The PPP procurement framework strikes a balance between penalties for under-performance and incentives to exceed minimum performance criteria. Identifying, correctly structuring and harnessing the incentive for managers to perform consistently to best practice standards is central to the performance of alternative project procurement methods. Public choice theory provides a framework for understanding incentives in the public sector and attempts to explain the drivers of public policy formation, implementation and management. The theory acknowledges public failure which arises when the state creates inefficiencies in the process of market interventions or when it could have solved a problem or furnished public goods more efficiently thereby achieving outcomes that are less than optimal (Wolf 1993; Winston 2006, pp. 2-3).17
In the private sector, incentive is generally linked to financial return although agency and privatisation theory and the Coarse theorem explanation of the powerful role of property rights suggest that what motivates the private sector in long-term contracts is not always readily identifiable. The procurement methods that create the strongest incentive for ex ante private investment and ex post operation are those where the private operator's remuneration is linked to key performance indicators that extend over the project lifecycle. These methods include asset-based procurement such as build own operate transfer (BOOT) arrangements, long-term outsourcing contracts and output specification-based PPPs (Hodge 2000; Megginson 2005). The objective of infrastructure projects is to deliver sustainable services over long periods of time in industries whose economics are frequently determined by short-term impacts such as volatile energy prices, changes to networks and the introduction of legislation imposing limits on greenhouse gas emissions. If we consider the relatively minor role that project delivery costs play in lifecycle service delivery outlays, the design of incentive-based remuneration structures that reward performance over contracts of up to 39 years duration assumes an important role.
Public goods delivered by traditional procurement and services managed by government agencies or business units operate within a poor incentive framework. These units achieve rates of return equal to or less than the bond rate (Productivity Commission 2007). There are several reasons for this - the institutions responsible for construction and management may be different, there are few rewards if management delivers ahead of time or earlier than planned, investment decisions may include social as well as economic objectives. At enterprise level, government agencies and business units are also expected to meet community service obligations, output pricing is not always set by reference to production costs and there can be political interference in board and senior management appointments. This is reflected in the state's poor track record of project delivery and asset management using traditional practices (NAO 2001).
PPPs based on availability payments generally contain a base charge calculated by reference to the goods or services supplied and a smaller incentive payment that is activated by performance against qualitative criteria or consistent achievement of key performance indicators. An abatement formula also applies to reduce payments in periods when the agreed quantity of goods or services is not supplied or performance falls below the required standard. PPPs involving full transfer of patronage risk also give the private operator a strong incentive to achieve forecast operating revenues and meet minimum debt servicing criteria.
Incomplete contracts with embedded real options also enter the incentive argument. Many PPPs contain maximum return on equity thresholds that cap investor returns, and revaluation gains attract profit-sharing arrangements with the state. These requirements limit windfall profits for the private sector without exposing the state to operating losses. The broad effect of these limitations on “blue sky” returns is to preserve incentives for investors to maintain efficient lifecycle operation whilst avoiding the possibility that it is cheaper for them to walk away from a project than continue with a contract that offers insufficient return or worst case, involves future losses. This occurred with the original arrangements for the franchised management of Melbourne's public transport assets.
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17 Competition and privatisation theory offer similar conceptual approaches in the context of delivery of public goods. In the absence of market failure, private firms operating in competitive markets are the most efficient means of production (Boardman & Vining 1989; Megginson 2005, pp. 44-45).