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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 6 - Incorporating Risk into Value for Money Analysis

The Role of Risk Assessment in Evaluating Public-Private Partnerships

Value for Money (VfM) analysis has been used in many countries to help government officials ensure that when entering into a P3 agreement, they are in fact getting a better deal for the government than they would through traditional approaches to procure the same project. Value for Money analysis is utilized to compare the aggregate benefits and the aggregate costs of a P3 project procurement against those of the traditional public procurement alternative. An assessment of project risks is a key input into Value for Money analysis.

Under the traditional design-bid-build procurement process, public agencies typically retain the majority of the risks associated with a project.  When public agencies take on major projects under a traditional procurement process they do evaluate risks but tend to undervalue those retained risks.  As a result, budget and schedule estimates are often optimistic.  Also, the full life cycle costs of a project are rarely considered.

P3 procurement processes require a transparent accounting and valuing of risks, because the risks transferred to the private sector will generally be factored into the costs of bids as a risk premium.  The bid price accounts for risks that the public sector may not normally consider, but must nonetheless be managed.  For example, force majeure - a natural event that may significantly damage the project or reduce the number of users – is a risk that will have an impact on the revenues of the project.  The private sector proposal will reflect the expected value of that risk, while the pricing for the traditional public sector approach typically does not (although the risk is taken into consideration if bonding of toll revenue is sought by the public sector). 

Through a VfM analysis the public sector can understand the totality of a project's costs and make certain risk cost adjustments to get an "apples-to-apples" price comparison of different procurement options.  VfM analysis can help answer the question:  Is it worth paying a price premium to a private operator to take on certain project risks in return for establishing a reliable fixed cost into the future?  The methodology for carrying out a VfM analysis basically involves:

  • Creating a Public Sector Comparator (PSC) which estimates the whole-life cost (including operating costs and costs of risks, which are not typically considered in traditionally procured projects) of procuring the project through the traditional approach, in terms of Net Present Value (NPV);
  • Estimating the whole-life cost of the P3 alternative (either as proposed by a private bidder or a hypothetical "Shadow Bid" at the pre-procurement stage);
  • Completing an "apples-to-apples" comparison of the costs of the two approaches.

A Public Sector Comparator (PSC) is first developed as a baseline against which a P3 procurement, either hypothetical or as proposed by a private bidder, will be compared. A favorable comparison, in which the P3 achieves the same outcome for lower overall costs, shows the P3's ability to generate value for money. An unfavorable comparison is evidence that the P3, as imagined or proposed, is unwarranted.

The PSC estimates the hypothetical risk-adjusted cost if a project were to be financed, implemented and operated by the public sector. The PSC is generally divided into five elements: the "raw" PSC, financing costs, competitive neutrality, retained risk and transferable risk.  The raw PSC includes all capital and operating costs associated with building, owning, maintaining and delivering the service over the pre-determined term of the P3 agreement.  "Competitive neutrality" removes any competitive advantages or disadvantages that accrue to a public sector agency such as freedom from taxes and is discussed further below. "Retained risk" refers to the value of any risk that is not transferable to the private sector, and "transferable risk" refers to the value of any risk that is transferable to the private sector.

"Competitive neutrality" removes any competitive advantages and disadvantages that accrue to a public sector agency by virtue of its public ownership, such as freedom from taxes. Taxes are costs that ultimately result in revenues to the public. It might be possible to distinguish among the various levels of government to whom taxes are paid, so that taxes paid to the Federal Government are treated differently from state or local taxes. A similar adjustment is required with respect to insurance. When the government chooses to self-insure, there is a perception that the government has saved on insurance premiums. In fact, the government is taking on risks otherwise covered by insurance, and the government should account for this additional risk. An adjustment is made to the PSC by adding an amount equivalent to the premium otherwise paid by the private sector under a P3 to account for the additional risks. Examples of public sector disadvantages include the additional costs associated with accountability, public scrutiny, and reporting requirements. A private company may sometimes have fewer of these costs in pursuing the same project.

Once established, the PSC's overall cost is used as a benchmark against which the costs and risks to be borne by the government under a P3 agreement are compared. The P3 option is analyzed for its whole-life total cost to the government, including the net present value of the project's direct costs and the value of any retained risks not transferred to the private sector.  Generally, as shown in Figure 6-1, a P3 proposal must cost less than the PSC in order to be preferable to a traditional procurement approach.

Figure 6-1

Figure 6-1: Comparison of PSC and P3 Procurement Alternative for VfM Analysis

Risk Cost Adjustments for Value For Money Analysis

Once risks have been quantified and allocated as discussed in Chapters 4 and 5, their value (i.e., the likely cost of these risks should they occur) needs to be incorporated into the Value for Money (VfM) analysis in order to compare procurement models on a risk-adjusted basis.

