Toll road sector in Brazil: Regulation by contract and recent innovations

Abstract

The existing stock of road infrastructure in Brazil is still suboptimal and presents a bottleneck for economic growth. Concessions are being used to leverage the development and delivery of road infrastructure, although the first concessions have experienced some difficulties. Based on past lessons, Brazil has revised the regulatory framework and concessions models, by acting at three main critical success factors: creating a clear and transparent regulatory framework, improving procurement rules to ensure a more effective search for the “right” partner (and filtering opportunistic investors), and, finally, establishing a more effective risk-sharing strategy, providing the right incentives to mitigate delays and contractual breach, while increasing the bankability and overall project’s quality. This paper provides an overview of these changes and provides valuable lessons for academics and practitioners involved in concession design and management, particularly, in the road sector.

Keywords

Concessions road sector Brazil

Introduction

Brazil has a long history of highway PPPs regulated by contract. In the ‘90s, Brazil set up the first round of highways concessions, both at national and subnational levels (Garcia-Escribano et al., 2015). Currently, Brazil has more than 22,000 km of toll-based (user pay principle) highways managed by the private sector under contractual agreements (Alves et al., 2021). The private managed network is critical to Brazil’s logistic system, carrying about two-thirds of all domestic truck cargo. Moreover, most of Brazil’s population lives close to a toll road concession.

On the one hand, it is widely accepted that bringing the private sector through toll road PPPs has allowed significant investments that would not be possible solely relying on the public sector (Neto et al., 2019). Users’ surveys also indicate that private managed highways are perceived to have a better infrastructure and quality of service than publicly administered road stretches, and some literature has provided evidence of lower fatalities on PPP managed roads (e.g., Alves et al., 2021). ABCR (2018) shows that 74.5% of PPPs are considered to have great/good quality of service in comparison with 26.6% of public roads. CNT (2017) states that among the 20 best roads in Brazil, 19 are private managed and only one is on the public sector’s hands. In case of São Paulo state, since 1998, its 7200 km of privately managed roads have helped reduce accidents by 12%, traffic-related deaths by 18%, and injuries by 21%. One of the most important impacts of road concessions is the reduction of accidents and fatalities. Albalate and Bel-Piñana (2019) found a positive correlation between PPP and better road safety outcomes using the Spanish road system as a case study.

On the other hand, toll road PPPs have shown some pitfalls (see more, for example, in Cruz & Sarmento, 2021; Neto et al., 2019). A combination of a lack of proper supervision from regulatory agencies and poorly designed tenders and contracts have led to investment delays and inexecutions, a number of financial rebalancing requests from concessionaires, and more recently to early terminations and projects being handed back to the government (Xiong et al., 2017).

As the first highway PPP contracts awarded in the ‘90s are due to expire, this represented a unique opportunity to rethink the Brazilian toll road regulatory model, drawing on the lessons of the last 30 years. Also, private sector participation in infrastructure has never been more important given the poor fiscal conditions of federal and subnational governments. In parallel, the timing allowed Brazil to explore the advantages recently made possible by digitalization, technology development and asset management practices, steps which support both better operations and infrastructure.

In sum, the challenge facing the country was to set the stage for the next decades of highway concessions in Brazil. This article describes the most important features of a new regulatory model for the road sector that emerged in São Paulo and then at federal level from the International Finance Corporation (IFC) recommendations. This can provide valuable lessons and insights for both academics and practitioners interested in infrastructure development and, particularly, road infrastructure.

To address this research challenge, the methodology used was a case study analysis focusing on the Brazilian toll road market, adopting a top-bottom approach. This means that the paper will provide some international and political context, after a theoretical underpinning on road concessions design and development. Next the authors present the specific reform on concessions award, from contract features and contract design to award rules and mechanisms.

The results of the Brazilian experience, so far, seem positive, but our research claims that it is necessary to ensure stability in the regulatory models, and it will be necessary to have a longer period of analysis for an in-depth final diagnosis.

This paper is structured as follows. The section Literature Review on Toll Road Concessions describes the literature review on toll road concessions worldwide. The section New Regulatory Framework in Brazil—at State (São Paulo) and Federal Levels: Rationale and Main Objectives describes the main rationale behind the new regulatory model. The section New Bidding Rules: From a Lowest Tariff Model to Upfront Concession Fee Auctions details the new bidding rules, focusing on the auction models developed for São Paulo and the Federal Government. The section Contractual Rules describes the main contractual changes, focusing on tariff adjustment mechanisms, the role of periodical and extraordinary reviews, the so-called bankability package (improved risk allocation and early termination provisions), and finally provisions related to financial rebalancing of the contract. The section Conclusion encompasses the conclusion and conjectures what would be the way forward in contractual regulation in the road sector in the next decades.

Literature review on toll road concessions

The provision of road infrastructure is critical for unlocking economic development as extensively discussed by many authors (e.g., Graham, 2007). The road network provides the backbone for economic activity and, as such, is often a priority for Governments, particularly, when the low level of road density and/or capacity, presents a bottleneck for economic growth and social development (Robinson & Thagesen, 2018). Although some authors have recently been skeptical on the overload of road infrastructure in some European countries (e.g., Crescenzi & Rodríguez-Pose, 2012; Rodriguez-Pose et al. (2018)), there is a relative scientific consensus that in countries with low levels of infrastructure endowment, the investment in infrastructure and, particularly, road networks, provides significant impact and spill-over effects. The argument for such theory is that the ability to access to new markets, new jobs and new pools of know-how and expertise, can increase the productivity, with positive impacts on economic growth. Additionally, there is abundant evidence on the short-term impact of road construction on job creation and reduction of unemployment, with a more significant impact on the lower-income groups (see more in Ianchovichina et al., 2013; Garz & Perova, 2021).

