Public Private Partnership in Infrastructure: A Critical Analysis

| Amitayu Sen Gupta

Public And Private Provisioning in Infrastructure

In the early 1990s, economic reforms that were ushered in India were based on the basic principle of shifting away from the ‘stranglehold’ of the State in the economic affairs of the country to let the private enterprises flourish. This was seen in the context of the ‘fiscal crisis’ that the Indian State was going through, where the balance of payments problem was primarily attributed to the high fiscal deficit that the State ran because of its predominant role in the economic affairs of the nation.

The role of the State in putting in place an infrastructure network was emphasized by the National Planning Committee (1938) and the Bombay Plan (1944) in pre-independent India. They provided the necessary building blocks for action on infrastructure under the subsequent plans in post-independent India when it largely remained a responsibility of the State. Consequently, Public Sector Units (PSUs) were the primary agents in the infrastructure sector of our country; the State having monopoly in power, roads, railways, ports, telecommunications, and other such areas of concern. In the post-independence period, given the economic situation of the country, there were really no other alternatives but to have the State play the role of putting in place the infrastructural set-ups of the country. The magnitude of investment, acquirement of technology, long gestation periods, the sheer scale of activities, and the subsequent risks arising from all that was beyond the scope of the private capitalists of the country.

However in the nineties, as a part of the reforms mentioned above, the infrastructure sector too was set for certain changes. PSUs in the infrastructure sector like power, transport, etc run high fiscal deficits, which were strongly looked down upon. This was seen as signs of inefficiency of the system. Moreover, any further development of infrastructure (the need for which is strongly reiterated across the spectrum) under the aegis of the public sector was incompatible in the current discourse of strict fiscal austerity prescribed for the State. The obvious solution was the involvement of the private sector.

According to Sebastian Morris (India Infrastructure report 2001), what failed was not state ownership per sebut the assumption that in a large market economy many infrastructural sectors could be run non-commercially. The argument goes deeper, as it questions the wisdom of planned growth that was followed by India. During the 1950s and 60s, there was almost global consensus on balanced growth, and planned development was the biggest tool to achieve that. However, it is argued that autonomous growth is not balanced or broad based till the industrialization process is complete. India tried to achieve growth in the widest possible sectors and with much depth. The Mahalanobis Plan tried to provide infrastructure before the need for it arose. The plan tried to provide both physical and social infrastructure with greater emphasis on providing basic infrastructural setup for the society to embark upon growth process. However, over the years, focus shifted from growth and distribution to redistribution. The stagnation that followed after 1965 was partially responsible for this change in outlook. When growth once again started in the 80’s and the 90’s it was found that infrastructure was lagging behind.

This however is interpreted as an advantageous situation. It is argued that if an infrastructure which has direct bearing on a productive economic activity is constrained, the benefits to be gained by relaxing these constraints can be large enough to provide profitability in its provisioning. To put it more simply, when infrastructural developments follow industrial growth, it provides the opportunity for private provisioning of the same. Private provisioning of infrastructural facilities ensures allocative efficiency. Investment allocation need not be based on assumptions, models, and exigencies of the planner and the politician. The economy and the market could determine investments and location choice in a transparent manner, based on the simple process of demand and supply. Another ‘advantage’ of lagged infrastructure development is that shortages and subsequent demand arising from it reveal willingness to pay. This willingness to pay acts as a market signal; drawing investments to cash on the potential revenues and thus act as an incentive for private investment. Such a system will ensure efficient allocation of capital and also better utilization of the facilities build as demand led development will not lead to projects with higher unutilized capacities or insufficient provisioning that planned development often resulted in.

This then is a rallying point for those who propose private investments in infrastructure. Even if one accepts the fact that public investment in infrastructure is beneficial for the economy even in a developed economy, there is no compelling reason to limit infrastructural financing to the public sector. The main benefit arises from infrastructural facilities and its effects on economy. The same benefits can be achieved if private investment is used to develop the same facilities. Given the issues of high fiscal deficits, lowered public capital accumulation and general inefficiencies of the public sector as brought out by Sebastian Morris, it was suggested that allowing private sector to provide infrastructural facilities was a win-win situation for all.

