Optimal Public–Private Partnerships, a Reality or Mirage?

“By domination only one side gets what it wants; by compromise neither side gets what it wants; by integration we find a way by which both sides may get what they wish.”

I had no doubt regarding that quote by Mary Parker Follett, the famous American management philosopher, when I first found it. Nonetheless, if you had the opportunity to wear hats from the three sectors (i.e., public, private, and nonprofit) in your professional life, then you would realize it is easier said than done, especially in a developing market such as the Saudi one. That was the case until I heard about a term that accompanied the amazing Vision2030 strategy. This term rescued my faith in the aforementioned quote. My beloved reader, allow me today to discuss with you the art and science of public–private partnerships (PPPs).

Beforehand, I would like to bring to your attention that whatever I include within the following lines was stolen—academically—by me from a free publication that was created jointly by the World Bank Group, Islamic Development Bank, and others in 2016 (please find the citation and download link at the bottom of the article). The CP3P certification training and exam are based on this publication. Thus, I poorly narrate, from the publication’s perspective, the definitions and recommendations below. By the way, the ridiculously long article you about to read will cover the general use of PPPs in public procurements. If you were interested in using them in building national innovation ecosystems, such as myself, then read also the handpicked publication I have added in the References section by OECD. That being said, let’s dive in!

I- What makes PPPs different from conventional procurement and privatization?

At first glance, I thought that the term public–private partnership included all projects that had at least two participating entities belonging to the two worlds: the public sector and the private sector. However, I discovered that I was completely wrong.

In the past, many governments had their own means for delivering public works, including their own equipment and personnel. Today, separate corporations that are contracted, in most cases, under a public tender construct practically all public works. Some public corporations are exceptions, but even in those cases, private corporations conduct most of the works under subcontracting schemes. The government traditionally finances public works and public infrastructure. The public budget is the fund source for such conventional procurement.

When infrastructure is procured by conventional means, the procuring authority pays for the works against its budget and assumes the entire responsibility of the asset once construction is completed. Payments are usually made as work progresses and at the stipulated price (or subject to revisions). The contractor may be responsible for fixing defects at its own cost during the short-run, whereas the ordinary maintenance tasks are usually contracted to another private party through a separate contract. In all cases, long-term management or life-cycle management (and related risks) remain the government’s direct responsibility.

Therefore, this short-term methodology lacks natural incentives for the contractor to care about the asset’s quality and resilience. On the contrary, the contractor has a clear motivation to increase profits by reducing costs (and hence compromising quality) or claiming extra payments (for example, for government variations to the contract’s scope). The risk of reduced quality or increased costs for the public sector may only be controlled with intensive quality assurance oversight and/or being highly prescriptive in defining the technical requirements.

On the other hand, privatization is a commercial agreement involving the permanent transfer to the private sector of a previously publicly owned asset, as well as the responsibility of delivering a service to the end user.

By definition, privatization in its true sense is not an option for governments to procure new infrastructure, as privatization implies the infrastructure has already been constructed, and the government will lose legal ownership and almost all control of the privatized asset.

Between retaining strong control and responsibility over an asset or a service through conventional procurement and surrendering the control and responsibility via privatization, we have Public-Private Partnerships. The PPP methodology is a broad concept to be applied to new or existing infrastructure and services A PPP may be defined as:

A long-term contract between a public party and a private party2 , for the development and/or management of a public asset or service, in which the private agent bears significant risk and management responsibility through the life of the contract, remuneration is significantly linked to performance, and/or the demand or use of the asset or service and the asset or service is handed-back to the public party by the end of the contract.

This definition is also intended to capture the two main types of PPPs: PPPs whose revenues are based on user payments (user-pays PPPs, also known in many countries as “concessions”). In user-pays PPPs, the source of revenue is primarily or totally in the form of the right to commercialize the use of the asset or service. Funds coming from users may be sufficient to cover operation and maintenance expenses, and long-term renewals with a surplus can then be used as a source to repay the financing of the asset’s construction.

The other main PPPs are those for which revenues are based on public or budgetary payments (government-pays PPPs, also known in many countries as public finance initiatives or PFIs).

II- What is good about PPPs?

To extract the most from the benefits of PPP methodology, allow me to focus on a special track of PPPs that I call “Optimal PPP.” Although PPPs are useful in procuring infrastructure and services, the optimal PPP should be a tool to deliver new or upgraded infrastructure. In this way, the greatest possible value from this procurement option can be extracted in order to help countries fill the infrastructure gap by accessing more private capital and expertise in an efficient and programmatic manner. This infrastructure may be a complete system, or it may include the relevant parts of a complete system that function as a single unit.

