Why do private investors risk their capital by investing in any particular project? The key to this question lies in the risk/reward calculations carried out by the potential operator. They are concerned with risks of various kinds:
• Project risks are posed by the project itself - How much will it cost to provide the required services? How much will users pay for the services? How will government regulation affect the operations?
• Country risks are posed by the country in which the project is located - Does the government honour contracts? Will the currency be devalued? Are there mechanisms for resolving disputes? Can profits be taken out of the country?
Ultimately, however, the key question is whether the risks that a private investor takes on are likely to be rewarded by the profits they earn. Governments play a crucial role in determining the extent of these risks. How the partnership arrangement is structured and implemented is the key to project risks. How the country treats private investors is key to country risks. How the municipality protects the interests of users, communities and municipal workers affected by the partnership arrangement is key to political risks.
Many governments also assume that only foreign private investment is available. Increasingly, however, local sources of private investment are being tapped. In addition to local commercial banks, such sources may include pension funds, local stock markets and local firms - particularly those already providing urban services and seeking to expand their businesses. Country risks are often not as much of a concern for local investors, given that they operate in the country already. As such, in some cases they may actually offer more attractive financing terms than international investors.
Negotiations with the private partners will focus not only on how the company is to make money (such as the fees to be paid or the tariffs to be collected), but also on the question of who bears what risks. As to the level of fees, they should be high enough to cover the costs of providing the service, plus a reasonable profit. As much as possible (and as discussed above), they should also enhance the incentives for timely improvements in performance. As to who should bear which risks, an old saying usually applies: 'risks should be borne by the party best able to manage them'. If the private firm is installing equipment or treating water, it should bear the risk of the equipment or treatment failing to work. If the government is responsible for setting performance standards, it should bear the risk of additional costs if those standards are tightened over time.
Risks associated with customer demand are often major points of conflict in urban services: Who pays if the customers refuse to buy the offered service, or pay the authorised fees for it? Private firms will seek either to have the municipality bear such risks (by seeking to have the municipality pay fees directly for the services provided), or to allow for a higher level of profit (to offset the increased risks) in its bid.