Historically, several examples can be found of the role of road systems in the economic and social development, spanning from the first road network of the Roman Empire (300 BC) to the US Federal Aid Highway Act 1956. Over the last 30–40 years, regional economics has several contributions studying the relationship between economic development and infrastructure stock (Krugman, 1979; 1995; Garcia-Milà & McGuire, 1992; Aschauer, 1988). This has pushed governments to accelerate infrastructure spending. In the context of the Covid-19 economic recovery, several governments are rolling out infrastructure plans such as the US $1.2 trillion Bipartisan Infrastructure Framework or the € 30 billion Connecting Europe Facility (CEF) program in Europe.

However, road infrastructure is highly capital intensive and entail an important caveat—availability of capital—often not compatible with public budgetary restrictions. In the context of searching for private capital to overcome the financing gap, concessions emerge as solution. Usually, this means a higher cost of capital, as argued by Ball et al., (2007), Fernandes, Oliveira Cruz, and Moura (2019), or Cruz and Sarmento (2018). There have been a number of studies on the financing of road projects, most of which questioning and analyzing the difference in the cost of public versus private financing (e.g., Debande, 2002; Blanc-Brude & Strange, 2007; Odeck & Bråthen, 2002). There are a number of factors that influence the cost of financing related with the country and market risk, project robustness, etc. (Cruz & Sarmento, 2020), but most studies show that, as expected, there is a higher cost of private financing, compared with public funding. This is not a problem per se, but needs to be accounted for when analyzing the value for money of concession option (Bain, 2010; Blanc-Brude et al., 2009). Shaoul et al. (2006) compared the real cost of private financing with the public finance option in eight UK shadow toll road concessions and found a private cost of 11% compared with 4.5% of the public finance option. Blanc-Brude et al. (2006) also found that PPP are, on average, 24% more expensive.

This does not mean that the use of concessions is necessarily more expensive. If provided with the proper incentives, the private sector can achieve higher value for money (Ball et al., 2007). Some authors have argued on the lower probability of cost overruns in concession-based projects. Chasey et al. (2012) analyzed the North American highway construction and found that PPP cost overruns averaged 0.81% and schedule overruns averaged 20.30%, compared with 12.71% cost overruns and 4.34% schedule overruns for publicly financed projects. The same applies to OPEX, where the private sector can achieve higher efficiency levels on maintenance and operation, as long as the right incentives are provided.

Achieving value for money, and delivering high quality infrastructure/service under reasonably priced projects, requires a number of critical success factors that ensure the effectiveness of the process. Osei-Kyei and Chan (2015) review over 20 years of studies on PPP critical success factors, and have highlighted, as the most commonly referred, the following: risk allocation and sharing, strong private consortium, political support, community/public support and transparent procurement. Additionally, for the specific case of Brazil, some authors mentioned the need of a clear, transparent and stable regulatory and legal framework (Neto et al., 2020). Carefully addressing these critical success factors is a fundamental requisite for achieving long-lasting partnerships, able to deliver value for money, and ensuring that both parties (public and private sectors) are able to fulfill their objectives.

Over the next sections, we will discuss the Brazilian experience considering three main critical success factors: regulatory framework (Section 3), procurement process (Section 4), and risk-sharing (Section 5). These factors were selected based on the authors experience and know-how of the Brazilian case study. For each, a detailed discussion will be provided identifying the main challenges and what has been the public policy orientation toward improving the delivery of road concession projects.

New Regulatory Framework in Brazil—at state (São Paulo) and federal levels: Rationale and main objectives

There is a consensus that private participation improved the quality of service in Brazilian roads in the last two decades through investments in capacity expansion and better operation, especially in São Paulo state. However, there were a number of recent cases of poor contract design and awarding rules at federal level that led to severe criticism by society as a whole toward the PPP toll road model. In fact, the last round of federal concessions, called third round, from 2011 to 2014, was characterized by significant tariff discounts at bidding stage that led to bankability issues followed by investment delays and multiple contractual defaults, ultimately resulting in several concessions being handed back to the government and early terminations. Table 1 shows that in 2019 only 18.4% of programed investments were completed on average in six concessions tendered from 2011 to 2013.

Table 1.

Programmed versus completed projects.

Concession	Programmed (km)	Completed (km)	Percentage (%)
Concebra	647.8	79	12.2%
CRO	453.3	116.7	25.7%
MSVIA	804.5	149.6	18.6%
VIA 040	702	69.5	9.9%
MGO	218.5	176	80.5%
ECO101	418.1	5.3	1.3%

On the demand side, the market that was once dominated by big construction companies and their operational arms (representing a significant barrier of entry for new entrants) was dismantled by the “car wash” corruption scandal that found many bribing cases between these groups and public officials at national and subnational levels, resulting in many going to jail and significant fines being applied to the construction companies, including impediments to contract with governments until everything was resolved by justice. The lack of national private players to close the gap on infrastructure deficit was then compounded by a financial crisis that hit the country in 2014 followed by the impeachment of President Dilma Rousseff in 2016.

