Chapter 4 RISK INVOLVED IN BOT MODEL ROAD PROJECTS 4.

1 Introduction:
In any construction project, risks are unavoidable. A risk is defined as any factor, event or influence that threatens the successful completion of a project in terms of time, cost or quality. Any project has a number of identifiable risks. Some are reasonably within the control of one or more of the parties to the project. Others may not be within any party's reasonable control, but may be insurable, at a cost. Still others may not be insurable. The conventional wisdom in project financing generally is that each risk should be assumed by the party within whose control the risk most lies. When making decisions regarding the choice of procurement approach as we move towards fully private, more risk is transferred to the private sector and vice versa. Every BOT project carries some risk. The challenge is to identify the risks, allocate risk to the party best able to handle it & reduce uncertainty/ risk to an acceptable level. This is called risk management.
Risk Identification

Risk Assessment

Risk Allocation

Risk Mitigation

Risk Review & Monitoring

Figure 4.1: Steps in Risk management

4.2 Risk Identification in BOT Infrastructure Projects:

In BOT Infrastructure projects project participants are exposed to various kinds of risks. As a nature it involves dealing with many parties, huge amount of money, and long period of time, therefore it is said to be very risky.

One main cause that leads to project failure is the inappropriate allocation of risks to the various parties in the project. Risk management starts by the identification of various types of risk that could be encountered in a project. In order to identify the risks it is essential to understand what each risk consists of and the reasons for project failure. Reasons for Project Failure are: Delay in completion, with consequential increase in the interest expense on construction financing and delay in the contemplated revenue flow. Capital cost overrun. Technical failure. Financial failure of the contractor Government interference. Uninsured casualty losses. Loss of competitive position in the market place. Financial insolvency of the host government.

4.3 Type of Risks:

BOT projects undergo significant change in their risk profile as they move from the High risk pre- completion to the low risk post- completion stage. While permitting risks and risks, associated with timely completion of the project dominate the pre- completion period, the primary risk in the post completion period pertains to the ability of the stretch to attract the necessary amount of traffic, and also for commuters to pay the requisite amount of tolls.

Pre-Construction Construction

Operation

Risk

Project development phase / Time Figure 4.2: Risk profile in various phases

In BOT project, Project Company is responsible for financing, development, and operation of project. In highway project, Project Company particularly has to face with some major risks. These risks include:

1. Pre-construction risk: Right-of-way acquisition, environmental compliances. 2. Construction: Design changes, unforeseen geological, delays, cost overruns. 3. Traffic and revenue: Low traffic demands, low toll rates. 4. Performance & operating risk: Failure to operate & maintain the project. 5. Inflation risk: Inflation based on WPI. 6. Currency: Exchange rate fluctuations, inconvertibility. 7. Political: Termination of project, breaches of concession agreement and high tax. 8. Force majeure: Floods, earthquakes and war. 4.3.1 Pre- Construction risk: It mainly includes delay in land acquisition & environmental compliances. The administrative departments concerned with the project should take the responsibility for obtaining the land acquisition & various clearances for the project. Shifting/ removal of utilities such as trees, telephone lines, sewage lines, etc., are another critical factor. There is a need for simplifying and streamlining administrative procedures and setting up single window clearances. Awareness for expeditious approvals by various state and local government bodies need to percolate to ground level as well. 4.3.2 Construction risk: There may be unexpected developments during the construction period which can involve time & cost over runs for the project or even shortfall in the achievement of the technical standards laid down for the given project. The reputation of project contractor consultant as well as the history of road construction in the state is important elements. Normally, the sponsor would sign a fixed price, firm date, turnkey construction contract with the contractor that includes: Completion & performance guarantees Liquidated damages for delays Bonus for early completion. The price of the turnkey project is, of course, increased by a risk factor to compensate the contractor for taking this risk. Construction risk is assumed secondarily by the project company, and indirectly by its equity investors, since their equity will be eroded to the degree that costs are increased due to delays or cost overruns which are not covered by damages from the contractors.

4.3.3 Traffic & revenue risk: In respect to toll roads, the project concessionaire has to deal with individual users and the traffic volume risks are expected to be borne by him. Risks associated with toll roads are primarily dependent on the following factors: The economic utility of the stretch: Projects, which serve a captive demand, for instance stretches, which connect to ports or city bypasses, which relieve congestion levels carry relatively lower levels of traffic risks. The availability of alternate freeways and other competing modes of transport, to which traffic diversion could take place. The composition of traffic along the stretch. Sensitivity of various user segments towards payment of tolls.

