Advantages of PPPs

Compared with conventional procurement, the advantages of PPPs are…

Better whole-of-life project evaluation: Under conventional procurement, individual private sector companies do not evaluate the whole-of-life viability of a project because they are only invited to tender for portions of the project. The whole-of-life assessment is carried out by a public agency which doesn't normally bear the financial consequences of getting it wrong to the same extent as a consortium in a PPP would.

…better whole-of-life project evaluation,

Public sector assessments often suffer from an optimism bias. (While the same is also true for many private sector projects, it is probably difficult to establish empirically whether, or the extent to which, public sector projects suffer more from optimism bias than private sector projects)6. Under a PPP the private sector has arguably a stronger incentive than a government agency to be realistic about the prospects of a project. This is because of the considerable financial investment the consortium has put at risk. One would expect the private sector not to submit a tender if the business case does not stack up.

It seems clear that there are stronger incentives to correctly identify the whole of life costs of construction and operation, and the likely revenue stream, under a PPP, if project risk is transferred to the private sector.

Optimization of design and operation in order to minimize whole-of-life costs: Under a PPP, if the designers and builders have a financial stake in the project over its whole life, they will have an incentive to design features and construction standards so they are optimized against the long-term cost of maintenance and operational requirements. The incentives to do so are likely to be stronger than under conventional procurement.

…stronger incentives to innovate and minimize whole-of-life costs,

The extent to which better optimization will result depends on a number of factors:

• The state of knowledge about construction methods and long-term maintenance and operational requirements. Where a public agency undertakes many similar projects, such as Transit NZ, there may be less scope for innovation and optimisation than in the case of more specialised projects that are done on a one-off basis, e.g. a city council contracting for a water treatment plant.

• The extent of scope given to the PPP consortium to vary designs and innovate. The scope is greater when the public agency specifies its requirements in terms of service levels. The less it can do so, i.e. the more it specifies the contract in input terms or in terms of physical or engineering specifications, the less scope there is for the private sector to achieve whole-of-life efficiencies beyond those already obtained by the public agency in developing its contract specifications. For example, the public agency may find it difficult to define a motorway project in a dense urban setting by way of service level specifications only. Poorly defined service level specifications could leave too much room for the private sector party to minimize costs at the expense of the traveling public or adjoining properties. The public agency may therefore choose to define the project in a way that leaves little room for innovation and whole of life optimization.7

• The extent to which the public sector agency, under conventional procurement, is influenced by budgetary considerations or other objectives. For example, under conventional procurement, budget constraints may lead to cheap construction at the expense of future increased operation and maintenance costs. Or, if the Government's capital budget is less constrained than its operating budget, the agency may over-specify at the design stage in order to keep future operating costs down.

In sum, the scope for private sector innovation and whole-of-life optimization (relative to conventional procurement) is another advantage of transferring risk to the private sector. But sometimes it will be not very significant.

Access to additional capital: The government does not have to provide capital in the case of PPPs. This can be an advantage where the government has a poor credit rating and is not able to raise finance, and where financial markets cannot readily distinguish between general government borrowing and government borrowing for a specific revenue-earning infrastructure project. This is not at present an issue in New Zealand.

In any case, where the infrastructure relies for its revenue on a public agency paying a user fee (e.g. prisons), then it is likely that the PPP financier will face no better credit rating for this project than the government, and is not, therefore, likely to have better access to capital, even if the government has a poor credit rating.

… and access to additional capital without affecting the gross debt target,

Off-balance sheet financing: When people say that PPPs will give access to more capital, i.e. will bring forward projects and free up public funds for other projects, they usually mean that PPPs are a way of financing projects without breaching the government's self-imposed borrowing limit. This appears to have been the motivation for PPPs in the UK and in Australia, at least in the early days.

The New Zealand Government must maintain prudent levels of total debt.8 To manage total debt at prudent levels the Government focuses on ensuring SOEs have debt structures that achieve best commercial practice and has a self-imposed borrowing limit in the form of a gross sovereign-issued debt target.9 PPPs could provide the opportunity to raise funds beyond what would be normally possible under the gross sovereign-issued debt target.

Financing public projects without breaching the government's sovereign-issued debt limit (referred to here as off-balance sheet financing) is feasible where projects are financed from 3rd party revenue, such as toll roads.

This is more difficult in the case of infrastructure that does not earn revenue from third parties, such as prisons, and roads financed from "shadow tolls".10 In such situations the Crown typically bears the demand risk. While accounting rules are in a state of flux on this point,11 it appears that where the demand risk is not transferred, financial liabilities arising from obligations under a PPP contract would need to be recorded on the Crown's balance sheet irrespective of who raised the capital.12

… but this can also be achieved in other ways than by entering into a PPP.

Note, if the Crown finances a project that would have been viable as an unsubsidised PPP, the debt would be matched on its balance sheet by a corresponding asset, namely the value of the income stream accruing to the infrastructure (e.g. a toll road). The net worth of the Crown is not immediately affected, although the set of financial risks faced by the Crown does change. The higher gross debt does not, therefore, reflect a higher economic burden on tax payers. In any case, the higher debt gradually reduces back to zero over the life of the asset. In such cases, there may be a case for treating the debt in the same way as SOE debt structures, and there may be ways of managing public perceptions of increased debt by, for example, reporting investments in income-earning assets separately from other assets.

The example of SOEs illustrates the point that there are other ways of managing concerns about the effect on gross debt than by entering into a PPP. These should be considered alongside any proposal to enter into a PPP, if the motivation for the PPP is to finance income-earning infrastructure without putting pressure on the government's gross debt target (i.e. off-balance sheet).

Assurance of good maintenance: The whole-of-life approach and the contractual obligations around maintenance ensure that it is fully maintained throughout its life. This is not always the case under the direct management of a public agency, where maintenance needs are sometimes subordinated to other priorities.

In the case where a public agency is the user (such as a schools PPP), this 'advantage' is a double-edged sword: a contractual obligation to provide the money for maintenance comes at the cost of reduced budget flexibility, yet limited deferment of maintenance need not always harm an asset unduly.