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Canadian Public Policy

The Economics of Public-Private PartnershipsAuthor(s): Jean-Etienne de Bettignies and Thomas W. RossReviewed work(s):Source: Canadian Public Policy / Analyse de Politiques, Vol. 30, No. 2 (Jun., 2004), pp. 135-154Published by: University of Toronto Press on behalf of Canadian Public PolicyStable URL: http://www.jstor.org/stable/3552389 .

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T h e Economics o f Public-Private

Partnerships

JEAN-ETIENNEE BETTIGNIESNDTHOMASW. Ross

SauderSchoolof Business

University f BritishColumbia

Vancouver,ritishColumbia

Lesgouvernements, 'interieur u Canada tatraverse monde, herchent e nouveauxmoyensde fournir

aux contribuablest auxusagersdes servicespublicsamoindre

cofit.Beaucoupd'entreeux ont choisi de

formerdespartenariatsecteurpublic/secteurriv6qui impliquente secteurpriv6dansunebienplus large

mesure.Ce choix est souventcontrovers6t les debats e constituentegulierement partird'une ddologie

plut6tqu'a' artir 'uneanalyse onsciencieuse.Cet articleajoutenotrecontributionupetitnombre '6tudes

d'universitairesonsacr6esace partenariat,nexaminantes facteurs conomiques uisonta abase de ces

relations,de maniereadecouvrireurs v6ritablescofitset benefices.L'objectifest de nous aidera mieux

comprendreoihet commentce systeme de partenariatpeut constituerune m6thode efficace pour le

ddveloppementes servicespublics.

Governments crossCanadaand around he world arelookingfor new waysto deliverpublicservices at

lowercosts to taxpayers ndusers.Manyhave chosento formpublic-private artnershipsP3s), involving

the private ector to a muchgreater xtent.This choice is oftencontroversial,with the debatesroutinelydrivenby ideologymore hancarefulanalysis.Thispaperadds o the limitedacademic iterature n P3sby

reviewing he fundamentalnderlyingconomicsof theserelationshipsogetattheirrealcosts andbenefits.

Thegoalis tohelpus betterunderstand hereandhow P3smaybe an efficientmechanism or theprovisionof publicservices.

INTRODUCTION

A sgovernmentsroundheworld truggleo

providemoreandbetterservicesto theirciti-

zens on limitedbudgets,organizationalnnovation

has come tothedeliveryof publicservices.Just ike

their private sector counterparts,public sector

decisionmakersre now asking ust whatservices

theyshouldprovidehemselves nd orwhich hould

they contractwith privatesector partners.This

search or new methods or theproduction nd de-

liveryof publicserviceshasgivenus newconcepts(or at least new labels) such as the moregeneral

"alternativeervicedelivery"ASD),and the more

specific"public rivate artnerships"PPPsorP3s).ASD refers o thefull set of alternativerrangementsthatcansupplygoodsandservices hatwouldother-

wise have been provided directly by public

enterprisesalone.This will includeP3s, but also

contracting-outf services andoutrightprivatiza-tion. The effort to find better ways to produce

governmentervices s not merenibbling roundhe

edgesof government to some it represents sea

change ntheverynature f government;thas even

beenreferred o as "reinventing overnment"see,e.g., Osborne ndGaebler1993;Trebilcock1994).

CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004



136 Jean-Etienne e Bettigniesand ThomasW Ross

Ourgoal in thispaper s to worktowardan under-

standingof the underlying conomicsof P3s such

thatwe mightbe betterable to advisegovernmentswith

respecto whereandhowthey might

representbetterwaysto deliverpublicservices.

The termpublic-privatepartnerships used in

slightlydifferentwayswith the result hataprecisedefinition o whichall will agree s elusive.The BC

Ministryof Financeoffereda straightforwardefi-

nition thatfocused on the use of P3s to replacetraditionalublicprovision: Public-privateartner-

ships (P3s) are contractual rrangementsetween

governmentnda

privatepartyor the

provisionof

assets andthe deliveryof services that have been

traditionally rovidedby thepublicsector" 2002).

Allan (1999) reportsseven definitionshe has un-

covered.' The central element reflectedin these

definitions and others is the sharingof decision-

making authority, which contrasts with the

"supplier"elationshipn whichgovernmentecides

exactlywhat it wants andbuys it and the "public

enterprise" odel n which hegovernment roduces

the services with no privatesector involvement.Manydefinitionsalso mention the sharingof re-

wardsandof risk.Thesharingof rewardss clearly

necessaryf theprivate ector s to be involvedvol-

untarily,2 nd the idea thatP3s permit heoptimalallocationof risk is pervasive n the P3 industry'sliterature ndwill be addressedn detailbelow.

While someexamplesof P3sgo backdecadesor

more,there can be little doubtthat interestgrew

rapidlyn the1990s.3TheUnitedKingdom articu-larly embracedwhat were called "privateinance

initiatives"PFIs) o get privateparticipationn the

provisionof publicservicesbeginningabout1992.

InitialBritishPFIswereconcentratedn the trans-

portation ector,butmorerecently heyhave been

used in a varietyof areas, ncludingroads,hospi-

tals,and schools.

