Public-Private Partnerships in the Czech Republic The importance of risk management in PPP projects Twinning Project CZ/2005/IB/FI/04 Training event on.

Public-Private Public-Private Partnerships in the Partnerships in the Czech RepublicCzech Republic

The importance of risk The importance of risk management in PPP projectsmanagement in PPP projects

Twinning Project CZ/2005/IB/FI/04Twinning Project CZ/2005/IB/FI/04Training event on risk management in PPP projectsTraining event on risk management in PPP projectsPrague, Ministerstvo financí, 26 May 2008Prague, Ministerstvo financí, 26 May 2008

Rui Sousa MonteiroRui Sousa Monteiro(Parpública SA, Portugal)(Parpública SA, Portugal)

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ContentsContents

• Is risk really important in PPPs?Is risk really important in PPPs?• What are the risk challenges?What are the risk challenges?• What are the goals of PPP contract What are the goals of PPP contract

management?management?• What are its main components?What are its main components?• How to deal with PPP risks?How to deal with PPP risks?

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This presentation conveys some overall This presentation conveys some overall good practices regarding risk good practices regarding risk management in PPP projects, and management in PPP projects, and particularly reflects the author’s particularly reflects the author’s research and experience in Portugal research and experience in Portugal and other countriesand other countries

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The establishment of an effective and The establishment of an effective and efficient risk management system efficient risk management system depends on idiosyncratic characteristics depends on idiosyncratic characteristics of each public administration and of each public administration and government departmentgovernment department

The recommendations here included The recommendations here included should be supplemented by rules should be supplemented by rules tailored to local circumstancestailored to local circumstances

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RiskRisk is defined as the uncertainty of is defined as the uncertainty of outcome, whether positive outcome, whether positive opportunity or negative threat, of opportunity or negative threat, of actions and eventsactions and events

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Is risk really important in PPP Is risk really important in PPP procurement and PPP contracts?procurement and PPP contracts?

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PPPsPPPs

Public-private partnerships (PPPs) are Public-private partnerships (PPPs) are long-term contractslong-term contracts between a between a public entity and a private entity...public entity and a private entity...

... for the provision of ... for the provision of servicesservices; ; usually they include the construction usually they include the construction or acquisition of infrastructure or or acquisition of infrastructure or assets with a long economic lifeassets with a long economic life

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Risk-transfer is criticalRisk-transfer is critical

The efficiency of a PPP contract depends on the effective transfer of some risks to the private partner

Private entities are efficient in the management of a project if they have money at stake, and if they face risks that they can manage

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Private managementPrivate management

PPP efficiency implies committing PPP efficiency implies committing private capital to the management private capital to the management of a public projectof a public project

But private-management efficiency But private-management efficiency will only arise if they face risks: a will only arise if they face risks: a private manager protected from private manager protected from risks will only manage rentsrisks will only manage rents

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Risk is costly (1)Risk is costly (1)

The private partner in a PPP long-term The private partner in a PPP long-term contract will be forced to design an contract will be forced to design an infrastructure and manage a project infrastructure and manage a project using a using a whole-life costingwhole-life costing approach approach

The efficient design of the infrastructure will depend on the credible expectation that the private partner will assume the long-term risks

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Risk is costly (2)Risk is costly (2)

If risks are not clearly allocated to the private partner, it could realise that it is more profitable trying to shift risks to the public sector than managing those risks

This way, the focus of the private partner could be risk-devolution, and not the provision of quality services to government/end-users

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Risk is costly (3)Risk is costly (3)

During tender, as well as during the life of the contract, the profit-seeking nature of the private partner will induce him to transfer back some risks to the public partner:

• formally, during procurement

• effectively, during contract life

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Risk managementRisk management

So, both the So, both the project managerproject manager (during the pre-procurement and (during the pre-procurement and the procurement phases) and the the procurement phases) and the contract managercontract manager (after contract (after contract close) are required to manage close) are required to manage risks carefully:risks carefully:

• Identifying and allocating risksIdentifying and allocating risks• Monitoring risksMonitoring risks• Mitigating risksMitigating risks

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What are the risk challenges for PPP What are the risk challenges for PPP projects and contracts?projects and contracts?

