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Summary of "Public Private Partnerships: An Introduction"

Benefits to government of PPPs:

Potential for value for money, early project delivery, gains from innovation, obviating the need to borrow to finance infrastructure investment, and access to improved services. The relevant government agency is responsible for assessing whether a PPP offers value for money compared with the most efficient form of public delivery. The agency deploys a 'Public Sector Comparator'.

PPPs operate at the respective boundary of the public and private sectors, being neither nationalized nor privatized assets and services. PPPss represent a third 'in between' way in which governments may deliver some public services.

Value for Money

The underlying rationale for PPPs is that they may offer value for money:

NSW policies require that privately financed options demonstrate superior value-for-money to the Government and community compared to conventional, publicly funded approaches to infrastructure provision. This is the sole reason for considering private financing and delivery with both States having low debt levels, off-balance sheet borrowing is not an attraction in its own right.

Forms of value for money:

Lower construction costs.  Lower operating costs.  More cost-efficient Capex maintenance

PPPs often involve the SPV providing a 'bundle' of services such as the design, construction and maintenance. Bundling thus differs from traditional contracting out whereby separate contracts are let for each service. Bundling can provide value for money that cannot be obtained by contracting services separately:

Integration of design, operation and maintenance over the life of an asset, within a single-project finance package often improves performance and reduces whole-of-life costs.

The sources of value for money ('drivers') are:

At the heart of all PPPs is the deployment of private sector capital. Within a PPP framework, this can result in greatly improved value for money for the government in terms of the risks transferred to the private sector (in cases where the latter is better able to assess the risks) and powerful private sector incentives for the long-term delivery of reliable public services.

Partnerships Victoria lists four major 'drivers': 

Risk Transfer

Risks incl Construction Risk, Demand or Patronage Risk, O&M Risk, Force Majeure Risk.  Changes to the Law and Regulations Risk. 

Risk should be allocated to whoever from the public or private sector is able to manage it at least cost.

The nature of risk allocation has been described as follows:

The essence of a public-private partnership arrangement is the sharing of risks. Central to any successful public-private partnership initiative is the identification of risk associated with each component of the project and the allocation of that risk factor to either the public sector, the private sector or perhaps a sharing by both. Thus, the desired balance to ensure best value (for money) is based on an allocation of risk factors to the participants who are best able to manage those risks and thus minimize costs while improving performance.

Partnerships Victoria, in the Risk Allocation and Contractual Issues guide, classifies major project risks into ten categories and recommends a government-preferred position on allocating each of the risks. In practice, the allocation of risk has not always been appropriate, and the government has had to assume risks that were initially transferred to the private party ie. Sydney airport rail link, which the NSW Government took over after the SPV that built and operated the link failed to meet scheduled payments to creditors.

Incentives

PPPs can contain incentives for the private sector party to perform well in order to earn a profit:

Much of the improved value for money comes from the fact that when private sector capital is deployed and is at risk to, for example, the long-term performance of public service delivery the right commercial decisions are made about design, operating regime, human resource planning, whole-life-of-asset costings etc.

For example, under a contract to construct a road, the developer has an incentive to do the minimum necessary to meet the contract terms. However, under a design, construct and maintain arrangement, the developer has an incentive to minimise whole-of-life costs and so construct the road to the standard that will minimise those costs. This incentive is reinforced by the fact that payment under PPPs depends on the developer meeting agreed maintenance standards.

PPPs can contain negative incentives for the public sector. Where the contract specifies that the asset is to be returned to the public sector at the end of the contract period, the private partner has an incentive to run the asset down especially in the later years of the contract. However, contracts typically specify that the government has a right to review the asset's condition before it is returned to ensure that the condition is acceptable. A third party sometimes conducts this review. Further, if running down the asset results in standards lower than those specified in the contract, the private sector partner will not be paid.

Public Sector Comparator

Assessment of whether it offers value of money is an essential part of a PPP process. This entails comparing the proposed PPP with the cost of the public sector undertaking the project. This requires the preparation of a public sector comparator (PSC):

In most cases, value for money will need to be demonstrated by comparison of private sector PFI bids with a detailed PSC. The PSC describes the option as to what it would cost the public sector to provide the outputs it is requesting from the private sector by a non-PFI route.

The comparator is based on 'best practice' assumptions. The Department of Finance and Administration has issued guidelines requiring that agencies prepare a PSC in certain circumstances.

