Transcript PUBLIC-PRIVATE PARTNERSHIPS: AFFORDABILITY, RISK SHARING AND VALUE FOR MONEY Philippe Burger University of the Free State OECD meeting Rabat – May 2008

PUBLIC-PRIVATE PARTNERSHIPS:
AFFORDABILITY, RISK SHARING AND
VALUE FOR MONEY
Philippe Burger
University of the Free State
OECD meeting
Rabat – May 2008
1. Defining PPPs
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Lack of definitional clarity.
Grimsey and Lewis (2005:346), “…fill a space
between traditionally procured government
projects and full privatization”
Need to distinguish them clearly from
traditional procurement and privatisation, but
also from concessions.
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IMF: PPPs refer to arrangements where the private
sector supplies infrastructure assets and services
that traditionally have been provided by the
government.
European Investment Bank: PPPs are
relationships formed between the private sector and
public bodies often with the aim of introducing
private sector resources and/or expertise in order to
help provide and deliver public sector assets and
services.
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Distinct from traditional procurement: role of
risk.
Distinct from privatisation: define what is a
partner.
Distinct from concessions: demand risk and
source of revenue.
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OECD:
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PPP is an agreement between the government
and one or more private partners (which may
include the operators and the financers)
according to which the private partners deliver the
service in such a manner that the service delivery
objectives of the government are aligned with the
profit objectives of the private partners
and where the effectiveness of the alignment
depends on a sufficient transfer of risk to the
private partners.
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The private partners usually design, build,
finance, operate and manage the capital asset,
and then deliver the service either to government
or directly to the end users.
The private partners will receive as reward a
stream of payments from government, or user
charges levied directly on the end users, or both
(Concessions vs PPPs).
Government specifies the quality and quantity of
the service it requires from the private partners.
There is a sufficient transfer of risk to the private
partners to ensure that they operate efficiently.
Figure 1.1. The spectrum of combinations of public and private participation,
classified according to risk and mode of delivery
2. Affordability
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Do PPPs create more space in the budget?
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Affordability and VFM: Relative vs. absolute
affordability.
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Affordability in principle terms.
Affordability in practical terms.
Efficiency and the cost of capital.
Affordability, limited budget allocations,
legally imposed budgetary limits and fiscal
rules.
2.1 Affordability in principle terms
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Affordability and VFM are the benchmarks for PPP
viability.
Affordability and VFM determines whether the PPP
route is the best alternative.
Because of the off-balance sheet nature of PPPs,
their use has led to some misconceptions regarding
their impact on the affordability of projects.
Confusion stems from the impression that because
government not responsible for the acquisition of the
asset, that PPPs are cheaper than traditional
procurement – this is a fallacy.
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Though PPPs may enable some projects to
become affordable, this does not stem from
their off-balance sheet nature.
The point is: Affordability not only relates to
PPPs, but to government expenditure items
in general.
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In principle affordability is about whether or not a
project falls within the long-term (intertemporal)
budget constraint of government.
 If it does not, then the project is unaffordable.
However, because the cash flows and balance
sheet treatment of PPPs differ significantly from that
of traditional procurement, some confusion exists
about the effect of PPPs on affordability.
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In principle terms, a traditionally procured
project is affordable if the present value of the
expected future revenue stream of
government:
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equals or exceeds the present value of expected
future capital and current expenditure of
government,
while a portion of such future expenditure
streams is allocated to such a traditionally
procured project.
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In principle terms, a PPP is affordable if the
present value of the expected future revenue
stream of government:
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equals or exceeds the present value of expected
future capital and current expenditure of
government,
while a portion of such future expenditure streams
is allocated to such a PPP.
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2.2 Affordability in practical terms
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Even though the above is technically correct, it has
one shortcoming:
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Although PPPs and the PSC used in PPPs involve detailed
present value calculations over the whole life of a PPP
contract, governments rarely use present value
calculations for the rest of their activities.
Governments also rarely budget for a longer horizon than
the upcoming year (although some use medium term fiscal
forecast).
This raises the question: how should affordability of
a PPP be assessed within an environment where
the planning horizon is not very long?
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As with other government activities in such an
environment a PPP project is affordable if:
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the expenditure it implies for government can be
accommodated within current levels of government
expenditure and revenue (as captured in the current
budget and medium term forecasts)
and if it can also be assumed that such levels will be and
can be sustained into the future.