Recenthigh-profileexamplesof public-private

partnershipsn Canada nclude the Confederation

Bridge connecting New Brunswick and Prince

Edward sland,completed n 1999; the 407 ETR

highway n SouthernOntariofirststagecompletedin 1998);and heCharleswood

ridgen

Winnipeg,completedn 1995. It is clear,however,hatevenin

CanadaP3s havegone beyondroadsandbridges o

include, orexample,airports, chools, ncineration

facilities,waterand wastewaterreatment,medical

facilities, recreation acilities, propertymanage-

ment,andutilities.4In a numberof countriesand

even some Canadian rovinces, pecialoffices have

been createdwithinthe governmentso collect P3

expertiseand promotethe use of P3s in certain

classes ofprojects.5

Whileholdingout the promiseof a more effi-

cientallocationof society'sresourcesand a better

"value ormoney" ortaxpayers,P3s arenotwith-

outtheircritics.Public ectorunionsareparticularly

opposedto whatthey see as attemptsby govern-ments to shift their work to privatesectorfirms

paying owerwagesandofferingan inferiorqualityof service(see, e.g., CUPE2002).And there s no

disputing he fact that some P3s have not workedout as well asprojected y thepartners.ntheirex-

amination of P3s, which included reviews of a

number of specific projects, Boase (2000) and

Daniels and Trebilcock 1996) recognizeboth the

potentialbenefitsand costs of P3s. The costs theycite include ack of transparencynd accountabil-

ity, andthe potentiallyseriousproblems hat can

arise when contracts re notwell-designed.

Thispaper s at once an introductiono an im-portant,andincreasingly o, area of government-businessrelationsanda call for research.Wearguethatbasic economictheory s extremelyhelpfulin

understandinghe potential or costs andbenefits

from these new arrangements.While even a short

libraryor Websearchwill uncover iterallythou-

sandsof pageswrittenon P3s, there s a surprising

shortageof what we mightcall objectiveresearch

on thetopic,orindependentvaluations f thesuc-

cesses and ailures.Mostof what s available omes




TheEconomicsfPublic-Privateartnerships137

from irms hatearn heir ncomes romP3s orgov-ernmentagencies charged with promoting and

implementinguchprojects.Whilesomeof this is

enormouslyhelpful,therecan be no doubt hat n-

dependent nalysesof thestrengths ndweaknesses

of P3s are warranted.6

THESCOPEOFPUBLIC-PRIVATEARTNERSHIPS

A SimpleFramework:TasksandGeneral

Policies

The processthroughwhicha project s developedto create

goodsandservices

might,orour

purposes,beroughly rokendown ntofourprinciple tasks":7

Task1: defininganddesigning heproject,

Task : financinghecapital osts of theproject,

Task3: building hephysicalassets(e.g., road,

school,etc.), and

Task4: operating ndmaintainingheassetsinorder o deliver heproduct/service.

One of the government's uties is to decide to

whomthese tasks shouldbe allocated;and in this

theyhaveessentiallythreegeneralpolicy options.Most commonly, hey let free marketsdo all the

work peopleearn ncome(usually n privatea-

bourmarkets) ndgo to outputmarkets o buythe

goods andservicestheyvalue fromprivatesector

sellers whoperformasks1 to 4. Thegovernment'srole in thesecases is limited oprovidinghe frame-

work laws and enforcement that make privatemarketsworkwell, including ontractaw,criminal

law,andcompetitionaw.

At the other end of the spectrums purepublic

enterprise,n which the government roduces he

goodorservice tself,withnoparticular rivate ec-

tor involvement except perhaps through the

provision f inputs old in standardmarkets.Refuse

collectionprovidedby municipal mployeeswould

be anexample.Theprivateector's nvolvementere

is limited to selling collection trucksandgasolineto the local governmentanitationdepartment.

Fora number f goodsandservicesgovernmentswould be unsatisfiedwith the quantity,qualityor

distributionf theoutputs esultingrompurelypri-vateprovision,andso theytakea moreactiverole.

It couldbe, for example, hat there s a significantsocial valueto a moreequalaccessto somegoodsthan ully privatemarketswouldprovide health

careandeducation ometo mindaspossibleexam-

ples.In othercases, it

maybe thatthe

goodcannot

be providedeffectivelyby the marketbecause of

public good andexcludabilityproblems.Here the

classicexamples nationaldefence,butroadswould

be a relatedexample.8 tmayalso be the casethat

thefreemarket utcome,n thepresenceof signifi-canteconomiesof scale relative omarketize, will

breakdowninto a monopoly,as was the expecta-tion withrespect o manypublicutilities.

Governmentnterventionnthesecases cancomein a number f forms,differing n theallocationof

responsibility ndcontrolover asks1to4, between

governmentndprivate ector.When t assumesall

thetasks,we havepurepublicprovisionandwhen

some tasksaredelegated o the privatesector we

havevarious ormsof contracting-outndP3s.

Public-Private artnerships ndOptimalPrivateversusPublicInvolvement

Evenstandard ublicprovisionof serviceshas tra-ditionally involvedpartnershipswith the privatesector to at least a limited extent.9 However,as

mentioned,n recentyearsmanygovernmentsave

begunto considerexpandinghe use of theprivatesector in the production f publicservices. In the

broadest ense of theterm his is privatization,hat

is, the assignment,o theprivate ector,of control

over somedecisionspreviouslymadeby thepublic

sector.10 It is common for the public sector to

perform asks 1, 2, and4, possiblyleavingtask 3





(construction)o theprivate ector.Construction f

publicbuildings,for example, s usuallydoneby

privatecontractors.1"nd it is not uncommonor

thegovernment

o "contract-out,"efusecollection;

that s, to puta collectioncontract ut forbids and

topayfor the serviceson behalfof localcitizens.In

such a case, the government pecifies a requiredlevel of service,solicits bids or proposalsand se-

lects a "winner."'2 heprivate ectorproviderhen

has considerable ontroloverhowthe service s pro-vided: for example,whatrouteswill be operated,whatequipmentwill beused,who willbeemployed,etc.13

P3s lie somewherebetweensimplecontracting-out and afully privatemarket n the spectrum f

private ersuspublic nvolvement. hemoreprivaterelative o publicinvolvement,he more"private"thepublic-privateartnership.

