Ex Post Risk Management in Public-Private Partnership Infrastructure Projects
Wei Xiong, Department of Public Administration, Tongji University, Shanghai, China
Xianbo Zhao, School of Engineering and Technology, Central Queensland University, Australia
Jing-Feng Yuan, School of Civil Engineering, Southeast University, Nanjing, China
Sai Luo, School of Business Administration, Hohai University, Nanjing, China
Public-private partnerships (PPPs) have been widely used in infrastructure development in the past 30 years. However, a number of PPP projects have suffered serious risk scenarios and ended up with project failures. The change from a short-term contract period of traditional projects (fewer than five years) to a long-term contract period of PPP projects (20–30 years) has raised challenges to the traditional risk management. The high occurrence of renegotiations and early terminations of PPP projects suggest that ex ante risk management is no longer enough and ex post risk management is needed. This study aims to propose an ex post risk management model, under which renegotiations and early terminations are introduced. The application of this model begins with risk impact evaluation, then ex post risk response measures assessment, selection, and enforcement. An illustrative case is provided in the Appendix at the end of the article. The outputs of this study would facilitate governments’ decision making in PPP projects under serious risk scenarios.
KEYWORDS: public-private partnerships; risk management; renegotiation; early termination
Project Management Journal, Vol. 48, No. 3, 76–89
© 2017 by the Project Management Institute
Published online at www.pmi.org/PMJ
In the traditional procurement model, public infrastructure is delivered by the public sector. Public-private partnerships (PPPs) provide an innovative procurement model to deliver public infrastructure by the private sector through contractual relationships between the public and private sectors. The public partner, hereinafter referred to as the government, has needs for new infrastructure, and then grants a concession to the private sector, hereinafter referred to as the contractor, to finance, design, build, and operate an infrastructure project (Zhang, 2009). The government supervises and regulates the concession through contracts and regulations. Meanwhile, the contractor provides relevant services/products according to the specifications and receives payments from the end users or the government itself. At the end of the concession, the contractor transfers the concession and the project assets to the government. This type of contract arrangement has been widely applied to infrastructure projects around the world since the mid-1980s (Carpintero & Petersen, 2015; Shen, Li, & Li, 2002).
Today, infrastructure investments depend heavily upon private capital markets for financing and on private firms for managerial expertise (Marques & Berg, 2011). However, project financing is more risky than traditional corporate financing in delivering infrastructure projects. One reason is that the leverage level of project financing is usually much higher than that of corporate financing. The equity invested by contractors is their long-term commitment to project lenders, and the higher it is, the lower the risk level is. However, for most PPP infrastructure projects, the debt ratio is higher than 50% (Pantelias & Zhang, 2010). For example, power projects tend to have a debt level of 70% to 90% (Zhang, 2005). In addition, contractors in PPP infrastructure projects are required to take more risks than those in traditional projects because governments transfer some risks to them (Hwang, Zhao, & Gay, 2013). Transferring risks to the private sector in PPP infrastructure projects has been one of the main objectives of governments (Yuan, Skibniewski, Li, & Zheng, 2010). Therefore, contractors in PPP infrastructure projects are likely to be exposed to excessive risks that are not within their expertise to master, or out of their capability to undertake.
Excessive risks could cause serious risk scenarios in PPP infrastructure projects. In the bidding documents, an inappropriate or excess transfer of risk to contractors might reduce the number of bidders and foster opportunism of the remaining tenderers (Zitron, 2006). One of the most popular opportunistic behaviors is that the contractor wins the bid with a low price and then forces favorable renegotiations after the contract has been signed. In the concession agreements, flawed risk allocation can raise the costs of infrastructure services (Akintoye, Hardcastle, Beck, Chinyio, & Asenova, 2003; Zhu, Zhao, & Chua, 2016), or even lead to contract failure, renegotiation, and/or early termination (Marques & Berg, 2011). Guasch (2004) examined approximately 1,000 Latin American concession contracts, and found that 53% of those in the transport sector and 76% of those in the water sector were renegotiated. In addition, Xiong, Zhang, and Chen (2015) found that 334 out of 4,874 PPP projects (6.85%) in developing countries were terminated early.
Serious risk scenarios, such as renegotiations and early terminations, are usually out of the capacity of practitioners in PPP projects, because traditional risk management focuses on dealing with risks in an ex ante way. The change from a short-term contract period of traditional projects (fewer than five years) to a long-term contract period of PPP projects (20–30 years) has raised challenges to the traditional risk management. In a short-term project, it is possible to identify and evaluate the majority of risks and prespecify their allocation strategies and mitigation measures in the contract. However, in a long-term project, it is impossible or too expensive to do so. Therefore, it is necessary to shift the ex ante risk management to a trade-off between the ex ante and the ex post way in PPP projects.
This study attempts to develop an ex post risk management mechanism for serious risk scenarios in PPP infrastructure projects. First, a framework for ex post risk management is proposed based on a literature review. Then, an ex post risk management model is developed based on the financial equilibrium of PPP infrastructure projects. After that, selection criteria of the ex post risk response measures are set according to their effectiveness and characteristics. An illustrative case is applied to demonstrate the applicability of the proposed ex post risk management model. Finally, conclusions and recommendations are presented.
