Germany: Risk allocation and incentive systems in the case of a Private Finance Initiative

Last Updated: 16 December 2004
Article by Ulrich Eder

Not every public sector investment project can be realized as part of a public-private-partnership (PPP). For those projects that cannot be realized in this form alternative forms of financing are available. Nevertheless, the penalties suffered by the public sector partner are normally much greater if it consents to a disadvantageous allocation of the project risks and allows the PPP project to be performed uneconomically. Consequently, an advantageous allocation of risks and the creation of an incentive system are two inseparable key elements when structuring the public-private-partnership to the advantage of the public sector.

Projects realized in Germany to date do not allow any uniform risk structure to be discerned. This is partly due to the fact that the projects themselves differ too greatly and the aims of the public sector are too varied. Consequently, there is only a limited degree of comparability. Moreover, the negotiating power of the public sector and the appreciation of the risks on the part of those acting for the public sector may also vary to a very great extent. At the time of planning and realizing the projects, there is a focus on the benefits of mutual success and an unwillingness to discuss the consequences and remedies of failure. Experience shows that specific risk allocation tends to be based on random considerations than on any form of systematic planning. It is necessary to say that there is no such thing as a generally acknowledged market standard in this area. Instead, it is possible to elaborate an individual risk profile tailored to the circumstances of the specific case.

The involvement of private capital and private expertise in public infrastructure projects is not an automatic guarantee of the economic efficiency of the PPP model. The private partner’s pursuit of profit in the transaction in accordance with the commercial principles can only be an incentive for cost-effective project realization if the public partner does not unilaterally bear the risk of the costs. For this reason, these risks must be structured and shared in such a way that private and public partners benefit equally from cost advantages and optimization. If the private partner has no particular incentive to realize the project better, faster and more cost-effectively than the public partner could do alone, the PPP model will gradually lose its attraction. For this reason, the creation of an incentive system is particularly in the public interest. Experience has shown that, in practice, it is impossible to separate risk allocation and the establishment of this incentive system and this must be regarded as a single structuring task.

The risks of PPP and their distribution between the parties

Construction of a public infrastructure project involves a large number of different types of risks. It makes sense to define and classify the specific risks when they can be, and will be, divided between different parties. Accordingly, public-private-partnership is a matter that necessarily requires careful evaluation of any existing risks.

Advisers and consultants are familiar with different risk classifications. On the one hand, origin-based criteria are defined and a distinction is made between commercial risks, political risks and force majeure. Secondly, there is a phase-related classification of risks during planning, construction and operation. Nevertheless, schemes of this kind are only of limited value to the public partner because it depends on implementation in the individual case. What is required is a multi-dimensional risk matrix geared to the individual measure that also takes account of any conceivable "worst case" scenario. If no proper care is taken to identify the nature, probability, time of occurrence and amount of damages of the conceivable risks, the ability to distribute the risks fairly between the parties is also impaired.

Risk matrix for PPP projects

Risk classes

Risk distribution

Risk assessment

  • Origin-based criteria (commercial risks, political risks, force majeure)
  • Phase-related criteria (planning, construction, operation)
  • Multi-dimensional matrix (type of risk, probability and timing, amount of damages)
  • The extent to which the risk can be influenced or controlled
  • Opportunities/risks – mirror principle
  • Ability to bear damages and insurability
  • Requirement of the individual case taking account of risk costs
  • Distinction between key risks and non-key risks
  • Economical efficiency of risk transfer
  • Risk acceptance and economic efficiency
  • Risk structuring as an incentive to minimize and avoid risks

Various principles can be applied to a possible distribution of risks. The degree to which they can be influenced and controlled can be used as a yardstick. Alternatively, risks can be assigned to the party, which benefits from the opportunities necessarily associated with the specific risk. Another aspect is the question of what party is in the financial position to bear the risk in the event of damages being suffered, and what party is able to insure itself against that risk.

The private partner frequently quotes alleged market standards for specific risk distribution and talks of a typical risk profile. This may – or may not be – true in the individual case. Ultimately, what is customary on the market is no decisive criterion for the public sector. If key risks only arise in the course of PPP projects and the public partner cannot hedge against these risks or devolve them onto the private partner, it may be appropriate for the public sector to dispense with the public-private-partnership. This may be relevant in the individual case with regard to certain insolvency risks.

