PPP-oriented legislation aimed at attracting investment in the utilities and infrastructure sectors has become a central policy for Middle East governments, driven in part by stretched government finances. However, delivering bankable PPP projects with equitable risk allocation has remained a challenge.
In response, many regional governments have introduced PPP legislation to help standardise risk allocation within their national PPP models in order to alleviate the concerns of intentional lenders.
Recently, however, some of the standardised positions to have been adopted have come under pressure due to industry restructuring and regional governments seeking to strike more competitive deals with the private sector. Under the circumstances, the following key issues have emerged for lenders.
1. Credit support
Payments to be made to the project company, such as capacity payments and compensation for cost increases or termination, are typically made by the procuring authority, and have traditionally had direct government support in the form of a guarantee.
While this has been a well-accepted approach, regional governments are becoming reluctant to offer primary credit support or will only offer such support in limited circumstances – for example, where the credit rating of the procuring authority falls below a certain threshold.
Moreover, given the utility sector restructuring that has taken place over the past few years, questions around credit support are more likely to be raised where the procuring authority is newly formed, not credit rated and otherwise untested or inexperienced.
A further issue arises in relation to the project company’s right to terminate due to the termination or invalidity of the credit support. In the event of termination for such a default, the project company would be entitled to require the procuring authority to either purchase the project and make payment to the project company of an amount to cover both senior debt and equity. In the event of such termination, however, the project company would not have the protection of the credit support in relation to such payments.
Again, this represents a standard risk allocation position and was typically accepted by lenders on the basis that – given the possible long-term negative ramifications for bidder and lender confidence in the regional PPP market should the procuring authority fail to make payment of the compensation on termination – lenders could expect that, if the credit support terminated or became unenforceable during the term of the concession, the procuring authority would arrange alternative security acceptable to the lenders.
However, lenders are now more often seeking further comfort to address the risks this raises, for example, by seeking an undertaking that a particular government entity should maintain a minimum shareholding in the relevant procuring authority, failing which the authority would be required to demonstrate an acceptable credit rating or provide further government support.
Given that the currencies of most jurisdictions in the region are pegged to the US dollar, foreign exchange risk is a growing area of concern for lenders to Middle East projects.
Concerns about forced devaluation of some currencies due to the fiscal environment in the region has increased the level of scrutiny by lenders in relation to these risks, and currency convertibility has been of particular concern in markets such as Egypt and Jordan.
Foreign exchange risk issues are more acute in certain jurisdictions given that the payment of compensation on termination or payments under any credit support will only be made upon a final arbitral award. This impacts on both the depegging risk and convertibility risk, which increases with the effluxion of time between the termination date and the date of the arbitral award.
To mitigate this risk, lenders are typically seeking (as a minimum) foreign currency protection in the payment provisions of the concession agreement and/or change of law relief in the event of depegging.
Diverting unfunded liability from the project company is a key element of the project finance model. Typically this involves passing through (or passing down) the majority of the construction and operational risk to the main subcontractors.
A combination of factors, including more projects to choose from, the economic and geopolitical issues in the region, regulatory constraints on foreign ownership/incorporation of local subcontractor companies and, in some jurisdictions, the limited number of alternative high-quality subcontractors available in the event of default, has produced a contractors’ market with some bids and projects being delayed or aborted due to the unwillingness of subcontractors to accept bankable pass-through positions.
4. Geopolitical risks
Recent events, such as the embargo against Qatar and the war in Yemen, have had an acute impact on lenders’ perception of political risk in the region. Some jurisdictions have, for example, introduced broad restrictions in the project documents on dealing with entities with whom the relevant procuring government no longer has ‘diplomatic relations’. Lenders are also regularly seeking political violence and terrorism insurance/reinsurance as standard on regional projects transactions.
Due to certain geopolitical and fiscal issues, fast-moving (and often unpredictable) legislative and regulatory reforms are also a feature in the region. Lenders are increasingly focused on the potential impact of such reforms and requirements, including VAT and local employment obligations.
In some jurisdictions in the Middle East, these issues are more acute for lenders than in others. Lenders and sponsors are increasingly mindful of the opportunities that the Middle East currently offers, but must tread carefully in order to navigate the various issues which arise from the current economic and political environment.
About the author
Joanne Emerson Taqi co-leads Norton Rose Fulbright’s projects practice in the Middle East