Public Private Partnerships

Public Private Partnerships

Baker & McKenzie

Introduction to Public Private Partnerships

The Mexican Federal Government is currently working on the implementation of a framework for the association of the public and private sectors known as the Public Private Partnership (“PPP”) scheme. Through coordinated efforts by the Ministries of Public Function, Communications and Transportation, Health, Public Education and Finance and Public Credit, the Mexican Federal Government is attempting to position Mexico as an attractive market for PPP investors. The purpose of this document is to offer a brief description of said scheme and its relevance as a business opportunity for private investors.

In general terms, a PPP is an agreement between the public sector and the private sector for the purpose of having the private sector deliver a project or a service traditionally provided by the public sector, (i.e. water treatment, road construction, waste management). The purpose of a PPP is to provide such projects or services in the most economically efficient manner by developing agreements whereby both sectors combine their respective skills and efforts and allocate the risks of a specific project or service to the sector, which, by its very nature, is best suited to assume such risk. The result of that combination should increase value in projects or services for public benefit, by means of technical innovation and efficiency that results in value for money.

PPP’s scope goes beyond the traditional agreements where a private sector contractor becomes the upfront project builder for the public sector; under a PPP scheme, the private entity becomes the long-term provider of services by combining the responsibilities of designing, building, and in some cases, operating and further financing the project, in order to deliver better public services.

The PPP approach is not new, in the U.S. alone, it may be traced back to the 18th century, when privately owned companies managed most of the country’s first urban water supplies. Thereafter, the great westward expansion in the late 19th century was driven by a major PPP between the federal government and the private railroads companies, the government provided rights-of-way and adjacent property to the railroads companies, while the latter used private capital to build the railroad facilities and railway wagons.

In recent years, the implementation of PPP has expanded to a number of countries, including Australia, Belgium, Canada, Finland, France, Germany, Iceland, Ireland, Japan, Portugal, Spain, the Netherlands and the U.K. The scope of projects developed through PPP has also expanded into various aspects of public sector activity such as prisons, healthcare and educational establishments.

Recently, the Mexican government has been considering the possibility of taking advantage of the private sector’s skills and financing ability as a means to satisfy the increasing requirements of services and infrastructure that surpass the current financial capabilities of the government. Preparation of pilot projects is now underway in three strategic sectors: highways, health and education. These pilot projects consist on the modernization of the Pénjamo-La Piedad and Celaya-State Limits highways in Guanajuato, the construction and operation of a public hospital in Coahuila and a public school in Nuevo León. These Mexican government initiatives open a window of opportunity to private companies that may be interested in participating as private contractors under PPP schemes. A brief description of some of the key aspects of the PPP implementation of projects, since they often provide incentives for the private sector to deliver capital projects within short construction timeframes. Because a core principle of any PPP is the allocation of risk to the party that is best suited to manage risk at the less cost, there is a better control of the complete range of project risks throughout the life of the project. PPP are long term arrangements with a sustainable approach to improving infrastructure and making better use of public money while retaining control of core areas of responsibility by the public sector.

Benefits of the PPP Approach

The benefits of the PPP approach include an acceleration of infrastructure or services provision; this is, the public sector is enabled to proceed with projects at times when the availability of public funds may be constrained, as upfront capital expenditures are translated into a later flow of ongoing service payments to the private contractor. Furthermore, the PPP usually lead to a faster implementation of projects, since they often provide incentives for the private sector to deliver capital projects within short construction timeframes. Because a core principle of any PPP is the allocation of risk to the party that is best suited to manage risk at the less cost, there is a better control of the complete range of project risks throughout the life of the project. PPP are long term arrangements with a sustainable approach to improving infrastructure and making better use of public money while retaining control of core areas of responsibility by the public sector.

The implementation of PPP projects for the construction and operation of public highways is well acknowledged internationally for the highway sector, financed mainly through tolls or “shadow tolls” (toll payments made by the government to the private sector based on pre-established rates). International experience has shown that users usually agree to pay a fee to access higher-quality road networks.

