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10 Combining PPP with EU Grants

Author(s):
Ana Corbacho, Katja Funke, and Gerd Schwartz
Published Date:
July 2008
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Author(s)
Hugh Goldsmith

Most of the infrastructure that needs to be built over the coming years in the 12 new member states of the European Union (EU) will be eligible for support from EU grant funding programs. At the same time, public-private partnership (PPP) is an increasingly prominent procurement route for public infrastructure projects. PPP potentially offers efficiency benefits. So how to combine PPP with EU grants becomes an important question.

The amounts at stake are huge. The investment needed to bridge the “infrastructure gap” in Europe, through both new construction and the modernization of existing assets, is guestimated by Deloitte (2006b) at several trillion euros. In the latest budgetary planning period (2007–13), the EU plans to spend €308 billion from structural funds in order to decrease disparities between the EU’s poorer and richer regions.

Most of the money will flow into the 12 new member states. Over 80 percent of EU funds will go to so-called convergence regions, whose per capita GDP is less than 75 percent of the EU average. The European Regional Development Fund (ERDF) can finance, among other things, infrastructure for research and innovation, telecommunications, environment, energy and transport, but it can also support financial instruments for regional and local development (risk capital funds, local development funds, and the like). The Cohesion Fund supports large projects in transport and environment in the 15 countries (EU12, plus Portugal, Greece and Spain on a transitional basis) whose gross national income per capita is less than 90 percent of the EU average. In addition, the Trans European Networks (TENs) EU regulation allows grant support, typically up to 20 percent of investment costs, for major transport infrastructure projects of European interest, which can include PPPs. Using these various funds efficiently and effectively is a massive challenge.

National authorities must decide how to use the funds, but there is a complex set of rules for defining expenditure eligible for grant support, establishing financial management systems, and timing of grant payments. But provided these rules are complied with, a capital investment project for, say, a new sewage treatment plant to comply with EU environmental standards, may receive up to 85 percent grant subsidy from the European Commission (EC).

Other EU Directives must be followed irrespective of whether the PPP involves EU grants. The procurement of public works or concession contracts must follow EU Procurement Directives1 or the principles established in the EU Treaty in the case of service concessions. The 2006 revision to the Public Procurement Directives specifies a procedure, the Competitive Dialogue, for awarding complex PPP projects. There are also State Aid rules to observe that can affect the level of subsidy permissible.

After describing the experience to date, this chapter suggests a framework for comparing the various models of combining grants and PPPs. It does not provide answers or a cookbook on “how to” in particular circumstances, since in practice this depends on many factors, including the sector, appropriate risk transfer, experience to date in the country, national legislative framework, public sector capacity, fiscal constraints on co-financing, and so forth. This chapter does, however, explain the new partnering initiatives that the EC, together with the European Investment Bank (EIB), is taking to develop practical solutions.

The proof of the PPP-pudding is in the eating or, in this case, in the successful delivery and operation of PPP projects, and the absorption of EU grants. For this we will have to wait several years to assess the outcomes.

PPP and public subsidies

PPPs are a way of procuring public infrastructure that focuses on future services to be provided (rather than simply building assets), on financial incentives to perform, and on appropriate risk sharing between public and private sectors. These goals are achieved through long-term, output-based, risk-sharing contracts that bundle design, construction, and finance with future operations and/or maintenance. A huge variety of such arrangements exists in Europe, from long-established French concessions and delegated management contracts to the UK’s Private Finance Initiative (PFI).

This spectrum of PPP approaches reflects different national attitudes to and legal frameworks for ownership and delivery of infrastructure and public utility services. The current fascination with PPPs, which started in the UK and is now rapidly spreading to the rest of Europe, can be seen as a drive to introduce greater efficiency in the delivery of major construction projects within the context of a broader public sector reform agenda. However, fiscal constraints to public sector indebtedness, such as those under the EU Stability and Growth Pact, have also played a part in forcing public authorities to seek off balance sheet ways of increasing infrastructure provision. Even so, Hemming and others (2006) demonstrate that PPPs are not without fiscal risks, depending on guarantees, risk transfer, and payment mechanisms.