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Three phasesThree phases

We need to consider three phases:We need to consider three phases:

• Project selection phaseProject selection phase

• Procurement phaseProcurement phase

• Contract management phaseContract management phase

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Project selection phaseProject selection phase

• Project risksProject risks

• Project-design risksProject-design risks

• Project-scheme risksProject-scheme risks

• Budgetary/fiscal risksBudgetary/fiscal risks

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Project selection risksProject selection risks

PPPs may significantly reduce project PPPs may significantly reduce project risks for the public sectorrisks for the public sector

But, if the appraisal framework is not But, if the appraisal framework is not appropriate, PPPs may:appropriate, PPPs may:

• bias the selection of public bias the selection of public projects, inducing the government projects, inducing the government to procure to procure low valuelow value projects projects

• endanger overall endanger overall fiscal disciplinefiscal discipline

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PPP budgetary risksPPP budgetary risks

PPPs increase budgetary rigidityPPPs increase budgetary rigidity

PPPs create political risks as they PPPs create political risks as they establish bounds and restraints on establish bounds and restraints on public policy changes:public policy changes:

• Formal boundsFormal bounds

• Financial boundsFinancial bounds

Those bounds may be redeemed Those bounds may be redeemed through financial compensationthrough financial compensation

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Designs and schemesDesigns and schemes

Some risks are not really accruing out Some risks are not really accruing out of a project, but out of the PPP of a project, but out of the PPP scheme designed for that projectscheme designed for that project

So, a specific project-design presents So, a specific project-design presents some risks that are related to that some risks that are related to that design ...design ...

... and risks that vary, depending on ... and risks that vary, depending on the kind of PPP-scheme selectedthe kind of PPP-scheme selected

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Project-scheme risksProject-scheme risks (1) (1)

For instance, consider a free highway:For instance, consider a free highway:

• • Construction risk is a project-design Construction risk is a project-design risk risk (whatever the PPP scheme, the (whatever the PPP scheme, the project will face construction risk)project will face construction risk)

• • Demand risk is a project-scheme Demand risk is a project-scheme risk risk (under a shadow-toll regime, there (under a shadow-toll regime, there will be demand risk, but under an will be demand risk, but under an availability regime there will be no availability regime there will be no demand risk for the project)demand risk for the project)

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Project-scheme risksProject-scheme risks (2) (2)

Consider now a toll-road PPP project:Consider now a toll-road PPP project:

• • Demand risk may affect the scheme Demand risk may affect the scheme significantly significantly (if traffic risk is allocated (if traffic risk is allocated to the private partner)to the private partner)

• • Or just marginally Or just marginally (if payments are (if payments are made according to a pure availability made according to a pure availability regime, there will be almost no demand regime, there will be almost no demand risk affecting the private partner)risk affecting the private partner)

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Project-scheme risksProject-scheme risks (3) (3)

Consider now an accommodation Consider now an accommodation project:project:

• • If some non-infrastructural services (e.g. If some non-infrastructural services (e.g. catering) are included in the scheme, catering) are included in the scheme, services’ demand will affect the contractservices’ demand will affect the contract

• • If those services are to be provided by a If those services are to be provided by a third party, there will be no demand third party, there will be no demand risk, but the scheme will now be risk, but the scheme will now be affected by interface risksaffected by interface risks

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During PPP procurement, beside all During PPP procurement, beside all the usual negotiation risks, there is the usual negotiation risks, there is the possibility that bidders change the possibility that bidders change contract provisions in a way that contract provisions in a way that prevents effective risk transfer to prevents effective risk transfer to the private partnerthe private partner

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Risk and procurementRisk and procurement

If risks are not clearly allocated in the If risks are not clearly allocated in the draft contract (included in the draft contract (included in the Invitation to Tender), bidders will Invitation to Tender), bidders will do their best to reallocate risks in do their best to reallocate risks in the final contractthe final contract

Unclear allocation of risks may also Unclear allocation of risks may also prevent effective competition and prevent effective competition and transparency during the tendertransparency during the tender

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After contract close, risk allocation is After contract close, risk allocation is written down in the contract, so it written down in the contract, so it is supposed to be established for is supposed to be established for the whole life of the contractthe whole life of the contract

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However, risk devolution, from the However, risk devolution, from the private to public partner, is always private to public partner, is always possible if there is no proper possible if there is no proper contract management by the contract management by the public authority ...public authority ...

