Risk Allocation Determines Project Success
Why risk allocation failure is the hardest to remedy among the 5 PPP/PFI failure typologies
Structural PPP/PFI failure patterns
5 typologies
Thalasso Fukuoka: opening to closure
2 years
Omihachiman Hospital PFI contract duration
5 years
Risk items for inclusion in allocation matrices
8 categories
PPP/PFI project outcomes depend more on risk allocation design at the project planning stage than on post-launch operational capability. When risk allocation is properly designed, the structure can absorb problems during execution. Conversely, when risk allocation design is flawed, it remains unclear "who does what" when problems arise, and the situation deteriorates until project failure becomes inevitable.
Japan Economic Research Institute's analysis classifies PPP/PFI failures into five typologies:
| Failure Typology | Description | Representative Case |
|---|---|---|
| Objective setting failure | Misalignment between project purpose and method | Applying PFI to non-revenue-generating projects |
| Risk allocation failure | Unclear risk ownership and response | Thalasso Fukuoka |
| Competition failure | Competitive environment not established | Perfunctory solicitation with single applicant |
| Messaging failure | Insufficient explanation to residents/legislature | Plan cancellation due to resident opposition |
| Governance failure | Absence of monitoring/intervention mechanisms | Problems undetected until escalation |
Among these five, risk allocation failure is the most difficult to remedy. Modifying risk allocation post-contract requires bilateral agreement, which is structurally difficult to achieve when one party is already bearing losses.
Case 1: Thalasso Fukuoka
Full demand risk transfer to the private sector leading to facility closure within 2 years of opening
Project Overview
Thalasso Fukuoka was a thalassotherapy facility utilizing waste heat from Fukuoka City's coastal waste incineration plant. Planned as a PFI project, it opened in April 2002.
| Item | Detail |
|---|---|
| Project method | BTO (Build-Transfer-Operate) |
| Project period | 15 years (planned) |
| Opening | April 2002 |
| Closure | November 2004 |
| Closure reason | Visitor numbers far below projections, financial deterioration |
Structural Failure Analysis
Thalasso Fukuoka's failure stemmed from full demand risk transfer to the private sector.
Over-estimated demand forecast: The business plan projected substantial annual visitors, but actual numbers fell far short from the first year. Demand projections for thalassotherapy — a service with low public awareness — were excessively optimistic.
Structural risk allocation deficiency: Demand risk (visitor volume fluctuation risk) was effectively transferred entirely to the private operator. The contract contained no provisions for government response (compensation, condition modification) when visitor numbers fell below projections, structuring the operator to absorb losses alone.
Project finance dysfunction: According to Daiwa Institute of Research analysis, lenders only extended financing "within the range recoverable through the city's facility buyback price," failing to perform the role expected of project finance lenders — due diligence on business viability and operator capability.
Lessons from This Case
- Full private-sector demand risk transfer is particularly dangerous for novel business formats with low awareness
- Demand forecast validity should be independently verified by the procuring authority (municipality)
- Prerequisites for project finance to function properly (lender due diligence) should be confirmed
Case 2: Omihachiman City Hospital
Structural factors behind a hospital PFI project collapsing within 5 years
Project Overview
Omihachiman City General Medical Center in Shiga Prefecture was an early application of PFI to hospital operations. The sequence of events is examined in a special contribution to the Annals of Public Policy Studies No. 5 (2011).
| Item | Detail |
|---|---|
| Project method | BTO |
| Project period | 30 years (planned) |
| Opening | October 2006 |
| PFI contract termination | 2009 (policy reversal; final termination 2011) |
Structural Failure Analysis
The Omihachiman failure resulted from governance failure due to core/non-core business separation combined with demand risk design error.
Core/non-core separation problem: In hospital PFI, medical services (core) are performed by the hospital while facility management, cleaning, food service, and medical accounting (non-core) are handled by the PFI operator. However, core and non-core hospital operations are tightly interdependent. Having different management entities for each generated decision-making delays, cost allocation disputes, and service quality inconsistencies.
