P3 CONCESSION AGREEMENTS - RISKS AND REWARDS

Bryan S. Shapiro - Shapiro Hankinson & Knutson Law Corporation

I. The Importance of Coordinating the Key Contracts Required for a P3 Project

A P3 project involves a number of important contracts which must interface and coordinate with
one another if a P3 project is to proceed smoothly from inception to completion. A graphic
example of these contracts and how the parties involved contractually relate to one another can
be found at the end of this paper. In a typical P3 project, a number of related agreements will be
required as follows:

1. Concession Agreement - Under the Concession Agreement, the public sector client
grants a concession to a private sector Project Company for a predetermined period,
which is known as the concession period. The Concession Agreement usually will also
refer to the legal system applicable to the project, including the environmental
obligations of the Project Company. The terms of the concession will require to satisfy
the requirements of all of the project participants, including the project Lenders.

2. Offtake Purchase Agreement - The Offtake Purchase Agreement secures the project
payment cash flow. It obliges the Offtake Purchaser to procure a certain amount of
project output or pay for an amount of project service, whether or not it is used, over a
given time. The Offtake Purchase Agreement may provide sanctions if the Project
Company fails to deliver output as promised, particularly if the construction of the
project is not finished within the time for completion or does not perform as required
when completed. The Offtake Purchaser will typically look for a guaranteed long-term
output from the project. An Offtake Purchase Agreement is unnecessary for some
projects, such as hospitals, tunnels, roadways and bridges, where no physical offtake is
produced. It is often the Client of the concession who will pay the Project Company for
use of the project. In such instances, the Offtake Purchase Agreement may be one and
the same with the Concession Agreement.

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3. Input Supply Agreement - The Input Supply Agreement obliges an Input Supplier to
deliver to the Project Company a specified quantity of input necessary to the operation of
the project, at a certain level of quality. This agreement allocates market risk involved in
the price and availability of the input. The Input Supply Agreement will only be required
where some supply of input is necessary for operation of the facility. In certain projects,
required service will be effectively an offtake, rather than an input. An example would
be waste water treatment projects where the Project Company would subcontract for the
removal and disposal of sludge, or in hospital projects for the removal of medical waste.
The latter type of agreement would require many of the same conditions and would raise
similar issues as would otherwise be found in Input Supply Agreements.

4. Construction Contract - The construction aspect of a P3 project is generally governed by

a turnkey Construction Contract, sometimes also known as an EPC (engineering
procurement and construction) contract. Typically, Lenders, who are seeking certainty,
require a Construction Contract that establishes a fixed lump-sum price and a set time for
completion, and places the majority (and in some cases substantially all) of the
construction risk on the Construction Contractor.

5. Financing Agreement - The Financing Agreement contains the terms and conditions
pursuant to which the Lenders agree to lend funds to the Project Company. The Lenders
for the project may include commercial banks, export credit agencies, bondholders and
multilateral and bilateral lending institutions such as the IFC. This relationship is
important in a P3 context as the Lenders will generally be responsible for financing a
substantial portion of the project. As a result, Lenders will often have a substantial
influence on the drafting of the other agreements involved in the P3 project in order to
ensure that the project is financially viable.

6. Operation And Maintenance Agreement - The Project Company will wish to ensure
proper operation of the work during the concession period, and will therefore enter into
an Operation And Maintenance Agreement with an Operator of the facility. The
Operator’s obligations should cover those set out in the Concession Agreement, the

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Offtake Purchase Agreement, and those required to ensure continued and efficient
operation of the project.

7. Shareholders’ Agreement - The Shareholders’ Agreement governs the relationship among

the Shareholders within the Project Company. The Shareholders’ Agreement will cover
topics such as the business of the Project Company, conditions precedent to its creation,
the issue of new shares, the transfer of shares, the allocation of project costs and the
management of the Project Company, including decision-making and voting. Such an
agreement will often also include a non-competition clause, providing that the
Shareholders may not enter into activities directly or indirectly in competition with the
Project Company.

The obligations of the Project Company and the tasks it must perform under the Concession
Agreement will be allocated to a series of other third party participants. The Project Company
will want the project participants to undertake the Project Company’s obligations set out in the
Concession Agreement and the Offtake Purchase Agreement, as well as local law and any other
obligations the Project Company is not equipped to bear. The Lenders will always seek
maximum divestment of the Project Company’s obligations to the other project participants.

Project risk sharing and task sharing between the Project Company and the third party project
participants referred to above will result in areas of interface, where the project participants must
act in a coordinated manner. It is for this reason that the key P3 contracts referred to above must
be coordinated so as to maximize the smooth interface between the obligations of the Project
Company with the other project participants. In order to ensure that the contracts are prepared to
maximize the appropriate interfacing of relationships and obligations, each of the non-
Concession Agreement contracts should be reviewed in the context of the Project Company’s
obligations to the Client, and as to how best to delegate responsibilities and risk from the Project
Company to the other project participants. A project may involve risk interfaces, and a sharing
of risk between project participants which may involve an interface in the management of the
risk. Each interface between the different project participants carrying out their project
obligations involves a risk, either that the interface will not occur smoothly or that the work

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packages will not interface properly. In order to reduce the possibility that these events will
occur, it is essential that the Project Company understands all of the risks inherent in the
Concession Agreement and in the Offtake Purchase Agreement so that it can delegate those same
responsibilities to others such as the Construction Contractor under the Construction Contract or
the Operator under the Operation And Maintenance Agreement.

Some examples of interfaces/coordination necessary between the P3 contracts typically include

the following:

1. Technology Interfaces - Technology interfaces may include anything from materials

employed to electrical requirements for construction or construction methods. Interfaces
between technologies in P3 projects are normally allocated to the Construction
Contractor, assuming a full turnkey Construction Contract. There may be a necessity to
coordinate with the Offtake Purchase Agreement where, for example, the Construction
Contractor must build infrastructure to connect with the Offtake Purchaser’s facilities.

