PPP contracts allocate risks between the government and the private partner. In fact, risk allocation is one of the most important tasks conducted during the whole of project preparation since it underlies most of the PPP’s potential advantages, as presented in chapter 1.5.2.
During the structuring of the contract, as will be presented in section 4, most resources focus on promoting an effective risk allocation (section 4.5). Nevertheless, a generic proposed risk allocation scheme is a necessary task during appraisal. It permits the project team to undertake several tasks required for feasibility exercises, such as the risk adjustment of baseline costs and the estimation of the required return on equity, as a part of the commercial feasibility assessment and the adjustment to the Public Sector Comparator as a part of the Value for Money (VfM) analysis.
To allocate a risk to a party means to decide which one of the contracting agents will suffer the positive or negative financial consequences of a variation of a value from its estimated base line. The general risk allocation principle states that the risks should be allocated to the party that is best able to manage them. This creates the appropriate incentives for risk management and provides economic efficiency in terms of reduced valuation or those risks. See box 4.4.
BOX 4.4: Examples of Risk Allocation
The ground conditions in a tunnelling project represent a considerable risk for the contractor because the conditions cannot be determined fully before tunnelling operations actually begin. How such a risk is managed when it is encountered can have a significant impact on the costs of the project. The contractor is obviously in the best position to manage such risks and should therefore bear them.
The risk that the level of demand for a facility is not forthcoming or declines is the major risk in PPPs. In the case of a prison, the demand for the prison is very much influenced by legislation and therefore by the government’s sentencing policy, by the sentencing policy of the courts, by the approach taken by parole boards, and by the Department of Corrections’ prisoner management policies. Transferring demand risk to the contractor would therefore be an inefficient allocation of risk. Instead, the payment mechanism should be based on some combination of service performance, availability, and occupancy rates.
Source: Guidance for Public Private Partnerships in New Zealand. National Infrastructure Unit of the Treasury (2009).
Contracts allocate risks through several mechanisms. Some examples are as follows:
- The revenue regime and payment mechanism, which can define how and when compensations to the private partner can be triggered;
- Express contractual provisions, including explicit guarantees and compensation obligations, which adjust the risk allocation implicit in the project structure; and
- Provisions for financial re-equilibrium of contracts when certain events occur.
At this stage, however, there is no need to develop a detailed description of contractual instruments to allocate risks. It is sufficient to develop a risk allocation matrix in which all the identified risks are described and a preliminary allocation is proposed.