Public-Private Partnerships: The Importance of Contract Design

Public-Private Partnerships: The Importance of Contract Design

Timothy Taylor 16/11/2020 2
Public-Private Partnerships: The Importance of Contract Design

Most transportation infrastructure in most countries is funded by government.

But in a public-private partnership, a private company puts up at least some of the money to build the project in exchange for being able to earn a return from that project in the future--typically through some combination of tolls or other charges to those using the infrastructure. 

For cash-strapped governments, a public-private partnership can sound enticing. Reduced need for public spending up front! Those who pay in the future will be users of the system after it is built! But unsurprisingly, whether a PPP is a good deal for the public turns out to depend on the details of the contractual arrangement. Eduardo Engel, Ronald Fischer, and Alexander Galetovic provide a readable overview of what we know in "Public–Private Partnerships: Some Lessons After 30 Years" (Regulation, Fall 2020, pp. 30-35). The subheading on the article reads: "The savings policymakers usually claim for these projects are illusory, but well-designed contracts can deliver public benefits." 

As the authors note: "[I]nvestment in PPPs over the last 30 years has been substantial, adding €203 billion of infrastructure spending in Europe and $535 billion of spending in developing countries. Most investments are in roads, seaports, and airports, but in some countries investment via PPPs has been significant in other types of infrastructure, such as hospitals and schools. In comparison, PPP investments in the United States have been small."

To understand the economic perspective here, consider the following question: If a PPP is such a good deal that businesses are bidding against each other for the contract, then maybe it would make sense for the government to spend the money up front, via deficit spending if needed, and then have the government collect the tolls or other revenues in the future. As the authors point out, the real economic gains from a PPP (if any) don't come from the private partner being willing to invest some cash up front. Instead, the gains come from incentives in the contract that would cause a private firm to to build or maintain or run the infrastructure in a more efficient or higher-quality way than if the government just took it over. 

For example, an accumulation of evidence suggests that the private firm in a long-term PPP may do a better job of ongoing maintenance than a government agency running the same project.  As the authors write: 

Many governments do not perform regular, continuous maintenance because building new infrastructure or repairing severely deteriorated projects is politically more attractive. ... Moreover, the annual logic of public budgets makes it difficult to set aside funds for future maintenance at the time the project is built. Indeed, a study suggests that one-third of expenditures on new infrastructure should be allocated to maintaining existing projects. The cost of poor maintenance under traditional provision can be high. Not only is the quality of service poor, but the cost of intermittent maintenance, which often involves costly rehabilitation, has been estimated to lie between 1.5 and 3 times the cost of continuous maintenance. We estimate that maintenance savings are somewhere between 10% and 16% of initial investment.

To put it another way, if a PPP has a contract where government inspectors will be checking to make sure that regular maintenance is done--and paid for--by the private firm, that maintenance is more likely to happen than via direct government spending, where other items will always seem to have a higher priority than regular maintenance. 

On the other side, lots can go wrong when negotiating a PPP contract. One of the major issues is that a firm may win the contract under the bright lights of transparency with a lowball bid, and then almost immediately initiate backroom discussions of why the contract now needs to be renegotiated for higher payments. The authors write: "When Mexico privatized highways in the late 1980s, Mexican taxpayers incurred costs of more than $13 billion following renegotiation of the initial contracts. In Chile, 47 out of 50 PPP concessions awarded by the Ministry of Public Works between 1992 and 2005 had been renegotiated by 2006, and one of every four dollars invested had been obtained through renegotiation." However, contractual terms can be redrawn to reduce this risk. As the authors write:  

To do so, the contract should limit the present value of a concessionaire’s compensation during the life of the contract to the amount determined by the original bid (the so-called “sanctity of the bid” principle). Moreover, any works added to the original project should be auctioned off to the lowest bidder and the concessionaire should be excluded from bidding. To ensure the sanctity of the bid, renegotiations should be reviewed by an independent panel and all contract modifications should be easily accessible to the public via the internet so that an informed public can question the reasons for renegotiations and the amounts involved.

Another issue arises when a private company is going to be allowed to impose tolls or user charges in the future. It has been a common practice that the right to charge is granted for fixed time period (and if the firm doesn't collect as much as expected, it then tries to renegotiate). This can lock in large payments to the private firm over a long period. The authors note: 

Portugal received €20 billion in PPP investments in roads, hospitals and other projects between 1995 and 2014. Of this amount, 94% was spent in highways that used “shadow tolls” that the government paid to the concessionaire per user. Government-guaranteed minimum revenue from the tolls amounted to 1% of the country’s gross domestic product annually over the period 2014–2020, though it will fall to an estimated 0.5% of GDP by 2030.

An alternative is for the contract to specify how much the private firm will collect over time, and when that amount has been collected, ownership of the project revert to the government. Indeed, the government can even decide, if it wished to do so, to pay the private firm the amount it was to receive in advance, and then let the government take over the project sooner. 

In short, with any PPP, it's worth remembering that the private partner isn't making investments to help the government "save money," but rather because the firm expects to earn a profit from doing so. If the contract is poorly designed, the firm will quite likely take every opportunity to renegotiate it upward.  The best reason for a PPP is that, if the contract is well-designed, it provides a way to reduce the government tendency to skimp on routine maintenance. In many settings, it can often work out better for society if government takes the role of active monitoring and oversight of the private provision of certain services, rather than having government try to monitor its own actions in providing those services. 

A version of this article first appeared on Conversable Economist

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  • Claire Walton

    Very interesting

  • Daniel Shelton

    Interesting piece !

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Timothy Taylor

Global Economy Expert

Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.

   

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