The main argument favouring private investment in infrastructure is based on one core argument; the private sector is more efficient in its operations. The argument of private sector efficiency stems from the efficient allocation of resources that a free market demand-supply led equilibrium can achieve. To recall Morris, private capital will react to market incentives arising from the user’s willingness to pay. Such direct incentive based market led infrastructural developments can be successful when the economy has to do a lot of ‘catching up’ in infrastructural facilities, i.e. when there is a pent up demand translating into revenue incentives and private providers step in to cash on it. This would entail a direct interaction between the users and the facility provider and like any other commodity or service; the market will determine an equilibrium price that will equate demand and supply. Alternatively, the overall benefits received from removing infrastructural bottlenecks to allow industrial development reach its full potential can be utilized to sponsor private provisioning of infrastructure through an indirect process not involving direct interactions between the service provider and the end user. This might involve some redistribution through the government or any other such intermediatory, but market incentive structures can be designed for the same. There might emerge a third alternative, where investments in infrastructure are required to trigger overall industrial development (the effect of which will be lagged as in most infrastructural developments). In such scenarios, the issue of revenue incentives assumes greater importance.

Under such private provisioning, the service users will have to pay a ‘price’ for the services. This by itself is a big departure from conventional norms where certain facilities are often provided free. However, it is argued that to ensure efficient provisioning, user’s have to be charged for the same. The social gains and economic benefits derived out of these investments will more than cover for the user charge. Free market operations will ensure that the price charged for the services will match the willingness to pay. Investments in infrastructural facilities will generate value addition which will pay for the initial investments. Given that the benefits generated are manifold, a private provider can actually earn a profit through the whole exercise. This in turn will ensure efficient provisioning of facilities such that the erstwhile practice of running deficits through public provisioning can be avoided.

The market is thus supposed to facilitate not only efficient allocation of resources, but also efficiency in the operations of the facilities. Efficiency of operations is not only measured in terms of quality of service, but also economic efficiency where the activity generates enough resources to sustain itself.

Evolution of the PPP Concept

Internationally, privatization of infrastructural facilities started in the late 1980s, when various developing countries decided to explore the possibility of the private sector providing basic infrastructure or utility services, such as highways, railways, water, sanitation, electricity, gas, and telecommunications. During the 1990s, privatization proved enormously successful in attracting investment to infrastructure. According to World Bank estimates, new private investment in developing-country infrastructure increased from negligible levels in the mid 1980s to about US$110 billion per year in the peak years of 1997 and 1998. The private sector invested around US$750 billion in the utilities of developing countries between 1990 and 2001. Going by region, Latin America witnessed maximum investment, East Asia and the Pacific the second largest, while Europe and Central Asia was third with South Asia, Middle East and Sub-Saharan Africa lagging behind. Going by sector, the bulk of the funds flowed into telecommunications and electricity, with transport third and much smaller investments in gas and water and sanitation.

However, the process of privatization started drawing criticisms as cases of failures started giving rise to a general uneasiness about the whole issue. East Asia witnessed the Thai government’s seizure of an elevated private expressway in Bangkok in 1993 and the cancellation of Enron’s Dabhol power plant in India in 1994. After the Asian financial crisis of 1997-1998, Indonesia, Pakistan, and the Philippines forced many independent private power producers to renegotiate the take-or-pay contracts they had with government power companies, which exposed charges of corruption in the awarding of original contracts in the process. In Latin America, the first dramatic failure was the bankruptcy of roughly two-dozen private toll roads in Mexico after the devaluation of the Peso in late 1994. That was followed by the seizure of a water concession in Tucumán, Argentina (1996); violent rioting that stopped planned water and electricity privatizations in Cochabamba, Bolivia (2000) and Arequipa, Peru (2002); and Argentina’s suspension of utility tariff revisions in the wake of the government’s default and devaluation (2002). The developed countries were not immune to bungled infrastructure privatizations either, the best known being California’s electricity crisis in the summer of 2000 and the bankruptcy of Railtrack, the private company that had bought all of Britain’s railway infrastructure, in 2001. As privatization seemed to lose its luster, the flow of new private investment into developing-country infrastructure began to fall off sharply, first in East Asia in 1998 and then in Latin America the following year. By 2002, the levels of new private investment were returning to the levels experienced in the early 1990s, at the beginning of the current wave of reforms.

It was slowly realized that the private sector had numerous shortcomings. Private sector works on profit incentives. No private investment would take place unless profitable remunerations are guaranteed. The efficiency of the private sector lies in its ability to optimize operations such that it generates profit out of the revenue. The optimization can take two form; either it can cut costs or raise prices charged to achieve it. The initial problems of privatization rose from both counts. Often, user charges levied were above what the users were willing to pay and perceived high charges were the biggest point of protest against most privatized facilities. The other side of the problem too was experienced, where the private sector was accused of compromising on the quality of the services provided given lower revenues.

