Risk Management in PPPglobalclearinghouse.org/Infradev/assets\10/documents... · · 2007-08-31Greater the risk, greater the potential for return as well as loss Maximise the upside

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Risk Management in PPP

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RISK MANAGEMENT IN PPPRISK MANAGEMENT IN PPP - Vaijayanti Padiyar, Tarun Shankar and Abhishek Varma IL&FS Infrastructure Development Corporation Ltd.

1.1. The Essence of Risks The Essence of Risks –– A Historical Perspective A Historical Perspective

An exact definition for risk is exclusive and its measurement is controversial. In literature, the word “risk” is used in many different meanings. Oxford dictionary defines risk as “chance or possibility of danger, loss, injury, etc”. Some of the other definitions of risk as

presented in literature are:

1. “A situation where there exist no knowledge of its outcome”

2. “The variation in possible outcomes that exist in nature in a given situation”

3. “High probability of failure”

4. “Lack of predictability about structure, outcome, or consequences in decision or planning situations”

5. “The chance of something happening that will have an impact on objectives. It is measured in terms of consequence and likelihood”

The essence of risk is characterised by three factors: the event, the likelihood and the impact of the event

(a) The event: A possible occurrence which could affect the achievement

(a) The likelihood: The chance (or probability) of the risk event occurring within the time period

(a) The impact: The financial value of the effect of the risk event

Some researchers restrict the risk definition to events with negative consequences whereas others define it with covers of both positive and negative consequences. Most of the

RISK MANAGEMENT IN PPP

1. The Essence of Risks – A Historical Perspective

2. Methods and

Tools for Risk Modelling and Analysis

3. Risks in PPP 4. Risks at different

stages of a PPP Project

5. Risk Mitigation

Strategies for PPP

6. Classification of

Risks


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above definitions refer to the uncertainty and adverseness of the event. In literature there is no agreement on the clear distinction between risk and uncertainty. When some authors see no difference between risk and uncertainty, others consider that a situation is risky when the probabilities of outcome are known and a situation is characterised as uncertain, if the probabilities of outcomes are not known.

Al-Bahar (1989) combined the essence of both risk and uncertainty and defined risk in the context of project management as “The exposure to the chance of occurrences of events adversely or favourably affecting project objectives as a consequence of uncertainty”. He also characterised risk with three components: risk event, the uncertainty of the event and the potential loss or gain. Martin and Heaulme (1998) have added another component “time of occurrence” to characterise risk in addition to event, probability and impact. Survey research conducted by Akintoye and Macleod (1997) among contractors and project management practices of UK construction industry has revealed that the average perception with respect to project risk is “the likelihood of unforeseen factors occurring, which would adversely affect the successful completion of the project in terms of cost, time and quality”.


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Risks and Risk Management under different circumstancesRisks and Risk Management under different circumstances

Risk in Different Risk in Different

ContextsContexts DescriptionDescription

Aim of Risk Aim of Risk

Management in the Management in the

Given ContextGiven Context

Risk as

opportunity

Greater the risk, greater

the potential for return as

well as loss

Maximise the

upside and

minimise the

downside within the

constraints

Risk as hazard or

threat

Potential negative events

which affects the goal and

the economic

performance of

Reduce the

probability of

negative events at

minimum cost

Risk as

uncertainty

Refers to the volatility of

the outcome

Reduce the variance

between anticipated

outcomes and the

actual


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2.2. Methods and Tools for Risk Modelling and AnalysisMethods and Tools for Risk Modelling and Analysis

There are many tools available to model system uncertainty. Work breakdown structure (WBS), risk breakdown structure, fault tree, event tree, cause-consequence analysis, influence line diagramming, CPM and PERT networks and decision tree are the various tools used in practice.

A fault tree is a logical diagram, which shows the relation between a specific undesirable event in the system, and failures of the components of the system. It is a technique based on deductive logic. An undesirable event is first defined and causal relationships of the failures leading to that event are then identified.

Event tree analysis is a method for illustrating the sequence of outcomes, which may arise after the occurrence of a selected initial event. This technique, unlike fault tree uses inductive logic. It is mainly used in consequence analysis for pre-incident and post-incident application.

Cause-consequence analysis (CCA) is a blend of fault tree and event tree analysis. This technique combines cause analysis (described by fault trees) and consequence analysis (described by event trees), and hence deductive and inductive analysis is used. The purpose of CCA is to identify chains of events that can result in undesirable consequences. With the probabilities of the various events in the CCA diagram, the probabilities of the various consequences can be calculated, thus establishing the risk level of the system.