We suggesttherearethreemain characteristics

of thenew waveof P3s.First,all P3s arereallyexten-

sions of contracting-outo a largernumber and

differentet)of thetasks istedabove.Thus, he con-tracting-outelationships the foundationf the P3.

Thesecondmaincharacteristic astodo withthe

"bundling"f responsibilities, r the allocationof

two or more tasks to a unique (consortiumof)

partner(s).t is verytypicalto havethe samepart-nerin chargeof theconstruction nd theoperationof a bridge,for example; ndeed thatpartnermaywell havepreviouslydeveloped he designfor the

bridgeandprovidedhefinancing.

Finally,the thirdnotablecharacteristic f manymodernP3s is the allocationof the financing ask

to theprivatepartner.Therecent ncrease n inter-

est in public-private artnershipsas been focused

on projects nvolvinga significantcapitalinvest-

ment typicallyneededto cover the construction

costs of some newbuildingor piece of infrastruc-

ture.Thenoveltyof P3s is thegovernment'secourse

toprivate unds o structurehese nvestments. pe-

cifically,governments round he worldhave been

using privatesector financingandexperimentingwith P3s to provideroads,bridges,hospitals,air-

port terminals, schools, prisons, passenger rail

services(heavy

andlightrail),

and waterservices,to namesomeof the mostcommon.Thesekindsof

projects, nd heprivateundsused tofinance hem,

have so dominated he P3 landscape hat in some

circles this arrangementasbecome theverydefi-

nition of a P3, and heywill be ourfocus here.

In the next threesections,we discuss in detail

these threecharacteristicsf P3s: contracting-out,

private inancing,andthebundling f tasks.

CONTRACTING-OUT:HEFOUNDATION FP3s

In the last 20 years,dissatisfactionwith the costs

associatedwithgovernment roductionas edmany

governmentso considerexpandeduse of the pri-vate sector in the productionof certain publicservices.14

Constructions the taskmost oftendelegated othe privatesector,in fact it is the norm n North

America.Whilegovernmentsmayretaincrews to

maintain,repair,and renovatephysicalfacilities,

seldomdo theyundertakearge-scaleconstruction

projects.Whether heprojectnvolves he construc-

tion of abridge, chool,hospitalorprison, henorm

is thatprivatecontractorswill do the work. It is

worthrememberinghis, as it remindsus thatthe

currentwave of P3s is not reallyso revolutionary

- the privatesector has alwaysbeenengaged n

manypartsof the provisionof publicservices, n-

cludingarchitectural ork andconstruction.What

is newer s the largernumber f tasksassignedto

the publicsectorandtheway theyare bundled o-

gether.Contracting-outemains he foundation f

modernP3s.

While the experiences of governmentswith

contracting-outrecertainly aried,heevidence ug-

gests hattcanreduce ostsand/or rovideorsuperior

levelsof service elative opublicprovision."15





Ex Ante CompetitionA key reasonfor the success of contracting-outt

reducingcosts appearsto be competition:while

therewillultimately

beonly

oneprovider

of the

service or a certainperiod and herefore ocom-

petition "in the market" the bidding process

allowscompetition"for he market." s pointedout

by Demsetz(1968) yearsago, ex antecompetition

for theprojectcanreplacecompetitionn themar-

ketto forcebidders o lowercosts,raisequalityand

beinnovative.Unhappinesswith heprivate ontrac-

tor can be punished the way the private sector

punishes: erminationor cause, lawsuits for con-

tractbreach,damageoreputation,nd oss of futurebusiness,etc. Thisdoes nothappenwithpublicsec-

torprovision f the service whereeachdepartmenthasmonopoly owerwithintssphere f influence).16

High-poweredncentivesandOptimalRisk

Allocation

Theotherkeyreason or the successof contracting

at reducingcosts is incentives-related. heprivatesector s generally egarded shavingagreater bil-

ityto delivermore nnovative roductsmorequickly,with moreflexibility,andat a lowercost (notnec-

essarily at a lower price) thanks to its access to

higher-poweredncentives.17

The oft-citedclaim thatP3s allow for a better

allocationof risks is but anexampleof the benefits

of higher-poweredncentives.Theidea s thatsome

kinds of risks are bestassigned o one partyor an-

other.'8In ourview, optimalrisk allocation s all

about ncentivemanagement, artiesshouldbe ex-posedto risktotheextent heycan bestmanagehat

risk,wherebymanagewe meanmeasurend, hroughtheir ctions,minimizeherisk.19f allriskwerepurely

exogenous,iketheweather,t wouldbe hard oarguethat here s anyadvantagen shiftingt to theprivatesectorgiven hat overnmentsre ikely o havedeeper

pockets) xceptperhapso insuranceompanies. he

advantageoshifting, ay,constructionisk othepri-

vatesectorpartners thatbearinghisriskgivesit a

strongncentiveo controlhoserisks hroughareful

andhigh quality onstruction.20

Scaleand/orLearningEconomies

In additiono ex antecompetition ndoptimalallo-

cationsof risks,thereareothergoodreasons ohire

privateontractorso constructacilities.The most

important elatesto economiesof scale. Govern-

ments ypicallydo nothaveenoughwork ogenerate

the volumes of business needed to allow a full-

serviceconstructionompanyogetunitcostsdown

to theirminimum,hrough cale or learning cono-

mies.21 As Williamson(1979) pointed out with

reference o the choice firmshave to makebetween

internalndexternali.e., market) rovision f goodsandservices, headvantageoesto the marketwhen

therearesignificantcale orlearning conomies hatcannot e achieved ythevolume fbusiness equired

bythebuyer inthiscasethegovernment).22

Contracting-out heory,Efficiency, nd

Incentives

Muchof thetheoryon contracting-outas focused

on the relationshipbetweenownershipstructure,

efficiency,andincentives,and in thatsense relates

to, and ormalizes, heideasdescribed arlier.Here

we present he maindirectionsof researchon thetopicin recentyears.

