Public-Private Partnerships: Canadian Case Studies

 

Public-Private Partnerships – From Taxpayers to Markets

Marty Thurston

     Public-private partnerships are not new, but have been used more frequently to manage the pressures for infrastructure renewal.  By drawing on three Canadian case studies, I will discuss the potential for net public benefits as they relate to the administrative function of these partnerships.  Transferring a project to the private-sector also implies transferring the appropriate risk and incentives to each party, which is more complex but essential to avoid fatal complications to the project.  In this respect, contracting is a very persistent issue in the P3 literature.

Basic Project Tasks:

  1. define and design the project
  2. financing the capital costs of the project
  3. building the physical assets (road, bridge, etc.)
  4. operating and maintaining the assets in order to deliver the product/service

 

     P3s typically vary depending on who is responsible for the allocation of the above tasks.  When governments allocate any one of the above tasks to the private sector, there is a good chance you are looking at either a P3 or other form of contracting-out.  On one end of the spectrum, and perhaps the most common, each of the four tasks are allocated primarily to the private-sector and free markets.  In these cases the role of the government may only be in the administration of “framework law”, responsible for tuning the partnership to perform well under market conditions. (Bettignies and Ross, 137)  Similarly, there can be primarily government-operated partnerships as well with fringe market potential. The classic example is garbage collection, where services are subcontracted, and the private-sector incentive is limited to supplying and servicing trucks and equipment. 

     Social interference can sometimes play a role in the type of partnerships government will create.  Healthcare and education are good examples of services where accessibility is prioritized over maximized quality.  As a definition of P3s with respect to the spectrum between public and private involvement, “P3s lie somewhere between simple contracting-out and a fully private market.  The more private relative to public involvement, the more ‘private’ the public-private partnership. (138) 

     Education has specific appeal for moving in the direction of partnerships because the process of building and maintaining schools is straightforward enough to avoid extenuating complications between parties.  To some degree, the same can be said for healthcare.  “Alberta, British Columbia, and Ontario are already developing partnership initiatives to bring new facilities into service, one proposed approach is to create multi-use, health-oriented facilities to generate private revenue streams that will help finance initial capital costs.” (Poschman, 27)

     There are a few important factors that have a tendency to make contracting-out negotiations successful by way of either cutting costs or providing better quality services to the public: ex ante competition, high-powered incentives, optimal risk allocation, and scale economies. (Bettignies and Ross, 139)  P3s are usually an easy answer because there is the relative security of a long-term contract, however, when there is a complex or uncertain exchange environment for the procurement of public services, long-term contracts are not usually optimal.  Instead, vertical integration is a method by which contract re-negotiation can be avoided and ex post inefficiencies might be remedied.

     Contracting-out will allocate the provision of services to a specific provider for a pre-designated period of time.  This eliminates the competition to provide that service in the market.  However, it does not eliminate competition for that market.  A bidding process of choosing a provider can reduce the costs of competition and allow providers to offer lower prices, and be more innovative in the process.  This however, assumes that bidder interest is high enough.

 

     “The private sector is generally regarded as having a greater ability to deliver more innovative products more quickly, with more flexibility, and at a lower cost thanks to its access to higher-powered incentives.” (B&R, 139) Allocation of risk can be made more efficient by allocating certain kinds of risk to certain parties. Ideally a party should only be exposed to as much risk as they can realistically manage.  It is also important to note that risk is not purely exogenous, that is, risk is also presumed by certain parties.  This illustrates the importance of the private-sector because a higher level of presumed risk means that companies will take steps to ensure compliance with regulations and quality controls.

     The principle-agent problem emerges when are monitoring problems because of either technical complexity or uncertainty.  Since the government has a difficult time evaluating the merit of a subcontractor’s costs, it can be beneficial to give the agent a share in the process, and offer performance-related incentives to smarter budgeting.  “Because the heightened uncertainty makes it more expensive to use incentive-based compensation, where risk is high we should expect to find few incentive-based arguments.” (Poschmann, 17)  By giving operators a share in potential rewards, those operators will adopt an incentive to manage the company with maximum efficiencies.