2. Methodology Interfaces - Commercial diversity may result in the Project Company

engaging a Construction Contractor, Operator and Input Supplier, each with potentially
diverse approaches to carrying out the project.

3. Public Sector Client Interfaces - The interfaces between the Client and the Project
Company will usually be defined in the Concession Agreement. Obviously, the Project
Company will wish to place most of the risk of these interfaces on the project
participants.

4. Interfaces between Construction Contractor and Operator - During the period between
completion of different sections of the project, the interfaces between the Construction
Contractor and the Operator will be compounded, since on one section of the work, the
Construction Contractor will be carrying out commissioning and testing while another
section will have been completed and will be in the hands of the Operator, resulting in
two project participants with responsibilities for the site at the same time. Tasks will

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require to be undertaken for the whole of the work, and shared between the Construction
Contractor and the Operator. These overlaps in responsibility will have to be dealt with
and foreseen with appropriate provisions in their contracts with the Project Company.

Similarly, at the end of the construction phase, the Construction Contractor may be
required to provide training for the Operator. These are relatively straightforward issues,
but should be provided for early on in the contract documentation in order to avoid
disputes at later stages.

In addition, performance testing may also need to be carried out. The Operator will need
to review the Construction Contractor’s activities to ensure that the operation of the work
is not impeded. The Operator and the Construction Contractor are likely to be involved
in extensive interfaces during takeover of the project and during the defects liability
period. These periods represent the transfer of responsibility for the site and the work
from the Construction Contractor to the Operator. This period will therefore involve
shared tasks, responsibilities and management between the Construction Contractor and
the Operator, all of which will require to be properly dealt with in their respective
contracts with the Project Company.

5. Interfaces between the Operator and the Offtake Purchaser - The Operator will liaise with
the Offtake Purchaser throughout the operation of the project to identify the amount of
output needed by the Offtake Purchaser, any additional services required by the Offtake
Purchaser and any other element of operation that the Offtake Purchaser wishes to
control. Obviously, this should also be provided for in their respective contracts.

6. Interfaces between the Operator and the Input Supplier - The Input Supplier will also
liaise with the Operator throughout the concession period, although not as extensively as
will the Offtake Purchaser. The interfaces between the Operator and the Input Supplier
will relate primarily to the delivery of input, how much is needed, when delivery should
be made and whether the service provided by the Input Supplier is consistent with the
Input Supply Agreement. Again, all of these requirements should be foreseen and

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coordinated within the contracts between the Input Supplier, the Operator and the Project
Company.

7. Shareholders’ Interfaces - The Shareholders of the Project Company may have

multiple roles in the project, including sponsor, investor, lender, manager and project
participant. Interfaces between Shareholders will generally be managed through a
Shareholders’ Agreement. Within the Shareholders’ Agreement, it is possible to
establish an efficient management model which will allow the Project Company to make
timely and decisive decisions during the course of the project.

II. What To Do Before Issuing Calls for P3 Request For Expressions Of Interest,
Request For Qualifications and Request For Proposals

The RFEI, RFQ and RFP documentation are also essential to P3 project organization. A P3
project is very preparation intensive, requiring careful analysis and negotiation before the project
contracts are awarded and performed. The most time-consuming elements include negotiating
documentation and structuring the project financing.

At the initial stages of the project, appropriate specialists’ advice should be obtained from legal,
insurance and financial advisors, as well as from technical and operational experts and parties
experienced in project operation.

Typically, feasibility reviews will be undertaken in the early bid process for the project to assess
project feasibility, availability of financing and profitability. They should be performed roughly
in parallel, although each project will have different requirements.

Once the need for a P3 type of project structure is identified, typically the Client will sit down
with his engineering department and legal advisors and devise a Request For Expressions Of
Interest, whereby interested parties to act as the Project Company/Concessionaire will be invited
to indicate their interest in becoming involved on the project. The criteria for interested parties
will be spelled out in the RFEI. The RFEI may also stipulate that the Expressions Of Interest
received will be broken down and graded according to listed criteria, such that a number of

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potential Concessionaires will be short-listed, from which list a Request For Qualifications will
be issued.

Sometimes the short-listing of the potential project Concessionaires will take place after both the
RFEI and the RFQ have been completed. At that point, a Request For Proposals can be issued to
the pre-qualified Proponents.

The RFP will typically contain a tendering procedure, giving the various criteria for success for
potential Proponents, and typically stipulating a weighting factor for various criteria of expertise
and technical ability which the Proponents will be required to demonstrate, indicating previous
experience and projects of similar nature, technical expertise, references from other clients, etc.
The RFP typically contains a list of all of the tendering procedures and decision-making
standards which the Client will employ in making its final selection as to the successful
Proponent. In most cases, the Client will not provide for any payment to the Proponents for
preparing their Proposals. As a result, the Proponents must take the cost of failed previous P3
Proposal efforts into account in formulating their proposed costs to act as Project
Concessionaire.

Typically, the RFP will also indicate that the Proponent will be rated, with the Client choosing to
begin negotiations with that Proponent closest to the required criteria, failing which the Client
may deal with the next most favourable Proponent, and proceeding until a Concession
Agreement is finally negotiated and agreed to with the successful Proponent who will become
the Project Company.

Before issuing calls for the RFEI, RFQ and the RFP, it is essential that the Client meet with all
of its technical, financial, legal, insurance and other advisors to ascertain the nature of the
project, the risks inherent in its formulation, design and construction, its financial viability, as
well as the basis for choosing amongst the array of potential Proponents who would be best
qualified to produce the project as meeting the needs of the Client.