There is nothing new in the idea of combining PPP with grants. Many EU countries use subsidies to keep PPP projects affordable to users or to the public authorities paying for them. In the UK, “PFI credits” are how central government provides revenue support to local authorities responsible for paying unitary charges. In France and Italy, many PPPs are bid on the “lowest value of subsidy” required during the construction stage to meet predetermined affordability constraints.

A few large, high-profile PPPs have received support from the Cohesion Fund, notably the Vasco da Gama Bridge in Portugal and the Athens Airport in Greece. In the absence of any firm data on PPP projects that had received EU grants, Johnson and Kramarik (2005) estimated that less than 5 percent of Cohesion Fund grants were given to PPP structures and that these grants were dominated by a few well-known large projects.

The latest EC (2007) report on past experiences and future prospects for economic and social cohesion policy, recognizes that PPPs should have a role to play in EU grant programs. PPPs are seen both as an important potential source of additional finance for investment and a tool to deal with chronic problems of delays and cost overruns in traditionally procured major projects, as highlighted in the evaluation by the research institute ECORYS (2004). But the limited progress to date is primarily due to public authorities having insufficient knowledge and capacity to deal with such complex projects, to the absence of robust legal frameworks, and to a lack of economic incentives.

As part of the preparation for enlargement, the EC Directorate-General for Regional Policy (DG REGIO) developed Guidelines for combining PPP and EU grants, together with a Resource Book of case studies illustrating successful and problematic PPP projects across Europe in different sectors and using a range of contractual forms (EC, 2003 and 2004). Very few of the projects presented in the case studies actually received EU grants, and the grants that were received were mainly in the form of payments to the construction consortium included within overall state subsidies, such as the Perpignan-Figueras rail project between France and Spain.

In addition to the usual prerequisites for entering into a PPP, the Guidelines and Resource Book state that PPPs involving EU grants must:

  • Ensure open market access and fair competition in the respect of State Aid rules when applicable.

  • Protect the public interest and maximize value added to citizens.

  • Define the optimal level of grant financing, both to realize a viable and sustainable project, but also to avoid any opportunity for windfall profits (or losses) from grants.

  • Assess the most effective type of PPP for a given project (balanced risk distribution, appropriate duration, clarity of responsibilities, and regulation).

The Guidelines and Resource Book recognize the potentially important part that PPP could play in delivering EU policy objectives. But they also emphasize that the Commission needs to verify that a project fully complies with all relevant EU regulations and that EU taxpayers’ interests are protected. The Guidelines offer very limited concrete guidance about practical issues to be addressed when submitting a PPP project for grant support, other than to underline the importance of early dialogue with the Commission and EIB. Most important, they were prepared before the new financial regulations governing the use of structural funds came into effect. In practice, the case-by-case approach taken in the past and the myriad legal and procedural obstacles to be overcome did not always engender an efficient process. Grant approval can be slow and cumbersome and not necessarily in step with the tight financial deadlines implied by private finance, particularly for major projects. Perez (2004) documents the complexities of dealing with EU-related environmental, procurement, and State Aid issues when using cohesion funds to finance the Vasco da Gama Bridge. Even the disclaimer at the front of the Resource Book states that the case studies therein are not necessarily models for the proper choice of private partners in PPP projects under Community law. Recent jurisprudence from the European Court of Justice has revealed some of the complexities in entering into such partnerships, irrespective of whether grants are involved.2

One of the main fiscal risks associated with mixing EU grants and PPPs is that the Commission could, in principle, reclaim misspent funds or refuse to disburse funds not used in line with EC regulations or directives. There is also a risk of “decommitment” of funds not spent fast enough under the so-called “N+2” rule stating that committed program funds must be spent within two years. Timing of the grant application for major projects, speed of implementation, and careful adherence to EU rules are a vital discipline for using EU funds, with or without PPP.

Analytical framework

Value for money

The main rationale for doing a PPP is to leverage in private finance to replace limited public finance and to achieve value for money (VfM) through risk transfer, competitive bidding, and innovation. Maintaining competitive pressure and maximizing innovation should be core VfM drivers, irrespective of whether or not a PPP involves grants. The degree of risk transfer depends on the sector and project characteristics, but needs to be balanced against the increased pricing of private finance and other factors. Table 10.1 summarizes the VfM trade-off.