Relationship-specific nvestmentsand

Contractual ncompletenessEx Post Inefficiencies.Consider he design,con-

struction,and operationof a bridge, hospital,or

school.23Whatdo theseprojectshave n common?

Onecommonalitys thatonce theproviderthegov-ernment mployeeor private ectorcompany)and

the customer thegovernment r taxpayer) tart otrade, that is, start to work togethertoward the

completion f, say,abridge, heyarebetteroffcom-

pleting the projecttogetherthanterminating he

relationship ndstartingo tradewith otherparties.The reason s that both the providerand the cus-

tomer makerelationship-specificnvestments hat

are morevaluable f the project s broughto com-

pletion thanif trade breaks down. The provider

investsin buildinga bridgethatcorrespondspe-

cifically to thatparticular ustomer'srequest(in

termsof location,design,equipment,iming,etc.).

CANADIAN PUBLIC POLICY- ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004



140 Jean-Etienne e BettigniesandThomasWRoss

If the negotiationsbetweenthe providerand the

customer reakdown, heprovidermay ndeedhave

trouble indinganother ustomer or thatbridge.

The initial customer also makesrelationship-

specific nvestmentse.g.,search ffort, ime,design

effort) hatareworthmorewiththe current roviderthanwithanotherdesigner/builder/operatoror the

bridge.The investment o find the provider,or to

collaborateon the design, maybe worth ittle if a

newprovidermustbe found,andthatnewprovider

mayhavecompletelydifferent echnological apa-

bilitiesandrequirea verydifferentdesign.

Thus, the consequenceof relationship-specificinvestmentss the formationf a surplusrom rade.

Transaction osts arisebecause boththe providerandthe customerwant to appropriatehatsurplusfrom trade,and the bargainingandopportunistic

behaviourhat s generatedmayin itself be costly.

Onewayto mitigate heseso-calledexpostinef-

ficienciesis to limitopportunitiesor negotiations

andbargaining y writing ong-term ontracts.Welimit transaction osts by reducing he numberof

transactions. n our example,the government an

mitigatetransaction osts by writinga long-term

contractwith the (private)bridgeoperator, ndby

encouragingong-termontracts etween heopera-tor andothersuppliers, uchas thedesignerand/or

thecontractor,orexample.This s theP3 scenario.

However,rade elationshipsreoftenverycom-

plexanduncertain. his evelof complexitympliesthat irst, t is impossible o planforeverypotential

contingency, ndsecond,evenif everycontingencycould bepredicted,t wouldprobably e difficult o

write downthese plans in a contractbetweenthe

customer nd heproviderhat s enforceable ylaw.

In thatcase, long-termcontracts uch as the ones

justdescribedareless helpfulbecause heycannot

be made o bind n somecircumstances: e saythat

the contracts re ncomplete.Coase(1937)wasthe

first to recognizethe economicconsequencesof

contractualncompleteness, ndhis ideas, as well

as those of Williamson(1975, 1979, 1985), and

Klein,Crawford ndAlchian 1978),sparked new

literaturen thesubject. t wasarguedhatbecause

of their ncomplete ature, ontractsmustconstantlyberevised nd/or enegotiatedstimegoeson(long-termcontractsareinfeasible),andthe problemof

ex post inefficiency generatedby relationship-

specificinvestmentsannotbe easilymitigated.

Hence when contracts are highly incomplete,vertical ntegration, y avoiding enegotiationlto-

gether,mayoffer the bestalternative.nsuch cases

itmay

beoptimal

oput

the sameparty thegovern-

ment)ncharge f thedifferentasks, uchasdesign,

financing, onstruction,ndoperation.t avoids he

bargainingostthatwouldbe generatedf the tasks

were allocated o differentparties.This s thepub-lic provision cenario.

Crocker ndMasten1996)make hiscomparisonbetween ong-termontracts ndverticalntegrationin the contextof franchise idding ersus egulation.

TheysummarizehechoicesveryclearlynFigure1,which we replicate elow,adaptingt slightly o fit

ourP3 versuspublicprovisionontext.

FIGUREOptimalrocurementfPublicervices

Relationship-specific ssets?

No Yes

ComplexrUncertainxchange

Environment?

No Yes

SpotMarkets Long-termontracts Verticalntegration[P3] [Public rovision]

CANADIAN PUBLIC POLICY - ANALYSE DE POLiTIQUES, VOL. XXX, NO. 2 2004




Without elationship-specificnvestments,here

areno transaction osts andspotmarketprovision

is thebetter olution:t allowsmore lexibilityrela-

tive tolong-term

contracts and itpermits

the

efficienciesassociatedwithcompetition ndprivate

provision.A good exampleof this would be food

stamps: he government rovidesa product food)

thatrequiresno specific investment,via the spotmarket supermarkets).

When there are switching costs, two sub-

possibilitiesarise: ong-term ontracts ffer hebest

alternativewhentherelationshipsemain elatively

simple (e.g., buildinga bridge)such thatwritingeffective contractss possible,but vertical ntegra-

tion is sometimesnecessary when transactional

complexitiesmakeex post inefficiencies oo large

(e.g., perhaps, ometypesof healthcare).

