Making P3s work – Canadian Government Executive

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May 7, 2012

Making P3s work

Public-private partnerships (P3s) have become increasingly important in Canada at both the federal and provincial levels. What can governments expect to achieve through the use of P3s?  How effective are P3s at delivering value to governments and citizens? What lessons can we draw from the recent Canadian P3 experience? These questions are important for Canadian policy because the amount of money involved is often very large (some P3s cost $2 billion in present value terms) and evidence from various sources – including other countries – suggests a fair degree of dissatisfaction with the outcomes of many P3s. Research by Aidan R. Vining of Simon Fraser University and Anthony E. Boardman of the University of British Columbia suggests that P3s can work if certain criteria are met.

We examined ten major Canadian infrastructure projects that were initiated as public-private partnerships (P3s), namely: Alberta Special Waste Management System (Alberta), Confederation Bridge (Federal), Highway 407 (Ontario), Highway 104 Western Alignment Project (Nova Scotia), Evergreen Park School (New Brunswick), O’Connell Drive Elementary School (Nova Scotia), Britannia Mine Water Treatment Plant (British Columbia), Moncton Water Treatment Facility (New Brunswick), Cranbrook Civic Arena (British Columbia) and Waterloo Landfill Gas Power Plant (Ontario). We also drew on the experiences in other countries.

Our framework for analyzing the use of P3s versus other ways of providing public services, especially infrastructure, is conceptually straightforward: governments should seek to minimize total social costs. Holding quality constant, this is equivalent to adopting a social cost-benefit analysis perspective. Social costs consist of production costs (which are usually paid by government to a P3 consortium), plus transaction costs and any (net negative) externalities affected by a project.

Thus, in assessing the merit of a P3 versus government production or standard contracting, governments or analysts should include transaction costs and externalities. This would seem uncontroversial until one recognizes that governments often use government revenues or budget expenditures as the primary evaluation and decision criterion. Also, because governments and private sector participants have conflicting goals in P3s, transaction costs may be high.

In our review of the case study evidence, we came to two major conclusions. First, although risk transfer is, at least initially, a major posited goal of many governments, the evidence suggests that in negotiating (and renegotiating) P3 contracts, governments often failed to achieve significant risk transfer. Construction, maintenance and operating costs are usually transferred to the P3, as one would expect, but revenue risk (or use risk) is rarely transferred to the private sector, especially if the project is large.

Furthermore, when construction costs of P3s are unexpectedly high, government has to step in and bail out the project. As we are currently more aware, low probability, high cost events do occur with positive probability and do have a high cost.  

Second, the transaction costs of many P3s are often high. These transaction costs include ex ante contracting and negotiation costs, as well as ex post (i.e., after formal contract agreement) costs, such as monitoring, renegotiation and termination costs. These costs may be borne either by government, by the private sector, or both. But, no matter who bears these costs, they represent real social costs that should be included in assessing the net social benefits of P3s.  

The case studies suggest that Canadian governments have generally found it difficult to effectively reduce either their total social costs (including transaction costs and externalities) or their budgetary risk exposure (by transferring revenue risk) through the use of P3s. At the same time, the for-profit private sector partners have sometimes had difficulty generating adequate profitability, although this is a tentative conclusion as they have usually had incentives to publicly emphasize losses, or potential losses, and to be secretive about profits.

One surprisingly common occurrence is the dissolution of P3s more quickly than envisioned in the original contracts, either through government buy-outs, redesign of the contract, bankruptcy of the private entity, or some mix of these. Also surprisingly common is protracted conflict, with high contracting costs borne by one party, or both.  

Our findings throw into doubt the social utility of P3s as a widely replicable mechanism for delivering public infrastructure, at least without extremely careful forethought by government. More encouragingly, however, P3s in Canada have worked reasonably in certain specific circumstances; namely, where:

  • governments have not attempted to transfer use or revenue risk to the private sector;
  • projects required specialized knowledge or proprietary technology that is only held by private sector firms (usually a small number of large global firms); and
  • governments were able to transfer construction risk by insisting on fixed price contracts.  

However, these circumstances are close to traditional “design-build-transfer” or “build-transfer” contracts. Government must either recognize that P3s should be limited to projects that meet these conditions or they must be much better at incorporating the potential for high transaction costs in contract design.

Ideally, this means writing contracts that bind their own future behaviour as well as that of private sector participants. While public servants may be prepared to do this, politicians aiming to get re-elected are often reluctant to make such commitments.

Given their spotty record, why are P3s so popular? There are often large political benefits from keeping capital expenditures off the government’s official budget or at least to transferring them to future time periods (and future politicians).

However, it is important to emphasize that the underlying economic reality of a public investment is not altered if it is not on the books. No matter how a project is financed, the government or users ultimately have to pay for its construction and operation.

By using a P3, government can usually defer its payment obligations and spread them over a longer time period. As this mainly affects the timing of the payments and is not likely to reduce the (production) cost of the project, this is a poor rationale for using P3s. Furthermore, it is compounded by the fact that private-sector financing costs are higher than government borrowing costs.

Aidan R. Vining is the CNABS Professor of Business and Government Relations in the Segal Graduate School of Business, Simon Fraser University. He is currently the academic director of the Executive MBA at the Segal School. Anthony Boardman is the Van Dusen Professor of Business Administration in the Sauder School of Business at the University of British Columbia.

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