Risk Management in PPP
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RISK MANAGEMENT IN PPPRISK MANAGEMENT IN PPP - Vaijayanti Padiyar, Tarun Shankar and Abhishek Varma IL&FS Infrastructure Development Corporation Ltd.
1.1. The Essence of Risks The Essence of Risks –– A Historical Perspective A Historical Perspective
An exact definition for risk is exclusive and its measurement is controversial. In literature, the word “risk” is used in many different meanings. Oxford dictionary defines risk as “chance or possibility of danger, loss, injury, etc”. Some of the other definitions of risk as
presented in literature are:
1. “A situation where there exist no knowledge of its outcome”
2. “The variation in possible outcomes that exist in nature in a given situation”
3. “High probability of failure”
4. “Lack of predictability about structure, outcome, or consequences in decision or planning situations”
5. “The chance of something happening that will have an impact on objectives. It is measured in terms of consequence and likelihood”
The essence of risk is characterised by three factors: the event, the likelihood and the impact of the event
(a) The event: A possible occurrence which could affect the achievement
(a) The likelihood: The chance (or probability) of the risk event occurring within the time period
(a) The impact: The financial value of the effect of the risk event
Some researchers restrict the risk definition to events with negative consequences whereas others define it with covers of both positive and negative consequences. Most of the
RISK MANAGEMENT IN PPP
1. The Essence of Risks – A Historical Perspective
2. Methods and
Tools for Risk Modelling and Analysis
3. Risks in PPP 4. Risks at different
stages of a PPP Project
5. Risk Mitigation
Strategies for PPP
6. Classification of
Risks
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above definitions refer to the uncertainty and adverseness of the event. In literature there is no agreement on the clear distinction between risk and uncertainty. When some authors see no difference between risk and uncertainty, others consider that a situation is risky when the probabilities of outcome are known and a situation is characterised as uncertain, if the probabilities of outcomes are not known.
Al-Bahar (1989) combined the essence of both risk and uncertainty and defined risk in the context of project management as “The exposure to the chance of occurrences of events adversely or favourably affecting project objectives as a consequence of uncertainty”. He also characterised risk with three components: risk event, the uncertainty of the event and the potential loss or gain. Martin and Heaulme (1998) have added another component “time of occurrence” to characterise risk in addition to event, probability and impact. Survey research conducted by Akintoye and Macleod (1997) among contractors and project management practices of UK construction industry has revealed that the average perception with respect to project risk is “the likelihood of unforeseen factors occurring, which would adversely affect the successful completion of the project in terms of cost, time and quality”.
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Risks and Risk Management under different circumstancesRisks and Risk Management under different circumstances
Risk in Different Risk in Different
ContextsContexts DescriptionDescription
Aim of Risk Aim of Risk
Management in the Management in the
Given ContextGiven Context
Risk as
opportunity
Greater the risk, greater
the potential for return as
well as loss
Maximise the
upside and
minimise the
downside within the
constraints
Risk as hazard or
threat
Potential negative events
which affects the goal and
the economic
performance of
Reduce the
probability of
negative events at
minimum cost
Risk as
uncertainty
Refers to the volatility of
the outcome
Reduce the variance
between anticipated
outcomes and the
actual
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2.2. Methods and Tools for Risk Modelling and AnalysisMethods and Tools for Risk Modelling and Analysis
There are many tools available to model system uncertainty. Work breakdown structure (WBS), risk breakdown structure, fault tree, event tree, cause-consequence analysis, influence line diagramming, CPM and PERT networks and decision tree are the various tools used in practice.
A fault tree is a logical diagram, which shows the relation between a specific undesirable event in the system, and failures of the components of the system. It is a technique based on deductive logic. An undesirable event is first defined and causal relationships of the failures leading to that event are then identified.
Event tree analysis is a method for illustrating the sequence of outcomes, which may arise after the occurrence of a selected initial event. This technique, unlike fault tree uses inductive logic. It is mainly used in consequence analysis for pre-incident and post-incident application.
Cause-consequence analysis (CCA) is a blend of fault tree and event tree analysis. This technique combines cause analysis (described by fault trees) and consequence analysis (described by event trees), and hence deductive and inductive analysis is used. The purpose of CCA is to identify chains of events that can result in undesirable consequences. With the probabilities of the various events in the CCA diagram, the probabilities of the various consequences can be calculated, thus establishing the risk level of the system.
An influence diagram is a compact graphical and numerical framework, which identifies the critical variables and explicitly reveals any conditional independence between them Decision trees provide a convenient way to organise the calculations in a decision problem when the actions and state of the domain is finite.
