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Privatisation and Public-Private PartnershipsStephen O. Mallowah LLB (UNZA), LLM (UCL), MSc (SOAS)

Introduction

The use of private financing in the development of public infrastructure, although

controversial, is becoming increasingly popular around the world. This paper critically

examines some of the issues surrounding public-private partnerships (PPPs), and

discusses their impact on service delivery as well as their fiscal consequences. The firstpart of the paper defines the concept of PPPs and outlines their main characteristics. The

second part of the paper looks at the pros and cons of PPPs through various

perspectives. This is followed by an analysis of some of the experiences with PPPs in

the United Kingdom whose Private Finance Initiative (PFI) is now responsible for about

14% percent of public investment. The paper concludes with some suggestions for

effective use of PPPs.

Public-Private Partnerships - Characteristics

Public-private partnerships (PPPs) are arrangements where the private sector develops

infrastructure assets and supplies services that traditionally have been provided by

government. PPPs combine private sector capital and, sometimes, public sector capital

to improve public services or the management of public sector assets. By focusing on

public service outputs, its proponents believe they offer a more sophisticated and cost-effective approach to the management of risk by the public sector than is generally

achieved by traditional input-based public sector procurement.1

PPPs can be used to build and operate various types of infrastructure such as hospitals,

schools, prisons, roads, bridges, rail networks, and water treatment plants. The attraction

for governments is that in situations of budgetary constraints private financing can

support increased infrastructure investment without immediately adding to governmentborrowing and debt. This is coupled with the belief that the private sector can deliver

services more efficiently than the public sector, thus leading to higher quality services at

lower cost. For the private sector, PPPs provide new business opportunities.

PPPs have had the effect of significantly expanding the privatisation horizons and have

emerged as a means of obtaining private sector capital and management expertise for

infrastructure investment, to enable and overcome obstacles to privatisation. Thus in

addition to private execution and financing of public investment, PPPs have two other

important characteristics: there is an emphasis on service provision, as well as

investment, by the private sector; and significant risk is transferred from the government

to the private sector.2

1 Gerrard, Michael B, Public-Private Partnerships, Finance & Development, IMF Publications, September

2001, Volume 38, Number 32 IMF (2004) Public-Private Partnerships, Washington: Fiscal Affairs Department, World Bank and Inter-American Development Bank, March 12. p 6

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Governments have traditionally undertaken public investment by designing and

financing a project and then contracting with the private sector to build the asset, which

is then operated by the government upon completion. The PPP alternative often takes

the form of a design-build-finance-operate (DBFO) scheme where the governmentspecifies the services it wants the private sector to deliver, and the private partner

designs and builds a dedicated asset for that purpose, finances its construction, and

subsequently operates the asset and provides the services deriving from it. The private

operators can sell the services to the government e.g. prisons; or sell services directly to

the public, as with a toll road.

There are four main ways in which the private sector can raise financing for PPP

investment. First, where services are sold to the public, the private sector can go to the

market using the projected income stream from a concession (e.g., toll revenue) as

collateral. Secondly, where the government is the main purchaser of services, shadow

tolls paid by the government (i.e., payments related to the demand for services) or

service payments by the government under operating contracts (which are based on

continuity of service supply, rather than on service demand) can be used for this

purpose. Thirdly, the government may make a direct contribution to project costs; in the

form of equity (where there is profit sharing), a loan, or a subsidy (where social returns

exceed private returns). Finally, the government can also guarantee the private sector

borrowing.3

It is generally believed that private ownership is to be preferred where competitive

market prices can be established, as competition ensures goods and services areprovided at prices consumers are willing to pay, while providing a profit to the provider.

Government ownership is seen as a way of correcting market failure, but in providingservices, government faces a trade-off between quality and efficiency; it may have the

capacity to achieve a desired quality standard, but may have difficulties containing

costs. The private sector has better management skills and innovative capacity which

can be applied to reduce operational costs, but at the risk of compromising service

quality in the process. PPPs are therefore a means of combining the relative strengths of

government and private provision in a way that responds to market failure but

minimizes the risk of government failure.

