While the latest wave of accession countries celebrated their EU entrance on 1 May, most would have been unaware of the events of the previous day, when the Commission released its green paper on 'public-private partnerships and community law on public contracts and concessions'. Yet if EU PPP legislation follows, in the form outlined in the green paper, the new member states' quest for economic and social parity with the rest of Europe could be made more difficult.

Now part of the EU, the 10 new member states - Poland, Czech Republic, Hungary, Slovenia, Slovakia, Estonia, Latvia, Lithuania, Malta and Cyprus - are entitled to significant cohesion and structural grant funds, some Eu24.5 billion in total. But the downside is twofold: one, this phase of grants runs until May 2006 and any amount that has not been successfully applied for will be decommitted and return to Brussels' coffers. And two, despite being significantly poorer, the countries are subject to the indiscriminate EU-wide eligibility criteria for EU grants - specifically cohesion and structural funds can only meet 75% to 85% of project costs. If all of the grants are used, the estimated co-financing requirement from accession country balance sheets will amount to about Eu5 billion.

That the remainder can be met from the public purse was not so much a problem for the previous round of accession countries, Ireland, Spain, Portugal and Greece, but these countries are poorer, and like the rest of the EU bound by the fiscal pact that stipulates states must not go beyond 3% of their GDP with their borrowing requirements.

Subject to these limits, the countries can co-finance from their own balance sheets, or alternatively, opt for PPP. Yet with free money on offer and budgetary restraint, there is a desire to find an alternative source of co-finance, a hybrid of EU grant funding and private money.

Hybrid funding - a perception gap?

It is almost a certainty that a PPP style concession for the 15-25% portion necessary to access the grants will not go through for this current grant window. "Although there is no explicit prohibition on using private co-finance, there is no obvious way to accommodate PPP concession structures in the application process used for EU grants - so in practice this has proved to be very difficult," says Andrew Briggs, partner at Lovells.

A recent PwC PPP report states that a perception gap persists between what the EU allows and what interested parties believe is permitted: "Considerable uncertainty has been expressed as to whether, or how, private financing can be used as a means of co-financing funds provided by the EU under its various grant schemes."

There have been a handful of projects that have combined PPP with grant funding, but there has never been a systematic use of hybrid funding as the previous round of accession countries, Ireland, Spain, Portugal and Greece, met their co-financing requirements from the public purse.

Despite the complexity of pulling together hybrid financing and the lengthier time to financial close on such deals, the report concludes that these could be facilitated through the establishment of a centralised European PPP knowledge base within the Commission, clarification of legislation, secondment and training to member states' governments.

These developments could be some way off, and with the 2006 decommitment date looming, the 10 newly accepted countries will probably pursue the grant route backed by public funds. In this respect they should benefit from the experience of their peers.

Ireland was the most successful at avoiding the consequences of the auto decommitment rule, taking 70% of earmarked grant, and Greece was the least successful, taking 45%. The rule holds that if the programme does not spend the money it receives within the allotted time, it must pay the unspent money back to the European Commission. Lessons learned from these divergent experiences include the need for realistic projects, timeframes, a coherent central plan and expeditious applications to the Commission.

Similar factors are crucial for the implementation of PPP projects. "The paradigm would be to have a central PPP unit positioned within the Ministry of Finance in charge of the purse strings for all other departmental spending and responsible for rolling out a PPP programme," says Andrew Briggs partner at Lovells.

The accession countries face a shortage of skilled people to drive procurement: it is these few people that in all likelihood will be both applying for EU grants and be responsible for pushing ahead with PPP. The situation is exacerbated by antiquated legislation that, for example, in Poland prevents hiring of experienced personnel on secondment because they cannot be paid more than a civil service wage.

In fact Poland - potentially by far the largest recipient of EU grants - faces a number of barriers to launching a fully-fledged PPP programme, despite signing its first PPP project, the Eu840 million A2 highway, at the end of 2000. Poland also faces the legal impediment that prohibits the state from paying a concession under a service contract. In the roads sector this could mean that a project stands on the unpredictability of the collection of tolls.

And in Poland there is a greater public antipathy toward PPP than in the past. Likewise in the Czech Republic, despite having a PPP unit in place, there is still a lot of discussion within government and, according to one source, "the Czech Ministry of Finance's mind is elsewhere."

Hungary for more?

One country that has shown willingness and is in the midst of some deal flow of sorts is Hungary. Hungary is currently finishing finance for the M5 motorway project and is about to award the concession for the M6 project to one of three consortia.

