3.5.5  Residual value risk

(a) Assessing Relative Importance

Residual value risk is the risk that at the end of the contract the asset will be worth more or less than expected at the outset and upon which the financial structure of the project is based.  In a project involving high upfront capital costs in comparison to the whole of life operating costs, residual value will have a greater level of importance than in the situation where the project involves low upfront capital costs in comparison to the whole of life operating costs although a number of other factors are imported in considering the importance of this risk. These are considered below.

To assist practitioners to evaluate the potential effects of residual value risk to assess its importance (significance) and its impact on the cash flow of the project, it may be necessary to consider what is the proportion of the present value of the residual value in comparison to the upfront capital costs.  In addition, other factors to consider will include:

•  how specific is the asset?

•  what is the potential for obsolescence of the assets?

•  what potential is there for technological change?

•  what is the period of the contract arrangement compared to the economic life of the asset?

Furthermore, what happens to the asset at the end of the contract term will also influence who is ultimately bearing residual value risk.

In determining the importance of residual value, it is recommended that the assessment is based upon the present value of the nominal written down value of the assets at the end of the project's life under the PPP arrangements.  The present value would be calculated using the Project Rate determined in Step 3.

A possible quantitative measure of relative importance of residual value risk is provided in 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 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)

The other factor that may be considered in assessing the overall importance of residual value risk is who determines the nature of the asset.  The specification of the service requirements by the Public Sector may be such that it provides the Private Sector with little flexibility to design the asset in a way that the asset could be used for alternative purposes, without incurring significant costs.  In such circumstances, the party who is bearing the residual value (asset ownership) risk will be bearing significant Systematic Risk depending upon the location of the asset, the length of the contract etc.  Furthermore, how the asset is designed and constructed can impact significantly on the operating and life cycle costs of the asset and may also impact upon the actual performance of the asset.

(b) Assessing Allocation

Having decided on the relative importance of residual value risk the next question to answer is who is bearing the risk.

Which party bears residual value risk will depend on the arrangements at the end of the contract.

To assist practitioners to evaluate the potential effects of allocation of residual value risk to its impact on the cash flow of the project and its impact on the party bearing the risk, the following range of different options are provided to assist practitioners in classifying residual value risk:

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