Australia: Allocating Risk in Public Private Partnerships

Australia has a long history of private sector participation in the provision of public infrastructure facilities, including roads, bridges, tunnels, railways, ports, water treatment facilities, sports facilities, hospitals and prisons. Since 1989, private spending on infrastructure in NSW alone has exceeded $5.5 billion. Recent years have seen an explosion of Government policy and guidance documents on which are now termed "Public Private Partnerships" (PPPs), as Governments at all levels in Australia seek to harness the benefits which private sector investment and/or participation in the provision of public infrastructure can bring. Indeed, the Federal Government and all State and Territory Governments have in recent years issued PPP policy documents (of differing levels of detail).

As part of this recent policy development, considerable attention has been given to the always challenging issue of risk allocation. Risk allocation is particularly challenging and important in the context of PPPs given the significant costs and risks associated with infrastructure projects, the high number of stakeholders and the resultant complexity of the contractual arrangements involved, and the fact that a value for money outcome for Government in adopting the PPP approach will often turn on the successful transfer to the private sector of those risks which the private sector can manage at lower cost than the public sector.

The risk allocation principles of the various PPP policies are easy to state but more difficult to implement. The objective of the policies is efficient/optimal risk allocation, that is that risks should be allocated to the party that is best able to manage the risk at the least cost.

While the principle of efficient risk allocation appears to be generally agreed by both Government and the private sector, the proper application of the principle to specific risks on various projects continues to be the subject of considerable negotiation. The reasons for this include:

Subjective views: Each party comes to the transaction with its own subjective views as to:

• the respective abilities of the parties to manage various risks;
• the likelihood of certain risks occurring and their consequences; and
• the costs which the other may incur in managing risks.

These subjective views, even if reasonably and honestly held, often differ.

Complexities: Many risks are not wholly within the control of one particular party. For some risks the ability of a particular party to manage the risk, and the costs which it will incur in doing so, will depend to a large extent upon how the other party conducts itself. In these cases, risks need to be shared, and obligations or restrictions need to be imposed on the party that is not best able to manage the risk in order to assist the party responsible for managing the risk. There are often many ways in which such risk can be sliced, diced and allocated and hence considerable scope for debate and brinkmanship.

Difficult risks: Similarly, for some risks (such as uninsurable events) neither party is particularly well placed to manage the risk. In a 2001 survey conducted by the Chamber of Commerce and Industry of Western Australia and the Institution of Engineers Australia on risk allocation in major West Australian construction projects, 35 percent of respondents said that risks which had been allocated to them were "impossible to manage". This figure rose to 67 percent of contractor respondents (as opposed to principals or consultants)[1].

Other influences: The principles of efficient risk allocation do not operate in a vacuum - there are other important influences on risk allocation which are also at play. In a 1999 survey of participants in infrastructure projects conducted by the Victorian Department of Treasury and Finance, it was found that the three most influential factors on risk allocation were:

• commercial requirements (linking risk and return);
• bargaining power; and
• debt financiers’ requirements[2]

In the context of PPPs, the risk allocation underpinning the Public Sector Comparator developed by the public sector to test the value for money of PPP proposal, and the dollar values attributed to retained and transferred risks, can also have a bearing on the willingness of Government to depart from its preferred risk allocation.

These influences dictate that, inevitably, risks will not always be allocated in accordance with the principles of efficient risk allocation. The reality is that sometimes risks will be allocated to the party least able to refuse the risk rather than the party best able to manage the risk. This is of course heightened at the time the Government is maintaining maximum competitive tension, ie. just before the announcement of a preferred proponent.

Measures which Government and other PPP participants can take to better manage the challenge of risk allocation include:

Don't lose sight of the basic principles: Firstly, Government agencies need to be careful, when drafting the contractual documentation on which bids will be based, not to lose sight of the principles of efficient risk allocation. There is often a strong temptation to start with an aggressive draft and see how the market responds before making the difficult calls on the difficult risks. The fact that Government is often in a strong bargaining position at the start of the tender process exacerbates this temptation. One of the risks which Government agencies run when they adopt such an approach is that bids will incorporate pricing that reflects the allocation of unmanageable risks to the private sector.

Price the risk: Where a party considers the allocation of a particular risk to it offends the principles of efficient risk allocation, it should be prepared to separately price the risk and advise the other party of the price. This would enable the other party to make an informed value for money assessment. Too often it seems that bidders are unwilling to separately price Government's preferred allocation of a particular risk, making it difficult for Government to assess whether the bidder's preferred risk allocation does, in fact, represent a better value for money outcome.

More precise drafting: More precise drafting (ie. avoidance of the "catch-all") can often turn the objectionable into the acceptable, thereby reducing negotiating time and costs. This is particularly the case with the Government tendency to include broad indemnities at the back end of the project agreement - potentially undoing the carefully negotiated risk allocation contained in the balance of the agreement, and introducing the unpriced unmanageable risk element.

Alternative risk transfer: Effective risk management requires smarter thinking and investigation of alternatives to what usually happens with delivery risk - loading it on the balance sheet of the D&C contractors, or chasing ephemeral insurance options in a market currently characterised by volatility. The usual approaches to risk allocation will also become historical if all States and Territories adopt the recent Victorian amendments to the Wrongs Act dealing with proportionate liability, which have the (possibly) unintended effect of allowing the judicial process to determine the allocation of risk after the event. So if a deal has been done to lay off a particular risk against a D&C contractor balance sheet in the project agreement, but a court later decides that the D&C contractor was only responsible for 10 percent of the crystallised risk (with a subcontractor responsible for the remaining 90 percent), that leaves the carefully negotiated risk allocation in tatters, with the party suffering loss being required to pursue the other 90 percent against the subcontractor with which it possibly has no contractual relationship. But what are these alternative risk mechanisms? The reinsurance market has been developing for some time the concept of catastrophe bonds, which allow parties wishing to lay off risk to access a much broader capital market than the reinsurance market alone. This will need to be the subject of much greater focus as there is an enormous pool of international capital which might be accessed via these alternative risk transfer mechanisms.