Despite the fact that they are among the more risky types of PPP investment on offer, and that the performance of those deals that have so far been done has sometimes been questionable, there are no shortage of light rail projects in the pipeline. Any research into the number of such developments either under construction or under consideration across the US, Europe and Asia throws up a seemingly endless list of projects ? it is almost as if no major conurbation is complete without its own light rail proposal. And the vast majority of these schemes are looking for private money.

But despite the fact that most of these schemes are being considered due to a desperate need to ease traffic congestion and that they are for the most part seen as preferable by travellers to other alternatives, they can be relatively risky from an investor's perspective. That is because they usually incorporate volume risk and are thus highly reliant on traffic projections being accurate. And while such projections are put together along with the deal it is impossible to foresee what changes may take place to public transport provision some way into the future.

Europe has seen several high profile light rail systems financed in the private sector in cities such as Barcelona and Lisbon and there are a host of further projects underway across the region from Dublin to Jerusalem. One country that has embraced the concept of light rail systems with enthusiasm is the UK which has experienced spectacular problems in trying to finance its ?heavy? rail industry in the private sector. But the country is now awash with new tram schemes ? the most recent of which include two new routes in London ? one from Uxbridge to Shepherd's Bush and the Cross River tram scheme from King's Cross to Brixton. Both will be looking for private money and both will run several metres above the subject of the most controversial and criticised PPP scheme of them all ? the part-privatisation of London's Underground system.

The first tram projects to be undertaken in the UK in recent years were the Croydon Tramlink and Manchester Metro (phases one and two). These deals should have paved the way for the string of new schemes that have sprung up in their wake and established a blueprint for how such projects are financed. Not surprisingly ? things have not really gone according to plan. One of the first projects ? and one that was seen as a test case for trams in the UK ? was the Croydon Tramlink. This scheme reintroduced trams to London after a 50-year absence and was formally approved in 1994. The DBFO concession was awarded for 99 years to Tramtrack Croydon, a consortium comprising Bombardier Transportation, CentreWest, Sir Robert McAlpine, Amey Construction and RBS. The scheme was projected to cost around £200 million with Tramtrack Croydon raising £95 million from the private sector and the balance being put in by central government. Finance was arranged by RBS and was provided by a group of banks and 3i. Co-arrangers were Bayerische Landesbank and Dai Ichi Kangyo (now Mizuho Bank) and the loan was further sold down to DNIB and Berliner Bank. 3i provided a small tranche of mezzanine finance.

The tram scheme itself is 28km long, a large part of which runs over former British Rail tracks. The project was delayed in negotiation but construction got underway in 1997 and the line was officially opened in May 2000. At the time it was projected to carry 20 million passengers per year and save two million car journeys ? hence justification for the hefty 62.5% public subsidy for the scheme. Two years on, however, and the projections on which the tram line was financed have proved to be a little wide of the mark.

?Patronage is below what was expected,? reveals one industry expert. ?As a result revenue is well below what was expected.? This factor is crucial as this scheme, which along with Manchester Metro Phases One and Two did not incorporate any availability payments. The public subsidy took the form of a capital grant. But this is not the only problem. The scheme was opened in sections, which was the best way to do it from a technical point of view but may have caused confusion. Add to the mix the fact that a competing bus route ? charging lower fares ? has opened up alongside the tram route and the kind of problems inherent in forecasting traffic volumes become very apparent.

?Patronage is not what was forecast,? admits a banker involved in structuring the deal. ?It is fair to say that if the structure had incorporated availability payments then the loan would be performing better.? This is because technically the system works very well. ?The trams are performing very well and operating to specifications. There are just not enough bums on seats paying the right price,? reveals the banker. So what can the newer schemes learn from Croydon's experience? Is it possible to improve traffic forecasting to make it more reliable or do such deals have to be structured to take into account any factors impeding traffic growth that might be thrown at them?