Toll road projects are very sensitive to Traffic demand risk. In order to attract private company to invest, government may assume the risk to some degree by providing supports to project company. 4.3.4 Performance & operating risk: Operating risk is the risk that the project will not conform to the required performance parameters over the period of the concession agreement. Typically, the performance parameters specified in the concession agreement are driving quality of the carriage way, safety standards, adherence to maintenance schedule, and availability standards as mentioned in the concession agreement. Non-compliance with the performance parameters can be an event of default and may impinge on the developers ability to collect tolls. The risk that the project will not perform as expected will be covered by warranties from the consortium of construction contractors and equipment suppliers and by performance guarantees in an operating and maintenance contract. In each case, these risks are substantially within the control of the parties assuming them. 4.3.5 Inflation risk: For the risk that arises out of inflation both equity investors & lenders will normally insist to government on some mechanism to protect themselves against inflation risk. This protection may be provided by price escalation clauses in the off-take agreement or by provisions in the concession agreement allowing the project company to increase tolls. For example toll road projects. Such price escalation clauses would attempt to take account of increased costs of the project due to inflation.

4.3.6 Currency risk: There are two types of Currency risks; one is the Convertibility; i.e. the assurance that revenues generated in domestic currency can be converted into Foreign Exchange for making payments abroad or for the transfer of profits in case of foreign investments. The government would need to provide guarantee for such convertibility. The other risk is the Variation in the exchange rate. The government must provide guarantees against such risk. 4.3.7 Political risk: Political risk is sometimes the most significant risk faced by foreign investors and lenders in developing countries because of the likelihood sudden political change. Such changes can jeopardize projects at a critical stage. Political risk is associated mostly with public sector projects. It includes the possibility that governments will not allow repatriation of funds, as well as regulatory or legislative changes that occur during project construction. Usually, political risks are difficult to control. Many developers involved in public sector transportation projects require the government to provide strong backing and expectations of high traffic flow. Providing tax-exempt financing is a commitment that the government can make to help mitigate this risk in domestic projects. Organizations like the Overseas Private Investment Corporation (OPIC) provide expropriation insurance to alleviate foreign political risk. Other organizations also provide insurance against political risk such as the MIGA (World Bank). 4.3.8 Force majeure: Force majeure risks represents the losses which are beyond control of the parties to the project arising from the events such as fire, flood, earthquake, war, riot & strikes, etc. some of the risks can be mitigated by covering them through insurance. For the rest they have to deal with as expected. The concession agreement should provide for extension of the concession of the concession period for such a situation or even termination if the circumstances so dictate.

4.4 Allocation of Risks:

From these eight types of risks, major groups that can generate enormous impact to project success are Traffic and revenue, Currency, Inflation & Political risks. These are called Country risks. Therefore, government normally provides support to these types of risks. Support schemes are explicitly written in the concession agreement between government and Project Company. Risks other than country risks are called Project specific risks. These are to some extent are controllable by the project sponsors. Every BOT project carries some risk. These risk to be managed through proper appreciation of their impacts on various players and allocation to the parties who are best able to control them, i.e. deal with them at least cost.

Table 4.1: Country & Project risks

Project specific risks Risks other than country risks are called Project specific risks. These are to some extent are controllable by the project sponsors Construction Performance & operating risk

Country risks: Risks which are associated with the political, economic and legal environment of the host country and over which the project sponsors generally have little or no control. Government normally provides support to these types of risks. Pre-construction risk Traffic and revenue Politic Currency Inflation risk

Most of the risks that are present in BOT Road projects can be shared between Government & the project company. The challenge is to reduce the uncertainty to an acceptable level and allocate responsibility to the party best able to handle it.
Table 4.2 Risk allocation between various parties Risk Pre- construction Construction Traffic & Revenue Performance & Operating Inflation Currency Political Force Majeure Company Allocation Government

4.5 Risk Mitigation:

Risk response and mitigation is the action that is required to reduce or eliminate the potential impact of risk. There are two types of response to risk one is the immediate change or alteration to the project, which usually results in the elimination of the risk; the second is contingency plan that will only be implemented if risks identified should materialize.

