New Russian Legislation on Public Private Partnerships in Public Utilities

New Russian Legislation on Public-Private Partnership in Public Utilities

The article is devoted to the recent amendments of the legislation of the Russian Federation on Public-Private Partnerships. It will analyze in detail how these amendments will affect the possibilities for the implementation of Public-Private Partnership projects in the public utilities industry. Special attention is paid to the interaction between concessions related legislation and industry-specific legislation related to public utilities. Finally open issues related to the implementation of Public-Private Partnership projects in public utilities industry shall be discussed.

KEY WORDS: public-private partnership, concession agreement, investment activity, public utilities, infrastructure, tariff regulation

  1. Appetite for Public-Private Partnership in Russia

The modernization of infrastructure including water, wastewater, waste management and other public utilities infrastructure is a complex issue to which the Public-Private Partnership structure (hereinafter referred to as the “PPP”) is a suitable response mechanism. The following facts support this:

  • The physical wear-out and technological obsolescence of public utilities infrastructure and the ensuing necessity for renewal;
  • The need for significant investments in infrastructure combined with a very limited budget to finance them, requiring the involvement of the private sector;
  • The need to stimulate competition in the public utilities sector in order to satisfy the value-for-money criterion;
  • The increasing demand for new technologies and international experience, especially to ensure environmental security and energy-efficiency of public utilities;
  • The fact that state support (in various forms) is a prerequisite to attract private investment in infrastructure.

Now that the need for private investment and a corresponding PPP mechanism is clear, an adequate legal basis must be established. This is a key condition to attract and involve private investment in the modernization of public utilities infrastructure in Russia through the use of a PPP structure.

 

  1. Existing legislation and PPP

At the moment Russia has positive experiences in implementing PPP projects in sectors like wastewater treatment and alternative energy use. Projects in the former sector include sewage treatment plants in South Butovo and Zelenograd (Moscow), the South-West sewage treatment plants in Saint-Petersburg, water treatment (South-West water treatment station in Moscow),  and waste management (waste disposal plant No. 3 in Moscow). The project in the latter sector concerned a Combined Heat and Power Plant that used biogas from the Kurjanovo sewage treatment plant in Moscow. These projects were all based on different PPP structures, such as BOOT (Build-Own-Operate-Transfer) and BOO (Build-Own-Operate) models. These PPP structures are all based on the general rules of Russian Law (Civil Code, Land Code, Federal Law dated February 25, 199 No. 39-FZ On investment activity in the Russian Federation performed as capital investments and Federal Law dated July 9, 1999 No. 160-FZ On foreign investment in the Russian Federation etc.).

No specific legislation on  PPP as a whole currently exists on a federal level in Russia. Certain regions and cities (Saint-Petersburg, Tomsk region, Nigniy Novgorod, Altay etc.) have adopted regional laws on Public-Private Partnership and have implemented PPP projects based on these laws[1]. However, some argue that such regional laws do not fully correspond to the federal legislation, for example, the public procurement and land legislation, and this may cause some blockages during the implementation of the project.

The only federal legal act devoted to PPP is the Federal Law No. 115-FZ dated July 21, 2005 “On concession agreements” (hereinafter referred to as the “Law on Concessions”), which introduced the only PPP model of concession so far. The concession model is based on the obligation of a private investor (or a Concessionaire) to invest in an infrastructure facility, and the obligation of a state (the Russian Federation, a Region of Russia or a municipality) to act as a Grantor to create suitable conditions for the implementation of a concession project, like providing a land plot. According to Article 4 (1) of the Law on Concessions, the following facilities can be subject to a concession agreement: motorways, railways, pipelines, sea and river harbors, vessels, airdromes, power and heat energy facilities, public utilities facilities, public health facilities, education and culture facilities etc. The Law on Concessions was adopted to serve as a legal basis for the implementation of PPP projects on a Federal level. Currently no further federal legislation on PPP providing for different PPP models is under consideration[2].

