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PPPs: What Is A Sensible Risk Transfer Strategy?

By Misbah Uddin

April 8, 2019

Public-private partnerships (PPPs) offer governments the possibility of lower whole life costs and accelerated delivery while retaining ultimate ownership of public infrastructure projects. But what are the lessons from previous experience?

MITIGATING RISKS IN PPP

PPPs are characterized by a higher level of risk transfer from the public owner to the contractor than is typical in other forms of project delivery. Studies of PPP performance highlight that while many have been successful, some have failed or entered bankruptcy.[1] It is worth understanding why some fail, so lessons can be learned and applied to risk mitigation.

Project Risks

PPPs involve an element of private sector participation, which can apply to all stages of the project life cycle from financing to designing, building, operating, or maintenance. As such, PPP projects are a risk-sharing arrangement between public and private parties.

Typical project risks include preconstruction risks (land acquisition, permits, etc.); construction period risks (rise in material costs, delays, etc.); O&M period risks (asset failures, unavailability of maintenance materials, etc.); and commercial and market risks (demand risk, change in the law, etc.).

PPP LEGAL STRUCTURE

In a typical PPP legal structure, investors form a Special Purpose Vehicle (SPV) funded by a mix of equity and debt. The lender is not ordinarily liable but can take over assets if an SPV fails, with the government granting step-in rights and operating license transfers to keep the infrastructure running.

STRUCTURING PPP CONTRACTS

Due to high cost and long payback schedules, PPPs often have very long-term contracts, sometimes up to 30 years. Concession contracts are frequently linked to the economic life of the asset. At the end of the term, asset ownership transfers back to the public sector, which may then bid various aspects of operation and maintenance (O&M) to other contractors or manage these services itself. A rail sector example neatly illustrates some of the procurement and delivery choices in PPP and associated risks for public and private parties. For instance, a public sector owner could either retain ticket revenue, or transfer revenue risk to a rail service operator.

Graphic representing forms of PPP.

WHAT THE PUBLIC SECTOR LOOKS FOR

Efficiency gains

PPP is more suited to large projects such as roads, power plants, bridges, prisons, pipelines, ports, waste-treatment facilities, schools, and hospitals. Scale and duration make the longer lead time for the procurement element of PPP projects less of an issue. For example, a short concession term of five years would not yield a sufficient payback for investors, given the typical two-year process to get through the procurement phase. Nor would it be good value for money from a public sector perspective to invest time and resources in developing a short-term project.

Furthermore, government payments are often distributed over the life of a PPP contract, instead of the usual front-loaded schedules for capital expenditure. On top of that, payments to contractors are only made when the benefits are delivered. For instance, in a road project, availability payments are contingent on the road being available for use.

PPP projects also tend to have all phases bundled into a single contract, with the advantage from a procurement management perspective of a single point of responsibility, even if the private partner may, for instance, have separate suppliers for construction and O&M.

Incentivized performance-based/output specification approach

In PPP projects, public owners set forth performance standards and contract requirements, leaving the contractor free to bring to bear their skills, knowledge, and experience on all phases of the project — particularly the project design phase. The government steps back from day-to-day project management and becomes the specifier. The contract will include a performance mechanism that allows for deductions if standards are not met.

Accelerated delivery

When planning public infrastructure projects, one of the risks typically faced by governments is that projects are delayed or canceled because of changing political priorities or stakeholder intervention. PPP can speed up delivery of projects, first by using the procurement and financing expertise of the private sector, and then by applying their project management skills to the design and construction of the project.

Given the penalties for private contractors missing deadlines, PPP projects should carry less risk of contractor delay. Since the concession term is fixed, it’s not in the contractor’s interest to delay the project, as this eats into their revenue during the life of the project.

Mitigating Risk Arising from Complexity

Public owners may consider certain projects to be complex, thus justifying use of the PPP project delivery method. This thinking is likely to be prevalent on projects of the kind that the public entity has never constructed. Conversely, for the private sector, complex projects tend to offer contractors a greater ability to utilize innovative ways to deliver the project that, in turn, may increase potential project returns and have a positive portfolio effect for the specifier.

WHAT DOES THE BIDDER LOOK FOR?

Private sector firms can use their expertise in delivering projects on behalf of a government entity and absorbing risk. The skill is in pricing the risk appropriately.

Return on Investment

The return on investment of a potential PPP should be sufficiently large to attract the investment needed to fund the project and for the investor to accept the transferred risks. If it is a revenue-generating project (e.g., a toll road, a parking garage in an urban area) this is likely to draw more interest from the private sector, providing there is comfort around demand and revenue certainty. With PPPs, there is also greater transparency in pricing through the submission of detailed financial models that deal with the internal rate of return of the project and equity pay-outs to the shareholders. Procuring authorities also benefit from lender due diligence on the investment opportunity.

Sensible Risk Transfer

A potential PPP contractor will carefully examine the proposed contractual arrangements to ascertain whether the risk transfer in the agreement goes beyond their threshold for risk. Hence the risk needs to be assigned to the one best able to manage or absorb these risks. For example, if the project design risk lies with the contractor even though the public owner has control over all portions of the design, or if all force majeure risk is placed on the contractor, the project would be deemed high-risk by the private sector. Some contractors may decline to bid, while others will propose higher costs in order to monetize and cover the additional risk. A similar scenario would be where land acquisition is required for laying a new road. Again, transferring the risk to a private company would make no sense, since government has compulsory purchase powers and is therefore able to secure a fair-value price.

Clear Legal and Institutional Framework

PPP contractors prefer clearly stated and enforceable “rules of the road” related to a project. The agreement must set forth the process by which decisions will be made and implemented, as well as in what time frame they will be made. It must also define the relationships between contract parties and various parties’ roles on the project. If the proposed contract fails to meet these standards, contractors may be reluctant to propose their involvement in the project.

