Chapter 9: Public–Private Partnerships

Le-Yin
Le-Yin Zhang is a senior lecturer and course director of M.Sc. Urban Economic Development at the Bartlett Development Planning Unit of University College London.
Marco
Marco Kamiya is coordinator of the Urban Economy branch of the United Nations Human Settlements Programme (UN-Habitat).

Introduction

Urbanization in developing countries is projected to add between 68 million and 71 million people to the world’s urban population annually between 2015 and 2025.1 This will only exacerbate the large infrastructure gaps already affecting the developing world.2 Remedying this situation and meeting Sustainable Development Goals require increased infrastructure investment, especially from the private sector.3 Of many methods of private financing of infrastructure, public–private partnerships (PPPs) have shown much promise in recent decades.

Private-sector involvement in developing countries’ infrastructure has risen from less than US$20 billion in 1990 to more than $200 billion in 2012—an all-time high—thanks to the growing popularity of PPPs as an investment model (see Figure A). However, the private sector currently contributes less than 10 per cent of the total estimated investment needs of emerging markets and developing economies.4 Thus, there remains significant scope for increasing the use of PPPs.

This chapter explains what PPPs are and how they work, detail the pros and cons of PPPs relative to public procurement, describes how to measure the success or failure of a PPP, and lays out the factors to consider when deciding upon a PPP.

  • 1. United Nations Department of Economic and Social Affairs, World Urbanization Prospects (New York, United Nations, 2015).
  • 2. United Nations, The Millennium Development Goals Report 2013 (New York, United Nations, 2013).
  • 3. United Nations Conference on Trade and Development (UNCTAD), World Investment Report 2014: Investing in the SDGs: An Action Plan (New York and Geneva, United Nations, 2014).
  • 4. B. G. Inderst and F. Stewart, Institutional Investment in Infrastructure in Emerging Markets and Developing Economies (Washington, PPIAF, 2014).
Figure
A
:
Private-sector involvement in developing countries’ infrastructure, 1990–2014
Figure A

Of many methods of private financing of infrastructure, public–private partnerships (PPPs) have shown much promise in recent decades.

What are PPPs, and how do they work?

PPPs are long-term contracts between a private party and a government entity, for providing a public asset or service, in which the private party bears significant risk and management responsibility.5 As Figure B and Table 1 show, PPPs encompass many forms of public–private collaboration, including operation and maintenance contracts; leases; concessions; build, operate, transfer (BOT); build, own, operate, and transfer (BOOT); and so on.

PPPs often take the form of concessions, where a public entity grants the right and the obligation to provide an infrastructure service to a private company that takes over an existing asset (see Case Study 1). This allows the state to delegate service provision to the private sector, but retain some control over the sector by incorporating in a concession contract or license the terms and conditions governing the infrastructure project or company. Payments are usually made by users or are substantially connected to the number of users (e.g., shadow tolls). In contrast, under BOOT, a private entity is contracted to design, finance, build, and operate a facility for a specified period before the final transfer of the asset ownership to the government (see Case Study 2).

Figure
B
:
Examples of “core” PPP contract types
Figure B
Table
1
:
Common types of PPPs and relevant terms
Table 1

In public–private partnerships, it is common practice for a project company, called a special purpose vehicle (SPV), to be established by the private firm or group of private firms running the project. It is the SPV that signs the PPP contract with its public entity counterpart, which then allows the company to build, own, and operate the infrastructure project.6 SPVs are especially useful for private firms engaging in PPPs because they offer additional security and reduce the risk of undertaking major infrastructure projects by acting as “a legally distinct entity to the parent company, and…[financing] large new stand-alone projects off the corporate balance sheet.”7 Figure C shows the structure of a typical SPV composed of the financer (major shareholder), the developer, facilities manager, and occasionally the government. The financing structure in terms of debt and equity is a key aspect of a PPP project and can have a big impact on its costs and affordability.

