5.2.2  Concession Agreement

A concession agreement is the only agreement that is unique to PPP projects. Other agreements for a PPP project is analogous in form and content to agreements found in other corporate or commercial transactions. A concession agreement underpins the whole structure of a PPP transaction, it defines the relationship between the public sector and the private sector, identifies and allocates vital risks in a project and represents and important part of the security documents for lenders.20 The concession agreement is sometimes called a "project agreement" or "development agreement" or "implementation agreement" (though agreements by these names may actually be EPC agreements).

Concession agreements in this guideline means an agreement between a project company and the relevant government authority whereby the project company undertakes to construct and operate a particular infrastructure or service, in return for the government granting the project company the right to use and receive the economic benefits arising from providing the infrastructure services. Alternatively, the ownership of the infrastructure asset may be transferred to the government on completion of the construction project, and the project company then leases this infrastructure asset from the government. In many cases, the right to the infrastructure asset will be transferred to the government at the end of a certain specified term, usually referred to as the concession period.

(a)  Nature

A preliminary question in relation to a concession arrangement is the nature of a "concession". This will depend on the laws of the jurisdiction in which the project takes place. Many countries, generally civil law based countries including France and several Latin American countries, have a separate category of laws dealing specifically with the concession.21 Where this is the case, it is important to look at these laws and see the extent to which they affect the discussion of the issues in this guideline.

In particular, in jurisdictions where a concession is seen as a "grant" dealt with under the administrative laws function, the concession may be revocable at the will of the government exercising its administrative capacity. The private sector, including the lenders, would obviously be concerned if this were the consequence of having a concession classified as an administrative act. The sponsors and the lenders want to ensure that the terms of any concession agreement cannot be unilaterally changed by the government.

This guideline assumes that the general contract law rather than administrative law govern the concession arrangement. That is, the government has entered into a concession agreement in its commercial capacity, and contractual rights and obligations under the concession agreement apply to the government no differently than to other contracting persons. If this assumption is not accurate, then the parties will need to consider the extent to which this changes the commercial rights of the project company. The project company, its sponsors and its lenders, may have concerns about irrevocability, certainty and enforceability of their rights that need to be addressed. An enabling legislation may need to be enacted to overcome these concerns.22

In any case, the concession agreement cannot be considered in isolation from the regulatory and legislative environment in which the project takes place.

(b)  Key Issues

This sub-section outlines some of the most important issues in negotiating a concession agreement. Although these issues are discussed separately, it is important to bear in mind that they are closely interrelated. For example, the length of the concession period is usually determined by deciding on the fair period of time for the project company to recover its construction costs (including borrowing costs) and make a return commensurate to its risks and undertakings. This will in turn depend on the tariffs the project company is entitled to charge and the extent of the risks such as revenue risks. Another example, if the project company is entitled set tariff, then it is unlikely to be as concerned about the risk of increased input costs, because it can pass on these costs to the consumers.

The issues discussed below are aspects often provided for in a concession agreement. The underlying concern of all of these issues is risk allocation, which is separately discussed in sub-section (c) below.

•  Concession period. The concession period means the length of time the private sector is able to operate the infrastructure facility. Although the concession period is often specified in terms of time, a more unusual alternative is to calculate the concession period on the basis of a fixed return on investment of the project company (that is, for the period of time necessary for the private sector to achieve a specified financial return). On expiry of the concession, it is usually appropriate to terminate rights and obligations rather than terminate the concession agreement entirely. For example, after the infrastructure is transferred to the government, the project company may still be liable for warranties in relation to the design and construction of the infrastructure. The appropriate length of a concession period would depend on a number of factors:

o  The cost of constructing the facility. If the cost of constructing the facility is large, then a long concession period is needed in order for the private sector to repay its loans and make the return on its investments.

o  The cost of the process for selecting the private sector. If the process of selecting a private selector (usually a tendering process) is lengthy and expensive, it may not be efficient to put the concession up for tender regularly.

o  The benefits of competition. Usually (though not always) a concession confers an exclusive right to operate in a certain market. The extent to which the private sector's monopolistic power is curtailed by regulations may also be limited, because heavy regulations would limit the extent of private sector's interest in the project. A shorter concession term (assuming this allows for recovery of costs for the private company) in this case would provide for greater competitiveness because the government can put the infrastructure facility for auction to other interested private operators in the market. This is sometimes called competition to a market, as opposed to competition in a market.

