Risk allocation in public private partnerships: A principal agent approach

This research examined risk allocation in public private partnership (PPP) projects in the China, particularly in the water sector. The primary objective of this study was to develop a framework for efficient risk allocation so that local governments implementing PPPs can make an informed decision on how the risks can be apportioned between the public and the private sector to achieve an efficient outcome for both the parties. This dissertation analysed risk and their allocation from the theoretical lens of the principal agent theory (PAT) where local governments implementing the PPP were taken to be the principals and the project companies were taken as the agents. Moreover, efficient risk allocation was defined as a situation where principal agent problems related to the lack of information for the government as well as opportunistic behaviour of both parties are minimal and consequently resulting in a win-win balance for the government and the private sector. The main research questions addressed were: (i) what are the risks in PPP water projects; (ii) how are these risks allocated and (iii) how can these risks be allocated more efficiently. To answer the research questions, 8 research objectives were formulated. Primary data for this study was collected from PPP consultants via 32 structured questionnaire surveys and 13 semi-structured interviews. In addition, 2 PPP contracts were also analysed. The data obtained from the questionnaire surveys were analysed using descriptive and non-parametric statistics, while the data from the interviews and the PPP contracts were analysed using qualitative methods. Investigation into risks in PPP water projects revealed risks that are significant for local governments. The stages at which these risks manifest during the PPP lifecycle and the relationship between risks were also analysed. The results showed that the most significant risks comprise of both external risks and project risks during the construction and operation stages and many of these risks are interrelated. Moreover, it was also found that these risks are strongly linked to principal agent problems. Examination of risk allocation in PPP water projects disclosed the features of risk allocation mechanisms in China. The findings demonstrated that the risks are not allocated efficiently and the key reasons identified were: (i) lack of local government understanding, (ii) too much risk transfer to the private sector and (iii) lack of measures to identify and assess principal agent problems. It was further revealed that governments taking on more external as well as project risks could lead to a more efficient allocation and reduce principal agent problems. In order to determine how risk should be allocated in PPPs, two approaches were taken. The first approach established efficient risk allocation, i.e. which party should take what risk and the second demonstrates efficient risk transfer, i.e. how risks can be efficiently allocated and transferred. Key parameters were identified for both approaches by reviewing the risk management literature and the principal agent theory. The parameters identified for efficient risk allocation were (i) control; (ii) information and (iii) incentives. The association between these parameters and their association with efficient risk allocation were statistically tested using Chi square tests. The results were significant revealing strong associations between the variables which implied that these parameters are necessary in determining efficient risk allocation. To demonstrate efficient risk transfer, the parameters (i) competition; (ii) monitoring and (iii) incentives were applied in two case studies. The findings demonstrated how these parameters are employed successfully in the allocation and transfer of significant risks. The findings illustrated that competition limits the problems related to ex-ante information and determines the private sectors ability to bear risks. Monitoring was shown to reduce ex-post information asymmetry and prevent moral hazard problems. The findings a so demonstrated the role of incentives to ensure that the risks are allocated to the right party and that they are efficiently managed. Finally, the parameters for efficient risk allocation and transfer were used to develop a risk allocation framework for PPP projects in China. The results of this study provided empirical evidence to support the validity of the framework.