This chapter analyses the risks of PPP arrangements from the perspectives of the various parties. For the public procurer, there is an obvious need to ensure that value for money has been achieved with public funds. To the project spon- sors, such ventures are characterized by low equity in the project vehicle and a reliance on direct revenues to cover operating and capital costs, and service debt finance provided by banks and other financiers. Risk evaluation requires not only the analysis of risk from these different perspectives but also intimate knowledge of the project. To this end, as well as considering the general prin- ciples involved, we draw on practical experience of evaluating such projects to present a framework for assessing the risks, using as illustration a case study which is typical of many PPP projects.1
The project concerned is the Almond Valley and Seafield (AV&S) project involving the construction and operation of a water treatment facility for East of Scotland Water (ESW), with a services contract over 30 years between ESW (the public procurer) and Stirling Water. There is also a sepa- rate operating agreement between Stirling Water and Thames Water, the private sector operator of the works. The project reached financial close in March 1999 and Figure 7.1 sets out the links and key contractual arrange- ments between the parties involved. This brings out the point that a major infrastructure venture such as this is complex in terms of documentation, financing, taxation, technical details, sub-agreements, and so on. In many ways, it has to be complex to handle adequately the large number of risks inherent in such projects.
The public procurer seeks an effective use of public funds which, in the case of a PPP, can come from incentives created by the integration of asset design, construction techniques and operational practices, and by the transfer of key risks in design, construction delays, cost overruns and finance and insurance to private sector entities. For the project sponsors, PPP (and PFI) is essentially project financing, characterized by the formation of a highly geared special purpose company for the project and using project revenues to pay for operating costs and cover debt financing while giving the desired return on risk capital. A project must meet the public sector’s value-for-money test and
171
the private sector’s need for robust revenue streams to support the financing arrangements (Grimsey and Graham, 1997).
The possibility that the predicted revenues do not materialize poses the greatest risk to the commercial viability of a project. This risk largely is borne by those providing finance or financial guarantees. Straight equity participa- tion is generally low, only 5 per cent of the total funding (£4.95 million out of funding of £99 million pounds) in the case of the AV&S project. This situation is more starkly illustrated by the case considered earlier in Chapter 5 of a design-construct-manage-finance (DCMF) of a PFI private prison currently operating in Bridgend, South Wales which was funded with only £250,000 of equity constituting 0.3 per cent of the total funding of £83.5 million.
Subordinated debt is often regarded as the equivalent of equity and is favoured in the UK because it enables the sponsors to extract cash from the project vehi- cle, where dividends would be restricted by the profit and loss account, and also because the interest is tax deductible. But in the AV&S project, subordi- nated debt comprised only a further 14 per cent of funds invested. A financial structure needs to be ‘engineered’ with as little recourse as possible to the sponsors while at the same time providing sufficient credit support so that the lenders are satisfied with the credit risks.
What are the risks? At least nine categories of risk face any infrastructure project (Chapman and Ward, 1997; Kerzner, 1989; Smith and Walter, 1990;
and Thobani, 1998). These include:
• technical risk, due to engineering and design failures;
• construction risk, because of faulty construction techniques and cost escalation and delays in construction;
• operating risk, as a result of higher operating costs and maintenance costs;
• revenue risk, e.g. because of traffic shortfall or failure to extract resources, the volatility of prices and demand for products and services sold (e.g. minerals, office space, etc.) leading to revenue deficiency;
• financial risks arising from inadequate hedging of revenue streams and financing costs;
• force majeure risk, involving war and other calamities and acts of God.
• regulatory/political risks, resulting from planning changes, legal changes and unsupportive government policies;
• environmental risks, because of adverse environmental impacts and hazards;
• project default, as a result of failure of the project from a combination of any of the above.
Successful project design requires expert analysis of all these risks and the
173
Figure 7.1 Contractual arrangements in a PFI/PPP project
MBIA Assurances
SA
design of contractual arrangements prior to competitive tendering that allocate risk burdens appropriately. With such a long list, it is important ‘not to lose sight of the wood for the trees’. Many risks alter over the duration of the project; for example, the construction phase will give rise to different risks from those during the operation phase. Some technical design risks diminish once the engineering work is done. Planning risks change after the necessary procedures are met. Other risks, such as market-related ones, may continue over the life cycle of the project, and some risks may lie outside anyone’s control.
For these reasons, some writers have sought to provide a taxonomy of risks according to type. Merna and Smith (1996) categorize risks as ‘global’
or ‘elemental’. Global risks are those that are normally allocated through the project agreement and typically include political, legal, commercial and envir- onmental risks, whereas elemental risks are those associated with the construction, operation, finance and revenue generation components of the project. Miller and Lessard (2001) classify risks into three categories.