Risks in PPP Infrastructure Projects
Risk is the probability of the occurrence of a harmful event (Hwang, Zhao, Yi, & Zhong, 2015; Parker & Handmer, 2013). Many scholars have studied the risks in PPP infrastructure projects. Some scholars identified significant risk factors in different countries. For instance, Ke, Wang, Chan, and Lam (2010); Roum-boutsos and Anagnostopoulos (2008); and Chung, Hensher, and Rose (2010) investigated the risks of PPP infrastructure projects in China, Greece, and Australia, respectively. Based on previous studies, Chan, Yeung, Yu, Wang, and Ke (2011) provided a comprehensive identification of risks in PPP projects, as shown in Tables 1. It contains two major categories: systematic risks and specific project risks, as well as more than 30 risk factors.
PPP infrastructure projects are usually vulnerable to risks due to several reasons. First, PPP contracts are too complicated and incomplete, and thus it is impossible to cover all the risks in the clauses (De Brux, 2010). In addition, many risks in PPP infrastructure projects are very difficult to be precisely assessed due to large project scales and long durations. For instance, underestimation of demand shortfall is quite normal in traffic projects (Cruz & Marques, 2013b). Moreover, stakeholders could overestimate their capability of taking risks. The risk appetite of the project manager determines the risk transfer from the government (Kwak & LaPlace, 2005). Nevertheless, the project manager could make mistakes in the perception of the project's risk capacity due to the reasons of unprofessional decision making, inadequate information, excessive risk-taking actions, and so forth. Therefore, it is not surprising that many PPP infrastructure projects have experienced serious risk scenarios in the past 30 years.
Risk Tolerances of Stakeholders
Risk tolerance refers to the capacity to withstand the effects of a risk, in other words, risk tolerance in terms of severity is the point above which a risk is not acceptable and below which the risk is acceptable (Newell & Grashina, 2004). Sometimes, risk tolerance is also regarded as a risk threshold or contract contingency (Project Management Institute, 2000). In PPP infrastructure projects, the main stakeholders are the contractors, the government, and the general public (Yuan et al., 2010). They share the risks according to their risk preferences, thus having different risk tolerances. Generally speaking, contractors focus on commercial risk tolerances, which are basically defined in the financial base case in terms of several financial indicators. Cruz and Marques (2013b) studied quantitative indicators to initiate renegotiation in Portuguese concession contracts, such as the impact of particular events measured by decreases of 0.03% on one of the following ratios: debt service coverage ratio (DSCR), loan life coverage ratio (LLCR), and shareholder's internal rate of return (IRR). These indicators are the commercial risk tolerances of a contractor. Similarly, other financial indicators, such as minimum revenue, minimum rate of return for equity, minimum traffic demand, least-present-value-of-revenue (LPVR), and least-present-value-of-net-revenue (LPVNR), can also serve as the commercial risk tolerances of a contractor.
|Systematic risk||Political risk group: government corruption, government intervention, expropriation, public credit, poor public decision-making process|
|Economic risk group: interest rate fluctuation, foreign exchange fluctuation, inflation, undeveloped financing market|
|Legal risk group: legislation change, imperfect law and supervision system, change in tax regulation|
|Social risk group: public objection of pollution/high toll rate|
|Natural risk group: force majeure, unforeseen weather/geotechnical conditions, environment risk|
|Specific project risk||Construction risk group: construction cost overrun, construction time delay, material/labor non-availability, unproven engineering techniques|
|Operation risk group: project/operation changes, operation cost overrun, price change, expense payment risk|
|Market risk group: market competition, demand shortfall|
|Relationship risk group: third-party delay/violation, organization and coordination risk, inability of the concessionaire|
|Other risks: land acquisition, delay in project approvals and permits, conflicting or imperfect contract, lack of supporting infrastructure, residual risk, inadequate competition for tender|
|Table 1: Risks in PPP infrastructure projects (adapted from Chan, Yeung, Yu, Wang, & Ke, 2011).|
Governments also have commercial risk tolerances, which are mainly the investment requirements committed by the contractor in the agreement. Delay or reduction in investment may initiate government-led renegotiation or early termination. However, governments should concentrate on the production risk tolerances since their main objective is to maximize the social benefits of projects. The production risk tolerance is usually indicated by a set of performance indicators in the specification, incorporating the tolerance of the failure probability for each item. According to Guasch (2004), renegotiation is more likely to occur in contracts with investment requirements (70%) than those with performance indicators (18%).
With regard to the general public, the commercial risk tolerance is mainly the toll rate tolerance; the production risk tolerance tends to include the environment pollution tolerance, the public facilities quantity tolerance, and the public services quality tolerance. In the past PPP experience, the general public's tolerances were more likely to be neglected. Therefore, many PPP infrastructure projects experienced serious risk scenarios caused by the general public. For instance, the high toll levels and traffic congestion on surface streets caused the community rejection of the Cross City Tunnel in Sydney (Chung et al., 2010); the pollution and damage to the marine environment caused a public protestation that suspended the construction of the Hong Kong-Zhuhai-Macao Bridge for five months. Hence, practitioners have focused on the general public's risk tolerances.
Serious Risk Scenarios
Serious risk scenarios are defined as situations when the risk impacts of risks exceed the risk tolerance of the stakeholders of PPP infrastructure projects. In this study, there are two determinants for serious risk scenarios: driving risks and risk tolerances. Among all the risks listed in Table 1, most risks are supposed to be tackled appropriately through risk management, and only a minority of them could be out of control and drive PPP infrastructure projects into serious risk scenarios. The driving risks could act individually or jointly. Cruz and Marques (2013a) indicated that the most popular driving risks of serious risk scenarios were demand shortfall, construction cost overrun, operation and maintenance (O&M) cost overrun, and public rejection of toll rate. In addition, serious risk scenarios in PPP infrastructure projects can occur to all the main stakeholders because all of them have risk tolerances. Any break of commercial risk tolerances or production risk tolerances makes the stakeholder claim for serious risk scenarios and forces favorable changes. For example, the private sector and the government can initiate renegotiations and early terminations, while the general public can protest to the government and force them to fight for the public interests.
