By Jonathan Loew, Michael McLindon
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About the Authors.. |
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Jonathan Loew is an infrastructure finance and privatization specialist for the Washington, DC-based Institute for Public-Private Partnerships, where he advises governments and international donor agencies on strategies to promote infrastructure finance and development, private sector participation, regulatory framework reform, and institutional capacity-building. |
| Michael McLindon , Ph.D., is an infrastructure investment and finance specialist with extensive experience in infrastructure project packaging, capital market development, and infrastructure project finance. He is a Senior Consultant at IP3 with over 20 years of experience in more than 50 emerging market countries. Dr. McLindon is the author of Privatization and Capital Market Development: Strategies to Promote Economic Growth, and is a highly regarded lecturer and trainer in IP3 training programs on infrastructure finance and management. |
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In recent years, governments in emerging markets have been turning with increasing frequency to the private sector for help in developing and delivering critical services. For governments facing growing demands for services, chronic operational and institutional deficiencies, and limited fiscal resources, the private sector is increasingly being recognized as a valuable source of new technology, management expertise, and investment capital. International experience demonstrates that, if properly designed, public-private partnership (P3) arrangements can bring dramatic improvements in the quality, availability, and cost-effectiveness of services.
Why are countries interested in P3?Studies by the World Bank (1994) on the relationship between infrastructure and economic development conclude that efficient infrastructure creates employment, develops human capital, promotes local and foreign investment and trade, fuels business productivity and expansion, raises standards of living, and improves access to critical services.
Both developing and developed countries need to strengthen and expand dramatically their physical, economic, and social infrastructure. The need for financing these services could reach well into trillions of dollars over the next decade. However, in many countries throughout the world, governments lack the resources necessary to meet this challenge. Public treasuries are insufficient to meet the current, much less future needs in the power, telecommunications, transportation, water, sanitation, agriculture, education, health, and rural development sectors.
The urgent need to speed up investment in infrastructure confronts governments in developing and developed economies alike. The mismatch between the investment needs of countries and the resources available from governments has resulted in an increased reliance upon public-private partnerships. According to the World Bank, from 1990 to 1997, private activity in infrastructure grew in developing countries from US$ 16 billion to US$ 120 billion. While this increase in significant, it is only the first step in a long journey.
What is P3?P3 arrangements are basically contracts between a private sector entity and the government that call for the private partner to deliver a desired service and assume the associated risks. In return for agreeing to provide the service, the private partner receives payment (in the form of a fee, tariff or user charge) according to certain standards of service and other criteria as specified in the contract. The government is relieved of the financial and administrative burden of providing the service, but retains an important role in regulating and monitoring the performance of the private partner.
Most literature on P3 identifies five (5) options for implementing P3 projects. They are:
- Service Contracts
- Management Contracts
- Leases
- Build-Operate-Transfer Contracts and Variants
- Concessions
Figure 1: Options for P3
These options can be arrayed along a spectrum according to the level of private sector involvement (see Figure 1). At one end are those contracting vehicles in which the government retains full responsibility for operations, maintenance, capital investment, financing, and commercial risk; at the other are those models in which the private sector assumes a greater share of the responsibilities and risks.
While these are considered to be the main options, it is important to note that, in practice, P3 arrangements are often hybrids of these models. For example, management contracts sometimes include revenue-sharing provisions common to lease agreements, and leases sometimes transfer responsibility for small-scale investment, rehabilitation, or renewal to the private sector, as is characteristic of concessions. The following sections present a brief overview of the models for P3, and suggest some lessons drawn from international experience in the use of each option.
Service ContractsService contracts are legally binding arrangements between a properly empowered government authority and a private partner to perform specific, usually non-core tasks. Examples include electric, water, or telecommunications utilities that contract out for janitorial services, meter reading and installation, information technology service design and delivery, billing and tariff collection, or security services. These contracts are typically competitively bid, and are for short periods of six months to two years, after which they are re-bid. The responsibility for provision of the overall service, as well as any capital investment, remains with the public authority. While service contracts require only a limited degree of private sector participation, they nonetheless provide opportunities for the introduction of competition and private sector expertise, and reduce government responsibility for such non-core services. Because the contract period is short, contractors are subjected to frequent competition, which encourages efficient performance and reduces the cost of the contracts. In large urban areas, different firms can be contracted in separate geographical areas to deliver the same services. Multiple contracts promote competition and allow the government to compare costs and performance on an ongoing basis. Service contracting can be an attractive form of PSP where there is strong political or community opposition to wider involvement of the private sector, opposition to price increases, or where the government is seeking to shed responsibility for non-core functions. Public authorities that plan to utilize service contracts may need to undergo some changes to fulfill their new role, which shifts from execution to supervision. For example, institutional reforms may be required to decentralize control, to provide technical assistance at the local level, to enforce standards for quality and control, and to manage staffing changes.