Risk Identification

Seek for riskmitigating solutions

Appraise new or residual risks

Evaluate or price risks

Risk monitoring and control

Figure 4.3: Risk management process

Risk management process The options for responding to risk are risk avoidance, risk reduction, risk transfer, insurance, risk retention, each should be assessed as one or more will apply in every circumstance. 4.5.1 Risk Avoidance: This method of mitigation involves the removal of the cause of the risk and therefore the risk itself. Ideally any approach involving avoidance is best implemented by the consideration and adoption of an alternative course of action. Other examples of risk avoidance include the use of exemption clauses in contracts, either to avoid certain risks or to avoid certain consequences flowing from the risks. Risk avoidance is most likely to take place where the level of risk is at a level where the project is potentially viable. 4.5.2 Risk Reduction: This method adopts an approach whereby potential exposure to risks and their impact is alleviated. Methods of risks reduction may require some initial investment which should then reduce the likelihood of the risk occurring. Risk reduction occurs where the level of risk is unacceptable and alternative action is available. Risk reduction exercises will always be worthwhile because they can lead to greater knowledge about the project and this reduced not only the potential impact of risks but also the level of uncertainty itself a major source of risk. However, risk reduction will result in an increase in the base cost (i.e. the estimate of all certain items) but should offer a significantly greater level of contingency required. It goes without saying that risk reduction should only be adopted where the resultant increase in costs is less than the potential loss that could be caused by the risk being mitigated.

4.5.3 Risk Retention Once all the avenues for response and mitigation have been explored a number of risks will remain. This does not imply that these risks can be ignored; indeed it is these risks which will in most instances undergo detailed quantitative analysis in order to assess and calculate the overall contingency levels required. The aim of the previous responses is to reduce project uncertainty and in doing so increase the base estimate to reflect the more certain nature of the project. However, it does not imply that these retained risks can simply be ignored. Indeed, they should be subject to effective monitoring, control and management to ensure that they are within the contingency allowances set. It should be noted that this contingency should be made up of residual risks which are assessed to be of a low likelihood and low potential impact. 4.5.4 Risk transfer: Risk transfer is the technique that plays a far greater role in infrastructure development projects and involves the complete or partial transfer of risks among the various parties involved in the implementation of the project. This is achieved through the web of documents that is formulated during the course of implementation of infrastructure projects. The documentation structure provides for the flow of risk transfers that are negotiated and agreed to in the course of development of an infrastructure project. For example, the construction risks would, typically, be transferred by the government to the private developer under the concession agreement. The private developer would then transfer all or most of the construction risks to the construction consortium under the construction contract. The construction consortium would distribute and transfer the risks among themselves or to various sub-contractors.

4.6 Risk Mitigation Techniques:

Various Risk Mitigations Techniques are available and can be divided into three categories which are as follows: 1. Contractual solution for Project Company 2. Government support 3. Insurance 4.6.1 Contractual Solution for Project Company: 4.6.1.1 Turnkey Construction contract: Completion, cost overrun and other risks typical of the construction phase are usually allocated to the construction contractor or contractors through a turnkey construction contract, whereby the contractor assumes full responsibility for the design and construction of the facility at a fixed price, within a specified completion date and according to particular performance specifications. The construction contractor is typically liable to pay liquidated damages or penalties for any late completion.

4.6.1.2 Performance Guarantee: In addition, the contractor is also usually required to provide a guarantee of performance, such as a bank guarantee or a surety bond. Separate equipment suppliers are also usually required to provide guarantees in respect of the performance of their equipment. Guarantees of performance provided by contractors and equipment suppliers are often complemented by similar guarantees provided by the concessionaire to the benefit of the contracting authority. 4.6.1.3 Operation and Maintenance Contract: Similarly, the project company typically mitigates its exposure to operation risks by entering into an operation and maintenance contract in which the operating company undertakes to achieve the required output and assumes the liability for the consequences of operational failures. 4.6.2 Government Support: To minimize the above risks in BOT projects government provides some supports to the project company. There are mainly eight categories of government financial support given to Project Company: 4.6.2.1 Equity guarantees: This kind of guarantee gives Project Company a right to sell the project to the government with a guaranteed minimum return on equity. 4.6.2.2 Debt guarantees: Under this guarantee, government provides a full guarantee or a cash-flow deficiency guarantee for repayment of debt. 4.6.2.3 Exchange rate guarantees: Fluctuation of currency can create significant impact on project which involved foreign capital. By the guarantee, government compensates the Project Company for increases in local cost of debt service due to exchange rate movements. 4.6.2.4 Grants and subordinated loans: Government can help in enhancing project economics by providing non-repaying grants or subordinated loan. Subordinated loan will be repaid to government after the senior loan. At such time, project would normally be in the relieved financial stage.

