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Real option theory for risk mitigation in transport PPPs

Article  in  Built Environment Project and Asset Management · November 2013

DOI: 10.1108/BEPAM-05-2012-0027

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Risk mitigation
Real option theory for risk in transport
mitigation in transport PPPs PPPs
Roberta Pellegrino
Department of Mechanical and Management Engineering,
Polytechnic of Bari, Bari, Italy
199
Nevena Vajdic
University of Belgrade, Faculty of Civil Engineering, Belgrade, Serbia, and
Nunzia Carbonara
Department of Mechanical and Management Engineering,
Polytechnic of Bari, Bari, Italy

Abstract
Purpose – Public-private partnerships (PPPs) require the analysis and allocation of a broad spectrum
of risks which are considered more complex than in traditional construction contracts. Traditional risk
management techniques tend to ignore the manager’s ability to recognize and exploit opportunities,
which arise as uncertainties are resolved over time and which could potentially increase the project’s
value. Therefore it is necessary that the risk management process takes account of the managerial
flexibility (e.g. real options). The objective of this paper is to explore the possibilities and rationale for
implementing real options strategies in the risk management process.
Design/methodology/approach – The approach is based on a literature analysis aimed at
identifying key risks and related mitigation strategies and on real option theory in order to model
these strategies as managerial flexibilities that naturally exist or are built “artificially” in contractual
conditions and clauses, guarantees, etc.
Findings – The paper develops an option-based risk management framework that associates to each
risk the related mitigation strategies, which are expressed in terms of real options. The latter is
expressed over the project phases conditioned to the natural evolution of risks over time.
Originality/value – This paper proposes a new “dynamic” risk management approach for PPP projects
based on real options that improves the traditional risk management techniques by supporting the
decision makers in finding a cost-effective combination of real options (or forms of flexibility) to embed in
a PPP investment in order to optimally control risk and maximize investment value.
Keywords Risk management, PPP, Mitigation strategies, Real options, Risk analysis
Paper type Research paper

1. Introduction
The inner characteristics of public-private partnership (PPP) projects, such as the length
of the contractual relationship, the significant amount of investment, and the competing
interests of involved parties, make the risk allocation process one of most important
elements in the partnership between the public and the private partners. One of the main
advantages for choosing the PPP instead of traditional contracts relates to the risk
sharing mechanism, given that the principle that rules the risk allocation in PPP projects
is to transfer the risks to the party that is best able to manage them. The aim, therefore, is
(or should be) to optimize, not maximize risk transfer.
PPPs require in depth analysis and allocation of a broad spectrum of risks which Built Environment Project and
include design and construction risk, operational risk, demand risk, technological Asset Management
Vol. 3 No. 2, 2013
risk, political risk, and others. Risk management in PPPs is not static, but dynamic pp. 199-213
r Emerald Group Publishing Limited
corresponding to the evolution of risks over time. Traditional techniques of risk 2044-124X
management, generally, are comprised of three phases: risk identification, risk analysis DOI 10.1108/BEPAM-05-2012-0027
BEPAM or measurement, and risk mitigation. The risk mitigation can be further divided into risk
3,2 avoidance, risk reduction, risk transfer or shifting, and risk retention (Cheah and Garvin,
2009). These standard techniques, however, do not consider the flexibility of management
in reacting to the market and environmental uncertainties. Project managers should
not adopt static strategies but could make the appropriate midcourse corrections to
change their decisions and actions as uncertainty about the future is gradually resolved
200 with the aim of reducing losses and exploiting opportunities. Contrary to the traditional
risk management techniques where the manager’s ability to recognize and exploit
opportunities to increase the project’s value is somewhat disregarded, risk management
and project evaluation in PPPs should, therefore, take into account manager’s choice to
react “proactively” to uncertainties (Cheah and Garvin, 2009). For this reason, it is
necessary that the PPP risk management process includes the managerial flexibility to
change decisions about the projects. This managerial flexibility can be considered a real
option, where real options represent the possibility (the right, not the obligation) of taking
actions in the future by incurring a certain cost to acquire this right.
The objective of this paper is to explore the possibilities and rationale for implementing
real option strategies in the risk management process, or, more specifically, in the risk
allocation mechanism in PPP projects, where there is an evident gap between the
significant work in the theory of real options among researchers and the implementation of
developed methods and models in practice (Triantis, 2005; Garvin and Ford, 2012). Thus,
the value of this paper is in the attempt to bridge this gap by broadening the “traditional”
risk management process and creating a “flexible” risk management process by mapping
the potential risk mitigation strategies in terms of real options in transportation PPPs.
To achieve the stated goal, the paper pulls together three components: initially, the
anticipated framework approach to risk management in the domain of real options is
considered. Background to real options and the option-based risk management
(OBRiM) framework is presented in the following section; second, as the application of
real options and flexibility in management is related to risks and their evolution over
time, the relevant risk literature for PPPs is reviewed structured to respond to the time
factor. This is presented in the third section of this paper. Finally, the third component,
and the most challenging one, concerns the strategies, that are usually adopted to
mitigate risks. These have been collected from literature on PPP risk management,
other non-PPP fields, and case studies and represented as real options. The purpose of
this parallel presentation of risk mitigation and related real options-based strategies is
to establish a basis for the further development of a framework for the quantification of
costs and benefits these strategies may have and their potential impact on a project’s
risk profile. Conclusion and further research close the paper.

