In order to benchmark international best practice, governments and private providers should consider the successes of leading international practitioners.
Delmon (2009:21) contends that best practice in PPPs can be encouraged by ensuring that PPPs are properly developed, as a means to reduce risk for both the public and private sectors. One of the utmost imperative concerns in designing a PPP contract is the appropriate allocation of risks (Iossa et al. 2007:3). As mentioned earlier in this study, one of the proponents of PPPs is the optimal sharing of risk. The process of allocating risk to the party most capable of bearing the risk is determined by whether a particular partner is risk-averse. A partner’s aversion to risk depends on the retention of possibilities to diversify control over risk. The control over diversifying the risk relates to the occurrence of the risk, the likelihood of the occurrence, and the impact.
To demonstrate, Iossa et al. (2007:4) explains the principles of risk allocation as follows:
The public sector should stand the risk that the private sector cannot control, or cannot control as well the public sector and vice versa.
In the instance that parties possess comparable risk-aversion, the risk should be allocated to the party who has more control over the risk.
In the case that parties possess similar control over the risk factor, the risk should
be “allocated to the party that is more able to bear it, i.e. the less risk- averse party”
(Iossa et al. 2007:4).
As mentioned earlier, control is based on the control over the likelihood of the occurrence and the impact in the case of occurrence. Risk-sharing between the public and the private party is appropriate under certain circumstances.
80 Firstly, when the private sector can control the risk in terms of impact, and the private sector has less control over the likelihood of occurrence, the risk should be shared between the two parties. Secondly, in the case where risk is difficult to forecast and transferring the risk to the private partner could create an extreme risk premium, the risk should be shared (Iossa et al. 2007:4).
Based on the recommendations for risk allocation provided by Iossa et al. (2007:4-15), a classification can be constructed for risk allocation.
The following table attempts to provide a summary of the suggested risk allocation for some risks relevant to PPPs.
Table 3.7: International Best Practice in Risk Allocation for PPPs
RISK APPROPRIATE
PARTY DETERMINANTS
Planning or Statutory Public Planning and statutory process undertaken in advance of tender
Misspecification of
Output Requirements Public
Information and resources relevant for output requirements
Performance Private Works adhere to contract specifications regarding performance
Financial Private The private party undertakes the investment and is responsible for the financing of capital expenditure Design Private A degree of risk-sharing can take place where
public partner has an informational advantage
Construction Private
Private sector performance is contractually binding. A degree of risk-sharing can take place where public partner has an informational advantage
Operation Private
Private sector performance is contractually binding. A degree of risk-sharing can take place where public partner has an informational advantage Utilities Private Utilise due diligence and contingency plans as
Demand Public Government provides guarantees
Subcontractor Private As mitigation measure utilise professional indemnity insurance
Time-Schedule Private Private sector performance is contractually binding
Latent Defects Private
Likelihood or impact can be mitigated through efficient environmental assessment and due diligence
Maintenance Private
Efficient facilities management, sub-contractor agreements and contingency funds can aid risk mitigation
Exchange Rate Public
Government provides guarantees for fixed real exchange rate, hedging of costs and by indexing tariffs
Changes in the Needs of the Wider Public
Public Government has informational advantage and needs of the public are often affected by policy
Cost Overrun Shared
Significant percentage should be carried by the private partner, taking into account economy, efficiency, financial management and subcontracting arrangements
Legislative or
Regulatory Shared
Neither the public nor private partner have influence over change in national legislation
Interest Rate Private Apply denomination tools for bargaining
Residual Value Private Ultimate reimbursement to private partner based on the condition of the facility
Availability Private Penalties applied as risk mitigation if private partner does not meet output specifications
Source: (Author’s Own Ideas, adapted from Iossa et al. 2007:4-15 and IMF 2004:18, 31).
The determinants in the above table suggest issues that affect the risk allocation, and risk allocation should consider the issues listed under determinants. However, risks are treated on a case-by-case reference because circumstances, context and resources differ from case to case, and the above risk allocation provides a yardstick.
82 The UNECE (2008:36-38) postulates a number of factors to ensure best practice in risk management, including:
risk transfer should be balanced; and governed by cooperative sharing and mutual support;
government should be prepared to mitigate risks;
governments should identify risks at the beginning of projects; and
a risk matrix should be utilised as a tool for risk management.
In the case of a national project, it is not feasible to transfer all risks of the project to the private partner (EU 2004:119). It is challenging transferring risks in major high-capital intensive projects to the private sector, because if such projects or the project team experience difficulties, governments have few options other than to provide surety and support the existing project team (EU 2004:123). Risk-transfer should not affect the cost of financing a PPP project (IMF 2004:12). Specifically, in unitary cost projects, the risk pricing should avoid excessive premiums. Risk-transfer may affect the pricing of risks in terms of premiums.
Assessing risk is a challenging task and the legal complexity of PPP contracts means that terms relating to risk are hard to interpret (IMF 2004:22). Contract design and contract management is fundamental to successful risk-transfer, and management and diligence should be taken into consideration in the careful design of contracts, ensuring that contracts provide sufficient specifications, but are also flexible enough to accommodate changes. Iossa et al. (2007:16) assert that “contract design should exhibit a consistent
link between output specifications, allocation of risks and incentives, and the payment mechanism”.
The imbursement method should be based on a pay-for-performance principle and certifiable outcomes of the service standards related to the output specifications. Standards should be interpreted into measurable output indicators, verifiable by an independent third party (Iossa et al. 2007:16).