For PPPs to be successfully implemented a critical success factor is the ability of the

government to write a fully specified, enforceable contract with the private sector.

These are situations where the government can clearly identify the quality of services it

wants the private sector to provide, and can translate these into measurable output

indicators. The service requirements should be consistent over time and not subject to

radical change in the short-medium term. Service payments can then be linked to

monitorable service delivery. Where the government cannot write complete contracts

because service quality is non-contractible e.g., national defence, PPPs are not

advisable. The UK has experimented with private provision of prison services with

3 Ibid p9

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mixed results; there has been innovation and the use of new technology introduced but

no significant outperformance of the public sector managed prisons.4

It is important to note that while private capital inflows and a change in management

responsibility are beneficial, significant risk transfer is a prerequisite to derive the fullbenefit from such changes. There are five primary types of risks which PPPs face:

construction risk, financial risk, performance risk, demand risk, and residual value risk.5

It is argued that transferring project risk from the government to the private sector

should not affect the cost of financing a project.6However, it is observed that private

sector borrowing generally costs more than government borrowing. The difference is

attributed to differences in default risk; the governments power to tax renders it

unlikely to default, and so can borrow at close to the risk-free interest rate to finance

risky projects. When private borrowing is substituted for government borrowing,

financing costs are likely to rise even if project risk is lower in the private sector.

Therefore for PPPs to offer a value proposition, their efficiency gains must offset higher

private sector borrowing costs.

Since risk transfer is crucial to the increased efficiency of PPPs, the government must

relieve itself of risks that it believes the private sector can manage better than the

government. It needs to price these risks, so that it knows what it has to pay the private

sector to assume them. Project-specific risk, which is diversifiable across a large

number of government or private sector projects, does not need to be priced by the

government. Market risk, which reflects underlying economic developments that affect

all projects, is not diversifiable and therefore has to be properly priced.7

The government and the private sector typically adopt different approaches to pricing

market risk. The government tends to use the social time preference rate (STPR) orsome other risk-free rate to discount future cash flows when appraising projects, while

private bidders for PPP projects include a risk premium in the discount rate they apply

to future project earnings. This results in public investment appearing as the more

attractive option. The question that arises is whether the government is under-pricing

the risk, or that the PPP costs are actually higher than the public sector costs.

Under-pricing of risk may lead to the private sector choosing techniques of production

or other project design features which are less efficient, simply because they carry lowerrisk; or compromise on the quality of construction and service supply to the extent

possible without obviously violating its contract with the government. Alternatively, the

government can overprice risk and overcompensate the private sector for taking it on,

which would raise the cost of PPPs relative to direct public investment. As

demonstrated below, this may be the case in the private funding of hospitals in Britain.

4 The Operational Performance of PFI Prisons Report by the Comptroller and Auditor General HC 700Session 2002-2003: 18 June 20035 IMF (2004) Public-Private Partnerships, op cit p116

Modigliani-Miller theorem, which says that the cost of capital depends only on the risk characteristics of aproject, and not on how it is financed.7 IMF (2004) Public-Private Partnerships, op cit p12

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Public-Private Partnerships Examples from the UKs Private Financing

Initiative

In critically analysing whether PPPs actually achieve the twin objectives of operationalefficiency and risk transfer it is useful to look at examples from Britain which has

actively embraced the concept. Since 1992 the British government has favoured paying

for public capital works through the private finance initiative (PFI). Hospitals are

designed, financed, built and operated by private sector consortiums. In return the

hospital (under a National Health Trust) pays an annual fee to cover both the capital and

financing cost, and maintenance of the hospital over the 25-35 year life of the contract.