Ex Ante Inefficiencies. Note that althoughthe

theoryon expost inefficienciesprovidespowerful

insights nto theadvantages f long-term ontracts

relative o spotmarkets, nd of integrationelative

to long-term ontracts, espectively themitigationand/oreliminationof ex post transactionosts), it

remainsmorevagueas to theirdisadvantagesin-

flexibility,bureaucracy). hefollowingdiscussion

of ex ante inefficienciesshouldclarify heseissues

by formalizing he trade-offbetweenbenefits and

costs for eachorganizationaltructure.

Recall that with relationship-specificinvest-

ments,a situationof bilateralmonopolyarises,in

whichasurplusrom rades created; nd hatwhencontracts re ncomplete,hetrading artiesbehave

opportunisticallyn theirattempto appropriatehat

surplus.Theability o behaveopportunisticallye-

pendsgreatlyon ex post bargaining ower,which

itselfdepends ntheparty'soutsidealternative,hat

is, thatparty'spayoff n theeventnegotiations reak

down.Whena partyhas anattractiveutsidealterna-

tiverelativeo atrading artner,e orshe s in abetter

bargaining osition,sufferinga smallerpenalty or

leaving herelationshiphandoestheotherparty.

In thelate 1980s Grossman ndHart 1986)and

HartandMoore 1990)gavenewimpetus o thelit-

eratureby underlininghe importance f property

rights.Property ightsover an asset confer ex

postbargaining ower,because the owner of the asset

keeps control over the asset, andcan prevent he

otherparty romusing t, shouldnegotiations reak

down.Inotherwords,property ights ncreaseone's

outside alternative elative o that of one's trading

partner, ndthatputsone in a betterbargaining o-sition. Consider gain herelationship etween he

customer(the government)and the provider n-

volved in the development of a bridge. If the

providers an ndependentirm/consortiumthepri-vate sector) trading at arm's length with the

governmente.g., P3),he or shehas somebargain-

ing power nrenegotiationecause heykeepaccess

to assets f tradebreaksdown,andthushavean at-

tractive utsidealternative. ncontrast,f theassets

usedby theprovider re ownedby thegovernment,thepublicsectoressentiallybuildsthebridge pub-lic provision), with the provideras government

employee.In case of disagreementhegovernment

canjust fire the individual, ndthus theprovider'soutsidealternativen thatcase is much ess attrac-

tive,andhe or she is in a weaker argaining osition.

Bargainingpower in renegotiation,and hence

assetownership,s important ecause t affects n-

vestment ncentives.The more ex post bargaining

power heprovider nticipates,heless likelyhe or

she is to be "held-up,"helarger he fractionof the

surplus reatedheywill be ableto appropriate,nd

thegreaterncentive heyhave o make elationship-specific investmentsn the first place. Of course,

morebargaining ower o the providermeans ess

bargaining ower o the government, ndthusless

incentivesandless investment y thepublicsector

customer.Thus,whenthegovernmenthoosesa P3

contractwith a privateproviderorthedesignand/

or construction f a bridge nsteadof publicprovi-

sion, it transferspropertyrights andbargaining

power o theprovider.This increases heprovider's

incentives o invest,butreduces ts ownincentives.





The insightof Grossmanand Hart(1986) and

Hartand Moore(1990) is thatproperty ightsover

an asset should be allocatedto the agent whose

marginal roduct f ex ante investments thehigh-

est. The government hould use a privatesector

provider or a particularask(e.g., design,financ-

ing,construction,rserviceprovisionorahospital)

only if themarginal fficiencyof theprovidernto

this"relationship"s higherhan hatof thecustomer

(government),because the transfer eads to a net

efficiency improvement.

Public versus Private Ownership

In thedescription

of the literatureonincompletecontractsofferedearlier,we adapted he theory o

the relationshipbetween the governmentandthe

provider.These models, however,were originally

developedoexplain heboundariesfprivatefirms.

In the past few years, economistshave started o

apply ncomplete ontractheorymorespecificallyto policy surroundingublicversusprivateowner-

ship.

Schmidt(1996) was amongthe first to investi-gate the trade-off between public and private

ownership n an incompletecontracts ramework.

His modelis based on the followingassumptions:

(i) themanager an exertan unobservable ffort to

reduceproductionosts, (ii) themanagereceivesa

privatebenefitfromproduction, nd(iii) property

rights confer better information: he governmentknows aboutcosts andprofits n the case of public

provision,but not in the case of privateprovision.

Theseassumptions ield two interesting esults.

First,withprivateprovision, heassociatedack

of information nablesthe governmento credibly

committo an incentive scheme for the manager.Based on a revelationgame,this incentivescheme

punishesthe managerwith low productionwhen

production ost is revealed o be high.Incontrast,

withpublicprovision, hegovernmentannotcred-

ibly commitnot to renegeon production ecisions,

and thus the managerhas lowerincentivesandex-

erts owereffort.Publicprovisionhus eads o lower

productive fficiency.

Second,withprivateprovision,hegovernment's

commitmento cutproductionwhencosts arehighleadsto too low a level of production omparedo

public provision. Public provision thus leads to

higherallocativeefficiency.Schmidtthusdefines

the trade-offbetweenpublicandprivateownershipas follows: although privateprovision generates

higherproductive fficiency,publicprovisiongen-eratesgreaterallocativeefficiency.

Hart,Schleiferand

Vishny(1997)focus on the

muchdebated rade-off etween owercost and ow-

ering quality of service provision. Indeed, they

provide he formal oundation or theargumenthat

privateprovisionmay eadto moreefficiency n re-

ducing hecost of serviceprovision elative opublic

provision, ut his mustbetraded ffagainstalower

qualityof service.

