PPP Key Risks

Financial

The awarding party wishes to secure the best value for money. A competitive process will be undertaken to structure the commercial and contractual terms in a way that optimises risk allocation and minimises the financial contribution required by the authority.

The lowest award in terms of net present value over the term, having regard to qualitative issues and risk transfer, must be assessed.  Best value for money will not necessarily be represented by the lowest bid.  Other important objectives for the authority may include ongoing service compliance in keeping the project off the balance sheet.

The consortium behind the project company will wish to deliver a profit.  There should be an offset of risk and reward.  If the private sector participants actually have genuine risk, a corresponding reward is appropriate and should be acceptable.

A contentious aspect will be the cost of aborted bids.  Money spent on bids that are lost may represent a significant cost.

There should be appropriate agreements between the participants and the consortium.  They may include different participants, such as repeat contractors whose interests conflict at certain points.  It is desirable that the consortium enter contracts regulating the relationship.

Members of the consortium will usually require a limitation of their exposure and recourse.  A separate standalone project company will be established.  Liability will effectively be limited to the agreed equity and other contributions.

Design

The design risk is a key element of PPP.  The authority specifies service requirements in terms of outputs.  The project entity is responsible for delivering that service.  Payment is made against performance.  Performance is graded to incentivise the project company to perform. Poor performance may be penalised.

Central to the notion is that the private sector is free to design the particular facilities and arrangements for delivery of the output or service.  In some cases the awarding party will specify the facilities.  In this case, it is not transferring the design risk.

In practice, the public sector will specify outputs and requirements in a significant amount of detail.  For example, there would be detailed requirements in relation to standards for schools, roads, prisons, et cetera, so that relatively little design risk will be transferred.  The output specification will determine the requirements.

Planning Permission

Statutory consents, including planning permission, are often a key risk in development and construction projects.  Certain public authorities enjoy public immunity from the requirement for planning permission but are required to undertake a process which allows public input.  Large schemes will necessitate environmental impact under European Union rule, by which another authority will have to approve environmental impact issues.

The time and cost associated with the planning process may be significant.  Because planning permission and its equivalent for public sector bodies require consent to a quite specific process, the planning process may not be commenced until after the design is chosen or finalised

Completion & Cost

Completion risk refers to the risk in relation to the delivery of the project on time and on budget. Late completion may result in loss of benefit to the public sector or increased cost to some other part of the public sector.

Commonly, liquidated damages will be applied for late delivery of a project.  There is a risk that the private sector will simply price in the risk of liquidated damages.

As with all construction projects, there will be a range of factors which may affect the agreed timetable.  There will be some events that are not the fault of either party but are external circumstances outside of both parties’ control.

There will be other events which are the fault of one party or the other.  A distinction is drawn between each type of event.  No compensation is payable for the latter, and both parties bear the risk.  Compensation is payable where the delay is the project company’s fault.

Completion of the project is critical.  As with construction contracts generally, the basic principle is that the price is set.  However, because complex projects can involve unforeseen factors, issues arise as to variations and the enhancement of the specifications, and there is a significant risk of upward price adjustment.

The authority will not wish to commence payments or, in particular, make a lump sum payment until completion has occurred.

Where the awarding authority requests variations, it will generally bear the cost.  In some cases, there may be costs outside the control of both parties, such as archaeological discoveries.  In other cases, escalations of costs are borne by the project company.

The obligation to complete to the required quality and standard is usually passed to the contracting company.  Specifications will set out the required standards.  Mechanisms will be used to test and measure compliance.  The project company may not be entitled to hand over the project, may not receive payments, or may be penalised for failures in quality.

Insolvency

The project company may have to post a bond or guarantee to cover the risk of insolvency.  Commonly as with construction projects generally, the awarding authority will usually enter direct agreements with contractors and designers so they can step in and take over a project in the event of default or insolvency of the project company.

Operational

Operational risk relates to the performance of the facilities as constructed.  Where the operational risk is transferred to the private sector, it will be responsible for the management and maintenance of facilities and the delivery of service.

The PPP normally transfers the risks in relation to the quality of completion to the private sector.  The obligation to commence payments and delivery will depend on the proper completion and meeting of commissioning tasks. In larger projects, there may be phasing elements or a takeover of existing services prior to completion. There may be proportionate payments as each phase is handed over.

The commissioning authority will wish to ensure that they are not exposed to the risk that the project company will become insolvent.  A bond or guarantee will usually be required.  It will enter into a direct agreement with the underlying contractor and designer.

The operational risk is important to many  PPP projects.  Payment should be against performance.  The facilities and services must be provided to the authority throughout the terms per the agreed specifications for agreed payments. The risk should lie with the PPP company.

However, the degree to which the risk rests with the PPP company will depend on the circumstances and the terms of the contract. Risks may be shared.. Risks which are within the control of the authority itself will rest with it.  Risks that are logically the responsibility of the PPP company will lie with it.

For risks that are outside the control of the parties such as actions of a third party or an event, different consequences may be provided for.  They may be referred to as relief events, which excuse performance or lead to a reduced payment or credit.  Some risks may be subject to insurance and the contracts will provide for who should undertake the requisite insurance.

Payments may be linked to availability and performance.  Performance would require adherence to particular standards.  There may also alternatively be an element related to the public’s use.  The payment mechanism will depend on the contract, which will be designed to incentivize performance.

In some projects, there may be a total or shadow total related to the volume of use.  In other cases, this type of risk may not be taken by the private sector.  Volume measures are appropriate in relation to projects where the service itself is delivered to end users.

Residual Value

Residual value risk refers to value of facilities at the end of the term.  Where a project is for a particular lifetime, the public service might be regarded as buying the service for that purpose for that period.  However, many facilities are only useful to the awarding authority.

The project company may price in the cost associated with projects so that they are written off over the term via the payment and that there is no residual price. Certain public projects, such as roads and prisons, are unlikely to have any residual value.

The awarding authority will not wish to expose themselves to the risk of insolvency of the project company.  The project company will usually be a special-purpose company with no value other than the project itself.

Payments will not usually begin until the project has been delivered.  Unlike conventional construction procurement, state payments will not usually be central.  The funders will have given enough of a commitment of capital so that there may be considerable financial security.

The project is likely to be set up in such a way that even if it terminates midstream, the value of facilities, which would revert to the authorities under property arrangement, will compensate for any loss and more

Where the project may involve the transfer of land, the authority will take steps to ensure that it is not exposed to the insolvency of the project company.  It would be likely to take the project over on default and ensure that the monies invested exceed any of the cost of ratification and completion.

The project company may take security for completion. The contractor arrangement will provide for fixed compensation on termination.  This may simply involve transfer of assets to the awarding authority. In the early stages of construction, a performance bond will commonly deal with the risk of default and insolvency. There are likely to be step in right to take over the project.