Risk Pricing Strategies for Public-Private Partnership Projects

Abdelhalim Boussabaine

Risk Pricing Strategies for Public-Private Partnership Projects

Innovation in the Built Environment

The complexity of public–private partnership (PPP) project procurement requires an effective process for pricing, managing and appropriate allocation of risks. The level at which risk is priced and the magnitude of risks transferred to the private sector will have a significant impact on the cost of the PPP deals as well as on the value for money analysis and on the selection of the optimum investment options.

The construction industry tends to concentrate on the effectiveness of risk management strategies and to some extent ignores the price of risk and its impact on whole life cost of building assets. There is a pressing need for a universal framework for the determination of fair value of risks throughout the PPP procurement processes.

Risk Pricing Strategies for Public–Private Partnership Projects addresses the issues of risk pricing and demonstrates the use of a coherent strategy to arrive at a fair risk price. The focus of the book is on providing risk pricing strategies to maximise return on risk retention and allocation in the procurement of PPP projects. With its up-to-date coverage of the latest developments in risk pricing, and comprehensive treatment of the methodologies involved in designing and building risk pricing strategies, the book offers a simple model for pricing risks.

The book follows a thematic structure: PPP processes map; risk, uncertainty and bias; risk pricing management strategies; risk pricing measurement and modelling; risk pricing at each of the project life-cycle stages – and deals with all the important risk pricing issues, using relevant real-world situations through case study examples. It explains how the theory and strategies of risk pricing can be successfully applied to real PPP projects and reflects the broad understanding required by today's project risk analysts, in their new and important role in PPP contract management.

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1

Mapping of the PPP’s Processes and Concepts

1.1 Introduction

Over the last two decades the demand for public services and infrastructures has increased dramatically. This increase has not been matched by the availability of finance to fund the required services to improve economic development and the wellbeing of society. The problem of funding is coupled with the public sector’s inability to deliver services efficiently and effectively. In contrast to the public sector, it has been argued that the private sector has the financial capacity and managerial skills to improve the efficiency of delivering public services. It was suggested (EIB 2005) that the ‘private sector is expected to bring rigour and expertise in the design, implementation and operation of a project that will benefit the society as a whole’. This notion has intensified the need for the private sector in the delivery and management of public projects. Although the participation of the private sector in the development of infrastructure projects is not new, a raft of financial and contractual legislations have been introduced worldwide to allow the private sector to participate in the development of public services and infrastructure. Several frameworks for project delivery emerged from this feverish legislation. Among the well-established frameworks is the concept of Public Private Partnerships (PPPs). Almost all forms of private sector participation are delivered under this partnership framework. The purpose of this chapter is to present the current mapping of PPPs’ processes and concepts. To achieve this aim, this chapter introduces the rationale for advocating PPPs as an efficient procurement route for public services and infrastructure projects; explains the complexity of the procurement process in PPPs; discusses the evolution of PPPs as a driver for risk transfer and efficiency of production and presents the concept of value for money; and demystifies the relationship between value for money and risk. The last section discusses issues emerging from the current financial crisis.

1.2 Rationale for PPPs

Before we embark on explaining the rationale for the evolution of PPPs, we provide a brief précis of the various definitions of PPP, which are subject to context of use and vary from country to country. There are several definitions in literature. For example, the UK Commission on PPPs defined it as ‘a risk-sharing relationship between the public and private sectors based upon aspiration to bring about a desired public policy outcome’; whereas as the Canadian National Council for PPPs defined it as ‘a contractual agreement between a public and private sector entity. Through this agreement, the skills and assets of each sector are shared in delivering a service or facility for the use of the general public. In addition to sharing of resources, each party shares in the risks and rewards potential in the delivery of the service and/or facility’ (Infrastructure Canada 2007). These definitions and others are centred on the following concepts (Malone 2005, HM Treasury 2006, Deloitte 2009)

1.2.1 Risk Transfer

One of the primary reasons for the evolution of PPPs is the transfer of risk to the private sector. Normally, risk transfer is used as one of the drivers for value for money computation. PPP procurement is based on the principle that risks should be transferred to the party best able to absorb and manage them.

1.2.2 Risk Sharing

The private partner normally bears a large portion of PPPs risks. However, the public sector retains those risks that carry a large price. The greater the proportion of risks borne by the private sector, the betterthe incentive to minimise whole life cycle costs and improve operational performance.