Table 10.1Drivers of value for money in PPPs
BenefitsCosts
BundlingTransaction costs
• Life-cycle approach• Bidding, negotiation, monitoring
Innovation• Renegotiation over life cycle
• Depends on scope in tender dossierPrivate finance costs
Risk sharingPursuit of cost efficiency may impact
• Better risk managementservice quality
Private asset ownershipInstitutional arrangements and
• Cost saving innovation and moreadministrative capacity requirements in
efficient contractingpublic sector
• Additional revenue generation

In practice, all VfM arguments rely on a counterfactual—a hypothetical public sector alternative project capable of delivering the same benefits. Of course, if the economic fundamentals are wrong, a PPP cannot turn a bad project into a good one!

The introduction of EU grants complicates the picture. The decision is no longer “Will a PPP offer VfM?” but instead “Given that EU grant funding is available, is it more efficient to procure the project or program using PPP or is it better to stick with traditional procurement?” The uncertainties produced by the new financial regulations,3 for instance, about exactly how different payment mechanisms will be treated mean that public authorities may be reluctant to use a PPP because of concerns about delays, difficulties in receiving payments, and ultimately the risk of losing EU grants altogether.

On pure VfM grounds, the potential gains from PPP clearly depend on how bad the public sector is at delivering and operating infrastructure projects in a particular sector. Furthermore, much of the potential for VfM comes from risk transfer to the private party, such that if projects go over time/budget, if operating costs are higher than expected, or if poor performance results in penalties, it is the private sector that bears the cost. Yet by its nature risk is contingent and may or may not occur on any individual project. Therefore, it may well be that VfM can only really be achieved at the program level.

While VfM provides an overarching framework for analyzing PPPs, we need another analytical framework for comparing alternative models of grant support to PPPs. The common rationale across all models is that grants improve the affordability of a PPP project. But other factors need to be considered when choosing between models.

In order to understand and compare different models of grant support to PPPs, we need to compare the efficiency of funding with the efficiency of outcomes in terms of VfM and risk. The relevant outcomes are both at the level of individual projects and at the level of programs. Specifically, we need to consider the (i) leverage of how much grant funds leave for additional private investment (debt and equity) to justify the cost and effort of including private finance; (ii) impact of grant finance on incentives for the private party to perform; and (iii) fiscal risk to national authorities from different grant-funding models.

Leverage

The substitution of private finance with grants clearly reduces leverage, but for national authorities EU grant funds are effectively “free.” Thus, there is a big incentive to maximize their use on large projects to speed up absorption of EU funds and to keep user charges or unitary charges low in what are by definition relatively poor regions.

The private finance model assumes that it is the private capital at risk that motivates the contractor to deliver on efficiency. There is also the issue that below a certain level of private investment, the transaction costs of involving private finance outweigh the potential efficiency gains. This is particularly relevant for the 85 percent grant rates possible for individual projects under the Cohesion Fund.

Incentives

From a simplistic viewpoint, leverage and incentives are just flip sides of the same coin. The more private capital is at risk, the greater are the private contractors’ incentives to deliver the project on time and on budget and to operate it according to the performance criteria in the contract.

However, the notion that incentives are directly related to equity stake may be misleading. First, if equity is traded there may be no direct relationship between the owners of a PPP special purpose vehicle and the contractors for construction and/or operations stages. The scrutiny of projects by banks lending at risk helps to ensure that contracts are better designed, but doesn’t fully protect against perverse incentives. Second, Smith (2007) illustrates how the detailed design of the contract, for instance, the use of penalty and reward mechanisms, as well as the form of partnership, can be as influential on incentives and behavior as equity stake. Nonetheless, the higher the level of private finance at risk, the more motivated project stakeholders will likely be, assuming the correct incentives to deliver are in place.

Fiscal risk

Other than with mega projects, fiscal risk is manifest at the program level. Individual projects may come in over or under budget and guarantees may or may not be called. But the cumulative effect of cost overruns across a public sector investment program can cause fiscal distress.

The fiscal risk to the public sector depends on the extent to which future budgets are put at risk if the project does not perform. On the one hand, there is the direct liability of future payments under a unitary payment mechanism. On the other hand, there may be a conditional liability if the project doesn’t go as planned.

