4.2 Pure Co-financing

Pure co-financing refers to public financing that is included in the mix of finance that is non-revolving, that is, it is acting in a conventional, public-financed project by means of direct payments for a certain proportion of Capex expenditure that the private partner is not required to pay back. It is also referred to as grant financing, as these funds are usually granted to the private partner and treated for legal and/or private accounting purposes as grants.

Situations in which the government provides pure co-financing generally fall into three categories;

• Viability gap financing in user-pays unfeasible projects: Co-financing by means of grants is one of the most common methods to solve a viability gap in a socially and economically sensible infrastructure project that is not self-viable on the basis of user-payments. This is explained and developed in section 4.4;
• Increasing commercial feasibility (in viable projects): The government may decide to co-finance (by means of grants or by public loans or equity investment, usually on favourable terms), for the purpose of increasing the commercial feasibility of the project, even when a financial structure relying entirely on private finance may be viable (that is, user-payments are expected to provide sufficient revenues) or affordable (that is, the yearly burden of government payments in that project may be affordable for a 100 percent private financing).
  This is most often done when the specific country does not have deep financial markets and there is a risk that the winning bidder will be unable to raise the funds required for the project. It is more commonly seen in “megaprojects”. These are projects that are of a very significant scale or size. There is not a standard definition for megaproject, but this nomenclature is normally applied to projects above US$1 billion in size (Capex); and
• Increasing affordability/lowering the cost of capital: In other cases (in government-pays PPPs), the government may simply prefer to avoid creating a large deferred budget burden as a result of the project. In such cases, the most effective solution is grant financing; loans on favourable terms will also help to decrease the weighted cost of capital, depending on the level of implicit subsidy (see chapter 1.7.4).

When a government is considering co-financing, it should carefully consider the risk of compromising VfM. If public financing is too significant as a financing component of the project, it will reduce the risks and derived motivations of the private partner to properly operate the project. The risk allocation and incentives may be converted into those of a normal procurement. Excessive public finance may also have fiscal/national accounting treatment consequences (that is, considering the project as a public investment and consolidating it with public debt).

The public direct co-financing evidenced in co-financed PPP projects commonly ranges from 30 to 40 percent of capital costs (for example, for Light Rail PPP schemes in Spain, 30 percent is the common percentage for the grant financing portion of the project). However, a greater degree of co-financing may be sensible depending on the specific features of the project and/or PPP program (see Spanish High Speed Rail PPP model and other examples in box 5.7).

Types of grant financing

Direct grants are the most common form of co-financing. Funds will be granted during construction under a non-reimbursable mode, usually being accrued and paid as a percentage of the value of work in progress or conditional upon the achievement of certain milestones. They may also be paid partially or totally at construction completion.

Sometimes grant financing will be paid on a yearly deferred basis as fixed payments. This uses a payment stream that goes beyond the construction term, not subject to deductions or adjustments related to volume or performance (as if the project was partially a Design-Build-Finance [DBF] project). This represents a good solution when the public sector wants to co-finance a portion of the project, but does not enjoy sufficient liquidity. In these cases, the special purpose vehicle (SPV) will raise the funds related to the grant, but the financial facility to “pre-finance” the public deferred committed funds will be much easier to negotiate since the basis of that loan agreement will be public fixed and irrevocable payments (as if it were a government bond).

As a structuring decision, the government must consider whether to increase the risk tension by making the co-financing conditional on achievement of milestones or completion and whether to defer the payments. As with any structuring decision, this is a question of VfM: more risk implies more incentive to meet milestones, but it introduces more uncertainty for the lenders and a higher price in terms of financing costs. Additionally, more time (deferring the payments) implies financial costs which will usually be above the cost of public debt, but below the cost of the private financing portion of the financial structure that is subject to deductions or adjustments related to volume or performance.

Finally, grants may also be in kind. For example, providing land, or elements of the future infrastructure already constructed and financed (e.g. depots in a LRT system).

Contract development matters

Whether the payments will be made as construction is in progress or on a deferred basis, the most important aspect of the co-financing scheme is when the payments accrue, that is, when the private partner has earned its right to claim the payment, as the absence of construction term risk and risk of final acceptance is paramount for the co-financing to be effective in decreasing the cost of capital. For example, in some projects (such as high speed rail PPPs in Spain), the co-financing portion of the project is paid on a deferred basis over a number of years on a pre-established timetable, and the right to receive the amounts of the future payments is earned monthly, based on a determined percentage of the value of works executed each month.

When and how payments accrue and when they are effectively paid has to be clearly incorporated into the contract, especially to facilitate access by the project company to a line of credit purely based on public counterpart risk.

Another potential complication related to grants is when the grant finance is coming from another administration, rather than from the authority or government that is procuring the project. This is typically the case in projects that are of interest to or even under the power and responsibility of more than one level of administration. This may be the central government and regional government (for example, a State in Australia, Mexico or the United States [US]), or regional government and local municipal government. This happens more commonly in transportation and especially in rail projects. Good practice is that the commitments assumed by the third party government are also assumed by the procuring authority in the contract. This avoids duplicating the counterparty risk for the private partner or the need for it to deal directly with another administration that is not its client.

A further question that must be considered is who will set the grant amount. In government-pays PPPs, the amount of co-financing is most commonly set by the government in the tender documents. This is not subject to offer, so the bidder will offer the service fee (availability or volume-based) depending on the structure.

Conversely, the size of the grant will usually be proposed by the bidders in user-pays PPPs, particularly where the co-financing is being used to solve a viability gap.