2. Risk management in PPP projects, mitigation strategies, and real

options application
The success of a PPP project often depends on the ability of project participant to
allocate and manage the project risks. Once the project risks are identified, the
likelihood of their occurrence assessed, and their impact on the project determined, the
participants must allocate those risks. The main options are to bear the risk; eliminate
the cause or reduce the criticality of risk; to transfer the risk to third parties such as
insurers; or to allocate the risk among contractors and lenders (Thomas et al., 2003).
The risk that the party decides to accept should be mitigated.
During the initial stages of the project (planning and design), the decision makers
identify main risks embedded in the project and decide about their allocation. After
identifying possible strategies that can be adopted to mitigate the risk, each party Risk mitigation
(both public and private) should quantify risks and risk countermeasures or their in transport
consequence on the cost and value of a PPP project and decide if its own level of risk is
acceptable, otherwise negotiate in order to reallocate them. Risk management as well PPPs
as PPP project evaluation should, therefore, take into account that managers react
“proactively” to uncertainties, i.e. they deploy risk countermeasures contingent on the
materialization of the risk (Benaroch, 2002). This “proactive” behavior changes the risk 201
profile of the project and, consequently, its cash flows. In other words, it has an impact
on the economic value of the project.
Conventional project valuation methods, such as Net Present Value, tend to ignore
the existence and value of the managerial flexibility. As a consequence, the expected
cash flows can differ from the forecasted values due to both uncertainty (the real world,
in fact, is not deterministic, rather probabilistic) and managerial flexibility that allows
project managers to change their decisions and actions as uncertainty about the future
is gradually resolved. This justifies including managerial flexibility in the decision-
making process, and particularly in risk management of PPP infrastructure projects.
This managerial flexibility can be modeled as real options, where real options represent
the right of taking some actions in the future by spending a certain cost to acquire this
right (Dixit and Pindyck, 1995; Leslie and Michaels, 1997). In other words, real options
refer to the flexibility embedded in real operational processes, activities, or investment
opportunities that are not financial instruments (Trigeorgis, 1996). The concept of real
option has its roots in the theory of financial options.
A real option is similar to that of the financial market, an option on a “real asset”
(Myers, 1984). A real option, generally, gives the holder the right (not the obligation) to
buy (call option) or sell (put option) a predefined quantity of an underlying asset at
a fixed price, called strike the price or exercise price, at or before the expiration date of
the option (maturity). The holder (buyer) pays a price for this right (option premium).
For example, the call option will be exercised only if the value of the underlying asset
(ST) is greater than the exercise price (K) and the profit will be max(ST-K, 0); otherwise,
the option will not be exercised and it will expire.
The aim of this research is the development of an OBRiM (Benaroch, 2002)
framework which will provide support to decision makers to find the most cost-
effective combination of real options (or forms of flexibility) to embed in a PPP
investment in order to optimally control risk and maximize investment value. In
particular, this research focuses on one step of the risk management process and
introduces real options as potentially “flexible” risk mitigation strategies.
Based on a revision of the approaches presented by Bing et al. (2005) and Cheah and
Garvin (2009), Figure 1 shows a revised risk management process for PPP project
which incorporates real options concepts, i.e. a “flexible” risk management process.
More specifically, the process starts with the risk identification phase (often based
on risk factors/matrix) and the allocation of risks to the party which is best able to
manage them. Then each party should assess its own risks and define the risk
management strategy which one decides to implement. If parties do not assume total or
partial risks, the traditional risk mitigation approach should be used, i.e. risk
avoidance, risk reduction, and risk shifting or transfer. Otherwise, “[y] parties who
are willing to assume total or partial risks will adopt an ‘option mindset’ to shape and
mitigate the risks” (Cheah and Garvin, 2009). This is intended to introduce flexibility
into the contracts or strategies and provide the means to change the strategy or take
actions to achieve reduced risks, i.e. to introduce real options based risk mitigation
BEPAM Risk identification: risk
factors/matrix
3,2

