RISK MANAGEMENT OF INFRASTRUCTURE PROJECTS

Although the magnitude and chance of risk may vary from one activity to the other, it is inherent in any economic activity. The amount of risk and its likelihood tends to be high in long-term investment projects due to such activities' extending into many years, increasing the uncertainty. In infrastructure projects financed through a PPP contract, the risk management framework must be devised such that the risk is effectively shared between the contracting parties: the public sector entity and the private partner. Failure to identify potential risk and effective allocation to the party that can best manage the risk can increase the chance of project termination, or it may lead to the project's costing the public sector more than what was initially anticipated.

Idiosyncratic risks to infrastructural development in developing countries

Risk can be systemic or nonsystematic. Systematic risk arises from changes in the overall political, social, and economic environment of a country. Such risks affect all economic activities in a given jurisdiction and hence are less amenable to diversification. The other types of risks are project-specific risks (i.e. idiosyncratic risks) that arise from the way the project is designed. This section focuses mainly on idiosyncratic risks emphasising the types of risks and their allocation among contracting parties.

The degree of risk exposure of infrastructure projects may vary depending on, among others, the nature of the project, its term, and the way financing is structured. We present in the next section what has been identified by Global Infrastructure Hub (2016) as the most common risk categories that affect infrastructure projects. However, we admit that the list should by no means be considered exhaustive, and our aim is to enable readers to understand the main risk classes and the potential mitigating techniques needed to address them.

LAND PURCHASE AND SITE RISK Land purchase and site risk refer to the risk of acquiring title to the land to be used for a project, the selection of that site, and the geophysical conditions of that site. Such a risk can be mitigated when the public sector entity undertakes detailed ground, environmental, and social assessments and discloses such information to the private partner as part of the bidding process. Such an assessment should consider any easements and covenants that may encumber the land.

DESIGN RISK This is the risk that the project has not been designed adequately for the purpose required. Mistakes may be discovered in the design of public infrastructure that require subsequent modifications that entail added costs in time and money. Such risks are borne by the private partner, due to its responsibility for ensuring the adequacy of the design of the system and its compliance with the output or performance specification. The public sector agency may retain some design risk in certain aspects of the system or related works, depending on how prescriptive the public sector agency is in the output specification.

CONSTRUCTION RISK This includes risks associated with time delays, noncompliance with legal and performance-related standards, additional building costs, increments of supplies costs, technical defects, and negative external effects.

DEMAND RISK This risk arises from the usage of incorrect demand projections or the fluctuation of demand due to factors unrelated to their actions. Such factors can be variations in the economic cycle, changing market trends, new direct sources of competition, or obsolescence.

OPERATION PERFORMANCE RISKS These are associated with the performance of the service to be rendered. They can happen due to lack of performance of the operator or other causes. This is a breach of the contract that may imply penalties on the operator or deductions on revenues if the private party is paid on performance. Incurring any of them leads to a reduction of revenues that will affect the overall business.

COMPLETION RISK Completion risk refers to the risk of commissioning the asset on time and on budget and the consequence of missing either of those two criteria. The principal risks arising out of delay are the loss of expected revenue, the ongoing costs of financing construction, holding costs of other contractors, and extended site costs.

FORCE MAJEURE RISK Force majeure risk refers to the risk that unexpected events occur that are beyond the control of the parties and delay or prohibit performance. Typical events include war, armed conflict, terrorism, or acts of foreign enemies; nuclear or radioactive contamination; chemical or biological contamination; and the discovery of any species at risk, fossils, or historic or archaeological artefacts that require the project to be abandoned or delayed.

EXCHANGE RATE RISKS Exchange rate risks involve changes in the rate of exchange that decreases the value of the part of the investment made in foreign currency. Concessions regularly affect the capital provided by investors and, in some cases, debt acquired in international markets.

INSURANCE RISK Insurance risk refers to the risk that insurance for a particular risk is or becomes unavailable. This can happen when a risk event occurs so frequently that the insurance industry no longer desires to cover the risk.

INFLATION RISK This risk arises when the costs of the project increase more than expected.

FINANCING RISK This relates to risks associated to the funding arrangements of the project, including, but not limited to, arranging the necessary funding, refinancing, and interest rate fluctuations that endanger the repayment of the financial obligations.

POLITICAL AND REGULATORY RISK This is the risk of government intervention discrimination, the total or partial expropriation or nationalisation of the asset, or the termination of the contract, without justified cause and in exchange for insufficient compensation. In general, actions by government bodies or by public authorities that can negatively affect a project's viability or profitability or that can limit or prevent recovery of the invested capital or obtained benefits are classified as political or regulatory risks.

ENVIRONMENTAL RISK Environmental risk includes the risk of the existing latent environmental conditions affecting the project and the subsequent risk of damage to the environment or local communities. Laws and regulations can impose environmental liabilities and constraints on a project.

SOCIAL RISK The risk of local stakeholders opposing the project or instability of any kind can cause lower earnings or jeopardise the conditions under which the project was framed.

DISRUPTIVE TECHNOLOGY RISK This is the risk that a new, emerging technology unexpectedly displaces an established technology used in the sector.

