Section 2: Risk Allocation

Risk allocation involves defining which party to the Privatization contract will assume each risk, i.e., identifying which risks the private sector party will be responsible for and to what extent, and identifying which risks the Entity will be responsible for and to what extent.

As part of the Third File, a detailed risk matrix will be prepared containing details of the risks identified and who will be responsible for it.

Allocation of risk to the private sector party is also referred to as "risk transfer", and allocation to the Entity is also referred to as "retained risk". Risk transfer is defined by the contract scope and the Privatization contract structure.

When the government undertakes an infrastructure project as a traditional public procurement, the government assumes most of the risks. For example, if the government designs the infrastructure asset, the government would be responsible for any additional costs incurred as a result of flaws in that design. One of the benefits of the Privatization model is that many of the risks can be transferred to the private party, reducing the risks to the government, and incentivizing the private party to mitigate and control those risks in an effective manner (for the least cost).

Risk transfer is related to the search for efficiency, which is one of the key motivations for undertaking a project as a Privatization. Transferring the financial consequences of the project risks to the private party creates the incentive for the private party to deliver the infrastructure and service to the public as scheduled and in the required condition. This is because the party with the higher capacity to control with respect to a particular risk (in a Privatization, this is usually the private party) has the best opportunity to reduce the likelihood of the risk eventuating and to control the consequences of the risk if it materializes.

Hence, the appropriate transfer of risk creates incentives for the private sector to supply timely, cost effective and more innovative solutions. For example, in a Privatization, the private party is normally responsible for project design and construction. Therefore, the private party should bear the risk of additional costs due to design flaws or construction issues, as they control the design and construction processes (an exception may be made for construction delays due to acts of nature [force majeure] beyond the private party's control).

Therefore, transfer of risk can generate efficiency, but only up to a limit; there are some risks which may best be retained by the government. For example, the risk of future regulatory change imposed by the government is one over which the private party has no control, and cannot effectively estimate the potential impact. Therefore, the Entity should consider remaining exposed to some of the financial implications of some of the risks and the uncertainty affecting the asset and the service. Also, the Entity will always remain exposed from a reputational standpoint, where they are the ultimate owner of the asset and have ultimate responsibility for the service delivery despite the delegation of service delivery to a private party.

The private party shall include any costs incurred in assuming and managing each risk in the bidding price (for example, in the user fees or government payments). This cost is known as a risk premium. There are types of risks and/or levels of uncertainty (amounts of potential exposure) for which the risk premium may become too high or expensive. In addition, the transfer of certain risks may not be feasible, i.e., they may affect the ability of the project to attract financing. On other occasions, a risk may be acceptable to the private party at a reasonable price, but the Entity may be better positioned to handle the risk and therefore may wish to retain it or to share it with the private party according to an agreed formula, and in so doing improve the project VFM.

When there are clear signs that the transfer of a risk to the private party will be unacceptable, or that it will only be accepted at a cost higher than the expected loss for the Entity if the risk were to be retained and managed directly (by the Entity), then the risk should indeed be retained (or taken back). Some risks will not be fully transferred or retained, but shared.

The optimum point of risk transfer/retention or the maximum point of VFM will be that point at which the marginal VFM (the additional benefit in terms of incremental efficiency) of changing the risk allocation is negative. In other words, coming from a full transfer of risks, the optimum risk allocation structure will be reached at the point in which VFM is reduced, provided that the additional risk retained. Or, conversely, coming from a full retention, it will be the point at which, if an additional risk is transferred, the VFM is reduced. If the risk transfer is too aggressive, the private sector may be unwilling to submit bids as it will not be able to manage all of the transferred risk. If the risk transfer is too conservative, it may be more appropriate to opt for a Design and Build arrangement rather than a Privatization (see figure below).