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Risk Assessment for Public-Private Partnerships: A Primer

January 2014
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Chapter 6 - Incorporating Risk into Value for Money Analysis

Role of Risk Assessment in Evaluating Public-Private Partnerships

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 conventional approaches to procure the same project. VfM analysis is used to compare the aggregate revenues and the aggregate costs of a P3 project procurement against those of the conventional public procurement alternative. An assessment of project risks is a key input into VfM analysis.

Under the conventional DBB procurement process, although contractors assume significant risks - such as labor supply and weather risks - public agencies typically retain a significant portion of the risks associated with a project. When public agencies take on major projects under a conventional procurement process, they do evaluate risks, but budget and schedule estimates are often uncertain. In addition, the full life-cycle costs of a project are typically not 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, which may be affected by the availability in the market of business interruption insurance, whereas the pricing for the conventional public sector approach typically does not (although the risk is considered 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 can 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 concessionaire to take on certain project risks in return for establishing a reliable fixed cost in the future?" The methodology for conducting a VfM analysis basically involves: 4

  • Creating a Public Sector Comparator (PSC), which estimates the life-cycle cost (including operating costs and costs of risks, which are not typically considered in conventionally procured projects) of procuring the project through the conventional approach, in terms of Net Present Value (NPV).
  • Estimating the life-cycle cost of the P3 alternative (either as proposed by a private bidder or a hypothetical "shadow bid," which attempts to predict the bidder's costs, financing structure, and other factors at the preprocurement stage).
  • Completing an apples-to-apples comparison of the costs of the two approaches.

A PSC is first developed as a baseline against which a P3 project, 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 than does the PSC, shows the P3's ability to generate value for money. An unfavorable comparison is evidence that the P3, as imagined or proposed, may be 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 predetermined 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 in the following paragraphs. 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 sector. 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 when 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 NPV of the project's direct costs and the value of any retained risks not transferred to the private sector. Generally speaking, as shown in figure 6, a P3 proposal must cost less than the PSC to be preferable to a conventional procurement approach.

The example depicted in the bar chart in figure 6 portrays a comparison between a public procurement with a baseline present cost of $60 million and a P3 shadow bid for which the baseline present cost (net of financing costs) is $65 million. Although the baseline P3 cost is $5 million more and imposes an additional $6 million in ancillary and financing costs, the $13-million reduction in the cost of risk, due to transfer of some risks to the private sector and $8 million in competitive neutrality adjustments, overcomes these cost differences and results in a net savings to the government of $9 million overall, offering 8 percent in value for money. This example illustrates the central tradeoffs that often characterize P3 procurement: The government trades away significant risks in exchange for higher baseline and financing costs in the P3 scenario.

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 VfM analysis in order to compare procurement models on a risk-adjusted basis.

Figure 6

Figure 6. Calculating quantitative value for money. PSC = Public Sector Comparator, P3 = public-private partnership.

Detailed description of Figure 6

Calculating quantitative value for money. Bar graph comparing value for money (in millions of dollars) between a Public Sector Comparator (PSC) and a public-private partnership (P3) option. The y-axis lists millions of dollars (between zero and 120 in increments of 20); the x-axis shows the bars representing the PSC and the P3 option. The two bars on the graph represent the estimated amount of money spent on various costs for a PSC versus a P3 option. The bars are broken down into various color-coded segments that represent five risks and costs: (1) competitive neutrality (represented in gray), (2) retained risk (red), (3) ancillary costs (green), (4) financing (yellow), and (5) base cost (orange). In this example, the base cost for both the PSC and the P3 option represent the greatest cost: $60 million for PSC and $65 million for the P3. Financing is $15 million for PSC and $17 million for the P3. Ancillary costs are $11 million for the PSC and $15 million for the P3. Retained risk is $20 million for the PSC and $7 million for the P3. Finally, competitive neutrality costs $8 million for the PSC in this example; this is not applicable to the P3 option. The total cost for the PSC is $114 million; the P3 option costs $105 million.

For the VfM assessment undertaken at the preprocurement stage, the main steps in the analysis are as follows:

  1. Develop quantified risk assessments for both PSC and shadow bid options. The main difference in cost will be due to risks transferred to the private sector in the shadow bid option, under which the expected cost of transferred risks will be lower.
  2. Sum up the present values of retained, transferred, and shared risk costs, allocating the cost of shared risks between transferred and retained risk costs by using a ratio of 50:50, unless specific allocations are available.
  3. 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 analysis 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 by using updated procurement phase information. If the P3 will be a tolled concession, the preferred proposal may be compared with either the shadow bid or the PSC.

