As noted, the combined incentives of the government in office and private firms and investors work in favor of excessive government guarantees. Over-guaranteeing provides a quick fix for a cash-strapped government in office and for private players but at the expense of vitiating project selection, distorting resource allocation, saddling future governments with large fiscal obligations, and increasing the chances that costs to the final beneficiaries are higher than they otherwise might be (and the quality of services lower than they otherwise might be).
To avoid over-guaranteeing, it helps to keep in mind that an important subset of PPPs may require minimal or even no government guarantees. There are indeed infrastructure projects that are not constructed by private firms alone not because risks are high, but because of coordination failures. In those cases, governments could award PPP projects simply by playing a catalytic role rather than by offering guarantees. By offering active coordination services and assigning the PPP on a flexible term basis (more on this below, under Sin #3), for instance, the government can shift much of the construction and demand (e.g., traffic volume in the case of a highway) risks to the private sector. There are in fact successful experiences of PPP highway concessions with no government guarantees on demand or construction.5 These projects require a good concession contract and a relatively sophisticated (deep and diverse) financial services industry.
If government guarantees must be provided, four important considerations can help. First, it is in general preferable to separate subsidies from finance. Hence, it would be better no to embed any subsidy that the PPP structure may contain (where warranted by identifiable un-internalized externalities) into the price of a government-originated guarantee or loan. Instead, governments should strive to price their loans or guarantees as fairly as possible using a price that reflects the best feasible estimate of expected loss.
Second, even where government guarantees are provided within a PPP structure at a fair price, it is in general superior for the government not to guarantee 100% of the risk (i.e., of the variance around the expected loss) or for the government-originated loans not to cover 100% of the finance. Government guarantees that cover 100% of construction or demand risks create incentives for private construction or maintenance firms to shirk or take excessive risks. If a government guarantee granted to a private creditor covers 100% of, say, the default risk, the private creditor would have no incentive to screen and monitor the project adequately. By offering only partial yet fairly priced guarantees, the government separates subsidies from finance and ensures that the private players involved in the PPP have skin-in-the-game, which is essential to align the incentives of the agent (the private firms and investors) with those of the principal (the government and, ultimately, the taxpayers).
Third, government guarantees should be transparently booked and disclosed. Guarantees increase the government's contingent liabilities, transferring risks to future generations. Absent sound accounting and disclosure standards, the contingent liabilities embedded in government guarantees not only undermine inter-temporal budget discipline but taxpayers (citizens) are deceived by the government in office into holding a heavy bag that they did not know existed. A solid accounting and disclosure framework for PPP-related contingent liabilities is, thus, essential.
And fourth, exchange rate guarantees should be limited, to the extent possible. Pressures for governments to provide exchange rate guarantees are likely to be higher where: (i) the local currency is not the preferred store of value and, as a consequence, the dollar is heavily used for financial contracts; (ii) there is not significant market for local currency-denominated long term finance; and (iii) exchange rate regimes are relatively inflexible. By yielding unduly to pressures to provide exchange rate guarantees, governments could reduce the maneuvering space for monetary and exchange rate policy. To be sure, however, the decision would depend on the counterfactual. For instance, in the extreme, if in the absence of a PPP governments would undertake the infrastructure project on their own, the counterfactual would be an explicit rise in dollar-denominated government debt, with similar implications for policy space.
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5. See Engel, Eduardo, Ronald Fisher and Alexander Galetovic (2013). "The basic public finance of public-private partnerships." Journal of the European Economic Association. February.