News that BrisConnections, which operate Brisbane’s Airport Link M7, has suspended trade on the ASX as it continues to talk with its debtors is likely to again lead to a debate about the role of Public-Private-Partnerships – or PPPs – in providing government infrastructure.
PPPs have been criticised in the wake of several high profile failures including Sydney’s cross-city tunnel, Brisbane’s Clem 7 tunnel and the consortium building the Ararat prison in Victoria, as well as the high cost to the public of PPPs undertaken in the 1980s and 1990s.
Supporters will argue that the PPP model works because ratepayers will be protected if the company that built and operated the tunnel fails.
Both sides are mistaken. Economic research suggests that PPPs can deliver better outcomes than traditional procurement but often governments choose PPPs for the wrong reasons and fail to take key steps to ensure their success.
Under public procurement, the government finances the construction phase of the infrastructure, tendering the construction to private parties. The operation and maintenance of the infrastructure also may be contracted to private parties.
Under a PPP, a government tenders a “bundle” consisting of financing, construction and operation to private parties. The contract is usually for a fixed period at the end of which the asset reverts back to the government.
An important advantage of PPPs is the potential efficiency gains from bundling the construction and operations/maintenance.
When bundling occurs, the winning firm minimises the total of construction and maintenance/operating costs. So design and construction are undertaken in a way to minimise the total cost of the project over its lifetime.
Another potential advantage from the involvement of private financing under a PPP is in avoiding the construction of politically motivated white elephants. Private parties will find it difficult to obtain financing for a project that is not commercially sound. Arguably, the PPP failures reported above could be related to the particular structure of those PPPs rather than the underlying economics of the projects.
There are also, however, wrong reasons for selecting PPPs over traditional procurement. For example, governments may favour PPPs over public tendering to alleviate its budget constraints. This argument is clearly wrong when PPPs involve direct government transfers, such as minimum income guarantees or other types of payments. It is also wrong to the extent that the PPP project is financed by user fees — a revenue stream which the government gives for the duration of the PPP contract.
Governments can be also attracted to PPPs because they perceive this model shifts the demand risk from the government to the private parties. This argument for choosing PPPs is erroneous for several reasons. Firstly, the private parties bearing demand risk do so in exchange for a risk premium. To the extent that they cannot influence demand, the government may be the best party to hold the risk. Secondly, the upshot of the financial difficulties with projects such as the M7 Airportlink is that it will be very difficult to find investors willing to finance similar ventures in the future.
Third, in a number of cases in Australia and overseas, governments have bailed out failed projects, for example, by renegotiating payments or taking equity stakes. In such cases governments ended up bearing at least some of the demand risk.
There are ways in which PPP tenders can be modified to allocate risk appropriately. For example, research developed over the past decade suggests a tender process that allocates risks appropriately. The key idea is to run a least-present value of revenue tender. The winner of the tender is the firm that has submitted the lowest required revenue (expressed in present value terms). The innovation of this process is that the duration of the concession is variable.
The contract only expires when the winner of the tender recovers the amount of revenue bid. This type of tender allocates the demand risk to the government, reducing financing costs and ensuring that the benefits of PPPs over public tender are realised. This approach has been successfully tested in Chile.
In the past decade, we have learned a lot about what works and what does not in PPPs. To avoid previous mistakes with PPPs, governments need to ensure that there is a robust process for evaluating PPPs. Moreover, closer attention needs to be paid in the design of PPP tenders and contracts, as suggested by both economic theory and international practice.
A longer version of this article is at Australian Policy Online.