Managing Project Performance Risks under Uncertainty: Using a Dynamic Capital Structure Approach in Infrastructure Project Financing

Abstract

Infrastructure project financing and public-private partnerships (PPPs) are underpinned by risk allocation between the public and private sectors. Project performance risks are often passed to the private sector as a contractual risk transfer that is often deterministic and inflexible. In complex projects where there are uncertainties in the scope of work and capital costs, performance risks may need more flexibility with active management on the evolution of project uncertainties over the life of the project’s development. Conventional fixed capital structures and project performance measurements cannot capture the evolution of project performance risks and their dynamics. This paper develops a dynamic capital structure approach that explicitly considers the performance risks of complex projects under uncertainty and allows the capital structure to be adjusted proactively to counter their impact on the project value. Unlike most models that focus on the operational phase when revenues are generated, this paper specifically considers the impact of project performance risks that occur during the development phase. This approach identifies the potential threat of default attributable to project performance risks and allows the private-sector-sponsored project company and lenders to make proactive management decisions using a real-options approach. Numerical results show that such a model can add significant value to a PPP project under uncertainty. Furthermore, numerical tests also show that with the flexibility in adjusting the capital structure, the probability of potential default can also be reduced.