CESifo Economic Studies Advance Access originally published online on November 2, 2007
CESifo Economic Studies 2007 53(3):466-490; doi:10.1093/cesifo/ifm013
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Public-Private Partnerships—A Public Economics Perspective*
The Eitan Berglas School of Economics, Tel-Aviv University, Tel-Aviv, Israel, e-mail: sadka{at}post.tau.ac.il
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Abstract
1 IntroductionPublic-private partnerships (PPPs) are spreading all over the world. It may be quite plausible that they were initially started mainly as an attempt to evade expenditure controls and hide public budget deficits. But if they are properly designed and transparently reported, PPPs can play a useful role in enhancing the efficiency of the provision of services that were supplied before solely by the public sector. This article provides a public economics perspective on PPPs. (JEL codes: H54, L33)
Key Words: PPP • private-finance initiative • build-operate-transfer
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1 Introduction |
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Public-private partnerships (PPPs) were initiated in the United Kingdom in the early 1980s. They constituted an element in the broader process of privatization undertaken (or accelerated) by the Thatcher government. Broadly speaking, privatization does not merely refer to the transfer of state-owned enterprises to private investors, but also to a shift of public sector activities to the private sector. Indeed, PPPs enter into this broader category. But they do this in a restricted way; not every transfer of the delivery of public services to the private sector is referred to as a PPP. For instance, the state may outsource the issuance of driver licenses to the private sector. This would not be normally referred to as a PPP. The latter term is reserved usually to an undertaking which involves a sizable initial investment in a certain facility (a road, a bridge, an airport, a prison, etc.), and then the delivery of the services from this facility.
Many formerly state-owned enterprises perform ordinary activities that were done elsewhere by the private sector. It is also quite widely accepted that they should not have been probably run by the state in the first place. Therefore, the involvement of the state in these enterprises should, and hopefully does, end upon their privatization. This is not, however, the case with the activities relegated to PPPs. These activities have some public good features. A road, for instance, is usually referred to and studied by the public economics literature as a congested public good. As any beginning student of welfare economics learns, congested public goods are characterized by externalities and market failures.1 Therefore, they are not privatized once and for all; rather, the state continues to be involved in some way or another, and one option is to set up PPPs.
Yet one may still argue that PPPs are not genuine partnerships that properly or efficiently share risks and liabilities (and profits). Rather, they are a means to disguise conventional contracting undertakings that are subject to standard budgeting processes as some new undertakings that are carried out off budget.2 This claim might have been particularly valid at the beginning, where most PPPs took the form of private-finance initiatives (PFIs), in which the private contribution was primarily in providing financing. Put differently, the private involvement amounts to not much more than providing the government with a channel through which it could finance infrastructure investment by implicit (or hidden) budget deficits and debts. In the words of Spackman (2002), "Early financing proposals were designed mainly to evade expenditure controls."
However, PPPs have by now gone a long way since their embryonic stages as PFIs. In many instances, they have developed into genuine partnerships aimed at properly pricing scarce public resources and efficiently sharing and managing risks. They may be still far from being perfected, but it would be inappropriate nowadays to dismiss them altogether on the ground of being merely a tool to make the government accounts look stronger. In a preface (written in January 2001) to a PPP manual for South Africa's national and provincial government departments, Trevor Manuel, the Minister of Finance, states: "...the availability of state resources for these purpose [to meet the socioeconomic needs of all South Africans, and in particular, to alleviate poverty] must be used to leverage much-needed private sector investment in public infrastructure and services". Indeed, the desire to raise private financing is explicitly acknowledged. But he immediately goes on to say: "The benefits [of PPPs] do not consist in an increase of funds, but in the better management of scarce resources."
Whether or not "born in sin", PPPs are now spreading worldwide. Furthermore, when properly designed and transparently reported, they can also play a useful role enhancing the efficiency of the provision of services that were supplied before solely by the public sector. This article provides a public economics perspective on the advantages and disadvantages of PPPs.
The organization of the article is as follows. The next section describes briefly the scope of PPPs. Section 3 analyzes some common feature of PPPs, most notably build-operate (BO). Section 4 introduces the notions of exogenous and endogenous risks. Section 5 points to the role of PPPs in rationalizing public investment decisions, while the importance of a proper cost-benefit analysis is discussed in Section 6. Section 7 is devoted to the analysis of risk sharing between the public and private partners. Section 8 discusses how the pricing of the service is affected when the facility is transferred to the public partner at the end of the partnership (namely, the end of the concession period). The role of user charges as Pigouvian taxes and their implications for the efficiency of PPPs are analyzed in Section 9. Section 10 addresses the off-budget character of PPPs and resource accounting. Politico-economic considerations associated with PPPs are brought forth in Section 11. Section 12 concludes.
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2 The scope of public-private partnerships |
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The design of an efficient PPP project depends crucially on the basic underlying economic environment under which it operates. Therefore, it would presumably be inappropriate to prescribe a model arrangement to be entered with between the public entity and the private entity in all PPP projects. Rather, these projects are becoming ever popular in many fields: transportation infrastructure, such as roads, bridges, tunnels, above and under ground rail, air and sea ports; utilities, such as water and electricity supply, sewage, and waste disposal; prisons; schools; hospitals; etc. They are therefore carried out against the background of a large variety of circumstances and uncertainties, so that each case may have to be examined, designed, and executed with a close reference to its own characteristics.