An influence diagram is a compact graphical and numerical framework, which identifies the critical variables and explicitly reveals any conditional independence between them Decision trees provide a convenient way to organise the calculations in a decision problem when the actions and state of the domain is finite.

Except WBS, CPM networks and decision trees all the above tools were primarily developed for system safety and reliability analysis. But many of these tools in combination with other risk assessment methods are being experimented in modelling and analysis of project risks and uncertainty.

Decision analysis, stochastic simulation, sensitivity analysis


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and conceptual models/artificial intelligence (AI) analysis are the different approaches that have been used in probability-impact evaluation of project risks. Akintoye and MacLeod’s (1997) survey research in UK construction industry revealed that sensitivity analysis and simulation technique have reasonably good acceptance among contractors and project management practitioners.

The methods of decision analysis are basically decision-making tools under uncertainty and include many methods like algorithms, mean end analysis, Bayesian theory and decision trees. An algorithm contains a sequence of instructions for problems solving. Mean end analysis is a method of clarifying a chain of objectives to identify a series of decision points. The decision tree shows sequence of known choices and their possible outcomes graphically and the decision maker can identify best alternatives that fulfil the objectives. It incorporates probabilities of risks and the costs or rewards of each logical path of events and future decisions. The decision analysis as a whole requires tremendous effort in data collection.

Project simulation uses a model that translates the uncertainties specified at a detailed level into their potential impact on objectives that are expressed at the level of the total project. The uncertainty models like WBS (suitable for cost risk analysis), influence line diagrams, network diagrams (schedule risk analysis) and fault tree can be used as simulation models. The application of this technique requires the specification of a probability density function for each input variable, which may often be difficult to obtain. Subjective or objective probabilistic information may be used for evaluation. Using this method, probability of project outcome is obtained by carrying out a number of iterations, depending upon the required degree of confidence. Sensitivity analysis examines the extent to which the uncertainty of each project element affects the project objective being examined, when all other uncertain elements are held at their baseline values. Like simulation, a base model that translates uncertainty is used in sensitivity analysis. One of the main reasons for its popularity is, its ability to discover the vulnerable factors in a project


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3.3. Risks in PPPRisks in PPP

Though BOT contract framework makes the arrangement best suitable for procurement of PPP projects, the complexity of the arrangement leads to an increased risk exposure for all the parties involved. Investors in BOT projects have to deal with many risk issues right from the developmental stage of the project. The three broad stages in a BOT project with different risk profiles are developmental phase, construction phase and operation phase. The whole process of project development is a complex, time consuming and expensive business. The level of negotiations is extensive and the opportunity costs are very high. Since the finance available during the initial project phase is limited to equity, the financial risk is also high during developmental phase.

The construction phase of a BOT project is also risky, because high financing costs, time spillovers and cost overrun often distort the future revenue generation and profitability prospects of the projects. The financial success of a BOT project is highly susceptible to the delay in completion. Compared to other industrial or commercial developments, there is usually a high investment requirement and longer construction period in an infrastructure project under BOT set up. A long construction period combined with the need to capitalise interest on the borrowed sums until completion (as no revenues are available until after completion) results in high financing costs. Risk also emerges due to underestimation of operating cost and overestimation of output or demand.

However, the operation phase is considered to be with relatively low risk. BOT project can be described as a high-risk construction project followed by a low risk utility project. Pre-completion risks are often perceived to be greater than post-completion market risks in a BOT type project whereas in an industrial project, the risk of product obsolescence and the competitive market forces create greater risk.


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Sources of risk in a typical PPP project are shown in figure below. Influence of many internal and external factors coupled with long lifecycle adds uncertainty to the projects

outcomes.

Risk Sources in PPP (source – Thomas A V, K N Satyanarayana and K Ananthanarayanan – Identification of risk factors and risk management strategies for BOT Road projects in India)

4.4. Risks at different stages of a PPP ProjectRisks at different stages of a PPP Project

An infrastructure project typically faces several risks throughout the project period, which the project participants seek to mitigate to enable financing on a limited project recourse basis. The types of risks are different at each stage of the project and hence need to be mitigated appropriately.

1. Engineering & Construction Engineering & Construction PhasePhase.. The project company draws down the majority of the loan to finance construction activity, equipment purchase, and other pre operating costs. This phase can last several years, depending on the size of the project.