In the midst of the institutional and macroeconomic crisis, São Paulo (SP) state government saw an opportunity to change the game in the road sector and rethink expiring concessions, which had seen little improvement in transaction structure for almost three decades. The International Finance Corporation (IFC), member of the World Bank Group, was then mandated by SP government to propose a new PPP model encompassing the following objectives:

• Create a new paradigm to attract players to the country’s infrastructure market, offering credibility, reduced regulatory risks and attractive returns, through improvements in the bankability of projects in national and international markets and eliminating barriers to international and different profiles of players;

• To attract the best operators of road concessions and create markets, bringing private equity funds and institutional investors through a competitive, transparent, and international competitive bidding process, taking into account international standards; and

• Improve quality of service and safety by introducing innovative features in road management to benefit users, including new ITS capabilities and services, creating better and safer road traffic.

Despite the economic crisis and uncertain investment environment, the new concession model attracted top international investors and financing through capital markets, including the first-ever standalone participation of a private equity fund in the country’s road sector. In this challenging context, the state tendered four road PPPs between 2017 and 2020, securing $6 billion in private investment. Among the successful transactions, we highlight the longest road concession in the country’s history—the 1273-km Piracicaba-Panorama (PIPA) highway concession that connects eight regions across SP state. The winning consortium was composed by GIC (the Singapore Sovereign Fund) and Patria Investments.

The success in São Paulo state led IFC to be mandated by the Brazilian Federal Government to structure more than 6000 km of road stretches in Brazil’s North, Mid-west, South, and Southeast regions, serving as the central nervous system of the country’s transport network. The deals include, for instance, the re-tendering of the most important concessions in Brazil (such as Dutra highway, the main connection between Rio de Janeiro and São Paulo—the most important cities in the country) and CRT and Concer, the two most important road connections between Rio and Minas Gerais states. Currently, there are eight projects being structured, totaling more than $16 billion in expected investments. BR-153, a strategic export corridor connecting the North and Mid-west of Brazil was successfully tendered last April to a Consortium comprised by Ecorodovias part of Gavio Group, one of the biggest infrastructure conglomerates in Italy, and GLP, a leading global investment manager and business builder in logistics, real estate, infrastructure, finance and related technologies. Dutra concession, the most important toll road in Brazil, was also successfully tendered in October to CCR, a major Brazilian operator in the transport sector.

In the next sections, we describe in detail the main characteristics of the new toll road regulatory model, both at tender and contractual dimensions that was developed jointly between the IFCand the governments of São Paulo and then later by the federal government of Brazil.¹

New bidding rules: From a lowest tariff model to upfront concession fee auctions

The procurement stage has traditionally attracted growing attention. The body of knowledge provides contributions in distinct topics, ranging from the comparison of cost estimates before the awarding and after (Blanc-Brude & Strange, 2006), analysis of contractual options for service delivery (Edkins & Smyth, 2006), analysis of procurement costs (Soliño & Santos, 2010), and some focused on the specific cases of auctions (Nombela & Rus, 2001; Ubbels & Verhoef, 2008).

The procurement process in Brazil has some particularities. The most common tender model is described as follows: first, bidders deliver three envelopes: (i) bid bond; (ii) price proposal; and (iii) qualification documents. Second, the procurement committee analyzes and approves the bid bonds. Third, the committee opens the price proposals (sealed bid phase) and in case there are at least two proposals within a 10 to 15% range, there is an open outcry auction phase. Finally, the commission opens the qualification documents of the winning bidder (legal, financial and technical). If the winning bidder fails to comply with the requirements of the RfP, the tender commission will analyze the documents of the next best bidder (and so on), as per the proposal classification order. This process is called “phase inversion” and has been the usual practice to prevent litigation. Indeed, the idea is to only assess the bid bond and pre-qualification documents of the winning bid to avoid long administrative disputes among bidders during the tender.

Historically and especially at federal level, toll roads were auctioned through a lowest tariff criterion. It is widely accepted that this model led to opportunistic and aggressive bidding that culminated in investment delays and inexecutions, structural defaults, and finally early terminations and projects being handed back to the government. In order to avoid the disincentives cited above, two models emerged: At state level (São Paulo), toll roads have been tendered through a pure upfront concession fee that must be paid before commercial closing, and at federal level, projects have been going to market through a so called hybrid auction that mixes the lowest tariff and upfront fee criteria.

At federal level, despite the fact that there is a history of poor contractual performance, there is a consensus among public officials, including the National Audit Court which is responsible for approving bidding documents before RfP, that users should capture some of the benefits coming from the competitive procedure in the form of lower tariffs. In this sense, given that a pure upfront fee model would not be accepted by the Government, it was proposed a hybrid auction that starts with the lowest tariff criterion down to a floor, followed by the highest upfront concession fee. The tariff floor (which is generally in a range of 15 to 17%), is calculated so that the resultant return at the floor would be financially sustainable and in line with the sector’s cost of capital. In other words, even at the maximum tariff discount, the IRR would be higher than or equal to the sector’s costs of capital, considering the feasibility studies prepared by the government.

