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FINANCIAL IMPLICATIONSOF PORT REFORM

M O D U L E 5

PORT REFORMTOOLKITSECOND EDITION

THE WORLD BANK

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© 2007 The International Bank for Reconstruction and Development / The World Bank

All rights reserved.

The findings, interpretations, and conclusions expressed herein are those of the author(s) and do not necessarily reflect the views of Public-Private Infrastructure Advisory Facility (PPIAF) or the Board of Executive Directors of the World Bank or the governments they represent.

Neither PPIAF nor the World Bank guarantees the accuracy of the data included in this work. The boundaries, colors,denominations, and other information shown on any map in this work do not imply any judgment on the part of PPIAF or theWorld Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries.

The material in this work is copyrighted. Copyright is held by the World Bank on behalf of both the World Bank and PPIAF.No part of this work may be reproduced or transmitted in any form or by any means, electronic or mechanical, including copying,recording, or inclusion in any information storage and retrieval system, without the prior written permission of the World Bank.The World Bank encourages dissemination of its work and will normally grant permission promptly.

For all other queries on rights and licenses, including subsidiary rights, please contact the Office of the Publisher, World Bank,1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail [email protected].

ISBN-10: 0-8213-6607-6ISBN-13: 978-0-8213-6607-3eISBN: 0-8213-6608-4eISBN-13: 978-0-8213-6608-0DOI: 10.1596/978-0-8213-6607-3

MODULE FIVE CONTENTS1. Introduction 203

1.1. Cost Risk 2041.2. Revenue Risk 204

Part A—Public-Private Partnerships in Ports: Risk Analysis, Sharing, and Management 2062. Introduction 2063. Characteristics of the Port Operator 207

3.1. General Aspects 2073.1.1. National Environment 2073.1.2. Industrial and Commercial Dimension 208

3.2. Specific Aspects Particular to the Port Sector 2083.2.1. Vertical Partnership with the Concessioning Authority 2083.2.2. Horizontal Partnership with Numerous Players 2093.2.3. Long-Term Commitment 210

4. Risk Management 2114.1. Country Risks 211

4.1.1. Legal Risk 2114.1.2. Monetary Risk 2124.1.3. Economic Risk 2134.1.4. Force Majeure 2134.1.5. Interference or “Restraint of Prices” Risk 2134.1.6. Political Risk 214

4.2. Project Risks 2154.2.1. Construction Risks 2154.2.2. Hand-Over Risks 2164.2.3. Operating Risks 2164.2.4. Procurement Risks 2174.2.5. Financial Risks 2174.2.6. Social Risk 218

4.3. Commercial or Traffic Risk 2184.4. Regulatory Risks 219

4.4.1. Regulatory Tools 2194.4.1.1. Technical Regulations 220

4.5. Economic and Financial Regulation 2214.5.1. Scope of Operator Activity 2214.5.2. Public Service Obligations 2214.5.3. Noncompetition Guarantees 2224.5.4. Pricing Controls 2224.5.5. Fee or Subsidy 223

4.6. Golden Share or Blocking Minority 2244.7. Risk and Port Typology 224

4.7.1. Operator Handling Only Its Own Traffic 2244.7.2. Operator Acting on Behalf of a Third Party in a Competitive Situation 2244.7.3. Operator Acting on Behalf of a Third Party in a Monopoly Situation 2254.7.4. Transit or Transshipment Traffic 2254.7.5. Mixed Situations 226

4.8. Other Concessioning Authority Guarantees 226

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4.9. Contractual Risks 2274.9.1. Contract Management 2274.9.2. Indexation Risk 2284.9.3. Credit Risk—Bonds 228

4.10. Approach of the Different Partners to Risk and Risk Management 2284.10.1. Concessioning Authority 2294.10.2. Project Sponsors 2294.10.3. Lenders 230

5. Concluding Thoughts 230Part B—Principles of Financial Modeling, Engineering, and Analysis: Understanding Port Finance and Risk Management from Public and Private SectorPerspectives 2316. Introduction 2317. Measuring Economic Profitability from the Perspective of the

Concessioning Authority 2317.1. Differential Cost-Benefit Analysis 2317.2. Commonly Used Economic Profitability Indicators 2327.3. Assessing the Economic Costs of the Project 233

8. Rating Risk from the Perspective of the Concession Holder 2338.1. Financial Profitability and “Bankability” of the Project 2338.2. Assessing the Project Risks by Producing a Rating 234

8.2.1. Commonly Used Financial Profitability Indicators 2348.2.1.1. Payback Time. 2348.2.1.2. Project IRR. 2368.2.1.3. Project NPV 2368.2.1.4. Investment Cover Ratio 236

8.3. Project Discount Rate—Cost of Capital 2368.4. Financial Debt Remuneration Requirement 237

8.4.1. Inflation 2388.4.2. Risk Rating by Determining rd 2388.4.3. Debt Remuneration Requirement Conclusion 238

8.5. Equity Remuneration Requirement 2388.5.1. Sharing of Public-Private Financial Commitments: Arbitration between

Financial and Socioeconomic Profitability 2409. Financial Project Engineering 240

9.1. Financial Structuring within the Framework of a Project Finance Set-Up 2409.2. Debt Structuring 2429.3. Long-Term Commercial Debt 242

9.3.1. Foreign Currency Loans 2439.3.2. Guaranteed Commercial Debt 2439.3.3. Export Credits 2439.3.4. Financial Credits with a Multilateral Umbrella (A- and B-loans) 2449.3.5. Bonded Debt 2479.3.6. Structuring Equity and Quasi-Equity 247

9.3.6.1. Equity Provided by the Public Sector 2479.3.6.2. Equity Invested by the Project’s Sponsors 2489.3.6.3. Equity Invested by Multilateral Institutions 248

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9.3.6.4. Equity Invested by Bilateral Institutions 2499.3.6.5. Specialist Investment Funds 249

9.4. Managing Exogenous Financial Risk 2499.4.1. Interest Rate Risk Management 250

9.4.1.1. Interest Rate Swaps 2519.4.1.2. Firm Financial Instruments in the Over-the-Counter Market 2529.4.1.3. Firm Financial Instruments in the Organized Markets 2529.4.1.4. Conditional Financial Instruments (interest rate options) 252

9.4.2. Foreign Exchange Risk Management 2529.4.3. Counterpart Risk Management and Performance Bonds 254

9.5. Financial Engineering and Political Risk Management 2549.5.1. Guarantees Offered by Multilateral Agencies 2559.5.2. Guarantees Offered by Export Credit Agencies 257

9.6. The Use of Private Insurers for Covering Political Risks 25710. Financial Modeling of the Project 257

10.1. Construction of the Economic Model 25710.1.1. Capital Expenditure Types 25710.1.2. Operating Revenues and Expenses 258

10.1.2.1. Operating Revenue and Charges in Terminal Management Operations 25910.1.2.2. Operating Finance Requirement 25910.1.2.3. Operating Account Balance 259

10.1.3. Tax Flows 26010.2. Construction of the Financial Model 260

10.2.1. Cash Flow Statement 26010.2.2. Profit and Loss Account (income statement) 26010.2.3. Balance Sheet 261

References 261Appendix: Risk Checklist—Principal Risks in a Port Project 263

BOXESBox 1: Richard’s Bay Coal Terminal: A Wholly Private Terminal 219Box 2: Port Réunion: A Single Container Terminal Using Several Handling Contractors 223Box 3: Owendo Ore Terminal in Gabon 225Box 4: Container Terminals in the North European Range 225Box 5: Container Terminal Operator in the Port of Klaipeda 226Box 6: Port of Djibouti: Transit and Transshipment 226Box 7: Djibouti Fishing Port: Public Service and Semi-Industrial Activity 227Box 8: Horizontal and Vertical Partnerships in the Port of Maputo, Mozambique 227Box 9: The Country Ranking Developed by Nord-Sud Export 235Box 10: An Example of Export Cover by COFACE in a Port Project 245Box 11: Principal Guarantees Offered by an Export Credit Agency for Project

Financing: The COFACE Example 246

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Acknowledgments

This Second Edition of the Port Reform Toolkit has been produced with the financial assistance of a grant fromTRISP, a partnership between the U.K. Department for International Development and the World Bank, for learningand sharing of knowledge in the fields of transport and rural infrastructure services.

Financial assistance was also provided through a grant from The Netherlands Transport and Infrastructure TrustFund (Netherlands Ministry of Transport, Public Works, and Water Management) for the enhancement of theToolkit’s content, for which consultants of the Rotterdam Maritime Group (RMG) were contracted.

We wish to give special thanks to Christiaan van Krimpen, John Koppies, and Simme Veldman of the RotterdamMaritime Group, Kees Marges formerly of ITF, and Marios Meletiou of the ILO for their contributions to this work.

The First Edition of the Port Reform Toolkit was prepared and elaborated thanks to the financing and technicalcontributions of the following organizations.

The Public-Private Infrastructure Advisory Facility (PPIAF)PPIAF is a multi-donor technical assistance facility aimed at helping developing countries improve the qualityof their infrastructure through private sector involvement. For more information on the facility see the Web site: www.ppiaf.org.

The Netherlands Consultant Trust Fund

The French Ministry of Foreign Affairs

The World Bank

International Maritime Associates (USA)

Mainport Holding Rotterdam Consultancy (formerly known as TEMPO), Rotterdam Municipal PortManagement (The Netherlands)

The Rotterdam Maritime Group (The Netherlands)

Holland and Knight LLP (USA)

ISTED (France)

Nathan Associates (USA)

United Nations Economic Commission for Latin America and the Caribbean (Chile)

PA Consulting (USA)

The preparation and publishing of the Port Reform Toolkit was performed under the management of Marc Juhel,Ronald Kopicki, Cornelis “Bert” Kruk, and Bradley Julian of the World Bank Transport Division.

Comments are welcome.Please send them to the World Bank Transport Help Desk.Fax: 1.202.522.3223. Internet: [email protected]

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This analysis demonstrates that the scope ofport terminal operator covers a range of differ-ent situations, depending on the type of traffichandled and the degree of competition sur-rounding the activity. This diversity substantiallyaffects the degree of required regulation of theoperator’s activity on the part of the portauthority or other regulating body (seeModule 6). This regulation, in turn, has majorimplications for the operator, both in terms ofthe level of risk carried and risk managementcapacity. Therefore, the principles adopted forsharing the risk between the port authority and

the terminal operator must take this essentialconsideration into account.

Reducing the situation to its simplest terms, theterminal operator carries two fundamental risks:a cost risk, or a risk of exceeding initial costestimates for the construction or operation ofthe project, and a revenue risk, or commercialrisk, depending on traffic and revenue yields.

There is nothing extraordinary about this situa-tion. Any enterprise operating in any field ofactivity has to carry these risks. However, theterminal operator conducts its activity largely in

5Financial Implications of Port ReformSECOND EDITION

1. INTRODUCTION

Over the last few years, there has been a strong trend toward theintroduction of private management in the port domain in bothindustrialized and in developing countries. This privatization

principally concerns the handling and storage of freight transiting via theport, and the funding and operation of the infrastructure, superstructures,and equipment required for these activities. This trend has involved theconstruction of complex, multidimensional partnerships between publicport authorities and terminal operators. Module 5 presents an analyticalframework for assessing the risks confronting port operators and with thegoal of identifying principles for the equitable sharing of each risk betweenthe public and private sector parties involved.

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the public domain, and can have the support ofpublic investment, supply a public service, andenjoy a de facto monopoly. Over and above theoverarching legislative and statutory frame-work, some measure of regulation of its day-to-day activity is often deemed necessary. This reg-ulation can cover a number of technical aspects(definition of the project, performance stan-dards, standards relating to maintenance of thefacilities, and so forth), economic aspects (pub-lic service obligations or field of activity restric-tions), and financial aspects (control of prices,fees, or subsidies). Module 6 reviews in detailthe aspects pertaining to economic and financialregulations.

What is the impact of regulation on the costand revenue risks, and in what way does it con-dition the principles for sharing these risks?

1.1. Cost RiskThe constraints imposed by technical regulationhave an impact on the initial estimation ofproject cost (investment and operation).However, provided the rules of the game areestablished at the outset, and provided theserules are clear, stable, and complied with, theydo not affect the excess cost risk, which thenonly depends (apart from cases of force majeure)on the ability of the operator to implement theproject. Under such circumstances, it is reasonableto expect the operator to identify and assumethe full cost of attendant risks.

Where risks and associated excess cost stemfrom changes in the regulatory system or legalframework established prior to signature of thecontract, the principles of risk sharing mustthen depend on the very nature of the activity.Two situations are possible in this case:

• The service provided by the operator isnot regarded as a public service. Thedegree of regulation is then low, and hasno reason to change. The risk of changesin the legal framework is considered bythe operator as a country risk, such asexists for any industrial company. It isreflected by an adjustment of the initially

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anticipated level of return, and can besubsequently passed on to customersthrough increases in charges.

• The service provided by the operator isregarded as a public service. The contractconcluded between the port authority andthe operator is then similar to a publicservice franchise agreement. Integrationof this risk by the operator wouldincrease the cost of the service providedand would have an adverse impact on theuser. Furthermore, regulation of tariffsimposed on the operator could make itimpossible for the operator to pass onincreases to the user at a later date. Ittherefore appears equitable that this riskshould be shared.

The principles of risk sharing should be clearlydefined on signature of the agreement, and cancover guarantees of stability or provide appro-priate compensation (for example, lifting ofpricing constraints, indemnities, or other con-siderations).

1.2. Revenue Risk In contrast to the cost risk, regulation has adirect impact on the extent of the revenue riskfor the operator and on its ability to managethis risk. The revenue risk is in fact the princi-pal risk involved in a port project due to theuncertainty inherent in traffic and throughputlevel predictions.

As a general rule, it is desirable to assign thetraffic risk to the operator. This is possible andjustified in a case where the activity is not apublic service. Sharing of profits between theport authority and operator can be envisagedunder certain circumstances. This is also possi-ble in the majority of cases where the activity issubject to genuine competition.

On the other hand, sharing of this risk is fre-quently necessary in the case of a public servicemonopoly. The substantial degree of regulationrequired in this case imposes such constraintson the operator that it has little means of man-aging the commercial risk. The port authority

can then, as appropriate, provide the conces-sionaire with a guarantee of noncompetition,possibly temporary, or even implement a nega-tive concession formula where the operator bidsfor the lowest level of subsidy required whenthe traffic is acknowledged to be too low tosustain commercial viability.

While the operator is then no longer fully atrisk for meeting the project’s projected revenuelevel, it must continue to bear responsibility forthe costs. The regulatory system therefore mustnot deviate from the principle of assigning theproject risk to the operator. This is the casewhere the contract provides for a guaranteedminimum level of return, or adjustment of ratesand charges according to costs.

Another risk for the operator is present in allcases. This is the political risk of noncompliancewith the terms of the contract by the publicauthority, or the imposition of discriminatorymeasures affecting the project. This risk can bereduced by various methods, or hedged. Theassessment of this risk nevertheless represents amajor factor in the decision of the operator toproceed or not with the project. Political riskmay manifest itself either as a revenue risk or acost risk.

In the end, the principles of risk sharing betweenthe public port authority and the operatordepend, to a large extent, on the degree of publicservice accorded (or not) to the activity concernedby the national authority and the resultantregulation. The initial situation frequently is thatof a stagnant public sector, with little means ofclearly identifying among the various tasks inwhich it is engaged those which relate genuinelyto the public service, and which, when delegatedor franchised to an operator, demand strict regu-lation. While a form of partnership always existsbetween the port authority and the operator, theactivities of the port terminal operator do notalways embody the characteristics of a publicservice, and do not therefore require the samelevel of regulation in all cases. Note, however,that any form of regulation imposes costs,namely the cost of the additional risk imposed

on the operator (reflected by a requirement for ahigher rate of return), the cost of resultant con-siderations, or simply the cost of supervision. Tominimize such costs, the objective should be toregulate only in those cases where it is clearlyessential.

The port terminal operator has numerous part-ners in the provision of comprehensive port andtransportation service, the most important ofwhich is the port authority itself. The portauthority therefore, is not often only a regula-tor, but also the primary partner of the terminaloperator. From this point of view, the type of“horizontal” partnership between terminaloperator and port authority does not differfrom that which can exist between two compa-nies. Of necessity, this partnership involvesreciprocal obligations, with the port authorityguaranteeing not only the services that it pro-vides directly, but also those which it may beled to delegate to other entities operating withinthe port complex.

The involvement of private companies in portmanagement leads to the introduction of a com-plex, multidimensional partnership with theport authority. This requires the establishmentof a clearly defined, stable, contractual frame-work that enables the operator to quantify andmanage the risks with which it will be confront-ed, and which is based on comprehensive legalprocedures and techniques. However, no con-tract can provide for all eventualities. It is there-fore necessary to include clauses that define theconditions and procedures for periodic reviewsand negotiations for the purpose of making nec-essary adjustments. Apart from this renegotia-tion process, the option of issuing new calls fortender at periodic intervals during the lifetimeof the project is a possibility, despite practicalproblems of implementation. In some cases, aclear division between infrastructure and equip-ment management and activities managementmay be desirable. See Module 4 for a full dis-cussion of legal issues.

Once the risks have been distributed betweenthe public and private partners, the privateoperator—the concessionaire—will seek to


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“quantify” and “rate” the residual risk it mustbear. The risk valuation will be determinedthrough country and project ratings. Tariff set-ting will be contingent upon a minimum finan-cial break-even point, below which prospectiveconcessionaires will be unwilling to participate.From the point of view of the concessionairethen, the riskier the project, the higher therequirement of expected returns.

A risk-return assessment is an integral part of acomprehensive profitability analysis of the proj-ect. Such analysis would help determine underwhat conditions and terms the project willsucceed in meeting the needs of the market,given the ever changing nature of these needs.This is what is implied when analysts speak of“project bankability.” The operator is nowfaced with two compelling sets of parametersresulting from the profitability analysis and thecost-effectiveness analysis of the project, andtheir impact on the socioeconomic returns forthe community at large. Because of thesemarket-driven financial constraints and thefragile nature of the public-private partnership,there is as much a case for sharing financialobligations as there is for risk distribution betweenthe port authority and the concessionaire. Toreach agreement on an equitable distribution ofrisks, the difficult balance between socioeco-nomic returns of a project and financialprofitability must first be achieved. Thisamounts to finding the optimal equilibriumwithin the framework of a regulatory systemacceptable to both partners.

Part A of this module focuses on the issue of“financial engineering” and the effort tosecure the best terms for financing and cover-age of the project based on the risk analysisand the financial constraints. The key compo-nents are the structuring of the project equityand debt, and the management of “exoge-nous” and political financial risks. Financialengineering is a complex process given theconstant introduction of new and moresophisticated financial tools; it is also a deli-cate process because financial partners com-mit to projects on a long-term basis. Since

project funding is such a critical element ofany significant port reform initiative, a solidunderstanding of financial engineering isessential. Part A takes a pragmatic view of thesubject and seeks to establish a basic under-standing of what is at stake. It does notattempt to undertake a comprehensive treatiseon the more sophisticated mechanisms forcoverage and financing.

PART A—PUBLIC-PRIVATEPARTNERSHIPS IN PORTS: RISKANALYSIS, SHARING, ANDMANAGEMENT

2. INTRODUCTION We are witnessing a vast movement toward theprivatization or private management of publicservices throughout the world, in industrializedas well as in developing countries. This trend isespecially marked in the port sector, where callsfor tenders to introduce private management toports previously under the control of the gov-ernment or other public entity have increasedsubstantially in the last few years. This trendhas created a market for companies to developport concessions. Projects of this type, whichare frequently set up on a project financingbasis, generate significant risks for the variousparties involved (private sector, investors, andlenders).

Port reform also requires public authorities totake on a new role, that of “concessioningauthority” or regulating authority. Thesechanges permit the public authority to concen-trate on its essential tasks of economic, social,spatial, and temporal regulation to achieve thebest balance among the interests and demandsof the various port and shipping entities and ofthe general public.

Part A of this module will review a number offinancial aspects of port reform using the exam-ple of a public landlord port that has decided totransfer a terminal into the hands of a privateoperator. (See Module 3 for a full discussion ofservice, tool, and landlord ports.) This involvesto a greater or lesser degree the delegation of


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design, construction, and operating functions tothe private sector. In this context, the partner-ship established between the port authority andoperator can take a number of different forms.These are difficult to describe accurately bymeans of a simple topology as many differenttypes of contracts can be used (see Module 4).Apart from the usual distinctions in terms ofthe delegated services, ownership of the facili-ties or the point in time at which the operatorintervenes during the lifetime of the project(operation and maintenance contracts, leasecontracts, concession, BOT [build-operate-transfer], or BOO [build-own-operate] agree-ment, and so forth), particular attention will bepaid to the problem of risk sharing between theport authority and the operator. All public-pri-vate partnerships are defined in a contract, thecontent of which must be adapted according tothe characteristics of the particular project.These contracts reflect the mutual commitmentsof the parties and in defining them, the risksassumed by each party.

One of the essential conditions for the successof port reform projects is the ability to identifyrisks. This is a prerequisite to determiningoptimum risk sharing between the variousparticipants according both to their respectivecapacity for risk management and their willing-ness to carry these risks. We shall thereforeaddress the question of risk sharing analysis ingreater depth, by means of a pragmatic exami-nation of what it signifies from the terminaloperator’s viewpoint. The tools we will employwill include a set of principles constituting acode of good practice that have proven accept-able to all parties for risk allocation and sharingin various situations, and an assessment gridthat can be used to perform a quick evaluationof the main risks of a project and the ability ofa candidate operator to manage these risks.

3. CHARACTERISTICS OF THEPORT OPERATOR In the majority of cases, private sector partici-pation in port operations comprises industrialand commercial activities, the foremost of

which are the handling and storage of merchan-dise passing through the port. These port activi-ties involve business practices common to allcompanies as well as aspects that are highlyspecific to the port sector.

One can characterize the port operator througha description of these basic and specific aspectsand, using this characterization, establish an ini-tial classification of the risks that the operator islikely to encounter. This approach deliberatelyleaves the definition of the “port” very broad todemonstrate the complexity of the environmentof the port operator, whose activity simultane-ously takes place in a port community, a trans-port chain, and national and an internationaleconomies, while nevertheless preserving theprincipal characteristics of an ordinary company.

3.1. General Aspects 3.1.1. National Environment

In common with any other private company, aport operator must transact business accordingto the legal, economic, social, and politicalenvironment of the country in which it isconducting its activity. The legal and statutoryenvironment incorporates the applicable com-mon law rules and regulations, whether stem-ming from national legislation or internationalagreements of which the country is a signatory.These include company law; rules of fair com-petition; tax law; exchange control; regulationsgoverning transfer prices and tax withholdingon the payment of dividends; labor laws; lawsrelating to the protection of the environment;police; concession and property ownership reg-ulations; and customs regulations. This environ-ment also comprises specific measures applica-ble to ports, such as those concerning their legalstatus, rules regarding police and security serv-ices, and even special measures relating to prop-erty ownership, labor laws (as specific to dockworkers), taxation, and so forth.

The economic environment is defined by therelevant macroeconomic factors (growth,inflation, exchange laws, debts, and so forth),as well as the wage and salary levels, the level of


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training and skills of local human resources,price levels, and so forth.

In its broadest sense, the political and socialenvironments are based on prevailing geopoliti-cal conditions, the stability of the existingnational, local, or regional government, the pos-sible risk of armed conflict, the labor climate,and so forth.

