European Institute

As a simple example, suppose a locality wants to build a new toll road. In the extreme, the locality could acquire the property, create a design for the road, obtain all required permits, hire staff, buy equipment and supplies, and build the road. All of this would have to be financed through existing revenues or debt. In some cases, the locality could issue a bond with the proceeds from expected revenues used to repay the debt.

Few localities, however, possess the competencies, financing, or flexibilities required to successfully complete this project. More realistically, they would either contract for all or parts of the project with third parties who bring the requisite competency and experience. The locality would still have to finance the project but could do so knowing that the risk of failure has been mitigated by the contractual provisions. A PPP would be different in that the third-party contractors would be repaid through the expected toll revenue. In essence, the third party assumes a significant portion of the risk in exchange for future remuneration. And, because the third party’s cost of money is likely higher than the municipality’s, the remuneration will need to reflect this added cost. This is the cost of risk or risk financing that underlies every PPP. Of course, along with the added risk, the third parties will likely want to exert more control. Thus, as noted in the ECA audit, large PPPs tend to attract fewer and larger bidders than more traditional contracts. In this way, the prime contractor can exert control over subcontractors and minimize their performance risk. This is also where many PPPs pave the path to failure.

Let’s take the same locality wanting to build a new toll road and assume it wants to enter into a PPP. It still needs to create the basic design and acquire the land. Then it needs to select its partner most likely through a competitive process. This time, however, the locality specifies that the partner will need to finance the project and will be compensated through future toll revenue once the road is completed and accepted. The partner will need to perform all necessary tasks from obtaining permits through to laying asphalt and painting the lines. The effect is that the locality has now shifted performance and other risks to the partner and the partner will factor those risks into their price. For instance, what if environmental concerns are raised and the permits are delayed by 6 months or more? The partner may encounter continuing costs from idle workers, equipment or supplies. The partner may also encounter increased legal and contracting costs. Or, the contractor and/or government overstates utilization projections leading to toll revenue shortfalls. Thus, the partner is likely to want to build contingencies into the contract for these types and other foreseeable and non-foreseeable problems.

Ultimately, the locality may not be able or willing to pay the additional costs for all the risks it has transferred to the partner. This is where negotiations begin. The partner may want a guarantee from the locality that all permits will be issued within a set period with an escalating cost if the guarantee is not met. This back-and-forth over this and many other risks and costs will drive the provisions of the final contract formalizing the PPP. As experience has proven, neither the locality nor the partner can predict and account for every possible problem that will be encountered. How they allocate this unknown risk is critical to the success of the project and its final cost.

The allocation of risk and how that allocation is articulated in the contract is often the most important factor in the ultimate success of a PPP. And, again, from the perspective of both the government and the contractor, how risks are allocated factors into the ultimate cost of the project.

Although some literature[3] suggests that a good working relationship between the government and the private contractor are key to achieving results, the governing contract will ultimately determine success. Relationships are important in managing normally expected issues, but the contract lays out the responsibilities of the parties, contingencies, and the process for resolving disputes. These three elements are key when circumstances beyond the foresight or control of the parties occur. The renegotiation process is where most PPPs fail.

Knowing the complexities and uncertainties of this contracting process, why go into a PPP? This is the key question being raised by the ECA and its recommendation that, “the choice of the PPP option is justified by value-for-money considerations.” In a PPP contract, the payments to the partner will be higher than if the locality (assuming it had the competencies and experience) was to undertake the project on its own or to pursue more traditional contracting methods. Therefore, it is incumbent on the locality to identify what additional value is added through a PPP and determine whether that value is worth the additional cost. Typically, this value-for-money calculation would and should be based on the project’s total lifecycle costs. In the case of a road, this lifecycle cost could include future maintenance because payments to the partner could be contingent on acceptance and maintenance over a ten or more year time period.

On the surface, PPPs will always be more expensive than government financed and operated projects. This is simply because the government’s cost of financing is less than that of a private entity---and it has shouldered all or more of the risk. Hence, it is important to look beyond the simple financing costs to understand why PPPs often provide more value for the money. And one way of thinking about value is to think about what the desired outcomes of the project are. In our example of the jurisdiction building the road, the desired outcome is likely to be the connection of two points with a road that is delivered on-time, within budget and of acceptable quality, and that does not need repairs outside of expected norms. Accomplishing this objective requires the employment of skilled labor, quality materials, and reasonable oversight. Governments can increase the probability that the objective will be met by transferring responsibility and risk for one or more of these functions to a third party and thus create value.

A final realm for the employment of PPPs is in the area of international development. PPPs have been used for development in countries across the globe and are similarly employed by development agencies including the World Bank and U.S. Agency for International Development (USAID).[4]

Conclusion

While there are many notable failures such as those cited in the ECA report, there is considerable momentum toward employing PPPs as an effective mechanism to expand and improve infrastructures across the globe.

Gary Glickman is an entrepreneurial, global senior executive with thirty years of providing leadership, in both the public and private sectors in the fields of Public Private Partnerships, Human Services, cyber security, electronic commerce and the application of technology to government.  Gary is a sought-after speaker and recognized thought leader that has written and spoken extensively on social impact bonds, electronic benefits (which totally revolutionized how food stamps where delivered and monitored), cyber- security, access to health care and cross-sector partnerships.  Now an independent consultant, he held executive positions at Accenture, the Office of Management and Budget within the Executive Office of the President of the United States, and within a number of other domestic and international organizations.