Project Agreements

Project Agreements

Overview

Pivotal180 project finance and infrastructure financial modeling course. covers one of the primary approaches for the revenue model being the Project Agreement.

For infrastructure projects there are two primary approaches establishing the revenue model being project agreements and concession agreements.

In this video, we discuss the function and the sample terms of project agreements, as well as how the structure can be used to mitigate the underlying risks.

Under a project agreement, the project company typically receives virtually all of its revenue from service fees that are paid by a government entity. These payment structures are common for situations in which the infrastructure is public, a service provided by the government to citizens who do not pay directly each time they make use of the infrastructure..

Video

Video Transcript 

For infrastructure project companies there are two primary approaches establishing the revenue model, project agreements and concession agreements. In this lesson, we’ll discuss the function and the sample terms of project agreements, as well as how the structure can be used to mitigate the underlying risks.

Under a project agreement, the project company typically receives virtually all of its revenue from service fees that are paid by a government entity. These payment structures are common for situations in which the infrastructure is public, a service provided by the government to citizens who do not pay directly each time they make use of the infrastructure. This would be common for public buildings like hospitals or schools.

The government needs the building, but it doesn’t want to face the full financial burden of the construction cost upfront. Instead, it wishes to pay for use of the building over time out of tax revenues or future bond issuances. But of course, if a private sector investor is going to take an ownership stake in the project, the government will need to provide a source of revenue. Because the project company can’t start charging the general public a fee to use that building.

The party making the payment is called the contracting authority. And for purposes of this lesson, we’ll assume that this authority is always a federal, state, provincial or local government entity. In most industrialized countries, governments have an investment grade credit rating. And credit ratings agencies consider the likelihood of default to be very low.

It’s far less risky to rely upon payments from the government than it is to rely upon payments from private companies or individual citizens. And project equity investors take great comfort in this and will generally accept a lower rate of return commensurate with the lower risk of government default.

Service fees are structured to compensate the project company for use of the infrastructure facility. This is a stable and predictable amount each period, which may be adjusted from time to time based upon inflation or changes in usage and efficiency.

For public infrastructure assets to get built under a public private partnership, private investors need to have confidence that all of the fixed costs and all of the variable costs of the project can be recovered. Including the cost of debt service and a reasonable return on equity.

The private sector is generally not keen to take on the risk of how much a public facility will be used. Perhaps the government wants to build a new hospital just in case it needs the extra capacity in the event of a global pandemic. It’s prudent for the government to be prepared, even if that pandemic never arrives. But private sector investors aren’t in the business of gambling on whether or not a new virus emerges.

The private sector investor needs to know that they will receive a financial return, even if that extra hospital capacity is never fully used by the public. To arrive at the appropriate level of service fees, it’s helpful to disaggregate the component parts. So basically, how can we establish a service fee system, which allows a project company to recover its fixed costs and its variable costs?

Fixed operating costs are incurred independently of the actual usage of an infrastructure facility. These costs include a certain amount of labor, basic maintenance, O&M, as well as debt service and a required return on equity. The sum total of fixed costs can be calculated in advance, regardless of the actual usage of the facility. So in negotiating a fee structure, the project developer will typically quantify the fixed costs of the project and then recover them through an availability payment made by the contracting authority. As long as the hospital is available, the project company will receive all of the availability payments. Thus, the investors are sure to receive their financial returns, even if it turns out that the extra hospital beds are rarely if ever used.

But when that hospital gets used there are sure to be certain variable operating costs, which are a function of the volume of patients being treated there. If the project company is responsible for procuring consumables such as heating oil or electricity or hot water for laundry services, these costs can be passed through to the contracting authority in the form of a usage payment. Similarly, a toll road project may seek to assist establish a usage payment structure to recover the variable costs of road repairs due to excessive amounts of traffic. As long as the variable costs can be passed through to the contracting authority, the project company will be indifferent to the actual usage of the infrastructure. If there’s a greater volume of patients in the hospital or more passengers on the road, it’s up to the government to pay for the incremental costs associated with volume.

So we can think of the classic service fee as having two components. The availability component, which is designed to cover fixed costs. And the usage payment, which is designed to cover variable costs.

In order to receive the entire service fee without penalty, the project company must deliver and establish output specification from the infrastructure facility. And the output specification governs both the availability of the facility and the performance or the quality of services provided. The output specifications are explicitly detailed in the project agreement. They should always be drafted in a manner that is smart.

What we mean by smart is they should be specific, measurable, achievable, realistic, and timely. It’s easiest to understand how these specifications might work. And we will practice by thinking through an example. So let’s focus on a hospital which receives an availability payment in every quarter. Let’s say the hospital has 100 standard rooms.