Theirresulthingeson two assumptions:ncom-

pletecontractsand a positiverelationship etweencost of serviceprovisionandqualityof service; hat

is, lowering ost has a negative ffectonthequalityof the serviceprovided.The incompletecontracts

assumptionmakes wnershipmportant:rivate ro-visionimplies hat heprovider wnsitsproduction

technology nd herefore asmorebargaining owerrelative o governmenthan f theservicewaspro-vided by a governmentemployee. Thus, if the

serviceproviders theprivate ector, t will have a

greaterncentive o invest n cost reduction xante,andin equilibrium ervice is providedat a lower

cost by the privatesector.On the otherhand,the

private ector ails to internalize henegative ffect

thatcost reduction asonservicequality, nd here-

fore has too much ncentive o reducecosts, to the

detriment f servicequality. nHart,Schleiferand

Vishny(1997), the private ectorhas more incen-

tivetoproducemoreefficiently,butso much o that

it tries to "cutcorners,"whichaffectsquality.The

choicebetweenprivate ndpublicprovision epends





on the importance f production fficiencyrelative

to this"corner-cutting."'24

TheSpecial

Caseof

Public Goods

BesleyandGhatak2001)focus ontheprovisionof

a public good. They ask whether a public good

shouldbeprovidedby thepublicsector,orby a pri-vateentitysuchasanon-governmentalrganization

(NGO),for example.The two parties nvestin the

production f the good andnegotiateover the sur-

pluscreated.n thesimplest rameworkrovided yGrossmanndHart1986)andHart ndMoore1990),

if negotiationsreakdown, he ownergetssomeben-

efitwhile heotherparty etsnothing.Because fthat,theownerof the assethasmorebargainingowerand

higher ncentives,andtransferringwnershipo the

agentwithhighestmarginalfficiency n investment

maximizeshetotalsurplus nd s optimal.

Whenthe good is public,however,bothparties

enjoysomebenefit f negotiations reakdown.Even

if tradebreaksdownbetween he NGOand hegov-ernmentand the NGO is no longer nvolved n the

development f the good, it still gets an "alterna-tive"benefit,dueto the publicnatureof the good.Forexample, he NGOwith aneducationalmandate

mayget a benefit rom hecreationof a new school

evenif it is not involvedwith its operation.

Besley and Ghatakdevelopa model wherean

increasenthe alternativeenefit due o investment

byoneor bothparties xante)raisesthecaringpar-

ty's valuationof thatalternative enefit morethan

the non-caringparty'svaluation.Consequently, nincrease n thealternative enefit mproveshe car-

ingparty'sbargaining ositionandexpectedpayoff,relative o theparty hatcares ess, whosebargain-

ingpositionandexpectedpayoffhaveworsened.To

maximize he total benefit n equilibrium,heallo-

cation of property ightsmustthereforemaximize

the marginal mpactof investmenton the alterna-

tivebenefit or themorecaringparty,andminimize

the marginalmpactof investmenton the alterna-

tivebenefitforthe leastcaringparty.

Thekey assumptionn this model is thatgiving

ownershipo a partymaximizes ts marginal rod-

uct of investmenton the alternativebenefit, and

minimizes he otherparty'smarginal roduct

f in-

vestmenton the alternative enefit.In otherwords,

"apartof the return f the investment f a player s

embodied n humancapitaland cannotbe realized

if the ndividuals fired" hat s, if negotiations reak

downand he ndividual oes not ownthe asset.

Itthen ollowsthatownershiphouldbeallocated

to thepartywiththehighestvaluation. f theNGO

values the school more than the government, t

shouldbegrantedheownership ight oprovideheservice.An interestingmplicationof the model is

thatthe efficiencyresultarguedby Grossman nd

HartandHartandMooremaynot hold withpublic

goods.Indeed, f thegovernment alues thepublic

goodmore han heprivateprovider,t is optimal o

havepublicprovision ven f thegovernments less

efficientthantheprivateprovider.

COMPLEMENTARITIESCROSSTASKS

DelegatingDesignand/orOperationso the

PrivateBuilder

As mentioned reviously, ne of thekeycharacter-

istics of P3s is thatresponsibilityor two or more

tasksmaybe givento the samepartner.nparticu-

lar,the designof theprojectprior o construction,

and/or he responsibilityor operationandservice

provision fterconstruction,maybeallocated othe

builder.

Theadvantages f privatizingasks1 and4 maybe similar o thoseassociatedwithcontracting-out

construction, hichweredescribedarlier.Consider

scale and/or earning conomies, orexample.It is

certainly ruethata number f P3s (e.g., highwayswithnewelectronictolling) nvolveprojectshatare

novel for the governmentn questionbut may be

familiar o a largemultinationalontractorhathas

workedon similarprojects n other urisdictions.25




144 Jean-Etienne e Bettigniesand ThomasWRoss

In such a case,thegovernmentanchoosetopayto

be educatedandthenperformheoperationstself,

or it canjustcontracthatserviceout.Contracting-outwill be particularlyttractive nder wo condi-

tions:(i) whenthe governmentwill notbe able to

amortize heexpenseof theeducation crossmulti-

ple projects;and(ii) whenthe operationsactivitywill benefit romongoingresearch nddevelopmentthatcannotbeeffectivelyreplicated y government.

Anotherpossibleadvantageromhanding esignand/oroperations ver to theprivate ectorderives

fromthegreater fficiencies hatmaybe attainable

withprivate

ectorproduction,hrough

xantecom-

petition, mprovedncentives,and hepresenceof a

market or corporatecontrol.26Theextensive it-

erature,referred o above,comparingpublic and

private provision of services and the effects of

contracting-out,asgenerallyound hat heprivatesectorwill deliverservices at a lower cost. How-

ever, the most commonly cited advantage of

allocating design and/oroperation o the builder

derives from complementaritiesassociated with

combiningdesign,construction,inancing,andop-erationwithinone firm or consortium). he idea s

thatby combining hesefunctions, he consortium

will have an incentive o minimize hefull lifetime

costs associatedwithprovidinghe service.27This

may involvespendingmorein construction o re-

duce maintenance roperation ostslater,an effect

the consortium an internalize.