Ex Ante and Ex Post Risk Management
Risk management in PPP projects should include both ex ante and ex post risk management. Ex ante here means the period before the signature of project agreement, whereas ex post means after. This expression is extensively used in economics, especially in contract theory literature (Aghion & Bolton, 1992; Hart & Moore, 1988; Tirole, 1988). Generally speaking, if a contract is treated as a complete contract, risk management can be seen as solely ex ante. This is because, according to the complete contract theory, all contingencies can be forecasted and pre-specified in contacts (Aghion & Holden, 2011). But if a contract is regarded as incomplete, risk management should involve the concept of ex post risk management. This is because according to the incomplete contract theory, it is impossible to resolve all risks in an ex ante way and those unresolved risks should be handled by ex post risk management. Some risks should be left unsolved deliberately and referred to ex post adjustments because it is too expensive to forecast and prespecify them in an ex ante way. It has been well-accepted that PPP agreements are typically incomplete contracts due to their long-term span, large scale, and complex nature (Hart, 2003; Hart, Shleifer, & Vishny, 1997; Iossa & Martimort, 2016).
Previous studies have investigated the ex ante risk management of PPP infrastructure projects, focusing on risk identification (Xu, Yang, Chan, Yeung, & Cheng, 2011), risk evaluation (Xu, Yeung, Chan, Chan, Wang, & Ke, 2010; Xu, Lu, Chan, Skibniewski, & Yeung, 2012), risk allocation (Cao & Zhang, 2008; Hwang et al., 2013; Jin, 2010; Ke, Wang, & Chan, 2010; Li, Akintoye, Edwards, & Hardcastle, 2005; Medda, 2007), financial risk (Pantelias & Zhang, 2010; Wibowo & Kochendörfer, 2005; Zhang, 2005), and political risk (Deng, Low, & Zhao, 2014; Wang, Tiong, Ting, & Ashley, 2000). However, few studies have focused on the ex post risk management in PPP infrastructure projects. Thus, this study can contribute to the literature through developing a quantitative ex post risk management model.
A general ex ante risk management process was developed by the Project Management Institute (2000), as shown in Figure 1. This process consists of risk management planning, risk identification, qualitative and quantitative risk evaluation, risk response, and risk monitoring and control. Compared with ex ante risk management, ex post risk management takes place after serious risk scenarios occur. In the discipline of public management, ex post risk management is usually referred to as “hazard management” (Parker & Handmer, 2013). The terms “hazard” and “risk” are often used interchangeably. However, “hazard” is usually an ever-present condition that leads to a harmful event, whereas risk can be seen as the probability that the exposure to a hazard will lead to a negative consequence (i.e., Risk = Hazard × Exposure) (Ropeik & Gray, 2002). After serious risk scenarios occur, the exposure is actually known. Therefore, the ex post risk management can follow the practice of hazard management. While hazard management normally focuses on natural disasters, ex post risk management mainly tackles man-made accidents in PPP infrastructure projects.
Hazard management comprises a series of stages including the evaluation of hazard impact; the evaluation, selection, and implementation of hazard reduction measures; and the establishment of enforcement procedures (Parker & Handmer, 2013). Similarly, the general ex post risk management process, as illustrated in Figure 1, includes risk impact evaluation, serious risk scenarios justification, ex post risk response, and renegotiation/early termination enforcement. After risks occur, risk impact evaluation is used to summarize the losses of affected stakeholders. If the risk impact is under risk tolerances, the affected party is supposed to retain the risks and no ex post risk response measures will be taken. However, if either the commercial or the production risk tolerance is exceeded, the affected party would take the ex post risk response measures to avoid further losses.
The ex post risk response is also called risk reallocation, which allows the excessive risk impacts to be distributed among the stakeholders. With respect to risk response strategies, risk mitigation focuses on prevention, and risk retention takes no measure. Therefore, available ex post risk response strategies are risk avoidance and risk transfer. The ex post risk response measures can be categorized into two groups: (1) renegotiations, where the affected party is compensated and the risks are transferred to other parties through substantial change in tariffs (standard, scheduled tariff adjustments excluded), investment plans and levels, exclusivity rights, guarantees, lump-sum payments or annual fees, coverage targets, service standards, and contract periods (Guasch, 2004); and (2) early terminations, where the government or the new contractor pays an amount of compensation to the original contractor and takes over the concession rights and project assets, and the future risks are avoided through giving up the original concession. Normally, the parties try their best to rescue the project through renegotiation at first, and early termination is the last choice when renegotiation fails (HM Treasury, 2007).
Figure 1: Ex ante and ex post risk management for PPP projects.
Developing a Quantitative Ex Post Risk Management Model
Confronted with serious risk scenarios, the government can use concession renegotiation to bail out the project and enable the private sector to finish the concession, or use early termination to buy out the project and finish the concession. In both strategies, the government has to pay compensation to the private sector so as to take over project assets. Since there is usually no free market for those assets, it is very difficult to determine the market value. A fair value that is widely used in the compensation of renegotiation and early termination is to fulfill the financial equilibrium of the private sector (HM Treasury, 2007). Thus, the objective function of the ex post risk management approach is structured based on the financial equilibrium.