Nevertheless, this should not be interpreted to mean that there can be no universal rules to follow. On the contrary, there is a widespread consensus among economists that transparency is crucial in the case of PPPs. Because PPPs may be used to channel public activities off budget and away from the public eye, all public liabilities must be at least properly reported, if not properly quantified according to some generally accepted accounting standards.3 These liabilities could be either direct (that is, materialize in any event) or contingent (that is, materialize only if a certain event occur); and either explicit (that is, legally binding) or implicit (that is, binding by some social norms, habits, tradition, etc.).4 Indeed, several countries have recently tried to identify and quantify all government obligations.5
We aim to analyze and discuss some basic features that are common to most PPP projects. These projects come under a variety of forms. A detailed description of these forms may be found in a report of a staff team from the Fiscal Affairs Department of the International Monetary Fund (2005). The most common forms are some variant or another of Design-Build-Finance-Operate (DBFO), in which a concessionaire from the private sector designs, builds, and finances a certain facility (e.g. an airport) and then operates it as well, or Build-Operate-Transfer (BOT), in which a concessionaire finances and builds a facility, operates it, and transfer it to the government at the end of the concession period. The BO combination features in all of these arrangements.
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3 Build-operate |
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In this section we address the issue of why this BO combination is so prevalent in PPP projects. An obvious alternative is conventional provision, under which the public entity first contracts with a private builder to construct a facility (e.g. a multilane highway), and then either contracts with a concessionaire to operate the facility for a specified period of time or operates the facility by itself. So, what kind of an advantage is there to be gained when bundling these two activities of building and operating under a PPP arrangement? A simple and useful answer was provided by Hart (2003).6 Suppose there are two kinds of investments that can be made in the construction stage of the road. One, termed productive, improves the quality of the road and reduces the cost of operation. For instance, the use of concrete rather than tarmac in building a road does both because concrete is much more durable than tarmac. The other investment, termed unproductive, reduces the service and the cost of operation but also the problem of service. For instance, one can build an extremely tight screening system in order to detect people evading tolls (i.e. free riders). This may slow down traffic on the road, it reduces the quality of the service. But it also lowers operation costs (or increases toll revenues).
Under conventional arrangement ("unbundling"), the constructor has no incentive whatsoever to incur the cost of any one of these two investments but under a PPP, the concessionaire internalizes the cost-reduction feature of these two investments, but not the quality-change feature. As a result, the concessionaire under invests (from a social point of view) in the first kind of investment, because she does not internalize the quality-enhancing feature of it; and she over invests (from a social point of view) in the second kind of investment, because she does not internalize its quality-reduction feature. Therefore, in general, one cannot tell whether bundling is preferable to unbundling or not.
But this illuminating example does provide an indication as to the circumstances under which a PPP arrangement is preferable. If the characteristics, especially the quality-related characteristics of the facility (the road in our example), can be well specified and, more importantly, well monitored and verified by the public partner at a relatively low cost, then a conventional arrangement (unbundling) may be adequate. However, public monitoring and verifying of the quality of a facility which is built to last for a long time are often very costly.7 In contrast, if the quality of the service, such as the uninterrupted flow of traffic at a certain minimum average speed throughout the day, at no more than a certain noise level, etc. can be well specified and verified, then a PPP arrangement can work fine.8 In this case, the specification of the quality of the service dictates to the concessionaire the quality of the facility itself, with no need to directly verify it beforehand (at the construction stage).
The specification of the quality of the service yields another advantage in favor of a PPP arrangement. In most cases, the capacity of the facility may have to be expanded over time. For instance, the number of lanes in each direction of the road may have to increase in order to adequately accommodate a rising volume of traffic. The size and the timing of the expansion do not have to be prespecified in a PPP contract. Again, it may suffice to specify that traffic should be able to flow at a certain minimum speed throughout the day which would persuade the concessionaire to add another lane to the highway in due time so as to avoid excessive road congestion which slows down traffic. Alternatively, the PPP contract may specify that the road must be enlarged when the volume of traffic surpasses a certain level per hour or per day. Similarly, a PPP contract for an airport may specify the number of incoming and outgoing flights per gate and/or the number of passengers per square meter of terminal space, etc. in order to ensure the appropriate expansion of the facility at the appropriate time.9
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4 Identification of the endogenous and exogenous risks |
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It is important to identify the circumstances under which a PPP operates. Modern economic theories of procurement (whether by the public sector from the private sector or whether wholly within the private sector) consider the procurement problem as that of ex ante asymmetric information coupled with moral hazard.10 Namely, the seller is better informed about production costs and quality than the buyer. But, after carefully examining the construction management literature and speaking with industry participants, Bajari and Tadelis (2001) report that they "have found little evidence that either the contractor or the buyer has private information at the onset of the procurement project. They both, however, share uncertainty about many important design changes that occur after the contract is signed and production begins, such as design failures, unanticipated site and environmental conditions, and changes in regulatory requirements".11 These uncertainties are exogenous to the private builder of the facility or the private provider of the service. To a large extent, they are also exogenous to the public entity that sponsors the facility. Even regulatory changes may be exogenous to the public entity, because they may be instituted by the legislators, by local governments, by rulings of the courts, etc.12
Similarly, there are exogenous uncertainties on the revenue or benefit side of public investment projects. In transportation infrastructure projects, future demand is certainly not certain. The use of a subway system may be severely depressed by terrorist threats. The volume of traffic on a highway depends on fuel costs, GDP growth, population growth, etc. The demand for electricity from a new power plant is a function of, among other things, GDP growth, the degree of industrialization, the development of energy-saving technologies, etc. Neither the government nor the private concessionaire is a priori better informed about these (risky) variables.
