Traffic Risk in PPPs, Part III - Allocating Traffic Risk: Prophet & Loss

Photo: Munish Chandel | Flickr Creative Commons

This is the final blog in a three-part series on traffic risk in PPPs
 
As explained in the previous two blogs – Traffic Risk in Highway PPPs, Part I: Traffic Forecasting and Traffic Risk in PPPs, Part II: Bias in Traffic Forecasts – traffic risk is inevitable, given our imperfect ability to predict traffic and revenue a long way (often several decades) into the future. And what makes it harder is that there are often biases at play in the typical project environment, which can cause a skewness towards over-estimation rather under-estimation of traffic flows. This, of course, can then result in financial losses and distress for the project, as manifested in a number of high profile bankruptcies, renegotiations and bailouts in the toll road sector.

In the new PPIAF and GIF publication, Toll Road PPPs: Identifying, Mitigating and Managing Traffic Risk, we outline various ways in which governments, bidders and financiers can take important steps to reduce the amount of traffic risk in projects. But we also acknowledge that the use of, for example, industry-standard forecasting techniques, better due diligence and a more stable policy environment will only go so far in reducing traffic risk. The reality is that there will always be some risk in any project, regardless of the best endeavors taken by the project parties. So, the key question is, what should we do with traffic risk and who should be responsible for bearing that risk?

An almost ‘conceived wisdom’ seems to be emerging, particularly since the financial crisis and the resulting tighter credit conditions for infrastructure finance, that traffic risk is now something of an anathema to commercial financiers because compared to government, the private sector does not have the policy tools nor the financial capacity to effectively manage the risk. This, in turn, has led to a larger number of ‘government-pays’ models of PPP (such as availability payment structures) being promoted in place of traditional ‘real-toll’ concession type structures or other risk-sharing approaches.

However, whilst in many cases these have likely been the most optimal value for money decisions, we must still be cautious not to buy in too easily to the ‘conceived wisdom’ and we should avoid thinking through this issue in an overly-deterministic and binary way. By definition, risk is a distribution of potential outcomes and the range and probability of those outcomes differs for every single project. For example, a ‘brownfield’ project that involves widening an existing toll road with an established customer base is going to have a much narrower set of ‘probable’ outcomes than a ‘greenfield’ new-build project in an area where there has been no previous history of paying tolls. Likewise, we need to think about the underlying profitability of the project. If a project has high volumes and high revenues, then the ability of that project to absorb lower-than-forecast revenues is obviously going to be higher than a project with lower traffic and revenues, where there is little financial redundancy if traffic turns out lower.

So, in simple terms, it is important to acknowledge that each project has a different level of both risk and reward and it is how this risk/reward equation comes out that will help governments to make the key structuring decision  on how to allocate traffic risk. In the final PPIAF Issue Brief on traffic risk, Models for Allocating Traffic Risk, we delve more into this structuring challenge and we provide, an albeit simplified, framework (see below) for thinking about what structuring options are available to government based on the relative risk and reward of the project. Basically, we have applied the golden rule… if in doubt….use a 2x2 matrix to explain a complex issue!
 

Finally, you may ask why is all this important? Well there are three key reasons:

1. Making the right decision here is crucial to the long-term sustainability and success of the project.
2. Governments should know and understand if there is an opportunity to leverage private capital for their project in a way that reduces its direct financial liabilities by at least exploring whether models that achieve full ‘cost-recovery’ from user payments are viable. Depending on how a project is accounted nationally, this can free up much needed capital and revenue budget to spend on other government priorities (see the latest guide from EPEC on accounting treatment of PPPs in the EU).
3. We should not assume that all investors and financiers are homogenous – different investors have different yield expectations and some are interested in taking some (or all) of this risk if the reward is sufficient.

In summary – and to be clear, this is not the manifesto of a traffic risk denier – I actually firmly believe that many correct ‘structuring’ decisions have been made in recent years that have sheltered private financiers significantly from the risk, and that the proliferation of more ‘government-pay’ models has largely been appropriate. However, this does not mean that this becomes the default position. We should consider this risk on a project-by-project basis, exploring and exhausting ways for sharing and transferring this risk and not holding governments hostage to a single, homogenous approach.    

We hope you have found this blog series interesting and would love to hear your views and feedback on the full publication.
 

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Toll-Roads PPPs: Identifying, Mitigating and Managing Traffic Risk

Related Posts

Traffic Risk in Highway PPPs, Part I: Traffic Forecasting — It’s ok to be wrong, just try to be less wrong

Traffic Risk in PPPs, Part II: Bias in traffic forecasts—dealing with the darker side of PPPs