Until now, not a single PPP project has been implemented in the public utilities industry based on the Law on Concessions. The reason is obvious; adopted as a universal legal act for PPP projects in various industries, the Law on Concessions contains only general regulations. It does not address problems and issues that are specific to the different industries it governs. As a result, before the first concession agreements on motorways were implemented (construction and operation on a paid-basis of a High-Speed Motorway Moscow – Saint-Petersburg, 15-58 km and construction of a new ling to Moscow Ring Road from a Federal Motorway M-1 Belarus Moscow-Minsk), a new Federal Law was adopted (No. 257-FZ dated November 8, 2007 “On motorways and road activity in the Russian Federation and on amendments to particular legislative acts of the Russian Federation,” hereinafter referred to as the “Law on Motorways”). The Law on Motorways included various provisions as a supplement to the Law on Concessions, and specifically regulated the use of concession agreements as a PPP model for the construction and operation of motorways (Articles 38-42 of the Law on Motorways).

No special law analogous to the Law on Motorways was adopted for the public utilities industry. As a result, the implementation of PPP projects in this sector is facing legal obstacles, in addition to other (economic) difficulties, such as attracting financing on a global capital market.

  1. Legal framework for the implementation of PPP in the public utilities sector

Russian Law on public utilities is very specific and based on the current situation in the industry, where state and municipal enterprises are major players. The legislation will be adopted with a view to attract private investment and use Public-Private Partnerships.

Firstly, legal regulation of the interaction between Law on Concessions and a key legal act in the public utilities sector – Federal Law dated December 30, 2004 No. 210-FZ “On fundamentals of regulation on tariffs for services of public utilities enterprises” (hereinafter referred to as the “Law on Tariffs”) is required. The majority of services in the public utilities sector that can be provided by the private sector (or a Concessionaire) are subject to regulation by state and municipal authorities according to the Law on Tariffs. Therefore clear guarantees for the profitability of the Concessionaire’s activity are required. However, no interaction between the Law on Concessions and the Law on Tariffs has legally been formalized. As a result, the profitability risks were high from an investor’s point of view, rendering investment in the project less attractive. Until recently for instance, the Law on Tariffs did not contain any guarantees that the tariffs would remain on a level that is acceptable for the investor (Concessionaire). Article 18 (4) of the Law on Tariffs stipulates that maximum tariff increases can be determined. taking into account the obligation to perform long-term investments of public utilities enterprises before the Law on Tariffs entered into force, and guaranteed by a region of Russia or a municipal authority. However, such a provision does not provide the required security for a Concessionaire. First of all, it does not impose an obligation to the governmental body; rather it leaves the tariff up to the authority’s discretion. Second of all, it does not cover concession agreements, as the Law on Concessions was adopted after the Law on Tariffs entered into force in 2005, and it has no retroactive effect.

However, positive aspects of effective legislation should also be mentioned. Among them is the possibility for the state to take partial financing obligations, covering part of the expenses of an investment project of a public utility enterprise (Article 11 [9(2) and 10] of the Law on Tariffs). This clearly includes concession projects.

Secondly, the Law on Concessions did not address the industry-specific issues of the public utilities sector, such as the increased importance of environmental protection. It also failed to consider that the majority of public utilities enterprises that operate the existing infrastructure and possess the land plots where this infrastructure is located, traditionally exist and act in a specific legal form of a state or municipal unitary enterprises (GUP or MUP). The role played by these enterprises in the public utilities industry is unique and shall be taken into account in the implementation of Public-Private Partnership projects in Russia.

  1. Recent Amendments to Russian Legislation and Their Effect on PPP in the public Utilities Sector

Based on a brief analysis of the existing legal regulation of PPP and industry-specific legislation on public utilities, special attention will be paid to the recent amendments to the Law on Concessions by the Federal Law dated July 2nd , 2010 No. 152-FZ “On amendments to the Federal Law on Concession Agreements.” Subsequently, a selection of legislative acts of the Russian Federation” (hereinafter referred to as the “New Law”)  and their role in the implementation of PPP projects in public utilities industry will be discussed.