Risk analysis and risk mitigation strategies

Risk identification is the first step in risk management, and risk analysis is conducted to understand the magnitude of loss and the chance that a risk event may occur. Risk events can be grouped into four categories: high probability and high magnitude; high probability and low magnitude; low probability and high magnitude; and low probability and low magnitude. A rational choice concerning economic activities that involve high probability and high magnitude risk is to abandon them, while activities with low probability and low magnitude risk events are managed through risk prevention techniques. For low probability and high magnitude risks, an appropriate insurance policy should be acquired. However, the insurance industry may not underwrite policies for all risks in this category, due to the low commercial value of such policies. This implies that contracting parties must put in place all the necessary preventive measures to ensure the risk does not occur or to minimise the loss should it occur.

Risk mitigation can be done at different stages of the contracting process. Essentially, most risk events can be addressed at a feasibility study stage by explicitly factoring them into the analysis. For instance, land purchase and site risk can be mitigated by conducting detailed ground, environmental, and social assessments and by disclosing such information to the private partner as part of the bidding process. Similarly, conducting the necessary due diligence to ascertain the environmental fitness of the site and disclosing all known environmental issues to the private partner can address environmental risk.

Additional measures can be embedded into the overall contract management process. This is the case particularly for completion risks that arise due to the private partner's failing to deliver on time. To minimise such a risk, the public sector entity must implement a multistaged completion process to ensure that the private partner begins receiving payment for its design and construction services once significant components of the project have been substantially completed. This can help increase cashflow during construction, reduce the private partner's financing costs, and incen- tivise the phasing of construction works to ensure critical components are completed on time. Moreover, financial penalties and liquidated damages can help enforce construction deadlines. For force majeure events, project insurance is be a key mitigating tool for physical damages and loss of revenue.

While the risk-mitigating tools presented earlier are necessary for ensuring the project will be completed according to the initial schedule without substantial additional cost, financiers of infrastructure projects may require additional measures in the form of credit guarantee and insurance. These measures can help mobilise commercial debt and private equity when governments or local infrastructure entities lack the creditworthiness or track record to attract finance on their own. The risk mitigation instruments are important in mobilising private capital to supplement limited public resources. They allow official agencies to leverage their financial resources and facilitate the development of commercial and sustainable financing mechanisms for infrastructure development. A credit guarantee transfers the risk of default to third parties, including official agencies (multilateral or bilateral) or private institutions. Insurance contracts ensure payments to the holder once the claims have been evaluated and liability established by the insurance company. Credit guarantees and insurance are crucial in increasing the bankability of infrastructure contracts.

CONCLUSION

Infrastructure plays a vital role in economic development through various channels. Primarily, infrastructure services such as electricity, water, telecommunications, and transport are critical inputs in the production process, and hence, the lack thereof constrains output. Also, infrastructure services contribute to national output by increasing the productivity of factors of production. Infrastructure is also important in ensuring inclusive growth - people without access to basic infrastructure services are likely to be excluded from social and economic activities. That is why building resilient infrastructure is part of the SDGs, and other SDGs, such as reducing inequality, ensuring access to water and sanitation for all, and ensuring access to affordable, reliable, and sustainable energy for all, are unlikely to be met in the absence of adequate infrastructure.

Poor infrastructure and lack of access to basic infrastructure services are typical characteristics of many African economies. Africa faces the twin challenges of a massive infrastructure gap and a financing gap. Access to infrastructure in the continent is one of the lowest in the world, and most of the investment in infrastructure is financed by the public sector. However, the weak financial capacity of the public sector means the infrastructure gap is bound to persist unless alternative financing techniques are used. Alternative financing techniques such as sovereign bonds, local currency bonds, commodity-backed bonds, securitising remittances, diaspora bonds, private equity funds, reserves in excess-saving countries, sovereign wealth funds, and PPP are proposed to help economies narrow infrastructure financing gaps.

Although most infrastructure services exhibit characteristics of a public good, their provision can involve private sector entities. Partnerships between private sector investors and public sector entities can be forged to tap into the financial capabilities and technical expertise of the private sector. Governments must, therefore, design various incentive packages to entice private sector entities to participate in infrastructure projects.

Incentives can include, among others, a tax holiday, provision of loan guarantee, and assurances as to the availability of hard currency. The incentive packages should be designed such that they are suitable to attract targeted private sector firms while keeping their impact on government finances to the minimum.

The effective participation of the private sector in infrastructure projects also hinges on the existence of legal and institutional frameworks. A strong legal and institutional framework is crucial in attracting private sector partners and also in getting value for money from the partnership. The participation of private sector partners is driven mainly by a profit maximisation motive, and as a result, the decision to participate is determined by their perception of a risk, in which a legal and institutional framework plays a significant role. Conducive legal and institutional frameworks increase investor confidence and hence reduce their perception of a risk.

Lack of a risk management capability in the public sector can render promising PPP projects worthless. Idiosyncratic infrastructure project risks, such as land purchase risk, design risk, construction risk, operational performance risk, demand risk, and force majeure risk, must be identified, and proper risk allocation must be done before commissioning the project.

Questions

  • 1 Discuss the economic and social infrastructure challenges in Africa.
  • 2 Beside transportation, oil, gas, power, and water sectors, discuss five other sectors where infrastructure is need to spur economic development in Africa.
  • 3 Explain why a legal and institutional framework is needed to successfully implement infrastructure

projects using public-private partnerships (PPPs).

  • 4 Discuss the pros and cons of locating the PPP unit at the highest level of government.
  • 5 Identify five of the most important risks in infrastructure projects and discuss the possible mitigating techniques for each.

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