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5 "White elephants" |
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We shall come later to analyze in more details the treatment of risk in PPP arrangements. For our purposes at this stage, it suffices to realize that the costs and the benefits cannot be determined for certain. In this context, PPPs may play a useful role in enhancing a proper cost-benefit analysis and reducing the likelihood of building "white elephants", such as a multilane highway that runs from nowhere to nowhere.
Because costs and benefits cannot be projected accurately, ex post (actual) costs and benefits are almost certainly going to be different from what was estimated at the onset. Thus, ex post, the net benefit from some projects would be negative or less than a priori expected, whereas the net benefit of other projects would be greater than a priori expected. However, as Prud’homme (2004) reports, costs are generally underestimated and benefits overestimated, and by large amounts, in public infrastructure projects. As Prud’homme puts it, "errors of 50 percent or more seem to be the rule rather than the exception". For example, the actual number of passengers that used the channel tunnel between the United Kingdom and France in its first year of operation was less than 25 percent of what was predicted by SNCF, the French-owned railway company. In 2003 actual revenues from the tolls were about a third of what had been predicted. As Tanzi (2005) puts it, "this happened in a density-populated area connecting two of the richest cities in the world (London and Paris) and two G-7 countries"! Similarly, Strong Guasch and Benavides (2004) report cost underestimations and benefit overestimates for toll roads in Argentina, Brazil, and Mexico.
These findings may be interpreted as providing some indication that prediction errors are biased.13 It is possible that public agents, motivated by self-interest, behave strategically. That is, out of a desire to maximize the volume of activity, which can serve to justify their existence, public agents in a sort of "wishful thinking" way underestimate costs and overestimate benefits or revenues. A PPP may be useful in sorting out the economically viable from the economically unviable projects, and rejecting the latter. The private sector will not be generally willing to enter into a public infrastructure undertaking in which it does not expect to recover all of its costs, including capital (direct or opportunity) costs. Therefore, the private sector will double-check the estimates of the public agents concerning costs and revenues. In this way, the private sector may serve as some safeguard, albeit perhaps imperfect, against "white elephants".
This is true even when, as under many PPP arrangements, the government provides the concessionaire with a guarantee against certain cost overruns or revenue shortfalls. Consider, for example, a PPP arrangement for a toll road. Suppose the government provides the concessionaire with some initial design, and agrees to compensate her for any cost increases resulting from changes in this design or from the occurrence of some prespecified events that were not initially accounted for. For instance, due to some public or political pressures by environmentalist groups, the government may decide later to change the path of the road, so as to pass through a tunnel rather than across mountain landscape. A PPP contract may specify that in such a case, the concessionaire will be compensated by the government for her extra costs. Similarly, the government may agree to compensate the concessionaire, if some contaminated land is found along the path of the road that needs to be treated, causing both a time delay and a cost increase. Also, the government may agree to compensate the concessionaire for future exchange rate changes, for future increases in the price of steel (which may constitute an important component of the cost of bridges and overpasses), etc. Still, the baseline cost (under the original design, price and exchange rate levels, etc.) is at least partially, if not fully as in this example, borne by the concessionaire. Therefore, she will not take at face value the original cost (under)—estimates prepared by public agents eager to undertake the project.
The same is true with respect to the benefit side. Public agents typically provide some forecasts of the use of the road—"baseline" estimates. The government may offer the concessionaire an insurance for the baseline estimates, by compensating the concessionaire if the actual use turns out to be less than what was estimated at the baseline scenario. As long as this compensation is not full, that is as long as the concessionaire is not fully compensated for revenue shortfalls, she bears some of the risk of such shortfalls. Again, the concessionaire cannot afford to take at face value the original revenue (over)-estimates prepared by investment-eager public agents.14 Thus, PPPs may serve as a safeguard, though not fool-proof, against "white elephants" which were not uncommon in many countries, developed as well as developing.
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6 Cost-benefit analysis: prices and discount rates |
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The scrutiny done by the private sector under a PPP is important for another reason. A key issue in any cost-benefit analysis is the prices at which costs and benefits are evaluated. Proponents of a certain public infrastructure project may argue for calculating costs on the basis of out-of-pocket costs for the government. Thus, a case may be made for evaluating the cost of labor at (lower) after-tax wages rather than at (higher) before-tax wages, for indeed all taxes paid on labor are after all recollected by the government.15 In a second-best world like that of Davis and Whinston (1965), one cannot totally dismiss this argument in all circumstances.16 However, following the work of Diamond and Mirrlees (1971), the public economics literature has established the superiority of aggregate production efficiency under quite general circumstances. That is, it is socially efficient for the production sector to maintain efficiency even though second-best economies, plagued by distortionary taxes and subsidies, are generally inefficient. An implication of this efficiency requirement is that all production activities, whether carried out by the private or the public sector, must be evaluated at the same prices—the prices (including those of labor) faced or paid by the private sector. Among other things, labor should be properly evaluated at the wages paid by private producers, namely the (higher) before-tax wages, in cost-benefit analyses of public investment projects. Since with a PPP the private sector is the final "referee" of the project, then indeed the economic viability of the project will be calculated at socially appropriate prices.
