TOOLKIT Risk Assessment For Public–Private Partnerships: A .

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TLOOKITTOOLKITRisk Assessment forPublic–Private Partnerships:A Primer

NoticeThis document is disseminated under the sponsorship of the U.S. Departmentof Transportation in the interest of information exchange. The U.S. Governmentassumes no liability for the use of the information contained in this document.The U.S. Government does not endorse products or manufacturers.Trademarks or manufacturers’ names appear in this report only becausethey are considered essential to the objective of the document.Quality Assurance StatementThe Federal Highway Administration (FHWA) provides high quality informationto serve Government, industry, and the public in a manner that promotes publicunderstanding. Standards and policies are used to ensure and maximize thequality, objectivity, utility, and integrity of its information. FHWA periodicallyreviews quality issues and adjusts its programs and processes to ensurecontinuous quality improvement.

Contents1234567Introduction3What Are Public–Private Partnerships?Public–Private Partnerships and Risk AssessmentStructure of This Primer344Project Risks in Public–Private Partnerships5Extent of Risk Transfer by Project TypeExtent of Risk Transfer by Type of Public–Private Partnership55Types of Project Risks8Risks in the Development PhasePlanning and the National Environmental Policy Act Process RisksPolitical RisksRegulatory RisksSite RisksPermitting RisksProcurement RisksFinancing RisksRisks in the Construction PhaseEngineering and Construction RisksChange in Market Conditions During the Construction PhaseRisks in the Operation PhaseTraffic RisksCompeting Facilities RisksOperations and Maintenance RisksAppropriations RisksFinancial Default Risks to the Public AgencyRefinancing RisksRegulatory RisksHandback or Residual Value Risks88999101010111111111112121212121313Risk Valuation Methods14Qualitative Risk AnalysisQuantitative Risk AnalysisFormula-Based Quantitative Risk AnalysisQuantitative Risk Analysis by Using Monte Carlo Simulation15161617Risk Allocation Strategies21Risk Allocation ProcessPublic Sector StandpointPrivate Sector StandpointOptimal Risk Allocation21222222Incorporating Risk Into Value for Money Analysis24Role of Risk Assessment in Evaluating Public–Private PartnershipsRisk Cost Adjustments for Value for Money AnalysisRisk Adjustments to the Public Sector ComparatorCalculation of Risk Premium for the Shadow Bid24252627Summary29Glossary30References32

CHA p T e r1IntroductionThe Federal Highway Administration’s (FHWA’s)Office of Innovative Program Delivery (IPD)assists States and local governments in developingknowledge, skills, and abilities in innovative financetechniques. Public–private partnerships (P3s) are one formof innovative finance. IPD supports the research anddevelopment of tools to facilitate consideration andimplementation of P3s, assists in building the capacity ofpractitioner communities, develops and implementsFederal policy on P3s, and collaborates with State andlocal partners to communicate the various aspects of P3sto elected officials, transportation leaders, and the public.A key IPD activity is the development of a series ofprimers to (a) assist in understanding P3s, (b) provide keyconsiderations in establishing a P3 program, and (c) showhow to compare a P3 procurement option with the conven tional approach. This primer is part of the series. Supportingguides and a training program are also being developed.Other primers and a variety of P3 resources are available viathe section devoted to P3s on IPD’s Web site at http://www.fhwa.dot.gov/ipd/p3/index.htm.This primer addresses the issue of risk assessment for P3s.Companion primers on the topics of Value for Money (VfM)analysis and financial assessment for P3s are also available aspart of this P3 primer series. P3s, risk assessment, and VfManalysis are briefly described in the following sections.What Are Public–Private Partnerships?P3s for transportation projects have been drawing muchinterest in the United States for their ability to access newfinancing sources and to transfer certain project risks. P3sdiffer from conventional procurements in which thepublic sponsor controls each phase of the infrastructuredevelopment process—design, construction, finance, andoperations and maintenance (O&M). With a P3, a singleprivate entity (which may be a consortium of several privatecompanies) assumes responsibility for more than one devel opment phase, accepting risks and seeking rewards.Design–build (DB) procurement—under which privatecontractors are responsible for both designing and buildingprojects for a fixed price—is considered by some to be abasic form of P3. Further along the P3 spectrum, the privatesector may also assume responsibility for finance and O&M,typically via a long-term concession (e.g., 30 years or more)from the public sponsor. This document, as well as theseries of FHWA primers on P3s, is concerned primarily withforms of P3s in which the private sector partner (called theconcessionaire) enters into a long-term contract to performmost or all of the responsibilities conventionally procuredseparately and coordinated by the government.Public agencies pursue P3s for a variety of reasons,including access to private capital, improved budgetcertainty, accelerated project delivery, transfer of risk to theprivate sector, attraction of private sector innovation, andimproved or more reliable levels of service. P3s, however,like conventional projects, require revenue to pay back theupfront investment. P3s are complex transactions, anddetermining that a P3 is likely to provide a better resultthan would a conventional approach is not simple. Thereare many factors that must be considered when determiningthe best procurement approach for a given project, includinglong-term costs, myriad uncertainties, risks both now and inthe future, and complicated funding and financingapproaches.1 Public agencies may conduct VfM analyses tocompare a P3 approach with a conventional approach.1. For more information on P3s, refer to FHWA’s primer, Public–PrivatePartnership Concessions for Highway Projects: A Primer, available at http://www.fhwa.dot.gov/ipd/p3/resources/primer highway concessionsp3.htm.Risk Assessment for Public–Private Partnerships: A Primer 3

