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Risk Assessment for Public-Private Partnerships: A Primer

September 10, 2012

DRAFT
For review by P3 Evaluation Toolkit Beta-Testers

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Chapter 3 - Types of Project Risks

All projects, whether undertaken using traditional procurement methods or using a P3 approach, have known risks, "known unknown" risks and unknown risks. Known risks are risks that have been identified. Identified risks need to be proactively managed throughout the project life cycle by identifying who owns the management of those risks and by what the risk entails, its triggers, and contingency plans that would prevent those risks from occurring or that would lessen the impact on the project should they occur. At times, the risks may simply be accepted by a project if the cost to avoid or mitigate the risk is more than cost of the potential consequences.

Unidentified risks can be "known unknown" or "unknown". Known unknown risks are those that are known, but it is unknown how they could affect the project. Unknown risks are totally unknown and therefore not possible to prevent or manage. A challenge during the risk identification process is to reduce the presence of unknown risks during the project life cycle. Examples of unknown risks may include unexpected legal changes, natural disasters and resource losses. Known-unknown and unknown risks cannot be managed proactively and thus most often are addressed by allocating an acceptable level of general contingency against the project as a whole that is adequate to manage a reasonable level of unknown risk.

Risk identification is an important component in the development of a P3 framework. The focus of P3s is on known risks which can be mitigated by allocation to one of the involved parties as well as by other methods, such as insurance and quality control. The most common risks of highway projects have been listed in Table 3-1. They have been grouped by project phase and are detailed in the following sections.

Risks in the Development Phase

Political Risks
To be successful, P3 projects must be supported by strong political will at the state and local level. This includes support from the legislative and executive branches as well as the general public. A lack of political commitment is one of the critical risks during the project development phase. It can lead potential private partners to withdraw from the project if concerns arise surrounding the certainty of investment terms. Manifestations of political risk include the outright cancellation of projects by the public agency, the inability to reach an agreement between the public and private partners on the project structure, and the failure to appropriate funds necessary for the proposed project.

Cancellation of a project or failure to reach an agreement between the private and public partners due to lack of political commitment can make it more difficult to attract the private sector in future P3 projects that may be proposed by the public agency.

Political risk is heightened if state P3 legislation allows for a veto of the project by a state or local assembly. The uncertainty surrounding final approval of the project and the inclusion of local political pressures in the decision-making process are powerful deterrents to private sector investment.

Table 3-1 Key Types of Project Risks to Public or Private Partners
Phase Type of Risk
Development phase Political will
Regulatory
Site
Permitting
Procurement
Financing
Construction phase Engineering and construction
Changes in market conditions
Operation phase Traffic
Competing facilities
Operation and maintenance
Appropriation
Financial Default Risk to public agency
Refinancing
Political
Regulatory
Handback

Regulatory Risks
A clear prerequisite to the development of P3 projects is the existence of P3 enabling legislation. Regulatory risk exists when an inadequate P3 framework is in place. State and local P3 legislation must contain certain provisions to ensure that the P3 program can be attractive to the private sector while protecting the public interest. P3 regulations should provide sufficient guidance, striking the right balance between flexibility and certainty. This will encourage private sector interest.

Desirable provisions in P3 legislation include a requirement for clear procurement guidelines and decision criteria, flexible project eligibility criteria, and the ability to revise toll rates over the project's life1.

Overall, restrictive P3 statutes (e.g., restricting P3s to a pilot program or requiring multiple legislative approvals for a project) are less likely to attract private sector interest than more flexible legislative provisions. Other regulatory restrictions may include limits on the type of procurement that is authorized, limitations on leasing, limitations on use of financing instruments (including mixing public and private funds on a given project), and restrictions on which public agencies are allowed to enter into P3 agreements (e.g., state departments of transportation but not local authorities). Restrictions on the type of projects and "pilot program" provisions are likely to be perceived by private sector entities as indicating a lack of long-term political commitment to P3s.