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III. Making the Concession Agreement a Part of the RFP

Since the Concession Agreement between the Client and the Project Company will form the
basis of the Project Company’s panoply of obligations to the Client, it is essential that the most
important components of the Concession Agreement be fleshed-out early so that the Client can
be made to verbalize its functional, financial, budgetary, scheduling and performance-related
requirements, including risk allocation factors, that will be required of the successful Proponent.
In performing this function, the Client should then consider making the Concession Agreement a
part of the RFP issued to the pre-qualified short-list of Proponents. In this way, the Proponents
will be informed at the outset that the Concession Agreement attached to the RFP will form the
general basis of the final Concession Agreement to be agreed to with the Client when the
successful Proponent is named. This procedure will cause Proponents who do not intend to
execute a Concession Agreement giving the Client its required needs on the project to fall by the
wayside. Those Proponents proceeding and submitting Proposals in response to the RFP will
then be obliged to proceed with negotiation of the basic Concession Agreement as enclosed in
the RFP documentation, as their bids will be required to indicate their agreement to be bound by
the basic form of Concession Agreement attached to the RFP package.

IV. Key Terms and Conditions of the Concession Agreement

The Concession Agreement between the Client and the Project Company sets out the general
project obligations which will require to be passed through to the various other project
participants. In a typical Concession Agreement, the Client grants a concession to a Project
Company over what would otherwise be a public sector project, for a given period, during which
the Project Company must build and operate the facility. The Concession Agreement allows the
Client to allocate project risk to the Project Company. The Client will identify those risks which
it is prepared to bear. It will allocate the remaining risks to the Project Company. The Client
may also wish to define, to some extent, the sharing of risk among the project participants
through the Concession Agreement. In certain cases, the Client may attach to the Concession
Agreement drafts of other project contracts, such as the Construction Contract, Operation And

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Maintenance Contract, Offtake Purchase Contract and Input Supply Contract. In this way, the
Client may ensure that the terms that it wants to include are properly set out and form part of the
concession itself. Typically, the Project Company Shareholders will attempt to resist this
attempt on the part of the Client to set the contractual goalposts, as it interferes with their
commercial relationships with the other project participants.

P3 projects will rarely involve all of the agreements referred to above. Typically, during the
term of a concession, the primary interests of the Client will generally be as follows:

1. Completion Date - The Client’s need for the infrastructure represented by the project in
question is generally immediate, often as much for political as practical reasons. Further,
the Client may be procuring other infrastructure or other investments closely related to
the completion of the project, such as the building of roads or public housing in
proximity to the work. Therefore, the success and revenue generation of several projects
may be at risk where completion is not achieved by the identified completion date.

2. Performance of the Project - Since the Client needs to receive sufficient output from the
project for the duration of the concession to meet its needs as well as to ensure a project
which performs in accordance with its requirements at the end of the concession period,
the Client will want to establish performance standards and requirements. The Client’s
requirements will cover issues such as output, consumption, efficiency of operation,
maintenance, needs and cost, life cycle, quality of the output generated and cost of
operation.

3. Maintenance Regime - The concession period is often when the project will have
depreciated both in value and in operating capacity by the time the transfer back to the
Client has arrived, where such a transfer has been built into the Concession Agreement.
In order to mitigate the detrimental effect of operation on the project during the
concession period, the Client will want to ensure that the maintenance regime
implemented by the Project Company during the concession is sufficient, given the
nature of the work involved.

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Some of the key terms and conditions of the Concession Agreement include the following:

1. Guarantees - The Client may require guarantees from the Project Company or from the
Shareholders/Sponsors associated with the Project Company, primarily where the Client
has transferred to the Project Company existing infrastructure or other assets.

2. Non-Competition - The Client may supply the Project Company with some form of
monopoly over the service to be provided. The Project Company may obtain from the
Client an undertaking to ensure that no other licence to perform the concession service or
some related service will be given to a third party within a specific area or otherwise in
competition with the Project Company during the concession period.

3. Taxation - The Concession Agreement may specify a maximum amount of taxes, fees,
levies, duties, royalties or other charges which may be imposed on the Project Company.
This maximum may be calculated per unit of production, as a total or annual amount or
based on the total revenues after costs, debt servicing or other such operation costs.

4. Compensation Events - Where an event, such as a risk assumed by the Client under the
Concession Agreement, results in some financial burden on the Project Company, the
Client may be required to compensate the Project Company for any cost, damages or loss
incurred. This can be done either by a cash payment directly to the Project Company or
by the Client extending the concession period or increasing the level of tolls or tariffs
allowed under the Concession Agreement. Such a provision is known as a “financial
balance clause.”

5. Compensation on Termination - The Client will generally provide the Project Company
with a payment in the event of termination of the Concession Agreement for the Client’s
default or due to extended force majeure conditions. This payment is intended to
compensate the Project Company for the project assets, which on termination will
generally revert to the Client upon payment of this amount, and for loss of project
income. The amount of the payment will generally equal the total amount due to the

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Lenders, plus equity invested, plus the net present value of the forecast return on equity,
generally calculated by reference to the financial model for the project.

It is also possible that the Client may be willing to compensate the Project Company
where the Concession Agreement is terminated because of the Project Company’s
default. In such instances, the payment is normally limited to the outstanding amounts
due to the Lenders, subject to certain reductions such as excluding any penalties charged
to the Project Company.

6. Design, Construction and Technical Requirements - The project will often be part of a
larger development scheme or may need to be able to interface with existing
infrastructure. As a result, the Client will want to define design and construction
obligations in the Concession Agreement. Technical specifications will set out in some
detail the technical requirements of the Client for the project. The Client will need to
ensure that the project meets quality and life cycle requirements. One way of doing so is
to specify the key materials and equipment to be used in the work, or to set out the basic
design for the project. However, the Client will not wish to relieve the Project Company
of any of its design responsibilities, and will therefore want to avoid taking over any of
the design responsibility. In addition, the Client will want the Project Company to
undertake the risk for any errors, defects or shortcomings in Client-provided designs.