Lessons from Croydon

Firstly, forecasting. ?You can't get away from the fact that traffic flows are very difficult to forecast,? says the banker involved in the Croydon deal. Two things are therefore of fundamental importance from the lenders point of view: does the deal include volume risk? And if it does how well are those risks understood? ?Understanding patronage risk is the main issue in light rail projects,? says Chris Brown, partner at law firm Masons in London. Masons has been involved in every light rail project in the UK to date. ?How many people are going to ride it and is there freedom in ticket pricing? This needs to be understood in order to establish a robust income stream.?

One of the main risks is that of competing modes of transport being introduced ? as was the case in Croydon. There is little that can be done to prevent this happening and it is therefore a risk that must be factored into the equation. ?The local authority's rights to introduce new transport routes cannot be fettered,? explains Brown at Masons. ?The contractual position must therefore take this risk into account.? Whether or not transportation is deregulated in a potential light rail location is thus a key issue. In Greater London transportation is regulated by Transport for London and thus a single authority controls new transport routes. Thus there may be some leeway for influencing whether routes are set up in competition with each other or for negotiating some form of compensation should a new route be established in competition with an existing scheme. It is understood that Tramlink Croydon may be in negotiations with Transport for London over some form of compensation payment. This situation is in contrast to other cities whether transportation may be completely deregulated. In this situation the risks associated with new bus routes may be higher.

Given that competing forms of transportation cannot be prevented, how can light rail schemes mitigate this risk? ?They simply have to be faster,? explains one financier advising a bid for one of the newer UK tram projects. ?This involves establishing how much of the scheme will be on-street or off-street (which is faster) and whether or not the tram will have green light priority,? she says. Achieving green light priority ? whereby the tram takes precedence over road vehicles at traffic lights ? is of paramount importance if the key objective of being faster than your competitors is to be met. But it can be hard to achieve both technically and politically.

Even if green light priority can be achieved and a large part of the system is off-street there will be volume risks associated with any light rail system that will be very hard to predict. That is what concerns lenders and what makes these types of PPP deals a tougher sell. ?PFI deals can be split into those that incorporate availability risk and those that incorporate volume risk,? explains the bid adviser. ?Those that incorporate volume risk rather than just performance risk will inevitably be towards the upper end of the risk spectrum.? Combine the fact that light rail projects can be risky, the economic record of some that have already been done and that there are a large number of projects needing cash and the inevitable question presents itself ? is the bank appetite there?

The answer to that question depends on how the deal is structured. ?Banks have become wary of revenue risk,? explains one banker. ?If projects are going to go down the farebox risk route then they are going to have to incorporate higher grants to offer a greater margin of safety [to the lender] in terms of cover ratios.? The fact that these projects need to reduce their levels of volume risk has not escaped the awarding authorities and there has been a marked shift away from 100% capital grants on light rail projects in the UK. As mentioned, the first deals took this form but by the time the Nottingham Express Transit deal received the go-ahead in 2000 sentiment had changed and the public subsidy for that deal (which amounted to a full 70% of its cost) was made in the form of availability payments. This was done because the amount of money that could be raised against the farebox on this particular scheme was predicted to be fairly low and availability payment was seen as better value for money. The concession was awarded to the Arrow Consortium (Bombardier, Carillion, Transdev and Nottingham City Transport) for 27 years. The deal was financed by ABN Amro, Dresdner Bank and BG Bank. It also attracted a £167 million 10 year government subsidy due to its impact in reducing environmental damage.

Since the beginning of 2001 the UK government has favoured a hybrid approach to these schemes ? as evidenced by the nature of the upcoming Leeds Supertram, £190 million South Hampshire Rapid Transit Phase One (for which three consortia are currently bidding: Smart (AMEC, Mitsubishi, Obayashi and Serco), Harbour Light Rail (Carillion, Nuttall, Alstom and Transdev) and South Hampshire Supertram (Stagecoach, Mowlem, Bougyes and Siemens))and £105 million Bristol (awarded to Citylink (Railtrack, First Group, Pell Frischmann, Norwest Holst and AEA Technology) projects.

