Optimal economics of public-private partnerships: is it possible?

Abstract:

– The theoretical and conceptual origins of public-private partnerships can be traced back to the Public Choice movement. The rise of conservative forces during the crisis of the 1970s, particularly in England, encouraged a reduction in public sector staffing and spending and the granting of greater management autonomy to certain services linked to performance targets.

– For the government, an optimal PPP contract must meet three requirements: make public investments in a context of budgetary constraints, benefit from the capabilities of private companies, and ensure an optimal distribution of risks between public and private partners.

– Finally, issues related to contract execution are paramount. A partnership seems more effective than in-house implementation when the service concerned can be clearly identified and described, and the contract remains relatively flexible.

Public-private partnership (PPP) is a generic term. It encompasses various forms of cooperation between the public administration and the private sector. It can involve the design, implementation, and financing of a public good or service. There is therefore no precise definition of public-private partnerships. However, it is possible to highlight certain fundamental characteristics of PPPs in the broad sense. Four criteria are defined in the Green Paper on Public-Private Partnerships published by the European Commission in April 2004:

− Long-term cooperation between the public and private partners covering several aspects of a project to be carried out.

− A method of financing the project that involves both the private and public sectors.

− An important role for the private partner, which may be involved at different stages of the project (design, development, implementation, financing).

− A fair distribution of risks between the public and private partners, taking into account their respective capacities to assess, control, and manage them.

1. Theoretical origins of public-private partnerships

The period of economic stagnation that began in 1975 combined recession and inflation in an unprecedented way. The unusual nature of this « stagflation » caught economic policymakers in most countries off guard. Thus, although Keynesian stimulus plans followed one after another, they did not provide a definitive solution to the crisis. This resistance convinced economists that the slump was in fact the result of a deeper blockage in the production and consumption system, paving the way for a resurgence of liberal theories in 1979, with a strong comeback for the liberal theories advocated by Friedman’s monetarist theses.

The accession of Margaret Thatcher to the post of Prime Minister of Great Britain in 1979 and that of Ronald Reagan to the post of President of the United States in 1980 elevated the Anglo-Saxon countries to the rank of models of neoliberal experiments. During the period 1980-1990, the community was increasingly less perceived as the sole provider of public services. The British government enacted various laws concerning the provision of services by local authorities. Conservative governments encouraged the privatization of public services such as electricity, gas, water, telephones, airports, and railways in order to reduce public sector employment and expenditure and to grant greater management autonomy to certain services linked to performance targets. (Combes, 2009)

However, the superiority of the private sector over the public sector remains to be proven, and the privatizations of the 1980s and 1990s have had mixed results. The social cost has been heavy, taking the form of both high unemployment and a sharp increase in precariousness and even poverty. (Berstein and Milza 2007) According to INSEE, from 1980 to 1987, unemployment grew significantly faster in the United Kingdom than in France. Furthermore, in 1990, the gap in living standards between the poor and the rich was the same as it had been in the 1930s. However, these mechanisms face many obstacles in their application, mainly due to their complexity. Furthermore, while it can draw inspiration from the strengths of the private sector, public management must be compatible with the foundations and values of the public sector. The theoretical and conceptual origins of public-private partnerships can be traced back to the Public Choice movement. At the very moment when Keynesian policies were triumphing, a liberal movement was developing in the United States, known as the « public choice school, » which rejected the view of the state as a neutral agent serving only the public interest. In Public Choice theory, individuals are thus considered to be seeking only to maximize their personal interests. The motivation of political agents is to maximize their own interests, which may include their conception of the collective interest, but not only that: they want to maximize their chances of being elected or re-elected and their utility (income, power, etc.).

2. Determining the optimal economics of public-private partnerships

The use of public-private partnerships is most often intended to respond to a threefold constraint. The government’s objective is to be able to make public investments in a constrained budgetary context while benefiting from the capabilities of private companies. It is also imperative that the distribution of risks between public and private partners be optimal. Economic analysis provides several angles from which to approach the commitment of a public entity to a partnership contract.