There is likely to be a certain technological

complementarityor economy of scope betweenbuildinganddesigning,and betweenbuildingand

service provision.28The complementaritys en-

hancedby the incentiveadvantages f combiningthese tasks- if you haveto build the projectand

your reputationdepends n parton the qualityof

the outcome,you havea strong ncentive o see it

well designed.29 Similarly, f the privatepartner

doingthe constructions also goingto operateand

maintain hefacility, t will be bearingall the costs

of the service andso willhave an incentive o mini-mize those costs. It makessensein a case like this

tobring hispartnernto thedesignprocessas well,

sinceotherwise t risks ivingwitha poordesign.

Contrasthis situationwiththe onein whichthe

governmentdesigns, finances, and arranges he

buildingof thefacility,butlets someoneelse oper-ate andmaintaint. Thefacilitycan be built so as to

require igheror lower evelsof maintenance nd t

is far from clear that with decision-making epa-ratedbetween hepartieshatefficientdecisionswill

be taken.Constructionirmsbidding nthecontract

to build hefacility, n aneffort o appearo bepro-

viding their services at lower costs, will not

necessarilyadvocate or moredurableand

expen-sive construction. f, on the otherhand,they are

bidding o provide heservicestheyhaveanincen-

tive to propose designandplanfor constructiono

minimize hecosts of theserviceover he full life of

thefacility oratleast he engthof thecontract).30

PrivatizingOperation nd the Government's

Loss of Control

Operatinghe asset andproviding he service are

thepublic aceof a P3: thehighlyvisible attributesto whichpeoplemostfrequently espond.

Themajor oncernof opponents f contracting-out in general,and P3s in particular,s typicallyabout heloss of controlassociatedwithgiving pri-vateproviders ertaincontractual ights.The fear

is that heperfectcontract an neverbe writtenand

that,even if it could,performanceannotbe per-

fectlymonitored. wonegative mplicationsollow:

first,theincompletenessmeans hatwhenchangingcircumstancesecessitate hanges n thebehaviour

of the private irm,this will have to be negotiated

(ina smallnumbers argainingituation, .e., with-

outbenefitof competition) nd his couldbecostly;andsecond, he mperfectmonitoringmeans hat he

privatepartner an cheat on qualityor some other

non-contractuallement.31It is concernover the

qualityof servicesthatwill be providedby thepri-

vatesector n say, ails, hospitalsor schools,that s

themajorhurdleP3s haveto overcome ogainpub-lic confidence n theirabilityto meetpublicneeds.

CANADIAN PUBLIC POLICY- ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004



TheEconomicsf Public-Privateartnerships145

Thechallenge,when theprivate ector s to use

the facility to providethe service, is in carefully

specifying he characteristics f the servicethat he

government ares about so that there s no misun-

derstandingordeliberatexploitationf incomplete

contracts) etween heparties.As withmanyaspectsof P3s, the contracting hallengeshere aresignifi-cant- importantharacteristics f servicequalitymust be measuredand verifiablestandards f ac-

ceptableperformancestablished.32 or his reason

it is notsurprisingosee thatmanyurisdictionsave

created pecialized gencies oreviewproposals nd

lay out contract ermsfor P3s. Thesegroupsoften

functionaswithin-government

onsultants n P3s,

andasrepositories fknowledge ndexperiencehat

provide governmentswith the skills they need to

structure 3s to theirmaximumbenefit.

TheoreticalLiteratureon P3s as the

Privatization f BothConstruction nd

OperationTherecent esearch ealing pecificallywithP3shas

defined hem,really,as thedelegation f twoor more

tasks,"bundling,"o theprivate ector.Herewe re-view the mainarticlesandpresent heirkeyresults.

Bundlingand IncompleteContractingIn a recentarticle,Hart(2003) adapted he Hart,

SchleiferandVishny(1997) model to analyzeP3s

specifically.Thegovernments concernedwiththe

buildingandtheoperation f anasset,saya hospi-tal or a prison.The buildercan maketwo typesof

investmentsat the time of constructionwhich af-

fect the operation of the asset. The productiveinvestmentncreases hebenefitandreduces he cost

of operation e.g., investmentn buildingquality),while the unproductivenvestment educesoperat-

ing cost but also its benefit (e.g., investment n

"corner-cutting," imilar to Hart, Schleifer and

Vishny).33With"conventionalrovision,"he gov-

ernment ontracts eparatelyhebuildingandthen

theoperation f theprison.Thebuilder s thuspaidbefore thefruitof his two investments rerealized.

Anticipatinghis, thebuilder nvestsnothing n thefirstplace. In contrast,with a P3, the government

contractswith the builder o both construct ndop-

erate the prison.34The builderanticipates e will

be ableto reapsome benefitsfrom nvesting in

termsof loweroperating osts - and thusmakes

positive investments n both buildingqualityand

corner-cutting. herefore, elativeto P3s, conven-

tionalprovision eads to more underinvestmentn

productiveffortbuildingquality,while P3s leadto

overinvestmentsn corner-cutting.Hartconcludes

that P3s may be optimal when building qualitycannotbe well specifiedandcorner-cuttingnvest-

mentsarerelatively asyto monitor, ecause nthat

case both overinvestmentsn corner-cuttingand

underinvestmentnbuilding quality

arerelativelylow.