Despite the potential long-term benefits to the population as a whole, the introduction of service contracting sometimes has a short-term negative impact on those employees working in the operations being contracted out who may be made redundant. Governments have addressed this dilemma by providing support to those employees in forming and financing private companies to compete for the service contract, or by providing retraining and severance to support employees in finding work in other professions.
Management Contracts
Management contracts transfer responsibility for the operation and maintenance of government-owned entities to the private sector. Under such contracts, ownership of the entity and responsibility for service provision remain with the government. Likewise, the bulk of the commercial risk and all the capital and investment risks remain with the public authority. Management control and authority, however, is transferred to a private partner, which applies its expertise to improve management systems and practices. Management contracts are generally three to five years in duration. Compensation may be in the form of a fixed fee, as in the case of a fixed fee management contract, or it may be linked to performance indicators, as in the case of a performance-based management contract. Under a standard Fixed Fee Management Contract, remuneration to the private partner is based solely on the payment of a fixed fee in exchange for the provision of specialized personnel who oversee the management of the company. More sophisticated Performance-Based Management Contracts provide for the introduction of greater incentives for efficiency by defining performance targets or contract milestones and basing remuneration, at least in part, on their fulfillment. One variant of this model provides for a profit sharing incentive, in which the operator's remuneration is a combination of a fixed fee plus a share in the profits of the utility. Both the performance-based management contract and the profit sharing variant are effective tools for ensuring that operating and commercial risks are shared by the management contractor. However, under both models, the public authority still bears the financial risk associated with its responsibility for capital investment.
Performance-based management contracting provides the management contractor with incentives to improve operating efficiency and achieve timely compliance with the performance milestones in its contract. An advantage to these contractual models is the ability to create incentives for the contractor to tackle issues (such as staff development) that are not revenue generating in the short term, but that may establish a foundation for more efficient and sustainable performance over the long term. Management contracts are most beneficial where the main objective is to rapidly enhance a public enterprise's efficiency, or to prepare for a deeper level of P3. They are also attractive when there is strong political or public resistance to increasing the price of services or where there is concern about handing over control of investments to the private partner. Management contracts provide little potential for expanding service coverage or increasing investment. Because they leave all responsibility for investment with the public authority, they are not recommended if a government has as one of its main objectives accessing private finance for new investments. And because they do not necessarily transfer financial risk to the management contractor, they provide few incentives for the private operator to reduce costs and improve the quality of services.
LeasesUnder a lease, a private firm (Lessee) leases the assets of an enterprise from a properly empowered government authority (Lessor) and assumes full responsibility for operations and partial responsibility for investments for a period usually between ten and fifteen years. Typically under a lease, the user fee, or tariff in the case of utility services, is used to pay the "Lessee Fee", which remunerates the Lessee for his costs, plus a reasonable return. The remainder of the tariff goes to the government and is used to fund capital investments.
As the Lessee's fee is dependent upon revenues, the lessee assumes much of the commercial risk of the operations. The Lessee's profitability will therefore depend to a large degree upon how much it can reduce costs, while still meeting the quality standards set forth in the lease. Best practice leases have built-in incentives that encourage the private operators to implement efficient billing and collection procedures to improve the collection ratio from customers (including government agencies). The Lessee also has an incentive to implement aggressive policies aimed at expanding service coverage to increase the revenue base (although it is important to note that the government retains responsibility for carrying out and financing service expansion), to reduce operating costs in order to maximize profits, and to carry out regular preventative maintenance to increase the reliability and longevity of plant and equipment.
Under a lease, the government retains title to the assets and bears the responsibility for financing and planning capital investments and rehabilitation of assets. It is therefore incumbent upon the government to raise financing and coordinate its capital investment program closely with the private partner's operational and commercial program. Leases are most appropriate where there is scope for large gains in operating efficiency but only limited need or scope for new investments. Leases have also sometimes been advocated as stepping stones toward a deeper level of P3 in the form of concessions. Their administrative complexity and the demands they place on governments are nearly as great as those of concessions, so a lease is a much bigger first step than a management contract. Due to their complexity, leases generally require that an independent regulatory body be established to monitor and enforce the private partner's fulfillment of its obligations under the lease.
Build-Operate-Transfer (BOT) Contracts and VariantsBuild-operate-transfer (BOT), build-own-operate (BOO), build-own-operate-transfer (BOOT), rehabilitate-operate-transfer (ROT), and similar arrangements are contracts specifically designed for greenfield projects or investments in infrastructure that require extensive rehabilitation. Under such arrangements, the private partner typically designs, constructs and operates facilities for a limited period of from 15 to 30 years, after which time all rights or title to the assets are relinquished to the government. Under a build-operate-own (BOO) contract, the assets remain indefinitely with the private partner.