202 Risk assigned to the

Risk shared between the
Risk retained by the
public and private
private partner public partner
partners

Risk pricing/
assessment
Risk allocation

Individual risk
management by both
the private and public
parties

NO
Risk retenation: total Other conventional risk
or partial risk mitigation strategies
assumption?

YES

Option strategies to
shape and mitigate risk

Avoidance Reduction Shift/Transfer

Residual risks

Acceptable to both NO
parties? Negotiation

Figure 1.
YES
Revised risk management
process for PPP project
with real options Final risk allocation/
Contract definition

strategies. After concluding this stage, each party (both public and private) should decide
if its own level of risk is acceptable, or otherwise negotiate in order to reallocate them.
Using real options, one can mitigate certain risks, while the residual ones should be
handled. In this case, conventional risk mitigation strategies (avoidance, reduction,
shift/transfer) can be adopted.

3. Risks in PPP projects over time

PPP projects usually involve high degree risks since they are characterized by having
many stakeholders, a huge amount of investments, and long-concession periods
(Wei-hua and Da-shuang, 2006). The importance of this theme justifies the
development of several studies on risk identification and allocation in PPP projects
which have been characteristic for these last years. The developed studies on risk
identification and categorization in PPPs can be divided into two groups: the first Risk mitigation
group comprises studies which focus on the nature of risks, whereas the second one in transport
contains studies which focus on the phase of project in which the risk typically
appears. PPPs
Based on the type of risks, Li (2003) classified risks as belonging to three levels: macro-
level risks (i.e. risks sourced exogenously, or external to the project itself); meso-level risks
(i.e. risks sourced endogenously, or risk events and their consequences occurring within 203
the system boundaries of the project); micro-level risks (i.e. endogenous risks which differ
from meso risks in that they are party-related rather than project-related). Grimsey and
Lewis (2004) have identified six areas of risk associated with PPP projects, namely: public
risk, asset risk, operating risk, sponsor risk, financial risk, and default risk. Bing et al.
(2005) analyzed risks in PPP/PFI construction projects in the UK. Particularly, they
conducted a survey to explore preferences in risk allocation by using the approach
proposed by Li (2003). Ng and Loosemore (2007) discussed risk allocation in the private
provision of public infrastructure.
Another approach for risks analysis in a PPP project is to classify risks over time,
namely according to the project lifetime. Such an approach is particularly important,
since it is widely recognized that the size of the impact of the risk, if it occurs, decreases
over time, conversely the probability that the risk occurs raises over time due to the
increase of uncertainty in the long run. According to this approach, risks in a PPP
project can be classified on the basis of the project lifetime. The five phases of a typical
PPP project are pre-investment, implementation, construction, operation, and transfer
(Tiong, 1990). Aoust et al. (2000) have classified risks by considering three phases of
the project: risks arising during the design-construction phase, operational risks,
and permanent or indirect risk. In the design-construction phase, technical risks and
economic-financial risks can affect the outcome of the project. Risks during the
project’s operation phase relate to the period when the project generates revenue, but
also continues to incur costs. Such risks can be classified as revenue risks, operating
cost risks, and financial risks. Finally, the indirect risks relate to the project’s
environment. These risks are residual, not pertaining specifically to either party in the
contract, and can be classified in three categories: risk of force majeure, macroeconomic
risks, and legal risks. Apart from the risks to which any infrastructure investment
project is subject to, Aoust et al. (2000) identify several categories of risks that are more
likely to arise under a PPP project, i.e. PPP-specific risks. They stem from the
particular relationship between private and public entities whose economic interests
are distinctively bundled in the project. These risks can be grouped into three
categories of PPP-specific risks: fiscal risks, residual value risks, and bidding risks.
Grimsey and Lewis (2004) have identified six areas of risk associated with PPP
projects: public risk, asset risk, operating risk, sponsor risk, financial risk, and default
risk. Tiong (1990) classified BOT risks based on the construction and operation phases,
while the classification of Beidleman et al.’s (1990) includes an additional phase, the
developmental phase. Thomas et al. (2003) considered another phase, the project life
cycle phase, in which risks occurring in more than one of the phases are included.