7. Modification of Technical Requirements - The Client will typically not wish to see its
technical requirements for the project modified by the Construction Contractor or the
Project Company, without its consent. Some provision for their modification without the
Client’s consent may be made where the changes are necessary for the safety and
integrity of the project, an improvement of the project where there is no need for
additional compensation of the Project Company or owing to changes in the Offtake
Purchase Agreement. The latter will depend on the relationship between the Offtake
Purchaser and the Client.

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In addition, the Client will want the right to change the technical requirements of the
project. This may prove to be a substantial difficulty for the Project Company as
assessing the impact of any change on the project can be extremely difficult, if it is even
possible. The Project Company will then require to protect its own interests in the
Concession Agreement by requiring that any such changes should not materially decrease
performance of the project, increase the cost of the project (either in construction or
operation/maintenance) or cause the construction or operation of the project to breach
any environmental requirements.

The Project Company will want compensation from the Client for any Client-instigated
changes that affect the project, such as delay in completion, increased costs or decreased
performance. It should be noted, however, that the actual or long-term effect of any such
change is very difficult to quantify accurately at the time the change is made. This is
particularly true of the increased cost of maintenance of the work and wear and tear.

8. Time for Completion and the Project Program - Given the importance of time in any
large infrastructure project, the Construction Contractor will be required to complete the
work in accordance with the project schedule. The schedule will take into consideration
the needs of the Client for a completed project within a given period. The Client may
also impose on the Project Company penalties in the form of liquidated damages where
the construction is not completed by the agreed date. The completion date will only be
extended for specific reasons set out in the Concession Agreement. These will generally
involve breaches by the Client or events falling within the Client’s risks.

9. Method of Operation - The Client will want to ensure that the Project Company runs the
project in a manner consistent with proper maintenance of the equipment, applicable
environmental standards, the requirements of the Offtake Purchaser and the Input
Supplier, if any, the regulations of government authorities, legal requirements and any
other constraints necessary to ensure the proper and continued operation of the project.
Unless the Client is also the regulatory authority, it may be difficult to control the actions

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of the Project Company directly, and the Client must therefore establish the standards by
which the project must be operated in the Concession Agreement.

10. Maintenance Manuals, Records and As-Built Drawings - The Project Company will
maintain certain records, manuals and as-built drawings, many originally prepared by the
Construction Contractor and required by the turnkey Construction Contract. The
maintaining and updating of such documentation is of particular importance for the
Client if the project is to be transferred at the end of the concession period. The Client
will want to have access to specific records and documents to educate its personnel about
the operation and maintenance of the work and to ensure that the work is being
maintained by the Project Company to standards sufficient for the Client’s needs.

11. Update of Project Technology - In order to ensure the transfer of know-how and
technology to the Client, the Concession Agreement may require the Project Company to
acquire any technical innovations which become available during the concession period
or which are developed by the Operator, either during the operation of the project or
otherwise, and then transfer such technology to the Client at the end of the concession
period. Where the technology originates from a third party, this obligation may be
limited by the Project Company’s ability to obtain the technology at commercially
reasonable rates.

12. Training - A P3 project can provide the Client with an important transfer of technology
and know-how. Therefore, the Client may want to mandate the maximum possible
interaction between the Project Company and local partners or the Client’s personnel in
order to ensure the proper transfer of such know-how.

During the period preceding transfer to the Client, a training regime will often be
implemented where the Project Company will train the Client’s personnel in the
operation and maintenance of the project. This may involve the Operator employing
certain of the Client’s personnel for a time or the Client hiring certain of the Operator’s
personnel to work on the project after the transfer has taken place.

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13. Approval, Appointment and Replacement - The Client will want to ensure that the project
participants are experienced and reputable parties to large infrastructure projects. The
Client may prefer to provide appointment criteria, such as international repute and
experience adequate for participation, or it may want an approval power over the identity
of the project participants and their replacements. The Project Company, on the other
hand, will not want to give up control over the management of its operations, nor will the
Lenders want to lose control over the identity of the project participants.

14. Granting the Concession - The procedure for the actual grant of the concession to the
Project Company is often included in the Concession Agreement. The concession may
be linked to enabling or issuing legislation. Therefore, the law should be reviewed to
ensure the power of the Client to grant the concession. Further, legislative or
constitutional acts may be necessary in order to validate the concession in certain cases.

15. Concession Fees - The Project Company may be required to pay concession fees for the
privilege of obtaining a concession. Such fees will generally be payable to the Client
before the commencement and possibly periodically during the concession period. The
amount of the fees will provide the Client with some early cash flow for its obligations in
the early period of the project, and will also provide the Project Company with the added
incentive to continue and complete the project.

16. Independent Expert - An independent expert may be appointed by the Client and/or the
Lenders to ascertain whether the project is being performed in accordance with the
project requirements. The independent expert will need to be given a right of access to
the site and the operation of the project. This may involve occasional visits to the site, or
a discretionary right of access to any and all parts of the site at any time. The expert may
also be allowed to perform tests, inspect the project or review the documentation and
records kept for the project. The access of the experts should be limited to that necessary
to carry out its role, given that the expert may be an impediment to the construction or
operation of the project.

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17. Restrictions on Transfer of Shares in the Project Company - Because of the importance of
the identity of the Shareholders of the Project Company, owing to their financial and
technical capacity, the Client may want to place certain restrictions on the transfer or
change of shareholding in the Project Company. The Client may want a right of approval
over the identity of any transferee, or to maintain some guarantee from the original
Shareholders. These restrictions will normally apply during the construction phase, and
may apply during some portion of the operation phase of the project or indeed throughout
the concession period.

