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NZ Treasury on PPPs

March 31st, 2006

The NZ Treasury has a paper looking at the advantages and disadvantages of Public-Private Partnerships (PPPs)*. The conclusions are almost exactly what I would have written myself.

This paper argues that:

* there are other ways of obtaining private sector finance without having to enter into a PPP
* most of the advantages of private sector construction and management can also be obtained from conventional procurement methods (under which the project is financed by the government, and construction and operation are contracted out separately), and
* the advantages of PPPs must be weighed against the contractual complexities and rigidities they entail. These are avoided by the periodic competitive re-tendering that is possible under conventional procurement.
The paper concludes that PPPs are worthwhile only if all three of the following conditions are met:

1. The public agency is able to specify outcomes in service level terms, thereby leaving scope for the PPP consortium to innovate and optimize.
2. The public agency is able to specify outcomes in a way that performance can be measured objectively and rewards and sanctions applied.
3. The public agency’s desired outcomes are likely to be durable, given the length of the contract.

The only thing missing is a discussion of the cost of capital. I’ve discussed this issue with NZ Treasury in other contexts, but I’m not sure where they would come out in relation to PPPs

* Acronyms are tricky things. In the post below, PPP means Purchasing Power Parity. And once upon a time, it meant Point-to-Point Protocol, which was used by modems.

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  1. March 31st, 2006 at 11:15 | #1

    Agreed entirely. PPPs are just a way for the politicians to weazel around the financing and delay having to pay for something. They tend to make little difference in the real world apart from giving more ways for the government to stuff something up.
    Essentially, (IMHO) it is much better to privatise whatever it is and leave the risks and benefits with those who know how to manage them.

  2. Terje
    March 31st, 2006 at 11:16 | #2

    Acronyms are tricky things. In the post below, PPP means Purchasing Power Parity. And once upon a time, it meant Point-to-Point Protocol, which was used by modems.

    I can assure you that PPP is still used with modems and in that context it still means “Point-to-Point Protocol”.

    looking at the advantages and disadvantages of Public-Private Partnerships (PPPs).

    In terms of private infastructure that was once public I would think that roads meet all the requirments you have outlined. The capacity of a road in terms of the traffic volume it must be able to handle can be objectively specified.

    When I look at the Cross City Tunnel fiasco in Sydney I wonder why the operator had to be given guarantees about surrounding roads. They should be prepared to wear the risk that the government (or some alternate operator licenced by the government) is mad enough to build a tunnel parallel to theirs. Plenty of private businesses build major pieces of infrastructure with no protection at all from such risks. For instance what guarantee do any of the mobile phone operators have that a new entrant won’t duplicate their infastructure and cut them to death on price?

    It is true that private roads probably need government input in terms of land acquisition (ie theft of property) however other than that they should be on their own in terms of price and dealing with competative threats. They should pay a fee for the privaledge of government assistance in much the same way as mobile phone operators must bid for government permission to use spectrum.

    The real problem with Public-Private Partnerships is the word “partner”. There are much better ways to describe such relationships. For instance we could refer to the parties involved as customers, suppliers and regulators. In principle I think it is wrong for governments to partner with the private sector. They should certainly get out of the way a lot more but that is a different matter.

    However there is no reason that roads should not be privately financed, built and maintained.

    The only thing missing is a discussion of the cost of capital.

    Governments only borrow cheaper because they can socialise the cost of failure. In general this is a cost shifting issue not a real net saving. The risk/cost of failure is just transfered to the taxpayer.

  3. Bill Posters
    March 31st, 2006 at 12:28 | #3

    When I look at the Cross City Tunnel fiasco in Sydney I wonder why the operator had to be given guarantees about surrounding roads. They should be prepared to wear the risk that the government (or some alternate operator licenced by the government) is mad enough to build a tunnel parallel to theirs. Plenty of private businesses build major pieces of infrastructure with no protection at all from such risks. For instance what guarantee do any of the mobile phone operators have that a new entrant won’t duplicate their infastructure and cut them to death on price?

    This is an interesting point. You would think so. In theory.

    In practice, although PPPs have shifted income (eg tolls) into private hands, risk has been retained in the public sector.

    This is one of the main things that makes them such a terrible deal in practice.

    Re the telephone example, you could draw an interesting parallel with the behaviour of Telstra over broadband rollout (demanding a regulatory climate that suits it etc).

  4. Peter Evans
    March 31st, 2006 at 13:01 | #4

    Terje, regarding your last point that the cost of failure for public borrowing is transferred to the taxpayer. That’s true, but isn’t it also the case for private business losses? Doesn’t the tax system precisely provide a significant buffer against losses made by companies and individuals (though maybe not to the same degree as for losses by publically owned entities)? After all, as far as business is concerned, Government has two uses. Risk mitigation through the tax system, and risk mitigation through legislative protection (government, after all, is just the legistaive arm of big business).

  5. smiths
    March 31st, 2006 at 13:20 | #5

    mr george monbiot has a lot of very good stories and case studies on this subject

    http://www.monbiot.com/archives/category/privatisation/

  6. wilful
    March 31st, 2006 at 13:38 | #6

    The only thing missing is a discussion of the cost of capital.

    Governments only borrow cheaper because they can socialise the cost of failure. In general this is a cost shifting issue not a real net saving. The risk/cost of failure is just transfered to the taxpayer.

