Public services: What can private and partnership approaches

deliver?

Paul A. Grout

Mexico, November 2008

Centre for Market and Public Organisation

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Outline• Background

• Definitions and taxonomy

• Some basic questions

– Why should sector matter?– The role of profit and competition– Public service motivation – is this a concern?– Can a long term partnership help?– What is the relevant benchmark?– How much does risk matter?

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Background

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• Private involvement in its various forms of delivery of public services is now vast.

• $3.24 trillion of assets had been transferred to the private from the public sector in the preceding 20 years (significant proportion of which consists of public services).

• 18 % of the global stock market value

• 39% of the non-U.S. total value

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• Trend to more private involvement in public services has not happened in isolation- roots lie in the broader privatisation strategy pursued by conservative governments in the 1980s.

• The word privatisation is now met with more scepticism - it carries a tarnished feel which the word partnership nimbly sidesteps since it suggests more of a close balanced relationship than is really present.

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• Public services, Public sector, Public Organisation

• Models:

– full privatisation (state’s role is ‘arms-length’)

– outsourcing type relationships (services are provided on short/medium term contracts)

– public-private partnerships

– not for profit .

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• Cost overruns:– 9 out of 10 infrastructure projects fall victim to cost

overruns– average cost escalation is 45%– for fixed links (bridges and tunnels) is 34% – for all roads 20%. – examples exist across five continents– cost escalation has not decreased over the past 70 years– average cost escalation for private fixed link roads is

34% compared to 110% for public

– NAO (UK) found on average cost overruns of around 28% road construction projects.

• So what?

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Why should sector matter?

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• contractual incompleteness is a significant issue if cost reduction reduces quality

• if a profit maximising private company owns assets then the company may to reduce costs regardless of the consequences

• In contrast, the public sector will care about quality as well as cost and any effect of quality reduction should be taken into account

• But the public agent is harder to motivate

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• Net effect is that the private sector should provide lower costs but lower quality.

• Where the social cost of non-contractible quality reduction is large relative to potential cost savings (e.g., brain surgery) then public provision may be optimal.

• Where the social cost of non-contractible quality reduction relative to potential cost savings is less of a problem (e.g., telecommunications) then private provision is likely to bring benefits

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The role of profit and competition

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• An alternative view is what really makes the public sector expensive is the absence of competition

• private sector then plays indirect role

• private sector matters because it is the enabler of competition (but it may not really matter which sector does the delivery)

• for competition to be real there has to be a genuine fear of termination of contract for the incumbent.

• evidence suggests competition matters

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Public service motivation:

is this a concern?

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• Public service motivation/pro-social behaviour/donated labour

• Organisational models

• Mission matching models

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PUBLIC/PRIVATE  

 

GrossIncome

WorkedHours

PayRate

Overtime Paid Overtime

Unpaid Overtime

Construction 0.95 0.91 1.07 0.62 0.66 0.60

Civil engineering 0.97 0.88 1.09 0.61 0.58 0.70

Prof & Techn Services 1.05 1.05 0.96 0.48 0.23 0.64

Cleaning 1.03 1.01 1.02 0.73 0.88 0.00

Education 1.16 0.85 1.33 2.31 0.34 2.85

Hospitals 1.46 1.05 1.38 0.76 0.66 0.96

Medical Practices 1.15 0.80 1.33 2.27 2.90 1.71

Social Welfare 1.64 1.02 1.65 1.19 0.86 2.67

Source: British Household Panel Survey (averaged over eleven waves: 1991-2001) Variables used are Usual gross pay per month: current job, number of hours normally worked per week, No. of overtime hours in normal week, No. of hours worked as paid overtime. Standard Industrial Classification 1980: 500 general construction & demolition work, 502 civil engineering, 837 professional & technical services nec, 923 cleaning services, 932 school education (nursery, primary & secondary), 951 hospitals, nursing homes etc, 953 medical practices, 961 social welfare, charitable & community services

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NFP/PRIVATE  

 