Although EU grants improve the overall fiscal position of the recipient country and can provide a massive boost to investment and growth, they may nonetheless leave the public authorities with a contingent liability if grants are withdrawn or claimed back, or if the project goes significantly over budget. The fiscal risks are borne by national or local authorities, because the EU grant is capped, and any additional costs necessary to complete the project are always a national responsibility.

Models for PPP-grant blending

A variety of models for combining grant finance4 with PPP have been used in different member states or have been proposed in the literature, see, for example, PricewaterhouseCoopers/Public Private Infrastructure Advisory Facility (PwC/PPIAF) (2006) and Deloitte (2006a). These can be simplified down to four basic models, as illustrated in Figure 10.1.

Figure 10.1PPP-grant support models

Model 1—Capex subsidy

This model is the most commonly used. Grant finance subsidizes the upfront capital investment, thus reducing either future user charges or unitary payments from the granting authority. The rationale for the grant is that it improves affordability. Both France and Italy have used this model combined with a tender to find the minimum value of subsidy required to deliver the project. Most previous EU grant-funded PPP projects have used this model.

Model 2—Parallel co-finance

This model is also widely used, especially for projects such as urban transport or roads that require subsidies and can be readily divided into separate contracts. For example, the public granting authority funds the construction of Lot A of a motorway under traditional procurement, but Lot B is let as a PPP concession together with the contractual responsibility to operate and maintain the full motorway. The applicability of this model depends on the divisibility of an overall project into separate components without creating excessive interface problems. The EU grants simply substitute part of the public funding requirement on the traditionally procured project, using well-tested procedures for cost definition and payment of grant funds.

Models 3a—Payment subsidy, and 3b—Debt repayment

In Model 3a, the grants are used to subsidize future unitary payments by the granting authority to the PPP company. While in principle this sounds straightforward, the mechanisms to define the level of support and to commit future funds to payments that may not start for over five years present many practical difficulties, including dealing with positive or negative adjustments for performance and with inflation. Another approach, under Model 3b, is to pay off a proportion of the debt as soon as the project becomes operational, thus lowering future unitary charges.

Model 4—Co-investment in PPP fund

In this model, public sector grants are combined with private capital in a fund that invests in a number of PPPs. Risk is spread across the portfolio. Such funds are already used for urban regeneration projects in the UK. The mechanism for selecting private investors should be fair and transparent. Any conflicts of interest between the investors and downstream project investments need to be addressed upfront. Given that the public sector investor will have different objectives from a private investor seeking maximum financial return, for example, affordability or the provision of social housing, a risk-sharing mechanism must be agreed that reflects the different parties’ objectives.

Comparison

Table 10.2 summarizes the relative impact of EU grants under the different models. The comparison assumes that a PPP is the preferred procurement route over traditional procurement because it potentially offers VfM.

Table 10.2Potential impact of EU grants
Model
1. Capex Subsidy2. Parallel

Co-finance
3. Payment Subsidy

and Debt Repayment
4. Investment

Fund
AffordabilityHighModerateHighLow
LeverageLowModerateHighHigh
IncentivesModerateModerateHighHigh
Fiscal riskModerateLowLowNone
Characteristics
  • Most common model

  • Bid criteria can include lowest value of subsidy

  • Widely used in transport

  • Grants can be targeted to eligible components

  • Like PFI credits

  • Equity, debt or guarantees

  • Private partners enter as investors at level of Fund

ExamplesVasco da Gama BridgeHSL, Florence tramwayUK schoolsUrban development fund
Key issues for using PPP with EU grants
  • Timing of grant commitment

  • Transaction costs versus scale of private finance

  • Fiscal risk depends on payment mechanism and guarantees

  • Timing of grant commitment

  • Interface problems

  • Ability to slice up project

  • Only for availability schemes

  • Eligible expenditure period beyond 2015

  • EU Grant Regulations unclear

  • Definition of project cost

  • Social objectives vs. profitability

  • Selection of private investment partners

  • Recycling of profits

To maximize affordability on an individual project, Model 1 with a fixed upfront subsidy of, say, 85 percent, is the proven approach. How the level of grant is fixed relative to construction costs, when this depends on the outcome of a competitive bidding process, requires some reflection, as it is well known that bid criteria influence the strategic behavior of contractors. For simplicity, to fix the upfront subsidy amount or the percentage has its appeal, but if affordability can be defined in advance, for instance via a pre-set level of tolls, then tendering the project on the basis of minimum subsidy required to deliver the project can also be attractive. It must be remembered that bidders may bid low with the intention of renegotiating in response to any changes required by the granting authority.