The financial equilibrium is one of the most important underlying principles of PPP infrastructure projects. Generally, the financial equilibrium of a concession means that revenues minus costs in the whole concession should provide a reasonable rate of return on capital investment. This principle has been well-acknowledged in previous PPP studies, and many simplified financial equilibrium equations were proposed for developing objective functions. For instance, based on financial equilibrium, Shen et al. (2002) and Wu, Chau, Shen, and Shen (2012) developed concession models; Pantelias and Zhang (2010) evaluated financial viability; and Guasch (2004) proposed a renegotiation model. In order to develop the objective function of this study, a tariff-based project is assumed to be procured through a PPP model with a fixed concession period, and its financial equilibrium is proposed as Equation (1).
where t0 is the construction period; L is the concession length; dt = (1 + r’)–t, r’ is the discount rate; λt is the currency exchange rate; Pt is the toll rate; Qt is the annual demand; OCt is the O&M cost in the concession period; FCt is the financial cost, including interest of debts from different sources; DCt is the depreciation of the construction cost; T is the tax rate; S is the annual subsidy or unitary payment from the government; r is the reasonable rate of return; and I is the capital investment. The data of these variables are usually available in the annual financial reports of PPP infrastructure projects.
Risk Impact Evaluation
In serious risk scenarios, excessive risk impact could break the financial equilibrium and cause a shortfall of profit from the expected level. Thus, the gap is defined as Equations (2) and (3).
where, Ψ(X) is the financial impact of hazards; X = [x1, x2, … xi] is the vector of driving risks in hazards; t1 is the year when hazards occur; M(X) is the actual profit in the past concession with the impacts of X; and M(X) is constant at t1.
Ex Post Risk Response
To reduce the impact of serious risk scenarios, the government has to resume the delivery of public facilities and service as soon as possible through either concession renegotiation or early termination. However, as discussed earlier, the private sector is willing to continue operation or sell the project to the government only if the deal provides a reasonable rate of return. The reasonable rate of return is usually between a guaranteed minimum rate of return and an expected rate of return. If a minimum rate of return has been guaranteed in an agreement, the reasonable rate of return can be the minimum rate of return and compensation will be made automatically to prevent project bankruptcy or bailout of the project; if not, the reasonable rate of return depends on an expected rate of return, which can be evaluated by the weighted-average-cost-of-capital (WACC) formula as Equation (4).
where, kE is the cost of equity; E is equity; kD is the cost of debt; D is debt; and T is the corporate tax. kE can be evaluated by the capital asset pricing model (CAPM) as Equation (5).
where kF is the risk-free return rate (e.g., return rate of government bonds); kM is the market return rate; and βA is the asset beta, which is related with sectors. kE could also be influenced by the bargaining powers of the private sector in hazards. For example, the private sector will suffer substantial losses if the project goes bankrupt, but the government is not so eager to bail out the project. Considering this, the private sector is very likely to decrease their expected rate of return.
Justification of the Proposed Model
The proposed model makes light of the post contract lock-in effect in PPP projects, which is that the contractor's bargaining power considerably changes in the post contract stage because she made a lot of sunk investments in terms of relationship-specific assets. Economists argue that ex post bargaining games are only determined by the quasi rent of continuing project delivery, rather than the financial equilibrium, which has been used ex ante (Hart et al., 1997). Hence, the contractor is subject to a serious lock-in effect and easily held up by governments in PPP projects (Chang, 2013). However, that is not likely to be the case in PPP practices. Many safeguards have been provided to protect the contractor's relationship-specific investments (e.g., government guarantees for serious risk scenarios and compensations for early terminations) (Xiong & Zhang, 2014a, 2014b), so ex post hold-up problems would not be as serious as economists perceive. Also, the third party (i.e., engineers) could significantly reduce hold-up problems in the post contract stage because it supervises contract implementation against opportunistic behaviors and reveals information for outsiders. Moreover, arbitrators and courts judge conflicts in PPP projects mainly based on the financial equilibrium, which is stated in the contract, rather than the quasi rent of continuing project delivery in serious risk scenarios; at last, using financial equilibrium as the foundation of ex post risk management can create a good relationship between the contractor and the government, and, consequently, encourage cooperation between them, which can significantly increase project performance (Xiong, Yuan, Li, & Skibniewski, 2015).
Selecting Ex Post Risk Response Measures
Once severe risk events are materialized, the government has to find a way to save the project based on the effectiveness and characteristics of risk response measures. In technical terms, the effectiveness index captures the extent to which the contractor's financial status can be improved due to the unit change in one measure, and the characteristic indicates the applicability of one measure.
When serious risk scenarios occur and cause great difficulties to a PPP infrastructure project, both the government and the contractor can ask for concession renegotiation. Guasch (2004) found that the majority of renegotiations tended to favor the operator, while a small number of renegotiations favored the government. Engel, Fischer, and Galetovic (2009) found that renegotiations increased total investment by nearly one-third of their studied cases, but the majority was borne by future governments, or transferred to end users via higher tolls and contract extension.