Except WBS, CPM networks and decision trees all the above tools were primarily developed for system safety and reliability analysis. But many of these tools in combination with other risk assessment methods are being experimented in modelling and analysis of project risks and uncertainty.
Decision analysis, stochastic simulation, sensitivity analysis
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and conceptual models/artificial intelligence (AI) analysis are the different approaches that have been used in probability-impact evaluation of project risks. Akintoye and MacLeod’s (1997) survey research in UK construction industry revealed that sensitivity analysis and simulation technique have reasonably good acceptance among contractors and project management practitioners.
The methods of decision analysis are basically decision-making tools under uncertainty and include many methods like algorithms, mean end analysis, Bayesian theory and decision trees. An algorithm contains a sequence of instructions for problems solving. Mean end analysis is a method of clarifying a chain of objectives to identify a series of decision points. The decision tree shows sequence of known choices and their possible outcomes graphically and the decision maker can identify best alternatives that fulfil the objectives. It incorporates probabilities of risks and the costs or rewards of each logical path of events and future decisions. The decision analysis as a whole requires tremendous effort in data collection.
Project simulation uses a model that translates the uncertainties specified at a detailed level into their potential impact on objectives that are expressed at the level of the total project. The uncertainty models like WBS (suitable for cost risk analysis), influence line diagrams, network diagrams (schedule risk analysis) and fault tree can be used as simulation models. The application of this technique requires the specification of a probability density function for each input variable, which may often be difficult to obtain. Subjective or objective probabilistic information may be used for evaluation. Using this method, probability of project outcome is obtained by carrying out a number of iterations, depending upon the required degree of confidence. Sensitivity analysis examines the extent to which the uncertainty of each project element affects the project objective being examined, when all other uncertain elements are held at their baseline values. Like simulation, a base model that translates uncertainty is used in sensitivity analysis. One of the main reasons for its popularity is, its ability to discover the vulnerable factors in a project
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3.3. Risks in PPPRisks in PPP
Though BOT contract framework makes the arrangement best suitable for procurement of PPP projects, the complexity of the arrangement leads to an increased risk exposure for all the parties involved. Investors in BOT projects have to deal with many risk issues right from the developmental stage of the project. The three broad stages in a BOT project with different risk profiles are developmental phase, construction phase and operation phase. The whole process of project development is a complex, time consuming and expensive business. The level of negotiations is extensive and the opportunity costs are very high. Since the finance available during the initial project phase is limited to equity, the financial risk is also high during developmental phase.
The construction phase of a BOT project is also risky, because high financing costs, time spillovers and cost overrun often distort the future revenue generation and profitability prospects of the projects. The financial success of a BOT project is highly susceptible to the delay in completion. Compared to other industrial or commercial developments, there is usually a high investment requirement and longer construction period in an infrastructure project under BOT set up. A long construction period combined with the need to capitalise interest on the borrowed sums until completion (as no revenues are available until after completion) results in high financing costs. Risk also emerges due to underestimation of operating cost and overestimation of output or demand.
However, the operation phase is considered to be with relatively low risk. BOT project can be described as a high-risk construction project followed by a low risk utility project. Pre-completion risks are often perceived to be greater than post-completion market risks in a BOT type project whereas in an industrial project, the risk of product obsolescence and the competitive market forces create greater risk.
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Sources of risk in a typical PPP project are shown in figure below. Influence of many internal and external factors coupled with long lifecycle adds uncertainty to the projects
outcomes.
Risk Sources in PPP (source – Thomas A V, K N Satyanarayana and K Ananthanarayanan – Identification of risk factors and risk management strategies for BOT Road projects in India)
4.4. Risks at different stages of a PPP ProjectRisks at different stages of a PPP Project
An infrastructure project typically faces several risks throughout the project period, which the project participants seek to mitigate to enable financing on a limited project recourse basis. The types of risks are different at each stage of the project and hence need to be mitigated appropriately.
1. Engineering & Construction Engineering & Construction PhasePhase.. The project company draws down the majority of the loan to finance construction activity, equipment purchase, and other pre operating costs. This phase can last several years, depending on the size of the project.
Risks in PPP
Operation
Demand
Contracts Construction
Government
Market
Legal & regulatory environment
Direct source
Indirect source
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Engineering &
Construction Phase
Start-up Phase
Operations Phase Loan
Exposure
2. Project StartProject Start--up Phaseup Phase.. During this phase, equipment is tested, raw material inputs are ordered, project staffing is completed, and marketing starts. Loan exposure may rise slightly during this phase due to working capital requirements and final payments to contractors and equipment suppliers. Initial sales from project start up enable loan payoff to commence.