In a unique move for road project financing, the M5 mandated lead arrangers, BES, WestLB, CIB and, the EBRD, repurchased the Eu205 million ($245.9 million) refinancing from seven syndicate banks following the government's decision to change from tolls to availability payments on the M5 motorway.

The government's decision to axe the original toll structure was motivated by poor road usage and the environmental impact on the communities along the roads adjacent to the motorway, particularly the effect of heavy goods vehicles on minor routes. The toll charging structure was said to be one of the most expensive in Europe, resulting in a motorway used only by wealthy businessmen.

The sponsor is AKA - 41% state owned - and the remainder of the equity is shared equally between Strabag and Bouygues. The Eu205 million facility's pricing was shunted down from 120bp with the MFB guarantee to 40bp. And the 20-year tenor reduced for this interim measure to under a year.

Financial close for M5 phase 2 - a Eu750 million ($928.1 million) facility - is scheduled at the end of September. The Eu750 million will refinance the original Eu205 million facility and pay for an extension of the motorway. Mandated lead arrangers, WestLB, CIB, BES and EBRD will take an equal portion and MFB, the state-owned Hungarian Development Bank, will take a smaller, subordinated piece.

Meanwhile three consortia are awaiting the announcement of a preferred bidder for the Eu500-600 million 22-year concession on the M6, which will follow the same structure as M5. The tender is for the planning, construction and maintenance of the new motorway section connecting Erd (near Budapest) with Dunaujvaros (south of Budapest), as well as the financing of the project.

Of the three consortia, the Euroinvest consortium, comprising TriGranit, Strabag, Bouygues, OTP, ASF and Egis, is believed to be the red-hot favourite to win the concession.

Bitter experiences and knocked confidence

The M5 experience is illustrative of the difficulty of financing greenfield projects on the back of traffic predictions and the shift in emphasis away from toll-based concessions to availability-type payments.

"Forecast traffic on a number of projects in central Europe has proved to have been in excess of actual traffic," says Robin Earle, Senior Banker, Transport Team, European Bank of Reconstruction and Development (EBRD). "It has been shown that it's very difficult to predict usage and increase in usage for greenfield projects in high growth economies - and on a toll road, less than predicted traffic means that revenue streams are out of line with DSCRs [debt service coverage ratios] and the project is thrown onto its back-up arrangements - and if there are no such arrangements, then it can be in difficulty."

Earle cites two Hungarian projects, M5 and the M1-M15, as examples where traffic forecasters have been too optimistic. "What is crucial in these projects is the extent to which the time saved is perceived by potential users as value for the toll paid," adds Earle. " The M1-M15, Vienna to Budapest project was a disappointment. HGVs stuck to the national roads because time saving for using the motorway could easily be lost at the border crossing. Similarly, the time saved on M5 was not sufficient to justify the expense of the toll in the eyes of the HGV drivers who kept largely to toll-free national roads.

As GDP increases disposable income also increases and the perception of the value of time alters; typically this means that economic development reaches a threshold at which the traffic increases at a markedly greater rate than before. If the projection of the timing of this upturn in traffic growth is wrong, then a toll road project may never reach the point where it can service its debt obligations without a rescheduling. Now, countries with high growth potential are looking at the availability-type fee structures of Western Europe which affirm the aim of these projects - to improve transport links, but not necessarily encourage traffic."

Commercial banks will also be wary of the uncertain political climate when weighing their exposure to a particular country. The Czech Republic did itself few favours with the lending community at the end of 2003 when it withdrew from a PPP scheme for the D47 motorway at the eleventh hour. One banker who worked on the deal said: "it was an unmitigated disaster".

In fairness, when the Czech administration pulled the project just days before financial launch it could at worst be accused of right principles, woefully poor timing. It was to be the country's first privately financed shadow toll road, and particularly significant for not having any EIB involvement. Deutsche was advising, with Abbey National, BES, Commerzbank and West LB arranging the debt and the bond issue, split in two halves of Eu850 million.

The D47 project was a legacy from the previous administration that had not been competitively tendered, and thought to be a significant factor in the conspicuous absence of the EBRD and EIB. It is believed that price per kilometre was far out of line with comparable road projects and it was impossible to demonstrate value for money.

Despite these difficulties, commercial banks and foreign investors will be back looking for more, because of the scope for economic growth and ROI. Accession and the political and economic stability that this should bring will dampen banks' concerns and confer ancillary benefits that should facilitate deal flow.

