Specific risks in PPP large-scale infrastructure projects

Due to the limitation on the use of public funds, governments are moving towards the private sector to invest in large-scale transportation projects. Investment amounts in transportation system projects, such as mass transit, are large-scale and long-term so that the success or failure of the project will have a large impact on its stakeholders. According to Ng and Loosemore (2007), large transport projects are generally long-term investments that typically involve various stakeholders and risks throughout the project lifecycle. The existence of a particular risk may adversely affect the success of the project.

Risk identification and risk analysis in large-scale infrastructure projects have been studied in many journals, scholarly works, country case studies, and reports. Wibowo and Kochendorfer (2005) performed a risk analysis of Indonesian toll road projects using a Latin hypercube simulation technique. The study concluded that the private investor and lender were exposed to cash flow uncertainty resulting from lower traffic volume and a delay in toll price

adjustment. The study also found that some government support, such as a land acquisition process, can help mitigate land price risk and project completion risk.

Schaufelberger and Wipadapisut (2003) performed an analysis of 13 case studies on build operation transfer (BOT) projects, nine of which were transportation projects. The study found that political, financial, and market risks influenced the selection of a financial strategy. The result of the case study showed that to mitigate these risks, the project required strong government support and guarantees lent from strong financial institutions and flexible contract provisions, such as price escalation and a mechanism for foreign exchange and interest rate adjustment.

EL-Amm (2003) classified the risks of toll road projects into project risk, country risk, and market risk. Among the risk factors mentioned, project risk is a specific risk that is limited to the project itself. Project risk is found at all stages of the project life and impacts the

profitability of the project. The market risk of the project is the risk that is subjected to demand and price volatilities, and the country risk is the risk occurred from government action, including political risk, economic risk, exchange rate risk, sovereign risk, and transfer risk.

44 2.11 Risk analysis and measurement

The second step of risk management is risk analysis and assessment. Risk analysis is a technique used to evaluate the project in terms of cash flow and the expected return on investment, with an assessment of the risks and uncertainties that threaten the project (El- Amm, 2003). The traditional approaches for evaluating project success are the expected NPV, the IRR, the project payback period, and the B/C ratio. The expected NPV is the most

favourable method for evaluating a project because it can provide a fairly accurate assessment of the impact of risks on the investment project, taking into account the time value of money and the scale of investment. NPV is a method calculated to determine the present value of an investment by the discounted sum of net cash flow over the whole project life. The cash flow is discounted by the interest rate equal to the opportunity cost of capital, which is composed of the risk-free rate, the risk premium, and inflation (El-Amm, 2003). Though NPV is widely used for evaluating projects, the disadvantage of this method is the uncertainties of the cash flow prediction and the discount rate. One should be aware by the appraisers that the NPV can undervalue many projects (Lewis et al., 2004). There are other measures, such as the IRR, the real option, and simulation that can help overcome this weakness. Table 2.9 presents the risk assessment tool used for evaluating a project.

Risk analysis tools Criticize

The expected NPV - The discount rate is a critical component in the

calculation of the expected NPV. In theory, the discount rate represents the expected return that is required to compensate investors for their exposure to risk factors. In reality, different investors have different attitudes towards risk (e.g., risk aversion, risk seeking, and risk-neutral), and attitudes towards risk change over time. Therefore, the use of a constant discount rate throughout the project lifecycle does not adequately reflect risks. For example, the use of a constant discount rate throughout the project lifecycle may not be appropriate, as a project is normally subjected to higher risks in earlier years of operation and lower risks when it reaches a steady stage of operation.

45 Risk analysis tools Criticize

- The NPV approach can capture the risks by doing a sensitivity and scenario analysis of the critical variables. A sensitivity analysis indicates the effect on NPV by

changing one variable at a time whereas a scenario

analysis considers the alternative possible outcomes. These two methods have a limitation in that they capture risks on the cash flow basis rather than adjust risks by using the different discount rates.

The expected utility theory

The expected utility theory explains the project investment decision by the investors‘ attitude to risk. For example, risk-averse investors will require a higher project NPV for the risky project to compensate for their risk-taking. Many empirical studies have revealed that most people express risk-averse behaviour when making investment decisions, especially people with low income (ADB, 2002). The drawback of the expected utility theory is the difficulties of estimating utility functions and quantifying the risk. The decision tree analysis The decision tree analysisisa path representation of the

expected NPV. This method allows the project investors to factor in both the probability and the impact for each path of every decision under consideration. The major

shortcoming of the decision tree analysis is the same as the NPV method in that it applies a constant discount rate for the whole path of the decision tree.

The simulation method The simulation method is used to capture the uncertainty of the project cash flow. The Monte Carlo simulation method is one of the most widely used methods for project evaluation. It overcomes the traditional NPV by i)

providing various risk factors in the simulation, ii)

providing the probability function with repeated sampling, iii) simulating interrelation among variables, and iv) providing flexibility for simulating random events.

46 Risk analysis tools Criticize

There have been many criticisms of the simulation method from practitioners:

- It is too complicated and contains too many variables. - It relies on a probability distribution.

- It neglects managerial flexibility to embark on the investment decision.

Real option Real option analysis is a useful tool for evaluating a project by including managerial flexibility in the investment decision. Real option applies the theory of financial option to evaluate investment options of real physical asset (Dixit and Pindyck, 1994). Real option exceeds the limitation of traditional project valuation by providing flexibility embedded into the investment decision (El-Amm, 2003). Real option has been used for evaluating projects in a variety of contexts, such as infrastructure, power generation, energy, and others. The nature of the real option approach, including its

methodology, application, and limitation, will be treated in greater detail in the next chapter.

Table 2.9: The risk assessment tools

Sources: ADB (2002), Dixit and Pindyck (1994), El-Amm (2003)