Meeting the goals of the project

One of the most significant goals (if not the most significant goal) of an infrastructure project structured as a public-private partnership (PPP) is to meet the growing need for the construction or renewal of vital public assets such as schools, hospitals, courthouses, highways, roads, bridges and water systems. Another key goal is the delivery of the project on time and within the budgets of the various stakeholders and participants (government, project company, equity sponsors, lenders, contractors and subcontractors). Generally speaking and among other things, a successful project may be considered one that meets the user demand, is fit for its intended use, delivered on time and on budget, avoids or mitigates expensive and lengthy conflicts or disputes, and meets (or exceeds) the standards of public safety and environmental laws.

What is risk?

Risk are anything that may negatively influence the success of the project and prevent it from meeting its goals. Parties must work together to mitigate and manage risks that might jeopardize the project from being a success. The general principle of risk allocation in PPPs is that a risk should be borne by the party that is best able to control the risk or influence its outcome. Difficulties can arise when risks are passed onto parties that are not adequately equipped to deal with risks in an efficient and effective way. Therefore, the identification, analysis and allocation of risks is crucial to the success of PPPs.

Basic Matrix for Risk-Sharing in PPPs

PPPs have changed the traditional allocation of risk by transferring a number of risks traditionally borne by the government to the private sector (when the private sector is actually better equipped to manage the risk). The below table provides a general illustration of the risk allocation in PPPs:

Please click here to view the table.

The idea is that the private sector can manage certain risks in a more efficient and effective manner than the public sector, thereby delivering greater value for money.

The three risk periods

Although risks are project-specific and vary from project to project, there are three general categories of risk in a typical PPP (note that the same risk may appear in more than one category or overlap more than one phase of the project):

  • Development and Procurement Risks
  • Design and Construction Risks
  • Operating Risks

Development and Procurement Risks

Common risks during the development and procurement stage of a PPP project include:

  • lack of political will
  • failure to obtain permits or other governmental approvals
  • public opposition to the project
  • aboriginal and First Nations issues (failure to consult, opposition by local governments, etc.)
  • weaknesses in the business framework of the project (e.g.: inaccurate cash flow projections, financing difficulties)
  • fraud in the bidding process
  • insufficient competition
  • inaccurate specifications
  • no market

The primary parties facing these risks during the development and procedure stage are the project sponsors, any development loan lenders, the government and other interested stakeholders (e.g.: environmental protest groups, taxpayers and the general public, residents living near the construction site).

Design and Construction Risks

Risks during the design and construction stage of a PPP project can include:

  • unclear building objectives
  • quality concerns
  • unexpected increases in construction costs
  • price changes caused by currency fluctuation or inflation
  • construction delays
  • bankruptcy / insolvency
  • force majeure events (e.g.: environmental disasters, poor weather conditions)
  • insufficient human resources and materials shortages
  • lack of knowledge or experience by construction contractor, subcontractors or suppliers
  • design changes required by law
  • labour strikes
  • pre-existing environmental problems
  • construction site safety problems

The design development and construction risks are primarily borne by the project sponsors and the construction loan lenders. The construction phase is generally considered to be the most risky phase of the project lifecycle because once the parties have signed the contract, it is difficult to make changes that do not increase the price of the project. The key during this phase is to have robust and rigorous processes for dealing with delays, enforcing the contract and mitigating against and managing unexpected events and changes in the project.

Operating Risks

During the operating period of the project, risks to the project company and long-term lenders may include:

  • decrease in availability of raw materials or fuel
  • decrease in demand for output of the project
  • problems in use of new technology
  • inflation
  • foreign exchange rates and convertibility
  • labour strikes and other production risks
  • increase in operating costs
  • insufficient personnel, recourses and experience of service provider
  • supply risks, regulatory changes
  • political changes
  • uninsured losses
  • management inefficiencies
  • competition from other projects
  • performance shortfalls

Risk mitigation and management

A number of project risks that have been discussed can be mitigated by establishing robust project governance and good management practices (strong organizational culture, proper due diligence, sharing of information and good communication, training, use of experts and professionals as necessary, etc.). The nature of PPPs also lends itself to the need to ensure the project processes and decision-making are transparent and accountable which can serve as a risk mitigation tool. Such practices will help ensure that risks are efficiently and properly allocated to the party best able to manage or mitigate them.

Risks are subjective

The parties in a PPP transaction have different capacities and objectives and an event or condition that is unacceptable to one party may be considered manageable by another.

