metadata: authors: 0: author: Augenblick, Mark
1: author: Custer, B. Scott
docna: 0: docna: The build, operate, and transfer
            ("BOT") approach to infrastructure projects in
            developing countries
docty: Policy Research Working Paper
subtopic: State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Transport Economics Policy & Planning,Inflation,Privatization,Toll Roads,Energy Privatization,Energy Demand,Energy and Environment,Energy and Mining,Intelligent Transport Systems,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Build, operate and transfer (BOT)
            projects are exceedingly complex from both a financial and a
            legal point of view.  They require an extended period of
            time to develop and negotiate.  If a country is not able to
            finance all of its needed infrastructure on the basis of
            budgetary resources or sovereign borrowings, the BOT
            approach is an option to be considered.  A BOT project
            appears to provide some "additionality" in tapping
            sources of private sector financing which otherwise might
            not be available.  The sponsors' commitment of
            substantial equity to a project assures that they will also
            remain committed to the project's successful operation
            over the concession period.  Their investment provides a
            strong incentive to have the project perform above its
            minimum expectations.  Likewise, having the design,
            implementation and operation of a BOT project largely in the
            hands of the private sector may provide economies and
            efficiencies that will balance out or even outweight the
            higher financing costs of non sovereign borrowing and equity
            investment.  The BOT approach appears to be a useful
            possible alternative to the conventional financing and
            operation of infrastructure projects in developing countries.
repnme: repnme: The build, operate, and transfer
            ("BOT") approach to infrastructure projects in
            developing countries
display_title: The build, operate, and transfer
            ("BOT") approach to infrastructure projects in
            developing countries
listing_relative_url: /research/1990/08/700190/build-operate-transfer-bot-approach-infrastructure-projects-developing-countries
topicv3: Road Tolls m1326463 1818,Energy and Extractives m1326595 507,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Privatization m1327236 1283,Traffic Management m1583399 4231
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy, Research & Ect Affairs
no_of_pages: 108
model_extractions: **Plc,Research, and External Affairs**

**If rastructure**

# WPS 498

- This paper commissioned by the Bank's Legal Department and co-sponsored by the Technical Department, Europe, Middle East, and North Africa Regional Office and by the Infrastructure and Urban Development - Department is part of a larger effort in the World Bank to review different techniques of privatization of traditional public sector activities, examine how they have been applied in practice, and evaluate their strengths, their shortcomings, and thc conditions for their successful application in World Bank member countries. Copies are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Dolie Schein, room F4-026, cxtension 70291 (51 pages, plus 46 pages of annexes).

Augenblick and Custer review the BOT (build, operate, and transfer) approach to building and financing such infrastructure projects as power plants, toll roads, port facilitics, transmission lines, and water supply systems in developing countries.

- In BOT projects, privatc-sector sponsors usually international construction contractors, heavy equipment suppliers, and plant and system operators, - often together with local partners make equity investments (typically 10-30 percent of the total project cost) in a private project company that will _build_ the project, _operate_ it long enough to pay back the project debt and equity investment, and then _transfer_ it to the host governmcnL

The project company raises debt financing (typically 70-90 percent of project costs) from commercial sources, usually backed by export credit guarantee agencies and by bilateral and multilateral Icnders. Substantial support from host governments is required.

The BOT approach was developed in the late 1970s in response to constrained developing country budgets and a downtum in work available for international construction firms. Construction firms may no longer be as interested in promoting BOT projects as they were earlier. Many BOT projects have been proposed, but few have procecded to financial closure, lct alone full implementation, in developing countries.

The BOT formula for infrastructure projects is by no means a panacea, concludc Augenblick and Custer. BOT projects are exceedingly complex, financially and legally. If countries can implement the same project in a more traditional way - with sovereign borrowings financing a turnkey construction contractthe time saved and the grcater certainty of the project going forward may warrant the more traditional approach.

- But if a country is unable or for budgetary or policy reasons prefers not - to finance all needed infrastructurc from budget resources or sovereign borrowings, the BOT approach is one option. And in the right context it appears to be workable.

Moreover, BOT projects should become easier to negotiate and implement as their basic structure is better understood and as standard solutions to common issues becomc more accepted by host governments and in the marketplace.

A BOT project may provide some "additionality" in tapping sources of private financing that otherwise might be unavailable. The sponsors' commitment of substantial equity to a project assures that they will remain committed to the project's successful operaLion over the concession period. Their "at-risk" investment provides a strong incentive to have **the** project perform above its minimum expectations. If the project is properly structured, the benefits of such enhanced performance will bc shared with the host govemment. Having the design, implementation, and operation of a BOT project largely in the private sector's hands may provide economies and efficiencies that balance or even outweigh the higher financing costs of nonsovereign borrowing and equity investment.

But a host government that wants to promote BOT projects must understand and be willing to accept the complexity and time-consuming nature of the process, the extensive host government support that must be provided, and the rates of return that commercial lenders and private equity investors will expect.

The PRE Working Paper Scrics disseminates the findings of work undcr wav in the Bank's Policy, Rcscarch, and Extemal AffairsComplcx. An objective of the series is to get these findings outquickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in thcsc papers do not necessarily represent ofticial Bank policy.

Produced by the PRE Dissemination Centcr
Paqe

# Table of Contents

||**SUMMAR**|**Y ..................................**<br>**....... *.v**|
|---|---|---|
|**I.**|INTRO|DUCTION ........................<sup>*.....</sup>|
|II.|BASIC|CHARACTERISTICS OF BOT PROJECTS<sup>.................... 5</sup>|
||2.1<br>|Host Government....<br>...<br>.........<br>....<br>5<br>|
||2.2|Sponsors; Project Company ........................<sup>7</sup><br> <br>|
||2.3|Financial Viability<br>......<br>........<br>**<br>..<br>......<br>9<br>|
||2.4|Local Partners..............<br>. .........<br>**.**......<br>9<br> <br>|
||2.5|Constructioii Ccnsortium ....<br>..............<br>10<br>|
||2.6<br>|Financing<br>... o .<br>**..**<br>**..**<br>**.**<br>**.**<br>**..**<br>**10**<br> <br>|
||2.7|Security to Lenders...................<br>**9**<br>.<br>.....<br>ll<br>|
||2.8|Transfer to Host Government ................<sup>oo... 13</sup>|
|III.|HOST|GOVERNMENT SUPPORT...<sup>.</sup> <sup>.....</sup><br>. ......<br>.......<br>.......<br>14|
||3.1|Political and Bureaucratic Support<sup>.............. 14</sup><br> <br> <br>|
||3.2<br>|Outside Advisers......<br>..................<br>9<br>......<br>15<br> <br> <br> <br>|
||3.3<br>|Assured Supplies ...<br>.................. --<br>**9--.-**<br>**99-**<br>.... 16<br>|
||3.4|Assured Revenues**.99.999.9999999999999999999999.16**<br> <br>|
||3.5|Loans; Equity Contributions.<br>.... 9....18<br> <br>|
||3.6|Earning Assets..................<br>**99**<br>**19**<br>|
||3.7<br>|Regulatory, Fiscal and Other Support<sup>............19</sup><br> <br>|
||3.8<br>|Project Risk .......<br>21<br>|
||3.9<br>|Force Maieure ........ ooo......................21<br> <br> <br>|
||3.10<br>|<br>**Inflation ........**<br>.<br>**22**<br> <br> <br>*****|
||3.11|<br>Foreign Exchange...............<br>**9.99.99.9.9.9.22**<br>|
||3.12|<br>Sovereign Guarantees ..............<sup>o. o..........24</sup><br> <br>|
||3.13|Protection from Competition<sup>**..................**</sup><br>**24**|
|IV.|RISK|ALLOCATION .............................<br>25|
||4.1|Completion Risk**.99.9999.99...9999....999...25**<br>|
||4.2|Performance and Operating Risk<sup>.................. 26</sup><br>|
||4.3|Cash Flow Risk ................................. <sup>27</sup><br>|
||4.4<br>|Inflation and Foreign Exchange<sup>Risk ............28</sup><br> <br>|
||4.5|Insurable Risks.<br>**.............**<br>**9999999999999.9.28**<br>|
||4.6|Uninsurable Risks (Force Maieure)<sup>.............. 29</sup><br> <br>|
||4.7|PoliticalRisk.,................<br>29<br> <br>|
||4.8|Commercial Risk insurance ........................<br>29|
|V.|NECES|SARY CONDITIONS FOR FEASIBLE<sup>BOT PROJECTS ......... 30</sup>|

_i j-
||5.1|Legal Environment ...............................<br>30<br>|
|---|---|---|
||5.2|Economic Environment..........................<br>. .31|
||5.3|Host Country Credit Rating ......................<sup>31</sup>|
||5.4|Political Environment<br>.....<br>...............<br>. 33<br> <br>|
||5.5|Sector Characteristics<br>......<br>...........<br>...<br>. 33<br>|
||5.6|Cyclical Considerations<br>...<br>...................<br>. 34|
|VI.|COST I|SSUES...................<br>....<br>.....<br>.35|
||6.1|Cost of Senior Debt .<br>.<br>.................... 35<br>|
||6.2<br>|Cost of Equity<br>.<br>...............<br>. 36<br>|
||6E3|Project Efficiencies<br>......................<br>38<br>|
||6.4.|Other Benefits ....................<br>. 38<br> <br>|
||6.5|BOT vs.BOO<br>...........<br>. ..<br>.38|
|VII.|PROCURE|MENT ISSUES.....<br>........<br>40|
||7.1|Unsolicited Proposals.<br>40<br>|
||7.2|Competitive Bids...............<br>..41|
||7.3|Integrity<br>of the<br>Process ......<br>.<br>42|
|VInI.|ARGUMEN|TS<br>FOR AND AGAINST BOT PROJECTS ......<br>42|
||8.1|Additionality<br>................<br>,42|
||8.2<br>|Credibility .................<br>......... ........ 43<br> <br>|
||8.3|Efficiencies<br>.<br>..........<br>....<br>.44<br> <br>|
||8.4|Benchmark.<br>..44|
||8.5|Technology Transfer and Training....|
||8.6|Privatization .<br>..................<br>44|
||8.7|Complication and Cost<br>..<br>................<br>. 44|
|IX.|WORLD<br>|BANKGROUP INVOLVEMENT IN<br>|
||BOTPR|OJECTS TO DATE................<br>..<br>...........<br>. ....<br>45|
||9.1|World Bank....................<br>45|
||9.2|IFC.**.<br>.<br>.<br>.<br>.<br>.<br>.<br>.<br>.<br>.<br>.<br>.<br>.<br>.<br>..<br>.<br>46|
|X.|FUTURE|ASSISTANCE<br>TO HOST GOVERNMENTS<br>...........<br>47|
||10.1|Education ................................<br>.<br>.<br>.<br>47|
||10.2|Advisers<br>.<br>...............................<br>47|
||10.3|Identification of Projects........................<br>. 47|
||10.4|Evaluation of Proposals ......................<sup>. ..</sup>.48|
||10.5|Local Regulatory and|
|||Financial Infrastructure....................<br>. 48|
||10.6|Direct Involvement................<br>..............<br>48<br> <br>|
||10.7|MIGA ..........................s * * *<br>.<br>.... 9-49|
|XI.|CONCLUS|ION ..........<br>..............|
||ANNEXES|
|---|---|
|Annex 1|BOT rnfrastructure Projects in<br>Devel'oina Countries ReDorted in<br>the P,.ess: A Partial List|
|Annex 2|Review of Selected Major BOT Projects|
|Annex 3|An Overview of BOT Proiects Prooosed in Turkey<br>(by J.-J. Lecat, Bureau Francis Lefebvre, Paris,<br>France)|
|Annex 4|Selected BibliograDhy|

- i _
# ACKNOWLEDGMENT

This report was prepared for the World Bank by Mark Augenblick and Scott Custer, who are partners in the Washington, D.C. law firm of Shaw, Pittman, Potts & Trowbridge.