18. Step-in and Continuous Operation Provisions - Where the Project Company breaches the
Concession Agreement in such a way as to entitle the Client to terminate the Concession
Agreement, and where the Client intends to act on its rights, the Lenders will want the
right to step in to the Project Company’s place, complete the project and avoid the
termination of the Concession Agreement. The Concession Agreement will therefore
typically grant the Lenders step-in rights. In the same way, the project is only of use to
the Client when it operates. The Client may therefore want the right to continue
operation of the project where it terminates the Concession Agreement. This is
sometimes referred to as the right to continuous operation, as it allows the Client to
ensure continuous operation of the project, even in the event of termination. The Client
will often not undertake such operations, but rather pass such responsibilities on to some
other party, such as the Offtake Purchaser.

19. Transfer or Re-Tender - At the end of the concession period, the Client will either put the
project out for re-tender or it will require the Project Company to transfer the project
assets to the Client. The process of re-tender will begin six months to a year before the
end of the concession period, at which point the Client will obtain specified information
from the Project Company. The Client will issue tender information to potential bidders
and may want the Project Company’s assistance in compiling information and generally
assisting with the re-tendering process. This may be complicated where the Project
Company itself intends to bid for the concession.

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The Client may wish to take over the project at the end of the concession period. The issues
involved in the transfer of the project will include the transfer of project assets, land rights,
testing of the work, training of personnel and treatment of the shares in the Project Company.

The state of the project on re-tender or transfer back to the Client will need to be defined as
exactly as possible. This may include testing and review by an independent expert. Failure to
meet the requirements for transfer will result in sanctions, either in the form of liquidated
damages for delay of transfer or possibly liquidated damages based upon the extent to which the
project does not meet the transfer requirements. There may also be some bonus payment to the
Project Company based upon residual value where the project, as transferred, exceeds the
transfer requirements. This will provide the Project Company with an incentive to maintain and
upgrade the project during and towards the end of the concession period.

The Client may wish to include some form of retention of payments to provide itself with some
security in the event that the Project Company does not deliver the project in the state intended.
This retention can either be made from funds due to the Project Company from the Client or
possibly from payments made by the Offtake Purchaser.

V. Foreseeing Project Risks

As with construction contracts generally, in preparing the various forms of contract indigenous
to a P3 project, it is incumbent on the parties and their legal counsel to foresee the most likely
project risks for the project participants, and deal with these appropriately in the individual P3
contracts.

The assessment of which parties will be affected by a particular element of risk, and in what
way, will be quite complicated and difficult to clarify since many project participants typically
assume several project roles. For example, the turnkey Construction Contractor may also be one
of the Shareholders of the Project Company and/or the Operator. In most projects, risk
allocation factors such as the following will operate: market risk will be assumed by the Project

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Company, design, construction and commissioning risk will be assumed by the Construction
Contractor, and operation and maintenance-related risks will be assumed by the Operator.

The majority of any political risk and delays by authorities will generally be allocated to the
Client through the Concession Agreement. Any residual risk will be borne, in the first instance,
by the Project Company, which will frequently attempt to transfer this risk to the Client. The
project Lenders, positioned as they are behind the Project Company, will want to limit their
assumption of any risk, but will generally be unable to displace all of it. Provisions that deal
with risk allocation may be drafted so as to mirror the language of the Concession Agreement
and other agreements. This will generally have to take account of considerations such as
identical language for force majeure and extensions of time (for example, for the Project
Company under the Concession Agreement and the turnkey Construction Contractor). Such
mirror-image language reduces the scope for ambiguity and gaps between the various
agreements. In order for this arrangement to function effectively, the governing law and dispute
resolution clauses will require to be identical. For example, to save time and money, and to
avoid the risk of conflicting decisions, the Client may wish to try to find a way of involving the
Construction Contractor in dispute resolution proceedings with the Client or otherwise to oblige
the Construction Contractor to accept findings made in such proceedings.

A practical solution to such difficulties is to include “if and when” language in the turnkey
Construction Contract, for example, stating that the Construction Contractor is entitled to
extensions of time under certain circumstances, if and when such extensions are granted to the
Project Company under the Concession Agreement. Few projects appear to actually implement
such arrangements. The Project Company may also wish to see an overriding provision in the
turnkey Construction Contract such that the Construction Contractor is under an obligation to
perform so that the Project Company is not in breach of its obligations in the Concession
Agreement and other project agreements.

Completion risks, containing elements of design, construction and commissioning risk as well as
other residual risk, will be a factor for all of the principle project participants. A certain number

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of them will typically bear the greatest level of such risk, in particular, the Construction
Contractor, but even an Offtake Purchaser may end up bearing some of the completion risk.

The allocation of risk for Lenders is further affected by the recourse that is open to them with
regard to the financing of the project. The financing may be recourse or non-recourse or limited
recourse. Recourse financing provides the Lenders with full recourse to the assets of the
Shareholders or other project participants in the event of default on repayment of the loan by the
Project Company. Non-recourse financing limits the Lenders’ recourse to the assets of the
project at hand. Limited recourse financing provides the Lenders with recourse to the assets of
the Shareholders up to a limited maximum amount and over a limited period of time.

In a limited recourse financing, the period of recourse may be limited to the period until
completion of the work which will generally be defined in the Construction Contract and will be
evidenced by the issue of a certificate or the passing of specified tests. It may be limited to the
period in which certain financial ratios are achieved or to the period until the work is up and
running, for example, subsequent to a period of performance at a certain level and over a certain
period of time. In the event of certain breaches of a covenant or representation by the Project
Company or its Shareholders (often limited to intentional breaches), such limitations may no
longer operate.

P3 projects are typically financed primarily on a limited or non-recourse basis with the cash flow
generated by the project and the project assets constituting the principle project security.
Therefore, project Lenders and consequently other project participants in such projects have
become particularly sensitive to the need to identify and allocate project risks at a very early
stage of the development of a project. Although the Construction Contractor assumes much of
the risk during the construction phase, the construction phase is the most critical stage for the
Lenders as in non-recourse financing they only have recourse to the project assets and as such,
the Lenders take on proportionally greater risk.

