8/6/2019 How Should Risk Be Evaluated and Allocated in PPP
Contracts
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How should risk be evaluated and allocated in PPP contracts?
[Response by Rui Cunha Marques, February 2010]
Risk is defined as the probability of a particular event
occurring. In PPP, risk allocation isimportant for the public
authority, as it is at the heart of the value for money of the
project,and therefore for determining the decision of opting for
the PPP procurement option or not.The principle is that risks
should be transferred to those able to control or mitigate them
atthe lowest cost . Improved risk allocation reduces not only
economic costs but also the needto enter a renegotiation process
and provides incentives for a sound management of thePPP.
The efficiency rule for allocating risk is quite simple. The
public authority (e.g. municipality)should not transfer to the
private partner risks that are under the authoritys control, nor
should it assume risks that are out of its control. The transfer of
risks to the private partner brings, in general, an increase in the
price of the project, so it is essential to ensure that thepublic
benefit of such transfers is greater than that increase in
financial costs . This additionalcost derives from the risk premium
that is required by the private sector to support it. Therisks
should be assigned to the right parties and carefully defined ex
ante before the signed
contract . A risk matrix should be defined for each project
where all the risks are identifiedand allocated, their probability
evaluated and their (financial) impact quantified.
Finally,mitigation measures should be established for each type of
risk.
a) Identification and classification of risks
In the design of a contract , it is crucial to identify and
allocate risks before the procurementstage. This should be done by
constructing a risk matrix. The bidding documents shouldlimit ex
ante situations that may lead to ex post opportunism and, in
particular, to therenegotiation of the contract . Renegotiation
should be restricted to the aspects that theprivate sector does not
control (public authority risk) and is not able to predict (e.g.
extremeevents or changes in public policy).
Among several possible classifications, risks can be divided
into production , commercial andcontextual risks . Some of these
risks are associated with the bidding process stage andothers with
the project implementation stage. While risks related to the
production processare almost always best borne by the private
sector , the commercial and contextual ones aremixed. Among the
production risks are those associated with the planning , design,
right of way acquisition, construction, environmental (e.g.
permits), archaeological constraints(discovered in the construction
phase), maintenance and major repairs, operational,technological
and performance risks . Commercial risks comprise mainly the demand
, collection, capacity availability, and competition riskswhere the
latter could stem fromchanges in public policy or dramatic changes
in technologies that alter the feasible scale of potential
entrants. Finally, within the scope of contextual risks ,
financing, inflation , legislativechanges, judicial rulings,
regulation , swings in public opinion, and force majeure are
the
most relevant. The importance of each risk depends on the
project under consideration.However, consumption/demand and
unilateral (one party) change risks are in general themost
problematic ones and are major reasons for contract renegotiation.
Contract renegotiation is one the main consequences of initially
incomplete allocation of risks .
b) Allocation of risks
The allocation of each type of risk between private and public
sector should occur accordingto the minimization of economic costs
. However, some risks can subsequently betransferred to third
parties. For example, the private partner can subcontract
activities,passing the associated costs on to the subcontractors.
Similarly, the private or public partners might transfer some risks
on to the customers/users (e.g. via price increases whennew
legislation mandates new environmental controls). In other cases,
risk can be mitigatedthrough insurance .
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