Moving Project Finance in Latin America Forward: Issues and Prospects
Latin American countries enjoy standards of living that are well above those in all but the Organisation for Economic Co-operation and Development (OECD) nations. Electrification is nearly universal, life expectancy for most countries has grown substantially and compares favourably with much of Asia, Africa, and even parts of Europe.
At the same time, Latin America’s economies have remained stubbornly dependent on commodities, much of the infrastructure is aging, and local financial resources seem insufficient to meet the growing demands for electricity, natural gas, roads, railways, water and other essential services.
The authors in this practice guide have looked at a wide range of countries and infrastructure issues, ranging from oil and gas in Mexico and Brazil to transportation in Peru and Colombia. A full array of the nuts and bolts concerns are addressed: law and regulation, financial transaction types, corruption and compliance, dispute resolution, and innovatory ways to identify and structure financing for infrastructure.
What ends must infrastructure investments serve?
Investments in infrastructure are generally seen by Latin American countries as involving their national aspirations. That is, the key issues and concerns go beyond simply connecting two points with a road, railway or pipeline. Rather, most countries are keen to see new infrastructure serve more than one essential national goal.
Meet growing energy and electricity demand
In Mexico and Argentina, development of the electricity grid must meet a demand that is doubling roughly every 15–16 years, compared with little net growth in the US and OECD Europe and Asia. Naturally, some parts of both countries are better served than other regions. An explicit aim of infrastructure policy is to even out some of the regional disparities. However, it is now generally understood that the state-owned utilities in these countries generally find themselves unable to mobilise the resources necessary to accomplish this expansion. Finally, this service growth must occur with an eye to rising standards of environmental stewardship.
A number of the chapters look at the key concerns for Latin American infrastructure planners, investors and regulators. It is generally agreed that major energy infrastructure projects must:
- meet growing demand;
- help to unify the country;
- mobilise foreign sources of debt and equity;
- maintain national sovereignty over mineral resources;
- provide greater levels of service reliability and quality; and
- do all of the above far more cleanly than in the past.
Examples abound in the newspapers. Underserved regions on the electricity network, such as Baja in Mexico, require greater attention than other, better-developed regions. At the same time, it is acknowledged that Mexico would have found itself unable to accomplish its electricity and gas service goals if it had continued to rely on the older legal and institutional framework. Accordingly, Mexico has substantially revamped its laws and regulations as they pertain to primary energy production, energy transmission and distribution, and the roles of the previously monopolistic state enterprises, Pemex, CFE and others.
Chapter 12, focusing on Mexico’s energy revolution, details the historic changes at each level of oil, gas and electricity. This legal revolution was driven by the changing circumstances of the country’s energy sector – falling oil production, growing imports of refined oil products, large and growing imports of natural gas, and electricity and gas networks that are unable to connect the entire country.
The key transition for Mexico is not legal, regulatory or even financial; it is psychological. When Mexico was a strong net exporter of energy, its primary considerations were all about the money – how to make the resources generate as much cash for the government as possible. As Mexico saw its self-sufficiency vanishing in oil and gas, becoming a net importer of refined oil products and natural gas, cash generation for the government needed to take a back seat to the technological and financial engineering of supply itself – how can the country meet its energy needs in the most cost-effective ways?
Chapters 8 and 11 show that this change in how a country looks at its energy needs, also occurring in Argentina, leads to a series of major legal changes in how various entities act in energy and electricity supply. For Mexico, this has meant a focus on cost-effective approaches to increasing energy output. Where the state-owned energy suppliers were found to lack resources sufficient to meet the challenge, the country has changed its laws to bring in other resources such as private investors in gas and power networks, operators and investors in oil refining, and, most significantly, risk investment by outside firms in upstream oil and gas.
Mexico understands that such an expansion of the role of private investors in its energy sector will call for far greater transparency and rule of law than may have been customary in the past, as well as vast changes in the power of the state-owned energy companies. Several of the chapters in this guide address these issues with discussion of Mexico’s resolve to create an improved investment culture, consisting of changes in the treatment of foreign investors, and specific measures in finance, governance and dispute resolution.
Chapter 11 focuses on the changing role of government and private investors and operators in the upstream oil and gas sector. As the price of crude has eroded the attractiveness of many of the upstream plays in Latin America, governments have responded with varying degrees of enthusiasm to these challenges. When oil prices were high, resources nationalism was coupled in many Latin American countries with a belief that the international oil companies (IOCs) had no alternative but to accept terms as offered. There was also a widespread belief that the China market would grow perpetually, relieving the producer countries from the need to offer IOCs attractive terms. This was, in effect, a shift from an equity model of development, prevalent in much of the rest of the world, where IOCs took most of the financial risk, to a debt-based model where the national oil companies (NOCs) took most of the risk.
