Special Purpose Entities (SPEs) and Public-Private Partnerships (PPPs)

1. Special Purpose Entities (SPEs) andPublic-Private Partnerships (PPPs) Government Finance Division Statistics Department IMF June 1-12, 2009

2. Introduction • Governments often create “independent” institutions or entities to perform certain functions on their behalf • Widely used in recent years • From a GFSM 2001 perspective, the legal framework of such an entity is less important than the economic substance of their operations • Two types of such arrangements in this lecture: • Part I: Special Purpose Entities (SPEs) • Part II: Public-private Partnerships (PPPs) Government Finance Division, IMF Statistics Department

3. Part ISpecial Purpose Entities (SPEs)

4. Contents of Lecture • Definition of SPEs • Uses of SPEs • SPE measurement challenges • Sectorization of SPEs Government Finance Division, IMF Statistics Department

5. Definition of SPEs(1/2) • An SPE is an entity that is created, through the transfer of assets, liabilities, or rights, to carry out a well-specified activity or series of transactions • These activities are directly related to the specific purpose for which it was formed • SPE’s can be in nonfinancial and financial corporate sector • In public sector, SPE activities are often instrumental to public private partnerships, BOOT schemes, or joint ventures • Securitization of assets/liabilities Government Finance Division, IMF Statistics Department

6. Definition of SPEs(2/2) • SPEs often involve three groups: • Transferor • The entity that transfers the assets, liabilities or rights • The entity that creates the SPE • Equity could be vested in transferor and/or partners • Transferee • The newly created SPE that receives the assets, liabilities or rights • Investors • Typically provide all funding requirements for SPE activities through loans extended to SPE or securities other than shares (e.g., bonds) issued by SPE Government Finance Division, IMF Statistics Department

7. Some Uses of SPEs • Can be misused (e.g., to conceal involvement of transferor), but justifiable and legitimate business purposes exist for use of SPEs, such as • Securitization of assets • Securitization/recognition of liabilities • Pre-funding certain payments • Managing risks in financial entities • Facilitating market development • Limiting tax liabilities • Gaining efficiency Government Finance Division, IMF Statistics Department

8. SPE Measurement Challenges • Existing financial and economic analytical tools do not always capture the financial and economic activities of SPEs sufficiently due to • Lack of disclosure transparency • What about off-balance sheet assets & liabilities? • Poorly performing assets may be hidden • Establishment of layers of accountabilities • Who are participants in SPE, and how are risks, rewards, and control divided among all participants? • Thus, legal framework does not always reflect economic substance of SPE’s operations Government Finance Division, IMF Statistics Department

9. Treatment of SPEs in Macroeconomic Statistics • Make sure it is securitization • Securitization can only occur when an existing asset is sold • A future stream of revenue is not recognized as an asset, and is treated as borrowing by the creator of the SPE (i.e, NOT securitization) • Treat SPEs (other than future streams of revenue) similar to all other entities in macroeconomic statistics regarding • Sectorization • Recording of flows and stocks Government Finance Division, IMF Statistics Department

10. Sectorization of SPEs in GFSM 2001 (1/3) No

11. Sectorization of SPEs in GFSM 2001 (and other macroeconomic statistics) (2/3) • For a nonresident institutional unit that performs fiscal (or quasi-fiscal) activities on behalf of government • Record all flows between general government sector and the nonresident SPE • If no flows occurred between general government and SPE, impute flows between the general government sector and the SPE • Other nonresident SPEs • Part of “Rest of World” Government Finance Division, IMF Statistics Department

12. Sectorization of SPEs(3/3) • To determine control, use indicators of control • Ownership of majority of voting rights • Control of board or other governing body • Control of appointment and removal of key personnel • Control of key committees of entity • Golden shares and options • Regulation so tight that it amounts to control • Control by a dominant customer (e.g., government) • Controls attached to borrowing from government • Other controls associated with entity’s constitution and rules • Totality of indicators  judgmental in nature • Also see “Risk Transfer” later in PPP lecture Government Finance Division, IMF Statistics Department

