Risk Management / Assessment

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Assignment:

The following information has been provided on a project opportunity. Your company has a standard risk assessment model (see the framework shown in tabular format below) and it wishes to use this so that a preliminary decision can be made on whether to increase the resource provided for the project and proceed with more detailed preparation. When there is no information provided on the given risk factor for the project, it is customary to assume the maximum risk. Complete the risk assessment and report your total risk score range (e.g., 130-155). Identify risk factors that can be mitigated to some extent by negotiating different terms and conditions with the client so as to bring down the overall risk score. Evaluate your new overall risk score range. (Hint: Use excel spread sheet to calculate the risk score and also state the assumptions under each risk factor for taking that risk score).

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Assignment: The following information has been provided on a project opportunity. Your company has a standard risk assessment model (see the framework shown in tabular format below) and it wishes to use this so that a preliminary decision can be made on whether to increase the resource provided for the project and proceed with more detailed preparation. When there is no information provided on the given risk factor for the project, it is customary to assume the maximum risk. Complete the risk assessment and report your total risk score range (e.g., 130-155). Identify risk factors that can be mitigated to some extent by negotiating different terms and conditions with the client so as to bring down the overall risk score. Evaluate your new overall risk score range. (Hint: Use excel spread sheet to calculate the risk score and also state the assumptions under each risk factor for taking that risk score). The project The project is a new 70 MW hydro-electric power station in Central Vietnam. The company has been asked to bid for the engineering, procurement and construction management of the mechanical and electrical engineering (M&E) works, with a contract value of approximately US$45 M. The project calls for the commissioning of two turbines, one to be completed in two years and t h e other following 3 to 6 months later. The owner has requested that a 100% financing proposal is required, i.e., the contractor will need to find a bank o r export credit agency or finance it in some other manner during construction. The bid will be fixed price. The form of contract will be the client's own conditions and the governing law of the contract will be the laws of Vietnam, al t ho ug h the contract language will be E n g l i s h and payment will b e in US dollars. Advance payments of 10% are available for both equipment and construction management although the follow-up payments are upon receipt of major equipment and on a monthly measure basis for construction management work. The contract documents call for the following: $500,000 bid bond, Performance security of 10% of contract price, recognition of the usual force-majeure situations, a defects liability period of 12 months from handover although it will be specifically 6000 hours use for the actual turbines. There are no retention clauses specified although liquidated damages for delay can be up to 10% of contract value and for performance can be up to 2.5% of turbine cost. The company would like to work with a consortium which is led by a large Japanese company. The Japanese are known to the company but they have no previous experience of working together. Case Study Public–Private Partnership Risk Factors in Emerging Countries: BOOT Illustrative Case Study Downloaded from ascelibrary.org by East Carolina University on 11/12/14. Copyright ASCE. For personal use only; all rights reserved. Karim S. Rebeiz, Ph.D., M.ASCE1 Abstract: A public–private partnership (PPP) is an agreement between a host government and a private entity in which the private sector supplies infrastructure assets and services that are traditionally provided by the government. The popularity of PPP projects has been steadily on the rise over the past few years. This upward trend is in large part driven by governmental fiscal austerity, particularly in the aftermath of a prolonged global economic recession. The perceived attractiveness of PPP projects is particularly acute in emerging countries because of population growth and increased urbanization. PPP projects are usually highly complex in nature. They require large capital expenditure, they have long durations, and they usually utilize sophisticated technology. For a construction firm willing to expand its services internationally, a PPP project represents a unique opportunity to leverage its core competency and achieve competitive advantage in both domestic and foreign markets. Risk, however, increases with foreign penetration because of unfamiliarity with the geography, the supply chain, the local codes, and the business practices. Using an illustrative case study of a build-own-operate-transfer (BOOT) thermal power plant project, this paper addresses the salient risk