The government and project company might agree that at least 95 of those rooms must be available for use at any point in time. So a portion of the service fee will be tied to room availability. At first pass, that seems like a very specific and achievable output, but it doesn’t establish any kind of standard for how to maintain the rooms. In the contract, the definition of availability needs to be crystal clear or else the parties could find themselves debating whether certain rooms should be deemed available, even if say the air conditioning isn’t functioning in the heat of summer.

So let’s consider a quantitative example. Assume our project company has entered into a contract in which room availability accounts for 100% of the service fee. And the standard requires that at least 95 rooms must be available for the entire period. What happens if 95 rooms aren’t available? What if a waterline burst due to poor maintenance and 55 of the hospitals rooms were out of commission for half of the measurement period. It’s an absolute disaster. For sake of simplicity, assume there are 90 days in the period and 55 rooms were unavailable for 45 of those days. We will take 55 rooms unavailable minus the five rooms that were permitted to be unavailable and multiply that by 45 days. And that equals a shortfall of 2250 room days, which we’ll use here as the numerator. We divide the shortfall by 90 days multiplied by 100 beds, which equals 9000. And that the maximum potential room days as the denominator. Multiply this fraction by the base case availability fee and our project company will be hit with a 25% reduction in its revenue. Seems only fair of how half of our rooms are out of commission for half the period. We would expect to lose 25% of the service fee.

Bonuses and penalties can be structured for a wide assortment of services ranging from keeping the elevators operational to completing the laundry within a specified amount of time. But the concept is similar. The project company fails to live up to a predetermined standard, it will be penalized. On the flip side, the project exceeds the standard it should receive a bonus payment. That is how the government incentivizes the project company to keep all of the 100 rooms available for the whole period.

Now one important thing to note, penalties are usually capped such they cannot exceed the service fee. For hospital rooms were out of commission for the entire period, the project company will lose the entire room availability portion of the service fee. But we can’t lose more than that. If the project company is frequently delinquent in its maintenance, there may be additional repercussions such as termination of contract, but it’s really a worst case outcome and we would never expect a project company to perform that poorly.

-Next, let’s talk about the key drivers of the size of the availability payment. Namely, the need to provide a financial return to the lenders and the equity investors. Recall that the magnitude of project finance debt and equity is determined by the amount of the government contribution paid at the time of construction. If the government receives equity in exchange for its contribution, its expectation for dividend distribution should be no different than that of all other equity investors. This kind of government investment wouldn’t help reduce the service fees that the project must charge to the contracting authority, but it would allow the government to receive a regular dividend from the project.

Alternatively, if the government contribution is used to reduce the amount of debt and equity required by the project, the project company can then reduce the service fee that it must charge to the contracting authority. This second approach to government contributions is commonly used in project agreements. So we will use it as the basis for our case study model. Now that we’ve covered how each component of the service fee is calculated, you’ll see why the financial model is such a crucial tool for project developers, lenders and equity investors.

Once the fixed operating costs and debt service are established, the calculation of the availability payment is just an optimization exercise in delivering a required return to the equity investor. And for the contracting authority. The financial model is an equally important tool as it enables them to reverse engineer the financial returns being achieved by project investors and understand whether or not the service fees are set on a fair and reasonable level.

-Before we move on from availability payments, I’d like to offer a few comments on the types of payments that might be negotiated for transportation infrastructure, like roads, buses, and trains. These services frequently involve a user fee or a toll. But a payment does not always come directly from the end users. In some cases, the government wishes to subsidize the public’s use of the road or public transport system. The reasons vary. Sometimes the road is too narrow to accommodate tollbooths. Or maybe the government wants to reduce congestion by incentivizing the use of city buses instead of private automobiles.

Regardless of the rationale, user payments subsidized by the government are called shadow tolls. Meaning the toll being paid by someone other than the end user. And sometimes the end user has no knowledge there’s such a toll as being paid at all. Shadow tolls differ from availability payments in that the fee is based upon actual usage rather than the availability of the infrastructure to be used. Often shadow tolls are paid on a variable scale where the fee per user decreases as traffic volume increases. Charging high tolls for the first tier of users allows the project company to have confidence that it will cover its costs. But charging low tolls on subsequent tiers of users can prevent the project company from making an excess of profit if traffic volumes are much higher than expected.

Some transportation contracts may entail additional revenue streams for the project company. These might include the right to develop rest stops for food and shopping along the highway or advertising on the side of city buses. Such ancillary revenue streams are considered separately from shadow tolls and availability payments, but usually entail some form of royalty or profit share with the government.

For obvious reasons, these sources of cash flow are no in near certain as the payments coming from the contracting authority. And in our experience, you will want your financial model to forecast these secondary revenue streams. But it’s a best practice to model them separately from the primary project and evaluate them on their own merits.