This is not to say that the private sector was inefficient. Many of these facilities privatized were run on subsidies by the state before they were privatized. The basic reason for such subsidization was that operating those facilities was not financially viable without such supports. While it is true that subsidization caused its own set of problems, the fact remained that given social responsibilities, it was often not possible to charge the kind of rates required for financial efficiency. This often is the biggest problem related to infrastructural facilities. Many of these amenities are public goods or social services for which often it is not possible to identify the payer or ask for equivalent prices. To expect the private sector to resolve the problem was often asking too much from it. To add to the problems, given its orientation, social benefits or its responsibilities do not feature in the private sectors priorities. Thus it often turned a blind eye or failed to incorporate these factors in its functioning. All that led to some resentment against private provisioning.

Thus, from a tradeoff between private and public sector, a new position of a symbiotic supplementary relationship was evolved for developing infrastructural facilities. The basic idea was to wed the capacity of the public sector to take up social responsibilities along with the efficiency of the private sector. It must be noted that private sector has been involved historically in developing infrastructural facilities for the state under construction contracts. The state or the public sector has floated tenders to which the lowest cost private bidder has been awarded the project. However, its role had been limited. The entire project was developed by the public sector and the private sector was limited to deliver certain aspects of the services with the state paying it off for the same. Planning, designing, operations etc were entirely up to the state. Proponents of PPP argue that the private sector is better equipped to handle some of these aspects such that involving it would bring down total cost of providing the facility. It was thus preferable to go for PPP rather than such construction contracts. In that sense, PPP lies somewhere between public provisioning and outright privatization.

The challenge was then how to define this symbiotic relationship. How does one wed profit motives with social welfare objectives? One way to identify the problem was to identify these projects as a series of risks. It was argued that while the private sector was well equipped to handle many of them, the public sector was better equipped to handle others. For example, to build a road, land has to be acquired, construction work has to be done, financing the project is a challenge, etc. The Public sector is best equipped to handle land acquisitions, as it is best suited to deal with rehabilitation, compensations etc. Whereas construction or financing can be done more efficiently by the private sector, where there is usually a consortium with members consisting of construction or engineering consultancy, financial agencies etc who are specialized in each of these fields. The whole notion of partnership in PPP concept lay on sharing these risks. If proper risk allocation is done with each risk allocated to the one best equipped to handle it, it was argued that total operational costs would be least. The least cost of provisioning ensures lowest cost for society which means greater social welfare. This is the fruit of private sectors efficiency.

Critical Issues

The entire process is of course not fool proof. Gausch studied a dataset of over 1000 concessions granted in Latin America between 1985 -2000 and came up with some startling statistics. 30% of all contracts had to be renegotiated. Out of which, 54.7% of all transportation contracts and 74.4% of all water and sanitation contracts had to be renegotiated. The outcome of the renegotiation processes had 62% projects ending with higher tariff rates, 69% with delay in investment obligation targets and overall 46% with changes in asset-capital base favourable to the operator. He concluded that the private sector engaged in rent seeking and often try to arm twist the public sector. There are numerous sector specific studies that have highlighted problems of PPP.

The study by Gausch highlighted another big issue. When a public entity opens a competitive bid to all private providers for a PPP project, a private entity faces competition and gives best bids. This is what proponents of PPP argue, that free market competition ensure lowest price. However, Gausch argues that bilateral renegotiations give the private operators greater bargaining power than competitive bidding and hence they resort to opportunistic high bidding to win a contract and then force renegotiations. The public sector often burdened by political and other obligations are forced to concede to such unequal renegotiations.

For example, just imagine the kind of pressure that the current government would have to face if any infrastructural project it announces during its tenure fails to materialize! This alone can become the rallying point of all oppositions in forthcoming elections. Given that a government’s tenure is time bound and terminal, it has to show results within it time bound tenure. Admitting that any contract it signed with any private agency is problematic would akin to admitting it made a mistake, a risk that no political party can take! At a time when the government is itself trying to popularize the concept of PPP, such admission would have grave consequences. Therefore, even if private agencies renege on a contract, the public agency cannot always take legal or punitive actions given political risk and, more often than not, they concede to renegotiations!!

