This is the authors version published as:

Pribadi, K.S., Soekirno, P., dan Pangeran, M.H. (2006). Integrating Qualitative and Quantitative Risk Analysis for Investment in PublicPrivate Partnership Scheme for Water Supply in Indonesia, Proceedings of the Tenth East Asia-Pacific Conference on Structural Engineering and Construction (EASEC-10), Bangkok, Thailand, Construction and Professional Practices, Nukulchai, W,K., Munasinghe, S., dan Anwar, N., Eds, pp. 201-208, Asian Institute of Technology.

The Tenth East Asia-Pacific Conference on Structural Engineering and Construction August 3-5, 2006, Bangkok, Thailand

INTEGRATING QUALITATIVE AND QUANTITATIVE RISK ANALYSIS FOR INVESTMENT IN PUBLIC-PRIVATE PARTNERSHIP SCHEME FOR WATER SUPPLY IN INDONESIA

Krishna S. PRIBADI1, Purnomo SOEKIRNO1, M. Husnullah PANGERAN2

ABSTRACT: The success of public-private partnership (PPP) investment scheme in water supply provision can not be separated from the implementation of risk management concept within the project. Proper risk management processes ensure a profitable operation to the private party as well as considerable benefit to the public interest. In risk management, risk analysis is a key step to understand the risk involved in such scheme and subsequently in defining appropriate risk management action. The paper presents a risk analysis approach integrating both qualitative and quantitative methods in assessing the feasibility of investing water supply infrastructure through PPP concession contract in Indonesia. Qualitative risk analysis is conducted using risk ranking-at-confidence level method to determine the priority risks, which are subsequently analysed using latin hypercube sampling cash flow simulation. The result of the analysis shows that uncertainty in tariff change (water price), nonrevenue water, and exchange rate fluctuation are significant risk factors. However, the impact of those factors is not always damaging to the investment, as there are cases where certain events lead to positive impact. Risk prioritizing should be conducted to prevent unnecessary exaggeration of risk notion in the investment scheme. KEYWORDS: Public-private partnership, water supply infrastructure, concession contract, risk analysis, priority risk, cash flow, latin hypercube simulation 1. INTRODUCTION To improve access to water supply and wastewater throughout the country, the Government of Indonesia currently seeks to involve the private sector investment in water supply sector, through Public-private partnership (PPP) scheme. This is now seen as an option to overcome the gap in investment, technology and expertise. It is also expected that private sector participation can lead to improvements in the operational efficiency of water supply utilities. However, as the investment in infrastructure is always associated with high capital outlay, long lead time, long operation, with a broad range of risks of uncertainties (Ye and Tiong 2000 ; Zhang 2005), investors need to evaluate properly any proposal before decisions are made. For this purpose tools and methods have been developed recently.

Lecturer Staff, Construction Eng.and Management Division, Faculty of Civil Eng. and Env., Institut Teknologi Bandung

Graduate, Master Program in Infrastructure Eng.and Management, Faculty of Civil Eng. and Env., Institut Teknologi Bandung

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Ye and Tiong (2000) developed the NPV-at-risk method to evaluate BOT infrastructure investment by the private sector, which involves risk of uncertainties in construction cost, completion time, operation and maintenance (O&M) cost, market demand, etc. Wibowo (2005) developed a cash flow simulation model to analyse the financial risk of BOT scheme in toll express way investment in Indonesia based on NPV as figure of merit, which involves risk of uncertainties in construction cost, construction schedule, initial and future tolls, traffic volume, macro-economic conditions, etc. However, the investigation did not explain how far the risks are prioritized in the simulation analysis, even thogh they are considered as major risk. A risk analysis approach integrating both qualitative and quantitative methods in assessing the feasibility of water supply infrastructure investment is proposed. Integrating both methods is needed in order to prioritize most influencing risk factors before in-depth risk analysis can be performed. 2. IQQ RISK ANALYSIS PROCESS The proposed integrated qualitative and quantitative (IQQ) risk analysis process consists of five main stages as shown in Figure 1.
Identifying the potential risks Qualitative Method Determining the priority risk Only the risk which is relevant to water supply investment and its scope of concession

