The Growing Need for PPPs
Public-Private Partnerships (PPPs) leverage private partners to provide public goods with reduced state capital at risk, making them attractive amid debt crises. PPPs, such as Canada's Samuel de Champlain Bridge, benefit from efficient risk management during construction, though optimal risk allocation requires careful negotiation to address complexities and viability gaps, ensuring the alignment of incentives for both parties.
Public-Private Partnerships, also known as PPPs or 3P, are a method of project delivery in which the state leverages private partners to provide a public good that they would previously have funded and managed themselves. The base idea is one of risk shifting. By involving private investors, project risks are spread among several stakeholders. Typically, the principal sources of funding for PPPs are handled by the private sector, meaning it is their responsibility to raise debt and equity. As a result, the state puts less capital at risk than if they were to front the entire cost. With the current debt crisis affecting many countries, PPPs provide an attractive avenue to deliver crucial infrastructure projects.
If the state is careful in the terms of its contracts with the private sector, it can use its oversight to allocate PPP contracts to the most economically impactful projects. In some cases, however, these projects may not provide the required rate of return to attract infra funds. Encouraging private investment thus requires government support in the form of Viability Gap Funding (VGF), a broad term encompassing subsidies, grants, and lower-interest loans.
Risk management is the name of the game when it comes to PPPs. The principal advantage of this project delivery method in infrastructure comes during the construction period. The private sector takes on construction risk, meaning it is their responsibility to oversee that the process is undergone smoothly, with minimal delays. PPPs have an incentive structure conducive to minimizing this period. As the private partner seeks to generate cash flows during their concession period to cover construction costs and debt payments, as well as to provide a return to equity holders, they have a unique profit incentive which drives efficient risk management. The state, on the other hand, lacks this incentive. This is due to the innate liquidity of the government, i.e. the ability to issue low-cost debt and to increase taxes in cases of delays or funding gaps.
In Canada, the more efficient structure of PPPs can be illustrated through the construction of the new Samuel de Champlain Bridge, which connects the island of Montreal to the mainland. This is a Build-Operate-Transfer (BOT) concession in which the private partner has an operation mandate of 30 years before oversight of the bridge is returned to the Canadian government. While, admittedly, the forecast construction period of 4 years was overrun by a few months, the build-time would almost undoubtedly have been longer if the state had overseen the process. Minimal delays in construction have led to a non-negligible economic impact, with the improvement in transport routes bringing in an additional estimated $20 billion in annual trade.
While the private partners bear risks, including construction, other risks may be borne by the state. These risks, when possible, are addressed in the partnership agreement. For instance, the state may take on demand risk. To cover potential threats to demand for the product, such as competitors entering the market, the state may ensure a minimum level of revenue for the private party during contract negotiations. Additionally, in the case of BOT contracts, where the product is transferred back to the state at the end of the concession period, they will bear residual value risk, the risk that the value of the product is lower than anticipated upon transfer. PPPs allow for an optimal risk allocation by shifting responsibilities to those stakeholders which are better equipped to handle particular risks.
This optimal allocation is difficult to achieve, given that neither party seeks to take on more exposure. In partnership negotiations, the private sector will attempt to shift as much risk as possible onto the state’s side and vice versa, requiring in-depth scrutiny from consultants and a lengthening of the negotiation period. Projects with more complex risks can cause problems in contract negotiations due to difficulties in formulating the legal language in the document. For instance, a ‘force majeure’ clause typically includes risk factors outside of the control of either party, such as natural disasters. Nonetheless, lack of clarity of the term’s coverage has led to cases of disagreement over whether other factors such as civil unrest fall under the purview of this clause.
More complex projects with large viability gaps have typically posed the biggest problems to PPPs being negotiated. Larger viability gaps make the private party more dependent on state funding. In long-term concessions, this can place them in a weak position and expose them to political risk, which lengthens negotiations. For instance, if the political party in power changes during the private party’s concession, the new political party may find the previously negotiated terms unsuitable and place pressure on the private party to renegotiate. In practice, this may be achieved by threatening a reduction in future contracts for the infra fund.
PPPs are a tool which bring significant benefits through cooperation, but they must also be used for the appropriate cause; choosing the wrong project can lead to large viability gap funding costs or can lead to negotiation complications by misalignment of risk-carrying incentives. An optimal PPP project entails efficiency gains from the private sector, which offset higher borrowing costs related to risk, a considerable net benefit to the economy. To take full advantage of these benefits, governments need to have the capacity to negotiate several PPPs simultaneously, and to reduce negotiation time. This should be handled through task forces specialized in the creation of robust partnership agreements.
Written by Romain Perusat