Why Emerging Market Governments May Prefer Put & Call Option Agreements Over Sovereign Guarantees

Clients often ask us why an emerging market government tendering a PPP may prefer to use a put & call option agreement (a “PCOA”) to provide sovereign credit support for an offtaker’s or contracting authority’s obligations instead of a sovereign guarantee.  This note examines five of the most commonly cited reasons that a government may prefer to offer a PCOA instead of a guarantee.

Background

For projects that are structured using a government-pays model (as opposed to a user-pays model),  the power purchase agreement, concession agreement or other project contract between the offtaker or contracting authority and the project company is usually the only source of revenues for the project company.  Most offtakers in emerging market counties lack an investment grade credit rating.  As a result, their financial obligations to the project must be supported by some form of credit enhancement in order for the project to attract long-term debt financing on reasonable terms.  The credit support offered should cover both ordinary ongoing payment obligations (such as capacity charges, energy charges, availability payments, and other fees), and extraordinary payment obligations (including termination payments).

Commonly used credit enhancements include:

• sovereign guarantees;
• PCOAs;
• liquidity enhancements such as letters of credits or escrow accounts; and
• third party credit support such as partial risk guarantees and political risk insurance.

A sovereign guarantee is a guarantee issued by the sovereign (the state or, in a federal system of government, the federal government, which we will refer to as the “host government”).  A sovereign guarantee typically guarantees to the project company the payment of each obligation of the offtaker under the power purchase agreement, concession agreement, or other project contract.  The guaranteed obligations include both ordinary ongoing payment obligations and extraordinary payment obligations.

In its simplest form, a PCOA is an agreement between a host government and the project company that creates a put option in favor of the project company and a call option in favor of the host government.  In the event that the power purchase agreement, concession agreement, or other project contract is terminated prior to the natural expiration of its term, then:

• the project company may – depending on why the contract was terminated – have the ability to exercise the put option, in which case the host government will be required to purchase the project from the project company at a price determined using a previously agreed mechanism; and
• the host government may – again depending on why the contract was terminated – have the ability to exercise the call option, in which case the project company will be required to sell the project to the host government at a price determined using the same previously agreed mechanism or a variation thereof.

Note that a PCOA is not a guarantee.  It instead creates direct contractual obligations between the host government and the project company.  Note also that a PCOA does not provide any credit support for ordinary ongoing payment obligations.  It only provides credit support for termination payments, which are re-cast as the purchase price or the exercise price in the context of a PCOA.

More complex PCOAs contemplate a transfer of assets or a transfer of all of the share capital issued by the project company, at the election of the host government.  By exercising an election to purchase the shares issued by a project company instead of the assets of the project company, a host government may be able to better preserve the value of a project, particularly if the other project agreements have been structured to ensure that an exercise of the put option or call option does not result in an event of default under those contracts.

Why would a host government prefer a PCOA over a sovereign guarantee?

Although we have heard many reasons as to why a government may prefer to use a PCOA instead of a guarantee, the reasons given are generally some version of the following five reasons.

• In several countries, local counsel has advised that a sovereign guarantee must be approved by the parliament or assembly in order for the guarantee to be duly authorized, valid, and binding.  For various reasons, the same requirements do not always apply to a PCOA.
• In some countries, issuing a sovereign guarantee is not politically palatable to the host government.
• Some governments have drawn a distinction between being comfortable guaranteeing all payments under a PPP contract (including ordinary ongoing payments and termination payments) and accepting a contingent liability that only applies to termination payments.
• Some governments have made binding commitments to the IMF that would be breached by a sovereign guarantee but not by a PCOA.
• Some governments have indicated a preference for a PCOA instead of a guarantee because of concerns as to whether a sovereign guarantee must be included as a liability on the national balance sheet.

Given the background laid out above, the first three of these explanations require no explanation.  A brief discussion of reasons 4 and 5 follows.

Commitments to the IMF

IMF lending programs usually involve policy conditions.  These are often contained in a letter of intent, which sometimes attach a memorandum of economic and financial policies.

During the diligence phase of structuring some projects, we have learned that the host government has made commitments to the IMF that would be breached by a sovereign guarantee, but would not be breached by a PCOA.  Determining whether a sovereign guarantee would breach a commitment to the IMF is very fact-specific.  The IMF publishes such commitments on its website.

Presentation on the national balance sheet

Some governments have indicated a preference for a PCOA instead of a guarantee because of concerns as to whether a sovereign guarantee must be included as a liability on the national balance sheet.  Although whether either a sovereign guarantee or a PCOA creates a liability that should be identified on a sovereign balance sheet is determined by local law and is a topic that should be discussed with the government’s statistics office or Ministry of Finance, it is worth examining two international frameworks that address this question – the IMF’s Government Finance Statistics Manual, 2014 (the “GFSM”) and The European System of National and Regional Accounts (“EAS 2010”)

Chapter 7 of the GFSM deals with the balance sheet.  It states clearly that “[c]ontingent assets and liabilities are not recognized as financial assets and liabilities,” and accordingly are not included in the balance sheet.  Instead, as described in Paragraph 4.47, the “details on the nature and composition” of contingent liabilities are recorded in a supplemental “Summary Statement of Explicit Contingent Liabilities and Net Implicit Obligations for Future Social Security Benefits.”  In addition, Paragraphs 7.234, et seq., deal with “memorandum items” (notes to a balance sheet).  These paragraphs and other parts of Chapter 7 indicate that significant contingent liabilities should be noted as memorandum items.  Paragraph 7.255 provides that information on significant one-off guarantees including potential payments resulting from PPP arrangements (such as a PCOA) should be “included as a memorandum item, at nominal value,” despite the likelihood that this approach may overstate the possible risk.

EAS 2010 sets the standards counties must follow when they report financial statistics to Eurostat.  It is binding on all members of the EU.  Chapter 7 of EAS 2010 arrives at the same answer as Chapter 7 of the GFSM for guarantees and other contingent liabilities generally.

With respect to PPPs specifically, EAS 2010 sets out a separate standard under which a country must determine whether the economic ownership of the assets and liabilities of a PPP lies with the country or the private partner.  This is in turn determined by whether the government or the private partner bears the majority of the project risks.  Section 20.284 provides that:

The risks and rewards are with the operator if the construction risk and either the demand or the availability risks have been effectively transferred. Majority financing, guarantees covering a majority of finance levied, or termination clauses providing for a majority re-imbursement of finance provider on termination events at the initiative of the operator lead to the absence of effective transfer of either of these risks.

Applying this standard is very factually specific in the case of both guarantees and PCOAs.  We have structured projects that are off-balance sheet for the government under this standard using PCOAs.  It is worth noting that whether a project is off-balance sheet for an offtaker or contracting authority involves a different set of considerations and that if off-balance sheet treatment is an important consideration, then it would be wise to involve accountants at an early stage during the structuring of the project.