It is now generally accepted that the transfer of risk to the private sector is only really cost-effective where the private sector is better able to manage and price these risks. Seeking to transfer inappropriate forms of risk onto the private entity merely adds unnecessary cost to a PPP agreement and will also undermine the value for money obtained from the deal. This is because attempting to transfer to the private sector a risk that it cannot control and .manage will result in the private sector entities trying to price that risk into the payments they seek or they simply fail. A good example was the United Kingdom Royal Armouries private financing deal, where the armouries had to take back certain risks previously allocated to the private sector supplier in a revised deal in July 1999.29 This arrangement also illustrated that it is not always desirable to transfer demand risk since the level of usage required of an asset or service under private financing deals is usually not within the private sector's control.
Optimal risk allocation seeks to minimise both project costs and the risks to the project by allocating particular risks to the party in the best position to control them. This is based on the proposition that the party with the necessary skills and experience with respect to a particular risk is best able to reduce, and/or take advantage of, the identified risk(s) and to manage the consequences. Allocating the risk in line with those opportunities creates an incentive for the controlling party to use its influence to prevent, mitigate or take advantage of the risk and to use its capacity to do so in the overall interests of the project.30
Identifying the most appropriate risk allocation between the parties to a PPP while maximising value for money to the public sector is not, however, at all straightforward. A NSW Treasury official commented to the NSW Public Accounts Committee that:
So although people talk about risk transfer and the ability to optimise it, it is not an easy topic. The easy ones are the ones that fall out first. The difficult ones are the ones that get caught up in a lot of complex legal frameworks whereby you are trying to allocate blame, accountability and risk transfer, where it is a difficult area. …There is a point at which you are going to get optimal risk transfer, and that is what we are trying to achieve.31
The conceptual framework used in the guidance material on PPPs recently released by the Victorian Government is that, because government is a service recipient providing full payment only on satisfactory delivery of the required services, all project risk is initially allocated to the private party. It is then a matter for government to determine, on a value for money basis and having regard to the cooperative framework of the partnership, what risks it should 'take back' to achieve an optimal risk position.32 Taking back means a deliberate decision by government to assume or share a risk that would otherwise lie at the door of the private party.33
As usual, the devil is in the detail, but experience is indicating some useful means of deciding on an appropriate allocation of such risks and assessing the true value for money offered by a PPP arrangement. For example:
• In an audit of a major private financing deal that had to be restructured when the private sector parties' initial revenue forecasts proved overly optimistic34, the UK National Audit Office (NAO) identified a number of important lessons to be borne in mind for future PPPs as follows:
- revenue forecasts for start up businesses are subject to great uncertainty;
- make sure that bidders for a deal are not encouraged to be over-optimistic;
- the equity capital to be invested in a project should reflect the risks of that project;
- government guarantees of project debts are unlikely to be costless;
- substantial risks arise if public sector assets are transferred in advance of external finance raising;
- monitor retained risks from the start of the project;
- reallocate risks if necessary;
- if a project requires public funding, give careful consideration to the most cost-effective route; and
- if a deal goes wrong, private sector partners should bear their share of the risk.35
● The previous New South Wales Auditor-General consistently commented that, although private sector owners had been given long-term rights over important road networks, there had not been a proper comparison of the cost-effectiveness of private sector involvement and the traditional public sector approach. Accordingly, the Auditor-General was unable to conclude that the projects that have been undertaken were in the State's best interests from a financial viewpoint.36 In particular, the opportunistic and ad hoc use of private finance was criticised as it was considered unlikely to improve the overall efficient use of the road network and reduce the total costs of road maintenance and management.37
● The Melbourne City Link project is one of the largest infrastructure projects ever undertaken in Australia with an estimated total cost of around $2 billion. It involves around 22 kilometres of road, tunnel and bridge works linking three of Melbourne's most important freeways. A report by the State Auditor-General at the time found that, while the users of the City Link via toll payments would, in substance, be the financiers of the project, the private sector has accepted substantial obligations associated with the delivery and operation of the City Link, including traffic and revenue risks. However, the auditors also found that the decision to establish the City Link as a toll road was not supported by a financial model which compared project costings on the basis of private sector financing versus government borrowings.38
● More positively, the NAO has found that the private financing deal for the redevelopment of the Ministry of Defence's (MOD) principal London office building, and the provision of subsequent maintenance and facilities management services, has the appropriate features of a private financing deal.39 NAO found that the deal provides incentives to the private consortium to complete this major project on time, without varying the cost to MOD, and then to provide the specified standards of service, and that the contract provides MOD flexibility on reducing the space it occupies.40 NAO concluded that a major benefit of the private financing initiative as a form of procurement is that it has enabled MOD to achieve an appropriate allocation of risk between itself and its private sector contractor.41
At the Commonwealth level, the importance of ensuring rigour in costing and evaluating the risk allocation aspects of tender proposals was highlighted in the sale of the supplier (known as DASFLEET) of passenger and commercial vehicles to the majority of Commonwealth bodies. The sale was finalised in July 1997 for a price of $408 million. Associated with the sale, a five year tied contract was signed for vehicle leasing and fleet management to be provided by the purchaser to the Commonwealth. A number of commercial disputes which started to arise out of the 1997 sale very soon after the sale process was completed were the subject of substantial negotiation between the parties and an independent arbitration process. Audits undertaken by ANAO of both the 1997 sale process and subsequent management of the tied contract indicate that, at the time of executing the relevant contracts, there was not adequate and shared understanding between the parties of the nature of the agreement, particularly in regard to the transfer of financial risk. Key audit findings made included that the following issues related to the accountability for performance:
● The Commonwealth considered that, in disposing of DASFLEET, it had engaged in a trade sale of the DASFLEET business together with a five year tied contract for the provision of vehicles leasing and fleet management services to agencies. The alternative of externally refinancing the fleet had been specifically explored and rejected. However, during the arbitration process for the DASFLEET sale agreement and tied contract disputes, it became clear that, contrary to the Commonwealth's view, the winning bidder had bid for DASFLEET on the basis that some $15 million of the total price tendered was for the purchase of the business and the remaining $392.9 million related to the sale and lease-back of the vehicle fleet. The operation of the tied contract was an external refinancing of the Commonwealth's fleet, resulting in estimated additional costs over four years of some $6.9 million compared to the cost of the Commonwealth funding the refinancing of the vehicle fleet itself. Through the residual risk management mechanism, the Commonwealth effectively bore all the risk for the vehicles leased.42
● The tied contract was a finance lease at the whole of Government level, and an operating lease at agency level. ANAO found that the financial implications of the tied contract were such that the Commonwealth was exposed to a range of commercial risks including increased leasing charges (the sale was intended to reduce costs) and potential responsibility for the cost of terminating the contract.43