The ex post risk response measures in concession renegotiation can rescue the project through compensating the affected stakeholders and transferring excessive risk impacts to other stakeholders. But many contractors seek opportunistic renegotiations, and huge public resources have been wasted in compensating them (Albalate & Bel, 2009). On the other hand, concession renegotiation could increase the flexibility of contracts and reinforce the durability of the public and private relationships (De Brux, 2010). In any event, once the project is confronted with serious risk scenarios, the government and the contractor should try their best to rescue it through concession renegotiation because early termination could result in more costs (HM Treasury, 2007). This study introduces six ex post risk response measures in concession renegotiation to reduce the financial impact of serious risk scenarios, and their reduction effectiveness and enforcement characteristics are explored as follows:
The effectiveness of toll adjustment can be computed using Equation (6).
where e1 is the effectiveness of toll adjustment; and is the toll elasticity. But Loo (2003) and Matas and Raymond (2003) showed that the toll elasticity of traffic projects was very low. Thus, this study regards Then, e1 solely depends on the future demand in the remaining concession. Toll increases can increase the revenue, on condition that the toll increase will not decrease the future demand dramatically. Toll increase has been well-accepted by both the contractor and the government in many cases because it effectively increases the revenue of the contractor without additional costs for the government. However, this measure transfers all the risks to the end user and probably induces dissatisfaction in the general public. Therefore, a toll increase should be used very carefully, especially when there have already been complaints for high toll rates. On the other hand, a toll decrease can also be used when the utilization of the project is far less than the design capacity or the general public complains about high toll rates. Since a toll decrease usually causes a reduction of revenue, it transfers the risks to the contractor.
The effectiveness of contract extension can be measured as Equation (7).
where e2 is the effectiveness of contract extension, and is determined by the net cash flow in year L. A contract extension allows the contractor to collect more profits to cover risk impacts, only if the net cash flow in year L is positive. This measure is favored by governments because it can effectively solve the problems, and at the same time does not affect other stakeholders. However, it transfers all the risks to future governments. It can be used only if toll increase and government direct reimbursements are not available. It is hazardous for the government to extend the expiry date because it simultaneously extends the government's commitment to project risks (HM Treasury, 2007).
Annual Subsidy or Unitary Payment Adjustment
The effectiveness of an annual subsidy or unitary payment adjustment can be computed using Equation (8).
where e3 is the effectiveness of an annual subsidy or unitary payment adjustment. This measure compensates the contractor through government payment, and all the risks are transferred to the government. However, the government benefits from paying for the excessive risk impacts gradually in the remaining concession since the lump-sum payment may cause budget stress. The constraint of this measure is that the government must have enough funding for an annual subsidy or unitary payment. The subsidy can be in many forms, such as reduction in annual payment to the government, government guaranteed loans, and so forth. The unitary payment is usually direct reimbursement paid by the government, which is fixed or related to the quality or quantity of service/production delivery.
The effectiveness of a tax waiver can be computed using Equation (9).
where e4 is the effectiveness of a tax waiver. A tax waiver is a discount of the tax rate. It transfers risks to the government. Unlike a pre-agreed subsidy, the amount of tax waiver is unknown at the time of renegotiation because the taxes are calculated based on the operational profits. For those unprofitable projects, the tax waiver may be not effective enough to cover all the excessive risk impacts, so it is widely used as a complementary measure.
Reduction in Contractor's Investment Obligations
The effectiveness of reduction in contractor's investment obligations can be measured as Equation (10).
where e5 is the effectiveness of reduction in contractor's investment obligations and is determined by the reasonable rate of return r. Reduction in the contractor's investment obligations can compensate the contractor because the contractor can use the reduction of the investment to invest in other projects and acquire profits to cover the risk impacts in the failing project. Apparently, this measure is only used when a project has financial problems and further investment could be unprofitable. However, it is not a favorite choice for both the government and the general public because the reduction of investment will influence infrastructure development and public service supply. Therefore, this measure transfers risks to both the government and the general public.
With effectiveness being evaluated, the adjustment value (ΔY) for measure Y is calculated as Equation (11).
Based on the adjustment values and the constraints, the government is able to select the most appropriate one or combination of ex post risk response measures in the concession renegotiation of a PPP infrastructure project.
In order to encourage private sector investment in infrastructure, many governments promise to compensate investors in the case of early termination. For example, the Spanish concession law establishes that if a contract is terminated early, even if the reason is bankruptcy of the concessionaire, the government has to pay compensation to the concessionaire for the work already built and not yet depreciated (Vassallo, Ortega, & de los Ángeles Baeza, 2011). After compensation, the project assets and concession rights are transferred to the government. In some cases, the project assets and concession rights are sold to the new contractors, and governments do not have to compensate the contractor. Compensation is the core mission in early termination cases.
The previous literature described five methods to compensate the contractor at the termination of a concession. Particularly, the historical cost method compensates the book value of an asset when it was purchased; the inflation-adjusted historical cost method considers inflation in the compensation; the depreciated replacement cost method compensates for the cost of buying a new equivalent asset; the optimized depreciated replacement cost method compensates for the cost of replacing the asset with the cheapest alternative that does the same job; and the optimized deprival value method compensates for the net present value (NPV) of future earnings or the amount the asset could be sold for (HM Treasury, 2007; Kerf, 1998).
This study categorizes these compensation methods into three approaches as follows: (1) the compensation in the historical cost method and the inflation-adjusted historical cost method are based on the book value of the project assets, which can be evaluated through analyzing the financial statements—they are defined as compensation based on book value (BV); (2) the compensation in the depreciated replacement cost method and the optimized depreciated replacement cost method are based on the retendering price of the project assets, so they are defined as compensation based on retendering; and (3) the compensation in the optimized deprival value method is the estimated market value of the remaining concession, which can be calculated through cash flow analysis, so it is defined as compensation based on market value (MV). Compensation based on retendering is not discussed in this study because this approach cannot be quantitatively analyzed, and the specific procedures and rules of retendering are available in HM Treasury (2007).