This working definition of affordability allows for the
use of present value calculations when estimating
cost of a PPP vs that of traditional procurement
(using a PSC), but to do so in an environment with a
short planning horizon.
2.3 Affordability and VFM
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Relative affordability: affordability of PPP compared
to that of traditional procurement.
 Interest rate and efficiency differentials main
determinants (of relative affordability and VFM).
Absolute affordability: Can the project (delivered
either trough a PPP or traditional procurement) be
accommodated within the budget without violating
the budget constraint.
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UK:
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Procuring authorities must complete affordability
model for any planned PFI (it includes sensitivity
analysis).
The models based on agreed upon departmental
figures for the years available and cautious
assumptions about future dept spending
envelopes.
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Victoria:
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Decision about how a project is funded is
separate from the decision about how it is to be
delivered.
Potential PPP compete with other capital projects
for limited budget funding to ensure that they fall
within what is considered affordable.
Funding is approved on the preliminary Public
Sector Comparator.
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Brazil:
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Project studies must include a fiscal analysis for
the next ten years. In addition, the commitment of
the federal budget to PPP projects is limited by
law to 1% of the net current revenue of the
government.
Hungary:
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From 2007 a limit on the amount of expenditure
on PPPs within the budget, so that each program
has to fit within this limit.
2.4 Affordability, limited budget allocations
and legally imposed budgetary limits
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Distinction between affordability, limited budget
allocations and legally imposed budgetary limits
In many countries there are:
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Limits on second- and third-tier government borrowing.
Fiscal rules that limit government expenditure, deficits or
debt.
Thus, project might be affordable, but legally
imposed budgetary limit prohibits borrowing.
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In some cases the opposite is also possible.
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In addition: budgetary allocations of government
departments and authorities that are done from a
central budget and within which expenditure plans
must be fitted.
Even if a traditionally procured project would not
violate the long-term budget constraint of
government, a project may still exceed the future
expected budgetary allocations of a specific
government department.
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Danger: less of a focus on VFM and create an
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incentive to get project off the books of government.
Two specific cases when there is an incentive to get
project of the books of government.
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The first case is one where a project cannot be
delivered through either traditional procurement or a
PPP within budgetary limits.
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Has 3 features, but a short-run focus on 1st and
disregard for the 2nd and 3rd by gov creates incentive
to go PPP route:
Should gov use traditional procurement: Large initial
capital outlay will cause a gov entity to exceed its
allocated budget.
Should entity then decide to go PPP route: May not be
able to make future fee payments to private partners
without exceeding expected future allocated budgets.
In addition, private partner also cannot levy user
charge on direct consumers of the service.
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Second case occurs when gov operates under a
fiscal rule that sets a limit on the overall fiscal
balance of gov (or a dept operates under a budget
allocation).
Results from cash-flow vs accruals accounting.
Traditional procurement: Capital outlays may
contribute to breaking the budgetary limit in the year
in which government undertakes outlays.
PPP: Private sector responsible for initial capital
outlay and government might be able to fit future
payment of fees to private partner into its budget
without exceeding the budget limit.
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In all three cases the budgetary limit may be
main reason why government might want to
get projects off its books.
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However, main reason should be higher VFM.
This is not an argument against budgetary
limits and rules – rather it is an argument in
favour of emphasising VFM as the main
rationale for going the PPP route.
3. VFM and risk transfer
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Reason for going the PPP route: Value for money, but effective risk
transfer to the private partner prerequisite to ensure VFM.
UK National Audit Office (2003): 22% of UK PFI deals
experienced cost overruns and 24% delays; compared to 73%
and 70% of public sector projects.
Scottish Executive and CEPA study (HM Treasury 2006):
 Authorities: 50% received good VFM, 28% reported satisfactory
VFM.
KPMG survey (2007) among private project managers in the UK:
 59% of respondents said performance of their projects in 2006
was very good, compared to 49% in 2005.
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However, having private partner is not in itself sufficient
to ensure VFM: need transfer of risk.
VFM: optimal combination of quality, features and price,
calculated over the whole of the project’s life.
Studies confirmed importance of risk transfer.
Risk: The measurable probability that the actual outcome
will deviate from the expected (or most likely) outcome.
Private partner carries risk if its income and profit is
linked to the extent that its actual performance complies
or deviates from expected (and contractually agreed)
performance.
