In a concession, the private-sector party has the responsibility for constructing and financing a new asset, or modernizing and expanding an existing facility. The concessionaire is given the right to operate the facility for a specified period, and the public-sector party regains asset ownership when the contract expires. A typical concession is a long-term contract with duration ranging from 25 to 30 years but it can go up beyond 60 years.
Concession contracts generally involve the construction or extension of the facility. If the concessionaire charges final users, it collects no revenues until the building phase is completed and service provision commences. To the extent that the public-sector party makes no payment to the private-sector party, the construction risk is fully transferred to the private-sector party in order to provide incentives to complete the building phase on time and to reduce costs. However, in some cases, the public sector pays a fixed amount during the construction. Liquidated damages can be imposed to the private-sector party if the construction delays as a consequence of its own actions.
In a concession, the private-sector party typically finances capital expenditure, and thus it bears the financial risk. Typically, the SPV borrows funds in capital markets to finance investments, pledging as collateral the revenue stream that results from charging users during the operation phase (IMF, 2004). The providers of finance look to the cash flow of the project as the source of funds for repayments. In this regard, financial security against the SPV is hardly sought because the SPV has minimal assets, and because the financing is without recourse to the sponsor companies. Indeed, the objective behind large PPP projects is to achieve a financial structure with as little recourse to the sponsors as possible, whilst at the same time providing sufficient credit support so that the lenders are satisfied with the credit risk.
Under certain financing structures, the financial risk may be an important issue for the private-sector party. In particular, exposure to interest and exchange rate risk results from using short-term, foreign-currency denominated debt to finance long-term, domestic currency revenue-generating assets. This exposure may be large in economies with weak currencies and high macroeconomic and financial instability. By transferring financial risk to the private partner, incentives are given to reduce exposure, e.g. discouraging purchases of imported goods produced by concessionaire-related firms, and borrowing in foreign currency (Lobina and Hall, 2003).
During the operation phase, the SPV receives income based on the usage of the facility assuming that the service provided meets a range of key performance indicators. There are normally abatement clauses in the concession contract, which can penalize the SPV for providing the services below the agreed standards. There are also penalty points, which if accumulated to a certain level, can lead to termination of the contract for poor performance.
In the concession, the demand risk is typically transferred to the private-sector party. The concessionaire charges consumers, e.g. toll roads, and so it bears the demand risk and suffers from demand falling short of forecasted levels. The public-sector party may however set a minimum revenues guarantee to reduce the risk borne by the private-sector party (see section 4 on payment mechanisms for further details).
Changes in the legislative and regulatory framework that have effects on operation costs and profits are likely to occur during the concession. When these changes are of a general nature and affect the whole industry, e.g. modifications in tax legislation, the rising costs can be either transfer to the private party or shared with the public-sector party. For instance, indexation provisions may allow the concessionaire to pass on the rising costs to consumers through price increases. On the other hand, when changes in law and regulation have a specific nature and affect only the concession project, it is often the public-sector party who bears the risk of rising costs (HM Treasury, 2007).
Concessions and PPPs have in common that both use the private sector to improve value for money (VFM) and efficiency, and both see risk transfer to the private operator as the essential element to drive VFM. Both a concession and a public-private partnership typically involve a private firm that operates, maintains and finances the asset during the contract period and a government that regains control of the asset at the end of the contract. Concessions and PPPs also typically use a whole-of-life project cycle approach when considering the net benefits of a project. Thus, PPPs and concessions share many features, so that the question remains: what distinguishes a public-private partnership from a concession? The two distinguishing characteristics concern risk and payment. First, although both PPPs and concessions involve the transfer of risk to the private operator, the level of risk transferred - especially demand risk (a type of risk discussed further below) - might in general be higher in the case of a concession. Second, although both PPPs and concessions might receive payment from the government and user charges levied directly on the users of the service, concessions usually depend on user charges for the majority of their income, and many do not receive any payment from the government. In fact, instead of the government paying the private operator for services delivered, in the case of a concession the private operator pays the government for the right to operate the asset. Having made this distinction, it should also be mentioned that much of the literature does not draw a clear line between PPPs and concessions when discussing the problems that give rise to contractual renegotiations or issues regarding affordability or value for money. The omission of a clear distinction is not necessarily a failure to distinguish clearly, but may result from the significant overlap in definition as well as from issues and problems that affect both modes of service delivery.25
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25 OECD, Public Private Partnerships. In pursuit of risk sharing and value for money, 2008