1.2.3 Sharing Skills

One of the most cited arguments for PPPs is that the private sector has superior management skills. If the skills are shared with the public sector, this would lead to better efficiency, i.e. lower capital and operational costs and better quality of public services’ delivery.

1.2.4 Sharing Assets

Collaboration between the private and public sectors entails sharing skills and assets in providing public services. It is expected that the private sector will provide efficient asset management. The private sector operates and manages the assets, whereas the public sector plays a role as regulator and controller of performance. The concession agreement dictates how assets are shared. However, it is expected that, at the end of the contract, property and residuals of all assets will be returned to the public sector.

1.2.5 Sharing Resources

In some instances, PPPs are defined as collaborative endeavours that combine resources (i.e. finance, human, technical, expertise, knowledge, etc.) and skills from both the private and public sectors to delivery efficiency in public services.

1.2.6 Sharing Rewards

In PPPs, the project agreement sets out the rewards, and terms and conditions of such rewards for both the private and public sectors. It is assumed that best value/reward is better achieved through long-term partnerships.

1.2.7 Sharing Responsibilities

PPPs have evolved to share risks, responsibility and accountability in the delivery of public services. It is stated that, by sharing responsibilities, PPPs will aid in minimising the risk of conflict, assuming the parties share the same vision for the project. All contracting parties in the PPP model of delivery have responsibilities and obligations. These responsibilities are shared through a PPP contract’s legal framework. Thus, the level of responsibility varies according to the type of PPP model used in the delivery of the public projects and services. Also, responsibilities are proportional to the risk-bearing capacity of the contracting parties.

1.2.8 Mutual Benefit

This is cited as key to successful partnerships. It is said that both the public and private sectors can benefit from medium- and long-term engagement in several ways, including strategic planning (i.e. focus on the specific part of shared tasks, effective business processes and organisational opportunities to exploit skills, etc.).

1.2.9 Achieving Value for Money

That is, maximising the efficiency of public services by reducing the cost associated with the design, construction and operation of public projects. Value is created by using the management skills of the private sector. Value for money is determined by using public and private sector comparators (see section 1.5).

1.2.10 Pursuing Shared Objectives

PPP collaboration must revolve around shared objectives and values between the partners. This is viewed as essential for delivering public services efficiently. This concept underpins the PPP contract framework. Shared objectives guide the PPP process from inception to the cessation of the contract. Hence, an agreement on such shared objectives is fundamental in risk transfer and value creation in PPP procurement.

1.2.11 Saving in Project Life-Cycle Costs

This is based on the assumption that because the private sector bears most of the operational risks, thus there is a huge incentive for the private partner to create further value by acquiring better building specifications in order to lower operation and maintenance costs over the life span of the concession. This approach helps minimise whole life-cycle costs through a trade-off between capital expenditure and operational cost.

1.2.12 Business Model

‘A PPP is a business entity—such as a corporation, partnership, limited liability company, or grantor trust—that is established by the private sector for a single specified purpose’ (Standard & Poor’s 2006).

Although there is a long history of private sector participation in the delivery of public services, the emergence of PPPs as one the main procurement routes to public infrastructure and services was due to the shift towards private sector participation and privatisation in general in the 1980s. The need for such a shift was dictated by public sector reform to improve efficiency in the provision of public services. This led to the quest to find new innovative methods of delivering public services. Not surprisingly, the public sector has turned to the use of market mechanisms to bring about both the efficiency and the funding required to change public services. This paradigm move has resulted in the widespread utilisation of PPPs and other forms of private–public collaborations throughout the world. The use of PPPs is now widespread in all types of public sector, including housing, health, IT, energy, waste, water, etc. Also, legislation to cope with such rapid expansion of PPPs has evolved globally in order to create and maintain contractual frameworks. According to McKinsey and Company (2009), one of the key rationales for PPPs evolution is ‘the recognition that many challenges do not fall neatly into either the public, civil or private sectors; instead, they require joint efforts from all sectors. For example, efforts to promote economic development are more likely to succeed when they include both the public and private sectors’. Boeuf (2003) attributed the evolution of PPPs to three aspects:

• Volume: PPPs increase the volume of investment in projects. This is not possible without private sector contribution as the public sector does have the finance to fund the required services.
• Efficiency/quality: the private sector has developed the capacity and experience to provide highly efficient services at lower cost.
• Competitiveness and fair competition: this is part of market mechanisms: the encouragement of competition to improve efficiency. It is thought that providing liberalisation and deregulation will lead to market competitiveness, thereby adding significant value to the delivery of public services.

