What we know and what we do not know: PPP as a key way to try to get out from the crisis
Implementation of Long-Term investments and optimal risk sharing
1. PPP: a public and private sector cooperation tool available to optimise the value for money of public projects and services
A public private partnership (PPP) is a long-term contract and/or legal entity built up by a public authority and the private sector for delivering a long-term (or less frequently short-term) asset or a service. The principal features of a PPP are:
- Provision of a service involving the creation of an asset that requires private sector design, construction, financing, maintenance and delivery of ancillary services for a specific period;
- a contribution of the public sector through land, capital works, risk sharing, revenue diversion, purchase of the agreed services or other supporting mechanisms.
Before analysing in depth the financial issues relating to the implementation of PPPs, it must be noted that there are wide-ranging models of PPPs across the world. Although there is no preferred or standard model – as it is determined by a number of factors such as the definition of core services, the value for money and the public interest - it is possible to identify two main broad frameworks:
- DBFM (Design-Build-Finance-Maintain): the private sector is responsible for the design, building, finance and maintenance of an asset. This incentivises the private sector to design the asset taking into account the long-term maintenance required;
- DBFO (Design-Build-Finance-Operate): the private sector designs, builds, and finances a new facility under a long-term contract and operates the related asset during the term of the contract.
The public sector purchases services that flow from the asset in this period and the ownership is usually transferred back to the public sector at the end of the contract.
PPPs are now particularly prevalent in economic sectors where they have proved their worth by increasing value for money and improving the service provided: transport, utilities and amenities.
There are opportunities for governments looking to develop PPP programs beyond infrastructure and to consider it in the service areas: healthcare, education, prison, innovative sectors etc. at a national or local level.
2. Why it is important to develop PPPs nowadays
In advanced countries, PPPs can contribute to solving the difficulty of building infrastructures or replacing ageing ones in a context of budgetary pressure.In emerging countries, PPPs can contribute to accelerating the answer to citizens’ demand for ongoing improvements in infrastructure and public service. The shortage of infrastructure in developing countries is an important obstacle to meeting the population’s needs and to developing enterprise. Recognised key benefits of PPPs notably induced by an increased competition are the capacity to bring about improvements to public services, shorter delivery times, better value for money and increased innovation. Moreover, from the public sector point of view, a PPP is a possible opportunity to reduce the risk and therefore to reduce financial contributions, which can alleviate the fiscal constraint the governments have to deal with. Lastly, in PPPs, the risk retained by the public sector is more explicit, thus increasing the confidence of its different partners and stakeholders among which are the citizens.
The main issues relating to PPPs that should be taken into account are:
- Risks related to the delivery of assets and services have to be clearly determined; the definition and combination of complementary skills and expertise from the different partner, the arrangement of an appropriate value chain and optimisation of the value for money are key in that respect;
- The different types of risks must be appropriately allocated between the different players involved (savers, financial intermediaries, enterprises, public entities);
- PPPs concerning "Innovation" - infrastructures involving alternative sources of energy, new outsourcing areas within public services (healthcare, education or prisons) must be particularly cautious on risk identification and allocation in order to facilitate the access to finance.
Nowadays, many governments obtain financing for PPP projects from organisations such as the World Bank, the Organization for Economic Co-operation and Development (OECD), the European Investment Bank (EIB) and the European Bank for Re-Construction and Development (EBRD). However, in the future, if the conditions explained below - transparency, optimal risk sharing and development of adequate financial tools - are gathered, private savers, investment funds and others will be involved in this business.
3. Risk allocation between private parties and the public sector
a. What is at stake
A bedrock for an optimal risk transfer is an accurate risk assessment, as risk should be allocated to whoever is best able to manage it. Transferring too much risk to a private provider that has little control over it can lead to delays, cost overruns and eventually discourage their participation to PPPs. The reverse behaviour is also true. Risk allocation seeks to assign project risks to the party in the best position to control them and therefore minimise both project costs and risks. The party with the greatest control of a particular risk has the best opportunity to reduce the likelihood of the risk eventuating and to control the consequences if it does. This implies that risk that can be mitigated by the private partner (e.g. operational efficiency, etc.) should be borne by the private sector, whereas risk of a public-interest nature (e.g. specific public demands including non-commercial objectives, etc.) should be born by the public sector. This suggests that an appropriate risk allocation requires beforehand an effective clarification of the actual public interest, and that assessing risk is a case-by-case exercise. Lastly, certain risks are outside the total control of both parties to some degree. Even in this case, the basis of the assessment of the likelihood of the risk eventuating, the related likely cost to the public party, and its ability to mitigate the possible consequences by testing different scenarios of risk allocation would enable public parties to understand whether the private party prices the risk and whether it is reasonable for the public party to pay for it.
b. Risk assessment methodologies
To assess the opportunity to start a project involving the private sector, it is relevant to perform the so-called Public Sector Comparator (PSC). It provides a financial benchmark for the quantitative assessment of the value for money brought by the different answers to the request for proposal (RFP).