The port operator is thus subject to the fullrange of national legal, economic, social, andpolitical influences that determine the stabilityof the nation and locale in which the project islocated. This must be analyzed in detail, as thisenvironment generates a number of risks, typi-cally referred to as “country risks.”

3.1.2. Industrial and CommercialDimension

A port operator is a service provider, althoughwith a substantial industrial and commercial(infrastructure and investment) dimension. Thisis one of the reasons behind the desire to intro-duce private management in ports. It is generallyadmitted that a private company has a degreeof flexibility and an ability to react quickly thatenables it to achieve greater efficiency than apublic entity.

In the course of its activity, the operator mustfinance, install, operate, and maintain the neces-sary infrastructure, superstructures, and equip-ment. In common with any other company, theoperator must apply its own expertise andresources, while also establishing contractualrelationships with various equipment suppliersor service providers (construction contracts andthe purchase of tooling, water, electricity, andso forth), employing subcontractors for specificoperations (maintenance, security, or even theoperations themselves), and with the bankingsector for the financial package on which theoperation is based. This industrial dimension ofthe operator’s activity creates what are referredto as “project risks.”

The port operator deals daily with its cus-tomers, whether shipowners or shippers, who

are sensitive to the quality of service suppliedand the rates charged. These aspects, in turn,are directly affected by the extent of competi-tion confronting the operator. This relationshipwith customers, on which the level of activity islargely dependent, generates a “commercialrisk” or “traffic risk” for the operator.

3.2. Specific Aspects Particular tothe Port Sector 3.2.1. Vertical Partnership with theConcessioning Authority

Apart from the legal environment as describedabove (common law and sector-related rules),under the terms of its contract with the opera-tor, the port authority imposes a set of measureson the operator defining, directing, regulating,or simply authorizing the operator’s activityover a given period. This form of relationshipbetween the port authority and the operator isdescribed here as a “vertical partnership.” Thisvertical partnership reflects the extensive scopeof public service activities the port authorityoften delegates to the port operator. Inclusionof these measures in the operator’s contract isjustified for a number of reasons:

• The port activity involves public issuesincluding issues relating to national eco-nomic development, land use, and thehandling of external trade.

• The tasks undertaken by the operatormay have the characteristics of a publicservice and may be burdened with at leastsome of the obligations inherent in thenotion of public service, including nondis-crimination and continuity of service.

• The nature of the activity in or the physi-cal location of the port can lead to thedevelopment of de facto monopolies withsubstantial entry barriers (for example,rarity of sites, need for public investment,or an insufficient level of activity for morethan one operator). This type of situationmakes the intervention of a regulatingauthority necessary to protect users froman abusive advantage due to a dominant


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position. However, this recognized needfor oversight should not cast doubt onthe principle of legal security, and mustavoid any malpractice whereby the portoperator could be subjected to arbitrarydecisions.

• The activity of the port operator canrequire public investment in addition toprivate investment. The investment nec-essary for the operator’s activity canproduce a return on invested capitalthat, while satisfactory for the publicentity involved, is insufficient for theprivate investor. This is the case wherethe project generates positive externali-ties and where it is not possible toobtain a direct contribution from all theindirect beneficiaries of these externaleffects. The need to draw on publicfunds also stems from the lengthy life-time of port facilities, which makes itnecessary to obtain a return from thelatter over periods that substantiallyexceed the term of loans available on thefinancial markets.

• The shoreline forms part of the publicdomain in many countries, which meansthat, at the least, express authorization(unilateral or contractual) is required toengage in an activity along the water-front.

It is the integration of these constraints by thepublic authority that makes a vertical partner-ship and government oversight essential. Theseconstraints also have substantial consequencesfor the port operator and the risk it incurs andits ability to manage this risk. These conse-quences flow from several factors including:

• The concessioning authority may imposeconditions and constraints on the opera-tor’s industrial project, resulting in costincreases.

• Regulation imposed by the concessioningauthority can limit the ability of the oper-ator to manage commercial risks, requir-ing a sharing of that risk.

• Vertical partnerships by their very naturelead to contractual risk for the operatorbecause the partnership with the portauthority is based on a contractual rela-tionship.

3.2.2. Horizontal Partnership withNumerous Players

The service a port operator provides to its cus-tomers, whether shipowner or shipper, is part ofa more global service of which the operatoronly provides one element. The operator is thusin a de facto partnership with service providershandling the other components of an integratedtransport and logistics chain. This is referred toas a horizontal partnership. This type of part-nership may also exist with the port authority ifit is a service provider, and with other playersof widely differing specializations. It can also bean impromptu partnership, not formalized bydirect contractual links between the parties con-cerned. The extent of and parties to this hori-zontal partnership depend on the legal positionand activity of the customer.

One can broadly describe the integrated serviceexpected by the port operator’s principal cus-tomers, shipowners and shippers. For ashipowner, the integrated service expected cov-ers all operations required for the ship’s call.The services provided by the terminal operator(handling and storage) represent the most sensi-tive and costly parts of the call, although a vesselcall also requires suitable maritime access, oper-ational buoying, properly maintained basinsprotected from the swell, efficient services to thevessel (pilot, tugs, in-shore pilot), and modernelectronic data interchange (EDI) and vesseltraffic services (VTS), and so on. Above andbeyond the service offered by the terminal oper-ator, this means that the shipowner is sensitiveto factors such as the level and reliability of thesupporting services provided in the port zone.This identifies a first level of horizontal partner-ship within the port community, where the part-ners can be other public or private companies,and the port authority itself. Procedures imple-menting this partnership are formalized in con-tracts concluded between the port authority and


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the companies operating in the port zone, or viapolice and operating rules and regulations.

For a shipper, the relevant service is the end-to-end transport service, using a transport chain inwhich transit via the port is merely one link, ormore precisely a node. This means that theshipper is sensitive to the existence and compet-itiveness of the land transport modes serving theport as well as to the coordination of these serv-ices with the port services. This depends on amultitude of factors—controlled by numerousplayers—including the quality of road, rail, orinland waterway transport infrastructure; thequality of the services provided by the operatorsof the different modes of transport; and variousregulatory measures (flag restriction, charges,and so forth). This leads to a second level ofhorizontal partnership, where the partners areof varying types and frequently remote from theport activities proper. This situation leads anumber of transport companies to seek the inte-gration of the port operator and land carrierbusiness to achieve more efficient control of alarger part of the transport chain.

In addition, it is clear that the ways in whichthe government agencies carry out their func-tions in a port (for example, customs, veterinaryand phytosanitary departments, or frontierpolice) represent another aspect of performancethat is taken into account by customers whenassessing the competitiveness of a particularport. In this context, for example, the EuropeanUnion recognizes that the conditions underwhich customs control is exercised can distortthe competitive situation (“Douane 2000” pro-gram). Similarly, a number of countries inAfrica have recognized this problem and takensteps to harmonize their customs rules andpractices (Central African States CustomsUnion).

It is therefore apparent that the port operatordoes not control all components of the globalservices delivered to its customers. The cus-tomer’s decision to use the operator’s services,then, also depends on factors external to theoperator. These factors are under the control of

numerous players with which the operator isnot necessarily in direct contact. This situationcreates a further commercial risk for the portoperator and complicates the management task.

3.2.3. Long-Term Commitment

The port operator runs a business.Consequently, it seeks to maximize profit,although its primary objective is at least toachieve a minimum acceptable level of returnon operations and investment to be able tocover its costs and to remunerate its lenders andsponsors. The investments that the operatormakes typically display two special characteris-tics: they are substantial, indivisible, and haveextended lifetimes, meaning that they can bedepreciated and yield a proper return only overperiods frequently exceeding 20 years, and theyare “nonrecoverable,” either because they can-not be physically dismantled (for example, acoffer dam) or because the concessionaire doesnot own the infrastructure or equipment inquestion.

The justifiable demand of the operator for areasonable return on investment necessarilyrequires that it have the right to exploit thoseinvestments for a sufficiently long period oftime. The above-mentioned characteristics gen-erally mean that an operator’s early withdrawalfrom a project would have substantial negativefinancial consequences. In some cases, though, along-term commitment by the operator mayalso become a source of concern to the conces-sioning authority. It is therefore in the interestsof both parties to seek a clear and stable legalarrangement by:

• Agreeing to an appropriate contract peri-od giving due recognition to the specialcharacteristics of the project.

• Attributing genuine rights of ownershipto the operator for facilities installed inthe public domain.

• Agreeing on an equitable and clear can-cellation procedure (stipulating causesand indemnification).


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• Adopting rules of the game that bothreduce uncertainty and ensure propertransparency.

4. RISK MANAGEMENT Risk management by the terminal operatorinvolves a number of steps. Based on theapproach adopted by many financial institu-tions for funding projects with limited or norecourse, these steps are:

• Risk identification.

• Sharing of risks with the port authority,the state, or other public authoritieswhere it is justified or possible.

• Sharing of risks with partners (for exam-ple, sponsors, customers, suppliers, orsubcontractors).

• Reduction of exposure to residual risk(or the probability of its occurrence).

• Reduction or limitation of the conse-quences of residual risks (for example,use of insurance or accruals).

• Adjustment of the expected rate of returnaccording to the degree of residual risk.

Two principles should be applied in situationswhere the activity of the operator represents thedelegated management of a public service. First,the reduction of the project’s global risk (andconsequently of project cost) requires the properallocation of risk. Risk sharing between conces-sioning authority and concessionaire on the onehand, and the various sponsors and lenders onthe other, must be based on analyses designedto identify and allocate risks to those partiesthat can carry them best (with least negativeimpact). Second, any risks allocated to theoperator will be reflected in a requirement forhigher profits, in terms of level or duration,with a resultant increase in the cost of the serviceprovided. It is, consequently, in the interest ofthe concessioning authority to restrict, as far aspossible, the unnecessary imposition of risks onthe operator when the operator is not in aposition to manage them. In other words, it isundesirable to make the operator carry risks

that the public sector would be able to carry ata lower cost.

This section explores the approaches operatorscan use to manage the various types of risk pre-viously identified, and applies the principles setout above to suggest equitable systems for risksharing between concessioning authority andconcessionaire.

4.1. Country Risks Detailed below are risks resulting from thenational and international framework withinwhich the projects must operate.

4.1.1. Legal Risk

Legal risks arise in connection with the lack ofprecision in and the possibility of changes in thelegislation and regulations governing theproject. It must be assumed that a set of rulesexist at the time the project is initiated.

Insufficient precision in applicable laws and reg-ulations can lead to disputes and misinterpreta-tions and therefore creates risk. In some cases,legal issues can be extremely complex, not onlybecause laws and regulations can be subject to avariety of interpretations, but also in terms ofjurisprudence. Furthermore, common practicefrequently imposes a number of mandatoryrules in terms of port operation (for example,FOB [free on board] Dunkirk, Antwerp).Consequently, a thorough legal analysis shouldbe undertaken prior to the implementation ofthe project. When the project is located in anarea unfamiliar to the operator, it is particularlyprudent to call on the services of local legaladvisors specializing in the various disciplinesinvolved in the project. This will help to reducethe incidence of circumstances that might delayproject implementation. The risk of noncompli-ance by the operator with legal or regulatoryrequirements through ignorance is one carriedexclusively by the operator.

The risk of changes in legislation or regulationsstems from the possibility that circumstances ineffect at the time of the agreement may changeat a later date. According to the principles put


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forward at the beginning of this chapter, onecan argue that the operator is justified in callingfor guarantees of legal stability to guard againstchanges over which the operator has no con-trol. Any such guarantee of legal securityshould not come at the expense of fair competi-tion among operators or jeopardize the contin-ued operation of any public service. On theother hand, in the case where management ofpublic service is delegated to an operator, theoperator is not in an ordinary business situa-tion. First, because the permanency of the oper-ator’s activity is essential to ensure continuity ofthe public service, and second, because thedegree of regulation imposed on the operatormay well prevent it from adapting to suchchanges in the legal environment. Consequently,it is desirable either to guarantee stability or toinclude a contract revision clause to avoid situa-tions where a change in the legislation or regu-lations could put the financial viability of theproject in jeopardy.

The risk of changes in legislation relating to theenvironment can be particularly significant, andcan materialize during the construction or theoperational phase. Prior to any decision con-cerning privatization, the prudent concessioningauthority should undertake an environmentalstudy of the project. Conventionally, such stud-ies include:

• The impact of the construction of marineinfrastructures on the existing marineenvironment.

• Management of pollution from shipwastes.

• Management of dredging-induced con-tamination.

• Management of pollution resulting fromaccidents.

With respect to environmental risk management,the aspects specific to environment-relatedregulations should be established prior to thebidding process and, where appropriate, negoti-ated at the time of signature of the contract.Any increased construction costs caused by

changes in environmental legislation during thelife of the concession should trigger renegotia-tion of the contract between the two parties todefine the amount of and procedures for indem-nification of the operator by the concessioningauthority.

4.1.2. Monetary Risk

In a country where the national economy isweak or unstable, macroeconomic problems orfiscal rules imposed by the host country create arisk, for both shareholders and lenders, that theproject may be unable to generate sufficientincome in strong currencies. The main mone-tary risks that can create this situation include:

• Exchange rate fluctuations.

• Nonconvertibility of the local currencyinto foreign currencies.

• Nontransferability (funds cannot beexported from the host country).

Where the project can generate foreign currencyincome, which is frequently the case when serv-ices are invoiced to foreign shipowners or ship-pers, the foreign exchange and convertibilityproblems can be easily overcome. The best wayof hedging the transferability risk is for theoperator to be paid via an account opened out-side the host country (offshore account). Use ofsuch accounts frequently requires approval bythe local authorities. When an offshore accountcan be opened, exchange controls or the prohi-bition of the export of foreign currency fromthe host country would have no direct impacton the economics of the project. In this case, themonetary risk is not hedged, but eliminated. Inthe contrary case, where no authorization canbe obtained to open an offshore account, othermeasures must be considered. The concessionaireshould seek convertibility and transferabilityguarantees from the government or centralbank. Decisions about such guarantees oftenbecome political issues.

As for the exchange risk, this can be partiallyhedged by ensuring that the majority of expensesare paid in local currency; for example, by rais-


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ing part of the debt in the currency of the hostcountry. However, frequently this is not suffi-cient; it is rarely possible to raise the requiredfunding for large projects locally. Further, for-eign investors must be remunerated in foreigncurrency. The latter also applies to part of thepurchases and personnel expenses (expatriatepersonnel). Where conditions allow, hedgingproducts (for example, exchange rate swaps)can be used to manage the exchange risk. If,on the contrary, such products do not existdue to the instability or weakness of the hostcountry currency, the exchange risk representsa major problem as it can only be carried bythe shareholders and lenders, unless anexchange rate guarantee can be obtained fromthe central bank of the host country. The lattersolution can only be envisaged in the event theproject is of critical importance for the hostcountry. Such considerations again add a polit-ical element to management of exchange risk.

4.1.3. Economic Risk

Port activities form part of national and inter-national transport chains. The volume of trademoving through these chains depends to a largeextent on macroeconomic factors, namely popu-lation, consumption, production, exports, andso forth. Consequently, the macroeconomic sit-uation and its expected evolution have a strongimpact on the level of activity in a port. It isessential to take this element into account in themarket survey conducted to estimate the trafficand throughput risk. The principles of trafficand throughput risk sharing are analyzed in alater section devoted to this topic.

4.1.4. Force Majeure

Force majeure generally covers all events out-side the control of the company and events thatcannot be reasonably predicted, or againstwhich preventive measures cannot be taken atthe time of signature of the contract, and whichprevent the operator from meeting its contrac-tual obligations. Apart from this general defini-tion, examples of force majeure are generallystipulated in the contract, including:

• Natural risks, such as climatic phenome-na (cyclones and exceptionally heavyrainfall), earthquakes, tidal waves, andvolcanic eruptions.

• Industrial risks, fire, or nuclear accident.

• Internal sociopolitical risks, such asstrike, riot, civil war, and guerrilla or ter-rorist activity.

• Risks of war or armed conflict.

In certain contracts, unilateral decisions by thelocal authorities can be included in the list ofevents covered by force majeure, in particularwhere such decisions discriminate against theoperator.

These risks are included under country risks, as itis the national context that determines the proba-bility of their occurrence. It is reasonable that ifany such event occurs, it should result in the sus-pension of reciprocal obligations of the partiesinvolved, with a resultant limitation (althoughnot elimination) of their consequences. The con-tract can also include procedures for sharing theburden of the consequences of such eventsbetween the parties, in particular where the oper-ator is managing a delegated public service.

4.1.5. Interference or “Restraint of Prices”Risk

Interference or restraint of prices risk coversthose risks that relate to the direct interventionof the public authorities in the management ofthe project. Public service requirements are nor-mally defined in contract specifications, and theconcessioning authority should not, in principle,interfere in any way during the construction oroperating phases, provided the concessionairecomplies with these requirements. However,concessioning authorities frequently do inter-vene in the name of public service or for theprotection of the users, for reasons of security,for the protection of the environment, or simplyon an arbitrary basis. Such interference can takethe form of the imposition of new operatingrequirements, additional investment, or newconstraints, the result of which is to increaseoperating costs or reduce revenue.


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Intervention by the government may be wellfounded, but the concessionaire can then legiti-mately expect compensation from the conces-sioning authority for the constraints imposedand indemnification of losses resulting from theconcessioning authority’s actions.

The best way of attenuating the interference risk isto have a contract that not only states unequivo-cally the objectives of the parties, but also specifiesthe limits on government authority to intervene.The contract may also include provisions thatwill obviate the need for arbitrary governmentintervention, for example, price escalation clausesor the obligation to increase capacity above acertain traffic or throughput level.

Clearly, it is impossible to foresee all events thatmight give rise to intervention by the govern-ment. Hence, it is a good idea to include con-tract provisions that call for periodic meetingsto discuss the status of the contract and allowfor renegotiation of the contract to account forsignificant changes in circumstances.

4.1.6. Political Risk

The operator cannot control the risks inherentin decisions taken by public authorities. Theoperator naturally seeks protection againstharmful decisions through the clauses of thecontract by transferring this risk to the conces-sioning authority. This is not sufficient, however,since noncompliance with the terms of thecontract by the concessioning authority or thegovernment is just one of the risks facing theoperator. In addition, the approval of contractsor the issuance of authorizations from adminis-trative authorities can cause delays and increasecosts for the operator. Finally, the risks ofexpropriation and nationalization are also adanger. The risks of noncompliance, inefficiencyor expropriation, and nationalization aregrouped under the designation of political risk.

Apart from the detailed analysis of contractualcommitments, there is also the problem of thecredibility of the applicable legal system. Theeffectiveness of contractual commitmentsdepends initially on the mechanisms available

for settling disputes. Recourse to internationalarbitration is desirable, involving a neutraljurisdiction applying recognized internationalrules, such as those of the InternationalChamber of Commerce. Likewise, the applica-ble contract law can be that of a mutuallyacceptable third-party country.

This purely contractual approach, while useful,is frequently inadequate to ensure the accept-able management of the political risk. In prac-tice, the arbitration phase of disputes is rarelyreached, but when it is, it reflects the degrada-tion of relations to such an extent that thefuture of the project is very often threatened.

There are, however, other strategies for protect-ing against political risk. The inclusion of multi-lateral organizations, such as the World Bank orthe International Finance Corporation (IFC),among the shareholders or lenders represents aform of protection for the operator. The pres-ence of these institutions is not a formal guar-antee, but governments generally seek to avoidantagonizing these important multilateral insti-tutions by imposing measures that would upsetthe equilibrium of a project in which they areinvolved. Similarly, the financial involvement ofsponsors or lenders from the host country canalso serve to limit the political risk.

Another approach involves recourse to theexport credit agencies such as COFACE inFrance or Export-Import Bank in the UnitedStates, which act as guarantors for the politicalrisk during the loan period.

Actual insurance cover can also be obtained tohedge certain specific risks. Such policies can beobtained from both public insurers such asMIGA (World Bank Group) and private insur-ance companies.

Quantification of the political risk is always adelicate matter, and there are no reduction orhedging methods that make it possible to elimi-nate the political risk entirely. Thus, if the per-ceived political risk is great, and the ability tomitigate those risks is slight, the operator mayopt to abandon the project.


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4.2. Project Risks Project risks are those risks associated with theinvestment in and operation of the resourcesrequired for implementation of the project bythe operator as set out in the contract betweenthe operator and the port authority. The majorityof these risks are carried by the operator, whotherefore manages and assumes theirconsequences.

Project risks include:

• Construction risks.

• Hand-over risks.

• Operating risks.

• Procurement risks.

• Financial risks.

• Social risks.

4.2.1. Construction Risks

Risks associated with the construction of theproject involve unforeseen cost increases ordelays in completion. A construction delay alsotranslates into increased costs, principally forthe operator, in one of several forms:

• Penalties the operator may have to pay tothe concessioning authority or its cus-tomers under its contractual commitments.

• Delays in start-up of the operationalphase of the project, causing a loss ofearnings.

• Increased interim interest charges (inter-est due during the construction phase,most often capitalized).

In turn, the principal causes of excess costs ordelays are:

• Design errors leading to the underestima-tion of the cost of equipment or work orthe time required to complete the job.

• Inadequate assessment of local conditions(terrain in particular), which can necessi-tate modification of the original technicalsolution.

• Poor management of the job site, poorcoordination of the parties involved, or thebankruptcy of a supplier or subcontractor.

These project design and management tasks areunder the control of the operator, thus the oper-ator should carry these associated project risks.The operator can then conclude a “design andbuild” type contract with the construction com-pany so that it can be associated with the proj-ect from the design phase on and help shape theproject for which it will be responsible. If notinvolved from the outset, the operator mustanalyze and accept imposed specifications (forexample, basis of design), proposing alternativesolutions or refusing certain aspects that it con-siders unacceptable, but may ultimately have toaccept a less than optimal design (for which itwill bear the consequences). Increased costs ordelays caused by the government or concession-ing authority are considered as country risks(for example, political, restraint of prices, orlegal risks) rather than project risks. In particu-lar, this is the case when the functional defini-tion of the project is modified or when, subse-quent to signature of the contract, constraintsare introduced concerning the choice of techni-cal solutions.

Hedging of excess cost increases and comple-tion delay risks by the operator are generallyundertaken simultaneously. A common methodof managing these risks is to transfer them to theconstruction company or equipment supplier.When the project includes a major constructionphase, the financial package generally requiresthe inclusion of the primary constructioncompany among the project sponsors. The con-struction risk (and design risk where applicable)is then allocated to the shareholding construc-tion company, enabling the nonconstructioncompany shareholders to avoid bearing a riskfor which they have little or no control.Transfer of the risk to the shareholding con-struction company is achieved via the construc-tion contract or the design and build contract.From the operator’s perspective, then, the objec-tive is to bind the construction company in alump-sum design and build a turnkey contract


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that incorporates a performance guarantee andappropriate penalty clauses. This makes it pos-sible to convert the construction risk of theproject promoter into a credit risk for the con-struction company.

Careful selection of a technically competent andfinancially sound construction company makesit possible to reduce both construction andcredit risks because of the assumed capacity ofthe construction company to honor its contrac-tual, technical, and financial commitments.

It should also be noted that the sponsors of theproject (future shareholders) and lenders to theproject do not always carry the construction riskin the same way. The lenders will often call onthe sponsors for a credit guarantee covering theconstruction phase, since the lender is protectedby limited recourse for the operating period.

4.2.2. Hand-Over Risks

Hand-over risks arise when the operator takesover the management of existing infrastructureand facilities, including operation and mainte-nance, and in some cases must first begin rehabili-tation work. The general rule is that the operatortakes over the existing facilities at its own riskand peril. The operator is authorized to carry outprior inspection of the facilities to assess theircondition and estimate the rehabilitation andmaintenance costs to which it will be exposed.