In a PPP, the private and the public sector are engaged in a partnership through a contract. Like any contract, the success of it lies in the agents’ foresight to cover for all eventualities. Any agent tries to utilize loopholes in contracts to further personal benefits. Thus the other agent has to be prudent enough to design the terms and conditions properly to prevent such possibilities. Contracts form a very important part of a PPP discourse. Proper risk allotment is the key to a successful PPP model and hence if a proper contract can be drafted, all these risks too can be suitably covered for. Much of the current discourse on PPP thus resolves round contract theories and bidding processes and how they can be improved upon to ensure exploiting the full potential of efficiency under PPP.

A study of contract and bidding literature points out that the state is always faced by a trade off between risk allocation and moral hazard or efficiency and bid revenues. Theoretical bidding models often suggest multiple equilibriums or absence of a unique Pareto Optimal equilibrium. Price based auctions fail to cover different social considerations that infrastructural facilities have to cater to while multi-criterion auctions are more susceptible to corruptions and malpractices. As Gausch’s study shows, the sheer volume of renegotiations and the end results of such renegotiations prove that the public sector is at a clear disadvantage in such interactions. Furthermore, there are no fool proof methods that bidding and auctioning theoretical models can offer to resolve this issue. Or in other words, there is no perfect contract. And without a perfect contract, there cannot be a perfect PPP model.

The most contentious issue in any PPP model is the issue of market risk. Market Risk refers to the question of profitability of the entire operation. Much of it stems from the issue of Revenue Risk, which is the most critical component of Market Risk. Most of the time, the Private Sector refuses to take entire market risk and seeks guarantees from the public sector. This is ironical because the efficiency of the private sector lies in the principles of free market interactions. The private sector thus is best equipped to handle market risk.

However, deeper introspection reveals that free market operation is not allowed in most cases. In BOT (Build, Operate and Transfer) models or its variations, the design specifications are predetermined. Even in models where the private sector is allowed to design, the public sector tries to strictly define the requirement specifications which form the framework for private sectors innovations. The more stringent the public sector’s specifications, the lesser space for the private sector to work on its cost structure. But the biggest grouse of the private is about the user charges allowed to be levied. Free pricing is not allowed in most cases as the state maintains some sort of price control. All these controls by the state curb the private sectors scope of operations and thus it is often uncomfortable to undertake market risks with so many strings attached.

While the private sector rallies for removal of price control, the basic conflict of profitability versus social benefits come to forefront. Price control is necessary on two grounds for the public sector. The government has to maintain a socially sensitive position which often creates a wedge between what the user should pay (as determined by market principles) and what the user can pay. Secondly, as in the case of roads, private provisioning essentially leads to a monopoly for the operator and hence price controls are necessary to prevent monopolistic price abuses. Given that the private sector has a tendency of rent seeking (as espoused by Gausch), price control becomes all the more essential.

This leads to the supposition that PPP cannot ensure private sector efficiency while at the same time safeguard social welfare obligations. The conflict of interests (or objectives) of the public and the private sector cannot be resolved by PPP. Safeguarding social welfare infringes on the profitability of the private sector. What then is the shortcoming of the theory of PPP?

Basic Problem of PPP

The problem lies in the fact that PPP essentially is a supply side argument. The argument states that involving the private sector reduces delivery cost to the least possible. While this claim itself is highly questionable given the various studies reported, even if one assumes an ideal condition where it does hold true, it in no way ensures that the price chargeable for the same can be profitable for the private player. Any form of price determination essentially entails two entities; the one charging the price and the one paying it. Equilibrium price can only be determined only when both parties agree on one. This agreement requires profit maximization of the facility provider on one hand and the willingness to pay of the facility user on the other.

Willingness to pay has a subjective part to it, and social awareness of the benefits derived is one way to tackle it. In cases of infrastructural facilities, given that many till date were free goods provided by the public sector, any introduction of user charges generally triggers opposition. However, as the argument goes, once the user realizes that such free provisioning is not tenable and that a shift to ‘user pay’ system can ensure better services, such subjective opposition can be resolved. To revert to Sebastian Morris, if removal of infrastructural bottlenecks triggers greater economic benefits, the beneficiary will be willing to pay the benefactor for its services. However, how much it will be willing to pay depends on the amount of benefit it derives. If the benefits derived are less than the provision cost, the problem of market risk will remain.

