2.5 Systematic Risk and the PSC

In developing this Guidance the treatment of Systematic Risk and the PSC was considered.  The PSC Guidance requires that project risks are identified and quantified, regardless of whether they arise as a result of the occurrence of systematic or Project Specific Risk.  Clearly where Systematic Risk is transferred to the PPP contractor it bears the risk of the variability in returns and at the very least, in theory, the risk that the returns will vary from expectation will be priced into the PPP Service Fee.

It might be argued that under the PSC Reference Project a similar level of risk transfer is achieved as under the PPP structure.  While this is likely to be the case, though perhaps less so than under the PPP structure, the PSC cash flows take no account of the potential variability in outcomes.  This variability is normally addressed through the return requirements of private sector investors in PPP projects.  This is not normally priced into PPP cash flows through additional return requirements and overall project fees and margins.

In theory if the PSC was developed under a pure cost plus contract structure, and the PPP was a 'hybrid' which was in all respects the same as the PSC except that the construction phase was delivered under a fixed price Design & Construction Contract, then the prices received from the market for the PPP hybrid would need to take into account the Systematic Risk Transferred under the PPP hybrid structure - ie, the PPP Discount Rate would need to include a premium over the Risk Free Rate.

For the purposes of example, assume the overall construction risk premium is 0.5 per cent.  Under the modified form of the CAPM, if the hybrid PPP transferred 20 per cent of this risk to the hybrid PPP contractor, the risk premium for this element would be 0.1 per cent.  If there was another bidder that put forward a full PPP solution and this transferred all of the construction Systematic Risk, then it would have a risk premium of 0.5 per cent.  Clearly in this case the difference between the two PPP structures is that the hybrid contains less risk transfer than the full PPP, though it does contain some systematic.

By extending the logic of this example, if the hybrid PPP was the Reference Project for public sector delivery, then the additional risk transferred under the expected structure would need to be accounted for in the PSC Discount Rate.  It should be emphasised, that this approach relies on the modified form of CAPM.  However, it is highly unlikely that the PSC pricing for the D&C component will have taken into account any allowance for the variability in outcomes as a result of the transfer of Systematic Risk.  This pricing is normally a business decision and is not reliably captured in the expected cash flows of a hypothetical Reference Project.  As a result, no adjustment is normally required to adjust the PSC Discount Rate using the modified form of CAPM.