Efficiency through risk transfer?

Submitted by admin on January 1, 1970

In theory, risks in PPPs are transferred to the party most able to limit and control them. In practice, however, whenever the private sector takes on risk, it expects a considerable profit for doing so.

In PPPs the private partner is responsible for completing construction or other infrastructure investments on time and for making the infrastructure available for use.

In some cases the public authority takes on the payment risk, committing to pay a fixed sum for the public use of the infrastructure (eg. for hospitals), while in some cases there is a ‘demand risk’, where the price paid for the infrastructure depends on the number of users - and if there is an insufficient number of users, the investment is at risk.

Poor risk allocation can lead to guaranteed profits paid for by public money

"The exclusive reliance on tolls has proven to be a failure [...] renegotiations of remuneration schemes, even the restructuring of entire projects, became necessary in many cases."

The UK Commons Treasury Committee has summed up the situation as follows:

“Allocating risk to the private sector is only worthwhile if it is better able to manage the risk and can pass on any subsequent savings to the client. The main benefit highlighted to us by PFI providers was the transfer of construction risk.

However a PFI contract which lasts for 30 years is not necessary to transfer this risk. There are also other methods such as turnkey contracts which can be used for the same ends. We have seen evidence that PFI has not provided good value from risk transfer - in some cases inappropriate risks have been given to the private sector to manage. This has resulted in higher prices and has been inefficient.”

Poorly allocated risk has been a serious problem in PPPs. Sometimes it has led to contracts guaranteeing profits at the cost of taxpayers (for example in the cases of the Trakia Highway and Zagreb wastewater treatment plant), while at other times it has led to dramatic disappointments for the concessionaire and subsequent attempts to extract income guarantees from the public sector.

The persistent over-estimation of traffic figures by project planners not only leads to difficulties with the concessionaire’s income or the public budget’s expenditures, but also leads to attempts to increase the amount of traffic using the motorways, in contradiction with the environmental objective of reducing road traffic and increasing the modal share of other means of transport.

“The exclusive reliance on tolls has proven to be a failure. The evidence supports the theoretical prediction that tolling small stretches of highway networks causes inefficient traffic relocation and seriously affects the profitability of the concessionaires’ investments. In the event, renegotiations of remuneration schemes, even the restructuring of entire projects, became necessary in many cases.” (Brenck, Beckers, Heinrich, Hirschhausen - see detailed references in the pdf version of this chapter)

Governments' limited ability to renegotiate the risk transfer

The renegotiation of contracts puts governments in a weak position as admitting the failure of a project negatively affects the image of the country and its ability to attract foreign investments. It may therefore lead to the public sector taking on much more risk than is really justified, with visible impacts on public accounts in the long run.

Where renegotiation has not succeeded, some projects, such as the M1/M15 and M5 in Hungary have been at least partly taken back into the public sector.

The unfortunate conclusion of poor risk transfer is that taxpayers always end up footing the bill, whether through guarantees for the concessionaire’s level of income or though the expense of renationalising the project.

As a result of these problems, often nowadays instead of the concessionaire directly collecting tolls and bearing the demand risk, the public sector pays a fixed availability fee in return for the concessionaire ensuring that the service is available. In the case of motorways there is extremely little risk for the concessionaire, which just has to clear some snow and do some maintenance. This lack of risk was one of the criticisms made for the D1 phase 1 PPP in Slovakia, for example.

The problem of ultimate inability to transfer risk has also been recognised by the UK Treasury Select Committee:

“Some of the claimed risk transfer may also be illusory - the government is ultimately accountable for the delivery of public services. Therefore it would not be able to allow a number of services provided under a PFI contract to cease for any length of time.”

Solutions remain elusive

While it is regularly recognised that PPP toll motorways often suffer problems, if payments are to be based on availability instead, a way has to be found to ensure that the fees are derived from vehicle tax or fuel tax and not from those who do not own a car.

Whatever solution is found, the private investor needs to take on a significant part of the financial risk of the road’s operation.