1. Public-Private Partnerships in the Czech Republic The importance of risk management in PPP projects Twinning Project CZ/2005/IB/FI/04 Training event on risk management in PPP projects Prague, Ministerstvo financí, 26 May 2008 Rui Sousa Monteiro (Parpública SA, Portugal)

2. 2 Contents Is risk really important in PPPs? Is risk really important in PPPs? What are the risk challenges? What are the risk challenges? What are the goals of PPP contract management? What are the goals of PPP contract management? What are its main components? What are its main components? How to deal with PPP risks? How to deal with PPP risks?

3. 3 This presentation conveys some overall good practices regarding risk management in PPP projects, and particularly reflects the author’s research and experience in Portugal and other countries

4. 4 The establishment of an effective and efficient risk management system depends on idiosyncratic characteristics of each public administration and government department The recommendations here included should be supplemented by rules tailored to local circumstances

5. 5 Risk is defined as the uncertainty of outcome, whether positive opportunity or negative threat, of actions and events

6. 6 Is risk really important in PPP procurement and PPP contracts?

7. 7 PPPs Public-private partnerships (PPPs) are long-term contracts between a public entity and a private entity...... for the provision of services; usually they include the construction or acquisition of infrastructure or assets with a long economic life

8. 8 Risk-transfer is critical The efficiency of a PPP contract depends on the effective transfer of some risks to the private partner Private entities are efficient in the management of a project if they have money at stake, and if they face risks that they can manage

9. 9 Private management PPP efficiency implies committing private capital to the management of a public project But private-management efficiency will only arise if they face risks: a private manager protected from risks will only manage rents

10. 10 Risk is costly (1) The private partner in a PPP long-term contract will be forced to design an infrastructure and manage a project using a whole-life costing approach The efficient design of the infrastructure will depend on the credible expectation that the private partner will assume the long-term risks

11. 11 Risk is costly (2) If risks are not clearly allocated to the private partner, it could realise that it is more profitable trying to shift risks to the public sector than managing those risks This way, the focus of the private partner could be risk-devolution, and not the provision of quality services to government/end-users

12. 12 Risk is costly (3) During tender, as well as during the life of the contract, the profit- seeking nature of the private partner will induce him to transfer back some risks to the public partner: formally, during procurement effectively, during contract life

13. 13 Risk management So, both the project manager (during the pre-procurement and the procurement phases) and the contract manager (after contract close) are required to manage risks carefully: Identifying and allocating risksIdentifying and allocating risks Monitoring risksMonitoring risks Mitigating risksMitigating risks

14. 14 What are the risk challenges for PPP projects and contracts?

15. 15 Three phases We need to consider three phases: Project selection phase Project selection phase Procurement phase Procurement phase Contract management phase Contract management phase

16. 16 Project selection phase Project risks Project risks Project-design risks Project-design risks Project-scheme risks Project-scheme risks Budgetary/fiscal risks Budgetary/fiscal risks

17. 17 Project selection risks PPPs may significantly reduce project risks for the public sector But, if the appraisal framework is not appropriate, PPPs may: bias the selection of public projects, inducing the government to procure low value projects bias the selection of public projects, inducing the government to procure low value projects endanger overall fiscal discipline endanger overall fiscal discipline

18. 18 PPP budgetary risks PPPs increase budgetary rigidity PPPs create political risks as they establish bounds and restraints on public policy changes: Formal bounds Formal bounds Financial bounds Financial bounds Those bounds may be redeemed through financial compensation

19. 19 Designs and schemes Some risks are not really accruing out of a project, but out of the PPP scheme designed for that project So, a specific project-design presents some risks that are related to that design...... and risks that vary, depending on the kind of PPP-scheme selected

20. 20 Project-scheme risks (1) For instance, consider a free highway: Construction risk is a project-design risk (whatever the PPP scheme, the project will face construction risk) Construction risk is a project-design risk (whatever the PPP scheme, the project will face construction risk) Demand risk is a project-scheme risk (under a shadow-toll regime, there will be demand risk, but under an availability regime there will be no demand risk for the project) Demand risk is a project-scheme risk (under a shadow-toll regime, there will be demand risk, but under an availability regime there will be no demand risk for the project)

21. 21 Project-scheme risks (2) Consider now a toll-road PPP project: Demand risk may affect the scheme significantly (if traffic risk is allocated to the private partner) Demand risk may affect the scheme significantly (if traffic risk is allocated to the private partner) Or just marginally (if payments are made according to a pure availability regime, there will be almost no demand risk affecting the private partner) Or just marginally (if payments are made according to a pure availability regime, there will be almost no demand risk affecting the private partner)

22. 22 Project-scheme risks (3) Consider now an accommodation project: If some non-infrastructural services (e.g. catering) are included in the scheme, services’ demand will affect the contract If some non-infrastructural services (e.g. catering) are included in the scheme, services’ demand will affect the contract If those services are to be provided by a third party, there will be no demand risk, but the scheme will now be affected by interface risks If those services are to be provided by a third party, there will be no demand risk, but the scheme will now be affected by interface risks

23. 23 During PPP procurement, beside all the usual negotiation risks, there is the possibility that bidders change contract provisions in a way that prevents effective risk transfer to the private partner

24. 24 Risk and procurement If risks are not clearly allocated in the draft contract (included in the Invitation to Tender), bidders will do their best to reallocate risks in the final contract Unclear allocation of risks may also prevent effective competition and transparency during the tender

25. 25 After contract close, risk allocation is written down in the contract, so it is supposed to be established for the whole life of the contract

26. 26 However, risk devolution, from the private to public partner, is always possible if there is no proper contract management by the public authority...

