5.6 Deciding on Risk Allocation

Default Situation and General Rules

When allocating risks, the government should be clear that risk transfer is defined by the contract scope and the PPP contract structure. Subject to the refinement of risk allocation, all risks inherent to the scope of the contract, and those appropriate to the economic ownership of the asset and the nature of the business, should be transferred unless the risk assessment clearly recommends the opposite.

The contract structure and therefore the default position on risk allocation is defined by two interrelated factors.

• The scope of the obligations and the service requirements, that is, what is constructed and operated and/or maintained by the private partner and which services are included in the service requirements. In particular, it concerns which performance requirements must be met to entitle the private partner to payments (or the ability to charge the user) and to what extent the private partner has to finance the project.
• The financial structure and the economic rights, that is, how and when will the private partner be paid and under which regime (including the payment mechanism in government-pays contracts).

This implies that the most basic and general rule to be covered in the contract regarding risk allocation is that design, construction, commissioning, operations, maintenance, revenues, and financial risks are to be generally borne by the private partner. In principle, all uncertainty and contingency over the cash flows inherent in those activities must be assessed, priced, and managed by the private partner, that is, to the extent that they relate to the economic operation of the asset or ordinary business activity. However, they should also include some exogenous events that may commonly affect the business outcome or are integral to it. For example, these can include the potential volatility of prices that affect costings, a shift in demand due to unexpected changes in the country’s economic growth, and so on. However, a number of exceptions can be made, as explained later in this chapter.

The risks related to responsibilities that are not naturally embedded in the project scope do not form part of the revenue regime (or the payment mechanism). They are not risks faced by ordinary businesses and should therefore be retained by the authority. It should be noted however that some risks can be allocated by removing certain obligations from the contract scope. Examples of this are the risk of reduced demand levels in a transport project where operating the transport service is not included in the scope, or the demand/use of a hospital where the clinical services are not included in the PPP. This category will also include any direct act by the public partner that affects or changes the obligations of the private partner (for example, service changes). It also includes other direct acts by the government that specifically affect the particular project (for example, a discriminatory change in law), which are a manifestation of political risks but do not include all potential political risks events (for example, a war or general strike, which are of a quite different category).[50] In some exceptional instances, responsibilities and/or risks that do not naturally form part of the project business are included within the scope of the contract. This is explained further.

In addition to these two principles about which risks should generally be transferred and which should be retained or taken back, there is a third general consideration. This relates to the risks that are beyond the respective responsibilities and capability of either party, and that neither party is able to manage. These risks should generally be shared to a significant extent. The general concept of force majeure explains the majority of these potential events, or their most relevance in terms of risk exposure. However, the contractual definition of the “force majeure” events is highly challenging (see section 5.7).

Even if a risk is completely out of the private partner’s management capability (either because it is not possible to assess the risk or control its occurrence), it may nevertheless be appropriate to have the private partner bear that risk to some extent. The private partner may be able to mitigate the consequences of an unforeseeable and irresistible event by making specific improvements in the design of a building, or it may be able to proactively reduce the impact by mitigating the consequences of the event. To be incentivized to do so, the contract should transfer some proportion of the risk, or the consequences of it, to the private partner.

The objective of risk structuring (leaving aside the public debt implications[51]) is to protect or maximize the VfM. Risk allocation should be structured so as to optimize the VfM of the project. In this sense, as proposed above, the first two general rules may have exceptions, in addition to the exceptional nature implicit in the third rule.

• It will be appropriate to fully or partially take back a number of risks (that is, to share them and limit the private partner’s exposure) that would naturally fall in the scope of responsibilities of the private partner if there is evidence that the private partner will not be able to add value in assuming and managing the respective risk. (This is addressed in the next section).
• It may also be appropriate to require the private partner to partially assume some risks not naturally related to its responsibilities in the contract scope. For example, providing incentives for the private partner to assume some of the risk of vandalism carried out on other assets not constructed or managed by the private partner (but related to its assets and close to them). This might apply where it is clear that this will be efficient for the private partner to provide security or protection for those other properties.

Jurisprudence, case law, some specific laws (in the case of force majeure), and experience of past projects have identified some categories of risk that should never be transferred, including:

• Force majeure events (which include acts of God). This risk may be partially transferred but cannot be fully transferred to a private partner because it has neither the capability to control the occurrence, nor the unlimited capacity that might be required to mitigate the impact. This is further discussed in section 5.6.
• Changes in service requirements or scope of works needed to adapt the project to new circumstances (for example, the need to increase the kilometers served by a LRT project and acquire more vehicles, or the need to upgrade a road as demand is much higher than expected).
• Discriminatory changes in law or policy, and other actions by the government that negatively affect the project economics (for example, the omission of its obligations of approvals and authorizations, payment delays, restrictions to convertibility and transfer of dividends abroad, or capricious changes imposed to the contract).

Ultimately, work to allocate risks is an exercise of defining exceptions to the general rules. This is especially the case with respect to risks that are naturally linked to the responsibilities and rights defined in the contract. It also applies to refining some general concepts to the extent that the respective jurisdictions allow (as with force majeure) to better fit the specific contract.

Dealing with the exceptions to the general rules. Which other risks should be taken back?

First, the risk allocation exercise. This is the definition of the exceptional events that will deserve a specific treatment in the contract, usually so that the government fully or partially takes back the risk. It should focus on the key risks (see section 5.4.2). The natural risk allocation should not be adjusted for risks that are meaningless in terms of their potential impact.

The main driver for risk allocation is the VfM. Therefore, when it is clear that a risk transferred to the private partner will result in a higher cost (because of risk premiums) than the expected loss if that risk were to be retained and managed directly by the government, then the risk should be retained (or taken back). However, this will only be possible to assess this if the probability of the risk occurring can be reasonably estimated and the consequences can be realistically measured.

For this reason, judgment is of the essence. In general terms, transferring a risk will help maintain VfM when the private partner is adding value in retaining and managing that risk (see table 5.3.).This capability to manage the risk better and apply an efficient price (risk premium) or incur lower costs may be due to one or more of the following features, inherent to risk management abilities.

• Greater ability to assess the risk (calculate probabilities and estimate consequences, that is, having the ability to better estimate the potential loss or diminish the uncertainty of the risk) due to experience and technical capability.
• Greater ability to negotiate with third parties so as to pass through the risk to them at a reasonable or efficient price (that is, more efficient than the price obtainable by the public partner).
• Higher capacity to reduce the probability of the occurrence of a risk. This is typically done by means of a more resistant design of the asset or by means of better protocols for control and monitoring of the risk, and so on, based on the experience, means, and methods.
• Higher capacity to mitigate the consequences of the risk occurring and repairing the damage more efficiently.

When none of these factors are present, and the risk event has a significant potential impact, that risk should be retained or taken back from the natural risk position.

These exceptions may be identified on the basis of: (i) real precedents, (ii) knowledge and experience of advisers or government’s own experience, and (iii) market tests/discussion with interested parties during appraisal and/or during this Structuring Phase.

This includes force majeure and similar risks in many jurisdictions where the freedom of the parties to agree on the contract terms prevails. In others that provide a legally defined term and leave narrow space for specific contract treatment, force majeure-related events would already be defined and prescribed by law.

The last heading of this section will discuss common allocation approaches for the risk categories suggested by this PPP Guide, noting that the most appropriate treatment of many risks will depend on, and vary with, each specific project. Appendix A of this chapter provides a deeper analysis and description of risk allocation matters.