Evaluation of Public Sector Contributions to Public-Private Partnership Projects
Part of Toolkit for the Economic Evaluation of World Bank Transport Projects
(Institute for Transport Studies, University of Leeds, 2003)
The World Bank’s Toolkit on Public-Private Options for highways (World Bank, 2001, [[1]] [http://www.ppiaf.org/toolkits/ppphighways/index.htm]) describes a Public-Private Partnership (PPP) as a sustained collaborative effort between the public sector and private enterprises to achieve a common objective – for example, a road infrastructure project – while they pursue their own individual interests. In a PPP each partner:
- shares in the design of the project;
- contributes a portion of the financial, managerial and technical resources needed to build and sometimes operate the project in accordance with each partner's comparative advantage, and;
- bears a share of the risks associated with the project and obtains a share of the benefits that the project creates.
The efficient design of PPP projects, the sources of benefits and costs, the incentive structure, risk allocation mechanisms and the basis for comparison with conventional public sector procurement are discussed in a very large international literature, to which the World Bank has contributed. Examples of the PPP experience in transport, including roads, railways and ports, can be found in World Bank publications Silva (2000) [[2]], Galenson and Thompson (1993) [[3]] and Peters (1995) [[4]].
For PPP projects, as for conventional public sector projects, it is usual to produce an economic appraisal which conforms to the principles set out in the Framework [Link]. But for PPPs there is a further question:
“what is the basis for
determining the appropriate financial contribution from the public sector”?
The Bank requires that any public sector contribution to a
PPP project be analysed and justified in economic terms. This Note will set out
the basis on which such an analysis could be made and the case presented.
1 PRINCIPLES for a public sector contribution
The general principles underlying the analysis are the following:
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General principles: (i) public contributions to PPP projects should be justified on the basis of external benefits from the project, compared with the scenario where no public contribution is made. (ii) these external benefits are benefits for the wider economy or society which will arise from the project, but which will not be appropriated by the private partner in the contract; (iii)
by implication, the social welfare gain must be greater than the amount of
public money invested multiplied by
the cost of public funds: WPC – WNPC ≥ CP * MCPF We will go on to explain all of these
principles and translate them into practical method. Note that these
principles imply that two or more scenarios may need to be considered for
comparison against the PPP project - a scenario in which the project proceeds but with different design, capacity or pricing from the original PPP project; - a scenario in which the project does not proceed in the absence of the public contribution. |
In practice, a range of different reasons can be – and have been – put forward to explain public contributions to PPP projects, including the following:
- to pay for positive externalities, such as decongestion or improvements in environmental quality;
- to contribute to the cost of mitigating negative externalities, which private providers often have little incentive to take into account when designing the project;
- to secure network improvements necessary for economic development or other planning benefits, for which users are in the short term unable to pay.
These are considered one by one in Sections 2, 3 and 4.
2 CONTRIBUTIONs to obtain positive externalities
Decongestion
When a new transport link is introduced into the network, one of the effects it may have is a decongestion effect on competing links. In economic terms, these competing links are substitutes, although perhaps imperfect ones, for the new link. Typical examples include: the old primary road, when a new interurban highway is built; or traffic on street, when a metro is constructed. Congestion on these competing links is often part of the motivation for providing the project in the first place. And once the project is operational, there are often quantifiable benefits to users of these competing links, in the form of decongestion. A key component of decongestion benefits is usually travel time savings. Another common component is a reduction in vehicle operating costs. Both can be evaluated in the same way as any other time or cost savings in transport appraisal, using the rule-of-a-half (see Framework [Link] and Note Treatment of Induced Traffic [Link]).
figure 1: Decongestion in a network
Unless the private sector partner is given control over the competing links as well, and the power to raise revenue from them, they will not be in a position to appropriate these decongestion benefits. What, then, should the public authority do?
If the project is financially sustainable for the private partner anyway, then the external decongestion benefits are not an issue. The private partner will secure their reward, and the citizens will take the decongestion benefit. There is no need for a public sector contribution.
However, if the project is marginal for the private partner, there may be a case for the public authority to contribute in respect of decongestion benefits provided. In this case, the relevant economic analysis is:
- an assessment of the total decongestion benefits on competing links, based on the usual transport appraisal principles and method;
- an assessment of the social opportunity cost of the proposed public sector contribution;
- a comparison, through the usual NPV and IRR procedures of the benefits against the costs of the public contribution (see Note When and How to Use NPV, IRR and Adjusted IRR [Link]).
Environmental Quality
Improvements
Another category of potential benefits external to the project is environmental quality improvements. Two common investments are:
- bypasses. There may be significant gains in environmental quality in a settlement when facilities are built to take through traffic away from it on a bypass. These benefits are measurable: noise, air quality and severance are all key indicators and the World Bank’s guidance on environmental assessment shows how to predict them.
- low-emission public transport in cities. Electric light rail, metro, even heavy rail, and low-emission buses can all contribute to reducing emissions and improving air quality in cities.
As discussed in the Note Treatment of Environmental Impacts [Link] these benefits, whilst measurable, are not always monetised in appraisals for a variety of reasons. In the case that they are not monetised, the approach should be to: set out clearly the benefits in quantitative terms; and calculate the opportunity cost of the public contribution (see Section 5). This will enable the cost-effectiveness of the public contribution to be assessed (see Note Where to Use Cost Effectiveness Techniques Rather than Cost Benefit Analysis [Link]).