3.1 Risks in transport PPP projects

Analyzing the game theory approach as a risk allocation model in transport PPP
investments, Medda (2007) identifies four main risk domains. Technical risks include
construction risks (cost overruns or delays in completion), risks in the design of tender
documentation, and design risks. Commercial risks (demand risk) are also identified as
BEPAM a risk domain, as well as political and regulatory risks. Economic and financial risks
3,2 represent a specific and complex risk domain for assessment since they originate from
uncertainties such as economic growth, inflation rates, currency convertibility, and
exchange rates risks. Analysis of case studies around the world of implemented
transportation PPP projects have provided useful information, and several major types of
risks are identified: site conditions risks; design, construction and implementation risks;
204 financial risks; operating risks; market risks; legislative risks; and asset ownerships risks
(AECOM, 2007). Summarizing the experience with toll road concessions in Argentina,
Nicolini-Llosa (2002) underlines five main risks in the concession contracts in a developing
country: exchange rate risk, traffic demand growth risk, political risk, contract rescission,
and renegotiation risk. Wibowo and Kochendorfer (2005) have classified financial risks
associated with Indonesia’s project financed toll roads into three categories: project-
specific risks, sector-specific risks, and country-specific risks. Project-specific risks
include low traffic risk, right-of-way acquisition, construction cost, and time overruns.
Sector-specific risks include unpredictable future tolls or change in legislation, whereas
country specific risks address risks such as inflation and interest rates. Drawing lessons
from the set of principles successfully developed by the federal government in the bidding
and contract stages of PPPs for roads in Brazil, the construction risk, traffic risk, and
financial risk are underlined as the main risks (Veron and Cellier, 2010).
A comparative analysis of PPP highway projects in Portugal, Spain, the UK, and
Australia shows that public agencies consider the effective risk allocation as an important
aspect for delivery of PPP projects (Brown et al., 2009). World Bank (2008) provides an
example of the risk distribution matrix for PPPs in roads. This matrix defines 12 types of
risk: design, site, construction, force majeure, revenue, operation and maintenance (O&M),
performance, external, other market risk, political, default, and strategic risks.
Investments in container terminals are subject to the same risks as for other
infrastructure PPP projects (Wiegmans et al., 2002). These risks are divided into five
main risk categories: political, financial, construction, operational, and commercial
risks. Returns on investments in airport parking facilities depend on the demand for
parking which is related to a number of variables such as demand for air travel,
parking fees, and the availability of alternative modes ( Javid and Seneviratne, 2000).
Financial risks for this type of transport infrastructure are grouped into three
categories: project risk, competitive risk, and market risk. Discussing the nature of
risks in urban rail transit PPPs, Phang (2006) considers five risk categories: general/
project environment (force majeure, macroeconomic, legal risks), design (change order,
permits, untested technology risks), finance (interest rate, exchange rate, counterparty
risks), construction and procurement (acquisition and right of way, construction
delays, counterparty, health and safety, and cost overruns risks), and O&M (ridership
projection, costs overruns risks).