There is evidence of strong ideological support for PFI from the government. The report

by the Comptroller and Auditor General on the PFI contract for the redevelopment of

West Middlesex University Hospital re-emphasises that there are generic benefits from

PFI deals that outweigh possible disbenefits. The report reveals that the government

would approve a PFI project that appeared slightly more expensive than conventional

procurement if there were convincing value for money reasons for proceeding with the

deal. In this case the Trust's initial financial comparison did show the PFI price slightly

higher than the cost of conventional procurement. Both the Trust and its advisers

KPMG considered the PFI option would deliver value for money taking all factors into

account. However, the initial financial comparisons were against the PFI option. The

Trust and KPMG re-appraised the figures to ensure the risks inherent in traditional

procurement were properly reflected in the public sector comparator (PSC). The final

calculations showed a risk-adjusted saving from using the PFI compared with a PSC.The re-assessed cost comparison therefore reinforced the value for money case for the

PFI deal.8

The value for money proposition espoused by proponents of PFI to build NHS hospitals

has been criticised by Allyson Pollock who argues that it is an expensive way of

building new capacity that constrains services and limits future options. The

justification for using private financethat it offers value for money through lowering

costs over the life of the project and by removing risk from NHS trustsis a sleight of

hand.9

The arguments against PFI, based on their research findings are threefold; first, in an

environment of budget surpluses which exceed the PFI deals, the argument that PFI

leads to more investment without increasing the public sector borrowing requirement is

superfluous.10 Secondly, PFI has displaced the burden of debt from central government

to NHS trusts and with it the responsibility for managing spending controls and

planning services, thereby hindering a coherent national strategy. Thirdly, the high cost

8 The PFI Contract for the Redevelopment of West Middlesex University Hospital - Report by the Comptrollerand Auditor General HC 49 Session 2002-2003: 21 November 2002, p39 Pollock, Allyson M, Jean Shaoul and Neil Vickers (2002) Private finance and value for money in NHS

hospitals: a policy in search of a rationale?, British Medical Journal, Volume 324, 18 May.p120510 Ibid, p1205the UK budget surpluses of recent years (23bn for 2000-1) have been much greater than the totalof 14bn private investment deals signed in 1997-2001.

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of PFI schemes has led to NHS trusts diverting funds from clinical budgets, selling

assets, and cutting back on bed capacity and staff in hospitals financed through PFI.

It is further argued that due to the negative impact on levels of service, proponents of

PFI have resorted to the value for money argument; PFI delivers value for moneythrough lowering costs over the life of the project because of greater private sector

efficiency and because the private sector assumes the risks that the public sector

normally carries.

Until 1991 all major capital expenditure in the NHS was funded by central government

from tax or government borrowing. Thereafter hospitals were treated as independent

business units in the public sector and were required them to generate surpluses to pay

for their use of capital through capital charges to the Treasury.11 The research further

demonstrates that the costs of raising the finance account for 39% of the total project

costs under the PFI while publicly financed capital does not incur these costs. The

annual costs of capital for PFI are almost double the estimated costs of a similar scheme

funded by public finance. On the aspect of risk, only after risk transfer was included

was the net present value of PFI less than the public sector comparator, by an

insignificant amount. Thus the contribution of risk to costs was almost the same

amount as the difference between the public sector comparator and the PFI.

The conclusion drawn is that value for money analysis seems to be a way of forcing the

numbers to stack up in favour of PFI. Even with a high discount rate (which favours

PFI), PFI costs are still higher than those of the public sector comparator. So the value

for money claims rest on risk transfer. This suggests that the function of risk transfer isto disguise the true costs of PFI and to close the difference between private finance and

the much lower costs of conventional public procurement and private finance.12

Risk is the most difficult and contentious part of the value for money methodology. The

argument is that by getting the private sector consortium to bear some of the risks

associated with the construction of the hospital and its subsequent management, a trust

enjoys greater value for money than under a publicly financed alternative, where the

trust would bear all the risks. There is no laid down mechanism for measuring and

pricing the risk, hence the iterative approach adopted in the West Middlesex Hospital

project in the quest for costs that favoured the PFI.