factors facing the construction firm undertaking a PPP in an emerging country. DOI: 10.1061/(ASCE)ME.1943-5479 .0000079. © 2012 American Society of Civil Engineers. CE Database subject headings: Partnerships; Private sector; Build/Operate/Transfer; Infrastructure; Risk management; Power plants; International factors; Developing countries; Case studies. Author keywords: Public–private partnership; Build-own-operate-transfer (BOOT); Infrastructure; Risk; Power plant; Emerging market; International construction. Introduction During the past decade, the financial market has endured prolonged periods of recession (Reinhart and Rogoff 2009). The repercussions of the recession have reverberated worldwide because of the globalization of businesses and the integration of financial markets. The emerging countries have experienced decreased gross domestic product (GDP) growth as a result of the deteriorated economic situation (Griffith-Jones and Ocampo 2009). A widely used strategy to reinvigorate the economy and boost aggregate demand is to invest in core infrastructure projects that include thermal power plants, toll roads, airports, waste water treatment plants, pipelines, and mines (Elwell 2010). The development of the infrastructure has been given more importance in emerging counties because of population growth and increased urbanization of the society (Iimi 2005). In addition, a well-functioning infrastructure has a positive effect on public safety and the quality of life. It also promotes the efficient and cost-effective flow of resources within and across geographical borders (Munnell 1992; Aschauer 1989a). In effect, economic research has shown that infrastructure development contributes to the productivity and economic expansion of the private sector, even after accounting for a possible crowding-out effect (Aschauer 1989b). In other words, the public investment would eventually generate a higher return of investment for the private sector. Another stream of research has indicated that public 1 Associate Professor, American Univ. of Beirut, Suliman S. Olayan School of Business, Beirut, Lebanon. E-mail: kr03@aub.edu.lb Note. This manuscript was submitted on April 4, 2011; approved on June 27, 2011; published online on June 29, 2011. Discussion period open until March 1, 2013; separate discussions must be submitted for individual papers. This paper is part of the Journal of Management in Engineering, Vol. 28, No. 4, October 1, 2012. © ASCE, ISSN 0742-597X/2012/4-421428/$25.00. investments would reduce the cost of production in the manufacturing industry (Nadiri and Mamuneas 1994; Morrison and Schwartz 1996; Moreno et al. 2002). Historically, the financing of energy infrastructure projects (primarily power generation plants and energy transmission systems) has been the sole responsibility of the government. The government secures financing either directly from fiscal budgets or by issuing revenue bonds. The government then bids the project, supervises the construction activities, operates the project, and collects the cash flow resulting from the operational activities through revenues and/or taxes. One part of the cash flow is used to reimburse the debt (such as coupon payments), whereas the remaining fund is used to balance the budget. The government retains control and ownership of the project from its inception to its completion. The government financing scheme is illustrated in Fig. 1. In the aftermath of a global recession, many government agencies in emerging countries may lack the resources and expertise to undertake development projects requiring significant capital outlay. An astute solution for infrastructure development projects is for the government to form a partnership with the private sector. Such an initiative is referred to as public–private partnership (PPP). There are different forms of PPP depending on the extent of private involvement in public projects. The private-sector participation in public projects varies in a continuum from limited control to full control of the assets and services. The various PPP models for infrastructure projects are shown in Fig. 2: • Procurement agreement: The government outsources procurement activities to the private sector. However, the overall management control of the infrastructure remains under the jurisdiction of the government. • Management agreement: This arrangement is similar to the previously discussed procurement arrangement. The difference is JOURNAL OF MANAGEMENT IN ENGINEERING © ASCE / OCTOBER 2012 / 421 J. Manage. Eng. 2012.28:421-428. The capital expenditures for PPP energy projects in India, Russian Federation, Brazil, and China are available in the Global Market Information Database (GMID) from the Euromonitor Database. The four aforementioned countries have been at the forefront of promoting PPP energy projects. In particular, India and the Russian Federation are emerging as leaders of PPP energy projects in terms of absolute expenditure and growth. Downloaded from ascelibrary.org by East Carolina University on 11/12/14. Copyright ASCE. For personal use only; all rights reserved. Nature of BOOT Construction Projects Fig. 1. Traditional government financing scheme of public infrastructure projects