Demand Risk Mitigation

Demand and revenue risks might be associated with the long-term nature of infrastructure projects, as well as the increased likelihood of political interference in infrastructure projects which could endanger a predictable and safe revenue stream, a prerequisite for financially viable and bankable projects. Demand risk thereby jeopardises the security of debt repayment and equity returns.

Availability payments and minimum traffic/revenue guarantees have been reported as being the most effective instruments for reducing demand risk.

  • Availability payments, mentioned by 80% of respondents, transfers demand risk to the off-taker, who is typically a governmental agency or State-Owned Enterprise (SOE). This transfers availability risk (i.e. the under-performance or unavailability of the facility) to the project company. If availability drops below the agreed level, payments will be reduced.
  • Minimum traffic/revenue guarantees, mentioned by 73% of respondents, compensate the project company if revenue or traffic falls below a defined minimum threshold. There are no available insurance products to cover demand risk.

 

mitigatedemandrisk

Allocation of Demand Risk

Demand and traffic risks may be shared between public and private sectors, at least at the initial stages of a PPP programme. This might improve the financial viability of a project and increase the number of bidders in the tender process, with a positive impact on competition, costs and contract terms.

  • Transferring the risk entirely to the public sector may lead to the proliferation of inflated demand and revenue estimations in project proposals, with the government bearing high contingent liabilities and fiscal risks, in the event of a complete risk transfer to the public sector.
  • Over time, as a country develops a track record of successful projects, it might gradually transfer demand and traffic risks to the private sector. For example, the Malaysian government covered traffic risks in the first toll roads and, after developing a successful track record, progressively transferred traffic risks to the private sector.

 

Sector-Specific Demand Risks

The willingness of private parties to bear demand risks will depend on the specificities of country, sector and counter-party characteristics.

  • Energy Sector
    Demand risks are often mitigated through contractual agreements with public counterparts. For instance, independent power producers (IPP) will expect either a take-or-pay contract or availability payments in order to guarantee payments covering the fixed capital and operational expenditures; fuel and variable operational costs, on the other hand, would be covered based on the output. These contracts transfer the demand risks entirely to the public sector, with the private project company only bearing the availability risks.
    The project company might also seek additional securities (e.g. sovereign guarantees) in countries with higher risk perception, such as Cambodia, Lao PDR, Myanmar or Viet Nam. Likewise, additional public securities might be requested to reduce breach of contract (BOE) and non-payment risks in the event of an off-take agreement with a sub-national entity or a small/insolvent SOE.
  • Toll Roads
    In certain countries, such as Malaysia and Singapore, project companies increasingly bear traffic risks. Other countries, such as Indonesia and Philippines, are also increasingly seeking to shift traffic risks to the project companies.
  • Other Economic Infrastructure
    Private parties are reluctant to take demand and revenue risks in capital-intensive infrastructure investments such as railways, water and sewage systems. Public financial support might be required as cost recovery prices are unlikely to be achieved.
    In social infrastructure projects, such as schools and hospitals, the government frequently bears the demand risk as revenues are directly generated through performance-based payment mechanisms.

Instruments for reducing demand risks in infrastructure projects
Instrument Description
Availability-based
or Take-or-Pay contracts
Take-or-Pay agreements guarantee the project company fixed payments by the off-taker, often a governmental agency or SOE, as long as the project company honours the agreed performance, environmental and social standards of the infrastructure.
Payments typically cover fixed costs (debt service, fixed operational and maintenance costs) and payments for variable operational and maintenance costs, with inputs/fuel depending on actual output. Contracts often include penalties if availability or Key Performance Standards are not met. Additional payments may be made for superior service delivery.
To compensate for the higher risks associated with off-takers offering fixed-prices, tracking accounts will track differences between contract and spot market prices, and payments will be due if a certain threshold is exceeded.
• Challenge faced: With the public sector covering full demand risks, the project company’s incentives to increase demand are reduced.
Example of usage: An off-take agreement between an independent power producer and PNL (an Indonesian SOE).
Economic balance If the internal rate of return (IRR) falls below a set minimum threshold, the project company is compensated through increased tariffs, subsidies or contract length. Maximum thresholds might also be used to limit potential profits, if traffic is far higher than estimated.
• Challenges faced: (a) Given the economic-balance cannot be specifically defined in the original contract. long and expensive renegotiations to define the economic balance are often required; (b) Project sponsors are not incentivised to reduce operational costs or increase revenues if the IRR approaches the minimum threshold.
• Example of usage: in France and Spain
Minimum revenue or traffic guarantees Minimum revenue or traffic guarantees trigger compensation from the government if revenues or traffic fall below a defined minimum threshold. The lower threshold can be combined with a higher threshold to share additional profits between the private and public side.
• Challenges: A strong correlation between economic shocks and decreases in traffic, leading to public payment obligations despite lower tax revenues and higher budget constraints.
• Examples: Minimum revenue or traffic guarantees proved successful in the Republic of Korea and in Malaysia, in terms of motivating companies to engage in PPI projects .
Duration adjustments Duration adjustment contracts link the duration of a concession to a predetermined level of traffic or revenue, so that the contract can end either at its maximal contract expiry date or when the present value of the revenues reach the determined amount. In the ‘Least Present Value of the Revenues’ (LPVR) approach, the bidder with the lowest present value of the revenues wins the tender process (Engel, Fischer and Galetovic, 2001).
• Challenges: Project sponsors do not favour duration adjustment contracts as these require them to bear the risk that revenues do not reach the LPVR before the end of the contract. In addition, they do not benefit from the upside opportunities since the concession ends earlier in case of higher traffic.
• Examples: Concessions in Chile; the ‘Litoral Centro’ highway in Portugal (EIB, 2007)
Public subsidies The public authority pays the project company subsidies to substitute user fees either partly or completely. Payments could be linked to the infrastructure facility availability or to key performance indicators. Penalties to reduce subsidy payments, where availability or performance criteria are not met, might be introduced. Additional payments could honour better service delivery.
Public payments are guaranteed to cover debt service of the project, in order to reduce credit risks, thereby improving access to finance.
• Challenges: The public contractor bears demand risk completely, increasing political risks as payments depend on public authorities.
Source: Authors’ compilation based on EIB (2007), Engel, Fischer and Galetovic (2001), WB (2007)