The identification and management of risks is at the core of the design of any PPP. This is particularly obvious in the context of the project finance dimensions of the PPP because of the non-recourse or limited recourse nature of project debt and the limited contractual undertakings of the project owner. Since each project faces a different set of risks, it is always best to try to identify them at the outset and allocate them to the appropriate parties. This is why one of the first tasks that public officials should address is to understand the distribution of risks to which each party is committed. In many renegotiations or regulatory disputes, the ultimate responsibility and resolution will be based on the assignments spelled out in the contract.
The experience of the last 10-15 years suggests that risks are actually very real! Various studies have shown the extent to which things often don't happen the way they were planned. According to Guasch (2002), about 75% of the transport contracts in Latin America were renegotiated. Flyvbjerg and his various co-authors have managed to document that the problem is just as important in developed economies. They show that risks should be a concern at all stages of the process.
For new projects, they start at the construction phase where the major risks are delays in completion and the commencement of project cash flows; cost overruns with an increase in the capital needed to complete construction; and the insolvency or lack of experience of contractors or key suppliers. Construction costs may exceed estimates for many reasons, including inaccurate engineering and design, escalation in material and labor costs, and delays in project start-up. Cost overruns typically are handled through a fixed-price and fixed-term contract, with incentives for completion and for meeting pre-specified investment goals. Other alternatives include provision for additional equity infusions by the sponsor or standby agreements for additional debt financing. It is always sensible for developers to establish an escrow or contingency fund to cover such overruns. Delays in project completion can result in an increase in total costs through higher capitalized interest charges. It also may affect the scheduled flow of project revenues necessary for debt service costs and operating and maintenance expenses.
In developing countries, in addition, there is also the risk of unavailability of equipment or materials for construction or operation must be considered. This is especially true with respect to rolling stock or in for specialized equipment, like gantry cranes or loading bridges used in ports or airports. Transit bottlenecks, tariffs, foreign currency fluctuations and other factors can cause a significant increase in costs. Moreover, there are also the risks that the main contractors and key subcontractors lack the experience, reputation, financial, technical, and human resources to be capable of completing the project in timely fashion on budget. This risk is best addressed through tough pre-qualification of bidders (if sponsors are also contractors); through certification and monitoring if unrelated parties are used; and by ongoing financial oversight of the contracting companies themselves, to make sure that poor results form other projects or from weak balance sheets do not spill over into the specific project of interest.
Transport projects can also have a substantial environmental impact. Such projects frequently attract strong opposition from community and environmental groups over issues of pollution, congestion, neglect of public transport and visual impact. Similarly, land acquisition can be a protracted process with the potential for extensive legal delays, particularly in developing countries.10 In general, the public sector often ends up taking on the responsibility for most of these risks since often it is easier for the public sector to take the responsibility for acquiring the rights-of-way, to pay for them and contribute this asset to the project. Project sponsors often try to ensure that the government bears the risk of providing all necessary land within a given time frame or being liable for damages. Furthermore, the cost of land acquisition can become a major factor where land values have risen rapidly or are subject to speculative activity over which the project developer has no control. In these cases, agreement on some form of cost ceiling may be necessary in the concession contract. In some cases, a special government body may be charged with implementing the land acquisition process. Generally, the host government should ensure that required licenses and permits be obtainable without unreasonable delay or expense.
But risks are also very present at the operating phase. The major risks for transport projects in these stages relate to technology, traffic/revenue risk; regulatory and legal changes; interest rate and foreign exchange risks; force majeure risk; and political risk.
PPP designers cannot ignore new technologies since they can either significantly improve the profitability of a project or adversely affect any project that uses obsolete technology. For example, the use of automatic toll collection technology reduces collection costs and incentives for graft. Another example is technological improvements in customs processing, so that border crossings on major arterial toll roads can be traversed more quickly, saving time for users and making the road more valuable.
Unlike project financing in other sectors, take-or-pay or fixed-price contracts are typically not available in transport, so that demand risk is a major issue in virtually all projects. Even when there is a reasonable level of confidence in forecasts, demand can be dramatically affected by competition form other modes or facilities, changing usage patterns, and macroeconomic conditions. These interrelated issues, over which the project sponsor often has little or no control, are very difficult to predict and represent a major risk to financing. In particular, forecasting during the early years can be quite subjective. To the extent that these risks are driven by economic conditions, there is a potential role for the government to play in risk-sharing, either through traffic or revenue guarantees or other forms of support. (These are discussed in more detail below.)
