Risk Transfer

How much risk should be transferred?

Answering this question correctly and allocating risks accordingly maximizes public value. There are several risk allocation conventions (for example, a private contractor is naturally positioned to efficiently manage construction risks, a government is better positioned to control and absorb regulatory risk), but every partnership is unique and carefully negotiated. Beyond the conventional wisdom of placing the various risks with the party best able to manage them lies the reality of competing public policy goals, the finite risk capacity of the marketplace and the difficulty of holding a risk allocation fixed throughout a negotiation. In short, risk allocation is the search for optimality.

As partnership models proliferate around the world, risk allocation principles are becoming increasingly sophisticated and the parties are becoming more adept at crafting structural solutions to risk capacity constraints. For example, many PPPs have been structured to isolate discrete and identifiable "chunks" of risk (such as tunneling) to avoid contaminating the overall risk-sharing approach with inefficient pricing. The public sector has discovered efficient ways to "write down" those elements and still achieve value. The key is to optimize, rather than maximize, the level of risk transfer.

One of the core tools being used in international P3 that is now gaining ground in the United States is Public Sector Comparator/Value for Money analysis. The term Public Sector Comparator (PSC) refers to the risk-adjusted whole-of-life cost of procuring an asset or service through whatever is considered the conventional public procurement method. The term Value for Money (VFM) refers to the result of a comparison between the PSC and the risk-adjusted whole-of-life cost of procuring the same asset or service from a private party.

The PSC/VFM analysis is used to describe the difference in risk-adjusted cost to the public sector between conventional procurement and PPP procurement. In a direct comparison, whichever model produces a lower cost is said to provide Value for Money (see appendix B for a schematic of the analytical process). The practice in many countries is to perform this analysis as part of the approval process for undertaking a project as a PPP. In those cases, unless VFM can be proven, the project is either aborted or pursued by conventional procurement means.

A key first step in developing a PSC/VFM framework is to define "conventional" public procurement. For U.S. public sector entities, that is likely to be a marrying of the best-practice contracting method (design-bid-build or design-build) with some form of bond financing. In countries where this analysis has been widely practiced, the sovereign cost of capital is used as the benchmark. That concept is irrelevant for the United States, where infrastructure is conventionally financed in the tax-exempt long-term debt capital markets.

Accurately assessing the value created by partnership structures in today's turbulent financial markets requires complete transparency in both the public and private sectors' costs. An accurate assessment also requires realistic assumptions about whether a project could actually proceed through traditional means if Value for Money is not demonstrated using PPP. With public funds less available and being used to finance an expanded number and degree of activities (social welfare needs, economic stimulus spending and financial system recovery), the validity of this assumption should be confirmed. If the project would not proceed unless a PPP is used to deliver it, then the benefits of expedited delivery should be factored into the analysis.