PPP contracts are characterized by a relevant level of risk transfer to the private-sector party, although the specific risk allocation varies with the form of PPP used for the project, as different is the scope of activities delegated to the private sector. Infrastructure projects involve long term contracts that allocate risks between the public and private parties.
The crucial point of designing a contract is first to recognize type of risks faced given the nature of the project, but also to provide the incentives in the contractual arrangement to tackle such risks. Those incentives have to target on reducing long-term costs and keeping projects within their planned timetables and budgets. In addition, the quality and revenues yield should also be included within the incentive structure. In that way, contract design will tackle the majority of endogenous risks. In that case, the allocation of risks between the public and private parties involved is crucial. This involves the definition of responsibilities, rewards, and transparency of processes to assure adequate risk insurance (Iossa, Spagnollo, Vellez, 2007).
Optimal risk sharing means it is efficient for less risk-averse parties to take a bigger proportion of the risk. One could argue that the government should be less risk averse than private operators, for which large infrastructure projects would potentially imply large risks that are not easy to diversify. This casts doubts on the government's ability to save money through PPP financing schemes. Instead, one should expect the private contractors to demand a higher remuneration from the government for having to bear significant risks. Moreover, private contractors will face less favorable financing conditions in capital markets because they are 'worse risks', having a higher default probability than the government, which benefits from its ability to tax. Pure risk sharing considerations, therefore, do not seem to offer a justification for PPP. Therefore, pure risk-sharing considerations do not seem to offer a strong justification for PPPs. In reality, the problem comes from the difficulty of disentangling exogenous risk from endogenous risk, that is, what the contractor can influence through his action.
Optimal risk sharing implies that the marginal cost of shifting risk from the public to the private sector equals its marginal benefit. It is therefore a good idea to neutralize the effect on the contractor's compensation of purely random shocks that can be independently observed. Relative-performance evaluation is thus about partly filtering out common shocks to lower the risk borne by each contractor for a given strength of incentive pay. Its goal is not primarily to induce contractors to work harder by pitting one against the other. But it is true that the availability of another contractor's performance measure leads to higher effort at the optimum by strengthening the relation between individual effort and performance.
Allocating the responsibility and ownership to the private sector through an ex-ante designed contract, aimed at delivering goods or services, depends on its comparative advantage in achieving efficiency and equity. A government that designs the characteristics and quality attributes through contracts chooses the degree of involvement from a private party to build and retain ownership. Managing and owning assets is highly relevant in contract design since it provides the necessary incentives to allocate efficiency.
If we consider the different stages of a project as comprising the design (D), the building (B), the finance (F) and the operation and management (O), we have that PPPs differ in terms of which of these four stages are delegated to the private sector. However, the term PPP is generally used to indicate a substantial involvement of the private sector in at least the building (or renovation) and operation of the infrastructure for the public-service provision. The bundling of project phases encourages the private-sector party (typically a consortium of firms) to think about the implications of its actions on different stages of the project (from the building to the operation) and thus favours a whole-life costing approach (Bennett and Iossa, 2006; Martimort and Pouyet, 2007)
In order to achieve efficient risk allocation Iossa, Spagnollo and Vellez (2007) propose two principles under which the issues of incentives and risk premiums minimization can be aligned so that risk is optimally allocated:
i. When the public-sector party is more risk averse than the private-sector party, then risk transfer to the private-sector party helps both to ensure incentives over non-contractible actions and to minimize the total cost of the project. The optimal risk allocation then calls for the private-sector party to bear all the risk.
ii. When the public-sector party is less risk averse than the private-sector party, then risk transfer to the private-sector party generates a trade-off: it helps to ensure incentives but it may lead to an excessive risk premium. Typically, however, the incentives consideration prevails and the efficient risk allocation has the private-sector party bearing a substantial amount of risk, the more the less risk averse it is.