Along with the resource nationalism came harsh fiscal terms, strict local content rules and differential treatment of national and international companies. Chapter 11 notes that the downturn in oil prices was driven in large measure by heavy investment by independents and then those same IOCs in one of the world’s most important remaining unexploited hydrocarbon resources, North American shale formations. With the world awash in natural gas and crude oil, and with the Organization of the Petroleum Exporting Countries in disarray, international firms were loath to take up the terms and conditions on offer in much of Latin America. This shifted the majority of the risk for existing field development back to the NOCs, who found themselves needing to borrow increasing sums for the privilege of competing against one another for the same markets.
The chapters show how Brazil and Argentina, in particular, have found the will to make substantial changes in their oil and gas sector governance. Local content requirements have been relaxed, regulations across different resource types – deep-water, on shore, unconventional – have been made to conform with the technological needs for exploiting such resources, and fiscal regimes have been improved, including the reintroduction of tax and royalty contracts. In Argentina, this has led to a pickup in activity in the country’s Vaca Muerte shale formation, one of the world’s largest, which promises to revolutionise the country’s roles in regional and world oil and gas markets. Finally, operator rules are starting to change, especially in Brazil, where the requirement that Petrobras take a 30 per cent stake and operatorship in all the sub-salt activity had placed an onerous financial burden on the company during a period of low oil prices.
Move people and goods more effectively
The discussion of Peru’s regulatory framework (Chapter 14) identifies the country’s vast investment needs for infrastructure. The evolving regulatory framework permits private companies to invest in public-private partnerships (PPPs), and new regulations permit private investors to propose projects not now included in government planning studies.
Perhaps the most important of Peru’s infrastructure projects is its section of the Inter-Oceanic Highway, running from Brazil’s Atlantic coast to Peru’s Pacific shores. The Highway is intended to facilitate trans-Pacific trade by Brazil and Peru, potentially opening up interior regions of each country to improved trade logistics. However, despite a generally favourable regulatory framework, acquiring land in Peru continues to prove more difficult than hoped. The framework is simply too slow and complex to work in the short time frame hoped for by the project’s sponsors. Peru’s experience is not unique, and where land cannot be acquired for infrastructure the results all too often are a combination of insufficient service plus expensive workarounds.
Other experiences with transport infrastructure appear more promising. Chapter 1 describes Brazil’s mixed experiences with PPPs. As the country’s economy moved from domination by the government and state-owned enterprises to a more mixed form in the 1990s and 2000s, Brazil found it necessary to enact a legal framework that would make private investor and operator participation possible in certain critical infrastructure – roads, ports, power generation, gas distribution.
Early in the process, Brazil found it necessary to distinguish between PPPs that could generate revenue sufficient to cover costs and those that could not. Not surprisingly, the more successful PPPs thus far have been those where a high revenue potential has coexisted with a straightforward physical investment. In toll roads, for example, Brazil has approved more than 11,000km thus far. For toll roads the requirements are generally relatively simple, both parties understand the nature of the investment and the revenue generation mechanism, and both are interested in promoting as much traffic as possible on the road.
The PPP-led rehabilitation and expansion of Rio de Janeiro’s Galeão Airport provides a similar example of the alignment of a well-understood revenue model with a physical facility possessing tremendous expansion and operational potential.
Other forms of infrastructure have proven more resistant to the PPP model. Chapters 1 and 13 discuss the reasons for this, which are many, and ascribes the unevenness of results to ‘(i) the high transaction costs; (ii) informational asymmetries; and (iii) misalignment of interests between the public and private parties’. This puts the onus on the government to devise mechanisms to reduce the incidence of these difficulties. Recent efforts in this vein have included the use of public funds to perform the technical and financial feasibility studies for proposed PPP facilities, promotion of sector-specific legal regimes for oil and gas, mining, use of public land, and radio and television, public mobility and sanitation, among others, to reduce the perceived risk on both the governmental and private investor or operation sides for entering into a transaction.