13. Part IIPublic-Private Partnerships(PPPs)

14. Contents of Lecture • Definition of PPPs (or “service concession arrangements”) • Reasons for establishing PPPs • Fiscal risks of PPPs • Risk transfer, leasing, and ownership • Managing and reporting fiscal risks of PPPs • Recording of PPPs in accounting standards and GFSM 2001 Government Finance Division, IMF Statistics Department

15. Definition of PPPs(1/4) • “Public sector contracts to purchase quality services on a long-term basis—principally involving the construction of new infrastructure to provide such services.” (UK Government) • “Contract between a public sector institution/municipality and a private party, in which the private party assumes substantial financial, technical and operational risk in the design, financing, building and operation of a project.” (South African Treasury) Government Finance Division, IMF Statistics Department

16. Definition of PPPs (2/4) • The IMF definition of PPPs • Arrangements where the private sector supplies infrastructure assets and services that traditionally have been provided by the government. • Main characteristics: • Private execution and financing of public investment • An emphasis on investment and service provision by private sector • Risk transfer from government to private sector • Classic scheme: Design-Build-Finance-Operate (DBFO) Government Finance Division, IMF Statistics Department

17. Definition of PPPs (3/4) • PPPs have been used as an alternative to public procurement in different sectors • Education (e.g., schools, museums, libraries) • Health (e.g., hospitals and clinics) • Water (e.g., sanitation plants, irrigation systems, pipelines) • Public administration (e.g., courts, police stations, and prisons) • Transport (e.g., roads, bridges, tunnels, railways, airports, ports) • PPPs provide services to the government or directly to consumers Government Finance Division, IMF Statistics Department

18. Public Procurement PPP Government Government Long-term service contract Operating Firm Operating Firm Bank Bank PPP-Special Purpose Vehicle Operating contract Financing contract Operating contract Financing contract Construction contract Construction contract Construction Firm Construction Firm Definition of PPPs (4/4)

19. Uses of PPPs • Particularly well-suited for economic infrastructure, less so for social infrastructure because: • High economic rates of return of sound projects, that address clear bottlenecks, are attractive to private sector • Services are directly provided to final users, so user charges are more feasible and even desirable • Economic infrastructure projects have a more developed market for bundling construction with services than social infrastructure projects Government Finance Division, IMF Statistics Department

20. Reasons for Establishing PPPs(1/4) • Increase efficiency • Benefit from private sector expertise • Improve timely delivery of quality services • Infrastructure “for free” • Tempting particularly for cash strapped governments trying to meet fiscal targets Government Finance Division, IMF Statistics Department

21. Reasons for Establishing PPPs (2/4) • However, PPPs can be risky from a fiscal perspective: • Move spending off budget and can create (explicit and implicit) contingent liabilities for government • Potentially threaten integrity of budget process and undermine efforts to safeguard macroeconomic stability • Perhaps more difficult to achieve fiscal discipline and good governance with PPPs Government Finance Division, IMF Statistics Department

22. Reasons for Establishing PPPs(3/4) • Right Approach: PPPs should provide better value for money • Responsibility for designing, building, financing, and operating (DBFO) an asset lies with private sector • Private sector provides service with higher efficiency • Efficiency gains need to make up for higher cost of private capital, fixed cost of administering PPPs, and lack of flexibility in long-term contracts Government Finance Division, IMF Statistics Department

23. Reasons for Establishing PPPs(4/4) • Wrong Approach: PPPs allow investments to be recorded off budget • PPPs can circumvent fiscal constraints (e.g., formal rules) for infrastructure investment • PPPs can, but should not, be used to solely • bypass expenditure controls • delay borrowing • move public investment off budget • move debt off the government balance sheet • Government can be left bearing most of the risk involved, facing potentially large fiscal costs over the medium term Government Finance Division, IMF Statistics Department

