Downside Risk in BOT (Build - Operate -Transfer) Projects

Prasanta K. Dey and Stephen O. Ogunlana The authors Prasanta K. Dey is Lecturer, Department of Management Studies, University of the West Indies, Bridgetown, Barbados and Stephen O. Ogunlana is based at the School of Civil Engineering, Asian Institute of Technology, Pathumthani, Thailand. ract Construction projects are risky. However, the characteristics of the risk highly depend on the type of procurement being adopted for managing the project. A build-operate-transfer (BOT) project is recognized as one of the most risky project schemes. There are instances of project failure where a BOT scheme was employed. Ineffective risk management is one of the major causes of such failure. Today’s projects are increasingly being managed using various risk management tools and techniques. However, application of those tools depends on the nature of the project, organization’s policy, project management strategy, risk attitude of the project team members, and availability of the resources. Understanding of the contents and contexts of BOT projects, together with a thorough understanding of risk management tools and techniques, helps select processes of risk management for effective project implementation in a BOT scheme. This paper studies application of risk management tools and techniques in BOT projects through reviews of relevant literatures and develops a model for selecting risk management process for BOT projects. The application to BOT projects is considered from the viewpoints of the major project participants. Discussion is also made with regard to political risks. This study would contribute to the establishment of a framework for systematic risk management in BOT projects. Electronic access Every human endeavor involves risk; the success or failure of any venture depends crucially on how we deal with it. Science and engineering increasingly progresses by major projects, many of them are high risk. However, the need to identify a project’s uncertainties, estimate their impact, analyze their interactions, and control them within a risk management structure has only in recent years been realized, mainly within the defense, construction and oil industries. For years the engineering and construction industry has had a very poor reputation for coping with risk, with many major projects failing to meet deadlines, cost targets, and specifications. New product development demands shorter project duration owing to a tremendous amount of competition and fluctuation of customers’ demand. Risk and uncertainty are inherent in all construction work no matter what the size of the project. Although size can be one of the major causes of risk, other factors carrying risk with them include complexity, speed of construction, location of the project, technology being used and familiarity with the work. The construction industry is exposed to more risk and uncertainty than others are. The construction process from initial phase to completion and use of the product is very long and complex, particularly in large projects. The process

so coordinating project goals is very difficult. . Recent trends in the industry indicate continuous use of alternative procurement methods such as design-build. In a sense. There have been studies about risk management for construction projects and some for BOT projects. a comparatively new project procurement scheme. build-operate transfer (BOT). it has not been sufficiently introduced in practice. the future development of this scheme is largely dependent on the risk management system. such as weather and geological conditions. which are yet to be implemented as BOT projects. from the viewpoint of private participants. the private sector is expected to assume much longer involvement in a project. and the latter to enhance efficiency by private participation.involves various kinds of people with various ideas. because governments tend to transfer more risk to private parties. and gives rise to the need for a new perspective in risk analysis. and so on. 20 or 30 years. this scheme has been employed more frequently in both developing and developed countries. there are a number of infrastructure projects all over the world. It might be universal in the industry. it is much more risky than traditional project schemes. Despite these efforts. and some new risks derive from the context of this new scheme. i. Establishment of an appropriate risk management system or a risk management framework is necessary to manage and control risks in BOT projects. They usually have different interests. These new procurement schemes require us to be more careful about risks. In the past few decades. It can be assumed that the same applies in other countries. construction management. The former employ the scheme mainly because of insufficient government funds for infrastructure investment. In this scheme. it is very risky to implement a BOT project because of the uncertainty inherent in a long project period and the complexity of the project scheme. Accordingly. failures are due to insufficient risk management. Governments cannot be totally free from risk. The government also has to assume some of them in order to carry out projects successfully. Among them. An appropriate risk management system is desirable for construction projects and seems indispensable for BOT projects. The complexity of the BOT arrangement leads to increased levels of risk exposure for all parties. In some cases. there have been many failures in BOT projects. There are various kinds of tools and techniques for risk analysis. To describe the applications of risk management tools and techniques for BOT projects. the objectives of this study are: 1. Particularly. has emerged to serve as an infrastructure arrangement scheme. The past records might have been the source of hesitation of project parties to participate in the projects. Owing to the risky nature. Understanding those strengths and weaknesses is indispensable for their appropriate applications to risk management. Each has its strengths and weaknesses. Generally. “Lack of understanding” by managers and others concerned is always blamed for the lack of implementation in many surveys. Enhanced understanding of risk analysis tools and techniques will provide the industry with improved risk management support. experience and skills. This complexity is compounded by a number of external and uncontrollable factors.e. according to a study in the UK. and are given a wider scope of works. because new schemes increase complexity of projects. As a result.e. i.

