Under a public-private partnership (hereafter abbreviated as PPP), a local authority or a central-government agency enters a long-term contractual arrangement with a private supplier for the delivery of some services. The supplier takes responsibility for building infrastructure, financing the investment and then managing and maintaining this facility.
PPPs are being used across Europe, Canada, the US and a number of developing countries as part of a general trend seeing an increasing involvement of the private sector in the provision of public services, under the form of privatization, deregulation, outsourcing and downsizing of government.1 In 2004-5, 206 PPP contracts were signed worldwide involving 52 US $ billion in investments (PWC, 2005). PPPs have traditionally been employed for example for transport, energy and water but their use has recently been extended to IT services, accommodation, leisure facilities, prisons, military training, waste management, schools and hospitals.
In Europe the PPP approach was pioneered by the Private Finance Initiative (PFI), which was launched in 1992 in the UK.2 As of December 2006, 794 PFI projects had been signed for a capital value of £ 55 billion (CBI, 2007). PPPs have also been in operation for more than 10 years in Portugal where investment through PPPs equalled about 20 percent of total public investment during 1999-2003.3 Other European countries have also invested in PPPs, especially Ireland, Greece, the Netherlands and Spain (EIB, 2004).
In the US, PPPs are most common for projects involving highway and road transportation, rail, and water supply and waste water treatment (CBO, 2007). The cumulative project costs of PPPs funded or completed by October 2006 totaled about $48 billion out of nominal capital spending on infrastructure by the federal government and states and localities of $1.6 trillion between 1985 and 2004 (averaging $80 billion annually).4 Whilst PPPs have not accounted for a significant share of public infrastructure spending in the US so far, they are being actively encouraged by Federal Departments (DOT 2007). PPPs are also being encouraged in Canada: In November 2007 the Canadian Federal government announced a plan to promote use of PPPs and created a national fund for PPP investments of 1.26 CD.
In developing countries, PPP agreements have grown steadily since the 1990s. According to the World Bank's Private Participation in Infrastructure (PPI) database, 2750 infrastructure projects involving private and public investment for capital value of USD 786 billion have been implemented in 1990-2003 (in 2002 constant dollars). Around 1000 projects and 47% of the investment took place in Latin American and the Caribbean (LAC) countries, where Chile and Mexico were pioneers in the use of PPPs (IMF, 2004). In Central and European Countries many PPP projects were conceived in the second half of the 1990s. The PPI lists 217 projects in the region by 2003, with 64 projects for building and operating new facilities amounting to an investment of EUR 22.6b.
Despite this growth, evidence on PPP performance remains mixed. On the one hand, PFI projects in the UK seem to be delivering cost saving compared to traditional procurement.5 Improvements in completion time and cost of delivery have also been achieved; the HM Treasury (2003) reports that 76% of PPP projects have been completed on time, compared to 30% of traditionally procured projects.
On the other hand, PPPs have resulted in higher water prices than traditional procurement in France.6 PPPs seem also unsuitable for fast-moving sectors; performance failures have been widespread in PPPs for specialized IT in the UK. Existing evidence also suggests that contract renegotiations has played a pervasive role in PPP arrangements worldwide. In LAC countries numerous instances have been recorded where governments have failed to honor contract terms and projects have been abandoned.7 Adverse institutional conditions have also mattered. High transaction costs and unrealistic demand expectations have made PPPs in Central and Eastern Europe less successful than in other countries.8
These pieces of evidence not only question the values of PPPs arrangements but also call for providing some theoretical framework to understand incentive issues in PPPs. This paper provides such unified framework and, equipped with such theoretical perspective and insights, identifies circumstances in which the main characteristics of PPP arrangements are suitable to provide adequate incentives for private contractors in infrastructure and public service provision. We also extensively describe the empirical evidence on PPPs and use our insights to derive clear policy implications.
For our purpose we characterize PPPs by three main features: (i) tasks bundling, (ii) risk transfer, (iii) long-term contract.
(i) Bundling. A PPP typically involves the bundling of the design, building, finance, and operation of the project, which are contracted out to a consortium of private firms. The consortium includes a construction company and a facility-management company and is responsible for all aspects of services. The DBFO model ('Design', 'Build' 'Finance' and 'Operate'), the BOT model ('Build', 'Operate' and 'Transfer') or the BOO ('Build', 'Own' and 'Operate') all account for bundling of building and operation albeit with differences in degrees.
(ii) Risk transfer. Compared to traditional procurement, a PPP contract involves a greater transfer of risk and responsibility to the contractor. A system of output specifications is used: The government specifies the service it wants and the basic standards, but it leaves the consortium with control rights and responsibility over how to deliver the service and meet the pre-specified standards. So design, construction and operational risk are generally substantially transferred to the private-sector party.
(iii) Long-term contracting. A PPP contract is a long-term contract lasting typically 20 to 35 years. The payments to the private-sector party for the use of the facility is made either by the government (as in the case of PFI projects) or by the general public as users of the facility (as in more standard concession contracts).
To capture those features, we present a simple model of procurement including both moral hazard aspects and features of the property rights literature. Moral hazard is key to investigate two issues that are pervasive in the economics of PPPs. The first one is related to the existing agency costs borne by governments when delegating to the private sector the task of providing a service for society. The second one concerns risk-sharing between this government and the delegatee. A key point of the analysis is to discuss the nature of these agency costs in a multitask environment where the agent not only manages existing assets necessary to provide the service but also may design, build and finance these assets.9 Consistently with real-world practices, our model features altogether aspects of the optimal contracting literature (the verifiability of the operating costs and the need to share operating risk between the public sector and the private firm) but also dimensions of the property rights literature. We present this basic model in Section 2.
