The construction and

building research
conference of the Royal
Institution of Chartered
Surveyors

Georgia Tech, Atlanta USA,

6-7 September 2007
COBRA 2007

Proceedings published by:

RICS
12 Great George Street
London SW1P 3AD
United Kingdom

In association with:

College of Architecture
Georgia Institute of Technology
Atlanta
United States of America

© RICS, Georgia Tech and the contributors

First published 2007

ISBN 978-1-84219-357-0

The illustrations used on the front cover are the winners of the 2007
‘Picturing the Built Environment’ photograph competition.

From the top:

Arthur Pichler: People and Places (overall winner)

Brad Layton: Heritage Works

Adam Blacklay: The Shock of the New

 Risk Allocation in Public-Private
Partnership Projects – An Innovative
Model with an Intelligent Approach

Xiao-Hua JIN and Hemanta DOLOI

Faculty of Architecture Building and Planning
The University of Melbourne
Parkville, Victoria 3010 Australia
ji@unimelb.edu.au

ABSTRACT
Both the increasing private participation in public projects and the critical
importance of appropriate risk allocation to the success of Public-private
partnership (PPP) projects justify specific research on how to establish
effective risk allocation strategies in PPP projects. Partner’s risk
management capability is currently the main concern to risk allocation in
PPP projects. Following the transaction cost economics, it is argued that
factors such as partner’s commitment and risk management structure
should be considered simultaneously in order to develop effective risk
allocation strategies. Based on the holistic capability-commitment-
governance-driven view, this paper proposed a model for generating an
optimal risk allocation strategy in PPP projects. The model is demonstrated
and described. An artificial intelligent technique integrated with fuzzy logic
for model testing and validation is then introduced and justified. The
innovative model is expected to provide a logical and complete
understanding of the risk allocation strategy selection process, and to
provide stakeholders with a richer framework than previously existing ones
to guide their decision-making on risk allocation strategies.
Keywords: Risk allocation, Risk management, Public-private
partnership (PPP), Artificial Neural Network (ANN), Fuzzy logic

INTRODUCTION

Public services, such as power supply, transportation, telecommunications,

education, and health, are so important to the survival of most societies
that non-delivery of them can cause serious social welfare disasters. Rapid
2 Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach
growth in many developed and developing countries has been leading to a
substantial demand for investment in these infrastructures. Conventional
provision of infrastructure funded by governments has lead to inefficacies
and subjected infrastructure development to the availability of
governmental funds. As a mechanism to balance such anomalies, the
concept of providing concessions to financially unattractive projects has
been used and enabled governments to maintain a strategic interest in the
infrastructure. For many governments throughout the world, a range of
Public-Private Partnership (PPP) arrangements are rapidly becoming the
preferred way to provide public services (Anonymous, 2004).
One of the greatest benefits for governments involving private
participation in a project is that appropriate risks can be transferred to the
private sector. Because private sector is supposed to be capable of
managing those risks better, cheaper and higher-quality infrastructure
services may be provided than if the government develops the project in
conventional way. However, risk management in PPP projects are
becoming more complex as social infrastructure projects, including courts,
hospitals, prisons, schools and public housing, have begun to appear in the
PPP market. The complexity of the arrangements has led to increased risk
exposure for all the parties involved (Woodward, 1995). Factors such as
the duration of the loan, susceptibility to political and economic risk, low
market value of the security package and limitations on enforcing security
all contribute to the complex risk profile of PPPs (Thomas et al., 2003).
Effective risk allocation in PPP project is therefore no easy job.
As PPP markets have grown globally, there has been a corresponding
rise in studies on PPPs, in particular with the focus on various risks
inherent in PPPs (Akintoye and Chinyio, 2005). Risk management
capabilities of involved parties are often the major concern when choosing
an effective risk allocation strategy. From the viewpoint of transaction cost
economics, however, much of the literature on organizational capabilities
suffers from a lack of attention to the business environment and the
resultant potential for opportunism (Foss, 1996, Mahoney, 2001,
Williamson, 1999). On the other hand, The literature on organizational
capabilities argues that transaction cost economics ignores or
underemphasizes differences in firm capabilities (Winter, 1988). It has also
been argued that transaction cost economics view overlooks the fact that
past transactions between partners may generate processes that alter the
calculus for future transactions (Gulati, 1995, Ring and Van de Ven, 1994).
Each of these concerns has some validity.
In this paper, an innovative model is proposed to address the
abovementioned questions by integrating the resource-based view of
organizational capabilities and transaction cost economics view of
business environment and organizational governance structure. In the next
section, major factors associated with risk allocation in PPP projects are
briefly reviewed. The model and the techniques to be adopted for model
testing and validation are then demonstrated. Finally, the possible
contributions of the artificial intelligent model are introduced in the
conclusion.
Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach 3
LITERATURE REVIEW

