the state assuming a senior debt role in the project. The nucleus of the transaction is the guarantee furnished by the consortium's bankers or a credit enhancement agency (monoline insurer) to the state as security for the loan. The objective of CGF is to reduce the consortium's cost of capital and thereby improve the long-run and overall value for money outcomes for the state. This arrangement is a departure from traditional project finance principles whereby senior debt is secured only by recourse to the underlying project assets. CGF is, in fact, full recourse debt and this does affect the traditional incentive mechanisms that are a feature of conventional project financings.
The CGF model was trialled with two PPP projects in the health sector in 2004 (Leeds) and 2005 (Portsmouth). In the Leeds project, the consortium's financiers provided the credit guarantee and for the Portsmouth project, the guarantee was furnished by a monoline insurer. An assessment of both projects identified lifecycle interest cost savings to be in the range 8-16% of aggregate finance costs.
The CGF model can lower the cost of capital and improve value for money. It also creates practical problems. These include:
1. The spread in funding costs at the AAA credit rated level between Commonwealth and United Kingdom governments, Australian state governments and private firms. The effective saving in interest cost may reduce interest costs by 50 basis points in average market conditions although the implicit risk transfer back to central government is of similar dimension.
2. Application of CGF requires Treasury to assume the role of an arm's length lending bank which involves loan administration, legal and advisory fees, oversight and industry-specific technical knowledge and the transaction and/or agency costs involved.
3. CGF introduces another layer of contractual complexity into the PPP transaction which contributes to additional transactional and decision-making friction and incurs time and cost delays.
4. Volatile capital market conditions have reduced the number of monoline insurers issuing credit guarantees in Britain and Australia which transfers this role to consortium bankers. This is not the core business of banks and not the optimal method for them to leverage their balance sheets to maximise interest spreads, underwriting and transaction fees.
5. PPP consortia are generally a collection of entities with different incentives and timing objectives. Therefore flexibility is of high importance and it is common for them to lock in on medium term debt with a view to potential refinancing windows where risk has diminished and asset value improved. The CGF model with its long term debt obligations inhibits this flexibility, which may reduce competitive tension in the bid process.
6. PPPs are an incomplete contract -commercial and financial settings change, risk profiles are dynamic, opportunity may arise for revaluations and re-financings and real and embedded options may change the marginal return on investment or underlying financial economics. Long-term debt arrangements may inhibit sponsor flexibility.
7. Economies of scale suggest that for the CGT program to derive large scale benefits for the state, it would need to be applied to a large number of industry-specific projects.9
The CGF model has not been applied beyond the Leeds and Portsmouth hospital PFI contracts. Guidelines have been put in place together with standard form documentation (HM Treasury 2003). There is no commitment to proceed further with CGF although it remains an option for the future.
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9 A further criticism of the CGF model is that it doesn't offer the incentive mechanism available with conventional PPPs whereby senior debt providers possess a right of subrogation in the event of default and are incentivised to negotiate a commercial and operational rescue of the project whilst maintaining service delivery. Under CGF, the incentives are less clear.