Especially in limited or non-recourse situations, SPVs are often the preferred form of PPP project implementation because “the lenders rely on the project’s cash flow and security over its assets as the only means to repay debts.”8 However, in these cases, the creditworthiness of the project is highly dependent on its expected cash flow. Nevertheless, there is mounting evidence that SPVs improve the financing options for PPPs and can overcome many of the traditional financial and legal barriers that have stalled successful private–public partnerships in the past.9

  • 6. L. Turley and A. Semple, Financing Sustainable Public-Private Partnerships (Winnipeg, International Institute for Sustainable Development, 2013).
  • 7. L. Turley and A. Semple, Financing Sustainable Public-Private Partnerships (Winnipeg, International Institute for Sustainable Development, 2013).
  • 8. UNESCAP, “Special Purpose Vehicle (SPV),” in A Primer to Public-Private Partnerships in Infrastructure Development (Bangkok, UNESCAP, 2008). Available from http://www.unescap.org/ttdw/ppp/ppp_primer/211_special_purpose_vehicle_….
  • 9. A. N. Chowdhury and P. H. Chen, “Special Purpose Vehicle (SPV) of Public Private Partnership Projects in Asia and Mediterranean Middle East: Trends and Techniques,” Institutions and Economies (formerly known as International Journal of Institutions and Economies), vol. 2, no. 1 (2010), pp. 64–88.
Figure
C
:
Typical structure of a PPP
Figure C

The pros and cons of PPPs, relative to public procurement

To provide a service or build an asset, a public entity can either use a traditional mode of public procurement or enter into a PPP. A distinctive feature of projects is that their requirements are defined in terms of outputs rather than inputs. This allows the public sector to focus on specifying the level and standards of the services required, giving the private entity the task of meeting the requirements. This enables the public sector to transfer certain project risks relating to designing, building, operating, and financing the project to the private sector.10

The pros of PPPs include better value for money (VfM), project sustainability, and additionality. As for cons, questions regarding the accountability and flexibility of PPPs have raised some concern among academics and policymakers.11

PPPs can improve the VfM of some projects. The VfM criterion of PPPs is defined as the expected reduction of life cycle cost and the estimated value of the risk transferred.12 This is evident in a higher positive net present value (NPV) in cost– benefit analysis (CBA). To establish whether a PPP represents better VfM, it is usually compared with a hypothetical public sector alternative, also known as a public sector comparator (PSC), which delivers the same service. The theory behind improved VfMs via PPPs is based on the assumption that the private sector is more effective at managing construction processes and risk.

PPPs can improve the sustainability of public services by reducing the overall costs and the variability of the cost of that service to government. Again this arises from sharing the risks of service provision with the private sector.13 The reverse side of the coin is that flexibility is limited in PPPs.14 This can be a problem if government wishes to introduce regulatory changes or alter the nature of the asset after the signing of a PPP deal. Renegotiation and cancellations of PPP contracts are costly.

In addition, commercial confidentiality and the work of SPVs as closed companies may diminish the accountability of PPPs.15 On the other hand, the reverse has also been argued; by transferring service delivery risk to the private sector, account-ability may be improved.16

Finally, PPPs provide an alternative source of finance to traditional government borrowing, thus offering the benefit of additionality. This is especially import-ant for developing countries, where domestic resources are limited and the cost of doing nothing is high due to lost economic growth (and development) incurred when infrastructure is absent and/ or inadequate.17

  • 10. European PPP Expertise Centre (EPEC), The Guide to Guidance: How to Prepare, Procure and Deliver PPP Projects (Luxembourg, EPEC, 2011).
  • 11. PPIAF, Note 1: PPP Basics and Principles of a PPP Framework (Washington, PPIAF, 2012); G. M. Winch, M. Onishi, and S. Schmidt, eds., Taking Stock of PPP and PFI Around the World (London, The Association of Chartered Certified Accountants, 2012).
  • 12. G. M. Winch, M. Onishi, and S. Schmidt, eds., Taking Stock of PPP and PFI Around the World (London, The Association of Chartered Certified Accountants, 2012).
  • 13. PPIAF, Note 1: PPP Basics and Principles of a PPP Framework (Washington, PPIAF, 2012).
  • 14. O. Merk, S. Saussier, C. Staropoli, E. Slack, J-H. Kim, Financing Green Urban Infrastructure (Paris, OECD Regional Development, 2010). Available from http://dc.doi.org/10.1787/5k92p0c6j6r0-en.
  • 15. G. M. Winch, M. Onishi, and S. Schmidt, eds., Taking Stock of PPP and PFI Around the World (London, The Association of Chartered Certified Accountants, 2012).
  • 16. PPIAF, Note 1: PPP Basics and Principles of a PPP Framework (Washington, PPIAF, 2012).
  • 17. G. M. Winch, M. Onishi, and S. Schmidt, eds., Taking Stock of PPP and PFI Around the World (London, The Association of Chartered Certified Accountants, 2012).