High-Level Commitment from Key Stakeholders

The stakeholders in the context of a PPP contractor’s consideration include primarily the public owner(s). These stakeholders make decisions on an ongoing basis, for example to resolve project roadblocks, underlining the importance of working in partnership. Moreover, the experienced PPP contractor will likely also consider the owner’s constituents — the taxpayers — as they are the intended users of the completed project. These stakeholders will impact, positively or negatively, the demand or usage of the completed project.

Reasonable Time Frames

In the first instance, a potential PPP contractor is concerned with the duration of the planned design and construction phase — to ensure there is adequate time to design, build, and commission the facility. The other schedule concerns the operation and/or maintenance of the constructed facility. The longer this period the greater the potential for a profitable PPP project for the contractor.

ANALYZING AND MITIGATING RISKS IN PPP PROJECTS

PPP projects tend to allocate more risks to private contractors than typical design-build or design-bid-build projects. However, the basic risk management and allocation process remains fundamentally the same. This process generally follows the steps outlined below:

  1. Identify: All risks the project may encounter should be identified.
  2. Analyze: Each identified risk should be analyzed to determine the probability of the risk occurring on the project.
  3. Assess: Each risk should be assessed to determine the potential impact on the project, both cost and time.
  4. Determine: For each risk determine whether to:
    1. Accept: Some risks may be accepted via the terms of the contract. For example, the risk of differing or latent site conditions are frequently accepted by owners through inclusion of a differing site conditions clause in the contract.
    2. Avoid: Contractors can avoid some risks by hiring specialty subcontractors. As an example, a contractor may hire a hazardous-waste subcontractor to deal with any asbestos encountered on the project.
    3. Reduce: Owners and PPP contractors can reduce risk by changing the project design, means, and methods, etc.
    4. Transfer: Owners and contractors can transfer some risks by purchasing insurance or bonds to cover certain risk events.
  5. Manage and Mitigate: Owners and contractors should prepare a risk register that includes all identified risks on the project. Owners and contractors should prepare specific risk management plans for each specific risk that has a high potential risk for occurrence and/or a potentially large impact (time and/or cost) on the project.
  6. Monitor: Finally, the project risk register should be routinely reviewed and reassessed as the project moves from one phase to another — design, construction, commissioning, and operation and/or management.
Value for Money

If the public sector owner retains risks and provides guarantees around payments to the private sector, the cost of privately provided finance falls, but this would also reduce the Value-for-Money of procuring via PPP compared to traditional procurement where the public sector retains most risks anyway. According to the UK National Audit Office, a sizable risk premium is added by the private sector for holding the financial risk in PPP bids, even when responsibility for paying out or making remedies contractually falls upon the public sector in the event of project failure. Reporting on the failed London Underground PPP, the Public Accounts Committee of the British Houses of Parliament published a report in March 2005 on what went wrong. It reported that the perception by financiers of political risk (such as the amount of central government support to local government), rather than project risk, appears to have accounted for most of the extra cost of private finance.[2]

SUCCESSFUL PUBLIC AND PRIVATE PARTNERSHIPS

Successful PPP projects rely on a working partnership between public agencies and private sector. They assume a legal and institutional framework exists to ensure that funding from investors is forthcoming. Projects should be carefully selected, and contracts specified under fair terms and performance targets. Thereafter risks must be appropriately allocated and priced. Ultimately, partnership allows issues arising to be dealt with during the concession life cycle, and possible renewal of the concession going forward.

CONCLUSION

PPP has become a legitimate and common project delivery method in a number of countries. It can provide greater certainty of project cost and contract value to the public sector before construction starts, maximize the use of private sector skills, and inject private sector capital into infrastructure. While many PPP projects have been delivered successfully, others failed in the long run. It’s worth noting that studies of PPP project performance have found that the main causes of failure are inadequate project governance and flaws in risk identification, allocation, and management.[3]

PPPs, if properly structured, can be successful and meet the needs of all parties. Careful and thorough risk identification, planning, allocation, and management will positively impact the value-for-money — thereby justifying the use of PPP as opposed to traditional procurement and delivery methods. Moreover, allocation of project risks will greatly affect project success and bankability from both a contractor and a lender’s perspective.

Inappropriate or unrealistic risk transfer through contract clauses allocating some key risks to the PPP contractor are inappropriate and may lead to project failure — for instance around usership, force majeure, obtaining all permits, or change of law. It’s important that public owners recognize that PPP agreements will not allow for wholesale transfer of all risks. However, appropriate risk transfer is not the only thing that helps to deliver a successful PPP project. The public owner should draft and negotiate realistic and thorough output specifications that encourage innovation with financial performance linked directly to achievement of these outputs. Finally, public owners and PPP contractors should look beyond contract execution to the design, construction, operation, and/or maintenance plans and even beyond to what happens when the term of the agreement is reached.


[1] Khalid Bekka, “Public-Private Partnerships for Infrastructure Development: Acquiring New Skills for a New Age,” HDR, Silver Spring, MD., May 2012.
[2] Louise Butcher, “London Underground PPP: background,” House of Commons Library, January 16, 2012, http://researchbriefings.files.parliament.uk/documents/SN01307/SN01307.pdf.
[3] Id. Citing Young Hoon Kwak, Ying Yi Chih, and C. William Ibbs, “Towards a Comprehensive Understanding of Public Private Partnerships for Infrastructure Development,” California Management Review, Vol. 52, No. 2, Winter 2009, and Antonia Solino and Jose Manuel Vassallo, “Using Public-Private Partnerships to Expand Subways: Madrid-Barajas International Airport Case Study,” Journal of Management in Engineering, Vol. 25, No. 1, American Society of Civil Engineers, New York.