By building on the broad definition of PPP mentioned previously, the optimal PPP could be defined as:

A long term contract between a public party and a private party for the development (or significant upgrade or renovation) and management of a public asset (including potentially the management of a related public service), in which the private party bears significant risk and management responsibility throughout the life of the contract, provides a significant portion of the finance at its own risk, remuneration is significantly linked to performance and/or the demand or use of the asset or service so as to align the interests of both parties and the asset is handed-back to the public party by the end of the contract.

Don’t worry. I won’t let you drown between the lines of this complicated definition. let’s analyze it to understand its hidden advantages:

A-“A long-term contract between a public party and a private party”

The long-term nature or condition of a PPP relates naturally to one of the essential features of any PPP, which is the effective risk and responsibility transfer to the private party over a significant portion of the infrastructure asset’s life. Thus, the period of the optimal PPP contract is usually five years or longer. Moreover, in the optimal PPP, the public party should seek groups of private parties that will form a consortium to bid for the PPP contract. If one consortium is awarded the contract, it should create a new company. This new company is referred to as the project company or as a special purpose vehicle (SPV) after being awarded the contract, but before signing it. The consortium members will subscribe to pre-agreed share percentages in the company (as committed at bid submission). The SPV signs the contract with the procuring authority.

Creating an SPV brings several benefits for the parties. One is that an SPV is usually a lender requirement before providing finance through project finance techniques, as this allows for better control of the credit risks. Project finance techniques allow equity investors to limit their exposure to risk, and they provide high leverage without the need for investors (generally) to provide corporate guarantees. Furthermore, the finance is commonly regarded as “off balance sheet” from the equity investors’ holding perspective. On the other side, the public party benefits from the existence of an SPV because the public party’s partner is dedicated only to the specific PPP contract.

A government-owned company or state-owned enterprise (SOE), including a potential government-owned SPV, may be regarded as a “private entity” subject to civil (rather than administrative) regulations. However, a contract between a procuring authority and such a government-owned “private” entity, when the government that procures the project owns the SOE, would not be considered an optimal PPP because there are reasonable doubts of risk transfer to the private sector.

B-“For the development (or significant upgrade or renovation) and management of a public asset (including potentially the management of a related public service)”

One of the essential features of an optimal PPP is the search for efficiency through the contractor’s involvement. This applies to not only the design and construction of the asset but also its long-term maintenance, so that construction and maintenance are bundled obligations. In some projects, management also includes operations (either of the infrastructure or a related service).

C-“In the contract, the private party bears significant management responsibility and risks through the life of the contract”

The private party should be materially and integrally in charge of the asset’s management (especially life-cycle cost management), rather than only being dedicated to specific and/or minor areas of management. Otherwise, there is no point in transferring life-cycle risks and in relying on a long-term contract under a PPP scheme because risk transfer is the main driver for PPP efficiency.

D-“and provides a significant portion of the finance”

Private participation in a project’s financing is not a necessary condition for a project to be regarded as a PPP. However, an optimal PPP is a privately financed one.

Private finance (usually under a “project finance” structure) may also be an essential factor for efficiency. When the private partner finances all or a significant part of the infrastructure and its remuneration is based on the infrastructure’s performance (availability and/or use), then financing is at risk. This is a powerful mechanism to align the objectives of the public and private partners. It incentivizes the private partner to be proactive in maximizing the public party’s objective, which is to ensure that the infrastructure is available and adequately operated and/or maintained. The private finance also incentivizes the private partner to manage whole-of-life costs (over the asset’s life cycle). This means that, after meeting operating costs, the private partner has sufficient revenue to service its debt and to provide a return to its investors.

E-“remuneration is significantly linked to performance and/or the demand for or use of the asset or service, so as to align the interests of both parties”

This notion is linked to the private finance feature and risk transfer characteristics of the PPP. The most effective way of transferring responsibility and significant risks over the life of the contract is to compensate the contractor (the private partner in a PPP) based on the asset’s performance (in the sense of quality of service), the level of use, or a combination thereof. Typically, the asset’s performance will depend on the degree to which the agreed service levels or the level or volume of use (when the main objective is to extract the financial value of the asset as a revenue maker) are met. The latter case is generally the case in user-pays PPPs, and the former is generally the case in government-pay PPPs.

The link to performance and/or use also results in another particular feature of the optimal PPPs: the contractor will only receive payments (or most of the payments) once the infrastructure asset is completed, that is, the procuring authority will pay only (or significantly) once the asset is in service.

The link of remuneration to performance is paramount for aligning the private partner’s interest (mostly focused on obtaining benefits) with the public sector’s objectives (mostly focused on service reliability and quality). However, interests should be aligned without being prescriptive in the applied means and methods (inputs) and leaving a reasonable scope for innovation.

F- “and the asset is handed-back to the public party by the end of the contract.”