Table 7. 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

Note: Discounted Risk Value = Risk Adjustment × Discount Factor.

Source: From The Public Sector Comparator: A Canadian Best Practices Guide, by Industry Canada, 2003, Ottawa, Ontario, Canada. Adapted with the permission of the Minister of Public Works and Government Services, 2013. The Government of Canada is not responsible for the accuracy, reliability, or currency of information contained in this document.

Detailed description of Table 7

Calculating aggregate expected value of risk. This table has four column headings as follows: Year, Risk Adjustment, Discount Factor, and Discounted Risk Value. Each row represents a year (Years 1, 2, 3, 4, and 5). For Year 1, the Risk Adjustment is 10, the Discount Factor is 1.000, and the Discounted Risk Value is 10.00. For Year 2, the Risk Adjustment is 2, the Discount Factor is 0.9434, and the Discounted Risk Value is 1.69. For Year 3, the Risk Adjustment is 3.5, the Discount Factor is 0.8900, and the Discounted Risk Value is 3.12. For Year 4, the Risk Adjustment is 0.5, the Discount Factor is 0.8396, and the Discounted Risk Value is 0.42. Finally, for Year 5 the Risk Adjustment is 0.5, the Discount Factor is 0.7.921, and the Discounted Risk Value is 0.40. The total Risk Adjustment is 16.5; the total Discounted Risk Value is 15.83. Note: Discounted Risk Value = Risk Adjustment x Discount Factor.

Table 8. 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

Note: Discounted Cash Flow = Total Cost × Discount Factor.

Source: From The Public Sector Comparator: A Canadian Best Practices Guide, by Industry Canada, 2003, Ottawa, Ontario, Canada. Adapted with the permission of the Minister of Public Works and Government Services, 2013. The Government of Canada is not responsible for the accuracy, reliability, or currency of information contained in this document.

Detailed description of Table 8

Illustrative cash flow example including risk adjustment. This table has nine column headings as follows: Year, Capital, Operating, Indirect, Disposal, Risk Adjustment, Total, Discount Factor, and Discounted Cash Flow. Each row represents a year (Years 1, 2, 3, 4, and 5) and the Totals for each column (with the exception of the Discount Factor column). For each year (1 through 5), Indirect is 4. For Year 1, Capital is 100, Risk Adjustment is 10, and the Total is 114; the Discount Factor is 1.000 and the Discounted Cash Flow is 114.00; nothing is listed for Operating or Disposal. For Year 2, Operating is 20, Risk Adjustment is 2, Total is 26; the Discount Factor is 0.9434 and the Discounted Cash Flow is 24.52; nothing is listed for Capital or Disposal. For Year 3, Capital is 10, Operating is 20, Risk Adjustment is 3.5, and the Total is 37.5; the Discount Factor is 0.8900 and Discounted Cash Flow is 33.38; nothing is listed for Disposal. For Year 4, Operating is 20, Risk Adjustment is 0.5, and the Total is 24.5; the Discount Factor is 0.8396 and the Discounted Cash Flow is 20.57; nothing is listed for Capital or Disposal. For Year 5, Operating is 20, Disposal is -50, Risk Adjustment is 0.5, and the Total is -25.5; the Discount Factor is 0.7921 and Discounted Cash Flow is -20.20; nothing is listed for Capital. The Totals are as follows: Capital is 110, Operating is 80, Indirect is 20, Disposal is -50, Risk Adjustment is 16.5, Total is 176.5, and the Discounted Cash Flow is 172.27. Note: Discounted Cash Flow = Total Cost x Discount Factor.

Risk Adjustments to the Public Sector Comparator

Because the purpose of the PSC is to estimate the cost of a project to the owner if it were procured conventionally - 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 risks 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 7.
  2. 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 8. When the risk-adjusted cash flows are discounted to calculate the NPC of the project, the resulting NPC will also be risk-adjusted.

Retained risks are quantified, where possible, by 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 in the next section.

Calculation of Risk Premium for the Shadow Bid

For VfM assessments undertaken at the preprocurement 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 who is 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 conventional procurement in which the incentives to achieve construction schedule are less significant. Because 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, and 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 in 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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Footnotes:

4. See FHWA's Value for Money Analysis: A Primer, February 2014.

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