    But governemtns can still borrow cheaper. And the actual risk of failure is no higher, so it makes sense and is a real net saving.

  7. Terje
    March 31st, 2006 at 13:50 | #7

    Re the telephone example, you could draw an interesting parallel with the behaviour of Telstra over broadband rollout (demanding a regulatory climate that suits it etc).

    I don’t think there is much parallel really. Telstra is not seeking to have regulations that stop competing infastructure. They are merely seeking to have control over the way in which they use infastructure that they pay for and build, just as most businesses do. They are looking to roll out a fibre customer access network, they are not suggesting that other businesses should not have that same freedom.

    Terje, regarding your last point that the cost of failure for public borrowing is transferred to the taxpayer. That’s true, but isn’t it also the case for private business losses?

    I don’t see how. The issue arises only because expences are tax deductable. The tax deductability of losses just means that you can in effect average the tax bill over several years.

    If there is any tax advantage at all it is with government owned entities and charities. They are allowed to retain 100% of profits for reinvestment whilst a private business can only keep 70%. Private businesses are placed at a disadvantage in terms of how they source capital.

    If a business fails then those that suffer are the creditors. Which is why people who lend money to businesses charge more interest typically than those people who lend money to governments.

    It is true that the ATO may be the creditor of a failed business but in general the ATO gets it 30% cut of any income in excess of expenses.

  8. Standard Deviant
    March 31st, 2006 at 17:45 | #8

    About the cost of capital: firstly, the yield on debt is not the same as the expected return on debt (cost of debt) (unless there in no default risk). Secondly, the cost of debt is not (generally) equal to the cost of capital. Terje is basically right. That the government’s debt is well backed doesn’t necessarily mean it’s more efficient for them to finance a given project. You could still argue that the government faces a lower external finance premium (i.e. reduces adverse selection problem), but I don’t think it’s that obvious that this is overly significant.

  9. jquiggin
    March 31st, 2006 at 19:55 | #9

    The cost of capital issue isn’t about default risk. It’s about the magnitude of the equity premium, which is too large to be explained (easily) in terms of systematic risk. More on this soon.

  10. Terje Petersen
    March 31st, 2006 at 21:24 | #10

    John,

    In my experience your “more on this soon” tends to be quite disappointing. I am still waiting to hear about:-

    1. Why we can cost Kyoto based on the protocol as it currently stands whilst focusing on the benefits that Kyoto Modified might one day deliver.

    2. Why larger class sizes in public education don’t imply higher demand for teachers and hence higher salaries if the supply curve is fixed.

    You don’t have to answer any of these questions however its a bit of a let down when you offer up some important point and then defer the explaination to some unspecified future date.

    Regards,
    Terje.

    P.S. I notice you get cited on this issue here:-

    http://en.wikipedia.org/wiki/Equity_premium_puzzle

  11. March 31st, 2006 at 22:41 | #11

    I’m sure Prof Bob Officer used to argue that the cost of capital wasn’t any different between .gov.au and the private firm. I’m sure he used a graph or two, a curve even tho it was a straight line, and a formula and possibly even a slight of hand to prove that gov couldn’t get $ any cheaper than anyone else. The main risk transfered in PPPs is industrial risk. Unions can’t easily target .gov directly.

  12. jquiggin
    April 1st, 2006 at 15:58 | #12

    Terje, in this case, the “More soon” is what is in the Wikipedia link – I just didn’t have time to locate the link. FXH, this includes counterarguments to Bob Officer, whom I’ve debate on this many times.

    On the others, I think I’ve already answered the Kyoto point several times, to summarise: Necessary first step. If you don’t like that answer, raise it next time I post on Kyoto.

    On the class sizes issue, it’s still coming Real Soon Now. Remind me again some time.

  13. Jonno
    April 1st, 2006 at 18:17 | #13

    The tide appears to be finally turning – UK Treasury apparently is also starting to have its doubts
    (http://society.guardian.co.uk/privatefinance/story/0,,1736456,00.html)
    (Australia is still to follow it appears).

    It is a nice case study in how long a fashion lasts. It looks like it will be about 15 years from point where ideology ruled and PPP was the only way a large project would be funded to when PPPs become just another tool in the public sector amoury for use when appropriate.

    Spare a thought for public servants who are going to have to try and negotiate every variation to these contracts over their long life from such a weak position.

  14. Derick Cullen
    April 2nd, 2006 at 16:56 | #14

    We seem to do PPPs every couple of weeks.

    I think we arrived at the following last round, at least for Australian PPPs

    1. Most involve an asset (or franchise) sale with deferred delivery of proceeds. Perhaps one thing to add is that usually these sales are not undertaken in an open market (an auction or tender for example) but are negotiated trade sales, whose terms and conditions are subject to commercial_in_confidence secrecy.

    2. Most involve some sort of cost shifting from states to Commonwealth in that there is a tax angle for the private sector participants which is not available to the state public sector. As a result there are few (no?) Commonwealth PPPs, and perhaps why the NZ Treasury can be less enthusiastic about them, than say NSW Treasury

    3. The political risk remains with the public sector. (e.g. cross city tunnel)

    4. The commercial risk is often found (too late) to remain with the public sector (e.g. Spencer St station).

    5. They are entered into through (possibly misguided) notions that public sector debt is “bad”, as reflected in ratings agency ratings of sovereign debt, and inadequate accounting measures. Whilst they are structured legally not to look like debt they are functionally equivalent to public sector debt.

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