Date created: 12/4/07
Last modified:12/4/07
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John Quiggin

New rationale, same old problems

Australian Financial Review

8 August 2005

Until the late 1990s, proposals to encourage private investment in the provision of public infrastructure were motivated primarily by the desire to reduce official measures of public debt. This was true both of once-off initiatives, such as the Sydney Harbour Tunnel and of systematic programs such as the Private Finance Initiative (PFI) adopted by the Thatcher-Major Conservative government in the UK.

As is now generally accepted, the supposed reduction in debt was illusory. However it is represented in the official accounts, a liability to make a stream of payments into the future is, in economic terms, a debt. There is no ‘magic pudding’ providing infrastructure services with no corresponding cost to the public.

This issue was the subject of vigorous debate, but has now been largely accepted, as far as official policy pronouncements are concerned. The Partnerships Victoria program, announced in 2000, and based on the revised version of the PFI adopted by the Blair Labour government was the first Australian program for private investment in infrastructure in which reduction in public debt was not a primary motive. Proposals of this kind, now generally referred to as public-private partnerships (PPPs), have been justified on the basis that they yield improved value for money by achieving an optimal allocation of risk.

Despite the change in official rhetoric, it is clear that much of the political appeal of PPP measures is generated by the possibility of reducing measures of debt, or ‘fast-tracking’ infrastructure developments that would otherwise go ahead. Although official announcements drafted by Treasury departments generally focus on risk allocation, unscripted statements by politicians and advocates of infrastructure investment indicate that the belief that PPPs provide ‘something for nothing’ remains strong in the public mind.

Partly because they were designed as exercises in financial cosmetics, early PPP initiatives yielded generally disappointing results. A number of them, such as the PPP hospital projects in Port Macquarie (New South Wales) and Robina (Queensland) had to be returned to the public sector, with substantial transactions costs being incurred by both government and private parties. Even where projects are widely seen as successful, as in the case of the Melbourne CityLink, no formal analysis of value for money has been undertaken, and estimates based on limited public information suggest that the public has paid a high price for transferring risk to the private partners.

An important consequence of the historic focus on creative accounting is that, although the general ideas associated with PPP programs have been in the policy domain for at least two decades, experience with systematic PPP programs aimed at optimal risk allocation is very limited. The oldest systematic PPP program in Australia is Partnership Victoria, established in 2000. According to the PV website, only four Partnership Victoria projects have reached the service delivery stage, and none of these has produced an evaluation of operating performance or even an annual report.

Although the Blair government’s version of the PFI has been operating longer, it suffers from defects which render attempts at assessing their net benefits little more than ‘mumbo-jumbo’ (the judgement of Jeremy Colman, who headed the National Audit Office group responsible for reviewing PFI projects). Most importantly, and unlike Partnerships Victoria, approval for project proposals in the United Kingdom is typically forthcoming only in the case where the PFI option is assessed as providing better value-for-money than the public alternative. The result is that assessments are systematically biased in favor of PFI, since it is in the interest of all relevant parties that it should come out ahead.

In these circumstances, any assessment of the effectiveness of risk allocation in PPP projects can draw on only limited empirical evidence, and must rely, to a large extent, on general principles of contract design, and on observation of the private business sector.

To begin with, it’s important to look at the assumptions embodied in the term Public-Private Partnership. The capitalisation suggests that such things are new, but any public provision of services involves interaction with private sector partners, whether as suppliers, contractors or (as in official PPP programs) joint venturers.

What is new in official PPP programs is a strong preference for relationships with two main characteristics. First, rather than contracting with a range of private partners for various phases and aspects of a project (construction, maintenance, corporate services and so on), all of these are bundled into a contract with a single partner, which then subcontracts the various components of the project.

Second, whereas service contracts in both private and public sectors typically operate over limited terms of five years or so, the preferred model in PPP contracts is typically twenty thirty years. Despite the supposed absence of financial cosmetics as a consideration, the standard term seems to reflect the financial structure of the project rather than any operational considerations.

Another problem with the use of the term partnership to describe these arrangements is that a partnership is normally a relationship between specific parties, who can be assumed to operate on shared understandings of mutual benefit, rather than relying primarily on written contracts. Much of the political rhetoric surrounding PPPs suggests that the public parties to these agreements anticipate a partnership of this kind. And the public partner is indeed committed to the relationship, with little or no ability to walk away from the deal.

By contrast, the income flows and obligations on the private side of the deal are tradeable and actively traded assets. Shared understandings with a private partner are of little value if the asset is sold to a third party. The bitter dispute between the Ontario government and the owners of the private toll road Highway 407 is an example of the way in which such understandings can break down.

Except in rare cases, it seems unlikely that the allocation of risk inherent in the standard PPP model will be the optimal one. There are two fundamental problems.

First, the standard PPP program involves the transfer of demand risk to the private party. Without this element, the deal is classed as a finance lease rather than an operating lease, and the debt remains on the books of the public. But in most cases, it is the government, and not the private partner that is best placed to manage demand risk.

This is obvious in the case of service-based PPPs like schools and hospitals where the level and location services is directly determined by public policy. But it is also true in relation to toll roads.

The traffic flowing over a toll road will depend to a certain extent on the design and construction of the road, the efficiency of the tolling mechanism and so on. But it will be much more affected by decisions concerning the rest of the road network, the provision (or not) of competing public transport decisions, and land use planning in areas feeding in to the road. All these decisions are in the hands of the private sector.

The result is that PPP road contracts usually involve either guarantees to the private partners against policy decisions adverse to their interests or rates of return that compensate for an inefficient allocation of resources. Making binding commitments regarding future transport policy is costly and inefficient.

On the other hand, compensating private investors for bearing risk that properly belongs with the public is also costly. When the Victorian Liberal Party proposed buying out the toll on the Scoresby Freeway recently, Premier Steve Bracks claimed that scrapping the toll would cost $7 billion, with a cost for buying the project outright estimated at $4.5 billion. It appears that the $7 billion is an estimate of the present value of the toll revenue needed for private finance of the road. Yet the estimated construction cost for the project is only $2.5 billion (‘other financial costs’ add another $1.3 billion).

The difference between the $7 billion value of toll revenue and the $4.5 billion buyout costs presumably reflects the difference between the cost of private equity capital and the government bond rate. It implies that the government could realise a gain of $2.5 billion, at fairly low risk by buying the project out and keeping the toll. The difference between the $4.5 billion private value of the project and the $2.5 billion construction costs reflects, in part, the cost of inappropriate transfer of demand risk.

The other problem, which is likely to emerge particularly severely in relation to PPPs associated with service providers like schools and hospitals is the term of the contract. Many of the services being provided in these PPP arrangements are commonly contracted, but the typical term is less than five years, rather than the twenty or thirty years proposed in PPP arrangements.

With a long term, the government not only forgoes any benefit that might arise from the entry of new competitors, but loses any capacity to alter the contract terms to meet changing needs and circumstances, except insofar as these can be negotiated with the private partner. As anyone who’s built a house knows, it is contract variations that are the source of most of the big blowouts in any project. Unless the government thinks it can predict in detail, the way in which individual schools and hospitals will be operating in twenty or thirty years time, it should not be signing contracts with such long durations.

There are, of course, cases where the terms associated with the PPP model are appropriate, particularly those involving complex and innovative projects with a tight link between design and operation. But these are the exception rather than the rule. Rather than favoring a particular model, governments should strive for a better understanding of the principles of risk allocation.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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