Mike Walker continues his discussion of the risk which occurs when public procurement means that organisations become involved in PPP

The basic principle behind the approach to risk allocation in PPP/PFI is that the Government underwrites the continuity of public services and the availability of the assets essential to their delivery, while the private sector bears the risk for its ability to meet the service requirements. Where it proves unable to do so, it is at risk to the full value of the debt and equity in the project.

The idea of setting performance measurement and penalty mechanisms within the PFI contract is to ensure the private sector delivers on the specific outputs that the public sector intends to purchase. This is particularly attractive to the Government in terms of risk transfer, as it means the public sector only pays if or when those services are delivered. Thus the contractor has a strong incentive to manage the risks associated with completing complex investment projects on time and on budget, as well as to provide good quality services thereafter.

Risk allocation

To be successful and provide the best value for all concerned, PFI projects need an optimal apportionment of risk between the public and private sectors, called 'risk allocation'. Certain risks are best managed by the Government, and transferring them would not offer value for money (see Tables 1 & 2).

The risks depend on circumstances and the project type and size. However, Table 3 identifies some of the major likely risks in the PPP process.

The SPV mitigates or lays off risk

Normally in a PPP/PFI contract, the risks transferred by the public sector to the private sector are then shared between the different private sector parties participating in the PFI project. This is done using the central SPV (consortium company) to set up subcontracts as a means of distributing these risks, to the private sector participants making up the SPV company (See Fig 1).

The SPV (consortium company) is normally owned by several equity investors, some of whom may also be the contractors to the central SPV company. These contractors will carry out construction, design or facilities management (FM) work in the project for a contracted fee from the central consortium; other participants may be financial investors.

The consortium will raise debt finance, in the form of a bank loan (or a bond), to pay for the costs of construction and operation. The SPV consortium is at risk if it is unable to meet its obligations.

The private sector transfers risk to the appropriate party, so that:

- the construction contractor under a subcontract with the SPV company, takes the design, construction and completion risk
- the service provider under a subcontract with the SPV takes the service provision risk
- the SPV's insurers provide protection for risks of damage and business interruption
- the SPV company, its lenders and investors are then left with a series of residual risks (for example credit risks on their subcontractors and suppliers).

In general terms, the following rules for risk sharing are generally applied to gain optimum value to both sides of a contract:

- As lenders are risk averse they will seek to transfer risk
- The more risks assumed by lenders the more expensive will be the loans; therefore it is necessary to avoid parking the risks in the SPV.

Essentially risk should lie with the party best able to control it. Fig 2 illustrates how the risks in the SPV company are transferred or offset to contracting parties.

The funders' or banks' approach to risk as lender is only to assume measurable or measured risk, and to have control over key project decisions, just as they require 'step-in rights' written into contracts to allow them to step-in and take over the contracts as soon as possible if the project hits problems.

The term 'bankability' is often used, and means the acceptability of the project's structure as the base of project financing, ie are expected revenues sufficient to run the facility and service the debt? Funders will take a risk on the venture, but need to understand the risk and whether the revenues are achievable. The ability of the project to generate cashflow to cover and repay debt is fundamental.

Because the projects are long term, and because much happens over 25 years, it is important to allocate and control risks between project participants through contracts. The underlying contractual and regulatory matrix is usually more important than credit rating of project sponsors. Involving the lenders at a very early stage is a sensible risk strategy, as lenders must be happy with the proposals. Otherwise they will either not be party to the project or will impose a higher interest charge.

Consider the risk/return profile from the point of view of the lender. It is clear what the other parties get. The Government and sponsor get the facility, and the SPV gains profits through entrepreneurial risk taking, but there is only a small up side for lenders, the downside being that they do not get their money back. Therefore, optimal allocation of risk is a vital objective. It is more advantageous in terms of bankability to transfer risks out of the SPV down to subcontractors or suppliers, leaving very little risk to be borne by the SPV itself.