     Scale economies are another reason why contracting-out can be particularly beneficial for governments.  “Governments typically do not have enough work to generate the volumes of business needed to allow a full-service construction company to get unit costs down to their minimum.” (B&R, 139) The balance here lies within internal and external provisions of the service.  Internal provision may be optimal unless the volume of business required by the buyer exceeds their capacity, in which case, a market approach will be usually end up being advantageous.

     Ex post inefficiencies primarily refer to the idea that once negotiations are underway, it is mutually beneficial for all parties to continue to work together rather than start over with new partners.  Once the initial investment has been made, complications to their contract can sometimes create tension between parties.  P3s are usually created under conditions where complex or uncertain factors are not considered to be foreseeable.  Where long-term contracts are infeasible, it might be a better idea to assign multiple tasks to one party, so as to avoid the costs that would arise out of bargaining between parties.  Bettignies and Ross consider this the public provision scenario.

Funding

     No matter how they are financed, any P3 must ultimately be paid for by either the government or the system’s users, and this is part of the reason why P3s are so popular from a political perspective.  “By using a P3, government can spread its cost obligations over a longer time period.” (Vining and Boardman, 4)  This has most to do with the timing of payments which can sometimes be favourable for politicians.  In effect, politicians are more than willing to provide any services necessary, so long as the cost of those programs does not end up in their budget.

Transaction Costs

     Concerning infrastructure projects that develop into P3s, it is very important to look at transaction costs.  These costs can ultimately be responsible for the success or failure of any given P3, and they are likely to be higher under three scenarios.  “Transaction cost theory suggests that contracting costs are likely to be raised when projects exhibit high asset specificity, high complexity/uncertainty and low competitiveness.” (Vining and Boardman (12) It is argued that this is particularly true for public infrastructure projects such as roads or bridges, as these designs are unique for each project.  Knowledge and technique may be passed along to other projects the physical design is usually tailored to a specific project.  In addition, unique P3s may raise questions about the feasibility of future usage/user fees.  Ultimately, transaction costs are usually dependent on the government’s aptitude for writing contracts.  If management skills are up to par, government should be able to anticipate contracting problems and work around them before the ink has dried on the contract.

Empirical Data / Case Studies

     The case studies of the Alberta Special Waste Management System (ASWMS), ConfederationBridge, and Highway 407 will provide a glimpse of how effective these P3s have been on a provincial and federal scale.

     ASWMS emerged in 1987 as a waste-treatment facility in Swan Hills, Alberta.  BOVAR Inc was the private firm that would own 60% of the project.  “Under the agreement, BOVAR received a guaranteed minimum return on capital of 3% over the current prime rate, depreciated at 10% per year for 10 years.” (Vining and Boardman, 14)  Alberta adopted this project because it was argued that the private sector would be able to build and operated the plant more efficiently, subsequently it was also recognized that the plant would not be commercially successful without large government subsidies.  The agreement was modified shortly after to accommodate for a capacity expansion which, as Mintz described was more costly to the government than expected.  “The parties later modified the agreement to permit a large capacity expansion.  Partly as a result of this expansion, the subsidy turned out to be considerably larger than expected – approximately $445 million in total between 1986 and 1995.” (ibid, 15)

     Another factor that has been attributed to the relative failure of ASWMS is that in 1997, the Americans lifted a ban on accepting a particular kind of waste that Swan Hills would accept, creating serious competition for Canada’s lone hazardous waste-management plant.  This is considered a residual value risk, because the lifting of the American ban significantly influenced the demand for services provided by ASWMS. Finally, the majority of any documented success in Swan Hills was largely due to the huge capital investments from the government, which was a 40% shareholder.  “More succinctly, the activity was important enough to government that it wanted it to happen even if a subsidy was required.” (Poschmann, 9)  It took until turn of the millennium to realize the project had not been turning profits; instead, it was being floated by the government.  “The flaw stems from a guaranteed rate of return that was set too high.  This ensured that whatever amount of capital the private partner chose to invest, the cost to taxpayers would be excessive.  It provided an incentive for the private partner to overcapitalize the project and it gave the private partner no compelling reason to monitor costs incurred by the plant operator. (Poschmann, 10)

     These factors together have the effect of distorting any potential for increased efficiency to the P3, and the case study of Swan Hills should be considered a failure.  On a more positive note, the ConfederationBridge in PEI is an example in which P3s can effectively reduce costs and efficiently deliver the service in a timely manner.