27. 27... namely if the contract manager is not permanently concerned with risk management and with the prevention of strategic moves by the private partner

28. 28 Risk devolution (1) After signing a PPP contract, the private partner will have plenty of opportunities to transfer risks to the public sector, due to: Technological, commercial, or demographic change Technological, commercial, or demographic change Political change Political change Force majeure events Force majeure events Some other unforeseen events Some other unforeseen events (e.g. archeological discoveries)

29. 29 Risk devolution (2) Improper contract management (by the public authority in charge of the contract) creates excellent opportunities for the private partner to transfer risks back to the public sector, shifting costs to the public sector shifting costs to the public sector or simply by not keeping up to the prescribed quality of service or simply by not keeping up to the prescribed quality of service

30. 30 Risk devolution (3) Government will always be politically responsible for public service So the private partner may behave in a strategic way, inducing the public authority to change service require- ments and pay compensation If change in not managed, authority’s room for maneuvre will shrink and it will lose bargaining power

31. 31 So, it is clear that significant risks will affect PPP contracts, and that they should be managed by the public partner

32. 32 How shall the public authority protect the public interest regarding risks accruing from PPP projects and contracts?

33. 33 Risk management shall be an integral component of an effective contract management

34. 34 What are the main goals of PPP contract management?

35. 35 Note that, beside the usual contract management goals, in the PPP case there is the long-term partnership characteristic that requires a mix of cooperation and skepticism

36. 36 Three goals for contract management a) Enforce the contract in order to achieve its objectives b) Facilitate cooperation between public and private partners c) Manage public sector risks, preventing strategic behaviour that may damage public interest

37. 37 Goal (a): contract enforcement Manage information interchange Manage information interchange Supervise asset and staff transfer Supervise asset and staff transfer Supervise construction phase Supervise construction phase Supervise operational phase Supervise operational phase Measure production & performance Measure production & performance Manage changes and conflicts Manage changes and conflicts Prepare/manage termination Prepare/manage termination

38. 38 Goal (b): cooperation/partnering Improve relations between private and public partners Improve relations between private and public partners Improve interfaces with other public entities: communication, licensing, regulation, feedback Improve interfaces with other public entities: communication, licensing, regulation, feedback Improve interfaces with end-users, taxpayers, and media Improve interfaces with end-users, taxpayers, and media

39. 39 Goal (c): strategic contract management Identify, monitor, and mitigate all risks potentialy affecting the contracting authority and the public sector, for the full life of the contract Identify, monitor, and mitigate all risks potentialy affecting the contracting authority and the public sector, for the full life of the contract Be aware of possible strategic behaviour (by private partners or other stakeholders) that may affect the service or the public interest Be aware of possible strategic behaviour (by private partners or other stakeholders) that may affect the service or the public interest

40. 40 A note on (a)+(b)+(c) Goal (a) requires careful planning and fast response, and it “goes by the book” i.e. the contract Goal (b) is based on a cooperative approach, while (c) requires a (game- theoretical) non-cooperative reasoning and a skeptical approach In a certain way, (b) activities aim also at balancing this skepticism with improved partnering

41. 41 Mismanagement effects Underperformance (low production or overproduction, low quality,...); if undetected, leading to payment of services not really provided Underperformance (low production or overproduction, low quality,...); if undetected, leading to payment of services not really provided Perverse behaviour by private partner e.g. cream-skimming, demand fostering, client rebuffing Perverse behaviour by private partner e.g. cream-skimming, demand fostering, client rebuffing Effective change in risk sharing, with some risks devolved back Effective change in risk sharing, with some risks devolved back

42. 42 What are the main components of contract management?

43. 43 Contract management components Planned routine activities: Planned routine activities: Information interchangeInformation interchange Construction and transition monitoringConstruction and transition monitoring Effective performance monitoringEffective performance monitoring Communication strategy and planCommunication strategy and plan Strategic reasoning: Strategic reasoning: Risk registering and monitoringRisk registering and monitoring Strategic awarenessStrategic awareness Risk prevention and contingency plansRisk prevention and contingency plans

44. 44 Contract management internal requirements Governance structure: Governance structure: Define structure of Contract Mgt teamDefine structure of Contract Mgt team Clarify roles (accountability, decision making rules, clear responsibilities with no overlap)Clarify roles (accountability, decision making rules, clear responsibilities with no overlap) Reports, interfaces with other entitiesReports, interfaces with other entities Capacity acquisition & development: Capacity acquisition & development: Staff requirements + consultancy useStaff requirements + consultancy use Hiring and retaining staffHiring and retaining staff Training staff, interchanging knowledgeTraining staff, interchanging knowledge