This problem is further accentuated in PPP mode of delivery, as the cost recovery is sought in a short time span. For example, a road once build has a long life. The benefits from such activities are often accrued with a time lag. The beneficiaries of such infrastructural projects are often indirect and many fold. To ask for returns in a shorter time span from a smaller set of direct users and that too with a profit margin can thus often lead to relatively higher charges demanded which exceeds the benefits derived by the one being asked to pay for it.

The most common solution to such problem is Government incentives and sops like tax concession, or direct transfers or debt rewriting, etc. Thus ultimately, the State has to provide financial support (direct or indirect) to the facility supplier as market conditions fail to provide an optimum price for the services that covers operating costs while at the same time does not exceed the society’s ability to pay. This is very similar to the earlier practice of providing subsidies to public sectors as it was impossible to economically operate the facilities at socially sensitive rates. However, the amount of compensation needed to pay to the private sector would be higher than the subsidies it would have to pay to a public sector unit as the rate of returns demanded by the private sector is much higher. Thus as the government gets into a contract with the private sector under PPP, it often becomes binding on the government to compensate the private sector for market failure. The PPP contract then becomes a liability for the government. More often than not, the private sector would refuse to get involved in any such project where either profit is not perceived assured or the state does not extend its support to guarantee it. The recent experience of low project allotment due to lower private responses in the case of the NHDP project is the most glaring example. The lobbying of the developers for changes in the tolling structure and the subsequent new tolling policy being contemplated by the state is proof of the fact that the state once committed to PPP by its own accord has very little options later but to yield to the private sectors demands.

The most common outcome in such situations is that PPP operates in cases where it is financially lucrative while the government is forced to continue providing the facilities in the non lucrative areas. However, it makes little sense for the government to allow private sector operations in lucrative areas while it itself bears the burden of the non-lucrative regions. Instead, it can use the extra revenue earned from the lucrative regions to cross-subsidize its activities in the non lucrative regions, a practice followed in the traditional process through public sector units.

Conclusion

It is characteristic of the free market dictated profit oriented private sector to not engage in any activity unless it is assured attractive remunerations, irrespective of how important and valuable the activity would be for society at large. Such an outlook is incompatible with the infrastructure sector which is driven more by social needs and concerns. The process of privatization sought to resolve this conflict by introducing free market efficiencies in the operations of infrastructural facilities. Market efficiencies were expected to make socially important activities financially lucrative as well. However, if the market fails, the private sector with its demand for higher rate of returns can turn out to be more inefficient than a state run public sector.

Developing infrastructural facilities is the responsibility of the state and not the private sectors. The former thus has to woo the latter with suitable incentives to get involved, which gives the latter greater bargaining power. The problem is intensified when the public sector unilaterally commits itself to PPP in such a way that it shuts off all possibilities of developing the facilities on its own initiative. The private sector owns no responsibilities of developing infrastructural facilities and thus is not finally answerable for the lack of it. The onus completely lies on the public sector. This would generate unequal partnerships.

Thus we find that often in PPP, all contentious risks are finally dumped on the public sector. The private sector in many cases even force renegotiations on the public sector, reneging on previously agreed terms simply because newer developments cannot ensure its perceived profits. The public sector in such cases is often forced to accept such renegotiations at terms spelled out by the private sector.

The discourse of profitability is often cited to justify these renegotiations or changes in regulations required under those renegotiations. It is often overlooked that infrastructural facilities have greater social value and thus those entities engaged in their provisioning cannot be judged simply in terms of revenue earnings or profitability. Profitability as the sole benchmark for judging any economic activity is characteristic of the private sector. If involving the private sector in providing infrastructural facilities entails such shift in paradigms, somewhere in the whole process the basic essence of social infrastructure is lost. This then is the biggest threat of Public Private Partnerships.

Reference:

Morris, Sebastian (2001): Issues in Infrastructure Development Today: The interlinkages, Chapter 2, India Infrastructure Report

Gausch, Jose-Luis (2004): Granting and Renegotiating Infrastructure Concessions: Doing it Right, The World Bank

Gausch, Jose-Luis, Antonio Estache, Atsushi Iimi & Lourdes Trujillo (2007):Multidimensionality of Auctions and Renegotiation: Evidence from Transport PPP in Latin America, Policy Research Working Paper Series No. 4665, The World Bank                   

COURTESY : PRAGOTI