Costs of Distress Situations

A valuation that is comprehensive of the economic costs of distress situations in the PPI contracts included in the PPI Database is extremely difficult and beyond the scope of this work. However, some tentative estimates can be presented that provide an idea of the orders of magnitude involved.

Three separate sources of costs can be identified: direct costs of cancelled or distressed projects, and indirect costs caused by contagion to other PPP projects. In turn, these arise via two different mechanisms: the perception of PPP risks by investors and the weakening of the institutions in charge of designing and implementing the PPP and the regulatory agencies in charge of oversight and regulation at the projects' construction and operation stages.

It must be stated that due to the nature of PPPs in the infrastructure sectors, the public sector is, in most cases, ultimately responsible for the service provision. Therefore, the possible cases of distress necessarily generate costs to the public sector which exceed the economic and financial costs borne by the private sector, even when the latter had undertaken certain risks in the transaction.

Part of the government costs relate to explicit and implicit guarantees. Explicit guarantees are known and defined at the design stages of the PPP contract. As Cohen and Perocco point out "Implicit ones are based on the perception that government will not or cannot back out certain obligation if a major disaster happens such as an earthquake, but also financial crises involving failures or bankruptcy of banks and major corporations…".

A first direct measure of the costs of projects in distress is the value of the investments committed in cancelled or distressed projects in the sample. According to the information available in the PPI Database, these projects total 85 billion dollars (see Table 24).

Indirect costs are the result of contagion effects on other companies. In competitive markets, the announcement that a company is filing for bankruptcy creates information telling that the market is performing worse than expected. This causes investors to adjust their estimates and, because the results of companies in the same sector are correlated, the information reveals that the industry is performing below the estimated levels.

Even though via different channels, similar behaviors can be expected in infrastructure services markets. Both sector-specific works discussed in the preceding section provide evidence of this fact.

For the water and sewerage sector, the IADB report notes that "regulatory agencies have weakened across the board, particularly in cases where serious conflicts were involved. The perception of governments and users is that such agencies failed to fulfill the role entrusted to them, despite the fact that, in many cases, they were not provided with the resources and technical and political autonomy required to carry out their task. Reactions have been particularly significant in Bolivia and in various Argentine provinces. Only in the case of Chile can it be said that the interaction between the regulator and powerful international operators actually allowed the agency to become stronger, as the five-year tariff settings and the development plan compliance requirements were successfully managed."

Without question, such institutional deterioration carries costs as far as reputation goes, as it would create in investors a perception of material risks associated with investments in that sector. Such risk affects the cost of capital and, consequently, the financing costs of all projects in the sector (country-wide and, possibly, region-wide). In fact, this situation may lead to a vicious circle of self-fulfilling prophecy: the increase in the perception of the risk by investors enhances the cost of capital which thus leads to an increase in the firms' costs (and tariffs) which may result in an increase of non-payments and therefore cause a greater economic and financial weakening of the firms

For the electricity sector, the World Bank report states that "Some of the important messages conveyed by the industry representatives included: - While it is important to develop more robust market models for the future, investors' confidence can best be built by addressing existing assets under stress". Put differently, the industry representatives interviewed in the context of this project view the lack of a solution for projects under stress as having a significant adverse impact on the investors' perception of risk.

Even though the costs of the contagion effect have not been quantified, the magnitude of the investment figures involved causes them to be inevitably relevant. We may carry out a "back of the envelope" estimation of distress indirect costs in PPP by considering the default frequency and the spread over the free-of-risk rate per S&P risk rating.

Standard and Poor's 2005 presents an estimation of the default frequency in the worst case scenario used to determine the risk involved in a transaction. It tracks the following methodology: "The default study identifies the highest historical default rates across various sectors by rating category over a period of years. The leading global economies, the U.S. and Europe, have not, over the past 15 years, represented a worst-case depression-like scenario, and so the default rates are grossed up to what Standard & Poor's believes to be worst-case levels. Through simulations of such scenarios across various sectors, Standard & Poor's calculates worst-case default frequency for long-term risks across rating category". The estimated values are detailed in the second column of Table 25.

Table 25: Default Frequency and Spreads

Source: S&P 2005 and Damodaran 2006

The third column shows the premium over the free-of-risk rate -expressed in basis points-estimated by Damodaran for each rating category.

By inverting the S&P value determination logic and comparing the default frequencies with the effect of distress in the PPI database, we may simulate the indirect cost -increase in cost of capital for all other projects- of distress situations in PPP. At an aggregated level, the impact of distress reaches 6.6%, which means that the global rating would be slightly over the relevant value of an AA rating8. The effect of distress on the water sector reaches 10.1% which places it between the A and BBB rating categories leading to a spread increase over the free-of-risk rate changing from 50bp to 115bp. By considering an intermediate value, it may be assumed that an intermediate value of about 80bp corresponds to a 10.1 default effect.

Considering a free-of-risk discount rate of 4%, the 80bp will represent an increase in the cost of capital of 20% associated to the probability of distress in the sector. That is to say, 90% of the projects not affected by distress have a 20% increase in their costs of capital basic rate. By considering the investment values (Table 24), distress indirect costs in the water sector are consistent with the project value in distress -16,428 million dollars. The 20% in indirect costs of the 36,382 million dollars in projects without distress must be added to the previous amount which, all together, represents the additional value of 7,200 million dollars. Therefore, the indirect costs associated to distress situations represent 45% of the relevant indirect costs.

Such estimation does not intend to be analytically strict since it is based on extreme simplifications and assumptions of some available basic data. The purpose is to illustrate the way in which the distress situations generate negative externalities which affect the group of projects. In the analysis, we have considered that this negative spillage occurs only in that sector but the effect may be more general and have an impact on the set of PPPs and the economy as a whole.

In this context, it is worth remembering that the nature of PPP projects in infrastructure sectors implies that the government has an ultimate responsibility over the service provision (see BOX 32: )146. Thus, distress situations directly and indirectly affect the costs borne by the government. Among these, the contingent tax costs represent an important additional element within the indirect costs of distress situations.

BOX 32: Government Step-in rights in the UK

The direct tax costs shall be related to possible guarantees provided by the government in distress projects147. Added thereto, and as a consequence of the spillage effect, there are costs associated to other guaranteed projects where the increase of the cost of capital may lead to an increase in the cost of the guarantees provided by the public sector.

Unquestionably then, reducing the incidence of distress cases and achieving rapid solutions that are perceived as equitable by all stakeholders involved carries major benefits that exceed those directly affecting distressed projects.

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146 Such ultimate responsibility arises in any legal regime -typically in most of the Latin American countries- based on the classification of an activity as Utilities.

147 The accounting treatment provided by the public sector to PPP projects establishes the measures in which contingent risks may or may not be specified in the public accounts. "The substance of a PPP transaction may suggest that it should be treated as a financial lease. This is the basis of accounting in Australia and the United Kingdom. Under the financial lease approach, limited risk transfer results in: PPP assets being placed on the government balance sheet; PPP investment being treated as public investment; and PPP debt being treated as a government liability. On the other hand, Eurostat decision is that PPP assets should be classified as private sector assets if the private partner bears most construction risk and either most availability risk or demand risks". Source: Public-Private Partnerships: Basic Considerations, Accounting and Reporting Issues. Presentation by Max Alier Resident Representative in Brazil International Monetary Fund Brasilia, April 26, 2005