Second. In many cases it is so difficult to collect a fee or toll from the service users that taxes and duties are the most practical manner for service pricing. Moreover. third. Although requirements of the infrastructure facilities are increased continuously. various kinds of risk analysis tools and techniques (RATT) are analyzed and. The price of the service tends to be improperly high unless the government intervenes to some extent properly. In a strict sense. there are many kinds of infrastructures. In our society. content and context of the BOT scheme is analyzed. but also indirectly to people outside. a model has been developed to select RATT for specific BOT project. The following schemes are presented as alternatives for privately financed infrastructure projects: . railways. such as roads. BOT scheme The concept of BOT. These facilities bring about external benefits together with internal benefits. In general. bridges. To formulate a systematic model for selecting risk management processes for BOT projects Methodology For the purpose of achieving the objectives mentioned above. etc. or in many cases they themselves invest for and operate the facilities. first. by means of thorough review of relevant literatures. many governments fail to implement the development projects owing to the government’s inability to finance such major projects that are remarkably high in cost. these external benefits are considerably large in infrastructure projects. These facilities can serve for so long-term periods once they are provided that they need to take a long term to recover the investment. The reasons for the intervention by government are: • • The initial investment is tremendously large. have been attracting both government and private sectors all over the world in recent decades. while demand for the service is relatively high. However. harbors. it is considered that a government or a public sector is required to intervene in provision of these infrastructures. which is very difficult for private sectors without appropriate assistance by the government. they provide benefits not only directly to the service users. The services provided by those facilities tend to be in a monopoly situation. Thus. so normally it is too much for private sectors. tollways. or any other privatization schemes. such as those who work in the industry in the society. In other words.2. demand for such privatization schemes as BOTand PFI is drastically increasing in both developed and developing countries. the term BOT is often used to imply a private-finance project scheme. private finance initiative (PFI). These facilities require large amounts of land acquisition. BOT is just one of the schemes for privately financed infrastructures.

political risk. Risk classification in BOT projects There have been several types of risk classification. . (5) Operating phase: performance risk. Global risks: – Political: government. off take risk. (4) Construction phase: completion risk. risk identification. The cash flow from the project must be attractive to lenders. liability risk. foreign exchange. . cost overrun risk. build own operate transfer (BOOT).. design build finance operate (DBFO). rehabilitate own and transfer (ROT). finance risks. . Risk identification in BOT projects The risks of BOT projects can be identified in the following categories . . other contingencies (3) Development phase: technology risk. credit risk. And build and transfer (BT) The country in which the project is situated should have a stable political system. equity resale risk. . . cost overrun risk. The economy should be promising in the long term with adequate local financial markets. legal risks. There should be limited competition from other projects. modernize own/operate and transfer (MOT). operation/ maintenance. The following are some examples of them: (1) Construction phase: completion delay. This is particularly necessary if expected income is to be paid in local currency. market. infrastructure risk (referring to other facilities in direct competition with the BOT project in question).e. following the risk management framework. . risk analysis. lease renovate operate transfer (LROT). risk attitude and risk response (or risk allocation). (2) Operational phase: raw material supply. There should be long-term demand for the service to be offered by the project. The currency exchange risk associated with the project should be predictable. . The risk scenarios should be predictable. political risks. . while still providing acceptable profit and cash flow Risk management in BOT projects Risk management in BOT projects is studied. political risk. design construct manage and finance (DCMF). technology. performance risk. bid risk. build own operate (BOO). . cost overrun. build transfer operate (BTO). rehabilitate own and operate (ROO). performance/technical. with governmental support being available to it. build operate transfer (BOT). . . . and . Profits from the project must be sufficient to attract investors. operating risks. i. . force majeure. build operate and renewal of concession (BOR). build lease (or rent) transfer (BLTor (BRT)). . construction completion risks. The legal system in the country should be predictable and to be reasonable. The project itself should be in the public interest. risk classification.

