Risk and Opportunity in PPP-based Government Procurement - Case Study Example

Please just send me message if you need anything. Thanks! Enterprise Risk Management Risk and Opportunity in PPP-based Government Procurement Abstract Changes in government procurement strategies provided new opportunities and additional risks. Since PPP or Public-Private Partnership is commonly adopted, risk associated with capital raised by private partner, performance and delivery failure, non-compliance with agreed obligation, and others must be dealt with accordingly. Analysis of different PPP procurement contract suggests that misidentification and negligence of risk can result to a number of negative consequences. A sudden drop in property value, can depreciate the feasibility of a PPP project thus risks that were transferred earlier to private partners will return to government including financial losses from failed project. Risk associated with PPP-based government procurement therefore should be allocated and manage efficiently to ensure completion of contract and realisation of value-for-money initiatives. Table of Contents Contents Contents 3 1. Introduction Changes in government procurement strategies in many countries provided new opportunities as well as different kinds of risks . The emergence and adoption of PPP or Public-Private Partnership and PFI or Private Finance Initiatives for instance, not only changed the traditional procurement environment particularly in asset and capability acquisition but also introduced new kinds of risks, which are mostly associated with finance, and failures of private partners to deliver. This is because although PPP or PFI contract provides opportunity for complete integration , they also create interdependence between privately built and operated public infrastructure and the risks associated with capital raised by the contracted private organisation . In view of the constraints cited by World Bank for PPP projects as cited in , this type of arrangement, aside from higher project cost and risks associated with cost attached to private sector debt, include provisions allowing private firm to reject responsibility over risks that are beyond their control (ex. exchange rate risks). More importantly, since citizens will hold government responsible for any quality and performance issue, government has to manage risks associated with quality of facility and services even after project completion to ensure private partner compliance with agreed obligations. With emphasis on PPP, the following section discusses the concept of PPP, the risk and opportunity associated with government procurement using PPP, safeguarding PPP procurement with risk management and others, case studies of actual PPP implementation where risks and opportunities in government procurement transpired, and concluding statements summarising the most important points. 2. Risk and Opportunity in Procuring Goods and Services Risk is defined differently and depending on the discipline, its definition can be narrow or comprehensive. For instance, most organisations often define risk as something that can significantly affect their objectives but this is not inclusive. This is because according to ISO Guide 73, ISO 31000, IRM or Institute of Risk Management as cited in , it is not only an “effect of uncertainty on objectives” but factors associated with an event resulting to change in circumstances or deviation in expected outcome. Moreover, its effect can be positive when it offers opportunity or loss of uncertainty and negative when it is hazardous or pure risk that has the potential to undermine organisational objectives negatively . Opportunity as mentioned above materialised when a certain risk has positive effects or the expected outcome is beneficial to the risk-taker. According to , opportunity risk is associated with organisation’s deliberate act to exploit a certain area in order to realised its perceived benefits. For instance, an organisation may opt to take risk in launching a new product or initiate a cost-saving program, merge and acquire another company, and others. In government procurement, privatisation through contracting may result to a number of risks and opportunities. For instance, although allowing a private enterprise to build a public infrastructure is risky in terms of cost and quality, private firms often complete a project faster than government thus private partnership in terms of time saved is more of an opportunity than a risk . However, since private capital is at risk, government will need to wait until the private partner sees it economically feasible to start construction. In contrast, since private enterprises are mostly after quick recovery of their investment, construction may be rushed and completed of low quality . 3. Risk and Opportunities in Public Private-Partnership A PPP according to , is a “long-term contractual arrangement” where government and private partners will share the risks. For this reason, the most cited features of PPP include risk transfer, long-term contract, and partnership agreement. In PPP contract, which is usually 10 to 20 years, risk transfer is considered a key element and allocated to a party that can adequately manage it. Therefore, government often transfers risks in design, construction, and operation to its private partner because of not only for having expertise and skills but its capacity to finance the project. Moreover, since PPP include partnership agreement; both government and private partner will be working to satisfy their mutual interest and joint commitment as shown in the traditional PPP framework below. Figure 1- Traditional PPP Framework The main benefit of PPP to government is enhanced value-for-money as there is less likelihood of cost overrun and delay compared to traditional procurement method . However, the mechanism involved in PPP such as transfer of risks and incentives create risks on both side. For instance, government at risk when its