•  Construction of the facility. The most important obligation of the project company under the concession agreement is likely to be the construction of the infrastructure asset. The common practice is to confer on the private sector the obligation to design and construct the infrastructure asset (subject to government's obligations as discussed below). The requirements, specifications of for the infrastructure need to be carefully defined in the concession agreement. The task of designing and constructing the infrastructure asset is usually subcontracted to a contractor on a fixed price, fixed time and turnkey basis under an EPC agreement. The issues relating to the design and construction of the infrastructure asset dealt with in the concession agreement are as follows: 

o  Time and price. The price of design and construction is usually not specified, because the project company relies on future revenue flow from the operation of the facility to recover its construction costs. The time for which the facility construction needs to be completed is usually specified in the agreement. If the project company fails to complete the design and construction of the facility within a specified time, the project company is usually required to pay liquidated damages. If the project company completes the construction of the facility within a specified time, there are sometimes provisions for the government to award bonus payments.

o  Government input. The concession agreement will provide for submission of designs and information to the government. There should be an opportunity for the government to review the design and supervise the construction of the infrastructure facility. There should, however, be no express obligation for the government to approve or provide input, because this may lead to contributory fault by the government if something is wrong in the design or construction of the infrastructure. For example, the private sector may argue that the government has approved the design of the faulty infrastructure asset.

o  Completion. One of the key milestone in the project is the completion of the construction of the infrastructure facility. Mechanisms for the government to test whether completion of the infrastructure facility has occurred needs to be built into the agreement.

o  Consequences of late completion. There needs to be target dates for completion of the infrastructure asset. For some projects, other milestones may also be appropriate. The consequences of not completing by those target dates should be dealt with. In general, what the consequences are would depend on whether the failure to complete is caused by the government, the project company (or its sponsors), or something that is the risk or control of either the government or the project company.

o  Consequences of early completion. The parties may consider a bonus payable to the project company for early completion, and consequently early commencement availability of the infrastructure asset. The reward for early completion, however, may already be inbuilt if the period for termination of the concession period is a fixed date. That is, the project company would benefit from a longer period where the infrastructure asset is operational and generating revenues.

•  Standards. The concession agreement will need to provide minimum standards that the project company ought to comply with, what mechanisms are in place to monitor compliance of these standards and the consequences if the project company fail to comply with the standards. The concession agreement will need to specify the standards, the government's monitoring rights and the failure to comply with these standards for each of these stages:

o  during the construction phase, technical specifications for design and construction of the facility;

o  on completion of the facility, standard for the operation and maintenance of the facility; and

o  on transfer of the facility to the government, the condition of that facility, including any warranties in relation to the condition of the facility.

•  Tariff. Tariff structure is one of the most important issues in a project. It determines the revenue of the project company (and therefore the stream of income against which the financing can be secured), but it is also a risk allocation tool. Note that there is a trade off between how tariff is determined and the willingness of the project company to accept risks. For example, if the project company were able to determine tariff, it would be less concerned about increases in operating costs because it would be able to pass this to the consumer. There are a number of specific issues to be decided in relation to tariffs.

•  Regulation. Should tariff be regulated, and if so how? Tariff for infrastructure services may be determined by the market or controlled, either through legislation, an independent regulatory authority or by contract. Often it is a mixture of all of these mechanisms, because there needs to be an appropriate balance between, on the one hand, the freedom of the project company to determine appropriate tariff, and on the other hand, the interest of the community against unjustified increases in the cost of infrastructure services.

o  Amount. Usually tariffs are calculated on the basis of a formula rather than a fixed price.

o  Tariff structure. Tariff may be charged on the basis of quantity used, on a one time fixed fees basis or a combination of these.

o  Access and discrimination. Will differential rates apply to certain groups in the community, for instance, poorer households or frequent users?

o  Integration. This refers to the integration of fees with other services. For example in transport, local bus fares that may be integrated with train fares.

o  Administration. The cost of metering and measurement of use and the cost (and probability) of collecting the tariffs.

