How should risk be evaluated and allocated in PPP contracts?

[Response by Rui Cunha Marques, February 2010]

Risk is defined as the probability of a particular event occurring. In PPP, risk allocation is important for the public authority, as it is at the heart of the value for money of the project, and therefore for determining the decision of opting for the PPP procurement option or not. The principle is that risks should be transferred to those able to control or mitigate them at the lowest cost. Improved risk allocation reduces not only economic costs but also the need to enter a renegotiation process and provides incentives for a sound management of the PPP.

The efficiency rule for allocating risk is quite simple. The public authority (e.g. municipality) should not transfer to the private partner risks that are under the authority’s control, nor should it assume risks that are out of its control. The transfer of risks to the private partner brings, in general, an increase in the price of the project, so it is essential to ensure that the public benefit of such transfers is greater than that increase in financial costs. This additional cost derives from the risk premium that is required by the private sector to support it. The risks should be assigned to the right parties and carefully defined ex ante before the signed contract. A risk matrix should be defined for each project where all the risks are identified and allocated, their probability evaluated and their (financial) impact quantified. Finally, mitigation measures should be established for each type of risk.

a) Identification and classification of risks

In the design of a contract, it is crucial to identify and allocate risks before the procurement stage. This should be done by constructing a risk matrix. The bidding documents should limit ex ante situations that may lead to ex post opportunism and, in particular, to the renegotiation of the contract. Renegotiation should be restricted to the aspects that the private sector does not control (public authority risk) and is not able to predict (e.g. extreme events or changes in public policy).

Among several possible classifications, risks can be divided into production, commercial and contextual risks. Some of these risks are associated with the bidding process stage and others with the project implementation stage. While risks related to the production process are almost always best borne by the private sector, the commercial and contextual ones are mixed. Among the production risks are those associated with the planning, design, right of way acquisition, construction, environmental (e.g. permits), archaeological constraints (discovered in the construction phase), maintenance and major repairs, operational, technological and performance risks. Commercial risks comprise mainly the demand, collection, capacity availability, and competition risks—where the latter could stem from changes in public policy or dramatic changes in technologies that alter the feasible scale of potential entrants. Finally, within the scope of contextual risks, financing, inflation, legislative changes, judicial rulings, regulation, swings in public opinion, and force majeure are the most relevant. The importance of each risk depends on the project under consideration. However, consumption/demand and unilateral (one party) change risks are in general the most problematic ones and are major reasons for contract renegotiation. Contract renegotiation is one the main consequences of initially incomplete allocation of risks.

b) Allocation of risks

The allocation of each type of risk between private and public sector should occur according to the minimization of economic costs. However, some risks can subsequently be transferred to third parties. For example, the private partner can subcontract activities, passing the associated costs on to the subcontractors. Similarly, the private or public partners might transfer some risks on to the customers/users (e.g. via price increases when new legislation mandates new environmental controls). In other cases, risk can be mitigated through insurance.

c) Probability and impact quantification

During the contract preparation, each type of risk should be described, establishing and enumerating the different causes that may lead to its occurrence. The probability of each development occurring should be estimated and quantified; then the analysts should identify the associated impact level. Notice that a certain risk could have a high or low probability and a low or high impact, respectively. Cost estimation of different risks and their corresponding allocation is central for the implementation of a PPP; this stands in contrast to traditional public sector procurement. The probability and the corresponding impact of risks depend on their nature and on the particular project under consideration. This task should preferably be carried out in the starting of the PPP feasibility studies and in the business and procurement model definition. In particular this is a key stage for the public sector comparator determination (Leigland, 2004).

d) Identification of minimization measures

For each type of risk, the contracting parties should develop strategies for mitigating that risk. These measures should be taken before the assignment of the contract. For instance, for inflation risk, minimization measures include indexing revenues to inflation, or forward contracts; both procedures (strategies), reduce the potential impacts of a negative event occurring. Fixed price contracting places the strongest incentive on the private partner to mitigate the inflation risk; this can be done through the purchase of insurance, hedging, or project diversification.