Long-term involvement Since the involvement of the parties concerned with a BOT project is much longer than that in a traditional project. too. A decision also should be made on what kind of risk analysis can . currency. Simplification of a problem Problems are very complicated in a BOT project because of the uncertainty inherent in its long project life and its complexity. then a solution to the initial problem could be derived from assessments of the elemental problems. evaluation. There would be many occasions when a decision-maker encounters such problems in a BOT project. – Operational: operation.– Legal: framework. problems should be broken down into simpler elements. Decisions in this phase are crucially important. Basically. The decision at each occasion should be made based on the availability and quality of information. Definite contractual documentation is also essential for multi-entity projects. such as consulting companies. maintenance. ecological. there are many parties concerned. People are incapable of assessing a problem properly when its complexity is more than what they can deal with. However. – Commercial: market. ownership. correlations of risk factors should not be disregarded. it is necessary to demonstrate in a systematic way how risk is anticipated. decisions for bidding is more difficult and important. and equity investors. This is particularly true when subjective judgement is to be made. The involvement of multi-entity necessitates risk analysis in a systematic and understandable manner. In order to overcome the inability of a decision maker. construction. Particularly. the systematic risk analysis should be recognized as indispensable for project management. training. and negotiation. Elemental risks: – Technical: physical conditions. correlations of some factors to the inflation rate should be incorporated in risk analysis of BOT projects. development Characteristics of risk analysis in BOT projects There are many parties involved in a BOT project. type of agreement. toll/tariff. it is desired to be taken care of in a Monte Carlo simulation. it is difficult to reach an agreement satisfactory to all the parties. design. From the project company’s viewpoint. Risk analysis implemented in an unclear and unsystematic process cannot be accepted by other parties. – Financial: form of financing. is very long and there are many occasions for decision making. return. In negotiation. For concessionaires. technology. because the bidding process in BOT projects is much more expensive and time-consuming. construction companies. the process of pre contract phase. although the simplification is important. Without such risk analysis. bidding process. which involves preliminary study. One undesirable result could be generated as the combined result of various factors. According to the reviewed studies. – Environment: impact. currency. Generally. operation companies. their involvement in a project is stronger than that in a traditional project. even within a single project company. input. – Revenue: demand. detailed study. a contract is made in order to define risk allocation to the parties concerned. Especially.

It is totally dependent on cases. Qualitative analysis (risk identification) Risk identification is important as the first step of risk analysis. Response to a risk should be determined considering the two-dimensionality of the risk: In theory. there can be some inherent risks in BOT projects which have extremely low probabilities but tremendously high severity. Subjective judgement is also needed in transforming existing information into available forms for a particular project. However. a risk should not be assessed by a single criterion of the expected value. In addition. BOT projects contain many inherent risk factors which must be identified in this step. Particularly. there are risks with very high likeliness to occur but relatively low severity. This decision can only be made by understanding of various RATTs. and to train experts who can make “good subjective judgement”. these two cases cannot be treated together. Because of the length and the complexity of the project scheme. In order to eliminate such failures. On the other hand. At the same time. That is particularly right for BOT projects. it should be assessed by both likelihood and severity of a risk. . BOT projects in developing countries are always subject to political risks. it is impossible to manage a risk. Twodimensionality of risk As studied in the preceding chapter. Unless identified. Ideally. losses with a low frequency and potentially catastrophic severity are unpredictable and are often beyond the budget capacity of the firm and should. In contrast. Questionnaire surveys and interviews by incorporating a brain-storming technique and Delphi technique can be employed in the identification stage. They should be assessed properly. all the projects on the BOT basis are unique. a drastic change in an economic policy in the host country may fall into this category. the identification must be implemented in such a way as to minimize the number of unidentified risk factors. In many cases. Subjective assessment Objective assessment is possible where sufficient data is available in objective forms. In other words. These risks have low likelihood but extremely high severity.and should be made at each occasion. That may be established by applying some of the existing RATT. One thing necessary is to construct a systematic framework with which a decisionmaker can make subjective judgements in a clear and straightforward manner. losses that have a high frequency and low severity can be retained without jeopardizing the financial strength of the entity. It is favorable that these risks are taken care of by government agencies in developed countries or international organizations. the history of a BOT scheme is still young and there is not sufficient accumulation of such data. Instead. Risk mapping technique is applicable to BOT projects. it should be implemented project by project. some risks which have so small likelihood that they can be disregarded in traditional construction projects cannot be disregarded in BOT projects. risk identification should be implemented very thoroughly in accordance with the situation of individual projects. it is also necessary to accumulate information of objective data. An adverse weather condition would be an example of this category. For example. unfavorable outcomes resulted out of the events which had not been identified as risk factors. be transferred to another party. Thus. where possible. it is always required to make subjective assessment to some extent. such as historical records. such as AHP. Therefore. or by developing other new tools and techniques.

