Any PPP-for that matter, any business arrangement-comes with risks. In order to realize a partnership, partners put up resources-time, money, political capital-and those resources run the risk of being sub-optimized. In some cases, partners may incur additional obligations that put them at risk even beyond the resources they commit at a project's start. This risk must be managed.
Determining, from the outset, to what degree you and your partners are willing to accept risk-and what kinds of risk are most palatable-can ensure a productive allocation of those risks between partners.
Generally speaking, PPPs are attractive to governments because they offer the potential of quality infrastructure "on the cheap." Faced with rising costs, a government looking to do "more with less" will be inclined to push risk-financial or operational-onto the private sector, removing costly liabilities from their balance sheets in exchange for allowing the private sector to share in the opportunity that large-scale projects offer.
Naturally, the private sector is quick to try to push as much of that risk as is rational back onto the public sector, while maintaining its share of opportunities. The allocation of risks and opportunities is a process of negotiation and renegotiation, and ultimately, successful partnerships are those in which risks and opportunities are allocated effectively and sustainably.
It is important to note that effective allocation of risks and opportunities does not necessarily mean that risks and opportunities are equally allocated among partners. One partner may take on more risk than another. Generally speaking, however, each partner's share of risk will be proportional to the share of opportunity it stands to realize. But of course, accurately quantifying risk and opportunity is easier said than done.
Let's return to the Lesotho National Referral Hospital to examine how an agreement can explicitly use the allocation of risk and opportunity to create a stronger partnership.
CASE STUDY Lesotho National Referral Hospital Recall that the Lesotho PPP project used performance metrics to determine the revenues that would be allotted to the private-sector partner. The Lesotho PPP project provides a perfect example of efficiently distributing risks and rewards among the partners. Because its profits are contingent on meeting performance metrics, the private sector assumes a degree of risk-the risk that the operator will not meet the standards and the venture will become unprofitable. But the Lesotho PPP was structured to provide a proportional degree of risk on the government's side, ensuring value alignment in day-to-day operations. The agreement stipulated that the government would pay a small sum-50 maloti (about USD $3.30)-for every patient exceeding the 310,000 patient cap set in the agreement, disincentivizing the government from offloading an undue burden of care onto the operator. With the patient cap and associated fee structure, the government of Lesotho depended on the country's existing healthcare infrastructure. If the existing network of clinics and hospitals proved insufficient or failed to improve in tandem with the new hospital, patients would flock to the new hospital, resulting in millions extra paid to the private sector-money that would have to come from other health services or ministries. |
In this case, partners in Lesotho achieved an efficient allocation of risk and opportunity, because while both partners stood to see some benefit from the PPP, both partners also had "skin in the game."28
Let's compare the sophisticated allocation of risk and opportunity on display in the Lesotho case with the case of the Indiana Toll Road, in which risk and opportunity were allocated much less effectively.
CASE STUDY Indiana Toll Road Recall that, in the case of the Indiana Toll Road, lower-than-expected traffic volumes-and lower-than-expected toll revenues-forced the private operator, Indiana Toll Road Concession Company, into bankruptcy. While the Indiana Toll Road case illustrates the dire financial consequences of flawed assumptions, it also demonstrates the consequences of improperly allocating risk. The financial implications of this spectacular failure only affected the private-sector partners, with few consequences for Indiana taxpayers. Risk, in this case, was eagerly assumed by the private sector. The public sector on the other hand, held almost no risk. The partnership contract set limits on toll increases for drivers, limiting ITRCC's ability to raise prices, and guaranteed public availability of the road. In some ways, the bankruptcy of ITRCC was actually the best-case-scenario for the state of Indiana. Under the contract, in the event that ITRCC went bankrupt and was unable to find new investors, tolling authority would actually have returned to the state. Simply put, Governor Daniels had out-negotiated the private sector. Under the terms of the deal, the state of Indiana held almost no risk. In 2015, Australian firm IFM Investors agreed to buy ITRCC for $5.75 billion (a higher price given that the costly infrastructure upgrades had already been completed), counting on increased toll revenues in a post-recession economy to make the investment worthwhile.29 And what about the allocation of opportunity? Did the failure of ITRCC have any effect on the government's returns from the project? No. Even post-bankruptcy, the State of Indiana benefited from the "free" infrastructure improvements to the road and the $3.8 billion windfall. The road remains open to traffic. As Governor Daniels told Barron's in 2009, "It was the best deal since Manhattan was sold for beads,"30 emphasizing the importance of strong negotiation skills. The failure of the Indiana Toll Road has become somewhat of an object lesson for future PPPs in public infrastructure. Most toll road agreements in the wake of the ITRCC deal feature some form of "availability payments," payments based on the availability of the road and inversely proportional to road usage. These kinds of payments insulate private-sector operators from fluctuations in traffic flow, which can be difficult to predict, shifting some risk from the private sector back to the public sector. Incentive structures that pit partners against each other speak to fundamental flaws in incentive design. Had this PPP better allocated risk and opportunity, the partnership might have weathered even the flawed traffic assumptions. |
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28Note that this kind of sophisticated structure is not easily established. Though the PPP employed powerful high-caliber partners such as the World Bank (WB) and the International Finance Corporation (IFC), and was armed with advanced skills and tools, nearly four years into the project, the WB approved a sole source procurement with PPP Initiative Trager and Guan) to help Lesotho develop its skills further. Ensuing executive education programs focused on advanced negotiation training prior to a re-negotiation. This speaks to the complex nature of the skills required by PPPs.
29Tom Hals, "Australia's IFM Investors to Pay $5.7 Billion for Indiana Toll Road," Reuters, March 11, 2015, https://www.reuters.com/
30Andrew Bary, "The Long and Binding Road," The Wall Street journal. May 11, 2009, https://www.wsj.com/