The term of Public-Private Partnerships (PPPs) has been interpreted

widely in the literature to encompass any arrangement between the
government and private sector to deliver services to the public. Although
there is no unified definition of PPPs, all definitions have common features
or characteristics (Li and Akintoye, 2003), such as the potential for synergy,
the development and delivery of a strategy or a set of projects or
operations, and the social partnership (McQuaid, 2000). In this study, PPPs
refer to a complex long-term contractual arrangement involving the
provision of services that require the construction of infrastructure assets
(Anonymous, 2004).
PPP is a method of procurement, which is used most frequently for
major infrastructure procurements. It involves the use of private sector
capital to fund an asset, which is used to deliver outputs for a government
agency. Emphasis is placed on the service or capability that the public
sector requires rather than the assets used to provide them. The private
sector is required to invest in the creation or acquisition of the assets
required to facilitate the delivery of a service or capability. On the other
hand, the public sector provides to the private sector payments that are
contingent on their performance, allowing them to recover their initial
investment. The arrangements are long-term in nature, typically extending
over 15 to 30 years (DFA, 2005a).
There are some underlying principles for PPPs. The core principle is
value for money (VFM), which refers to the best available outcome after
taking account of all benefits, costs and risks over the whole life of the
procurement (DFA, 2005a, DTF, 2000). With VFM, a service or capability
could be delivered at a lower cost, an expected financial outcome could be
achieved with greater certainty due to less exposure to significant risks,
and the end-users could receive increased benefits due to the public
sector's focus on service delivery rather than asset procurement (DFA,
2005a). Risk transfer, whole-of-life costing, innovation, and asset utilisation
are usually stated as the VFM drivers for PPPs (Hayford, 2006).
Many different arrangements have been developed for PPPs with
various degrees of partnership and shared control (Morledge et al., 2006).
In this study, PPPs are referred to as concession-based methods. The
terminology and acronyms used to describe concession-based project are
not used consistently though concession-based approaches are the oldest
forms of PPPs. Whilst a number of terms are virtually synonymous,
different project that apparently use the same terms may vary significantly
in the actual contractual arrangements (Morledge et al., 2006). The most
commonly used variants since the emergence of PPPs include BOT (Build-
Operate-Transfer), BOO (Build-Own-Operate), BOOT (Build- Own-
Operate-Transfer), and DBFO (Design-Build-Finance-Operate).
In PPP projects, risk is perceived from the public sector’s view as ‘any
event which jeopardizes the quality or quantity of service that they have
contracted for’, and from the private sector’s view as ‘thought of any event
which causes the cash flow profile of the project to depart from the base
case and jeopardize the debt servicing ability of the project or its ability to
4 Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach
generate a dividend stream for shareholders’ (Arndt, 1999). It is critical for
government to understand that while it is sub-optimal for the public sector
to retain inappropriate risks, it is also sub-optimal to transfer inappropriate
risk to the private sector (Arndt, 1999). This is because transfer of risks to
the private sector comes at a price though it is one of the key VFM drivers
in a PPP transaction (Hayford, 2006). Risk allocation strategy is integral to
determining the VFM potential of a PPP project as distinct from other
delivery options (DFA, 2005b). Inappropriate risk allocation can damage
the VFM proposition of a PPP deal because the Public Sector Comparator
(PSC) and Private Financing Predictor (PFP), both approximate measures
of the whole-of-life project cost, are highly sensitive to the allocation of
risks. If risks absorbed inappropriately in the public sector, government
would raise taxes or reduce services to pay for its obligations when the
risks materialize. In contrast, if risks absorbed inappropriately in the private
sector, excess premiums would be charged to the government or even
directly to the end users.
Moreover, a particular pattern of risk allocation may be criticized as
improper under certain circumstances while being deemed equitable or
optimal under some other circumstances. While some others need to be
allocated differently from project to project, some risks may be common to
all projects that share similar allocation in general (Rahman and