The current models (upfront concession fee or hybrid) have four main advantages. First, the project’s cash flow is protected at the tender stage and the auction model guarantees that the concession will remain bankable at the end of the competitive procedure. Second, the upfront concession fee component works as an additional barrier of entry (in addition to minimum equity requirements), assuring that bidders will have the necessary financial capabilities to perform the contract. Third, it may be argued that if the financial barrier of entry (equity plus fee) is correctly calibrated, it eliminates the need of additional technical qualifications or participation rules. In fact, regarding the former we can say that if a sponsor is putting significant financial resources at risk, it will find the technical skills needed to undertake the project. Regarding the latter, a consortium made of a number of small players would have to compete in price and then in capital cost against traditional Brazilian operators and large international infrastructure groups. If this consortium manages to compete with large players and pay upfront the equity requirements as well as the concession fee, it could perfectly undertake and perform the contract. Therefore, there would be no reason to establish additional participation rules. Fourth, the upfront concession fee is a clear example of an asset monetization mechanism. Resources generated from the auction could be reverted to investment in other projects in the infrastructure sector or even feed the project’s liquidity cushion (through a cash waterfall mechanism) that is used to deal with events that were not foreseen at project preparation stage (e.g., investments inclusions and compensations connected to the contract risk matrix).

Contractual rules

Tariff adjustment mechanism and incentives

One of the main problems related with concessions are renegotiations, that take place whenever there are unforeseen events, that require changes in the contract (in the risk matrix) and/or on the contracted payments (Athias & Nunez, 2009; Cruz & Sarmento, 2018). The best practices recommend that tariffs updating should be established under an automatic mechanism in the contract. Additionally, it should also include specific incentives to ensure quality levels, for example, the increase in tariffs can be negatively affected by the underperformance in some quality dimensions (e.g., availability and fatalities). The typical incentives in road projects are related primarily with availability, capacity increases (if applicable) and safety (Cruz & Marques, 2013).

First, note that the Concessionaire will only be entitled to tariffs that incorporate the evaluation of performance and compliance with interventions schedule. That is, the tariff adjustment calculation follows the classic PPP formula whereby availability of infrastructure and operational performance are evaluated. The formula, if correctly calibrated, incentivizes the concessionaire to bring forward or to complete investments as scheduled in the concession contract and also to operate as efficient as possible, in order to comply with the quality-of-service indicators.

Second, it is important to highlight that tariff discounts are caped (in the example above, cap is equal to 10%). The rationale behind the cap is that sponsors must be incentivized to perform by having their equity at risk but at the same time revenue should be sufficient to cover debt amortization and also operational expenditures. In fact, financiers have limited capacity to monitor the concession’s performance and it is clear that supply of services must be preserved to protect public service users. This provides a balanced solution that protects the different nature and interests of the members of the consortium.

Third, take notice that this system prevents adjustments to directly impact tariffs (i.e., users will always pay tariffs linked to RPI) to not cause fluctuations (up and down) that could affect toll prices and would not be easily understandable by users. This is a critical point because whenever user tariffs are affected, this shifts the social value of the project and raises equity concerns among different users.

Fourth, an important feature of this formula is that the surplus generated by the discounts on the concessionaire remuneration shall be automatically reverted to an escrow account mechanism that is called “liquidity pool.” These resources could be used to compensate the concessionaire by additional investments included in the contract or even as a compensation by a trigger connected to the project’s risk matrix, for example, within a renegotiation process. The liquidity pool will be explained in more detail later on in the article.

Frequent User Discount Mechanism

Brazil has more than 5000 municipalities and as toll road concessions are located in most populated areas, they are largely used by short distance travelers that have their daily activities in adjacent urban areas. As so far fixed toll plazas have not been differentiating tolls by the distance traveled, there ate innumerous legal claims against concessions to obtain toll exemptions, besides, from a mobility management perspective, creating an uneven situation. Given this situation, in order to emulate a tariff structure similar to the free flow model whereby drivers pay for traveled distance, avoiding technical obstacles such as fraud and evasion and reducing the inequality intrinsic in tariff policies, a Frequent Users Discount mechanism (FUD) was introduced in the new concession contracts. The discount is applied progressively, proportionally to the monthly frequency of the trip in the same plaza and direction. Also, the discount is only offered to users with light vehicles and using the electronic payment system (TAG). The model is such that accumulated payment in the month (up to 30 trips) should be similar to what would be paid in a “pay per km” system.

Investment Incentives

As known, performance contracts and in particular PPP contracts are characterized by having regulatory instruments that incentivize infrastructure availability and also quality of service and efficient operations. Despite the fact that the first waves of toll road contracts in Brazil allowed important investments in the last decades, these contracts lack specific regulatory tools to not only incentivize infrastructure delivery through ramp up revenue mechanisms but also to properly penalize the concessionaire in case of investment delays and even contract defaults and inexecutions.

