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Sharpen your pencils
Optimizing risk transfer – the best part of the deal

by Abraham A. Akkawi

Entering the 21st century, the main vehicle used to accomplish the transfer of government-run entities to the private sector will be a public-private partnership (P3). P3s, gaining favour in the United Kingdom in the 1980s under the Thatcher government as the Private Finance Initiative (PFI), have now become more popular in many westernized regions.

A P3 is a cooperative venture in which the public and private sector partners share the risks inherent in the provision of a public service. P3s are often structured with the purpose of financing and delivering large-scale public infrastructure development projects and/or vital public services. If structured properly, the prevailing logic argues that taxpayers, communities and the economy as a whole will benefit from the complementary strengths of both the public and private sector.

As the table below illustrates, P3s take many forms and can be categorized based on the extent of public and private sector involvement and the degree of risk allocation – unique to each partnership.
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P3 Option When it is used Average Term (years) Primary Funding & Financing Requirements Responsibility
Contract O&M New or Existing Systems 5-20 Capital Improvements Public
Design/Build/Operate New or Existing Systems 5-20 Debt & Equity Financing Public/Private
Concession/Lease Existing Systems 15-25 Routing O&M Costs
Debt Refinancing
Working Capital
Public/Private
Finance, Design Build and Operate New Systems 20-25 Debt & Equity Financing Public/Private
Build, Own, Operate and Transfer New Systems 18-25 Debt & Equity Financing Private
Own and Operate New Systems or Asset Sale/Transfer 20-25 Debt & Equity Financing/Refinancing Private
Asset Sale/ Transfer Existing Systems 25+ Debt & Equity Financing Private
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The greatest challenges for establishing a successful P3 arrangement, independent of the option chosen, include:

  • both the private and public sector requiring an in-depth understanding of which functions should properly remain as the government’s business and which services/capital assets need to remain under public ownership;
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  • proposals secured from the private sector need to be properly set up so there is a substantive risk transfer from the public to the private sector; and  
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  • risk elements need to be defined and measured, in order to determine whether proposals represent good value for the money.

It is critically important that there be an optimized transfer of risk to the private sector that creates the best value for money to the government. However, risk transfer alone is not the only objective – a careful and detailed evaluation of all aspects of the project must be performed to ensure that value for money is actually achieved.

Risk can be defined as any factor, event or influence that threatens the successful completion and operation of a project in terms of cost, time or quality. The achievement of value for money in a P3 will often depend upon the level and cost of risk allocated to the private partner. As a result, it is important that a detailed risk assessment be performed and that this assessment be both technically sound and supported by reliable assumptions. Given the comparatively higher cost of private sector finance, it is the extent and effectiveness of risk assessment and eventual allocation that often underpins the delivery of value for money solutions. The many types of risks that could exist within a public sector project include:

  • Project Risk: The project will be more costly to develop than originally planned through factors such as construction delays, environmental or technological difficulties, and costing errors.  
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  • Operating Risk: The project will not operate as planned, with consequent cost overruns.  
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  • Market or Appropriations Risk: Revenues to support the project(s) will be less than planned. The nature of the revenue stream plays a role in determining the level of such risk.  
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  • Technical Risk: Ranges from nominal to material depending on the nature and location of the project and the service levels and technology required.  
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  • Financing Risk: Financiers assign a risk premium to the project, which can contribute significant additional financing costs. If the risks identified by financiers cannot be mitigated, the transaction may not proceed. Mitigating interest rate or debt service cost risk over the life of the financing for the project is particularly critical. In addition, if the term of initial financing is shorter than the contract/concession term, refinancing risk will have to be addressed.  
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  • Regulatory Risk: Changes in regulation may result in additional costs or reduced benefits to the user, which may represent a serious risk for roads projects that require environmental impact assessments, or for projects where current or future regulation can affect the stated mandate.  
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  • Public Policy Risk: The nature of public services provided is not in accordance with the public’s wishes. Development of specific public policy objectives will be critical in assisting private sector partners to design partnering options that address the achievement of these objectives.  
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  • Legal/Political Risk: This arises from the fact that projects typically require some level of legislative support, creating an embedded political risk for the project.  
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  • Force Majeure: Risk associated with, or arising from, what might be described as “Acts of God.”

Having identified the risks existing within the project, the next step is to quantify them. This involves isolating a financial impact should the identified risk transpire. Although this can be somewhat subjective, determining the true cost of doing business can give the parties involved unique insight to costs beyond the day-to-day operations.

Risk quantification is often performed within a Public Sector Comparator (PSC) – a document that involves a risk-adjusted analysis of the public sector solution, in both qualitative and quantitative terms. With respect to the quantitative element, common practice is to forecast costs over a number of years and then discount those costs using a Net Present Value (NPV) method, which provides an indication of future costs of the operation, represented in today’s dollars.

The PSC ensures that, over the life of the project, the analysis includes all the costs detailed below :

  • Capital Costs: related to the design, development, and construction of an infrastructure project.  
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  • Operating Costs: related to running the operation (e.g., maintenance, salaries).  
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  • Life-cycle Costs: maintaining the operation’s assets in good condition (e.g., equipment upgrades, leasehold improvements). These are long-term capital financing costs.  
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  • Hidden Costs: not usually considered in government operations (e.g., overhead, depreciation, self-insurance). In order to make an accurate comparison to any commercial option, these costs must be included.  
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  • “Risk” Costs: financial impacts of the major risks identified in the project. A probability of occurrence is usually attached to the financial impact of each major risk.