The public party will stay the legal owner of the asset at the end. It will reserve the right to terminate the contract, change the contract if needed, or perhaps sell the asset or change its purpose after the contract ends. Therefore, one of the famous names for PPPs is a build, operate, and transfer project (BOT).

III- What is bad about PPPs?

Although the optimal PPP methodology would provide the aforementioned efficiency, effectiveness, and innovation-related benefits, as well as maximize transparency and minimize the pressure on public budget and debt, PPP is a procurement option that has weak spots and potential disadvantages. Therefore, it should be adopted with a grain of salt.

?First, PPPs are significantly more complex than traditional procurement methods are. Consequently, there is a significant risk in sinking resources into unworthy or unsuitable PPP projects that consume more resources than conventional and less-complex procurement routes. PPP projects demand more highly specialized resources and government attention. The time needed for PPP project preparation is longer than it is for public works projects, and governments wanting quick results may be discouraged from following the PPP route.

Second, the PPP route has more visibility and political exposure. After political change, new government administrations can perceive that they are only paying for infrastructure projects that generated political benefits to others (their predecessors) in the past. Worse, it is also currently reducing their budgets to develop new projects. Furthermore, public controversy may emerge due to the public belief that PPP implies either a rise in charges or the application of new user charges. Both the public and the unions may react and oppose PPPs, especially when they imply substitution for the direct provision of a public service.

Third, PPP procurement has significantly higher transaction costs for the public sector and the private sector/contractor community. These higher costs are inherent in the higher complexity of the procurement, particularly during the tender process, and in preparation/appraisal and monitoring of resources. Moreover, PPPs produce a higher cost in terms of surveillance for governments, introducing higher performance monitoring to make sure that the efficiency and quality gains are actually delivered. However, this higher cost is part of the price of a more reliable quality of service. In traditionally delivered projects, the costs of ongoing quality monitoring are often less visible because they are seen as “business as usual” for the procuring authority and, therefore, not project costs. In addition, the private-financed-PPP route appears to be more expensive in terms of financing because the cost of private financing includes a risk premium in the form of a margin in interest rates and the equity internal rate of return (IRR) requested by the private equity capital, which by definition is a more expensive financial instrument than the alternative of direct government financing.

Fourth, countries with less-sophisticated accounting and fiscal monitoring regimes face a risk that PPPs will result in excessive budget commitments that threaten long-term fiscal sustainability. When a PPP is not recognized as contributing to public debt, there is a risk of ignoring/dismissing the long-term fiscal implications. Long-term budget sustainability may be endangered as a result. This may be offset with a robust appraisal (which is more demanding than in a normal procurement) and an appropriate policy framework in terms of controlling aggregated PPP commitments as a long-term contractual relationship.

Finally, PPPs could result in minimizing the competition (post award). After signing the contract, renegotiations are frequent. When this happens, as a monopolistic supplier, the private operator has an advantage in negotiating with the government, compared to a supplier in a competitive market.

IV- A reality or mirage?

Maybe I am exaggerating a bit regarding the greatness of the PPP solution, but the majority of the reports produced by (or for) governments and audit institutions have concluded that PPPs generate significant value for money (VFM).

For instance, United Kingdom studies have indicated that government departments that implemented PPPs registered cost savings between 10 and 20 percent. According to the 2002 census of the United Kingdom National Audit Office (NAO), only 22 percent of PFI deals experienced cost overruns, and 24 percent experienced delays, compared to 73 percent and 70 percent of projects undertaken by the public sector and reviewed in a NAO survey in 1999.

In 2006, the HM Treasury reported that, according to a study for the Scottish Executive by the Cambridge Economic Policy Associates (CEPA), 50 percent of authorities administering PPPs reported that they received good VFM, with 28 percent reporting satisfactory VFM.

In 2008, Australia’s National PPP Forum (representing Australia’s national, state, and territory governments) commissioned the University of Melbourne to compare 25 Australian PPP projects with 42 traditionally procured projects. The study found that traditionally procured projects had a median cost overrun of 10.1 percent, whereas PPP projects had a median cost overrun of 0.7 percent. Traditionally procured projects had a median time overrun of 10.9 percent, whereas PPP projects had a median time overrun of 5.6 percent.

So my beloved reader. Do you think that optimal PPP methodology would accelerate the execution of the passionate vision of the Kingdom of Saudi Arabia if applied extensively?

V-References

ADB, EBRD, IDB, IsDB, and WBG. 2016. The APMG Public-Private Partnership (PPP) Certification Guide. Washington, DC: World Bank Group. Link: https://ppp-certification.com/pppguide/download

OECD. 2016. "Strategic public/private partnerships", in?OECD Science, Technology and Innovation Outlook 2016. Paris. OECD Publishing.

Link:?https://doi.org/10.1787/sti_in_outlook-2016-10-en .