Assuming that transparent market relations prevail, risks are assumed in return for a fee. For this reason, the public partner "sells" not only the project responsibilities but also the project risks to the private party and pays a certain price for the same. This object of achieving economic efficiency through the agreement is defeated only if the price for acceptance of the risk is too high. For this reason, it will normally be uneconomic to transfer risks that lie within the area of influence and control of the public sector. It will be advantageous, on the other hand, to devolve groups of risks to a private contractor where the occurrence of such risks depends on his own proficiency, his degree of care and his performance capability. This will give him an incentive to prevent the risk occurring. The premium for the risk is an inseparable part of his remuneration. For this reason, there is a direct link between the acceptance of risks and an incentive-based system of remuneration.

The incentive towards economic efficiency

Statistical surveys in industry indicate efficiency advantages of approx. 10 to 25%. Since reports of this kind are normally interest-driven, and it is almost impossible to make a direct comparison with performance of a purely public contract, this does not in itself constitute evidence of the economic efficiency of the involvement of private expertise and capital. The public partner must consider the fact at each phase of the project that it is perfectly entitled, in accordance with established commercial principles, to exploit any scope for negotiation in its own financial interest and not from a public welfare point of view.

If the public partner receives financial advice only from the private investor (a not infrequent occurrence), the incentive system will normally consist of the private company’s "share in the profits" from a fast or cheap performance. More appropriate is a comprehensive form of performance control that rewards a fast, improved and more favorable performance of the contract and also effectively sanctions delays, quality sacrifices and rising costs. The ultimate result must be reconciliation of interests between the private partner’s pursuit of profit and the public partner’s need for economic efficiency, if the PPP project is to be taken to its successful conclusion.

Incentive-based remuneration systems

Description of service

Assessment of performance

Remuneration agreement

  • Standard of performance in terms of type, scope and quality
  • Availability requirements and time frame
  • Balance between functional (output) and substantial specifications (input)
  • Objective measuring system
  • Technical and time-schedule monitoring of performance
  • Duty of verification and transparency
  • Tailored to overall life cycle
  • Profit-sharing if over-achieved (bonus system)
  • Loss-sharing if under-achieved (premium system)
  • Specification of costs as a lump sum
  • Incentive to minimize risks, improve performance, solve problems and innovation

In spite of the peculiarities of each individual case, it is possible to distinguish three elements in proven incentive systems:

  • Starting point is a comprehensive and clear performance description. It defines the standard of performance in terms of type, scope and quality and describes the availability requirements of the contracting authority. The private partner will typically ask for a performance description based, as far as possible, on output, e.g. a functional performance description. The public partner must additionally consider the fact that although even a simple construction will fulfill its primary purpose, urban planning considerations make higher demands on the actual substance of the infrastructure facility, and therefore, also on its acceptance.
  • The equally important second element is an agreement on performance evaluation. This requires an objective measuring procedure that allows technical and time-schedule monitoring of performance. Assessment and measurement mean that the quality and quantity of performance must be clearly verifiable. Transparency is harmful only to the party that does not have it. Performance evaluation agreements frequently suffer in practice from the fact that they are not geared to the entire life cycle and, in particular, do not take adequate account of energy costs.
  • The third element of the incentive system is the agreement on remuneration. It includes a profit share in the event that specifications and expectations are exceeded (bonus system) and a share in losses in the event of failure to meet specifications and expectations (premium system) and the stipulation of costs in the form of a lump sum to simplify matters and reduce bureaucracy. The remuneration agreement is frequently not so flexibly structured as to be a genuine incentive towards innovative problem solving. If there is no financial incentive for the private partner to depart from established procedures, that partner will not normally be willing to accept the associated cost risk. This unnecessarily restricts and channels creative potential.

    To ensure that the private partner continues to be given incentives throughout the course of the project, a system of remuneration must not be too rigid at the start of a project and then be executed without any criticism. Instead there is a need for examination and adjustment throughout the entire course of the project that continually reflects and reconciles the conflicting interests of the contractual parties. If the state bows to the persistent pressure exerted by the commercial party, it fails to appreciate that the need for economic efficiency is a dynamic challenge and not a static milestone.

    Risk allocation and incentive system as the key to a successful PPP

    Efficiency advantages, i.e. quality improvements and efficiency gains (quantitative benefits) justify the involvement of private capital and private expertise in the performance and realization of public projects. For this reason, it is in the interests of both parties in the long term for companies to be measured against their own self-made claims and for the competition of ideas and opportunities to be preserved.

    Therefore, independent financial advice obtained by the public partner to achieve an advantageous risk structure and create an incentive-based remuneration system is no barrier to the negotiation of project contracts. Instead it is a necessary corrective to the negotiating restraints and information deficits that have emerged as a consequence of the underlying conditions of public procurement and its traditional financing structure.

    The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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