private partner who is also affected by a certain event (i.e recession, exchange rate, etc) failed to perform in the manner expected . Moreover, although PPP can attract private investment, this investor will also borrow the money and take the financial risk. Therefore, the government’s private partner must generate substantial profit to repay debt and gain from the project, which is also subject to associated risks such as insufficient revenue from sale of property or services as demonstrated by case studies in Section 5. PPP can also prevent “white elephant” (an idiom for valuable but burdensome possession) projects because no private enterprise will take a non-feasible PPP project. However, this is not always true as feasibility of certain project for the private-sector is often focus on financial viability and seldom consider the overall economic impact of a certain project on society . Since risks are innate in PPP infrastructure projects , it is often advantageous for both government and private sector to safeguard a PPP project through efficient risks management, appropriate risk allocation, and adequate government support as discussed in the following section. 4. Safeguarding PPP Procurement with Efficient Risk Management, Appropriate Risk Allocation and Adequate Government Support Since infrastructure projects regardless of procurement method are risky , it is often necessary to manage the risk throughout the duration of the project. Both parties involved in PPP procurement can apply risk management. For instance, private sector can take advantage of ERM to deal with risk and opportunities that can significantly affect value creation by identifying potentially damaging events. These include risks associated with events that can damage company reputation, competitive level, failure to deliver customer requirements, social or cultural trends, impact of future technological innovation, political and regulatory change, and financial risk such as inflation, interest rate, foreign exchange and others . Appropriate risk allocation is also advantageous as PPP is mainly based on this concept. Moreover, the degree of risks in PPP differs from project to project and to the complexity of contract arrangements, thus likelihood of risk exposure is high. For instance, a private contractor entering a PPP contract must understand how the system interacts with time, economy, performance, and emerging events . Regardless of risk allocation, adequate support from government can make a difference in PPP procurement. For instance, done carefully and retaining certain level of risk transfer and incentives, government guarantee of private loans can improve private partner’s bankability and reduce the cost of its debt. Similarly, ensuring the financial equilibrium and support mechanism such as those associated with revenue streams, tariff variation, subsidy, output-based aid, performance and revenue shortfalls can benefit PPP projects in terms of long-term viability and in reducing investor risks . 5. Case Study Analysis of PPP Generated Risk and Opportunity in Government Procurement 5.1 Case 1- Dublin City Council Social-Housing Estate Regeneration Projects The study conducted by suggest that this PPP projects include 10 estates in Dublin, Ireland. These include the Fatima Mansions, St. Michael’s Estate, O’Devaney Gardens, and others. The initial findings reveal that primary reasons given by the Irish government on its decision to use PPP instead of traditional procurement is to address public infrastructure and service deficit more rapidly. The Irish government was also upset with traditional procurement’s slow delivery, inefficiencies, and cost overruns of previous public-sector projects. They also firmly believed that additional funding and project efficiency could be achieved through private-sector financing, expertise and skills. More importantly, they believed on the ability of PPP to provide value-for-money, speed of delivery, efficiency, and quality of service through risk transfer. This “risk transfer” was identified as one of the key benefit of PPP thus more preferable than traditional methods of delivery where funding is direct capital borrowing. Moreover, despite awareness the PPP procurement is an expensive source of funding over the long-term, the idea of risk transfer encouraged Dublin officials to assume mortgage-type PPP payment more preferable than waiting for full capital subvention from central government, borrow the money, or use budget surpluses. In fact, the transfer of the maximum risk such as responsibility, risk of running over budget, and others was considered key to success. Consequently, PPP was imposed despite some opposition from government department and local-authorities that some projects are better procured with traditional mechanism . The Fatima Mansions regeneration was a success because it indeed improved the conditions of residents, which according to government can be attributed to social regeneration services funded from PPP . However, this is not the case for other estates because reliance of PPP model on private property market resulted to delays and collapsed of flats requiring urgent regeneration. Consequently, a significant number of residents was disillusioned not only with their condition but the lengthening time-scale for regeneration. As conditions on the estate continue to deteriorate, residents became seriously violent and demonstrating different anti-social behaviour . Moreover, aside from the negative effects of de-tenanting (in preparation for demolition), residents of these estates were disheartened by the fact that they were not given similar opportunity to negotiate the content of PPP as those provided in Fatima Mansions. This community disempowerment resulted to residents agreeing to plans and less favourable offers from private developers who seems prioritising their requirements and interest in the projects. Moreover, the complex contract and negotiation process in PPP