Annex 3 to the report on proposed BOT projects in Turkey was prepared by Jean-Jacques Lecat of Bureau Francis Lefebvre in Paris and is reproduced here with his authorization.

The report was initiated by Charles Vuylsteke, then of the World Bank's Legal Department, with the support of Abderraouf Bouhaouala, Director of the EMENA Technical Department. It was commissioned by the Legal Deipartment and co-sponiored by the EMENA Technical Department and PRE's Infrastructure and Urban Development Department.

Pierre Guislain of the Legal Department's Private Sector Development Advisory Group coordinated World Bank Group contributions to the report and provided guidance and advice throughout its preparation.

The authors are also grateful to the many World Bank Group staff members who commented on various drafts of this report, and in particular to Frida Johansen, Jeffrey Gutman, Ian Newport, Amir Al-Khafaji and Cengiz Yucel front the cosponsoring departments. The authors would also like to thank sources outside the World Bank Group who were interviewed.

- iv -
# SUMMARY

This report revievs the BOT (build, operate and transfer) approach for building and financing infrastructure projects, such as power plants, toll roads, port facilities, transmission lines, and water supply systems, in developing countries.

# BOT projects involve:

- **00** Private sector sponsors, usually international construction contractors, heavy equipment suppliers, and plant and system operators, often together with local partners,

- **00** Making equity investments, typically 10% to 30% of the total project cost, in a

- **GO** Private project company which will build the project, operate it for a period of time sufficient to pay back the project debt and equity investment, and then transfer it to the host government.

- **00** Debt financing (typically 70% to 90% of the total project cost) is raised by the project company from commercial sources, usually backed by export credit guarantee agencies, and from bilateral and multilateral lenders.

- **00** Senior lenders to the project company typically are not covered by direct "full faith and credit" sovereign guarantees, but substantial support from host governments is required, including guarantees of the performance of government entities involved in the project and guarantees of foreign exchange risks. In some cases, government support has included a government standby credit facility to provide subordinated loans to the project company when necessary to cover senior debt service.

- The BOT approach was developed at the end of the 1970s as a way for countries with limited sovereign borrowing capacity and severe budgetary restraints to acquire needed infrastructure. A general downturn in work

v
available for international construction firms seemed to make these firms particularly eager to promote, invest in and develop their own projects. At the current time, while the th?-d world debt crisis continues to restrict sovereign bcrrowings, and while government budgets are still constrained, international construction firms are busy and may no longer be as interested in promoting BOT projects as they were earlier.

In spite of great interest on the part of host governments, potential sponsors, lenders and foreign aid agencies, and although numerous BOT projects have been proposed, relatively few large infrastructure projects have actually proceeded to financial close, let alone been fully implemented in developing countries.

° Extensive negotiations in Turkey, where the BOT label was invented, have apparently still not resulted in the implementation of a single major project. The negotiations for one cr more large coal fired power plants, which several times have been announced as virtually completed, as well as for a metro system and an airport expansion, are apparently continuing.

- 3 The governments of Malaysia, the Philippines, Pakistan, Thailand and Indonesia continue to show strong interest in the BOT approach.

- -3

ROT projects are highly complex from both a legal and financial point of view. They require potential sponsors to spenld years and millions of dollars on development and negotiation. They present novel "sues for many host governments as to the proper all.. tion of risks and rewards among the parties.

e Proponents believe that a BOT project, if properly structured and priced, can provide significant "additionality" in financial resources for developing countries while achieving overall cost savings from efficiencies in design, construction and operation.

- ° The World Bank Group has supported the development of BOT projects in a number of countries. In addition to sector studies, feasibility studies and advice for host governments generally,

- Go The World Bank has provided or has proposed loans to the governments of Pakistan and the Philippines which those governments will in

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turn be able to use to finance or sipport BOT projects.

- **00** The World Bank is looking at other ways to support BOT projects as part of its "Expanded Cofinancing Operations."

- **00** IFC is prepared to act as an investment banker to host governments or project sponsors and to makze equity investments in BOT projects, provide direct loans and underwrite and syndicate commercial loans.

- °° MIGA is prepared to provide investment guarantees to BOT projects.

Although there is still too little experience with BOT projects to draw definite conclusions, the BOT approach appears to offer one possible method for developing and financing infrastructure projects in certain third world countries, provided those countries are sophisticated enough to deal with the technical, financial and l.egal complexities, are willing to provide the necessary government support, and are sufficiently creditworthy to attract the necessary private sector equity investment and debt financing.

- **0** Any host government contemplating a BOT project should obtain expert counsel and advice on the technical, financial and legal issues involved.

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## THE BUILD, OPERATE AND TRANSFER ("BOT") APPROACH TO INFRASTRUCTURE PROJECTS IN DEVELOPING COUNTRIES

# I. INTRODUCTION

This report is intended to provide an int,4<sup>oduction to the</sup> build, operate and transfer {commonly referred to as "BOT") approach to financing, building and operating infrastructure projects in developing countries. Recent examples of projects which have been proposed on the BOT model include power plants, airports, port facilities, toll roads, metro systems, bridges, tunnels, water treatment plants, and submarine pipelines and cables.

In the post-World War II era, most infrastructure projects in developing countries have been built under the direct supervision of the government itself, or of a government agency or utility, and paid for by budgetary resources or sovereign borrowings. Several trends seem to have converged in the late 1970s and early 1980s leading to an attempt to find an alternative way to finance these projects. First, with continued population and economic growth in many developing countries, the need for additional infrastructure continues to grow. Second, the growing third world debt crisis has meant that developing countries have had less borrowing capacity and fewer bu^getary resources of their own to finance the projects that are needed. Third, major international contracting firms which, in the middle 1970s, had been kept very busy, particularly in the oil rich Middle East, were, by the early 1980s, facing a significant downturn in business. They were loaking for creative ways to promote additional projects. Finally, in the course of the 1980s a number of governments as well as international lending institutions have become increasingly interested in promoting the development of the private sector and in the 'privatization' of traditionally public sector enterprises.
The search for a new way to promote and finance infrastructure projects in developing countries turned to techniques that are in fact not all that new. Similar arrangements, often known as "concessions," were widely used in the 19th and early 20th centuries to develop infrastructure in France and many other parts of the world. One of the best known projects to be developed in this way was the Suez Canal, but myriad examples could be cited of privately financed concessions to build railroads, tramways, water works, electric utilities and so on.

In more modern times, new techniques of providing substantial non-recourse project financing for major privately owned projects, particularly in the area **of** oil and gas exploration and extraction, were perfected in the 1970s. In the United States and other developed countries, similar project financing techniques have been applied to numerous privately promoted infrastructure projects, involving power plants, waste disposal facilities, bridges, tunnels, toll roads and office buildings.

Beginning in the late 1970s and early 1980s, some of the major international contracting firms and some of the more sophisticated developing countries began to explore the possibility of promoting privately owned and operated infrastructure projects financed on a non-recourse basis under a concession type arrangement. The term "BOT" seems to have been coined in the early 1980s by Turkey's Prime Minister Turgut Ozal to designate a "build, own and transfer" or a 'build, operate and transfer" project (the terms are often used interchangeably). Other variants include: BOOT (build, own, operate a'-' transfer); BOO (build, own and operate, i.e., without any obligation to transfer); BRT (build, rent and transfer); BOOST (build, own, operate, subsidize and transfer); etc.

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U7nder the BOT approach, one or more sponsors from the private sector are authorized to create a private "project company" to build public works. The sponsors typically include a major international engineering and construction firm and one or more equipment suppliers. The sponsors will also expect to act as builders and suppliers for the project. The project company may include passive equity investors and even a minority equity participation of the host government.

The project company will then raise the bulk of the financing required for the project from commercial lenders, usually supported by export credit guarantee agencies; and from bilateral and multilateral financial institutions. The financing is typically on a "non-recourse" basis -- that is, the lenders will have no financial recourse for repayment of their loans against either the project sponsors (i.e., in the normal case the shareholders of the project company) or the host government. Recourse is limited to the project company and its assets, including real estate, plant and equipment and whatever contractual rights, performn4ce bonds, insurance and government guarantees the project company has been able to obtain.

The project company will own and operate the facility for a period of time which is intended to be sufficient to pay off the debt incurred and to provide a reasonable return to the equity investors. At the end of this period, the project company will transfer ownership of the project to the host government.

This report will focus on the BOT approach for infrastructure projects in developing countries. Thus it will not discuss various types of privately owned projects built with non-recourse financing in the industrial, commercial, oil and gas, or mining sectors. The fact that goods or raw materials produced by such non-infrastructure projects can be sold in a competitive world

-3-
market and for foreign currency generally makes these projects easier to finance on a non-recourse basis than infrastructure projects. Nor will .e report treat BOT infrastructure projects in developed countries, such as the Channel Tunnel between the United K.ngdom and France or the various bridge and tunnel projects currently under construction in the United Kingdom, Australia and elsewhere. While these projects do serve, in some sense, as models for similar projects in developing countries, the typical political and economic uncertainties in a developing country environment raise additional obstacles to the BOT approach which are generally not present in developed country projects.

When first conceived by Prime Minister Ozal, and in the optimistic view of some host country governments even today, a major attraction of the BOT approach was supposed to be that a BOT project would be entirely "privately" financed, without any financial commitment from the host government. In practice, however, there has not yet been a purely private BOT infrastructure project of any significant size in a developing country. Extensive host government support, including a substantial financial commitment at one or more stages of the process, appears to be a central requirement.

