Technical Discussion on Guarantees for Private Infrastructure
By SDS/IFM (08/99, En) See also Infrastructure and Financial Markets
MFI Working Group on Support for Private Infrastructure
May 25, 1999
Washington, DC
Table: Guarantees Issued by Multilateral Development Banks
Under the auspices of the MFI Working Group on Support for Private Infrastructure, the World Bank and the Inter-American Development Bank (IDB) cosponsored a seminar on May 25, 1999 to discuss the technical issues related to the provision of guarantees for private infrastructure by the multilateral financial institutions (MFIs). The purpose of the meeting was to provide an opportunity for guarantee experts from the various MFIs to exchange information, discuss technical topics (e.g. pricing and scoring of guarantees), and share ideas regarding best practice (see attached agenda). In addition to representatives from the World Bank and the IDB, participants included representatives from the Asian Development Bank (ADB), the Andean Development Corporation (CAF), the Caribbean Development Bank (CDB), the European Bank for Reconstruction and Development (EBRD), and the Multilateral Investment Guarantee Agency (MIGA) (see attached list of participants).
Role and Scope of Guarantees
The first session of the meeting focused on the role and scope of the various guarantee products offered by the participating institutions. To begin the session, each institution provided an overview of its guarantee program:
- IDB explained that it is authorized by its charter to provide guarantees, and the initial expectation was, in fact, that it would provide more guarantees than loans. The IDB's Regional Departments can provide partial credit and partial risk guarantees with a sovereign counter-guarantee, while its Private Sector Department can provide partial credit and partial risk guarantees directly to the private sector without the need for a sovereign counter-guarantee. To date, two guarantees have been provided: one for a water treatment project in Bogota where the guarantee covers foreign exchange availability and political risk for some of the bonds used to finance the project, and a second for a rail concessionaire in Buenos Aires to guarantee the commercial payment obligations of the government as well as currency transferability. These two guarantees have been provided within the scope of the partial risk guarantee program that provides coverage for currency transfer and convertibility, breach of contract, and other political risks including expropriation of physical assets and related arbitrary and confiscatory government action. In neither case was a sovereign counter-guarantee required. The limit for these partial risk guarantees is US$150m or 50% of total project cost. In addition to the partial risk guarantee, the IDB is hoping to develop a partial credit guarantee ("comprehensive guarantee") in local currency which can cover all risks for either part or the entire term of a loan. The limit for these partial credit guarantees is US$75m or 25-40% of total project cost. One important issue confronting IDB in its use of guarantees is the need to reduce processing times below three months, while still meeting environmental requirements which are as stringent for guarantees as they are for loans.
- ADB offers both partial credit and partial risk guarantees, the former providing all-inclusive coverage and the latter covering sovereign risk. Guarantees can be regional or local, issued in foreign exchange or local currency. According to the ADB charter, a sovereign counter-guarantee is "generally required." All guarantees must be provided in conjunction with an ADB loan. Pricing is on a cost basis and, unlike the IDB and the World Bank, the ADB does not allow for acceleration. For guarantees without government counter-guarantees, the limit is US$50m per project (US$35-40m after subtracting interest costs) or 25% of total project cost. Since 1988, the ADB has issued 10 guarantees, all partial credit. Through 1995, all guarantees were issued in conjunction with an A/B loan structure to stretch the maturity of the B loans to match the ADB loan. In 1997 and 1998, two guarantees were issued for floating rate loans in Sri Lanka, and one US$950m facility was established in Thailand to guarantee early maturities and help that country regain access to the debt market. One issue, as seen in the Thai case, is that the guarantee can often become more expensive than a loan from ADB. Other lessons learned include: (i) many countries could access capital markets without guarantees, at least before the Asian financial crisis; (ii) other countries may have sufficient resources from the multilaterals and thus may not require guarantees; (iii) partial risk guarantees are unpopular because governments do not want to provide sovereign counter-guarantees covering commercial risk associated with off-take agreements; and (iv) the longer processing time and the limited exposure required for guarantees without counter-guarantees limits their usefulness.
- EBRD explained that 80% of its projects are with the private sector. There is no department responsible for guarantees, rather each guarantee is tailored to the specific demands of a given project. EBRD's total exposure with a guarantee cannot exceed 150m euros or 35% of total project cost. For infrastructure projects, the demand has been for guarantees to expand access to local currency financing, thus the EBRD issues full credit guarantees for bonds issued by project companies and also provides guarantees to local banks (e.g. for loans to toll road projects). In one example, a "refinancing guarantee" (a guarantee of a US$50m balloon payment that banks could choose whether to accept and could cancel at will) extended the maturity of available financing. EBRD also provides partial risk guarantees. Under political risk guarantees, the sponsors assume all project risk with the exception of a few specified events (e.g. political violence, confiscation, expropriation, license revocation). These do not require a sovereign counter-guarantee, though the municipality may provide a counter-guarantee in certain cases. As an example of a partial risk guarantee, EBRD guaranteed government payment obligations associated with the construction of a satellite platform in Russia. To date EBRD has not seen much demand for guarantees, but it wants to use them to increase support for local currency financing of infrastructure projects and for an extension of maturities for project borrowings.