But demand uncertainty must be viewed realistically. Over-optimism in traffic projections is common for privatization teams focusing on convincing private operators of the value of their business and for potential operators who want to get the deal, convinced that they can renegotiate almost anything once they have taken over the business.11 To see this, take the case of toll roads. Traffic volumes are very sensitive to income and economic growth and the failure to recognize this may be one of the main reasons why so many toll road projects have failed or ended in bitter renegotiations. Motorization and vehicle-kilometers traveled tend to increase faster than income levels. This high income elasticity, especially for leisure trips, makes toll roads especially sensitive to macroeconomic conditions. For roads that serve export activities, exchange rate changes can dramatically affect trade, leading to major changes in demand patterns. Many toll road projects in the last decade have dramatically overestimated traffic levels. In some of the Mexican road concessions, traffic volumes were only one-fifth forecast levels. In Hungary, the M1 Motorway attracted only 50 percent of expected volume in its first year of operation. The Dulles Greenway, outside of Washington, initially only attracted one-third of its expected daily volume. Even after a toll reduction of forty percent, the Greenway still was only able to achieve two-thirds of its originally forecast volume. Note that some of these demand risk can be hedged against through contracts with flexible duration as proposed by Engel, Fisher and Galetovic. 12
Financial risk is the risk that cash flows might be insufficient to cover debt service and then to pay an adequate return on sponsor equity. Financing constraints, especially the lack of long-term debt capital, are a significant hindrance to toll road development. Since the advent of financial crises in emerging markets, few projects are able to generate returns on investment sufficient to attract private capital. This suggests that until macroeconomic risk premiums decline and traffic growth is more established, only a limited set of projects will be undertaken without substantial government support. The financial crises will force many programs to slow down and force debt restructuring of many of the existing concessions. There is a need to promote more secure financing structures to reduce the risk of potential bailouts.
In theory, financial risk is best borne by the private sector, but in transport projects there is likely to be substantial government risk sharing either through revenue or debt guarantees, or participation by state or multilateral development institutions. There also may be cash grants or other financial contributions that serve to improve the project rate of return on private finance. Passenger transport tariffs tend to be very politically sensitive and governments are often more willing to grant subsidies to finance costs than to aim at full cost recovery as they more often do with freight transport.13
The recurring financial crises of the last 15 years have shown that currency risks need to be taken seriously. The main currency risk is driven by the impact on the value of the business of fluctuations in the exchange rate. In addition, the toll concession can be subject to a convertibility risk which refers to the possibility that the operator may not be allowed to exchange local for foreign currency. These are major issues for some projects, where revenues are commonly in local currency and adjustments for inflation and exchange rates may lag or encounter political opposition. Projects can reduce this risk by tapping domestic capital markets where possible. Most projects attempt to mitigate exchange risk by provisions for indexing to inflation, although in practice the magnitude of exchange volatility has made such requirements difficult to enforce.
There is also increasing evidence that PPP designers need to anticipate more carefully force majeure issues. This refers to risks beyond the control of either the public or private partner, such as floods or earthquakes, which impair the project's ability to earn revenues. While some private insurance is becoming available for catastrophic risks, the public sector generally is faced with the need to restructure the project should such disasters occur. This may take the form of extending the concession term, or to provide additional financial support. The rule is that remedies in the event of force majeure risks should be stated in the contracts; for example cash compensation or an extension of the concession term equal to the length of the disturbance.
In addition to these business related risks, there are risks associated with the interactions with the public sector. The main risks in this category are regulatory, legal and political risks. Regulatory risk stems from the weak implementation of regulatory commitments built into concession contracts but also in laws or other legal instruments relevant to the value of the transaction. The question asked is whether the regulator will exercise its authority and responsibilities over prices, public obligations, competition rules and similar rules that are specified in the contracts and that influence the value of the business. The solution is to try to make sure that regulators have rules to follow and that they are independent enough to be able to enforce them.
But even if regulatory rules are clear enough, they are only as effective as the regulators can be. The best designed regulatory environment is useless if the regulator is not independent or fair. This risk is more common than it appears and pressures on regulators are a major source of concern which investors reflect in their required rate of return. In 1999, a major factor in the restructuring of Mexico's toll road program was the pressure on regulators to cut tolls. In Thailand, a similar concern resulted in decision by the government to cut by 50 percent a toll level it had committed to in a BOT contract. Similar examples could be provided for a large number of countries in more recent years. The outcome is generally that the government ended up taking over the facility.
PPPs typically cover periods of ten years or more. The relevant legal and regulatory environment is likely to change substantially over that period. The rules dealing with the financial consequences of these changes between government, users and operators are critical and yet often forgotten. The rules must cover the possibility of adaptation of the contract terms during the tenor of the project financing.