- Setup the questionnaire, choosing respondent - Data analysis method (unique but simple)

Integrating process

Is there any priority risk for further analysis yes no Analyzing the impact of the priority risks

Risk ranking based on risk index and interpretation

Quantitative Method

- Modeling cashflow (basic assumption, basic relationship, modeling risk variables, choosing discount rate) - Simulation using Latin Hypercube sampling technique

Reporting the results

Risk profile of the investment via statistical information

Figure 1. IQQ Risk Analysis Procedure

The process is described further below. 3. IDENTIFYING THE POTENTIAL RISKS The water supply system forms an entity of physical and non physical systems of water infrastructure and facilities which, from the PPP point of view, can be realized under any possible form of partnership scheme. The contract may include different scope of services, ranging from the provision of raw-water intake, water-treatment, transmission and distribution up to revenue collecting service. The arrangement options are quite broad and involve a continuum of options ranging from a relatively low level up to high level PPP, such as service contract, management contract, leasing contract, BOT contract, concession contract, and divestiture under license or new entry of private sector participants through BOO arrangement (see World Bank,1997 ; Asian Development Bank, 2000). The concession contract was the most selected method offered during the Indonesian Infrastructure Summit in 2005 (a forum for promoting investment in infrastructure provision), i.e.13 out of 20 offered projects were concession, while the rest were in the form of BOT contract.

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For concession contract scheme, Pangeran (2006) had identified 23 risk factors relevant to water supply concession, based on a literature survey of published best practice and toolkits such as World Bank (1997) dan Asian Development Bank (2000). Table 1 summarizes those factors.
Table 1. Potential risk factors relevant to water supply concession No R01 R02 R03 R04 R05 R06 R07 R08 R09 R10 R11 R12 R13 R14 R15 R16 R17 R18 R19 R20 R21 R22 R23 Type of Risk Design/Development Risk Cost overrun Delay in completion Failure to meet performance criteria Raw/bulk water quantity Raw/bulk water quality Operating cost overrun Interruption in operation Shortfall in service quality & quantity Operating cost overrun Non revenue water Change in tariff rates. Water demand Exchange rate Foreign exchange Interest rates Force Majeure Change in Government Political interference Legal and regulatory Institutional legal Risks Insurance risk Environmental Risks Source of Risk Defect in tender specifications Inefficient work practices and wastage of materials Lack of coordination of contractors, failure to obtain standard planning approvals, failure to grant contractual land use rights or rights of way Quality shortfall/defects in construction Poorly defined rights to water Potential for pollution and salinity upstream Unexpected breakdown, Industrial relations-friction caused by staff reductions, Change to license conditions Operator fault, Interrupted electricity supply Operator fault Increase in bulk water charges, Operator failure Increase in non revenue water (operator fault) Increase in water charges not accepted by regulator Level of water demand within the concession area Exchange rate fluctuations Nonconvertibility or nontransferability Fluctuation in interest rates Floods, earthquake, riots Unexpected change to contract Cancellation of license, Restrictions on overseas remittance Changes in tax law, customs practices, environmental standards Complex Government bureaucracy Uninsured loss or damage to project facilities Site remediation, pollution/discharge, Pre-existing liability

4. DETERMINING THE PRIORITY RISKS Qualitative methods to analyze risk are available, such as direct judgement, ranking options, comparing options, and descriptive analysis (Flanagan and Norman 1993). Each method has its own complexity. The authors develop a method of risk ranking-at-confidence level (RRCL) to determine the priority risk for further analysis, based on descriptive analysis. This approach is used because of its simplicity. Baecher and Christian (2003) commonly defined risk as the product of probability and consequence. To rate the risk factors, the method considers two attributes i.e. the level of probability of occurrence, p, and the degree of impact or consequence of loss, c. The risk importance index, symbolized by RII, is then expressed as a function of the previous two attributes : RII = f (p, c) (1)