A related issue is the discount rate to be used in evaluating (discounting) future costs and benefits.17 The private sector borrows typically at a higher rate than a financially solvent government. Thus, the private sector employs a higher discount rate than the government. In most, if not all, infrastructure investment projects, the bulk of costs have to be incurred up front, whereas the benefits accrue much later. Therefore, an increase in the discount rate tends to have a significant negative impact on the attractiveness of a project. Hence, a project which has a positive net benefit when evaluated by the government, may have a negative net benefit when evaluated by the private sector, and, consequently, rejected by the private sector. At first glance, this may seem to be a deficiency of PPPs. But after a careful scrutiny, things turn out to be to the contrary.
Savers are indeed willing to lend money to the government at a lower rate (a "risk-free" rate) than they are willing to lend money to the private sector. This is because savers correctly perceive that the government will not default on its loan, whereas the private sector may. The government is indeed less risky than the a private borrower from the point of view of the savers, as they are willing to finance a (risky) infrastructure project at a lower interest rate when it is carried out by the government than when it is carried out by the private sector. But this has nothing to do with the underlying, fundamental riskiness of the project itself. The latter risk does not change depending on whether the project is undertaken by the government or the private sector. Put another way, savers know that if, for instance, the project fails to generate enough revenues in order to pay the interest or repay the principal, then the government can use its power to tax its citizens in order to cover the project revenue shortfalls. The explicit extra cost of private borrowing (over government borrowing) is merely replaced by a contingent tax liability, when a project is built and financed by the government. Thus, one concludes again that an infrastructure investment project should be evaluated at the private sector prices (namely, discount rates), as is indeed the case with PPPs.
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7 The allocation of risk between the public and private partners |
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An important issue in PPP arrangements is the sharing of risk between the public and the private sector or more concretely the transfer of risk from the public to the private sector. As was pointed out above, much risk is exogenous, and the private partner is neither better informed about this risk than the public partner, nor can more efficiently manage or bear it. On the contrary, one may argue that the public sector is less risk-averse than the private partner, so that the former should bear all the exogenous risk. In the words of Dewatripont and Legros (2005): "It is thus in the interest of the State to insulate the contractor against exogenous risk."
Note, however, that insulating the private partner from exogenous risk does not necessarily imply that the public partner would bear this risk. Consider, for example, inflation risk. The general price level is undoubtedly exogenous to the private partner. In fact, it is largely endogenous to the public (i.e. government), since inflation is primarily an outcome of present and future monetary policies. The public partner may choose to insulate the private partner against inflation risk, but this does not mean that the public partner would compensate the private partner for future rises in the general price level. This risk may instead be shifted to the users of the facility, say a toll road, by linking the toll to the Consumer Price Index (CPI), for example.18 Similarly, in a PPP in the rail section, where the locomotives operate on diesel fuel, the risks associated with the future prices of diesel fuel could be shifted to the users by linking the fares to these prices through some formula that takes into account the weight of fuel costs in total costs.19 But not all risk is exogenous to the private partner. Some risk is endogenous to the private partner, and can be partially managed or controlled by actions or efforts made by the private partner.
On the cost side, there are many risk elements that are either exogenous to the private partner or endogenous to the public partner, and it is inefficient to make the private partner bear them. The general price level, the general construction index, oil prices (which affect, in particular the price of bitumen, a material used to make the tarmac), steel prices, etc. are beyond the control of the private partner. Design changes, new environmental or safety regulations, etc. are not only exogenous to the private partner, but also endogenous to a large extent to the public partner, because the latter often initiates design changes and new regulations. The public partner or the users (that is, the final beneficiaries of services provided by a PPP) should therefore bear the associated risk. This is usually done either through direct compensation from the government to the private concessionaire or by allowing the concessionaire to raise user charges (such as the toll on a road or the price of water from a desalination plant, etc.) that she collects.
But there are also risk elements that are endogenous to the private partner and/or it is better informed about them than the public partner. Even putting aside design changes, new regulations, oil and key commodity price changes, occurrence of adverse effects (such as contaminated land, the discovery of new archeological sites), and the like, still there remains quite a lot of risk concerning production or construction costs. The quantities of the various inputs, such as labor, sand, cement, and similarly their future prices, can only be estimated ex ante (and for some of these inputs such as labor, for instance, there are no forward markets). Under conventional contracting (unbundling), a fixed-price bid may lead the contractor to compromise on the quality or durability of the facility by saving on input quantities or by employing low-quality materials. Assuring high quality is perhaps the reason for which in many construction projects (and almost in all construction projects in the area of transportation) the bid is a fixed-variable price, rather than a fixed price. That is, the price P offered in a bid (or in a negotiated contract) is of the form
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In contrast, in a PPP, where construction of the facility and operating it for an extended period of 25–30 years are bundled together, the concessionaire has an incentive to build a facility of good quality that will last for long and will not require heavy maintenance costs. In this case, all the endogenous risk associated with the production costs aforementioned above is shifted to the concessionaire. The public partner is insulated from all this risk, which is often a major source of cost overruns under conventional contracting. This is a major advantage of PPP arrangements. The concessionaire's incentive to keep the facility in good conditions is further enhanced, when she is also required to transfer the facility in good conditions to the government at the end of the concession period. This is the case with BOT projects.
