The application of expected values in the PSC takes account of risk in the sense that all possible outcomes are considered and a mean or expected value is derived, as in Table 1 above. However, the expected value calculation does not in itself provide any information as to the potential variance of that value over time. The PSC has to incorporate adjustments for the variance of project cashflows due to risk. Finance practitioners generally classify project risks as either systematic - ie risks to project revenues and costs that are associated with the broader economic cycle - or unsystematic, which are risks specific to a particular project.
A fundamental principle of corporate finance theory is that an investor can eliminate project-specific or unsystematic risk by holding a diversified portfolio of investments. If, for example, Company A's revenues decline in cool weather, while Company B's revenues decline in warm weather, the investor can eliminate its exposure to lower investment returns due to the weather by investing in both A and B. In this case, the weather is an unsystematic risk. In finance theory investors are not rewarded for accepting unsystematic risk - by demanding a higher return on their investment relative to other investments - as these risks can be eliminated through portfolio diversification.
The investor is nevertheless unable to eliminate the risk of decline in investment returns from both companies as a consequence of factors unrelated to the weather, for example, economic recession. Recession is a systematic risk. Consequently, the only relevant risks in any investment are systematic risks. Typical systematic risks in PPP arrangements are demand or end-user risk, inflation risk and residual value risk.
Compensation for accepting systematic risk is achieved by adding a risk premium to the project's cost of capital, which is notionally the risk-free rate of interest before any adjustment is made for systematic risk. The extent of the premium depends upon the extent to which project returns vary with the returns from the broader economy. Private sector proponents will structure their bids on the basis of their assessment of the systematic risks that they will be required to manage under the partnerships arrangement and will reflect the risk premium attached to the project's systematic risk by individual bidders.