Even with the ability to inspect facilities, it isdesirable to include a clause in the concessioncontract to safeguard the concessionaire againstrecourse relating to events and conditions exist-ing prior to the contract, thereby exempting theoperator from resulting liabilities.

4.2.3. Operating Risks

The concessionaire operates the facilities neces-sary to meet its contractual obligations at itscost, risk, and peril. Consequently, operatingrisk is allocated entirely to the operator.Operating risk principally comprises:

• Nonperformance risk, which can lead topayment of penalties to the concessioning

authority and adversely affect commercialoperations (for example, cause traffic lev-els to fall below expectations) and resultin financial losses.

• Risk of operating cost overruns stemmingfrom underestimating operating costs inthe bid proposal (for example, omitting acost category or making a defective calcu-lation) or inefficient management of theproject by the operator.

• Risk of loss of revenue not associatedwith a drop in traffic level; for example,as a result of the noncollection of rev-enue, fraud, or theft in a case where theoperator has not complied with the pro-cedures demanded by the insurers, andclaims by customers or frontage residents.

Nonperformance risks can be minimized byselecting an operator with recognized experi-ence in port and terminal management. Costoverrun and loss of revenue risks can betransferred to the operator through use of afixed-price contract between the master conces-sionaire and operator (which may provide forescalation by application of an indexing formu-la), with the possible inclusion of a variablecomponent designed to reward better-than-expected commercial performance.Concessionaires and port authorities shouldavoid cost-plus-fee type contracts with operatorsbecause they do not transfer any of the risks.

Like the project construction company, theoperator may become one of the project spon-sors. This then makes it possible to associatethe operator at the outset with the definitionof the operating system and its cost, thus mak-ing the operator fully responsible for the aspectsof the project for which it will subsequentlycarry the risks.

Such measures, however, do not eliminate theoperating risk completely. The responsibility ofthe operator is necessarily capped. Furthermore,this approach in fact converts the operating riskinto a credit risk for the operating company.The latter generally has limited initial capital,which will not exceed its working capital


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requirement because it has no investmentexpenses. The responsibility of the operatingcompany can then be covered by shareholderguarantees or a bond system.

In any case, the concessionaire should have theresources to manage this endogenous operatingrisk, and it is therefore logical that this risk beallocated to the concessionaire in full.

4.2.4. Procurement Risks

Procurement risks arise due to the potentialunavailability of critical goods and services andunforeseen increases in the cost of externalresources necessary for the project. This is sig-nificant for port projects since they oftendepend on public monopolies to supply criticalservices, for example for the supply of waterand electricity.

Two approaches can help the operator to reduceor eliminate this procurement risk. The operatorcan choose to produce the critical resource itself.For example, the installation of a dedicated gen-erator in a refrigerated container park or refrig-erated warehouse makes it possible to reduce thecost of the resource in some cases and limit therisk of power cuts (which, in addition to simpleinterruption of the service, can cause damage tothe merchandise). This solution often requiresspecific authorization from the local authorities.Furthermore, providing such goods and servicesoneself may not always be possible or financiallyfeasible for the operator.

Alternatively, the operator can sign a long-termpurchase contract with the producer of theresource. This makes it possible to set the pur-chase cost using a predetermined price escala-tion formula, and to limit the risk of a unilater-al price adjustments or restrictions on supply.Further, the contract may include a clause toindemnify of the operator against lossesincurred in the event of interrupted supply of acritical resource. This is referred to as a “put orpay” contract.

The concessionaire may require the assistance ofthe concessioning authority or the government

to be able to conclude a put or pay contractwith the public monopolies concerned. Thisusually can be justified in cases where the proj-ect has a substantial public service dimension.

Where the procurement of imported supplies isconcerned, the procurement risk can stem fromcustoms-related problems; thus, it becomes acomponent of the country risk. In such cases,the concessioning authority may reasonablybear a portion of the risk.

4.2.5. Financial Risks

The operator bears all risks associated withraising the shareholders’ equity or obtainingloans required for funding the project. Likewise,the operator carries all risks associated with for-mation of the project company (the special pur-pose company or SPC). Contractual documentsdefine the relationships among the various pri-vate players involved in the project (for exam-ple, the shareholders’ pact and loan agreement).Apart from raising the initial tranche of share-holders’ equity and loans, the establishment ofstandby credit loans should also be consideredbecause it makes it possible to fund any excesscosts with which the project company may beconfronted.

Likewise, the interest rate fluctuation risk is car-ried exclusively by the operator. This risk ariseswhen loans used to fund the project are basedon floating rates (for example, Euro InterbankOffered Rate [EURIBOR] plus margin). Anincrease in the reference rate consequentlyincreases the amount of interest to be paid, andhence the project costs. This risk can be hedgedby means of appropriate financial instruments(for example, rate caps, ceilings on variablerates, or rate swaps).

When projects are built or operated with theaid of subsidies, there is the risk that the gov-ernment will fail to make good on its subsidypayments. This risk is relatively small whereinvestment subsidies are concerned, as the con-struction phase covers a relatively short period.However, international agreements (for exam-ple, the Marrakech Accords) or the dictates of


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internal law can still intervene to prevent thepayment of subsidies.

4.2.6. Social Risk

The social risk arises when operators have torestructure the workforce and bear the cost ofseverance payments, retraining, and otheremployee issues. The risks of general strikes orcivil disturbances in the host country are fre-quently classified as cases of force majeure (seecountry risk), which means that they are oftenonly partially covered by the protections affordedin the contract. Additional insurance can beobtained to cover residual social risks.

The port sector presents special challenges relat-ing to social risk:

• Dock workers often enjoy a special statusunder national law, which may put theoperator in the diminished position ofmerely acting as an employer of hiredlabor. These special treatment situationsare disappearing in some countries, butwhere they still exist they are a source ofrisk and excess cost for the operator.

• Port or terminal concessions, while requir-ing the operator to continue employing aportion of the existing personnel, oftenresult in a very substantial reduction inthe number of port workers (reductions of50–70 percent are not exceptional).Although the port authority or govern-ment may give the concessionaire freereign to rationalize the port workforce,this alone is not sufficient to eliminate thesocial risk. The operator must also beassured that the local authorities have thecapability to manage the social situationthus generated (for example, throughretraining, early retirement, relocationallowance, or other program). Otherwise,displaced port labor may seek recourseagainst the concessionaire.

In addition to the social risk relating to dockworkers, the presence in the port of other cate-gories of personnel with special status (forexample, seamen, customs officers, and port

authority personnel) can amplify the socialrisks. Module 7 describes port labor issues indepth.

4.3. Commercial or Traffic Risk Commercial risks arise from potential shortfallsin projected traffic and from pricing constraints.Traffic and pricing risks are significant in portreform projects due to the high degree of uncer-tainty associated with medium- or long-termprojections of port activity. These risks areaffected by the operator’s pricing decisions andby any price regulation imposed by government.

The nature of the partnership between the opera-tor and the port authority leads, in practicallyevery case, to sharing of traffic risk, both in termsof responsibility and consequences. The terms ofthe concession agreement effectively allocate theserisks between the two parties. However, eventhough they are partners in port reform, there is anatural tension between the port authority as acustodian of the public interest and the operatoras a profit-maximizing business.

When the number of customers using a port, aterminal, or other facility is limited, or when asmall number of customers represents a majorshare of the activity, the operator can protectitself against traffic or commercial risks bymeans of establishing minimum volume guaran-tees. This is a long-term contract under whichthe customer undertakes to generate a minimumlevel of traffic and agrees to pay a fixed sum tothe operator whether or not the service isrequired or used.

A terminal’s main customers—shipping lines orlarge shipping companies—will frequentlybecome project sponsors, much like construc-tion companies or operators. In such cases, thecustomer-shareholder carries part of the com-mercial risk. However, this arrangement has anumber of disadvantages, particularly the riskof discrimination against nonshareholder cus-tomers. Nonshareholding customers can guardagainst this possibility by entering into a mini-mum guarantee contract with the terminal oper-ator (see Box 1).


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4.4. Regulatory Risks The relationship between the concessionaire andthe port authority or other government agenciesis important in defining the rules of the gamefor the concessionaire and, hence, its risks.

The concessionaire generally desires to limit thescope of the vertical partnerships with the portauthority, taking the view that operator activityshould be regulated predominantly by marketconditions. Consequently, the operator seeksgreater freedom of action in the management ofits project to be in the strongest possible posi-tion to manage risks.

The concessioning authority is concerned withprotecting the user, safeguarding the generalinterest, and avoiding abuse of dominant mar-ket positions. The concessioning authority, con-sequently, seeks to restrict the operator’s free-dom of action through technical or economicregulatory measures.

The search for a fair balance between regulationimposed by the concessioning authority and thediscipline imposed by the market is complexand effectively determines how the commercialrisk will be shared (see Module 6 for a detaileddiscussion of economic regulation).

Regulation invariably generates costs. Theseinclude costs for the concessioning authority inthe form of additional compensation it mayhave to pay to the concessionaire plus the directcosts of enforcing the regulations throughinspections and other measures. Regulation alsogenerates costs for the concessionaire, whichbears greater risks and has less freedom ofaction than it would in the absence of regula-tion. Thus, the concessionaire will expect thishigher risk level to be rewarded.

The costs or regulation are ultimately borne bythe port users or by the taxpayer. Governmentregulation, therefore, should be kept to theminimum necessary to correct market imperfec-tions and protect the public interest.

The nature and extent of government regulationin connection with port reform are many andvaried. Ideally, the concessionaire and the portauthority or other regulating entity can arrive ata compromise acceptable to both parties byadjusting regulation and the guarantees andcompensation allowed to achieve equitable risksharing. Because situations affecting port reformvary so widely, there is no single set of rulesapplicable under all circumstances. Instead, thissection describes the different regulatory toolsavailable to the port authority and identifieshow each might affect the distribution of risk.

4.4.1. Regulatory Tools

Regulation often takes the form of specifica-tions and performance standards included in theconcession contract itself. These might be set bythe concessioning authority in detail prior tothe initiation of the selection procedure. Or,they might be defined only in broad terms, withthe bidders required to provide details in theirproposals (for example, maximum price levels,fee, or expected amount of subsidy to bereceived). In the latter case, these elements serveas a means for comparing the submitted bids,and then become the performance standards tobe applied to the winning bidder.

Regulation by the concessioning authority canbe classified as either technical or economic.


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Box 1: Richard’s Bay Coal Terminal: AWholly Private Terminal

South Africa is one of the world’s leadingexporters of coal. The seven mostimportant mine operators in the country

have funded, built, and now operate a hugecoal terminal at Richard’s Bay with exceptionalrail access facilities to serve their exportbusiness. The terminal has no public serviceobligation and handles the traffic of its share-holder-customers on a priority basis. Thisplaces the small producers in a situation ofdependence. They in effect are obliged to selltheir production to large operators or useother, less competitive and more expensiveports (Durban or Maputo), or use the terminalas second-class customers.

Source: Author.

4.4.1.1. Technical Regulations. These regulationsdefine the minimum technical requirements ofthe project. They establish a set of parameterswithin which the concessionaire must operate,and go a long way toward defining the risks towhich the concessionaire will be exposed.Technical regulation includes regulation ofinvestments, maintenance, and performance.

Regulation of investments. Regulating invest-ments is necessary only when the operator isitself responsible for the execution of the proj-ect. The port authority may then choose toimpose a number of regulatory measures:

• A functional definition of required capacityor traffic and throughput thresholds thatwould trigger new investments in capacityto ensure a minimum level of service(where market conditions might lead toundercapacity).

• Construction standards to ensure that thework is satisfactorily executed.

• Constraints or particular specificationsrelating to security or protection of theenvironment.

Oversight by the concessioning authority should belimited to the verification of compliance with thedefined measures, and should not extend to theimposition of specific technical solutions, as long asthe concessionaire meets the performance stan-dards. Any requirement on the operator to obtainapproval of various aspects of the project by theport authority, above and beyond these predefinedstandards, creates uncertainties that increase theconcessionaire’s risks. This makes it difficult for theoperator to properly estimate future costs for theproject, adding an element of risk for which theoperator will seek compensation.

Tenders should not be judged solely on thebasis of the amount proposed to be invested bythe candidate. Indeed, making sure that a mini-mum amount is invested is not an end in itself(except perhaps for the construction company).Such one-dimensional measures can haveadverse effects by possibly encouraging noneco-nomic investment. It is preferable to impose

functional obligations and performance require-ments on the operator and to leave to the inge-nuity of the operator the task of finding the bestway to meet those requirements.

Regulation of maintenance. Defective mainte-nance of port facilities creates three types ofrisks: commercial risk for the operator as a con-sequence of the deterioration in the level of serv-ice offered to customers, risk of default by theoperator with respect to the public service obli-gations contained in the contract, and risk ofdeterioration of assets during the term of thecontract. The commercial risk is properly borneby the operator, and poor service will be penal-ized by the market. No regulation by the conces-sioning authority is required to guard againstthis aspect of maintenance-related risk. The pub-lic service obligation, in particular the obligationfor the operator to provide continuous service,typically is defined in performance requirementscontained in the concession contract orsubcontract with the operator. An interruptionof service resulting from a failure to performmaintenance can then give rise to penalties.

In the case of a concession where assets arehanded over to the port authority on termina-tion of the contract, the need for regulation cango beyond a definition of functional obligations.It is normal for the concessioning authority torequire that repair and maintenance work iscorrectly carried out to ensure that the installa-tions are handed over in good operating condi-tion at the end of the concession period. Theconcessioning authority can impose specificmaintenance standards in the contract to ensurethe satisfactory preservation of the assets.

Regulation of performance. Finally, where thelack or absence of competition is liable to dis-courage the operator from providing an adequatelevel of service, the concessioning authority caninclude specific performance standards in theconcession contract, for example, minimumlevels of productivity. While sometimes deemednecessary, this approach is not without difficul-ties, since it assumes that the concessioningauthority:


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• Is in a position to define and codify alevel of service, whereas the content ofthe service and the required level of per-formance can change over time.

• Is capable of determining compliance bythe operator with the set standards.

• Has the ability to apply either incentivesor penalties when the performance objec-tives are exceeded or not achieved,respectively.

Beyond productivity criteria and service stan-dards, performance standards can also include aminimum capacity for the terminal. These stan-dards might be based on investment levels or ondirect measures of storage and throughputcapacity. Generally, it is preferable to permit theconcessionaire sufficient flexibility to meet thestandards in the most cost-effective manner (forexample, extension of yard space versus thepurchase of higher stacking equipment).

4.5. Economic and FinancialRegulation Virtually all concession contracts contain eco-nomic and financial provisions defining thescope of permissible activity, the minimum serv-ices required, the degree of competition theoperator can expect, the freedom to set prices,and any fees or subsidies associated with theproject. These provisions are designed to estab-lish some level of certainty for the operatorwith respect to its flexibility to manage theproject so that the operator can assess risks andways to manage them.

4.5.1. Scope of Operator Activity

The concession contract should define the activ-ities the operator is authorized to conduct in thearea defined by the contract. The port authoritywill define this scope based on its reform strategyand operational needs. For example, the portauthority may prohibit the operator fromengaging in any activities other than thehandling and storage of merchandise within theproject’s defined domain, or specify the types oftraffic the operator will be authorized to han-dle. In the latter case, such limitation may be

the consequence of an exclusivity guarantee pre-viously granted by the port authority to anotheroperator in the port.

By restricting the scope of permissible activity,the port authority increases the commercial riskfor the operator. With a narrow scope, theoperator’s capacity to adapt or diversify itsactivity in response to market changes is limit-ed. On the other hand, the port authority couldallow the operator considerable freedom of ini-tiative and action to exploit port land and facil-ities in return for the operator’s performingunprofitable public service activities.

4.5.2. Public Service Obligations

The port authority may require the operator tocomply with principles governing the provisionof a public service. This obligation typicallyimposes requirements for service continuity,with the assessment of penalties or early termi-nation of the contract in cases where the serviceis interrupted due to the fault of the operator,and also requires equal access and treatment forusers (nondiscrimination with respect to pricing,priorities, level of service, and so forth).

It is not always possible or desirable to avoidall discrimination among an operator’s cus-tomers. For example, obliging an operator whois a subsidiary of a shipping line to serve othercompeting shipping lines under the same condi-tions as its affiliated company, irrespective ofcontractual stipulations, is unrealistic. Thisproblem can and should be avoided whendeveloping the concession bidding qualifica-tions. Business affiliations of the bidder, andany restrictions thereon, should be taken intoaccount when designing the concession andawarding the contract.

The principle of nondiscrimination among usersdoes not prohibit prudent commercial manage-ment of the affected activity, including differen-tiation in tariff or pricing, berthing priority, andservice levels, provided these are based onobjective criteria such as annual traffic orthroughput volume, the period of commitmentof the parties, or the characteristics of call or


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vessel, and provided these are applied uniformlyto all similarly situated users.

4.5.3. Noncompetition Guarantees

Under certain circumstances it may be reason-able for the concessioning authority to grant theconcessionaire a noncompetition guarantee tocompensate for the imposition of strict regula-tion, if such regulation may deprive the conces-sionaire of the normal means available to acompany for positioning itself in a competitivemarket. This type of guarantee is generally lim-ited in time and terminates on a specified date,or when the level of traffic reaches a predefinedthreshold.

Although they can be useful in limiting a conces-sionaire’s risks, we do not recommend creatingmonopolies de jure unless necessary, even if theyare limited in time. Instead, we recommend thatthe concession contract provide for renegotia-tion in the event that the competitive situationsignificantly changes. Renegotiation may includea review of the regulatory clauses to adapt themto new market conditions. In certain cases, thiscould lead to the indemnification of the operatorwhere the newly created situation calls intoquestion the viability of the project.

4.5.4. Pricing Controls

The procedures for setting tariffs represent acritical element of the economic regulatory sys-tem. Prices and pricing flexibility affect the ter-minal’s level of traffic and throughput and theprofitability of the concessionaire’s operation.Regulation of prices by the public authorityaffects the operator’s flexibility in two keyways: the ability to negotiate the terms of serv-ice provided to the customer on a case-by-casebasis or the obligation of the operator to pub-lish a list of charges applicable to all users, andin the case of a published list, the ability to setthe level of charges.

Operators should be free to set tariffs withoutsignificant government oversight when the mar-ket is effectively regulated by competition.Competition can come from another terminal in

the port, another port, or another means oftransport (air, land, or coastal transport).Estimation of the true level of competition canbe difficult (see Module 6 for a methodologicalapproach). From the concessioning authority’sperspective, the objective of price regulationshould be to limit the risk of the operator abus-ing a dominant market position. As indicatedabove, when sufficient competition exists to dis-cipline pricing, the tariff regulation need benothing more than an obligation to treat allusers on an equal basis and the requirement topublish a tariff.

Government oversight can also be kept to aminimum when the activity in question does notconstitute a public service. This is the casewhere the operator only conducts its activity forits own account or on behalf of its sharehold-ers. This is also the case where the port cus-tomers are not national economic units (forexample, when they represent transit traffic ortransshipment activity). The operator shouldthen be free to negotiate charges with its cus-tomers on a case-by-case basis.

Pricing regulation is necessary, however, inother cases, namely when the operator providesan essential public service and is in a position ofstrong market dominance. Apart from therequirement of equal treatment of users and thepublication of prices, in such cases the adminis-trative authority may choose to establish a max-imum charge (a price cap). This maximumcharge can be set initially by the market, as theset of tariffs submitted by the terminal operatoras part of the bid. The price caps are generallyaccompanied by price escalation formulasindexed to a set of economic indicators.However, these escalation formulas are general-ly applied only for a short term (for example,for a period of up to five years). Following that,periodic renegotiation of the price caps isrequired, which becomes another source ofuncertainty and, hence, risk for the operator.

The problem of regulating public monopolies overthe life of a long-term concession continues to be asubject of concern in industrialized countries.


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So far, no clear and fully satisfactory responsehas been produced. The problem is even moreacute in the developing countries where regulato-ry oversight capabilities may be weak.

A radical approach to regulating such monopo-lies would be to recompete the entire concessionat periodic intervals, at the same time settingnew tariffs according to market conditions. Butsuch a recompetition of the concession cannotbe envisaged every five years. Moreover, arecompetition would also require the inclusionin the contract of provisions on equitablewithdrawal conditions for the concessionaire,including concession repurchase clauses. Theseare generally based on the discounted value ofanticipated profits from the concession throughthe original termination date. This amountdepends directly on the tariff assumptions forthe residual period.

Another approach might be to require the conces-sionaire to use several handling companies for thesame facility, as in Réunion Island (see Box 2).

4.5.5. Fee or Subsidy

Vertical partnerships between the concessioningauthority and concessionaire involve some form

of fees or subsidies. This constitutes anotherform of regulation, as the level of the fees orsubsidies is closely linked to the tariff policy.The fees or subsidy mechanism typically has afixed and variable component.

The fixed component can be a fee equivalent to arent paid by the operator to the port authority forthe use of land and facilities or utilities providedby the public sector. This fee also incorporatesprofit sharing, that is, the rental fee effectivelyincludes an element to reward the concessioningauthority for permitting the operator to profitfrom the operation of the terminal. Conversely,the fixed component can be a subsidy paid to theoperator when the concession is acknowledged tobe an unprofitable undertaking. This is a way ofcompensating the operator for providing essentialpublic services. In this kind of concession, thesubsidy level will usually be one of the mainaward criteria during the selection process.

The variable component of compensation to theconcessioning authority can be a payment bythe operator of a fee based on the level of activ-ity. The variable component can also be anindexed subsidy based on traffic level. Thesesame things include a minimum traffic thresh-old that can be used to share the traffic risk andindemnify the operator if the level falls belowthe predefined threshold. This latter approachmay be most appropriate when there is signifi-cant uncertainty about the potential trafficmoving through the terminal and when the con-cessioning authority desires to impose tighttechnical and pricing regulations.

Experience shows that these fee and subsidy lev-els and any escalation clauses should be decidedas part of the concession contract and should bebased on traffic levels rather than the degree ofprofitability for the operator.

The port authority could choose to set the ini-tial levels for the fixed and variable componentsof subsidies or fees. However, these levels repre-sent the most frequently adopted financial cri-terian for judging bids and, therefore, prefer-ably should not be set by the port authority, butleft for the bidders to propose.


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Box 2: Port Réunion: A Single ContainerTerminal Using Several Handling Contractors

In common with the majority of islandeconomies, Réunion does not generate suf-ficient traffic to justify more than one con-

tainer terminal. The majority of the containersare consequently handled by a single containerterminal. However, the containers are handledby a number of competing cargo handlingcontractors.

This has not prevented recourse to privateinvestment or management. The resourcesrequired for these operations have been pro-vided by an economic interest group compris-ing the cargo handling operators and otherpartners. The partners include the Chamberof Commerce and Industry, yard equipmentowners, land storage management, andgantry crane owners.

Source: Author.

4.6. Golden Share or BlockingMinority Over and above the contractual conditionsincluded in the bid specifications, the conces-sioning authority can retain a “right to know”concerning decisions taken by the concession-aire. The most commonly used techniques forthis are to hold an equity interest in the projectcompany and to hold a “golden share,” orblocking minority. This enables the concession-ing authority to exercise oversight from within,but also can invalidate the risk sharing balanceby introducing chronic interference by the con-cessioning authority in the management of theconcessionaire company.