Regarding the incentives for infrastructure delivery, the new concession contracts encompass two forms of ramp up mechanisms (or capacity-based revenue instruments) whereby additional revenue streams are linked to new infrastructure availability. The first instrument refers to a tariff structure characterized by the existence of a specific tariff for single lane and a higher tariff (usually 40%) for a double lane infrastructure. As soon as the duplication of a particular stretch is finalized, the concessionaire is authorized to increase toll prices, proportionally to the stretch extension. This regulatory tool is a powerful investment incentive mechanism, especially for projects characterized by CAPEX programs in which the concessionaire is responsible for duplicating long single lane road extensions. Also, note that under this tariff structure, road users do not pay in advance for future infrastructure. In this sense, users understand why they are paying more, given the additional infrastructure available. The second instrument refers to tariff increases that are connected to specific construction works and was developed for double lane highway projects since the first mechanism would not have any effect. This concept was applied to Serra das Araras capacity expansion in Dutra project (new infrastructure in a mountainous region) and to several urban ring roads in Parana Program that includes six new concessions totaling more than 3300 km of road stretches.

Also note from the tariff adjustment formula above that 4% of total annual revenue is connected to infrastructure delivery. Therefore, in case there is an investment delay, the concessionaire not only would not be able to charge a higher tariff (e.g., double lane) but also part of its revenue would be discounted up to 4%, disincentivizing delays.

Regarding quality of service and efficient operations, as explained in the formula above, up to 6% of total revenue is tight to a quality of service indicator that comprises a series of sub-indicators covering the quality of infrastructure (pavement, signalization, etc.) but also operation (mechanical vehicle support, medical and rescue services, etc.).

These mechanisms represent a powerful incentive tool as any contract default impacts the concessionaire’s rate of return.

Road Safety Incentives

One of the biggest issues in road transportation in Brazil is the lack of incentives for road safety improvements. This is indeed reflected in the number of fatal accidents in Brazilian roads in the last years. From 2007 to 2017, 83 thousand people died in Brazilian federal roads, whereas 25 thousand people died in São Paulo State roads from 2015 to 2019. In order to prevent unnecessary deaths and accidents, the new road concessions include the iRAP (International Road Assessment Program) methodology, which aims at roads designed to limit probability of accidents, as well as to minimize the severity of occurrences. The methodology has already been applied successfully in more than 80 countries, in more than one million kilometers of roads.

IRAP is meant to evaluate road conditions based on visual surveys over the whole concession segments and generate which countermeasures can be applied (considering several variables, such as cost × benefit, accident track record, and type of users). New Concession contracts include as mandatory investments the countermeasures identified by iRAP methodology (e.g., barriers, signaling, geometry measures, and pedestrian passageways) and in the case of SP contracts there is also a bonus in case the concessionaire exceeds the results (grades) that are established in the contract.

Therefore, the iRAP methodology has been applied in concession contracts through three pillars:

i. Evaluation of the current situation and proposal of mandatory investment plan contemplating countermeasures during the concession;

ii. Periodic evaluation of the road safety situation of the highway, in order to evaluate the effectiveness of the investment program, encouraging comparability among other roads internationally (star rating) and identifying opportunities for improvement; and

iii. Incentive to improve road safety of the concession through the concessionaire’s bonus for exceeding the goals proposed in the Concession Agreement.

This methodology provides a standardized approach to road safety evaluation, creating a level playing field for all road concessions, and, simultaneously, allows to by-pass the difficulty in having real-time audited data on road accidents.

Therefore, in order to incentivize the Concessionaire to exceed the road safety levels estimated to be achieved during the feasibility studies, the concession agreement establishes the possibility of a periodic premium (financial compensation), aligning incentives of all parties involved in the project. That is, the Concessionaire, at its own risk, may implement a road safety program, in accordance with the iRAP methodology. The Program will be related to a road safety indicator with targets for each type of user. In case the Concessionaire’s road safety performance exceeds the targets specified, it will be entitled to a financial compensation to be paid during ordinary revisions.

Review Procedures

As mentioned before, despite the fact that the concession model in the road sector was able to generate better quality of infrastructure and service in Brazil, there are a number of recent projects in which most of the programmed investments were delayed or even unexecuted. Neto et al. (2019, 2020) identified an overall low execution rate for the projects pipeline in most States. For the entire sample analyzed by the authors, the average conversion rate was 21%.

At the same time, there have been innumerous requests to include investments and financial rebalancing events from concessionaires that led to endless discussions between the parties (with the corresponding delays in the processes) and in significant tariff increases, difficult to explain to users and that erode the economic and social value of the projects. On the top of that, the analysis of financial rebalancing events and the way these requests are currently processed by the regulatory agency is not well organized, and depends on the maturity, experience, and know-how of the PPP units, which are very heterogenous in Brazil (see more in Neto et al., 2020). At the end, it is not easy for users to understand tariff reviews due to rebalancing events that happened many years before.

In order to mitigate the problems cited above, in the new contracts, the rebalancing methodology is divided into two categories, which are (i) periodic reviews (five or four-year cycles) and (ii) extraordinary reviews.

The periodic revisions are meant to organize a process that is unexceptional in contract administration in Brazil—claims from both parts. Therefore, instead of having a significant regulatory burden thorough the whole life of the concession, periodic revisions centralize potential claims in regulated and detailed processes, which happen every four or 5 years. This provides a more structural approach, and allows the regulatory agencies to fully prepare and allocate the proper resources, whenever these processes occur. Also, periodic revisions are a strong political instrument: municipalities, especially those in the countryside, which are traditionally very fragile, often request minor interventions related to the federal or state roads (e.g., frontage roads, pedestrian passageways, and small access roads)—hence, the periodic revisions are a way to evaluate and organize these claims in regular periods. Additionally, as said before, in previous contracts there could be requests to include new investments at any time. The periodic reviews came, in fact, to discipline and to limit the unilateral power of the State to include new investments.

