Light rail projects are among the most difficult to procure on a PPP basis, and many either fail to reach financial close, or suffer financial difficulty during their operational period, necessitating renegotiation or additional government support. Light rail projects also represent a close interface with a very large cross-section of the local population and can often be highly politically charged.
Having advised on a number of major light rail projects across the globe, we fully understand the technical, legal and political challenges involved in bringing a light rail PPP project to a successful close and under a framework best suited to stand the test of time.
We welcome the opportunity to discuss our experience with you in more detail.
Strengths and weaknesses of the PPP model in light rail projects
The principal purpose of the PPP structure is to harness the skills of the private sector in the most efficient manner possible to deliver the project at hand. PPP structures are not a panacea for the public sector, absolving them of all risks on the project; rather, they are a method of packaging up a combination of tasks and allocating it to a private sector consortium better placed to manage them.
For light rail projects, the PPP structure can be an effective way of transferring the substantial challenge of integrating civil works, complex engineering equipment and systems (such as traction power and signalling), rolling stock delivery and commissioning, despatching and operations, and preventative and lifecycle maintenance for the whole project, and aligning these matters towards a singular goal of achieving a reliable and punctual service for an efficient price.
The PPP model becomes difficult to implement where the overall service outputs required of the private sector involve the management of external events beyond the private sector’s control. The more such events are included within the scope, the less efficient the PPP risk transfer is likely to be. In an extreme scenario, an alternative procurement structure may prove more efficient in the longer term.
PPP structures do not create an affordable project where none fundamentally exists. There are only two sources of revenue for any light rail project – farebox revenue and taxation. Where farebox revenue is not sufficient (or cannot be guaranteed to be sufficient) to cover the cost of financing and operating the project and meeting likely project contingencies, some form of taxation-based support within the payment structure is essential. Research has shown that virtually all demand-risk light rail PPP projects have over-estimated ridership and revenues – in some cases by over 80 per cent – and where this presents itself in operation there is very little that the operator can do to mitigate the shortfall in revenue (as price/ demand elasticity is often high).
Analysing the risks
Understanding the wider contingencies inherent in a project – and where these may ultimately translate into risk retained by the public sector – is an important part of being able to justify internally to stakeholders why the project has to be structured in a certain way. This may be necessary to overcome preconceived notions of ‘complete risk transfer’ which are often associated with PPP projects generally (and which may be found to a substantial degree in projects with extremely compelling stand-alone business cases).
Retained risk analysis
A ‘retained risk’ matrix for a project may start at a high level, as shown in this table. The table presents a typical spread of risks for a light rail project. Some of the ‘retained risk’ issues will be a function of how prescriptive the government party is when preparing the output specification and/or whether specific constraints of the selected route might limit the design options available to the private sector.
(Please note that for brevity we have omitted the risks which would traditionally sit fully with the private sector, such as achievement of the design and construction output specification requirements, shortage of subcontractors or materials, supply chain insolvency or default, etc.)
The concession agreement
Ideally, a draft concession agreement for the PPP will not be issued until an appropriate landing point has been reached on the principal risk allocation issues. If there are a number of open issues, it may be appropriate to create an intermediate stage and prepare a ‘Heads of Terms’ for the concession agreement, summarising the key contract terms to allow the government team to focus on the specific mechanics by which the intended outline risk allocation will be achieved. If sufficient agreement can be reached at an early stage, it may be appropriate to release the draft Heads of Terms to bidding consortia, either at prequalification stage or early post-qualification, and invite market sounding on the proposed structure. Feedback received may give the government party an idea of which bidders are able to work constructively with the public sector on the development of the project, a quality that will be needed to see the project through the bid phase and subsequent development. The government may also take account of feedback in finding appropriate structures that fit best with the bidding consortia’s expectations in terms of appropriate risk allocation. For example, whilst opportunities may exist to part-fund the project through exploitation of real estate development opportunities, it may be difficult for project-finance lenders to bring this type of less-familiar risk successfully through their credit approval processes.