How to measure the success or failure of a PPP?

In measuring the success or failure of a PPP, a crucial question is whether it has produced the benefits that PPPs are supposed to generate.

First, a successful PPP should deliver better VfM in comparison with a PSC. This depends on whether risks have been effectively transferred to the private sector at a reasonable cost. This is not always easy to establish though, as the comparison relies on a counterfactual (i.e., a PSC). Through a PPP, the public sector is effectively buying an insurance policy from the SPV for the project, the price of which is the difference between the base cost and what is paid to the SPV.18 Due to limited competition among the SPVs, there is high risk that the public sector may pay too high a premium. Research shows that the estimated premium is about 25 per cent, not so different from those quoted for the overrun on publicly financed projects.19

Neither CBA nor PSC analysis is straightforward. The choice of the discount rate in CBA can significantly impact the NPV. Moreover, the CBA exercise tends to favour a PPP relative to a PSC when the discount rate is high, since many of the costs for a PSC would occur early on, but later for a PPP. In terms of a PSC, it is not always possible to find one comparable to a PPP in terms of outputs.20 On the other hand, ex-ante VfM analyses focus on the risk-adjusted financial costs and may underestimate the non-financial benefits of PPPs.21 These “socio-economic” benefits to service users or wider society from a PPP may take three forms: accelerated delivery (delivering service earlier), enhanced delivery (delivering service to a higher standard), and wider social impacts (greater benefits to society as a whole).22

A total cost approach is needed in this assessment. A project represents better VfM only if the PPP option delivers the same level of services at less cost to the public after all costs, benefits, and risks are taken into account. It is important to assess whether the greater operational efficiency of the PPP option is likely to outweigh factors that might make the PPP option more costly due to the latter’s high transaction, monitoring, and financing costs.

Second, a successful PPP ensures additionality and sustainability that provides the long-term availability of investment capital. A PPP that is aborted, that delivers poor service at too high a price, or that excludes large sections of the population cannot be considered as successful.

  • 18. G. M. Winch, M. Onishi, and S. Schmidt, eds., Taking Stock of PPP and PFI Around the World (London, The Association of Chartered Certified Accountants, 2012), p. 14.
  • 19. G. M. Winch, M. Onishi, and S. Schmidt, eds., Taking Stock of PPP and PFI Around the World (London, The Association of Chartered Certified Accountants, 2012), p. 14.
  • 20. J. Loxley, Asking the Right Questions: A Guide for Municipalities Considering P3s (Ottawa, Canadian Union of Public Employees, 2012).
  • 21. European PPP Expertise Centre (EPEC), The Non-Financial Benefits of PPPs: A Review of Concepts and Methodology (Luxembourg, EPCE, 2011).
  • 22. European PPP Expertise Centre (EPEC), The Non-Financial Benefits of PPPs: A Review of Concepts and Methodology (Luxembourg, EPCE, 2011), p. 6.
Shanghai, China

What are the prerequisites for PPPs?

There are two principal requirements for successful PPPs. First, the local government must have the authorization of upper-level government to do so. Usually, this means that the national government would have an established regulatory framework for such undertakings, including rules regarding contract enforcement and disagreement resolution.

Second, the project must offer a good risk-adjust-ed return that is attractive for the private sector. This may involve good cash flow based on project revenue (paid by users) or service fees (paid by authority). PPPs are considered less viable for the provision of basic infrastructure, as there might be a problem of affordability. In the event of debt financing, the public sector might be asked to provide guarantees. Alternatively, the public entity can either purchase a guarantee from private providers or access an increasing number of guarantee schemes that multilateral and bilateral agencies have set up.

