3.5.3 Demand risk

(a) Assessing Relative Importance

Demand risk is the risk that the demand for the use of an asset will be greater, or less than predicted, or expected as a result of broader economic activity causing unexpected fluctuations for the contracted service.  This may often be the most important systematic factor in PPP projects and the extent of the potential variability in demand and its impact on the cash flows of the project will be a primary factor influencing the assessment of the overall viability of the project.

For most social infrastructure PPP projects, while the public sector is normally considered to bear the bulk of Systematic Risk, it is important to recognise that the private sector is normally exposed to an element of demand risk.  Even though the public sector is typically required to make payments over time - to the extent that the private sector's performance is satisfactory - changes in demand for the infrastructure can often expose the private sector to material risk.  That is, although the private sector usually builds for a fixed capacity, which is nominated by the public sector, they will prepare their bids (and their pricing) in a competitive process on a view of the profile of demand over time.  During the contract term, this profile can change significantly, usually due to broader economic, or social factors.  The most common example here is that ultimate capacity is reached at an earlier point than expected and maintained for a longer than expected period (or anticipated lulls in demand do not eventuate).  For the private sector, this can mean increased maintenance costs and refurbishment costs, or more intensive service delivery such as additional help-desk, cleaning, or waste management services.  Often these increases are not reimbursed by the public sector.  The public sector would otherwise bear this risk, which would manifest in the same cost pressures.

Similarly, for a schools project, a lower level of utilisation over time might reduce the level of life-cycle investment; lower demand meaning that there is less utilisation of, say, air conditioning systems.  Under most PPP contracts this type of under-utilisation would result in a higher return for the PPP contractor.

To assist practitioners to evaluate the potential effects of demand risk in order to assess its importance (significance) and its impact on the cash flow of the project, the following comments on possible factors are provided:

•  If the fixed costs of the private operator to supply the service outputs to the Public Sector are high, then the importance of demand to cover these fixed costs is high.  This results in high fluctuations in returns if economic demand fluctuates.  The level of revenue certainty will impact upon this assessment.

•  Where the private sector bears the cost of increased, or decreased costs associated with changes in demand, such as increased life-cycle maintenance costs where demand increases, but receives no corresponding adjustment in the fee it receives from the government, then demand risk for this factor lies with the private sector.

•  There may be instances where there is uncertainty about the level of future demand for the services provided by the Private Sector operator.  For example, there may be uncertainty over the extent to which an asset will be used, such as the development of a new school ahead of demand in a growth area.  In this case, demand risk will be more significant and who bears it will be highly relevant to determining the appropriate allocation of premium to determine the appropriate Discount Rate.  According to CAPM, it is only the Systematic Risk of the school that should generate a return.  That is how much the estimate could vary from its Expected Value due to economy wide factors and not the variability that can be caused purely from a lack of information for reliably estimating future use of the facility.

•  The length of the contract may influence the significance of demand risk.  In general, demand risk will be greater the longer the term of the contract, since it is usually more difficult to forecast for later periods.  For example, in a short-term IT contract there may be very little likelihood of demand varying greatly from the levels predicted under the contract.  In such a case, demand risk is not significant and little weight should be given to this test.

•  A possible quantitative measure of relative importance of demand risk is provided in the following table (the decision criteria and percentages in the table are indicative only and practitioners will need to apply a degree of judgement to adapt these to the specific project):

Based on an assessment of the above factors, practitioners can complete Table 3 where:

•  Risk is HIGH then place a 5 in the Weighting column (Column 1)

•  Risk is MEDIUM then place a 2.5 in the Weighting column (Column 1)

•  Risk is LOW then place a 1 in the Weighting Column (Column 1)

(b) Assessing Allocation

Having determined the potential dependence of the project on demand, the next stage is to consider how demand risk is allocated.

Ultimately to identify the party who is bearing demand risk, will depend on the answers to the following interrelated questions:

1.  Will the payments to the Private Sector reflect the usage of the asset, or does the Public Sector have to pay regardless of the level of usage?

2.  Who will gain if demand is greater than expected, or agreed?

If the Public Sector is obliged to pay for the output, or capacity of the facility (e.g. available places) whether or not it is needed, it will have retained demand risk.  Conversely, where PPP payments vary proportionately over all reasonably likely levels of demand, the Private Sector operator will bear demand risk. However, in many cases the PPP provider will be exposed to the impact of under, or over utilisation.

To assist practitioners to evaluate the potential effects of allocation of demand risk to assess its impact on the cash flow of the project and on the party bearing the risk, the following comments are provided:

•  The key issue with the allocation of demand risk, is to ascertain what level of Private Sector revenue is at genuine risk due to unknown/unpredictable levels of demand for the use of the asset or service

•  It is also important to distinguish where demand risk is significant from a situation where the terms of the contract are such that it is passed to one, or other party.  For example, while there may be much uncertainty over the demand for a certain type of asset in the long term, the terms of a long term PPP contract for such an asset may be that the Public Sector will provide a guarantee (or a floor/base level of demand use) to the private operator (provided the service is available for use).  In such a case, the Public Sector may have retained the majority of demand risk.  Factors to be considered could include the level of the floor/base level of demand in relation to total demand and the cost profile of the Private Sector operator.

•  A possible quantitative measure to guide consideration of the allocation of demand risk is provided in the following table (the decision criteria and percentages in the table are indicative only and practitioners will need to apply a degree of judgement to adapt these to the specific project):

To complete Table 3, where:

•  Risk is with Public Sector then place a 0 in Column 3

•  Risk is with Private Sector then place a 1 in Column 3

•  Risk is Shared then place a 0.5 in Column 3