Principles of Risk Allocation, Part 1 Brian Chase CLC 1030

Risk is real Risk defined: the chance of an event occurring which would cause actual project outcomes to differ from those assumed. Collapse of Shunji Bridge in 2006 Bangkok Airport protest in

All infrastructure projects are subject to risk  New construction (greenfield)  Rehabilitation (brownfield) Many different types of risk: General risks  Political risks  Devaluation risk of local currency  Legal and regulatory risks Project-specific risks  Design and construction risk  Resettlement risk  Operations and maintenance risk  Demand and revenue risk Bolivian water-privatization protestors at a rally in

Project Risk Profiles Each project has a unique risk profile due to its:  Type of asset  Geographic location  Date of construction  Current condition  Public and private parties involved  Parties’ available resources; and  Parties’ willingness and ability to handle risk Each project’s risk profile must be carefully analyzed before selecting a procurement delivery model 4

Why risk matters Public and private partners involved in an infrastructure project both care about risk, but for different reasons:  Private partner: risk impacts its profitability in performing project work  Public partner: risk impacts the level of efficiency it is able to achieve in delivering infrastructure services to the general public Risk management holds the key to project success or failure for both the public and private partners:  Lower risk premiums  Greater private investment and more projects  Additional private sector competition in responding to projects  Less need to provide sovereign guarantees 5

How PPP Projects Address Risk Delivery models are distinguished by how they apportion and manage risk Unlike conventional procurements, PPP structures more deeply involve the private sector in infrastructure service delivery and risk sharing during the rehabilitation/construction phase; operation and/or maintenance of the facility; and financing for the project A PPP does not make risk magically disappear; it is simply allocated differently to achieve a more optimal sharing of risk 6

How PPP Projects Address Risk (cont.) Variety of PPP procurement approaches and contracting structures are used to shift project risk to private sector partners Examples: BOO (Build Own Operate) BOOT (Build Own Operate Transfer) DBMO (Design Build Maintain Operate) DBFM (Design Build Finance Maintain); and DBFO (Design Build Finance Operate) Challenge is to select the PPP approach that achieves optimal risk sharing between the public and private partners 7

PPP Delivery Methods Level of Private Sector Involvement Risk Transfer 8

Overview of Risk Management Process Risk management seeks to identify, prevent, contain and mitigate risks Risk management is an ongoing process which continues throughout the life of a project and occurs in 5 stages: 1. Risk identification 2. Risk assessment 3. Risk allocation 4. Risk mitigation; and 5. Monitoring and review 9

1. Risk Identification Identify all risks relevant to the project Done by experienced personnel during project development phase Typically start with generic risk categories and/or risks based on different phases of the project and then identify project-specific risks 10

2. Risk Assessment Determine likelihood of identified risks materializing; and Magnitude of their consequences, if they do occur Low risk Low consequence High risk Low consequence Low risk High consequence High risk High consequence 11

3. Risk Allocation Basic principle = Optimal risk allocation  Risk goes to the party best able to control its occurrence and consequences Goal of risk allocation  Reduce the likelihood of the risk occurring by giving the party best able to control it a financial incentive to prevent its occurrence  That party also likely in best position to access information about the likelihood of the risk materializing and can therefore establish a realistic premium for taking the risk 12

3. Risk Allocation (cont.) Various groups to whom project risks can be allocated: Private sector partners (operators, builders, investors) Government sponsor Multilateral agencies Bilateral agencies/Export credit agencies Private financial entities Users Symmetrical risk allocation Party should be entitled to both benefits and liabilities from risk (e.g., refinancing risk) Risk over which no party has control If highly speculative and uncertain, may need to be shared by parties 13

3. Risk Allocation (cont.) Risk matrix reflects allocation decisions  Tool to list project risks and allocate them  Responsible party takes listed mitigation steps Public partner’s goal should not be to transfer as much risk as possible to the private partners, since they are unlikely to accept responsibility for this risk without including a substantial risk premium in their pricing for the project Public sector overreaching can also inhibit the ability of the private partner to obtain financing for the project 14

Design and construction Traffic / revenue Planning Legal/FM/ insurance Public sector riskPrivate sector risk Risk Allocation….. Each project is different and needs an individual risk allocation 15

4. Risk Mitigation Actions taken to reduce the likelihood of the risk occurring and the degree of its consequences for the responsible party Mitigation practices vary depending on: Risks being considered; and Whether the responsible party is public or private Examples: Insurance (for political and commercial risks) Credit guarantees (partial or full) Use of subcontractors Suppliers Financial instruments (hedges, currency and interest rate swaps) Exit strategy (assignment; refinancing rights) Use of contingency planning for emergency events 16

5. Monitoring and Review Once risks have been allocated and a contract has been signed, the procurement team needs to establish a risk monitoring system for both: Identified risks New risks  Arise as the project develops and its environment changes  Must be assessed, allocated, mitigated and monitored 17

Barriers to Effective Risk Management Unquantifiable major project risks Inadequate project risk assessment Lack of careful due diligence during the pre- procurement phase Risk averse public sector Agency overreaching 18 Risk management is an art as well as a science due to unique mix of circumstances for each project Risk management is an art as well as a science due to unique mix of circumstances for each project

PPP Contract and Risk Contract should reward good risk management: Private sector investors expect return on their investment More risky the project, the higher the required compensation is likely to be Access to cheap funding is in itself not a good reason for an entity to assume more risks. Indeed, cheap funding can encourage ill-judged and ill-managed risk taking 19

Key Message All infrastructure projects are subject to risk, and each project has a unique risk profile that must be carefully analyzed Risk management has a significant impact on whether a project improves infrastructure service delivery outcomes PPP and conventional project delivery models allocate risk differently Optimal risk-sharing is more likely to result in value for money, and will help build long-term public support for infrastructure projects 20