disadvantaged the communities who are unfamiliar and cannot negotiate effectively with professionals who are fully aware and in a position to maximise their own outcomes from the process . In the latter part of 2007 and in 2008, risks associated with PPP procurement transpired as property prices in Ireland dropped and lowering the estimated potential profit margins of developers from the sale private residential and commercial units. Consequently, private developers of the regeneration project considered their contracts awarded, signed during this period as very risky investment, and impossible to undertake . By analysis, this PPP –based government procurement in Dublin demonstrated a number of risks and opportunities. These include risks associated with the dependencies created by PPP between provision of critical social infrastructure (i.e housing) and the market, the risk taken by DCC or Dublin City Council with public assets, PPP deals that were based on private partners’ risks assessment of the potential value of the apartments, and the risk associated with market forces. More importantly, it revealed the danger of handing over the power and responsibility to the private sector and lack of provision in PPP that can safeguard the interest of residents and government. Clearly, the “transfer of risk” discussed earlier to justify Dublin Council’s used of PPP is market-dependent thus any changes in market circumstances is risk for the government. It did not materialise in practice despite agreement that DCC’s private partner will take the risk in exchange for additional €300 million from the sale of private apartments and commercial buildings (Hearne). In fact, DCC took the risk, incurred losses of about €5 million, and allowed its private partner to abandon the project in exchange for €1.5 million project withdrawal fee . As shown in the figure below, government procurement based on PPP in Ireland was never successful. Figure 2- PPP based projects in Ireland from 2005 to 2008 5.2 Case 2- Collapse of the East Coast Rail Franchise in the United Kingdom In the summary provided by , the 2009 collapse of the East Coast Rail was due to the failure of UK government to consider the risk associated with PPP. In the 2011 news article of BBC online, National Express, the government private-partner for operating the East Coast line was reported giving up its 2007 contract to operate and provide rail services. However, instead of absorbing all the financial risk amounting to 1.4 billion pounds, it only paid the government £120 million when the contract is terminated in 2009 or after two years of agreed 7 years franchise. Consequently, the UK government absorb the buyout cost and other financial burden and is now operating the rail line . The National Express in this case study gave up the partnership mainly because it cannot pay the government the agreed concession fee amounting to £1.4 billion. The actual revenues expected by private enterprise are lower than forecasted thus decided to abandon its obligation and transfer the risk back to UK government. During the renegotiation, National Express appeared to be confused as it assuming that government would guarantee any losses despite the PPP agreement . Further investigation of this PPP disaster suggests that the UK government played an important role in the failure of its private partners. For instance, in 2005, an American company GNER or Great North Eastern Railway won a 10-year PPP contract for the East Coast Mainline in exchange for £1.3 billion plus another £100 million for upgrading stations and rolling stock. However, GNER did not attract sufficient number of passengers due to high fares and cost-cutting measures affecting jobs and services and two years later, GNER was pulled out from the route as its parent firm experienced significant financial problem. In the same year, the East Coast franchise was awarded to National Express but similar to GNER, it had agreed to pay the UK government £1.4 billion plus £7.4 million in upgrading. A year later, National Express already lost £20 million thus asked the UK government for renegotiation of the PPP contract but the latter refused . Evidently, as discussed in Section 4, both GNER and National Express went to a partnership with UK government without realising the risk associated with operating a public transport and the effect of PPP risk transfer to private partner. They failed to manage the risk, establish appropriate risk allocation, and acquire guaranteed support from the UK government. By analysis, UK PPPs seldom succeed and as shown in Appendix A, PPP arrangement seems clouded and governed by assumptions that everything will go smoothly as evidenced by government’s excessive reliance on PPPs benefits and private partners unfounded and extravagant promises. 6. Conclusion PPP-based procurement has a number of advantage but risks associated with public-private partnership if not identified and manage can lead to serious consequences. As shown in Case Studies 1 and 2, the difficulty arise when a certain even occurs. In Dublin PPP procurement, the excessive power given to private enterprises and the drop in property value depreciated the feasibility of the project thus the risk return to government. Similarly, the failure of GNER and National Express to manage the risk associated with excessively costly franchise and unexpected turn of events led to losses and termination of their PPP contract. The government or the public partner on the other hand suffered the consequences and take all the risk that were transferred to its private partner at the signing of the PPP contract. It is somewhat evident that PPP-based government procurement entails opportunities that are matched by a number of uncontrollable risks. It is therefore best to safeguard PPP contract with efficient risk management, appropriate risk allocation, and guaranteed support from both sides. 7. References 8. Appendix A. List of failed PPP Projects in the UK Read More