Fig. 2. PPP models for public infrastructure projects that the government relinquishes some aspect of control and operation of the asset to the private sector. • Lease agreement: The private sponsor leases or rents the infrastructure from the government for a specified time period. The private sector has the right to cash flow, resulting from the operation of the infrastructure. • Concession agreement: The government gives the private sector the right to finance, build, and operate an infrastructure project. The private sector has the right to cash flow for operating the infrastructure over the concession period. At the expiration of the concession period, the private sponsor transfers the control and assets’ ownership back to the government. At that point, the government could either decide to operate the plant itself or put the operation up for another round of bidding. Popular forms of concession agreements include build-own-operate-transfer (BOOT) and build-lease-transfer (BLT). • Divesture: The government fully transfers the ownership and control of the assets to the private sector. A build-own-operate (BOO) falls under this category as it permits the private sponsor to retain ownership of the project indefinitely with no obligations to return it to the government. A construction project could be viewed as a temporary and dynamic network made of many independent groups, including multiple layers of consultants, contractors, and suppliers. The work is initiated by the owner/promoter who develops the project scope, defines the project parameters, and devises a plan to secure key resources. The work is then allocated through contractual agreements to the key production players who, in turn, subcontract parts of the work to other parties. The contractual agreements delimitate the rights and obligations for performance of the various parties to the project. The network eventually disintegrates and ceases to exist at the completion of the construction project. The product development process in construction is typically characterized by fragmentation of resources and discontinuation of expertise. The output of a typical construction endeavor is a unique project, using a customized design and produced in situ under highly variable and uncontrollable environmental conditions (such as uncooperative weather). As a way of comparison, the output in a manufacturing environment is often in the form of mass or continuous production of a large number of similar products (i.e., standardized products). The production is performed under steady state and under controlled conditions. As such, the risk factors in construction are often higher than in other production environments. As noted in some studies, the key success factors in construction greatly depend on the ability to proactively and efficiently manage the risk factors (Chapman and Ward 2004; Loosemore and Teo 2000). Specifically, the initiation process of a BOOT project in the context of a PPP is typically as follows: The host government identifies a need for the infrastructure project. An expression of interests is requested by the host government to interested private parties. The private parties submit their credentials that encompass both financial capacity and technical expertise. A short list of 10 to 15 firms is typically retained for further consideration. Eventually, the concession agreement is awarded to one private sponsor. The private sponsor manages the PPP project from its inception to its completion. The BOOT concession agreement is the one binding the private sponsor to the host government. It stipulates the important terms for constructing and operating the infrastructure energy project. It specifies the concession period, the rights and responsibilities of each party during the concession period, and the tariff that will be collected by the private sponsor during the operation phase. The quality of assets and the performance standards at the end of the concession period are also important stipulations in the concession agreement. The private sponsor is either a private organization (such as a construction/engineering firm) or a consortium of private firms (such as construction/engineering firms, equipment manufacturers, investors, and venture capitalists) that coalesce for the specific purpose of financing, constructing, and operating the project. The reason why various private firms may join forces is to combine resources and expertise. This joint effort also allows the achievement of economies of scale and the diversification of risks. 