This report has been prepared generally from secondary sources publicly available. These sources are listed in Annex 4. We have had the benefit of the views of a number of people who have been involved in negotiating and imolementing BOT projects. We have not, however, been able to review the actual contractual documentation for any of the BOT projects discussed. Nor have we had access to detailed financial information that would allow us to evaluate the true cost of BOT projects and to compare those costs with infrastructure projects financed directly by host governments. Finally, because there is often a time lag between the

-4-
happening cf events and reports in the press, some of our information as to the status of particular projects is no doubt already out of date.

The purpose of the report is not to make any definitive judgments about BOT projects or their future. Rather, it is to provide an overview of the BOT approach and to raise a number of the issues which should be considered by anyone involved in deciding whether or how to implement a project on a BOT basis. The report will draw on various existing or proposed SOT projects for illustrative purposes. Specific projects are not discussed in detail in the report itself, although Annex 1 provides a partial listing of BOT infrastructure projects in developing countries which have been reported in the press, Annex 2 reviews a few of the major projects in more detail, and Annex 3, prepared by Mr. Jean-Jacques Lecat of Bureau Francis Lefebvre in Paris, provides a brief overview of BOT projects which have been proposed in Turkey.

# II. BASIC CHARACTERISTICS OF BOT PROJECTS

Although no two BOT projects will be exactly alike, there are generally a set of basic characteristics and a generic structure for a BOT project which can be summarized as follows. (Table I on the next page provides a schematic diagram for a typical SOT project.) 2.1 Host Government. The most important participant in any BOT infrastructure project is the host government. The host government must want the BOT project. A half-hearted commitment will not be sufficient. To no less degree than in a traditionally financed infrastructure project, the host government remains the ultimate client or purchaser of the project.

-5-
# Table I

<!-- Start of picture text --> BOT PROJECT STRUCTURE<br>| Host Govemment |-- Investment Bankers i<br>Sponsors ~~~~~~~~~Legal Counsel<br>Sponsors Technical Advisers<br>AdV<br>Equity kwstnun Raw Material/<br>ivestment BankerS Sh__W1ftW Agr"'s"O Energy Suppliers<br>Legal Counsel _______<br>Passive Equity \ E 9 g o Cw*vd<br>Export C tInsurers<br>La TOM OffTom\_<br>Purchaser lV4<br>Prooject C,ompany<br>'nvestors ~ ~ ~ ~ ~ ~ Cntrcto Consorteu l<br>Escrow Ajent Agnce<br>-<br>LendersTrustee<br>\~~~~~GW* Consftrston ConsortiumXv<br>X ~~~~~~~~~Equipment Suppliers<br>Export Credlt|<br>Gurnty Agencies<br><!-- End of picture text -->

- 6 -
The host government will normally have to authorize the project in the first instance, which often will require special legislation and specific goverrnmental approvals. The host government or one of its agencies will normally enter into an elaborate implementation or concession agreement with the project company which will spell out in detail the support to be provided by the host government and the rights and obligations of the project company. The host government may be providing part of the financing, either as debt, equity or on a-standby basis. It or one of its agencies may be purchasing the output of the project or providing financial guarantees as to revenues. Finally, it will undoubtedly be called upon to provide all sorts of other types of support to the project. Thus, where developing countries and infrastructure projects are concerned, the BOT approach cannot be expected to result in a purely private sector venture which can be realized without substantial exposure or commitment on the part of the host government. The range of host government support normally required is discussed in greater detail in Chapter III below.

2.2 Sponsors; Proiect Company. The second essential ingredient for a successful BOT project is a financially strong, experienced sponsor, or group of sponsors, who will form the project company. The project company may own the underlying assets required for the project for the life of the concession or operate the assets under a form of lease. Sponsors usually form a consortium which includes a major international construction and engineering firm and one or more suppliers of heavy equipment. The consortium may include a separate firm interested in operating and maintaining the project under an operating contract.

The process of developing a BOT project is immensely complicated, time consuming and expensive. The Bechtel group, for example, claims to have spent some US$7 million over nearly five

-7
years in its unsuccessful attempts<sup>to pursue, on a BOT basis, a</sup> power plant and a port project in<sup>Turkey. Kumagai Gumi report-</sup> edly spent the equivalent of<sup>some US$5 million in pre-signing</sup> costs on a toll road project in<sup>Thailand. Because of the high</sup> costs involved -- for feasibility studies, financial<sup>and legal</sup> advisers, travel expense, executive<sup>time, etc.--</sup> sponsors interested in a BOT project must have<sup>patience and staying power.</sup> They should work out early in the<sup>process a cost sharing arrange-</sup> ment among the members of the consortium<sup>for the initial develop-</sup> ment costs.

Many sponsors who have been involved<sup>in BOT projects cite</sup> the need to form the project company at an<sup>early stage so that</sup> it, rather than one or more of the individual<sup>sponsors, can nego-</sup> tiate with the various parties which will<sup>be involved: the host</sup> government; the sponsors themselves<sup>acting as construction con-</sup> tractors, suppliers or operators; lenders;<sup>insurers; other equity</sup> investors; and so on. If the project company<sup>includes "indepen-</sup> dent" equity investors not otherwise<sup>engaged in the project</sup> (e.g., investment bankers, a multilateral<sup>or bilateral lending</sup> agency, or the host government) or<sup>a sufficient balance of inter-</sup> ests, it may more easily succeed in acting<sup>independently of any</sup> one investor or sponsor and negotiating<sup>at arm's length with each</sup> of them.

An equity participation by the host government<sup>may be useful</sup> in this regard and may help the host government<sup>feel that the</sup> project is being negotiated fairly<sup>and with full disclosure. On</sup> the other hand, some promoters of the<sup>BOT concept believe that</sup> inclusion of the host government among the<sup>project company share-</sup> holders can lead to the sort of bureaucratic<sup>interference with</sup> project development and operations that<sup>"privatization" is sup-</sup> posed to avoid.

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2.3 Financial Viability. The financial viability of a BOT project over its intended life must be clearly demonstrable to potential equity investors and lenders. This means that the project must have a clear and certain source of revenue that will be sufficient (a) to service principal and interest payments on the project debt over the term of the various loans and (b) to provide a return of and on equity which is commensurate with whatever development and long term project risk the equity investors are being asked to-take. In the case of a power plant, the source of revenue will normally be a long term off-take contract with a government owned utility. In the case of roads, tunnels and bridges, the source of revenue will either be the tolls which can be generated (perhaps with a minimum level of traffic being guaranteed by the host government) or some sort of similar periodic payments by the host government or other users (e.g., railroads) based on future traffic. In the case of water distribution systems, the source of revenue may either be payments made by a government authority or direct sales to consumers.

Since the revenue must be sufficient to service the project debt, the total cost of the project must be reasonably predictable, and investors and lenders must have confidence that the project can actually be built and operated as planned. Normally plant and equipment will be provided and constructed on a fixed cost turnkey basis. Also, normally only proven technology will be used. Experimental techniques or untried, "state of the art" technology is less likely to be approved by lenders who are being asked to commit substantial sums on a limited recourse basis.

2.4 Local Partners. A number of participants in BOT projects have spoken of the advisability of including among the sponsors or equity investors in the project company a strong, well connected and well respected private participant from the host country. Such a participant might be a potential supplier

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of civil works to the project, but also might be a strong local industrial, commercial or financial group. Such a local partner can help the sponsors better understand the local environment, better deal with the host government and better resolve local issues as they arise. A local partner can also provide needed logistical support during the development stage of the project.

2.5 Construction Consortium. At the heart of the typical BOT project is a large building job often involving the supply of considerable heavy equipment. Because of the need to assure equity investors and lenders that the project will be built on time and at an agreed cost, both the building contractor and the principal equipment suppliers will normally be companies of proven reliability, expertise and financial strength.

Often members of the consortium will come from a number of different countries. While perhaps not essential, this is helpful in two ways. From the host country's perspective, it assures that the project is an 'international' one, rather than one which might appear to benefit a single, particular foreign country. This may make the project more acceptable politically. Having suppliers from a number of different developed countries also helps to attract financing supported by different export credit guarantee agencies, thereby spreading a risk which no one agency would be likely to take on entirely.

2.6 Financing. Most BOT projects proposed or agreed to date have involved a combination of equity provided by the sponsors and debt provided by commercial banks, international financial institutions and bilateral government lenders. The percentage of equity seems to fall most often within the range of 10% to 30%, although the equity component in some projects has been outside this range. It is entirely conceivable to have a BOT project without any substantial true equity, but rather with
various levels of senior and subordinated debt. The senior lenders (e.g., normally the commercial banks) will want to have a "cushion" to support their senior debt, but may not be too concerned whether that cushion is in the form of subordinated debt or equity. The host government will normally want to have some form of long term financial commitment from the sponsors through the operating period. The precise form of that commitment (subordinated debt, invested equity, equity in the form of deferred fees) may not be crucial. International lending agencies, however, are more likely to demand that a significant part of the financing be provided in the form of more traditional equity invested at the outset.

The proportion between foreign currency and local currency in both the debt and equity financing will depend on the nature of the project and the country involved. The ability of the local banking and securities markets to mobilize local capital or the availability of "blocked" local currency in existing external commercial debt which can be recycled in swap transactions may also influence the mix between local and foreign currency in any given project.

The financing for some BOT projects appears to recognize the fact that SOT projects tend to have two distinct phases, with different risks: first, a high risk construction phase, and, second, a lower risk, "public utility" operating phase. Both equity investors and lenders can be expected to seek different rewards and require different guarantees depending upon which of these two different phases they are investing in.

2.7 Security to Lenders. One of the key challenges to be met in a BOT project is how to provide adequate security to nonrecourse or limited recourse lenders. An infrastructure project differs dramatically from the typical large commercial real

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estate project well known in the United States in which nonrecourse lenders will often conisider themselves adequately secured simply by the right to foreclose on the project real estate, plant and equipment in the event of default. In the BOT context, non-recourse lenders rightly fear that, if the project company defaults, there will be no ready market for a partly built toll road or tunnel or a power plant that does not work. Various security devices, therefore, are typically found in BOT projects to protect the senior lenders. By and large, to the degree that these devices are designed to ensure that the project remains financially viable, and therefore performs as intended, these protections are also in the overall interest of the host government.

First, project revenues are usually collected in one or more escrow accounts, maintained by an escrow agent which is independent of the project company, for payment according to stipulated priorities. The lenders normally insist that from-the beginning a special debt reserve escrow account be established, built up and maintained sufficient to pay senior debt service for a minimum period (six months or longer) before any distributions can be made to equity investors.

Second, the benefits of the various contracts entered into by the project company (e.Q., the turnkey construction contract, performance bonds, supplier warranties, insurance proceeds, etc.) will normally be assigned to a trustee for the benefit of the lenders.