Key steps and considerations in deciding a PPP

The PPP project cycle involves four phases: 1) project identification, 2) detailed preparation, 3) procurement, and 4) project implementation (see Table 2). Each phase can in turn be broken down into further stages and steps.23 The first phase (project identification) is crucial and, therefore, is the primary focus here. It involves two stages and a series of steps, as shown in Table 2.

  • 23. These are explained in more detail in European PPP Expertise Centre (EPEC), The Guide to Guidance: How to Prepare, Procure and Deliver PPP Projects (Luxembourg, EPEC, 2011).
Table
2
:
PPP project cycle: phases, stages, and steps
Table 2

The first stage involves project selection and definition. A key task here is to specify the outputs, as altering this specification will involve expensive renegotiation.

In assessing the PPP option, in the second stage, the authority and its financial advisors need to answer four key questions:24

  1. Is the project affordable? This considers the capacity of the project to pay by either the users of the services or the authority (or a combination of both). Services can be paid in two different ways: the user-pays type, or the unitary charge type.25 The first type trans-fers more risk to the private sector. Investors will be interested in the “annual debt service cover ratio” (ADSCR), which is defined as the ratio of free cash (i.e., cash left to the project after payment of oper-ating and essential capital costs) available to meet annual interest and principal payments on the debt.26
  2. What are the key sources of risks of the project? What are the optimal risk allocation and risk management strategies? There are three broad types of risks: commercial (including supply-side and demand-side risks), legal, and political. Best-practice principles of risk management suggest that risks should be allocated to the party best-placed to manage or absorb them. Thus, the private sector assumes the commercial risks, while the public sector assumes legal and political risks.
  3. What are the financing sources for the project? Questions include whether it is bankable (i.e., whether lenders would be willing to finance it) and whether it would attract equity capital or public funding. A bankable project would be cheaper to finance, but it requires a healthy cash flow.
  4. Even if the project is affordable and bankable, does the project represent value for money? This requires the conduct of the CBA and PSC exercises described earlier.

In addition, depending on the institutional and regulatory context of the country, it is necessary to consider the tax and public finance treatment of the

For example, returns on bonds may be exempt from capital gains tax, thus reducing the financing cost of the PPP deal.

  • 24. European PPP Expertise Centre (EPEC), The Guide to Guidance: How to Prepare, Procure and Deliver PPP Projects (Luxembourg, EPEC, 2011). This list can be extended. For a set of 10 critical questions, see J. Loxley, Asking the Right Questions: A Guide for Municipalities Considering P3s (Ottawa, Canadian Union of Public Employees, 2012).
  • 25. G. M. Winch, M. Onishi, and S. Schmidt, eds., Taking Stock of PPP and PFI Around the World (London, The Association of Chartered Certified Accountants, 2012), p. 9.
  • 26. European PPP Expertise Centre (EPEC), The Guide to Guidance: How to Prepare, Procure and Deliver PPP Projects (Luxembourg, EPEC, 2011), p. 48, footnote 12.

Conclusion

PPPs provide a financing mechanism by which local governments and private firms partner together to deliver important infrastructure projects and improve the efficiency and quality of public facilities and services. Various PPP arrangements exist to satisfy the specific requirements and context of the proposed project and protect private sector interests that want to finance important public infrastructure projects. While the private sector holds a large share of the responsibility for financing and arranging PPPs, the public sector and municipal authorities must critically assess the long-term viability of the PPP project and its capacity to generate adequate returns on investment.

The success of PPPs in developed and developing countries alike confirms the broad applicability and effectiveness of this financing instrument. While PPPs present their own legal and regulatory challenges, the success of PPPs in financing a wide range of projects from transportation infrastructure to hospitals make them a promising financing instrument for municipal authorities to consider.