4. Framing mitigation strategies as real options

Tables I-IV presents the OBRiM framework. Where, for each risk first the most suitable risk
mitigation strategies are identified and then operationalized in terms of potential real
option-based strategies. In other words, the following tables present a map of risk mitigation
strategies and related real option-based strategies and provide support to decision makers
to find the cost-effective combination of real options (or forms of flexibility) to embed in a
PPP investment in order to optimally control risk and maximize investment value.
The various risk management strategies for the most important risks in PPP
projects have been identified from the literature on PPP risk management, other
Risk category Risk mitigation strategy
Site risks
Land use and Compensation clause in
acquisition/ concession agreement
resettlement and Provision for increase in
rehabilitation construction/concession time
risk Contingency fund for increased
land cost
Exit clause in concession
agreement
Clause of effective start date and
contingent effective start date in
concession
Design risk Defect liability clause in contract
Construction risks
Cost overrun Contingency fund is a contingency
percentage assigned to the budget
for overruns or unforeseen costs
Cost-plus fee contract and cost-plus
fee contract with the option of
maximum price or incentive fee
(Pfeffer, 2010; Hoffman, 2007)
Guaranteed maximum price
agreement with or without the
option to replace the contractor: the
private party and contractor can
agree to cap the price (Pfeffer, 2010)
Sponsor escrow fund: the sponsor
provides an escrow account
containing sufficient funds to
complete the project (Nevitt and
Fabozzi, 2005)
Take out of lenders: the loan
agreement can require the sponsor
to purchase the asset and take out
the lenders if the project is not
completed and operating according
to specification by a certain date
(Nevitt and Fabozzi, 2005)
Delay in Completion guarantee extension to The government guarantees the lenders on
completion debt maturity: this guarantee can servicing their debt if the project company
contain a provision that debt will fails to do so
be guaranteed until maturity in the
event completion is not achieved
by a certain date (Nevitt and
Fabozzi, 2005)
Real option-based strategy
Risk mitigation
in transport
Right-of-way contract, option to develop
PPPs
surrounding land (Zhao et al., 2004)
The private party has the option to extend the
length of the construction/concession time
The private party has the option to dedicate a
205
contingency fund to meet increased land cost
Time-to-build option (staged investment)
(Trigeorgis, 1996)
Option to defer investment (Trigeorgis, 1996)
Option to default
The private party has the option to dedicate a
contingency fund to meet upgrade costs
subject to government agreement
The contractor has the right to receive
incentive fees from the private party if
performance exceeds the set level; the
private party has the guarantee of a
maximum price
If costs exceed the maximum price guarantee
the contractor absorbs these costs or
alternatively the private party has the right to
replace the contractor and terminate the
agreement (Hoffman, 2007). If the cost is
below the capped amount, the private party
and the contractor can share the savings
benefits according to a predefined percentage
The contractor has the option to receive
escrow funds from the sponsor in order to
cover these costs and complete the project.
After project completion the contractor must
reward the sponsor of the same amount of
money
The lender has the right to shut down the
contract and receive an amount of money
from the sponsor if the project is not
completed and operated according to
specification by a certain date
Table I.
Mitigation of
(continued) technical risks
BEPAM Risk category Risk mitigation strategy
3,2
Completion/performance
guarantees: this coverage insures
against financial loss from a delay
in project completion attributable
to specified causes, such as a
206 failure of a party to perform on
time
Penalties, liquidated damages: an
amount or rate calculated in
advance, usually payable by the
contractor, for a delay to a project
or performance failure
Supply guarantee fee: it is an
assurance that the supply will be
where it is needed, when it is
needed
Failure to meet Performance guarantees: financial
performance security provided by a party to
criteria secure the performance of the
contractual obligations of the other
(Stephenson and Dalay, 2008)
Operating risks
Operating cost Standby funding for increased
overrun operating costs
Supply or pay contracts
Shortfall in Performance guarantees from
service quality operator
Table I.
Real option-based strategy
The lender has the right to step in and
complete construction and seek
reimbursement from the guarantor in case of
delay in project completion (Gibson, 2009)
If a project is not completed in time, the
project company has the right to receive
liquidated damages from the contractor
which will compensate the loss due to delay
in completion
The contractor may pay a fee to the supplier
to ensure a supply at any given moment
If a project does not operate after completion
at guaranteed levels, the project company has
the right to receive performance liquidated
damages from the contractor which will
compensate the increased operating cost or
reductions in revenue associated with the
failure of the contractor to meet the agreed
upon performance criteria (Hoffman, 2007)
If there are higher than expected operating
costs, standby funding for additional
financing either from the project lender or
subordinated debt lent by project participants
or third parties can be used
The project entity has the option to receive
the requisite amounts of the raw material
specified in the contract or else payments that
are sufficient to cover the project’s debt
service
A performance guarantee is a form of
financial security provided by a party to
secure the performance of the contractual
obligations of another party