Events play a role as well, and the fall in commodity prices, coupled with Brazil’s economic downturn in 2013–2016, have reduced the potential participation by local capital markets in PPP transactions. This reduction in participation by local capital markets has put greater pressure on the country’s development bank, BNDES, to step up to a greater transactional role. Recent PPP bidding reforms, described in greater length in Chapters 1 and 13, were aimed at mobilising additional financing resources for renewable energy, urban transportation, and water and sanitation.
Mobilise additional private and public investment with less risk to national governments
Chapter 4 discusses the role of development banks and multilateral lending agencies (MLAs) in financing Latin America’s infrastructure. There are three major elements:
- the rise of new infrastructure financing banks, the BRICS’ New Development Bank, NDB, and the Asian Infrastructure Investment Bank, AIIB;
- changes in the traditional roles of the World Bank, International Finance Corperation (IFC) and the Inter-American Development Bank (IDB); and
- national changes in PPP laws and regulations that have made many countries better able to use these new funds in conjunction with private investments.
The outsized Chinese role in the BRICS and AIIB institutions is focused largely on infrastructure. Projects funded by these two banks resemble the earlier infrastructure financing roles of the MLAs in the 1960s–1980s. In particular, this has meant loans to governments or state-owned enterprises. The NDB is now in the process of expanding its subscriptions and operations beyond the BRICS countries to others in Latin America.
The MLAs traditionally serving the Latin American market, World Bank, International Finance Corporation, and IDB have moved to align their activities with the changing realities in the region. The World Bank has improved its operational framework for issuing partial risk guarantees. This risk-mitigating instrument has allowed Argentina to issue a 1GW tender for renewable energy technologies, tapping sources of financing in dollar, yen and euro markets that were unavailable to the country just a few years ago.
The IFC has initiated a National Distressed Asset Relief Program aimed at restoring its existing borrowers to health. Priority activities in this vein have included market support, capital funding, investor mobilisation and access to the IFC’s structuring expertise.
The IDB has moved aggressively into supporting various ‘clean development’ projects in energy, transport and water.
To access these IFC and World Bank instruments, several countries throughout Latin America have initiated serious reforms. Chapter 9 shows how Argentina overhauled its PPP laws, creating a major opportunity for the IFC to restructure some distressed companies. Several Central American countries have moved toward the PPP model to push reform in the electricity sector, especially with regard to renewable energy technology promotion. Mexico and Colombia have both modified their PPP rules to access additional IFC and capital market funds for roads. Mexico has also applied these reforms to electricity generation, especially hydro and other renewables.
One exception to this trend of increased receptivity to risk-sharing has been Ecuador. Chapter 2 shows how the country overhauled its PPP law in late 2015 to ensure that the PPP investors bear all the risks of a transaction. This allocation of risk is coupled with significant regulatory oversight and permitting requirements. There are some issues outstanding, including dispute resolution and the rights of investors with regard to Ecuadorian SOEs. The first eight months of the new PPP Law have seen four signed agreements with Chinese, Turkish and Middle Eastern investors.
Chapter 3 comes at this subject from a different perspective: how can local companies and banks change their ways of doing business to adapt to an evolving economic and political environment? The downturn in commodities after 2013–2014, along with the economic and political problems in Brazil, combined to create a situation that weakened such Brazilian stalwarts as Odebrecht, reducing their (and Brazil’s) ability to implement large new infrastructure projects.
Other collateral damage from the downturn included such major international players as Spanish companies Abengoa and Ferrovial, spreading to US, Mexican and Korean firms Sun Edison, Empresas ICA and Hanjin, respectively. The re-emerging markets of Argentina, Brazil, and Peru have had to devise more flexible transaction structures. Local banks have taken a larger role in a number of industries. However, the problem of risk concentration in regions, sectors and industries may limit some local financing options.
Some governments have started to divest assets held by state-owned enterprises (SOEs), with an assist from the IFC’s National Distressed Asset Relief Program. The chapter notes, once again, the emphasis on infrastructure and renewable energy in the re-emerging Latin American economies.
How is the legal and institutional environment evolving?
First, put out the fires
While the ‘car wash’ scandal at Brazil’s Petrobras has captured headlines, it also helps to point out the safeguards in place and those that might be needed in the future to limit the damage from such scandals when they occur. Chapter 10 points out the steps taken worldwide to place boundaries on the kinds of problems errant employees can cause through criminal or negligent behaviour.
