Cooperative Sharing and Mutual Support
GOVERNANCE CHALLENGE Theory in project finance suggests that risks should be borne by the party best able to manage them, but many PPP projects often fail because the parties cannot agree on the allocation of risk, with each side trying to shift the risk to the other. It is also difficult to calculate risks, especially in transition economies when the rate of economic growth is sometimes less predictable, which makes forecasting demand especially in transport projects a difficult exercise. |
Principle 4 - PPPs allow risk which is most able to be managed by the private sector, to be transferred to them. However, governments also need to accept their share and help to mitigate those allocated to the private sector in mutual support.
Balancing risk is of crucial importance to PPP development…
The main benefit from PPPs arises from the transfer of risk to the private sector. But such a transfer and the degree to which the private sector is ready to assume it sometimes impairs the feasibility of projects. The lenders tend to be highly risk averse and will turn down even the most socially desirable project if they perceive it to have too many risks - a fact which disappoints and frustrates the public sector.
… And governments should identify risks at the start of projects…
A good starting point may be to use a checklist of the risks, which typically apply to infrastructure service projects.
…Establish a risk matrix…
A useful tool to both government and the private sector is the risk matrix, which should be applied to each project phase, setting out the government's preferred position on allocation. During the pre-tender and tender phases, it can assist government practitioners in listing all the relevant project risks and their proposed allocation. During negotiations it can act as a checklist to ensure all risks are addressed, and after signing of the contract it can be a useful summary of the risk allocation effected by the contract.
…And be prepared to mitigate the risks...
Governments can use a number of tools such as insurance to mitigate the risk of a force majeur event, which could damage a state-owned network essential to the private component of the project. Such systems may be insurable by undertaking research before issuing tenders and specifying desired outcomes of the project (while taking into account government policy). Since the project is in the public interest, it is also essential to provide transparent regulatory procedures, especially at the bidding stage. Once the project starts, the government will have to establish a risk monitoring system to ensure that services are delivered according to contracted performance specifications. Accordingly, this will allow for payment for services to be appropriately verified while ongoing surveillance will monitor that the project is progressing as planned.
…While taking on their own share of risk within the areas where they have influence…
Governments need to address political risk, including the concern that governments will come in unilaterally and change the rules (the swing from a positive approach to PPPs to a negative approach and cancellation of PPPs after an election is commonplace in some countries).25
…While also responding to private sector concerns over 'red tape'…
A further challenge the private sector faces concerns the difficulties in obtaining the needed planning and other approvals to start projects, since red tape and unnecessary interference can delay the project. With respect to 'red tape', Governments can intervene to smooth over such problems in order to facilitate the project to start on time.
…And changing agreements, but only in the right way.
Governments can change the conditions of the agreement because of the long duration of projects. Yet, it is important before the change is made, that the private partners are fully consulted. Similarly, a government can 'step in' or terminate the contract if it perceives the project to be going awry. Here the private sector's anxieties can be addressed by contractual clauses, which make termination and 'step in' measures of last resort.26 | There 'is a general perception that a private sector provider is "contracting with the umpire" which creates a general unease about changes to all areas of legislation and policy'. Source: Partnerships Victoria |
Attention must also be paid to the potential effects of lengthy cure periods and particular defaults, while also taking into account the government's capacity to deliver core services and its ability to deliver or procure the delivery of replacement ancillary services that the private party is unable to provide.
At the same time, it is also crucial that the government provides necessary support…
Many projects, especially in transport, require massive private sector investment and here the private sector may not accept one of the various commercial risks for these projects.27 The public sector must provide support to a project and lower the risks sufficiently to stimulate the desired levels of private sector investment.28
There are various forms of support which the government can give to a project in order to mitigate the risk to the private sector (See Annex). To take one such example, guarantees may be an appropriate form of government intervention, in particular to shield the private sector from risks that it cannot anticipate or control. Indeed, many PPP contracts provide for minimum revenue guarantees that limit the private sector's exposure to demand risk.
…However these types of guarantees and supports by governments must be provided with care…
It must be noted that under this scheme, governments take on liabilities which have important fiscal implications. There is a risk too that inadvertently the governments create a 'guarantee culture' where the private sector seeks guarantees as an alternative to managing the risk themselves. Governments must stay focused on the fact that the whole point of the PPP is to improve performance of the project, which is done by using the risk to its investments as an incentive to the private sector to perform well.
Because guarantees are valuable to beneficiaries and are provided at the discretion of government, this can undermine governance. In reviewing this issue, government officials may wish to follow IMF Guidance on National Accounting. These guidelines argue that such guarantees do not count as part of a sovereign guarantee ceiling calculation, provided that they are being given to commercially viable entities, and it is unlikely at the outset that they will be called absent in the occurrence of an unforeseen event.
Flexibility is important in risk allocation Case of Spanish Toll Roads Every situation is unique and there are no hard and fast rules or models for risk allocation. Often governments can introduce less orthodox and flexible tools in risk-sharing, which can have welcome benefits. For example, over thirty years ago the Spanish government, in an effort to upgrade its roads around its coastal seaside resorts to boost tourism, made a brave decision. It assumed the exchange rate risk on the project, something that, according to common practice, may have been considered to be ill-judged. Exchange rate protection continues up to the present day. However, based on a calculation of the costs of taking on such a risk and not taking into account the externalities of the benefits from tourism flowing from the improvement in the roads, it appears that over this period the government lost nothing in accepting this risk. |
…Because the risks and the benefits should both be shared.
After a PPP project such as prison, school, or hospital is built, the level of risk falls substantially. This is because with the facility built, the risk that the facility may not be completed on time disappears. As a result, banks become receptive to review the interest rates it charges and to cut the cost of the loan. This leads to the creation of financial surplus and raises the question of who should gain from the success, bearing in mind that it has been typically the private sector that has taken on the construction risk in the first stage of the project?
Current practice suggests that all parties, rather than one exclusively, should share in the gains and that gains could be shared out by a formula agreed by the various parties before the agreement is signed.
ACTION POINT PPPs afford both the public and private sector with a unique opportunity to share risk while providing complementary support in order to ensure that the project leads to mutual benefits to both sectors. |
Sources and Further Information
• Partnerships Victoria, Risk Allocation and Contractual Issues, June 2001.
• IMF, PPP and Fiscal: International Seminar on Strengthening Public Investment and Managing Fiscal Risks from Public-Private Partnerships, Hungary, 7-8 March 2007.
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25 In some cases, however, the PPP can survive. For instance, the A1 road project in Poland survived eight changes of government during its negotiation process.
26 In the case of a step in, relate only to emergency access and where there had been a material service default (which includes continuous or repeated non-material defaults); and in the case of termination, seek to ensure that 'cure periods' are fair and that as far as possible, the conditions under which termination or government step-in may occur, are clearly specified and limited to material defaults so as to avoid hair trigger termination events.
27 These include: the risk that in the promotion and development stage of the project, there is still no guarantee that the project will take place; the high-risk construction phase due to the likelihood of cost overruns throughout the lifetime of the project; and the uncertain revenues once a project starts operating and the potential for policy changes to undermine the viability of the project.
28 For example, if the public sector does not plough enough resources or fails to offer other ways of lowering commercial risk, then projects such as TENS, which require massive private sector investment to be completed, will not be realized.