• Construction risk (mainly delays in construction)

• Technology risk (arises when the technology is not a proven one)

Types of risk in a PPP

• Sponsor risk (ability of the sponsor to deliver the project)

• Environmental risk

• Commercial risk (lower than expected demand for services produced by the project)

• Operating risk (inefficiency in operation leading to higher operating cost)

• Legal risk (change in law)

• Regulatory risk (change in regulatory regimes)

• Political risk (change in government policy)

• Force majeure (risks due to unpredictable natural and man-made events such as earth quake, flood, civil war, etc.)

An important aspect of PPPs is an explicit arrangement for sharing of risks between parties involved. Many different techniques ranging from rule of thumb (based on past experiences) to sophisticated simulation models are available for the assessment of different risks in a project.38 A risk matrix is developed after assessing risks in quantitative and/or qualitative terms for all possible risk factors. PPP contracts often include incentives that reward private partners for mitigating risk factors. An example of a risk matrix has been in Appendix 2.39 Though it is set up from the perspective of the government, it provides an example of how risks can be identified, assessed, and mitigated.

Risk matrix

The risk matrix identifies the risks, their magnitudes and possible mitigation measures and serves as a useful tool for the purpose of sharing risks between the parties. The general principle is that project risks are allocated to the party that is the best equipped to manage them most cost effectively. For example, political and regulatory risks are more appropriate to the public sector while construction and operating risks are more suited to the private sector. The allocation of commercial risks is generally more common to the private sector. However, in certain cases, a part of the commercial risks due to lower than expected demand for services produced by the project may be shared by the public sector. In such cases normally a provision is also set to share any excess revenue if the demand exceeds the expected level. Table 3 provides an example of an arrangement for sharing of various risks.

What the risk matrix shows

Risk

Contractor

Operator

Equity

Lenders

Government

Insurance

Unallocated

1. Construction overruns/delays

*

*

2. Change in legal regimes

*

*

*

3. Land acquisition

*

4. Approvals/ licences/permits

*

*

5. Variations

*

*

*

6. Taxation

*

*

*

*

7. Tariffs and charges

*

*

*

8. Revenue/Traffic/ Demand

*

*

*

9. Operation

*

10. Maintenance

*

11. Defects liability

*

*

12. Natural disaster

*

*

13. Industrial action

*

*

*

14. Environmental

*

*

15. Civil disobedience

*

*

*

16. Insurance

*

17. Force majeure

*

*

*

*

*

18. Confiscation

*

*

*

*

19. Interest rate risk

*

*

20. Repatriation of capital and profit

*

*

*

*

Note:

Risks of political nature and some other types of risks (items 2 and 20, for example) can be covered by special risk guarantee instruments. See discussion below.

Source:

Adapted and modified from Antonio Estache and John Strong, The Rise, the Fall, and the Emergency Recovery of Project Finance in Transport, World Bank Institute. Available at <http://wbln0018.worldbank.org/Research/workpapers.nsf/0046a83407e91901852567e50051cc43/8b0290555c2424f3852569130063d5 ee?OpenDocument>

It is important to note that risk transfer is a key element in effective PPP design. If a good balance in sharing risk is not achieved, it will result in increased costs and the inability of one or both parties to fully realize their potential. The magnitude of project risks are also assessed as a part of the due diligence process undertaken by lenders. The higher the assessed/perceived risks of a project, lenders would charge a higher risk premium for lending money. Consequently, the financing cost of project becomes higher. This means, holding project capital and operating cost constant, the same project in a country with higher risk perceptions would require a higher tariff than in countries with lower risk perceptions.

The necessity of good balance in risk sharing risk sharing

The government can provide loan guarantees (partial or full) for a project to help reducing its risk level and thereby financing costs. This is also helpful to make a project commercially viable. If such a guarantee is available, investments risks can be assessed at the zero or no risk level (compared with sovereign borrowings). However, such guarantees expose the government to potential liabilities in the event of a loan default and as such have implications for fiscal discipline (see Chapter III). Further, full guarantee by government reduces the incentives for the private operator to manage the project risks.

Implications of loan guarantees

Multi-lateral agencies such as the Multilateral Investment Guarantee Agency or MIGA of the World Bank Group provide loan guarantee of developing country private sector projects. MIGA provides guarantee against foreign currency transfer restrictions, expropriation, breach of contract, war and civil disturbance. Many other development banks such as the Asian Development Bank, and ECAs have also similar mechanisms for providing loan guarantee to private projects.

Risk guarantee instruments