Taking a hybrid structure

The first authority to adopt this hybrid approach was the Greater Manchester Passenger Transport Authority in commissioning the extension to its existing Manchester Metrolink tram system. Phase One of this scheme was operational in 1992 at a cost of £145 million (£69 million of which came from the private sector). Phase Two, which entailed a £110 million extension of the line to Eccles was 40% financed by the public sector. Both Phase One and Two were contracted to Serco and the scheme has been very successful, cutting car usage by five million journeys per year. The current project entails the extension of Phases One and Two by 38.5km to various destinations including the airport and will entail the successful bidder buying out the first two phases of the project. Thus the deal will involve not only finance for the scheme but acquisition finance as well. The awarding authority is expected to make a decision on preferred bidders in mid-July for the project that could run to £500 million in size. Bidders include Bombardier, First Group, Mowlem, Stagecoach, Bechtel, Amey and Serco itself. The public subsidy will be part capital grant and part availability payment ? the latter having been set at £5 million per year.

Another large project at the bidding stage is the Leeds Supertram, another £500 million project that will see a 28km system established serving the city centre and branching out to the north, east and south of the city. The concession also runs for 27 years (after a four year construction period) and 75% of funding will come from the public sector. This concession again adopts a hybrid approach to subsidy with a capital grant being offered along with availability payments of £10 million a year. Three consortia are bidding for the deal: the Airelink consortia (Arriva, Siemens and Project Investments), Momentis (First Group, Bombardier, Bougyues and Jarvis) and Leeds Tram Link (Amey, Bechtel, MTR Corp, Egis Semaly). Another consortium, Leeds Tramways (Stagecoach, John Mowlem, WS Atkins) pulled out in May 2002. Best and final offers are due by the end of 2002.

The hybrid approach has clearly been adopted to make the risks more palatable to the bank market. But will bank appetite be stretched given the number of deals in the works? The Dublin Metro project, which will see 70km of metro built in two stages (12km to 14km of which will be underground) is likely to run to Eu2.5 billion in size and is just one of many projects that will be looking for money. The deal is at pre-qualification stage and news of bidding consortia is expected by the end of the year. ?There has been a certain initial stamping of the ground by the banks [given the performance record of other projects] but they are still queuing up to lend to these deals,? says Chris Brown at Masons. ?The capital markets are coming into play more and there is a ready appetite for this type of risk.? Others are more cautious. ?There are a core number of project finance banks who have genuine experience of farebox and volume risk who are interested,? says the bid adviser. ?But there is genuine caution out there. Appetite has suffered from schemes not performing well economically.? She adds that as the banks involved in those deals have been ?fairly leaky? in letting the market know their shortcomings the perception has spread that all these deals do not perform well.

?These deals are more risky than standard PFI transactions and thus lenders may seek to offset those risks through the concession agreement,? explains Robert Lewin at Investec European Capital, which is advising the Momentis bid for the Leeds Supertram concession. He explains that one way to do this is for the risks to be shared between the public and private sector. This concept was used in the Barcelona Metro Light Rail system in Spain which established a new 11km route in the city. The local transport authority, ATM, awarded the 50 year concession and the public sector has taken a 20% stake in the Eu218 million project. Alstom, FCC Construccion and Societe Generale were awarded the concession in May 2000 and the system is due to be operational in 2003. Under the terms of the concession if patronage levels fall below an agreed level the government assumes 50% of the risk. Lewin does not expect to see this type of agreement featuring in UK deals anytime soon as it would require primary legislation.

Whether or not bank appetite will be sufficient to fund all of light rail projects that ask for it is anybody's guess. Presumably banks will lend ? but at what price? But despite all the risks associated with these schemes companies are still queuing up to undertake them so confidence remains high. Indeed, bidders for the three-times postponed Jerusalem light rail system were announced in early June this year. The system is expected to cost NIS1.7 billion and begin construction in 2003. Two bidding groups have emerged: Pasim (Africa-Israel Investments, Feuchtwanger Industries, AECON and German light rail operator Vestra) and City Pass (Alstom, Elco Industries, Ashtrom and Polar Investments).

A tougher environment in which to forecast patronage levels is hard to envisage.