November 2001

911 - P3 - Power

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2001/01/19)
 

Global energy policy is so much at the fulcrum of our post-911 world that the ongoing machinations associated with the remodeling of regulation of the domestic power industry blurs into the background – high dollar and societal issue that it is. Thrust more into the foreground are two ideas much associated with the international power business in the recent past, which have taken on new casts today: “risk management” and “publicprivate partnerships” (“P3”). The U.S.’s ability to keep the world’s course on a growth rather than a confrontation- oriented keel will depend on its facilitating innovative approaches to risk management in the structured finance of overseas power and other infrastructure. Just as the U.S. faces a massive domestic conventional insurance shortfall post-911, so too does it face a need to assure continued credit enhancement of global development investment as well. P3 thinking will be critical in this regard.

As a nation, we have not been keen in recent decades on governmental solutions to problems, particularly overseas. Notwithstanding that fact, U.S. governmental bilateral agencies (sometimes in conjunction with multinational bodies or other foreign bilaterals) have been a primary force in facilitating privatization and host country P3s in power and infrastructure throughout the world. (None dare call it “nation building.”) While the U.S. Export-Import Bank (Ex-Im) and Overseas Private Investment Corporations (“OPIC”) each has a statutory mandate to be sources of “last resort” capital and risk management support to private overseas trade and investment initiatives, their respective roles in power and other project development risk mitigation have relentlessly moved them each forward into the front lines of actually getting a large number of deals done.

That is true because however well projects are transparently procured, contracted for and managed consistent with the design-build-operate model, and financed on rational and firm concession bases, the reality is not obviated that the infrastructure project marketplace is seen by those investing in it as a series of risks for which potential reward may be insufficient, in the absence of internal transaction arrangements or external third-party mitigation devices that satisfactorily limit the probability of those risks.

Historically, the first-line approach applied by international agencies to cope with project risks that private parties refused to absorb has been to advance or loan funds directly or in concessionary terms, or provide support of project host country loans with guarantees strong enough to, in effect, bolster host credit with their own.

This effective bundling and transfer of risks to international credit sources has on occasion distorted behavior on the part of private project sponsors or host governments in projects. It has proved to be sub-optimal, particularly where the local political environment and model of economic operations of the host remained unreceptive or risky to projects, and the ensuing economic results from them were not sustained at the robust levels at which they were projected. Boom and bust interest in emerging markets, continuing defaults and restructurings, and bailouts of untenable original risk calculations have been the outcome on several occasions. This has slowed the flow of capital to emerging markets. Particularly, at a time when capital markets pride themselves on sophisticated, probability- based “scientific” modeling of all contingencies – and have factored multilateral and host government undertakings into them – the results have been viewed as disappointing and ultimately not acceptable. It has led to global redlining and, in some measure, is a consequential damage to the overall national security situation we face today.

Particularly in the past few years, there has been a new focus on ways in which risk mitigation assistance can be undertaken through alternative financial engineering and risk transfer methods, analogous to those now being used in the private sector. This has been not only because of the absolute constraints on international agency resources for development but also because of recognition of the need to stimulate improvement of host country managerial policies toward internationally facilitated P3 projects. This new focus derives both from increased sophistication in project and structured finance lending and, institutionally from the private sector convergence of insurance, reinsurance, bank and financial intermediary/ investment activities into multi-service institutions which can offer money, credit enhancement, risk contingency backstops, liquidity, or derivative returns correlated to other events embedded in financings.

Better disaggregation of project risks and their sophisticated parceling out are the watchwords of the present structured finance world.

International agency collaboration to coordinate and cooperate with this effort has become a source of important recent P3 innovation.

Essentially all U.S. bilateral and even global multilateral support of Design-Build-Operate-Transfer projects of the past decade (comprised of private sponsors, host government public financial commitments, and some external assumption of certain risks caused by host public policy) are P3 arrangements. In essence, all of these international institutions are now seeking to sponsor and support use of much more sophisticated risk allocation devices, both by the private sector and by project host governments, to produce more efficient financing and more effective project development.

Specific examples in this regard are coming more to the fore since 911 as a result of geopolitical pressures and the emerging global shortfall in available private insurance.

Two initiatives initially undertaken prior to 911 are suggestive of directions in which U.S. (and foreign) bilaterals may go farther in the future, perhaps in conjunction with multilaterals. Each of these initiatives is essentially innovative risk sharing through the use of P3.

Ex-Im has procured and is now negotiating a cost efficient structure whereby private risk capital will participate in a share of Ex-Im’s exposure fees on a predefined portfolio of future medium- and long-term Ex- Im insured and guaranteed loans.

Under the proposal currently being negotiated with a private financial institution with respect to the securitization of a future Ex-Im transactions portfolio having certain defined credit characteristics, while Ex- Im would take first loss position, the private institution would take second loss position (and then deal with its resulting risk exposure in the private capital markets by using some combination of reinsurance or other credit derivatives). Ex-Im would assume the final third loss tranche. The resulting securitized loan portfolio would be sold in the private capital markets. Loans ineligible for these arrangements because they did not meet portfolio criteria simply would be held by Ex-Im as in the past. The benefit of this type of arrangement would be an expansion of Ex-Im credit risk capacity – a development that, in turn, increasingly has meant enlarged support for US overseas project development in complex structured transactions. In addition, the involvement of the private sector institutions in Ex-Im Bank credit operations for purpose of securitized portfolio development should serve to enhance Ex-Im’s other operations as well.

OPIC has also been engaging in several creative initiatives for overseas projects also. One approach has involved provision of currency convertibility insurance, which addresses a critical problem not previously the target of its political risk coverage focus. Another initiative has involved, in effect, the private leveraging of its limited per project statutory authority to credit enhance or directly support individual projects through collaboration with multilaterals, and allocation of its limited per project credit authority between the support of private lenders to a project and to the investment by private project sponsors in it. The result is the facilitation of higher total private investment in its project, because risk has been more broadly and suitably allocated among participating and supporting parties.

Again, risk management in P3 settings is enlarging the otherwise available pool of global capital.

Two of the important ancillary consequences of 911 have been to highlight the fragility of the sophisticated global insurance and credit structure and the limitations of the U.S. ability to project the social and economic benefits of the American System (itself a mixture of private and public rights and responsibilities) around the world. The more sophisticated U.S. private infrastructure structured finance mechanisms become, the more threatening these problems become to the future of global power and other infrastructure development.

The looming domestic shortage of domestic risk sharing capital only serves to exacerbate what would be a problem in any case. One important collateral result of 911 therefore should be reemphasis on how U.S. bilateral agencies, themselves publicprivate partnerships, can be fostering P3 arrangements in the diverse societies outside our borders in need of power and other infrastructure development enhancements – and producing results. The message, then, internationally as well as domestically: 911-P3-Power.

ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years.  In particular, he has analyzed and executed a wide variety and substantial value of project financings.  He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration.  He is a graduate of Brown University, Yale Law School and Harvard Business School.