"European Union membership will definitely assist projects in the region," says Karsten Landgraf at DVB bank. "Banks usually have defined credit limits per country outside the EU, but they're not restricted to specific limits inside the EU. Also there is a great potential for strong growth, and capital investment in the region." The need for large-scale motorways is greatest along the axis from mid Central Europe through East Europe to Asia - principally Poland, the Czech Republic, Slovakia and Hungary.

Mott McDonald is currently advising the Slovakian state as to the feasibility of an East-West highway using a PPP concession. That the state is paying for this advice out of its own money rather than EU aid is a sign of its seriousness and will be viewed by investors as a step in their direction.

Away from the central axis, the Baltic countries have no major road projects scheduled, on the grounds of affordability and population, and have kept to upgrading and maintaining their existing network. The largest infrastructure investment the Baltic region is likely to see in the short term is the brownfield extension of the Baltic ports.

Options for financing

The accession countries - learning from the Irish experience - will foremost look to access the EU grants before opting for PPP concessions, without the time or experience to go for hybrid funding.

Still, weighing heavily in these countries' favour is the divergent sources of funding available outside the plethora of EU grants and via the private sector through PPP, with or without ECA support, and the TENS programme. For example, the EIB recently provided a Eu200 million loan for the construction of two motorway sections on the southwest part of the Prague outer ring road as part of the Corridor IV of the Pan-European transport network connecting Germany, Prague, Bratislava and Vienna.

And whereas the EIB is the policy lending institution of the EU, the EBRD operates higher up the risk-return curve with the remit to help the transition from a centrally planned state to market economy. The EBRD is therefore able to assist in complex structures at the development stage despite the risk of failure, and provide subordinated and mezzanine debt to help the gearing on a project.

"There are three local conditions which we believe are critical to ensure efficient project delivery for outside investors," says Derek Potts, Managing Director of Laing Roads. "One, political will to deliver the projects; two, that the public sector procurement agency has access to experienced advisers; and three, that there is an appropriate client structure - namely, that the people we're dealing with have responsibility and sufficient authority to effectively manage the project during the procurement process."

Although the CEE countries are not competing for EU grants, applications need to be filed expeditiously to avoid reabsorption by Brussels. They are, however, competing with the rest of Europe for commercial lending on PPP projects, in the West with the French market and Germany venturing closer to fully-fledged PPP programmes. In addition, outside the EU, there is the Eu371 million Croatian Zagreb-Macelj road project, currently in syndication, and the two Romanian road PPP concessions in the pipeline, each around the Eu500 million mark: the Bucharest-Ploiristi and Pradel-Braslov highways.

Commission PPP uncertainty

The accession countries' task could be made even more difficult if the Commission pushes for legislation on PPP. Investors' feeling is the Commission does not particularly like PPP. The Commission has been persistently aggrieved by the failure of some member states to apply private procurement procedures in the spirit of community law - the chief culprit is Italy, with its anticompetitive promotore provisions - so there is currently no direct European legislation on PPP, save for directives on procurement and a Eurostat decision that highlights when a PPP project can be considered off balance sheet.

Interested parties are divided about the need for legislation, but with the clear majority hoping that the Commission leaves well alone. These parties are certain to be disappointed. History shows that when the Commission gets as far as issuing a green paper, legislation follows, and the green paper on PPPs and Community law on public contracts and concessions was issued 30 April.

In May 2002, the European Parliament invited the Commission to examine the possibility of adopting a draft directive aimed at introducing homogenous rules for PPP. And the Economic and Social Committee also considered that such a legislative initiative was called for. But the Green Paper has attracted some heated criticism.

Of the paper, one banker vents: "It will be a shambles if anything in this sees the light of day - it's the worst thing I've ever seen. They have got the wrong end of the stick on so many occasions; it was obviously written by someone who's never been within a thousand miles of a PPP project."

One example of where the paper detaches from pragmatism is in its dealing of step-in rights when a project is failing. The Commission is concerned that these step-in rights could infringe community law on public contracts due to the lack of competition - yet private parties are unlikely to be queuing to take on a failing project.

Although the hot topics are whether the EU will directly legislate on PPPs following this poorly received green paper, and the possibility of blending PPP concessions with EU grants, the relative mutual exclusivity of both procurement processes could throw up an interesting phenomenon: the number of PPPs in the new member states could fall, with potential private investment being displaced by grant funding. In such circumstances, questions could be levelled at the rationale of EU funding  that this money would be better spent on commercially unviable projects for the social good, or spread more thinly than is currently the practice, across more numerous hybrid projects.