As with decongestion, there should be no presumption that public sector contributions are needed. The aim of the analysis should be to establish what additional benefits the contribution secures, over a scenario without the contribution.
3 CONTRIBUTIONs to Mitigate negative externalities
For some projects, governments do agree to meet the cost of mitigating potential environmental externalities. By mitigation, we mean for example: noise barriers to minimise the effect of transport links on adjacent settlements, measures to minimise the severance effects of new infrastructure, and measures to compensate in kind for any damage to ecology – for example, by creating replacement habitats away from the new transport facility.
Public authorities need to be very aware of the incentive effects of such offers, on the private providers of schemes. For example, if a public authority states its intention to meet the additional costs of environmental mitigation, a principal-agent problem arises, because a lot of the variables which determine the size of environmental mitigation costs are in the hands of the private provider. For example, there may be an incentive to run the scheme closer to sensitive areas if that reduces the cost to the provider for a given level of revenue, whilst incidentally raising the cost of the scheme to the public purse Baumol and Oates (1988) [[5]].
Many countries deal with this by controlling environmental impact not through state-funded mitigation, but through environmental impact regulations with legal status. The incentives are then internalised within the private provider to find the lowest cost (or most profitable) way of delivering the project without infringing the agreed standards.
The latter may be a more efficient way of proceeding, from the country’s point of view. Any appraisal of the alternatives should consider:
- the extent to which the aims of environmental protection are met;
- the cost to the public sector budget (see Section 5).
4 contributions TO compensate private partners for users’ inability to pay
A further possible basis for public contribution is that a project may create wider economic impacts at the regional or national level which cannot be internalised by the private partner. Caution against accepting such arguments uncritically should be exercised (see the SACTRA (1999) [[6]] for a comprehensive review). However, where the case for wider economic impacts additional to the user and operator benefits is sustained, it may be that charging full commercial tolls for the use of the facility in the early years (before incomes have risen) risks jeopardising that growth - and the use of the facility.
The Hungarian M1 and M5 ‘motorway cross’ is an example of this phenomenon in action. The citizens’ ability to pay was not high enough to meet the tolls on the new roads, so long-distance traffic continued to use the conventional road network, whilst the motorways operated far below capacity – and 45% lower than forecasts – with serious financial implications for the concessionaire (see Silva (2000) [2]).
The underlying problem concerns the time profile of the costs vs. that of the benefits. The government regards the project as a ‘necessary’ condition for growth of the economy in the medium to long term. Meanwhile, the private investor wishes to see their commercial return over a short to medium term horizon. In effect, the government may find itself wishing to subsidise provision of the infrastructure in the short term in order to secure a longer term gain in productivity and GDP per capita.
Deferment of the project should of course be considered (see Note When and How to Use NPV, IRR and Adjusted IRR [Link]). But if there is no case for this, then the government may want to consider – and appraise – a public sector contribution.
In this case, it might be an explicit part of the contract that the state will taper the subsidy away to zero over a stated period, say 10 years.
Figure 2: Compensating the provider for users’ short-term inability to pay
In making the case for public contributions, the essential steps are:
- to consider the alternatives, including: allowing the private partner to raise revenue from the existing network in the early years to improve their cash flow [see (see Silva (2000) [2]); scaling down the project to a lower-cost solution; postponing the project until demand has grown sufficiently; or removing any constraints on commercial pricing of the new facility.
IF those are shown to be ineffective in meeting the country’s development needs, then proceed:
- to set out the demand forecasts for the alternative toll/pricing scenarios in the early years;
- to calculate the corresponding consumer surplus benefits for users in each scenario;
- to determine the Marginal Cost of Public Funds (MCPF) for the country concerned World Bank (1998) [[7]], and use this to estimate the opportunity cost of the public contribution;
- to carry out an incremental IRR calculation (see Note When and How to Use NPV, IRR and Adjusted IRR [Link]) including the additional user benefits in the scenario ‘with public contribution’ versus ‘without public contribution’, and the stream of public contributions at opportunity cost.
Cases where a public contribution may be difficult to
justify
In cases where the project is designed to relieve chronic congestion or crowding on an existing network, it is not appropriate to assume that public contributions are the best way to obtain these benefits. Instead, the aim should be to find ways for the new infrastructure to be paid for by its users, in this way securing the means to manage the future use of the resource effectively. This is discussed further in Note Evaluation Implications of Sub-Optimal Pricing (see Sections 1 and 3) [Link]. Of course, there are counterarguments, including the ‘decongestion and environmental benefits’ case outlined in Section 2 above. Whatever case is put, appropriate supporting evidence should be provided, in line with the guidance in this Toolkit.
5 calculating the irr of public contributions
The first step is to monetise the stream of incremental external benefits as usual (see Note When and How to Use NPV, IRR and Adjusted IRR [Link]). These should be set against the stream of public contributions, multiplied by the MCPF. Calculate an IRR or NPV in the usual way. This is the IRR or NPV of the public contribution.
Example 1 represents a situation where the project would not go ahead without a public contribution, as a consequence of the marginal commercial return available from it. With a public contribution, however, the project is found to be financially sustainable for the private partner. The question arises: what is the case for the public intervention? In this example, analysis has identified that there are decongestion benefits from the project which are not appropriated by the private partner.