Can the cost of the project be lowered by the government providing some of the finance?
1. Refinancing gains: The financial arrangement of the contractor is often restructured after the end of the construction period to recognise the changed risk characteristics of the project. Either some of the equity is replaced by debt to recognise the reduced risk, or the interest rate on the debt is reduced. The latter is referred to as a refinancing gain.
Infrastructure Australia guidelines advise that refinancing gains should be shared between the government and the private party.
The refinancing gains are in effect the reward for the risk taken during the construction phase. This is sometimes forgotten, giving rise to the public perception that the contractor appears to be making excessive profits. The purpose of sharing in the gains is to reduce that perception.
The issue is similar to profit/revenue sharing: sharing in the refinancing gains reduces the benefits of a PPP because it reduces the contractor's incentive to optimise whole-of-life costs and benefits. It also adds complexity to the PPP arrangement. The need for sharing in the refinancing gains should be tested with the government in every instance.
2. It is sometimes asserted that the government's cost of borrowing is less than the private sector's. This is of course correct, but what matters is the total cost of capital, which is the sum of the cost of debt and the cost of equity.
Equity provides debt-holders with some security that the debt will be repaid, because debt is repayable before anything is paid to equity holders. The lower the gearing (ie, the debt equity ratio), the greater the security provided to debt holders and therefore the lower the cost of debt.
In the case of the government, there is no equity. However, the cost of borrowing is low because of the taxpayer guarantee. Because the guarantee is unlimited, it provides greater security than any level of equity. The "gearing" is therefore effectively extremely low. The guarantee is typically not accounted for, and is indeed difficult to value. However, it is by no means costless - the debt has to be repaid out of taxpayer funds even if the project is a failure.
Finance theory suggests that the cost of capital in relation to a project depends on the risk characteristics of the project and not on the characteristics of the entity that owns the project. A common mistake is to assume that the cost of capital required to fund a project is the average cost of capital of the entity that owns the project. So, for example, if the project is owned by an entity with a AAA credit rating then it is assumed that the cost of capital is lower than if it is owned by an entity with a CCC rating. But this is incorrect -what should be taken into account is the incremental cost of capital. So if the project itself is risky, then it will have the effect of reducing a little the average credit rating of the AAA entity, but it might not reduce the average rating of the CCC entity if the project has a similar risk profile as the rest of the entity. The marginal cost of capital is therefore likely to be the same regardless of which entity owns the project.
3. It is sometimes claimed that the government's cost of capital is lower because the risk premium demanded by private sector investors is excessive.
Whether the risk premium demanded by private sector investors is excessive is a controversial issue in the literature of corporate finance. It is not clear, however, why this implies that the government's cost of capital would be lower. If private sector investors demand a high risk premium, for whatever reason, then presumably they will also demand it when "investing" in government projects by way of the taxpayer guarantee associated with government borrowing.
We therefore conclude that there is no reason to believe that the government's cost of capital in respect of a particular project is lower than what the private sector's cost of capital would be in respect of an investment in the same project.