  • Sponsor: The project sponsor oversees the development of the project. It is motivated to accurately assess the risk profile of the project, conduct comprehensive due diligence (on the site, specifications, projections, etc.), develop and stick to a budget and schedule, present a strong business case, limit the exposure of the sponsor’s other assets by using non-recourse financing, achieve flexibility with loan covenants in existing and future transactions, obtain favourable financing terms, meet the needs of the user group and avoid or mitigate against events that will delay or increase the price of the project (e.g.: litigation, failure to meet construction site safety standards, belated discovery of preexisting environmental contamination) and receive the financial benefits of its investment.
  • Construction lender: The construction lender is concerned with the design and construction risks because completion of this stage is a condition precedent to the repayment of the construction loan. Its concerns are timely completion, satisfaction of performance levels and any adverse change in the condition of the project during construction that affects repayment of the construction loan.
  • Long-term lender: The long-term lender wants to ensure that there is sufficient debt to finance the total construction costs, absence of any other lender in a more senior collateral or control position, and satisfactory intercreditor agreements if more than one lender is involved in the financing. Lenders are also concerned with the project contracts that act as credit support for the financing and will focus on their economic value, legal adequacy and viability in a loan workout scenario.
  • Construction contractor: Under the turnkey contract, the construction contractor must deliver the project at a fixed or predictable price on a certain date with warranties to perform at certain levels. The construction contractor will look to limit risks of any change in the cost of the project (e.g.: injunctions, protests, change orders, construction site accidents, change in scope of project), protect itself from consequences of late delivery and ensure it has sufficient time to satisfy performance guarantees. It may also be motivated to assume the risk of reaching the completion date on time and on budget by the reward of an increased construction price or bonus payment.
  • Service Provider: The service provider will be motivated to limit price risk by operating the project pursuant to a budget and within the parameters of the performance levels, laws and industry practice. It is also motivated to ensure that the project is designed and constructed to a certain standard to be able to meet the minimum performance levels throughout the life of the project.
  • Government: A major priority for the government is to stick to the project schedule and ensure on time and on budget delivery. As a public entity, it is also subject to scrutiny from taxpayers, public interest groups and other bodies of government. It will be motivated to carry out its due diligence, properly identify the scope of the project and needs of the user group, obtain permits and approvals, develop and implement a budget, establish a robust and rigorous procurement process, and establish a review process to track progress of the project and ensure accountability and transparency. If the project is successful, aside from receiving the needed infrastructure and services, the government can use the project for political benefits and also to attract other developers and future projects. Other benefits include job creation and increased tax revenues.

Impact of risk structuring on bankability

Bankability is the acceptability of a project’s structure as the basis of a project financing. We can gauge what may be considered bankable by looking at market practices, but the concept of bankability varies from deal to deal: what is considered bankable for one project may be not bankable for another project with a slightly different risk profile.

Lenders like predictability

As a general principle, lenders will not accept risks which cannot be properly assessed or analyzed or which are “wildcards”. For example, lenders will generally not take the risk of a change in law in a project where the cost consequences cannot be passed onto the consumer or an offtaker. The change in law is a wildcard because it is impossible to tell whether the risk will actually materialize and if it does, what the consequences will be.

Lenders’ wish list

Broadly speaking, lenders will attempt to structure financing with the following characteristics:

  • all costs before construction completion are without recourse to the lender for additional funds
  • construction contractor satisfies performance guarantees
  • there is recourse to other creditworthy project participants for delay and completion costs, if the project is abandoned and if minimum performance levels are not achieved
  • there are predictable revenue streams that can be applied to service debt
  • revenue streams are long-term, from a creditworthy source and in an amount that covers operating costs an debt service
  • incentives under the operating agreement ensure that the project will operate at levels that maximize revenue and minimize costs, comply with environmental laws and maintain long-term facility integrity

Dealing with residual risk

Once the risk profile of a project has been assessed, parties can agree to implement other techniques to deal with the residual risks (those risks that remain after all other risks have been transferred or eliminated). The following list provides some examples:

  • Contractual undertakings. Undertakings can be provided to ensure that parties’ obligations will be fulfilled, that certain performance standards can be met, that parties can obtain compensation in the event of unforeseen circumstances or failure to meet certain requirements, etc. For example, guarantees can help mitigate against the risk that the construction contractor must deliver the completed project on time and on budget. Failure to meet this obligation due to late completion or unsatisfactory performance levels can trigger compensation to the project company by way of liquidated damages (usually capped). Lenders will sometimes require that such financial undertakings be supported by a payment guarantee, performance bond or other surety instrument.
  • Drop-downs or back-to-back contracts. Such contracts allow for nearly all risks to be passed down from the project company to the contractors and subcontractors
  • Reserve funds. The construction budget contingency reserve fund is set up to pay cost overruns during the construction period. Subordinated debt commitments and letters of credit by the project sponsors can also provide support. Similarly, operating cost reserve accounts, overhaul reserve accounts and debt service reserve accounts can mitigate against the risk of insufficient revenue to pay operating costs, planned and extraordinary equipment overhauls and debt service. These funds can be funded by loan proceeds and project operating revenue, although they may also be left unfunded if backup credit support exists (e.g.: letter of credit).
  • Insurance. Construction all-risk insurance can be obtained to protect the project during the construction phase. Casualty, liability and equipment insurance policies can be obtained to cover inherent risks during the operating stage.
  • User guarantees. “Take or pay” or “Take and pay” arrangements can be used to ensure a minimum guaranteed revenue and mitigate against the risk of insufficient demand.
  • Cash traps: Cash traps can be used to balance the competing concerns of the project sponsors and lenders. Profits are distributed to the sponsors as long as a negotiated debt service coverage test is satisfied or other conditions are met. If the test is not met, the excess cash not needed for project operation or debt service is held in a collateral account and may be used for debt service (or debt prepayment).