However, governments consider other factors as well as the comparator.  NSW and Victorian policies specifically include a public interest test:

P[rivately] F[inanced] P[rojects]/PPPs are assessed against public interest criteria including effectiveness, impact on key shareholders, accountability and transparency, public access and equity, consumer rights, security, and privacy. This assessment takes place before the project is put to the market.

Political Attraction

PPPs operate at the boundary of the public and private sectors, being neither nationalized nor privatized assets and services. Thus, politically, they represent a third 'in between' way in which governments may deliver some public services. Moreover, in a practical sense, PPPs represent a form of collaboration under contract by which public and private sectors, acting together, can achieve what each acting alone cannot.

Budget Constraints

How a PPP is paid for depends on whether it is self-financing. When a project is self-financing for example, when the private sector finances, constructs, and operates roads and recovers costs through direct tolls on road users the government does not have to borrow or levy taxes to finance the project because it is paid for by direct user charges. When the project is not self-financing the government has to levy taxes to meet payments to the private sector provider. This does not necessarily mean that the government has to raise taxes since the project could be financed from within the existing tax framework. A third category of project combines cost recovery and government subsidy. Many social infrastructure projects are not self-financing.

In the UK, PFIs were introduced to circumvent constraints on public sector borrowing. The main alternative to PPPs with private sector finance is for the government to borrow through the issue of debt such as bonds. For governments with large debts and hence reluctant to borrow more, having the private sector finance infrastructure obviates the need to borrow.

Private sector financing can allow governments to bring forward projects that might otherwise be delayed because of budget constraints. Delaying projects can have adverse consequences:

The public sector will often find it difficult to provide dedicated funding for large projects out of annual budgets. In the past, this has resulted in lengthy delays before projects proceed and/or projects proceeding incrementally over a number of years. Delayed access to necessary infrastructure is costly to the community. Also, budget constraints can lead to sub optimal project forms. For example, government agencies may opt for lower up front cost infrastructure with much higher maintenance costs or a shorter life.

When a project is not self-financing, regardless of whether the public sector or the private sector under a PPP finances investment, governments have to fund payments to meet future costs:

Even though social infrastructure may be financed by the private sector, the government, through payments made during the contract's life, will ultimately fund it through payments for the services provided. These payments commitments are as real as those associated with servicing balance-sheet debt and, in the context of a government's fiscal strategy, need to be considered in a similar manner.

Issues in PPPs

Public Versus Private Finance⁽

The case for using private sector finance in PPPs has been put as follows:

The importance of the finance element of privately provided infrastructure lies in the incentive it can provide for the performance of the infrastructure, and the disciplines external financiers can provide on the delivery of project to time and budget. It is difficult to replicate the strength of these incentives and disciplines within a conventional funding process where all the risks of delivery reside with the government.

Critics have claimed that PPPs involving private sector finance should not be used because public sector finance is cheaper. The Department of Finance and Administration's policy principles for the use of private financing state:

It is generally more expensive for the private sector to raise capital through private capital markets, than for the Commonwealth to do so directly.

However, critics of the argument that public sector finance is cheaper claim:

It's a myth that governments have access to 'cheaper' finance to undertake projects: a government's ability to borrow more cheaply is purely a function of its capacity to levy taxes to repay borrowings. But, when it comes to raising finance for a project, it's the risk of the individual project that determines the real cost of finance. The difference between the private and public sectors is that private-sector capital markets explicitly price in the risk of the project into the sources of finances. In the public sector, taxpayers implicitly subsidise the cost of a project by bearing the risk of cost overruns, time delays or performance failures, which are not priced into the government borrowing rate.

It has been claimed that when risks are factored into the cost of government debt, the differential between the cost of government debt and private debt in the case of a project with a 'guaranteed' revenue stream from government is only 15 basis points. If so, it is difficult to use the 'higher cost of funds' argument especially if the benefits of risk transfer outweigh the additional cost of private finance.

The Bureau of Transport and Communications Economics observed that:

The transfer of financial risk from lenders to taxpayers provides no obvious benefit to society. The interest rate differential [between government and private sector borrowings] is therefore no indication that public ownership reduces the cost of capital to society.