Risks in PPP

Operation

Demand

Contracts Construction

Government

Market

Legal & regulatory environment

Direct source

Indirect source


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Engineering &

Construction Phase

Start-up Phase

Operations Phase Loan

Exposure

2. Project StartProject Start--up Phaseup Phase.. During this phase, equipment is tested, raw material inputs are ordered, project staffing is completed, and marketing starts. Loan exposure may rise slightly during this phase due to working capital requirements and final payments to contractors and equipment suppliers. Initial sales from project start up enable loan payoff to commence.

3. Operation PhaseOperation Phase Inadequacy of revenue is the most significant risk during this phase, especially from the perspective of debt servicing and acceptable return to project investors. Over a period of time, as the project cash flows stabilize and the exposure of the lenders / investors gets reduced, the risk perception also reduces

The above figure reflects upon the risk profile during the various stages of the implementation of an infrastructure project. The level of exposure faced by lenders does not necessarily correspond directly to the risks involved. Specific strategies are adopted at each stage of the project’s life either to reduce the likelihood of adverse events or to lay risks off to parties best positioned to manage them.

In addition to the risks specific to each phase of the project, there are other risks like political risks and force Majeure risks that remain throughout the project period, though the impact may vary based on the project phase.

Time

Project Risk Phases


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5.5. Risk Mitigation Strategies for PPPRisk Mitigation Strategies for PPP

Efficient risk allocation and mitigation are central to bringing infrastructure projects to financial closure and to providing appropriate incentives during construction and operation. Projects may still be financeable if some risks are not allocated according to this principle, but costs – and ultimate tariffs – will be higher. Sponsors and lenders expect higher rewards for assuming higher risks.

Risk in any transaction cannot be eliminated. It always exists for both parties to the contract. However, risk can be managed to an acceptable level, using the following protocol:

1. Identify the risk: What events or actions would adversely affect the cost, performance, timing or viability of a project? E.g. what would happen to the project if the inflation rate increased significantly?

2. Determine the severity of the risk: What is the specific cost, time delay or reduction in performance if this event happens?

3. Allocate the risk: The “golden rule” of risk management in contracts is that a risk should be managed by the party best able to manage that risk. Shifting risk to party not able to manage that particular risk costs more, and creates even more risk to a project.

4. Mitigate the risk: Determine what must be done to reduce the likelihood of an adverse event. E.g. Construct all structures above the 100 year flood elevation to reduce the likelihood of flood damage.

5. Price the risk: Determine the cost of addressing the risk. E.g. the cost of flood insurance.


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Risk Management Tools and Technique for Projects (source – Thomas A V, K N Satyanarayana and K Ananthanarayanan – Identification of risk factors and risk management

strategies for BOT Road projects in Indian)

Checklists

Flowcharts

Interviews

Delphi technique

Brainstorming

SWOT analysis

Surveyinvestigations

Riskidentification

Risk response

Riskassessment

Qualitative riskassessment

Quantitative riskassessment

Uncertaintymodelling

Data collection

Probability andimpact evaluation

Objective data

Subjective data

Fault tree

Decision tree

Work break-down structure

Event tree

Cause sequenceanalysis

Influencediagramming

CPM/PERT

Decision analysis

Stochasticsimulation

Conceptualmodels/Artificial

intelligence

Algorithms

Bayesian theory

Mean endanalysis

Tree analysis

Fuzzy sets andlogic

Expert systems

Neuralnetworks

Analyticalhierarchyprocess

Cross impactanalysis

Sensitivityanalysis

Avoidance

Prevention

Retention

Transfer

Risk breakdownstructure

Riskmanagement

Reduction

Case studies


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6.6. Classification of RisksClassification of Risks

If private investment in infrastructure has to succeed on a sustainable basis, it is necessary to reduce both the perception and the reality of risk. The basic approach to risk management should be based on the principle that the party best able to manage a risk at least cost should mitigate it.

The risks associated with infrastructure projects can be broadly classified as under:


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Risks associated with Infrastructure Projects

Project Risks

Political & Social Risks

Commercial Risks

Market Risks

Financial Risks

Legal and Regulatory

Risks

Operational & Maintenance

Risks

Force Majeure Risks

Environmental Risks Land

Acquisition Risk

Delays in Project

Development

Technology

Risk

Cost Overruns Risk

Risk in various contracts (source – Isaksson T, Model for Estimation of Time and Cost Based on risk evaluation for

Tunnel Projects, PhD Thesis)

Cost reimbursement

Target

Lump Sum Price escalation

Lump Sum Fixed Price

Turnkey

Project’s Cost Contractor’s Risk Owner’s Risk

100%

0% 100%

0%


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Risk Matrix in a PPP TransactionRisk Matrix in a PPP Transaction

Risk CategoryRisk Category Phase of Phase of

PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation

1. Land

Acquisition

Project

Development

Delays in the land acquisition and in

providing unencumbered right of way to

the EPC contractor (Notice to proceed to

the Contractor) can lead to delays in the

start of construction resulting in

escalation of project cost. Additionally,

the risk of the costs of acquisition not

being contained within the estimates

provided in the project cost estimates

also increases.