This is a basic concept to order the rank of each risk factor. In this method, the value of p and c are based on respondent judgement/opinion, obtained from a survey where respondent are asked to identify a list of relevant risk factors in water supply concession contract. In this case, the value of loss is just a relative perception on investment profitability. Respondent bias is reduced by providing a guidance to respond to the questionnaire. For p value, the respondents were asked to just select one level among five levels of probability of occurrence, namely: absent/extremely rare, rare, occasional,

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frequent and extremely frequent. For assessing the degree of loss, they may select one among five grades, namely: minor/no, low, moderate, high, and extremely high. By considering the confidence level of the response statistics, the RII can be defined as the RII-atconfidence level (RII-at-CL). In this case, the authors assumed that respondent opinions are normally distributed. The probability density functions of the attributes values are obtained by integrating f(p) and g(c) from to + , p and c at a given confidence level . RII-at-CL can then be expressed as deviations of p and c from the mean in units of their standard deviation :

RII - at - CL = [mean p ( ) ] [mean c ( ) ]

(2)

where Z() = number of units of standard deviation corresponding to the given confidence level of . At the 95% confidence level, Z() = 1.65. This means that there is 95% possibility that the respondent opinions fall within the range of 1.65 to . The priority risk is determined based on the value of the RII-at-CL, based on the scale of : 0<RII-at-CL4 (not important), 4<RII-at-CL9 (moderately important), and 9<RII-at-CL25 (very important). 5. SURVEY RESULT FOR RISK RANKING AND PRIORITIZATION Questionnaires were distributed directly to respondents in Jakarta from July to September 2005. A non-probabilistic/non-random sampling technique was used based on the consideration that only respondents directly related to the water supply concession issue were appropriate for selection. They were divided according to their affiliation to national government institutions (Department of Public Works and the National Committee for Acceleration of Infrastructure Development, Jakarta Water Supply Regulatory Body)) and non-government institutions (PT. PAM Jaya, PT. PAM Lyonnaise Jaya, PT. Thames PAM Jaya, all are Jakarta water supply companies, and the consultant for Private Provision of Infrastructure Technical Assistance - PPITA) . From 20 distributed questionnaires, 14 or 70% were returned and analyzed. Respondents included 64% government institutions and 36% nongovernment; 72% had more than 15 years of experience, the rest had less experience; 43% said as very knowledgable in concession contract, the rest had fair understanding. Using equation (2), the analysis showed that no real significant risk factors (very important) were found. However, three risk factors were identified as moderately important, i.e. (R11) non-revenue water (NRW) (RII-at-CL = 5.70), (R14) exchange rate (5.44), and (R12) change in tarif rates (5.34). The low values of the RII-at-CL were obtained probably due to the large standard deviation, representing large variance in respondent opinions. Table 2 summarizes the result.
Table 2. Response values and ranking of risk importance index-at-confidence level Probability of occurrence No Risk factor Mean R11 Non revenue water R14 Exchange rate R12 Change in tariff rates. R13 Water demand R05 Raw/bulk water quantity R07 Operating cost overrun R21 Institutional legal Risks R06 Raw/bulk water quality R23 Environmental Risks Continued table 1 3.57 3.64 3.64 2.93 3.21 3.14 3.50 2.86 2.93 Stdev 0.85 0.84 1.22 0.92 0.89 0.77 1.22 0.86 1.07 at 95% CL 2.17 2.25 1.64 1.42 1.74 1.87 1.48 1.43 1.16 Consequences of loss Mean 3.79 3.64 4.14 3.71 3.50 3.14 3.29 3.36 3.50 Stdev 0.70 0.74 0.53 0.61 0.85 0.77 0.83 0.93 0.76 at 95% CL 2.63 2.41 3.26 2.71 2.09 1.87 1.92 1.82 2.25 RII-atCL 5.70 5.44 5.34 3.83 3.64 3.50 2.85 2.61 2.61 Rank

1 2 3 4 5 6 7 8 9

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R03 R09 R10 R08 R20 R02 R16 R01 R18 R22 R17 R04 R15 R19

Delay in completion Shortfall in service quality and quantity Operating cost overrun Interruption in operation Legal and regulatory Cost overrun Interest rates Design/Development Risk Change in Government Insurance risk Force Majeure Failure to meet performance criteria Foreign exchange Political interference