Once fully drafted, the concession agreement and its technical requirements will present a complex matrix of rights and obligations.
Typical key risk issues on light rail projects
Click here to view table.
Performance regime and payment structure
As a result of the lack of success of many demand-risk rail sector projects in previous years, most light rail PPP schemes are now procured on an availability basis. On many projects it is clear from the outset that the farebox revenue is likely to only cover a proportion of project financing and operating costs and that a transfer of demand risk (in whole or in part) would be inappropriate.
The structure of the payment mechanism and performance regime will largely be driven by the scope of the service. Where train dispatching and operations are part of the project operations (DBFOM structure), performance would typically be governed by a reliability and a punctuality metric, being the key outputs for a ‘successful’ service. Where operation of the vehicles is retained by the government or let to a third party (leaving a DBFM structure), it would be more appropriate for the concessionaire’s obligations to be measured solely on the availability of the physical assets (rolling stock, track, stations) rather than customer-focussed measures, although we have seen exceptions to this. Another recent development on some light rail projects is where the government retains control over the procurement of the light rail vehicles (for cost reasons). This creates a number of complexities in terms of testing, commissioning, adaptation, defect management, insurance and replacements, each of which create bespoke risks to be dealt with in the concession agreement provisions.
To the extent that external events beyond the concessionaire’s control can impact on these metrics, some relief may need to be given; this can often be structured as a list of ‘excusing events’, however an overly long list may create a solution that is too bureaucratic to manage efficiently. As a consequence, it may be more appropriate to look at a lower performance threshold, or a mechanic where good performance over a sustained period can be used to cancel out future poor performance. This is likely to be an area where bidders and their funders will spend a significant amount of their time, as it goes to the heart of the allocation of day-to-day risk on the project.
Project flexibility will also be a key issue where the details will need to be refined with care. Ridership levels can be expected to increase over time, necessitating additional vehicle procurement and deployment; road traffic levels (or priorities) may change over time (which is relevant to non-segregated projects); and the government party may wish to maintain flexibility over timetabling and integration between different modes of transport. Whilst not all conceivable issues can be considered in advance in any long-term contract, the payment mechanism should ideally have an express mechanic which unambiguously deals with as many of these situations as possible. From the government party’s perspective, the fall-back solution (namely, use of the project variation procedure in the concession agreement) should be avoided where possible, as post-contract variations in PPP projects have a tendency to be costly and difficult to implement, particularly as project funders generally take an extremely cautious view of any change to their original risk profile. Project flexibility is also an issue when considering potential route extensions (which may be difficult for the original funders to assume the risk of) and the possibility of bringing the operational role back within public sector (for example where multiple routes exist and a horizontally integrated operator would be more efficient).
Note that where the public sector has decided to make substantial capital contributions to the project during the construction phase, the ‘financing’ element of the concessionaire’s revenues will form a smaller part of the overall operating cost. In such a case it will be an important part of the risk assessment and financing approach on the project to assess the extent to which the lenders are at risk of poor project performance, and not just the operator or maintainer. If the lenders are largely isolated from performance risk, this may create lower financing costs and reduce the cost of the project, but this may come at the expense that the lenders may be less motivated to ‘police’ the project for the greater good of the stakeholders.
The choice of procurement strategy should be defined by the circumstances. For example, the complexity of the scheme may suggest that it would be more advantageous to follow a more ‘open’ procurement method which builds in significant and useful dialogue between the technical teams on public sector and private sector side before the final call for tenders is issued. Flexibility may be necessary in the final tender documentation to clarify the terms on which bidders can put forward variant proposals. PPP projects in the rail sector are sometimes criticised for lack of innovation, as the rigid PPP risk allocation structure will discourage project investors and financiers from following such risks; accordingly government parties may wish to create a mechanism to incentivise alternative proposals.