(a) Timely provision of land for

construction of facilities and

systems should be made a

condition precedent to the

Lease/Concession Agreement.

(b) For delay related to consents,

approvals, clearances, the

government should grant

necessary permissions and the

same should be executed within

specified time.

(c) On delay, the concession period

should be extended by an equal

period

2. Delays in

Project

Development

Project

Development

During the development phase, the

critical activities that may be identified

are:

(a) Finalization of the project structure

(b) Finalization of the contractual

(a) Arranging finance during the

project development phase to

ensure timely availability of funds

to meet development

expenditure.


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framework viz. the Concession

Agreement, the EPC Contract the

Support Agreement and the O&M

Agreement

(c) Availability of requisite approvals

and clearances

(d) Achievement of Financial Close

(e) Delay in project commissioning

(b) Employing consultants with

correct management skills (both

“hard” and “soft”).

(c) Employing lawyers with the

requisite expertise soon after the

project is conceptualized.

(d) Sensitizing government to the

number, type and timing of

government approvals much in

advance of the requirement for

the approvals.

(e) Incorporating the concerns of

lenders and potential equity

investors in project structure and

legal documentation prior to

approaching the market for

funds.

3. Project

Completion

Risk

Construction

Period

The project completion risk or the

contractor’s risk refers to the possibility

of non-completion of the project within

the designated period from the Notice

to Proceed. Any delays in the

(a) This risk should be mitigated

through a Provision under

Concession Contract (CC)

(b) CC with EPC Contractor to

include turnkey, fixed price


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construction may be expected to result

in increased construction costs

design & construction contract

with payments made on reaching

certain milestones

(c) Contractor to pay Liquidated

Damages for delays during

construction

(d) Independent Engineer should

review and monitor progress

4. Project Cost

Risk / Cost

Overruns

Construction

Period

If the EPC Contract is a unit rate

contract rather than a fixed price

contract, there is a possibility of an

increase in the project cost as compared

to the current estimates.

1.1. The detailed Project Report

should be made specifying in

detail, the cost estimates for

various sub-components of the

project on the basis of which the

EPC bids should be invited.

2.2. Additionally, adequate

contingency provision and

insurance cost for unforeseen

circumstances should be built

into the project

3.3. Strict construction monitoring by

the Independent Engineer

5. Technology Construction / This pertains to the risk that the project (a) The project to be designed after


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Risk Operations

Period

may be either physically inappropriate

to handle the projected demand or is

inappropriately designed to meet local

socio-economic needs (i.e. increased

requirements) and hence rectification of

these design defaults could escalate the

O&M costs during the operations

period.

a comprehensive analysis of the

local conditions

(b) The construction supervision

should be carried out with strict

penalties for non-compliance of

the technical design by the

Contractor.

(c) The cost of rectifying such non-

compliance would also be borne

by the Contractor

(d) The Contractor should provide a

performance bond with a validity

of eighteen months (defects

liability period) after project

commissioning to take care of

any construction lacunae, that

may be detected during the

initial phase of project

operations

6. Regulatory

and

Administrativ

Operations

Period

During the operations phase, the delays

and costs associated with complying

with the regulatory requirements of the

(a) Debt Service Reserve:

Maintenance of cash reserves

aggregating to one year’s debt


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e Risk government, lenders and multilateral

institutions can adversely impact the

financial viability of the project. In

particular, delays in toll notification will

adversely affect cash flows, weakening

the project debt service capability

(especially in the critical initial years)

and investor returns

service reserve requirement for

the next year to ensure that any

temporary shortfall of revenues

due to non-increase of tariffs

does not adversely impact debt

servicing in the short run

(b) Extension of Concession Period:

In the event of chronic delays in

tariff review adversely affecting

the achievement of the

designated return on the project,

the Concession Agreement

should provide for extension of

the concession period till the

designated return is achieved.

7. Commercial

Risk

Operations

Period

This category comprises of various risks

that are associated with the underlying

economic rationale for the project. E.g.

project viability is critically dependent

upon realization of demand as projected

and hence any significant adverse

variation from the estimates would

(a) The demand estimates should be

conservative since, actualization

of demand in line with estimates

is a key economic risk that the

project participants would bear.

