The Committee found that quantitative empirical evidence is extremely thin and as one witness noted:346
The idea of risk transfer is all good theory, but until you can go to a large project and look at the risks that have actually occurred and document who has borne what [risks] at what price, and so on, you really don't know whether or not the theory of risk transfer has been risk transfer or risk sharing or risk shafting, and I don't think empirical work is being done at the moment …
There were, however, a number of useful case study observations presented, and furthermore, many opinions and judgements on success.
The Victorian Auditor General informed the Committee that:347
It would be true to say that the first generation of PPPs involved the allocation of substantially less risk to the private sector than later arrangements, as reflected in the provision of substantial guarantees and indemnities by the government to the private sector, which had the substantive effect of reverting the major financing risks back to the state (for example, the Victorian Government Infrastructure Program and the World Congress Centre).
This report noted previously the advice of the Department of Treasury and Finance that lessons had been learned from the excessive risk transfer and excessive focus on lowest cost that featured in some projects, between 1990 and 1999, for example the Latrobe Regional Hospital and Port Phillip Prison.348
The Victorian Auditor-General concurred with this view in his evidence to the Committee. He stated that:349
The nature of these [PPP] arrangements, including the risk allocation between the public and private sectors, has substantially evolved over the last decade. This reflects the increasing development and maturity of private investors, and their willingness to accept certain levels of risk.
As investment markets deepened and the prevalence of private sector involvement in the provision of public infrastructure world-wide increased, over the past decade the sophistication of such arrangements has increased, and so too has the risk allocation. Investors are now more willing to accept operational and demand risks than at any time in the past. This is reflected in such arrangements as the Melbourne CityLink project and the regional water infrastructure projects.
In commenting about the government's ongoing responsibilities in the infrastructure arena, the Auditor-General argued that a key challenge of PPP arrangements 'is to establish appropriate risk allocation, effective management and adequate oversight, which ensure that the public interest is protected'.350 In other words, the whole arena is still a significant challenge.
The Auditor-General noted that PPPs such as the:351
Latrobe Public Hospital and the Metropolitan Women's Correctional Centre, were established in a highly competitive environment, with tenderers participating in a selection process with the view to entering the Victorian market, and submitting low-cost proposals incorporating aggressive assumptions regarding available cost efficiencies … While the original arrangements placed considerable risk with the private sector and allowed the government to 'walk away' from the arrangement … in each case the government decided to take over … principally due to its underlying obligation to provide the related public services.
The Auditor-General also noted that 'there are a number of later PPPs that incorporate greater risk allocation to the private sector and overall appear to be operating quite successfully, such as the Melbourne CityLink'.352
Submissions from the private sector cited risk transfer from the public to the private sector as a major benefit to government of PPP projects.353 Some organisations such as the Property Council of Australia also advised that they support the government's current policy position on risk allocation.354 Other private sector organisations have made observations about the translation of policy into practice with Hyder Consulting stating, for example, that:355
… the axiom that risk should be placed where it can best be managed in order to achieve best value is well understood and often quoted. However, it seems rare for this stance to be translated into the final contract documents. The public sector usually pushes more risk onto the proponent than is consistent with best value.
There may be a number of reasons for this, as outlined in the submission from Hyder Consulting:356
First, market forces have dictated that many of the projects awarded to date have been bid in a highly competitive environment. In these circumstances proponents have been willing to accept risks that should clearly be owner risks, to secure the deal. This applies particularly in the PPP environment where bid costs are high; there is no prize for coming second. The downside (from the government perspective) of a proponent accepting inappropriate risks, is that the contract is likely to run into trouble, with consequent ramifications for all parties.
Secondly, PPP projects are typically delivering a public service, and the client's agents are public servants. The culture within the public sector is generally risk averse. Public servants do not get rewarded for taking risks. This is not intended as a criticism, but as a comment on the way the world is. If best value is to be achieved, then this issue needs to be recognised and addressed.357
The Institution of Engineers Australia advised that:358
While it is recognised that the Partnerships Victoria documentation includes a substantial segment on risk allocation, it is noted that the approach taken is that risk transfer equates to risk management, which is far from the truth, and that the risks itemised in the risk matrix are presented as solely financial or 'time lost' risks.
We have previously noted that several risks are not included within the Partnerships Victoria guidelines. The Victorian Auditor-General in a presentation stated that:359
One thing is clear about PPPs and that is that the political risks are not transferred through PPPs, and neither is the public interest lessened. Other risks include public safety risk, public consumer risk, environmental risk, public consultation risk, transparency risk and public confidence risk. The dominant theme is that while services might be outsourced effectively, some risks cannot. There is therefore a need to look more carefully at the practices of assessing and allocating risks as well as the historical evidence on how well risks have indeed been transferred in Victoria.
On the first matter, the Institution of Engineers Australia advised the Committee that:360
Generally high level risk identification and allocation is done well for Victorian major projects. However qualitative risk analysis, including probability calculating, consequence analysis and risk mitigation, is poorly done.