Compensation Based on Book Value
This approach calculates the compensation based on the book value of the project's assets. No matter how much the project will lose or gain in the future, the compensation equals the unreimbursed cost (plus reasonable profits or default deductions on some occasions) at the termination date t0. The formula is shown as Equation (12).
where ZBV(X) is the compensation to be paid by the government through the BV approach. Capital investment, price, demand, and other variables are all stated in the financial statements of the project, except that the reasonable rate of return is determined by negotiation between two partners. If the government terminates the concession unilaterally, and the contractor has no default, r is supposed to be the expected rate of return to protect the investor's interest. However, if the early termination is caused by the contractor's default, such as overestimation of demand, r should be much lower. The determination methodology of r can be pre-agreed in the contract.
From the perspective of the contractor, this approach is more appropriately used in projects without market value but with the utility charge set out in the contract. Similar projects include prisons, hospitals, schools, sewerage treatment plants, and so forth. In such cases, the only way for contractors to be recouped in early termination is from government compensation, which means that contractors have no alternatives, such as selling the project assets in the open market. Additionally, this approach is also satisfactory in the compensation of uncompleted projects. Without a clear picture of the total construction cost, project assets are very difficult to be sold out at real values. The potential new contractors prefer to offer a much lower price for uncompleted projects to cover construction risk. Another reason is that without the historical data on project performance (e.g., traffic demand), it is impossible to make a precise prediction for future revenues.
The main feature of the BV approach is that there are no uncertainties in calculating compensation because all the data are stated in the financial statements. The negotiations focus on the default responsibility and the associated deduction from the rate of return. Therefore, this approach is procedurally fast, and the project assets can be transferred to the government or the new contractor rapidly. However, governments take all of the long-term project risks in this approach because the compensation is not related to future performance. It is not value for money for governments to take over projects with poor performance.
Compensation Based on Market Value
In the MV approach, the government can compensate the contractor for the estimated market value of the remaining concession, in terms of the NPV of future cash flows. The compensation is shown as Equation (13).
where ZMV(X) is the compensation to be paid by the government through the MV approach. Unlike the BV approach, there are great uncertainties with the estimated value of the remaining concession. Qt is one of the biggest sources of uncertainties, while overestimation of demand has caused many PPP infrastructure projects to fail, especially for transportation infrastructure projects (Vassallo et al., 2011). In addition, OCt also fluctuates due to inflation and other risks. Actually, the compensation made by the MV approach is more representative of the real value of a project. When the remaining concession is sold on the open market, the tenders are buying a real option for collecting revenues in the remaining concession, instead of the project assets. Therefore, the book value of the contractor cannot reflect the real value of the project in this situation.
The MV approach is properly used in the compensation of PPP infrastructure projects that have substantial tariff revenues, such as traffic projects, water supply plants, and power plants. Once the construction is completed, the project can generate revenue, which can be used to repay the lenders and reimburse equity holders. In early terminations, the project has huge market value because of the revenue in the remaining concession. Thus, there is an alternative choice for the contractor offering sale on the open market, instead of sale to the government. If the government wants to buy out the concession, it has to offer a competitive price for the deal because the contractor has the ability to bargain with the government (Wilbur Smith Associates Limited, 2011).
In this approach, contractors take all long-term risks because the future cash flows for compensation are estimated based on project performance before early termination. Thus, if contractors do not perform well in construction or operation, or make severe errors in demand forecasting, the compensation from the government should be low. On the other hand, if the contractor behaves very well and the market is also good before the termination, the government has to pay a great amount of compensation to the contractor in early termination.
This article belongs to a series of research concerning renegotiations and early terminations in PPP projects (Xiong & Zhang, 2014b, 2016; Xiong, Zhang, & Chen, 2015; Zhang & Xiong, 2015). However, we found that practitioners in both the public and private sectors do not prefer the term of renegotiation and early termination in their communications because it is easy to relate them to project failures. On the other hand, risk management has been widely used in PPP projects, and it is more acceptable for practitioners if renegotiation and early termination are indeed involved in the framework of ex post risk management.
The ex post risk management also emphasizes an important issue in project risk management that has been ignored by scholars for a long time (i.e., the costs of ex ante risk management). Theoretically, all risks can be dealt with appropriately through excellent ex ante risk management, but the cost associated with such works could be tremendous. Previous literature relating to project risk management generally concerns the risk indexes of different projects and advanced techniques for risk analysis, but practitioners indeed care about a trade-off between the benefits and costs of risk management. That is why renegotiations and early terminations are very common in PPP projects.
The proposed ex post risk management model is mainly applied for decision making in the serious risk scenarios of PPP projects. When one party's risk tolerance is exceeded, the government should propose ex post risk response measures to take care of the excessive risk impacts. A three-step protocol is suggested as follows: (1) risk impact assessment, referring to Equations 2 through 5; (2) risk response effectiveness assessment, referring to Equations 6 through 13; and (3) risk response measures selection, which is based on the effectiveness assessment. An illustrative case is shown in the Appendix to show the applicability of the proposed ex post risk management model.