Site Risks
During the development phase, greenfield or hybrid P3 projects are exposed to a variety of risks related to the project site's ground conditions. Issues can arise with regard to the suitability of the site, including environmental contamination, poor geological conditions, and archeological remains. Community relations can also lead to site risks if there is a significant amount of local hostility toward a project. In these cases, site risk becomes closely tied to political risk, as local opposition to a project can jeopardize its political support.

Community relations issues can also lead to or worsen right-of-way acquisition risk. In some cases, the public agency will take responsibility for the acquisition of the required land, or the land will be federal or state-owned land. Occasionally, however, the private sector entity must acquire land (e.g., Dulles Greenway in Virginia), which allows for the possibility of a real estate-related upside, but also increases the risk to the private sector. The state may still need to use their condemnation rights in extreme cases.

Permitting Risks
The successful development of P3 projects is tied to the ability of the private sector entity to receive the required federal, state, and local permits. Permitting issues stemming from a lack of preparedness or from difficulties caused by the project's design can cause considerable delays and additional costs. As with site-related issues, public agencies and the private sector partner can share the responsibility for permitting to varying degrees.

NEPA Process Risks
The environmental review required under National Environmental Policy Act (NEPA) provisions is a time-consuming and costly effort, and environmental issues raised during the review process can threaten the viability of the project. While the role that the private sector can legally play in the NEPA process is severely restricted, the cost of the NEPA review can be shared between public and private partners. In addition to the NEPA requirements, certain states, such as California, have specific environmental requirements. One way to mitigate NEPA risks is for the public sector to have the environmental process near completion before releasing a P3 solicitation.

Procurement Risks
Procurement risk refers to the risk of failed procurements, where no bids, or noncompliant or low-quality bids, are submitted. Procurement issues can be caused by general market conditions, but they most often stem from flaws in the design of the procurement process or unsuitable project structures/ risk transfer expectations. It is important that public agencies not be constrained in their procurement practices by regulations requiring that they award contracts to the lowest price bidder rather than to the bidder presenting the best value.

P3 legislation or guidelines often include procurement procedures for P3s that specify evaluation criteria for P3 proposals, including technical, financial and innovation criteria. However, procurement issues can arise from a lack of clarity in response requirements, excessive financial commitment requirements, insufficient protection of design and proprietary information, or a lack of transparency in the selection criteria. The procuring agency's track record with P3s and other procurements also influences bidders' perception of procurement risk. Procurement risk for private entities seeking to bid on a project can be significant since it is very expensive to prepare a proposal.

Financing Risks
Risks associated with financing for P3 projects can result in the inability to reach financial close or lead to default on project debt during the operating period.

Inaccurate or overly optimistic traffic projections and underestimated project costs can lead to the development of pro-forma financials that appear to justify the investment decision, but that do not reflect the project's actual ability to repay debt or to meet equity investors' return requirements. Lenders will generally take a conservative view of traffic volume and cost projections, and their conclusion on the viability of the project might differ from the more aggressive outlook of the private sector entity. This could make financing difficult to obtain on reasonable terms.

Both commercial and public lenders make their decisions based not only on the intrinsic risk of project default, but also on external factors. Transportation projects have high capital costs and long-term revenue streams and are, therefore, generally financed over 20 or 30 years. With the constrained financial markets since 2007, however, banks became reluctant to have repayments outstanding for such lengthy periods of time. Commercial lenders have demanded more stringent terms, including higher minimum debt service coverage ratios and shorter loan life terms, tighter dividend distribution covenants, higher margins, mandatory refinancing and cash sweep provisions, and requirements for multiple reserve accounts (e.g., for debt service, O&M, and capital improvements).

Many P3 projects today are reliant on government loan programs, such as the Transportation Infrastructure Finance and Innovation Act (TIFIA) program, to provide long-term subordinate debt. The availability of TIFIA financing depends on the project's eligibility, the amount of budgetary authority available to TIFIA and the successful mitigation of project risks. Financing risk exists even for projects with strong economics due to the limited amount of credit available from private and public sources.

