The United States has a long history of private roads dating back to the 18th century, but the latest interest in privatization began about a decade ago with privately developed and financed roads in high population growth states. In addition to those greenfield projects, more recent developments have included privatization of three government-owned toll facilities through long-term concession agreements with corporate entities. They include Chicago's Skyway, the Indiana Toll Road, and the Pocahontas Parkway in Virginia.

The concession arrangements obligate a government-owned toll facility to give a private for-profit company the right to maintain the road and levy tolls that are subject to increase, usually annually, in return for a large up-front payment. Debt issued to finance roadways has spiked upward in recent years – a reflection of a large and growing need for transportation funding – and these concession agreements represent a new source of funding, driven by the burgeoning global demand for public transportation assets.

We expect that state and local governments will carefully review the economic and political benefits and risks of the various proposals by the private sector. While it is premature to predict which, if any, privatization models will be most widely adopted, Moody's expects the following benefits and risks are most likely to drive the privatization debate:

Benefits
• Concessions can provide substantial cash payments to governments that can help pay for other projects or governmental services
• Privatization can accelerate transportation projects
• Concessions transfer toll facility operating risk to the private sector
• Concessions can remove most political obstacles to raising tolls

Risks
• Annual toll increases for the life of a concession will be necessary to service the large amount of debt used in some transactions, and the viability of continuous annual toll increases has not been tested in the US
• A concession contract that is not properly crafted may result in poor asset maintenance and/or increased operating costs
• Non-compete clauses could create political pressure to change concession terms or undo the agreement
• Bankruptcy by the concessionaire could place operating burden on the government
• A default by the government on the terms of the concession could result in a termination payment

Cash and rating benefits

The primary benefit to a government is an infusion of cash, which can be an enhancement to a government's credit quality, if used prudently. The first major concession in the US was the Chicago Skyway, a 99-year concession sold by the City of Chicago to Cintra-Macquarie for $1.8 billion. Here the primary impetus for the concession was the allure of a large cash payment to the City of Chicago, which used the proceeds to retire debt associated with the initial Skyway financing, create reserves, and pay for non-transportation related projects and services. The effects of the cash infusion contributed to Moody's upgrade of Chicago's general obligation bond rating to Aa3 from A1 in February of 2006.

In the case of Indiana's 75-year concession to Cintra-Macquarie for $3.8 billion, the state earmarked a sizeable portion of the proceeds to fund transportation projects through fiscal 2015. Subsequent to this transaction, in August 2006, Moody's revised the rating outlook for Indiana to stable from negative (Aa1 issuer rating) due to the state's gradually improving economy and strong fiscal management that for fiscal 2006 led to Indiana's first balanced budget in eight years. The longer-term prospects for continued balanced budgets improved in part due to funding of the state's transportation capital plan and the moderation of the state's debt burden.

Accelerating projects

As is expected in Indiana, the upfront cash payments received by a government in exchange for a concession grant can help accelerate transportation projects that may be otherwise stalled because of a lack of funding. Privatization structures, in which the government pays a private company for the construction or operation of a road, can also move new projects more quickly to completion by allowing governments to leverage private capital, which in some cases may be more attractive than issuing debt. Examples of this type of privatization range from contracts to design and build a new roadway to the use of availability payments. Availability payments are attractive to governments that wish to prudently manage their debt burden. The Florida Department of Transportation is pursuing an availability payment scheme to finance the construction and operation of the Miami Port Tunnel project, currently estimated to cost $1.5 billion.

The Texas Department of Transportation (TxDOT) is an example of a government that is aggressively using privatization to accelerate road projects and introduce toll roads into its planned statewide, multimodal Trans-Texas Corridor. With tax-based funding no longer able to meet the state's massive infrastructure needs, private investment is seen as an efficient solution to accelerate road construction and provide for operations and maintenance. TxDOT has thus far awarded four comprehensive development agreements (CDAs) for road construction projects and is working on many others. Through these CDAs, Texas transfers much of the development, construction and operating risks of road projects to the private sector, while maintaining overall planning and oversight control.