The chapter points out that people are not angels, and that US and UK anti-corruption legislation plays a critical role in establishing procedures that serve as deterrents, and if that fails, a trail of evidence, to reduce corporate and individual misbehaviour. First, the Foreign Corrupt Practices Act (FCPA) of the US acts as a restraint on companies worldwide, but especially those listed on US exchanges or doing business in the US. Similarly, the UK’s Anti-Bribery Act deters and documents misbehaviour for firms doing business in the EU. Brexit may complicate the EU angle, as similar laws in Germany and France are not seen as having the breadth of the US and UK approaches to corruption.
Chapter 10 notes that Brazil’s anti-corruption law focuses on individuals while the US and UK Acts also make the company responsible for the errant actions of their employees. The authors contend that the employer must be held responsible to some degree for criminal acts by employees lest the company feign ‘shock and surprise’ when their employees are found to commit acts contrary to the country’s laws. While non-participation in corrupt contracting or purchasing schemes is often cited by firms as a challenge to their success abroad, the authors contend that more robust enforcement of these acts has also created opportunities for firms that are able to comply fully with the requirements of these laws.
The Sarbanes-Oxley legislation from the US, drafted in the wake of the Enron scandal, also acts as a deterrent to corporate and individual malfeasance. Companies must report payments, including questionable ones, and they must report risks to the company, including those from employee activities that may violate laws in Brazil or in some other jurisdiction.
Compliance as a deterrent to corporate misbehaviour
A web of laws, agreements, and practices has grown up around the efforts to fight corruption and foster corporate transparency worldwide. This is the subject of Chapter 8. As noted above, prosecutors worldwide now wield several big sticks over companies under their purview. Moreover, the MLAs and even the Organization of American States have evolved rules to combat bribery and to prescribe the details for reporting on transactions and payments.
For Brazil the key components of the legal edifice combating corruption are the FCPA of the US, the UK Anti-Bribery Act and Brazil’s Clean Companies Act. These three acts create an environment that requires senior management to commit to the following behaviours and actions:
- establish rules and procedures with regard to reporting and oversight;
- carry out risk assessments on suppliers and customers;
- nominate a responsible officer within the company’s corporate structure to oversee these efforts;
- train and certify employees and executives in avoidance of corrupt practices;
- establish internal controls consistent with Securities and Exchange Commssion or Committee of Sponsoring Organizations of the Treadway Commission standards so as to integrate financial controls into a company’s enterprise risk management system. Such controls serve to limit an individual employee’s latitude for misbehaviour;
- carry out due diligence on transactional partners, including suppliers and customers, and undertake regular audits of departments and transactions;
- file reports as required by law;
- establish investigative procedures in the event of suspicious behaviour; and
- monitor ongoing activities.
These actions, if undertaken in good faith, provide a powerful deterrent to corrupt practices and mitigate a company’s liabilities in the event not all its employees are angels.
And what if none of this works? The emerging arena of dispute resolution in Latin America
Chapters 5, 6 and 7 address dispute resolution. Chapter 6 starts with the basics: an enforceable agreement with arbitration clauses should improve the quality of the initial contract. The authors are not entirely certain on this point and cite some exceptions. The chapter enumerates the rationales for involving arbitration rather than a country’s court system or a third-country court system. Nevertheless, the differences in local legal systems, mostly between civil and common law, remain significant obstacles to local resolution of contractual disputes.
Chapter 5 opens with a discussion of the improved business and legal environments in Latin America as countries generally move from closed, protectionist systems to more open ones. The authors repeatedly stress the differential treatment of SOEs and private companies, foreign or domestic, and note that Latin America, while contributing a large number of disputes, is a seat for few arbitration fora.
Miami remains the arbitration capital for Latin America. Participants believe that the local law regime still matters, and international arbitration ‘needs to be protected against local legal quirks’, its neutrality is essential and arbitration agreements must be enforceable. These are not generally characteristic of potential Latin American arbitration seats.
State-owned or controlled entities represent another ongoing issue in arbitration. In addition to the ‘Bolivarian exception’ – no arbitration with regard to SOEs in Bolivia and Ecuador – arbitration cases involving local SOEs are problematic due to the heavily regulated contracts and ‘loaded dispute clauses’ in favour of the state entity. The authors conclude that sometimes the parties may be better off in court and see these problems as yet another reason to impose stricter legal limits on the freedom of action for some SOEs in Latin America.
Finally, the authors express the hope that an improving legal and investment climate in Latin America will lead to the region becoming more favoured as an arbitration seat. They see Peru and Colombia, and possibly Argentina, as the first Latin American countries to be so favoured.