The periodic review is a procedure that occurs at every 5-year cycle (at state level, there is a four-year cycle) with the purpose of assessing the demands for new investments and/or other imbalance events arising from risks stated in the risk matrix. Therefore, the periodic review is the correct vehicle for the regulatory agency to assess all the demands from society (from users, municipalities, etc.) between reviews.

If any imbalance events that significantly impact the Concessionaire’s solvency or even supply of road services, the Concession Agreement establishes a fast-track procedure to be analyzed in a short period of time by the Granting Authority to preserve the concession, thus without the need to wait for the periodic reviews.

The main purposes of dividing rebalance discussions are (i) create separate procedures considering the impact in the Concessionaire’s solvency and/or the continuity of the concession and (ii) establish predictable and detailed deadlines and procedures, which can be properly implemented by the regulatory agencies.

Also, in line with international practice (e.g., Chile), the new concession agreements have some provisions to limit the number and relevance of rebalancing requests during the contract execution. These rules aim to limit opportunistic behavior on both sides that may have incentives to include additional investments that were not priced in a competitive procedure. For instance, in São Paulo projects, in case a rebalance request results in a potential credit rating downgrade, the concessionaire has the right to refuse the request coming from the granting power. Also, the rebalancing requests analyzed at each revision process might not increase the contract’s length to more than 5 years (in case of federal projects there is a total cap of 5 years of contract extension due to financial rebalances). There is also a limit of 15% of the original CAPEX for investment inclusions, and in the last 4 years of the contract, new investments can only amount to up to 5% of the original CAPEX (at federal level, in the last 5 years of the concession, investment inclusions are not allowed). Moreover, in terms of rebalancing regulation, there are also several provisions regarding calculation (discount rates, project development, and CAPEX/OPEX budgeting) and process, which was something that was discussed with and asked by lenders and investors. Overall, this allows to decrease the uncertainty in how these processes will unveil, reducing the value at risk and increasing the attractiveness of the projects. In this sense, it is believed that current’s contract framework of programmatic periodic cycles combined with fast-track procedures for extraordinary reviews can reduce long-lasting discussions and bring more effective solutions considering the level of urgency.

Bankability package

One of the most important aspects of the new regulatory framework of concession contracts in the road sector in Brazil is what we call “bankability package,” a set of regulatory tools that aims to attract new players by enhancing the projects’ bankability in national and international markets and to increase the long-term reliability of the country’s road infrastructure. Bankability is critically related with the ability to attract well prepared players, and avoid predatory behavior by poorly committed partners, as discussed by Vining and Weimer (2016).

This bankability package includes (i) cash waterfall mechanism that segregates financial resources to mitigate risks, to compensate investment inclusions and financial rebalances in accordance with the contract’s risk matrix; (ii) risk mitigation mechanisms customized per project basis such as FX risk and revenue risk; (iii) Direct Agreement; and (iv) better rules for early termination.

Cash waterfall mechanism: Liquidity cushion

The core of the bankability package, and to some extent of the new regulatory model proposed for the road sector in Brazil at federal and subnational level, is the introduction of an escrow account mechanism that will retain financial resources to “solve the concession’s problems,” without creating any fiscal burden to the public sector. This liquidity cushion is created through resources coming from upfront concession fees at the tender stage and also variable concession fees (% of annual revenues) during the whole concession. These resources can be used to

• mitigate specific risks such as demand or FX risks;

• compensate the concessionaire to CAPEX inclusions that were not foreseen during project preparation; and

• compensate the concessionaire for financial rebalancing requests.

Customized risk allocation

Historically, concession contracts in Brazil were awarded with an underlying assumption that the private partner would have to assume almost all risks related to investment and service operation. Indeed, besides specific risks related to environment (e.g., indigenous locations or archaeological findings) all remaining risks such as demand, construction, land acquisition and resettlement, O&M, financing, interest rates, and FX risks were transferred to the private player in the first round of concessions. As mentioned by Carbonara et al. (2014), risks should be allocated to the party best capable or managing it, and there is no benefit in allocating risk that the private sector has no direct or indirect influence. Naturally, this inefficient risk allocation was one of the reasons that led to innumerous financial rebalancing requests and also at the end did not manage to attract international players to the Brazilian market. Due to that, one of the objectives of the new model was to establish a culture to allocate risks in a more customized way, in a project-by-project basis and also to observe international best practices. Below, we provide two examples of risk allocations to show the rationale of the new model.

Revenue Risk

The real-toll model is the most-risky from a demand perspective as the Project Company retains both price and volume risk associated with toll collection, unlike availability-payment schemes where the demand risk is eliminated (or strongly mitigated). These structures are most bankable when brownfield traffic is present for all (or a substantial part) of the road network to be operated by the private sector (with track record regarding public acceptance of toll rates or “willingness to pay”) because overall this decreases the uncertainty inherent to traffic volume in greenfield projects. For real-toll exposures, there is a clear preference from international players for brownfield traffic and track record of other successful in-country real-toll projects (including user willingness-to-pay, toll indexation, and toll collection procedures).

