5.8 Introducing the Main Project Risks and their Potential Allocation [56]

This subsection introduces a list of the most relevant risks as they are commonly identified in different guides and protocols (while acknowledging that there may be material differences in the classification of risks from some country practices to others).

Appendix A provides a deeper explanation of the risks, some subsets of risks, and further reflections on common practices and pitfalls regarding the allocation decision and its incorporation into the contract.

5.7.1 Risks Related to the Design and Construction Phase, including Site Conditions

• Land availability and acquisition. The unavailability of the land or site to construct the infrastructure at the time of contact signature will obviously cause delays and indirectly increase costs (through renegotiation of construction agreements, higher interest during construction, and so on). Furthermore, the uncertainty of site availability will be a reason for failure in the tender, making it likely that no bidders will participate.

The site should be available at tender launch in any social infrastructure project. In linear infrastructure, it is more common that the right of way is not entirely available and that the acquisition of the land has to still be managed. Many countries consider the responsibility of land acquisition as a public matter, while in some others the practice of delegating such work to the private partner is more common.

This PPP Guide considers it good practice that in such circumstances when the risk of costs is higher than expected (and the benefit in the converse situation) that it be retained by the public party. In some countries and practices, this is done partially with the public partner sharing the risk. As such, a cap should be established so as to limit the risk exposure of the private partner or, at a minimum, granting the status of an extraordinary and compensation event to the case of extraordinary deviations occurring in the actual cost, due to unforeseen circumstances[57].

• Environmental (or environmental assessment) risk. Most projects must pass an Environmental Impact Assessment (EIA)[58]. Environmental issues may be related to a number of environmental aspects (general contamination or pollution, noise pollution, water contamination, impact on the natural environment, and so on). An adverse (different than anticipated) assessment may require changes in the design, causing a direct impact in terms of capital expenditure (Capex) costs, in addition to delays.

This risk is essentially a design risk and should generally be borne by the private partner. An exception is pre-existing contamination: when there has been an existing operation, the government usually accepts responsibility for pre-existing environmental problems (for example, site contamination for a power plant or waste dump).

Environmental impacts have to be anticipated to the largest possible extent by the authority in order to limit or mitigate this risk for the benefit of both parties. The authority should remain responsible for adverse assessments related to the specifications settled in the contract.

It should be noted that these risks are usually categorized in the Construction Phase. However, the risk analyst and/or the structurer of the contract should note that the risk may also affect O&M costs (for example, noncompliance with environmental legislation that is detected during operations or changes in environmental law).

• Other permits. Generally, the private partner should anticipate the permits needed and assess the implications and related risks.
• Design risk. As the private party commonly develops the design in PPPs, the private party should generally bear the design risk.
• Construction risk. Construction risk represents the possibility that during the Construction Phase, the actual project costs or construction time exceed the projected time and costs. This risk is generally borne by the private partner who will pass it through to the construction contractors. However, the contract should provide relief and/or compensation for certain risk events that might occur, the main categories of which are explained below and in appendix A (for example, force majeure).
• Completion and commissioning. The completion risk or the commissioning risk refers to the risk of failing to meet the construction outcome or finalization as prescribed. It also refers to the project, as constructed, failing to provide services as expected. As a general rule, it is a construction or design risk that has to be borne by the private partner.

Specific risks related to the site that may be regarded as interruptive and therefore treated as relief or as compensation events. Risks related to unanticipated ground conditions (especially related to geo-technical conditions), archeological findings, utility reallocation risks, or latent defects in an existing infrastructure (in secondary stage PPPs) and risk of squatters may be significant in certain projects, which will have to be detected in the Appraisal Phase. In some circumstances, these risks may be treated in the contract as relief events, and some of them potentially as compensation events. Those circumstances essentially depend on the likelihood and potential impact of the risks and the reliability of available information. It is not good practice to provide full relief for these types of events (that is, taking back the whole of the risks in terms of financial impact), as even if the risk may not be entirely under the control of the private partner, it should be properly incentivized to manage the risk (mitigating its likelihood, managing the event if it occurs), assuming that this will be for a price (risk premium).

5.7.2 Risks during the Operating Phase

• Revenue risk in user-pays. This refers to the risk of the revenue flows not being correctly assessed. The main or most likely reason is volume risk, that is, the potential impact of demand or usage not being at the anticipated level. This risk is at the heart of user-pays structures and should generally be borne by the private party. However, to share this risk and/or limit it to some extent may provide Value for Money (by providing a guarantee for minimum traffic or minimum revenue), especially when the likelihood of the risk occurring is very significant. This danger should be assessed during appraisal and even tested with the market, including stress tests and break even analysis (see chapter 4.6.9). A subset of the revenue risk is the network risks and competing facilities (see appendix A).

The same reflections may be applied to volume risk in government-pays PPPs based on usage.

