By Vijaya Ramachandran, Alan Gelb, and Martin Buehler
Emerging markets face multiple challenges that discourage foreign investors, including: political and macroeconomic instability, corruption, poor security, small market size, and unreliable services. With regard to the latter, service performance guarantees (SPGs) can give investors greater confidence by providing compensation if utilities and other services are inadequate. SPGs may work particularly well in industrial estates and special economic zones (SEZs) where service performance can be measured, reported on, and quickly improved.
Service performance guarantees (SPGs) are contracts between an economic zone’s operator (including the government) and firms renting space in the zone (manufacturers, traders, and the providers of other goods and services). Issued by a bank or insurance company, an SPG provides compensation if the delivery of designated services such as electricity, water supply, and customs’ inspection is poor. Such pay-outs by local authorities or industrial zone operators can be made from a first-loss guarantee fund that is provided by an international finance institution (IFI) or development agency, which is supporting private sector growth.
Making SPGs operational
Implementing an SPG begins with understanding the biggest impediments to investment. While some of the problems listed above such as macroeconomic or political instability are too difficult to measure, others such as poor delivery of utilities can be covered by an SPG, using international norms for its standards.
Once the decision to offer SPGs has been made, firms within an economic zone are offered the opportunity to purchase a contract that provides protection against service lapses. To avoid a zone operator prioritizing certain firms, it is best to insure against zone-wide service delivery problems, rather than those experienced by individual firms. This also simplifies monitoring and reporting.
Compensation can be provided with two ceilings — one related to the level of protection purchased, and the other to the volume of investment, sales, or exports. This ensures that firms are not able to profit by betting on poor performance of the economic zone’s operator. It is also necessary that the fund for paying compensation is large enough to cover all firms. SPG compensation payments apply only to poor service delivery because it is not practical to provide contracts that cover business losses. For example, the absence of power for x hours or x days would result in a payment of y. If climate events are included (wind storms, floods, droughts), indexed triggers can be used. These are site-specific weather variables, including temperature, rainfall, snowfall, and severe storms that use data measured and reported by global meteorological agencies.
Monitoring takes place on a monthly basis as part of the performance agreement and is reviewed by a tripartite commission comprising government, investors, and the IFI or donor. If lapses in performance occur beyond specified levels, the firms insured with SPGs are automatically compensated. If firms are located in an industrial estate, payments could comprise rebates on rent and fees for services. Because extremely poor service delivery could result in payments greater than such rebates, a reserve fund is necessary with a total liability based on the length of the SPG (for example, 10 years). Financing for the reserve fund could come from the country’s development assistance funds that have been designated for improving private sector development.
Mitigating the risk of poor quality services will signal that the government is committed to making and sustaining improvements, which will help attract more FDI to emerging markets. Learn more in this recent EM Compass Note 62 Service Performance Guarantees for Public Utilities and Beyond — An Innovation with Potential to Attract Investors to Emerging Markets.
About the authors
Vijaya Ramachandran and Alan Gelb are Senior Fellows at the Center for Global Development, Washington, DC.
Martin Reto Buehler, Principal Insurance Officer, Insurance and Financial Guarantees, Financial Institutions Group, IFC.