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VI. Employing Democratic and Practical Principles in Allocating Contract Risk

The usual adage that risk should be allocated to the party best able to manage it also applies to
the contracts employed in a P3 project. However, in employing this self-evident maxim, it is
important to appreciate that principles of equity and fairness should also apply in allocating risk.
In other words, simply allocating risk to the “weaker” party who is less likely to present a strong
bargaining position in the negotiation of a P3 contract, risks an unnecessary escalation in the cost
of the project as the so-called “weaker” parties will perceive the various project risks as being
onerous and will build such risks into their cost projections for delivering services, performing
work or for operating and maintaining a project facility.

Unequal or overwhelmingly one-sided contracts, throwing the major risk on to the Project
Company under the Concession Agreement, can result in a later breakdown of relationships
during the course of the P3 project, rather than making for a smooth cooperative process
throughout the term of the project. This will ultimately translate into acrimony, claims and
difficulty in achieving an overall successful project as one party or the other in the P3 grouping
perceives that it is being taken advantage of and that it has signed a less than fortuitous contract.

Some of the principles used in allocating contract risks include the following:

Political risk - The Client generally carries the greater burden of the political risk. The
risk of events related to governmental issues which might have an impact on the project
are usually borne by the Client. If the Client is an arm of government, provincial or
federal, the political risk which the Client is willing to bear will normally include acts of
its own authority or acts of government which might otherwise, as between private
companies, be treated as force majeure. For this reason, the Client should be prepared to
protect the Project Company from any acts or omissions of its own authority, of local
governments or of administrative authorities.

Completion Risk - The completion risk is generally wholly allocated to the Project
Company, except for any delay caused by the Client or a Client-related risk. In certain

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circumstances, the Client may be convinced to share a portion of the risk. For example,
as a general rule, the Project Company will be required to take the risk associated with
the project site which will be passed through to the Construction Contractor. However, if
the cost of certain aspects of site risk is disproportionate, and the Client can be persuaded
of this, the Client may also be willing to take certain risks which are specific to the site.
The Client may be best placed to identify certain risks involved with the ground
conditions which might be discovered during construction.

Operation Risk - The Client will bear the part of the operation risk relating to the
responsibilities it is taking on in the project. For example, in certain cases, the operation
of the project may be based on the characteristics of existing infrastructure or the ability
to connect to such infrastructure, as in the construction of a water treatment plant which
treats water provided by the Client and delivers it to an existing water system. In such
event, where the Client maintains responsibility for the existing infrastructure, the Client
may bear the risk of availability of water or the proper functioning of the existing
infrastructure. Without sufficient water and offtake, the plant will not operate, tests
cannot be performed and commissioning cannot occur.

Further, where other facilities are necessary for operation, such as transportation by
national roads, bridges or tunnels, use of national railways, utilities connected to the site
providing electricity, water, gas or other fuel, obtaining and maintaining licences and
consents, or the operation and maintenance of any associated facility which falls within
the public domain, any such risk might be allocated to the Client as it can generally
manage such risks most efficiently.

Permits and Licences - The Construction Contractor and the Operator will need to go to
the Client, or to some other related authority, to make requests for permits and licences to
do the work necessary to carry out the project. These permissions will range from
construction permits to operating licences. The permits will need to be renewed
regularly, requiring further interfaces with the Client, or some government agency,
throughout the period of construction and operation of the work. The Project Company

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will also need to coordinate with the Client or with some other related authority to
maintain and renew these permits and licences.

Transfer and Re-tendering - As stated earlier, an important event for the Client occurs at
the end of the concession period. At that time, the project will either transfer back to the
Client or the Client will relet the project to the same or a new Project Company. The
Client will want to ensure that transfer occurs properly and with the appropriate amount
of assistance by the Client’s personnel. During this period, the Project Company may be
required to train and otherwise prepare the Client’s personnel to manage the operation of
the project. The Client will want to make sure that the project has been appropriately
maintained and managed during the period immediately preceding the transfer of the
project. Where the Client intends to re-tender at the end of the concession period, the
Project Company may be required to provide information and assist generally in the
process of re-tendering. This may include providing accounting for the project, details
on project assets, employment records, life cycle projections and information on existing
subcontracts.

VII. Risk Sharing and Risk Bearing

The successful P3 project must incorporate a financial structure and security package that will
ultimately satisfy both the Lenders and the Shareholders, while maintaining commercial
flexibility and profitability of the Project Company. The successful project will also benefit
from workable, commercially viable and cost-effective risk-sharing. Given the differing
interests and objectives of the parties involved, effective risk allocation will be an essential part
of the drafting of the project documents and an integral part of the project’s success.

Risk is the probability of an event occurring and the consequences of its occurrence. The event
in question which needs to be considered in the context of the project will generally have a
negative effect on the project, either increasing cost, delaying completion, reducing performance
or possibly rendering the project itself impractical. Risk cannot be ignored, but should be
managed as efficiently as possible at the time of entering into the P3 contract. By the same

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token, project risks must be managed in a reasonable manner. As stated earlier, improper or
inequitable risk allocation will result in unnecessary increases in project cost. Several principles
are useful in the analysis of the management of risk. A party to a contract should generally bear
a risk where:

(a) the risk is within the party’s control;

(b) the party can transfer the risk (for example, by insurance), and it is most
economically beneficial to deal with the risk in this fashion;

(c) the preponderant economic benefit of controlling the risk lies with the party in
question;

(d) to place the risk upon the party in question is in the interests of efficiency,
including planning, incentive and innovative efficiency;

(e) if the risk eventuates, the loss falls on the party in the first instance and it is not
practicable or there is no reason under the above principles to cause expense and
uncertainty by attempting to transfer the loss to another.

The above view of risk management/allocation can be broken down into three questions:

(a) Who can manage the risk most cheaply, efficiently and easily?