45. 45 Routine and strategy Routine tends to be overwhelming, preventing the Contract Manager from strategic thinking and planning Routine tends to be overwhelming, preventing the Contract Manager from strategic thinking and planning Routine contract enforcement activities typically involve a lot of paperwork and information interchange, marked by a sequence of deadlines for reports, invoicing, payments and licensing Routine contract enforcement activities typically involve a lot of paperwork and information interchange, marked by a sequence of deadlines for reports, invoicing, payments and licensing

46. 46 Some routine activities Output measurement Output measurement Performance measurement Performance measurement Invoice validation and auditing Invoice validation and auditing Checking contractual milestones Checking contractual milestones Periodical review / benchmarking Periodical review / benchmarking User and staff surveys User and staff surveys

47. 47 Planning The Contract Manager should plan all routine activities, in order to guarantee that there are enough resources free for a) Keeping a broad view on the contract, focussed on outcomes b) Managing risks and preventing damaging strategic moves

48. 48 How to deal with PPP risks?

49. 49 Public sector risks PPP risk management involves a sequence of steps that need to be repeated over time: Identifying risks, based on formal contract risk allocation, on past experience and on logical reasoning Identifying risks, based on formal contract risk allocation, on past experience and on logical reasoning Assessing risks (impact and likelihood of occurrence) for all parties Assessing risks (impact and likelihood of occurrence) for all parties Monitoring and mitigating risks Monitoring and mitigating risks

50. 50 Risk management before contract close The identification, assessment, and allocation of risk must be done having in mind that, because the PPP contract is a long-term contract: The private partner will be able to engage in strategic moves aiming at benefiting from changes and unforeseen events The private partner will be able to engage in strategic moves aiming at benefiting from changes and unforeseen events In preventing those moves, the public authority will be bounded by the need to provide high-quality public services In preventing those moves, the public authority will be bounded by the need to provide high-quality public services

51. 51 Risk management after contract close After contract close: The contract manager should identify risks through a careful analysis of the contract and the fundamentals of the PPP scheme The contract manager should identify risks through a careful analysis of the contract and the fundamentals of the PPP scheme But be aware that exogenous change and strategic moves by the private partner (or mismanagement by the public partner) may create additional risks But be aware that exogenous change and strategic moves by the private partner (or mismanagement by the public partner) may create additional risks

52. 52 Risk register (1) Each contract manager should have a risk register, listing all risks during the construction and operational phases It should be reviewed regularly, to include new risks and to reassess impacts and likelihood of occurrence The responsibility for managing each risk should be allocated to one specific institution or individual

53. 53 Risk register (2) The listing of risks should be exaustive, considering all possible potential threats to the project, regardless of being addressed in the contract or not Change (political, commercial, technological,...) and innovation will create new risks, so the listing itself should be reviewed regularly

54. 54 Risk identification Requires: Analytical skills Analytical skills Good acquaintance with the contract Good acquaintance with the contract Knowledge transfer between projects Knowledge transfer between projects Intensive game-theoretic reasoning Intensive game-theoretic reasoning

55. 55 Risk assessment Recourse to past evidence and to the advice of external technical experts Recourse to past evidence and to the advice of external technical experts Simplicity: you are not pricing the risk, you are just assessing its significance. Simplicity: you are not pricing the risk, you are just assessing its significance. So, impact may be measured using a critical / high / medium / low scale; and the likelihood of occurrence may be presented by probability intervals

56. 56 Risk monitoring For many risks, the probability of having them affect the public sector will depend: On preventive measures On preventive measures (that require strategic reasoning) On the reputation and perceived ability of the contract management On the reputation and perceived ability of the contract management (it will impact on the likelihood of private partner’s strategic moves)

57. 57 Risk management Do not try to “learn by doing” Do not try to “learn by doing” Risk management theory and practice has a long track record, with many “good practices” and “bad practices” already established; profit from them Risk management theory and practice has a long track record, with many “good practices” and “bad practices” already established; profit from them

58. 58 Non-naive approach But do not forget that PPP contracts, being long-term contracts, need an adequate non-naive approach: do not assume public administration is perfect and able to react quickly; do not assume public administration is perfect and able to react quickly; do not assume the private partner is a charitable institution working on behalf of the public do not assume the private partner is a charitable institution working on behalf of the public

59. 59 Final note PPPs present an opportunity for efficient provision of infrastructure Efficiency implies transferring risks to the private partner But, if risk is not properly managed, the public-service and long-term characteristics of PPPs allow the private partner to transfer back risks and so jeopardise efficiency

60. 60 Thank you Rui Sousa Monteiro Parpública SA Rua Laura Alves, 4, 8º, 1050-138 Lisboa, Portugal tel: (+351) 217 950 507, (+351) 969 845 042 fax: (+351) 217 817 170 e-mail: rui.monteiro@parpublica.pt