Moreover, the application of ex post risk response measures should also consider the enforcement constraints of the project. In renegotiations, if the government is more worried about public satisfaction, such as in the year of a general election, a toll increase will not be selected because it may cause public opposition; if the government has budget constraints, then annual subsidy and unitary payments are not preferable because they may involve a huge slice of the government budget; if the government is keen to absorb private funding to develop infrastructure, reduction of investment obligations is unlikely to be selected. In early terminations, if compensation for early termination through the MV method is applicable, but it is difficult for the partners to achieve a consensus on future cash flow estimation, compensation for early termination through the BV method could be used; the partners can then negotiate the rate of return instead of future cash flow estimation.
Serious risk scenarios have forced governments to take measures to renegotiate or terminate many PPP infrastructure projects. The criteria for justifying serious risk scenarios are risk tolerances. A clear declaration of the commercial and production risk tolerances in agreements can be very helpful for risk management. Aiming at tackling these serious risk scenarios, a quantitative ex post risk management model was well-proposed in this study. The ex post risk response measures in concession renegotiation and early termination were discussed in detail as well. The potential applications are discussed and an illustrative case demonstrated the good applicability of the quantitative ex post risk management model.
This study clarified the risk management principles and developed the conception of ex post risk management based on the literature of hazard management. Confronted with serious risk scenarios, ex post risk management can reduce the excessive risk impacts and bring the project back to appropriate operation. The objective function is based on the financial equilibrium, which is a well-accepted body of knowledge in PPP research. The application of this model begins with risk impact evaluation, then ex post risk response measures assessment, selection, and enforcement. The common measures in concession renegotiation include toll adjustment, contract extension, annual subsidy, or unitary payment adjustment, tax waiver, and reduction in the contractor's investment obligations; and the common measures in early termination are the BV and MV compensation methods.
Different ex post risk response measures have different reduction effectiveness and enforcement characteristics in application. A set of equations were developed based on the general model to evaluate the reduction effectiveness of these measures. A suitable measure can be selected according to its enforcement characteristics. The toll adjustment has to consider the end user's ability to tolerate high toll rates; the contract extension must be cautiously adopted since huge risks may emerge for future governments; the annual subsidy or unitary payment adjustment may cause stress for the government budget; the tax waiver is usually not adequate for compensation; the reduction in contractor's investment obligations may influence the development of infrastructure; the BV approach is suitable for utility charge-based projects and uncompleted projects, and the MV approach is suitable for tariff-based projects.
Contributions to the Body of Knowledge
There are two main contributions of this study. First, this study develops a framework for ex post risk management, which has long been ignored in the literature. The conventional wisdom of risk management is solving all the risks ex ante through a well-designed contract, but frequent occurrence of renegotiations and early terminations shows that ex ante risk management is not sufficient for projects that are extremely complex and risky, such as PPP infrastructure projects. The ex post risk management is a complement of ex ante risk management and can be used to deal with risks dynamically in the long concession period of PPP projects. The framework can be a foundation for future studies of renegotiations and early terminations in PPP projects. Second, this study proposes a quantitative ex post risk management model, which involves a series of ex post risk response measures in concession renegotiation and early termination. There has been some literature about renegotiation and early termination in PPP projects, but most literature concerns particular types of them, such as that from Xiong and Zhang (2014b), which develops concession renegotiation models for three types of renegotiations and that from Xiong, Zhang, and Chen (2015), which builds a compensation model for early termination based on the MV method. The ex post risk management model involves seven different types of risk response measures and compares their effectiveness and characteristics, so it enables the decision makers to select the most suitable one in serious risk scenarios.
Limitations and Future Research
A main limitation of this research is that the illustration of the ex post risk management approach is based on a hypothetical case. Since the quantitative model is original and not applied in real life PPP projects, much effort should be devoted to applying and testing this model in the future. Some suggestions for future research are as follows:
- The execution of renegotiations and early terminations should be studied. This research only constructs a theoretical framework and conceptual models for an ex post risk management approach, but more executive insights on how the proposed approach may be written into initial contracts are needed.
- The transaction costs of different risk response measures should be evaluated. In the choice of risk response measures, effectiveness and characteristics are certainly main concerns, but transaction costs of different measures are also important.
- The hold-up problems in ex post risk management can be investigated. The authors build the objective function of ex post risk management based on the financial equilibrium. Nevertheless, we do not exclude the possibility of hold-up problems, so combining hold-up problems and financial equilibrium in ex post risk management is a topic for future research.
The authors’ special thanks go to all reviewers of the article and to the National Natural Science Foundation of China (NSFC-71472037, 71671042); the Social Foundation of Jiangsu Province, China (13GLB005); and the Program for Outstanding Young Teachers of Southeast University (2242015R30009).
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Wei Xiong, PhD, is Assistant Professor in the Department of Public Administration, Tongji University, Shanghai, China. He holds a doctoral degree from the Hong Kong University of Science & Technology. His current research interests are in the areas of public-private partnerships, risk management, governance, and sustainability. He can be contacted via email at firstname.lastname@example.org.
Xianbo Zhao, PhD, is a senior lecturer in the School of Engineering and Technology, Central Queensland University, Australia. He holds a doctoral degree from the National University of Singapore. His current research interests are in the areas of risk management, rework and productivity, sustainable construction, as well as construction partnering. He can be contacted via email at email@example.com.
Jing-Feng Yuan, PhD, is an Associate Professor in the Institute of Construction Management and Real Estate, Department of Construction and Real Estate, School of Civil Engineering, Southeast University, Nanjing, China. His research interests are in public-private partnership, risk management, construction safety, and sustainable management. He can be contacted via email at firstname.lastname@example.org.
