Financial

Financial

Risk Management

The project company throughout the life of the concession contract, is responsible for the entire project. Because it is financed largely by debt, the project company needs to structure the economics of the concession such that the future revenues and costs are highly predictable, thus minimising risk.

Risk assessment and risk management are a fundamental aspect of Balfour Beatty Capital's activities.

Under UK PFI projects the public sector contracts through a Project Agreement with the private sector to build and then operate public infrastructure over a long period. Importantly, the Project Agreement also seeks to make the private sector supplier responsible for any risks associated with delivery of the different elements in a seamless way.

Thus it is as important to consider what risks are being adopted as it is to understand the scope of works being procured. In a typical PFI, the major risks borne by the private sector are:

  • Completing the initial construction works on time and on budget
    • .
  • Meeting the annual budget for operating costs, subject to increases only for RPI.
  • Providing a quality service in operations, with deductions possible from the annual fee in the event of falling below the expected threshold.
  • Maintaining the infrastructure in a fit state over the period of the contract and handing back the asset at the end of the contract with no maintenance or renewals backlog.
  • Meeting all regulations and legislation such as health and safety, environmental and employment, even if these change.

Under a typical PFI project structure the private sector partner will establish a Project Company which usually subcontracts the bulk of the required works and services to specialist construction and operating subcontractors who are used to managing the risks associated with that aspect of the overall project. The majority of risks adopted under the Project Agreement by the Project Company are therefore passed onto these subcontractors. The key risks retained by the Project Company are that of contract administration, integration of the works and the long term maintenance and renewals obligation.

This placing of risk, with the party that is best able to manage it, allows the Project Company to borrow a high proportion of its funding requirement (often in excess of 90%), which is secured only on the cash flows under the Project Agreement, with no recourse back to Balfour Beatty Capital. This provides a cost effective source of financing to the public sector in PFI contracts.

Risk Mitigation

Income Risk
Project Company income under PFI is, for the most part, based on either “Availability and Service Delivery” or by “Throughput”:

  • Availability and service delivery income is received on most types of projects nowadays and is a series of payments over the life of the concession (usually constant in real prices but inflated over time by RPI) based on the extent to which the asset is “available” for use in the manner intended (e.g. clean, dry, warm, decorated). Where Availability or service performance is less than contractually anticipated, a series of income deductions is applied according to contractual formulae. Generally, there is no demand risk in these projects.
  • Throughput based income is generally relevant in earlier roads and wastewater/sewage concessions. In these concessions, the project company is paid on the basis of a fixed price (inflated over time by RPI) per unit of Throughput (eg vehicles, litres of water). Although demand risk is present in these projects, it is generally correlated with economic factors unconnected with the willingness to pay by the user.

Risk mitigation for the project company lies primarily in ensuring that future projections are reasonable, either by correlating required availability of buildings with known performance or, in the case of Throughput based charges, by extensive economic forecasting and modelling. In addition, where loss of income could be attributed to the performance of a subcontractor (e.g. delay in completion or inadequate maintenance), appropriate contractual remedies are available to recover the shortfall in income from that subcontractor.

Construction Risk
Construction will be procured under a fixed price turnkey design and build contract, with such construction obligations as exist under the concession agreement passed down to the contractor under the construction contract. There will be liquidated damages for delay, based on the Project Company’s resultant loss of income.

Maintenance Risk
The maintenance and management of the project asset will often be subcontracted to a facilities manager or maintainer under a contract spanning a number of years; ranging from 5 to 7 years up to the full 25 or 30 year concession term. The subcontract will incorporate the obligations contained in the concession agreement relating to the performance of the asset once built and, in particular, will pass down any deductions from Project Company income incurred as a result of poor performance. Accommodation facilities management contracts tend to be fixed price (plus RPI) for a defined output. Road maintenance contracts can be a mixture of schedule of rates and fixed price sums for elements of the work.

Financing Risk
Many investors look to reduce or eliminate financing risk such that financing costs are fixed. This is achieved by a variety of financial risk management products such as fixed/floating rate and RPI swaps.