3.5.6  Risk of downturn in broader market

(a) Assessing Relative Importance

There is a risk that events may occur in the broader market economy, which increases the potential risk of insolvency and impacts upon suppliers or customers of the Private Sector operator.  This is the risk of secondary factors, which ultimately adversely impact on the Private Sector operator and its ability to continue to provide a service.  This could manifest itself through a reduction in the level of provision, or increased costs through the procurement of a replacement supplier.

For social infrastructure PPP projects, such as a public hospital, public sector backed fixed (or indexed linked) payment streams tends to insulate the private sector from economic down-turn.  Should the public sector decide that for economic reasons, it did not want to continue with the PPP, the private sector is well protected from any cancellation of the PPP contract through the standard compensation set out in the termination clauses.

For example, under a PPP contract if the lead construction contractor is declared insolvent, the PPP provider would be required to replace the construction contractor.  Failure to do this would lead to a default style termination event and the project lenders would be at high risk of losing the capital invested in the project.  The replacement of the construction contractor is likely to involve significant expense - both in terms of the costs of procuring a replacement contractor and the high likelihood that the replacement contractor will require a higher cost to complete the project, than is allowed in the PPP provider's budget.  Under PPP contracts, the responsibility for this risk lies with the private sector; this is applied through the Payment Mechanism, which allows for no increased costs, despite any increased costs faced by the project sponsors and through the termination regime, which are likely to make it uneconomic for project sponsors to abandon the project.  In this example, equity returns (and potentially debt) will be eroded by the cost of procuring a replacement, to the extent that the cost of the replacement contract exceeds that originally forecast.

The condition of the economy, both at large and in key sub-groups, has an impact on PPP projects.  For example, a down-turn in economic activity may lead to an increase in insolvency risk.  Key PPP contractors, such as construction and facilities management companies could be affected.

It is not possible to assess and classify the importance of the risk of insolvency in the broader market in the same manner as the other Systematic Risks.  To assist practitioners to evaluate the potential effects of the secondary insolvency risk and to assess the relative importance (significance) and its impact on the variability of the cash flow of the project, it may be necessary to consider the following factors:

•  Reliance of the Private Sector on a concentrated customer base.

If the revenue stream of the Private Sector operator is dependent on a limited number of customers (excluding the Public Sector) for a significant proportion of its revenue, then broader economic events may significantly impact upon its business and its ability to earn the desired return then the importance of insolvency events risk is HIGH.  A contributing factor may be that the specification of the contracted services is such that the private operator is unable to scale down costs in times of reduced economic activity.

•  Reliance on suppliers to provide service

If the Private Sector operator is dependent upon a limited number of critical suppliers who may be significantly exposed to broader economic events which impact upon their costs, or ability to supply, then changes in the broader economy may significantly impact the business of the Private Sector operator and its ability to earn the desired return, therefore, the importance of insolvency events is HIGH.

On the other hand, if the Private Sector operator has a range of alternate suppliers available in the market which provides it with a degree of flexibility in sourcing inputs to provide services and earn its desired return, then the importance of insolvency events risk is LOW.

If events in the economy impact upon suppliers, or customers which have a moderate impact on the Private Sector operator but it is still able to provide a service, albeit with a lower return than desired, then the importance of insolvency events risk is MEDIUM.

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)

Only in extraordinary circumstances would it be likely to expect that this risk would be assessed as High.  It would more normally be regarded as a secondary factor in comparison to the other Systematic Risks.

(b) Assessing Allocation

Having decided on the relative importance of insolvency risk in the broader market the next question to answer is who is bearing the risk?

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

•  In the context of PPP arrangements the risk to the Private Sector operator caused by potential insolvency events in the broader market will generally lie with the Private Sector.

•  Only in circumstances where the PPP arrangements with the Public Sector allow for the Private Sector operator to pass through cost increases (a cost plus type arrangement), or where the Public Sector is providing a Private Sector operator with a guaranteed minimum return from providing a service will the impact of risk of insolvency events be shared.

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

The risk of the Private Sector operator failing as a result of events in the economy, resulting in its inability to continue to provide a service and the potential cost to the Public Sector of having to step-in and maintain the delivery of services, is not a Systematic Risk and therefore should not be reflected as a proportion of the premium transferred to the Private Sector for the purpose of calculating the PPP Discount Rate.  This risk is retained by the Public Sector and should be dealt with in the construction of the PSC cash flows and probabilities as to the likelihood of events occurring and potential cost impacts properly assigned in the cash outflows.