Third, lenders will probably insist upon the right to take over the project in the case of financial or technical default, well prior to the "bankruptcy" stage, and to bring in new contractors, suppliers or operators (depending upon the nature of the default) to complete the project. Juridically, this would

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normally be accomplished by having the project company's equity owners pledge all of their stock as security for the loans. By foreclosing on the stock, the lenders would become owners of the project company.

Finally, as explained in more detail in Chapter III, commercial lenders and bilateral export credit agencies may insist on measures of government support, such as standby subordinated loan facilities, which are functionally almost equivalent to sovereign guarantees of project risk.

2.8 Transfer to Host Government. The typical BOT project requires that ownership be transferred to the host government at the end of the agreed concession period. What such "ownership" may consist of, and therefore what precisely needs to be transferred, will vary from project to project. In some cases, the project company will actually own the land, plant and equipment which make up the project. In others, it .would appear that the host government may have retained "ownership" in the land and provided some type of leasehold interest to the project company. In that case, it might be more accurate to speak of the reversion of the underlying land tc the host government, rather than a 'transfer," although normally the improvements (i.e., plant and equipment) would still be "transferred." The transfer may require a final payment to the equity investors from the host government. Such payment is likely to be based on financial criteria -- i.e., the amount required to provide the equity return to the owners which was originally negotiated (provided performance has been satisfactory) -- rather than on the then fair market value of the project. Such payment should also be conditioned on an inspection of the project property and certification that it has been properly maintained and is still in good working order. Where distributions to the

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equity investors over the concession period are projected to be sufficient to provide both a reasonable return on and a return of the original equity investment, the final transfer could require only a token payment. In that case, the project company's obligations to maintain the project in good working order would have to be enforced in other ways, e.g., perhaps by yearly inspections and certifications as a condition to the continued right to operate.

There might also be a movable transfer date, with earlier transfer if the project company exceeds projections and realizes its full equity return earlier than expected, or a longer concession period if expected returns to the equity investors have not been reached because of factors beyond their control.

# III. HOST GOVERNMENT SUPPORT

As indicated above, strong host government support, including most often a substantial financial commitment, appears to be an essential ingredient for the development and implementation of a BOT project. The discussion which follows highlights the areas in which such support may be required and raises some of the issues which host governments will be asked by sponsors and lenders to help resolve.

3.1 Political and Bureaucratic Support. The host government must provide powerful bureaucratic support to be able to resolve various regulatory and other issues as they arise. Normally a single person or department within the executive branch of the host country government must be prepared to act as a mentor for the project. The mentor must have sufficient political clout and bureaucratic ability to maintain continuing support over the life of the project and to override bureaucratic opposition. Such opposition often comes from the established public

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sector entity which would<sup>otherwise build and operate the project</sup> (e.g., the government utility,<sup>public works administration, high-</sup> way authority, etc.).

Another layer of complexity<sup>is added if new legislation is</sup> required from the host country's<sup>national parliament in order to</sup> implement the BOT project in question.<sup>In such a case, the</sup> chances for success will be<sup>greatest if the host government can</sup> obtain broad legislative authority<sup>and a delegation of powers to</sup> someone in the executive branch<sup>who can then carry through the</sup> development and implementation<sup>of the project. If SOT sponsors</sup> are required to lobby their<sup>own bill through a national parlia-</sup> ment, the chances of ultimate success<sup>will be considerably</sup> diminished.

The host government must assign<sup>sufficiently trained and</sup> experienced personnel to understand<sup>the complexities of a BOT</sup> scheme and to be able to negotiate<sup>its terms. The government</sup> negotiators must be of sufficiently<sup>high rank and have sufficient</sup> authority to commit their governments<sup>or government agencies to</sup> the terms of the transaction in a timely<sup>manrter. Otherwise, the</sup> negotiations are likely to drag<sup>on so long that the project may</sup> be abandoned. Even if it is<sup>eventually implemented, the delay</sup> will have imposed substantial lost<sup>opportunity costs.</sup> 3.2 Outside Advisers. Given<sup>the unusual technical, finan-</sup> cial and legal complexities<sup>of BOT projects, host governments</sup> should retain at the outset competent<sup>outside technical, finan-</sup> cial and legal advisers familiar<sup>with the types of private sector</sup> arrangements involved. The<sup>project sponsors will themselves have</sup> substantial technical expertise<sup>and will have experienced inter-</sup> national legal counsel and investment<sup>bankers on their side of</sup> the negotiating table. No matter<sup>how experienced or sophisti-</sup> cated the government negotiators<sup>may be, by adding outside</sup>

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technical advisers, investment bankers and legal counsel of stature to their team from the outset, the host government will normally be better able to structure the initial BOT proposal in the most favorable way for the government. The presence of such advisers will ler.d considerable credibility to the host government's negotiating position as the proposal evolves and should help to find creative solutions to problems which arise in the course of the negotiations. Although the cost of employing such outside advisers will be considerable, the resulting benefits in any significant BOT project will normally be well worth it.

3.3 Assured Supplies. In most BOT projects, the host government will provide some level of logistical support. For example, the government may provide the land on which the project will be built; road, rail or port facilities; transmission lines to take power from a power plant; raw materials and utilities under long term supply contr&cts; or even free supplies of energy (e.q., locally mined coal) over the life of the project.

3.4 Assured Revenues. Even more crucial, the host government will often be the sole purchaser of the output of a BOT project. For instance, in the case of power plants, the power will normally be sold into the government owned power grid. Since an assured revenue stream is essential to persuade both equity investors and lenders to commit their funds, the host government or its wholly owned utility will normally be required to enter into a binding long term agreement with the BOT project company to purchase power (or to pay for capacity) on a "take or pay" basis sufficient, at a minimum, to pay off the project debt and pay back the equity investors. Normally, the sponsors will insist that this off-take agreement be backed by the "full faith and credit" of the host government.

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The formula for pricing the payments due under a power offtake agreement will vary. Turkey and Pakistan appear to have included in their proposed BOT projects a power tariff formula which starts with input and financing costs (subject to price escalation clauses over the li5e of the agreement) and derives a '"cost plus" price for both a capacity charge per kwh and an additional kwh charge for energy actually taken. The Philippines, on the other hand, appears to be soliciting bids based on a flat rate per kwh for both a capacity-fee and an energy fee to be set by the bidder. The implication is that the Philippines would then accept the lowest bid without negotiating precisely how the bid has been derived.

The problem is somewhat different where a BOT project will be selling its goods or services directly to the public rather than to the host government. In the case of a toll road, for instance, the senior lenders may be reluctant to take the risk that the volume of toll paying traffic will be too low to pay off the debt. The equity investors may also be reluctant to take significant risks in this regard, unless they are given a chance to reap significant rewards if traffic meets or exceeds projections. One solution to this problem is for the host government to agree to provide subordinated loans to the project company whenever toll revenues fall below a certain minimum. This seems to be the solution being used in the North-South Expressway project in Malavsia. The host government may have sufficient budgetary resources to be able to make such a commitment on its own. If this is not the case, a standby facility, such as the one in the power sector in Pakistan financed by a World Bank loan, might be needed to solve this problem. Another solution is to provide additional revenue to the project company from some other source, e.q., increasing revenue sharing from other sectors

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of the toll road system. This<sup>is the solution apparently being</sup> proposed for the Bangkok Second<sup>Stage Expressway.</sup> 3.5 Loans: Equity Contributions.<sup>It is not incompatible</sup> with the coincept of a SOT project<sup>to have the host government</sup> fund part of the project<sup>costs by direct loans to or an equity</sup> investment in the project company.<sup>in the case of the North-</sup> South Expressway in Malaysia,<sup>for instance, the government is</sup> providing a substantial support<sup>loan for ten years. In the case</sup> of a power project in Pakistan,<sup>the government was expected to</sup> provide a subordinated loan<sup>of up to 30% of the total estimated</sup> project cost. In the case of<sup>the proposed Gazi power project in</sup> Turkey,l/ the government had<sup>proposed to take 30% of the equity</sup> in the project.

Opinion is divided as to whether<sup>having ti,a host government</sup> as an equity partner in a SOT<sup>project is iielpful. One view is</sup> that BOT projects should be<sup>completely privately financed and</sup> privately run. In this view,<sup>having the government as an equity</sup> partner is likely to bring undue<sup>government influence and lead to</sup> "bureaucratic" inefficiencies<sup>in management and operation.</sup> The other view is that having<sup>the government as an equity</sup> partner may be quite helpful.<sup>It may help to make the project</sup> company independent of any one<sup>of its sponsors and better able to</sup> negotiate with its major shareholders<sup>for construction contracts</sup> and equipment supplies. It should<sup>help to convince the host gov-</sup> ernment of the transparency<sup>of the project's financial structure</sup> (which may be needed as a quid<sup>pro auo for the government support</sup> being sought). It may make it easier<sup>for the government to allow</sup> I/ The Gazi project is used<sup>for illustrative purposes in this</sup> report, even though it now seems<sup>to have been abandoned, because</sup> substantial information about<sup>it was made public. See Annexes 2</sup> and 3 for more details.

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a reasonable return to the equity investors, with a reasonable system of penalties and rewards based on the degree to which the project meets or exceeds projections, when the government itself will share in such risks and rewards.

3.6 Earning Assets. A familiar feature of a number of SOT projects has been the contribution by the host government of existing assets capab]e of producing earnings which can be used to pay capital costs, debt service and operating expenses. To borrow examples from developed countries, in both the Dartford crossing project in the United Kingdom and the Sydney Harbor tunnel project in Australia, existing toll bridges or tunnels were made available to the project company by the host government so that the tolls could be used to finance the new project. Likewise, in the case of the North-South Expressway project in Malaysia and the Bangkok Second Stage Expressway project in Thailand, tolls from existing toll roads will be made available to the project company.

3.7 Regulatory, Fiscal and Other Su2ort. There is a wide range of legislative, regulatory, fiscal and similar support which a host government should be prepared to provide to a BOT project. The government may have to provide basic legislative and regulatory authority for the project to be built and operated in the private sector, since often government monopolies will be involved. Special legislation may be required to authorize the private ownership and operation of power plants, toll roads, telecommunications facilities, airports, water works, and so on. The authority to acquire land for the project by eminent domain may need to be specially provided. These various authorizations may be provided by general legislation or by a "single purpose" law or decree providing all of the necessary powers and authorizations for the BOT project in question. As indicated above, the chances for success will be greatest if general legislative

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authority can be obtained early in the process, with power being delegated for implementation to a responsible official who is prepared to act as the host government's mei.tor for the project.