Public–Private Partnerships andRisk AssessmentRisk analysis is used in the development of a P3 project fora number of reasons:Project risk must be identified, evaluated, and managedthroughout a project’s life for the project to be successful.Management of risks requires a public agency to proactivelyaddress potential obstacles that may hinder project success,as well as take advantage of opportunities to enhance successor save costs. P3s are considered to be a form of risk manage ment as the public sector and private sector parties seek toachieve optimal risk allocation, thus allowing for themanagement of risks by the party best able to handle them.Project risk management is an iterative process thatbegins in the early phases of a project and is conductedthroughout the project’s life cycle. It involves systematicallyconsidering possible outcomes before they happen anddefining procedures to accept, avoid, or minimize the effectof risk on the project. Under a P3 transaction, risk allocationtends to be “by exception,” so the concession agreementcontains a finite list of “relief events” and “compensationevents” that are tightly drafted and highly constrained.Everything else is allocated to the concessionaire. In contrast,under a conventional delivery approach, if a circumstance orsituation arises that had not been contemplated up front,that risk (whether or not it could have been foreseen) isowned by the public sector.2 Risk management follows aclearly identified process, which includes: To develop agreement provisions that optimize valuefor money (discussed in chapter 6). Risk identification. Risk analysis. Risk response planning (including transferof risks to the private sector). Risk monitoring, controlling, and reporting.2. For more information on the risk management process for construction,refer to FHWA’s Guide to Risk Assessment and Allocation for HighwayConstruction Management, available at 32.pdf.Another useful resource is the TransportationResearch Board’s Guidebook on Risk Analysis Tools and ManagementPractices to Control Transportation Project Costs (NCHRP Report658), available at t 658.pdf.4 Risk Assessment for Public–Private Partnerships: A Primer To calculate risk adjustments as part of valuefor money assessments. To help determine project contingency amounts. To identify and monitor mitigation actions(i.e., risk management).Note, however, that P3s may be used to manage not onlyconstruction risk, but also to address pre-construction(development phase) risks, financial risks, and risks relatedto the project’s life cycle.Structure of This PrimerThis primer is structured as follows: How the extent of risktransfer varies by type of project and type of P3 contract isdiscussed in chapter 2. The key types of risks faced in P3projects are outlined in chapter 3. The analysis of projectrisks to assess their cost impacts is discussed in chapter 4,and how risks are optimally allocated between the publicand private sectors to minimize total project life-cycle costsis explained in chapter 5. In chapter 6, there is a discussionof how costs of risks under conventional and P3 procure ments may be incorporated into VfM analyses, which isoften used to compare the two procurement options, and asummary and conclusion are provided in chapter 7.

