Risk Transfer in Ppp Projects by als32300


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									                        ECONOMIC RISK IN PPP ENERGY PROJECTS
                                             Martin Benes, Oldrich Stary
                     Czech Technical University in Prague, Faculty of Electrical Engineering
                                 Technicka 2, 166 27 Praha 6, Czech Republic
                Phone +4202 2435 3309/Fax: +4202 3333 4232/E-mail: benes@fel.cvut.cz

    The text is aimed to present the issue that is in the border of theory and practice. The research
    team was asked by the municipality of city Koprivnice to develop the economic scheme of
    Public Private Partnership project (PPP project) which deals with the project of centralized
    heat supply of the centre of the city. The team has faced the problem to evaluate economic
    comparators. The municipality advantage is risk diversification between public and private
    part to split the overall risk to the components that each part will manage risk component by
    their best way. In other words the total risk for customers is minimized. The method of
    economic valuation of risk is the key factor for decision making process and can highly
    influence the chosen variant.

    The basic principles are described in methodology from EU rules for PPP projects evaluation.
    These rules have to be adapted to specific conditions of any particular project. The first step
    is the identification of possible risk sources. Subsequently a few variants of risk division
    should be considered. The main criterion for risk evaluation according to previously
    mentioned EU rules is such called “Value for Money”. The net present value approach is
    used in value for money computation. The positive value means that partnership with private
    subject is effective for municipality. What is different from classic NPV approach is that the
    evaluation process covers not only systematic risk but part of individual project risk as well.

1. PPP projects advantages
There are many types of managing PPP projects according to several factors like ownership, risk
sharing, duration, etc. One possible classification of PPP projects is in the Table 1.

Table 1: Characteristics of Main Types of PPPs
Types of PPPs                    Mode         of   Operation     and   Investment   Ultimate       Market
                                 Entry             Maintenance                      Ownership      Risk
Build, Own and Transfer                                                                            Private
Build, Own, Operate and                                                             Semi-private
Transfer                         Greenfield
Build, Own and Operate                                                                             Private
Build, Lease and Own                                                                               Private
Partial Privatization                                                                              Private
Full Privatization                                                     Private                     Private
Rehabilitate, Operate and                                                                          Semi-
Transfer                                                                                           private
Rehabilitate, Lease/Rent         Concession                                                        More-
and Transfer                                                                                       private
Build, Rehabilitate, Operate                                                        Public
and Transfer
Management Contract                                                                                Public
Leasing                          Contract                              Public                      Semi-

Source: Thomsen (2005), OECD Secretariat, World Bank’s PPI database.

Public Private Partnership (PPP) is a partnership of public and private sector in order to realize the
projects of public infrastructure and services. Public sector utilises against the classic method
advantages of private sector, its expertise and sources. It means that such public investment is not
built, operated and provided by public sector (state, region, municipality) directly but in cooperation
with private sector (private firm or syndicate of firms). After given time the project is transferred to
public ownership. Private sector performs as a manager and controller of private suppliers in PPP
projects as well as a contracting authority.

Figure 1: Role of public and private sector in PPP projects

                                             Roles of

              public sector                                      private sector

                •   Regulation                                   •   Service supply
                •   Basic strategy                               •   Building design
                •   Service planning                             •   Bulding phase
                •   Monitoring                                   •   Operation management
                •   Conctracting                                 •   Financing

Source: PPP Centrum, 2005

The following tables show the main strengths and weaknesses of the both approaches to provide
public infrastructure, traditional public tenders and PPP.

Table 2: Traditional public tender – strengths and weaknesses
Weaknesses                                                           Strengths
Finance has to be budgeted from the initial stage of the project     The initial and realization
                                                                     stages are quicker
All risks are on the side of public sector                           Lower        cost     during
Necessity to hold of new public tender whenever the important Lower                 administrative
reconstruction has to be made during the lifetime of the investment. demand of the project
Cost overrun during building and operational stages
Extension of building time against plans

Table 3: PPP method – strengths and weaknesses
Weaknesses                                                   Strengths
Project lasts longer of the selection stage of the private   Higher foresee ability of cost and time of
partner                                                      realization
Project has extra costs of private partner financing         Cost of the initial stage of the project must
                                                             not be budgeted

Weaknesses                                                                                          Strengths
Higher cost of preparation and selection stages (on both                                            Strong operational incentives motivating to
public and private sides)                                                                           meet the defined quality level of services
Lower level of flexibility during all stages                                                        Main risks of building up and operation of
(management, inputs and outputs)                                                                    the project are transferred to private

Lower level of budgetary flexibility in changing Orientation to the value for money in the
preferences of voters to extent of public services during whole life cycle of the project
long time
                                                          Building up and operation is guaranteed by
                                                          one private partner, this brings some

The main weakness of the projects realized by classic approach using the public tenders is usually
overrun of time schedule and financial budget. There is a chance that this can be avoided by PPP as
the time of construction and costs are bound in the contract. Public sector does not pay for any supply
before the PPP project is operated.

