February 22, 2008
A primer on Public-Private Partnerships

Posted by Francois Michel

If experts still argue about the proper definition of Public-Private Partnerships (PPPs), their microeconomic foundations, or their possible role as an antidote to the worldwide downturn in infrastructure investment, there is one fact that garners universal agreement: PPPs are one of the most popular reforms of the last decade in public financial management. A growing number of countries show interest in following the most advanced administrations on the topic, including Australia (Partnership Victoria) and the U.K. (Private Finance Initiative). Developing countries, in particular, try to develop PPPs to address economic infrastructure bottlenecks. However, the trend is universal: a recent study of PPPs in Europe found that between 1990 and 2005, more than a thousand partnerships had been signed in the European Union alone, representing an investment of almost 200 billion euros.

These developments have triggered intense (and remarkably fruitful) academic research. Thus, although much remains to be done, the major opportunities and challenges posed by PPPs, especially the fiscal risks induced by the absence of an effective accounting framework and the crucial notion of risk sharing, were identified with enough precision by the end of 2003 to allow the IMF to issue a series of reference publications on the subject.

What is a PPP?

A simple, though not universally acknowledged, definition of PPPs refers to arrangements in which the private sector supplies infrastructure assets and services traditionally provided by governments. Some authors add that the presence of external financing as a necessary condition; others focus specifically on design-build-finance-operate arrangements. However, unless they introduce a particular microeconomic model, these definitions do not constitute the core of the academic debate. For instance, the PFM literature, as opposed to microeconomic studies, insists on the fact that PPPs are government contracts with the private sector that, through their flexibility and complexity, put the public entity’s assets at significant risks. This is because they are partially exempt from traditional procurement schemes and regulations and are used by ministries less trained than their private sector counterparts to develop efficient risk management procedures.

Is there agreement on PPP's?

In this young, rapidly evolving area, the consensus currently crystallizes on a few singular points:

1. PPPs should be limited to projects delivering greater Value for Money (VFM) than other forms of procurement.
2. the contractibility of the quality of service,
3. the transfer of a significant share of risks to the private sector,
4. the presence of competition or incentive-based regulations,
5. a sound institutional and legal framework,
6. a sufficient level of technical expertise in the government, and, last but not least,
7. the proper disclosure of PPP commitments, along with government guarantees, in government financial statements (and in debt-sustainability-analyses).

What does the research on PPP's say?

The research literature on PPPs follows various strands. One, following Schleifer (1998) in the comparison of the respective interests of private and public ownerships, underlines the roles of potential cost reduction leading to non-contractible deterioration of quality; innovation; competition and consumer choice; reputation mechanisms; and government’s credibility (non versatility). Its results are confirmed by another strand of literature, following a model pioneered by Hart (1998) and focusing on the advantage of contracts bundling construction and operation (in an incomplete contract setting, which confers a role to the allocation of ownership).

Overall, the research suggests that bundled contracts are preferable when there is room for high-powered incentives to innovate or improve the infrastructure before the operational phase. More recent studies have focused, among others, on the level of details of contracts, the presence of private finance (and concentrated investors as monitors), the essence of cost overruns (as costs associated with trying to make contracts complete), the need for a careful review of contracts, and the usefulness of properly designed auctions (because ex-post trading between participants cannot ensure efficient allocation).

What are the fiscal issues surrounding PPPs?

As insightful as this research might be, the fiscal consequences of the generalization of PPPs are yet far from clear, as are the best systems to negotiate and manage these contracts. Two sets of issues, in particular, have gathered attention in the fiscal area:

1. Accounting and off-budget spending. The accounting treatment, until now, has focused on the classification of PPPs as either public or private investment (see Eurostat’s 2004 decision). This creates a considerable incentive for governments to use PPPs to move investments off budget, and to shift liabilities to the future. Indeed, traditional accounting tools and methods have been unable to provide an effective control mechanism over PPPs. This can be partly explained by the absence of general accounting and reporting standards, even if the literature provides guidelines on the treatment of financial leases. This “demise of the accounts” is not so surprising inasmuch as PPPs blur the line between public and private risks and economic ownership—and that they fundamentally allow the creation of economic value through this greater flexibility.
2. Adequate control procedures. Another difficulty stems from the fact that specific PPP procurement decisions are technical in nature (especially for the VFM calculation). Hence, the political and external control over PPP decisions is likely to be weak, and calculations subject to manipulation. Building up adequate control procedures is even more challenging as cost overruns and renegotiations inevitably occur and as these controls will need to be performed by multiple bodies.

Many other questions can certainly be raised. A few of them are provided below, if only to underline the many challenges posed by PPPs and encourage further research on the topic:

* What are the best accounting methods for PPPs to improve government’s governance mechanisms (and incentives)?
* How should risks arising from PPPs be examined, integrated in the budgetary framework, and aggregated at the ministry/government level (in a multi-year framework featuring contingency reserves)?
* Under which safeguards should PPPs be allowed for local governments? What capacity within governments needs to be developed to assess risks?
* How do tax regimes affect the choice between PPPs and traditional procurement schemes?
* What is the optimal role of internal and external controls in a PPP program?
* To what extent can transparency substitute for procedural controls?
* Provided that they are possible and enforceable, how would transparency clauses affect PPP negotiations?