The ins and outs of concession pacts
Public-private partnerships (PPPs) will be the buzzword as infrastructure becomes the main driver of the construction sector. MARTIN PRESTON* looks at a key contract – the concession agreement which forms the cornerstone of PPP projects.
01 August 2009
THE recent Norton Rose (Middle East) survey of the region’s construction market, Boom and Recovery: Understanding the Middle East Construction Market has highlighted the fact that the majority of respondents expected infrastructure projects, particularly the transport, power and water sectors, to be the main drivers of the recovery in the region’s construction market.
Although it is possible that some of these infrastructure projects will be procured on the basis of separate construction and operation and maintenance (O&M) contracts, the prevailing trend (certainly in relation to the transport and wastewater sectors) is for such projects to be procured as public-private partnerships (PPPs). This article looks at the key contracts and some of the issues arising out of such projects.
The cornerstone of any PPP project is the concession agreement, under which the government entity (or ‘Grantor’) grants an exclusive right to, for example, build and operate a road or wastewater treatment plant for a period of, typically, 20 to 25 years.
The company to whom the concession is granted (the ‘Company’) is usually a special purpose vehicle, which is a company set up solely for developing the project, and does not engage in any business other than the performance of its obligations under the concession agreement and the other project documents.
Finance for construction of the asset will typically be provided through a combination of equity contributions from the project sponsors and bank debt that is loaned to the company on a project finance basis.
Project finance lending does not look to the company’s assets to determine whether or not to lend. Instead, the banks will look at the various project documents and the cash flow under those documents to ensure that the company will be able to operate the project satisfactorily and to meet its debt service obligations to the lenders.
Consequently, the lenders will be heavily involved in the due diligence process undertaken by the company and its sponsors to determine the economics of the project. This will involve an analysis of the revenue that will be generated under the concession agreement and the ability of the grantor to deduct amounts from that revenue if the company fails to meet the required performance standards.
The vast majority of the company’s obligations will be passed down to two principal sub-contractors – the construction contractor (the ‘Contractor’) and the O&M contractor (the ‘Operator’).
The contractor will be responsible for constructing the asset that is required to provide the service being procured under the concession agreement, for example the road or the wastewater treatment plant. The company and its lenders will want to divest all of the company’s construction obligations under the concession agreement to the contractor to the fullest extent possible.
It will, therefore, be necessary to ensure that the contractor is able to construct the asset to a specification that will enable its services to be provided. Both the concession agreement and the underlying construction contract will contain an outline specification, only which will state what the asset has to achieve in terms of performance – for example, how much waste-water needs to be treated on a daily, weekly or annual basis. The contractor will be responsible for ensuring that whatever is constructed is capable of performing to these standards.
Both the company and the lenders will engage technical advisers to review the design being produced by the contractor in order to satisfy themselves that this is the case. The operator is also likely to have an input and may highlight aspects of the design that may be impracticable in use. The testing regime for the asset will obviously be of critical importance to make sure it is capable of performing at the required level, and the grantor and the lenders will both wish to witness any tests to ensure that this is the case.
Payment for the construction costs will usually be funded out of equity and debt. This is repaid from the revenue received during the operational phase, which may be received from the grantor or by end users. It is, therefore, important to ensure that the operator’s obligations mirror those of the company under the concession agreement, with certain modifications. For example, the company will want to ensure that it receives payment under the concession agreement before it is required to make a payment under the O&M agreement.
Ideally, the company will have a “pay when paid” clause, so that the operator is not entitled to payment unless the equivalent payment has been received by the company under the concession agreement. At the very least, the company should ensure that the payment period under the O&M agreement is longer than that under the concession agreement so that if payment is made on time under both agreements, the company will receive payment under the concession agreement before it is liable to make payment under the O&M agreement.
Since the operator will be performing the majority of the company’s operational obligations under the concession agreement, the grantor’s termination rights under the concession agreement should be passed down as termination rights of the company under the O&M agreement.
However, thresholds and time periods for termination under the O&M agreement should be shorter than those under the concession agreement to enable the company to terminate the employment of the operator and put a substitute in place before it is itself terminated by the grantor under the concession agreement.
Due to the requirement that the contractor and the operator take on the company’s
obligations under the concession agreement, it is usual for them to be involved in the negotiation of the concession agreement as the company will need to ensure that it is able to pass down the obligations it is accepting to its sub-contractors.
A further complication is the interface between the contractor and the operator. Defects in the asset may prevent the operator from performing its obligations under the O&M contract and this may, in turn, put both the operator in breach of that agreement and the company in breach of the concession agreement.
The ideal position for the company is for there to be an interface agreement between the contractor and the operator so that the company can pass on any deductions it suffers under the concession agreement to the operator under the O&M agreement. To the extent that these result from defects, the operator can then claim directly against the contractor.
The alternative is for there to be joinder of disputes so that the company is not at the risk of inconsistent decisions between the construction contract and the O&M contract. However, this involves the company getting involved in arbitration or other legal proceedings and is, therefore, less attractive (but easier to achieve) than having an interface agreement.
Since the lenders are advancing funds against the revenue stream derived from the project documents, it is important that the project remains viable. Consequently, in the event of a breach by the company of either the sub-contracts – giving one or both of the sub-contractors the right to terminate for company breach – the lenders will wish to step in and remedy any such breach to keep the project alive and maintain the revenue stream.
Similarly, if the company is in breach of the financing agreements and the lenders replace the company under the concession agreement, they will want to maintain in place the O&M contract and (if applicable) the construction contract to ensure that the relevant obligations under the concession agreement continue to be performed. This is achieved through the use of direct agreements that give the lenders the right to step in and replace the company under the sub-contracts.
In addition to the basic framework set out above, a typical infrastructure project will have specific provisions dealing with matters such as the calculation of the payment to be made to the company over the term of the concession (possibly incorporating benchmarking and market testing to ensure that it remains competitive with other similar projects); compensation on termination (which will be of particular interest to the lenders who will be seeking to ensure that their debt will be repaid irrespective of the cause of termination); and treatment of the physical assets at the end of the term (do they remain with the company or pass to the grantor?).
* Martin Preston is partner, Infrastructure and Construction, at the Dubai office of Norton Rose (Middle East) LLP.
Legal queries related to the construction sector can be addressed to Norton Rose (Middle East) LLP through Gulf Construction magazine at editor@gulfconstructionworldwide.com.
Norton Rose Group has had a presence in the Middle East for 30 years and has advised developers, lenders, and contractors in relation to the legal aspects of a wide variety of construction and infrastructure projects in the region. With a combined team located in Bahrain, Dubai and Abu Dhabi, Norton Rose (Middle East) LLP is able to provide both contentious and non-contentious support to financiers, developers, contractors and specialist contractors in the region.
