Risks need to be identified early. This sounds obvious but often risks are identified too late in the process. Risk identification requires early and targeted due diligence, assessing the likelihood of the risk arising and then determining the impact on schedule, costs, operations and revenue if that risk materialises. Given the long project life for many infrastructure projects, this exercise can involve detailed sensitivity analysis/modelling and taking long-term views.
Risk allocation is key
Risks should be properly allocated to the right project party. The phrase "risk should be allocated to the party most able to manage it" has gone beyond cliche status because it is sound principle. Care is needed to ensure that all risks within a "basket" or scope of work (like a full construction work scope) are identified, considered and addressed by the party that will ultimately be bearing that risk.
Not all risks can be managed
Some risks are unmanageable in the traditional sense. This can happen if the probability of their occurrence and/or their impact is difficult or impossible to determine in a precise manner. The answer may be for the risk to reside with the party best able to "manage an unmanageable risk" or to provide for contractual review or termination. In a public infrastructure project, some level of government coverage or assumption of that risk might be required.Insure insurable riskBy and large, risks that are insurable should be insured. Maintaining insurance coverage over the life of a project can be a challenge. Careful thought is needed to work through and allocate among the project parties the risk of uninsurability and/or the risk that the cost of vital coverage increases materially.
Is the risk affordable?
It is important to consider the credit standing and financial ability of responsible parties to deal with risk. Potential costs flowing from risks that materialise can be eye-watering. Examples include the likes of remedial works, demobilisation and remobilisation costs, insurance excesses/deductibles and delay costs. Project parties need a high degree of confidence that each other party has the means to deal with the financial consequences of the risks they take on. Counterparty due diligence on the relevant parties' credit standing is important. In many cases, credit enhancement or performance security will be useful or required (for example, in the form of parent company guarantees, letters of credit or cash collateral). But even after the best due diligence and risk allocation, project parties should also consider worse case scenarios and "Plan Bs" in the event of counterparty insolvency.
Be aware of contractual limits
Project parties typically spend a lot of time ensuring that key project risks are passed-through contractually to the relevant project party. It's important project parties understand that a risk allocated to someone else does not always result in full risk offload. Contractual limits can apply in some cases. For example, in relation to schedule risk passed through to a construction contractor, caps will likely apply on the construction contractor's delay liquidated damages and overall liability under the contract.
Risk-planning reduces cost
It takes a lot of effort to create a workable risk allocation framework that works from the perspectives of all the project parties (for example, government parties, equity sponsors, contractors and banks). Sometimes the project parties or their advisers will have pre-conceived ideas on where risks should reside and departure from those pre-conceived positions can involve significant negotiation, time and cost. It needs to be factored into timelines and budgets.
New ideas
It is unwise to approach a risk allocation exercise on the basis that there is a single formulation or answer that will apply in all cases. While earlier deals and precedent can be useful, there can be real value in new ideas in allocating and managing risk. The ability to approach the exercise with an open mind, particularly in a small market like New Zealand, can be a real strength.
Ultimately, if the right work is done, risk should be something that should be understood and respected rather than feared.
• Tom Fail is a Minter Ellison Rudd Watts partner with expertise in project finance and infrastructure matters.