- MIGA is an insurer that covers certain specified risks: currency transfer and convertibility, expropriation, war and civil unrest, and breach of contract. The goal is to cover political but not commercial risk. With infrastructure projects, MIGA has been hesitant to insure against breach of contract because it is difficult to isolate the political from commercial risks (e.g. in the case of power purchase agreements). One potential solution is to cover the agreement of both parties to submit to arbitration and to enforce the agreement. MIGA will cover debt repayment until arbitration is complete, and it will then recover its payment from the appropriate party. Project limits have increased to US$200m per project (US$600m per country) and 95% of total project cost (including potential arbitration agreement). MIGA can insure both debt and equity, together or alone. Acceleration is not typically allowed, but not categorically prohibited.
- The World Bank views the guarantee of sovereign payment obligations as the main impetus for its guarantee program. All World Bank guarantees (as opposed to instruments of MIGA and the International Finance Corporation) must have a sovereign counter-guarantee. To date, the World Bank has provided six partial risk guarantees and seven partial credit guarantees. Pricing on the partial credit guarantee is based on loan equivalency, while partial risk guarantees are priced with a premium to the private borrower to reflect the underlying risk coverage. There are currently 30-35 guarantee operations in the pipeline, however processing time remains a problem.. The World Bank is looking toward co-guarantees as a means of supporting larger projects.
The discussion following the introductory presentations began by focusing on the relationship between guarantees and policy reform, specifically on the question of whether there should be some requirement that sector reform in the country concerned be sufficiently advanced so that the guarantee will not serve as a substitute for policy reform. The point was made that guarantees are meant to allow for a test of a new policy and regulatory environment, therefore MFIs need to ensure that guarantees are testing and not substituting for reform. Guarantees should also be limited to covering political rather than commercial risk.
While loans and guarantees have similar characteristics once disbursed (acceleration is a legally permitted remedy for loans, though it has not been exercised), guarantees can be difficult to revoke once they have been issued (i.e., disbursements cannot be suspended should a government abandon its reform efforts). To provide some incentive for governments to persist on the reform path, the World Bank is considering including covenants in its counter-guarantee agreements to limit the Bank's liability under a guarantee to the disbursed loan amount, should a government default or breach its obligations. Private lenders also typically include these covenants in their loan agreements such that they can suspend disbursements if the covenants are breached (although these do not generally transfer political risk to the project). While some viewed it as unfair to project sponsors to suspend a guarantee based upon government violation of a covenant unrelated to the specific project (e.g., a default on other debt owed to the World Bank), it was argued that, empirically, a government is unlikely to default to a multilateral institution and continue respecting its obligations related to the guaranteed project.
The question was raised as to whether the eligibility criteria for government access to guarantees could be tightened. One consequence would be that the multilaterals would issue fewer guarantees. The point was also made that, with reforms progressing so quickly in the infrastructure sectors, MFIs need to avoid constraining reform possibilities by pre-establishing overly conservative criteria for sector reform.
Other issues raised briefly but not discussed included: (i) guarantees for cross-border projects; (ii) how to determine when a guarantee is triggered (at time of breach or only after arbitration), and how debt servicing should be handled between the time of the breach and the conclusion of arbitration; (iii) subrogation rights; (iv) preferred creditor status; and (v) indemnity agreements.
Guarantees without Sovereign Counter-Guarantees
The second session focused on the provision of guarantees to private sector entities without the use of sovereign counter-guarantees. Participants discussed the difference in exposure for the multilaterals when there is no counter-guarantee. Many felt that the difference was not material, given that MFIs typically have much implicit influence with governments. While most institutions said that they would not suspend all operations with a government whose actions resulted in the call of a guarantee, they would certainly pressure that government to conform with its obligations. MIGA can require a sovereign counter-guarantee, but typically does not. In a breach of contract situation, it would proceed against the government, pursuant to the decision of an arbitrator (MIGA breach of contract coverage insures payment of arbitration award).
Guarantee Capacity. Both MIGA and IDB discussed initiatives to cooperate with private sector co-insurers and re-insurers. IDB explained that the number of its guarantees had been limited in the past by project caps, however new, higher limits would allow it to work more with private sector re-insurers and guarantors. MIGA has a "facultative reinsurance agreement" under which it works with private re-insurers to increase its insurance capacity. The maximum exposure per project MIGA can carry alone is US$110m, but coinsurance allows this cap to increase to US$200m. The reinsurance agreement allows this exposure to increase even further. Even with re-insurer participation, the insurance is provided according to MIGA decisions on tenor, country policies, and pricing, such that the buyer is typically unaware that private re-insurers are involved.