In Section 3, we use the basic model to study the conditions under which bundling of project phases (in particular building and operation) into a single contract is optimal. An important distinction that we draw is between positive and negative externalities across different stages of production. We use the term 'positive externality' (resp. 'negative externality') when a building innovation is associated with reduced (resp. increased) cost at the management stage. Bundling induces the contractors to look at the long-term performances of the asset (the so called 'whole life asset management') and this affects incentives to invest in asset quality. We shall however show that bundling improves the contractor's incentives when the externality across stages is positive but it has a negative or no effect when the externality is negative. Provided there is an incentive problem, our results hold regardless of the contractual framework used and of the quality of the information held by the government.
An interesting feature of optimal contracting which we emphasize is that bundling goes hands in hands with higher power incentives: When bundling is optimal, more risk is also transferred to the contractor. This provides the rationale for both bundling and risk transfer to be key features of PPP arrangements. It also explains the greater risk premium that is typically observed in PPP contracts compared to traditional procurement. Furthermore, we show that private ownership during the contract dominates public ownership and the gain from bundling with private ownership is greater for generic facilities, such as leisure centres, accommodations and public housing, than for specific facilities, such as prisons, hospitals and schools which have limited use outside the public sector.
Once equipped with the rationale for bundling and risk transfer in PPP agreements, we develop our basic insights in more elaborated environments which have been viewed as particularly interesting both in the public debate and within recent academic research.
Section 4 deals with the issue of risk transfer in more depth by analyzing how demand risk should be optimally shared between the private and public partners. We then analyze some of the factors that affect the optimal allocation of demand risk and derive their implications for users charges and the choice of contract length. We also discuss the case of financially-free standing projects where users' fees represent all of the contractor's revenue. This allows us to discuss another important characteristic of many PPP arrangements, namely the use of private finance and its impact on contract length and incentives.
Section 5 makes a powerful extension of our basic model that provides the basic relationship that operator and financiers may entertain under a PPP agreement. This issue is of tantamount importance given the estimated size of investments in infrastructures that is forecasted for the next twenty years, and the role that infrastructure funds will thus play.10 We show that outside finance may improve risk-allocation if it helps alleviating moral hazard and that transaction costs of outside finance are relatively weak.
Long-term contracts also suffer from uncertainty over the future evolutions of users' needs. This might make them unsuitable in circumstances where users needs evolve rapidly and the output specifications set up in the initial contract become quickly obsolete. We discuss this cost of PPP contracts in Section 6. We argue that, for fast-moving sectors, the benefit of bundling needs to be weighted against the cost of contract rigidity. This cost may be severe enough to make PPPs unsuitable when users needs evolve rapidly.
Section 7 analyzes how long-term agreements are subject to contractual hazards especially in view of incentivizing investment over the length of the contract. We start by considering the case of a public authority having a strong commitment power; the risk of unilateral changes of contract terms by governments is then minimal. The optimal long-term contract entails increasing incentives over time to foster the renewal of investment. Cost-plus contracts arise in early periods whereas fixed-price agreements are expected close to the end of the contract duration.
Long-term contracts however suffer from being signed in contexts where uncertainty over the realizations of future demand and cost levels is pervasive. When estimates turn out to have been optimistic, renegotiation of contract terms may occur, partially nullifying the incentive power of the initial contract. We then extend our analysis of the dynamics of PPPs by considering the distortions that are needed to prevent cost-overruns. Incentives should be tilted towards being low-powered and less risk should be transferred at earlier stages of contracting. However, this non-stationarity of incentives does not necessarily undo the benefits of bundling.
Section 8 analyzes how the institutional environment, and most specifically the risk of regulatory opportunism, affects contract design and incentives. We consider thus settings where the risk of unilateral changes of contract terms by governments is significant. This typically might depict developing countries with weak governances but, beyond, the kind of political uncertainty that we have in mind certainly has a broader appeal even for developed countries subject to the political risk that electoral uncertainty generates. Relaxing the assumption of full commitment, we discuss the importance of institutional quality. We show that, in such environments, cost-plus contracts should be preferred. This of course reduces the benefits of bundling without again coming to the conclusion that bundling should be given up.
Section 9 summarizes our conclusions and discusses the scope for future research.11
Proofs not provided in the text are relegated to an Appendix.
_____________________________________________________________________________________________________
1 See e.g. Armstrong and Sappington (2006).
2 Grout (1997).
3 Välilä, Kozluk and Mehrotra (2005).
4 In the US, a number of PPPs were also developed in the 70's for inner-city infrastructure (see Rosenau, 2000).
5 Arthur Andersen and LSE (2000).
6 Saussier (2006).
7 Guash (2004).
8 Brench, Beckers, Torsten and von Hirschhausen (2005).
9 In our view, this multitask aspect of the modeling is what makes the analysis of PPPs arrangements quite specific compared with the whole literature on privatization. This literature analyzes the agency cost of delegation to the private sector in a framework where a single task has to be performed by the delegatee. See the seminal papers by Sappington and Stiglitz (1987) and Shapiro and Willig (1990) for instance, and for some overviews of that approach Shleifer (1998) and Martimort (2006).
10 Levita (2008) reports that those needs are up 2500 millions U.S. dollars overall among which one fifth will be invest in "greenfields" projects.
11 One omitted domain of investigation for this paper is the macro-economic/public finance side of PPPs. On this issue we refer to Välilä (2005), Välilä, Kozluck and Mehrotra (2005) and Sadka (2005).