Financing risks can also be related to regulatory risks. For example, if the tax treatment is not clearly outlined by the P3 regulations or the concession agreement, private lenders are likely to be unwilling to accept the risks. This reinforces the importance of transparency and predictability in P3 legislation, policies and guidelines.

Risks in the Construction Phase

Engineering and Construction Risks
Engineering risk encompasses several sub-risks, including design risk, construction cost risk and latent defect risk.

Design risk refers to the potentially negative effects to the project resulting from flaws in the design work. Design flaws can lead to delays and cost increases, as well as environmental and safety issues, both during the construction and during the operations period of a project.

Construction costs are an important risk area for P3 projects as they can be affected by increases in labor and material costs, as well as by delays and the cost of performance bonds. Construction costs are estimated during the design phase and can be locked in through lump-sum turnkey contracts (design-build) which allow for fixed costs and penalties in case of completion delays. Performance bonds and completion guarantees can also be written into the construction contract to further incentivize the construction contractor to complete work on time and to reduce risk, although this practice can result in a higher contract price.

Latent defect risk is a form of risk linked to a project's construction that is present after the completion of construction. It is the risk of flaws in the infrastructure that are not apparent until operation of the facility begins. Most construction contracts make the engineering, procurement and construction (EPC) contractor liable for such defects, and they include penalties and damages to compensate the owner and operator against lost revenue caused by the underperformance or lack of availability of the facility.

It is important to note that construction cost risk is the only risk that is typically transferred under traditional procurement, although not always successfully since the private sector often claims design flaws led to cost overruns. The desire to control cost overruns is a key motivator for the public sector. For the private sector, managing construction costs is a key risk, which the concessionaire usually handles by a design-build contract with another private firm.

Change in Market Conditions During the Construction Phase
Once the final investment decision has been made by the public agency and private sector entities and the P3 agreements have been signed, significant costs are incurred for the permitting, financing, design and construction of a project. Although it is possible to lock in engineering costs, other market conditions can change during the construction period and negatively affect the project. Changes in macroeconomic conditions can affect inflation rates, as well as projected material and labor costs. A public agency can protect itself from construction cost increases by requiring the concessionaire to submit a fixed price contract. The private sector entity will normally add an inflation factor into its final bid, which "expires" after a certain time period to protect against changes in market conditions.

Risks in the Operation Phase

Traffic Risks
Traffic risk (for toll-based concessions) refers to the risk that over the life of a project actual traffic levels do not reach projected levels. This would negatively affect the project's cash flows and the ability of the concessionaire to repay debt and generate sufficient equity returns. Traffic risk is often the core component of toll-based concessions, and its allocation defines the project and determines the remainder of the contractual arrangements. Traffic risk is present in any revenue generating facility. It is borne either by the public agency (in the case of availability payments) or by the private sector entity (in the case of toll-based or shadow toll-based concessions), or may be shared by both.

Traffic risk can be influenced by several factors, including the quality of the initial traffic projections, changes in the macroeconomic environment, the existence of alternative routes, and the level of user fees. Initial traffic projections are subject to a thorough vetting by lenders. This vetting can include requiring a review of the initial projections by an independent expert, lowering the risks associated with the quality of the projections.

Competing facilities present revenue risk for toll-based P3 projects. Existing or planned competing facilities can be integrated into traffic and revenue projections, and diversion from the proposed toll facility can be modeled. However, calculating the risk of new (i.e., not previously planned) competing facilities built during the operation phase of a P3 project is less straightforward. Some P3 agreements include a non-compete clause whereby the public agency agrees not to grant permits to a competing facility, or to compensate the concessionaire if a new competing facility is constructed that negatively impacts revenue from the existing P3 facility. The burden of proof typically lies on the private party to demonstrate harm.

Positive impacts from facilities built by the public sector must also be taken into account. In Texas, the concession agreements specify that construction of facilities that induce traffic on the P3 facility must also be taken into account and the net effect must be considered.