2CHA p T e rproject risks in public–private partnershipsExtent of Risk Transfer by Project TypeP3s can involve existing “brownfield” projects (i.e., the leaseof an existing facility), or they can involve proposed newfacilities, which are known as “greenfield” projects.For brownfield projects, a public entity generates a capitalinflow or debt payoff by transferring the rights, responsibili ties, and revenues attached to an existing asset to a privatesector entity for a defined period. Risks to the private entityare lower, because little or no new construction is involved,and traffic volumes and toll revenues can be more accuratelyprojected based on existing traffic patterns.In the case of a greenfield project, a public agency trans fers all or part of the responsibility for project development,construction, and operation to a private sector entity.Greenfield projects generally present higher risks to bothparties than do brownfield projects because of the greateruncertainty surrounding traffic forecasts, permitting, andconstruction. Given the complex role that revenue riskplays in a P3 deal, this particular risk is generally separatedfrom other risks when considering whether to have a tollconcession or an availability payment concession (discussedlater in this chapter).In the case of a hybrid project, an existing facility is inneed of capital improvement (usually either extension orexpansion), and a private sector entity is brought in to financethe necessary improvements and to operate the facility.Although traffic risks may be lower for a hybrid project rela tive to a greenfield project, they may still be significantbecause of difficulties in forecasting the users’ willingness topay any new or substantially increased tolls that may beproposed to cover the costs for the project. In addition, theremay be contentious issues with regard to latent defects.Extent of Risk Transfer by Type ofPublic–Private PartnershipP3s encompass a variety of contractual structures, withvarious degrees of risk transfer to the private sector. Theextent of risk transfer in the most common forms of projectprocurement is illustrated in table 1.Table 1. Procurement models and range of risk transfer to the private sector.P3 StructureDesignConstructionFinancialO&M andTrafficRevenueRiskRiskRiskRehab RiskRiskRiskXYes, if toll ortraffic-basedpaymentYes, ifperformance based paymentPartlyDesign–Bid–Build (DBB)Design–Build (DB)XXDesign–Build–Finance ain(DBFOM)XXXNote: P3 public–private partnership, O&M operations and maintenance, Rehab rehabilitation.Risk Assessment for Public–Private Partnerships: A Primer 5

The P3 structure with the lowest level of private sectorinvolvement is DB. Under DB, the same firm is responsiblefor both the design as well as the construction of the facility,whereas under the conventional design–bid–build (DBB)approach, separate firms are responsible for design andconstruction. For both structures, the public agency remainsresponsible for financing and operating the project; however,a greater amount of risk is transferred to the private sectorentity under a DB structure, because the contractor providesa maximum price for both design and construction. The prin cipal reason that DB transfers significant risk away from thepublic owner is that many construction claims arise due toissues at the design–construction interface, including designerrors and omissions and constructability problems. The DBform of contract eliminates the source for construction claimsof this type by introducing single source accountability.With a design–build–finance (DBF) structure, the privatesector entity is in charge of financing and building the projectbut leaves the O&M of the facility to the public in (DBFOM) addsprivate financing to the design, construction, and O&M ofthe project (see figure 1). The public agency may have toprovide a public subsidy to the project, which may requireuse of bond proceeds or budgetary authority, but the publicagency will not usually finance the entire project under thisP3 structure. This form of P3 is also called a concession.In the case of a toll-based DBFOM concession, the privatesector entity shoulders a considerable amount of risk linkedto the uncertainty of traffic over the life of the project. Theinvestment decision and the financing structure are deter mined based on traffic projections: If actual traffic is lowerthan projected, then the private sector partner is exposed tofinancial loss and to the risk of defaulting on project debt. Iftraffic and revenue are higher than expected, then theprivate partner could make super profits. To protect againstthis, a revenue-sharing clause is usually included in the P3agreement. In some P3 agreements, the concessionaire maybe protected from revenue shortfalls when lower thanexpected traffic is realized by allowing for “flexible term”concessions and “revenue bands.” With flexible term conces sions, the term of the concession ends when a specified netpresent value (NPV) of the gross toll revenue stream isreached. With the revenue band approach, upper and lowerbounds of the expected toll revenue stream are set contrac tually. On one hand, if toll revenue is below the lowerbound, then the public sponsor provides a subsidy to makepublic SponsorSubsidySharedRevenueEquityInvestmentsBonds, loansLendersequity InvestorsConcessionaire (SpV)DividendsRepaymentsTollRevenueFunds to build,maintain, and operateFacilityFigure 1. Public–private partnership structure under a ssion. Solid lines cash flows into project. Dotted lines cash flows out of project.SPV Special Purpose Vehicle.6 Risk Assessment for Public–Private Partnerships: A Primer

