The Productivity Commission’s draft report on public infrastructure provide a variety of helpful recommendations to get projects evaluate and deliver on schedule. The report doesn’t go beyond the conclusion public-private partnerships are not a magic bullet. New research shows that private investment can make efficiency gains. However, it is best to look at what happens if the project fails.
Although this may seem counterintuitive, it is because private investors have the ability to seek bankruptcy protection, while governments can’t. This causes a distortion in their behaviour and may lead to inefficiencies. When PPPs are compare to traditional public investments, this issue is often overlook.
Private financing is use often because it is believe that it will provide the appropriate incentives for the private partner to maintain the project’s schedule and budget. This argument stems naturally from similar arguments for fixed-price contracts in conventional projects. For example, a fixed-price contract for construction provides powerful incentives to the contractor to finish on time and within budget. The argument is not valid in the context of PPP.
A PPP is not just a construction project, but a multi-decade agreement to deliver and maintain the infrastructure. We have not explored the consequences of a private partner entering the post construction phase with large debts. What effect will this debt have on performance reliability over the 25-30 year period of a typical concession?
This question was the basis of the two research papers Matthew Ryan and I co-authored. The government has real potential to manipulate the private sector by borrowing large amounts from its partners to pay for construction costs.
Private Public Borrowings
PPPs usually combine construction with ongoing operation and maintenance in a single long-term contract. Private investors are require to raise funds for all phases of construction. Sometimes, the government doesn’t have to pay until the road is complete and meets pre-specify performance standards.
It may take many years before the project can make a profit if it’s fund through the collection of tolls. This model was use in the Cross City Tunnel, Sydney, and the Airport Link and Clem7 Tunnels, Brisbane. All these projects ran into financial difficulties.
It is the idea of transferring the cost and risk to governments to a private partner. However, despite how appealing this may seem, there is no way to transfer the risk. Construction typically privately fund in a PPP. This means that the private partner will have to service significant amounts of debt after the completion of construction.
To Force The Government To Do What You Want
If the demand is lower than anticipate and the project is paid by tolls the private partner could default on its loans. In this case, its bankers may try to renegotiate with the government. Because the political cost of renegotiating and reassigning the contract is high, the government will likely be more open to making a transfer payment in order to keep the private partner financially viable.
The transfer does not have to be a payment. This could include allowing an increase or prolonging the contract. Private financing, in other words, exposes the government’s ability to bail out the private partner when it is under financial strain. The private partner can exert some control over the transfer by strategically choosing the level of its debt.
Other countries have recognized the negative effects of renegotiating contracts on efficiency. Some of them have made specific arrangements for arbitration.
These long-term contracts will reduce efficiency because liability is not unlimited. Because the private partner’s efforts at cost containment and its handling of debt can impact its default probability and the amount it can get from the government, this is called the private partner effect.
Split The Bill Public
This distortion could be neutralize by public financing. Construction and maintenance do not have to be paid separately just because they are combine. Construction could be fund by the government.
The government would pay the total amount to the winning bidder, while all construction costs could be invoice. The remaining balance would paid in regular service payments throughout the term of the contract.
This would eliminate the need for the private partner take on significant debt. However, even with low debt, financial problems could still arise if the costs are too high. But, there are small guarantees and minimal equity participation requirements that could reduce hold-up risk.
This problem could be address by requiring minimum equity or guarantees that are much higher than the current requirements.
A closer examination of the relative merits and disadvantages of private and public financing of PPP projects is need. Our research shows that there efficiency issues hidden in PPP projects. These are mention in the Productivity Commission draft report but not fully understood. This is why the debate about infrastructure funding seems to have missed them.