3.29 3.36 2.21 2.21 2.21 3.00 2.50 2.43 2.50 2.29 2.29 2.21 1.79 2.07

0.91 1.22 0.80 0.70 0.70 1.04 1.02 1.02 1.29 1.07 1.20 0.97 0.97 1.21

1.78 1.35 0.89 1.06 1.06 1.29 0.82 0.75 0.38 0.52 0.30 0.61 0.18 0.08

2.86 3.43 3.00 3.00 2.86 3.07 3.14 3.29 3.86 3.07 3.79 3.07 3.43 4.00

0.86 1.02 0.55 0.78 0.77 1.07 0.86 0.91 0.66 0.92 0.80 1.27 1.02 0.96

1.43 1.75 2.08 1.71 1.59 1.30 1.72 1.78 2.76 1.56 2.46 0.98 1.75 2.41

2.54 2.37 1.86 1.81 1.68 1.68 1.41 1.34 1.04 0.81 0.74 0.59 0.31 0.19

10 11 12 13 14 15 16 17 18 19 20 21 22 23

Note : 0<RII-at-CL4 (not important), 4<RII-at-CL9 (moderately important), 9<RII-at-CL25 (very important)

A Mann Whitney U test, a non-parametric test used to compare two independent groups of sampled data (George and Mallery 2000, in Zhang 2005), was performed to determine whether the mean significance of each risk items is equal accros the government and non-government respondents. At a significance level of 0.05, it was found that there were three factors (13% from 23 factors) with significant statistical difference for probability of occurence attributes, namely : raw/bulk water quantity, operating cost overrun, and change in tariff rates. For the consequence of loss attributes, only two factors (8.7%) were found to have siginificant difference, namely : raw/bulk water quantity and design/development risk. It can then be concluded that there is a trend of uniformity in the respondent perception of risk in the water supply PPP concession scheme in Indonesia. 6. ANALYZING THE IMPACT OF THE PRIORITY RISKS ON INVESTMENT The next phase of the IQQ Risk Analysis is analyzing the impact of the priority risk factors which have been determined by their ranking based on RII-at-CL. In this case, the risk factors are : uncertainties in NRW, exchange rate fluctuations, and change in tarif rates. Traditionally, there are ways to evaluate financial viability, i.e. payback period, discounting payback period, net present value, and internal rate of return methods. But the common use of all of them are based on the assumption that the project cashflow is certain. These include risk-adjusted discount rate methods (such as capital asset pricing model, arbitrage pricing theory, and the weighted average cost of capital), called deterministic approach (Ye and Tiong 2000). However, PPP projects are more complex with a broad range of risks and uncertainties, and a more appropriate risk analysis is required to assess their outcomes. Savvides (1994) stated that the output of a risk analysis is not a single-value but a probability distribution of all possible expected returns. The prospective investor is therefore provided with a complete risk and return profile of the project showing all the possible outcomes that could result from the decision to stake his money on a particular investment project. To demonstrate the analysis method, the authors use a probabilistic risk analysis latin hypercube simulation technique on the case study of water supply full concession scheme. The simulation technique is an option to the more traditional Montecarlo simulation. Wibowo and Kochendorver (2005) had also used this simulation technique to analyze financial risk of Indonesian toll road concession schemes. 6.1. CASE STUDY PROJECT