•  Role of the government. The government should not assume that a PPP means that all the risks and responsibilities of operating the project transfers to the project company. The government may offer the project company incentives to invest, construct and operate infrastructure services. Some of the typical incentives are:

o  Tax incentives. This may include exemption from corporate tax for a period ("tax holidays"), exemption or concession from other indirect taxes, exemptions from import duties on equipment, raw materials and components of construction, operation and maintenance of the project.

o  Contribution of land and assets. The government commonly provides the land on which the project is conducted. Usually, the right to the land including all easements over adjoining property and facilities such as roads, water suppliers and energy transmissions as needed to conduct the project is conferred until the end of the concession period. Occasionally, such rights is conferred until the end of the construction phase, following which the infrastructure assets are transferred to the government and the project company then leases the infrastructure assets from the government until the end of the concession period. Some concession agreements provide for the project company to reimburse the government for the land over the life of the project.25

o  Network and logistical support. The infrastructure facility under the concession agreement may be part of a larger network, for example, roads, telecommunications and electricity. The government may need to construct, or arrange for the construction of, associated infrastructure facilities and the logistics involved with connecting the infrastructure facilities together.

o  Supply of labour and materials. The government may be responsible for ensuring the availability of labour in the local workforce. The government may ensure that building materials and inputs needed for the construction and operation of the project facilities are available. This is particularly important if monopoly suppliers (usually state owned enterprises) dominate the supply of the building materials and inputs. The project company may request that the government guarantees the availability of sufficient supply at a reasonable price.26

o  Remittance of income from the project. Foreign currency restrictions may prevent the conversion of local currencies into a foreign currency, or the remittance of income from the project abroad. Where this is the case, and the project sponsors and lenders are overseas entities, then the private sector may require that the government provide assurances that the project company can convert and remit currency out of the country without undue restrictions.

o  Guarantees and stand-by financing. While the government sometimes provide guarantees and stand-by financing for infrastructure projects, any requests for these guarantees should be carefully considered. The sponsors and/or the contractors, and not the government, should provide guarantees of events that are their responsibilities, for example, completion guarantee. A common form of guarantee is an off-take agreement in which the government is a purchaser, if there is a specified minimum purchase, then this in effect is a guarantee of minimum revenue to the project company (usually subject to the project company having the capacity to provide a minimum level of the infrastructure services).

o  Non-competition. The project company may require an assurance from the government that competing infrastructure facilities will not be constructed. While a certain degree of assurance is reasonable given the private company's investment in the project, the government should be careful not to create monopolies at the cost of consumers. A compromise might be to ensure no competing infrastructure facilities unless certain revenue targets are met. This would not impede unduly on the development of a country's infrastructure assets.

•  Change orders. The government normally wishes to reserve the right to issue a variation or change of orders, to modify the specification, design and/or scope of the project at its discretion. Change orders usually (but not always) relate to the construction rather than the operation of the infrastructure asset. To exercise this right, the government is likely to be required to compensate the project company for additional costs.

•  Termination. The concession agreement needs to provide for termination provisions. Termination provisions need to specify:

o  when either the project company or the government can exercise the right to terminate the concession agreement, usually this is on insolvency or liquidation events of the other party, and for material breach (the scope of which should be carefully considered);

o  the mechanisms needed to exercise the termination right, there is usually a requirement to provide a notice of termination, except for termination on insolvency or cases where breaches of the agreements are not capable of being remedied, this may give lenders time and opportunities to exercise any step-in rights;

o  the compensation payments on termination, usually the government needs to compensate the project company for the investments already made in infrastructure facility;

o  other rights and obligations of the parties following termination, for example surviving confidentially obligations;

o  the termination provisions need to be reconciled with the lenders' step-in rights, the lenders would want to forestall a possible termination of the concession agreement to keep the project alive until the lenders have been paid out.27

•  Force majeure. Related to the issue of termination is the issue of force majeure. Laws relating to force majeure are different in different jurisdictions, but in general force majeure relates to the ability of a party to excuse itself from performance of the party's contractual obligations where performance has become difficult or impossible due to abnormal or unforeseeable circumstances events that are not the fault of either party, and which the party pleading force majeure could not avoid despite the exercise of due care. The usual list of events that constitute force majeure includes acts of god, war including civil war, revolution, riot, civil disturbance, cyclone, flood, earthquake, volcanic eruption, tidal wave and nuclear accident. The way the force majeure clause is drafted should carefully be considered in the context of the country and the project involved. Force majeure are sometimes called "risk events" or "compensation events" in concession agreements.