Kumaraswamy, 2002). The optimal risk allocation may also vary with
different individual experiences of the decision-makers. Improper allocation
of risks among stakeholders in PPP projects may lead to sub-optimality
and result in higher than necessary prices for risk transfer (Thomas et al.,
2003). It is therefore necessary for both sectors to analyze carefully their
strategic aims and objectives and relative abilities to manage risks and
control relevant situations (Thompson and Perry, 1992).
Optimal risk allocation seeks to minimize both project costs and the
risks to the project by allocating particular risks to the party in the best
position to control them (DFA, 2005a, DTF, 2000, Hayford, 2006, Kangari,
1995). This is based on the principle that the party in the greatest control or
possessing the best capability of management with respect to a particular
risk, has the best opportunity to reduce the likelihood of the risk
eventuation and to control the consequences of the risk, if it materializes,
and thus should assume it (Rahman and Kumaraswamy, 2002, Thomas et
al., 2003). Allocating the risk in line with those opportunities creates an
incentive for the controlling party to use its influence to prevent or mitigate
the risk and to use its capacity to do so in the overall interests of the project
(Ahmed et al., 1999). Optimal risk allocation will also lead to lower risk
premiums and therefore reduces overall project costs (DFA, 2005b).
Nonetheless, a common perception that privatization involves transfer
of all risks to the private sector is prevalent in many countries until recent
days. Although this has major limitations and many governments now
recognize that privatization is a partnership in which they must retain some
risk, the principle of optimal risk allocation is often not followed in many
PPP projects (Faulkner, 2004, Thomas et al., 2003). Sometimes risks will
inevitably be allocated to the party least able to refuse them rather than the
party best able to manage them, especially when the government
Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach 5
maintains maximum competitive tension. Major reasons may include: (1)
each party holds its own subjective views as to the likelihood and
consequences of certain risks, the ability of the respective parties to
manage various risks, and the costs that other parties may incur when
managing various risks; (2) many risks are not wholly within the control of
one particular party and thus its risk management ability and costs may
depend more or less upon the behavior of other related party(s); and (3)
many influential factors affect risk allocation, such as commercial
requirements and bargaining power (Hayford, 2006).
Nonetheless, little serious pondering has been made over the
mechanism underlying the risk allocation decision making process. It is
submitted in this paper that the transaction cost economics (TCE) is an
appropriate theory that can serve the explanation purpose. Transaction
costs are the costs of running the economic system (Arrow, 1969). Such
costs are the economic equivalent of friction in physical systems and
distinguished from production costs, which is the cost category with which
neoclassical analysis has been preoccupied (Williamson, 1985: pp.18-19).
TCE poses the problem of economic organization as a problem of
contracting. Ex ante and ex post costs of contracting are the major types of
transaction costs. They must be addressed simultaneously as they are
interdependent (Williamson, 1985: pp.20-21).
TCE assumes that (1) human agents are subject to bounded
rationality, where behavior is ‘intendedly rational but only limitedly so
(Simon, 1961: p.xxiv)’, and (2) are given to opportunism, which is a
condition of self-interest seeking with guile (Williamson, 1985: p.30). TCE
further maintains that there are rational economic reasons for organizing
some transactions one way and other transactions another. The principal
dimensions with respect to which transactions differ are asset specificity,
uncertainty, and frequency; with the first being the most critical dimension
for describing transactions (Williamson, 1985: p.52). The organizational
imperative that emerges in such circumstances is to ‘organize transactions
so as to economize on bounded rationality while simultaneously
safeguarding them against the hazards of opportunism’ (Williamson, 1985:
p.32).
Based on the literature discussed above, a model that could facilitate
decision-making on an effective risk allocation strategy in PPP projects has
been conceptualised. In order to construct such a holistic model, factors
such as organizational commitment should also be taken into consideration
while organizational capabilities in risk management remain the major
concern.