GrossIncome

WorkedHours

PayRate

Overtime Paid Overtime

Unpaid Overtime

Construction 1.20 2.43 0.74 0.12 0.00 0.44

Business Services 0.72 0.87 0.92 0.66 0.65 0.67

Education 1.18 1.13 1.02 1.34 0.55 1.57

Health 1.47 1.35 1.07 0.87 0.56 1.39

British Household Panel Survey (averaged over eleven waves: 1991-2001) SIC 1980: 50 Construction, 83 Business services, 93 Education, Health is a combination of all 95X categories, i.e., 951 hospitals, nursing homes etc, 952 other medical care institutions, 953 medical practices, 954 dental practices, 955 agency & private midwives, nurses etc, and 956 veterinary practices & animal hospitals

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• BHPS data set: after including a robust set of individual and job-specific controls, individuals in the non-profit sector are 12 percentage points (or more than 40 per cent) more likely to do unpaid overtime than individuals in the for-profit sector.

• Using a fixed effects regression model can show that there is no evidence that individuals change their ‘donated labour’ when they switch sector.

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Can a long term partnership help?

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Why can partnership help?

• Bundling long-term service delivery with build is potentially beneficial

• Particularly if cost of improving build is small relative to information rent

• Bundling gives an incentive to build well since this keeps delivery cost low and hence increases the return (through information rent).

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Some key ‘modelling’ elements

• Moral hazard problem at build stage

• Consequences of build stage emerge slowly

• Information rent at service stage

• ‘Positive externality’ between build cost and service delivery

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Problems• Contract is based on service hence incentivisation

has to be done through service – this may be too expensive

• Hold up problem - lose residual rights with PPPs.

• Note potential for ‘hold-up’ may not be all bad news

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• A mechanism to modernise infrastructure without having to find or borrow money today

• In terms of commitment a legal duty to pay in the future may not be different from borrowing today (this may depend on the risk that the private sector is bearing).

• signing a PPP may be different from borrowing if the final destination of borrowed funds is more obscure and fungible than signing a PPP.

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When to choose PPP? • The traditional approach to choice of technique has

been CBA based – compares benefits minus costs of the alternatives

• Now simple tests are often used (e.g., VfM tests used in many countries).

• The simple tests are unusual - they compare ‘costs’ of alternatives from the Treasury point of view but this is not a comparison of costs in an economic sense.

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When do CBA and simple tests give same answer?

• No excess profit for the consortium

• Equal benefits across sectors

• ‘Identical’ discount rates for identical cash flows between sectors

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Investment against Bureaucracy Quality (PW database)

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Investment against Corruption (PW database)

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• More likely to deliver on time

• More likely to deliver on budget

• More expensive but not once public overruns taken into account

• Private management without build also advantageous

• Procurement

• Renegotiation

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What is the relevant benchmark?

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• criticisms of payment delay justification assume that public sector could borrow and do the project.

• not the relevant test – need realistic not hypothetical alternative.

• politicians are usually deemed to be too short term

• the poor state of public sector infrastructure (hospitals, schools, etc.) in many countries (including the UK) is well documented

• So a mechanism that allows politicians to improve the infrastructure of the country while passing on the cost to those future generations as they benefit from it seems a plausible way of correcting the distortion.

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There have always been political economy influences from the start

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How much does risk matter?

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• There are some obvious incorrect views on risk

• Risk necessary for incentivisation

• So risk transfer is essential

• However, some differences in discount rates are purely financial measurement issues

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• An economic project has a cost stream and a revenue/benefit stream.

• ‘Cost’ to Treasury of public delivery is the PV of the cost stream of public delivery, i.e., a true cost stream

• Cost to the Treasury of private delivery is the PV of the revenues paid to the consortium, i.e., a revenue stream based on benefits.

• Risk profile of costs and revenues can differ substantially

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• Therefore public and private sector discount rates may be the same for identical cash flows but there may be significant differences between public and private discount rates.

• Risk differs because – Low marginal cost– Incentivisation of private sector through

payment systems

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• In specific, but plausible circumstances

costmarginal

price

Cost

Revenue

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Figure 1. Regulated and control portfolios' beta coefficients estimated for sub-periods

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Grout & Zalewska, Journal of Financial Economics, 2006

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What can we conclude?