3.1  Step 1- What are the Systematic Risks in the project?

Practitioners first need to identify the nature and extent of Systematic Risks inherent in the project.  The Systematic Risks identified in this step are used throughout the Methodology and provide a link to data obtained from the financial markets for use in CAPM in later steps.

While not an exhaustive list, it is likely that in a PPP project Systematic Risks will mainly be of the following nature:

•  Demand Risk:  That element of demand risk that is related to the level of general economic activity (but not that element of demand risk related to performance of services by an operator).  That is, the risk of volatility in general economic activity affecting the demand for the contracted service resulting in the projected returns of the project being below expectations.

•  Unexpected Inflation:  This could be represented by unusually high or low CPI or Average Weekly Earnings that is not funded by the Public Sector.  That is, the risk that the real value of payments made, or received during the term of the arrangements is eroded (or increased) by inflation with a diminution (or increase) in returns.  This includes both during the construction and operational phase.

•  Residual Value:  This is the impact on the residual value of the assets caused by the unexpected effect of interest rates, currency changes (not the direct impact on the cost of finance or the cost of procurement), or the unexpected effect of changes to market demand/use of assets, or services specific to the project assets.  This is the overall risk that either on termination of the services contract, or during the course of delivery of the contractual arrangements, the asset does not have the value originally forecast when the arrangements were established and the cost of services were priced.

•  The increased risk of downturn:  Caused by factors in the broader market.  That is, the risk of loss of the ability to provide a service caused by secondary effects arising in the broader economy, which result in the private sector operator no longer having the ability to provide the services as anticipated.  For example, this may result in a key supplier / contractor going into administration requiring a replacement contractor to be found.  Where the services are specialised this may result in significant disruption to service and additional costs, e.g. as an appropriate alternative supplier is identified.

There are a number of sources of information available to practitioners to assist in identifying the nature and extent of Systematic Risks inherent in the project.  Likely useful sources of information include:

•  a review of key commercial terms within the PPP contract agreement will provide the practitioner with a basis for a more detailed analysis of the allocation of Systematic Risks inherent in the project.  The key commercial terms may already be documented in a set of project specific commercial principles and will also be reflected in the Project Agreement and Payment Mechanism.  Appendix B provides examples of commercial terms that may give rise to Systematic Risk;

•  the project risk matrix will identify relevant project risks.  Practitioners will need to consider those that are likely to demonstrate the attributes of Systematic Risk.  The risk matrix will also indicate how project risks are allocated between the parties.  For example who is bearing demand risk, inflation risk and residual value (asset ownership) risk etc; and

•  how Systematic Risks manifest themselves in a Project Agreement will also be through the Payment Mechanism that is reflected in the Project Agreement.  The Payment Mechanism specified in the Project Agreements will indicate how the actual cash flows of the project are to be formulated, the key variables subject to variability and which party will be impacted.  Practitioners will be able to assess what factors are likely to cause variability and the potential for variability in the payments made, or received.  Practitioners will then be able to assess how the variability in cash flow resulting from the Payment Mechanism is a result of systematic factors.  For example, in relation to the risk of the inflation rate being different from that allowed for in the Payment Mechanism, some of the important questions for the practitioner will be: who will bear this risk?; what is the potential impact on the payments made, or received as a result of this unexpected inflation?; and is this variability significant in terms of the overall cash flow?

Appendix B considers how the Payment Mechanism can give rise to different levels of Systematic Risk and Appendix A considerers, in particular, the impact of different indexation proposals, including the particular issues associated with fully indexed payment profiles.