CHAPTER 2 Assessing the Benefits and Drawbacks of P3s in Procuring Public Infrastructure

In this chapter, we investigate whether (and under what conditions) procuring public infrastructure assets using P3s can generate efficiency gains relative to conventional forms of infrastructure procurement by the public sector.1 Efficiency gains take the form of cost savings or time savings achieved in procuring a given quantity and quality of infrastructure. They can also take the form of any quantity or quality improvements in infrastructure for any given cost. The overall proposition is that P3 procurements provide private sector firms with strong incentives to deliver the infrastructure outcomes valued by the public sector owner, resulting in efficiency gains relative to conventional procurement methods. The efficiency gains from P3 procurements are achieved through one or more of the following mechanisms:

1.  Performance-based contracts, which specify deliverables in terms of outputs (e.g., lane availability, skid resistance, smoothness, and snow-clearing requirements in the case of roads) rather than prescribing specific materials to be used. These types of contracts also encourage innovation, since private contractors have greater discretion over how to deliver the outcomes cost-effectively.

2.  Optimal risk allocation between the public sector owner and the private sector partner, which means that many of the risks are transferred from the public sector to the private consortium if it can manage these risks more cost-effectively.

3.  Integrating the design, construction, and operation and maintenance phases of a project to minimize total life-cycle costs for the infrastructure. For example, it can be more cost-effective to build a facility with features that are more expensive at the outset but will result in reduced maintenance costs over the whole life-cycle of the facility.2 A private firm that is responsible for only one phase of the project does not have an incentive to incur these additional costs, even if those costs would be more than offset on a present-value basis by the savings achieved in a subsequent phase.

4.  Private financing, which includes project-specific debt and equity, is one of the key mechanisms for ensuring that the risks transferred to the private partner are effectively assumed and managed by that partner. By requiring the private consortium to finance most of the development costs through to completion of the construction phase, the public sector owner ensures that the consortium has a compelling incentive to deliver on its contractual commitments and do so on a timely basis. This is because any delays in meeting the project commitments lead to higher debt-servicing costs, as the consortium must carry its debt load for a longer period. This incentive ensures that the private debt providers, which are usually banks or bond holders, exercise active project oversight over and above that provided by the equity holders. In contrast, under conventional construction contracts, private firms require only limited working capital, because they tend to be paid monthly and usually according to the percentage of the contract that is completed at the time. As a result, under conventional contracts, firms do not face as strong an incentive to meet schedule commitments on a timely basis, because they have more limited financial exposure in the event of any contractual delays.

The benefits of this procurement model are expressed through a combination of:

♦  cost savings or quality enhancements in the design or construction of a new facility, and in the operation and maintenance of the facility (i.e., in the service provision phase); and

♦  time savings in the delivery of a public infrastructure facility fit and available for use.

It is also important to recognize that these benefits come at the expense of additional costs relative to conventional procurements. Specifically, P3s entail the following additional costs:

♦  The costs of transferring selected risks to the private partner. A P3 contract usually entails additional risks to the private partner compared with the risks that the partner would usually accept for the same infrastructure project under a conventional contract (e.g., risks of escalating construction costs and other such risks that are retained by the public sector under conventional contracts-see box "Risk Allocation Between Public and Private Partners"). The cost to the public sector of transferring these risks to the private partner is known as the "risk premium." If the private partner has better control over the transferred risks than the public sector, which is often the case for design and construction costs, it can either avoid certain risks or mitigate their impact. As a result, the risk premium will be lower than the public sector's risk exposure under a conventional approach, where it retains responsibility for the risks.3

♦  The higher costs of private financing used in P3s (primarily debt and usually a small tranche of equity) relative to the public financing (i.e., government bonds) of conventional procurements.4

♦  The higher transaction costs incurred in developing, monitoring, and managing P3 contractual agreements compared with those incurred in developing, monitoring, and managing a succession of contracts over the same period using a conventional approach to infrastructure procurement. These higher costs are the incremental transaction costs borne by the public sector, such as the additional due diligence and advisory costs incurred during the procurement process. However, it can be a tricky process to identify the incremental transaction costs, because many of the planning and management costs that occur at later stages under a conventional procurement approach are necessarily incurred upfront in a long-term P3 agreement. Thus, to accurately identify any incremental transaction costs in P3 approaches relative to conventional procurement approaches, we have to compare transaction costs incurred during the full P3 contract period with those incurred during an equivalent period characterized by a succession of conventional contracts. It should also be noted that the transaction costs of private sector bidders tend to be higher than they would be under a conventional approach and that one would expect these costs to be passed on to the public sector through the cost of the winning bid.

If the three categories of costs described above are offset by the value associated with transferring selected risks to the private partner, the overall costs of the project will be lower under a P3 approach than under traditional project delivery.

The benefits of a P3 procurement do not always outweigh the costs, which is why it is standard practice for public sector procurement bodies to undertake early screening of projects to determine the suitability of a project for a P3 procurement process. If the project is deemed suitable, a VfM assessment is done to compare the total costs of procurement (for construction, operation, and maintenance) under the P3 approach with those under a conventional approach.5 In principle, a P3 procurement should be used only if there is a positive VfM result, that is, a net benefit is expected from proceeding with a P3 procurement.

In the remainder of this chapter, we examine each of the benefits and costs discussed above: the cost and time savings resulting from P3 procurements and the additional or incremental costs of adopting a P3 procurement approach. (The four explanatory factors responsible for driving efficiency gains under P3 procurements are discussed in Chapter 3.) We also discuss additional factors that have been raised as potential benefits and costs of P3 procurements, such as debt reduction benefits and the potential costs resulting from reduced flexibility during the term of a P3 contract. These costs could be triggered by any change in infrastructure or service requirements due to changes in public requirements, changes in policy, or changes in technology. For each benefit or cost discussed below, we conduct a review of the relevant literature and summarize the available evidence, focusing on evidence from the second wave of P3s initiated by P3 procurement agencies since 2004.

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1  The terms "benefits," "efficiency gains," and "savings" are used interchangeably in this report.

2  The terms "infrastructure" and "facility" are used interchangeably throughout this report.

3  Note that this discussion of risk is from an ex ante perspective, which refers to the estimated value or cost of exposure to a certain risk in advance of the project. During the project execution, some of the contingencies that drive the risks (e.g., design errors, construction cost escalation) may turn out to be either better or worse than expected. If the risk in question is held by the private partner, a contingency that doesn't arise or turns out better than expected will benefit the private partner's bottom line (since the risk is already priced into the bid); however, a risk that turns out worse than expected has a negative impact on the private partner's bottom line.

4  Some P3 practitioners consider the risk premium to be part of the private financing cost, perhaps because private financing is seen as the only way of effectively transferring risks to the private partner. However, we maintain the distinction between the risk premium and the incremental cost of private financing in this report, because the risk premium can take the form of a higher design-build price or higher operating costs. Infrastructure Ontario maintains a similar distinction in Assessing Value for Money, pp. 6-9.

5  Some VfM studies, such as those undertaken for Partnerships BC, also take into account qualitative factors, such as the ability of the procurement approach to support the achievement of the project objectives.