Despite its drawbacks, this form of governmentoversight is widespread. In over one-third of theprivatized port terminals worldwide, the port ormunicipal authority owning the port also hasan ownership interest in the terminal operatorcompany (International Association of Portsand Harbors [IAPH] Institutional Survey,1999). For example, in the case of Hamburg,the port (owned by the Hamburg regional gov-ernment) has a majority interest in the operatorcompany. This situation often gives rise to con-flicts of interest between the shareholder andregulator roles of the concessioning authority,which tend to outweigh the perceived benefitsof such a scheme. Control and monitoring ofthe concessionaire’s behavior generally is bestcarried out through a well-drafted concessioncontract, making proper allowances for the con-cessioning authority’s interest in reviewing cer-tain strategic decisions of the concessionaire.This will safeguard the concessioning authori-ty’s role as an impartial regulator with all itsoperators, which runs the risk of being compro-mised if it becomes involved as an equity holderin any of the private parties it is supposed tooversee.

4.7. Risk and Port Typology Risk sharing and the extent of required govern-ment oversight can also be influenced by thenature of the terminal operations being conces-sioned. This section identifies several different

types of operations and the resultant implica-tions for regulatory oversight and risk sharing.

4.7.1. Operator Handling Only Its OwnTraffic

This method of operating is frequently encoun-tered in the case of a terminal handling industri-al bulk (ore or oil) and general cargoes (forestproducts or fruit). Under these circumstances, itis frequently the shipper, a group of several ship-pers, or the shipowner itself who serves as theoperator of the terminal. This type of specialpurpose operation does not necessarily representa public service, hence, it does not require sys-tematic regulation by the port authority.Nevertheless, standards governing the mainte-nance of the facilities can be imposed for thepreservation of the assets given in concession.

The administrative document formalizing thecontractual relationship between the portauthority and the operator of special purposefacilities merely needs to authorize the use ofthe site for the defined activity. A fixed fee istypically paid for the occupation of public land,and where appropriate, the provision of infra-structure or equipment by the public sector.Port dues billed directly to users (shipownersand shippers) by the port authority already gen-erate remuneration for the use of the generalinfrastructure, and therefore would not be fur-ther billed to the terminal operator (see Box 3).

4.7.2. Operator Acting on Behalf of a ThirdParty in a Competitive Situation

In this case, it is desirable for the traffic risk tobe carried in full by the concessionaire. Thismeans that the concessionaire must be able tomanage this risk by controlling the operatingparameters affecting its competitive position.This assumes substantial freedom for the con-cessionaire in terms of investment, level of serv-ice, and the tariff, although some limited regula-tion may still be necessary to ensure compliancewith public service obligations, preservation ofpublic assets, and maintenance of minimumcapacity. Because the market is regulated bycompetition, the tariff can be set freely. The


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contract is awarded to the candidate proposingthe highest rental fee or the lowest subsidyrequirement, whichever is relevant (see Box 4).

4.7.3. Operator Acting on Behalf of a ThirdParty in a Monopoly Situation

This situation is relatively common in developingcountries, particularly in African and insular

countries. The existence of a natural monopoly ofthe port terminal management activity undeniablyintroduces a public service dimension requiringclose economic oversight. This can involve thesetting of charges and awarding of the concessionto the candidate proposing the highest fee (orlowest subsidy), or, alternatively, setting theamount of the fee (or subsidy) and awarding theconcession to the candidate proposing the lowestweighted mean tariff rates. Price escalation andindexing clauses are essential in all cases.

There are several ways that traffic risk andprofit can be shared between the concessioningauthority and private operator. First, the con-cessioning authority can guarantee that themonopoly will be protected from competitionfor a specified time or until a specified trafficlevel is reached. The agreement may containclauses providing for modification of the regula-tory system or even indemnifying the conces-sionaire from completion of the contract shouldthe monopoly disappear.

Second, the concessioning authority can guaran-tee minimum traffic levels when the volume oftraffic forecast by the concessioning authority isregarded as highly uncertain by the concession-aire. When such uncertainties exist, the conces-sion agreement typically limits the amount ofthe fixed part of the fee and introduces a vari-able part (reduction) if traffic fails to reach aminimum threshold to protect the operatorfrom significant revenue shortfalls.

Finally, the concessioning authority and theoperator can agree to share profits when trafficexceeds a specified volume (see Box 5).

4.7.4. Transit or Transshipment Traffic

Transit traffic refers to goods whose origin ordestination is a country other than that of theport. Transshipment is the discharge of cargo orcontainers from one ship and the loading of themonto another in the same port (vessel-to-vessel).Both activities may have a positive impact onthe economy of the country, generating oppor-tunities for value-added activities, jobs, andnational wealth.


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Box 3: Owendo Ore Terminal in Gabon

The Owendo ore port was built in 1987 toexport manganese ore mined in MoandaProvince. A number of agreements were

signed at the time, including an agreement forthe construction of the port and another forthe use of public land and installations andthe operation of private facilities. Theseagreements provide for the transfer of respon-sibility from the port authority to the privateoperator for maintenance of the facilities anddredging along the wharf, thus making theoperator responsible for all maintenance andmanagement of the terminal it uses. In returnfor the operator assuming these responsibili-ties, the port authority reduced the fee paidby the operator.

Source: Author.

Box 4: Container Terminals in the NorthEuropean Range

The current situation in Northern Europeprovides an example of genuine compe-tition between different terminals in the

same ports, and between the different portsof the Le Havre-Hamburg range. The highlevel of traffic, the opening of European fron-tiers, and the quality of the available landtransport services support the existence ofnumerous container terminals, while providingshippers and shipowners with a genuinechoice of port and operator. This situationallows the coexistence of public andshipowner-dedicated terminals.

This situation, however, is rarely the case indeveloping countries, where traffic is thin, bor-der crossings are difficult, and intermodal con-nections are poor. Hence, the ports on the WestAfrican coast have virtually no competition.

Source: Author.

When the customer is not an economic unit inthe country of the port, the government doesnot have the same interest in protecting the cus-tomer. Consequently, in the absence of anyspecial agreement, there is little reason for thegovernment to accept any of the risks associatedwith transit and transshipment traffic or toregulate economic activity by the operator.

In fact, the port may benefit from the operator’smarket dominance in handling transit traffic,which is disciplined by the existence of alterna-tive transport systems (transit), the capacity ofcompeting ports in the region (transshipment),and the degree of international competition.Under these circumstances, it is reasonable forthe port authority to seek to obtain maximumprofit from this favorable (although perhapstransitory) situation. In this case, the portauthority charges an operator with the manag-ing of this “natural resource” (that is, the coun-try’s geographic advantage) with the objectiveof maximizing spin-off benefits for the country.

Regulation of the activity is not required, apartfrom the actual authorization and an obligationto preserve existing assets where appropriate.There is no need to subsidize the activity nor toshare commercial risks because they are fullycarried by the operator. On the other hand, theport authority will seek to maximize its profitby awarding the concession to the highest bid-der, namely the candidate proposing the mostfavorable profit-sharing arrangement (fixed andvariable fee) to the authority (see Box 6).

4.7.5. Mixed Situations

The situation frequently existing in ports is a mix-ture of the configurations described above, furthercomplicating decisions about the procedures to beadopted. This leads to a hybrid approach, combin-ing compensation systems, regulatory oversightmechanisms, and encouragement of “situationrents” (highly profitable operations in select activi-ties to help fund a needed public service thatmight otherwise generate a loss) (see Box 7).

4.8. Other Concessioning AuthorityGuarantees The existence of a horizontal partnershipbetween the various players in the port commu-nity and its relationship with the transportchain was described earlier. The operator willoften seek to combine the various servicesrequired by customers into an integrated wholeor, alternatively, give contractual guarantees tocustomers as to the level of service provided inthese various domains.


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Box 5: Container Terminal Operator in thePort of Klaipeda

The Port of Klaipeda in Lithuania has anew container terminal designed tohandle import-export traffic as well as a

high volume of (competitive) transit trafficbetween Western Europe and the BalticStates and Russia. Although the terminal wasfinanced from public development aid funds(EIB), an operating concession was awardedto the German operator Eurogate in associa-tion with local partners.

Source: Author.

Box 6: Port of Djibouti: Transit andTransshipment

The independence of Eritrea has deprivedEthiopia of its maritime access (ports ofAssab and Massawa). Ethiopia is now

landlocked. The recent conflicts between thetwo countries have made Ethiopia substan-tially dependent on the Port of Djibouti for itsmaritime trade. A lack of budgetary resourceshas led the Djiboutian authorities to seek pri-vate funding for the necessary developmentprojects (for example, a cereal terminal). Thisproject, based on the realization of a “situa-tion rent,” should achieve a fair yield for theinvestors. It will generate new revenue for theindependent international Port of Djibouti andeconomic activity for the country.

The Port of Djibouti has long enjoyed astrategic situation in the container transship-ment domain, this activity representing asignificant proportion of its container trafficand resources. The Dubai Ports Authority nowmanages the Djibouti container terminal undera concession agreement.

Source: Author.

It is logical for the port authority to provide theoperator with guarantees concerning standardsof facilities and performance of services in theport (for example, depth of access, buoying,operating hours, and ship services), whetherprovided directly by the port authority itself ordelegated to other service providers within theframework of a vertical partnership. Thesecommitments, frequently grouped in a clauseheaded “concessioning authority’s obligations,”can result in financial penalties against the portauthority in the event of failure to meet its obli-gations. The resultant commercial risk for theoperator is then transformed, theoretically, intoa credit risk for the port authority. Clearly, it isimportant for the operator to conduct a thor-ough analysis of the complete port community,its operations, and its reputation before com-mitting to the project. Irrespective of the clausesincluded in the contract with the port authority,the operator will inevitably suffer the conse-quences of any defective operation of the port.

Likewise, while it may be useful to include guar-antees regarding land transport modes (for exam-ple, hours of operation, access to carriers, creationof new infrastructure, maximum charge, or mini-mum capacity for a rail service), the quality of theintermodal service at the port is critical to efficientand cost-effective operation and should be ana-lyzed before the operator puts in a bid (see Box 8).

4.9. Contractual Risks Relationships between the port authority andconcessionaire, as well as between the conces-sionaire and its suppliers, lenders, customers,and subcontractors, are defined in contracts.This section highlights the principal risksinvolved in the drafting and implementation ofsuch contracts.

4.9.1. Contract Management

To protect both the concessioning authority andthe concessionaire, contracts typically include


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Box 7: Djibouti Fishing Port: Public Serviceand Semi-Industrial Activity

The Republic of Djibouti has constructeda fishing port to encourage the develop-ment of a small-scale fishing industry

that can provide the country with newsources of animal protein for human con-sumption. Financed by public developmentaid funds (concessional loan from the AfricanDevelopment Bank), the port cannot be finan-cially profitable on the basis of this small-scale activity alone.

However, the fishery resources of theregion, combined with certain advantagesgranted to the country Lomé 4, make it possi-ble to look toward the development of anexport-oriented semi-industrial fishing activity.Furthermore, this project has led to thepreparation of reclaimed, back-filled sites, aprivileged location that will provide space forthe development of various activities.

Placing the complete entity under conces-sion could possibly enable the concessionaireto make a profit from the overall project, whilemeeting its public service obligations relatingto small-scale fishing activities.

Source: Author.

Box 8: Horizontal and Vertical Partnershipsin the Port of Maputo, Mozambique

In a horizontal partnership, the public portauthority awarded a concession for theMatola Terminal to a private operator, with

the goal of developing transit traffic for theexport of coal from South Africa. As theadmissible draught of vessels is a majorstrategic element for the operator, the con-tract stipulated that the port authority wouldmaintain a minimum access channel depth.The concessionaire has claimed that the portauthority has failed to meet this commitment,and has declined to pay the scheduled fee asa result.

In a vertical partnership, the port itself andthe railway that serves the port are in theprocess of privatization. The port has beenprofitable while the railway has operated atsignificant losses. Separate privatizationrequires adjustments to balance the two con-cessions without raising doubts as to theglobal cost of the transport chain for cus-tomers. A solution under considerationinvolves the creation of a joint price regulationauthority for the port and railway concessions.

Source: Author.

provisions governing the possibility of changedcircumstances or disputes about contract imple-mentation. The main elements of the contractgoverning such developments include:

• Revision clauses: At the outset of theproject it is impossible to foresee all theevents that might arise over a period ofseveral decades. This means that revisionswill be required to adjust the terms of thecontract to changing situations. The con-ditions and procedures for these revisionsmust be defined, for example, periodicrevision at defined intervals, revisionsscheduled for key project dates, revisiontriggered when a particular throughputlevel is reached, or revision at the requestof one or other of the parties.

• Contract termination or renewal clauses:The duration of the original contractperiod is a major risk consideration forthe operator. The possibility for renewalor extension of the contract must bedefined, as must the procedures for take-over or repurchase of the project assetson termination of the contract.

• Early termination clauses: These clausesdefine the conditions potentially leadingto cancellation or early termination at therequest of one party or another, and theapplicable procedures relating to penal-ties or compensation. These clauses mustalso be compatible with the underlyingloan contracts signed by the operator,where these agreements provide for alender’s right to substitute another opera-tor in the event of the bankruptcy of theoriginal operator.

• Procedures for settlement of disputes:Risks associated with disputes wereaddressed in the section on political riskmanagement. The relevant clauses coversettlement out of court, the eventual inter-vention of independent experts subject toprior acceptance by the parties, and arbi-tration clauses (for example, place, appli-cable law, arbitrator, expenses).

4.9.2. Indexation Risk

Indexation formulas have been mentioned on anumber of occasions in connection with changesin tariff levels, long-term contracts with cus-tomers or suppliers, operating contracts, and soforth. Indexing designed to enable the operatorto cover or reduce certain risks (in particular theinflation risk) itself induces other risks, such asrisk of significant deviation of real-world condi-tions from the indexation formula over a certainperiod and the risk of divergence between theindexing conditions of different contracts signedby the port authority and the operator (procure-ment, operation, and sale). The risk for theoperator is that the indexing formulas can leadto an increase in costs that exceed the increase inrevenue or the potential reduction in negativeeffects. The risk for the concessioning authorityis that the operator’s prices rise too high whencompetition is inadequate.

4.9.3. Credit Risk—Bonds

Sharing or mitigating the many risks associatedwith port projects frequently gives rise to con-tractual obligations and attendant financial sanc-tions if one party’s or another’s obligations arenot met. Sanctions convert the risk into specificfinancial obligations (payment of penalties). This,in turn, generates the credit risk of the partnerthat is unable to meet its financial obligations.

The most efficient method of ensuring that thepartners honor their financial commitments is torequire bank bonds. These are frequently demand-ed from the concessionaire or by the operatorfrom its private partners. The amounts and callconditions for these bonds must accurately reflectthe respective commitments of the parties.However, the operator’s credit risk with respect tothe concessioning authority cannot be covered bybonds, and generally remains a political risk.

4.10. Approach of the DifferentPartners to Risk and RiskManagement Part A of this module has been largely devoted toanalyzing the principles of risk sharing between


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the public port authority (as the entity offeringthe concession) and the private concessionaire.This section looks in general terms at otheraspects of risk sharing from the perspective ofeach party and the particular risks affecting it.

4.10.1. Concessioning Authority

The primary challenge for the port authority isto identify and define a balanced set of riskmanagement measures. This requires expertisein numerous areas, which can lead to the use ofspecialist consultants. In addition to the termsof the contract concluded with the operator,which defines risk sharing between the portauthority and the operator, the composition andcharacteristics of the sponsors raise major issuesfor the port authority in terms of:

• The capacity of the operator to complywith the terms of the contract.

• The degree of commitment of the variousshareholders.

• The commercial positioning of the opera-tor, with particular reference to the equaltreatment of users or customers.

• The transfer of technology and the partici-pation of national players in the project.

This means that the process for selecting thepartner is a matter of prime importance for theport authority. Apart from selecting a partnerwho can meet financial objectives (for example,reasonable tariff levels, minimization of subsi-dies, and maximization of the fee), the portauthority must also be able to select a reliablepartner, one capable of complying with all theterms of the concession contract and capable ofcarrying all of its allocated risks.

Recommendations relating to the managementof calls for tender are published by the principalinternational financial institutions (IFIs). Thesedocuments describe in detail relevant selectioncriteria and methods for achieving the satisfac-tory selection of candidates. The involvement ofthe IFIs in these privatization initiatives alsomay permit port authorities to avail themselvesof additional assistance provided by these

entities. These sponsors can thus play the dualrole of lenders and advisors to the concession-ing authority.

Apart from the challenge of selecting the origi-nal partner, as time passes there is also an issueassociated with the continued commitment ofthe shareholders. A particular risk arises if theinitial shareholders decide to dispose of theirinterests in the project company to third partiesthat do not meet the expectations of the conces-sioning authority. This risk must be anticipatedby appropriate contractual clauses.

4.10.2. Project Sponsors

Having first analyzed the risks of the project,the shareholders will logically seek to align thelevel of risk with the expected return on theoperation. Their decision to become involved,consequently, depends on their assessment ofindicators such as the project internal rate ofreturn, investment coverage ratio, or return onequity.

However, apart from this determination, whichis the same one every investor must make, eachsponsor generally adopts its own particularapproach according to its own agenda, enablingit to reduce this risk/shareholder return profile.For example:

• A constructor or equipment supplierseeks to maximize its return for the con-struction phase and through the upstreamservices it provides.

• An operator seeks a return on the facilitymanagement services that it provides.

• A customer, shipper, or shipowner looksfor a high quality of service and reason-able rates over the long term.

• A financial investor is primarily looking forthe sustainability of the project throughoutthe life of the investment period.

The agendas of the various sponsors can lead todifferent expectations in terms of concessionairepolicy. This situation also creates major differ-ences in each sponsors willingness to carry risk


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or in the length of time over which they expectto earn a return. The concessionaire consortiumclearly must manage possible differences inobjectives among the sponsors; but these differ-ences also concern the concessioning authoritybecause they can lead to situations that are prej-udicial to the general interest, for example, serv-ice continuity.

4.10.3. Lenders

The project’s lenders primarily look for the projectto have the capacity to repay its debts. They con-sequently adjust the amount of the debt and therepayment profile according to the annual andactuarial debt coverage ratios (see Part B of thismodule for a precise definition of these concepts).

Apart from these financial ratios, the lendersfrequently impose other constraints on thesponsors to ensure their continued commitmentthroughout the defined repayment period. Thisstems partly from the fact that the loans are not(or are only partially) guaranteed by projectassets (which tend not to be liquid in port proj-ects), but principally from the cash flows fore-cast for the period of the loan.

The lenders, therefore, invariably call for a min-imum equity investment on the part of thesponsors. Alternatively, lenders may considerthe replacement of equity participation by sub-ordinate debt (which presents the same advan-tages) as acceptable. Furthermore, reserves canbe set up for the purpose of earmarking cash-flow surpluses for debt repayment, thereby pre-venting the shareholders from recovering theirequity contributions before loans have beenrepaid. It is also rare for “nonrecourse” loansto be genuinely without recourse, and thelenders frequently impose guarantees on thepart of the sponsors, particularly during theconstruction period.

The techniques adopted by the lenders to limittheir risk also include other measures includingcomfort letters or commitments by the conces-sioning authority, domiciliation of revenue ordebt, assignment of debt, and technical andfinancial performance bonds.

5. CONCLUDING THOUGHTS It is not possible to cite universal principles forrisk sharing in view of the widely varying char-acteristics and environments of port projects,but one important area to consider is the publicservice obligation. The public service dimensionof port operations, which the public authorityassigns to each port activity, is a core element inthe process of defining and sharing risk.However, the notion of public service is by nomeans universal. While some principles are con-stant, the definition of public service varies fromone country to another, and does not remainconstant over time even within a given country.

This variation, consequently, is a major consid-eration in the preliminary debate on the intro-duction of private management in ports. Thedelineation of public services is all the more deli-cate as the initial situation is frequently one of astagnant public sector, often with limited capacityfor clearly identifying the responsibilities that fallwithin the public service domain. For example,the activity of a port terminal operator cannotbe qualified as a public service in all cases, andis more akin to a purely commercial activity inmany instances. At the same time, the activity ofthe port terminal operator cannot be fully classi-fied as to that of a commercial company, as thenotion of partnership with the port authority isstill present, although the levels of regulationand guarantees may be considerably reduced.

In a case where the public authority assigns thispublic service dimension to the activity, it islegitimate for the authority to retain carefuloversight of the activity, while being free to del-egate its actual implementation. The publicauthority might regulate the activity of theimplementing entity to a greater or lesserdegree, while the delegatee must reconcile theright of fair competition with the proper protec-tion of the interests of users (or customers).This has complex implications for risk sharing,for which the procedures must be very carefullyadjusted to achieve a fair balance, one thatrespects the objectives and constraints of theparties involved.


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The main objective of this part of this modulehas been to describe various approaches foridentifying risks involved in port reform proj-ects and to suggest ways that these risks mightbe shared equitably among the interested par-ties. Part B of this module will introduce analyt-ical tools and risk measurement options avail-able for port authorities contemplating portreform.

PART B—PRINCIPLES OFFINANCIAL MODELING,ENGINEERING, AND ANALYSIS:UNDERSTANDING PORTFINANCE AND RISKMANAGEMENT FROM PUBLICAND PRIVATE SECTORPERSPECTIVES

6. INTRODUCTION Concessioning authorities, concessionaires(SPCs), investors, lenders, and guarantorsinvolved in port reform use a wide variety ofeconomic and financial analytical tools and per-formance measures to evaluate the feasibility ofprospective projects. Each party has a differentperspective on what makes a proposed project asuccess and, consequently, may use somewhatdifferent tools and measures. All measures,however, are designed to capture the economicvalue of the proposed project to the interestedparty, including an assessment of the likelihoodthat the full economic value will materialize(that is, taking uncertainty and risk intoaccount).

Part B of this module provides a tour of themost commonly used analytical tools and meas-ures of economic performance and risk to famil-iarize interested parties with the types of toolsand measures that are used by their potentialpartners in port reform projects so they can bet-ter understand what motivates and concernseach of them. It will especially help governmentdecision makers without a private sector financebackground to appreciate the private sector’sperspective on port reform and will permit them

to “speak the language” of their private sectorcounterparts. This, in turn, should help govern-ments and concessioning authorities design portreform projects to be more attractive to the pri-vate sector.

7. MEASURING ECONOMICPROFITABILITY FROM THEPERSPECTIVE OF THECONCESSIONING AUTHORITY

7.1. Differential Cost-BenefitAnalysis Traditionally, economic assessment is based ona comparison of two solutions: a solution witha proposed project and a reference solution(that is, a solution without a proposed project).In the case of a proposed expansion versus agreenfield project, the reference solution corre-sponds to a solution in which the existing portinfrastructure would evolve without moderniza-tion or expansion.

The assessment is based on a differential cost-benefit analysis. The costs and benefits areassessed in terms of economic value. This has adual implication in terms of methodology:

• The project assessment framework mustbe calibrated according to the nature ofthe national economic entity in question:state, local authority, port community,and so forth. In other words, economicassessments must be carried out at severallevels to ascertain to which economicentity the benefits of the project willaccrue.

• The various costs and benefits must beconsidered net of all taxes (direct or indi-rect tax, customs duty, and so forth) andnational subsidies, regardless of thenature of the national economic entity inquestion. The various taxes and subsidiescorrespond to monetary transfersbetween national economic entities andare therefore not to be taken into accountin the national economic assessment ofthe project.


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The assessment of commercial benefits andcosts does not pose any particular valuationproblem because their value is determined bythe market. However, assessing noncommercialbenefits and costs is more difficult.