A range of judgements in terms of risk can be applied to the Victorian experience. Critics of the Victorian guidelines argue that the general principle of allocating risk to the party best able to bear it is sound. However, the detailed treatment of risk is less satisfactory. The presentation of such a long list of risks raises the danger of 'not seeing the woods for the trees'. 361
Professor Quiggin advised the Committee that in terms of the Melbourne CityLink project, 'an estimate of the excess cost may be obtained by comparing the present value of toll revenue to be levied over the value of the project, which appears likely to be around $4 billion, with the construction cost, around $2 billion'.362 He further states that: 'the gap of $2 billion between the construction cost of the CityLink project and the tolls paid to the private consortium is, in part, compensation for the real costs of risk misallocation'.363 Most others364 evaluated the Melbourne CityLink project more positively in terms of the treatment of risk arguing that the Melbourne CityLink project saw a range of risks transferred to the private sector and included independent review mechanisms. This structure has ensured that the significant commercial pressures to close agreements for PPPs did not result in compromising engineering and safety quality. Deacons law firm informed the Committee in respect to CityLink that:365
The full risks other than direct government action against the tollway, were transferred and accepted by the private sector. When problems arose in the construction of the Burnley tunnel, the problem remained with and was settled by the private sector with no call on the taxpayer.
In addition, they argued that the Victorian Government has instituted high standards of probity and accountability, suggesting that Treasury has an in-depth understanding of the issues relating to the allocation and management of risk in PPP projects.366
In terms of Berwick Hospital, Thiess commented that some documents were not released until midway through the short tender period, resulting in unnecessary stress on the tender process.367
The Berwick hospital tender is an example where some documents are not to be released until midway through a short tender period of 11 weeks, and the information that has to be compiled and supplied is voluminous.
With regard to the Latrobe Regional Hospital, the Victorian Auditor-General's Office found that the BOO model effectively transferred a significant proportion of the financial risk to the private sector.368 Substantial operating losses within a year of operations, however, resulted in an inability of the private sector consortia to make efficiency gains originally assumed and 'ultimately, the step-in provisions set out in the agreement were exercised and the hospital's operations were transferred to the public sector'.369
The Fitzgerald report did not present any quantitative assessment of risk performance for Victorian PPPs. The precise extent of risk transfers and relative value for money of risk arrangements cannot, therefore, be established.
Commenting on Victoria's approach to risk assessment, however, Fitzgerald noted that:370
Consistent with the UK reforms to its PFI policy, there would be benefits from Victoria moving to an approach to risk assessment that builds upon an empirical base, such as that undertaken in the Mott McDonald Report, but also includes other risk factors such as contract default and forced revision.
The Committee strongly concurs with this assessment and notes the disappointing lack of empirically based risk estimations, valuations and reporting to date.
There is a need for government to develop further expertise to properly assess risk and that attention be given to the long term retention of project management knowledge within the public sector.
This is similar to the experience in other jurisdictions such as the United Kingdom, with the Auditor-General advising the Committee:371
A further issue that emerges from these long term 'outsourcing' arrangements is that, over time, there is a loss of expertise in the effective oversight of these arrangements, given that the state may no longer be involved in areas similar to those subject to PPPs and therefore individuals responsible for oversight functions may not fully appreciate the associated management issues. Therefore, it is important that effective strategies are developed by the public sector to mitigate these risks. This is particularly important, given the public sector's ongoing duty of care associated with key aspects of public sector service delivery.
The Auditor-General nevertheless advised that irrespective of the mode of infrastructure provision/funding, certain risks associated with public infrastructure are difficult, and in some cases inappropriate, to transfer to the private sector (such as a government's duty of care), reflecting the public sector's underlying responsibilities associated with public sector service provision. The Auditor-General also stated that the risk allocation principles embodied in recent Victorian frameworks acknowledge this important issue and promote the allocation of risks to the parties best able to manage them.372
Regarding the concern that the government would inevitably carry risks despite the initial commercial contract, ABN Amro advised the Committee that:373
For existing PV projects, like the County Court project, Spencer Street374 Station project and Berwick Hospital project, it is unlikely they will ever need a public bailout.
According to ABN Amro, this was because most of the project risk is carried during the building phase, a large proportion of capital investment is made up-front, the operating and maintenance costs are lower than initial capital costs and risks, and the essential service risks are retained by the government.375 On the issue of the provision of essential services and associated risks, the Institution of Engineers Australia advised the Committee that 'the public perceives that governments ultimately carry the responsibility for ensuring that essential services are provided.'376. Deacons law firm reinforced this view:377
Core public functions will remain within government under the current Partnerships Victoria policy. This is a recognition .. that, whatever the commercial arrangements reached, government will always have a duty either at law as a non-delegable duty, or as a matter of public policy to step in to remedy service failures. This was evidenced by the service difficulties at the Metropolitan Women's Prison and the Coronial findings relevant to the Port Phillip Prison.