 

  1. Financing of PPP Projects

Due to the magnitude of the necessary investments, PPP projects in public utilities need external (debt) financing. The attractiveness of a project for a financing bank is subject not only to general political and economic conditions, but also to legal factors, such as the existence of a security package required to ensure a certain return on investment. The Law on Concessions contained certain limitations on the establishment of a security package. These limitations had a detrimental effect on the attractiveness of concession projects to the private sector. The limitations include a prohibition on:

  • Pledge of the concession agreement’s object (Article 3(6));
  • Pledge of rights under the concession agreement (Article 5(2));
  • Assignment of rights and transfer of obligations under the concession agreement prior to construction completion (Article 5 (2)).

Furthermore, the Law on Concessions in its initial version did not stipulate the possibility to conclude a direct agreement between project financing banks and the Grantor. This option is traditional in the international practice of PPP. Such direct agreements usually give financing banks the right to replace the Concessionaire, if this is necessary for further project implementation and the Grantor’s corresponding obligation to avoid termination of the concession agreement. Other rights and guarantees usually provided to banks include the right to receive direct payments from the Grantor in case of termination of a concession agreement, which avoids any negative consequences to the solvency of the Concessionaire.

The numerous obstacles associated with this security package make it difficult to attract external financing, which consequently hinders the effective implementation of PPP projects.

The New Law enables to use Concessionaire’s rights  as a security measure to ensure the performance of its obligations towards financing banks (Article 1 (3b) of the New Law). Obviously, this allows for the  Concessionaire’s rights to be pledged for the benefit of the banks that finance the PPP project in the public utilities industry. However, an effective implementation of this mechanism requires a contractual regulation of the application procedure and conditions, as the New Law contains no details on that matter. Furthermore, special attention must be paid to the fact that the Concessionaire’s rights of possession and use of immovable property, being subject to a concession agreement, became subject to state registration. This is an encumbrance to the ownership right of the Grantor to that immovable property. As a result to become a valid object of pledge, Concessionaire’s rights shall be registered by competent state authorities.

Consequently, a possibility to pledge the rights of the Concessionaire under the concession agreement stipulated by the New Law will provide financing banks with substantial guarantees. This makes it easier to attract external financing, once a secure mechanism for the due execution and enforcement of this mechanism is created.

Another important amendment to the Law on Concession must be mentioned in relation to the previous one Under the New Law, once the Concessionaire’s rights are pledged as a security for a benefit of a financing bank, a direct agreement shall be concluded between the Grantor, the Concessionaire and the bank. This direct agreement shall “define the rights and obligations of its parties (including responsibility in case of non-performance of obligations by the Concessionaire towards banks),” under Article 1 (3b) of the New Law. Furthermore, the direct agreement shall provide a procedure for a tender, conducted to find a replacement for the Concessionaire.

The possibility to conclude a direct agreement and replace a Concessionaire is doubtlessly considered as a positive development. The previous version of the Law on Concessions had no similar provisions. However, the New Law stipulates a rather complicated mechanism for the Concessionaire’s replacement, using a separate tender procedure to select the new Concessionaire, to be conducted by the Grantor. Such a procedure does not fully correspond to the existing international PPP practice, which uses a step-in mechanism that enables financing banks to choose and appoint a new Concessionaire on their own. On a positive note, the intention of the Russian government to stimulate competition and use international standards of PPP is clear. However, a tender for the selection of a new concessionaire that is carried out by financing banks and not by the Grantor will attract more foreign investment in Russian PPP projects.

Furthermore, according to the New Law a direct agreement is concluded only with a single creditor. This provision clearly does not consider the fact that the majority of PPP projects require large amounts of investment, which cannot be provided by a single bank. This contradiction may be eliminated if one of the financing banks will act as an agent for all financing banks within the direct agreement with the Grantor. It surely will require financing banks to conclude a respective agency agreement or any other corresponding agreement, depending on the law the parties choose to apply to that agreement.

Although the New Law introduced a mandatory mechanism for the replacement of the Concessionaire’s, no excessive restrictions are placed on the content of direct agreements. As a result these can include provisions on both execution and enforcement of a pledge of Concessionaire’s rights under concession agreement and other provisions that are routine in international PPP practice and required for the implementation of PPP projects, as long as they do not contradict the Law on Concessions and Russian Law in general.