To attract foreign equity investment and non-recourse debt financing, foreign investors have to be satisfied that the host country has an overall legal and regulatory system which is conducive to foreign investment. This normally presupposes an ascertainable and stable system of law, supported by a court system in which private party litigants can seek redress. For example, labor laws are required which allow private sector employers to hire and fire employees and workers on a reasonable basis at reasonable cost.

In the tax area, the host government will often make available to the BOT project a special regime. Standard features of such regimes are a waiver of local income tax on the project company for the concession period, a waiver of any withholding tax on interest and dividends paid to foreign investors and a reduction or elimination of local income tax on the salaries of expatriate personnel required to staff the project. The rationale for providing such tax benefits is that foreign investors will look at the returns they are seeking net of local tax. Thus any tax payable will simply increase the overall cost of the project which normally the government will be paying directly (e.Q., in the power tariff) or indirectly (e.g., when a toll road project must charge higher tolls or provide a longer concession period to the project company). Similarly, the rationale for providing local tax relief for expatriate personnel is that the project company will normally have to reimburse expatriate personnel for the additional burden of local taxes. Stich reimbursement will then become part of the overall cost of the project which, one way or another, will be passed on to the host government or the local public.

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3.8 Prolect Risk. Most foreign lenders (and their export credit guarantee agencies) have been reluctant to accept any substantial project risk in BOT infrastructure projects in developing countries. The host government, therefore, will normally be asked to protect the senior lenders against the risk that their debt will not be serviced due to project failure. The solution which seems to be emerging for providing this protection, and which is a common feature of the coal fired power plant projects in Turkey, the North-South Expressway in Malaysia and other BOT projects, is for the host government to commit to make subordinated loans available on a standby basis over a certain period of time to provide for senior debt service when and if the project company's cash flow is insufficient for such propose.

3.9 Force Maieure. Force maieure risks which cannot reasonably be covered by insurance pose a dilemma. Foreign lenders will rarely be willing to take force maleure risks. Equity investors, unless they are offered considerably more upside potential than a 16% to 18% return, are also going to be reluctant to take force maieure risks, and will certainly not guarantee the lenders against force maieure risks except to the limit of their own equity investment. Thus some form of government support will normally be required to cover force maieure risks.

The standby facility which the Turkish government had agreed to in the Gazi project reportedly would have operated to cover shortfalls due to force maieure events as well as other cases of shortfall, but would have protected only the lenders, not the equity investors. In the Bangkok Second Stage Expressway project in Thailand, the government has apparently provided in the concession agreement for a number of "exceptional events," whic" would include uninsurable force majeure events, in which one or more remedies, as appropriate, would be available to allow both lenders and equity investors to recover their investments.

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3.10 Inflation. Both lenders and equity investors will normally insist on some mechanism to protect themselves against inflation risk. This protection may be provided by price escalation clauses in the off-take agreement (e.2., in the case of power projects) or by provisions in the concession agreement allowing the project company to increase tolls (e.g., in a toll road project). Such price escalation clauses would attempt to take account of increased costs of the project due to inflation. -They may also be drafted with the intent of maintaining the purchasing power of the project's net income and equity generally. Normally such protection is not complete. Price adjustments are allowed only periodically, lagging behind actual inflation, and may only be partial. The negotiation of the precise terms of the price escalation formulas in BOT projects will probably be time consuming and extremely detailed.

3.11 Foreign Exchange. Typically a BOT infrastructure project, which will be selling its output into the local economy, will receive its earnings in local currency.Both lenders and equity investors who have invested in foreign currency will want firm assurances that they will be able to recoup their original investment, together with interest or dividends, in the same or a comparable foreign currency, and that they will be able to do so at a reasonable exchange rate. The host government, therefore, must be prepared to provide some mechanism to assure the foreign investors (and their government insurance agencies) that they will be authorized to convert local currency earnings into foreign currency, that there will be enough foreign currency available when the time comes for the host country or its banking 2/ Where a project will have foreign users who can be charged in foreign currencies, as in the case of airports or port facilities, this problem may be less severe.

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system to make the conversion and that the rate will not be unduly unfavorable.

These issues have been resolved in different ways in recent BOT projects. In Turkey, for instance, for the Gazi project, the host government proposed that its power authority would malce its periodic payments under the off-take contract in a basket of currencies, consisting of Japanese yen, German marks and U.S. dollars, designed to match the payments required to be made to different foreign lenders and investors. In another country, on the other hand, the government intends to rely principally upon an exchange risk insurance scheme operated by the Central Bank, with the premium (e.g., 3% per annum in the case of U.S. dollars) being an additional cost of financing and thus an additional cost to be covered in the power tariff. In return for the annual premium, the Central Bank guarantees that it will convert local currency earned by the investor into dollars at the exchange rate fixed on the date the insurance contract is entered into. If for any reason such insurance is not available, it appears that the government of this country has considered having the power tariff adjusted for exchange rate movements (actually for the greater of inflation or exchange rate loss).

The ratio of foreign currency to local currency to be invested in a BOT project will differ significantly from project to project. A power plant, because of the heavy equipment invalved which usually must be imported, will normally require a relatively large proportion of foreign currency. In a toll road project, however, much of the investment can be made in local currency, if sources of financing are available. Thus the plans for the Bangkok Second Stage Expressway indicate that at most 10% of the needed investment might come from foreign currency loans. In such a situation, foreign exchange risk becomes more manageable and may not need host government support. In the Bangkok

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project, for instance, it does not appear that any specific government support of exchange rates was required. In the NorthSouth Expressway project in Malaysia, however, in which apparently a substantial amount of foreign currency borrowing is contemplated, the government has provided a 17 year external risk undertaking to cover increased costs from adverse foreign exchange movements and adverse interest rate movements on foreign loans to the project.

3.12 Sovereign Guarantees. Although host governments will not normally provide a sovereign guarantee for the loans made to a BOT project company, they will be asked to provide sovereign guarantees, or equivalent assurances, for some aspects of the project. For instance, if a government-owned corporation has contracted with the project company, as when a government utility enters into a long term off-take contract or undertakes the long term supply of fuel or energy to the project, the government itself will often be required to guarantee the utility's performance. Moreover, the basic concession agreement between the host government and the project company will normally contain numerous obligations undertaken by the host government which will be backed by its "full faith and credit." 3.13 Protection from Competition. Finally, the host government may have to provide some assurances as to the competitive environment in which a BOT project will operate. In the case of a toll road project, for instance, the project sponsors would normally want assurances as to any parallel toll or non-toll roads which might be built during the concession period. Even in the case of a power plant project, in which the government will be committed under a long term off take contract to take or pay for a certain minimum amount of power, the equity investors will normally be counting on making their profits from selling more than these minimum amounts. They will want some commitments,

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therefore, from the host government as to how many other potentially competing sources of energy will be allowed to function during the concession period.

# IV. RISK ALLOCATION

A BOT project has a. number of identifiable risks. Some are reasonably within the control of one or more of the parties to the project. Others may not be within any party's reasonable control, but may be insurable, at a cost. Still others may not be insurable. The conventional wisdom in project financing generally is that each risk should be assumed by the party within whose control the risk most lies. Usually a party will insist on some reward commensurate with the risk undertaken. The typical risks in a BOT project are summarized below.

4.1 Completion Risk. The risk that the project will be completed on time and for the price stated is normally covered by a fixed price, firm date, turnkey construction contract with stipulated liquidated damages,-/ often supplemented by performance bonds. The price of the turnkey project is, of course, increased by a risk factor to compensate the contractor for taking this risk. Completion risk is assumed secondarily by the project company, and indirectly by its equity investors, since their equity will be eroded to the degree that costs are increased due to delays or cost overruns which are not covered by damages from the contractors. Whether any completion risk will be assumed, at a third level, by lenders to BOT projects has been a vexing question.

3/ A liquidated damages clause attempts to set forth precisely in the contract the monetary damages payable by the contractor on account, for example, of each day of delay in completing the project, or for the completed project's failure to meet specifications.

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As already indicated in Chapter III, commercial and certain bilateral lenders, and the export credit guarantee agencies which guarantee commercial loans, have been reluctant to assume completion risk. In several instances, as a condition to making their loans, they have required undertakings from the host government to make subordinated loans to the project company sufficient to guarantee senior debt service through project completion.

While BOT purists may argue that such standby commitments vitiate the private, non-recourse nature of the BOT approach, from the host government's point of view such contingent commitments may be the most economical alternative. For example, in theory, commercial standby subordinated debt financing might be arranged to take the place of a government standby facility. Any such financing, however, would surely reauire high interest rates and commitment fees to compensate for the risks being undertaken. It is also theoretically possible that some sponsors would agree to provide standby equity commitments to cover completion risk. As a practical matter, however, equity investors are likely to accept such a commitment only in exchange for substantial potential rewards. Venture capitalists in a private project of this nature in a developed country, such as the United States, would expect annual returns of 35% to 40% on equity for taking such risks. In a developing country, the potential returns would have to be even higher. Host governments probably will not want to pay this high a price. They may prefer, therefore, to supply the standby commitment themselves.

4.2 Performance and OperatinQ Risk. The risk that the project will not perform as expected will be covered by warranties from the consortium of construction contractors and equipment suppliers and by performance guarantees in an operating and maintenance contract. In each case, these risks are substantially within the control of the parties assuming them. As with 26 -

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completion risk, however, operating risk is again assumed secondarily by the project company. Whether lenders will assume any operating risk, which from their point of view becomes important only when operating or performance failures lead to interruptions in cash flow, is discussed in the next section.

4.3 Cash Flow Risk. As indicated earlier, lenders to BOT projects will insist upon elaborate escrow arrangements to cover forward debt service and to guard against possible interruptions or ups and downs in cash flow. Some lenders have been prepared, however, to lend on a fully non-recourse basis (i.e., nonrecourse other than to the project company and its assets) to a project in its operating phase, once construction is complete and normal operations begin. For instance, in the proposed financing of the Gazi project in Turkey, the government's standby obligation to provide subordinated loans during construction and start-up would have fallen away after three years of successful operation (provided sufficient balances had been built up in the escrow accounts to cover forward senior debt service for approximately three years).

As an alternative to standby commitments from the host government, commercial insurance is available in the London market to cover cash flow risk in BOT type projects (see Section 4.5 below). The cost of such insurance would, however, become part of the overall cost of the project and would inevitably be reflected in higher revenue payments to the project company. In the case of a power project, for instance, there would be a higher cost of power to the host government in the off-take agreement. Thus a host government may find it more economical to bear this risk itself, if need be, through a mechanism such as a standby subordinated loan facility, rather than allowing a project company to obtain, and be reimbursed for the cost of, commercial insurance.