3. Operation PhaseOperation Phase Inadequacy of revenue is the most significant risk during this phase, especially from the perspective of debt servicing and acceptable return to project investors. Over a period of time, as the project cash flows stabilize and the exposure of the lenders / investors gets reduced, the risk perception also reduces
The above figure reflects upon the risk profile during the various stages of the implementation of an infrastructure project. The level of exposure faced by lenders does not necessarily correspond directly to the risks involved. Specific strategies are adopted at each stage of the project’s life either to reduce the likelihood of adverse events or to lay risks off to parties best positioned to manage them.
In addition to the risks specific to each phase of the project, there are other risks like political risks and force Majeure risks that remain throughout the project period, though the impact may vary based on the project phase.
Time
Project Risk Phases
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5.5. Risk Mitigation Strategies for PPPRisk Mitigation Strategies for PPP
Efficient risk allocation and mitigation are central to bringing infrastructure projects to financial closure and to providing appropriate incentives during construction and operation. Projects may still be financeable if some risks are not allocated according to this principle, but costs – and ultimate tariffs – will be higher. Sponsors and lenders expect higher rewards for assuming higher risks.
Risk in any transaction cannot be eliminated. It always exists for both parties to the contract. However, risk can be managed to an acceptable level, using the following protocol:
1. Identify the risk: What events or actions would adversely affect the cost, performance, timing or viability of a project? E.g. what would happen to the project if the inflation rate increased significantly?
2. Determine the severity of the risk: What is the specific cost, time delay or reduction in performance if this event happens?
3. Allocate the risk: The “golden rule” of risk management in contracts is that a risk should be managed by the party best able to manage that risk. Shifting risk to party not able to manage that particular risk costs more, and creates even more risk to a project.
4. Mitigate the risk: Determine what must be done to reduce the likelihood of an adverse event. E.g. Construct all structures above the 100 year flood elevation to reduce the likelihood of flood damage.
5. Price the risk: Determine the cost of addressing the risk. E.g. the cost of flood insurance.
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Risk Management Tools and Technique for Projects (source – Thomas A V, K N Satyanarayana and K Ananthanarayanan – Identification of risk factors and risk management
strategies for BOT Road projects in Indian)
Checklists
Flowcharts
Interviews
Delphi technique
Brainstorming
SWOT analysis
Surveyinvestigations
Riskidentification
Risk response
Riskassessment
Qualitative riskassessment
Quantitative riskassessment
Uncertaintymodelling
Data collection
Probability andimpact evaluation
Objective data
Subjective data
Fault tree
Decision tree
Work break-down structure
Event tree
Cause sequenceanalysis
Influencediagramming
CPM/PERT
Decision analysis
Stochasticsimulation
Conceptualmodels/Artificial
intelligence
Algorithms
Bayesian theory
Mean endanalysis
Tree analysis
Fuzzy sets andlogic
Expert systems
Neuralnetworks
Analyticalhierarchyprocess
Cross impactanalysis
Sensitivityanalysis
Avoidance
Prevention
Retention
Transfer
Risk breakdownstructure
Riskmanagement
Reduction
Case studies
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6.6. Classification of RisksClassification of Risks
If private investment in infrastructure has to succeed on a sustainable basis, it is necessary to reduce both the perception and the reality of risk. The basic approach to risk management should be based on the principle that the party best able to manage a risk at least cost should mitigate it.
The risks associated with infrastructure projects can be broadly classified as under:
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Risks associated with Infrastructure Projects
Project Risks
Political & Social Risks
Commercial Risks
Market Risks
Financial Risks
Legal and Regulatory
Risks
Operational & Maintenance
Risks
Force Majeure Risks
Environmental Risks Land
Acquisition Risk
Delays in Project
Development
Technology
Risk
Cost Overruns Risk
Risk in various contracts (source – Isaksson T, Model for Estimation of Time and Cost Based on risk evaluation for
Tunnel Projects, PhD Thesis)
Cost reimbursement
Target
Lump Sum Price escalation
Lump Sum Fixed Price
Turnkey
Project’s Cost Contractor’s Risk Owner’s Risk
100%
0% 100%
0%
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Risk Matrix in a PPP TransactionRisk Matrix in a PPP Transaction
Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
1. Land
Acquisition
Project
Development
Delays in the land acquisition and in
providing unencumbered right of way to
the EPC contractor (Notice to proceed to
the Contractor) can lead to delays in the
start of construction resulting in
escalation of project cost. Additionally,
the risk of the costs of acquisition not
being contained within the estimates
provided in the project cost estimates
also increases.