non-PPP fields and case studies and potential real option-based strategies. In the
following tables the second column presents the strategy traditionally adopted for risk
mitigation, in the form of guarantees, insurance, the possibility of changing
contractual terms/clauses, etc. Such strategies can involve different parties, e.g. the
private party and the government, as in the case of revenue guarantee; the project
company and the contractor who executes the works, as in the case of the majority of
construction risks; or the project company and the client, as in the case of “take and
pay” or “take or pay” agreements. Since these strategies should be forms of flexibilities,
these risk mitigation strategies are presented as real options (third column).
 Risk mitigation
Risk category strategy
Revenue risks
Changes in Tariff guarantees
taxes, tariffs
Defer payments of the
concession fees
Demand/ Traffic/revenue guarantee
usage risk
Revenue sharing mechanism
Revenue distribution
mechanism
Least present value of revenue The private party has the option to modify the length
mechanism: the concession
ends when a specified level of traffic is higher than expected, the concession will
least present value of the
accumulated revenues is
reached
Defer payments of the
concession fees
Expand project capacity
Contract project capacity
Minimum revenue guarantee
Usage guarantee
Risk mitigation
Real option-based strategy in transport
PPPs
The government guarantees that the service can be
adjusted in a timely manner following the increase of
domestic consumer price indexes. If not, the
government compensates the project sponsor an 207
equivalent amount ( Wibowo, 2004)
Option of deferring payments of the concession fees
If the actual volume is lower than the guaranteed
minimum level, the concessionaire receives a basic
payment ( put option written by the government).
Alternatively, when the actual volume surpasses the
capped normal level, an adjustment tariff becomes
applicable (cap on the tariff-call option owned by the
Government) (Huang and Chou, 2006; Vassallo, 2006;
Chiara et al., 2007; Brandao and Saraiva, 2008;
Shan et al., 2010)
The government has a right to claim a certain
percentage of the revenue if the rate of return on the
project’s investment is above a specified value
(Gomez-Lobo and Hinojosa, 2000)
The government provides a guarantee of extra
revenues. In turn, the concessionaire will make
additional investments in the project and the
concession will end when the guaranteed value of
revenue is collected (Vassallo, 2006)
of the concession based on the level of revenue. If real
finish earlier, on the contrary the concession will
finish later
Option of deferring payments of the concession fees
Option to expand (Trigeorgis, 1996): if market
conditions are more favorable than expected, the firm
can expand the capacity of the project (Zhao et al., 2004)
Option to contract (Trigeorgis, 1996): the
management may decide to contract the capacity
of the project
The concessionaire has the right to recourse to
government to receive compensatory payments
whenever the revenue is below a pre-established level
(Chiara et al., 2007; Shan and Garvin, 2010)
Government guarantees the project company a Table II.
certain level of usage (e.g. traffic level in a toll road Mitigation of commercial
project) even if usage falls below a certain level risks

As shown in Table I, there are a number of risk mitigation strategies for technical risks.
These mitigation strategies are, in general, defined as a clause in the agreement or
some form of guarantees provided by one of the participants. However, defining the
cost of the selected strategy can be challenging as its application in the future is
BEPAM Risk Risk mitigation
3,2 category strategy Real option-based strategy

