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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 5 - Risk Allocation Strategies

Risks identified in a risk register (as discussed in Chapter 4) may be categorized in one of three ways:

  1. Transferrable risks, i.e., risks fully transferrable to the private sector.
  2. Retained risks, i.e., risks for which the government bears the costs, e.g., the risk of delay in gaining project approvals.
  3. Shared risks, i.e., risks that are shared based on a combination of the above two allocations due to the nature of the risk, e.g., earthquake risk.  (If the facility were to be damaged by an earthquake, the private sector may be only partially responsible for repairing the asset, depending on the extent of damage.)

Risk allocation is at the core of P3s, which are structured around the sharing of risks (and rewards) between the public agency and private sector entity. It is the transfer of risks that provides incentives to the private entity to innovate in the approach it takes to delivering a project under a P3.  One study of 17 P3 projects found that risk transfer valuations accounted for 60% of the total forecasted cost savings under a P3 approach.1  This may be due to the private entity's ability to manage a specific risk more efficiently, or its acceptance of a lower confidence level in the valuation of the risks (as discussed in Chapter 4).

Transferring too little risk to the private sector would constrain the value for money that could be achieved.  Conversely, transferring too much risk (e.g., risk that the private sector is unable to manage) will result in high risk premiums, making the project more costly and driving down the value for money.

Projects with P3 agreements lend themselves to a wide range of strategies for allocating risk. This Chapter examines risk allocation strategies most commonly used in managing risk for highway projects. 

Risk Allocation Process
Prior to allocating risks between the public and private sectors, the risks must be identified and analyzed, as described in Chapters 4.  Although some level of project risk is an objective fact, the public agency and the private sector entity often have different assessments of risk from their dissimilar points of view and priorities. A comparison of differing risk assessments is an important step in achieving the optimal allocation of project risks among parties and achieving maximum value for money. For example, the public sector may have less appetite for financial risk because it is difficult for the public agency to insulate the rest of its budget from the consequences of a default or bankruptcy.  P3 partners create special purpose ventures that generally limit the liability of partners to the amount invested.

To determine the optimal allocation of risk, an agency compares the public sector's ability and willingness to manage each risk to the ability and willingness of a potential private partner to do the same. Risks that the private sector is more capable of managing are transferred; risks that the public agency is more capable of managing are retained. Where possible, the party with responsibility for managing the risk will seek to mitigate or avoid that risk. If a risk is difficult to assess or manage, it may be appropriate that it should be shared between the public and private sectors. An effective risk allocation should create incentives for the private sector to supply quality and cost-effective services.

While the concept behind optimal risk allocation is clear, the practice of how agencies allocate risks is more of an art than a science. Typically, the public sector will be expected to take on site risks and regulatory risks. The private sector will be expected to take on risks arising from the building, operation, finance, and management of the project. The concessionaire may choose to transfer risks to other private parties by selling equity stakes, holding subcontractors responsible for performance, and/or insuring against certain risks.

Public Sector Standpoint
From the public agency's standpoint, P3 projects are considered to be a means for transferring some of the project risks to the private sector. However, transferring all of the risk to the private sector entity does not necessarily produce the optimal outcome, particularly if there is no potential upside for the private sector entity; in such cases, it will only increase the private sector entity's required return on investment as it will not be able to efficiently manage all of the risk transferred to it. Additionally, the private sector entity may lose interest in the project during the development phase, leading to failed bids.  If the private entity does accept excessive risk, it could face financial difficulties during operations, leading to default and potentially to an interruption or decline in service. Risk allocation is better envisioned as the practice of finding an equilibrium point, where the level of risk to be borne by the public agency and the private sector entity is acceptable to both.

The public sector may be unwilling to transfer certain risks to the private sector if the end result is an increase in the delivery cost compared to the public agency's traditional procurement. Transferring traffic risk, in particular, can cause the private sector to propose to charge higher toll rates than a public agency potentially would, because the private sector entity must include a higher return on investment to account for the revenue risk. Such investment propositions may not be acceptable to the public agency if the toll exceeds the implicit tolerance level.

P3s are structured based on risk-reward trade-offs. Both the public and the private sectors have tolerance levels for risk and required returns (see Figure 5-1). P3s must contain a balanced risk/reward profile to be considered attractive by the public and private sector.

Private Sector Standpoint
From a private sector entity's standpoint, P3 projects need to adequately balance risks and rewards. In other words, if there is a risk of loss (downside risk), there should be an opportunity for higher gains (upside risk) to compensate.  For example, private sector entities will not accept excessive traffic risk if tolls are capped at relatively low levels.

The private sector entity's willingness to accept a particular risk also depends on its ability to manage the risk, the existence of sufficient rewards to compensate for the risk, and the clarity of the contractual dispositions transferring the risk. Private sector entities have a risk/return tolerance level above which their investment decision becomes positive. The shape and position of this risk tolerance (see Figure 5-1) can change over time as the cost of capital and return requirements change.

Optimal Risk Allocation
A successful P3 arrangement allocates risk in an optimal manner that is acceptable to the public agencies and private sector entities alike. Each risk is allocated to the party best suited to manage or mitigate it.

Graphically, the optimal risk allocation can be represented as the area that is within the acceptance level of both parties (see Figure 5-1). This area forms the boundaries for the negotiations of P3 agreements. Public agencies strive to ensure that this optimal allocation is achieved at the lowest possible cost for taxpayers, while private sector entities attempt to maximize their returns within the acceptable boundaries. Under an optimal risk allocation scheme, risks are generally allocated as shown in Table 5-1, which shows how risk allocation differs for DBFOM projects relative to traditional procurement (Design-Bid-Build) and Design-Build.

Figure 5-1

Figure 5-1.  Optimal Risk Allocation in P3 Projects for Both the Public and Private Partners

Table 5-1. Common Risk Allocation Under Traditional and P3 Procurement
Risk Design Bid Build Design Build Design Build Finance Operate Maintain
Change in Scope Public Public Public
NEPA Approvals Public Public Public
Permits Public Shared Private
Right of Way Public Public Shared
Utilities Public Shared Shared
Design Public Private Private
Ground Conditions Public Public Private
Hazmat Public Public Shared
Construction Private Private Private
QA / QC Public Shared Private
Security Public Public Shared
Final Acceptance Public Private Private
O&M Public Public Private
Financing Public Public Private
Force Majeure Public Shared Shared

Source: Virginia DOT's PPTA Risk Analysis Guidance, September 2011

1 Source: Study by Andersen and LSE Enterprises for the Treasury Task Force, UK. Value for Money Drivers in the Private Finance Initiative.  January 17, 2000.

 

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