7.2. Commonly Used EconomicProfitability Indicators Socioeconomic discounted profit or net presentvalue (NPV). In the field of public investmentand port investment in particular, the principalcriterion on which the investment decision isbased is the socioeconomic discounted profit.This criterion enables the intrinsic value of theproject for the community to be assessed, andonly projects with a positive discounted profitshould be selected.

The discounted profit is defined as the differ-ence between the discounted investment expen-diture and the discounted value of the net bene-fits generated by the project during its lifetime.We also use the expression economic net pres-ent value or economic NPV.

For a project whose operations begin in year t,the discounted profit is calculated as follows:

C = Discounted investment cost

a = National economy discount rate

Ai = Benefits in year i

t = Year in which the infrastructure is putinto service

The discounted profit criterion enables govern-ment officials to decide on the appropriatenessand interest of the project for the community.However, employing this tool does not provideany information as to the date on which itshould be carried out. With certain hypotheses(for example, investment made at the beginningof a period, or net annual benefits increasingwith time, unchanging chronicle of benefits

with time) it can be shown that discountedprofit reaches a maximum for a certain commis-sioning date, referred to as the optimal commis-sioning date. If the project is carried out beforethat date, the community loses benefits.Conversely, once that date is passed, the projectshould be carried out as quickly as possible.

Internal rate of return or economic IRR. The(positive or negative) value obtained when cal-culating the discounted profit is an absolutevalue (as opposed to a relative value) that doesnot allow public decision makers to weigh therelative merits among several projects or vari-ants. To permit this weighing of alternatives,another way of tackling the economic assess-ment of a project is to consider the value of thediscount rate at which the net discounted profitis zero, or the economic IRR of the project.

The economic IRR is the solution r of the equa-tion:

C = Discounted investment cost

Ai = Benefits in year i

This second criterion enables us not only toassess the intrinsic interest of the project for thecommunity by accepting only projects whoseeconomic IRR is higher than the discount rateof the national economy, but also enables us toarbitrate among several projects or variants bychoosing the one with the highest economicIRR.

Sensitivity studies. The economic assessment ofa project is normally supplemented by a sensi-tivity study, which enables decision makers toascertain the effect of changing a number ofparameters on the value of the economic IRR.

By way of illustration in the port sector, we cantest the effect of changes in traffic levels, invest-ment costs, operating costs, and cargo handlingproductivity on any project’s discounted costsand benefits.


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7.3. Assessing the Economic Costsof the Project Assessment of market economic costs.Traditionally, the market economic costs of aproject consist of investment costs, maintenanceand operation of equipment, and materials usedin each solution (that is, the solution with theproposed project and without the project). Inthe case of a project to expand an existinginfrastructure versus a greenfield project, thecosts to be considered in the reference solutionaccount for the normal expenses necessary tomaintain the operating life and the normal safe-ty conditions of port equipment and structures.

The inventory of project costs includes inducedinfrastructure costs, such as the new landservice networks required by the project. Forexample, a greenfield project often requires thebuilding of a new access road, for which theinvestment cost to the community can sometimesbe higher than the cost of the port project itself.

Assessment of nonmarket economic costs. Theinventory of project costs must also take intoaccount “nonmarket” economic costs. In theport sector, these include but are not limited to:

• The costs related to transferring trafficfrom one transport route to another (forexample, if several ports are competingwithin the same country).

• Possible effects of the project on townplanning (particularly traffic congestion).

• The impact of the project on the environ-ment and safety (for example, marinepollution, nuisance to locals, and pollu-tion resulting from handling bulkcargoes).

Assessing these economic costs is a particularlydifficult exercise, but one that is essential to deter-mine the economic rate of return of a project.

Assessing the economic benefits or positiveexternalities of the project. The economic bene-fits of a port project can be analyzed as anincrease in real revenue for the various elementsof the national economy. They can take the

form of a direct increase in national addedvalue corresponding to an increase in the wagescreated by net job creation, or an increase incompany profits (new activities whose develop-ment depends on the realization of the project).Another benefit is a price reduction translatinginto an increase in real income for consumersand an increase in profits for companies. Thiscovers, for example, reductions in ship turn-around times resulting from improved handlingefficiency (theoretically leading to a fall infreight rates), benefits from economies of scale,lower insurance costs, reduced cargo inventorycosts, lower inland transport costs, and more.

The benefits can theoretically affect all nationaleconomic agents who, in some way or another,are concerned with the production, marketing,transport, and handling of goods passingthrough the port in question.

8. RATING RISK FROM THEPERSPECTIVE OF THECONCESSION HOLDER

8.1. Financial Profitability and“Bankability” of the Project Once the risk allocation chart between the pub-lic and private sectors has been produced, asdescribed in Part A of this module, the privateconcession holder will then seek to quantify andprice the residual risk of the project that mustbe borne. This risk is assessed by producing acountry and project rating. Once this first stageis carried out, rating the risk is then defined bysetting a minimum financial profitability thresh-old for the project below which a private con-cession holder will refuse to commit itself. Inother words, the more risk associated with theproject by the concession holder, the higher therequired project profitability.

It is within this framework that one analyzesthe financial profitability of the project. Thefinancial analysis is designed to determine theconditions under which the proposed projectcan respond to market requirements, whichusually vary with time, or in other words, deter-mine the bankability of a project. In terms of


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methodology, the financial profitability of aproject is determined by forecasting the cashflows generated by operation of the project.This aspect will be developed later in the sec-tion on financial modeling.

The calculation of the financial profitability of aproject does not take into account the envisagedfinancing structure. In practical terms, onlyoperating cash flows (calculated after tax andduty), consisting of investment and operationalflows, are considered. Taking the predictedfinancing structure into account in the project’sforecasted cash flows would result in account-ing for them twice. The purpose of this firststage of the financial profitability analysis is todecide whether it is interesting for the privateconcession holder (sponsors and banks) to con-tinue the analysis of the project from a financialpoint of view. In fact, a financially unprofitableproject at this stage will not become profitableregardless of how it is financed.

This economic model of the prospective project,described later in this module, is usually pro-duced by the sponsors in collaboration with thefinancial advisors (merchant banks or specialistagencies). The economic model should not to beconfused with the economic analysis carried outby the concessioning authority as describedabove.

8.2. Assessing the Project Risks byProducing a Rating Part A of this module presented the principlesfor allocating and managing risks between theconcessioning authority and the concessionholder on the one hand, and between the con-cession holder and the sponsors or lenders onthe other. The method used, inspired by thelogic of the banking analysis of project financ-ing, consisted of:

• Drawing up a list of risk types: for exam-ple, country risks and project risks.

• Distributing the risk to the party bestable to assume it, for example, conces-sioning authority, sponsors, lenders, cus-tomers, suppliers, or subcontractors.

• Reducing the exposure of the SPC or thelikelihood of the occurrence of a residualrisk.

The next stage consists of quantifying the resid-ual risk that will be borne by the SPC. This riskis assessed by producing a rating. There are twotypes of ratings: a country rating to quantify therisk attached to the project’s background and,therefore, to establish whether the country riskis acceptable to the market, and a project rat-ing, a project risk assessment through the estab-lishment of a checklist, which establisheswhether the intrinsic risks in the project werecorrectly handled by the sponsors.

There are numerous country risk assessmentmethods. Box 9 presents the method developedby Nord Sud Export (NSE), which acts as anadviser to the French insurance companyCOFACE (Compagnie Française d’Assurance duCommerce Exterieur) in its country risk assess-ment process.

The project rating checklist, established followingthe principles spelled out in Part A of this mod-ule, is included as an annex to this document.

8.2.1. Commonly Used FinancialProfitability Indicators

The purpose of financial profitability indicatorsis to determine the conditions under which theproposed project is financially justified. Thereare four main measures used to assess a pro-ject’s financial viability: payback, IRR, NPV,and investment cover.

8.2.1.1. Payback Time. The payback time, orthe time required for a return on investment, isthe first indicator enabling investors and opera-tors to assess the financial profitability of aproject. It is measured by relating the value ofthe investment to the average annual cash flow.

T = years to pay back investment

I = total investment


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The country ranking process by Nord-SudExport (NSE) ranks a hundred or soemerging economies according to market

opportunities and the risks the individual coun-tries may represent for international operators(industrialists, bankers, or insurers), either formere export operations or for investments.This ranking is made possible thanks to anobjective rating system based on more than100 criteria, coming out of a database devel-oped by NSE over 18 years.

What Is Included in the Country Risk?

Strictly speaking, the country risk conceptincludes three main kinds of risks:

• The political risk, which may affect propertyrights through confiscation, expropriation, ornationalization, with or without compensa-tion, through contract or debt repudiation.

• The transferability risk, when a country’s cen-tral bank cannot convert resources in localcurrency into international means of payment.

• The payment risk for governments them-selves, or for public enterprises, when thepublic buyer or debtor does not meet itsfinancial commitments.

These three risks make up the basis of thecountry risk, that is:

• For lawyers, the act of government, knowingthat recourse against a foreign governmentis for all practical purposes a very difficultundertaking.

• For bankers, the sovereign risks, knowing asovereign guarantee often constitutes thefinancial safety scheme.

• For insurers, the political risks, knowingthose risks can be interpreted as catastro-phe risks, and as such should be covered byspecialized insurance companies actingeither on behalf of governments or within themarket reinsurance framework.

Country Ranking Methodology Proposed byNSE

NSE developed a two-step methodology: arating of risk factors identified and distributedby categories, and use of weighing coefficientsfor each identified risk factor.

Rating of Country-Risk Factors

The country risk assessment is establishedbased on the following classification:

Parameter 1: Sovereign financial risks

• Importance of public debt and debt service(6 criteria)

• Sovereign default risk (6 criteria)

• Inconvertibility risk (3 criteria)

Parameter 2: Market financial risks

• Command of fundamental economic bal-ances (5 criteria)

• Exchange risk, sudden currency devaluation(4 criteria)

• Systemic risk and economic volatility (6 criteria)

Parameter 3: Political risks

• Homogeneity of the social fabric (4 criteria)

• Government and regime stability (7 criteria)

• External conflicts (4 criteria)

Parameter 4: Business environment

• Conditions for foreign investments (6 criteria)

• Labor conditions (4 criteria)

• Good governance (5 criteria)

Weighing of the Risk FactorsThere cannot be any country ranking withoutweighing of the risk factors. The exercise is allthe more difficult to carry out when there areabout 100 criteria to assess. Furthermore, thespecificity of NSE’s country ranking method isto provide for a differentiated weighting systemdepending on whether a country is beingassessed from an exporter’s standpoint (takinga risk for less than 18 months), or from anindustrial investor’s standpoint (local long-termdevelopment). This leads, therefore, to propos-ing two specific weighing systems.

One needs to know how to make good useof country rankings, which can lead to ques-tionable results for at least four reasons:• It is hazardous to compare countries as dif-

ferent as South Korea and Egypt, forinstance, speaking of countries within thenewly industrialized economies.

• Country ranking methods mix various riskfactors according to a necessarily subjectiveweighting system.

• Most country rankings are made after experts’assessments, and therefore reflect more theirown perceptions of the risks involved, ratherthan the sheer reality of the countries.

• Finally, country rankings have as an objec-tive to deter commercial operations incountries deemed to be—objectively or

Box 9: The Country Ranking Developed by Nord-Sud Export

R = average annual operating income

C = average annual operating costs

R – C = average annual operating cash flow

Other things being equal, an investment projectwill be more interesting for the private investorif its payback period is shorter. A high value forT reveals, among other things, the need forlong-term financing and introduces great uncer-tainty.

8.2.1.2. Project IRR. The advantage of the IRRis that it does not rely on the notion of averageyear cash flow, which can be dangerous in thecase of income and costs that are very change-able with time.

The project IRR is the solution r of the equation:

Ii = amount invested in year i

Ri = operating income in year i

Ci = operating costs in year i

Ri – Ci = operating cash flow in year i

n = length of concession contract

The higher the value of r, the more interesting aproject will be from the financial point of view.

8.2.1.3. Project NPV. A third indicator of finan-cial profitability is the project NPV. A projectwill be considered insufficiently profitable froma financial point of view if the obtained projectNPV is negative. The NPV value is an absolutefigure that does not allow for comparisonsamong several projects or variants. Because ofthis shortcoming, it is generally appropriate tocalculate the investment cover ratio as well.

Ii = amount invested in year i

Ri = operating income in year i

Ci = operating costs in year i

n = length of concession contract

t = project discount rate

8.2.1.4. Investment Cover Ratio. The investmentcover ratio (ICR) compares the project’s dis-counted cash flows to the total of the discountedinvestments.

The factors are the same as those used in calcu-lating the project NPV.

A project will be considered profitable from afinancial point of view if its ICR is greater thanone. This is a variant of the previous indicator,but it has the advantage of providing a relativevalue, thus enabling investors to compare theresults of several projects or variants.

8.3. Project Discount Rate—Costof Capital Apart from the rate of return on investment (thepayback method), the other three measures ofprofitability noted above take into account per-formance over a project’s lifetime. These methodsrequire the use of a project discount rate based on


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Box 9: The Country Ranking Developed byNord-Sud Export (Continued)

subjectively—high risk, when no countryranking system is able to foresee events ofa revolutionary type. As a result, mostcountry ranking systems have to gothrough sudden and ex post downgradings,an impediment to effective decision making.In other words, it may be questionable for acompany to decide on long-termcommitments only on the basis of countryrankings, which, by definition, offer onlylimited reliability.

Source: Jean-Louis Terrier, NSE Founder.

the notion of the time value of money. This ratecan be used directly in the formula (project NPVand ICR) as well as indirectly (comparing theproject IRR obtained to the project’s discount rate).The concession holder, therefore, requires an accu-rate value for the project discount rate. In financialanalysis, the profitability of an investment is meas-ured against the cost of the financing required toown the resources placed under the company’scontrol. In other words, it is the cost of capital(weighted average cost of capital [WACC]) thatgives a true measure of the project’s discount rate.

Traditionally, the cost of capital represents theweighted average cost of all the financialresources invested in the project and is meas-ured as follows:

g = financial gearing or leverage or the amountof the financial debt in relation to the totalfinancial capital

rd = cost of the financial debt or the financialdebt remuneration requirement

re = cost of equity (the return on equity requirement)

In the next section, the remuneration require-ments of the various private capital providers(lenders and sponsors) will be analyzed, includ-ing the determination of both rd and re.

8.4. Financial Debt RemunerationRequirement The financial debt remuneration requirementrelates to the yield to maturity of the financing.It is the discount rate that cancels the presentvalue of the sequence of expenses created bythis financing. It therefore incorporates all theelements of the cost of finance, that is, the inter-est rate of the loan and all the fees charged insetting up the loan. If there are no fees andexpenses, the yield to maturity is the same asthe interest rate.

The yield to maturity engendered by the flowsequence [F0,F1,...,FN] is the solution for therate r of the equation:

There are four fees usually charged by lendersin financing projects:

1. An arrangement fee (up front commis-sion) to pay for the time spent in study-ing and setting up the dossier.

2. A participant’s fee to pay for the timespent in studying the dossier.

3. A commitment fee designed to pay forthe commitment to make unused fundsavailable in the future (for example, thecost of a forward rate agreement).

4. An agent’s fee, which pays for the adminis-trative work consisting of checking andapplying the loan agreement and managingcredit flows (draw downs or repayments).

The interest rate is expressed as follows: interestrate = base rate + bank margin. The bank mar-gin is known as the “spread.” It is usually fixedand determined when the loan agreement issigned.

The interest rate may be any of the following:

• In the case of a fixed rate loan, a referencerate such as the return on treasury bondsof the country of the currency concerned.

• In the case of a revisable or variable rateloan, a reference rate quoted in a finan-cial market such as EURIBOR or LIBOR(London Interbank Offered Rate).

• In the case of an indexed rate loan, theprocedures for changing the base rate arelaid down from identified parameters (forexample, inflation).

It should be remembered that a rate is said to be“revisable” if the reference is predetermined; inthe bond market, the coupon relating to a period(paid at the end of the period) is known at thebeginning of the period. Also, a rate is said tobe “variable” if the reference is postdetermined;in the bond market, the coupon relating to aperiod is not known until the end of the period.


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8.4.1. Inflation

Real and nominal interest rates translate thecost of money at a given moment in time, for aspecific period, and in a specific financial mar-ket place. The nominal interest rate initially rep-resents the sum of the real interest rate andexpected inflation. The real interest rate there-fore represents the cost of the money excludingall monetary erosion. The relationship betweenthe real and nominal interest rates is given bythe following formula:

Within the framework of assessing financial

profitability, the rate used for the initial approx-imation is the nominal interest rate.

8.4.2. Risk Rating by Determining rd

The financial analyst faces the difficult problemof translating the risk, established by means ofthe project rating, into a remuneration require-ment. That is, the analyst must determine therisk premium, or the spread attached to theproject for the lenders on the understandingthat there are no guarantees other than the cashflows produced by the project.

The spread is established by the lenders andaccounts for:

• Intrinsic characteristics of the loan (matu-rity and repayment terms).

• Sovereign risk assessment.

• Diversification policy of the bank’s assetportfolio.

• Liquidity level in commercial banks whenthe financing is being structured.

8.4.3. Debt Remuneration RequirementConclusion

Based on these various elements, it becomes arelatively easy task to determine the financialdebt remuneration requirements. However,these largely theoretical calculations must not

lead one to lose sight of the fundamental objec-tive of commercial banks to not get “stuck”with a high level of commitment above the ceil-ing allowed by their management board anddefined within the framework of their owndevelopment and risk management policies.

Since the beginning of the 1980s, deregulationof financial activities has occurred contempora-neously with an increase in market volatilityand competition between financial establish-ments. This situation has contributed to thedevelopment of assets and liabilities manage-ment as a stand-alone function in the bankingworld. Traditionally focusing mainly on devel-opment of commitments and increases in mar-ket share, commercial banks have come toappreciate the need to enhance their balancesheet value and their operating margins.

The decision on whether to invest in a specificproject thus has to meet all these considerations,largely intrinsic to the company and generallyunknown to the other private partners in theproject. And when a positive decision is reached,it is not unusual to notice significant differencesin the remuneration levels required by differentbanks. This underscores the theoretical nature ofthe approach described above and illustrates thecomplexity of the job of the financial analystassigned to this kind of project.

8.5. Equity RemunerationRequirement Assessing the equity remuneration requirementin a port project is a difficult exercise.Undoubtedly the most commonly usedapproach in financial analysis is the capitalasset pricing model (CAPM), which is used inassessing the risk-profitability profile.

The equity remuneration requirement, re, isgiven by the formula:

re = equity remuneration requirement

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β = equity beta parameter representing sensitivity

rm = market rate

rm – rf = market risk premium

α = sovereign risk factor

This method is based on the strong hypothesisthat the risk in any financial security can bebroken down into two categories: market risk(systematic or nondiversifiable risk) due to a setof factors exogenous to the company (for exam-ple, changes in the economy, tax system, inter-est rates, inflation), and specific risk (intrinsicor diversifiable risk) due to a set of factorsendogenous to the company (all the risks previ-ously mentioned under project risks).

The CAPM translates the fact that the prof-itability required by an investor is equal to therisk-free money rate plus a security risk premi-um, that premium being equal to a market-riskpremium multiplied by the security’s volatilityfactor. The market risk premium measures thedifference in profitability between the market asa whole and the risk-free asset. The currentlevel market-risk premium in France is in theregion of 3–4 percent.

There are two questions that are essential for afinancial analyst involved in a port privatizationproject to pose:

• How does one translate a risk quantifica-tion (achieved by establishing the afore-mentioned ratings) to an equity andquasi-equity remuneration requirement?In this regard, what should be the riskpremium attached to the equity suppliedby the project’s sponsors?

• What dividend payment policy should berecommended? In other words, how doesone reconcile the necessarily antagonisticobjectives and interests pursued by thelenders and shareholders (who wantthe cash flow from the project to exceedthe term of the loan) on the one hand,and between the sponsors and the SPC,on the other?

These are complex questions requiring complexanswers. As far as the risk premium is con-cerned, it is generally determined following nor-mative approaches. These approaches consist ofdetermining the beta parameter for each of thesectors the project sponsors are involved in(contractors, terminal operators, cargo handlingcompanies, shipowners, shipping companies,and so forth) and comparing them to theparameter generally assigned to a port operat-ing company. The value assigned to the project,called asset beta, should logically be the highestvalue uncovered in this process. Finally, thedetermination of the equity beta stems from thedifference that could exist between the specificfinancial structure of the project (as determinedby the SPC) and the one observed in the norma-tive approach.

“Differentiated” remuneration requirementsdepend on the type of shareholder. It should beremembered that the expected remunerationrequirement levels of the project differ depend-ing on the type of shareholder concerned. Thisfundamental point can be explained by the dif-ferent outcomes sought by the various sponsorsinvolved in the project:

• Constructors or equipment manufacturerswill seek to maximize their margin in thesale of the works contract to the SPC.

• The operator will seek to maximize itsmargin in the downstream supply ofmanagement services.

• The customer (shipper or shipowner) willseek a high quality of service in the longterm and a maximum reduction in thecost of using the port.

• The pure investor will primarily seek themaximum financial return on investmentin the project.

There is also the difficult problem of differenti-ating the remuneration requirement for the pureinvestor and the other types of sponsors, withrespect to which the SPC represents only a frac-tion of their objectives in the project. Generallyspeaking, discussions relate to the optimal time


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for the pure investor to place its capital with theSPC, given a traffic risk may be experienced. Inthis regard, should the investor come in as earlyas the project set-up stage, at the beginning ofthe operating stage, or when the operation ofthe investment has shown its ability to producesufficient revenue?

All of these questions, which are of interest notonly to the concessioning authority but also tothe lenders, are at the heart of the discussionssurrounding the financial analysis of the project.

8.5.1. Sharing of Public-Private FinancialCommitments: Arbitration betweenFinancial and Socioeconomic Profitability

If the project offers both a positive discountedsocioeconomic net benefit and project NPV, itshould be carried out because it is favorable forthe community and the concession holder alike.Conversely, when both discounted socioeco-nomic net benefit and project NPV are negative,the project should not be carried out. These arefairly straightforward outcomes leading to rela-tively straightforward “go no-go” decisions.

The real challenge is how to reach a reasonabledecision when the operation is profitable fromthe socioeconomic point of view but not fromthe financial point of view. With port projectsthis is the most frequent situation given thatport infrastructure investments are discontinu-ous or “lumpy,” with a long working life. Theymust therefore be designed from the start totheir definitive size, even if port traffic onlybuilds up gradually.

As a result, it is not unusual for the governmentto contribute to the funding of a project. Thisconstitutes the value of the project to futuregenerations, which is often difficult to ask thecustomers of the present generation to bearwithout running the risk of increasing the costof using the port to such a level that the portloses its competitiveness. Even though properremuneration of the benefits offered within areasonable economic life of the project shouldbe the rule, depreciation and remuneration ofthe government’s contribution over a longer

period, commensurate with the life of the long-term assets it financed, should not be seen as adeparture from this principle. It would obvious-ly be different if the capital market offeredfinancing on a cycle equal to the investmentcycle existing for port projects (25 to 50 years).This, however, is not the case today.

In conclusion, the financial constraints imposedby the market on this fragile public-privatepartnership often leads to a sharing of financialcommitments between the concessioningauthority and the concession holder. The searchfor an equitable split is based on the need tobalance the socioeconomic profitability of aproject and the financial profitability.

9. FINANCIAL PROJECTENGINEERING Capital markets are highly diversified. Whetherone should use such a source of finance isdependent on many criteria, such as its cost, thetype of assets to be financed, the guaranteesrequired, flexibility of use, and conditions ofacceptability by the financial market. The finan-cial engineering of a project consists of seekingout the optimal terms and conditions of financeand cover for the project based on analysis ofthe financial constraints and risks of the market.