Structural deficit: Deficits emerged from FY2006 (the opening year) onward with cumulating losses. The city terminated the 30-year PFI contract early, paid a penalty, and returned the hospital to direct management, judging that continuing the contract would cost more.
Lessons from This Case
- The scope of PFI-applicable operations must be carefully assessed (hospital-like operations with high specialization and difficult core/non-core separation are poor fits)
- Long-term PFI contract early termination conditions and penalties should be rationally designed at contract stage
- Mechanisms for early determination (monitoring) of whether post-opening deficits are structural or temporary are essential
The Demand Risk Transfer Paradox
The paradoxical structure where VFM pursuit increases demand risk
Mitsubishi UFJ Research & Consulting has theoretically analyzed the "demand risk transfer paradox" in PFI projects.
Structure of the Paradox
To maximize VFM (Value for Money), transferring as much risk as possible to the private sector appears rational. However, fully transferring demand risk produces paradoxical outcomes:
- Reduced bidders: Under conditions of full demand risk assumption, operators capable of properly evaluating the risk avoid bidding
- Increased risk premiums: Bidding operators add premiums (additional profit margins for risk) to project costs
- Reduced VFM: Risk premium additions increase overall project costs, actually decreasing VFM
- Decreased competition: Fewer bidders mean competition fails to function, further increasing costs
Strategies for Avoiding the Paradox
Design principles for circumventing this paradox include:
Risk-sharing introduction: Rather than fully transferring demand risk, share it within defined parameters. For example: "when demand falls below 80% of plan, the government compensates 50% of the shortfall."
Graduated risk transfer: During early project stages, the government bears most demand risk; the private sector's share gradually increases as operations stabilize.
Demand-linked payment design: Government payments to private operators are linked to demand (user numbers). When demand rises, operator revenue increases; when it falls, government payments decrease — an incentive-aligned structure.
Fundamental Principles of Risk Allocation
Concretizing the principle of 'risk to the party best positioned to manage it'
The Cabinet Office's Guidelines on Risk Allocation in PFI Projects establishes the following fundamental principles:
Principle 1: Risk should be borne by the party best positioned to manage it
"Manage" means having the ability to reduce the probability of risk occurrence or minimize losses when risks materialize.
- Design/construction risk → Private sector has management capability → Private sector bears
- Regulatory change risk → Government has information and influence → Government bears
- Demand fluctuation risk → Both parties' influence is mixed → Shared
Principle 2: Pre-agree response measures for risk materialization
Beyond merely allocating risk, pre-agreeing on "response actions when risk materializes" is crucial. Design not only "who bears the risk" but "what happens when the risk becomes reality."
Principle 3: Give risk allocation legal force as part of the contract
Risk allocation matrices should not remain "reference materials" but should be incorporated as contract annexes with legal binding force. Verbal agreements or memoranda-level documents will not function in disputes.
Designing the Risk Allocation Matrix
8 risk categories and allocation decision criteria
Below are 8 risk categories that should be included in PPP/PFI risk allocation matrices, with allocation decision criteria.
| Category | Risk Content | Default Allocation Approach |
|---|---|---|
| 1. Design/construction risk | Design errors, construction delays, cost overruns | Private sector (has management capability) |
| 2. Demand fluctuation risk | User volume/revenue deviations from plan | Shared (with pre-agreed parameters) |
| 3. Operations risk | Personnel costs, utilities, maintenance cost fluctuation | Private sector (with escalation clauses) |
| 4. Price fluctuation risk | Construction material/labor cost inflation | Shared (government adjusts above thresholds) |
| 5. Regulatory change risk | Additional compliance from relevant law amendments | Government (holds information) |
| 6. Force majeure risk | Natural disasters, pandemics, conflict | Shared (insurance + pre-agreed allocation) |
| 7. Political risk | Changes in leadership or legislative direction | Government |
| 8. Residual value risk | Facility value/disposal at project end | Joint consultation (pre-agreed rules) |
Practical Risk Allocation in Public Asset Utilization
Risk allocation design for Park-PFI, Small Concession, and Designated Manager projects
Park-PFI Risk Allocation
Park-PFI has smaller project scales than conventional PFI and a different risk structure. The following are Park-PFI-specific risks:
- Weather risk: Parks are outdoor facilities where weather directly impacts visitor numbers
- Seasonal fluctuation risk: Large visitor differentials between summer and winter
- Surrounding environment change risk: Development and transportation infrastructure changes near the park affect visitor attraction
For Park-PFI, designing usage fee calculation bases (the ratio between fixed and variable components) that account for these risks is the key practical consideration.