(a) Timely provision of land for
construction of facilities and
systems should be made a
condition precedent to the
Lease/Concession Agreement.
(b) For delay related to consents,
approvals, clearances, the
government should grant
necessary permissions and the
same should be executed within
specified time.
(c) On delay, the concession period
should be extended by an equal
period
2. Delays in
Project
Development
Project
Development
During the development phase, the
critical activities that may be identified
are:
(a) Finalization of the project structure
(b) Finalization of the contractual
(a) Arranging finance during the
project development phase to
ensure timely availability of funds
to meet development
expenditure.
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
framework viz. the Concession
Agreement, the EPC Contract the
Support Agreement and the O&M
Agreement
(c) Availability of requisite approvals
and clearances
(d) Achievement of Financial Close
(e) Delay in project commissioning
(b) Employing consultants with
correct management skills (both
“hard” and “soft”).
(c) Employing lawyers with the
requisite expertise soon after the
project is conceptualized.
(d) Sensitizing government to the
number, type and timing of
government approvals much in
advance of the requirement for
the approvals.
(e) Incorporating the concerns of
lenders and potential equity
investors in project structure and
legal documentation prior to
approaching the market for
funds.
3. Project
Completion
Risk
Construction
Period
The project completion risk or the
contractor’s risk refers to the possibility
of non-completion of the project within
the designated period from the Notice
to Proceed. Any delays in the
(a) This risk should be mitigated
through a Provision under
Concession Contract (CC)
(b) CC with EPC Contractor to
include turnkey, fixed price
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
construction may be expected to result
in increased construction costs
design & construction contract
with payments made on reaching
certain milestones
(c) Contractor to pay Liquidated
Damages for delays during
construction
(d) Independent Engineer should
review and monitor progress
4. Project Cost
Risk / Cost
Overruns
Construction
Period
If the EPC Contract is a unit rate
contract rather than a fixed price
contract, there is a possibility of an
increase in the project cost as compared
to the current estimates.
1.1. The detailed Project Report
should be made specifying in
detail, the cost estimates for
various sub-components of the
project on the basis of which the
EPC bids should be invited.
2.2. Additionally, adequate
contingency provision and
insurance cost for unforeseen
circumstances should be built
into the project
3.3. Strict construction monitoring by
the Independent Engineer
5. Technology Construction / This pertains to the risk that the project (a) The project to be designed after
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
Risk Operations
Period
may be either physically inappropriate
to handle the projected demand or is
inappropriately designed to meet local
socio-economic needs (i.e. increased
requirements) and hence rectification of
these design defaults could escalate the
O&M costs during the operations
period.
a comprehensive analysis of the
local conditions
(b) The construction supervision
should be carried out with strict
penalties for non-compliance of
the technical design by the
Contractor.
(c) The cost of rectifying such non-
compliance would also be borne
by the Contractor
(d) The Contractor should provide a
performance bond with a validity
of eighteen months (defects
liability period) after project
commissioning to take care of
any construction lacunae, that
may be detected during the
initial phase of project
operations
6. Regulatory
and
Administrativ
Operations
Period
During the operations phase, the delays
and costs associated with complying
with the regulatory requirements of the
(a) Debt Service Reserve:
Maintenance of cash reserves
aggregating to one year’s debt
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
e Risk government, lenders and multilateral
institutions can adversely impact the
financial viability of the project. In
particular, delays in toll notification will
adversely affect cash flows, weakening
the project debt service capability
(especially in the critical initial years)
and investor returns
service reserve requirement for
the next year to ensure that any
temporary shortfall of revenues
due to non-increase of tariffs
does not adversely impact debt
servicing in the short run
(b) Extension of Concession Period:
In the event of chronic delays in
tariff review adversely affecting
the achievement of the
designated return on the project,
the Concession Agreement
should provide for extension of
the concession period till the
designated return is achieved.
7. Commercial
Risk
Operations
Period
This category comprises of various risks
that are associated with the underlying
economic rationale for the project. E.g.
project viability is critically dependent
upon realization of demand as projected
and hence any significant adverse
variation from the estimates would
(a) The demand estimates should be
conservative since, actualization
of demand in line with estimates
is a key economic risk that the
project participants would bear.