Case study
1
:
Water services in Manila

Metropolitan Manila’s water system in the 1990s suffered from extreme inefficiency and poor maintenance. Approximately two-thirds of the water produced was lost because of leaks and illegal connections, and only eight per cent of homes were connected to the municipality’s sewage line.27 Meanwhile, the government agency in charge of the city’s water and sanitation services, the Metropolitan Waterworks and Sewage System (MWSS), was in debt and lacked the necessary financial resources for maintaining Manila’s water system.

Following the National Water Crisis Act of 1995, the Philippine government decided to privatize MWSS in order to improve the operation, coverage, and quality of the city’s water system. The government awarded two concessions for operating Manila’s water and sanitation system. One concession went to the Manila Water Company, and the other was awarded to Mayniland Water Company. The concession contracts allowed the two private companies to collect revenues from water tariffs, but were responsible for all operational and maintenance costs in addition to payment of a concession fee to the government.28

The tariffs were set according to recommendations made by the regulatory office of MWSS and accounted for a number of external factors such as inflation and other shocks that would affect the price of water and sanitation services. The collaboration between the private entities responsible for operating and maintaining Manila’s water and sanitation system and MWSS’s regulatory office created an environment in which public and private interests were able to improve the access to and quality of the city’s water system.

Ultimately, this public–private partnership was enormously successful. Today, Manila Water Company and Mayniland Water Company service 99 per cent and 97.8 per cent of their concession areas, respectively, and are operational 24 hours a day. In addition to improved coverage, the efficiency of the city’s water and sanitation has dramatically improved. While Manila’s experience with public–private partnerships was largely a major success, it did face challenges along the way. For example, the tariff formulas were determined inadequate and had to be restructured following the PPP agreement, and later on, financial difficulties with one of the concessionaries resulted in the government stepping in to provide funding in order to ensure the continued operation of water and sanitation services across the city. Nevertheless, this case provides a useful example of how private operators can improve the efficiency of public facilities and services while working in collaboration with government agencies and regulatory offices.

Case study
2
:
Landfill greenhouse gas emissions in Vancouver

29The City of Vancouver in British Columbia, Canada, owns and operates a large landfill site approximately 20 kilometres south of the city, which serves approximately one million people and receives over half a million tons of solid waste each year. The decomposition processes of solid waste sites such as this one produce large amounts of methane and carbon dioxide gas that contribute significantly to Vancouver’s green-house gas emissions. Initially, the city installed a landfill gas collection system in 1991 in order to control the environmental impact of the landfill. Then, in 2001, the city decided to delegate the responsibility of managing and operating the landfill’s greenhouse gas emissions to a private company that would transform the gas emissions into an energy source for the municipality. As part of the selection process, the municipal government requested that the private company selected be responsible for designing, building, operating, and financing the project. In 2002, Vancouver selected Maxim Power Corporation as its private sector counterpart for a co-gener-ation power plant at the landfill site, which was completed in November 2003.

Under the PPP agreement, Maxim Power built a 2.9 kilometre pipeline to transport gas from the landfill to a co-generation plant. The co-generation plant run off of the landfill’s gas emissions produces approximately 7.4 megawatts of electricity, which is then sold to the provincial energy provider BC Hydro. Any waste heat is recovered and used by Village Farms Greenhouses to produce vegetables, and further excess heat is also utilized directly in the provision of heating to the landfill’s administrative and maintenance buildings.

The city continues to maintain and operate the landfill site, which includes the management and operation of the gas collection facility. In this way, the government assumes the risk associated with gas supply, but avoids the initial capital investment required for the co-project. Maxim Power has invested approximately CAD10 million, and signed a purchase agreement with BC Hydro in addition to a 20-year agreement with the City of Vancouver. Maxim Power retains all proceeds from the sale of the power and thermal energy, with the exception of a 10 per cent royalty fee that is paid to the City of Vancouver. The city’s project costs and royalties are approximately CAD250,000 and CAD400,000 per year, respectively.

Vancouver’s partnership with Maxim Power confirms that innovation and efficiency gains are often triggered when private operators are introduced in the management and operation of public facilities and services. This case study also provides an example for other countries of how private companies can be incorporated into public sphere in innovative ways.