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4.4 Inflation and Foreign Exchange Risk. Both equity investors and lenders to a project in a developing country will be concerned about the risks associated with inflation and foreign exchange. These investors will argue that such risks are totally beyond their control and should be the government's responsibility. In a typical BOT project, the potential rewards to lenders and equity investors will nct be great enough to ccmpensate them for taking either inflation or foreign exchange risks. Local investors mav be content with protection on'ly against inflation. Foreign investors will want protection against both inflatior. and adverse changes in exchange rates.

As indicated in Chapter III, the host government has often been prevailed upon to cover these risks. Tio cover inflation, the long term off-take contract (in the case of a power plant) or the agreement with the host government as to mi.-mum revenues to be collected from the public (in the case of toll roads or a port) will normally provide for periodic adjustments in the price of the goods or services to be sold by the project based on some relevant index of local inflation. The host government will also normally be required to guarantee convertibility, the availability of sufficien-t foreign exchange and the exchange rate. As not-ed earlier, the precise mechanisms used to achieve these guarantees will vary.

4.5 Insurable Risks. A BOT project typically will have casualty insurance covering its plant and equipment, third party liability insurance, workmen's compensation insurance, and insurance covering other commercially insurable risks. It may or may not, depending upon the support which the host government is willing to provide, seek commercial insurance covering business interruption, interruption in cash flows and similar risks. In this connection, there are several new forms of insurance which have been developed by the London insurance market which might be

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useful for BOT projects.4/ One is a "funding" policy to cover cash flow shortfalls mainly in the pre-completion phase of a project. The other is a more traditional cost overrun insurance policy specifically adopted for BOT projects.

4.6 Uninsurable Risks (Force Maleure). Some risks (usually force maL.-re risks) are either not insurable at all, or not insurable at a reasonable cost. Commercial lenders and export credit agencies will normally be reluctant to assume the force majeure risks in a BOT context and will seek to have support provided by one or more of the other parties. Equity investors may assume the force maieure risks for themselves but normally will not be willing to protect the lenders against force maieure. The lenders, therefore, will normally insist that the host government provide some coverage for uninsurable force maleure events.

4.7 Political Risk. Both foreign commercial lenders and foreign equity investors in BOT projects will normally seek political risk insurance, either from their own export credit agencies or from such sources as the Multilateral Investment Guarantee Agency. Political risk insurance will normally in'lude coverage for any breach by the host government of specific undertakings provided to the BOT project.

4.8 Commercial Risk Insurance. The United Kingdom's Export Credits Guarantee Department ("ECGD") recently announced a new optional addition to its traditional insurance for political risks. ECGD will now insure, in certain cases, up to 60% of the commercial risk of approved projects. As of early June 1989, however, cf some 80 proposals received, only one had proceeded to 4/ See South, "New Insurance Approaches to the Pre- and PostCompletion Risks in BOT Projects," in Legal Studies & Services Limited, The Second International Construction Projects Conference: Documentation (London, June 5 and 6, 1989).

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an actual signed policy. Both the U.S. Export<sup>Import Bank and</sup> the U.S. Overseas Private Investment Corporation<sup>also have the</sup> authority to provide commercial guarantees<sup>up to certain limits.</sup> It is not clear, however, to what extent such coverage<sup>will</sup> alleviate the need for host government support<sup>in the typical BOT</sup> context, since the export credit agencies<sup>will want their own</sup> assurances from host governments. For instance, it was<sup>the U.S.</sup> Eximbank which insisted on having the Government<sup>of Turkey pro-</sup> vide for standby subordinated loans to the<sup>Gazi power plant</sup> project as a condition of Eximbank's proposed<sup>financing and</sup> guarantees.

# V. NECESSARY CONDITIONS FOR FEASIBLE BOT PROJECTS

5.1 Legal Environment. The legal structure of a typical BOT project is complicated. This suggests that only<sup>developing</sup> countries with a fairly mature legal system will<sup>easily accommo-</sup> date the BOT approach. The laws and regulations<sup>under which the</sup> BOT project operat . must be readily ascertainable<sup>and must be</sup> compatible with the project's private nature. Private<sup>ownership</sup> of the particular type of infrastructure facility (power plant, toll road, telecommunications network) must be<sup>allowed by local</sup> law.

Private sponsors and lenders will want assurances<sup>that the</sup> basic contractual comrititments to the BOT project both from the host government and from other private parties will<sup>be respected</sup> and can be enforced. In some instances, the reliability<sup>of the</sup> host country's own legal system may provide some<sup>of these assur-</sup> ances. Nevertheless, the essential contract documents<sup>--</sup> both with the host government and among the other<sup>parties--</sup> will almost always provide for international arbitration<sup>in a neutral</sup> jurisdiction and will specify a governing law which<sup>is familiar</sup>

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and acceptable to the private sector participants. This may or may not be the law of the host country. Alternatively, special legislation may be sought to resolve specific issues which are not otherwise adequately covered by existing law.

5.2 Economic Environment. A BOT project will normally call for some proportion of local lenders and local equity investors. Finding such lenders anid investors will be easier in a count-y which has a developed banking system and some sort of organized financial market. The fact that such markets exist to some degree in Thailand, Malaysia and Pakistan, for instance, appears to make it possible to attract equity from local sources for ROT projects in those countries.

Most BOT projects will derive their revenues from outputs priced in local currency which must often be used to pay for imported raw materials or fuel, as well as for debt service and equity reimbursement. Such projects will be more easily launched in an economic environment free of excessive inflation or unduly rapid exchange rate movements. Even if the host government is willing to protect investors in the project against both inflation and currency risk, it will be far easier to find mechanisms to do so in a relatively stable economic environment than in a highly unstable one.

5.3 Host Country Credit Rating. The BOT formula by no means eliminates consideration of the host country's overall creditworthiness as a major factor in the decision of both private and public lenders to finance a project in a particular country. The more host government support and guarantees are needed to make a project viable, the more lenders will be looking to the credit of the host country as well as to the project for eventual repayment. In the case of commercial lenders, and their respective export guarantee agencies, loans to a BOT project in a

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particular country still count as loans to that country for purposes of exposure limits. For some countries, these limits may be exhausted, so that a particular lender or agency would not be willing to finance or guarantee any further projects in that country, whether or .aot a BOT formula is used.

Developing countries which still have a relatively strong credit rating -- for instance countries like Thailand and Ma:aysia -- seem to have a better chance of developing BOT projects than countries whose credit is not regarded as being so strong. Countries with intermediate credit ratings -- such as Indonesia, Turkey, Pakistan, Mexico, Chile and the Philippines-/ -- may still be sufficiently highly rated to make BOT projects possible. Countries whose credit rating is regarded as being lower than those cited are less likely to be able to attract BOT projects until their rating improves.

In some countries, special factors may favor BOT approaches. For instance, the Philippines may benefit from a politically motivated desire on the part of some capital exporting countries to help the new democracy there. China seems to have benefited in the past from the willingness of commercial lenders to take rather unusual risks in order to enter a new market of enormous long term potential. Mexico and Brazil may be able to take advantage of the availz,bility of substantial amounts of existing sovereign debt which can be "swapped" into new BOT projects.

5.4 Political Environment. Another necessary pre-condition for the successful implementation of BOT projects (which may already be taken into account in the country's credit rating) is the host country's political stability. Without political 5/ This list is not intended to be exhaustive, but merely illustrative, and of course is subject to change.

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stability, the extensive governmental support needed to implement a BOT project may not be possible. Even if promised, the promise would probably not be credible. Private sponsors will not be willing to spend the substantial amourts of ti'me and money required to put a BOT project together, and then remain at risk for the 10 to 25 year periods which are typically required, if they cannot count on political stability and continuity over such period.

5.5 Sector Characteristics. In theory, the BOT formula could be applied to any sector of the economy. All that i.. required is that there be an assured source of revenue over the proposed project life. The revenue can come either from a government-owned purchaser (e.g., the government power authority in the case of a power plant), from commercial end users (e.g., airlines in the case of an airport, shipping companies in the -ase of a port facility) or from individual consumers (e.g., drivers on a toll road, subway riders, retail customers for water distribution). Part, or even all, of the proposed revenue could also come from direct government payments. For instance, if the government wanted to have an expressway built, without incurring what some observers have criticized as the inefficient burden of tolling, it could agree to pay for the expressway over time according to some formula based on road traffic.

The history of BOT projects to date, some of which is briefly sketched in Annex 2 to this report, indicates that the greatest interest in BOT projects has been in the power sector and in toll roads. Nevertheless, a number of other types of BOT projects have been implemented or are being seriously negotiated, including port facilities, airports, free trade zones, bridges, tunnels, metro systems, and water treatment plants and supply systems.

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5.6 Cyclical Considerations. A major<sup>impetus for BOT</sup> projects in the early 1980s came<sup>from the general downturn in</sup> international construction work.<sup>Major contractors found them-</sup> selves with large staffs and a<sup>dearth of projects. They were</sup> willing, therefore, in that particular<sup>economic environment, to</sup> spend considerable time and money<sup>in an effort to develop and</sup> promote projects. Furthermore, they<sup>agreed to become equity</sup> investors in those projects contrary<sup>to their prior practice.</sup> There does not seem to be the same<sup>impetus today for this</sup> kind of involvement. A number of<sup>major U.S. engineering firms,</sup> for instance, have restructured<sup>their operations since the early</sup> 1980s, cutting their work force to<sup>less than one-fourth, at the</sup> low point, of their size when business<sup>was at its height. Busi-</sup> ness has now begun to pick up again,<sup>and U.S. firms are expand-</sup> ing. In the power sector in particular,<sup>but also in civil engi-</sup> neering generally, these firms see<sup>ample work in the immediate</sup> future in developed countries. As<sup>a result, they will probably</sup> be less willing than they were several<sup>years ago to put up with</sup> the complexities and risks of BOT<sup>projects in developing</sup> countries.

Whether the view of U.S. firms is<sup>shared around the world is</sup> not clear. It may be, for instance,<sup>that Japanese firms will</sup> still be as interested in BOT projects<sup>as previously. But the</sup> upturn in the business cycle for<sup>international construction work</sup> generally may be a significant<sup>constraint on BOT projects in the</sup> near term.

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# VI. COST ISSUES

One of the key questions for host governments and for their financial advisers, such as the World Bank, is whether the overall cost of a BOT project is higher than that of a project financed directly by sovereign borrowings and, if so, whether such higher cost is nevertheless reasonable in order to implement projects which could not otherwise be funded because of fiscal or budgetary restraints. If BOT projects cost more, the host government, or its citizens, will end up paying this higher cost one way or another: through a higher power tariff, higher tolls or water charges, a longer concession period or a greater sharing of revenues from existing assets. A full response to this question would require access to detailed financial information which is not publicly available. We understand that the World Bank plans to do a separate study of this question. The following observations are offered as a guide to issues which might be covered in such a study.