Financial risks
Interest rates Interest rate guarantee Interest rate guarantee: it is a guarantee that limits the
movement of interest rate within a specified range
(Wibowo, 2004)
208 Maximum interest guarantee: the government
compensates the project sponsor an equivalent amount
if the interest rate turns out to be higher than the
expected value (Wibowo, 2004)
Inflation Adjust concession price Option to adjust concession price
Debt guarantee Debt guarantee: the government will take over the
outstanding debt at the expiry of the concession
duration ( Wibowo, 2004)
Compensation payment Option on the overall inflation rate: option that
securitizes the right of a compensation payment by the
government if the inflation rate over a fixed time interval
exceeds the specified level (Kruse, 2009)
Option on the future inflation rate: option that
securitizes the right of a compensation payment by the
government if the future inflation rate over a future time
interval exceeds a pre-specified level (Kruse, 2009)
Inflation caps/floors Inflation caps and inflation floors: options in which the
buyer receives payments by the government at the end
of each period in which the inflation rate exceeds
a pre-specified level (Kruse, 2009)
Exchange Exchange rate guarantee Exchange rate guarantee: the government provides
rate exchange rate guarantees to cover repayment of foreign
currency debt (Gomez-Lobo and Hinojosa, 2000)
Table III. Debt Flexible price formula to Debt guarantee: the government will take over the
Mitigation of economic servicing risk meet revenue deficiencies outstanding debt at the expiry of the concession
and financial risks duration (Wibowo, 2004)

uncertain. Thus, the related real option-based strategy provides flexibility in terms of
reacting proactively to changes and acquiring realistic costs for having this right.
For example, having an exit clause in a concession agreement as a strategy for
mitigating site risk can be a strategy which allows the private party to terminate the
contract. The question is how to formulate the rights and obligations in the agreement
for this particular clause and how to price this risk. Time-to-build option, as a related
real option-based strategy, gives a right to the company to default during the
construction phase (Trigeorgis, 1996). This option is based on the principle of staged
development and series of investment outlays. In other words, the required
investments are divided into stages where the company has a right to abandon the
project between stages, i.e. to default on the upcoming investment tranche. Since this
clause is specified in the agreement between the public and the private party and
the risk should be borne by the public party, the private party could be entitled to the
compensation which, for example, covers the level of investment up to that time when
the company defaulted.
Table II presents the list of risk mitigation strategies and related real option-based
strategies for mitigating commercial risks.
Risk category Risk mitigation strategy
Regulatory/political risks
Changes in law Abandon the project
Political issues Abandon the project
Early cancellation
Compensation from government
Extension of concession
Real option-based strategy
Risk mitigation
in transport
Option to exit (Triantis, 2000)
PPPs
Option to exit (Triantis, 2000)
Option of early cancellation (American put
option) (Alonso-Conde et al., 2007; Rose, 1998)
The government repays the lenders if the
209
PPP company cannot refinance its debt
because of political or financial crisis.
Equally, if the PPP company manages to
refinance its debt, but on more onerous terms,
the Government pays the difference
The private party has the option of extending Table IV.
the length of the concession in case of losses Mitigation of political
due to political causes risks