24. Fiscal Risks of PPPs • PPPs entail a variety of risks: • Construction risk, financial risk, demand risk, availability risk, political risk, natural disasters • Who should bear the risk? • Public and private sector have certain advantages relative to the other in managing specific risks, e.g., • Private sector – construction risk • Public sector – political risk • Appropriate level of risk transfer depends on each project and country • Adequate risk sharing is essential to achieve value for money! Government Finance Division, IMF Statistics Department

25. Risk Transfer, Leasing, and Ownership(1/2) • Risk transfer from government to private sector has significant influence on whether PPP is more efficient and cost-effective alternative to public investment and government provision of services • Have to assess risk transfer and ownership by looking at: • Risks in owning asset • Risks in operating asset Government Finance Division, IMF Statistics Department

26. Risk Transfer, Leasing, and Ownership(2/2) • Leasing • PPPs can be set up as operating leases, unusual to take form of a financial lease • But, from GFS and fiscal risk point of view, we look at economic owner of asset by asking who bears the ultimate risk or most of the risks associated with ownership • If government, then impute a financial lease through which government acquires the asset • Often difficult to assess risk transfer • Full disclosure essential, but even then it may be problematic to assess risk transfer Government Finance Division, IMF Statistics Department

27. Managing and Reporting Fiscal Risks(1/4) • Currently, significant scope to strengthen the environment for PPPs to mitigate fiscal risks, focusing on four areas: • Good projects • Good laws • Good institutions • Good accounting and reporting Government Finance Division, IMF Statistics Department

28. Managing and Reporting Fiscal Risks(2/4) • Good projects • Systematic 2-step investment process: • Choose right projects (strategy, prioritize) • Do PPPs for the right reasons (value for money, include in medium-term budget framework) • Good laws • Legal framework for PPPs: • Introduce a clear and consistent PPP law or harmonize existing laws to provide consistent legal framework • Integrate PPP proposals and guarantees with budget cycle • Clarify roles and responsibilities Government Finance Division, IMF Statistics Department

29. Managing and Reporting Fiscal Risks(3/4) • Good institutions • Management and oversight framework • Clarify institutional roles and responsibilities • Introduce a central PPP unit • Implement a “gateway process” overseen by Ministry of Finance to authorize PPPs at each stage of project life cycle • Strengthen technical capacities throughout government institutions handling PPPs Government Finance Division, IMF Statistics Department

30. Managing and Reporting Fiscal Risks(4/4) • Good fiscal accounting and reporting • Problems! • PPPs are chosen to move public investment off budget and debt off government balance sheet • Government still bears considerable risk and potentially faces large fiscal costs • General accounting and reporting standards for PPPs are still to be developed • Proper accounting and reporting of the fiscal implications of PPPs is essential to prevent their misuse, and to make increased efficiency their main motivation Government Finance Division, IMF Statistics Department

31. Recording of PPPs in Accounting Standards and GFSM 2001 (1/2) • Topic was extensively discussed in review of SNA93 • Not yet reached a final outcome (as of May 2007) • But, already agreed to • Look at each PPP contract to determine recording • Follow the outcome of international accounting standards in recording of PPPs • In the mean time, we have fairly straight forward existing accounting and GFSM 2001 reporting standards for • Operating contracts; concessions and operating leases; financial leases; and the transfer of PPP assets to government Government Finance Division, IMF Statistics Department

32. Recording of PPPs in Accounting Standards and GFSM 2001 (2/2) • Accounting for risk transfer • Eurostat: Classify PPPs as in the private sector if private partner bears most construction risk, and either most availability risk or most demand risk. • IMF: Should look at all risks to determine who bears ultimate risk to determine control • If government controls, then PPP assets are government assets • IPSAS: Not yet determined. Leaning towards the notion of who controls asset (Consistent with SNA) • If government controls, then PPP assets are government assets Government Finance Division, IMF Statistics Department

33. IMF Operational Approach to Managing and Reporting Fiscal Risks • Aims to mitigate potential moral hazard • Emphasis on comprehensive disclosure of known and potential future costs of PPPs for public finances • Incorporation of costs into Debt Sustainability Analysis and medium-term budget framework