6.1 Cost of Senior Debt. On the senior debt side, a BOT project company's cost of borrowing could be expected to be slightly higher than a host government's cost of sovereign borrowing would be, since the creditworthiness of a sovereign borrower should, in theory, command a lower interest rate. To the degree that commercial lenders can obtain the support of government export credit guarantee agencies, however, the cost of senior non-recourse borrowings in BOT projects may not be that different from the cost of sovereign loans. Moreover, because of the equity component of a BOT project, there may be less senior debt overall than there would be sovereign borrowings in a project directly financed by the government.

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6.2 Cost of Equity. The equity component of BOT financing will clearly be more expensive than long term sovereign debt.<sup>6</sup> 1 To compensate for the substantial project risk which equity investors will normally be taking, they will insist on a higher return than that sought by senior lenders. The host government does get some consideration for this higher cost, however. It gets the insurance benefit which the equity cushion provides to cover cost overruns during construction and operation. It also gets the technical benefit of the investors' long term commitment to the project.

The information we have been able to gather as to projected returns on equity in BOT projects is set forth in Table 2 on the next page. As the table indicates, BOT projects will often provide a system of up-side rewards and down-side penalties to equity investors, depending upon whether or not the project meets, exceeds or falls short of its projections. In BOT power projects in Pakistan, for instance, the Government has indicated a willingness to consider proposals which project an 18% return on equity at a plant utilization factor of 60-65%. If utilization increases to 75%, the rate of return to the equity investors would increase accordingly. The cost of power to the government in the latter case would also decrease significantly, so that both parties benefit. The risk/reward system negotiated for the Turkish Gazi project was reported to be much less attractive. Not only was the 16% base case return considered by one participant to be low to begin with, but apparently there were serious 6/ BOT projects often have a layer of subordinated debt. This will be more expensive than the senior debt, but should be less expensive than equity.

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penalties for failure to meet projections, without comparable rewards for exceeding projected performance.7/ An overall cost comparison between the BOT approach and a sovereign debt financing would have to take into account the potential effect of these adjustments. It should also put some monetary value on the "insurance" aspect provided by having equity investors or subordinated lenders in a BOT project, which would not be present in a sovereign debt financed project.

Table 2

# REPORTED EQUITY RETURNS IN BOT PROJECTS

|Proiect|Information<br>Source|Projected<br>Return<br>on Equity|
|---|---|---|
|Pakistani Power<br>Projects|Presentation of Mohammad<br>Akram Khan, Advisor, Minis-<br>try of Water and Power, Gov-<br>ernment of Pakistan, London<br>BOT Conference, June 1989|18%|
|Gazi Power Plant,<br>Turkey|Stevenson, "The Turkish BOT<br>Power Project Experience,"<br>May 1989|16%|
|Labuan Water Supply<br>Project, Malaysia|Remarks of Mohamad Hanafiah<br>Omar, London BOT Conference,<br>June 1989|18%-20%|
|Bangkok Second Stage<br>Expressway|BECL, Presentation to Inves-<br>tors, September 1988|3%-21%8/|

7/ See Stevenson, "The Turkish BOT Power Project Experience," May, 1989.

8/ These are figures for the base case assumptions. The 3% return is for the first 10 years; it becomes 21% over the 31 year life of the concession.

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6.3 Project Efficiencies. In deciding whether BOT projects are more expensive or less expensive to host governments than traditionally financed ones, one would have to consider the overall cost of the project rather than simply comparing rates of return on debt and equity. Proponents of BOT projects contend that the long term equity commitment required of SOT sponsors, as well as their control over design, construction and operation, will normally lead to significant cost efficiencies over what a comparable project, designed, built and operated by a public authority, would cost. Some government officials might contest this view. A definite answer to this question may have to wait until more experience is gained from successfully completed BOT projects.

6.4 Other Benefits. The analysis of the overall cost of a BOT project should also consider other potential benefits to the host country. The BOT approach may provide greater training benefits and more continuous transfer of technology (particularly, for example, in the case of a power plant project) than would be true for a government owned project. The private planning, development and management of the BOT project by the project company may save the host government considerable development, overhead and management costs which would be incurred if the government were fully responsible for the project. Finally, proponents of "privatization" believe that the private sector management and operation of an infrastructure facility over the life of the concession period will yield additional benefits not immediately measurable in cost savings -- e.g., in quality of services rendered, environmental protection, and modernization.

6.5 BOT vs. BOO. There is some question as to whether the "transfer" feature of a BOT scheme is necessary to meet a host country's objectives or whether in some cases a BOO (build, own

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and operate) approach might not be preferable. The Philippines has recently asked that proposals for power plants be submitted in the alternative, as both a BOT project and a BOO project. A proposal on the latter basis might be significantly cheaper for the host government over the initial period, since the sponsors would in theory have "forever" to recoup their investment and to earn a reasonable return. Most private investors, however, do not give much weight to returns which are 15 to 20 years away. The typical BOT sponsors, therefore, may well want nearly the same total return over the first 20 years of a BOO project as they-would want from a BOT project. In that case, there would not be any substantial savings to the host government from a BOO approach.

Moreover, as just noted, under the BOT approach host governments should benefit from the training and technology transfer which are implicit in the fact that the project must be transferred to government control at-the end of the concession period, and the government should, therefore, have included in its agreement with the project company provisions to assure that it will have sufficiently trained personnel and access to technology to carry on the project thereafter. These benefits might be lacking in a BOO project. On the other hand, a BOO scheme might provide more incentive for the owners to maintain and refurbish the plant or other installation during the concession period, thereby saving the host government from having to take on that responsibility at the end of the project. Both in the case of training and technology transfer and in the case of maintenance and refurbishing, of course, the host government may be able to protect its interests sufficiently by contract, regardless of the form of the investment.

Finally, in the case of the BOT project, it would still be possible for the host government to negotiate an operating and

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maintenance agreement with the project company after the initial concession period. Negotiating a new agreement for continued operations should be cheaper for the host government than merely extending the concession period, since there would no longer be any need for debt service or compensation to equity investors.

# VII. PROCUREMENT ISSUES

As has been noted, developing and negotiating a BOT project is complex, time consuming and costly. Sponsors can be expected to spend the years of time and millions of dollars requi:ed only if the process for awarding projects is reasonably orderly and the chances for success, and thus the recovery of their initial investment, are predictable.

7.1 Unsolicited Proposals. Given the large amounts of money typically involved in a BOT project and the substantial measure of government support needed, it may be politically dangerous, as well as unwise as a matter of economic policy, for a host government to accept unsolicited proposals from a single sponsor without any evaluation or review of competitive alternatives. In a sector such as the generation of electric power or the construction of toll roads, however, such proposals can sometimes be evaluated on the basis of whether or not the proposed cost of power or highway construction is lower than the cost in similar government owned projects. Occasionally the cost might also be measured against the cost of existing BOT projects which themselves were selected by competitive bidding. Having such an external yardstick may be sufficient protection for the host government to obviate the requirement of competitive bidding in a particular case. In general, however, some form of initial competitive selection is probably preferable.

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7.2 Competitive Bids. The normal procedure for awarding BOT projects should be similar to that for awarding public works projects. Ideally, a host government would itself identify the projects it wished to do on a BOT basis rather than simply responding to proposals. The government would define the project specifications, the level and nature of government support to be given, the proposed method for calculating the power tariff, tolls or whatever the source of revenue for the project is to be, the debt/equity ratio required and other parameters for the transaction. The government would then invite preliminary proposals. A preliminary winner would be selected on the basis of normal competitive criteria (price, experience and track record of sponsors, side benefits for the host country, etc.). A letter of intent would be signed with the preliminary winner, and negotiations would proceed to finalize the financing and the various agreements among the parties.

As indicated above, tne sponsors of a BOT project will normally include a principal engineering and construction contractor, one or more major equipment suppliers, and a party willing and able to take on the operating and maintenance responsibility of the project.9/ Their only reason for being sponsors and equity investors is to be able to provide services and equipment to the project. It is not realistic, therefore, to require a sponsor consortium, once tentatively selected to do a BOT project, to use international competitive bidding for the goods and services which the consortium members wish to provide.

Use of a preliminary award and then further negotiations pursuant to a letter of intent should make it possible for 9/ The operator does not have to be part of the sponsoring consortium. On the other hand, the operator may in some instances be the same as, or an affiliate of, the principal contractor or one of the equipment suppliers.

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potential sponsors to limit<sup>their expenses in the pre-letter of</sup> intent stage, when their chances<sup>of winning the project are</sup> highly uncertain. Once the<sup>letter of intent is issued, they can</sup> then commit the substantial<sup>additional time and resources needed</sup> for detailed feasibility studies<sup>and final negotiations with</sup> lenders, equity investors, suppliers,<sup>contractors and the host</sup> government with a reasonable degree<sup>of confidence that their</sup> project will go forward and<sup>that their investment can be</sup> recovered.

7.3 Integrity of the Process.<sup>There will always be some</sup> tension between the need to preserve<sup>the integrity of the compet-</sup> itive bidding process and a host<sup>government's desire to get the</sup> best possible price for any given<sup>project. The latter desire</sup> might lead a host government<sup>to continue to shop initial bids</sup> until it is certain that it<sup>has achieved the best possible price.</sup> If, however, a government becomes<sup>known for allowing upset bids</sup> to be made after initial bids are<sup>submitted, it is likely to find</sup> the initial bids on subsequent projects<sup>starting out much too</sup> high, as well as finding that<sup>some potential bidders will no</sup> longer want to participate in<sup>a bidding process that will lack</sup> credibility. The Turkish government<sup>may have fallen into this</sup> trap in its negotiations for major<sup>coal fired power plant</sup> projects. (See Annexes 2 and<sup>3.)</sup>

# VIII. ARGUMENTS FOR AND AGAINST BOT<sup>PROJECTS</sup>

Although this report does not<sup>come to any final judgment as</sup> to whether or not BOT projects<sup>should be encouraged, there are a</sup> number of arguments which can be<sup>made in favor of theBOT</sup> approach and at least two fundamental<sup>arguments against it.</sup> 8.1 Additionality. An argument often heard in favor<sup>of the</sup> BOT approach is that it is supposed<sup>to provide significant</sup>

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"additionality.1 In cases in which a host government has neither the budgetary resources nor the borrowing capacity to finance an infrastructure project as a public sector project, the BOT formula, according to this argument, offers the possibility of realizing a project which would otherwise not get built. Financing "additionality" is provided in the form of the sponsor's equity investment, as well as, in many cases, passive equity and subordinated debt. In some cases, commercial banks may be willing to lend to a BOT project with a specifically tailored security package where they might not be willing to make new loans to the government itself. Governments which are actively promoting the BOT approach, such as Turkey, Pakistan, Malaysia and the Philippines, have cited this "additionality" factor as a principal reason for their interest.