One of the most rehearsed arguments for the adoption of PPPs as one of the main drivers for public services delivery is advocated by Palmer (2009): it ‘can help alleviate chronic underinvestment in capital intensive projects. They can serve as a vehicle for the injection of private sector financing while allowing government to maintain their fiscal targets and avoid taking on additional debt’. For example, the EC (2010), in its strategy for Europe 2020, advocated the use of PPPs as one of mechanism to eleviate the chronic shortage of finance to fund public projects. It states it is necessary to ‘pursue new avenues in using a combination of private and public finance and creating innovative instruments to finance the needed investments, including public-private partnerships’. It is clear from this passage that the public sector uses PPPs as a leverage mechanism to get around budgetary constraints. This view was supported by UK Treasury rule budgetary control in the 1990s: ‘The golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending’ (HM Treasury, 1995).

From the public point of view the attraction of PPPs is based on:

• The need for innovative solutions to meet the ever-evolving needs of public services.
• Public infrastructure and services suffering from underinvestment.
• Increasing public efficiency by using private sector contracting and financial expertise.
• Spreading the cost of providing public services over a long period of time.
• Providing better value for money in the provision of public services.
• Provision of better maintenance and operation of public assets.

From the private sector point of view, PPPs allows:

• Diversification in a portfolio of investments.
• A stable business model, i.e. using long-term relationships will help to avoid boom and bust cycles.
• Managing project risk efficiently through innovative contracting methods, i.e. special purpose companies.
• Integration across all specialities of a company to provide whole life-cycle solutions.
• The opportunity to change from contractor status to investor and service provider, i.e. act as developer, operator and investor.

Despite the above benefits, there are many opponents of PPPs who argue that PPPs do not provide value for money because the cost of borrowing is substantially lower for the public sector than it is for the private sector. Also, there is insufficient risk transfer to the private sector to justify the perceived added value for money (Hall, 2008). Opponents also argue that the risk of additional costs of time and budget overruns should be added to the cost of borrowing before a value for money comparison is carried out. Another aspect of PPPs that has attracted criticism is the complexity of the financial transaction and accounting procedures, which lack clarity, accountability, and are costly to run. Some opponents also claim that private sector providers should not gain large profits for delivering low-risk public services, and they argue that the excessive profit would be better invested in public infrastructure. Adversaries of PPPs also dismiss the notion that the private sector brings innovation and efficiency to public services’ delivery. They cite the fact that the evidence from past PPPs projects shows that R&D investments have not increased. Hall (2010) argues passionately that PPPs contracts are subsidised: ‘apart from this lobbying, governments and international public sector bodies are supporting PPPs through substantial state aid, in the form of privileged access to government guarantees or public finance’. He goes on to suggest that, for example, the EU Commission ‘has already developed a number of “financial engineering” instruments to help PPPs, by making it easier for them to use EU (public) money from the cohesion funds’. Our view on this is that PPPs are still evolving as a credible alternative for delivery of public services. There are shortcomings, but if these are addressed properly this will enable them to mature into a viable alternative procurement route. To arrive at this status, partners need to tackle the issue of risk pricing and transfer through new innovative, equitable and ethica methods. Also, the question of efficiency and value for money should be based on credible assumptions and analysis. It is also imperative that the public sector must not subsidise PPP contracts in any form or shape. We must also not forget the necessity for more public finance public services. It must be remembered that the sole purpose of partnering is to create mutually beneficial relationships and equitable value creation between all participants in a project.

1.3 Key Stages in the PPP Procurement Process

PPP is now widely used as an alternative procurement method for public services worldwide. Hence, public authorities and private institutions in different countries have produced their own guidelines and frameworks for the implementation of PPP processes. Hence, the reader may find slight variations in the content details of a typical PPP project life cycle. However, ...

Table of contents

• Cover
• Series page
• Title page
• Copyright page
• Preface
• 1 Mapping of the PPP’s Processes and Concepts
• 2 Uncertainty in Pricing Risk
• 3 Bias in Risk Pricing
• 4 Management Strategies for Risk Pricing
• 5 Framework for Pricing PPP Risks
• 6 Risk Measurement and Modelling
• 7 Risk Allocation Networks in PPP Contracts
• 8 Pricing Development and Construction Risks
• 9 Pricing Operational Risks
• 10 Financial Risk Assessment in PPP Projects
• Index