In addition. it is time and effort consuming. Together with that. The former is obviously measured in a monetary term.e. host government. Understanding how risks are analyzed in each RATT is necessary to make a good risk analysis. efforts for risk identification are desired to be made at general but rather specific levels so as to facilitate a risk identification process in individual projects. and it can form a risk checklist for BOT projects. whether general or specific. because risk allocation needs to take account of the attributes of risks so as to allocate them to those who can treat them best. it is often required in a BOT project to quantify the effects and impacts of risks into monetary terms when risk analysis is to be conducted. VFM and CE of a project contain uncertainty and risk. In this regard. i. in order to recognize the cost-efficiency in a concessionaire’s bid. It is important to determine which quantitative analysis method is to be selected. such as social welfare and time saving in transportation. In addition. Therefore. Host government The government’s principal responsibility is to achieve VFM or cost efficiency (CE) by implementing a project. the main objective is always financial profit making. Thus. a problem is that the analysis result can be different. static or dynamic. Thus. and so on. as well as being difficult to identify all the potential risks in projects one by one.However. evaluation of VFM and CE should be conducted in terms of risk analysis.e. Risk analysis to parties in BOT projects This section discusses the risk analysis from the standpoints of major project participants. “risk identification in international business” could also serve as a good tool. It is also important to identify attributes of risk. Quantitative analysis Generally. too. funders and project companies. Identification of common risks prior to project implementation at a rather general level can save such time and efforts. VFM includes not only money terms. Risk classification can be made in accordance with those attributes. However. the best alternative for infrastructure arrangement must be selected. and “risk identification in BOT tollway projects” does the specific but common risks in tollway projects. However. The latter is also measured by the money value in most cases. “A study on risk identification in BOT projects” can present common risks in a BOT project in general. government needs to . Concessionaire selection under risk should be considered. “A study on risk identification in BOT transport projects” presents those in transport projects. or “efficiency gain”. i. from a private company’s standpoint. because they are values of the project in the future. Generally. and can serve as a guidance or reference for individual projects. Since many BOT projects are implemented in international environments. but also non-monetary terms. it is also important how to quantify the impacts of risks into monetary terms. depending on the analysis methods and how to quantify the impacts of risks in the money value. Selection of the most cost-efficient concessionaire is also an important responsibility of government. one of the major objectives of BOTand PFI arrangement is always to achieve “value for money”.

Since these factors are very important in BOT projects. and . Since lenders. a discount rate.know how risk is anticipated and involved in the bid. Because BOT projects contain much more risk than traditional ones. A small change in these rates results in a very big change in the project cash flow. which must be involved in the modeling. the most essential thing governments have to do is to set up clear objectives. either single or plural. However. Funders There are two major categories as funders in BOT projects. over the concession period of a project as long as 20-30 years. let us suppose Concessionaire A offered a higher bid price (or higher tariff rate. The impacts of change in the interest rate and the inflation rate should be tested by sensitivity testing. too. longer concession period) because he anticipates risk sufficiently and as a result included the risk premium in the bid price. return on investment (ROI). awarding the concession to Concessionaire B may cause a disaster. because lenders are more exposed to the demand risk in the former than in the latter. Things are more complicated and serious in BOT transport projects than in BOT power projects. In BOT projects. By constructing cash-flow models. any worst-case scenario is necessary and needs to be examined by sensitivity analysis. pay back period (PBP). such as bankers. the loans are made on the limited or non-recourse basis. In such a case. lenders need to be very aware of risk. “Lenders tend to focus on the downside risks while investors tend to look at the upside opportunity” Lenders are mainly concerned with the cash flow of a project. . . Concessionaire B. they should be analyzed separately from cash-flow analysis.e. and other analyses as well. in other words. However. as examples: . risks in management by a concessionaire and so on. internal rate of return (IRR). For example. lenders take a look at some of these terms of a project. and . . cash-flow analysis is difficult to incorporate qualitative risk factors. there are many factors influential to the demand. cannot assume so much risk. in turn. Therefore. and risk premium. return on rquity (ROE). governments expect private companies to assume as much risk as possible. Another important point is risk transfer. In many cases of BOT projects. offered a lower price simply because he does not analyze risk sufficiently. their concern is directed to the down side. net present value (NPV). Cash flow of a project is analyzed and measured by the following terms. By analyzing risk in terms of likelihood. Finally. severity. Without doing it. risk transfer is always accompanied by risk premium as an additional cost. risk analysis cannot be conducted sufficiently. The cash-flow analysis is often conducted by means of Monte Carlo simulation and sensitivity analysis. i. One of the very important and difficult things in cash-flow modeling is how to predict an interest rate and an inflation rate. Generally. These factors include political risks. a government must consider the best risk transfer. the worse cases in sensitivity analysis. governments must understand how risk is analyzed and anticipated by concessionaires so as to avoid the disaster as shown in the example. One is lender and the other is investor. or.