(b) The Concession Agreement

should also provide for an


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impair the debt servicing capability of

the project.

extension in periods of two years

each, till designated returns are

achieved

8. Operations

and

Maintenance

Risk

Operations

Period

In the event of O&M costs exceeding the

estimates used for the establishment of

financial viability, the residual cash

flows for debt/equity servicing would be

lower than anticipated thereby affecting

project returns

(a) The selection of O&M operator

will be on the basis of

competitive bidding. The

selection criteria should take into

account of its past record,

fiduciary responsibility exhibited

in other assignments, financial

strength etc.

(b) The O&M contract should provide

for a fixed & a variable fee which

could be based upon the O&M

requirements set forth in the

Concession Agreement.

(c) O&M Contract is a fixed price

contract, with the risk of cost

over-runs to be borne by the

O&M Contractor

9. Financial Risk


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(a) Interest

Rate Risk

Operations

Period

Determination of project viability is

predicated on the existing interest rate

scenario prevailing in the country. A

drastic increase in the interest rate

scenario may affect the debt servicing

capability through project cash flows

and significantly depress shareholder

returns, even though the project may

still achieve the designated return

The project should be financed on an

optimal mix of fixed rate and floating

rate instruments, to hedge the

interest rate movement risk.

(b) Foreign

Exchange

Exposure

Risk

Operations

Period

In the absence of any natural hedge of

export revenues, the project cash flows

would be exposed to the currency

devaluation risk

(a) Tariff adjustments permitted

under the concession agreement.

(b) Forex debt should be kept to the

minimum and to be swapped for

Rupee debt to the extent

possible

(c) Inflation

Risk

Operations

Period

The tariff rates being inflation indexed,

the project revenues and consequently

the achievement of the designated rate

of return would be adversely affected in

case the inflation rate is lower than

what has been, assumed in the financial

model

Tariffs to be adjusted for inflation

during operations as per formulae

given in the concession agreement.


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10.

Termination

Risk

Operations

Period

The risk pertains to the possibility of

unilateral termination of the concession

agreement prior to the achievement of

the designated rate of return on

frivolous grounds

Compensation package should be

structured in case of Termination of

the Concession Agreement with in-

built disincentives for any contracting

party to seek termination on frivolous

grounds

11.

Force

Majeure

Throughout

Project Cycle

This risk category deals with non-

political events of force majeure

considered as ‘Acts of God’ such as

epidemics, natural disasters,

earthquakes, floods during construction

phase affecting construction and such

other events. The impact of these risks

on construction and/or the project

operations could range from minor to

severe, say in case of an earthquake,

where the damage may be severe

enough to render the facilities

irreparable

(a) Comprehensive Insurance

Coverage

(b) In Force Majeure risks of types

which are not insurable, the

investors should get a yield of

certain percentage on equity on

the date of termination

12.

Political and

Social Risks


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(a)(a) Events of Events of

WarWar

Throughout

Project Cycle

In the event of war or widespread civil

disobedience, the project’s commercial

viability may be adversely affected

(a) The probability of such a risk is

very low. Though the insurance

companies do not have a

package available for the

operating company, a risk

coverage is available to

international lenders from

various financial institutions like

MIGA etc.

(b) The Concession Agreement could

also provide for a relief to each

affected party from its respective

obligations including payment of

Liquidated Damages

(b)(b) NationalizatNationalizat

ion or ion or

RevocationRevocation

Throughout

Project Cycle

The political risk pertains to relegation

of contract terms and/or nationalization

of infrastructure services being

provided.

The Concession Agreement should

provide for Termination in case of

certain politically motivated events

affecting the project. In such a

scenario, the compensation payable

by the government for transfer of

project assets should at least be

equal to the outstanding dues to the


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project lenders, thereby fully

protecting the lenders.

(c)(c) Social RiskSocial Risk Throughout

Project Cycle

This is the risk that civil/political

problems may surface as a result of the

project, manifesting in boycotts,

sabotage etc. Such disturbances may

arise from a number of different

concerns, public objection to imposition

of tariffs, public discontent with the

environmental impact of civil works or

with other features of the project. An

event similar to any of the above could

impair the ability of the Concessionaire

to collect revenue thereby affecting the

project viability

Appropriate insurance package for

the project should be designed that

provides adequate cover against

these risks

'Water Privatization' becomes a signature issue in Atlanta

Documents

Risk Management in PPPglobalclearinghouse.org/Infradev/assets\10/documents... · · 2007-08-31Greater the risk, greater the potential for return as well as loss Maximise the upside