Public-private partnerships (also referred to as P3s or PPPs) are perhaps one of the most unnecessarily controversial topics when it comes to infrastructure. This is partially due to the unitiated not understanding that this term refers to a variety of arrangements and not just one. There is also a lack of care on the part of public officials to explain how these arrangements can be constructed well or poorly.

Practically speaking, a public-private partnership is a contractual arrangement between a governmental entity and a private firm to design, construct, operate, and maintain an infrastructure asset over some established period of time. At the end of this period, the responsibility to operate and maintain the asset reverts back to the government. The government typically maintains ownership of the asset during the whole process.

Philosophically speaking, a public-private partnership is a means for governments and the private sector to share the risks and rewards associated with infrastructure investment. The risks these counterparties are comfortable assuming and the rewards they seek will determine the specific terms of the contractual agreement.

Availability vs Demand Risk Models

One of the best discussions of the types of public-private partnerships that I have seen is in Moody’s Investors Service’s report, The Global P3 Landscape (September 8, 2014 — research subscription required). Please forgive me for quoting heavily from this report below.

There are broadly two types of public-private partnerships: availability and demand risk. Not unlike the types of municipal bonds I described in an earlier post, these categories reflect the source of the payments that a private investor receives from an asset. The risks associated with these approaches vary with different phases in the project cycle.

Moody’s:

What are availability payments? Once an asset is built to the specifications required by the government and the government accepts the project, the private developer is entitled to payments from the government as long as the asset is made available to the public at the standard required by the government. Availability payments are sized to cover operating and maintenance costs as well as debt service costs and equity returns.

Also important, availability payments are not subject to swings in demand, such as traffic levels in the case of toll roads, for example, and are adjusted only for lack of performance or availability to the public. The payments are usually subject to annual appropriation by the sponsoring government.

P3 availability-payment projects carry higher risk in the early years of construction, usually commensurate with Baa-level credit risk. They carry lower risk when the project reaches a steady state of operation, in line with A-level credit risk.

This would put the projects on par with many local governments credit-wise.

Moody’s:

What is demand risk? In this model, the government grants the private developer the right to collect fees from the public for the use of a road, a bridge, a subway, an airport. This right is sometimes called a concession, since the government is conceding the asset to the developer for a defined period. The private developer takes on revenue risk under this fee-for-service model, because it relies on fees for use of the asset to pay for operations and to pay back debt issued to build the asset.

One of the advantages to the government of using the demand risk model is that the developer has more of an incentive to complete the project on time or ahead of schedule. This is because the developer will not start collecting revenues until the project is operational. The availability model provides no such incentive because the payments the developer is to receive from the government have been predetermined. The ability to push off construction risk to the developer is a major advantage, since completing a project on time is one of the largest risks associated with a project in terms of cost overruns.

Another consideration of using the availability model is its potential credit impact. Some argue that availability payments could be construed as a form of debt because they involve a contractually obligated stream of payments.

Prevalence

The use of these models differs geographically. Almost all of the public-private partnerships in the United Kingdom and Canada use the availability model. Latin American projects mostly use the demand risk model. Both types can be found in the United States and Europe.

This can partially be explained by the kinds of projects involved. Some projects, like transportation infrastructure, can work well with a demand risk structure. Others, like social infrastructure (hospitals, school buildings, etc.), may only work with the availability model.

By Moody’s classifications, the United Kingdom, Canada, Australia, India, and Chile have mature markets for public-private partnerships. The United States, Brazil, Peru, Mexico, and Colombia are considered to have expanding markets for public-private partnerships.

The UK has the most expansive market for public-private partnerships globally. The UK began using public-private partnerships in the 1990s with roads and hospitals, and then moved on to schools and waste projects.

According to Moody’s, “More than 725 projects [in the UK] have reached financial close since the 1990s, one of the highest numbers in the world … Excluding the UK, Europe had over 500 new and primarily availability-payment P3s reached financial close from 2002–13 … Just over half of these projects are in Spain and France.”

Canada has the most mature public-private partnership market in North America and primarily uses the availability model. Mexico primarily uses the demand risk model.

Why Doesn't the United States Have a Mature P3 Market?

The United States has been late to the game. Moody’s:

Many US states have yet to authorize the use of P3s for transportation projects, the classic beginner market for P3s. Virginia, Florida, Texas, Indiana and Colorado are leading the charge, while P3 authorizing legislation has failed in New York and Kentucky. That said, the momentum of states authorizing the use of the P3 model has notably increased over the past five years: 33 states and Puerto Rico have P3 authorizing legislation for transportation projects, and 39 states have some form of P3 authorizing legislation, either for transportation or social infrastructure projects.

There are a number of reasons the United States does not have a mature market for public-private partnerships, although this is in the process of changing.