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A proposal of water supply full concession scheme in the Tangerang area (west of Jakarta) was offered for bid in the 2005 Indonesian Infrastructure Summit, for a proposed concession period of 25 years. Investment value is estimated at Rp. 186.011 Billion (current exchange rate 1 USD = Rp 9.288 at the time of the study), which consist of provision of 620 lt/sec raw water intake, 400 lt/sec water treatment plant, transmission and distribution network. Total number of customer connections during the first year of operation is estimated at 22,318, increased by 9,299 additional connections in the second year, 8,580 additional connections in the third year and followed by constant number of connections until the end of the concession period. Operation and maintenance cost is estimated at Rp. 1,225/M3 of produced water. New connection tariff is set at Rp. 1.5 million/connection. Water sale price for consumers (household, social, industry, etc) is Rp. 3,700/M3 and Rp. 2,000/M3 for bulk supply, both in the first year of concession. Composition of funding in term of debt to equity ratio (DER) is set at 65% : 35%. Using the CAPM approach, PPITA (2005) recommended that the proposal was feasible, with a payback period of less than 5 years, NPV of Rp. 82 Billions and 22.% IRR. The recommendation was based on a single value result and not showing the risk profil of the investment. It does not provide the clue for different situation, such as the case of high NRW or the failure to increase the sale price or the fluctuating exchange rate. 6.2. MODELLING CASHFLOW TO COMPUTE FINANCIAL FEASIBILITY Several assumptions were used in the analysis. Straight line depreciation method was used and equity is denominated in local curreny (Rupiah), while the debt is in US Dollar. A 30 % tax rate, based on the Indonesian current rate for corporate income > Rp 100 Millions, was used. Discounting payback period, NPV and IRR of the investment were analysed based on net cashflow (NCF) analysis, as shown in the diagram of process model in Figure 2.
Total water production

Water price

Total loss

Total revenue (from water) Exchange rate

Concession fee to LG

NRW

+ Total water consumption Unconsumption water New connection fee

Total revenue

Total O&M cost

Tax deduction

Total debt payment

Earning before tax

Total revenue (new customer)

x
Tax rate

Earning after tax

Annual NCF

DER

Loan requirement

x
Interest rate Depreciation (from asset)

+
Total investment cost

: uncertainties

Figure 2. Model of process to compute NCF

Choosing the appropriate discount rate for present value analysis of a project under simulated environments remains the subject of debates. There is no substantial concensus whether the risk free rate or the opportunity cost of capital, which can also be the opportunity cost of debt or the cost of equity if dealing with source of financing, should be choosen (Wibowo and Kochendorver 2005). Ye and Tiong (2000) used the weighted average cost of capital (WACC) method to define the discount rate in developing the NPV-at risk analysis method.

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PPITA (2005) employed the capital asset pricing model (CAPM) to define the discount rate in analysing the feasibility of the case study project, using the beta value of the stock market listed Indonesian infrastructure corporates, such as Telkom and CMNP (Indonesian private toll road company). Currently there is no Indonesian water supply company listed in the stock market. Brealey and Myers (2000) suggested the use of risk-free rate to avoid pre-judging the risk as simulation is already a way of understanding the risk. The authors use an 18.5 % risk-free rate to discount uncertain cashflows, based on the value of the yield of the Indonesian Government Obligation Bond i.e bond yield 11% and risk premium 7.5%. 6.3. MODELLING RISK VARIABLES USING PROBABILITY DISTRIBUTION Probability distribution is a way of modeling the uncertainty risk variables. Subjective as well as objective method (based on historical data) are used to determine the distribution function types for the NRW, exchange rate and change in water price risk variables (see Table 3). NRW distribution function is fitted from the data obtained from 112 Jawa-Bali local water supply companies (Perpamsi Directory 2000). Exchange rate distribution function is fitted from the exchange rate (Rp./USD) data during the periode of January 2001 Juli 2005. Distribution function of percentage of change in tariff rates was subjectively assumed as triangular. Minimum value = 0% (no increase), most likely value = 10 % estimated by PPITA (2005), and maximum of 27% obtained from maximum tariff increase experienced by Jakarta water companies.
Table 3. Probability distribution of risk variables Risk variables Non revenue water Exchange rate Change in tariff rates Assumed Distribution Normal Normal Triangular Parameter 0.29 ; 0.12 9,288 ; 788 0 ; 0.1 ; 0.27

Note : Exchange rate ; Rp/USD, Normal (;),

6.4. SIMULATION RESULTS AND DISCUSSION A latin hypercube simulation of 10,000 iterations using @RISK commercial software (Palisade 2002) is applied. Table 4 contains a list of key output statististics.
Table 4. Key output statictics simulation Statistics Minimum Maximum Mean StDev Skewness Kurtosis Mode 5th percentile 50th percentile 95th percentile The investment financial performance at risk free rate Discounting payback Net present value Internal rate of return 9.90 -50,069 0.12 24.99 162,533 0.29 18.94 21,285 0.20 3.07 26,565 0.02 0.00 0.47 -0.01 2.19 3.42 3.02 21.87 -18,112 0.19 14.02 -18,644 0.16 18.84 19,271 0.20 24.00 67,362 0.23

Note: except skewness and kurtosis values, payback in year, NPV in million rupiah, IRR in percent.