Regarding international experience in PPP projects for the treatment of waste, the PPP

scheme has been a booster for the development of new waste disposal methods, such as waste-to-energy schemes and recycling plants, which require substantial investment and specialized technical know-how. The private sector has traditionally developed a specialized capability to meet these requirements, taking over responsibility for the development and operation of new waste disposal facilities within PPP schemes.

With regard to water supply and treatment, many countries need to invest a substantial amount of capital in new water supply and wastewater treatment facilities in order to meet the requirements of new environmental directives. As a result, countries that have not yet involved the private sector in private sector engages in the designing, building, and operation of the project, and the “DBOF model” where the private sector engages in the design, building, operation, transfer and financing of the project.

Implementation of PPP Projects

The classic expression of the PPP approach applicable to infrastructure projects on highways, water and waste projects has been through the so called “BOT model” (for the English abbreviation of Building, Operation and Transfer) where the private sector engages in the building of the necessary infrastructure for the provision of the service, its operation during the term of the agreement, and the transfer of the infrastructure to the public sector upon expiration of a term. This model has generated a wide range of alternative structures, such as the “DB model” (for its English abbreviation of Design and Build) where the private sector engages only in the designing and building of the infrastructure, the “DBO model” where the private sector engages in the designing, building, and operation of the project, and the “DBOF model” where the private sector engages in the design, building, operation, transfer and financing of the project.

Highway schemes are commonly structured as DB contracts, as this scheme allows the transfer of the design and construction risks to the private sector through a fixed price contract. DBO contracts are generally implemented where the private sector will collect user tolls on behalf of the public sector, but the public sector will finance the project and accept the risk associated with traffic demand, while DBOF contracts are commonly used where the private sector will accept some of the risk associated with traffic demand.

Major highway projects may be funded in part or in whole by user tolls (i.e. bridges and tunnels) where there is a clear benefit to be gained from choosing the tolled route over a different alternative route. When user tolls are not practical or applicable, the private sector may be paid on the basis of “shadow tolls”: under a “shadow toll” road project structure, services are provided to the public sector in return for a payment stream to the private sector, typically based on the number of vehicles using the road with guaranteed minimums. In general, the income streams for the service provided will be based on factors as availability, usage and quality of service. “Shadow tolls” are not a financing source in themselves, but rather a payment mechanism that can employ a variable range of financing methods, and can permit a viable financing structure that fits the characteristics and needs of specific projects. “Shadow tolls” are commonly seen as a good alternative to real toll projects, which in some instances may face resistance from users.

Relevant contractual issues of PPP Projects

Among the wide range of aspects that must be analyzed during the implementation process of a PPP project, from the structuring of the scheme, to the negotiation of its specific terms and the operation of the project during its life up to its termination. Such aspects include financing, whether by means of public financing, private equity, bank debt, public investment or a combination thereof, timeframes for delivery of the services, bonds, late service delivery, events of force majeure, payment mechanisms, insurance provisions, change of law, change of control of the private contractor, step-in rights, and compensation on early termination.

Conclusion

The experience of PPP deals in other countries constitutes evidence that, when properly implemented, the PPP approach constitutes a viable method for developing infrastructure projects. The interest of the Mexican Government in considering alternative methods for the development of infrastructure projects (such as the PPP scheme) will lead to new business opportunities for the private sector in Mexico. While it will be necessary for the Mexican Government to provide the legal framework for the implementation of said scheme, private companies that may be interested in participating in such projects should become prepared to take advantage of the learning experiences of the first pilot projects being currently implemented. The experience of other countries and the participation of international sponsors with experience in PPP deals will also be essential.

By Baker & McKenzie

For further information, please contact us at info.mexico@bakernet.com All Rights Reserved © Baker & McKenzie Abogados, S.C. Mexico 2003