Ms. Sai Luo is a doctoral student of Business Administration, Hohai University, Nanjing, China. Her current research interests are in the areas of risk management, technology economics, and business management. She can be contacted via email at email@example.com.
Appendix: An illustrative case.
In order to illustrate the application of the ex post risk management, this study presents a toll highway concession comprising a two-year construction phase and 35-year operation phase. The assumptions made, as shown in Table 2, refer to the case in Shan, Garvin, and Kumar (2010). The government offers a guarantee of a minimum rate of return for equity (7.5%), which is slightly higher than the interest rate (7%), but is much lower than the expected rate of return for equity (72%). The capital investment comprises 80% debt and 20% equity. Since the minimum rate of return has been guaranteed at the outset, any breach can be defined as a serious risk scenario.
|Operating Variables||Capital Variables|
|Initial traffic volume per day||15,000||Capital cost||US$110,000,000|
|Annual traffic growth rate (year 1–10)||6.00%||D/A||80%|
|Annual traffic growth rate (year 11–20)||3.50%||Debt||US$88,000,000|
|Annual traffic growth rate (year 21–35)||2.00%||Equity||US$22,000,000|
|Initial toll||US$1.30||Interest rate||7.00%|
|Annual toll growth rate (year 1–5)||5.00%||Risk-free rate||5.00%|
|Annual toll growth rate (year 6–10)||3.00%||Tax rate||30%|
|Annual toll growth rate (year 11–35)||2.00%||Minimum rate of return for equity||7.5%|
|Initial O&M cost||US$6,500,000||Debt service coverage period (year)||15|
|Annual growth rate of O&M cost||3.00%||Expected rate of return for equity||72%|
|Annual growth rate of subsidy||3.00%|
|Table 2: Project information for case illustration.|
Since most of the renegotiations occur in the first two years of operation (Guasch, 2004), this study assumes that the contractor claims for renegotiation after the project has been operated for two years (year four) because of certain serious risk scenarios. The serious risk scenarios could be caused by the following driving risks: demand shortfall, construction cost overrun, O&M cost overrun, and public rejection of toll rate (Cruz & Marques, 2013a). As shown in Table 3, the serious risk scenario is “Yes” if the rate of return for equity is lower than 7.5%; otherwise, it is “No.”
Risk Impact Assessment
The risk impact is evaluated by the shortfall of the actual profit from the guaranteed profit. The severity of driving risks is represented by “M.” The severity of demand shortfall, O&M cost overrun, and public rejection of toll rate is defined as the variance between the actual and planed initial traffic volume, initial O&M cost, and initial toll rate, respectively. It should be noted that the annual growth rate of traffic volume, O&M cost, and toll rate is assumed to be unchanged. That's because it is impossible to predict the long-term growth rate trend while the project only has historical data for two years. The severity of construction cost overrun is defined as the variance between the actual and planed capital investment. Sensitivity analysis is also conducted using different risk severities, as shown in Table 3.
|Driving Risks||Rate of Return (M = 10%)||Serious Risk Scenarios (Y/N)||Rate of Return (M = 20%)||Serious Risk Scenarios (Y/N)|
|Construction cost overrun||14%||N||—15%||Y|
|O&M cost overrun||8%||N||—57%||Y|
|Public rejection of toll rate||—55%||Y||—240%||Y|
|*M = the severity of driving risks|
|Table 3: Risk impact evaluation.|
According to the risk impact simulation, the case falls into a serious risk scenario when the severity of the demand shortfall or the public rejection of the toll rate is 10%, and when the severity of any risk is 20%. With the same severity, the demand shortfall and the public rejection of the toll rate have the same impact, which is higher than that of construction cost overrun and O&M cost overrun. Even though serious risk scenarios may be caused by a combination of risks, this study only analyzes the risk individually for sample illustration.
After the risk impacts of driving risks are evaluated, ex post risk response measures can be taken. Among the available measures, the government has to assess the reduction effectiveness, determine the adjustment values, and select the most suitable one. Even though the government can also select a combination of measures, this study only analyzes individual measures for sample illustration. The adjustment values of all the available measures for the illustrative case are calculated when the severity of driving risks is 20%, as shown in Table 4.
Table 4: Ex post risk response measures evaluation.
Ex Post Risk Response Measures Selection
The selection of most suitable ex post risk response measures depends on their effectiveness in solving problems. The evaluation of ex post risk response measures is shown in Table 4. With regard to renegotiations, a toll increase is very effective in this case because a US$0.50 toll increase would adjust off all excessive risk impacts, except that a toll increase is not applicable when the driving risk is public rejection of toll rate; contract extension is also effective, but it is dangerous for the government to extend the concession by nearly one-third of original length when the driving risk is demand shortfall or public rejection of toll rate; annual subsidy or unitary payment is direct and effective, but it occupies a huge amount of budget, which is up to around US$2.5 million per year when the driving risk is demand shortfall or public rejection of toll rate; tax waiver is effective when the driving risk is construction cost overrun, but is not effective enough when the driving risk is demand shortfall, O&M cost overrun, or public rejection of toll rate; reduction of investment obligations is effective only if there is such an amount of investment obligation in agreements. With regard to early terminations, compensation for early termination through the BV method is applicable, if the driving risk is caused by the government or has been assigned to the government in agreements, and the compensation is much higher than the capital investment; compensation for early termination through the MV method is applicable, if the driving risk is caused by the private sector or has been assigned to the private sector in agreements, and the compensation is lower than the capital investment when the driving risk is demand shortfall or public rejection of toll rate.