PPPs involve the development of projects or services through the mechanism of project finance. They also allow the public entity to have the projects built or services provided without having to pay for them immediately or without having to pay for all of it immediately. In certain cases, the public entity pays for the service/project in instalments over the agreement period or sometimes, the users pay for it. In all these cases, the public entity usually bears some of the risks of the project. One such risk is to compensate the private partner if the agreement is terminated before expiry. The sharing of risks and liabilities between the public entity and the private partner makes lenders and investors cautious about their investments in PPPs.
| What are Committed and Contingent Liabilities? Committed liabilities are those liabilities and obligations which are set out in the agreement. The parties to the agreement are liable to perform such obligations and they are not dependent on certain events happening or not happening. Examples of committed liabilities include the payment of annuity, construction /development expenses, insurance, sharing of revenue, etc. The term 'contingent liability' is problematic, both conceptually and in practice, and the International Accounting Standard Board has proposed eliminating it from accounting standards (IASB 2005). The probability of payment under a contractual obligation can vary continuously from 0 to 1, and any division of that interval into two parts, one for contingent liabilities and the other for ordinary liabilities, is arbitrary. Although not all these risks create contingent liabilities for accounting purposes, they do create obligations that are conveniently, if loosely, called contingent liabilities. Traditionally the conditions which determine the value of the contracting liabilities were known (committed liabilities), as opposed to contingent liabilities whose value depends on the occurrence of future events and uncertainties. The contingency factors may be endogenous or exogenous with respect to who is responsible for them. For example, a natural disaster is an exogenous factor for the State, while a change in the tax rate is an endogenous factor. Source: Managing Contingent Liabilities in PPPs in Australia, Chile and South Africa, Timothy Irwin and Tanya Mokdad, June 2009 |
In India, many projects are being implemented across sectors and in various formats. Public entities usually take up multiple projects simultaneously. Most of these projects involve contingent liabilities and these liabilities would be fiscal or otherwise in nature. It would be useful for any public entity, before providing for contingent liabilities in any project, to adequately understand the liability, quantify it and estimate its future bearing on the public entity. It is prudent for a public entity to commit itself to liabilities only when it has the capacity to bear them. Therefore, it is crucial to continuously balance and check the provisions for contingent liabilities in agreements.
As contingent liabilities call for expenditure from the parties to an agreement on the occurrence of an unlikely event, it becomes all the more necessary to manage this issue. The Chapman's Peak Drive project in South Africa reflects the need for management of contingent liabilities during the contract documentation and contract management stages of a project lifecycle.
| Chapman's Peak Drive Case • Chapman's Peak Drive is a road developed alongside a mountain near Cape Town in South Africa. It was considered to be a challenge to develop the road and was constructed over a span of seven years from 1915 to 1922. The road was usually prone to falling rocks and other debris owing to landslides in the region. In January 2000, the Western Cape Provincial Government closed the road after fire and heavy rain caused major rockslides and the death of a passenger. • The Government then proposed to develop the proposed road through a PPP arrangement and invited proposals from interested private parties in August 2001. Two consortia bids were received for the project, and in May 2003, the Government and the Entilini concession company signed a 30-year concession contract. The private partner repaired the road and, using modelling and engineering, reduced its vulnerability to rock falls. The road reopened in December 2003, at an estimated capital cost of about South African rand (R) 150 million. The estimated cost of construction of the project was split equally between the Government and the private partner. • The Government hoped that tolls would cover the costs incurred by the private partner. At the same time, it also agreed to compensate the private partner in certain circumstances if the toll revenue was less than a forecast made in 2002. When the road was opened for commercial operations, the private partner was required to collect tolls from a temporary plaza while it waited for approval from the national Department of Environmental Affairs and Tourism to build permanent toll plazas. The provincial Government agreed to bear the traffic risk until that approval was granted and the plazas were built. It also agreed to bear the traffic risk during certain road closures. Additionally, the Government gave a revenue guarantee that, independent of the provisions relating to toll plazas and road closure, partially protected the private partner's lenders from revenue risk. • After lengthy appeals, final approval for the toll plazas was granted in June 2008, and only then could construction of the toll plazas begin. As often happens, traffic initially fell short of forecasts. In the absence of permanent toll plazas, the Government had to top up the private partner's revenue. Revenue eventually reached forecast levels. But in July 2008, the private partner closed the road because of another rockslide. Because the toll plazas were not yet constructed, the Government bore the traffic risk and had to pay the private partner an amount equal to all its forecast revenue. • From December 2003 to January 2009, it paid the private partner R 57 million. This experience raises the question whether the best means to compensate the private partner for the absence of permanent toll plazas was for the Government to pay the difference between actual and forecast traffic. But it is easy to be wise after the fact; decisions about risk-bearing are better judged on the basis of the information available at the time of the decision. • Nevertheless, this case illustrates the kinds of contingent liabilities that arise in PPPs and the need for Governments to pay attention to them, both after a contract is signed and before. Source: Excerpt from the World Bank and PPIAF report on Managing Contingent Liabilities in PPPs, Practices in Australia, Chile and South Africa; Timothy Irwin and Tanya Mokdad, June 2009. |
Typically, projects such as the development of roads on a shadow toll format, projects developed on a take or pay principle or power projects that operate on guaranteed returns, involve contingent liabilities.