Concern over the lack of genuine risk transfer was also clearly evident in academic literature and the media. For example, an article in The Economist stated that:378
The underlying problem with all these projects is that they are as important as they are expensive. PFI [private finance initiative] deals are supposed to transfer risk from the public to the private sector. But with so much at stake politically, the government cannot afford to let them fail. One way or another, the railways have to work and the underground has to run. This makes it impossible to genuinely transfer risk from the public to the private sector, which undermines the purpose of PFI.
The validity of this statement has been shown internationally and in other jurisdictions. From a commercial perspective, the greater the risks taken by any sector, the greater the expected financial return. Thus, if the private sector genuinely takes on significant risks, it should expect to receive financial returns commensurate with these risks. And so for the public sector.
The matrix of risk identification, assessment, valuation, allocation and management is overshadowed not by the logic and concepts espoused, but by the reality of the price paid for either sector to bear allocated risks. The Committee considers that there is currently a gap between the concept of best practice and best practice in reality. Thiess put it succinctly when it advised the Committee that:379
The intent of Partnerships Victoria is to be admired. However, a lingering concern is that both government and private sector participants retain unrealistic expectations of the risk allocation outcomes.
This gap between concept and practice is also a risk when it comes to matters of new, innovative financing arrangements. Critics point out that few government activities have failed as regularly or incurred as large losses as financial innovation.380 To the degree that innovative financing or innovative lending practices can reduce overall costs, they deserve support. But to the degree that such financial re-engineering leads to artificiality, circumvention of proper project evaluation procedures, or more fashionable arrangements from a policy perspective, they ought to be seriously questioned, and if necessary, rejected. In the end, the public must rely on government for its stewardship and to ensure that the old maxim 'caveat emptor' is adhered to. This area clearly warrants further independent research. The need for both more and higher veracity independent investigations into the net benefits of private investment in public infrastructure is best summed up by the commentators de Bettignies and Ross, who noted:381
Supporters claim that PPPs represent a true organisational innovation for the efficient delivery of public services. Opponents argue that they are an ideologically driven plan … It is time for more independent research to determine the true benefits and costs of public private partnerships.
The Committee recommends that:
Recommendation 20: | The Victorian Government make representations to the National PPP Council to arrange for independent research to be undertaken on the degree to which discount rates should include a component for risk, and the size of this component. |
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346 Professor G Hodge, transcript of evidence, p.59
347 Mr W Cameron, (then) Victorian Auditor-General, submission no.13, p.2
348 Mr G Maguire, Assistant Director, Commercial Division, Department of Treasury and Transport, transcript of evidence, p.5
349 Mr W Cameron, (then) Victorian Auditor-General, submission no.13, p.2
350 ibid.
351 ibid. p.3
352 Mr W Cameron, (then) Victorian Auditor-General, submission no.13, p.3
353 For example, Australian Council for Infrastructure Development (AusCID), submission no.18; and ABN Amro Australia Ltd, submission no.23
354 Property Council of Australia, submission no.33, p.2
355 Hyder Consulting (Australia) Pty Ltd, submission no.12, p.2
356 ibid.
357 ibid.
358 Correspondence from the Institution of Engineers Australia - Victorian Division, 8 July 2002
359 Mr W Cameron, (then) Victorian Auditor-General, IPAA Breakfast Seminar, Presentation, 3 October 2000, p.6
360 The Institution of Engineers Australia - Victorian Division, submission no.29, p.5
361 For example Professor J Quiggin, submission no.25, p.27
362 Professor J Quiggin, submission no.25, p.47
363 ibid., p.11
364 Dr R Arndt, Dr C Duffield, and Professor Hodge
365 Deacons law firm, submission no.14, p.4
366 Deacons law firm, submission no.14, p.4
367 Thiess Pty Ltd, submission no.32, p.13
368 P Barrett, Public-Private Partnerships - Are there gaps in public accountability?, Australasian Council of Public Accounts Committees, 7th Biennial Conference, presentation, Melbourne, 3 February 2002, p.16.
369 ibid.
370 P Fitzgerald, Review of Partnerships Victoria Provided Infrastructure - Final Report to the Treasurer, January 2004, p.25
371 Victorian Auditor-General's Office, submission no. 13, p.5
372 ibid.
373 ABN Amro Australia Ltd, submission no.23, p.18
374 Later renamed as the Southern Cross Station
375 ABN Amro Australia Ltd, submission no.23, p.18
376 The Institution of Engineers Australia - Victorian Branch, submission no.29, p.5
377 Deacons law firm, submission no.14, p.4
378 'Enron-on-Thames: Railtrack and British public finance', The Economist magazine, 30 March 2002
379 Thiess Pty Ltd, submission no.32, p.12
380 For example Professor J Quiggin, submission no.25, p.40
381 J E de Bettignies and T W Ross, The Economics of Public-Private Partnerships, draft report, Vancouver: Sauder School of Business, University of British Columbia, 2003