For example, the construction risk of a project could be quantified by applying the probability of the occurrence, say 10 percent, times the historical trend that construction costs have over-exceeded budget by a certain percentage, say 12 percent of a $50M budget. In this instance the construction risk factor is valued at $600,000. The same analytical process could be applied to all the cost elements per year of possible occurrence to be incorporated in the NPV of the PSC.

Central to any successful P3 is the optimization of the transfer of risk from the public to the private sector. Risk transfer is viewed by many experts as the most important element within a P3 transaction. In a true partnership, risks should be assumed by the partner best able to manage them. An underlying assumption exists whereby the private partner has superior capabilities in handling various risks and thus will also find the partnership advantageous. The key objective is to achieve better value for taxpayers’ dollars by shifting the responsibility for the operation and/or financing of non-core activities to the private sector, without compromising the quality of service provided.

A successful P3 does not usually involve allocating all risks to the private sector partner. The ability of the public and private sector partners to efficiently and effectively mitigate each risk should govern the allocation of each risk. A successful P3 builds on the experience of each partner to meet clearly defined needs and provide a net benefit (or value for money) to the general public through the appropriate allocation of resources, risks and rewards.

The Canadian Council for Public-Private Partnerships has suggested that the definition of a project as a P3 procurement requires a resolution of two issues: Has there been a sharing of project risk and is the sharing of risks equitable given the potential returns to the partners?

Some would argue that if the only criteria required for the selection of the delivery method for goods and services was the cost of funds, then it would be logical for the government entity to provide all goods and services as no private sector entity can borrow at the rates currently available to the Crown. Similarly, if the private sector could do everything better and adequately self-regulate its activities, why would we need extensive consumer protection in the form of government regulations? Clearly, there are roles for both the public and private sectors. The challenge is to determine the optimum mixture of public and private resources that lead to the optimum method of providing public services at acceptable levels of quality and cost.

Governments’ role is fundamentally different than that of the private sector. When negotiating, the public sector will likely have different needs than that of the potential private sector partner. This may cause difficulties in negotiating an arrangement that maximizes the satisfaction of all negotiating parties. Prior to entering into a P3, public sector negotiators should usually ensure that at least the following are considered:

  • legitimate social and political requirements of the government and public authorities must be crafted into the transaction through contract rights, special consent, veto powers, or regulation;  
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  • a request for qualification (RFQ) and/or request for proposal (RFP) competitive process should be considered, in order to achieve open communication between the public and private sector, provision of adequate substance of the transaction to private sector bidders, and transparency of the process to all stakeholders;  
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  • fair market value principles should be used to balance competing expectations between buyers and users or customers;  
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  • benefits and risks need to be shared with financiers fairly;  
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  • recourse to government should be limited; and  
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  • all stakeholders (i.e., users, employees, government, private investors, etc.) should be protected through a stakeholder analysis and a comprehensive promise of performance, as well as through regulatory oversight and/or contract obligations.

Government, under a P3, needs to ensure that the value of the risk transfer outweighs any extra costs compared to the cost of doing the project conventionally. It should also be mindful of incremental risks it may have assumed by not using conventional means (i.e., transaction completion risk by the private sector, any indemnities provided, and up-front transaction costs). If the benefits can be shown to exceed all incremental costs, the project should be considered.

Working towards achieving a substantive transfer of risk, the public sector should set out the objective and expected outputs in broad terms. It should not focus on how the private sector should provide the service, but rather on what service it should provide. Then the private sector proponents should develop solutions that provide for the most efficient risk management possible and pass at least part of the resultant benefits on to its public sector partner.

As a result, a well planned and executed P3 can result in lower risk and lower costs for the private and public sectors than could be accomplished under traditional procurement means – a win-win situation.

Substantive transfer of risk to the private sector can be a fundamental requirement of a P3 because it provides the incentive for the private sector to manage and mitigate that risk. The private sector can manage some types of risk more efficiently, resulting in a division of labour that underlies and justifies the P3 initiative. Therefore, if the right risks are transferred with appropriate incentives and conditions, then the overall risk is diminished.

Private sector participants are usually concerned about sustainability, risk and return. As such, focus should be expected on basic issues such as:

  • ensuring financial stability through an adequate revenue stream along with ongoing government commitments to subsidize or permit revenue or rate adjustments (depending on framework employed), and/or the ability to securitize cash flows;  
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  • minimizing perceived political and regulatory risk that arises as a result of the sovereignty of the government and the various instruments available to the government to affect the success of the project;  
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  • maintaining flexibility for the private partner to address operational issues by raising revenues, altering costs structures, and enhancing volumes; and  
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  • realizing that sufficient flexibility must be present for any private partner to earn satisfactory returns, while accepting regulatory constraints on the ability to raise fees and charges so as to avoid adverse political consequences.

Risk can take many forms. The nature and degree of risk transfer can, and will, vary from project to project, and also between proposals related to the same transaction. This is where the truly skilled negotiations take place amongst the parties to optimize their key issues including their objectives, costs, service delivery requirements, stakeholder issues, due process and the ability to withstand public scrutiny. In short, a transaction will involve trade-offs and government must try to realize value for money while continuing to exercise its social mandate obligation.


Abraham Akkawi is a vice president at PricewaterhouseCoopers Financial Advisory Services, leading the Ottawa practice in Public-Private Partnerships. He has almost 20 years’ experience in the development of P3s for various levels of government.

 

 

 


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