Accounting for Public Private Partnerships

From a government budget perspective, PPPs involving the government buying services move spending from the capital to the recurrent budget or, to put it another way, today's capital investment by the private sector becomes tomorrow's current spending by the government. However, an issue is how governments should account for PPP payments and, in particular, whether they should be brought into the government's balance sheet as debt. When the government issues debt, it has to repay the interest and principal to debt holders. The government records the total outstanding debt as a liability in its balance sheet. Repayments of principal are recorded as reductions in outstanding debt. Critics of PPPs claim that governments can use PPPs to understate debt by not recording in the balance sheet the total value of payments. In other words, PPP obligations are 'off the balance sheet'.

The NSW and Victorian Governments acknowledge the need for accounting standards:

A recognised Australian Accounting Standard capable of addressing the complex risk allocations issues in a PFP/PPP transaction does not exist, and the existing standard on accounting for operating and finance leases has tended to be adopted by some parties as a default. An inter-jurisdictional group has been working actively to develop proposals for a better accounting treatment of these transactions, to ensure that they are appropriately reported within a State's accounts.

Transaction Costs

The process of defining and bidding for PPPs is costly for the private sector and the government. The Australian Council for Infrastructure Development has described these 'transaction costs' as follows:

Bidding for complex PPPs is time consuming and expensive. 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. For this reason it is essential for the government to prepare good processes with a common approach across the whole-of government Transaction costs can also be reduced by following the UK's example and developing standard risk allocations and conditions of contract

The often short-term focus of government budgeting decisions and delays in making decisions are particular difficulties for private firms. Standardisation of some contract documentation, procedures and definitions can reduce bid costs and accelerate project timetables.  But the fact that each project is different limits the scope for contract standardisation.

Other Issues

The traditional contracting out of activities to the private sector means that some of the benefits of private sector involvement in the provision of public goods and services have already been obtained. PPPs potentially may offer additional value for money especially if services are bundled to incorporate design, build, and lifetime operation and maintenance of assets, and through appropriate risk transfer. And the use of comparators and other considerations helps to ensure that PPPs offer value for money.

However, PPPs are potentially fraught with difficulty. The design and implementation of PPPs are usually very complicated. The essence of the business relationship between the public and private sectors is contractual. This requires that the services to be delivered have to be specified in great detail. Assessment of whether a PPP would offer value for money is often difficult to determine. Some risks are difficult to identify let alone quantify, and it is difficult to assess to what extent the transfer of risk is deemed optimal.⁽⁵⁸⁾

These considerations have been summarised as follows:

In areas like infrastructure, where large-scale investment is needed, so-called public private partnerships (PPP) may be an option, where private investors design, build, own, maintain and operate facilities like highways under long-term contracts. By deferring payment and by making it contingent on facilities being operable through the contract period, PPP contracts transfer investment risks to the private investors, such as those arising from delays in construction projects, and ensure a life-cycle perspective on costs. Private contractors may be better equipped than government for managing construction projects, especially where there is considerable scope for reducing maintenance and operation costs through innovative design. However, PPP usually entails a higher cost of capital than if the risks were carried by the general government budget and investment were financed via public lending. Moreover, complex financial contracts, involving commitments to future payments, may reduce transparency, requiring strong institutional checks. And while PPP contracts shift investments off the government's balance sheet, the commitments to pay for future service-flows have largely the same macroeconomic effects as public debt. Most importantly, the inherent long-term character and complexity of PPP contracts may pose a number of problems. It may have adverse effects on the effectiveness of competition, as fewer firms are able to make a bid, and contracts must be able to accommodate changes in future need which are inherently difficult to foresee. As far as large-scale infrastructure is concerned, achieving co-ordination among alternative routes and means of transport is crucial and having a range of different private owners may entail complicated and costly negotiations to accommodate changes. Furthermore, insofar as the government may ultimately be held responsible for outcomes, the transfer of risks to private contractors may be partial, with the government having to step in if something goes wrong.

Note that this summary seems to accept the claim that government finance is cheaper than private finance.

PPPs could have adverse effects on competition. As noted, the potential for savings from PPPs could be undermined by the long time periods of contracts. Moreover:

the specificity of assets (such as a hospital building or an IT-system) implies that the private and public partners become mutually dependent in a way that may stifle competition. When the contract expires, other potential contractors may be reluctant to undertake the effort necessary to make a bid in a renewed tender process, knowing that the incumbent will have a considerable cost advantage other things being equal.