Managing the transfer of risk

Proponents of privatization point to the efficiencies that private-sector operators bring to a toll road and the transfer of operating risk away from the government. Moody's views this risk transfer in a generally positive light. Governments granting a concession to build or operate a toll road can gain considerable benefit from being relieved of the operating, maintenance, and construction risk associated with roadways. Concessions typically include performance standards that must be met as a condition of retaining the concession. These performance standards create incentives for the private operator to maintain the road in a condition stipulated by the government. However, governments must actively and intelligently manage the concession contract to enforce performance standards, since they run the risk of being held politically accountable if a toll road is not maintained properly.

Removing political pressure

Concessions can remove many of the political obstacles to raising tolls. A failure to raise tolls because of political pressure can lead to pressure on a toll facility's financial margins, lower debt service coverage ratios, and elevated credit risks. Concession agreements give toll-raising authority to private operators, but the ability to raise tolls is typically restricted to negotiated parameters. The Indiana Toll Road agreement allows tolls to increase 70% by 2011, after which they are annually adjusted by GDP inflation or a 2% minimum. The Chicago Skyway tolls can also escalate significantly in the first five years, with escalations afterward similar to the Indiana concession. Although calculating annual increases at these rates leads to sharply increasing tolls, we expect that the actual toll rates will likely be limited by political and market forces.

Watching the leverage

While Moody's firmly believes that debt financing is essential to an efficient capital structure, the way in which debt capacity is used, and the contractual limitations on leverage are key factors in assessments of creditworthiness. The high degree of leverage and debt repayment terms required to obtain a winning bid on a concession may ultimately affect the government if the concessionaire is unable to make the debt service payments. The Chicago Skyway concession was sold for $1.8 billion, or about 40 times pre-sale annual revenue and has a 99-year term. The Indiana Toll Road, priced at $3.8 billion, is also roughly 40 times revenue and has a 75-year term. These deals used complex or non-conventional financing structures that relied on escalating debt service payments, back-ended principal repayment, interest rate derivatives and refinancing in order to support very large amounts of debt. These deals also relied on an aggressive view of toll revenue growth based on steady indexed toll increases.

The Skyway financing included the use of bullet maturities and interest rate derivatives that created a synthetic floating rate zero coupon debt instrument. The structure facilitated the issuance of floating rate securities, which enhanced the marketability of the senior debt and enabled the project sponsors to achieve a lower interest rate than would have been possible with a fixed rate financing. The structure also enabled both the deferral of principal amortization and the fixed-rate payments to the swap counterparties from the early years to the later years, when higher toll rate increases are forecasted to take effect. Financial Security Assurance, a bond insurer rated Aaa by Moody's, insured not only the senior secured debt, but also provided a forward commitment to guarantee certain refinancing debt in later years of the concession.

The Indiana Toll Road included an accreting interest rate swap for 100% of the debt, with escalating swap rates from 2006 to 2026, starting at 3%. This structure also enabled deferral of principal amortization to later years, when toll revenue is forecasted to be much higher. The risk to investors is that the toll road operator is dependent on achieving the higher levels of revenue growth in later years based on high assumed traffic demand and low elasticity as toll rates rise.

While not necessarily true for the Chicago and Indiana deals, in some cases, excessive or poorly structured debt could cause the concessionaire financial stress, increasing the need for a possible bailout or takeover by the government if the concessionaire declares bankruptcy or otherwise defaults on the concession contract. On the other hand, if Moody's believes that the use of non-conventional debt instruments is beneficial in terms of affording higher liquidity or lower refinancing risk in the context of a project's risk profile, these structures may serve to enhance the credit rating.

The rating outlook on Transurban Finance Company's (TFC) A3 credit rating recently changed to negative from stable, partially as a result of its acquisition, along with Depfa Bank, of a 99-year concession to operate the Pocahontas Parkway toll road. The Virginia Department of Transportation (VDOT) granted the concession for Pocahontas Parkway, a troubled start-up facility located in suburban Richmond. The Parkway failed to meet forecasted traffic and revenue levels and was in danger of payment default on subordinate lien bonds. Transurban paid the relatively modest amount of $603 million for the 8.8 mile Parkway, roughly equivalent to the outstanding revenue bond principal and interest and outstanding VDOT loans. The outlook change on TFC's credit rating was driven by the ongoing diversification of TFC into higher-risk assets such as the Pocahontas Parkway. It also reflects a pattern of using high levels of debt funding for new acquisitions and ongoing uncertainty surrounding TFC's credit profile, given its intention to grow in the US toll road market.

