3.4 Related Literature and Applications
Literature : Our model has merged two strands of the literature on PPPs which have both emphasized the multitask nature of the procurement problem when building and managing assets are at stake. Hart (2003) built on Hart, Shleifer and Vishny (1997) provided a model where the sole source of incentives is ownership. A builder can perform two kinds of investment (productive and improductive) which may both reduce operating costs, although only the productive investment raises also the benefit of providing the service. Under traditional procurement, the builder cannot internalize the impact of his effort neither on benefits nor on costs and, as a result, implements too little of the productive investment but the right amount of the unproductive one. Under PPP, the builder internalizes partly the impact of his productive investment whereas he also exerts too much of the unproductive one. Turning to the case where ownership concerns a public good and still using the property rights approach, Besley and Ghatak (2001) showed that ownership should lie in the hands of that player with the highest valuation for the public good, explaining thereby that non-governmental organizations may be given property rights. Finally, Francesconi and Muthoo (2006) considered the case of impure public goods and, in a model where each party may have control rights on a subset of decisions, showed that shared authority can be optimal in case the parties' investments are comparable. On similar issues, see also King and Pitchford (2001).
Bennett and Iossa (2006) studied the desirability of bundling project phases and of giving ownership to the investor. In their model innovations are non-contractible ex ante but verifiable ex post. Ownership of the asset gives control right to the owner to decide whether to implement quality enhancing or cost-reducing innovation proposed by the investor. It is shown that the hold-up problem is less severe under PPP, compared with traditional procurement, when there is a positive externality between the building and managing stages. With a negative externality the opposite can hold. Further public ownership acts as a commitment for the government to renegotiate and share with the investor the surplus from the implementation of the innovation. Private ownership is however optimal for generic facilities with high residual value.
Martimort and Pouyet (2008) built a model where both the quality of the infrastructure and operating costs are contractible. Agency costs are lower under a PPP when there is a positive externality between building and managing assets compared with traditional procurement. Granting ownership is an imperfect way of aligning incentives but, to a large extent, the important issue is not who owns the asset but instead whether tasks are bundled or not. That insight is developed in various extensions of their basic model allowing for risk-sharing as a motive for forming consortia, or political economy. In this respect, a common theme of their model and ours is that PPP comes with higher powered incentives which are prone to collusion and capture of public officials. When those institutional costs are taken into account, relying on PPP becomes less attractive.
An alternative, complete-contract, approach to PFI was taken by Bentz, Grout and Halonen (2001). They showed that the government will wish to buy services (as in PFI) rather than facilities (as in traditional procurement) if the building and service delivery costs are low.
Applications: Our results suggest that PPPs are likely to deliver efficiency gains when a whole-life cost approach to the project has the potential to yield significant cost savings and when risk is effectively transferred to the private operator. Transfer of design, construction and operating risk to the contractor provides incentives for within cost delivery of the infrastructure and in general provision of the service. A report commissioned by the Treasury Taskforce (Arthur Andersen and LSE, 2000) estimated saving on a sample of PFI projects equal to 17%, compared to traditional procurement.22 Interestingly, significant cost savings were realized in the prison sector. The National Audit Office (2003a) reported that innovative design solutions helped to reduce the level of staffing needed to ensure security and this resulted in an overall cost reduction by approximately 30%. 80% of a prison's running costs are indeed staff costs. Conclusive evidence is however still to be found. Blanc-Brude, Goldsmith and Välilä (2006) studied a sample of road projects financed by the EIB between 1990 and 2005 in all EU-15 countries plus Norway. They found that ex ante construction costs (i.e., costs before construction actually starts) are some 20% higher for PPP roads than for traditionally procured roads. The data does not reveal the actual (ex post) cost of the projects and thus whether risk transfer under PPP was effective in containing cost overruns.
Our results also suggest that, when a higher asset quality increases social benefit but it has a negative impact on whole-life cost, the scope for PPP is reduced if not eliminated. Evidence of negative externalities is more difficult to find. However, a report by the Audit Commission (see PPP Focus, Education 2, 2004) noted that the quality of many early PFI school buildings was disappointing. Schools had few windows, poor acoustic and air quality, compared to traditionally procured schools. School quality has a direct positive impact on pupil behavior and educational achievement and a higher number of windows which provide daylight is more costly to maintain because of the risk of school vandalism. Local Education Authorities now anticipate this problem and include more detailed output specifications in the contract. As a result the quality of school buildings has improved.
Our results also shed some lights on the current approach to facility ownership. Under PPP, ownership of the infrastructure during the contract period belongs to the consortium, but the ownership once the contract expires varies depending on the circumstances. Assets tend to revert to the public sector either when there is no practical alternative use for them or when the asset is needed to provide a continuing service after contract end (for example, schools, prisons and hospitals). For generic facilities with an alternative use outside the public sector and no clear long-term public sector need, ownership is retained by the private sector.
We have focused on the benefits of bundling that may come from inducing the contractor to take a long-term approach to the project. However, bundling also brings other effects, not discussed above. First, PPP projects are characterized by a longer procurement process and by higher costs of bidding than traditional procurement. Albeit with differences between sectors, it has been estimated that PPP tendering periods last an average of 34 months (NAO, 2007) and that procurement costs can reach 5-10% of the capital cost of a project (Yescombe, 2007). These transaction costs are also to a large extent independent of the size of a project, which suffices to make PPP unsuitable for low capital value projects. The HM Treasury (2006) currently considers PFI projects for less than £20m as poor value for money.
Second, bundling of different phases of the project increases project complexity and limits participation of small construction companies that do not have the necessary financial resources to sustain the costs and risks of bidding for PPP contracts. Albeit with differences across sectors, in the UK there is an average of 4 bidders per PPP contract. This is problematic as collusion among bidders is certainly more likely if the number of participants is small.
In our basic model we have talked about only two tasks: building and operation. In practice, the realization of a project comprises a wider variety of tasks. Services in the operational stage for example include 'soft' facility-management services (e.g. cleaning, catering, security) and 'hard' facility-management services (e.g. routine and/or life-cycle maintenance of buildings and equipment). The arguments set up in this section apply to hard services where asset quality matters but less so to soft services where asset quality plays a limited role. Whether to include soft services in PPP contracts should follow other considerations. On the one hand, their inclusion has the advantage of creating a single point of responsibility within the private sector in charge of final service provision. On the other hand, unbundling helps to employ short-term contracts for soft services and thus to benefit from more competitive pressure. Separate tendering for soft services also favors the participation of small firms. There are no uniform experiences across countries regarding service unbundling and the HM Treasury (2006) currently advises against their inclusion.
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22 However, Pollock and Vickers (2000) question the Andersen report and argue that once outliers are excluded from the calculations the average saving is 6 per cent.