Political risk concerns government actions that affect the ability to generate earnings. These could include actions terminating the concession; imposition of taxes or regulations that severely reduce the value to investors; restrictions on the ability to collect or raise tariffs as specified in the concession agreement; precluding contract disputes to be resolved in reasonable ways. Governments generally agree to compensate investors for political risks, although in practice justifications for government actions may be cited to delay or prevent such payments. Thus, private investors generally assume the risks associated with dispute resolution and the ability to obtain compensation should the government violate the concession agreement. The issue of meeting financial obligations while disputes are resolved may be achieved through a requirement of debt service reserves, escrow, or standby financing.14
The credibility of the government to uphold contractual obligations and the willingness and ability to provide compensation for political risks are key issues for project finance. Issue of delays or denials of tariff increases have made many prospective parties wary of entering into new projects. This is especially true for foreign capital, which is perceived as especially vulnerable to political risks. Some of the more risky emerging markets may require support from multilateral or bilateral financial institutions to reduce this risk exposure. In addition, political risk insurance may also help manage issues of inconvertibility, transfer, and confiscation.
The project finance component of PPPs involves many participants, each with important roles to play. They include the government, the constructors, the operators/concessionaires, the lending commercial banks and the very heterogeneous groups of other lenders which include national and regional development banks, bilateral agencies, export credit agencies, and development finance institutions.
The allocation of risks among all these actors is thus clearly an essential dimension of the design of PPPs. One of the long-standing tenets of project finance has been that the project participant who controls or is best able to manage the risks should bear them. While true in principle, reality often fails to live up to the goal. Risk allocation is complex and difficult, and for all practical purposes it is a negotiated process. For example, governments are responsible for changes in the law, yet the risk and consequences of such changes are often shifted to the private sector. Or, the central bank may have the greatest responsibility for inflation and interest rate outcomes, yet in reality it is often the project developers, creditors, and equity providers who end up bearing the interest rate risk. There are numerous other risks that do not necessarily end up being borne by the party best able to manage it. More often, it is the best and most experienced negotiator that ends up bearing the least amount of risk.
Also, the level and type of risk encountered may change over time. The 1998 Asian crisis increased perceived risk levels enough to increase the required rate of return to levels unachievable for most projects. On the other hand, governments may fall prey to a "fear-greed cycle", in which governments become afraid of program failure and thus offer increasingly better terms. Alternatively, prospective concessionaires who worry that they will get left out bid unrealistically. Subsequently, the element of greed takes over in which governments may fail to live up to commitments and the private sector seeks ways to privatize gains and socialize the project's risks.
Successful PPPs have been characterized by a broad level of risk-sharing between the public and private sectors. Generally, the private sector is better at managing commercial risks and responsibilities such as those associated with construction, operation, and financing. In contrast, transport projects most likely depend on public participation in areas such as acquisition of right-of-way, political risk, and in some cases, traffic and revenue risk. PPPs has worked best when experienced, well-capitalized firms have enough discretion over design and confidence in pricing policy to accept construction and some degree of traffic risk, while the government assumes the risks that it controls and gives consideration to financial support or guarantees if traffic levels in the early years are insufficient.
Ultimatelly, the market seems to be adjusting in the kind of contracts it is writing. Athias and Saussier (2007) highlight the fact that the contracting parties try to sign not only complete rigid contracts in order to avoid renegotiations but also flexible contracts in order to adapt contractual framework to unanticipated contingencies and to create incentives for cooperative behavior. In the case of toll roads, this gives rise to multiple toll adjustment provisions and to a tradeoff between rigid and flexible contracts at the design stage. In an econometric assessment of 71 contracts, they find that the standard view that a rigid contract is to be preferred as soon as specific assets are high, may be true only if other conditions concerning poor adaptation of costs, renegotiation costs and the probability to see the contract enforced are met.
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10 For example, land assembly was a major factor in delays in the construction of the Bangkok elevated highway.
11 See Trujillo, Quinet and Estache (2002) for a longer discussion of the strategic behavior in transport bids.
12 Engel, Fisher and Galetovic (2001)
13 In many countries, often developed, infrastructure subsidies are also quite common for ports and rail.
14 These political risks are starting to be documented quite well empirically. For instance, Athias and Saussier (2007) find that contracts signed with left leaning public authorities, rather than with right leaning public authorities, appear to be more likely rigid. This seems to corroborate the conjecture that private concessionaires have a better reputation among right wing public authorities..