4.6.2.5 Shadow tolls: In this system, government, instead of users, pay a specific annual payment per vehicle corded on the road to Project Company. The shadow tolls can be made into several rates depending on demand volume. 4.6.2.6 Minimum traffic guarantee: Government will compensate to Project Company in cash if traffic falls below a specified minimum level. This is the common type of support in BOT project. In some case, besides the minimum guarantee, the contract may specify ceiling traffic level too. 4.6.2.7 Concession extensions: Government may give right to Project Company to extend the concession term if revenue falls below a specified level. This type of support give less financial exposure to government, but also give less efficiency in easing financial status of Project. 4.6.2.8 Revenue enhancements: Government normally enhances project revenue by limiting competition, facilitating demands, or allowing development of ancillary facilities. These eight types of government support have different features. Following figure shows impact in project financing and government financial exposure of each type of the supports and the government has benefit sharing from the excess volume too. 4.6.3 Insurance: Insurance is a form of risk management primarily used to hedge against the risk of contingent loss. It is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of a guaranteed small loss to prevent a large, possibly devastating loss. The term 'insurance' does not refer to the various warranties, liquidated damages, indemnities, etc. which may be offered by contractors, operators, host governments, or others. Rather, it means the contractual undertakings by third-party insurers to indemnify project participants for certain types of risk. Although insurance cannot create the blanket protection from risk that many project developers seem to feel it should, it is an essential part of any BOT project. Some type of insurances used in BOT projects are: 1. Political risk insurance 2. Force majeure risk insurance

4.6.3.1 Political Risk Insurance: Multinational enterprises and banks face a number of risks when conducting business overseas. Some of these risks can be removed or mitigated by conducting due diligence on the parties involved and on the economic viability of the proposed business. Other risks are harder for investors or lenders to predict. These include some commercial risks and, noncommercial- or political - risks. Political Risk Insurance (PRI) is a tool for businesses to mitigate and manage risks arising from the adverse actions - or inactions - of governments. As a risk mitigation tool, PRI helps provide a more stable environment for investments into developing countries, and to unlock better access to finance. Political risk insurance is generally provided by various multilateral agencies such as MIGA (Multilateral Investment Guarantee Agency) & OPIC (Overseas private Investment Corporation). 1. MIGA (Multilateral Investment Guarantee Agency): The Multilateral Investment Guarantee Agency (MIGA) is a member of the World Bank Group. Its purpose is to promote foreign direct investment by providing political risk insurance (guarantees) to investors and lenders, and by helping emerging economies attract private investment. MIGA offers political risk insurance for projects in a broad range of sectors in 147 developing member countries, covering all regions of the world. Political risks covered under MIGA are: 1. Currency inconvertibility & transfer restriction. 2. Expropriation. 3. War and civil disturbance. 4. Breach of contract. Terms of coverage: MIGA prices to risk, and premium rates are decided on a per project basis. MIGA provides coverage for up to 15 years (and possibly 20 years if justified by the nature of the project). Amount of coverage: For equity investments, MIGA may guarantee up to 90 percent of the investment, plus up to an additional 450 percent of the investment contribution to cover earnings attributable to and retained in the investment. For loans and loan guaranties, the agency generally offers up to 95 percent of the principal (or higher as determined on a case-by-case basis), plus up to an additional 135 percent of the principal to cover interest that accrues over the term of the loan. For technical assistance contracts and other contractual agreements, MIGA may insure up to 90 percent of the total value of payments due under the insured agreement (up to 95 percent in exceptional circumstances).

2. OPIC (Overseas private investment corporation): The Overseas Private Investment Corporation (OPIC) is an agency of the United States Government established in 1971 that helps U.S. businesses invest overseas and promotes economic development in new and emerging markets. Through OPIC Political risk insurance is available only to U.S. investors, contractors, exporters and financial institutions involved in international transactions. Political risk insurance can cover currency inconvertibility, expropriation and political violence, and is available for investments in new ventures, expansions of existing enterprises, privatizations and acquisitions with positive developmental benefits. Political risks covered under OPIC are: 1. Currency Inconvertibility 2. Expropriation 3. Political Violence 4. Standalone Terrorism 4.6.3.2 Force Majeure Risk Insurance: Force majeure risks represents the losses which are beyond control of the parties to the project arising from the events such as fire, flood, earthquake, war, riot & strikes, e.t.c. some of the Force majeure risks can be mitigated by covering them through insurance. Some of the firms which provide insurance for Force majeure risks are: 1. New India Assurance 2. SERV (Swiss Export Risk Insurance)

4.7 Conclusion:
Road projects developed on BOT basis are exposed to various kinds of risks. As a nature it involves dealing with many parties, huge amount of money, and long period of time, therefore it is said to be very risky. This present Chapter elaborates the various risks involved, how these risks are allocated to various parties involved mainly in between concessionaire & how these risks are mitigated. Following Chapters contains the details of concession agreement & financial analysis of Road projects.