MODEL CONSTRUCTION

Based on the practice of TCE, partners organize their transactions to

minimize total costs (Hoetker, 2005, Williamson, 1996). By assigning
transactions to governance structures in a discriminating way, transaction
costs are economized (Williamson, 1985: p.18). Because any issue that
can be formulated as a contracting problem can be investigated to
6 Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach
advantage in transaction cost economizing terms (Williamson, 1985: p.17),
it is proposed in this paper that risk allocation can be viewed from a TCE
perspective. Choosing a risk allocation strategy could actually be viewed
as the process of deciding the proportion of risk management responsibility
between internal and external organizations based on a series of
transaction characteristics in order to achieve the optimal risk management
performance.
Without transaction friction, the total costs for providing a required risk
management service are only the production costs. Accordingly, production
costs can be defined as the costs for providing required risk management
service when transaction costs are not considered. In this situation, given a
particular level of total costs, the partner who is more capable will generally
achieve better performance. When the transaction friction is considered,
however, total costs include not only the production costs but also the
transaction costs (mainly governance costs). The trade-off between these
two types of costs is acknowledged. Given the same level of total costs as
mentioned before, worse performance will be achieved due to the fact that
some of the total costs are expensed for governing the transaction rather
than directly for the production.
Nonetheless, the total costs can be minimized when adopting a
particular risk allocation strategy, i.e. a particular governance structure. In
other words, given the same level of inputs, a particular governance
structure (i.e. risk transfer, risk retaining, or risk sharing) is supposed to
maximize the outputs. In this study, inputs include partners’ capability and
commitment, which are the indicators to the principal dimensions (asset
specificity, uncertainty, and frequency) regarding which transactions differ
(Williamson, 1985: p.52). On the other hand, outputs are measured by risk
management performance. In PPP projects, public partner would opt to
retain or transfer a risk when the difference of total costs between private
partner and itself is within or exceeding a predetermined level. This is
because it is assumed that if risk management performance discrepancy is
too huge, joint management would not reduce the total costs further below
the costs individual management would incur. Otherwise, public partner
may decide to manage that risk jointly with private partner, either equally or
unequally, by assuming that joint management would reduce the total costs
below the costs either partner would incur when managing the risk
individually.
A conceptual model for effective risk allocation in PPP projects is
illustrated in Figure 1. The model comprises of five constructs, which are
‘environmental uncertainty’, ‘risk management commitment’, ‘risk
management capability’, ‘risk allocation strategy’, and ‘risk management
performance’. ‘Opportunism’ is deemed as an intermediate variable
between ‘environmental uncertainty’ and ‘risk management commitment’. It
is hypothesized that: (1) the level of environmental uncertainty should
determine the commitment level of a partner (Hypothesis 1), and (2) the
combined effects of governance structure of, organizational capabilities in,
and commitment to the management of a certain risk should determine the
risk management performance (Hypothesis 2). Theoretically, when risk
management performance is optimized, the corresponding risk allocation
Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach 7
strategy is the optimal one for the available partnership combination in
terms of partners’ capability and commitment. The detailed discussion of
the constructs is not included in the paper due to space limit.

Figure 1 The model for effective risk allocation in PPP projects

TECHNIQUES FOR MODEL TESTING AND VALIDATION

Conventional Techniques for Data Analysis

There have been many analysis tools and procedures for mitigating the
risky nature of construction projects. Historically, the mathematical theory
of probability is widely used as an uncertainty reasoning tool. The analytical
method relies on the calculus of probability to convert normal measures of
uncertainty input into an incorporated measure of project uncertainty in the
form of subtraction, addition, or multiplication of random variables. The
most common tools include decision tree, influence diagrams, Bayesian
networks, Monte Carlo simulation, and sensitivity methods (Han and
Diekmann, 2004). These methods can analyze various risk variables and
predict project performance on the basis of probabilistic measures. They
have been used for investment analysis, and risk appraisal of cost and
schedule uncertainties, among many other applications.
The abovementioned approaches are attractive under some
conditions because they can develop quantitative evaluation tools and the
output can be readily interpreted (Han and Diekmann, 2004). However,
most of these techniques often require formulation of mathematical
representations, assessment of conditional probabilities, or definition of
probability density functions. Because most of them are basically
probability-oriented, they do not identify all the factors necessary to reflect
8 Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach
realistic situations, especially those qualitative and non-monetary factors
such as political, legislative, and social ones, and cannot cope with a
problem bearing complex relationships among various variables (Thomas
et al., 2006). In reality, it is always difficult, if not impossible, to elicit the
probability of each variable with uncertainties. Therefore, a procedure
which can model a complex situation by eliciting the respondents’ non-
crispy or uncertain judgment regarding the relationship among variables is
desirable. In this study, a method called fuzzy artificial neural network
(FANN) will be used to model (1) the proposed relation between
environmental uncertainties and partner’s risk management commitment,
and (2) the proposed relation between capability-commitment-governance
factors and risk management performance.

