Paying the proper price to manage risk

Citation

(2001), "Paying the proper price to manage risk", Balance Sheet, Vol. 9 No. 4. https://doi.org/10.1108/bs.2001.26509daf.001

Paying the proper price to manage risk

The government will be judged during this Parliament by the improvement in the public services that it manages to achieve. It has indicated already that it expects the private sector to play a continuing, perhaps increasing, role in the provision of services formerly considered the province of the public sector. This means, among other things, extending the use of the Private Finance Initiative (PFI) and Public Private Partnerships (PPPs).

The essence of these structures is that the private sector provides capital and services previously supplied by the public sector. An important corollary is that the private sector takes on new risks. The difficult problem is to decide how much the private sector should be paid for assuming those risks. It is an issue because some of the risks are new to the private sector, and hence difficult to price. This is compounded by the fact that the public sector has little experience of managing risk. Indeed in some cases officials are not even aware that there is a risk. Under these circumstances there is, not surprisingly, great reluctance to pay the proper price for managing risk.

This point can be illustrated using one of the standard PFI examples: instead of tendering to build a bridge for a fixed cash sum, the private sector is invited to accept payment in toll revenues' which depend on future traffic flows. The successful bidder becomes an equity stakeholder in the bridge project, rather than a supplier. The bridge becomes an asset on the company's accounts (valued at the cost of building it) matched by a liability, which is the debt or equity finance used to meet that cost. The bridge thus becomes a balance-sheet item, with a significant risk attached to it. Finance Directors contemplating PFI deals often ask "How much risk can I afford to take on my balance-sheet?"

In fact risk doesn't really reside on the balance-sheet. The real risk is that the cash flows generated by the PFI deal turn negative (or at least insufficient to cover the appropriate cost of capital). The only way to assess whether a company can afford to take on a PFI contract, and/or the price at which it should do so, is with careful modelling of future cash flows. In the end all risks hit the cash flow. With every PFI contract there corresponds a stream of expected future cash flows. When it enters into the contract, the firm assumes the risk that the cash flows turn out less favourably than expected.

The risk the company runs in the toll bridge deal described above can be illustrated as follows. Suppose the company found the money to pay for the construction of the bridge by taking on new debt. The company has to pay interest on that debt, which should, if the project was properly scoped, be more than matched by the income from the toll revenues. But if too few use the bridge, the toll revenues may not match the interest payments, and the project will make a loss. If the costs and revenues of the project form a large part of the P&L, the company itself will be loss-making. At best, if toll revenues are likely to increase in future, the company will face a liquidity crisis. At worst, if there is no such prospect, there is a genuine risk of insolvency.

The whole point of the PFI, according to the Treasury mantra, is that the risk should be assumed by the party best placed to manage it. A real problem is that some of the risks that are made explicit by PFI are risks that nobody has much experience of managing.

In the simple toll bridge example there are two sorts of risk involved: the cost of building, maintaining and operating the bridge is difficult to estimate precisely, and so is the amount of traffic that will use it. A typical construction firm that might tender for the PFI contract to build the bridge has plenty of experience in managing construction, but less in managing whole-life maintenance and traffic. Arguably that risk should rest with the government, which has plenty of experience of commissioning bridges. It carries out the surveys and is probably best placed to forecast traffic.

However, making forecasts is not the same as managing risk. The private sector is inherently better placed to manage risk, because it is used to dealing with a set of incentives which develop those skills. Private companies take risks because they seek a reward. If their judgement is wrong they make a loss. The process of natural selection eliminates companies that don't learn from their mistakes. Only good risk managers survive.

These brutal forces don't exist in the public sector. If a private firm builds a hotel in the wrong place and attracts too few guests as a result, the loss shows up in the accounts. Questions are asked by the shareholders, and heads roll. If a bridge is built which turns out to carry less traffic than expected, the waste of capital is just as monstrous in real terms, but there is no accounting mechanism to reveal it. People complain about queues to get on to bridges, congested roads and crowded hospitals, but under-utilised roads, bridges and hospitals are much loved by those who use them. So there is no financial pressure to get these decisions right and no political pressure either.

The upshot is that, when PFI is extended into a new area, the private sector is understandably nervous of the unknown risks, and builds in a sensible margin to protect itself. This gives ammunition to those hostile to the PFI, who conclude that the public sector provides much better value for money.

But the conclusion does not follow. The fact is that a bridge or hospital built in the wrong place represents exceptionally poor value for the taxpayer. Asking the private sector to assume the risk that it might be in the wrong place gives private companies a strong incentive to assess the risks involved in this sort of contract. If there is a high risk of failure, it is inevitable that in some cases this will be reflected in a high price, which sends a signal that perhaps the bridge should not be built.

If officials decide, as a result of this high price, not to award the contract and shelve the project, then consider who wins and who loses. The company clearly loses, because it has put resources into scoping the risk and preparing its bid and has nothing to show for its efforts. But the public wins if the right decision has been taken – e.g. the taxpayer is saved the cost of an uneconomic project. These facts must be borne in mind when looking at the case where the tender is accepted despite the high price. If there is a high profit margin, it is not a rip-off. It is a due reward for scoping and managing the risk involved, and a necessary payment for participating in all those unsuccessful tenders, which also save the public money.

Bill Robinson is head UK business economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former special adviser to the Chancellor of the Exchequer.