 

  1. Participation of Major Industry Players in PPP Projects

The New Law provides for the participation of state and municipal unitary enterprises (GUP and MUP) in PPP projects on the side of the Grantor. These enterprises may perform some Grantor’s functions in the project, based on provisions of the concession agreement that stipulate their rights and obligations (Article 1 [3a] of the New Law). This amendment reflects the role of state and municipal enterprises (GUP and MUP) in the Russian public utilities industry, the most powerful of which are the Moscow State Unitary Enterprise “Mosvodokanal”[3] and the State Unitary Enterprise “Vodokanal of Saint-Petersburg”[4]. From a practical perspective this renders the implementation of a PPP project more effective.

Once in possession of public utilities infrastructure, a GUP or a MUP may choose to transfer them to Concessionaires for reconstruction purposes. Furthermore, as lessees of the land plots on which the infrastructure is located, these enterprises may directly transfer their rights and obligations under land plot lease agreements to a Concessionaire. They may also sublease the land plots to a Concessionaire to construct public utilities infrastructure under concession agreements (Article 2 (1b) of the New Law). Furthermore, state and municipal unitary enterprises that have direct access to customers may act as a client for a Concessionaire, for instance, in relation to water treatment or sewage treatment services provided by a Concessionaire. However, due to their unique position in the sector, state and municipal enterprises may perform other functions within PPP projects. They could i.e. act as a partner of the Concessionaire in a joint-venture operating public utilities infrastructure. Consequently, state and municipal infrastructure shall participate in the drafting of the concession tender documentation, as well as in the drafting and the execution of a concession agreement.

The need for simplification and acceleration of the implementation process of PPP projects has become clear since the first attempts to structure concession projects. In this light several amendments have been drafted. Among these is the provision of the New Law (Article 1[1b]), which provides that the property possessed by state and municipal unitary enterprises may be transferred to Concessionaire directly from these enterprises. A preliminary transfer of that property to the state or municipality, as it was required by the initial version of the Law on Concessions, is no longer necessary.

 

  1. Termination of Concession Agreement

Originally, the Law on Concession created a complicated procedure for the termination of a concession agreement; only a court could terminate a concession agreement based on a claim of serious violation by one party, or in case circumstances severely changed (Article 15 (1)). Moreover, an obligatory remediation period was established. A party shall request the violating party in written to remove the violation within a reasonable period. Only after expiration of that reasonable period may a party bring the claim to the court (Article 15 [11]).

The recent version of the Law on Concessions includes a list of serious violations of concession agreement, which did not include a potential violation on the part of the Grantor. As a result, the Concessionaire’s ability to terminate a concession agreement was severely limited and a balance between the rights of the parties of the concession agreement could not be reached. To provide additional protection to Concessionaire, the New Law foresees three situations that could occur as a result of  the Grantor’s actions under concession agreement (Article 1 (8b) of the New Law):

  • delay in transfer of an object of the concession agreement to the Concessionaire;
  • transfer of an object of the concession agreement to the Concessionaire, which does not meet the conditions prescribed in the concession agreement;
  • Grantor’s failure to fulfill the obligations on financing of (re-)construction and/or operation of an object of concession agreement.

These situations are serious violations of the concession agreement and grant the Concessionaire the right to demand termination of the concession agreement through the procedure briefly described above. This novelty aims to create a more balanced relationship between the Grantor and the Concessionaire. Presumably this will be considered as a positive development by potential private participants of PPP projects in public utilities sector.

 

  1. Objects of Concession Agreements

According to the previous version of the Law on Concessions, only state or municipal property could become object of concession agreements. In practice this means that only that immovable property, state or municipal ownership rights registered by a state (under the Federal Law dated July 21, 1997 No. 122-FZ “On state registration of rights to immovable property and transactions with it”) could be the object of a concession agreement. Since no state or municipality ownership rights are registered in relation to the majority of public utilities objects, the implementation of PPP projects could presumably be postponed before ownership state registration. In practice this could take up to 6 months.