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... namely if the contract manager is ... namely if the contract manager is not permanently concerned with not permanently concerned with risk management and with the risk management and with the prevention of strategic moves by prevention of strategic moves by the private partnerthe private partner

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Risk devolution (1)Risk devolution (1)

After signing a PPP contract, the After signing a PPP contract, the private partner will have plenty of private partner will have plenty of opportunities to transfer risks to opportunities to transfer risks to the public sector, due to:the public sector, due to:

• Technological, commercial, or Technological, commercial, or demographic changedemographic change

• Political changePolitical change• Force majeureForce majeure events events• Some other unforeseen eventsSome other unforeseen events

(e.g. archeological discoveries)(e.g. archeological discoveries)

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Risk devolution (2)Risk devolution (2)

Improper contract management (by Improper contract management (by the public authority in charge of the public authority in charge of the contract) creates excellent the contract) creates excellent opportunities for the private opportunities for the private partner to transfer risks back to partner to transfer risks back to the public sector,the public sector,

• shifting costs to the public sectorshifting costs to the public sector• or simply by not keeping up to the or simply by not keeping up to the

prescribed quality of serviceprescribed quality of service

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Risk devolution (3)Risk devolution (3)

Government will always be politically Government will always be politically responsible for public serviceresponsible for public service

So the private partner may behave in a So the private partner may behave in a strategic way, inducing the public strategic way, inducing the public authority to change service require-authority to change service require-ments and pay compensationments and pay compensation

If change in not managed, authority’s If change in not managed, authority’s room for maneuvre will shrink and it room for maneuvre will shrink and it will lose bargaining powerwill lose bargaining power

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So, it is clear that significant risks will So, it is clear that significant risks will affect PPP contracts, and that they affect PPP contracts, and that they should be managed by the public should be managed by the public partnerpartner

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How shall the public authority protect How shall the public authority protect the public interest regarding risks the public interest regarding risks accruing from PPP projects and accruing from PPP projects and contracts?contracts?

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Risk management shall be an integral Risk management shall be an integral component of an effective component of an effective contract managementcontract management

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What are the main goals of PPP What are the main goals of PPP contract management?contract management?

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Note that, beside the usual contract Note that, beside the usual contract management goals, in the PPP management goals, in the PPP case there is the case there is the long-termlong-term partnershippartnership characteristic that characteristic that requires a mix of cooperation and requires a mix of cooperation and skepticismskepticism

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Three goals forThree goals forcontract managementcontract management

a)a) Enforce the contract in order to Enforce the contract in order to achieve its objectivesachieve its objectives

b)b) Facilitate cooperation between Facilitate cooperation between public and private partnerspublic and private partners

c)c) Manage public sector risks, Manage public sector risks, preventing strategic behaviour preventing strategic behaviour that may damage public interestthat may damage public interest

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Goal (a):Goal (a):contract enforcementcontract enforcement

• Manage information interchangeManage information interchange• Supervise asset and staff transferSupervise asset and staff transfer• Supervise construction phaseSupervise construction phase• Supervise operational phaseSupervise operational phase• Measure production & performanceMeasure production & performance• Manage changes and conflictsManage changes and conflicts• Prepare/manage terminationPrepare/manage termination

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Goal (b):Goal (b):cooperation/partneringcooperation/partnering

• Improve relations between private Improve relations between private and public partnersand public partners

• Improve interfaces with other public Improve interfaces with other public entities: communication, licensing, entities: communication, licensing, regulation, feedbackregulation, feedback

• Improve interfaces with end-users, Improve interfaces with end-users, taxpayers, and mediataxpayers, and media

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Goal (c): strategic Goal (c): strategic contract managementcontract management

• Identify, monitor, and mitigate all Identify, monitor, and mitigate all risks potentialy affecting the risks potentialy affecting the contracting authority and the public contracting authority and the public sector, for the full life of the sector, for the full life of the contractcontract

• Be aware of possible strategic Be aware of possible strategic behaviour (by private partners or behaviour (by private partners or other stakeholders) that may affect other stakeholders) that may affect the service or the public interestthe service or the public interest

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A note on (a)+(b)+(c)A note on (a)+(b)+(c)

Goal (a) requires careful planning and fast Goal (a) requires careful planning and fast response, and it “goes by the book” i.e. response, and it “goes by the book” i.e. the contractthe contract

Goal (b) is based on a cooperative Goal (b) is based on a cooperative approach, while (c) requires a (game-approach, while (c) requires a (game-theoretical) non-cooperative reasoning theoretical) non-cooperative reasoning and a skeptical approachand a skeptical approach