up some of or the entire shortfall. On the other hand, reve nues in excess of the upper bound are shared with or turnedover entirely to the public sponsor.Excessive traffic risk can deter private sector entities orreduce their ability to secure financing. For greenfield proj ects, traffic volume is more difficult to accurately forecastthan for already existing brownfield projects. Public agen cies may therefore modify the P3 structure for greenfield orhybrid projects to offer guaranteed payments to the privatesector partner. A shadow toll-based concession allows thepublic agency to compensate the private sector entity basedin part on a “shadow toll” or fee3 paid by the public agencyfor each vehicle that uses the facility. Such payments gener ally have a fixed component that guarantees partial revenue,even if traffic volume were to be below projections.With an availability payment-based concession, thepublic agency retains the traffic risk by making paymentsdirectly to the private sector partner based on the avail ability of the facility rather than on the number of vehicles.Payments are contingent on achievement of pre-agreedperformance standards; however, the private entity isexposed to long-term appropriations risk. Examples in theUnited States include the Interstate-595 express lanes inFlorida and the Presidio Parkway in California.3. A shadow toll is called a pass-through toll in Texas and is used primarilyfor interagency agreements rather than for concession agreements.Risk Assessment for Public–Private Partnerships: A Primer 7

CHA p T e r3Types of project risksAll projects, whether undertaken by using conventionalprocurement methods or by using a P3 approach,have known risks, “known–unknown” risks, andunknown risks. Known risks are risks that have been identi fied. Identified risks need to be proactively managedthroughout the project life cycle by (a) identifying whoowns the management of those risks and (b) determiningwhat the risk entails, its triggers, and the contingency plansthat would prevent those risks from occurring or that wouldlessen the impact on the project should they occur. Attimes, the risks may simply be accepted by a project if thecost to avoid or mitigate the risk is more than the cost ofthe potential consequences.Unidentified risks can be known–unknown or unknown.Known–unknown risks are those that are known, but it isunknown how they could affect the project. For example,the probability of some risks occurring, such as changes inmaterial costs and even natural disasters, can be calculatedbased on historical information. Unknown risks are totallyunknown and therefore not possible to prevent or manage.Examples are certain unprecedented events, such as terroristattacks, civil unrest, or natural disasters uncommon to aregion. A challenge during the risk-identification process isto reduce the presence of unknown risks during the projectlife cycle. Known–unknown and unknown risks cannot bemanaged proactively and thus most often are addressed byallocating an acceptable level of general contingency againstthe project as a whole, which is adequate to manage areasonable level of unknown risk.Risk identification is an important component in thedevelopment of a P3 framework. The focus of P3s is onknown risks that can be mitigated by allocation to one of8 Risk Assessment for Public–Private Partnerships: A Primerthe involved parties as well as by other methods, such asinsurance and quality control. The most common risks ofhighway projects are listed in table 2. They are grouped byproject phase and are detailed in the following sections.Risks in the Development PhasePlanning and the National Environmental Policy ActProcess RisksThe environmental review required under NationalEnvironmental Policy Act (NEPA) provisions is a timeconsuming and costly effort, and environmental issues raisedduring the review process can threaten the viability of theproject. Project alternatives that are considered during theNEPA process should be viable and financeable as a P3,taking into consideration the availability of public funds.NEPA is often a major constraint on a private entity’s abilityto offer Alternative Technical Concepts (ATCs), because anysignificant change can invalidate NEPA approvals. When aproject is considered for procurement as a P3, there arevarious best practices that can ensure that the NEPA processis conducted in a way that allows efficiency for a future P3, forexample, by avoiding over-specificatio

Project risk management is an iterative process that begins in the early phases of a project and is conducted . Risk analysis is used in the development of a P3 project for a number of reasons: Todevelop agreement provisions tha

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