Risks come in many forms and often depend on the characteristics of a particular project. The risks involved in providing a playground for a school are sure to differ in some aspects from the risks associated with a large scale transport project. The transfer of risk differs with PFI public services contracts in that it enables the transfer of project financing risk to the private sector. Therefore, an essential condition of any PFI project is that sufficient financial risk is transferred to the private sector to secure value for money.
The main benefit of transferring financial risk to the private sector is that they are perceived to have an advantage over the public sector in handling financial risks. Most successful private sector firms have risk analysts especially in the financial sector. Public services project financing risk; the risk of delivering an economically viable financial package, can be divided into two main types, internal disposal risk and external financing risks.
Disposal risk is the risk that the expected value of surplus departmental assets, detailed for disposal in a PFI contract to fund public services, is lower than expected. Departments can reduce their exposure to this risk by transferring assets, such as redundant hospital buildings and grounds, which have, or are to become, surplus to requirement to the private sector contractor as part of the PFI contract. External financing risk is the risk that the private sector contractor fails to raise sufficient funding for a public services project on the market. As with any contract, the ability of the private sector contractor to secure the finance required to complete a PFI project, must be determined by the sponsoring department before the deal is signed. External financing risks are also related to interest rate risk, which is the risk that the interest rate will change between the time a bid is tendered and the time a contract is signed. Adverse movements in the interest rate during this time mean that the private sector contractor has to pay more to service their debt, which may reduce the attractiveness of a PFI contract.
The transfer of project financing risk generates incentives for the private sector to supply services on time and of a higher quality as they only start to receive service payments when a flow of public services actually starts, and continued payment depends on meeting specified performance criteria.55 A further effect of transferring a project's financing risk to the private sector is that it reduces the general risks of public service projects that have been retained by the public sector. However, risk and reward go hand in hand: the higher the perceived risk that is being transferred to the private sector, the greater the risk premium that will be required by the contractor from the public sector to compensate them for their exposure. Given that some risks are difficult to quantify it is difficult to determine whether a private sector contractor, for accepting a particular risk, is charging a suitable risk premium for either party.
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55 Treasury Taskforce, Partnerships for prosperity, 1997