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Risk Assessment for Public-Private Partnerships: A Primer

January 2014
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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 - Risks fully transferrable to the private sector.
  2. Retained risks - Risks for which the government bears the costs, for example, the risk of delay in gaining project approvals.
  3. Shared risks - Risks that are shared based on a combination of the above two allocations due to the nature of the risk.

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 percent of the total forecast cost savings under a P3 approach (Andersen & Enterprise LSE, 2000). This may be due to the private entity's ability to manage a specific risk more efficiently or due to 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. In contrast, 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 chapter 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 not only the optimal allocation of project risks among parties, but also 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.

Although the concept behind optimal risk allocation is clear, the practice of how agencies allocate risks is more of an art than a science. In a typical scenario, the public sector will be expected to take on regulatory risks. Site risks - for example, utilities, ground conditions, or hazardous materials - may be transferred or shared. 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 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, transferring all of the risk 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. In addition, 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.

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

Private Sector Standpoint

From a private 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) 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 entities alike. Each risk is allocated to the party best suited to manage or mitigate it.

Optimal risk allocation can be graphically represented as the area that is within the acceptance level of both parties (see figure 5). 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, whereas 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 6), which shows how risk allocation differs for DBFOM projects relative to conventional procurement (DBB) and DB. Note that there is a significant level of detail not shown in table 6. For example, even though it is a starting point to transfer all permit risk to the private sector under a P3, it is often a more complex risk allocation in practice: The public sector takes on the risk of the initial permits, but the private sector takes on the risk of any permit amendments associated with detailed design.

Figure 5

Figure 5. Optimal risk allocation in public-private partnership projects for both the public and private partners.

Detailed description of Figure 5

Optimal risk allocation in public-private partnership projects for both the public and private partners. A line graph depicting risk-reward trade-offs for both the public and private sectors. The x-axis is labeled Increasing Risk; the y-axis is labeled Private Financial Returns/Public Sector Costs. A blue line depicts the relationship risk-return from the public sector perspective. For this line, the costs and the risks start nearly at zero, steadily increase, then begin to plateau. A red line depicts the relationship risk-return from the private sector perspective. This line starts off at a higher level of cost than does the public sector line. The associated risks for the private sector increase more gradually than those associated with the public sector as costs increase. Costs then take a sharp upward turn, while risk stays relatively stable. The curves overlap in two places, depicting the possibility for a public-private partnership. The first overlap happens when both costs and risk for both groups are rising but still relatively low. The second overlap occurs when costs are steadily rising for the private sector but risk is basically stable, and when both cost and risk begin to plateau for the public sector. To the left of the red curve, a private sector entity will accept any investment. To the right of the blue curve, the public sector will accept any agreement, which represents the lack of willingness of the public sector to allow extremely high returns to the private sector, even of the risk taken on by the private sector may warrant it.

Table 6. Common risk allocation under conventional and public-private partnership procurement.
Risk Design-Bid-Build Design-Build Design-Build-Finance- Operate-Maintain
Change in scope Public Public Public
National Environmental Protection Agency 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
Quality assurance/ Quality control 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

Note: O&M = operations and maintenance.

Source: From PPTA Risk Analysis Guidance (p. 18, table 4), by the Virginia Office of Transportation Public-Private Partnerships, September 2011, Richmond, VA. Copyright 2011 by the Virginia Office of Transportation Public-Private Partnerships. Adapted with permission.

Detailed description of Table 6

Common risk allocation under conventional and public-private partnership procurement. This table shows how risk allocation differs for Design-Build-Finance-Operate-Maintain (DBFOM) projects relative to conventional procurement (Design-Build-Bid, or DBB) and Design-Build (DB). Four columns are labeled as follows: Risk, Design-Bid-Build, Design-Build, and Design-Build-Finance-Operate-Maintain. 15 risks are listed: (1) change in scope, (2) National Environmental Protection Agency (NEPA) approvals, (3) permits, (4) right of way, (5) utilities, (6) design, (7) ground conditions, (8) hazmat, (9) construction, (10) quality assurance/quality control, (11) security, (12) final acceptance, (13) O&M (operations and maintenance), (14) financing, and (15) force majeure. The risks for DBB projects are taken on by the public sector for all risk categories except for construction (which belongs to the private sector). For DB projects the risks that are taken on by the public sector are change in scope, NEPA approvals, right of way, ground conditions, hazmat, security, O&M, and financing; the risks are shared for permits, utilities, quality assurance/quality control, and force majeure; private sector risks include design, construction, and final acceptance. Only two risks are usually allocated to the public sector in DBFOM projects: change in scope and NEPA approvals; permits, design, ground conditions, final acceptance, O&M, and financing are allocated to the private sector; right of way, utilities, hazmat, security, and force majeure are shared risks in DBFOM.

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