Environment and Governance. Participants also discussed the issues associated with enforcing MFI standards on the environment and corruption in the context of guarantees. The IDB can place policy conditionality on the provision of a guarantee, but, once the guarantee is provided, there is little leverage for enforcing this conditionality. The World Bank conducts due diligence to ensure that the sponsor has sufficient funding to comply with environmental requirements, but a call on a guarantee could not be rejected if the sponsor ending up failing to comply with these requirements. The World Bank's only recourse in this situation would be to cap its liability at the amount of the disbursed loan. Of course, the World Bank could refuse to work with the concerned sponsor in the future and could pressure private lenders to apply their powers of moral suasion with the sponsor. If the government violates environmental standards, the liability could again be capped and future loans could be suspended. In the case of MIGA, a guarantee can be canceled for violation of the World Bank Group's environmental and child labor standards.
Scoring of Guarantees
IDB scores guarantees on a one-to-one basis with loans. According to IDB's statute, it must be absolutely certain that it has sufficient "headroom" to cover the guarantee should it be called. Thus, the IDB is forced to treat guarantees the same as loans for internal scoring purposes.
While the IDB focuses on "headroom" as the binding constraint with respect to scoring, the World Bank bases its scoring on capital adequacy provisions. At the World Bank, there is little debate regarding scoring of partial credit guarantees: they are scored at their net present value. Partial risk guarantees for a given country are also scored the same as loans to that country, because empirically the probability of a call on the guarantee and the probability of sovereign default on a World Bank loan are thought to be closely linked. In other words, it is unlikely that a country would default on a World Bank loan and still respect its guaranteed obligations under a given project.
Both IDB and World Bank agreed that, even if a guarantee is not callable until sometime in the future, provisioning must begin at the time the guarantee is issued. Since the banks do not know what their income will be in the year the guarantee is callable and the commitment is irrevocable, they need to smooth provisioning over time.
Pricing of Guarantees
During the last session, each institution offered an explanation of its pricing policies.
- MIGA explained that, while it attempts to ensure some consistency in its pricing, each of its projects is priced individually according to the associated risks. Prices take into account both project and country risk, and each of the four types of cover is priced differently. Discounts are provided when more than one type of cover is purchased. In general, MIGA prices are competitive with OPIC and CDC, and higher than MITI and the European ECAs. Prices vary when compared to private insurers as the latter adjust prices according to capacity constraints in given countries, and MIGA prices on the basis of the actual risk in a given project.
- IDB 's pricing principle is that prices should be set to make the Bank and the borrower indifferent when choosing among the Bank's various financial instruments. For guarantees with a sovereign counter-guarantee, the IDB establishes a "facility fee" to create pricing parity between the guarantee and a loan. It does not distinguish by risk, sector or country when setting prices for these guarantees. Prices for guarantees without a sovereign guarantee are based on the overall risk characteristics of the project and on the number and type of risks being covered, but the final price must at least clear the Bank's hurdle rate regarding net income neutrality. Prices are also set so that the final cost of borrowing for the private entity will more or less equal the cost of borrowing on the private market without the guarantee. The premium is deposited in a loss provision fund.
- EBRD prices each guarantee individually. It attempts to price in accordance with markets, however it has struggled in setting the price of its breach of contract guarantee as sponsors have always found it to be too expensive.
- ADB prices guarantees to public sector borrowers on a cost basis, and the fee is equivalent to the commitment fee on loans. Guarantees to private sector borrowers without government counter-guarantees are priced according to the market, however none have actually been issued.
- The World Bank only issues a guarantee when it receives a sovereign counter-guarantee. A standby fee of 75 basis points is charged and functions much like a commitment fee. The World Bank currently waives 50 basis points of this standby fee and thus retains only 25 basis points, which is equivalent to the post-waiver commitment fee on loans. The standby fee accrues on the NPV of the amount committed but undisbursed (e.g., for coverage of a bullet bond, the standby fee is based on the NPV of exposure from year one to the point of call). In addition to the standby fee, a guarantee fee, equivalent to the interest spreads charged for a Bank loan (typically 75-100 basis points), is assessed (for partial risk guarantees, a premium of up to 25 basis points is added, based upon the level of risk coverage). Of this guarantee fee, 50 basis points is retained by the World Bank while the balance is passed through to the government issuing the counter-guarantee. The guarantee fee is applied to the "callable amount" (generally the disbursed and outstanding loan amount during the callable period). Other one-time, up-front fees include a "front-end fee" of 1% of the total value (not applicable for IDA guarantees), and initiation and processing fees for partial risk guarantees. Fees are either paid up-front and discounted accordingly, or paid periodically (typically the case with partial risk guarantees as they are accelerable). Historically, the fee has been fixed over the life of the project, however recently fees have been linked to contractual spreads on loans and waivers over the life of the project.
Last updated: 05/08/07