Optimal rules for defining the contract according to incentive theory

PPPs can be analyzed according to incentive theory (Cahuc, 1993). According to this theory, a PPP contract is a « principal-agent » relationship. The public actor must therefore deal with a double asymmetry of information vis-à-vis private firms. In the first phase, it faces an « anti-selection » problem, i.e., it is extremely difficult to distinguish the best-performing firms. Ex post, the opacity of the private company’s behavior poses a moral hazard problem: the public entity finds it difficult to determine whether the private partner is making every effort to reduce its costs and offer the best service.

Thus, different public procurement methods may have varying degrees of effectiveness depending on the degree of information asymmetry, the nature of the transaction, or the diversity of bidders (Mougeot and Naegelen, 1988). The procedures must be adapted to the situation. Competitive procedures (such as calls for tenders) can increase the economic efficiency of the project if the market is competitive and the buyer has clear and established preferences. However, there is a downside to this practice: when, in order to win the contract, companies engage in a bidding war based on their ability to respond to the call for tenders, even though they do not have the appropriate skills. Conversely, if the public purchaser cannot set precise specifications for its needs and the market is close to a bilateral monopoly, a negotiated procedure[1]may prove more effective.

When it comes to risk sharing, the rules sometimes favor a transfer to the public actor. This has the advantage of being able to pool risks across its many activities (known as risk pooling) and spread the additional costs associated with possible failures across all taxpayers (risk spreading). As a result, taking on the risk minimizes the risk premium demanded by private partners and thus improves the overall return on the project. Nevertheless, this must be weighed up, as one negative consequence is that it greatly reduces the incentives for private firms to control their costs and limit risks (Mougeot and Naegelen, 1993). Furthermore, as seen above, the government often seeks to use PPPs to reduce risks rather than to save costs.

When PPPs are used to seek an incentive-based contract, fixed-price contracts seem preferable to cost-reimbursement contracts, even though the latter reduce the risk premium for private companies (Laffont and Tirole, 1993). In these contracts, known as Cost Plus Fixed Fee Contracts, the public sector reimburses the costs incurred by the private partner and thus guarantees a reasonable return on invested capital. The firm, which no longer bears any risk, therefore has no incentive to make additional efforts to achieve savings. The incentive power of such contracts is therefore very weak. Conversely, fixed price contracts have a strong incentive effect in that the firm is ultimately responsible for any additional gains or losses compared to the forecasts stipulated in the contract. Another advantage for the buyer is that they have a fixed idea of the price as soon as the contract is signed, which allows them to better manage their available budget.

The public entity must therefore strike a balance between giving up informational rents to the service provider (in the case of fixed price contracts) and reducing the risk of cost overruns and creating incentives for private service providers (Mougeot and Naegelen, 1993). The MacAfee and MacMillan model developed in 1986 demonstrates how it is possible to minimize costs for the public entity through a cost reimbursement formula combined with a penalty/reward system based on the difference between the actual cost and the announced cost.

Problems with contract enforcement, the theory of incomplete contracts

The approach developed above raised the question of the optimal contract, but contributes littleinsightinsight into issues related to contract performance. However, PPPs often involve complex arrangements, and the effectiveness of the contract is not limited solely to the quality of the contractual structure itself. Given the difficulty of constructing a contractual framework that encompasses all possibilities and provides a solution for each one, it is interesting to consider the issue of PPPs in the context of incomplete contract theory [2](Hart and Moore, 1990).

Let us first consider the partnership from the perspective of property rights. The transfer of property rights eliminates the risk of expropriation. This gives the asset manager strong incentives to perform well, as they no longer fear losing the fruits of their investments (Hart and Moore, 1990). However, it would be simplistic to reduce PPPs to the sole issue of privatization. First, because these partnerships sometimes involve areas of public authority for which privatization is not an option (defense, etc.). Secondly, for political reasons: the public entity may choose PPPs as an alternative to privatization, allowing it to retain control over the definition and delivery of services to the public, as was the case in the United Kingdom when the Private Finance Initiative (PFI) was introduced. (Bös, 1996) The PFI program was set up in Great Britain in 1992 by John Major’s government. The Thatcher government’s objective was to keep public spending below 40% of GDP, a target that was subsequently reinforced by the Maastricht Treaty and the obligation on EU member states to reduce their budget deficits. In this context, the Private Finance Initiative launched by Norman Lamont had the advantage of offering a compromise: it was possible to finance the construction of numerous public works using private capital, without increasing the public budget, as public spending was spread out and divided into several small payments. In simple terms, PFI is a « program whereby the private sector is responsible for the design, financing, and operation of infrastructure necessary for the provision of public services » (Thomas, 1997).