Figure 3.4. The categorising of risk
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Many factors that may affect its actual performance
Some can be managed, others not.
Thus, need to distinguish between endogenous and
exogenous risk.
Transfer endogenous risk: Company can influence
the extent to which actual outcome deviates from
expected outcome.
Key question: Is whether the adverse outcome is
foreseeable and if it is, can it be managed?
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Examples of endogenous risk:
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Equipment and physical structure (e.g. buildings, roads)
deterioration.
Wasteful use of inputs (i.e. x-inefficiency) – includes
wasteful use of raw materials, appointment of too many
personnel.
Failure to manage risk related to input prices (e.g. failure to
negotiate best price of raw materials and labour services;
failure to use hedge prices through use of future and
forward contract).
Failure to implement accounting and auditing procedures
that leads to theft, fraud and corruption.
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Examples of exogenous risk:
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Unforeseen technological redundancy (e.g. ICT).
Unforeseen demographic changes (e.g. migration,
changes in labour force participation, changes in
population composition).
Unforeseen changes in preferences (e.g. high-speed trains
vs. airplanes).
Unforeseen environmental changes (e.g. costs arising from
pollution management and pursuit of cleaner energy use).
Unforeseen natural and manmade disasters (e.g. costs
arising from floods, wildfires or political acts).
Unforeseen exchange rate movements driven by
speculation.
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Transfer of risk in PPP does not imply the
maximum transfer of risk to the private
partner.
It means that the party best able to carry the
risk, should do so.
Principles of Optimal Risk Transfer
VFM
VFMmax
σoptimal
Risk transferred
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Confusion about what ‘best able to carry risk’ means
Leiringer (2005): Is this the party with largest influence
on the probability of an adverse occurrence
happening, or the party that can best deal with the
consequence after an adverse occurrence?
Corner (2006): To best manage risk means to manage
it at least cost.
If cost of preventing an adverse occurrence is less
than cost of dealing with consequences of the adverse
occurrence, then risk should be allocated to the party
best able to influence the probability of occurrence.
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Cases where cost of preventing occurrence (incurred by private
partner) is lower than cost dealing with fallout (incurred by both
private partner and government):
 Example 1: Cost of road maintenance vs. rebuilding sections of
road once it degraded and damages paid because of accidents –
probably cheaper to maintain road.
Cases where cost of preventing occurrence (incurred by private
partner) is higher than cost dealing with the consequences
(incurred by both private partner and government):
 Example 2: Cost of maintaining some types of ICT equipment vs.
cost of dealing with the consequences of broken equipment –
cost of dealing with broken equipment is cheaper than to
maintain it.
6. Competition and Value for
Money
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Why is competition important?
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Competition for the market.
Competition in the market.
Contestability and competition.
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Monopolistic behaviour and lack of competition: no
VFM.
Competition important in pre- and post-contract
phases.
Pre-contract phase competition occurs in the bidding
process.
Zitron: 86 recent UK PPPs at tender stage: on average
3 bidders for each contract. However, 20% of 86 PPPs
less than 3 bidders.
Few bidders increase danger of opportunistic
(monopolistic) behaviour by the bidders.
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Too few bidders: VFM is not attained.
How does government end up with too few bidders?
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Paradox of many potential and few actual bidders.
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With many bidders: probability of being preferred bidder is
small.
Given bidding cost, this may cause strong potential private
partners not to bid, even if the project itself and the risks
that it entails are acceptable to them.
Few specialist companies.
Danger is that just a small group of companies may
bid for every project that comes along.
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Distinction should be made between bidding risk
and the risk of the project itself.
Can address this by having government cover the
bidding cost.
However:
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Government will have to enter this subsidy as as part of the
total project cost.
Before agreeing to pay a private company’s bidding cost,
that company must first demonstrate that they have the
capacity to bid and to deliver the service in the event that
they should get the contract.
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Competition in the post-contract phase also a
complex issue.
Once preferred bidder is announced and the
contract is signed, the unsuccessful bidders
move on, some leaving the industry.
Thus, once the contract is signed, the
preferred private partner becomes a
monopolist supplier.
Exception if the market is contestable.
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While risk transfer is the driver of efficiency
and VFM, competition and contestability
ensures effective risk transfer.
In the absence of competition or potential
entry it will be difficult to attain higher
efficiency and VFM.