First, the United States has a long tradition of funding projects through the public sector as opposed to the private sector. Although there were toll roads even in the 18th century, the bias has been strongly in the other direction.

(For an excellent discussion of how the public versus private debate played out when the United States itself was considered an emerging market, I would recommend Carl Smith’s book, City Water, City Life: Water and the Infrastructure of Ideas from University of Chicago Press.)

Although this bias may be unconscious, I suspect it contributes to the negative press public-private partnerships often receive and the media and other observers’ general unwillingness to study the mechanics of risk transfer in these projects. The Indiana Toll Road is an excellent example of what I am talking about here.

Second, unlike the rest of the world, the United States has a multi-trillion-dollar municipal bond market. State and local governments can borrow with a relatively low cost of capital. State and local governments are limited in their capacity to borrow, however, as the revenues used to support these projects are crowded out by other political priorities, such as pensions, health care, and education. This is the major driving force behind governments seeking private investment.

Third, the United States has approached authorizing public-private partnerships in an ad hoc manner when other countries have standardized procurement processes and contracts.

It is also worth noting that there is a traditional preference for design-bid-build project delivery versus design-build project delivery models at the state and local levels. For states to incorporate public-private partnerships into their programs, they would have to become comfortable with design-build delivery models.

Advantages of Public-Private Partnerships

So far, I have focused on risk and risk transfer in public-private partnerships. Now let’s talk about why they might be a compelling component in a capital construction program.

One thing I have always found interesting about opponents of public-private partnerships is that they tend to portray project risks as one-sided. They fixate on the risks associated with public-private partnerships and neglect to mention that there are risks associated with traditional procurement methods.

One risk is that the public sector (smaller governmental entities especially) is not aware of the latest innovations.

From Patrick Sabol and Robert Puentes’s paper, Private Capital, Public Good: Drivers of Successful Infrastructure Public-Partnerships:

While the public sector brings significant expertise to projects; many private sector firms have access to technologies, materials, and management techniques that exceed the capabilities of an individual governmental agency or department. PPPs are one way to harness the ideas and breadth of experience the private sector brings to projects by fully incorporating them into the procurement process.

Public and private sector collaboration from the outset of an infrastructure project, whether greenfield or brownfield, can lead to a number of innovations. These can come in the form of new materials, faster project delivery, increased use of technology, operational efficiencies, or enhanced building techniques. An open PPP procurement process, at minimum, provides the possibility for new ideas that the public sector may have never considered.

Another risk is traditional methods offer limited control over the pace of construction. The increased costs associated with project delays and blown budgets are a good reason to differentiate between up-front costs and value for money:

PPPs are rarely the lowest-cost way to procure infrastructure for several reasons. For one, the transaction costs for PPPs are usually higher than traditional bid-build contracts, which average around 10 percent of the entire value of the project. Plus, private sector borrowing costs are generally higher than those available to the public sector, as governments are able to access the tax-exempt municipal bond market. Despite these limitations, a well-structured PPP can deliver better value for the public dollar. This value can be derived in a number of ways.

Driven by the need to deliver profit to investors and shareholders, the private sector is less tolerant of cost overruns and project delays than the public sector. Therefore, transferring construction, operational, and/or demand risk to the private sector can result in quantifiable savings for the public sector, as taxpayers and ratepayers do not bear the costs if the project takes longer than expected to complete, goes over budget, or underperforms. The company or consortium that assumes responsibility for the infrastructure asset may also opt to invest in more durable materials or efficient technologies that drive down lifecycle costs. These might not be the cheapest options in the short term, but they do have the potential to drive savings over the long term through decreased energy usage, lower maintenance costs, or enhanced resiliency.

These are all important considerations because the kinds of assets we are talking about have long useful lives.

The fact that developers are profit-driven and have to answer to shareholders also reduces or eliminates the potential for corruption. Although true financial distress is rare for state and local governments, when it does occur it is usually attributable to fraud and incompetent managment. Jefferson County, Alabama, and Harrisburg, Pennsylvania, were both left insolvent due to corruption in undertaking and financing major construction projects.

State and local governments also tend to cut capital investment following recessions. This has the effect of reducing the useful life of existing infrastructure. Having a private entity handling operations and maintenance for an asset insulates it from particularly lean budget cycles.

Furthermore, public-private partnerships provide an opportunity for governments to spin off the responsibility of operating and maintaining facilities that are auxiliary (as opposed to essential) government functions. Some examples would include housing and dining, athletic, and recreational facilities at public universities; parking lots and garages; and publicly owned water and electric utilities. These operations are perhaps already better suited for the private sector and can divert scarce resources from government budgets.

In my next installment, I will propose ways to expand the market for infrastructure in the United States.