•  Stabilisation. The long-term nature of most concession agreements means there is a risk that events would occur that significantly change the nature of the agreement, or the assumptions that underlie either the government or the project company's risks, rights and obligations under the agreement. For this reason, the concession agreements often contain "stablisation" provisions to deal with what happens if "exceptional events" occur. The exceptional events may be changes in law, modifications to licenses or permits, economic disruption or loss of basic investment protection rights (however they are defined).

•  Dispute resolution. The parties need to ensure that a court or an arbitral body in whom the parties have confidence can resolve any conflict or disputes in relation to the agreement. In addition, the parties need to ensure that the final determination of the court or arbitral body concerned is enforceable against the other party. The parties would want to be able to enforce any decision in the jurisdiction (or jurisdictions) in which the assets of the other party are located. Most countries have laws that prevent or limit the enforcement of judgments of a foreign court in its jurisdiction (that is, without review by a court in the jurisdiction). Many countries, however, are signatories to an international convention on the enforcement of arbitral awards, which means that (in theory at least) the parties would be able to enforce the arbitral awards in that jurisdiction. Other advantages of arbitration are that they can be private, the parties can select their own arbitrators and the process can be more flexible than the court process. The downside to arbitration is that it is often more expensive than the court process, the process can be cumbersome and administrative, and there can be delays in arbitral hearings. 

•  Choice of law. The choice of law is usually, but not always, the venue of dispute resolution. For example, arbitration process in Singapore can have agreements governed under the laws of the United Kingdom. Though quite unusual, it is also possible for the parties to submit to the exclusive jurisdiction of a specified court and choose the law from another jurisdiction. This means that the courts of one jurisdiction will be forced to decide on a case based on the law of another jurisdiction.

(c)  Risk allocation

Risk allocation underlies all aspects of the concession agreement. As discussed, project financing depends on precise and highly structured assumptions and allocation of risks for a project. The key issues discussed in sub-section (b) above are, in effect, ways to "manage" or "allocate" risks between the parties. Some of the most common commercial risks of a project are described below.

•  Construction and completion risks. Examples are cost overruns and delays in performance. As a general rule, the responsibility and risk of designing the infrastructure are with the private sector. The project company in turns transfers the responsibility and risk to the contractor under an EPC agreement containing back-to-back obligations, usually for a fixed price. As between the government and the project company under the concession agreement, however, it is clear that most (if not all) risks of construction lie with the project company. The project company may be reluctant to assume specific responsibilities or risks, in particular for risks that relate to political or country risks. The project company may also not accept risks where it has had inadequate opportunity to conduct proper due diligence, for example, where a project relates to construction of an infrastructure asset on a land provided by the government, if the land contains adverse sub-soil conditions, the project company may not accept the risks relating to adverse conditions of the sub-soil that cannot be foreseen. Whether or not the government should accept these specific construction risks should be carefully considered. The project company with the responsibility for construction may be the most appropriate and best qualified person to assume this risk.

•  Operating risks. Examples are volatility of input costs (for example reserves, fuel, labour costs) and technology changes. Concessions for infrastructure projects are typically long term contracts, and operating costs over the life of the concession term are difficult to estimate. Depending on the project and the government's objectives, there are two ways of dealing with this issue. First, the government could allow the project company to pass the increased input costs on to the consumers of the infrastructure services. Second, the project company could mitigate the input risks by entering into long-term supply agreements with reliable suppliers (although this means the project would not benefit from downward pressures in costs). Such long-term supply agreement is often with a government owned enterprise (for example for the supply of gas). This issue has a significant impact on the risk, and subsequently, cost of the project. 

