The paradox of ‘P3s’

Save money. Create jobs. Transfer risk from taxpayers to shareholders. There are potential upsides when government and business team up on big building projects — from old-fashioned bridges to sustainable “biosolids” facilities. However, as Joshua Newman explains in his book Governing Public-Private Partnerships, it’s an evolving success story. This is the third in a series of excerpts from this year’s nominees for the Donner Prize, a $50,000 award for the best public policy book in Canada. The winner will be announced May 15.

Public-private co-operation has existed for centuries. For a long time, roads and bridges were maintained by private individuals on behalf of the state, under an arrangement of shared revenue. But if “P3s,” or public-private partnerships, are not new, their reappearance in a modern context of retrenchment of the state from public service delivery provokes a number of questions: What if things go wrong? What are the consequences when P3s fail?

The challenges start with contracts themselves. Longterm contracts for “P3s” can never perfectly account for all of the financial, business cycle, technological and political changes that may arise as a project unfolds. In fact, contracts are renegotiated before their original end dates as often as 75 per cent of the time in some industries — ongoing positive interaction between the public and private partners is required.

Consider, for instance, a P3 service in which variations in demand cause extreme fluctuations in profitability. In theory, this kind of risk ought to be calculated, priced, and divided appropriately between the partners, so that each partner takes on the risk that they are best able to handle. Risk transfer is often cited as one of the major benefits of using a P3 arrangement for infrastructure.

In general, construction risk is usually assumed by the private sector partner, so that budgetary setbacks and cost overruns due to scheduling delays do not fall to the public purse. The public sector partner might then assume some of the demand risk by applying a minimum revenue guarantee for the private investors. In a P3, at least some components of construction risk and operations risk are usually “bundled” to motivate the private partner to spread appropriate resources across multiple aspects of production and delivery.

But in practice, partners in a P3 are often surprised by demand variation, and conflict can ensue as blame is passed around and the partners seek to extract damages from each other. This is precisely what happened to the Sydney Airport Link P3: demand was significantly lower than predicted by the preliminary estimates, which resulted in the bankruptcy of the private sector partner. This led to a legal dispute between the partners in which the private investors sued the government for damages, alleging that the government had not lived up to its end of the agreement.

In the end, the contract

was renegotiated in a way that disadvantaged the government by reducing its share of revenue. In this case, although the demand risk was supposed to be held by the private partner (who had full authority in setting user fees), the design of the contract and the uncertainty of demand for the service led to incomplete risk transfer that was not predicted by the contract’s original negotiators.

Critics also argue that private companies and investors engaging in P3s will charge excess premiums to take on risk, or that the true cost of risks to the public sector may not be known or may be hidden within overall project costs. They further argue that risk is never fully transferred to the private sector, because the private partner is always a special-purpose vehicle that can go bankrupt if necessary to avoid responsibility.

In any case, governments seek to fulfill social and political objectives. If a private partner were to go bankrupt or otherwise withdraw while financing a P3 project, the state would presumably still want to complete the project in order to achieve its policy goals. This is what happened when the private partner withdrew from the London Underground improvement and maintenance P3 in 2007 — the U.K. Department of Transport assumed the costs and continued with the project.

Governments take on considerable political risks when engaging in public-private ventures as well — risks that cannot be transferred to the private sector, because in the event that outcomes are negative, there is always the chance that voters will associate the government with the failure of the project, even if the private partner assumes responsibility for failure.

Clearly, P3s are defined by a kind of paradox: the state is expected to retain a role, to protect vulnerable segments of the public, for example, or to reduce the impact of pollution, but at the same time not get in the way of the expertise and innovation that private companies can offer.