 

     In 1988, a fixed link was given the go-ahead connecting PEI to the mainland.  The federal government opened up the bridge project for bids from private consortiums.  Strait Crossing Development Inc. (SCDI) won the bid and the partnership was intended to be a BOT P3 where SCDI would build, operate, and then over thirty-five years, transfer the service back to the federal government.  One incentive to SCDI was that the government “provided an annual $13.9 million revenue guarantee and agreed to bear a number of the residual risks.” (Vining and Boardman, 16)  Funding for the bridge came via a special purpose vehicle of New Brunswick, the Strait Crossing Financing Inc.  The bonds sold by this SPV were also guaranteed by the federal government.  The final outcome was that a functioning bridge was constructed on schedule.  This alone might make this P3 a success but Vining and Boardman subsquently note that there were significant financing costs, namely, “the bonds were sold at a 4.5% interest rate, at a time when similar federal issues were priced at 4.1%.  SCFI also paid a sales commission of 1.75%, compared to a rate of 0.6% for federal real return bonds.” (ibid, 17)  They argue that because the bonds were guaranteed by the federal government, there was no real reduction in exposure to risk.  A P3 must not only create and deliver an asset, but in this case, SCDI needed to show that they were still being cost-effective, in spite of higher interest, commission, and borrowing rates.

     The Highway 407 Express Toll Route is a section of highway in Toronto North, proposed in 1993.  An Ontario recession was a major driving factor the proposed toll road, but the proposal was not as lucrative as the private-sector had hoped.  “The private partner would be remunerated from toll revenues, but neither traffic levels nor toll revenues were guaranteed. These government guarantees are usually intended to offset the increased fiscal risk to the private operator.  Consequently, the private partner was financially exposed to the operating risk.” (Vining and Boardman, 17) A main problem emerged because private consortiums bidding on the project were unwilling to take on the full burden of risk including financing, construction, and operating risks, especially considering the fact that there was no guarantee on toll revenues from the federal government.  This demonstrates the relative complexity of the request for proposals (RFP) process.  Poschmann elaborates on these complexities:

“The reason is that under the request for proposals approach, the potential longevity of the project and the uncertain future demands on the contracting parties introduce an element of partnership between them.  The outside contractor, who may have to agree to fixed terms for continuing maintenance and upgrade, for example, effectively takes on some part of the financial risk of the project. (6) 

 

     Another red flag for the 407 project was the assumption that an RFP bidding process would encourage many bidders to assemble, and a winner to be chosen among them.  However, if there is a small amount of potential bidders, (as was the case for RFP 407) there is less likelihood that the winning bidder will be considered the best-of-the-best.  “The fact that the RFP focused on ends rather than means made that problem bigger, because the bids were quite different and therefore hard to score against each other on a value-for-money criterion.” (Poschmann, 17)

     After repeated toll increases over a number of years, usage of the 407 decreased significantly which led to increased traffic-flow on secondary roads. This is a demonstration of performance risk, because in order to ensure continuity in provision of services, the tolls had to be increased.  People started using the highway less, and much of the discontent led right back to the government. In response, “the consortium agreed to implement a $40 million ‘customer-benefit program’, reducing tolls by up to 15% for 100,000 frequent users over the next four years, and providing discounts for truck drivers during evening and weekends.  In exchange, the government withdrew its demand for a toll rate rollback. (Vining and Boardman, 19)  The project construction aspect of this agreement went through in a relatively trouble-free manner, but there were some issues arising from the government’s ability to effectively transfer financing risks.  In this case-study it was not surprising that the private partner had more interest in profit potential than the effective flow of people and their cargo across Toronto.  Even though construction was completed in a timely fashion, the province ended up retaining the finance risk on the highway construction, and afterwards sold the operations to a private operator.  “This order of events made the project more like a privatization of a public asset than an asset constructed in partnership. (Poschmann, 19)

Theory behind Successful P3s

     Minassian, with the International Monetary Fund, released a report outlining the ideal preconditions for the development of successful P3s.  “PPPs would be well suited to 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 government can then enter into a contract with the private sector which links service payments to monitorable service delivery. (11) With respect to ASWMS, the government failed to efficiently translate the output indicators required to get an accurate projection of project revenues.  With respect to Highway 407, the government had difficulty linking service payments to monitorable service delivery because they failed to acknowledge the private partners need to substantially raise tolls.  P3s are ideally suited for projects where the services being delivered are not expected to radically change.