Artificial Neural Network (ANN) and Fuzzy Logic

An Artificial Neural Network (ANN) is a massively parallel distributed

processor made up of simple processing units, which has a natural
propensity for storing experiential knowledge and making it available for
use (Aleksander and Morton, 1995, Lin and Lee, 1996). It resembles the
brain in two respects, i.e. knowledge is acquired by the network from its
environment through a leaning process; and interneuron connection
strengths (synaptic weights) are used to store the acquired knowledge
(Aleksander and Morton, 1995). It involves a statistical learning algorithm,
drawn from the field of biological neural network. It adopts non-parametric
regression estimates made up of a number of interconnected processing
elements between input and output data (Han and Diekmann, 2004).
Owing to their excellent learning and generalizing capabilities, ANN
techniques have been applied to a variety of construction domains,
including predicting potential to adopt new construction technology (Chao
and Skibniewski, 1995), forecasting of construction productivity (Chao and
Skibniewski, 1994), predicting earthmoving operations (Shi, 1999),
simulating activity duration (Lu, 2002), and the forecast of residential
construction demand (Goh, 2000). To date, most research efforts regarding
the application of ANN to construction have focused on utilizing the ANN’s
capability to handle highly nonlinear aspects.
Fuzzy concept was first proposed in 1920s by Lukasiewicz
(Lukasiewicz, 1957, Rescher, 1969). His work formed the basis of the
inexact reasoning technique, which was named possibility theory. Zadeh
(1965) extended the work on possibility theory into a formal system of
mathematical logic for representing and manipulating fuzzy terms, which is
called fuzzy logic. Fuzzy logic is the logic to infer a crisp outcome from
fuzzy input values (Zadeh, 1965, Zadeh, 1979). It is a branch of logic which
uses degrees of membership in sets rather than strict true or false
membership (Tah and Carr, 2000). Fuzzy logic is primarily concerned with
quantifying and reasoning with vague terms that appear in natural
language. These fuzzy terms are referred to as linguistic variables. It is
useful for uncertainty analysis where probabilistic data is not available
and/or when interval values of input variables are uncertain (Han and
Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach 9
Diekmann, 2004). A detailed review on fuzzy logic and fuzzy sets theory is
not included in the report due to the scope and length limits. Fuzzy logic
has been applied to many industrial sectors, including the construction
industry.
In general, artificial neural networks can classify inputs. With their
plasticity being maintained, ANNs can continuously classify and also
update classifications. Moreover, ANNs can also retrieve crisp information
from incomplete or fuzzy input. With their stability being reached, ANNs are
robust when inputs become less defined, i.e. fuzzy inputs, or when some of
the neurons do not function properly, i.e. fuzzy network parameters
(Kartakapoulos, 1996). On the other hand, fuzzy systems deal with current
fuzzy information and can provide crisp outputs (Liu and Ling, 2005).
Though each having their own shortcomings, ANNs and fuzzy systems
have a close relationship and both can work with imprecision in a fuzzy
space. The shortcomings of both may be overcome if fuzzy logic
operations are incorporated into ANN and ANN’s learning and classification
into fuzzy systems (Lam et al., 2001).
The fuzzy artificial neural network (FANN), one of the three categories
of the merging format of ANN and fuzzy sets, keeps the advantages of both
sides whilst its structure is easily understood and applied (Liu and Ling,
2005). In FANN, the ANN part is primarily used for its leaning and
classification capabilities and for pattern association and retrieval. It
automatically generates fuzzy logic rules and membership functions during
the training period. Moreover, as it keeps learning from the input signals,
the ANN keeps updating the membership functions and fuzzy logic rules
even after training. In contrast, fuzzy logic is used to infer and provide a
defuzzified output when fuzzy parameters exist. Therefore, FANN will be
adopted for the study.
In detail, environment uncertainties and partner’s risk management
commitment will respectively be the input and output of the FANN model
for testing Hypothesis 1 (Sub-Model 1). Subsequently, partner’s risk
management commitment, i.e. the output of the aforementioned model,
partner’s risk management capabilities, and risk allocation strategy will be
the inputs of the FANN model for testing Hypothesis 2 ((Sub-Model 2). Risk
management performance will be the output of Sub-Model 2. After
appropriate supervised training, the integrated FANN model is expected to
predict the optimal risk management performance and to identify the
corresponding optimal risk allocation strategy. The integrated model and
the two sub-models will be tested and validated in future empirical
fieldwork.

CONCLUSION

This paper presented an innovative conceptual model for effective risk

allocation in PPP projects. By taking a transaction cost economics (TCE)
perspective, the model explains the risk allocation decision making process
in a more logical and holistic way and consequently supersedes the
capability-only view in optimal risk allocation theory. The theories
10 Risk Allocation in PPP Projects – An Innovative Model with an Intelligent Approach
underlying the major constructs and supporting the two main hypotheses
are articulated in detail. The artificial neural network and fuzzy logic
techniques will be adopted for further testing and validating the model. The
advantages of these techniques are briefly described. The conceptual
model is expected to provide a logical and complete understanding of the
process of selecting the allocation strategy for a particular risk, to provide
government agency with a richer framework than previously existing ones
to guide their selection of suppliers of risk management service, and to
apply to any situation in which an organization must choose a partner
under uncertainty.

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