Published 6 April 2006
A Treasury policy perspectives paper issued last Friday has found public-private partnerships (PPPs) may offer the Government nothing that it can’t get in other ways.
Treasury analyst Dieter Katz drew up lists of pluses & minuses in employing PPPs, but weighed in with unresolved problems attached to every plus.
The outcome is a Treasury document telling the Government PPPs would have limited worth for it.
One of the key reasons the private sector has given for employing PPPs is that major projects can be brought forward. Mr Katz said the Government still had to recognise the debt on its books and stay within prudent debt levels, although he could see ways of dealing with the higher debt to overcome public perceptions of a debt increase.
A common refrain from the private sector is that the private sector does it better. Mr Katz acknowledged that, of 61 PPP projects in the UK, 89% were delivered on time or early and all were delivered within public-sector budgets. But he also said only a few were more than one-third the way through their lives.
He also acknowledged changes which occur in purely public sector projects that reduce their efficiency or value, such as budgetary considerations or “other objectives”.
Perhaps most importantly, Mr Katz found “the cost of both successful & unsuccessful bids is, in effect, built into total project costs.” Having several bidders tender for a PPP project “involves a cost which can add up in total to 10s of millions. It has been estimated that total tendering costs equal around 3% of total project costs as opposed to around 1% for conventional procurement.
“The Australian Council for Infrastructure Development has expressed the view that â€˜unless tendering processes are well run it is possible that the benefits of using a PPP for delivering the project may be outweighed by the tendering costs’. Under conventional procurement, the sunk costs of private contractors are much smaller and contracts (eg, for operations) often do not exceed 5 years. The risks to be covered off in the contract are therefore significantly less.”
NZ Council for Infrastructure Development chief executive Stephen Selwood criticised Mr Katz’s paper for “largely ignoring international experience that shows public-private partnerships can & do provide better value for money than conventional procurement methods.”
Said Mr Selwood: “The key advantage of PPPs is that by having a vested interest in the performance of an asset over time, the private sector is highly incentivised to innovate and keep costs down over the whole life of the project. The private sector also shares & manages the risks.
“But the Treasury paper argues that most of the advantages of private sector construction & management that PPPs provide can also be obtained from conventional procurement methods. This is in stark contrast to overseas experience.”
Mr Selwood cited a series of UK Treasury reports which concluded: “An increasing body of evidence has shown that the better risk management of private finance initiatives results in a greater proportion of assets being delivered on time & to budget. Research into completed PFI (the UK version of PPP) projects showed 88% coming in on time or early, and with no cost overruns on construction borne by the public sector. Previous research has shown that 70% of non-PFI projects were delivered late and 73% ran over budget.
“The NZ Treasury paper concludes that using private-sector finance to build & operate new infrastructure may be a good way of procuring services, provided service levels can be specified, performance can be measured objectively and performance objectives are durable. These benefits need to be weighed up against the contractual complexities & rigidities PPPs can entail. The Council for Infrastructure Development agrees with this but considers that these preconditions can readily be addressed.”
Mr Selwood said most countries were taking advantage of the public-private approach and significantly advancing construction of infrastructure projects that would otherwise have taken years to build through traditional public sector financing: “The reality in New Zealand is that while the Government could borrow to speed up the construction of roads & other essential infrastructure it seems very reluctant to do so, at least at a level that will advance critical projects. Instead we see a continual deferral of economic projects.”
Key points in the Treasury document:
The main benefits usually attributed to PPPs are accelerated provision of infrastructure projects as a result of using private sector finance and better value for money, due to private-sector innovation & whole-of-life cost minimisation, than can be obtained under conventional private-sector procurement.
This paper argues that:
here are other ways of obtaining private-sector finance without having to enter into a PPP
most of the advantages of private-sector construction & management can also be obtained from conventional procurement methods (under which the project is financed by the Government and construction & operation are contracted out separately)
the advantages of PPPs must be weighed against the contractual complexities & rigidities they entail. These are avoided by the periodic competitive re-tendering that is possible under conventional procurement.
The paper concludes that PPPs are worthwhile only if all 3 of the following conditions are met:
The public agency is able to specify outcomes in service level terms, thereby leaving scope for the PPP consortium to innovate & optimize
The public agency is able to specify outcomes in a way that performance can be measured objectively and rewards & sanctions applied, and
The public agency’s desired outcomes are likely to be durable, given the length of the contract.
Advantages of PPPs
Better whole-of-life project evaluation: Under conventional procurement, individual private-sector companies don’t evaluate the whole-of-life viability of a project because they are only invited to tender for portions of the project. The whole-of-life assessment is carried out by a public agency which doesn’t normally bear the financial consequences of getting it wrong to the same extent as a consortium in a PPP would.
