3.5.2 Identifying the proportion of Systematic Risk

How Systematic Risk is allocated between the Public and Private Sectors is fundamental to determining the appropriate Discount Rate to adopt for the evaluation of Private Sector bids. If the PPP arrangement does not transfer all Systematic Risk to the Private Sector, then the appropriate Discount Rate to use in evaluating bids will be less than the Project Rate.

It must be noted that the allocation of Systematic Risk is not an exact science. The basic question for each Systematic Risk is whether, it represents a potentially large proportion of the premium to be allocated and who is bearing the predominant portion of the risk, or is it reasonably shared.

The key test is to establish who will bear any variation in cash flow and return as a result of the Systematic Risk allocation. Depending on the particular project arrangements and the nature of Systematic Risks inherent in a project of its type, there will be a range of factors to consider in order assessing the variability of cash flow and returns.

To enable the identification of the proportion of Systematic Risk borne by the parties, and allocate the Systematic Risk Premium, a two stage process is required:

1. Assess the relative importance (weighting) of each of the Systematic Risks

2. Assess how the risk is allocated between the parties

Completing Table 4 will assist practitioners to estimate the amount of Systematic Risk transferred to the Private Sector and therefore, the Systematic Risk Premium to add to the Risk-free Rate so as to arrive at the PPP Discount Rate. The Systematic Risk Premium allocation table will provide a reasonable approximation of the Systematic Risk Premium for each Systematic Risk. The next section provides further guidance to completing the table.

The information required to populate this table will be provided from undertaking the analysis in the earlier steps. A worked example using the table is provided in Appendix C.

Table 4 - Systematic Risk Premium Allocation Table

The Estimated Portion of the Systematic Risk Premium (Column 2) is calculated as the portion of the weighting for each Systematic Risk (Column 1), divided by the sum of all weightings (Column 1), multiplied by the Systematic Risk Premium (as calculated in Step 3). This step cannot be undertaken until all Systematic Risks have been assessed. An illustration of the calculation is provided in Appendix C.

A five-point scale has been adopted for weighting the relative importance of Systematic Risks to ensure that sufficient differentiation is possible between risks, without introducing an unwarranted level of sophistication that a larger scale would imply. For example, it could be that the Systematic element of Demand Risk warrants a weighting of five, where all other Systematic Risks only warrant a relative weighting of one. The principal reasoning for this could be that unexpected levels of demand, that will potentially cause the most significant variability and impact on the cash flow streams of the parties and who is bearing this risk of variability will be extremely important in the context of the overall assessment when compared to the potential impact of other factors.

To enable these assessments to take place, there are a number of questions that need to be answered with respect to each of the identified Systematic Risks. The following pages provide practitioners with guidance to enable them to undertake the required assessments to complete the table and arrive at the portion of Systematic Risk Premium to be transferred.

In undertaking the analysis, where quantitative factors are used, practitioners should use the present value of the relevant cash flow streams (for the purpose of allocation of the premium the cash flow streams should be discounted at the Project Rate).