In a certain way, (b) activities aim also at In a certain way, (b) activities aim also at balancing this skepticism with improved balancing this skepticism with improved partneringpartnering

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Mismanagement effectsMismanagement effects

• Underperformance (low production Underperformance (low production or overproduction, low quality, ...); if or overproduction, low quality, ...); if undetected, leading to payment of undetected, leading to payment of services not really providedservices not really provided

• Perverse behaviour by private Perverse behaviour by private partner e.g. cream-skimming, partner e.g. cream-skimming, demand fostering, client rebuffingdemand fostering, client rebuffing

• Effective change in risk sharing, Effective change in risk sharing, with some risks devolved backwith some risks devolved back

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What are the main components of What are the main components of contract management?contract management?

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Contract management Contract management componentscomponents

• Planned routine activities:Planned routine activities:• Information interchangeInformation interchange• Construction and transition monitoringConstruction and transition monitoring• Effective performance monitoringEffective performance monitoring• Communication strategy and planCommunication strategy and plan

• Strategic reasoning:Strategic reasoning:• Risk registering and monitoringRisk registering and monitoring• Strategic awarenessStrategic awareness• Risk prevention and contingency plansRisk prevention and contingency plans

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Contract management Contract management internal requirementsinternal requirements

• Governance structure:Governance structure:• Define structure of Contract Mgt teamDefine structure of Contract Mgt team• Clarify rolesClarify roles (accountability, decision making (accountability, decision making

rules, clear responsibilities with no overlap)rules, clear responsibilities with no overlap)

• Reports, interfaces with other entitiesReports, interfaces with other entities

• Capacity acquisition & development:Capacity acquisition & development:• Staff requirements + consultancy useStaff requirements + consultancy use• Hiring and retaining staffHiring and retaining staff• Training staff, interchanging knowledgeTraining staff, interchanging knowledge

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Routine and strategyRoutine and strategy

• Routine tends to be overwhelming, Routine tends to be overwhelming, preventing the Contract Manager preventing the Contract Manager from strategic thinking and planningfrom strategic thinking and planning

• Routine contract enforcement Routine contract enforcement activities typically involve a lot of activities typically involve a lot of paperwork and information paperwork and information interchange, marked by a sequence interchange, marked by a sequence of deadlines for reports, invoicing, of deadlines for reports, invoicing, payments and licensingpayments and licensing

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Some routine activitiesSome routine activities

• Output measurementOutput measurement

• Performance measurementPerformance measurement

• Invoice validation and auditingInvoice validation and auditing

• Checking contractual milestonesChecking contractual milestones

• Periodical review / benchmarkingPeriodical review / benchmarking

• User and staff surveysUser and staff surveys

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PlanningPlanning

The Contract Manager should plan all The Contract Manager should plan all routine activities, in order to routine activities, in order to guarantee that there are enough guarantee that there are enough resources free forresources free for

a)a) Keeping a broad view on the Keeping a broad view on the contract, focussed on outcomescontract, focussed on outcomes

b)b) Managing risks and preventing Managing risks and preventing damaging strategic movesdamaging strategic moves

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How to deal with PPP risks?How to deal with PPP risks?

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Public sector risksPublic sector risks

PPP risk management involves a PPP risk management involves a sequence of steps that need to be sequence of steps that need to be repeated over time:repeated over time:• Identifying risks, based on formal Identifying risks, based on formal

contract risk allocation, on past contract risk allocation, on past experience and on logical reasoningexperience and on logical reasoning

• Assessing risks (impact and likelihood Assessing risks (impact and likelihood of occurrence) for all partiesof occurrence) for all parties

• Monitoring and mitigating risksMonitoring and mitigating risks

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Risk managementRisk managementbefore contract closebefore contract close

The identification, assessment, and The identification, assessment, and allocation of risk must be done having in allocation of risk must be done having in mind that, because the PPP contract is a mind that, because the PPP contract is a long-term contract:long-term contract:

• The private partner will be able to engage The private partner will be able to engage in strategic moves aiming at benefiting in strategic moves aiming at benefiting from changes and unforeseen eventsfrom changes and unforeseen events

• In preventing those moves, the public In preventing those moves, the public authority will be bounded by the need to authority will be bounded by the need to provide high-quality public servicesprovide high-quality public services

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Risk managementRisk managementafter contract closeafter contract close