Prior to the banks agreeing to the finance for the SPV, a process of due diligence is applied to the SPV as borrower and to the contract proposals. This process is a risk control exercise and requires the examination by technical experts of the following aspects:

- legal
- technical
- insurance
- audit of financial model and sensitivity analysis
- country/political risk
- covenant of building contractor
- compensation on termination.

In this way the banks can be assured of the potential risks to the project that they are funding.

Examples of transfer and control

In the context of the schools sector, the private sector can reduce the risks and costs associated with maintaining a school for 25/30 years:

- by consideration during the design stage of the proper specification for longer-lasting materials, eg hardwood windows only need repainting every 10 years, rather than five years, as with softwood
- by consideration at the design stage of such things as sloping high-level internal surfaces, so that dirt does not so easily settle, for easier cleaning.
- by designing floor coverings and drains in wet areas, for more simplified cleaning
- by security entrance and exit considerations so that fewer security staff are required
- by offsetting the cleaning specification to a specialist company back to back with the SPV contract to the authority, so that risk is passed on by means of a sub-contract.

The cost risk for items such as cleaning is not priced by the SPV for the whole 25 years, as this would involve the private sector making a large contingency provision. However, the risk is reduced by the fact that such contracts are benchmarked and undergo a market review every five years to re-align them with market rates.

In prisons, the Government has gone a stage further, and transferred the risk, not just of constructing and maintaining the premises, but also of the actual running of the prison, including the management and care of prisoners. This means that a whole range of further risks has been transferred to the private sector SPV, including health care of the prisoners, their security, provision of meaningful work, feeding, clothing them, and guarding them. The SPV is also often responsible for transferring them to and from court proceedings.

In the hospital sector, the UK Government has not gone as far as to transfer responsibility for hospital clinical management and provision of clinical services (ie doctors and nurses). Yet this model has been used elsewhere in Europe, in Portugal for example. There appears to be no reason why this model could not work in the UK, other than Government policy on risk transfer.

Also relevant to risk and PFI are the Transfer of Undertakings (Protection of Employment) regulations (TUPE). These basically cover the rights of workers who used to work for the local council, but whose employment has been transferred to the SPV. This can be a difficult area for the potential employer, and the risks can include such items as protection of earnings, maintenance of early retirement rights, provision of working conditions (even down to providing a kitchen or parking space) and can also stretch to caretakers' houses. Many SPVs are wise to use an employment lawyer when dealing with these aspects of PPP.

Time will tell

PPP/PFI has been in the main a successful way of procuring public facilities. However, there are many risks in addition to the huge investment risk. The difficulties faced by authorities in predicting what their requirements will be for the next 20-30 years, and attempting to build in flexibility into an output specification can be imagined.

The true test of these forms of procurement will only be realised towards the end of the 25 year period. No UK PPP has been in existence for this period so the jury is still out as regards the true benefits. But generally it is believed that there will be more benefits accruing, than not.

Part I of this article appeared in StrategicRISK October 2005

- Mike Walker is a director at Currie & Brown, Tel: 020 7600 8787, E-mail: mike.walker@currieb.co.uk

Table 1: Risks usually retained by the government

- The need for the facility on the date given
- Adequacy of its overall size to meet public service needs
- Possibility of a change in public sector requirements in the future
- Whether standards of delivery (set by the public sector) will meet public needs
- Extent to which the facility is used or not used over the contract's life
- General inflation risk - unitary charges are linked to inflation, and are subject to the same inflation risk as future maintenance or other costs would be in a conventional procurement.

Table 2: Risks usually transferred by the government by contract to the private sector

- Meeting the required standards of delivery (ie if the project design was unable to provide the required service, the private sector would pay for rectifying the design)
- Cost overrun risk during construction. If for example, ground conditions require considerably more extensive foundations, the private sector will cover those extra costs
- Completion of the facility on time
- Underlying costs to the operator of service delivery, and the future costs associated with the asset
- Risk of industrial action or physical damage to the asset
- Certain market risks associated with the scheme (for example, on a road scheme, the actual traffic using the road).