Small Concession Risk Allocation
Small Concession projects have project costs of roughly less than ¥1 billion, requiring simplified risk allocation.
Over-detailing risk allocation matrices for small-scale projects raises entry barriers, reducing applicant numbers. A practical approach focuses on "clarifying allocation for critical risks (demand, force majeure, regulatory change) while addressing others through consultation rules."
Designated Manager System Risk Allocation
Under the Designated Manager System, gaps frequently emerge between formal risk allocation (as stated in agreements) and actual risk allocation (as practiced on the ground). Particularly when repair cost responsibility thresholds ("repairs under ¥X are the manager's responsibility") don't match reality, operator frustration accumulates, ultimately causing declination.
Risk allocation design is the "insurance" of PPP/PFI projects. It goes unnoticed while projects proceed smoothly but reveals its critical importance only when problems arise. The lessons of Thalasso Fukuoka and Omihachiman City Hospital demonstrate that "underestimating risk allocation design produces irrecoverable outcomes."
Clearly defining "who bears which risk" and pre-agreeing "response measures when risks materialize" — this is the foundation supporting PPP/PFI project success.
PPP/PFI 7-Method Comparison
Comparing risk structures across 7 PPP/PFI methods. Decision criteria for method selection.
Public Facility Management Support Guide
Practical processes for PPP/PFI implementation, including risk allocation design methodology.
What to do next
When responding to withdrawals or unsuccessful calls for designated managers, examine the reasons before reviewing management methods and solicitation terms.
| # | What to check or consider | Responsible team or contact |
|---|---|---|
| 1 | Ask operators why they withdrew or did not apply. Check which conditions caused difficulties, including the management fee, term, repair costs and staffing | Current manager and interested operators |
| 2 | Review how the management fee was calculated, checking staffing assumptions against current minimum wages and other relevant costs | Responsible department |
| 3 | Review repair requests and funding over the past five years. Identify outstanding repairs and expected future costs | Facilities and budget teams |
| 4 | Compare direct operation, appointment without open solicitation, revised re-solicitation and other methods, using the withdrawal reasons, management fee and repair costs | Responsible department and decision makers |
| 5 | If re-soliciting, review price adjustment provisions, the designation period and responsibility for repairs | Solicitation drafting team |
Before re-soliciting, examine the reasons for withdrawals or unsuccessful calls and review the conditions for sustainable operation. Distinguish operator-specific circumstances from problems with the solicitation terms.
References
Examination of the 'Demand Risk Transfer Paradox' in PFI — Learning from PFI Failure Cases for PPP Success — Mitsubishi UFJ Research & Consulting (2012)
Guidelines on Risk Allocation in PFI Projects — Cabinet Office, PPP/PFI Promotion Office (2021)
Hints for PPP Finance from the 'Failure' of Thalasso Fukuoka — Daiwa Institute of Research, Fumihiko Suzuki (2011)
Issues in Hospital PFI Projects Seen Through Contract Termination Cases (Annals of Public Policy Studies No. 5, special contribution) — Nobuhisa Sano / Hokkaido University School of Public Policy (2011)
Related Articles
Operator Bankruptcy Response
Municipal risk management for PFI and designated managers
