Distribution of Risks in an Infrastructure Project
Infrastructure projects tend to have a lot of financial risks. In many cases, the risks are poorly managed. In fact, incorrect risk management is one of the main reasons behind the delay, which can cause cost overruns in the long term. It is difficult to reduce the total risk that any infrastructure project faces. However, the distribution of risk needs to be done in such a manner that both parties have the incentive to stop expensive delays and cost overruns. Therefore, risk management in infrastructure financing is all about deciding which party can manage which risks better and then allocating the same to them.
Some examples of poor risk management have been mentioned below:
- In many cases, governments have started giving guarantees to the private sector. These guarantees provide a certain source of cash flow, which the private party can take recourse to in case of a cost overrun. The problem here is that such financing arrangements tend to make the private company overly complacent and even inefficient. These guarantees basically insulate the company from any losses which may arise as a result of their inefficiency. Hence, they do not have the incentives to achieve a higher level of efficiency. Also, research has shown that genuine private parties do not look upon the government to insure their risks. Hence, it doesn’t really add value to efficient contractors. Instead, such policies make infrastructure projects a breeding ground for corrupt and politically connected contractors.
- In many cases, governments follow the exact opposite of the policy, which has been mentioned above. This means that they tend to transfer all the risks excessively to the private party. The problem here is that the private party is stuck with all the risks, many of which may not even be insurable. Prima facie, this may seem to be a good deal for the government. However, the reality is that it is not! This is because the private contractors end up charging a premium for taking up all the excessive risk. Hence, in the end, the government pays for it anyway!
It is, therefore, clear that giving too much or too little risk to the private sector is an inefficient way. Hence, risks need to be apportioned between the private party and the government. Some of the methods of doing so have been listed in the article.
Distribution of Risks
The best way to distribute risks is to ensure that the party also has a fair degree of control on the parameters which create risk.
- For instance, infrastructure projects involve a lot of political risks. It would be incorrect for the government to assume that the private party would be capable of managing such a risk. The government is the party that has maximum control over political factors. Therefore, if a project gets delayed as a result of political issues, it would be unfair to penalize the private party. This is because the private party has no control over the matter. They cannot expedite the project when there are political protests happening or when there are environmental clearances missing. Instead, the project charter should ideally force the government to offer higher compensation to the private party in the event of political risk.
- On the other hand, risks related to the execution of the project should be borne completely by the private party. This is because the private party should ideally have complete control over the cost and quality of the infrastructure which is being created. In many cases, the private party may claim that a delay by a third party supplier is causing the problem. However, in this case, also, the private party should be held responsible if it was given complete autonomy while selecting the third party suppliers. The bottom line is that if the private party has some degree of control over the factors which create risk, they will be able to obtain an insurance policy to protect themselves.
- There are many risks that are beyond the control of both the government as well as the private party. These risks include interest rate risks as well as exchange rate risks. Interest rates, as well as currency rates, are determined in the international market. Hence, the government cannot really influence these factors beyond a certain extent. Fortunately, there are financial instruments available which allow these risks to be hedged. Derivatives like options, futures, and swaps can be used to mitigate these risks and ensure that the cash flow remains unhindered.
- Lastly, since infrastructure projects go on for long periods of time, they may also face many force majeure events. Examples would include events such as floods, drought, cyclones, etc. It is important to account for such events while distributing risks amongst the stakeholders. In most cases, there are insurance companies that make good the loss is such events occur. However, if the loss is not covered by insurance, ideally the government should provide recourse. The government may itself charge a premium and act as an insurance company. However, the idea is to make sure that even acts of God should be managed in the risk management plan.
Hence, it would be fair to say that a private party is incapable of handling all the risks. Instead, the risks should be apportioned between parties that can handle them best i.e., private parties, government organizations, insurance companies as well as financial brokers.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Infrastructure Finance: An Introduction
- Infrastructure as an Asset Class
- Infrastructure Finance Projects: Major Sources of Funding
- Why Doesn’t the Private Sector Invest In Infrastructure Projects?
- The SPV Structure in Infrastructure Finance
- Financing Needs of Infrastructure Projects at Different Stages
- Different Types of Contracts for Infrastructure Projects
- Distribution of Risks in an Infrastructure Project
- Risks Faced By Infrastructure Projects in Emerging Markets
- Bank Loans vs. Bonds: Debt Financing In Infrastructure Projects
- Key Decisions to Be Taken During Infrastructure Bond Issuance
- Parties Involved in Infrastructure Debt Issuance
- External Credit Enhancement in Infrastructure Financing
- Revenue Bonds and the Cash Trap Mechanism
- Managing Revenue Risks in an Infrastructure Project
- Cost Overruns in Infrastructure Projects
- Causes for Cost Overruns in Infrastructure Projects
- Third-Party Risks in an Infrastructure Project
- Vendor Finance in Infrastructure Projects
- Securitization in Infrastructure Finance
- Leasing in Infrastructure Finance
- Strategic Use of Land in Infrastructure Financing
- Usage of Collateralized Debt Obligations (CDO) in Infrastructure Finance
- Infrastructure Investments in Renewable Energy
- Should the Government be an Equity Partner in Infrastructure Projects?
- Lifecycle of Public Private Partnership (PPP) Projects
- Payment Mechanisms in Public-Private Partnerships
- Adjustment Mechanisms in Publich-Private Partnership (PPP) Contracts
- Early Termination of a Public Private Partnership