Defining the way PPPs should be represented in public finance
By Henrieta Isufllari
Public-Private Partnerships (PPPs) were introduced in Chile in the early 1990’s as part of the plan to expedite the construction of the country’s much needed infrastructure backbone, designed by Ricardo Lagos, Minister of Public Works at the time. The reform saw local and international private firms building and running a number of public projects from highways and ports, to hospitals and other healthcare services. But as the mixed signals by the current Bachelet Government with regards to hospital concessions demonstrate, the debate over the concession of public works in Chile - or their outsourcing to the private sector - still hasn’t settled the dilemma whether this type of contracts, or their extent, is indeed beneficial to the nation’s welfare.
Governments usually undertake PPP initiatives on projects that require large initial capital and expand over several decades. These initiatives are allocated to private firms through competitive auctioning. The previous decade saw the annual value of European PPP projects between 2002 and 2006 reach Є 22.9 billion; while in the developing countries, annual PPP values in 2008 alone were as high as 154.4 billion dollars. As part of the process, governments and winning firms agree upon the terms of the concessions: length of contract, user fees, government compensation, and revenue sharing agreements among others. The prevailing clause is that all assets involved in these contracts become property of the government upon fulfillment of the contract. However, due to the lengthy contract durations, and the difficulties in calculating accurate cost-benefit analyses when unknown risk factors are present, there seems to be no unique consensus on the usefulness of PPPs.
The general agreement among policy makers is that this type of outsourcing to the private sector is especially helpful for exhausted government budgets, as it releases much needed public funds for use in other projects. But as economic theory is catching up with the practice of PPPs, results which may not be in line with conventional wisdom are also emerging. One of the findings of a recent paper by MIPP researcher and Professor of Economics, Ronald Fischer (Universidad de Chile), together with professors Eduardo Engel (Yale University and Universidad de Chile), and Alexander Galetovic (Universidad de Los Andes), is that PPPs do not release public funds even when the payback to the private firms is entirely done through user fees. Whatever the short-term gains are in not collecting taxes to directly finance the construction of a project, they are offset by the loss in revenue that a completed project would bring in.
The focus of their paper, “The Basic Public Finance of Public-Private Partnerships”[i] is to provide additional insight to the theoretical modelling of PPPs by analyzing the structure of the PPP contracts. In doing that, the authors design an optimal contract, in which it is assumed that the most cost-efficient way to finance PPPs is through the collection of user fees. Due to inherent inefficiency caused by government bureaucracy, it is less costly for the consumer to pay the private firm directly than through tax collection because the private sector is more effective in controlling overhead costs and corruption.
The authors derive the optimal PPP contract in this setting, with minimum and maximum revenue levels for the private firm during the life of the PPP contract. The minimum income guarantee boundary is guaranteed revenue for the private firm, whether by user fees or government subsidies, while the upper boundary, or the revenue cap, is the maximum a firm can earn. In high demand cases, when the revenue cap is reached, the government terminates the contract and resumes ownership of the project. If forecasted revenue will not reach the minimum income guarantee amount, the government pays the private firm the difference. In the case where revenue is expected to fall between the two thresholds, no subsidy is paid and the firm continues to run the project indefinitely (in the real world, concession law specifies a maximum concession length).
The paper shows that competitive auctioning can be used to implement the optimal PPP contract. User-fee revenue depends directly on the demand for using the public good offered by the PPP, so when the government announces the auction, it also provides firms with information on the distribution of demand volumes as expected by the government (assumed correct). Based on information on the distribution used by the government, firms bid for both a minimum income guarantee and a maximum revenue cap. The government then computes the expected cost of the bids using the demand distribution and selects the firms with the least costly bid. To avoid low quality provision by the winner, the authors assume that governments can verify the quality of the work, a process that is often seen in reality throughout PPP contracts around the world.
For the longest time, PPP contracts have had a fixed duration, but recent years have seen the emergence of flexible-term contracts, which bear a close resemblance to the optimal contract introduced in the paper. Flexible-term contracts, as the authors explain, are a step closer to balancing the risk that firms face in the case of a decline in the demand for the services offered. Elimination of demand risk relieves the Government from issuing guarantees, which if materialized, are a substantial burden on Government budgets. Furthermore, as Professor Fischer points out, “a change from fixed-term to flexible-term contracts can lead to considerable welfare gains – between 16% and 64% of the upfront investment.” In the case of the Chilean toll road program, the authors estimate the reduction in the cost to users of toll roads to be about US$ 1 billion, or one third of the investment cost. At a government level, the debate on which kind of contract to adopt is a result of conflicting interests between the Ministry of Public Works, which favours the concession lobby’s preference for fixed-term contracts, and the Ministry of Finance, which is more interested in minimizing the overall subsidy payments. In Chile, the balance of power between these two government bodies switched to the Ministry of Finance after 2003, following a period of overspending by the Ministry of Public Works. The concession of Route 68, connecting Santiago with Valparaíso and Viña del Mar is one example of a flexible-term contract and the first one in the country.
An additional question explored in the paper is the impact of PPPs on the government budget. The researchers find that from the point of view of public finance, PPP initiatives resemble more public concessions than privatization. Privatization is a one-time transaction, where the government sells a project to a private firm, and the later assumes all risk associated with future revenue. PPPs on the other hand require that governments provide subsidies in case of low demand, and they end up carrying most of the risk. This is why the paper recommends that when it comes to budgetary planning, PPPs should be treated the same as conventional concessions. This implies that the decision to use PPPs as a means to free up budget constraints is not justified. "PPPs do not release public funds, contrary to the common belief among policy makers" concludes Professor Fischer. A better case to be made is the authors’ findings that through user-fee financing, PPPs reduce inefficiency costs inherent in government revenue collections.
[i] Journal of the European Economic Association, 2013