The SDM and CGF meet two important needs in present market conditions. First, both approaches preserve the PPP procurement method and permit its continued evolutionary development. Second, they offer a form of state project participation and risk sharing in projects. Both models preserve the basic characteristics and advantages of PPPs - risk transfer, an output specification, innovation and new technology. Nevertheless, both approaches raise several potential difficulties.
The first concerns the sustainability of lower cost of capital after adjusting for higher levels of equity or mezzanine capital and the friction costs associated with loan administration.
The second concerns direct and indirect costs. The state will finance these projects by borrowing in capital markets, raising taxes or sourcing the capital from existing appropriations. The first two methods attract deadweight costs and the third carries an opportunity cost.
The third concerns the removal of the capital markets disciplines normally associated with bank or bond finance. PPPs rely on symmetrical incentive frameworks - bankers seek to minimise the probability of default and put in place comprehensive reporting, governance and monitoring systems to administer the loan. These include performance criteria that include debt to value profiles, contributions to sinking funds and reserve accounts, debt service coverage ratios and cash flow management. This process operates quite independently of the operational performance indicators agreed with the state under the franchise agreement. The state monitors performance under its contract management framework and this continues for the term of the loan. This is essentially the monitoring of operational performance although a comprehensive contract management framework will include matters at a corporate level that may affect a company's participation in a long-term contract.86
Each of the central parties to the PPP arrangement, the state, the consortium or SPV and lenders, are contractually linked in a tripartite agreement. If the SPV defaults under either the PPP or the loan agreements, the lender holds step-in rights to secure the asset and maintain service delivery. Failure to preserve this incentive framework will affect the long-term performance of PPPs. The removal of capital markets disciplines affects the incentive framework of the PPP and reduces investor flexibility.87 This may have an adverse effect on private sector appetite for PPP projects in the future and depth in competitive bid markets. Finally, the CGF and SDM require the state, as a project lender, to administer the loan, ensure adequate management practices are in place and regulate the PPP arrangement. This will add significantly to transactional friction and cost which should be explicitly recognised in the value for money evaluation.
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86 This is essentially a relationship management role that is framed around monitoring of operational performance and the state of health of the SPV and its members (Partnerships Victoria 2001d).
87 This is a greater concern in economic infrastructure projects where investors are exposed to full or partial patronage risk. In social infrastructure projects, the scope for revaluation gains is reduced if revenue takes the form of a capital charge or availability payment. Nevertheless, the existence of abatement and incentive payments in the early years' operation may lead to high investor return volatility and refinancing gains (NAO 2005b).