VfM Assessment Process
For the VfM Assessment undertaken at the pre-procurement stage, the main steps in the analysis are as follows:

  • Develop quantified risk assessments for both PSC and Shadow Bid options. The main difference in costs will be due to risks transferred to the private sector in the Shadow Bid option, under which expected costs of transferred risks will be lower.
  • Sum up the present value of retained, transferred and shared risk costs, allocating costs of shared risks between transferred and retained using a ratio of 50:50 unless specific allocations are available.
  • Apply the total values of retained and transferred risks to the PSC and Shadow Bid base estimates. A range of values may be used in a sensitivity analysis, resulting in a range of VfM results.

After bids are received, if the P3 alternative will be based on an availability payment structure, the preferred proposal may be compared to the PSC. The PSC estimate of costs and revenues will need to be risk-adjusted using updated procurement phase information.  If the P3 will be a tolled concession, the preferred proposal may be compared to either the Shadow Bid or the PSC.

Risk Adjustments to the Public Sector Comparator
Since the purpose of the Public Sector Comparator (PSC) is to estimate the cost of a project to the owner if it were procured traditionally, with no transfer of risks to the private sector as under a P3, the expected value of these retained risks must be added to the cost of the PSC.

The incorporation of risk into the PSC can be accomplished in one of two ways:

  1. By calculating the aggregated expected value of risk during the development, construction and operational phases, and then discounting them to a net present cost (NPC) to be added to the overall project NPC, as shown in Table 6-1; or
Table 6-1. Calculating Aggregate Expected Value of Risk
Year Risk Adjustment Discount Factor Discounted Risk value*
1 10 1.000 10.00
2 2 0.9434 1.89
3 3.5 0.8900 3.12
4 0.5 0.8396 0.42
5 0.5 0.7921 0. 40
Total 16.5   15.83
*Discounted risk value = Risk Adjustment x Discount factor
Adapted from Industry Canada, The Public Sector Comparator: A Canadian Best Practices Guide
  1. By adjusting the annual cash flows in the development, construction and operating periods to appropriately account for the risks, thereby making the project cash flows risk-adjusted, as shown in Table 6-1. When the risk-adjusted cash flows are discounted to calculate the NPC of the project, the resulting NPC will also be risk-adjusted.
Table 6-2. Illustrative Cash Flow Example Including Risk Adjustments
Year Capital Operating Indirect Disposal Risk Adjustment Total Discount Factor Discounted Cash flow*
1 100   4   10 114 1.000 114.00
2   20 4   2 26 0.9434 24.52
3 10 20 4   3.5 37.5 0.8900 33.38
4   20 4   0.5 24.5 0.8396 20.57
5   20 4 -50 0.5 -25.5 0.7921 -20.20
Total 110 80 20 -50 16.5 176.5   172.27
*Discounted cash flow = Total cost x Discount factor
Adapted from Industry Canada, The Public Sector Comparator: A Canadian Best Practices Guide

Retained risks are quantified, where possible, using the methodologies explained in Chapter 4, with the resulting expected value being equivalent to the government's expected cost of self-insuring them. A contingency fund, reflecting the value of these retained risks, may be included in the financial assessment and in the agency's project budget and funding analysis.  The process used to value transferred risks is discussed below.

Calculation of Risk Premium for the Shadow Bid
For VfM assessments undertaken at the pre-procurement stage, the Shadow Bid includes the cost of bearing transferred risks in its costs of financing as well as in its contingencies relating to both construction and operating budgets.

An important consideration in the quantification of risk is that the potential financial impact of a risk event is determined from the perspective of the party retaining the risk. A risk that is transferred to a private partner better able to avoid or mitigate that particular risk would have a lower value under the Shadow Bid than under the PSC. For example, in the absence of the discipline imposed by at-risk equity finance under a P3, costs associated with the potential for construction delay risk might be considered more likely (higher) under traditional procurement where the incentives to achieve construction schedule are less significant.  Since the most qualified firms will be attracted to the project, they will be best able to manage the risks without adding a large premium.

Risk premium value may be affected by market forces.  For example, it would be low if there are few projects relative to the number of contractors looking for work. The analyst team determines the value to be included for the risk premium. This value is added to the Shadow Bid estimate.

If a risk can be insured, the cost to obtain the insurance (i.e., the insurance premiums) is used to value that risk in the Shadow Bid, rather than the expected value of the outcome of the risk if it were to occur. Such insurance typically includes (among others) construction and contractor insurance, third party liability, business interruption, equipment failure, and technology-related risk. The premiums represent the actual cost to the private partner of bearing the underlying transferred risk. In the case of the PSC, the value of these insurance premiums is also used to represent the value of these risks if they are retained by the public sector.

Risks that are not transferred to the private sector are considered retained by government, and represent a cost to the project regardless of the procurement model selected.

 

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