Technical Risk Allocation

Inherent Risks

The most common inherent risks to infrastructure project implementation are:

  • Permitting risk (issuance or delay in issuing building and environmental permits; securing land rights, easements, and rights of way; Foreign Investment and National Security Act approvals; guest worker visa approvals; import licenses)

  • Construction risks (design risk, geotechnical risk, completion, construction delay, construction cost overrun, technology failure, force majeure, labor disruption, equipment/supply chain disruptions, construction defects; hazardous materials releases)

  • Government risk (change of law, change of tax/fiscal regime, appropriation failure)

  • Political risk (change of government, change in policy)

  • Market risk (demand miscalculation, pricing collapse, technology obsolescence)

  • Financial risk (capital market upset, cost of capital fluctuations, insolvency/bankruptcy).

 

The mantra of commercial negotiations states that parties to a transaction should allocate these risks to the party best able to manage the risk. “In other words, the party that is best able to understand a risk, control the  likelihood of the risk occurring and/or minimize the impact of the risk should also be responsible for managing it.  When the party that manages the risk also bears its financial cost, it will face incentives to mitigate the risk.” Pauline Hovy, Risk Allocation in Public-Private Partnerships: Maximizing value for money. August 2015, International Institute for Sustainable Development.  

 

One perspective is that state and local governments cannot practically transfer completion risk to the private sector, given that politically, the public looks to the government for successful infrastructure service provision (see e.g., Indiana Toll Road Project Failure). Additionally, risk transfer is costly, with the private sector charging a premium for holding any risk that the government seeks to transfer. In traditional delivery methods, governments have generally owned permitting risk, financial risk, market risk and government risk; the private sector has generally owned construction risk (except for force majeure, unforeseen conditions, and government default), with most governments requiring bid bonds, completion and performance guarantees or sureties and extensive insurance coverages and indemnities. A typical contractor price add-on for these risk mitigation tools can equal two to three percent of the construction cost.

 

The difference between risk allocation under DBB and P3 procurement are a matter of little differences. Under both procurement methods, the government enters into a contract with a contractor to deliver the project for a fixed cost (whether it be the low bid award price or a negotiated contract price); the government typically retains pre-construction permitting risk and mid-construction force majeure and unforeseen conditions cost risk; and the contractor typically provides a performance bond and/or a payment bond hedging the completion risk and risk of non-payment of subcontractors and a post-construction warranty to hedge construction deficiencies risk. Potentially, one could argue that the pricing of this risk allocation scheme differs between the two procurement methods since the government doesn’t negotiate bid awards, but can negotiate P3 contracts, given that bids may artificially raise the cost charged by the contractor for the risk allocation, whereas in open negotiation the contractor may be more willing to reduce the cost of the risk premium to seal the deal. Empirical data demonstrating such a difference, however, is lacking.  

 

Adding an operating component to a P3 procurement could also be one way to differentiate operational risk allocation from DBB procurement. Theoretically, if the contractor must operate the infrastructure once complete, they have a greater incentive to initially build the project to better minimize operational risk than would a contractor without an operational component to its contract. However, the cost of construction could also increase. Alternatively, if a government thought a significant operational risk accompanied the completed infrastructure, and that it was advantageous to hedge such operational risk, the government could do a separate procurement for privatized operations and reach a similar risk-hedging result. Overall, from the risk allocation perspective, the method of procurement does not necessarily favor one procurement method over the other.