Model 2 has the advantage of separating the two procurement procedures and potentially allowing the rapid absorption of EU funds into a traditional procurement contract. But only certain types of projects lend themselves to this type of investment slicing. There may also be interface problems if the public sector contract is delayed or has quality issues, when the private contractor will have to take over operation of the overall project.

Model 3a has the attraction of maximizing incentives in the construction phase to deliver on time and budget, but still provides a subsidy to help affordability. The difficulty is that currently the regulations are geared up to subsidize the capital costs of projects, not future performance related availability payments. Several member states have written to the Commission seeking clarification on precisely this issue in relation to TENs as well as structural funds. The regulations limit any financial expenditures under the funds to 2015 (two years after the end of the programming period), although there may be ways to overcome this limitation by making a one-off payment to some form of holding fund. Another interesting variant, Model 3b, halfway between Models 1 and 3a, would be to pay off a proportion of the private debt once the project has been successfully delivered. This maximizes incentives during the construction phase, but avoids problems of time limits on eligible expenditure.

If the purpose is to maximize leverage, then Model 4 may be preferred. On the other hand, absence of grants will negatively impact on affordability.

There is no “best” model: all depends on local circumstances and the objectives of the public granting authority.

New rules and instruments

As mentioned already, the rules governing EU grant funds have changed. Following lengthy discussions with member states, the new implementing regulation for the structural and cohesion funds was adopted by the Commission in December 2006. The regulation sets out detailed rules on how the funds will be managed in the 2007–13 programming period. It contains a number of changes from previous regulations aimed at increased simplification, transparency, and accountability. However, some of the changes potentially have significant implications for PPP.

Johnson and Kramarik (2005) and Deloitte (2006a) identify various practical barriers to combining EU funding and PPP under the new regulations. These barriers are created by specific regulations concerning the absorption of structural and cohesion funds, the definition of final beneficiaries, the application of State Aid rules, and the way in which revenue-generating projects are analyzed to determine the grant rate.

The main areas of uncertainty introduced by the new regulations are:

  • The definition of public versus private eligible expenditure and the need for “additionally” at the program level, that is, private finance cannot substitute for overall national co-financing.

  • Whether a private beneficiary can be an “initiator” of a project.

  • Whether availability payments or shadow tolls should be treated as revenues for the project.

  • How the co-financing rate calculation will work in practice in the case of revenue-generating projects.

  • The impact of State Aid rules in different sectors on the maximum co-financing rate.

  • The implications of additionality requirements at the program level.

  • Timing of the application and grant decision relative to financial close for major projects requiring ex ante approval.

  • Implications of the “N+2” rule in case of availability based payment schemes with payments extending beyond the time horizon of the financial regulation (2015).

  • Developing appropriate models for grant blending and tender/bid criteria in different sectors.

On a positive note, the potential role of PPPs is recognized and encouraged in the new regulations, which make several explicit references to PPP mechanisms, usually in association with the EIB, including the use of infrastructure and urban development funds.

The largest single area of concern is Article 55 of the new regulations addressing revenue-generating projects:

Eligible expenditure on revenue-generating projects shall not exceed the current value of the investment cost less the current value of the net revenue from the investment over a specific reference period.

Does project revenue include shadow tolls or availability payments? What is the reference period? If this refers only to revenues from user charges, it implies that the eligible expenditure for calculating the grant rate is net of the private finance contribution, as this must be covered by future toll revenues less operating expenses in order to attract private investment. These are very substantial questions that must be addressed before PPPs incorporating EU grants can be designed with confidence. Fortunately, help is at hand.

Under the new Financial Regulations, the EC and EIB created a number of new initiatives related to PPP. JASPERS (Joint Assistance to Support Projects in European Regions) is a joint policy initiative of the EIB, the European Commission (DG REGIO) and the European Bank for Reconstruction and Development (EBRD). JASPERS’ role is to assist the new member states to absorb EU structural and cohesion funds over the 2007–13 budgetary-planning period by providing technical assistance for the preparation of high quality project funding applications for major projects, primarily in the transport and environment sectors.