‘Market-related’ risks derive from the markets for revenues (e.g. demand for road use) and financial markets (interest rates, exchange rates). ‘Completion’
risks come from technical designs or technologies employed, construction cost and time overruns, and operational problems. Finally, ‘institutional risks’
arise from laws and regulations, opposition from environmental and local groups, and government bodies wanting to renegotiate contracts. These clas- sifications are designed to give some broad idea of the different sources of risk. Based on a study by Millar and Lessard of 60 large engineering projects around the world, managers ranked market-related risks as dominant in 42 per cent of projects, followed by technical risks (38 per cent) and institutional risks (20 per cent).
Most of these risks are common to any project-financing activity, and apply with more or less force depending on the project concerned. With some PPP agreements, revenue risk might be low, indeed negligible. For example, the revenue from a toll bridge might be more assured than that of an oilfield, while a private prison is likely to operate with a higher occupancy rate (e.g. 100 per cent) than a luxury hotel! At the same time, however, there is clearly the risk of losses arising from a changing political climate toward the provision of public services by the private sector, while the prices charged for many public sector services are politically sensitive and may be regulated or price-capped in some way.
Nevertheless, in principle, the risks of PPP projects seem little different from those of some other project financing activities, and can be evaluated using much the same basic techniques. The critical question, as always, is whether revenue streams can cover operating costs, service debt finance and provide returns to risk capital.
Consider the case of infrastructure in the form of a power plant. Sponsors of the power project borrow money to build a generation plant. The sponsors contract to supply power to utilities, projecting that the contract revenues will suffice to pay debt service and generate profits. But risks abound. Will the plant actually be built on time? Will the plant work? And will the market value of the contracts enable participants to avoid an income shortfall? Can rates be raised to levels that more or less equal the utility’s costs for providing elec- tricity, an activity that has historically been regulated by government? None of these questions can sensibly be dodged or ignored in project evaluation.
In fact, Lessard and Miller (2001) describe large engineering projects (and many PPPs are that) as being ‘high-stake games’ that are characterized by
‘substantial irreversible commitments, skewed reward structures in case of success, and high probabilities of failure’. They go on:
Once built, projects have little use beyond the original intended purpose. Potential returns can be good but they are often truncated. The journey to the period of revenue generation takes 10 years on average. Substantial front-end expenditures prior to committing large capital costs have to be carried. During the ramp-up period, market estimates are tested and the true worth of the project appears; spon- sors may find that it is much lower than expected. (p. 2)
Ultimately, because of the high gearing, the ‘bottom line’ (i.e. project default risk) is borne by the financiers if debt cannot be repaid, although significant costs fall on the government if it has to ‘step in’ to guarantee conti- nuity of services, which is why the public procurer must concern itself with the risks facing the private body and not simply home in on the lowest bid.
When considering this default scenario, possible future cashflows can be thought of as falling into two categories:
1. Moderate (and perhaps not so moderate) deviations from estimated cash- flow projections, resulting from fluctuating prices, costs, timing delays, minor technical problems, etc.
2. Disasters to a project, resulting from a major cost overrun, downturn in the economy, change in legal rulings, alteration to the political climate, environmental disaster etc., which could lead to project failure and bank- ruptcy.
This difference (according to Blatt, 1983) is not simply one of scale, but reflects the Knightian distinction between ‘risk’ and ‘uncertainty’ that we examined at length in the previous chapter. Blatt argues that the ‘moderate deviations’ can be described in statistical terms and handled by risk analy- sis. But ‘disaster scenarios’ cannot for they represent situations of true uncertainty where actual probabilities cannot be assigned to the possible
occurrences because the potential outcomes and causal forces are not fully understood.
Knight considered that the main function of the ‘entrepreneur’ is to bear the brunt of uncertainty. The profits of enterprise (‘pure profits’ over and above interest payments on debt capital and/or dividend payments to shareholders) are a reward for facing this uncertainty. Sometimes, however, the reality in the financing of projects is often quite different to that envisaged by Knight. For example, developers who put up blocks of offices or flats for future sale commonly set up a new limited company for each new building. This company borrows money and/or sells equity shares. If the building fails to make a profit, this particular company goes bankrupt, but the sponsor may survive. The successful entrepreneur is often one who knows how to shift the burden of uncertainty onto others in such a way that he himself will survive, waiting for a more opportune time for others to again be persuaded to take chances with their money. As Blatt (1983) puts it, the prudent entrepreneur reacts to true uncertainty by attempting to make others bear the consequences.
In many instances, investors, financiers and other creditors are at risk.2 In other cases, the risk is to the pockets of taxpayers.
Clearly, in these circumstances, an analysis of the nature of the risks – and who bears them – is vital. As is the case with the theory of taxation, the distinction between the initial incidence and the final incidence must be borne in mind, and a detailed study of the project structure is important. Also the evaluation of projects requires the use of several risk analysis techniques tailored to suit the interests of the various parties to the project.3 Nevertheless, the Knightian distinction remains. At least in theory, risk can be evaluated, calculated with different probabilities, hedged or transferred, pooled and diversified, transformed or insured against, but true uncertainty or a disaster scenario is something else again. How are risks handled in prac- tice in PPPs? To answer this question we will look first at the risk allocation
‘tools’ and then consider risk analysis in the particular case of the AV&S project.