In general, based on the mean value of each figure of merit (excepting discounting payback), the proposal is considered attractive. Compared to the deterministic analysis using the CAPM model, the simulation offered better information for assessing the feasibility profile. Despite the possibility of having the payback at the end of the concession period, negative NPV and IRR < risk free rate, there are possibilities that the figures of merit exceed the expected means. This shows that the impact of risk occurrences is not always deteriorating for the investment.

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7. CONCLUSION PPP in water supply infrastructure investment is supposed to bring benefit to all partners. It is required to fill the gap in government infrastructure funding and for this to happen, return of the investment has to be ensured. The success of a PPP scheme, where a fair return to the private investor as well as benefit for the society are ensured, will depend on how good the risk is managed and proper risk analysis is the key to this. It should provide a fair and balanced assessment information and can prevent excessive pre-judgment. The developed IQQ method, which is based on a combination of qualitative risk ranking-at-confidence level method with the quantitative method of latin hypercube (or Montecarlo) simulation, proposes a simple model for performing complex risk analysis process in analyzing the feasibility of investment in water supply infrastructure PPP concession scheme. The analysis provides a complete information on what risk to be aware of and at the same time provides different angles of view of the risk profile for the investor, which could not be obtained by using a simple deterministic approach. 8. ACKNOWLEDGEMENT The authors wishes to thank the Directorate General of Higher Education, Ministry of National Education, Republic of Indonesia, and Mr. D. Aditya Sumanagara, President Director, PT. Aneka Tambang, Tbk., for providing the financial support which has made this research possible. 9. REFERENCES 1. Asian Development Bank. (2000). Developing Best Practices for Promoting Private Sector Investment in Infrastructure-Water Supply Manila. [www.adb.org] (03 Desember 2004) 2. Baecher, G.B., and Christian, J.T. (2003) Reliability and Statistics in Geotechnical Engineering, John Willey and Sons, England. 3. Brealey, R.A., and Myers, S.C. (2000). Principles of Corporate Finance, 6th. Ed., McGrawHill, New York. 4. Flanagan, R and Norman, G. (1993). Risk Management and Construction Blackwell Science, Australia. 5. M. Husnullah Pangeran (2006). Identifikasi dan Analisis Dampak Risiko-Risiko Dominan Terhadap Kelayakan Finansial Konsesi Infrastruktur Air Minum, Master Thesis, Department of Civil Engineering, Institut Teknologi Bandung. 6. Palisade Corporation. (2002). @RISK : Advanced risk analysis for spreadsheet. New York. 7. Savvides, Savvakis. (1994). Risk Analysis in Investment Appraisal, Project Appraisal Vol 9 No. 1, 3-18, March 1994, Beech Tree Publishing [www.bcs.org] (10 September 2005). 8. Wibowo, A. and Kochendrfer, B. (2005) Financial risk analysis of project finance in the indonesian toll roads. J. Constr. Eng. Manage, 131 (9) 963-72. 9. World Bank. (1997). Toolkits for Private Sector Participation in Water and Sanitation Washington, D.C. [http://rru.worldbank.org/Toolkits] (23 Juni 2005) 10. Ye, S. and Tiong, R.L.K. (2000) NPV at risk method in infrastructure project investment evaluation. J. Constr. Eng. Manage. 126 (3), 227-33. 11. Zhang, X. Q. (2005) Critical succes factors for public-private partnerships in infrastructure development. J. Constr. Eng. Management, 131 (1) 3-14. 12. Zhang, X. Q. (2005) Criteria for selecting the private-sector partner in public-private partnerships. J. Constr. Eng. Management, 131 (6) 631-644.

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