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Appraising PPP Projects

44.4 Estimating Risk-Adjusted Costs

Estimated risk-adjusted costs are a central output of the design of the technical requirements, and this data is used to feed the financial model. Depending on the type of infrastructure, the nature of this data can change. However, the typical sets of cost estimates that should be produced at this stage are as follows.

  • Capital costs and their distribution in time; and
  • Operational and maintenance costs during the lifetime of the project.

The costs projected should reflect, as far as possible, the projected costs of the private sector. In some cases this entails the recognition of efficiency gains compared to typical public sector costs. In other words, the private costs can be lower than the traditionally procured alternative. This might occur due to possible technical innovations that can be foreseen, or differences in regulatory requirements between the public and private sectors.

This adjustment can and should be done if there are strong reasons to believe efficiency gains are in fact justifiable. If this proves effective, then extreme care should be taken to avoid overly optimistic assumptions (optimism bias) that can lead to underestimation of the costs for the project.

There is also an unavoidable level of uncertainty in much of the financial data estimated during the design of the technical requirements. This could lead to severe misinterpretation of the results of the feasibility exercises that use this information. To account for this uncertainty, the costs need to incorporate risk allowances so as to reflect, as accurately as possible, the private sector’s perspective on the project’s financial description. This can be accomplished by adding an expected risk value on top of the estimates, which will be the fundamental input to the financial model, described below.

In most cases, the adjustment for risk generates the expected value of costs. That is different from the most likely cost or the best case costs because it adds an economic value of risks to the base line costs. The simple approach to this risk adjustment is to calculate the value to be added by multiplying the probability of a certain additional cost by its financial impact.

For example, if the capital expenditures (Capex) of year Y will be $1 million higher if a water pipe is found beneath a construction site, and, given prior constructions around the area, the probability that this will occur is 25 percent, the value of $250,000 should be added to the Capex of year Y. Conversely, if there is a 20 percent chance of a construction cost to be $500,000 less expensive due to better geo-technical characteristics, the cost should be reduced by $100,000. The final figures indicate the weighted average of the possible cost outcomes, considering each of its probabilities. Since the probabilities of each cost outcome are also uncertain, it is common to choose a few scenarios of costs which are later used to feed the sensitivities tool of the financial model (see section 6.10).

A much more sophisticated approach is the use of probabilistic analysis, typically based on Monte Carlo simulations. This approach estimates the impact of events building upon a great number (commonly tens of thousands) of iterations based on previously inputted probabilities. This produces a distribution function of the possible outcomes (as well as other statistical results such as percentiles). Since the reliability of the conclusions depends on the accuracy of the assumed probabilities, it is good practice to only conduct probabilistic analysis when reliable information about the likelihood of events is available. When this is not the case, the simpler approach to risk should be chosen, as it is more intuitive, reduces complexity, and simplifies the interpretation and communication of the results.

Not all of the risks can be incorporated in this way. Technically speaking, only project specific risks should be addressed in the cost structure. The so-called systemic risks (for example, risks related to general economic conditions) cannot be diversified with “portfolio” strategies, and as such, can only be paid for by a general increase in the return of an asset. In other words, risks that relate to the general performance of economic assets should be reflected in a higher rate of return required by the investor, as will be presented in section 8.1.2.

It is important to note that the costs identified at this stage are a description of the costs and risks from the private sector’s perspective. Later, as a part of the Value for Money (VfM) exercise, an additional risk adjustment will be made to incorporate the possible cost overruns if the traditional procurement route was followed.

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