By Hassan Abdulrahim

Public-Private Partnership (PPP) projects play a crucial role in developing and maintaining public infrastructure by leveraging the strengths of both the public and private sectors. A fundamental aspect of PPPs is risk allocation, which significantly influences the project’s success. Proper risk allocation encourages private sector participation and innovation, while improper allocation can deter investment and reduce project value.

The risk allocation general rule is “the risk should be allocated to the party best equipped to manage it”. This section of Visionary Consulting Company’s executive guide explores the primary risks in PPP projects and how they can be effectively allocated between public and private partners.

Land Availability: One of the initial risks in PPP projects is land availability. Without suitable land, infrastructure projects cannot proceed. Land may be unavailable due to legal issues, contamination, or preservation requirements for historical sites, causing delays. For instance, acquiring land for a new highway might be delayed if archaeological findings are discovered during preliminary surveys, necessitating additional time for preservation efforts. Typically, the public partner is better equipped to handle land acquisition risks due to their familiarity with legal procedures. Securing land before the tendering process is recommended to mitigate these risks and ensure the smooth progression of the project.

Construction Risk: Construction risk is another significant factor. This includes cost overruns and delays during the construction phase. Studies show that about 86 percent of public infrastructure projects exceed their initial budgets by an average of 28 percent. In contrast, PPP projects tend to stay within budget and are completed on time, as the private sector is not remunerated until construction is complete. Thus, construction risk is usually allocated to the private partner, who has the expertise and incentive to manage it efficiently. By aligning the private partner’s financial interests with project completion, PPPs encourage timely and budget conscious construction practices.

Operational risk: Operational risks arise after the construction phase, where maintaining an asset might be costlier than planned. Factors like higher salaries and input prices or service interruptions can increase operational costs. For example, a toll road might face higher-than-expected maintenance costs due to increased traffic volume and wear and tear.

These risks are typically borne by the private partner and can be mitigated through tariffs adjusted for inflation and long-term supply contracts. The private partner can also implement advanced maintenance techniques and technologies to control costs and ensure service quality.

Hand back risk: At the end of a PPP contract, the risk that the asset might be in poor condition when handed back to the public sector needs to be managed. This can be addressed by linking final payments to the asset’s condition and stipulating maintenance standards in the contract. For instance, a PPP agreement for a hospital might include provisions that require the private partner to meet specific cleanliness and functionality standards before the asset is transferred back to the public sector. Such measures ensure that the public continues to benefit from high-quality infrastructure even after the PPP contract ends.

Demand risk: Demand risk involves the possibility that the number of users of a public asset may be lower than anticipated, leading to financial distress. Accurate long-term demand forecasting is challenging due to factors like economic and demographic changes or the emergence of competing services. For instance, a new airport might experience lower-than-expected passenger numbers if a competing airport opens nearby or if economic conditions reduce air travel. Shifting demand risk to the private partner can incentivize high-quality service delivery, but if the private partner has little control over demand, this risk should be shared. Public guarantees ensuring minimum revenue, concession period extensions, or exclusivity rights can help balance this risk. Public guarantees can provide a safety net, ensuring that the private partner receives a minimum revenue stream regardless of user numbers.

For example, a minimum revenue guarantee for a toll road ensures the private partner can cover operational costs even if traffic volume is lower than projected. Extending the concession period can allow the private partner more time to recoup their investment if initial demand is lower than expected. Exclusivity rights prevent competing infrastructure projects from being developed in the same area during the PPP term, protecting the private partner’s revenue.

Financial Risk: Financial risks include the availability of funds once a project is awarded. Banks might refuse financing after due diligence, a risk shared by both partners. Involving banks early in the process and including financial commitments in bidding documents can mitigate this risk, although it might increase transaction costs. For example, requiring banks to provide conditional financing commitments during the bidding phase can reduce uncertainty and ensure funds are available when needed.

Currency mismatch is another financial risk, particularly in developing countries, where project revenues in local currency might not cover foreign currency loan repayments if the local currency devalues. This risk can be managed by borrowing in local currency or by the public authority supporting the risk if local currency loans are unavailable. For instance, if a PPP project in an emerging market relies on local currency revenues but has foreign currency debt, the public authority might provide support through currency hedging mechanisms to protect against exchange rate fluctuations.

Political Risks: Political risks also impact PPP projects. These include changes in legislation or regulatory actions that could negatively affect a project’s revenue. Political risk insurance and “change in law” provisions in contracts can offer protection. For example, if a government changes tax laws in a way that significantly increases the cost of a PPP project, the private partner can seek compensation under a “change in law” clause. Additionally, regulatory risks, such as a non-independent regulatory authority lowering tariffs, can jeopardize project viability. Guarantees regarding tariff setting and recourse against adverse regulatory actions can mitigate these risks. For instance, a PPP water supply project might include contractual guarantees that tariffs will be adjusted based on inflation or other economic indicators to ensure the project’s financial stability. This protects the private partner from politically motivated tariff reductions that could undermine the project’s viability.

Force majeure risk: Force majeure events, like natural disasters or civil wars, pose significant risks. Contracts should address whether the private partner should receive compensation for such events and under what conditions the contract should be terminated. Compensation mechanisms are crucial but should complement, not replace, insurance against force majeure risks. For example, a PPP project in a region prone to natural disasters might include provisions for compensation if a major event significantly impacts the project’s operations. Insurance coverage for such events provides an additional layer of protection for the private partner.

A well-structured force majeure clause ensures that both parties understand their responsibilities and rights in the event of unforeseen circumstances. This clarity helps maintain the project’s stability and the partners’ relationship, even during challenging times. Having outlined the primary risks that might face PPP projects, it is worth mentioning that risk allocation is vital in PPP project structuring and contract negotiation. A risk matrix, developed early in the project development process, can facilitate discussions and outline risk allocations. Effective risk allocation enhances project attractiveness and influences profit margins for private investors, ultimately contributing to the success of PPP projects.

A risk matrix is a tool that outlines potential risks, their impacts, and the party responsible for managing each risk. Developing this document early in the project ensures that both partners understand their roles and can prepare accordingly. For instance, a risk matrix for a PPP transportation project might list risks such as construction delays, cost overruns, demand shortfalls, and regulatory changes, specifying how each risk will be managed. Effective risk allocation not only attracts private investment but also promotes efficiency and innovation in project delivery and operation. By aligning the interests of both public and private partners, PPP projects can deliver high-quality infrastructure and services that meet public needs and provide value for money.

Ultimately, the success of PPP projects hinges on carefully balancing risks between the public and private sectors. This balance ensures that both partners are incentivized to perform efficiently and effectively, maximizing the benefits of the PPP model for all stakeholders involved.

Note: Hassan Abdulrahim is senior instructor, Economics & Finance, at Canadian College Kuwait and Deputy CEO at Visionary Consulting Company