After contract close:After contract close:

• The contract manager should identify risks The contract manager should identify risks through a careful analysis of the contract through a careful analysis of the contract and the fundamentals of the PPP schemeand the fundamentals of the PPP scheme

• But be aware that exogenous change and But be aware that exogenous change and strategic moves by the private partner (or strategic moves by the private partner (or mismanagement by the public partner) mismanagement by the public partner) may create additional risksmay create additional risks

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Risk register (1)Risk register (1)

Each contract manager should have a risk Each contract manager should have a risk register, listing all risks during the register, listing all risks during the construction and operational phasesconstruction and operational phases

It should be reviewed regularly, to include It should be reviewed regularly, to include new risks and to reassess impacts and new risks and to reassess impacts and likelihood of occurrencelikelihood of occurrence

The responsibility for managing each risk The responsibility for managing each risk should be allocated to one specific should be allocated to one specific institution or individualinstitution or individual

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Risk register (2)Risk register (2)

The listing of risks should be exaustive, The listing of risks should be exaustive, considering all possible potential threats considering all possible potential threats to the project, regardless of being to the project, regardless of being addressed in the contract or notaddressed in the contract or not

Change (political, commercial, Change (political, commercial, technological,...) and innovation will technological,...) and innovation will create new risks, so the listing itself create new risks, so the listing itself should be reviewed regularlyshould be reviewed regularly

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Risk identificationRisk identification

Requires:Requires:

• Analytical skillsAnalytical skills

• Good acquaintance with the contractGood acquaintance with the contract

• Knowledge transfer between projectsKnowledge transfer between projects

• Intensive game-theoretic reasoningIntensive game-theoretic reasoning

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Risk assessmentRisk assessment

• Recourse to past evidence and to the Recourse to past evidence and to the advice of external technical expertsadvice of external technical experts

• Simplicity: you are not pricing the risk, you Simplicity: you are not pricing the risk, you are just assessing its significance.are just assessing its significance.

So, impact may be measured using aSo, impact may be measured using acritical / high / medium / lowcritical / high / medium / low

scale; and the likelihood of occurrence scale; and the likelihood of occurrence may be presented by probability intervalsmay be presented by probability intervals

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Risk monitoringRisk monitoring

For many risks, the probability of For many risks, the probability of having them affect the public sector having them affect the public sector will depend:will depend:

• On preventive measuresOn preventive measures(that require strategic reasoning)(that require strategic reasoning)

• On the reputation and perceived On the reputation and perceived ability of the contract managementability of the contract management(it will impact on the likelihood of private (it will impact on the likelihood of private partner’s strategic moves)partner’s strategic moves)

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Risk managementRisk management

• Do not try to “learn by doing”Do not try to “learn by doing”

• Risk management theory and Risk management theory and practice has a long track record, practice has a long track record, with many “good practices” and with many “good practices” and “bad practices” already established; “bad practices” already established; profit from themprofit from them

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Non-naiveNon-naive approach approach

But do not forget that PPP contracts, But do not forget that PPP contracts, being long-term contracts, need an being long-term contracts, need an adequate adequate non-naivenon-naive approach: approach:

• do not assume public administration do not assume public administration is perfect and able to react quickly;is perfect and able to react quickly;

• do not assume the private partner is do not assume the private partner is a charitable institution working on a charitable institution working on behalf of the publicbehalf of the public

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Final noteFinal note

PPPs present an opportunity for PPPs present an opportunity for efficient provision of infrastructureefficient provision of infrastructure

Efficiency implies transferring risks to Efficiency implies transferring risks to the private partnerthe private partner

But, if risk is not properly managed, But, if risk is not properly managed, the public-service and long-term the public-service and long-term characteristics of PPPs allow the characteristics of PPPs allow the private partner to transfer back risks private partner to transfer back risks and so jeopardise efficiencyand so jeopardise efficiency

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Thank you

Rui Sousa MonteiroRui Sousa Monteiro

Parpública SParpública SAARua Laura Alves, 4, Rua Laura Alves, 4, 88º, 1050-138 Lisboaº, 1050-138 Lisboa, Portugal, Portugalteltel:: (+351) 217 (+351) 217 950950 507507,  (+351) 969 845 042,  (+351) 969 845 042faxfax:: (+351) 217 817 170 (+351) 217 817 170e-mail: e-mail: [email protected]@parpublica.pt