The government will typically pay the BOT partner at a price calculated over the life of the contract to cover its construction and operating costs and provide a reasonable return. In the utilities sector, the contract between the private partner and the utility is usually on a "take-or-pay" basis, obligating the utility to pay for a specified quantity of water or electricity whether or not that quantity is consumed. This places all demand risk on the distribution utility. Alternatively, the distribution utility might pay a capacity charge and a consumption charge, an arrangement that shares the demand risk between the utility and the private partner.
While BOTs are attractive for new assets that require large amounts of financing, such as large water treatment plants or electricity generation plants, they can be economically inefficient due to the difficulty in tying increases in production with increases in demand. Effective implementation of BOT type contracts requires careful attention to the design of tender documents and can involve a relatively lengthy bidding process. Experience with some BOTs shows that they achieved some savings in capital construction costs and facilitated more rapid investment in infrastructure. However, they can be an expensive way of substituting private debt for public debt if there is a take-or-pay contract involved. Additionally, many BOTs have failed to deliver optimal outcomes for government or consumers because the government's agency responsible for negotiating allowed too much of the risk to remain with government, especially where foreign exchange guarantees are provided, or where take-or-pay contracts are signed.
Concessions
Under a concession, the private partner ("Concessionaire") bears overall responsibility for the services, including operation, maintenance, and management, as well as capital investments for rehabilitation and renewal of assets, and the expansion of services. The fixed assets either remain the property of the public authority or revert to public ownership at the end of the concession period. Concession contracts usually have a duration of twenty to thirty years, depending on the level of investments and the period required for the Concessionaire to recover its investments plus a reasonable rate of return. Concessions are typically awarded based on price, with the award going to the bidder proposing to provide the services and meet the investment targets for the lowest fee or tariff. The concession is governed by a contract which sets out service standards, performance incentives, arrangements for capital investment, mechanisms for adjusting fees or tariffs, and arrangements for dispute resolution. Penalties are imposed if the Concessionaire fails to comply with the performance targets specified in the contract.
The Concessionaire is paid for its services directly by the consumer, based on the contractually set fee or tariff, which is adjustable over the life of the contract. The Concessionaire retains the balance of revenues after paying back any taxes and charges levied on consumers by the government. If expenses exceed revenues, the Concessionaire must absorb these losses. Combining the responsibility for operations and investments under a concession agreement provides the Concessionaire with an incentive to make efficient decisions regarding investment and technological innovations, because the operator will benefit directly from any efficiency improvements. The main advantage of a concession is that it passes full responsibility for operations, maintenance, rehabilitation, renewal, and service expansion to the private partner and so creates incentives for efficiency in all the utility's activities. Therefore, concessions are an attractive option where large investments are required.
Concessions are administratively complex undertakings for governments, because they confer a long-term monopoly on the Concessionaire and thus require rigorous monitoring and enforcement. The quality of regulation is therefore important in determining the success of the concession, particularly the distribution of its benefits between the concessionaire (in profits) and consumers (in lower prices and improved service).
The following table summarizes the main types of P3 arrangements that governments typically enter into with the private sector:
Type of contract Duration What the contractor usually receives Nature of contractor performance Examples Service contract Short-term(1-3 years) A fee from the government for performing the service A definitive, often technical type of service Facility repairs and maintenance; laundry Management contract Medium-term(3-8 years) A fee from the government for the service and a performance-based incentive Manage the operation of a government service Regional water supply management Lease Long-term(8-15 years) All revenues, fees or charges from consumers for the provision of the service; the service provider pays the government rent for the facility Manage, operate, repair and maintain (and maybe invest in) a municipal service to specified standards and outputs Existing airport or port facilities Build-operate-transfer Long-term(15-25 years) The government mostly pays the service provider on a unit basis Construct and operate, to specified standards and outputs, the facilities necessary to provide the service Building, construction and maintenance of regional schools, prisons or hospitals Concession Long-term(15-30 years) All revenues from consumers for the provision of the service; the service provider pays a concession fee to the government and may assume existing debt Manage, operate, repair, maintain and invest in public service infrastructure to specified standards and outputs New airport or seaport facilities, toll road or bridge
What are the benefits of P3? The potential benefits of P3 include access to private sector finance, managerial expertise, access to new markets, new technology, better project design and implementation, and more efficient use of resources. P3 arrangements improve accountability by clarifying the responsibilities of each party, establishing standards for the provision of services, and defining clear and transparent processes for dispute resolution. The benefits of P3 can accrue to all stakeholders, from government to the private partner and consumers, provided the contracts are competitively tendered and an adequate enabling environment (including a legal and regulatory framework) exists.