Defining operating standards is key

Operating standards, frequency of inspections, and methods of enforcement are key aspects of any roadway concession contract and could become a credit concern if not properly crafted. This is the mechanism through which the government monitors the health of a roadway and ensures the concessionaire is maintaining the asset properly. The risk to governments is that the concession is not crafted to provide adequate public safety, which could create political pressure at a later date to renegotiate the concession's terms. In most cases, we believe that the concessionaire has sufficient incentive to maintain the road to maximize revenues for disbursements to equity investors. However, as with any contract, there remains a risk of non-performance or under-performance.

Pressure on non-compete clauses

Similarly, the inclusion of a non-compete clause in a concession contract can be a potential credit concern. While the clause helps the concessionaire protect its investment, the restrictions it places on a government's ability to improve mobility can potentially create political pressure to stop a concession, as happened with SR 91. The California Department of Transportation (Caltrans) had granted a 35-year concession to the California Private Transportation Company (CPTC) to build and operate high-occupancy vehicle lanes (HOV) on SR 91, which links employment centres in Orange County with residential centres in Riverside County. The franchise included a non-compete clause that restricted the construction of roads within a 1.5-mile-wide corridor on either side of the toll lanes for the life of the agreement.

At first, drivers supported the new privately owned lanes, which opened in December of 1995 and were among the first US toll roads to implement variable or congestion pricing by time of day and day of week to maximize traffic flow and revenues. But later, opposition to the non-compete clause grew, especially after traffic congestion increased on the adjacent toll-free lanes. Caltrans wanted to connect the free lanes on SR 91 to publicly owned roads on the Eastern Transportation Corridor. Caltrans argued that the connecting lanes were needed for safety reasons, one of the provisions that overrode the franchise agreement's non-compete clause. Ultimately the dispute was settled with CPTC's sale of SR 91 for $207 million to the Orange County Transportation Authority (OCTA), which now operates the lanes as a standalone enterprise. Under government ownership by the OCTA, the SR-91 (rated A1) now has one of the most innovative congestion-pricing schemes and some of highest toll rates in the US.

The Indiana Toll Road has a non-compete clause and the long-term consequences of its inclusion remain to be seen. The clause prohibits any action by the government, the effect of which is principally borne by the concessionaire or private operator or which affects the fair market value of the toll road. Contravening the non-compete clause could result in a substantial payment from the government to the concessionaire or the termination of the concession and payment by the government of the fair market value of the concession at the time of the termination. The Chicago Skyway concession does not include a non-compete clause.

On the alert for bankruptcies

Market observers often cite the potential disruption from a bankruptcy by a concessionaire as a key concern. The outcome of a bankruptcy will depend on the terms of individual concessions and states' bankruptcy laws. In the case of debt-financed concessions, bondholders may have step-in rights to prevent a bankruptcy from happening. If a bankruptcy does occur, there is some possibility for the government to benefit if it can successfully terminate the concession and is allowed to lease the road again. In Moody's opinion, government needs to be prepared to assume control of the road during the life of the concession and have the necessary staffing and capital to ensure a smooth transition in the case of a contract termination.

Government default can stress ratings

A default by the government on the terms of the concession, on the other hand, could result in a substantial termination payment equal to the fair market value of the concession at the time of the termination. In the case of the Chicago and Indiana concessions, events of default by the government include a failure to abide by the terms of the concession, payments due from an encumbrance on the toll road created or incurred by the government, or an inability of the government to pay its debt or a filing for bankruptcy protection, a remote risk in Moody's opinion. Termination payments could necessitate a use of reserves, a bond sale, or both; and these actions could have a negative impact on a government's credit rating.

The US has only a few examples of long-term concession sales. As the market for toll road assets evolves, we expect that there will be a period of adjustment among governments as they learn how best to structure concessions and other operating agreements. Not all governments will decide that privatization is the best route. We expect that future concessions may include partial privatizations and more provisions for revenue sharing for the government. Our assessment of the credit risks and benefits of privatization will evolve as more deals are done and concessions mature. n

Maria Matesanz is a senior vice-president and infrastructure team leader and Joshua Schaff is an analyst at Moody's Investors Service. Email them at: maria.matesanz@moodys.com and joshua.schaff@moodys.com