Figure 2: Comparison of cost of PPP and classic service supply
                       Cash Flows - PPP Project                                                 Cash Flows - Classic Public Service

 900                                                                          900

 800                                                                          800

 700                                                                          700

 600                                                                          600

 500                                                                          500

 400                                                                          400

 300                                                                          300

 200                                                                          200

 100                                                                          100

   0                                                                            0
       0   1   2   3    4   5   6   7    8      9   10 11   12   13 14   15             0   1   2    3   4   5   6    7    8      9    10 11      12   13 14   15

                                    Financial                                                            Investment   Financial       Operation

Source: PPP Centrum, 2009

Private sector is able to supply some public services more effective, cheaper and more reliably than
public sector that is the important outcome of PPP. Nevertheless the control remains in the hands of
public sector, private sector guarantees the high quality of service in the long run. Risks of the project
are distributed between both partners in optimum way. The transparency of the contract is assured by
the only one public tender for complex service at the fixed price. On the other hand PPP is not always
the best solution for project implementation in case of lack of finance. PPP should be use only of it is
economically viable and private sector is able to provide the service more effectively with higher

2. PPP projects appraisal
The basic variant used for comparison with other variants of the project is standard supply of the
service by public tender enumerated as the “Public Sector Comparator”. In the initial stage of

preparation of the PPP project such called Referential Project is evaluated in order to estimate the
scope of potential savings and available value for money.

The initial inputs to the project like an extent of maintenance, repairs and reinvestment have to be
same for all variants of the project to assure the comparability of all variants and the same value of the
assets in the end of the concession contract. Next the private offers are evaluated in the selection
procedure phase. The best offers are compared again with the basic variant – to retain the mutual
comparability of the variants the private offers are adjusted in terms of risks or other differences.
Subsequently adjusted variants are used to calculate the expected value for money.

The main factors making the difference between PSC and PPP variants are primarily financing costs
that are included into PPP, and usually lower operating and personal costs as the private management
is able to reach higher effectiveness. Some risk is transferred to private partner and decrease the
comparator value in consequence.

Figure 3: Public Sector Comparator and Accessible Value for Money for Given Offers

                   PSC level
                                               Value for money
                         Transferrable risk

                                                                                 Net present value
                                                                                  of public sector
                                                                                   payments for
                                                 Net present value
  Expected costs

                                                  of public sector
                                                   payments for

                            Gross PSC

                          Risk covered by        Risk covered by                  Risk covered by
                           public sector          public sector                    public sector
                                 PSC                 Offer A                          Offer B

Source: PPP Centrum, 2009

The project should be realized by PPP method if the substantial value for money is generated. The
value for money means that the public sector gains the maximum available value for spent public
sources. If the project has no positive value for money it should be realized traditionally or if it is not
effective it should not be realized at all.

The value for money is not realized when submitter purchases at the best available conditions but the
service is not required or its quality is not satisfactory. The submitter cannot reach the value for money
when the project has not transparent selection procedure or whenever the competition in this public
tender is not sufficient.

The value for money shows the gain of the PPP project against classic public service (measured by
PSC value). The study carried out for The Treasury Taskforce (the commission of the ministry of
finance of Great Britain) in 2000 presented the basic factors influencing the value for money of one
third of PPP projects in Great Britain. The total number of examined projects was 29. The factors
differ from project to project but there are common factors like:
    • cost decrease during the total project lifecycle
    • better risk allocation
    • faster project realization
    • higher service quality
    • additional revenue generation

Other additional factor that could have substantial influence to the value for money should by taken in
the account: quality of the project, the state of the market environment, innovative applications, effects
to the current employees, externalities and effects to nature, etc. The study of the Treasury Taskforce
used the questionnaire of many project managers from both public and private firms, the managers
appraised the significance of factors influencing the value for money from their personal experience.

The key factors for British projects were identified as follows:
   • risk transfer
   • long term contracts (the total life cycle costs are included)
   • project is output oriented
   • competition and market environment
   • operation evaluation and stimulation/incentives
   • managerial competence of private sector
   • innovations
   • balance of the interests of both sectors
   • development potential of public sector
   • public sector comparator

3. Discount rate in PPP
The final value of the net present value depends on a chosen discount rate very much. The discount
rate is such a yield rate that can be reaching by another investment variants with comparable risk.
Theoretically it is the best yield of all available alternative investments. The discount rate is used to
carry the future cash flows to their present value by the process called discounting.

Discount rate contains the time value of risk free investment plus the premium paid for systematic
risk. The premium is the measure of the volatility of yield of the project portfolio. Theoretically it
should be different from project to project in project evaluation practice one general discount rate is
used or the sector rate is used. In discounting process the appropriate discount rate has to be used
taking into account whether discounted cash flows are given in nominal or real values. The discount

rate should reflect the opportunity cost of public expenditures the discount rate assigned by the central
bank cannot be used in this case.