Transaction cost theory[3]also provides some answers. The public sector must decide between providing the service internally or entrusting it to a private partner; in other words, it must choose between doing it itself or having it done. However, the existence of transaction costs (such as the costs of competitive bidding or the costs of monitoring the service provider) can make it more economically attractive to provide the service internally, even if the private sector has more expertise in the task in question. It is therefore possible that transaction costs may prevail even in cases where in-house provision is not the most efficient solution (Williamson, 1999). PPPs can be studied as part of a vertical integration strategy, which is addressed by incomplete contract theory.

One of the main advantages of PPPs is the involvement of the private partner in all stages of the project. This empowerment of the private partner is intended to ensure overall economic performance optimization. In a situation of information asymmetry, the builder may indeed want to carry out the project at the lowest possible cost without taking future operating needs into account. Thus, while it is difficult for the public entity to control the implementation of the project, it can nevertheless align its interests with those of the private partner by transferring the burden of operation. The main advantage of PPPs is that they manage the consequences of information asymmetries in the most optimal way, both ex ante (i.e., at the design and implementation stage) and ex post (at the operational stage). (Hart, 2003)

Furthermore, if the public entity entrusts the service provider with the development of technical specifications, it is important to define the expected quality in advance (APCC, 2002). If the public purchaser cannot clearly define the expected technical characteristics, it is possible that the solution of using a single PPP contract may be more economically efficient than several separate contracts covering construction on the one hand and operation on the other.

This approach is illustrated in the two models created by Oliver Hart in 1997 and 2003. In particular, in the second model, the public decision is studied taking into account its temporal dimension. Hart separates two periods: the contract signing and implementation phase, and the operation phase. The starting assumption is that the contract cannot foresee all possible scenarios, so it is an « incomplete contract. » The private partner can choose between two types of investment, which will have an impact on its profits and costs. The first type is a productive investment, i.e., one that minimizes the operating costs of the facility. Conversely, the second is a so-called non-productive investment, as it only reduces operating costs at the expense of quality. The private provider makes a trade-off in order to maximize its profit. The model shows that under two separate contracts, the private provider has incentives to minimize its construction costs without taking into account their impact on operating costs, which will be borne by another firm. The project’s life cycle is therefore not optimized.

On the contrary, with a comprehensive contract where the private partner’s remuneration is linked to the quality of service to be achieved, it will be in the partner’s interest to make investments that minimize both construction and operating costs. (Marty, Voisin, and Trosa, 2006) Nevertheless, once again, such a comprehensive contract is only effective if the public partner is able to precisely define its quality objectives at the time of negotiation in order to be able to put in place incentive clauses. A poorly designed contract would be counterproductive, particularly in the context of a comprehensive contract.

The model developed by Bentz, Grout, and Halonen (2004) shows that a partnership contract may be preferable to a traditional acquisition, particularly when investments in the infrastructure construction phase and contracting costs are relatively low. Conversely, when these costs are higher, the choice of a capital acquisition seems more appropriate (Pachnou, 2003). This model links the question of optimal acquisition methods with that of its operation, which is particularly interesting and provides a more accurate picture of reality. Similarly, the model developed by Bennett and Iossa (2004) defines a decision rule between the use of a comprehensive partnership contract and traditional acquisition, taking into account the externalities that arise between the construction and operation phases, as well as their impact on the quality of the final good or service.

Conclusion

In conclusion, the use of public-private partnerships is complex to evaluate and involves several criteria, whether economic, financial, political, or social. There can therefore be no definitive, universally applicable answers.

However, certain details are important, particularly when negotiating and implementing contracts. The selection of projects to be financed must be carefully conducted and these projects must be supervised throughout their development, while leaving the private partner considerable leeway to establish genuine cooperation and a flexible and effective partnership. To achieve this, it is necessary to have a clear vision of the expected objectives of the PPP.

The various economic models analyzed have come to the common conclusion that a partnership seems more effective than internal implementation when the service concerned can be clearly identified and described, and when the contract remains relatively flexible.