Similarly, on the revenue side, there are many risk elements which are exogenous to the private partner. A major source of uncertainty in infrastructure projects is future demand. The latter depends crucially on macroeconomic variables such as population growth, GDP growth, fuel costs, the degree of urbanization, etc. These risks are efficiently borne by the government. Furthermore, some other factors are endogenous to the government as they constitute policy variables. For instance, the demand for the services of an underground metro in a certain city crucially depends on whether the (local) government will enact means to restrict private cars access to the city center. Similarly, the volume of traffic on a toll road depends on whether or not the government will develop an alternative fast rail service and at which (subsidized) rates; it depends also on whether or not the government will develop access roads to the toll road according to the time table presumed, at the planning stage. The demand for water may depend on the price subsidy that may be determined ex post for socioeconomic or merely political considerations.
But, again, there still remain many risk elements that are endogenous to the private partner. Consider again the case of a toll road. The uncertain demand depends also on some hard-to-verify actions or efforts undertaken by the concessionaire-operator. The operator can encourage demand by investing in aggressive advertisement and marketing, by providing clean and comfortable rest areas along the road, by providing fast and good breakdown services, by charging a toll below the maximum level allowable in the concession agreement (if demand is elastic), etc. If the government guarantees the private partner a fixed revenue, such as in the case of a shadow toll paid by the government on behalf of the motorists according to a prespecified traffic volume, then the concessionaire-operator has no incentive whatsoever to boost traffic on the road.20 On the contrary, because a higher volume of traffic would probably inflict higher maintenance costs on the concessionaire-operator, she has an incentive to depress traffic. Therefore, some revenue-sharing arrangement, between the public and private partners, would seem to be efficient, as it would maintain an incentive for the concessionaire to take demand-enhancing measures. Typically, the ex ante estimated demand is set out as a benchmark. If actual demand falls short of this benchmark, then the public partner pays to the private partner a fraction 
of the deficit; if actual demand exceeds the benchmark, the private partner transfers to the public partner a fraction β of the surplus.21
In this context, it is important to distinguish between two alternative terms in which the demand guarantee is set out. One way is to set out the guarantee in terms of the quantity of demand; the other way is in terms of revenue. The first seems to be more efficient, because revenue is the quantity multiplied by the price actually collected, and the private partner may be required to exert some effort to actually collect the proper price. Consider again the case of a toll road. Collecting tolls is not a costless or effortless activity. The collection of the tolls may be relatively simple if there are manual toll booths at all entrances to and exits from the road. But this method certainly slows down traffic and may require very large spaces for installing manual toll booths, especially on heavily trafficked roads. These spaces are quite scarce, in particular in densely populated areas. For these reasons, the exclusive use of electronic means may be preferred by the public partner and imposed in the concession agreement. The collection of the tolls is no longer simple when the use of manual means at the road entrances and exits is strictly forbidden. In this case, a guarantee set in the form of a benchmark traffic volume rather than a benchmark revenue seems to be a more efficient way of (endogenous) risk sharing, as it enhances the concessionaire's incentive to collect tolls.
An alternative specification of the revenue guarantee (putting aside the possible distinction between quantity and revenue guarantees) is to endogenize the terminal date of the concession. That is, the concession agreement can specify that the concession terminates at the date by which the discounted sum of revenue reaches a certain benchmark. Unlike the revenue-sharing alternative discussed above, the public partner has the advantage in this variable terminal date alternative of not having to make out-of-pocket payments to the private partners. Still, this alternative also provides some sort of revenue sharing between the two partners on the up side, as the private partner receives all the revenue only until the termination date of the concession (which is pushed earlier), and the public partner pockets all the revenue thereafter. However, it seems that the incentives for the private partner to enhance demand and revenue are weaker under the variable terminal date alternative. The gain that the private partner enjoys when she makes an effort to boost demand is only her saving in maintenance costs as a result of the consequent shortening of the concession period.22 This gain seems meager relative to the gain under a direct revenue-sharing alternative (with in the order of magnitude of 0.7–0.8 and β in the order of magnitude of 0.5–0.6).
A further advantage of the revenue-sharing, fixed terminal date alternative over the variable terminal date alternative is that, under the former, the private partner bears much of the endogenous risk associated with the length of construction period. The fixed terminal date may be specified independently of the date of the completion of the construction of the facility. For instance, the PPP agreement can specify that the concession period is 30 years from the beginning of the project. This period covers both the construction and the operation periods. Thus, the concessionaire has an incentive to shorten the construction period of the facility as much as possible, to extend the operation period in which she collects the revenue from the use of the facility. (Note that the public partner also benefits from a longer revenue-generating operation period under a revenue-sharing scheme; and the public at large also benefits from a longer period of use of the facility.)
The idea of revenue sharing as a demand guarantee has also some practical advantages. The distinction between endogenous and exogenous risks may not be clear-cut in practice. Furthermore, their direct implications for the cost and benefit of a PPP may also be hard to separate from each other and evaluate. For instance, an observed decline in toll revenues from a highway may ensue because the public partner failed to construct access roads on time, because the private partner failed to provide a high-quality service or charged a too high toll (though within the limits set by the concession agreement), because of bad weather, and so on. It may be impractical to try to decompose the observed decline in revenue into its various possible causes. A prespecified formula for revenue sharing may thus provide a "reasonable" rule of thumb for risk sharing between the public and private partners.23
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8 Transfer of the facility |
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Another widespread practice in PPPs is the transfer of the facility to the public partner at the end of the concession period. The most common form of a PPP with this feature is the BOT arrangement. The concessionaire is usually required to transfer the facility in good condition at the end of the concession period. The transfer element seems to be inevitable for no public partner would agree to set no time limit to the concession (operation) period. But this element can be distortionary if not properly treated.