Regulatory Risks
During the operations phase, relevant federal or state statutes may change, e.g., laws governing High Occupancy Toll (HOT) lanes such as vehicle occupancy requirements for toll-free service or minimum speed requirements. The public and private partners will need to address these risks in the P3 agreement. For example, for HOT lane P3 projects, the state may retain the risk from changes to state statute relating to HOT lane projects and the private sector may retain risks from any other changes in statute.

There are also risks associated with how contract performance standards are interpreted and overseen by the public agency. One risk considered by the private sector is that a new political administration will come in that is hostile to the deal and seek a more stringent interpretation or enforcement of certain standards in order to undermine the private partners' credibility. There are also regular changes to State DOT policies regarding technology, asset management and maintenance practices that the private sector may be expected to conform with.

Operations and Maintenance Risks
Operations and Maintenance (O&M) risk may result from actual physical issues with facilities or by an increase in O&M costs. O&M risk can also translate into loss of revenue if the facility needs to be closed for an extensive overhaul or if its capacity is reduced during maintenance activities.

O&M costs forecasted at the time of the project's development generally include increases in costs based on inflation or other predetermined factors. Costs can, however, increase beyond the anticipated level, e.g., in cases where labor costs increase above expectations.

Insufficient maintenance can lead to a deterioration of the condition of a project and can ultimately lead to closures, which in turn will cause a loss in revenue (for toll-based projects) and damage the public's perception of the project. Loss of availability due to natural disasters and similar events is, however, generally considered to be caused by force majeure events and may be insured, or may be designated as a risk to be shared by the public and private partners.

Appropriations Risks
Appropriations risk is the risk that the public agency is incapable of meeting its financial obligations to the project because funds for the project fail to be obligated into its budget. Appropriations risk can affect P3 projects where the public agency is expected to make payments, either as lump-sum payments during the construction period or as availability payments during the life of the project. This risk can be caused by political issues (if there is strong local opposition to the project) or by a change in economic conditions affecting public sector revenues.

Financial Default Risks to the Public Agency
Financial default risk is the risk borne by the public entity that the private sector entity will have financial difficulties that will prevent it from performing its duties according to the P3 contract's terms. Unless there are flaws with the project itself, projects for which a private partner is in financial difficulty can generally be sold to another private sector entity or to a government entity, which allows for continuity of operations. An example is the South Bay Expressway P3 project in San Diego, CA, which went into bankruptcy and was sold to the San Diego Association of Governments (SANDAG), a government entity. Normally, a P3 agreement is set up to allow for lender step-in rights prior to the private sector entity's default. The lenders are then able to manage the project while ensuring the public agency is fully involved in the process.

Refinancing Risks
Financing risk remains present during the operating life of a project. Depending on the initial financing terms, P3 projects can be exposed to interest rate risks, especially if the sponsors have entered into a floating rate loan and have opted not to hedge. Loan agreements can also carry mandatory refinancing provisions; this provision exposes a project to financing risk when it seeks to refinance its existing loan. To maintain similar debt service coverage ratios, and therefore the same level of default risk, private partners must be able to secure a loan of the same amount as the outstanding principal at the time of refinancing for a sufficient loan repayment period and at an equally or more favorable interest rate.

The availability of debt at the time of the mandatory refinancing cannot be known to the private partner at the time of the initial financing, making refinancing risk difficult to estimate accurately. In the past there has been a lot of upside to refinancing risk, though less so recently. Many recent P3 contracts have provisions that require that the private party share any gains from refinancing with the public agency.

Handback Risk or Residual Value Risk

This is the risk that facility conditions are worse than anticipated at the end of the project. Hand back provisions include the terms, conditions, requirements and procedures governing the condition in which a private partner is to deliver an asset to the public sector upon expiration or earlier termination of the P3 agreement, as set forth in the contract. Contracts need to be structured so that there are financial incentives at the end of a contract to encourage the private partner to make the investments necessary to handback the facility to the public agency in suitable condition.

1 Nossaman, "Overview of Key Elements and Sample Provisions State PPP Enabling Legislation for Highway Projects", October 2005, http://www.fhwa.dot.gov/ipd/pdfs/legis_key_elements.pdf (accessed September 10, 2012).

 

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