Implementing financial engineering is a sensitiveand complex exercise, sensitive because of the com-mitment of the financial partners over periods thatcan be very long, complex because of the multiplic-ity and increasing sophistication of the financialtools available in the market. It is also essential tounderstand that the financial project engineeringmust first and foremost conform with a pragmaticlogic that is dictated by common sense and a thor-ough understanding of the issues. It should not bebased on a desire to use sophisticated finance andcover mechanisms for their own sakes.

9.1. Financial Structuring withinthe Framework of a ProjectFinance Set-Up Once the financial profitability of the projecthas been determined, the SPC must define the


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structure of its liabilities, that is, the value of itsequity and quasi-equity and the value of itsdebts.

In project financing schemes, the structure ofthe SPC’s liabilities directly stems from the pro-ject’s ability to service its debts. The main meas-ures being used in this respect are:

• Capital structure ratio: The most com-monly used ratio to ascertain the financ-ing structure is: (equity + quasi-equity) ÷financial capital. Financial capital coversall of the financial resources invested andplaced under the company’s control bythe capital providers. In other words, itincludes permanent financial resources(equity and quasi-equity + medium- orlong-term financial debts) and bankadvances (short-term financial debts).

• Annual debt service cover ratio: TheADSCR is calculated as: ADSCR = avail-able cash flow for servicing the debt ÷annual debt service. This ratio is calculat-ed each year and therefore provides acontinuous view of the project’s ability toservice its debt. It also enables the debtrepayment profile to be changed if thevalues obtained reveal too high a dispari-ty during the finance cycle.

• NPV debt cover ratio: The average of allthe annual cover ratios, known as “aver-age debt cover ratio” is also used bysome analysts. This ratio enables, amongother things, a comparison to be madebetween several methods of paying offthe loan and provides a global view ofthe economics of the project.

These three ratios enable one to assess from theoutset the amount of the debt with limitedrecourse that is acceptable to the banks. Fromthis flows the amount of equity and quasi-equityrequired to finance the project.

If the shareholders’ aim in financing the projectis to enable the project to benefit from a nonre-course or limited recourse loan, then this meansthat the repayment ability of a project may be

less than the amount of external finance thatthe shareholders wish to obtain. In this case, theloan will be split into several tranches differenti-ated according to the degree of recourse thelenders want to be granted with respect to theproject shareholders; this is called subordinateddebt or mezzanine debt. In this case, thesefinancial resources are considered to be thesame as the partners’ current accounts, namelyquasi-equity.

But, as always happens in financial analysis, thediscounted value of a series is preferred to itsaverage value because the time value of moneyis taken into account. For this reason, we preferthe NPV DCR, which is defined as follows:NPV DCR = NPV of cash flow available forservicing the debt ÷ outstanding debt. The dis-count rate used in calculating the NPV is that ofthe average interest rates of the financial debts.As regards the period over which the NPV iscalculated, there are two possibilities: the lengthof the financing cycle, in other words the lengthof the loan (the loan life cover ratio [LLCR]), orthe length of the investment cycle or concessioncontract (the project life cover ratio [PLCR]). Ifthe debt is not repaid by the time the loanagreement expires, subsequent cash flows willbe used to pay it off.

What are the minimum requirements for theseratios in the case of a port project? In practicalterms, it is difficult to suggest precise thresholdsfor the foregoing ratios that could apply to allprojects. However, it seems reasonable to statethe following, as far as project financing inOrganisation for Economic Co-operation andDevelopment (OECD) countries is concerned:

• A capital structure ratio below 15 percentwould likely lead the lenders to demandan increased equity or quasi-equity con-tribution from the sponsors as a token oftheir commitment to the project.

• An annual ADSCR below 1.3 wouldinevitably require restructuring of thefinancing set-up, likely along the lines ofan amendment of the loan amortizationprofile.


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• An NPV DCR below 1.7 would run therisk of deterring any potential privateinvestor; the project would then requirean increased public financial contributionto make it viable for the private partners.

These thresholds are given only as potentialindicators and do not apply to all cases, nor dothey take into account the country risk factor.Clearly, their final assessment is contingentupon the overall project risk analysis describedin Part A of this module.

9.2. Debt Structuring Debt markets are highly diversified.Consequently, in complex transactions, debt isoften broken down into several tranches (seg-ments) of different loans. The aim of structuringthe project’s debt consists of seeking the opti-mum finance conditions for each of thesetranches to reflect the requirements of the pro-ject’s various financial partners.

Debt financing is usually defined by a set ofintrinsic characteristics. The four main ones are:

• Length or maturity of the loan: The dateon which the last repayment of the loanor the tranches of the loan has to bemade by the SPC.

• Availability period: The closing date ofvalidity of the loan, which limits thelender’s undertakings in time.

• Loan repayment terms: The repayment ofa loan must be tailored to the project forwhich it was set up. There are three typesof repayment profiles generally used:

~ Equal installments of principal.

~ Equal installments of interest and prin-cipal.

~ Installments depending on the availablecash flow.

Some terms include deferred repayment or agrace period, which means that over a certainperiod (rarely more than two years) the borrow-er pays only interest to the lenders. Deferredrepayment may prove necessary for projects in

which the ability to generate operating incomesignificantly lags behind project costs. This isusually the case with greenfield port projects.

• Average length and loan duration: Theaverage duration of a loan is usually usedas an instrument of comparison when theloan repayment profile is dependent onavailable cash flow.

The average duration of a loan is given by theformula:

Outstanding amount i represents the variousannual outstanding amounts of the loan over itslifetime. A variation of average duration of theloan introduces the discount factor and repre-sents the “center of gravity” of the financeflows over time. A credit sequence [F1, F2,...,Fn] at a discount rate of t has a duration of:

This latter measure of duration is more oftenused as an instrument for measuring and man-aging the rate risk.

9.3. Long-Term Commercial Debt To finance public service infrastructure, the firsttwo methods that spring to mind are publicbudget finance and investment prefinancing bythe project sponsors. Both of these methods arereferred to as corporate financing. This impliesthe inclusion of the amount of the investment inthe public accounts of the concessioning author-ity as well as in the company accounts of theconstructor, respectively.

These finance solutions have the major disad-vantage of being a burden on the investmentcapacity and balance sheets of the parties. Thisis particularly true in the case of transportinfrastructure where the sums to be financed arelarge and the balance sheet ratios (see above)


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are weak in the first few years of the projectdue to the slow increase in revenue generatingtraffic. An alternative to these methods is proj-ect finance.

It is difficult to define the characteristics of atypical project finance set-up because tailor-made solutions are so important. However, thefinancial set-ups have one essential point incommon: repayment of the loan is either prima-rily or solely dependent on cash flows generatedby the project itself. In the first case, this iscalled limited recourse financing and in the sec-ond, nonrecourse financing.

The two characteristics common to limitedrecourse financing are that the loan is repaid onthe basis of cash flows generated by the project,and that the lender has no guarantees otherthan the assets of the project itself, which oftenare not financially recoverable for port projects.

9.3.1. Foreign Currency Loans

One way of reducing exchange risks is to obtainfinancing in local currencies. However, this typeof financing quickly reaches its limits in devel-oping countries. In fact, the weakness or nonex-istence of a national money market, high localcurrency interest rates, and the absence ofinvestors willing to provide finance over periodscompatible with infrastructure projects all com-bine to exclude local currency debt or at leastrestrict its use to a short-term revolving line ofcredit designed to finance operating expenses.Foreign currency debt also poses problems ofexposure to the residual exchange risks of con-vertibility and transferability.

9.3.2. Guaranteed Commercial Debt

Export credits and financial credits with a mul-tilateral “umbrella” export credit agencies(ECAs) and multilateral agencies (MLAs) offerguarantees or “cover” that can mitigate politi-cal risks associated with port projects and there-fore open up new financing possibilities. Whenthe commercial banks are to a large extent freedfrom worrying about political risks, they canconcentrate their efforts on the commercial risk

within the framework of terms offered by theseagencies. The fact remains that these agenciesare themselves subject to term and cost con-straints that must be taken into account (partic-ularly the OECD Consensus for export creditagencies).

9.3.3. Export Credits

Export credits can prove very useful when theproject is located in a developing country andinvolves the contribution of foreign technology.Among export credits, one must distinguishbetween supplier credits (credit granted directly bythe exporter) and buyer credits. Buyer credits, themore common of the two, are granted by com-mercial banks for a maximum length of two yearsto a foreign borrower to enable the borrower topay cash to the supplier (the exporter) accordingto the terms of the commercial contract. Buyercredits free the exporter from the financial risk ofmaking a credit-based sale to the buyer.

When an export sale is supported by a buyercredit, two distinct cross-referenced contractsare signed: the commercial contract between theexporter and the foreign buyer, and the creditagreement between this same buyer (as a bor-rower) and the lending banks. The commercialcontract spells out the respective obligations ofthe supplier and the buyer. It must indicate thepayment modalities (in particular the downpayment to be made before delivery and theoverall payment schedule) that will serve as abasis for the buyer credit. The credit agreementis signed between the commercial bank and theforeign buyer. Under this agreement, the bankcommits itself to pay the exporter and the buyeragrees to pay back the bank for all amountspaid to the supplier according to terms andmodalities spelled out in the credit agreement.

Buyer and supplier credits can both benefitfrom public support for medium- and long-termexport financing. This support, governed by theconsensus rules drafted by the OECD membercountries, can be expressed in two ways:

• Provision by credit insurers of cover forpolitical and commercial risks on foreign


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debtors (the SPC would be the foreigndebtor within the framework of a projectfinance transaction).

• Provision of a fixed rate for the loan,known as the reference commercial inter-est rate (RCIR), for instance in the caseof COFACE, the French export creditagency. In Europe, such a rate stabiliza-tion mechanism is possible for loans inboth euros and foreign currencies.

Buyer credits are of three varieties:

• Administered credit is when the buyercredit benefits from public supportthrough a rate stabilization mechanismon top of a guarantee provided by anexport credit agency. Also, this type ofloan is placed at a more competitive level(fixed rates and long terms) than syndi-cated financial loans or bonded debt.

• Pure cover credit is when the buyer creditonly benefits from a guarantee providedby an export credit agency. In this caserates are neither stabilized nor enhanced.They are freely established by the banks,indexed on a reference index (EURIBORor LIBOR, for instance), and can be vari-able, revisable, or fixed.

• Financial credit or free credit is when thebuyer credit is established without anypublic support and without any exportcredit guarantee. The manufacturing riskis carried by the supplier and the creditrisk by the bank. Because of the riskinvolved, it is in fact limited to the best-known borrowers, and generally limitedto down payment financing.

Export credit agencies exist in most industrial-ized countries: COFACE in France, SACE inItaly, HERMES in Germany, ECGD in England,CESCE in Spain, and Ex-Im Bank in the UnitedStates and Japan.

In a port project, this source of financing relatesmore to port equipment (for example, handlingequipment, container gantries, and computersystems) than infrastructure (for example, civil

engineering or dredging), which is usually sub-contracted locally. To enjoy the export creditcover, the project must fulfill certain criteria.The first of these is that payments made underthe contract concluded with the exportingequipment manufacturer must represent 85 per-cent of the share able to be repatriated (nationalshare + foreign share). Box 10 describes howthe concepts come together in an example.

It should be pointed out that while the principalactivity of export credit agencies is now tocover political risks, some of them have projectfinancing teams and are beginning to considercovering the commercial risk in some projects.Furthermore, there is an increasing number ofmajor project financing contracts in the form ofmultisourcing operations, in the sense that theyare structured either by major multinationalgroups that can source from different countriesthrough their subsidiaries, or by multinationalconsortiums organized on a cocontracting orsubcontracting basis. This change can beexplained by the fact that the ever increasingsize of the investment level of the projects doesnot always coincide with the total commitmentlimitations (geographic or sector) set by theexport credit agencies and governments withinthe framework of their risk policy (see Box 11).

9.3.4. Financial Credits with a MultilateralUmbrella (A- and B-loans)

Multilateral organizations, such as the WorldBank Group, through the International Bankof Reconstruction and Development (IBRD)or regional development banks (EuropeanBank for Reconstruction and Development[EBRD], Asian Development Bank (ADB), andInter-American Development Bank [IDB]),are also involved in these types of transactionsalongside commercial banks and exportcredit organizations. This is referred to ascofinancing.

Most of the time cofinancing is carried out inthe form of parallel financing where the projectis split into separate lots, each covered by aWorld Bank loan or a commercial debt grantedby a bank or a buyer credit covered by an


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export credit agency. These cofinancingmethods, relating to financing of separate lots,should not be confused with the technique ofjoint financing, which combines several sourcesof finance in a single lot, according to a per-centage agreed to in advance.

In practice, the involvement of a multilateralagency in this type of set-up leads to the financialcredit being structured at two levels (or in twosegments): an A-loan granted by the multilateralorganization itself, and a B-loan underwrittenby commercial banks under the multilateralumbrella.

The World Bank, through the IFC, can beinvolved in A-loans in three ways:

• Direct financing of the last installmentsof the loan granted by the commercialbanks, usually translating into a 10–25percent participation.

• Provision of a guarantee relating to thelast installments, in return for a guaran-tee fee.

• Conditional participation of the WorldBank in variable rate credits, if the finalcharge corresponding to payment ofinterest exceeds the repayment ability asoriginally assessed.

As far as B-loans are concerned, the notion of amultilateral umbrella does not mean that themultilateral organization gives the commercial


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Assume there is a greenfield port con-struction project in China requiring thesupply of quayside gantries. Let us fur-

ther assume that the equipment manufacturer,whom we shall call the “exporter,” identified forthis service is French, and that the commercialcontract concluded between the SPC and theindustrialist represents an investment of 100 MFRF broken down as follows:

• French share, 50 M FRF (parts exporteddirectly from France).

• Foreign share, 10 M FRF (parts manufac-tured in Germany, for example, and exportedto China).

• Local share, 40 M FRF (for the installation ofport equipment in China subcontractedlocally by the exporter).

The proposed financing for this contract is abuyer credit (structured by the exporter’sFrench bank) with a request to COFACE forexport cover against the political risk during themanufacturing stages (six months, for instance)and credit (five years for this kind of investmentaccording to OECD rules) with an applicationfor stabilization of the loan’s interest rate. Thenotion of export cover is a complicated one aswill be illustrated by the following example.

During the manufacturing stage, the extentof the export cover granted to the exporter is100 million FRF, for an amount of cover whichcan vary (depending on the policies issued bythe export credit agencies from 70–85 percent

of the value of the commercial contract, thatis, 70–85 million FRF in this example). The15–0 percent of the value not covered cannotbe covered by additional insurance by theexporter.

During the credit stage, the extent of theexport cover granted to the exporter’s bankamounts to 100 percent of the portion of thecontract that can be repatriated (that is, theFrench share plus the foreign share, or 60 millionFRF). The amount of cover granted to the bankis 95 percent of the extent of cover (theremaining 5 percent cannot be covered byadditional insurance by the bank).

In other words, the export cover granted byCOFACE in terms of cover for the political riskand rate stabilization only relates to an amountof 60 million FRF. The additional financingrequired for the port investment (40 million FRFin this example) is then known as “straightback-up credit.” It can be provided either bythe exporter’s bank or by another commercialbank (a local Chinese bank, for example).

Generally speaking, finance structuring withexport credit leads to the credit being split intotwo tranches: one guaranteed and the othernot guaranteed at market conditions (rate andduration). This can also be referred to as ajoint financing technique because each ofthese tranches refers to one and the sameinvestment.

Source: Author.

Box 10: An Example of Export Cover by COFACE in a Port Project


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Box 11: Principal Guarantees Offered by an Export Credit Agency for Project Financing: TheCOFACE ExampleCOFACE insurance policies cover four cate-gories of risks:

• Manufacturing risk: Materializes when thefulfillment of the exporter’s contractual obli-gations is suspended for at least a 6-monthperiod, inasmuch as this situation resultsexclusively from factors spelled out in theinsurance policy subscribed by the exporter.

• Credit risk: Materializes when the exporter’scommercial bank finds it impossible torecover all or part of the debt relating to theguaranteed contract, inasmuch as this situa-tion results exclusively from factors spelledout in the insurance policy subscribed by theexporter.

• Performance bond and advance paymentreimbursement guarantee risk: Upon requestfrom the exporter, these guarantees andbond commitments may be included in thescope of the manufacturing or credit riskguarantees.

• Bid guarantee risk: Materializes when theexporter cannot recover from the beneficiaryof the bid guarantee all or part of the guar-antee amount.

In principle, COFACE also demands that tocover the manufacturing risk, the credit riskmust be covered, and that to cover the creditrisk, in the case of progressive payments, thatthe manufacturing risk must be covered.

Facts Triggering Guarantees

COFACE general conditions list eight factorstriggering a call on guarantees (manufacturingor credit):

• Arbitrary cancellation of the guaranteed con-tract by the debtor.

• Mere carence of the debtor.

• Insolvency of the debtor, consisting of itsincapacity to meet its financial commit-ments, resulting from:

~ A judicial act resulting in the suspensionof individual lawsuits (as the judicialliquidation).

~ An agreement reached with all creditors.

~ A de facto situation leading the insurer toconclude that any payment, even partial, isunlikely.

• General moratorium enacted by the govern-ment of the debtor’s country or of a third-

party country through which the paymentmust be processed.

• Any other act or decision of a government ofa foreign country preventing the guaranteedcontract from being carried out.

• Occurrence, outside of France, of war, revo-lution or riot, or acts of nature such as hurri-cane, flood, earthquake, volcanic eruption,tidal wave, or similar event.

• Political events and economic hardshipsoccurring outside France, or legislative oradministrative measures taken outsideFrance, preventing or delaying the transfer offunds paid by the debtor or its guarantor.

• Act or decision by the French government,such as a ban on exports of the goods orservices that are the object of the guaran-teed contract, or requisition of the goods inthe course of manufacturing.

Principal Guarantees Offered by an ExportCredit Agency for Project Financing:Concepts

The risk definitions above, as well as the guar-antee triggers, constitute the basis of the guar-antees offered by COFACE to its clients.However, to get a good understanding of thescope of the guarantees offered, it is neces-sary to grasp the following concepts:

• Public buyer: An entity exercising the govern-ment’s responsibility and which cannot bejudicially bankrupt. When a public buyer bene-fits from a letter of guarantee from its financeministry, it is then called a sovereign buyer.

• Private buyer: A buyer that does not meetthe previous criteria, and which can there-fore be judicially bankrupt.

• Political risk: Risk resulting from a politicalfact, such as a war, revolution, or an act ofgovernment preventing the contract frombeing carried out. It becomes an extendedpolitical risk when the event leading to thematerialization of the risk is not of sovereignorigin, but comes from a local community, apublic establishment, or similar organization.

• Commercial risk: Risk resulting from thefinancial instability of the private buyer(insolvency). This implies that any paymentdefault by a public buyer, sovereign or not,exclusively results in materialization of apolitical risk, or broad political risk.

banks any kind of guarantee on this credit. Itsimply means that the banks will feel reassuredby the participation of the multilateral organi-zation because the host states are unlikely totake detrimental measures against the projectbecause of their presence.

Finally, although multilateral institutions are oftenunwilling to bear certain risks, they have theadvantage of being able to offer much longer loanperiods at fixed rates than the commercial banks.

9.3.5. Bonded Debt

Bonded debt is a source of long-term financingthat is currently enjoying widespread popularity,particularly in financing transport infrastructure.It is used extensively in the North Americanmarket and is reserved for institutional clients.

This option should not be confused with bondissues for public savings.

Issuing bonded debt (under what is referred toas Rule 144A) enables financial terms (marginsand fees) to be obtained as well as maturitiesthat are more favorable than those available inthe banking market. This method of financing isfairly recent, as it only took off in the early1990s and it has still not reached maturity. Infact, it is only in the last few years that the mar-ket has come to agree to cover financingrequirements during the construction period. Itis therefore more a method of refinancing forbanks than of financing for investors.

It should also be noted that using this type offinancing source can create problems for inter-creditor relations. While the problem of senioritybetween the debt categories can be easily solved,the ability of the various quorums to call in theirsureties and the differences in the level of infor-mation supplied to the protagonists poses majorproblems (for example, a club of a few banksdoes not receive the same information as a large,liquid syndicate of heterogeneous investors).

9.3.6. Structuring Equity and Quasi-Equity

Equity is a financial resource that is flexibleenough to earn its return over a variable andunspecific time frame, without creating any riskof financial sanction by the equity holders. Inother words, equity refers to financial resourcesplaced under the control of the company anddesigned to cover the materialization of projectrisks.

9.3.6.1. Equity Provided by the Public Sector.There are many ways in which the public sectorcan become involved in port investments.Which of these is applied depends to a largeextent on the configuration of the project. In anonexhaustive way, one can list the followingoptions:

• Contribution of assets: This solution hasthe dual advantage of reducing the initialamount of the investment and possiblyproviding income during the constructionperiod. Within the framework of a port


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Box 11: Principal Guarantees Offered by anExport Credit Agency for Project Financing:The COFACE Example (Continued)Specificity of Risk Coverage by COFACE inProject Financing

In project financing schemes, the borrower isthe SPC. Therefore, in all cases, even whenthe public partner would have chosen to takeequity participation alongside the privatesponsors, the borrower is considered a pri-vate buyer. However, COFACE will not cover,in principle, the SPC’s commercial risks, thatis, insolvency resulting from an inadequateassessment of future traffic in particular.

Political risks are covered, both manufactur-ing and credit. As far as the extended politicalrisk is concerned, the risks potentially eligiblemust be measurable, and refer to specific claus-es in the contract, the nonrespect of these claus-es allowing the SPC to terminate the contractwith a right to indemnity by the public partner.This indemnity is defined to allow it to cover, as aminimum, the outstanding debt balance.

Political risks refer to the public partner’scommitments to do or to pay, with specificcontents spelled out in the contract. In case ofnoncompliance, this constitutes a breach ofcontract. These may include availability ofland, issuance of building or operating permits,payment of investment or operating subsidies,fiscal measures initially granted, and so forth.

Source: Author.

extension project, a contribution of assetscould consist of entrusting the privateconcession holder with the operation ofan existing terminal managed until thenby a public port authority. In this way,the financial profitability expected byinvestors is reinforced by the assurance ofcash flows on signature of the concessionagreement; this is known as backing.

• Cash contribution: The concessioning pub-lic authority can invest cash in the projector provide operating subsidies. This increas-es the available cash flows for servicing thedebt. For example, in the case of a green-field port project, investment subsidies arefrequently required for financing swell pro-tection structures because of the discontinu-ous (lumpy) nature of this investment.

• Guarantee contributions: The concessioningpublic authority offers a minimum revenueguarantee, a guaranteed return on investedcapital, or a guarantee to make good on lia-bilities in the case of force majeure.

There are many financing vehicles for the publicsector to contribute equity to the SPC. Theintervention can take the form of:

• Public financing drawn from the budgetof the concessioning authority or the hoststate of the project.

• Export credit (usually buyer credit) grant-ed to the concessioning authority by oneor more export credit agencies (creatingsubsovereign risk for the bank).

• Bilateral financing (for example, theFrench Development Agency) or govern-ment protocol (now renamed EmergingCountry Reserve in France).

• EU financing, which can come from theEuropean Investment Bank (EIB) or theEuropean Commission (EuropeanDevelopment Fund financing in particular).

• Multilateral financing from the WorldBank Group (IBRD or IDA) or regionaldevelopment banks.