It is expected to assume as much risk as possible. cost overrun. Project companies A project company in a BOT project is a core entity of the project. These two can only be achieved by sufficient risk analysis. Accordingly. neural network approach has great potential for sensitivity testing in BOT projects in case the functions are implicit. particularly in developing countries. a risk of currency exchange rate is one of the most concerns for project participants. Risk analysis by a project company would be tough when the project is implemented in an international environment. The reason is because the analysis needs to involve more political and legal elements. The strength of the analysis is that it can identify the points for attention by management. their equity investment to a BOT project normally forms one portion of their portfolio. However. i.e. PERT and fuzzy set networking are currently available for this purpose. techniques for financial risk hedging.they interact in complex manners. From another aspect. for external investors. according to the review studies. Risk analysis for investors is directed to diversification of risk in their portfolio. The project company must be able to demonstrate how risk is anticipated and how risk is included in its bid price. The same can be said for negotiation with funders. a project would result in higher cost. much higher return is expected and required by investors. Because income of a project solely depends on the demand. In this regard. Obviously. Risk analysis on such occasions must be conducted thoroughly from risk identification to risk assessment. risk factors and their relationship should be fully identified. the lender should recognize the impact of various risk factors to the demand by sensitivity analysis. risk analysis is very important. Network scheduling considering risk and uncertainty is also useful for risk analysis in terms of duration. this approach requires a sufficient amount of recorded data. It must be fully understood through a thorough risk analysis process from identification to sensitivity testing. Sensitivity analysis is applicable when functions between input variables and output variables are explicit. In this case. In many cases of BOT environments. This risk factor is inherent in BOT projects. These techniques are also available to cash-flow analysis in an operation phase. Because BOT projects are highly risky by nature. and risk in operation are supposed to be allocated on a project company. sensitivity analysis and neural network approach can be useful techniques. Particularly to lenders. such as exchange rate swap. On the other hand. can be employed as long as the risk is fully analyzed. because the analysis works effectively in the negotiation with government. Accumulation of the data available for this sort of analysis would be very important for the future of BOT projects. Political risk analysis . as is often the case with BOT projects. risk taking by a project company must result in VFM and CE. Cost prediction models and cash-flow models incorporating risk elements should be necessary. Unless risk is properly anticipated. Monte Carlo simulation. Lenders in general are supposed to be well-knowledged in financial techniques. However. risk in terms of construction. On the other hand. a project company cannot expect any loan arrangement unless risk analysis is properly demonstrated. delay and quality deficiency.

and (5) sensitivity testing. debt. because it can be greatly affected by stability of the country and economic policies. closely proportional to instability of the host country’s political system. These analyses are applicable to assess political risks at a rather macro level. especially in developing countries. The exchange rate risk is also one of the most important risks in BOT projects. such as GDP. The ratings are performed by experts in relevant professions. but also with additional risks of political and legal elements. .: (1) identification of risk. and so on. legal risks in host countries of projects.BOT projects are not only faced with normal risks inherent in any construction projects. The second analysis was conducted in terms of five steps in risk analysis. i. Accordingly. both funders and project companies are greatly concerned about the political risks. in general. (2) identification of risk relationship. Political risks are. (3) assessment of risk impact. The indices are represented as summations of rating on various indicators of countries’ conditions. and weighted in accordance with their importance to form the indices. These factors were concerned as common factors for some of the RATTs in previous studies.e. This risk must be analyzed from a political aspect. (4) assessment of risk likelihood.

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