422 / JOURNAL OF MANAGEMENT IN ENGINEERING © ASCE / OCTOBER 2012 J. Manage. Eng. 2012.28:421-428. Downloaded from ascelibrary.org by East Carolina University on 11/12/14. Copyright ASCE. For personal use only; all rights reserved. The organizational type of the private sector could take the form of a corporation, a joint venture, a partnership, a limited partnership. or other organizational forms. The private sponsor forms a project company (PC) to construct and operate the project. The PC is in charge of the engineering, procurement, construction, and operation phase. It secures the key resources and it selects the consultants, the prime contractors, and the operators of the project. The PC has the right to cash flow for operating the infrastructure over the concession period. The host government reviews and approves the design. It also takes part in the approval of the performance tests to ensure proper compliance with the specifications of the concession specifications. In addition, it facilitates the necessary approvals and other authorizations for constructing and operating the facility. The government plays an active role in quality control and assurance in its capacity as the steward of public interest. The public is the final user of the project. The government also has a claim on the ownership of the infrastructure assets at the term of the concession period. The success of the BOOT depends on the extent by which the goals of the private sponsor are congruent with those of the host government. As shown in Fig. 3, each party has its own set of motives. The private sponsor needs to earn profit, control the activities under its jurisdiction with minimal political interference, and collect its tariff (payment processing) during the operation phase. The host government needs to minimize the life cycle cost of the project, ensure quality standards, and ensure minimum performance standards. The incentive scheme of the concession agreement should address all the previously discussed aspects, and should emphasize the common interests between the public and private sectors, namely the timely completion of the project, the performance of the project, the coordination and integration of various operating activities, and transparent transactions. riskier than projects with relatively little investment outlay and fewer participants to the construction process. There are more uncertain variables in high magnitude projects that could adversely affect the cost, quality, and duration of the project than in low magnitude projects. A second risk factor is related to the duration of the project: Projects with long durations are inherently riskier than projects with short durations. The variables occurring in the long-term horizon are less defined and more uncertain than variables occurring in the short-term horizon. A third risk is related to the financial structure of the project: Projects with high debtto-equity ratio are financially riskier than projects with low debt-to-equity ratio. The earnings of projects with high leverage are more volatile than those with low debt-to-equity ratio. Highly leveraged projects/firms are less able to meet their obligations to the creditors than low leveraged ones, thus pushing the project closer to potential bankruptcy. The financial risk increases with the debt-to-equity ratio, the intensity and schedule of the debt, and the duration of the project. A fourth risk is related to the type of construction: Complex and highly customized projects using untested technologies are riskier than standardized projects with well-established technical and regulatory precedents. The exogenous risk factors are those related to the external variables belonging to the macro-environment in which the project operates, including the political and geographical environment. For example, projects located in areas in which the macro-environmental is rapidly changing (e.g., price increases, social trends, demographics, technological innovations, regulatory changes) are facing more uncertainties than projects located in relatively stable macroenvironments with slow-moving changes. The risk of construction projects further increases with foreign penetration (Gunhan and Arditi 2005). The country (sovereign) risk factor is substantial, notwithstanding the unfamiliarity of the sponsors with the geography, the local codes, the business practices, and other idiosyncratic cultural and operational issues. Risk Factors of BOOT Projects A BOOT project is recognized as one of the riskiest project delivery schemes (Dey and Ogunlana 2004). The risk management of BOOT projects starts with the identification of the risk factors resulting from the inherent characteristics of the project itself and the risk factors resulting from exogenous factors in the external environment. An implementation plan is then put in place to avoid the risk, mitigate the risk, diversify the risk, or allocate the risk to the party best able to assume it. The inherent risk factors of BOOT projects are those that are related to the characteristics of the project itself. One risk is related to the cost magnitude of the project: Projects that require relatively large capital expenditure and large number of participants are Fig. 3. Public and private sector motives in a BOOT project Illustrative Case Study The demand for electricity has been on the rise in an emerging country. In an effort to sustain the projected demand, the government has decided to initiate a PPP for the construction of a state-of-the-art 850 MW combined-cycle thermal power plant using natural gas as its fuel source. The cost of the project is estimated to be $900 mils. The government has decided to commission the project to the private sector using a BOOT approach. The concession period is 25 years. A private sponsor has been awarded the BOOT conce ...
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