To mitigate that risk, the New Law made an amendment to Article 15 (3) of the Law on Concessions providing that a state registration of the Grantor’s ownership on the object of a concession agreement may be performed simultaneously with state registration of Concessionaire’s rights to it under that concession agreement.

Furthermore, under the New Law the object of a concession agreement can include not only immovable property (as it was in former version of the Law on Concessions), but also movable property that is “technically connected” to the immovable property and jointly intended for activity under the concession agreement (Article 3(1) of the new version of the Law on Concessions).

The amendments indicated in this paragraph clearly facilitate the use of PPP for the modernization of the public utilities sector in Russia by taking certain industry-specific aspects into account.

 

  1. Updating Tariff Regulation

Both the Law on Concessions and the Law on Tariffs have been amended to attract more private investment in concession projects in public utilities.

According to the New Law, a decision to conclude a concession agreement, tender documentation and concession agreement shall include “long-term parameters for the regulation of the Concessionaire’s activity” (hereinafter referred to as the “Parameters”) approved by state or municipal authorities regulating prices (tariffs) for the Concessionaire’s services (products) under the Law on Tariffs (Article 1(12) and (13b) of the New Law). However, the New Law did not include a list of such parameters, and shall be approved by the Government of the Russian Federation later (Article 3(3) of the New Law).

Under Article 3(3) of the New Law, which will enter into force on January 1st 2012, the Parameters shall be considered when approving tariffs for goods and services of the Concessionaire. Due to the uncertainty of this provision, the definition of the project risks will take the circumstances of non-compliance of approved tariffs with Parameters into consideration. Article 1(11b) of the New Law foresees that if approved tariffs do not comply with the Parameters indicated in the concession agreement, this agreement shall be amended upon request of the Concessionaire. In fact, the legislation establishes no obligation of the Grantor to compensate the Concessionaire for the difference between the factually approved tariff and the tariff calculated based on the Parameters fixed in the concession agreement. Such an obligation could have satisfied the Concessionaire and the financing banks. However, the New Law only provides for a possibility to amend a concession agreement in this situation. No regulation on how it will be amended and on what procedure shall be used for that amendment is defined by the New Law. Obviously, such a situation can have a negative impact on the attractiveness of a project in terms of financing and security. All remaining uncertainties shall be regulated by the concession agreement itself. In the opinion of the author, the following proposals may be used to amend the concession agreement (i) a limitation of the Concessionaire’s investment obligations that resulted into a decrease in the reimbursement of the Concessionaire’s investment expenses through tariffs and/or (ii) prolongation of a concession agreement and operation period that resulted into an increase of Concessionaire’s income.

 

Furthermore, a concession agreement shall include a reimbursement procedure for the Concessionaire’s expenses and not return through the operation period before the expiry of the concession agreement (in accordance with Article 1 (5b) of the New Law, adding clause 11 to the Article 10 of the Law on Concessions). The New Law provides a guarantee of investment reimbursement. However, there are severe limitations to this guarantee: (i) only those expenses that can be reimbursed under the Law on Tariffs will be reimbursed, and (ii) the reimbursement takes place only after the concession agreement expires.

To understand which expenses are reimbursable it is necessary to analyze the Law on Tariffs, the Law on Concessions and the amendments introduced by the New Law. Under the Article 10 (11) of the Law on Concessions, the Concessionaire must have an investment program containing the planned amount of investment and their source, approved under a special procedure and established by the Law on Tariffs for public utilities enterprises. Only the expenses that were made in accordance with the investment program can be subject to reimbursement under the new version of the Law on Concessions. As a result, the compensation of other expenses of the Concessionaire will depend mostly on the content of the executed concession agreement.

 

  1. Conclusion

The amendments to the legislation on PPP and the adoption of the New Law illustrate that concession projects are being integrated in the existing legal framework governing the public utilities sector in Russia. The necessary legal regulation for PPP projects in public utilities has been established and the way for PPP projects is now open.



[2] Public-Private Partnership in Russia. URL: http//www.ppp-russia.ru

[3] http://www.mosvodokanal.ru

[4] http://www.vodokanal.spb.ru/eng/