Government guarantees can help persuade private investors to finance valuable new infrastructure. But because their costs are hard to estimate and usually do not show up in the government’s accounts, governments can be tempted to grant too many guarantees.

Drawing on a diverse range of disciplines, including finance, history, economics, and psychology, Government Guarantees: Allocating and Valuing Risk in Privately Financed Infrastructure Projects aims to help governments give guarantees only when they are justified. It reviews the history of government guarantees and identifies the cognitive and political obstacles to good decisions about guarantees.

It then develops a framework for judging when governments should bear risk in an infrastructure project (seeking to make precise the oft-invoked principle that risks should be allocated to those best placed to manage them); explains how guarantees can be valued; and discusses how aspects of public-sector management can be modified to improve the likely quality of government decisions about guarantees.

Preface:

Many governments want private firms to finance new infrastructure. The firms, in turn, often want the government to bear some of the risks. They might ask the government to compensate them if demand falls short of forecasts or to promise to repay their debts if they become insolvent. At the very least, they probably want the government to allow them to charge a certain price or else compensate them accordingly.

This book aims to help governments respond to such requests. As well as seeking to make precise the oft-invoked principle that risks should be allocated to those best placed to manage them, it explains how governments can value the guarantees they are thinking of granting and how they can modify aspects of public-sector management to improve the likely quality of their decisions about guarantees.

Although intended mainly for governments and those who advise them, this book may be of interest to others, since the problems of allocating and valuing exposure to risk are not specific to governments. For similar reasons, although the focus of this book is physical infrastructure, it may be of interest to people working on public-private partnerships in education, health care, and other social services.

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Government Guarantees:  Allocating and Valuing Risk in Privately Financed Infrastructure Projects
Timothy C. Irwin

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

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CHAPTER 1: Overview

The use of government guarantees1 to help persuade private investors to finance new infrastructure is appealing because it can allow the government to get the infrastructure built without paying anything immediately and to benefit from the skill and enterprise of private firms. But it can cause problems.

In the 1990s, for example, the government of the Republic of Korea guaranteed 90 percent of a 20-year forecast of revenue for a privately financed road linking Seoul to a new airport at Incheon. The government didn’t have to pay anything up front and would get to keep any revenue exceeding 110 percent of the forecast. When the road opened in 2000, however, traffic revenue turned out to be less than half the forecast. As a result, the government has had to pay tens of millions of dollars every year. How much it will have to pay over the life of the guarantee is uncertain; as a present value, it may be about $1.5 billion (Irwin 2004).

The government’s guarantee may not have been wrong, but it does raise questions. Should the government really have borne demand risk in the project? Could it have estimated the cost of its guarantee before granting the guarantee? If so, should it have disclosed an estimate of the cost in its accounts? More generally, could the government have built the road more cheaply using public finance? Or would it have been better to use private finance without a revenue guarantee, if necessary giving the firm a straightforward subsidy?

These questions are hard to answer even though governments have been using guarantees to help finance infrastructure since the early 19th century. Argentina, for example, guaranteed railway investors returns of 6 or 7 percent on the capital they invested.2 The guarantees helped Argentina attract investment from foreign capital markets and reflected a view that Argentina had to compete for such funds by offering incentives like those offered by other countries. Yet the government didn’t always have enough money to meet its commitments, in part because of the difficulty of accurately budgeting for claims and in part because the government usually had to make larger payments just when its tax revenue was low. In time, the guarantees contributed to a fiscal crisis that may sound familiar:

As the principal official obligation, railway guarantees . . . were largely responsible for the crisis of confidence which brought the whole fragile edifice of the Argentine economic miracle to ruin. . . . Many of the companies formed during this period were committed to long-term dependence upon the guarantee. Indeed . . . it might be argued that many were projected merely for the purpose of obtaining a guarantee. (Colin Lewis 1983, 86)

Guarantees do not always cause such problems. The Chilean government has given many revenue guarantees and a few exchange-rate guarantees to privately financed toll roads. The revenue guarantees typically ensure that the concessionaire gets revenue equal to 70 percent of the estimated present value of its costs, including the costs of investment, operations, and maintenance; the guaranteed revenue might be spread over 20 years, providing as much as 85 percent of forecast revenue in early years and less later on. So far, the government has attracted a great deal of investment without having to pay much because of these guarantees.

Even in Chile, however, the guarantees raise questions. A recession would cause traffic to grow more slowly than expected, possibly triggering many guarantees just when tax revenue was weak. How serious is this risk? How can the government measure it? What is the value of the government’s outstanding liability? And should the government be planning now for the possibility of future payments?

The questions raised by guarantees are most pressing in developing countries but are not unique to them.To take just one example, the state of New South Wales in Australia gave a revenue guarantee in the early 1990s to the Sydney Harbour Tunnel, a project developed as an alternative to the Sydney Harbour Bridge. Toll revenue was expected to be too low to cover the tunnel’s costs, but by the terms of an “ensured revenue agreement,” the government contracted to give the tunnel company a specified amount, less tolls on the tunnel. Thus, the government, not the company, bore demand risk. The auditor-general concluded that the project was more public than private and that, for accounting purposes, the tunnel and associated liabilities were the government’s. It qualified its audit of the financial statements of the government agency promoting the road and argued that the agency had chosen nominally private but effectively public finance partly as a way of circumventing a cap on public borrowing (Government of New South Wales,Australia,Auditor-General’s Office 1994). ...

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