2.4 The concept of sharing Systematic Risk between Private and Public Sectors
One of the prime motivations for Private Sector involvement in public infrastructure, is to instigate risk-sharing arrangements between public and private parties to increase the efficiency of projects and improve VFM. In a PPP framework risks are allocated via contract to the party who is perceived to have the best potential to manage risks of particular types. The party that bears the particular risk should receive the rewards and losses that result from holding that risk.
Generally, a PPP project results in Systematic Risks being shared between the Private Sector and Public Sector, although it is possible that a project could involve all the Systematic Risks being borne by the Private Sector or the Public Sector.
Example - Contrast of Procurement Options |
The following example looks at three examples of projects with different levels of Systematic Risk. |
Example 1 - the public sector pays an inflation indexed fee to the private sector for a PPP schools facility. The Service Fee will be adjusted for any over, or under utilisation of capacity. Underlying costs are indexed against specific cost indices. In this case, it is likely that any demand risk (which is a component of Systematic Risk) is likely to be predominantly borne by the government. Example 2 - for a Pathology Service the Public Sector pays the Private Sector operator 60 per cent of the required annual fee and pays the operator on a per pathology service basis. In this situation, the Private Sector operator is exposed to a degree of demand risk (for example, if demand for pathology services is much less than forecast due to factors related to the economy as a whole) and therefore demand risk are shared between the parties. Example 3 - again for a Pathology Service the Private Sector operator obtains 100 per cent of its income on a per pathology service basis and is therefore fully exposed to demand risk and cost fluctuations from inflation. Given the likely Systematic Risks in this situation, demand risk and inflation risk would represent the vast majority of Systematic Risks and these have been transferred to the Private Sector. |
Risk sharing may take any number of forms, including explicit guarantees, take-or-pay contracts or cost-plus contracts. They may also take the form of capacity payments formulated to fund the capital costs of the business and to provide an equity return to investors in the Private Sector operator.
It is important that the Discount Rate used to evaluate a Private Sector bid in a PPP project takes account of both the Systematic Risk of the project and the amount of Systematic Risk that is to be borne by the Private Sector, or shared between the parties. If the Private Sector Discount Rate is applied to Public Sector projects without taking into account the reduction in risk due to the risk sharing activities, then the risk of the project to Private Sector investors will be overestimated. If this happens the Private Sector parties will receive a return above and beyond what is due to them having regard to the Systematic Risk they will bear and the Public Sector will pay too much for services received. On the other hand, if the private sector bears systematic risk under the PPP contract and its bid is compared to the PSC which does not include any allowance for Systematic Risk, its submission will be unfairly disadvantaged if the differential in risk between the two options is not specifically addressed.
The PSC represents the cost of the project at its expected outcome. It should not incorporate any cost premium for the Systematic Risk borne by the Public Sector under public sector delivery, even where the Reference Project would transfer such risks. Under the modified form of the CAPM the PPP Discount Rate is adjusted to reflect a premium for Systematic Risk transferred from public to the private sector under the PPP arrangement. This 'compensates' the PPP for taking additional risk (over and above the PSC). Accordingly, the private sector cash flows under the PPP include Systematic Risk Transferred, this is of benefit to the public sector, and the additional risk in those cash flows, ie, higher variability in returns, leads to a premium being calculated under the modified form of CAPM, which is used to identify the risk premium related to the risk Systematic Risk Transferred. This premium compensates the private sector for bearing Systematic Risk.