For greenfield projects on the revenue side, that is, projects that will have most of its future revenues based on new toll plazas, risk sharing instruments such as Minimum Revenue Guarantees (MRG) were introduced. These structures are present where the granting power agrees to “top-up” any shortfall in revenues—generally in exchange for sharing of upside if revenue performance is better-than-expected.

This is the case, for instance, of BR-153, a strategic federal road stretch that connects the North and Mid-west regions of Brazil. In this project, an MRG with a floor/cap of −10%/+10% of estimated revenues was included in the contract provisions as this concession will base its future cash flow on nine new toll plazas. The calculation of shortfalls or upsides is explicitly stated in the contract and an eventual compensation to the concessionaire will come from the liquidity pool described above. That is, the instrument does not have any fiscal cost to the government. The premium is estimated ex ante in the tariff prices through a variable concession fee that will be directed to the escrow account mechanism to mitigate demand risk.

FX protection mechanism

This mechanism was introduced in the new contracts per market requests, given the potential existence of credit restrictions and also the number of projects going to the market in the next years.

First of all, it is important to mention that the mechanism is optional to the concessionaire and can be implemented without any fiscal impact on the government or any change in the tariffs. The mechanism uses part of the project’s revenue (3% of annual gross revenue) to mitigate the FX risk, that is, the compensation is priced ex ante in the initial toll prices.

Second, the mechanism is very similar to a FX swap as it follows a market interest rate (inflation plus a spread calculated from recent FX Swap transactions). That is, the concessionaire supports any devaluation below a defined threshold and is compensated in case the devaluation is higher than the market rate defined in the contract.

Third, the mechanism is symmetrical and both parties can be compensated depending on the currency’s fluctuation. In case the concessionaire is entitled to a compensation, it will be automatically able to reach the amount in the escrow account (3% of annual gross revenues). If this amount is not enough to ensure the payment of the compensation, the concessionaire will be exempted to pay future variable concession fees until the compensation is fully paid. In the case of a currency appreciation, the variable fee, usually 3% of total annual revenue, increases up to 6% to compensate the government. Again, note then that the mechanism compensation is capped and priced ex ante. That is, the mechanism does not provide full FX risk protection.

The idea behind the FX protection mechanism in the new contracts is to provide an option for those who raise financing in FX, (i) not fiscally affecting the government (crucial for its implementation) and (ii) not affecting tariffs during the concession. Brazil has had experiences whereby the tariffs were indexed with FX linked inflation and it did not work—users did not accept having to pay more tariffs due to FX fluctuation and the contracts needed to be rebalanced and adjusted to Consumer Price Indexes.

Direct Agreement

The general purpose of the Direct Agreement in infrastructure projects is to protect the lenders against the loss of their investment if the project company defaults under one of the key contracts it has entered into (typically the concession agreement), and as a result, termination of that contract is threatened. In other words, it enables lenders to exercise control over a distressed project (by exercising the step in rights).

In the context of the Brazilian market, the introduction of the Direct Agreement in the new generation of toll road concession contracts intended to (i) mitigate the asymmetric information between regulatory agency/concessionaire and lenders; indeed, without the agreement, lenders are unable to closely monitor the concession’s performance and do not have precise information about penalties/fines that may be impacting the amount to be paid in case there is an early termination, which consequently may impact the final value due to lenders; and (ii) operationalize the step in rights that are allowed by the national concession law 8.987/1995. The Direct Agreement covers the following key points:

1) The Granting Authority (Regulatory Agency) notifies the lenders (or their agent) of any default by the project company under the concession agreement;

2) Upon such a default the regulatory agency is required to suspend any right it has to terminate the project agreement for a minimum period (suspension or standstill period);

3) During this suspension period the lenders would have the right either to cure the default in question or to take over the rights of the project company by “stepping in” to the project contract;

4) In the event of temporary administration, the creditors shall formulate a Restructuring Plan, to be approved by the Regulatory Agency, containing measures intended to regularize the contract execution in order to prepare the concession for a new sponsor. Also, during the restructuring period the application of default fines or any penalties by the regulatory agency due to poor performance may be suspended. At the end, in order to transfer the concession to other sponsor, the regulatory agency shall approve its technical, legal and financial capacity, following the RfP.

5) The lenders would then be given the right to step out at any time should they not want to continue with their involvement in the project contract; subject to performing all their obligations under the project contract during the step-in period. If the restructuring plan is not successful, the regulatory agency may decide for an early termination on the concessionaire’s default.

Early termination rules

Early termination risk represents one of a handful of crucial bankability provisions for transport concessions. Early termination of the Project Agreement without due compensation leaves the debt and equity providers without the means to recover their investment. Road assets offer little in terms of collateral security, so early termination provisions are particularly critical. In addition to a source for repayment, well-drafted early termination provisions can also provide a deterrent effect to granting authorities and are key in creating balanced discussions/negotiations throughout the life of the project.