Mitigation strategies for commercial risks are either in the form of guarantees, options
(i.e. to expand or contract project capacity), or mechanisms. These mechanisms
essentially present an agreement between the public and the private party which
defines rights and obligations if a certain event occurs. For example, with a revenue
sharing mechanism, the public sector would have a right to claim the percentage of the
revenue if the project internal rate of return exceeds some value and the private party
has an obligation to fulfil this claim. Although this mechanism by its form represents
essentially a real option (defining rights and obligations), defining the strategy itself
raises an important question of finding the price for this kind of agreement where real
options theory provides a spectrum of tools and models which can be applied to this
matter (Trigeorgis, 1996).
The minimum revenue guarantee, for example, can be modeled as a series of
European style put options that can be exercised only on predefined dates (Huang and
Chou, 2006). Chiara et al. (2007) recognize three distinct types of options for a revenue
guarantee option: European (can be exercised one time only at the end of its life),
Bermudan (can be exercised one time on predefined dates during its life), and
Australian (can be exercised multiple times on predefined dates during its life). Shan
and Garvin (2010), for example, consider for options duration two possibilities (ramp-
up phase or until all the debts are paid off) and four possibilities for underlying assets
(toll revenue, traffic volume, earnings before interest and tax, and free cash flow to
equity). Thus, one risk mitigation strategy can be priced and modeled differently
depending on the selected types of real options and other input parameters.
Table III presents risk mitigation strategies for economic and financial risks which
provide the flexibility to design investment decisions rather than engineer the
decisions. Although only financial risks are shown in the table, it should be noted that
some of these risks are consequences of the country’s economy and the global financial
market conditions and can be crucial in reaching project financial closure. For example,
if the project’s expected revenue stream is evaluated and meets all financial
prerequisites, the country’s rating, as an additional evaluation criterion, may have an
impact on the willingness of potential lenders and private investors to invest in the
project. Thus, the government might be compelled to provide some guarantees (e.g.
interest rate guarantee) in order to ensure the project’s financial closure.
BEPAM Analysing the characteristics of the real options, they can be categorized as those
3,2 that are either “on” or “in” projects (de Neufville, 2002; Garvin and Ford, 2012). “Real
options ‘on’ projects are financial options taken on technical items, treating technology
[or project] itself as a ‘black box’” (Wang and de Neufville, 2005), such as those
strategies modeled by traditional options as defined in the classic Myers or Dixit and
Pindyck sense, i.e. the options to expand, to contract, to switch input, to abandon, and
210 to defer the project. “Real options ‘in’ projects are options created by changing the
actual design of the technical system” (Wang and de Neufville, 2005), such as those
strategies that “involve proactive measures that managers may take to alter outcome in
face of uncertainty” (Garvin and Ford, 2012), as in the case of guarantees (revenue,
traffic, usage, debt, inflation, etc.).
Table IV presents strategies for the mitigation of political risks. These strategies
can be considered options “on” projects, e.g. the flexibility to abandon the project. As in
the previous table, these risks are the results of the country’s political stability rather
than the project’s technical and financial viability. As mentioned earlier, the
government sometimes might be compelled to provide some sort of guarantee or
compensation mechanism depending on the political history and current government
structure in order to attract international investors.
The question of finding the real price of the presented strategies as well as defining
the rights and obligations of the involved parties is not an easy task. For example, an
exit clause in the concession agreement for the mitigation of site risks (Table I), which
can be treated as an option to abandon the project, is different from the option to
abandon the project as a risk mitigation strategy for political risk (Table IV), though
they are essentially two different options granting the same right to the option holder –
the right to abandon the project. The differences between these two options are
numerous: the level of involved investment, the time when these options can be
exercised, the exercise price, the value of the underlying asset, etc. Thus, the “real”
price of these options can be substantially different depending on the selected and
agreed input parameters such as the type of the option, the defined underlying asset,
and the option’s maturity.

5. Conclusions and further research

An adequate risk management process in PPPs is fundamental to an assurance of the
project’s success. Decision-makers should identify, evaluate, and control key risks
during the various phases of a PPP project. These risks are not only challenges but also
opportunities for the private concessionaire as well as for the government. This needs
a correct and “proactive” risk allocation and evaluation which may require the
application of financial tools such as real options. Analyzing transport PPPs, this
research focuses on one step of the risk management process, i.e. the identification of
strategies to shape and mitigate risks as a first step in the development of an OBRiM
framework that associates related option-based risk mitigation strategies to each risk.
These mitigation strategies expressed as real options provide a range of
possibilities and support decision makers to find the most cost-effective combination of
mitigation strategies to embed in a PPP investment in order to optimally control risk
and maximize investment value.
The foundation of this framework is that for the specific risks one seeks to control,
one could indicate which specific option to use. Although there are a number of real
options available in the literature, the application of these options in real world settings
is not straightforward. Thus, this framework represents an effort to address the
evident gap between the real options theory and its application in management Risk mitigation
practice. With this aim, further research will be focused on the assessment of each in transport
mitigation strategy expressed in terms of real options in order to evaluate its
effectiveness in mitigating risks and its impact on the project value. When multiple PPPs
strategies are available for mitigating the same risk, the approach will be to compare
strategies and choose the cost-effective one.
211
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pp. 198-211.

Corresponding author
Roberta Pellegrino can be contacted at: r.pellegrino@poliba.it

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