The case for PPP 2.0
After about 30 years of experience with the PPP model there is still no definitive judgement on whether it works. Some countries promote it, others reject it.
Perhaps the most significant PPP related news in the recent history was that the model lost political support in the UK, which was its cradle in Europe. The UK is likely the last place in the world, where one could argue that the failure was due to the inadequate execution of an otherwise sound approach or institutional immaturity.
Should we be worried? Is the model fundamentally sound and therefore politically sustainable or not?
Against this background the International Transport Forum at the OECD (ITF) recently published the last report from a batch of 20. The project essentially investigated the soundness of propositions surrounding the PPP model, the economics and the evidence. One of the key propositions is the claim of superior efficiency, when compared to public procurement.
The core “engine” of superior PPP performance consists of two fundamental propositions. The first is the idea that the bundling of the project phases internalises opportunistic behaviour by those responsible for individual phases. Moreover, bundling is also supposed to stimulate life cycle cost optimization.
The second idea is that such a structure lends itself to the use of high-powered incentives. For example, the turn key EPC contract involves high penalties for non-performance and the maintenance contract too is essentially a fixed price contract with pass-throughs for uncontrollable risks. In theory the total transfer of responsibility and risk should force the contractors to exert maximum effort leading to the best possible result.
The available evidence indeed shows that PPPs have a better on-budget and on-time performance. The scant evidence on life-cycle cost optimisation is inconclusive. And the perception of the ‘better’ maintained road for example, depends on the chosen counterfactual to compare with. If the State does not have the money to properly maintain its network, a PPP won’t create more funding. It will commit more resources to one part while leaving less for the rest of the network.
If user charging is possible then the state can introduce user charging on publicly procured roads too, leading to funding stability. No study focusing on maintenance so far considered comparing apples with apples. Hence, in terms of outcomes there is no solid evidence that PPP is better apart from on-time and on budget performance.
The economics used to defend PPP superiority though – the engine – has an issue. The PPP model requires that the contractors commit to a fixed price for the risks they accepted in advance – the construction of a major complex project and decades of its maintenance. The trouble is, the contractors don’t precisely know what the risks are and uncertainty can’t be fully eliminated. For example, the EPC (Design-Build) approach, the complexity of the asset, and the long duration of the contract (the bundling) all add to the uncertainty bidders face during tendering.
The combination of increased uncertainty and the need to fully price the contract in advance results in large contingencies. Strong evidence exists to show that competition here isn’t enough to erode them. Even in small road contracts with sizes of a few million USD, where uncertainty is limited, asking for a lump-sum price leads to substantially higher infrastructure cost.
Is the problem identified equally relevant for all PPPs?
In the ITF project we clarified that a PPPs model still might work reasonably well in cases, where there is less sunk cost investment and where continuous pressure on efficiency and rents exists throughout the life of the contract.
A typical example here would be sea ports, where the terminals are competing for the same catchment area. Airport concessions may also qualify. The same continuous pressure though cannot exist in any availability based scheme or where the users pay but are captive, because there is no alternative or the alternative is a substantially inferior option. Most PPP applications around the world to date such as roads or social infrastructure fit the latter case.
But what should the governments then do in cases where the use of PPPs isn’t recommended?
The ITF put forward three sets of solutions, depending on how inclined a government is to pursue private investment in infrastructure or insist on PPPs:
a) An advanced public sector governance model with a user funded infrastructure manager, which should be subject to a utility regulation or RAB model.
b) The privatized version of option a) – a preferred alternative to the PPP model.
c) Targeted remedies to the PPP model that can improve value for money performance but not fundamentally resolve the issues of the model
What is the advanced public sector alternative or its privatised version?
In multiple countries around the world, road agencies have been transformed to state owned road corporations. These focus on road asset management, procure new infrastructure through an array of different contract designs, and maintain their assets through performance based maintenance contracts. The recently corporatized Highways England in the UK is funded through a multi-annual contract with the state, while in more ideal cases such as Austria or Slovenia, the companies are user funded.
A further step is to subject these infrastructure managers to economic regulation, similarly as is the case for electricity transmission. The ITF endorsed the RAB (Regulatory Asset Base) model, which was initially deployed on railway infrastructure and more recently on Highways England. At the risk of oversimplification, in a RAB model an external body – the economic – regulator tracks the performance of the regulated company and sets periodic performance targets. If the regulated company exceeds the target it can earn more than an average return, and if the targets are not met, the company is penalized. The big difference with the P3 model is that the RAB model generally concerns a network (i.e. multiple assets), spreading risk over time and across the network. The periodic price reviews (ex-post corrections) allow adjustments over the long term, breaking down long-term uncertainty and there is no need for rigid fixed price ex-ante commitment as in P3. Moreover, the procurement design of individual projects by the regulated infrastructure manager is driven by the nature of the project, whereas in P3 the procurement design is driven by the financing model, making the fixed-price/date EPC contract is the default option.
The last point to add is that in regions which subscribe to less transparent public debt accounting arrangements (e.g. the EU), the use of PPPs was driven by their off-the-balance sheet characteristics. The same can be achieved with a user funded State Owned infrastructure manager, which is what many countries in the EU do.
What remedies are possible to improve the existing PPP model?
If the core or “the engine” of the PPP is broken, there can be no PPP 2.0, only a replacement. Nevertheless, if countries still want to pursue PPPs there are a few options to improve the performance of the model, while not fundamentally resolving its issues.
First, much can be done to de-risk the suppliers, despite the requirement they use high-powered contracts. Public clients could invest in extensive pre-project preparations, information gathering/joint-risk registers, creating a fully costed outline design, which is detailed where the state does not wish to see alternatives from the bidders and has degrees of freedom where innovation is desired etc. These efforts are aimed at reducing uncertainties contractors face during the bidding process.
Second, large parts of the value of projects (e.g. removing ground material) have no scope whatsoever for life-cycle cost optimisation, i.e. leading to lower maintenance and operation costs later. Yet, when included in a PPP scheme they will carry a premium due to the use of private finance and long-term contracts. These could be excluded and contracted separately. The crux here though is, that this option is not attractive to public clients, when the objective is to push the (entire) project off the balance-sheet.
The details of the discussion above and numerous other considerations have been extensively worked out in dedicated reports and the project synthesis, all available here. More recently a dedicated report that further corroborates the issues with the PPP propositions and takes a broader look at infrastructure procurement in general was prepared for the NBER.