In the new regulatory model developed at federal and state levels, as a general rule, in case of early termination of the concession agreement, the private party will be entitled to the compensation of amounts invested and not yet amortized (impairment analysis are also undertaken). That is, the payment framework is based on the unamortized value of the assets related to accounting book value of the project company. As in other civil law countries, in Brazil, there are legal restrictions to apply methodologies directly based on the outstanding debt. Market valuation methodologies could be used but market prices are not available and cash flow methodologies are full of subjective assumptions. As discussed by Liu et al. (2017), the asset book value provides a straightforward and simple alternative, easily auditable.²

In the event of early termination due to the concessionaire’s default, the compensation will be paid after the relevant assets of the concession are retaken by the granting authority, while, in the case of termination at the administration convenience, the compensation must be previous to the “expropriation” of the concession assets. Within this general framework, early termination can happen in the following categories:

Termination at the convenience of the granting authority

When the concessionaire is not in breach at all (mere expropriation), that is, the private party will be entitled to previous compensation for investments made and not amortized which must encompass: (i) costs in connection with termination of agreements with suppliers, granting fee and loss of profit (it somehow emulates, given the legal restrictions, a methodology of restoring outstanding debt + equity plus a compensation payment).

Termination due to breach of the concessionaire (bankruptcy of the concessionaire is considered a breach)

The private party will be entitled to compensation for investments made and not amortized, to be paid after the termination/resuming of assets. Applicable fines/penalties will be offset from compensation amount and the concessionaire is not entitled to loss of profits.

Termination claimed by the concessionaire, due to breach of the agreement by the Granting Authority

Same rules of termination under convenience of the granting authority are described above.

Amicable termination (“way out” alternatives provided for in the agreement)

(a) For retendering of existing concessions, if related to an event of failure by the Granting Authority to transfer the system of roads to the concessionaire, rules of termination under convenience of the Administration will apply.

(b) If related to an event of failure of the concessionaire to obtain long term financing: the private party will be entitled to compensation for investments made and not amortized, with no compensation for loss of profits.

(c) If related to an event of non-insurable force majeure, rules of termination under convenience of the Administration will apply.

The amicable termination is also allowed by the Law 13.448/07 that was initially created to resolve past projects in the Airport and Toll road sectors under stress and presenting structural contractual defaults. The rationale was to provide an easier way out in comparison to early termination by the concessionaire’s default that usually involves severe penalties to the concessionaire (as it should be) and long lasting discussions between the parties. As the law 13.448/07 could also be applied to future concession agreements, there has been some criticism as the new law could be increasing opportunistic behavior and adverse selection, as the new framework could be weakening the enforcement incentives of the early termination instrument.

It is also important to highlight that the concession contract clearly states the compensation formula for each of the modalities above, significantly mitigating the risk of long ending discussions between the parties. This raises the question on the trade-offs between increasing the used of ordinary review mechanisms versus a more discretionary regulatory approach. The first strategy places a greater emphasis on the contract, and therefore, it is more critical to have quasi-complete contracts, increasing the transaction costs. But on the other hand, it increases the risks associated with the discretionary approaches that, although might provide a better control over unforeseen events, they also tend to expose the project to higher risks of regulatory-capture. The higher the risk, the less mature the overall institutional, legal, and regulatory environment.

Conclusion

Brazil is an extraordinary case study considering it is one of the largest economies in the world but still lacking a matching infrastructure that facilitates economic trade, the movement of people, and ultimately, directly contributing to economic and social growth. The magnitude and scale of the necessary investments in infrastructure in general, and roads in particular, makes it inevitable to leverage the road development under concession agreements. The worldwide experience with concessions is two-folded. On the one hand, there is plenty of evidence on the ability to deliver infrastructure at a fast pace, but on the other hand, poor contracts can lead to significant public burden, high tariffs, and generating public and political discontent.

Based on previous experience, the SP and Federal governments were able to adapt and innovate by creating a new framework that is already providing successful results, by acting at three main critical success factors: creating a clear and transparent regulatory framework, improving procurement rules to ensure a more effective search for the “right” partner (and filtering opportunistic investors) and, finally, establishing a more effective risk-sharing strategy, providing the right incentives to mitigate delays and contractual breach, while increasing the bankability. Overall, there is a clear potential to increase the attractiveness of the projects, involving more committed and well-prepared partners, accelerating infrastructure delivery.

However, the international experience shows that there are still some risks. First, it is necessary to ensure stability in the regulatory models, and that can only be accessed in the long term. There is plenty of evidence worldwide of changing rules due to political reasons. Second, the role of regulatory agencies and PPP Units is fundamental, and there is a clear need to increase the know-how and resources of such governmental bodies, frequently ill prepared and understaffed. These are important factors to account for by public decision-makers. In terms of main recommendations, the authors believe it is important to create and maintain a close monitoring of the implementation of these contracts, not just from the perspective of the public procurement process, but, most importantly, from an execution perspective. This will allow to ensure whether the expected results in terms of improved road safety are achieved. This is an important recommendation not just for Brazilian authorities but for any government considering green or brownfield projects in the road sector.

Brazil will remain as one of the most interesting case studies on concessions and PPPs and certainly that this new wave of concessions will provide a fertile ground for future evaluation and research.

Footnotes

Declaration of conflicting interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author(s) disclosed receipt of the following financial support for the research, authorship, and/or publication of this article: Carlos Oliveira Cruz is grateful for the Foundation for Science and Technology's support through funding UIDB/04625/2020 from the research unit CERIS.

ORCID iD

Carlos Oliveira Cruz

Notes

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