•  Demand and price risks. Examples are product market, project cost structure, sensitivity of demand to (for example) commodity price. The returns on an infrastructure asset will depend on certain assumptions made about the revenue from the infrastructure services. Some projects such as toll roads and electricity are highly dependent on the revenue paid by the public. Usually the private sector would bear this risk, but would insist on some measures form the government to mitigate the risks. For example, the government may undertake not to build roads that directly compete with the project company for the life of the concession. Alternatively, the government may effectively "guarantee" the revenue of the project by agreeing to purchase a minimum quantity of the services (in a "take or pay" arrangement) or to pay for a difference in the shortfall of revenue. 

•  Technology risks. There are two main types of risks associated with technology. First, latent defects in the technology used in the project would affect the outcome of the project. Second, developments in technology may make the technology used in the project obsolete, or the provision of services with the old technology inefficient or uncompetitive.

•  Change of law risks. The project may be adversely affected by the changes affecting the laws of a country. It is usually stated that since changes of laws are within the control of the government, the government should accept bear the risk of adverse circumstances arising from the project. How this would translate in the legal document, however, require careful consideration. In general, the project company ought to bear the risk of changes of law if these changes affect the project company's competitors equally. For example, if there is a change in tax legislation. A position advocated by the UK Government's taskforce28 is that the government should compensate the project company only for losses arising from discriminatory changes of law. 

•  Environmental risks. Environmental risks may be pre-existing conditions or arise during the construction or operation of the project. The issues to consider are compliance with applicable environmental regulations, responsibility for compliance (and failure to comply), the cost of clean-up on abandonment. The usual position is to make the government liable for pre-existing conditions of the land where the government has the obligation to provide the land to the project company, often achieved through including warranties and indemnities. Following the transfer of possession or ownership to the project company, however, the project company should be obliged to conduct the project in such a way as to comply with applicable environmental regulations. 

•  Casualty risks. This would be particularly relevant if the construction of the project is dangerous. Is the casualty risk insurable? 

•  Ownership and Borrower risks. On the one hand, the sponsors would be concerned that they have a valid interest in the project. On the other hand, the sponsors would want assurance that the project is "bankruptcy remote." This means that if the project company has insufficient funds to pay its creditors, the assets of the sponsors would not be at risk (except in limited circumstances where a guarantee was provided by the sponsors). 

•  Property and contingent liabilities. This refers to protection of property ownership, risk of expropriation by the government or a public authority and compensation in case of expropriation. 

•  Country and political risk. The project is affected by the civil and political stability of a country. Examples are the risk of strikes and civil strife. 

•  Counterparty credit risk. To minimise this risk the government needs to ensure that it is dealing with reputable, credit-worthy organisations. If the counterparty is a newly incorporated special purpose vehicle (which it often is), undertakings or guarantees from reputable and credit-worthy organisations may be appropriate. 

•  Exchange rate risks. It is likely that the revenues earned in providing infrastructure services is in the local currency. Most overseas sponsors report their earnings in a different currency, consequently the earnings of the project company may not reflect the project's performance but the exchange rate fluctuations. Moreover, principal and interest for finance obtained is sometimes in a different currency and a depreciation in the value of the local currency may make it difficult to repay the loan and may lead to default on the loan repayment obligations. Exchange risks may be managed or "hedged" by purchasing forward contracts.

•  Interest rate risks. Most international lenders provide finance on the basis of the cost of risk free interest (usually LIBOR rate) plus a mark-up (where this mark up reflects the lender's perception of the market risks). Consequently, the project company is often left to bear the risk of a general rise in interest rates. The government needs to consider whether this rise in interest rate could indirectly be passed on to the customers (for example as an adjustment to tariffs resulting from increase in debt servicing expenses).

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20  Ibid 1.

21  Ibid 2.

22  See for further information United Nations Commission on International Trade Law (UNCITRAL), Model Legislative Provisions on Privately Financed Infrastructure Projects, 2004.

23  UNIDO, above, 167-9

24  Ibid, 169-71, it also contains further details of how each of these charges is calculated.

25  Ibid 61

26  Ibid.

27  Christopher Clement-Davies, above, 7.

28  OGC Guidelines