The contrary argument is that commercial lenders and export credit guarantee agencies will be constrained by the same country risk limits, whether or not the BOT approach is used. Moreover, the high level of host government support which is required for a BOT project may displace other projects.

8.2 Credibilicv. A second argument in favor of the BOT approach is the credibility it provides. The willingness of equity investors and lenders to take on the risks associated with a BOT project and to make a long term commitment to the project are seen as practical indications that the project is considered to be viable by knowledgeable experts. A number of observers believe that the private sector will be better able to evaluate whether and how a particular project should be built than the public sector. The **BOT** approach, therefore, should save developing countries from "white elephant" projects which might otherwise be carried out as public sector projects. This benefit might be lost, however, if so much government support for a BOT project is provided that the sponsors bear no real risk.

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8.3 Efficiencies. A third argument often cited in favor of BOT projects, which may be only a corollary of the second, is that the private sponsors' control of and continuing economic interest in the design, construction and operation of the project will produce significant cost efficiencies which will benefit the host country.

8.4 Benchmark. A number of government commentators have mentioned the usefulness to the host government of having a private sector project to use as a benchmark to measure the efficiency of similar public sector projects in the same country.

8.5 Technology Transfer and Training. The continued direct involvement of the private sector sponsors in a BOT project over the life of the concession period may promote a more continuous transfer of technology from the contractor, equipment suppliers and operator to the project company, and hence to the host government, than would be likely in a public sector project. A BOT project would normally also include a strong training program, so as to leave a fully trained local staff in place at the end of the concession period. Such training could, of course, take place without a BOT project, but the BOT scheme provides a context in which the presence of the foreign sponsors may facilitate such training.

8.6 Privatization. Finally, if one of the political and economic goals of a host government is to move its local economy as much as possible into the private sector, a BOT project will have obvious appeal over a project finea2ced by public sector borrowings and owned and operated Ly host government bureaucracies.

8.7 Complication and Cost. The case against BOT projects rests primarily on two points, one incontrovertible, and the second open to discussion. It is incontrovertible that BOT projects

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are highly complicated undertakings. They take money, time, patience and sophistication to negotiate and bring to fruition. The history of the Turkish negotiations for a major coal fired power plant, which is described in some detail in Annex 2 to this report, suggests that, from a host country's point of view, the lost opportunity costs of such a time consuming process are severe. If a developing country has the budgetary resources or borrowing capacity to do a project as a publicly financed project, therefore, it may be advisable to do so just for this factor alone. Likewise from a prospective sponsor's point of view, getting involved in the promotion of a BOT project must still be seen as a highly risky endeavor.

The second point often raised against BOT projects is that their overall cost to host governments is greater than a traditional public sector project. This point is contested by proponents of BOT's, who argue that the overall costs are in fact less when design and operating efficiencies are taken into account and the full cost of public sector alternatives is measured.

# IX. WORLD BANK GROUP INVOLVEMENT IN BOT PROJECTS TO DATE

The history of the World Bank Group's involvement in BOT projects to date can be briefly stated as follows.

9.1 World Bank. The World Bank, by its charter, is limited in its lending activities to making loans to sovereign governments or loans that are covered by a sovereign guarantee. Thus, it has not been able to lend directly to BOT projects, none of which so far has carried a sovereign guarantee. The World Bank has found indirect and creative ways, however, to assist its member countries in implementing BOT projects.

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In Pakistan, for instance, the World Bank played a key role in establishing a US$520 million Private Sector Energy Development Fund (the "PSEDF"), which is intended to make long term loans to finance up to 30% of the cost of qualifying projects, including BOT projects, in the energy sector. In the Philippines, an energy sector loan from the World Bank is intended to be used by the Philippines government and its government agencies in part to fund investments or standby facilities for BOT projects.

Another way in which the Worli Bank helps its member countries carry out BOT projects is by conducting sector studies. These studies have been done for the power sector in Turkey, Pakistan and the Philippines. They have helped to identify the need for and to determine the feasibility of BOT power plant projects in these countries.

In addition, the World Bank is currently studying various measures under the general heading of "Expanded Cofinancing Operations" which might be used to facilitate BOT projects. These measures include providing World Bank guarantees for commercial bank loans and local bond issues.

9.2 IFC Involvement. Although IFC has apparently considered participating in a number of BOT projects, as of early October 1989 it had still not committed to any. IFC can support BOT projects at three different levels. It can invest equity, provide direct loans and underwrite or syndicate commercial bank loans. It cai. also perform studies for host governments on the need for various projects. Finally, it can act as a paid financ. l adviser to host governments. Some of the projects which IFC has reportedly been considering are referred to in Annex 2.

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# X. FUTURE ASSISTANCE TO HOST GOVERNMENTS

The foregoing discussion should make clear that there are a number of areas in which the Bank and IFC, if they wish to encourage BOT projects in the developing world, can provide significant assistance to host governments. The World Bank's newest affiliate, the Multilateral Investment Guarantee Agency ("MIGA") may also play a role in this area.

10.1 Education. First, given the complexity of most BOT projects and the sophisticated legal and financial concepts involved, the Bank or IFC could help to explain to host governments what a BOr project is, its possible advantages and disadvantages and the kinds of government support that may be needed.

10.2 Advisers. If a host government decides to pursue one or more BOT projects actively, we believe it is essential that the government hire early in the process a qualified financial adviser and experienced legal counsel to advise and represent the government in both the selection process and in negotiations with potential sponsors. An outside technical adviser, with experience in the sector involved (e.g., power plants, roads, airports, subways, etc.) should also be added to the government team. The Bank or IFC should encourage host governments to make use of such advisers, could provide lists of recommended advisers and may be able to provide funding to pay for them.

10.3 Identification of Prolects. The Bank can be of significant help to developing countries in analyzing their needs for infrastructure projects and sorting out priorities. The Bank can perform (or finance) sector studies and feasibility studies and help host governments identify specific projects to meet their general needs. If the decision is made to attempt to do a 47 -

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project on a BOT basis, the Bank or IFC can advise the host government as to how to frame the request for proposals.

10.4 Evaluation of Proposals. Given the Bank's extensive experience with large construction projects generally, and the growing experience of both the Bank and IFC with BOT projects, each can play an important role in counseling and advising host governments during the negotiating process. As their familiarity with BOT projects grows, both the Bank and IFC can help by offering tested solutions to recurring issues.

10.5 Establishment of Local Regulatory and Financial Infrastructure. As indicated above, BOT projects are more likely to be feasible in environments which have a legal and regulatory framework favoring private foreign investment. The Bank can be helpful in focusing the attention of host governments on these issues. It may be able to provide funding for Lhe host governments to enlist outside advisers in shaping such programs.

BOT projects also seem more likely to be successful in developing countries which have a reasonably strong local banking network and established local financial markets. The ability to tap local private investors in Thailand, Malaysia and Pakistan seems to have facilitated the implementation of BOT projects in those countries. The Bank's current efforts to strengthen those sectors in developing countries generally may, therefore, be of particular benefit to future BOT projects.

10.6 Direct Involvement. Both the Bank and IFC should also be able to play direct roles in BOT projects by providing or arranging necessary financing. IFC, as noted earlier, can invest directly in the equity of a BOT project company, can lend directly to such a company and can put together a syndicated loan from commercial banks. The Bank, although restricted by its

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charter to sovereign lending, can still play a leading role in providing financing for BOT projects. The PSEDF in Pakistan and the energy sector loan in the Philippines have already been cited as examples of significant Bank contributions. With or without a fund of this nature, the Bank may provide direct loans to host governments to participate in the financing of a BOT project. The Bank might also provide a standby line of credit to a host government to back up the latter's contingent commitments to BOT projects. Other possibilities may exist under the "Expanded Cofinancing Operations" currently being developed.

The Bank could lend directly to BOT projects if the host government would provide a sovereign guarantee. As this report has attempted to show, in the case of infrastructure projects in developing countries, there is no such thing as a "pure" BOT project without extensive host government support. A false sense of doctrinal purity, therefore, should not prevent host governments from examining this possibility.

10.7 MIGA. The purpose of MIGA, the newest member of the World Bank Group, is to encourage foreign investment in developing countries by offering political risk insurance. This insurance protects foreign investors against occurrences such as adverse changes in exchange control laws; expropriation; war, revolution or civil disturbance; and repudiation or breach of contract by the host government. Forms of foreign investment that can be covered by this insurance include equity, loans and loan guarantees.

There are certain limitations, however. Although MIGA can insure up to 90% of the investment amount, it is subject to a per-project, per-coverage limit currently set at US$50 million. This limit may be too low to be of much use in the typical BOT infrastructure project. Also, the duration of a contract

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guarantee will typically be for a maximum term of 15 years, although occasionally the term may be extended to up to 20 years. Many BOT projects run for longer than 20 years.

In addition to its guarantee program, MIGA is apparently prepared to provide advisory services to developing member countries to improve their attractiveness to foreign investment. This program is designed to support and reinforce the guarantee program. MIGA's participation in a BOT project through these interrelated programs might enhance confidence that an investor's rights will be respected by a host country.

# XI. CONCLUSION

The BOT formula for infrastructure projects in developing countries is by no means a panacea. BOT projects are exceedingly complex from both a financial and a legal point of view. They require an extended period of time to develop and negotiate. If -- the same project can be implemented in a more traditional way i.e., with a turnkey construction contract financed by sovereign borrowings -- the time savings, together with the greater certainty of having the project go forward, may warrant pursuing the traditional approach.

If, however, a country is not able, or for budgetary or policy reasons prefers not, to finance all of its needed infrastructure on the basis of budgetary resources or sovereign borrowings, the BOT approach is an option to be considered. In the right context, it appears to be workable. Moreover, as the basic structure of BOT projects becomes better understood, and as standard solutions to the various issues posed become more accepted by host governments and in the marketplace, BOT projects should become somewhat easier to negotiate and implement.

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A BOT project appears to provide some "additionality" in tapping sources of private sector financing which otherwise might not be available. The sponsors' commitment of substantial equity to a project assures that they will also remain committed to the project's successful operation over the concession period. Their "at risk' investment provides a strong incentive to have the project perform above its minimum expectations. Likewise, having the design, implementation and operation of a BOT project largely in the hands of the private sector may provide economies and efficiencies that will balance out or even outweigh the higher financing costs of non sovereign borrowing and equity investment.

A host government which wishes to promote BOT projects, however, must understand and be willing to accept the complexity and time consuming nature of the process, the extensive host government support which will have to be provided, and the rates of return which commercial lenders and private sector equity investors will expect. With that being understood, the BOT approach appears to be a useful possible alternative to the conventional financing and operation of infrastructure projects in developing countries.

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