(b) The Concession Agreement
should also provide for an
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
impair the debt servicing capability of
the project.
extension in periods of two years
each, till designated returns are
achieved
8. Operations
and
Maintenance
Risk
Operations
Period
In the event of O&M costs exceeding the
estimates used for the establishment of
financial viability, the residual cash
flows for debt/equity servicing would be
lower than anticipated thereby affecting
project returns
(a) The selection of O&M operator
will be on the basis of
competitive bidding. The
selection criteria should take into
account of its past record,
fiduciary responsibility exhibited
in other assignments, financial
strength etc.
(b) The O&M contract should provide
for a fixed & a variable fee which
could be based upon the O&M
requirements set forth in the
Concession Agreement.
(c) O&M Contract is a fixed price
contract, with the risk of cost
over-runs to be borne by the
O&M Contractor
9. Financial Risk
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
(a) Interest
Rate Risk
Operations
Period
Determination of project viability is
predicated on the existing interest rate
scenario prevailing in the country. A
drastic increase in the interest rate
scenario may affect the debt servicing
capability through project cash flows
and significantly depress shareholder
returns, even though the project may
still achieve the designated return
The project should be financed on an
optimal mix of fixed rate and floating
rate instruments, to hedge the
interest rate movement risk.
(b) Foreign
Exchange
Exposure
Risk
Operations
Period
In the absence of any natural hedge of
export revenues, the project cash flows
would be exposed to the currency
devaluation risk
(a) Tariff adjustments permitted
under the concession agreement.
(b) Forex debt should be kept to the
minimum and to be swapped for
Rupee debt to the extent
possible
(c) Inflation
Risk
Operations
Period
The tariff rates being inflation indexed,
the project revenues and consequently
the achievement of the designated rate
of return would be adversely affected in
case the inflation rate is lower than
what has been, assumed in the financial
model
Tariffs to be adjusted for inflation
during operations as per formulae
given in the concession agreement.
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
10.
Termination
Risk
Operations
Period
The risk pertains to the possibility of
unilateral termination of the concession
agreement prior to the achievement of
the designated rate of return on
frivolous grounds
Compensation package should be
structured in case of Termination of
the Concession Agreement with in-
built disincentives for any contracting
party to seek termination on frivolous
grounds
11.
Force
Majeure
Throughout
Project Cycle
This risk category deals with non-
political events of force majeure
considered as ‘Acts of God’ such as
epidemics, natural disasters,
earthquakes, floods during construction
phase affecting construction and such
other events. The impact of these risks
on construction and/or the project
operations could range from minor to
severe, say in case of an earthquake,
where the damage may be severe
enough to render the facilities
irreparable
(a) Comprehensive Insurance
Coverage
(b) In Force Majeure risks of types
which are not insurable, the
investors should get a yield of
certain percentage on equity on
the date of termination
12.
Political and
Social Risks
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
(a)(a) Events of Events of
WarWar
Throughout
Project Cycle
In the event of war or widespread civil
disobedience, the project’s commercial
viability may be adversely affected
(a) The probability of such a risk is
very low. Though the insurance
companies do not have a
package available for the
operating company, a risk
coverage is available to
international lenders from
various financial institutions like
MIGA etc.
(b) The Concession Agreement could
also provide for a relief to each
affected party from its respective
obligations including payment of
Liquidated Damages
(b)(b) NationalizatNationalizat
ion or ion or
RevocationRevocation
Throughout
Project Cycle
The political risk pertains to relegation
of contract terms and/or nationalization
of infrastructure services being
provided.
The Concession Agreement should
provide for Termination in case of
certain politically motivated events
affecting the project. In such a
scenario, the compensation payable
by the government for transfer of
project assets should at least be
equal to the outstanding dues to the
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Risk CategoryRisk Category Phase of Phase of
PredominancePredominance Risk Identification / DescriptionRisk Identification / Description Risk MitigationRisk Mitigation
project lenders, thereby fully
protecting the lenders.
(c)(c) Social RiskSocial Risk Throughout
Project Cycle
This is the risk that civil/political
problems may surface as a result of the
project, manifesting in boycotts,
sabotage etc. Such disturbances may
arise from a number of different
concerns, public objection to imposition
of tariffs, public discontent with the
environmental impact of civil works or
with other features of the project. An
event similar to any of the above could
impair the ability of the Concessionaire
to collect revenue thereby affecting the
project viability
Appropriate insurance package for
the project should be designed that
provides adequate cover against
these risks
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