JASPERS brings together experts from the EIB, EC, and EBRD to provide assistance at any stage of the project cycle, from initial conception through to the final application for EU funding. The assistance may cover technical, economic, and financial aspects and any other preparatory work needed to deliver a fully developed project.

JASPERS is demand-led through task requests from member states, several of whom have requested support with preparing pilot PPP projects and help with interpreting the new regulations. JASPERS can facilitate a dialogue between national authorities, advisors, and Commission officials responsible for interpreting the regulations.

JESSICA (Joint European Support for Sustainable Investment in City Areas) is a new policy initiative of the EIB, DG REGIO, and the Council of Europe Development Bank (CEB). JESSICA’s objective is to provide member states and authorities managing EU funds with a tailored solution to financing projects for urban renewal and development, using a combination of grants and loans, or other financial products as appropriate. The JESSICA Taskforce within the EIB is specifically focused on the identification, financing, and realization of sustainable urban regeneration projects by channeling EU structural funds through Urban Development funds.

JESSICA works together with the managing authorities to provide funding for a wide variety of PPPs or other urban development projects capable of repaying in the long term the resources invested in them (revolving funds). The structural fund regulations foresee simplified procedures for accessing funds via JESSICA.

A further initiative still under discussion is the proposal to form a European PPP Expertise Center as a network of national and regional EU PPP Taskforce units, with some core staffing and funding provided by the EIB and EC. The purpose will be to identify, share, and disseminate best practice related to PPP across the EU public sector. Working themes on which best practice papers have been requested include the Competitive Dialogue procedure and PPP-EU grant blending.

Prospects

There is a clear EU policy commitment to allow and even encourage PPP-EU grant blending. However, the mechanisms for doing this depend on the interpretation of the detailed rules in the Financial Regulations. These introduce a number of uncertainties, which can only be resolved through dialogue with Commission services using real pilot project applications. Areas of concern for PPP include the definition of eligible expenditure, the treatment of revenue-generating projects, the method of accounting for expenditures, and last but not least the period of availability of committed funds.

The main additional fiscal risks associated with EU grant co-financing of PPPs are decommitment of funds or need to repay funds in the case of mis-procurement or misuse of funds.

Despite a limited number of successful examples from previous programming periods, there is a clear need to establish new success stories under the new regulations that can demonstrate both that EU funding rules can be followed and that there are advantages over traditional procurement methods.

The JASPERS and JESSICA joint initiatives between the EC, the EIB, and other partners are specifically designed to support member states in developing, among other things, PPP projects in the transport, environment, and urban sectors. But it will take time to arrive at a constant flow of well-prepared PPP projects incorporating EU grants.

In the meantime, the Portuguese and Greek pilot projects offer many lessons for new countries seeking to use PPPs for Cohesion Fund projects. Experiences in other EU countries offer other learning points about possibilities and pitfalls. Sharing experiences at the EU level through public sector knowledge networking is another way to boost the public sector’s capacity to plan and deliver complex PPP programs.

Finally, it is essential that public authorities don’t embark on PPP for the “wrong” reasons—that is, for purely fiscal treatment reasons and not in a search for efficiency and improved quality of contracted public service. The guiding objectives in choosing a procurement route should be to:

  • Make best use of EU grant funds.

  • Improve the cost and time certainty of public procurement.

  • Deliver better public services.

  • Achieve demonstrable VfM.

The role that PPP will play in the delivery of the objectives will only be known when the programs come to be evaluated sometime after 2010. In the meantime, public authorities should explore all avenues for more effective use of both national and EU taxpayers’ funds in partnership with the EC and EIB.

Notes

Any public contract is subject to the EU Directive 2004/18/EC or EU Directive 2004/17/EC for contracts in the utilities sector. The Directives came into force on January 1, 2006.

See decisions relating to Teleaustria (C-324/98), Parking Brixen (C-458/03), Teckal (C-107/98), Stadt Modling (C-29/04), and Stadthalle (C-26/03) concerning the applicability of fundamental EU Treaty provisions to concessions (equality of treatment, transparency in contract award, non-discrimination, proportionality, and mutual recognition), and concerning contracting of in-house services.

EC (2006).

The use of public funds to provide guarantee instruments is not addressed in this chapter.

References

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