Public-sector assessments often suffer from an optimism bias: While the same is also true for many private-sector projects, it is probably difficult to establish empirically whether, or the extent to which, public-sector projects suffer more from optimism bias than private-sector projects). Under a PPP the private sector has arguably a stronger incentive than a government agency to be realistic about the prospects of a project. This is because of the considerable financial investment the consortium has put at risk. One would expect the private sector not to submit a tender if the business case doesn’t stack up. It seems clear that there are stronger incentives to correctly identify the whole-of-life costs of construction & operation, and the likely revenue stream, under a PPP if project risk is transferred to the private sector.
Optimisation of design & operation in order to minimise whole-of-life costs: Under a PPP, if the designers & builders have a financial stake in the project over its whole life, they will have an incentive to design features & construction standards so they are optimised against the long-term cost of maintenance & operational requirements. The incentives to do so are likely to be stronger than under conventional procurement.
Access to additional capital: The Government does not have to provide capital in the case of PPPs. This can be an advantage where the Government has a poor credit rating and is not able to raise finance, and where financial markets cannot readily distinguish between general government borrowing & government borrowing for a specific revenue-earning infrastructure project. This is not at present an issue in New Zealand.
Off-balance sheet financing: When people say PPPs will give access to more capital, ie, will bring forward projects and free up public funds for other projects, they usually mean PPPs are a way of financing projects without breaching the Government’s self-imposed borrowing limit. This appears to have been the motivation for PPPs in the UK & in Australia, at least in the early days.
Financing public projects without breaching the Government’s sovereign-issued debt limit (referred to here as off-balance sheet financing) is feasible where projects are financed from third-party revenue, such as toll roads. This is more difficult in the case of infrastructure that does not earn revenue from third parties, such as prisons, and roads financed from “shadow tolls” In such situations the Crown typically bears the demand risk.
While accounting rules are in a state of flux on this point, it appears that where the demand risk is not transferred, financial liabilities arising from obligations under a PPP contract would need to be recorded on the Crown’s balance sheet irrespective of who raised the capital.
An example of SOEs illustrates the point that there are other ways of managing concerns about the effect on gross debt than by entering into a PPP. These should be considered alongside any proposal to enter into a PPP, if the motivation for the PPP is to finance income-earning infrastructure without putting pressure on the Government’s gross debt target (ie, off-balance sheet).
Assurance of good maintenance: The whole-of-life approach and the contractual obligations around maintenance ensure that it is fully maintained throughout its life. This is not always the case under the direct management of a public agency, where maintenance needs are sometimes subordinated to other priorities.
Disadvantages of PPPs
Tendering and negotiation: PPP contracts are typically much more complicated than conventional procurement contracts. This is principally because of the need to anticipate all possible contingencies that could arise in such long-term contractual relationships. Each party bidding for a project spends considerable resources in designing & evaluating the project before submitting a tender. In addition, there are typically very significant legal costs in contract negotiation. Having several bidders do this involves a cost which can add up in total to tens of millions.
Contract renegotiation: Given the length of the relationships created by PPPs and the difficulty in anticipating all contingencies, it is not unusual for aspects of the contracts to be renegotiated at some stage. Wherever possible, provisions are included in the contract that spell out how variations are to be priced. But, given the length of time spanned by the contract, it is almost inevitable that circumstances will arise which cannot be foreseen. Where the need for renegotiation comes from the public agency (which, it appears, is often the case, perhaps as a result of a change in government policy) and no pricing rule is contained in the contract, the Crown can end up paying a heavy price, since the price is not determined in a competitive bidding context. The cost of such changes is difficult to factor into the original project evaluation, since by definition it is unanticipated.
Performance enforcement: One of the difficulties with performance specification in the area of service delivery is that performance sometimes has dimensions which are hard to formulate in a way that is suitable for an arms-length contract.
Political acceptability: Given the difficulty in estimating financial outcomes over such long periods, there is a risk that the private-sector party will either go bankrupt, or make very large profits. Both outcomes can create political problems for the Government, causing it to intervene. Both kinds of risk are often reduced by including in the contract loss-sharing or profit-sharing provisions. But such provisions reduce the extent of risk transfer, and therefore the advantages of PPPs.
Value for money test
Some jurisdictions, such as Victoria & the UK, require the establishment of a “public-sector comparator” against which a PPP is evaluated. This “value for money” test is, however, problematic. In particular, it is difficult to factor in the cost of things going wrong over the total life of the project. More generally, the public-sector comparator is necessarily hypothetical, so its credibility is difficult to test.
It should not be surprising that there has been much debate about whether PPPs offer value for money. The limited available empirical evidence favours PPPs.
There is little reliable empirical evidence about the costs & benefits of PPPs. This paper has therefore made a qualitative assessment. It concludes that the more complete transfer of risk that is possible under a PPP results in better project evaluation & stronger incentives to innovate & minimise whole-of-life costs. But these advantages must be balanced against the large contract negotiation costs, the inflexibilities of a long-term contract and the reduced competitive pressures on performance after the contract has been entered into (compared with a situation where the contract is re-tendered periodically over the life of the infrastructure).
Attribution: Treasury document, NZCID statement, story written by Bob Dey for this website.