Common Approaches To Unbundling Risks

The general principles for risk mitigation are well known. The various risks projects generate should be unbundled and assigned to market participants who are able to manage them- at least the cost (using financial engineering techniques and products).

Of course, there is cost associated with the process of transferring risks, which is included in the final price/tariff charged by the sponsors. If risks have been efficiently assigned to those best able to manage them, the cost of risk management is minimised and the price/tariff is a minimum-cost tariff.

Some of these risks identified below are common in most investment projects. Many are particularly important in infrastructure projects.

Construction Risk.
Construction risk refers to unexpected developments during the construction period that lead to time and cost overruns or shortfalls in performance parameters of the completed project. High capital intensity and a relatively long construction period makes project costs especially vulnerable to delays and cost overruns. As a result, construction risk is generally higher in sectors such as power and roads and lower in sectors such as telecommunications and urban services.

Construction risk can be reduced through a variety of instruments. The reputation and experience of the sponsors and the engineering, procurement, and construction contractor is an important element in assessing construction risk. Project sponsors can shift a portion of the construction risk to the contractor through engineering, procurement, and construction contracts that provide for turnkey responsibility, with penalties for delays and shortfalls in performance parameters of the plant on completion.

Such performance adds to the cost of the project. While construction risk can be shifted to some extent, it cannot be eliminated entirely, since penalties for non-performance are typically capped at certain levels and the residual risk has to be borne by investors.

Operating Risk.
The technical performance of the project during its operational phase can fall below the levels projected by investors for a number of reasons. Operating risk is usually low for infrastructure projects that rely on a tested technology, as is the case with most power plants and roads. It is higher in sectors in which the technology is untried or is changing rapidly, such as telecommunications.

Operating risks are typically mitigated by entrusting operation to experienced operations and maintenance contractors. Contractual arrangements with such contractors can include some provisions for liquidated damages. Many risks during the operational phase, including certain force majeure risks, are commercially insurable, and private investors will typically insure against such risks.

Market Risk.
Market risks relate to the possibility that market conditions assumed in determining the viability of the project are not realised. Non fulfilment of demand projections is an obvious example of market risk. In certain situations, investors expect the monopoly purchaser to guarantee a minimum level of purchase thus eliminating market risk for the investor. This is typically the case when an independent power producer sells power to a monopoly distributor or a water supply project sells water in bulk to a monopoly urban water distributing company.

Interest Rate Risk.
Interest rate risks arise because interest rates can vary during the life of the project. They are particularly important in infrastructure projects because of the high capital intensity and long payback periods. High capital intensity implies that interest costs represent a large part of total costs; long payback periods mean that financing must be available over a long period, during which interest rates may change.

One way of handling interest rate risk is to pass it on to consumers, for example in arrangements in which the impacts of interest rate variations on unit costs are treated as a pass-through into the tariff. In the cost-based tariff formula used in many power projects, for example, interest costs are built into the tariff. Such an approach is neither necessary nor desirable, however, since any arrangement that automatically passes on these costs to consumers reduces incentives for cost minimisation.

Foreign Exchange Risk.
There are two types of foreign exchange risks. One relates to exchange convertibility, the assurance that revenues generated in domestic currency can be converted into foreign exchange for making payments abroad. This risk must be borne by the government through suitable convertibility guarantees. The other type of risk is exchange rate risk, the risk that exchange rate changes lead to large increases in the domestic currency costs of payments denominated in foreign currency. This risk is extremely important for infrastructure projects that rely heavily on foreign financing but that have tariffs fixed in domestic currency.

The absence of hedging instruments is not the only problem. The inherent uncertainty about exchange rate movements in developing countries is such that even if hedging instruments were to evolve, they would be very expensive. The only way to reduce foreign exchange risk in this situation is to limit the extent of external financing. This in turn depends on the existence of a healthy domestic capital market capable of providing sufficient domestic financing for infrastructure projects.

Payment Risk.
Investors in infrastructure also face the risk of not being paid for services delivered. The importance of this risk varies across sectors. It is not very important in projects in which the sponsor deals directly with a several consumers, as in the case of a telephone company, a toll road, or a port. It becomes very important in situations in which an independent power producer has to supply electric power to a monopoly buyer, such as a public sector distributor, or a water purifying company has to supply water to a municipal distributor. Because the financial condition of public sector utilities in developing countries is often very weak, investors are naturally concerned about the risk of non-payment for power or water delivered to the distributor when the producer has no alternative outlet for the product.

Regulatory Risk.
Regulatory risk arises because infrastructure projects have to interface with various regulatory authorities throughout the life of the project, making them especially vulnerable to regulatory action. Tariff formulae ensuring remunerative pricing at the start of the project can be negated by regulatory authorities on the grounds that the tariff was too high. In general, regulatory risk is best handled by establishing strong and independent regulatory authorities that operate with maximum transparency of procedures within a legal framework that provides investors with credible recourse against arbitrary action.

Political Risk.
Infrastructure projects have high visibility, and there is always a strong element of public interest. This makes them vulnerable to political action that can interrupt or upset settled commercial terms; in extreme cases it can even lead to cancellation of licenses or nationalisation. These risks can be partially mitigated through political risk insurance offered by multilateral organisations, such as the Multilateral Investment Guarantee Agency, or bilateral investment protection agreements.

The World Bank's new partial risk guarantee instrument, which covers debt service payments in case they are interrupted because of non performance of specific government obligations, is another instrument that can play a useful role in this context.

In conclusion, there are several risks associated with infrastructural development, especially in developing countries. Some of these risks can be managed by transferring them to market participants that can best handle them for a fee. This fee is normally added to the total cost of the project and therefore the price or tariff charged. Other risks can be dealt with by improving the strictures and institutions of the country.

The writer is an economic consultant and former Assistant Professor of Finance and Economics at Alabama State University, Montgomery, Alabama [email protected]