In the case of a toll road the length of the concession period and the tolls are typically determined with the aim of making toll revenue during the concession period cover the costs of construction, maintenance and operation (all in present values). But, abstracting from possible externalities, this policy may result in a toll set at a higher-than-efficient level. The users of the road end up paying to finance a facility (the road) which in effect they have not used, because the facility is transferred to the government like new ("in good condition"), due to proper maintenance whose costs were also financed by these users. Thus, the tolls cover more than all the economic costs of the PPP project.
Alternatively, the public partner could buy the facility (namely, the road) from the private partner at the "market" price. Because there are no markets for toll road, the market price would be probably set at the cost of constructing a new facility of similar standards. The public partner can "resell" the facility to a new operator, and so on. Compared to the toll under this alternative (of transferring the facility to the public partner at cost at the end of the concession period), the commonly used free transfer alternative can result in a significantly higher toll. Table 1 provides some illustrations of the "markup" between these two tolls.
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One can think of the users of the facility under the transfer-at-cost alternative as taking a loan from the public partner (through the private concessionaire) in which they pay throughout the concession period interest only, and then repay the whole principal at the end of the concession period. Under the free-transfer alternative, the users pay a fixed annual payment which covers both the interest and the principal, so that at the end of the concession period they owe nothing to the public partner.24 So, we essentially have to compare the annual payment on a loan when the principal is repaid at the end and when the annual payment covers the principal too. This comparison depends on the length of the loan period and on the interest rate, as illustrated in Table 1. With an operation period of 20–25 years (which may be common under a concession period of 25–30 years with a construction period of about 5 years) and a real interest rate of 4–5 percent per annum, the toll under the free-transfer alternative is about 42–84 percent higher than under the transfer-at-cost alternative.25
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9 Pigouvian taxation |
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The sizable markup of the toll discussed in the preceding section points to another deficiency of PPPs. A PPP project tends to be carried out in a "closed budget" or "stand alone" framework. That is, revenues from user charges (for instance, tolls on roads, airport "taxes", etc.) are expected to cover more or less the costs (of construction, maintenance, operation, etc.) of the facility. However, recovering the costs cannot be the sole, or not even the major, consideration behind the determination of the level of the user charge. For many, if not all, investments in infrastructure are of a congested local public good nature. That is, each user of the facility generates an external diseconomy on other users. The user charge must therefore play another crucial role in this setup, that is the role of a congestion toll as a Pigouvian, externality-corrective tax. As was pointed out by Oakland (1972), an efficient congestion toll rarely covers the costs of constructing, maintaining and operating the facility.26 This depends on the specific functional form of the congestion externality and the returns to scale in production.
Furthermore, major toll highways may often be less congested than freeways. The users of a toll road may generate a positive externality, relative to the users of a freeway, in that they reduce the level of traffic congestion on the freeway. For instance, the Cross-Israel Highway (CIH), the only toll road in Israel, constructed as an international PPP, is rarely congested. In contrast, the almost-parallel coastal, freeway is often heavily congested. A more efficient allocation of traffic between the two roads can be achieved by lowering the toll on the CIH and introducing a toll on the freeway. Such a cross-subsidization cannot, of course, emerge when the PPP is a stand-alone enterprise. Therefore, PPPs may distort the efficiency of resource allocation.27
But one can in a straightforward manner conceive of a different framework under which efficient tolls may be charged. For instance, a public national or a regional authority may be put in charge of construction, maintenance, and operation of all intercity highways in the nation or the region. This authority may impose tolls on all roads, if required. When deemed feasible and appropriate, this authority can initiate the construction of a new toll road under a PPP. It can use its revenues from other tolls in order to offer a certain grant or a toll subsidy in the specification of the bid for the PPP, so as to enable the concessionaire to charge a efficient toll even in circumstances under which the efficient toll is below the level that would be required in order to cover all costs of the project.
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10 Off-budget investments and resource accounting |
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It may be quite plausible that the whole idea of PPPs was "invented" out of a desire to circumvent regular budgetary procedures. In the words of Dewatripont and Legros (2005): "... it is clear that PPPs have been attractive for Governments trying to make their accounts ‘look good’, thereby (ab)using public accounting rules that do not properly value State assets and liabilities". No matter whether this claim is true or not, still, as we have seen earlier, properly designed PPPs entail many economic advantages that cannot and should not be dismissed just because they "were born in sin". Nevertheless, in their embryonic stage, PPPs indeed took mostly the form of PFI which, may be seen as providing not much more than window dressing for conventional public investment.
PFI, as its name suggests, provides merely private financing for public investment. For instance, the government may contract with a private party to construct an office building to be occupied by it. But, instead of the government paying the private party a certain price on completion of construction and taking possession of the building, the government agrees to rent the building from the private partner at a predetermined monthly or annual payment for a predetermined period of time. At the end of this period, the building is transferred to the government at a predetermined price (often zero). Similarly, the government contracts, for instance, with a public party to construct a highway; but instead of paying directly for the construction of the highway, the government "rents" from the private party the services of the highway (on behalf of the motorist users) at a predetermined "shadow toll" for a predetermined period of time; at the end of this period, the highway is transferred to the government.