The opportunity costs of public expenditures are such costs that originated from higher redistribution
of income through public sector expulsing private consumption and investment and cut down the
economic growth. Therefore the discount rate used for NPV of alternative projects is higher than cost
for the state debt financing.

All nominal cash flows should be expressed before taxation. Then the proper discount rate and cash
flow is used. Whenever the public sector belongs to normal tax mode as the private subject, the use of
cash flow after taxation should be considered together with an appropriate after tax discount rate.

The nominal discount rate for project is calculated by Fischer formula with the real discount rate and
the expected inflation rate as follows:

                        rn = (1 + rr ) × (1 + α ) − 1

        rn      nominal discount rate
        rr      real discount rate
        α       inflation rate

The real discount rate used in Canada, Australia or Great Britain is about 6 %. The projects financed in
middle developed countries by the International Finance Corporation from the World Bank Group
have the real discount rate 10 %. The discount rate value that is obligatory for the calculation of the
NPV of PPP projects is set by the Ministry of Finance of the CR. For the pilot projects the discount
rate set by the public notice to concession bill is 3 %. The nominal rate depends on expected inflation
rate and risk premium and can differ from project to project.

4. Value for money and real options
The value for money can be assumed as the sum of real option. In the most common case when the
some cost item like maintenance cost is fixed in concession contract there are two real options in it.
The underlying asset is the actual cost, the consumer hold the call option to cut the high price level in
the market while the concessionaire holds the put option to have an extra profit if the management is
able to save the money on maintenance respecting the quality of level. The example for this case is in
the Figure 4 and Figure 5.

Figure 4: Real Option and PPP – Public Sector Position
 Real Costs

                                      E                                    Actual Costs

                  Call Long       Put Short       Actual Costs       Position

The concessionaire faced with actual costs and made the profit only in the case that actual cost are
below agreed level E. This possible profit might be one reason for making the contract. From the other
side, i. e. consumers of the services covered by PPP, the contract are more attractive for low E or for
actual cost above E.

Figure 5: Real Option and PPP – Profit and Loss of Concessionaire
 Profit / Loss

                                      E                                    Actual Costs

                   Actual Costs         Conctracted Costs         Profit/Loss

For positions where cost is fixed (the investment cost for instance) an approach using options premium
leads to the same result as classic approach using NPV difference with different discount rates as is
described in previous paragraph. Whenever the contract results in complex financial position, i. e. both
customers and supplier cover the part of the cost risk an approach using the calculation of option
premiums is easier than the calculation of multiple NPV for many possible states of the world. The
inputs are the same as for option value calculation: current cost level (price of underlying asset),
number and type of options (put/call), level of fixed cost (exercise price), risk (standard deviation of
cost), time of contracts (time to maturity, usually 1, 2, ... years), risk free discount rate. This approach
is easier than Monte Carlo simulation or binomial trees. We recommend using the standard Black
Scholes formula:

                       Vc = N (d1 ) ⋅ S 0 − N ( d 2 ) ⋅ E ⋅ e − i⋅(T −t )

                                     S0          σ2
                               ln(      ) + (i +    ) ⋅ (T − t )
                        d1 =         E           2
                                         σ ⋅ (T − t )

                                     S0          σ2
                               ln(      ) + (i −    ) ⋅ (T − t )
                        d2 =         E           2
                                         σ ⋅ (T − t )

        Vc      value of call option
        S0      present value of costs
        E       fixed (guaranteed) level of costs
        i       risk free rate
        T-t     time to expiration
        σ       expected standard deviation of costs
        N(x)    cumulative distribution function of standard normal distribution

Despite being discussed if the primal assumptions of Black Scholes formula are valid for real options,
this approach is suitable for practical use eventually. The alternative ways of enumeration of real
option values lead to practically same results.

5. Conclusions
The main criterion used for evaluation of profitability of PPP projects in comparison with public
services supply is “Value for Money”. This value is positive if the private sector is able to provide
service more efficiently than municipality. The private company has higher experience and often more
competent management in the fields of financial management, management of human resources,
bargaining with other private subjects, competence in making contracts, etc. The fruitfulness of PPP
contract depends also on successful risk transfer. The real option analysis is the alternative approach
for risk transfers evaluation and it can replace the more complex methods in many cases.

6. References
[1] Cernohous, J.: “Public - Private Partnership” In POSTER 2007. Prague: CTU, Faculty of Electrical
Engineering, 2007

[2] Indráková, M: “Risk management of PPP projects in energy sector” In POSTER 2009. Prague:
CTU, Faculty of Electrical Engineering, 2009

[3] Akintoye A., Beck M., Hardcastle C.: “Public-Private Partnerships - Managing risks and
opportunities”, Blackwell Science, United Kingdom, 2003, ISBN: 063206465X

[4] PPP Centrum (Agency of Czech Government) materials, www. pppcentrum.cz, sections Guidance
and Legislation, 2009


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