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Structuring and Drafting the Tender and Contract

59.4 Compensation Events and Rebalancing

When a compensation event occurs, the private partner has the right to claim compensation to offset the loss suffered or that will be suffered, or part of the loss suffered in shared risk events. The loss may include forgone revenues (for example, revenue lost due to a delay in construction, where the delay is a result of a risk covered by the contract as a compensation event).

This process is commonly known as “rebalancing the contract” in most civil code countries, that is, the process of restoring the financial equation of the project cash flows as if the event had not occurred.

The contract should set out the process of claiming, determining, and implementing the compensation, including in the last case the potential means to grant the compensation.

Once the loss is determined (or estimated in events that impact future cash flows), the government will have to proceed to compensate the private partner. As a common rule, events that impact on Capex will be compensated by a direct payment, and events that affect future revenues or costs will be compensated by supplementary payments or by agreeing to a change (increase) in the service price or in the tariff (in user-pays contracts).

However, it is not uncommon for Capex-related losses to be financed by the private partner. In some contracts, the government may, at its discretion, request that the private partner finance the loss. In this context, it is good practice to make that obligation conditional upon the availability of funds from the private party’s shareholders and lenders, and to require the private party (if requested by the government) to use its best endeavours to raise the necessary funds.

When the private partner is requested to finance the loss, the cost of repaying that finance and paying a return on it will reduce the private party’s equity IRR and potentially its creditworthiness too (due to a lower DSCR). Therefore, it is good practice for the contract to require the government to restore the equity IRR and respect the private partner’s minimum DSCR by allowing an increase in revenues to repay and remunerate the additional investment. This increase in revenue may take the form of a tariff increase, service price increase, direct payments or contract extension, or a combination of some of these.

Some contracts use the net present value of the project revenues and costs as the indicators to be restored, rather than the equity IRR and the project company DSCR. That is not considered good practice, as it may not fully compensate the private party or its equity investors.

Extension of the concession term may be used to restore the financial balance of a contract, but only when it does not affect the ability of the private partner to meet its debt covenants and when it provides sufficient additional cash flows to restore the equity IRR.

Box 5.34 explains how the financial model is used to assess and define the compensation so as to restore the financial equation[87].

The approach used to calculate compensation and restore the balance should be described in the contract.

 

BOX 5.34: Process of Rebalancing and Use of the Financial Model<br />
The most common way to deal with compensation calculations financed by the private partner is to use the financial model. When the model is properly used, the risk of over-compensating can be avoided.<br />
The process revolves around the equity IRR and DSCR.<br />
• The first step should be to estimate the loss produced by the compensation event, noting that in the absence of agreement, the parties may ask for the opinion of independent third parties through the conflicts or dispute resolution procedures.<br />
• Once the loss (the amount of additional investment and/or missed revenues plus potentially higher O&M costs) is estimated, such loss is introduced into the financial model together with the additional funding (which usually — if the impact is significant — will be financed by a mix of equity and debt). The rest of the inputs are unaltered (as in the original version of the financial model, that is, before the adjustment of payments or other rebalancing mechanism), and the new (lower) economic internal rate of return (eIRR) and DSCR are observed.<br />
• Revenue inputs (for example, service payment amounts) are changed, introducing incremental amounts of payments so as to: (i) restore the original eIRR and (ii) respect the minimum DSCR.<br />

 

[87] While this PPP Guide prefers the methodology and process described, there may be other ways to deal with this matter. See, for example, the methodology used in Brazil as an alternative to restore financial balance, namely “marginal cash flows”.

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