- The PSC represents the net present value of the total whole-of-life cost required for the public party to meet the specified output in the case of a self-procurement;
- RFP responses are therefore ranked according to their risk-adjusted Net Present Cost ("NPC") and compared to the risk-adjusted PSC;
- The financial impact of the risk retained by the public party is added to each RFP response to show the total project delivery cost. Adjustments may be made to the NPC of individual RFP responses according to a preferred risk allocation scenario.
Nevertheless, identifying the best outcome requires a flexible valuation process and a complete value for money assessment requires also considering the qualitative factors of each RFP response.
c. Public Sector Challenges
Long-term commitment from public parties to PPPs is important for business confidence. Hence, political stability is key to PPPs’ continued success. Lenders will be reluctant to enter and invest in PPP markets if there is no clear and reliable political support. Investors will be unwilling to put capital at risk unless their rights and responsibilities – vis-à-vis the public sector, other enterprises and the general public – are firmly established and enforced by independent entities.
In an environment where laws and agreements cannot be effectively enforced, most other success criteria are of secondary importance. A sound and stable legal and institutional framework is a vital precondition for the success of any PPP market. This situation does not preclude governments from exercising their right to regulate in the public interest, including by changing legislation bearing on the viability of infrastructure projects. However, they should do so in a transparent and, as far as possible, predictable manner, including prior consultations with the private sector participants. Moreover, transparency on the procurement process and on the performance of existing PPPs etc. means an easier access to private investors.
An example of how to construct political stability and transparency is provided by the UK experience:
- The creation of The Office of Government Commerce (OGC) has provided a sound and certain framework to guide procurement actions;
- The creation of the National Audit Office (NAO) responsible for scrutinising government spending and conducting regular investigations on the performance of PPPs, has provided transparency on PPPs.
Among the Public Sector challenges, the resolution for the lack of efficiency and experience in the risk management cannot be omitted and, moreover, the innovations that have been experienced in the traditional public service provision. This can incentive governments to partner with the private sector, in order to utilise their experience and resources. The private sector can offer skills and experience that bring innovation and efficiency to services and will improve outcomes. In order to remove barriers in developing the PPP model, it is considered essential to improve public procurement through skilled professional public managers who need expertise in project management, contract management, market management and model design. Procurement and commercial skills are considered essential ingredients as they lead to positive partnership relationships with providers. To fully develop these skills, the public sector should build links with the private sector by sharing best practices in order to deliver increased value for money in public services, and if necessary by setting up sector specific procurement ‘academies’ to pool procurement and contract management expertise. Lessons in this field come from the UK: here the Treasury has developed guidance particularly with respect to the risk management techniques, a field in which the public sector tends to have limited experience. Moreover, governments should develop partnership models for public authorities to demonstrate how successful partnering relationships look like and the skills required to make them successful. These bodies can act as a source of procurement and contract management excellence. An example comes from the experience of the Czech government, which has entered into partnership with the UK and The Netherlands through a EU twinning project. These countries provide PPP expertise to the Czech Ministry of Finance to help increase efficiency and develop PPP methodology and standards.
4. PPP access to finance
a. Cost of financing a PPP
Compared with the risk free rate of government-debt that applies to public procurement procedures, PPPs bear an additional risk premium because they explicitly allocate risks to the private sector. These risk premiums represent as such value for money. Indeed, they provide a quantification of the risk related to the project. These risks are different but they exist when the project remains within the public sector. Unfortunately, public-dept rates do not reflect underlying project risks as the Government-borrowings are virtually considered as risk-free because of the taxpayers’ backing. The comparison of the spreads of the public and private debt does not adequately capture the differences between public and private specific risks, nor they reflect their respective value for money or the attractiveness of sharing risk within a PPP. On the contrary, risks become more explicit in a PPP approach. Risks and value for money are in this case priced individually for each procurement option that can be appropriately compared.
b. Role of the public sector in financing PPPs
The key role of the Public sector is to appropriately set the terms of the competition in a RFP for a PPP project, in order to give to the private sector the right incentives and to obtain the best value for money. The terms for the financing of the PPP are part of these terms. The public entity has in particular to define the type of financial counterpart it wants: the PPP contractor, credit providers, specialised insurance companies. The public sector may also define in advance some restrictions on the financing options which will be accessible to the PPP contractor, e.g. fixed income, mix of fixed and index linked bond issues, involvement of bank finance etc.
The public sector should also precise the use or not of hedging instrument to mitigate interest rate risks as the public sector may prefer to consider its exposure to interest rate risks as a whole.