Put differently, a PFI bundles together the conventional provision of a public facility with its financing. Instead of first contracting with a private party to construct a facility (a highway, an office building, etc.), and then resorting to its tax revenues or borrowing in the domestic or international capital markets to secure the funds required to finance the construction of the facility, the government forces the provider of the facility to provide the financing. It is hardly conceivable that the private party has any comparative advantage over the government in raising funds in the domestic, not to mention the international, capital markets. But the government accounts certainly look nicer with a PFI than with a conventional (unbundling) arrangement, if the government is able to put in its budgetary accounts only the annual rent (or shadow toll) payment for the facility under a PFI rather than the entire amount of the investment in the facility right away under a conventional contracting. With the restrictions put on the members of the European Union under the Stability and Growth Pact, PFI may certainly look attractive to many governments.
A similar "advantage" could be obtained with the method of "resource accounting" that has been adopted in the United Kingdom. The latter method postulates that the true annual economic cost of the use of an economic resource (say, an office building) is its annual rental price. Therefore, the cost of using a building must be evaluated annually by its rental price and recorded accordingly in each annual budget over the life time of the building rather than recording the entire purchase price in budget for the year it was purchased.28
One should note, however, that the proponents of resource accounting often make also a legitimate claim that it promotes the allocative efficiency of the government's use of economic resources. In the example of the office building, a sound case may be made that resource accounting will enhance an efficient use of office space by government as departments will be charged annually for the space that they occupy and will therefore internalize the annual cost of occupying an office. In contrast, when they are charged once and for all for the entire purchase price of a building, they have no incentive to save on office space in subsequent years.
Further note that the seemingly advantageous feature of PFI (or resource accounting) in making governments’ accounts look nice dissipates in the long-run steady state. That is, this advantage prevails only in the transition period from conventional to PFI contracting (or from the conventional cash-based accounting to resource accounting). To see this, suppose that the government makes every year an investment in a new public facility of $1000. Suppose further (merely for computational ease) that the interest rate is zero. Under conventional contracting, the government records every year an outlay of $1000. Now, suppose that in year 1 the government shifts fully to PFI contracting (or resource accounting). Assume also that each facility lasts intact (like new) for 10 years and then collapses. The annual competitive rent or "shadow rent" of each facility is therefore $100. Then the government budget will show an outlay of $100 in year 1, instead of $1000 under conventional contracting. But in year 2, there will be an outlay of $200 (consisting of a rent of $100 for the facility built in year 1 and a rent of $100 for the facility built in year 2), and so on. In year 10 there will be an outlay of $1000, exactly as under conventional contracting.29 Thus, one may argue that in the longer run, after a possibly quite long transition period, private-financing initiatives entail only the real advantage of a more efficient resource allocation, with no meaningful bearing on how governments’ accounts look. With resource accounting, this "look good" advantage dissipates even faster, if the government acts quickly to estimate the "market values" of its existing capital assets and to charge its departments an offices rents based on these values.
Furthermore, PFI may play a useful economic role in transition periods. Consider a situation in which infrastructure investment has been largely neglected over a relatively long period. This may give rise to the so-called "infrastructure gap" between the existing stock of the infrastructure capital and some notion of a "growth-maximizing" stock of infrastructure capital.30 Suppose further that the government decides to embark on a major plan to close this gap. A good case may be established on economic grounds as to whether the government should partially use debt to finance the closing of the gap during this transition period, provided that the public debt is relatively low and increasing it will not form the risk rating of the country. PFIs indeed facilitate the use of debt, as the latter is a built-in feature of them.
First, if the current generation has a finite time horizon it may question the rationale from an intergenerational economic justice point of view as to why it should pay taxes at present in order to finance the closing of an infrastructure gap that has been accumulated by preceding generations; and, furthermore, the benefits from closing the gap would probably accrue only to future generations. Therefore, from the perspective of economic justice among generations, one can make a case for extending the cost of the transitory increase in investment to future generations as well. That is, it may be appropriate for the government to partially resort to debt to finance the closing of the infrastructure gap.
Second, there are also economic efficiency grounds. Because the marginal excess burden of taxation is usually rising, one should attempt to smooth taxes over time in order to minimize the total excess burden of taxation.31 Therefore, efficiency considerations would imply that the transitional acceleration of investment in infrastructure could be financed partly by debt rather than fully by current taxes. In this way, taxes are smoothed over time.
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11 Politico-economic considerations |
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A PPP, even its least advantageous form of a PFI, may have another advantage when politico-economic considerations are taken into account. True, PPPs may allow the government to shift public investment off budget (and out of the public eye). But one has always to bear in mind than in many political systems, especially with multi-party coalition governments, the alternative to spending money on PPPs may be spending money on other budget items, such as government current consumption or transfer payments. For instance, the treasury may put forth to a cabinet meeting its proposed budget for the coming year, concentrating first on some general guidelines such as certain caps on total expenditure, total revenue, and the ... budget deficit (or surplus). Explaining to cabinet members that these caps are essential to enhance economic growth and macro and financial stability, the treasury may be able to obtain a unanimous cabinet approval of its proposed caps.
The real hurdle, however, will come later when discussing the allocation of total expenditure. In a coalition government, composed of many small parties and sometimes even without the prime minister's party enjoying a solid majority within the government, it is quite hard, if not impossible, to resist demands by cabinet ministers to allocate money to their constituencies.32 Public investment tend to take a long time to complete and even much longer time for their benefits to show up; also, their benefits tend to spread in little bits over very large populations.33 Therefore, political parties may not be particularly interested in public investment. Thus, in the budget approval process, either at the government level or more often at the parliament level, public investment may well be cut in favor of other spending (such as defense34 or social transfers to the elderly).
