CLASSIFICATION OF RISK
Understanding and addressing the risks of a PPP project early on is important for both the parties in PPP. This chapter presents many of the risks involved and actions that can be taken to mitigate them.
Promoters would invest in a project only if the risks in the project are less than the reward which the project fetches. PPP projects carry several risks that are unique to this type of delivery system in addition to the risks associated with more traditional assignments. Some of the risks in PPP are
- Market and revenue risks.
- Design risks
- Construction risks
- Operating risks
- Financial risks
- Political risks
- Legal risks
- Environment risks
- Force Majeure risks
1. Market and Revenue risks
Revenue risk is the uncertainty in relation to the revenue that a project would actually generate. The market and revenue risks that a PPP project may face can be grouped into the three broad areas discussed below.
- Insufficient Income from Fares or Tolls. In the case of a PPP project operating under a government concession, it would be expected that that the concession company would request a cash compensation from the government for a deficiency in income from fares or tolls, request authority to increase tolls or fares, or extend the concession period. Here it is necessary to identify its risks clearly with respect to cash flow or its returns, as they may be affected by an extended concession period.
- Insufficient Income from Other Operations. In this case, similar opportunities exist for requesting the government to provide cash compensation for deficiencies and/or extending the concession period. In addition, the concession company would have opportunities to increase rents or pursue different business strategies, including alternate uses of major portions of the concession facility.
- Insufficient Traffic. It is important for the PPP contractor to obtain a commitment from the government, to the extent possible, with respect to anticipated traffic levels and to negotiate a sufficient compensation arrangement for deficiencies. In the event that the government has not offered to provide such additional compensation, needs review its role carefully as it relates to traffic and earnings forecasts for a PPP project.
2. Design Risks
This risk relates to any defect in the design of the infrastructure facility or the design requirements stipulated for the project. This is an inherent risk in the project as it is very difficult to conclusively ascertain that damage to the facility is actually caused due to the defect in the design parameters or the very design itself. Generally it is the design contractor who is responsible for the design aspects of the project. In the event of the design parameters being stipulated by the grantor of the concession or license, the risk would be within the control of the grantor.
3. Construction Risks
The construction risks are essentially a bundle of various individual risk factors that adversely affect the construction of a project within the time frame and costs projected and at the standards specified for the facility. Construction risks are associated with PPP projects, more traditional construction projects and the simpler forms of design/build projects. They include:
- Land Expropriation. These risks may flow to both the government and concession company. Available actions include claims under expropriation legislation or claims by the concession company of liquidated damages from the contractor.
- Cost Overruns and Time and Quality. These risks affect the concession company directly. The available actions are to either claim liquidated damages from the contractor or draw down standby finance from the project lenders. (A major issue is that design requirements in PPP projects are different than those for a traditional owner.)
- Cost and Scope of Identified but Unspecified Work and Variations. These risks flow directly to the contractor and the concession company and represent a potential area of future disputes.
- Increased Financing Costs. This risk flows directly to the concession company, which may attempt to mitigate the risk either by a new injection of equity or subordinated debt from the sponsors. Alternatively, the concession company may draw down standby finance from project lenders.
- Contractor Default. This is a risk to the concession company, which may claim liquidated damages from the contractor or make a claim against the contractor’s performance bond and bonding company.
- Default by Concession Company. This is the flip side of the prior risk. This risk is to the contractor, with the primary mitigating measure being claim of liquidated damages from the concession company.
- Environmental Damage. This risk accrues to the concession company primarily and may result in claims on insurers or the party causing the damage.
- Force Majeure Event. This risk accrues to the concession company primarily and would result typically in a claim to the project insurers.
4. Operating Risks
Some of the risks that we may face in a PPP project apply also when we are providing operations and maintenance (O&M) -type services. Except for termination of the concession by the concession company, these risks flow directly to the concession company. Some of the risks and actions available to the concession company include:
- Performance risk: The completed facility cannot be effectively operated or maintained to produce the expected capacity, output or efficiency.
- Operation cost overrun: The operating costs exceed the original estimates
- Operating Contractor Default: The concession company may terminate the operations and maintenance contract and appoint a new O&M contractor
- Force Majeure or Environmental Damage: In this type of event, the concession company would most likely place a claim with its insurers because risks of this type would be normally insurable.
- Default: The default may be caused by the actions of a third party, in which case the concession company could make claims of damages against that party.
5. Financial Risks
Financial risks fall into these categories:
- Exchange rate risk relates to the possibility that changes in foreign exchange rates alter the exchange value of cash flows from the project. Prices and user fees charged to local users or customers will most likely be paid for in local currency, while the loan facilities and sometimes also equipment or fuel costs may be denominated in foreign currency. This risk may be considerable, since exchange rates are particularly unstable in many developing countries or countries whose economies are in transition. In addition to exchange rate fluctuations, the project company may face the risk that foreign exchange control or lowering reserves of foreign exchange may limit the availability in the local market of foreign currency needed by the project company to service its debt or repay the original investment.
- Interest rate risk. Force the project to bear additional financing costs. This risk may be significant in infrastructure projects given the usually large sums borrowed and the long duration of projects, with some loans extending over a period of several years. Loans are often given at a fixed rate of interest (for example, fixed-rate bonds) to reduce the interest rate risk. In addition, the finance package may include hedging facilities against interest rate risks, for example, by way of interest rate swaps or interest rate caps.
6 Political Risks
The project company and the lenders face the risk that the project execution may be negatively affected by acts of the contracting authority (Government), another agency of the Government or the host country’s legislature. Such risks are often referred to as political risks
- Nationalisation of project
- Changes in law
- Development approvals
- Adverse government action or inaction
- Payment failure by government
- Increases in taxes
- Political force majeure (including changes in government)
- Termination of concession by government (or unplanned competition).
7. Legal Risks
Some of the legal risks that a PPP project can face are related to:
- Title/lease of property
- Ownership of assets
- Corporate and security structure
- Financial failure or insolvency of concession company
- Breach of financing documents
- Enforceability of security.
8. Environment Risk
These are risks relating to occurrence of environmental incidents during the course of implementation of the project. These risks are generally within the control of the construction, and the operation and maintenance consortium. This risk has increased due to the presence of strict legal liability in relation to such environmental incidents, which can result not only in adverse affects on the financials of a project but may also cause a closure of any work or operations of and in relation to the facility.
9. Force Majeure Risks
These risks are regarding the events that are outside the control of any party and cannot be reasonably prevented by the concerned party. These risks generally arise due to causes extraneous to the project. The defining of force majeure events, these include:
- Natural force majeure events
- Direct political force majeure events
- Indirect political force majeure events
Natural force majeure events comprise of all events that can be attributed to natural conditions or acts of God such as earthquakes, floods, cyclones and typhoons. These risks should be shared equally among the parties.
Direct political force majeure events are events attributable to political events that are specific to the project itself such as exploration, nationalization.
Indirect political force majeure events are events that have their origins in political events but are not project specific such as war, riots etc.
However, the mechanism of managing and mitigating such risks cannot be categorically stated as they vary with each project and the circumstances surrounding each project.