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5 Risk Allocation

Figure 5-1 . Risk Allocation

5.1 Purpose and principles of risk allocation

Risk allocation (see Figure 5-1) between the public agency and private sector entity is one of the core principles of P3s. International and domestic studies show that the transfer of risk accounts for a large portion of the total forecasted VfM of the P3 approach. Therefore, the purpose of risk allocation as part of a risk assessment is to optimize this risk transfer from the public agency to the private sector.

5.2 Several tips and tools for good risk allocation include using VfM as a guiding principle, assessing manageability per actor, and additional criteria

5.2.1 The guiding principle for an optimal risk allocation is VfM

A generally accepted principle is that risk should be allocated on the basis of both the ability and willingness of different entities to manage each risk. Risks that the private sector is more capable of managing are transferred; risks that the public agency is more capable of managing are retained.

Transferring too much risk to the private sector will result in higher risk premiums, making the project more costly and decreasing VfM. Public agencies that are starting to explore the potential of P3s for the first time may make the mistake of trying to transfer too much risk to the private sector. Conversely, transferring too little risk to the private sector constrains the magnitude of the VfM that can be achieved.

The P3 reference guide of the World Bank's Public-Private Infrastructure Advisory Facility (PPIAF) summarizes the risk allocation principles in three steps as seen below in Figure 5-2: ⁴

Figure 5-2 . Risk Allocation Principles

5.2.2 Risk allocation is also about marketability and incentives

A successful P3 is not just about the party that is best able to manage the risk, but also:

• An assessment of marketability for sponsors, subcontractors, and financial institutions: Continuous discussions between the procurement agency on the one hand, and concessionaire, subcontractors, and financial institutions on the other hand will help structure a risk allocation that is both workable and optimal for the creation of maximum VfM. The outcome depends heavily on the private sector's risk appetite; this willingness to accept risks can change over time due to better information on risks.
• Structuring of incentives: Even if it is clear that the private sector is not able to control a certain risk (e.g., vandalism) it may still create VfM if part of that risk is transferred by letting the contractor share in the cost consequences of such an event. Whereas the contractor may not be able to fully control the probability of the event happening, it can take risk mitigation measures to reduce the probability of the occurrence and can also influence the potential damage by designing vandalism proof assets to reduce the costs of repair. Providing these incentives aligns the interests of the private sector bidders with those of the public agency to minimize the negative financial effects of external risks.
• Ensuring a holistic approach that limits exceptions: The starting point for a P3 contract is that the private operator is responsible for all tasks and risks, unless the contract states differently. If the contract is laden with exceptions with regard to what the private operator is responsible for, "gray areas" are introduced that can cause large transaction costs. An example of this is exceptions in maintenance responsibility due to weather circumstances. This is not efficient and can seriously harm VfM, only becoming visible after financial close.

5.2.3 Key questions to be answered

Deciding which risks to allocate to which party brings up a number of questions that must be answered from the perspective of both the public agency and the private entity. For instance, it is important for the practitioner to ask: "To what extent can the public agency...

• Manage the likelihood of this risk occurring?
• Manage the impact of this risk?
• Absorb the impact of the risk?
• Take specific measures to manage the risk?"

Naturally, the same questions must be asked concerning the ability of the private entity in a P3 procurement. The information above allows the most important question of all in risk allocation to be answered: "Who is best able to manage and absorb this risk?"

In addition to the above considerations, checks should be made to answer the following:

• Similar contracts: Are there specific reasons to deviate from the risk allocation chosen in earlier transactions and described in the model P3 contracts?
• Marketability: Are there any reasons to assume that the private sector will not accept the risk or price the risk at an unreasonably high value?
• Incentives: Do any of the potential risk allocation mechanisms create unintended incentives for the private sector?
• Holistic approach: Do any of the potential risk allocation mechanisms create "gray areas" in terms of responsibility?

5.3 Process, timing, information, and expertise needed

Process: Risk allocation is at the core of the structuring of any delivery method, and requires transaction experience and market knowledge. To a large extent the allocation determines the success of a contract and the VfM expected and achieved, and this is why risk allocation is an extremely important step in any P3 preparation process. The purpose of this step is not only to define the risk allocation, but also to develop the mechanisms to refine the risk allocation. An example of this is defining compensation events in the P3 agreement and also developing payment mechanisms. The financial and legal teams typically execute this because it requires both distinct disciplines.

Timing: The initial risk allocation has to be determined before the drafting of the P3 agreement is completed. In practice, the process of drafting the agreement often triggers discussions on risk allocation, and this can be facilitated by a sound risk assessment.

Information: Optimal risk allocation in a P3 is by definition project-specific and evolves over time. At the same time, 95% of the risk allocation should be similar to other projects based on the same delivery method. In order to avoid "reinventing the wheel," a good starting point is to look at earlier transactions to understand the considerations in the risk allocation. The FHWA model contracts (under development) are also a good source for further guidance on risk allocation. Optimal risk allocation in a P3 evolves over time; therefore it is advised to look at more recent and up-to-date contracts .

Defining the optimal risk allocation can be quite challenging. In a risk allocation workshop, participants are asked to jointly answer the key questions as described in section 5.2.3. There is no need to do this individually, but it is more important to jointly determine a convincing argument for a risk allocation for each of the risks. In some instances, the VfM assessment not only proves helpful for the allocation of individual risks, but more importantly for maintaining the focus on VfM as the leading principle throughout the project's development.

The next step is to define the mechanisms reflecting this risk allocation. Most mechanisms-like the definition of, and compensation for, supervening events-are standard, and have been used in most prior P3 transactions. However, the devil is in the details, and project-specific considerations may lead to adjustments in these mechanisms.

Expertise: As in all other steps in risk assessment, risk allocation requires input from a range of disciplines:

• Technical, environmental, permitting, and traffic and revenue experts to determine the risk measures and manageability by risk type.
• Costing experts, to determine the costs of risk mitigation measures.
• Insurance experts, to determine insurability of certain risks (facilitating risk transfer to the private sector).
• Legal experts, to provide the risk allocation framework to be defined in the P3 agreement.
• Finance experts, to determine the marketability of certain risks.

Preferably these experts have also been involved in project risk identification to ensure that everyone present has a good understanding of the specific risks.

5.4 Output: Optimal risk allocation

The output of this process is an optimal risk allocation to be included in the P3 agreement, and the reflection of the risk allocation-and retained risks-in the PSC and the shadow bid. The outcome of the analysis can be used in the VfM assessment to assist in choosing the optimal delivery method.

Footnotes

4. PPIAF. Public Private Partnership Reference Guide. 2012. https://ppiaf.org/documents/1317?ref_site=ppiaf

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