  INGREDIENTS FOR A SUCCESSFUL PPP

The UK National Audit Office (NAO) in a report titled Managing the Relationship to Secure A Successful Partnership in PFI Projects found that most (81 per cent) public bodies involved in PFI projects believed that they are achieving satisfactory or better value for money from their PFI contracts. Feedback from service users was generally positive. Over 70 per cent of authorities and contractors viewed their relationship as being good or very good with only four per cent of contractors feeling their relationship with authorities was poor.

The NAO report identified the following necessary ingredients for a successful PPP:

• As PFI projects are long-term arrangements, a successful outcome is best achieved by authorities and contractors balancing both contractual and relationship issues to approach projects in a spirit of partnership. Authorities and contractors should seek to understand each others businesses and should have a common vision of how they will work together to achieve a mutually successful outcome to the project. Authorities should regularly reassess their relationships with contractors and the value for money their projects are delivering, to identify ways in which relationships can be improved.

• The long-term nature of PFI projects means that some contractual changes are likely to be necessary during the life of the project. The report found that although most PFI projects are still at an early stage, around half of the contracts surveyed had been changed since they were entered into. Changes related to the specification, new services, additional building work or design changes and performance measurement arrangements. Appropriate procedures for dealing with change should be built into the contract. This includes procedures to ensure that value for money is maintained when contract changes occur.

• Having staff with the right skills is critical to good contract management, yet there is considerable variation in the extent of training provided in contract management skills, with some authorities providing little or none. Attention needs to be given early in the procurement process to staffing, training and contract management issues, and how the relationship between authority and contractor will be developed.

Conclusions

The development of PPPs is an on-going process. Shortcomings of early PPPs have been recognised and the lessons learned incorporated into subsequent projects. For example, it has been recognised that:

Early in both States' [NSW and Victoria] experience the temptation was for maximum transfer of risk, and inevitably risks were sometimes transferred that ultimately came back to Government.

It is also recognised that the 'one size fits all' approach doesn't work. For example, whereas BOOT schemes have been the preferred form of PPP for urban roads, design, construct and maintain arrangements might be better suited to rural roads.

Despite the difficulties that PPPs have encountered, it seems likely that more and more countries will use them and for increasingly varied purposes. One person involved in PPPs has predicted 'explosive growth' in PPP programs internationally over the next few years and expects the following developments:

More diversity in PPP models Design Build Finance Operate contracts will always be important, but so too is the need for flexibility and closer alignment of the private sector with public sector objectives.

Structural changes in the private sector Consortia will give way to genuine operator companies, a trend already being seen in the UK. Corporate finance will become as important as project finance in supporting PPP investment.

Structural changes in the public sector - Aside from the need for changes to initially facilitate PPP programmes, new structures will develop.

More focus on the workforce involved in PPPs Internationally, there is growing concern about the impact on public sector employees transferring to the private sector where much greater efficiencies are being promised.

Increasing internationalisation Many of the players in PPPs are still domestically focussed, but will follow international opportunities where they have competitive advantage from past experience.⁽⁷⁰⁾

Appendix One: Forms of Public-Private Involvement in Infrastructure

Traditional Design and Construction (TDC)

The Government, as principal, prepares a brief setting out project requirements before inviting tenders for the design and construction of the project. Private sector contractors undertake to design the project in accordance with the brief, and construct it for an agreed sum, which may be fixed or subject to escalation.

Operation and Maintenance Contract (O&M)

These projects involve the private sector operating a publicly-owned facility under contract with the Government.

Lease - Develop - Operate (LDO)

This type of project involves a private developer being given a long-term lease to operate and expand an existing facility. The private developer agrees to invest in facility improvements and can recover the investment plus a reasonable return over the term of the lease.

Build - Own - Maintain (BOM)

This type of arrangement involves the private sector developer building, owning and maintaining a facility. The Government leases the facility and operates it using public sector staff.

Build - Own - Operate - Transfer (BOOT)

Projects of the Build-Own-Operate-Transfer (BOOT) type involve a private developer financing, building, owning and operating a facility for a specified period. At the expiration of the specified period, the facility is returned to the Government.

Build - Own - Operate (BOO)

The Build-Own-Operate (BOO) project operates similarly to a BOOT project, except that the private sector owns the facility in perpetuity. The developer may be subject to regulatory constraints on operations and, in some cases, pricing. The long term right to operate the facility provides the developer with significant financial incentive for the capital investment in the facility.

Explained in Section 17