13

Risk transfers can be valued up to50% of the total capital cost to the private sector. Evidence suggests that the risk is

being overpriced hence leading to overpayment by the taxpayer.

The issue of whether risk is actually transferred in the first instance is not settled. In the

case of hospitals, it would be difficult for the government to walk away from a failing

hospital, or where the contractor goes bankrupt. Several failed private finance schemes

in the UK, show that ultimately the risk is not transferred and the taxpayer ends up

paying for private sector risks. Apart from financial risk, other residual risks still lurk in

11 Capital charges are included in the prices charged to purchasers and comprise depreciation, interest, and

dividends based on the current replacement value of the assets12 Pollock, op cit p120713 Ibid, p1208

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the unknown future over 30 years technology will change, consumer needs,

regulations etc. But the public sector procuring entity may still be tied down in these

long term obligations, even while services are no longer being delivered.

Conclusion

It is sometimes argued that PPPs are not genuine partnerships that properly or

efficiently share risks and liabilities between the private and public sector but are a

means to disguise conventional contracting undertakings that are subject to standard

budgeting processes as some new undertakings that are carried out off-budget. Although

carrying out an activity off budget does not necessarily imply that transparency is

impaired, governments tend to put items off budget in order to conceal them from

public scrutiny. The UK examples further demonstrate that the concept of risk transfer

may also not be as effective as touted by its proponents.

However, PPPs seem to be evolving. In an environment of budget deficits and public

sector inefficiency, they have a role to play. From their initial incarnation as merely

vehicles to provide governments with a channel through which to finance infrastructure

investment by implicit budget deficits and debts and evade expenditure controls, they

have developed into genuine partnerships aimed at properly pricing scarce public

resources and efficiently sharing and managing risks. In the words of Trevor Manuel,

the South African Minister of Finance: ...the availability of state resources for these

purpose [to meet the socioeconomic needs of all South Africans, and in particular, to

alleviate poverty] must be used to leverage much-needed private sector investment inpublic infrastructure and services. The benefits [of PPPs] do not consist in an increase

of funds, but in the better management of scarce resources. 14

The discussion above illustrates that, despite the positive rhetoric by some

commentators, there should be no presumption that the private sector (or the public

sector) can deliver projects more efficiently or effectively. Instead, decisions should be

made on their merit and outcomes are judged on the basis of the public benefits

obtained.

14

PPP Manual (National Treasury PPP Unit, 2004), quoted in: Sadka, Efraim, (2006) Public-PrivatePartnerships: A Public Economics Perspective, IMF Working Paper No. WP/06/77

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References

________________________________________________________________________

Comptroller and Auditor General (2002) The PFI Contract for the Redevelopment of West

Middlesex University Hospital, London: The Stationery Office [National Audit Office, HC 49,Session 20022003, 21 November].

Comptroller and Auditor General (2003) The Operational Performance of PFI Prisons,

London: The Stationery Office [National Audit Office, HC 700, Session 20022003, 18 June].

Gerrard, Michael B, Public-Private Partnerships, Finance & Development, IMF Publications,

September 2001, Volume 38, Number 3

IMF (2004) Public-Private Partnerships, Washington: Fiscal Affairs Department, World Bank

and Inter-American Development Bank, March 12.

Pollock, Allyson M (2004) NHS plc: The Privatisation of our Health Care, London: Verso

Pollock, Allyson M, Jean Shaoul and Neil Vickers (2002) Private finance and value formoney in NHS hospitals: a policy in search of a rationale?, British Medical Journal, Volume

324, 18 May.

Sadka, Efraim, (2006) Public-Private Partnerships: A Public Economics Perspective, IMF

Working Paper No. WP/06/77

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