(b) Who benefits most from its management?

(c) Who has the greatest incentive to manage it?

As also stated earlier in this paper, risk tends to be allocated on the basis of commercial and
negotiating strength. The stronger party will allocate risk that it does not want to bear to the
weaker party. This scenario does not necessarily provide the most effective and efficient risk
management. Improperly allocated risk will have an impact on the entire project and may affect

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the stronger party as well as the weaker. Allocation of risk to the party best able to manage it
efficiently, inexpensively and easily will generally result in a more successful and profitable
project and will benefit each of the parties involved.

VIII. Risk and Financing

Financing for a P3 project is provided by lending institutions who are generally not in the
business of construction or operation of such projects. Lenders will not be in a position and
therefore will not want to take many of the risks commonly associated with such projects. In
order to avoid bearing project risk, the Lenders will insist in the context of their review of the
project documents, that as far as possible, project risks are allocated to the project participants,
such as the Construction Contractor and the Operator, and away from the Project Company, their
debtor. The project participants will charge higher fees for bearing such project risks, which will
be included in the contract price, increasing the financial exposure for the Lenders. However,
such increased sums will represent value for money for the Lenders, since the project
participants are better placed to manage such risks and the Lenders will be able to evaluate their
exposure and cost-out the risk.

IX. Allocation of Risk Generally

In most conventionally financed projects, it is accepted that certain risks, such as market risk,
political risks and completion risk, will be allocated by the Client to the Project Company in
relation to the role that the Project Company plays in the project. For bearing such risks, the
Project Company is compensated by return on its investment.

In a project-financed P3 project, financing is obtained primarily through the Lenders, rather than
the investment or liability of the Shareholders. The Project Company, as a special purpose
vehicle, must avoid taking on risks which the Lenders are not prepared to assume. The Lenders
will be compensated for their financing of the project in the form of a rate of interest appropriate
to lending and will not benefit from project revenues which are higher than forecast. Residual
risk will be borne in the first instance by the Project Company and therefore by the Lenders. The

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Lenders will attempt to limit their assumption of project risk by allocating to the project
participants’ risk placed on the Project Company through the Concession Agreement.

Ascertaining which parties will be affected by a particular element of risk can be quite
complicated since the project participants may assume several project roles. For example, the
Construction Contractor may also be one of the Shareholders and/or the Operator.

The effort to transfer all project risk to the project participants is known as “back-to-back risk
allocation.” The Concession Agreement will define what risk the Client will take. All other
project risk is borne by the Project Company. The other project documents will transfer the risk
allocated to the Project Company by the Concession Agreement back-to-back to the other project
participants. Complete back-to-back risk allocation will result in transfer of all project risk
assumed by the Project Company to the other project participants. Rarely will a P3 project
achieve complete back-to-back risk allocation.

X. General Theory of Risk Allocation for Specific Risks

The following are certain project risks encountered in a typical P3 project. These risks are
generally allocated among the project participants based upon a number of considerations.
Considering risks in isolation is unsatisfactory and does not provide a complete view of project
requirements. The nature of the project participants and the project itself will have a
fundamental impact on the risks encountered and their allocation. The following risk allocation
issues should be viewed generally, as each project must be considered as a unique allocation
situation.

(a) Development Risk - The development phase involves the preparation of the
project before financial closing, including Requests For Expressions Of Interest,
Requests For Qualifications and Requests For Proposals. Given the nature of a
P3 project, its complexity and the length of negotiations, risk during the
development phase can be considerable. Usually, a large proportion of the
development phase of a P3 project is carried out by the Project Company before

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the Lenders or some of the other project participants become involved. At this
stage, the Project Company, and more particularly, the Sponsors, will bear the
majority of the development risk.

(b) Completion Risk - The construction phase involves the most costly project risk.
The nature of P3 projects is such that an incomplete project will have little value.
Therefore, both the Client and the Lenders will have a significant interest in
ensuring that the work is completed in accordance with the project specifications.
Completion risk includes construction and testing and commissioning of the
project. This risk is then allocated to the Construction Contractor by the Project
Company. These risks include construction risks which will generally be
allocated to the Construction Contractor, as it is the Construction Contractor who
designs and builds the project. The requirements for the project should be defined
very specifically and completely in the Construction Contract based upon the
requirements and specifications of the Concession Agreement. Any gap or
inconsistency may defeat the back-to-back allocation of risk and leave additional
risk with the Project Company.

Commissioning is another risk that the Construction Contractor must deal with. This can be
done by satisfying certain tests and inspections in order to ensure compliance with the project
specifications. The responsibility for commissioning the project is generally allocated to the
Construction Contractor. The commissioning may be carried out in part, or verified, by the
Operator and possibly by an independent expert engineer, but the responsibility for successful
completion of commissioning will remain primarily with the Construction Contractor.

Time for completion is also of great importance to the Project Company, the Client and to the
Offtake Purchaser. The Project Company will want to commence operation of the project as
soon possible in order to earn maximum revenue and improve return on investment. As
construction and commissioning risks are placed on the Construction Contractor, so too will be
the risk of timely completion. If the Construction Contractor fails to complete the work on time,
sanctions will be imposed to reflect the losses the Project Company will incur, which may

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include debt servicing requirements, Input Supply Agreement penalties, Offtake Purchase
Agreement penalties and Concession Agreement penalties.

Cost increases are another risk that require to be dealt with or allocated. As this risk is basic to
the interests of the Lenders, the risk of cost increase allocated to the Project Company will be
passed very carefully on to the project participants, as far as possible, and away from the Project
Company. Some of the factors which might influence cost increases include currency risk,
inflation, taxes, input price increases, construction cost increases, operation cost increases, cost
of spare and replacement parts, decrease in output prices and the risk of cost overruns. All of
these will require to be allocated to the parties best able to carry the risk or will ultimately be
allocated by the “stronger” parties and placed upon the shoulders of the “weaker” project
participants.

