A major responsibility of the government (or the regulator) is not to allow any excessive profit to the private sector in a PPP deal. Ideally, the price should be set at a level that allows a fair return on the investment to recover the cost of financing and to meet the contractual obligations.
An appropriate level of base tariff can be established by considering the cost of capital. Ideally, the Internal Rate of Return (IRR) of a project should be equal to its cost of capital. If IRR is greater than the cost of capital, the concessionaire/investor makes excess profit, and if IRR is less than the cost of capital, the concessionaire/investor loses money.
The established base tariff rates can be adjusted periodically (yearly, or every two years, etc) according to an agreed formula based on a weighted adjustment index that may take into consideration items such as:
• The total amount of outstanding debt to finance the project;
• The rates of inflation in the host country and the overseas countries that provided equity and debt;
• The increase in cost of operation due to cost escalation by major components; and
• The local/(agreed) major international currencies exchange rate.
The issue of subsidy may also be taken into consideration when the pricing structure of infrastructure services is established. A PPP does not mean that there would not be any element of subsidy in pricing. Even when government subsidy is not available, pricing may be based on cross-subsidization between two groups of users of a facility or between two components of the same project, if possible. For example, cross-subsidization of domestic users by industrial and commercial users can be considered while the pricing structure of water from a water project is considered. The government may also consider providing price subsidy to a particular group in the society to achieve its broader social and political objectives.
There are five main ways to compensate a private investor of a PPP project:
• Direct charging of users
• Indirect charging of (third party) beneficiaries
• Cross-subsidization between project components
• Payment by the government (periodic fixed amount or according to use of the facility or service)
• Grants and subsidies (discussed below)
Direct charging of users by the private investor is most common for economic infrastructures, such as power, telecommunication, water, and transport, particularly for port, airport and railway projects. In case of road projects, however, compensation may be provided either through direct charging of users or payment by the government. Direct charging of road users may not always be possible because of social and political reasons. In such a situation, the government pays the operator on behalf of the road users.
Systems for collecting payment from the indirect beneficiaries of many projects can constitute a major source of compensation. Such systems include a capital gains tax in the form of certain land-related taxes and fees imposed on the property owners and developers. However, in most countries, such payment systems either do not exist or have very limited applications. Some countries have used the land readjustment tool27 for the financing of urban infrastructure projects.
PPPs can be designed based on cross-subsidization between project components, when excess revenues generated from one component can be used to compensate the shortfall in another component in order to make the whole project commercially self-sustainable28.
The government may make periodic payments of fixed amount or according to the use of the facility, product or service at a predetermined agreed price. This is a common feature of the PFI model and is commonly used for social infrastructures such as schools, hospitals and other public buildings. However, this is also practiced for many economic infrastructures. Shadow tolling of roads is an example.
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27. Land readjustment is a comprehensive technique for urban area development that provides network infrastructure and other utility facilities and amenities in an integrated manner together with serviced building plots. This approach is also known as land pooling or reconstitution of plots. It may be undertaken by a group of landowners or by a public authority. In this method, all the parcels of land in an area are readjusted in a way that each land owner gives up an amount of land in proportion to the benefits received from the infrastructure which is determined on the basis of the size and location of each site. The provision of public facilities enhances the land value and a sound urban area is created. The land contributed by the landowners is used to provide community facilities and amenities and can also be sold or leased out to meet the project costs including those for the infrastructure.
28. The rail-property development model used in Hong, China is a good example of such an arrangement. In this model, part of the profit made from real estate development on lands at or close to station areas, and along the right-of-way of rail transit routes is used to partly finance the rail system.