Political costs trash public-private infrastructure benefits

Sydney’s Cross City Tunnel has gone into voluntary administration twice since it was opened, and the government has become embroiled in legal action to recover costs. AAP/Dan Himbrechts

Last week’s Productivity Commission draft report on public infrastructure made a number of useful recommendations about getting projects assessed and delivered on time. But the report does not go far beyond the conclusion that public-private partnerships are “not a magic pudding”.

However, new research tells us the best way to assess whether private investment will deliver efficiency gains is to see what would happen if the project failed.

This may seem counter-intuitive, but because private investors can seek bankruptcy protection while governments cannot, there is a distortion in their behaviour and inefficiencies may arise. This issue is often missed when PPPs are compared with traditional public investment.

Private financing is often used because there is a belief it will provide appropriate incentives for the private partner to keep the project on schedule and on budget. The argument is a natural carry-over from similar arguments in favour of fixed-price contracting in conventional projects.

A fixed-price construction contract, for example, provides high-powered incentives for the contractor to complete on time and on budget. But the argument does not carry over perfectly to the PPP context.

In a PPP, the “project” is not a discrete construction task, but a multi-decade arrangement to deliver and maintain the infrastructure.

The consequences of the private partner entering the post-construction phase with substantial debts have not been extensively explored. How will this debt affect performance reliability during the 25-30 years of the typical concession?

This is the question that formed the basis of two research papers I authored with Matthew Ryan from the University of Auckland.

It turns out the need for private partners to borrow large amounts to meet up-front construction costs creates real potential for strategic manipulation of the government.

Private borrowings, public risk

As a rule, PPPs bundle construction and ongoing operation and maintenance into a single long-term contract.

The private investor is required to raise funds for the entire construction phase. In some cases the government isn’t required to make a payment until the road is complete and meets various pre-specified performance standards.

Similarly, it may take several years for the project to generate a profit if it is funded by the collection of tolls, which was the model used in the Cross City Tunnel in Sydney and the Airport Link and Clem7 tunnels in Brisbane, all projects that ran into financial difficulty.

The idea, of course, is to limit the risk and costs for governments, and transfer them to the private partner. But a proper analysis shows that irrespective of how desirable this is, the possibility to transfer the risk is limited.

Because construction is privately financed in a typical PPP, the private partner enters the post-construction phase with significant debt servicing costs.

Forcing the government’s hand

If demand turns out to be weaker than expected and the project is funded by tolls, the private partner may default on its loans and its bankers will inevitably try to renegotiate the contract with the government.

And because there is a high political cost in reassigning and renegotiating the contract, the government will be more willing to make a transfer payment to keep the private partner afloat.

Former NSW Premier Bob Carr was summoned to appear before a parliamentary inquiry into Sydney’s Cross City Tunnel, which later went into voluntary administration. AAP/Dean Lewins

This “transfer” doesn’t need to be a direct payment. It could be anything from allowing an increase in the toll rate to extending the length of the contract.

In other words, private financing exposes the government to hold-up when the private partner comes under financial pressure. By choosing its debt levels strategically, the private partner can exercise some control over the expected transfer.

The impacts renegotiating a contract has on efficiency has been recognised by other countries around the world, some of which have inserted specific arrangements for arbitration of these disputes into law.

Knowing liability is limited will eat away at the efficiency gains that are meant to arise from these long-term contracts.

This is because the private partner’s efforts to contain costs, and how it deals with debt levels, can affect its likelihood of default and, therefore, the transfer that it can extract from the government.

Split the bill

Public financing would be one means of neutralising this distortion. Just because construction and maintenance are bundled together does not mean both have to be funded privately. The government could provide up-front funding for construction.

The winning bid would determine the total payment from the government, and all the construction costs could be invoiced to the government. Whatever remained in balance would then be disbursed in the form of regular service payments over the life of the contract.

This would remove the need for the private partner to undertake any significant borrowing. Of course, even with low debt, there could still be financial difficulties if costs were high enough. However, small guarantees or modest equity participation requirements could eliminate hold-up risk.

Much larger guarantees or minimum equity requirements would be needed to address this problem, which might harm participation in the tender.

More generally, the relative merits of public versus private financing of PPP projects need closer scrutiny. As our research shows, there are hidden efficiency issues which, while mentioned in the Productivity Commission’s draft report, are not fully understood and appear to have been missed in the debate on infrastructure funding.