Performance Risk - In order for the project to maintain sufficient revenue to satisfy debt
servicing and to provide a return for the Shareholders, the project must perform to
specified levels. Therefore, performance requirements are provided in the Concession
Agreement and in the Offtake Purchase Agreement which are then passed on to the
project participants, in particular, to the Construction Contractor and to the Operator.
Some of these performance risks will include risk related to design and construction,
operation, input supply and offtake purchaser infrastructure.

Operation Risk - The operation of the project involves certain risks of operation,
performance and maintenance. Generally, this risk is shared by the Operator and the
Project Company after takeover of the project from the Construction Contractor until the
end of the concession period.

Market Risk - There are a number of primary market risks which are likely to be
encountered in a P3 project. The Lenders will not want to bear market risk in relation to
the project, and will therefore require that the contractual structure of the project allocate
market risk away from the Project Company and to the project participants. Some of
these market risks include output price and input cost risks.

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Environmental Risk - Although environmental risk is a performance risk, it deserves

some special consideration. Environmental risk has become a far more central
consideration over recent years. Developers will wish to consider carefully possible
changes in environmental laws and the potential consequential effects on the project.
The primary aspects of a P3 project relevant to environmental risk are building the
project, including the design and construction of the work, the maintenance and operation
of the project and the quality of input provided. The performance requirements linked
with environmental issues will be defined both by existing applicable law, the
requirements of the Client and any requirement imposed by lending agencies.

An environmental impact assessment and statement will generally be required before a major
project can be let by the successful Project Company. This assessment will identify and help to
allocate environmental risk. Environmental risk will generally be allocated between the Client
and the Project Company and then passed by the Project Company to the Construction
Contractor, the Operator and the Input Supplier. Allocating the responsibility between these
entities for such risk may not be straightforward. The cause of environmental damage may be
difficult to identify and the potential level of damage is such that project participants will not
wish to bear such risk.

XI. Mitigating Risk Through the Use of Bonding And/Or Insurance

Various forms of construction bonding and insurance are available to provide additional security
for the performance of the various project participants. The Project Company and the project
Lenders must be comfortable that the project participants are able to assume their project
obligations as set out in their individual contracts, in order to ensure the financial viability of the
project. The Project Company and the Lenders will need to review the credit risk of the various
project participants. Where the Project Company or the Lenders are not comfortable with the
credit risk of a project participant, various methods are available to the Lenders in order to
enhance a party’s credit, including obtaining bonds and guarantees from that party.

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The most important credit risk relates to the project payment flow, either from the Client or from
the Offtake Purchaser. If this party is a bad credit risk, the Project Company or the Lenders may
require a guarantee from the government or from some other credit-worthy third party, letters of
credit, an escrow arrangement over the entity’s income or a combination of same.

Otherwise, when dealing with the risks of performance by the Construction Contractor, the
Project Company will typically look to construction bonding as a method of securing appropriate
performance. A construction bond is a three-party arrangement between the Project Company,
the Construction Contractor and the bonding company in which the bonding company agrees to
indemnify the Project Company should the Construction Contractor fail to fulfil its obligations.

Typically, the obligations of the Construction Contractor to the Project Company to perform
would be guaranteed through the requirement for the Contractor to supply a Performance Bond.
This bond, typically written for 50% of the contract price or 100% of the contract price set out in
the Construction Contract, guarantees that the Construction Contractor will promptly and
faithfully perform the Construction Contract in strict accordance with its terms and
specifications. Performance Bonds minimize the financial risk to the Project Company, both
during construction and during the maintenance period thereafter. Prudent Construction
Contractors will also reduce their risk by requiring their subcontractors and suppliers to provide
Performance and Labour and Material Payment Bonds.

Labour and Material Payment Bonds are usually issued in conjunction with Performance Bonds
and for the same amount. The standard form of L & M Payment Bond guarantees that the
Construction Contractor will pay his direct subcontractors and suppliers for labour and materials
employed in the Construction Contract as it is these parties who are potential claimants under the
Bond, not the Project Company.

Construction Bonds are preferable to cash deposits or Letters of Credit issued by banks or other
financial agencies to guarantee the obligations of the Construction Contractor because they do
not tie up the Construction Contractor’s working capital or bank line of credit. Project
Companies normally hold the bid security until the contract is awarded and the performance

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security is provided. If a cash deposit is used as performance security, it may be held by the
Project Company during both the construction and maintenance period. This can add
substantially to the Construction Contractor’s financing costs and make him less competitive
than those using construction Bonds.

In North America, bonding is a highly specialized facet of the insurance industry. Only about 20
insurance companies in Canada write a significant volume of constructions bonds. These
companies carry on most of their business through insurance brokers with departments that
specialize in bonding. Contractors who may require bonding should establish an account with
such a broker at the time they commence business to ensure that bonds can be obtained when
they are needed as security on P3 projects.

It is important for the Project Company to realize that it is possible to prejudice its right under a
construction Bond in a claim against the Construction Contractor. Such bonds cannot be
cancelled by the Construction Contractor or by the bonding company. They can only be
cancelled by the Project Company or at law. This is a major advantage to Project Companies on
P3 projects. Bonding companies may be relieved of their obligations by the provisions of
common law if the Construction Contract has been materially changed without their knowledge.
Project Companies must obtain the consent of the Bonding company when materially increasing
or decreasing the contract price, knowingly paying the Construction Contractor for work not
performed or otherwise providing him with financial assistance in anticipation of recovering
such amount from the Bonding company, making material changes in the location or nature of
the contract work, making material changes in the completion time, making material changes
with regard to payment such as variations in the holdback which might present a major deviation
from the intent of the original contract. In summary, the Bonding company must be notified by
the Project Company and must consent to any change other than minor changes that are usual to
Construction Contracts.

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