• Revenue risk – inflation and indexation. Any contract must provide clear rules as to how payments will be indexed to reflect any rise in cost-inflation. Generally, the risk of cost inflation not being compensated for by revisions to pricing should be assumed by the private partner. However, specific issues may arise in the context of user-pays PPPs where the authority reserves for itself the ability to settle the tariff level during the course of the contract. In this case, when the tariff is not approved at the level anticipated by the private partner, specific measures to neutralize the impact on the private partner should be a part of the contract.
• Revenue risk availability and quality. Revenue risk linked to availability and quality issues — when the performance requirements and performance target levels are not met — must be the responsibility of the private partner. Failure to meet these requirements may affect the revenue directly (abatement of payments) or indirectly (imposition of penalties or liquidated damages (LDs)). This risk is borne by the private partner as it is the essence of the PPP objectives. Sometimes the risk is referred to as performance risk.
• Other revenue risk events. Other risks related to revenue may arise on some projects or in some countries. Sub-categories (not present in every project) are:
• credit risk or counterparty risk
• third party and ancillary revenues
• Foreign exchange risk (forex) for cross-border investors. However, it should be noted that risk with respect to cross-border loans in hard currency is better treated under “financial risks”
• fraud/non-payment by users. This is a crucial risks in most EMDE countries.

All these are generally borne on the private side, with potential qualifications described in the appendix, especially for non-payment.

• Maintenance and operating costs. This is also a natural risk to be allocated to the private party, as the maintenance obligation is a core element of any PPP contract scope. The risk may correlate with the design risk as improper design may drive higher maintenance costs, especially major maintenance and renewals (life-cycle costs). It is not uncommon to consider some exceptions to the general transfer of risk rule for some particular risks and cost elements in specific projects: utility costs (especially energy), soft services, insurance premium costs, and “inverse risk of usage[59]” (see appendix).

Technology obsolescence is another subset of risk that generally has to be assumed by the private party, unless related to mandatory technological enhancements which are a subset of changes in law described below.

• Residual value and hand-back conditions. A risk to be borne by the private partner to meet with the requirements specified in the contract (see section 8.9).

5.7.3 Financial Risks

• Availability of finance. This represents the risk of financing (especially third party financing, that is, debt arrangements) not being available at commercial close or before construction starts, or only being available on prohibitive conditions. This risk relates to an essential obligation of a PPP and should generally be assumed by the private partner. However, the government has to proactively mitigate the risk by proper preparation and appraisal, and potentially (in some projects in EMDE countries) share the risk by putting in place public institutional finance (see section 4).
• Financial costs/interest rates. This is another essential private risk in PPPs, with the exception of the interest base rate risk between bid submission and financial close, which is taken back or shared by the authority in a number of countries (see appendix).
• Refinancing. Some jurisdictions include the obligation for the private partner to share any refinancing gains with government. In some specific projects, governments also share the downside refinancing risk.
• Forex risk. In the context of hard currency cross-border financing this is a major issue.

5.7.4 Other Risks that Affect or May Occur in Both Phases of the Contract Life

• Changes in law – specific and discriminatory changes in law. This risk may impact the project by imposing the need for increased investment or by affecting the O&M costs. Any change in law (including changes in policies and regulations) that generally affects any business should be borne by the private partner. However, it is good practice to establish risk sharing and limiting mechanisms in the contract. This is to take back part of the potential impact for what may be regarded as discriminatory changes in law (intended to affecting the specific project), as well as specific changes in law (affecting only the sector in which the project company carries out its activity).
• Changes in services (including changes in the scope of works). An authority should have the ability to ask for or order changes in the scope of services or works (under the legal limits established by the respective legislation). But it should include provision for fair compensation for these changes, under rules clearly established in the contract (see section 9.6).
• Force majeure (i) (acts of God). Natural disasters or other natural events with potential extraordinary impact, such as hurricanes, earthquakes, storms, and so on, are events not controllable by either party and should be shared (and specifically defined as such, if possible, in the contract).
• Force majeure (ii) (political risks). Certain events of a political nature with low likelihood but unmeasurable effects such as wars, terrorism, nuclear contamination, and so on, are also uncontrollable by either party and should be shared. Some countries or some specific contracts may also include malicious damage (and more exceptionally riots) under the force majeure concept.
• Uninsurable risks. This is a risk potentially embedded in the force majeure definition. However, there are other risks which, according to the insurance requirements (see section 9.5), should be covered by insurance but may become uninsurable during the course of the contract. In such circumstances, the contract should provide relief from the obligation of being insured.
• Early termination. The risk of early termination, from the perspective of the private partner, is the risk of the compensation sum due to early termination being insufficient to meet its financial obligations or being less than expected. This risk (as perceived by the private partner) is relevant for the authority in terms of commercial feasibility since a compensation method perceived as unfair or unbalanced, or one that is ambiguous or difficult to assess, may involve losing competitive bids or even facing a no-bids situation. Section 9.8 provides information additional to the appendix.