For this reason, there may be a preference to excluede certain public investment projects from the public budget, and propose lower caps on total expenditure and the budget deficit. It can then resort to PPPs to promote those projects that are fit for such partnerships. Furthermore, it may well be the case that when a public facility is financed by the private sector, it is politically more feasible to impose a user charge, such as a highway toll, for instance. When a highway is financed by tax revenues, the users-taxpayers may feel that they have a "right" to use the highway freely, as it was built by their own tax money. Moreover, in many cases, there is a widespread belief among civil service professionals that PPPs are the only means by which large public investment projects can be carried out without compromising fiscal sustainability. Not withstanding this belief, fiscal responsibility may be seriously hampered, unless all government liabilities in connection with PPPs—implicit or explicit, direct or contingent, and at all layers of government—are properly evaluated and recorded.
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12 Conclusion |
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PPPs are becoming nowadays a major vehicle for investment in public infrastructure and other facilities that provide public services. They cover transportation infrastructures such as roads, bridges, tunnels, above and under ground rail, air and sea ports; water and sewage infrastructures; electricity and gas infrastructure; prisons; hospitals; government office buildings; and others.
It may well be the case that PPPs were initiated as a means of evading expenditure controls and hiding budget deficits. They enabled a government to spread a certain amount of an investment over many future budget years rather than report the whole amount of the investment in the same year it was carried out, thereby converting a present budget deficit into future budget deficits. But there is nothing inherent in PPPs that leads inevitably to fiscal laxity and imprudence. Needless to say, there is a wide consensus among economists that these sins could and should be corrected: all government liabilities, whether direct or contingent, or whether explicit or implicit, have to be properly evaluated and accounted for.
This article takes a public economics look at PPPs. The latter can serve as a safeguard, albeit imperfect, against the construction of ‘white elephants’. They can also play an important role in enhancing the efficiency of resource allocation. When properly designed, in particular with respect to the sharing of risks between the public and private partners, PPPs can improve the quality of services provided before solely by the public sector, without raising their costs to society as a whole. Their major drawback is in their complexity, which renders PPP transactions costly in both money and time terms, and makes them impractical for small undertakings.
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Footnotes |
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*The views expressed in this article are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.
1 See, for instance, Arrow and Hahn (1971).
2 It should be noted that carrying out an activity off budget does not necessarily imply that transparency is impaired. In principle, full transparency may be maintained for off-budget items. But when a government wishes to conceal a certain item from the public eye, or from the international institutions and the business community, it will usually prefer to carry it out off budget.
3 This would be true even though such comprehensive standards may yet to be developed.
4 See Brixi and Mody (2002).
5 For a notable example, see Echevery et al. (2002).
6 See also Riess (2005).
7 One should bear also in mind that a high level of public monitoring and supervision may lend itself to bribery and corruption.
8 Another example of specifying the quality of the service can be drawn from water projects. There are several techniques or methods to desalinate water (some may be protected under patent rights). The government does not have to specify the size of the desalination and the technique to be used. It may suffice to specify that the public partner provide at least a certain quantity of water per year, with no more of a certain level of salinity, at a price not to exceed a certain cap, etc.
9 The same kind of expansion may be achieved under traditional public procurement, but most likely with undue delays.
10 See, for example, McAfee and McMillan (1987) and Laffont and Tirole (1993).
11 As an illustrative example, Bajari and Tadelis (2001) describe the adaptation process in the building of the Getty Center Art Museum in Los Angeles, which is a 24-acre, $1 billion facility that took over 8 years to construct: "The project design had to be changed due to site conditions that were hard to anticipate. The geology of the project included canyons, slide plans, and earthquake fault lines, which posed numerous challenges for the team of architects and contractors. For instance, contractors ‘hit a slide’ and unexpectedly moved 75 000 cubic yards of earth. More severely, in 1994 an earthquake struck. Cracks in the steel welds of the building's frame caused the contractors to reassess the adequacy of the seismic design standards that were used. The project design also had to be altered due to the regulatory environment—107 items had to be added to the building's conditional use permit. These problems were very hard to predict, both for the buyer and the contractor."
12 In fact, PPPs which are of quite a long duration serve the current government to precommit future executive and other branches of governments.
13 Note, however, that we may be missing data on projects where the costs were overestimated and the benefits underestimated; such projects may have been discarded because of yielding negative net benefits.
14 We shall elaborate more on the importance of less than 100 percent revenue guarantees later.
15 See also Spackman (2002) for a related issue concerning interest costs.
16 An even stronger (Keynesian) argument is to evaluate the cost of labor, especially low-skill labor, at zero in times of relatively high unemployment rates, for the social opportunity cost of unemployed labor is supposedly zero, or even negative, if unemployment benefits are saved. However, one has to recall that high unemployment will not necessarily persist throughout the construction stage of the project. Also, the unemployed labor may be utilized in another, more beneficial, project.
17 See also Groot (1997).
18 Note that when a risk is shifted to the public partner, it usually means that the risk is shifted to the public at large (or to the public in a certain area, if the public partner is a regional government). The group of the users of a facility is typically a smaller group than the public at large. In general, user charges can be thought of as conforming to the "benefit approach" to taxation, as distinct from the "ability-to-pay approach", see Musgrave and Musgrave (1989).