With the exception of export credits, the benefi-ciary of this type of financing is the host stateof the project, which then retrocedes the credit,frequently granted on concessionary terms, tothe port authority concerned. While this tech-nique has an undeniable advantage for thelenders of avoiding the risk of a shortfall causedby the local public authority, given that thecredit enjoys a “sovereign guarantee,” the factremains that in some developing countries (inAfrica in particular) this procedure of the stateretroceding the credit is carried out on termsand conditions that are not always favorable tothe local company, as the state wants to make aprofit on the transaction.

Financial analysts compare all of these publicsector financial investments in the project toequity, whether or not the concessioningauthority is one of the shareholders of the SPC.The risk that these resources will not be madeavailable to the private concession holderremains. This risk is an integral part of thepolitical risk. One can therefore understandwhy the private concession holder (and thebanks in particular) have tended to preferinvestment subsidies, payable right at the startof the concession, to operating subsidies.

9.3.6.2. Equity Invested by the Project’sSponsors. Equity contributed to the project byits sponsors is paid into the SPC’s share capital.This is determined according to the minimumrequired by legislation and the available fundsof the future shareholders. Banking require-ments are usually not too strict in terms of theamount of share capital required, as only thevalue of the equity and of similar funds is sig-nificant in terms of financing structure. Theequity balance is usually given to the SPC bythe sponsors in the form of confirmed letters ofcredit in the name of the shareholder.

9.3.6.3. Equity Invested by MultilateralInstitutions. Some multilateral institutions havefinancial tools that enable them to invest inthese operations as a shareholder of the SPC inthe same way as the project’s sponsors. The bestknown of these institutions is the International


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Finance Corporation (IFC), a subsidiary of theWorld Bank Group, which invests in privatecompanies in developing countries. It acts as acatalyst, in the absence of a government guaran-tee, by providing coinvestors with protectionagainst noncommercial, expropriation, andprofit repatriation risks.

There are three ways in which the IFC can beinvolved:

• Direct investment in the capital of theSPC.

• Long-term subordinated loans granted tothe SPC and then considered as quasi-equity in the financing structure.

• Shareholder advances granted to the proj-ect sponsors, which are similar to part-ners’ current accounts and are also con-sidered as quasi-equity.

9.3.6.4. Equity Invested by Bilateral Institutions.Some bilateral institutions become involved inthese projects by investing in the SPC. InFrance, this is the case with PROPARCO, aninvestment subsidiary of the FrenchDevelopment Agency (ADF). Established in1977, PROPARCO (Société de Promotion et deParticipation pour la Coopération Economique)has a mission to promote the creation anddevelopment of private enterprises in developingcountries, particularly in Africa. PROPARCO’sequity participations are to be sold after anaverage of six years, when the enterprise reachesa satisfactory growth rate.

9.3.6.5. Specialist Investment Funds. In somecases, the use of specialist funds (geographic,sector, or religious) can also finance majorprojects. These sophisticated sources of financeare usually similar to quasi-equity because theinvested capital is mostly supplied to the SPC inthe form of mezzanine debt.

This subordinated debt, which is junior in rank-ing to traditional bank debt, is frequently givento the project for a long term and attracts amuch higher rate of interest than traditionalbank debt. This type of financing is therefore

reserved for highly specialized private investors,for example, pension funds, institutionalinvestors, or finance company subsidiaries ofmajor groups.

9.4. Managing ExogenousFinancial Risk Exogenous financial risks are a category of mar-ket risks as opposed to political risks. Theyarise from the perpetual changes in the capitalmarket. Such risks usually relate to interestrates, exchange rates, and counterpart risks.With regard to interest rate and exchange riskcover, there are two main families of marketsthat although different, are also interdependent:

• The interbank market (forward), wherecontracts are negotiated by private agree-ment and the bank usually acts as anintermediary between several counter-parts for a commission. This is alsoknown as the over-the-counter market.

• The organized markets (futures), whosemain feature is the offer of standard con-tracts, futures contracts, and option con-tracts continuously quoted on the inter-national stock exchanges. Standardizationrelates to the nominal value (also knownas the notional value) and the maturitydates of those contracts.

While the cover principles are identical in bothof these markets, the methods employed in theiroperation are quite different. Three reasonsexplain why:

• Standardization of contracts (nominalvalue and fixed maturity dates) impliesthat the cover obtained in the organizedmarkets is always imperfect for theinvestor, contrary to what happens in theinterbank market. Imperfect means thatthe level of cover is only rarely an exactmultiple of the nominal value of thefutures contract. Similarly, it is almostequally as rare for the cover expiry dateto correspond to the maturity date of thefutures contract. Also, futures contractsprovide only partial cover, and there


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continues to be a residual risk for thecompany.

• In the organized markets, the vast majori-ty of contracts do not involve actualdelivery of the underlying securities.These delivery and receipt undertakingsare in fact offset before maturity by atransaction in the opposite direction tothe original one. Conversely, in the inter-bank market, the obligation to deliver orreceive the underlying security usuallyexists. In jargon, the futures markets aresaid to be “paper contracts” as opposedto the “physical contracts” pertaining tothe underlying security.

• Because the interbank market is an over-the-counter market, transactions are exe-cuted principal to principal, whichimplies a counterpart risk that is notpresent in organized markets due to thepresence of a clearinghouse.

The financial engineering of a project in termsof risk cover always has to be tailor made. Assuch, it must adapt itself to the configuration ofthe project and its environment, the coverrequirements sought by the investors, and thelocal conditions of the country. Also, the prod-ucts available on the capital market are notapplicable to all developing countries.

Several previously described methods of financ-ing already incorporate cover against certainfinancial risks in their design. This is particular-ly the case with guaranteed credits, which,depending on circumstances, can offer the SPCexchange or interest rate guarantees. Also,while it is easy to dissociate the method offinancing a project from the cover for financialrisks in theory, in practice it is more difficult.Designing the financial engineering of a projectmust therefore fall within a global approachwhere the financing and the financial risk man-agement methods are dealt with simultaneously.

All of the cover products (detailed in the fol-lowing paragraphs) are used more during theoperating period than the construction periodfor two main reasons. First, cover requirements

are without common measure in terms of dura-tion, a few years for construction and typicallya minimum of 20 years for operation. Second,using such products requires an accurate priorknowledge of the amount of flows to be cov-ered, an exercise that is much more difficult toachieve during the construction stage.

The principles of cover are based on the notionof transfer (and not removal) of the financialrisk to a counterpart. The counterpart agrees tobear the risk for payment of a premium becauseits cover need is the opposite of that required bythe investor. In other words, all these mecha-nisms involve the notion of counterpart risk,which can be difficult to manage in the case ofa project financing set-up.

The market sees new risk management andcover instruments every day. Their sophistica-tion is limited only by the imagination of thefinanciers. It would therefore be futile toattempt to deal with this field exhaustively. Thegoal of the following section is to make themechanisms understandable and explain theissues, specifically within the framework of aproject financing set-up.

9.4.1. Interest Rate Risk Management

As already mentioned, debt financing usuallyinvolves a variable interest rate, consisting of areference rate (variable) and a margin (fixed).As far as the SPC is concerned, the interest raterisk occurs when the reference rate rises and,along with it, the financial costs of the project.Given that concession contracts are concludedfor long periods, the concession holder’s mainconcern is to try to cover itself against the riskof rates rising in the long term.

Several issues regarding interest rate risk man-agement merit further explanation. The riskassociated with rising reference rates (for exam-ple, EURIBOR or LIBOR) can result from twoindependent sources, the first being an increasein inflation in the countries in which the refer-ence index is calculated, that is, the developedcountries. This creates a need to neutralize thenegative impact of inflation on the cost of the


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debt, since it will make the debt more expensive.Neutralizing the effect of inflation is possibleonly if the price indexing parameters laid downin the concession contract make provision forthis. Delaying the adverse affect of inflation isthe existence of a lag factor, of varying length,between the time the real interest rates rise andthe time they are passed on in the concessionholder’s interest charges. This increase mightlead to an increase in the project’s revenue if theproject is carried out in one of the indexingcountries, thereby partially offsetting the affectsof increased inflation and interest rates.

The second source is an increase in real interestrates wherein the annual increase is not offset by aparallel increase in available cash flow for servic-ing the debt. This implies a corresponding rise inthe cost of the debt. Consequently, the SPC bearsthe whole brunt of the rate rise if no other covermechanism was originally provided in the set-up.

Conversely, interest rates could fall significantlyduring the operating period. If the SPC hadmanaged, either directly through the loansgranted to it or indirectly through the coverinstruments it contracted, to maintain a fixedinterest rate on its debt, it would experiencehigher interest expenses than competitors withvariable rate debt. This would imply that theport’s customers would have to bear this sur-charge through the prices they were charged. Inother words, setting up a fixed rate loan duringa period of falling rates would translate into aless favorable competitive position for the SPC(compared to other competing ports or termi-nals that may have opted for a variable rateloan), leading to a rise in the commercial risk. Aprudent mix of fixed and variable rate loans istherefore advisable, on the understanding thatthere is no ideal formula. Although a 50-50ratio is often used as an initial approximation,the final determination of this cover threshold isan extremely complex exercise as it assumes theability to forecast long-term rate trends over a10-, 15-, or 20-year financing cycle.

Finally, let us remember that existing coverinstruments are used more during the operating

than the construction period. It is harder todetermine the rate risk and fix drawings on theloan in time (dependent on the state of progressof the works) than to fix the repayments thatare stated in the loan agreement.

9.4.1.1. Interest Rate Swaps. The use of swaps toprotect against the risk of interest rate changes,particularly long-term rates, has become popularover the last few years. Banks have played a leadrole in the development of this market. A swap isan exchange of interest rates between two deal-ers, the bank usually acting as an intermediaryand charging a commission. A rate swap can alsobe obtained where two counterparts are involvedin different currencies. In practice, the SPC witha variable rate debt pays the corresponding inter-est and receives in return interest calculated onthe basis of a fixed rate. This effectively providesthe SPC with a fixed rate debt.

In project financing, it can be difficult to find acounterpart who will agree to swap interest rateswith the SPC, primarily for two reasons: first, theSPC can only offer the cash flows produced bythe project as a guarantee. Also, the credit riskattached to the SPC, which the counterpart willhave to accept, depends on the project configura-tion. In countries subject to significant politicalrisks, a possible but difficult to implementmethod consists of transferring this credit risk tothe project’s sponsors by asking them to guaran-tee the swap if the SPC were to fail. The secondreason it is difficult to find a counterpart to swapwith is that a variable rate loan granted by abanking syndicate usually has a repayment pro-file based on the profile of the cash flows pro-duced by the project. It is extremely rare for thisto correspond perfectly to the counterpart’s coverrequirements. It is also common for the swap torelate only to a fixed portion of the loan repay-ment (possibly smoothed out over the financingperiod), the balance remaining exposed to therate risk. This is known as a residual interest raterisk. This technique enables the SPC to enjoy apossible rate reduction on the uncovered portionof the loan, while at the same time enjoyingcover on the portion with the fixed rate in theevent of a rise.


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9.4.1.2. Firm Financial Instruments in the Over-the-Counter Market. Two firm financial instru-ments exist on the over-the-counter market, aforward-forward rate, which enables a compa-ny or an investor who wishes to borrow on afuture date and over a set period to fix the costof borrowing now, and a forward rate agree-ment (FRA), which enables a company or aninvestor who wishes to borrow on a future dateand over a set period to cover the rate positionwith a bank or financial institution.

While these two products offer excellent protec-tion against rate risks, they differ on one essen-tial point. The FRA completely dissociates therate guarantee transaction from the financingtransaction, which is not so in the case of theforward-forward rate. For this reason, FRAs aremore frequently used in project finance, giventhe diversity and specific nature of the loansgranted in these set-ups.

9.4.1.3. Firm Financial Instruments in theOrganized Markets. In the organized markets,futures are also able to offer efficient protectionagainst interest rate risks. The standard contractstraded in these markets are undertakings todeliver (for the contract vendor) or to receive (forthe contract purchaser), on a clearly defined date,fixed-income financial securities with featuresstrictly specified by the contract itself, at a pricefixed on the day the contract was negotiated.

The general principle with these cover transac-tions is to take a position in the contract marketopposite to that held in the cash market of theunderlying security, the loan transaction in thiscase. In practice, an SPC wishing to cover itselfagainst an interest rate rise (particularly long-term interest rates) will sell forward standardcontracts. The number of contracts sold is calcu-lated in such a way that the duration factor,defined in advance, is equal in both transactions.

9.4.1.4. Conditional Financial Instruments (interestrate options). An option confers a right on itsholder to buy or sell the underlying security ofthe option (for example, financial securities) ata rate fixed in advance (called the exercise priceor striking price). This right can only be exer-

cised during the life of the option, that is, up tothe exercise date. If the option grants its holderan option to buy, it is called a call option; if theoption grants its holder an option to sell, it iscalled a put option. In return for the rightresulting from the purchase of the option(regardless of whether it is a call or put), thepurchaser pays the vendor of the option a pre-mium, which the vendor keeps whether theoption is exercised or not.

There are two main types of interest rateoptions available to an SPC fearing a rise inrates, one is a cap that enables borrowers to setan interest rate ceiling beyond which they nolonger wish to borrow and will receive the dif-ference between the market rate and the ceilingrate. This product is perfectly suited to thecover requirements sought by an SPC, while atthe same time enabling it to benefit from a gainin the event of rates changing favorably, whichin this case would translate into a rise in rates.The other interest rate option is a collar that isa combination of a cap and a floor (whichenables a borrower to set a floor rate). Thisproduct enables a dealer to set an interest ratefluctuation range outside of which it has to paythe difference between the market rate and thefloor rate and within which the counterpart willhave to pay the dealer the difference.

Although these products exist on organizedmarkets, they are more commonly traded on theover-the-counter market, which offers the pur-chaser of the option, the SPC, a product tailormade to meet its requirements.

The principal limiting factor in the use of thesecover instruments is the sometimes extremelyhigh premium associated with them, that is, thecost of the option. As the volatility of the under-lying security depends on the exercise date of theoption, a cover application from an investorrelating to a very long period of time will auto-matically result in a rise in the return required.

9.4.2. Foreign Exchange Risk Management

For a company investing in a foreign country,the risk of a change in foreign exchange rates


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traditionally materializes in two different ways: aconsolidation exchange risk or asset risk thatarises when the financial results of a subsidiarycompany (the SPC in this case) are included inthe consolidated accounts of the sponsors in dif-ferent currencies, or a transaction exchange riskthat arises when investments or operating incomeand expenditure involve several currencies.

The consolidation exchange risk, although some-times overlooked by financial analysts in privati-zation projects, is a major concern for the pro-ject’s sponsors. The ways of managing it relate tothe accounting and taxation details of the consoli-dation, which will not be dealt with here becausethere are large local disparities in these detailsbetween one country and another. We note simplythat the consolidation risk is usually approachedfrom the point of view of tax optimization of theproject and is dealt with once the methods offinancing and risk cover have been set.

As far as the transaction exchange risk is con-cerned, several risk management methods werementioned in the section devoted to risk man-agement. These techniques are intended to elim-inate the risk by pricing the port services in for-eign currencies (the project is then said to beforeign currency generating) or obtaining a loanin local currency or transfer the exchange riskto public entities by obtaining an exchange rateguarantee over the period of the concessionfrom the host country’s central bank (at therequest of the ministry of finance), which con-verts the exchange risk into a political risk.

These techniques, although highly desirable forthe concession holder, are a challenge to imple-ment. Depending on circumstances, the SPCwill have to bear a part of the exchange risk.Against the backdrop of an international econo-my characterized by floating currencies andwide fluctuations in currency rates, managingthe foreign exchange risk is a necessity for anSPC. Consequently, it will strive to transfer thisrisk to a counterpart expert in dealing in theforeign exchange markets.

The foreign exchange market is the most chal-lenging segment of the capital market. Spot and

forward transactions between banks occupy acentral position in the market. It would bewrong, however, to think that the foreignexchange market is reserved for these interbanktransactions. Since the beginning of the 1970s,new markets, the derivatives markets, havegradually developed.

Within the derivatives markets, it is customaryto make a distinction between standard contractmarkets, which are located in stock exchangesthat have clearinghouses, and nonstandard con-tract markets, which are a compartment of theinterbank market in which over-the-counterdeals are transacted. Within these standard con-tracts, there is a further distinction betweenfutures and options.

All of the methods relating to interest rate riskcover also exist for exchange risk cover. Thus,the cover products available on the derivativesmarkets are:

• Forward currency sales on the interbankmarket.

• Currency futures on the organized markets.

• Foreign exchange options in both com-partments of the foreign exchange market.

As a rule, investors involved in project financeset-ups tend to prefer the over-the-counter mar-ket, which is more flexible in terms of thechoice of amount to be covered (which mayexactly match the expected amount of flow),maturity dates, and exercise prices in the case offoreign exchange options.

With regard to the options market, there existsan “option option,” which has proved to be aparticularly interesting product for the investorat the stage of bidding on a tender. The projectprofitability calculations carried out by the com-pany are based on certain assumptions aboutexchange rates even though the company is notcertain of winning the contract. If it wins thecontract after the invitation to tender, it is notuncommon for the market to have shifted signi-ficantly in the meantime. Also, an option optiongives the option holder the right to buy a foreign


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exchange option whose exercise price is close tothe reference exchange rate used, thereby cover-ing itself as early as the tender stage. If the com-pany is not successful, it doesn’t exercise itsoption option. Also, it is worth mentioning thatsince the volatility of the price of an option isless than the volatility of its underlying security(in this case the foreign currency), the price ofthe option option tends to be low.

Finally, the use of these cover products, as inthe case of rate risks, requires an accurate, priorknowledge of future foreign currency cashflows. This is referred to as the company’s “netforeign exchange position.” Determining thisposition is a difficult exercise, particularly dur-ing the operating period. Assessing the value ofthe basket of currencies to be covered can there-fore only be a “guesstimate.” Nevertheless, it isimportant to estimate these flows carefully dur-ing the financial modeling of the project. Thispoint will be discussed further at a later stage.

9.4.3. Counterpart Risk Management andPerformance Bonds

All of the techniques mentioned in the Part A ofthis module relating to risk management are basedon the principle of risk sharing in project financingset-ups: to minimize the costs of covering risks,they must be borne by the party in the best posi-tion to assume it. This involves transferring eachidentified risk to a private counterpart. The riskthat any of these counterparts may disappear iswhat is called the counterpart risk or credit risk.

The counterpart may be directly involved in theproject and therefore belong either to the SPCor the bank syndicate. But, it may also take nodirect part in the project other than through therisk it agrees to take on, either because it count-er balances an opposite cover requirement orbecause it expects payment for doing so.

Also, with regard to counterpart risk manage-ment, a distinction must be made between thecredit risk relating to the sponsors of the projectand the credit risk resulting from the othercounterpart, as the financial cover instrumentsused are of a totally different kind.

The need to cover the counterpart risk in aproject financing set-up stems principally froma requirement of the bank syndicate that struc-tured the loan and wishes to satisfy itself as tothe solvency of the various sponsors of the proj-ect (for example, builder, operator, supplier,owner, or shipper). To satisfy itself that theseparties will honor their financial contractualcommitments, which might be expressed interms of contract penalties, the bank syndicatemay require the establishment of guaranteesknown as performance bonds. These are usuallyissued by one of the party’s “friendly” banks,which must also have an acceptable rating. Thebank syndicate is then confident of beingindemnified if any of the project’s sponsorsbecome insolvent. This is also a good way forthe arranging banks to limit their liability, byonly accepting projects with top ranking part-ners as sponsors.

Counterpart risk cover instruments also includecredit derivatives that are beginning to appearin the project financing market. For themoment, however, they are still handicapped bya certain lack of liquidity and a small choice ofavailable counterparts.

As far as the other financial counterparts of theproject are concerned (banks, insurers, and spe-cialist financial institutions), the use of creditrisk cover products is still not common today. Infact, project financing set-ups remain a reserveof a small number of players of internationalstature who usually have an excellent rating.

9.5. Financial Engineering andPolitical Risk Management Political risk is an expression that covers allrisks resulting from unfavorable and unilateraldecisions taken by the public authorities of thehost country of the project, whether they arethe state, local authorities, or port authorities.Financial engineering of political risk manage-ment consists of setting up adequate insuranceproducts to mitigate any financial consequencesthat may result from a public decision that isdetrimental to the viability of the project.


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The separate presentation of political risk andmarket risk (the exogenous financial risks pre-sented in the previous sections) within theframework of this module needs to be distin-guished. The risks of nontransferability andnonconvertibility of the local currency, whichare components of foreign exchange risk, can beused as an example. While it is clear that fluctu-ations in foreign exchange rates are partly dueto market dealings, the fact remains that theyare also dependent on the monetary policyeither set by the national central bank or thegovernment. It is impossible to determine withprecision the exact split between these twoclasses of risk and, hence, to design the optimalcover arrangement. This example illustrates a“grey” area that makes the financial analyst’schallenge a little more complex.

The financial treatment of political risk manage-ment harks back to the notion of investmentguarantee, which poses the difficult question ofknowing under which balance sheet headings toplace this cover. While the answer may seemobvious with regard to the guarantees offered bysecured loans (which were dealt with in the sec-tion covering the financial structuring of theproject), existing insurance products relating toinvestment guarantees can, depending on thetype of policy, relate either to a guarantee ofequity invested by the sponsors or a guaranteerelating to all the project’s assets. This distinc-tion, which is fundamental in terms of its poten-tial consequences, is difficult to grasp in practice.

The calling in of these guarantees and indemni-ty procedures provided by insurance policies inthe event of default is not without problems.Without going into detail, it should be men-tioned that the notions of “events of default”and “subordination of rights” between aninvestment guarantee and a secured loan inpractice prove to be particularly complex anddifficult to manage for all private partners.

9.5.1. Guarantees Offered by MultilateralAgencies

The best known of the multilateral agenciesoffering investment guarantees is the

Multilateral Investment Guarantee Agency orMIGA; its goal is to “encourage investments forproductive purposes between member countriesof the World Bank Group.” In this sense, it is ina position to guarantee the SPC’s investmentsagainst losses that may result from noncommer-cial risks, including:

• The risk of nontransferability as a resultof restrictions imposed by the host gov-ernment.

• The risk of loss as a result of legislativeor administrative measures or omissionsof the host government that effectivelydeprive the foreign investor of ownershiprights or the ability to exercise investmentcontrol.

• The risk of breach of contract by the hostgovernment in relation to the investor.

• The risk of armed conflict and civil dis-turbance.

Since 1994, the World Bank (Bank or IBRD)has promoted the use of political risk mitigationguarantees to address the growing demand fromsponsors and commercial lenders contemplatingfinancial investment in the infrastructure sectorsof developing countries. The Bank’s objective inmainstreaming guarantees is to mobilize privatecapital for such projects on a “lender of lastresort” basis while minimizing the host govern-ment’s requisite indemnity to the Bank as a con-dition of providing the guarantee.

Bank guarantees are provided to private lendersfor infrastructure financing where the demandfor debt funding is large, political and sovereignrisks are significant, and long-term financingcritical to a project’s viability.

The Bank offers commercial lenders a variety ofguarantee products: partial risk, partial credit,enclave and policy-based guarantees in IBRDcountries, and partial risk guarantees in IDA-only countries. Broadly speaking, all guaranteesprovide coverage against debt service defaultarising from sovereign risk events. Each guaran-tee is tailored to match the specific need of anindividual transaction.