Risk

 

P3 risks can be grouped into five semi-overlapping branches:

(Minassian, 11-12)

 

  1. Construction risk

-         These risks can include design problems, building cost overruns, project delays, etc.

  1. Financial risk

-         Mostly concerns variability in interest rates, exchange rates, and other financial risks

  1. Performance risk

-         Referring to the availability of an asset and continued quality of service

  1. Demand risk

-         How strong is the demand for services, and can quality of services be justified

  1. Residual value risk

-         How will the future market price of an asset affect operations of the P3?

 

     This speaks to the efficiency of a P3. Generally project risk is transferred from the public to the private sector, but this has very much to do with whether one thinks that the private-sector is better capable of managing risk than the public-sector.  The argument is strong on both sides because some would argue that governments have an easier time managing debt because they can spread it out over a larger base (taxpayers).  Also, the private sector usually has to pay much more in borrowing costs simply because the government is far less likely to default on their debt.

     The other side of the coin is that while governments can spread risk over the public, the private sector can do much the same over financial markets, and is usually better at it than government officials are.  “Then the key issue is whether PPPs result in efficiency gains that more than offset higher private sector borrowing costs.” (Minassian, 12)

     Risk-pricing is a term used to describe how much governments are willing to pay private firms to assume the greater deals of risk that come in a P3.  This is not to say that governments take full responsibility for all risks.  Project-specific risks do not have to be priced by the government because there are certain risks that fall outside of anyone’s control. The point here is that governments risk-price on market risk, “which reflects underlying economic developments that affect all projects, is not diversifiable and therefore has to be properly priced. (Minassian, 13)

     Contractual obligations in P3s are usually so complex that even measuring a few risk factors can be very difficult.  Minassian claims that making the fiscal consequences of P3s fully transparent is the best way to work alongside a complicated legal obligations.  “Contracts should be disclosed, and simplifications and standards should be sought.” (28-29)  This would also imply disclosing government guarantees and future contract payments.

     Traditionally, successful P3s in Canada have followed the build-operate-transfer scheme, and for the purposes of this paper, the BOT may not be a textbook P3 because there is not a significant degree of risk-transfer to the operators in terms of revenue risk.  This was the case for the ConfederationBridge in PEI.  In most cases, it is questionable whether the private operator should be responsible for project operations.

     Public-Private Partnerships, as they apply to Canada have proved to have potential net benefits.  One of the main tasks in securing these benefits is to observe the P3 as a partnership entity rather than one of competing interests.  If government opposition or, more importantly public perception tends to view the partnership as a for-profit scheme, P3s could become seriously endangered.  Likewise, P3s should be applied sparingly, ideally suited for classic build-operate-transfer projects.  Operating and financing the project carries more significant risks that the private-sector is often unwilling or unable to assume.  Accountability and transparency are also present in any successful P3 project. Legitimizing the partnership, be it through sound written contracts, risk allocation, or sheer cost effectiveness; is essential to bring the public on-side and observe any real net benefits to public procurement.


References

 

 

Aidan R. Vining and Anthony E. Boardman (2008), “Public-private partnerships in Canada: Theory and Evidence”, Canadian Public Administration 51:1 (March), 9-44; online at:

http://0-web.ebscohost.com.darius.uleth.ca/ehost/results?vid=2&hid=8&sid=01060c88-e045-4be6-8f87-65a5b7227eb5%40sessionmgr7

 

Jean-Etienne De Bettignies and Thomas W. Ross (2004) The Economics of Public-Private Partnerships. www.carleton.ca/spa/News%20and%20Events/Ross-public-private.pdf

 

INTERNATIONAL MONETARY FUND Public-Private Partnerships. Prepared by the Fiscal Affairs Department (In consultation with other departments, the World Bank,

and the Inter-American Development Bank)

Teresa Ter-Minassian. March 12, 2004 -  www.imf.org/external/np/fad/2004/pifp/eng/031204.pdf

 

Poschmann, Finn (2003),“Private Means to Public Ends: The Future of Public-Private Partnerships”. C.D. Howe Institute Commentary (June)

 

 

 

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