Lastly, the public entity may prefer to be directly involved in the financing architecture in order to provide PPP contractors with a favourable standing and reduce financing costs.
c. Conditions for accessing financial markets
A specific OECD recommendation asks for phasing out any restriction in access to local and private financial markets and obstacles to international capital movements. Access to capital markets to fund operations is essential to private sector participants.
In all cases, giving full access to capital markets bolsters the efficiency of PPPs. Where currencies are fully convertible and capital can easily move in and out of the host country, infrastructure operators fund their operations at competitive international rates and consequently need to shift no "financing premium" onto the domestic infrastructure users. When infrastructure projects are set in countries without fully convertible currencies or with uneasy repatriation of the profits and of the redemption of the capital invested, projects find it difficult to mitigate exchange risks and have a strong incentive to fund themselves locally. Countries with well-functioning domestic capital markets find it both easier and cheaper to involve private operators in their infrastructure. On the contrary, the experiences made so far by public authorities accepting infrastructure tariffs linked to foreign currency to compensate investors’ exchange risks have been far from encouraging.
c.2 Areas for progress
In order to phase out restrictions in access to local and private financial markets and obstacles to international capital movements two approaches should be adopted:
- Facilitating access of local small-scale projects to financing: to facilitate assistance to overcome the challenge of preparing bankable projects, support linkages with bigger operators and promote more SME(P) (small and medium enterprises/Project) friendly banking and financial systems. The aim would be to provide a faster, cheaper funding solution, which maintains the benefits of private bank finance but reduces its inefficiencies when applied to smaller schemes. In this regard, several strategic partnership models have been developed which provide umbrella organisations to procure smaller PPP projects. An example of this model is the Local Improvement Finance Trusts (LIFTs) in the health sector performed in the UK since 2004. LIFTs were an innovative approach to meet the challenges of investing in small health scheme projects. The individual projects undertaken by LIFTs were structured in similar ways to PPP projects: the individual contracts were grouped together and standardised terms were used. Contract batching benefits come from the use of a coherent strategy, economies of scale and repetition of contracts. Moreover, batching attracts larger construction companies into the market and private sector partners bring expertise in terms of project delivery and property development. The key benefit of such a model is that it can offer improved flexibility: financiers are able to spread risk across a number of small-scale projects, allowing more scope for flexible development and innovations, and recycle in a easier way capital into funding new projects. Further benefits include a more streamlined procurement process and the ability to drive value from working with a consistent supply chain for sequential projects, therefore building expertise and better understanding between project partners over time. To strengthen the availability and optimality of this model, the NAO report on the LIFT programme found that it is effective and it offers value for money, a suitable route for smaller projects that would be unsuitable for standardized PPP infrastructural projects.
- Loans to infrastructure projects can be securitised: private participation in infrastructure can also help develop financial markets. Loans to infrastructure projects can be securitised with the double benefit of lowering the funding cost and adding depth and liquidity to domestic capital markets, and moreover removing obstacles to international capital movements. Despite some concerns about the role played by monoline insurance companies involved in PPPs projects, there are equipped financial intermediaries such as banks, private sector companies and public sector clients who are gaining a greater knowledge of the PPP market and are better and better able to accurately reflect the long-term costs of the project in the initial contract. PPP schemes are now financed largely by long-term bonds: in this regard, the financial resources for purchasing such instruments could be available in the insurance and pension sectors of most countries. Once the risks associated with the set-up – such as construction risks – are overcome, these assets offer large and reliable returns matching the increasing the demand for investments with very long duration and with yields better than those offered by government securities, as required by insurance and pension sectors. So PPP contracts could be also considered as a proper way to create new and attractive sources of long-term investment.
Despite some concern about the secondary market in PPP assets, there is a limit to how much financial gain can be generated for private investors through financial engineering. The focus of the secondary fund manager is the long-term performance of investments. A good management of the PPP project in which they have invested is in their interest, in order to effectively maintain assets and meet service specifications. A valuable benefit is that the sale of the asset allows to recycle the capital in order to fund other projects. Moreover, from a macroeconomic point of view, there is an opportunity for governments to encourage the development of a virtuous circle between pension investment needs and public service funding. To the national economy, the benefit of recognising and encouraging this symmetrical market could be a greater overall long-term financial stability.
The Private Finance Initiative –October 2003 - Research Paper 03/79 House of Commons UK.
Building on success: the way forward for PFI – June 2007 – CBI.
Private Sector Participation in water infrastructures – 2009 – OECD.
OECD Principles for Private Sector Participation in Infrastructure – 2007 – OECD.
The world of public private partnerships –July 2007 – CBI.
National Public Private Partnership - December 2008 - Australian Government.
National Public Private Partnership Guidelines –December 2008 - Australian Government.
Editor: Alberto Maria SORRENTINO
© 2011 ASSONEBB