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IBRD guarantees are offered for projects inIBRD-eligible countries, with the exception ofcertain foreign exchange earning projects inIDA-only countries. IBRD guarantees can beboth partial risk and partial credit in nature.Bank guarantees are generally available forprojects in any eligible country, irrespective ofwhether the project is in the private or publicsector. The Bank may, however, at times limitthe availability of guarantees in certain coun-tries, for example in countries undergoing debtrestructuring.

IBRD partial risk guarantees ensure payment inthe case of debt service default resulting fromthe nonperformance of contractual obligationsundertaken by the government or their agenciesin private sector projects. Sovereign contractualobligations vary depending on project, sector,and circumstances. The obligations typicallyinclude:

• Maintaining an agreed regulatory frame-work, including tariff formulas.

• Delivering inputs, such as fuel to a pri-vate power company.

• Paying for outputs, such as power orwater purchased by a government utility.

• Compensating for project delays causedby political actions or events.

Partial risk guarantees may also cover transferrisks that may be caused by constraints in theavailability of foreign exchange, proceduraldelays, and adverse changes in exchange controllaws and regulations.

Partial risk guarantees are used in IDA membercountries in sectors undergoing significantreforms. IDA guarantees are offered on a pilotbasis to private lenders against country risksthat are beyond the control of investors andwhere official agencies and private markets cur-rently offer insufficient insurance coverage. IDAguarantees are available selectively, where anIBRD enclave guarantee is not available. IDAguarantees can cover up to 100 percent of prin-cipal and interest of a private debt trench for

defaults arising from specified sovereign risks,including government breach of contract, for-eign currency convertibility, expropriation, andpolitical violence.

Partial credit guarantees cover all events of non-payment for a designated portion of the financ-ing. While these guarantees historically havebeen used to encourage extension of maturityby covering the later years of the financing, theBank recently structured a partial credit guaran-tee to cover a single coupon interest paymenton a rolling basis throughout the life of thefacility, plus the final principal repayment.

Enclave guarantees are highly selective partialcredit guarantees structured for export-orientedforeign exchange-generating commercial projectsoperating in IDA-only countries. Enclave guar-antees may cover direct sovereign risks such asexpropriation, change in law, war, and civilstrife, but may not cover third-party obligations(such as those of an output purchaser or inputsupplier), nor will it guarantee transfer risk. Inall cases, the scope of risk coverage under theguarantee would be the minimum required tomobilize financing for a given project.

Bank guarantees facilitate the mitigation ofrisks that lenders cannot assume, catalyze newsources of finance, reduce borrowing costs,and extend maturity beyond what can beachieved without the bank guarantee. Theyalso provide more flexibility in structuringproject financing. Clearly, within the WorldBank Group, IFC, and MIGA are the preferredsources of support to the private sector. Assuch, sponsors and financiers should consultwith IFC and MIGA concerning their potentialinterest in financing or covering the project.IFC supports private sector projects throughequity and debt financing, the syndicated B-loan program, security placement, and under-writing and advisory services. MIGA providespolitical risk insurance primarily for equityinvestments, but it can also cover debt financ-ing as long as it is also covering equity financefor the same project. These agencies cannotaccept host government guarantees.


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9.5.2. Guarantees Offered by Export CreditAgencies

Export credit agencies also issue guarantee poli-cies covering investment operations abroad.These instruments usually provide a guaranteefor the SPC against the political risks of anattack on shareholders’ rights and nonpaymentand nontransfer of the payment, or nontransferof the investment or of the indemnity providedin the concession contract, in the event ofnationalization.

The guarantee package (with a cover ratio inthe region of 90–95 percent) relates not only tothe initial investment, but also to the self-financing produced by the project, that is, theprofits to be reinvested and the profits to berepatriated. Generally, there is a ceiling on thebasis of cover relating to the self-financing pro-duced by the project: in the case of COFACE inFrance, the cumulative limits are respectively100 percent (with respect to profits to be rein-vested) and 25 percent (with respect to profitsto be repatriated) of the initial investment.

Finally, it should be noted that securing such aguarantee is conditional on the existence of abilateral investment agreement between thecountry of the export credit agency and the hostcountry of the project.

9.6. The Use of Private Insurers forCovering Political Risks Private insurers sometimes offer viable alternativesto public insurers for covering political risks. Thecost of this insurance may be quite high, but it issometimes the only alternative for making financ-ing of projects in difficult countries possible.

A private insurer covers the banks against theoccurrence of a political risk causing the loan todefault. Private insurers are sensitive to themonitoring procedures that the banks put inplace to assess the political risk and its develop-ment. The banks must therefore provide evi-dence of their ability to assess and avoid politi-cal risks during the project set-up stage; this is acondition of underwriting the policies.

10. FINANCIAL MODELING OFTHE PROJECT

10.1. Construction of theEconomic Model Constructing the economic model of a portproject consists of identifying, from the SPC’spoint of view, all of the forecasted cash flows tobe generated by the investment. They fall intothree main categories: capital expenditure, oper-ating revenue and expenses, and tax-relatedmatters.

10.1.1. Capital Expenditure Types

Investment breakdown. The production of acapital expenditure (Capex) statement requiresthe gathering of data that are usually fixed andset out in the various contracts defining theproject: the concession contract, constructioncontract, equipment supply contract, and soforth. The investment breakdown must be suffi-ciently detailed. The total amount of the invest-ment should be broken down by type ofhomogenous assets; that is, assets that have sim-ilar working lives and methods of depreciation.Capex categories relevant to port projects mightinclude buildings, open areas, port equipment,infrastructure, superstructures, and dredgingwork. The categorization of Capex must alsotake account of the type of work envisaged; forexample, refurbishment of existing structuresand/or new works.

Investment phasing. Traditionally, determiningthe investment phasing at the set-up stage satis-fies two requirements: it records the Capexflows required by the project in the economicmodel and it fixes the value of the basis of theinstruments providing cover against exogenousfinancial risks (rates and foreign exchange).Also, investment phasing enables the financialanalyst to structure the project as accurately aspossible according to its ability to support itsmethod of financing. Investment phasing alsoallows the analyst to reassess the appropriate-ness of the investment decision by testing realoptions, for example, to defer the execution ofthe project, to defer progress of the works, to


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abandon the project, to reduce activity, or tomake the project more flexible.

Investment currencies. The amount and therequired currency of payment by the SPC mustcorrespond to each item on the investmentstatement. The equivalent of this amount in themodel’s reference currency can be found by cal-culating the exchange rate initially set in themacroeconomic hypotheses. The foreign curren-cy breakdown of the Capex thus enables theSPC to ascertain its exposure to exchange risksthroughout the life of the concession contract,that is, allowing its net exchange position to becalculated.

Economic depreciation and tax allowances state-ments. A depreciation statement must accompa-ny the Capex statement for each of the identifiedheadings. It is based on knowledge of the periodof depreciation of each asset and the method ofdepreciation authorized by the tax legislation ofthe host country of the project, for example,straight-line or double-declining balance.

Confusion often arises between the notions ofamortization, depreciation, and tax allowances.This confusion usually stems from the improperuse of the same expression to express three dif-ferent financial concepts. Amortization refers tothe capital repayments of financial loans.Depreciation is designed to adjust the economicvalue of an asset according to the loss of eco-nomic value it undergoes with time.Appropriations to depreciation appear in theprofit and loss account, while accrued deprecia-tion appears on the balance sheet, which givesas true as possible an account of the assets ofthe company. Tax allowances represent thedeductions that the tax authorities allow on theinvestments the SPC makes. While they are,generally speaking, based on the depreciation ofthe asset, considerations of economic policyalso enter into the equation for tax allowances.This is to encourage investors by allowing themto write off their assets over periods shorterthan the economic life of the asset. In terms offinancial analysis, this overdepreciation leads toan underevaluation of the entity’s financial

results at the beginning of the investment cycleand an overevaluation at the end of the cycle.

In the case of port projects, understanding thenotion of depreciation is complicated by thenature of the assets entered on the SPC’s bal-ance sheet. If the depreciation methods seemeasy as far as port equipment or new infrastruc-ture works are concerned, the fact remains thatthe question of the length of ownership or ofthe potential life of the refurbished assets is farfrom obvious. For example, what is the residualworking life today of a fully refurbished 30-year-old concrete quay?

Similarly, the distinction that must be madebetween appropriations to depreciation, whichby their nature are not cash flows (referred toas calculated charges), and maintenancecharges, which are cash flows, is not alwayseasy. For example, should one depreciate dredg-ing works, and if so by what method, when themaintenance charges relating to maintainingdepths close to the quay or in the access chan-nel are already included in the charges accountof the profit and loss account? Prevailing prac-tice, in fact, is not to depreciate dredging worksand access channels.

Residual value of the investment at the end ofthe concession. There is always an “exit” for anyinvestment, whether it is liquidated, ceded to theconcessioning authority, or sold. Thus, inevitablythere is a need to assess the residual value of theinvestment. There are several methods based onthe notion of value in use or replacement value.In the port sector it is very difficult to assess theresidual value of infrastructures that do not havea true market value at the end of the concession.Therefore, when a residual value methodology isnot defined by the project (for example in theconcession agreement) Use of the book value ofthe assets at the end of the term or project hori-zon is recommended.

10.1.2. Operating Revenues and Expenses

It should be noted that the word “operating” isused here as opposed to the word “construction.”This distinction enables one to identify all the


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revenues contributing to the formation of thegross operating surplus, the true balance of theoperating account. The summary statement ofoperating revenues and expenses includes:

• An item-by-item breakdown of operatingrevenue and expenses. The same projectmay produce very different types ofincome. It is therefore important to knowthe various revenue headings according tothe type of creditors and any interde-pendence between them.

• A fixed (annual percentage that does notdepend on the level of production) andproportional (amount per productionunit) breakdown for each of the variousheadings. This exercise, which is difficultto perform in practice, is fundamental interms of financial analysis for determin-ing the company’s economic break-evenpoint and for assessing the level of riskattached to the formation of the grossoperating surplus.

• The foreign currency or currencies foreach of the revenue and expense headings.

10.1.2.1. Operating Revenue and Charges inTerminal Management Operations. The varioussources of revenue produced by the operationof a port project stem directly from the contentsof the concession granted by the port authority.The revenues break down into categories withinthe framework of a port project:

• Port dues, which are distributed betweendues on ships and dues on cargoes andtypically cover the use of the port’s basicinfrastructure.

• Services to ships, for example, piloting,towing, stores, bunkering.

• Estate revenues, which constitute a signif-icant source of revenue for port authori-ties and an operating charge for terminaloperators.

• On-board and on-land services to car-goes: for example, cargo handling, stor-age, and packaging.

• Revenue from administrative operations.

• Miscellaneous, for example, equipmentrentals.

The main items making up operating chargesinclude maintenance charges, personnel charges,and the operating royalty due under the conces-sion contract.

10.1.2.2. Operating Finance Requirement.Traditionally, a company’s operating financerequirement is determined from an analysis ofthe company’s operating cycle: production, stor-age, and marketing. In the case of a terminaloperator, the operating cycle is simply the deliv-ery of the service rendered to its customers. Itcorresponds to the cash advance or workingcapital that the company must have at its dis-posal between the time it begins operating andthe time it begins receiving payment for its serv-ices. There are four factors that determine acompany’s need for working capital:

1. Volume of business (the more turnoverincreases, the higher the need).

2. Length of operating cycle (the longer thecycle, the higher the need).

3. Customer or supplier credit policy (thelonger the customer payment time, thehigher the need; the reverse is true withregard to supplier credit policy).

4. Operating cost structure (the more oper-ating costs increase, the higher the need).

10.1.2.3. Operating Account Balance. The grossoperating surplus (GOS) is the first indicator ofrevenue produced by the operation of the SPC.It is measured by subtracting operating chargesfrom operating revenue. In practice, it forms thebalance of the operating account. In jargon, theSPC is said to achieve basic equilibrium if itsGOS is positive. Changes in the operatingfinance requirement should be deducted fromthe calculated GOS. One then gets the operatingcash surplus (OCS), which is a cash flow, unlikethe GOS, which is an accounting aggregate. TheOCS will subsequently be included in the cashflow statements.


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10.1.3. Tax Flows

Tax flows are all the cash flows resulting fromthe impact of the tax system on the project. Inaddition to the deductibility of financialcharges, which will later need to be built intothe financial model (cash flow statements), thetax flows relate to taxes on company profitsand the (total or partial) carrying over of taxlosses from previous years.

Traditionally, corporation tax is calculated bymultiplying a rate, which can vary from countryto country, by a basis of taxation, which isdetermined according to the type of investmentmade. While it is easy to obtain the rate of cor-poration tax, calculating the basis of taxation isdifficult as it requires principles of accountingestablished by the tax legislation of the hostcountry.

Tax losses from previous years can be carriedforward over a number of years depending onnational legislation. Losses carried over in thisway can then be considered as a tax creditgranted to the SPC. In the financial model, thiscalculation is important to include to avoidoverestimating the impact of corporation tax onthe net profitability of the investment.

10.2. Construction of the FinancialModel A financial model of the project traditionallyinvolves the production of three financial state-ments: the cash flow statement, the incomestatement, and the balance sheet.

10.2.1. Cash Flow Statement

Cash flow statements show all the company’sincoming and outgoing cash flows. They there-fore include all the cash flows involved in theestablishment of the operating cash surplus andall Capex.

Capex stems directly from the choice of thefinancial resources needed to accumulate finan-cial capital. It refers to equity and debt investedin the company by capital providers (sharehold-ers and lenders).

Equity-related capital expenditure refers toincreases in capital granted to the project byshareholders on the one hand and a return paidon the invested capital on the other. Withregard to the latter, this is directly related to thedividend payment policy decided upon by theshareholders and accepted by the lenders.

The most commonly used method for modelingdividends consists of distributing the maximumprofit (after tax and any reserve obligations) upto the value of the available cash. Models usual-ly provide what are called reserve accounts, thepurpose of which is to freeze any cash flow sur-plus from the project until the total value ofthese accounts reaches a certain minimum level(usually set by the banks). This minimum levelis usually set at six months of debt service.

Capex related to financial debts and quasi-equi-ty is entered in a flow statement called a debtservice account. Traditionally, there are fiveheadings in this account, which are:

• Balance at beginning of period.

• Drawings on the credit.

• Financial costs (including interest on cap-ital paid during the construction period).

• Repayment of loan principal.

• Balance at end of period.

The order of subordination of the loans must beclearly shown in the model.

In virtually all tax systems it is common toallow the deduction from income of the finan-cial charges of the SPC. These financial chargesrepresent the interest paid by the company onthe loans it takes out. However, repayment ofthe loan principal, which relates to the project’sassets, has already been depreciated in the oper-ating profit/loss and is not a deductible expense.

10.2.2. Profit and Loss Account (incomestatement)

The purpose of the profit and loss account is todetermine the amount of corporation tax, thenet profit/loss, and to model dividend payments


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to shareholders. The main stages of the calcula-tion enable the principal interim financial bal-ances to be determined:

• Gross operating surplus.

• Operating profit/loss.

• Financial profit/loss.

• Current pretax profit/loss.

• Corporation tax.

• Net profit/loss.

It should be stressed that an extraordinary prof-it/loss forecast is fairly exceptional in this typeof operation.

10.2.3. Balance Sheet

The SPC’s balance sheets enable the company,investors, and others to monitor the changes inthe financial structure of the company through-out the life of the project. It should be remem-bered that, unlike an accounting balance sheet,the items on the asset side of a financial bal-ance sheet are shown at their gross value. Thededuction of the accrued depreciation of thesegross values appears under the liabilities of theSPC.

REFERENCESPublications

Benichou, I., and D. Corchia. 1996. “Le Financementde Projects.” Editions ESKA.

Cass, S. 1996. Port Privatization: Process, Players andProgress. Cargo System IIR Publications Ltd.

Chance, Clifford. 1991. “Project Finance.”

Cohen, E., and C. Henry. 1997. Service public ,Secteur public. Conseil d’Analyse Economique, Ladocumentation Française.

Courtot, H. 1998. “La gestion des risques dans lesprojects.” Economica.

Denoix De Saint Marc, R. 1996. Le service public.Rapport au Premier Ministre, Collection des rap-ports officiels, La documentation Française.

Flora, J., and S. Holste. 1994. “Public/PrivatePartnerships: Roadway Concessions.” TransportDivision, World Bank.

IAPH (International Association of Ports andHarbors). 1999. Institutional Survey.

Martinand, C. “L’expérience FranÇaise duFinancement Privé des Equipements Publics.”Economica.

Nevitt, P. K., and F. Fabozzi. 1995. Project Financing(sixth edition). Euromoney Publications.

Peters, H. J., and M. Juhel. “Changing Role andFunctions of Ports: Addressing the ReformAgenda.” TWUTD, World Bank, Washington DC.

Shaw, N., K. Gwilliam, and L. S. Thompson. 1996.“Concessions in Transport.” TWUTD, WorldBank, Washington, DC.

Stoffaës, C. 1995. Services publics, question d’avenir.Rapport de la commission du CommissariatGénéral du Plan, Editions Odile Jacob/ LaDocumentation Française.

World Bank Group. “Procurement for PrivateInfrastructure Projects.” World Bank Group,Washington, DC.

UNCTAD (United Nations Conference on Trade andDevelopment). 1998. “Guidelines for PortAuthorities and Governments on the Privatizationof Port Facilities.” UNCTAD.

Reviews and Articles

Behrendt, D. K., and W. Thomson. 1997. “PortOwnership: Public Responsibility or PrivateEnterprise.” Ports and Harbors (October.)

Chapon, J. 1998. “Réflexion pour une politique por-tuaire européenne.”

Chapon, J. “Partenariats public/privé en matièreportuaire.” Conférence CIMER 98, Saint Denisde La Réunion. 1999. Published in TransportsNo. 394 (March–April).

ENPC. “Gestion and analyze financière, Suivi finan-cier des contrats long terme.” module.

Euro News. 1997. “Engineering Consultants:Where Would Europe Be Without Them?”Special edition, No. 27, Project Financing, EFCA(September).


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Juhel, M. H. 1999. “Global Challenges for Portsand Terminals in the New Era.” Ports andHarbors (March).

Martinand, C. “Politiques de transport.” ENPC Module.

Monpert, J. Y. 1998. “Le contexte des privatizationand les acteurs: motivations and attentes des opéra-teurs—le point de vue de SAGA / BOLLORE.”AFD Conference, 19/10/98.

Mountford, R. 1997. “Financing the Development ofPorts.” Ports and Harbors (November).

Orsini, J. A. 1995. “L’appréciation des risquesinhérents au projet.” Paper presented at Lemontage des Financements de ProjectsSeminar, Management Global Information(November).

PdI (Port Development International). 1994. “APrivate Affair.” Privatization supplement, PdI(September).

Ratheaux, O. 1996. “Options de gestion des portsmaritimes, Cas des ports africains.” AFDRezenthel, R. 1996. “Les régimes portuaires dans lemonde.” NPI, 30 December.

Rezenthel, R. 1996. “Les régimes portuaires and ledroit de la concurrence.” NPI, 30 December.

Rezenthel, R. 1997. “Les concessions portuaires.”Gazette du palais (September).

Rezenthel, R. 1998. “La délégation de service publicand les concessions portuaires - Doctrine.” DMF583 (June).

Smagghe, J. 1999. “L’évolution institutionnelle desports.” Colloque Africa Port 2000, Lomé (January)

1996. “Major issues in transport and communica-tion: Concepts and Guidelines for theImplementation of the Commercialization andPrivatization of Ports.” Ports and Harbors(April).

1998. “Major issues in transport, communication,tourism and infrastructure development:Commercialization and Private sector Involvementin Ports.” Ports and Harbors (November)

1998. “Les financements internationaux d’infra-structure: la fiscalité des BOT.” Les ECHOS 12May.


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APPENDIX: RISK CHECKLIST—PRINCIPAL RISKS IN A PORTPROJECTI. Country RiskA. Government/Administration

Stability Reputation (negotiations, administrativeinefficiency) Links establishedConcessioning authorityPolitical risk: low, medium, high

B. Currency Revenue in foreign currency?Revenue in local currency?Stability of local currency over last fewyearsConvertibility of local currency=> Exchange risk: low, medium, high

C. Social Does the operation induce a major reduc-tion in personnel? If so, is a redundancy scheme planned?Funded? By whom? Must a proportion of local personnel betaken on? Qualification of local labor?=> Social risk: low, medium, high

D. TaxationLevel of knowledgeProfits tax?Sales tax?Withholding on dividends or intragrouptransactions?Stability of fiscal system=> Tax risk: low, medium, high

II. Traffic Risk A. Market

ActivityTraffic established? (stable, sharp fluctua-tions, or steady growth)New traffic Growth factor General economic activity Sector/domain activity Acquisition of market share Previous quality of service Nonexistent

Poor/fair/good => Prediction reliability: poor/fair/good Customers Identified major customers “Atomized” market Competition/captive traffic Present situation

Competitor terminal in port? Competitor terminal in country? Competitor corridors?

Traffic volatile or stable? Future situation Contractual guarantee of exclusivity? Entry barriers? Risk of changes: low, medium, high Risk of competition: low, medium, high

B. Obligations Public service obligations Technical Minimum capacity Performance standards Tariffs Free rates Price cap Escalation formulas Exemptions? Fee payable to concessioning authority Up-front fee?

Fixed annual part: fixed amount, judg-ment criterion?

Variable annual part: fixed amount,judgment criterion? Concessioning authority subsidy Investment

Fixed annual part: fixed amount, judg-ment criterion?

Variable annual part? Guaranteed traffic? Cost + fee?

C. Guarantees Extra franchise port services What port services do my customersrequire? Who is in charge? (me, public or privateport authority, potential problem) Level of service guaranteed? Level of service satisfactory? Price levels satisfactory?

Pilot service


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Work and supply contracts Concessionaire-employer Approval of concessioning authorityrequired? Call for tenders obligatory? Thresholds? Maintenance standards imposed? Construction period/commissioning date

Underestimated Reasonable Comfortable

Penalty level Operation Public suppliers (water, electricity, and soforth) Safety rules Subcontracting authorized/approval

IV. Contractual RisksStatus of project company State or concessioning authority hasblocking minority interest? Proportion of capital reserved for localinvestors? Contracts with third parties

What contracts taken over by conces-sionaire?

Concessioning authority’s approvalrequired for signature of new contracts? Bonds

Nature of bonds Amount Call conditions

Consequences of legislative regulatorychanges

Borne by concessioning authority Borne by concessionaire or not

specified Possibilities for recourse

Contract revision Instigation of concessioning authority Instigation of concessionaire No provision

Force majeure Causes Procedures

Early termination Concessioning authority’s request:

causes, procedures

Berthing services Haulage Buoying Maintenance of access Maintenance of basins Maintenance of protection structures Other Operating hours for these services

Degree of sensitivity to inspectionCustomsVeterinary and phytosanitary Other

Vessel waiting time Priorities granted Land transport What modes of transport are used for mytraffic?

For each mode: Capacity of operators Quality of service of operator(s) (time

taken, security, and so forth) Obstacles to the work of these opera-

tors (regulatory, political, and so forth) III. Project Risks

Investment amount Dredging Infrastructures Buildings Facilities Missions Design Construction/installation Rehabilitation/repair Maintenance (infrastructure, superstruc-ture, and dredging) Operation Security Obligations relating to investments Functional specifications Technical specifications Functional specifications related to athreshold (future subject) Information supplied and technical speci-fications imposed Investigation campaigns Contractual information? Preliminary design Detailed design

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Concessionaire’s request: causes,procedures Disputes

Possibilities for claim Contract law Arbitration clause

V. Financial AspectsFranchise period Project IRR over this period Payback period

VI. Tender Assessment CriteriaPreselection Technical assessment Financial assessment


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