BundlingandAsymmetric nformationIn contrastwith thepreviousmodels,whichstarted

from anincomplete ontracts ramework,he most

recentpaperon P3s takes a completecontracting

approachwhereagencyproblemsbetween he cus-

tomer government)nd heprovidertheagent, he

privatesector)stem fromasymmetricnformation

andnon-observabilityf effort. Bentz,GroutandHalonen 2002)consider heconstruction ndserv-

ice provisionrelated o a product uchas a school.

They analyzewhethera governmenthouldoptfor

"conventionalelivery" inwhichcaseitcontracts

with a builder, akespossessionof the school,and

then writesa separate ontractwith a servicepro-vider or for a P3, in whichcasethere s a uniquecontractbetweenthe governmentand a "consor-

tium" hatbuildsandmanages heschool.

Bentz,Grout ndHalonen ssume hat hebuilder

canexerteffort oimprove fficiencyof servicepro-

vision,and hat hisefficiency s observable nlyto

the serviceprovider utnotto thegovernment.With

P3s, there s a uniquecontractandthe model sim-

plifies to a standardadverse selection set-up in

which the builder/serviceprovider s inducedto

truthfullyreveal whetherservice provisioneffi-

ciency s highorlow.Theinformationentgivento

the agentto inducetruth-telling lso generatesn-centives oexerteffortat thebuilding tage,and hus




146 Jean-Etienne e Bettigniesand ThomasW.Ross

providingncentives s relativelycheapwith P3: it

allows the governmento "hit two birds withone

stone." Conventionaldeliverydoes not have this

advantagend therefore he

paymentmade

bythe

governmento inducehigheffort s higherwithcon-

ventionaldelivery.

Ontheotherhand,compensation as to be paidless frequentlywithconventional elivery hanwith

P3. Indeedefficiencymaybe highdue to thebuild-

er's effort,or simplydue to the forcesof nature.

Withconventional elivery, he agent/buildermust

be compensated nlywhenefforthas beenexerted,

whereaswithP3s thepaymentrom hegovernmentis madewhenever fficiency s revealed o be high,

which ncludes he casewherehighefficiency s the

resultof nature.Thus s the trade-offbetweencon-

ventional delivery and P3s in this paper:

compensationo theagent s higherbut ess frequentin the former han n the latter.

PRIVATE INANCING NDTHETRUE COSTOF

CAPITAL

Traditionally,overnmentsinancedpublicprojects

themselves,either rom currentaxrevenuesor by

borrowing.Perhapshe moststrikingaspectof the

newwaveof P3s is the extentto which the financ-

ing is beinghandledby the private ector.Indeed,

one of the mostfrequent easonsgovernmentsm-

ploytojustifytheiruse of P3s is that heyarecash-

strapped nd too debt-laded lready,and therefore

need an infusionof capitalfrom theprivate ectorif theproject s to proceed.While almostcertainlytrue for many underdevelopedand developingeconomies (whereP3s have been used for some

time), the arguments made more and more fre-

quentlyby governmentsndeveloped conomiesas

well.35

Criticsof P3s askhow it canbe better o let the

privatesector financeprojectswhengovernments

(at least those n Canada ndmostof thedeveloped

world)can borrowat lower rates of interestthan

private irms.They argue hatsuchP3s are a trick

employedby governmentswanting o fool taxpay-ers into thinking hey areholdingdown levels of

publicdebtwhile

continuingo offerdesired ervices.

Weagreethat the use of P3s to "hide"debt s a

concern.Herewejustmake hefairlyobviouspointthatundercertainassumptionshere s a financial

equivalencebetween a policy in which a govern-mentborrows o payfor a projectandthenrepaysthe loan oversomeperiodand a policyin whicha

governmentets aprivate artypayforandconstruct

the asset and then pays that partyback through

"lease"payments verseveralyears.Inbothcases,the government ets the benefitof usingsomeone

else's money(the lender'sor the privatedevelop-

er's)to secure onstruction,nd henpays t offover

time. Dependingon how the accounting s done,

however, he P3 maynot showup as debt on the

government's ooksandfor governmentsookingto convince axpayershattheyarenotoverspend-

ing, thismaybe a good thing, f thetaxpayers an

be so fooled.36

However, herearea number f reasonswhy it

may makesense for the financingto be done by

partiesother thanthe government.A careful re-

sponseaddresses wo points:first,that it is not at

all clear hatgovernmentsanborrowmorecheaply;and second,that theremay be complementaritiesbetween inancingand the other askssuch thatwe

shouldookat hecombinedostsofhavinghose asks

performed,otthe cost of financingnisolation.

Canthe Government orrowMoreCheaply?To begin,we note that a comparisonbetweenthe

borrowingrates chargedto governmentsand to

privatepartnerss notnecessarily omparing ppleswithapples,as theprivateborrowers acquiring

put optionwith its loan andthismustcost it some-

thing.To see this,assume hatbecauseof its very

low probability f bankruptcy,hegovernmentan

borrowat therisk-free ateof interest, aythis is 5

percentover 20 years.If aprivateborrower ad an

equally owprobabilityf bankruptcyt wouldalso





be ableto borrowat 5 percent,butin fact overthe

courseof 20years here s anot-insignificanthance

it will be unable o meetits debtobligations.Thus,

a loan contractwith thisprivateborrower,ay at7

percent,s actuallya combination f a loanplusan

optionto "put" he remainingportionof the debt

backto theoriginal ender.

Theimportant bservation ere is that the gov-

ernment oesnotget thisput optionwhen t pays5

percent, t mustrepaythe loan in full, no matter

what.Thisis not to say thatthe cost of borrowing

hasto be identicalwhenwe take heput option nto

account,t is

justto

pointout that the listed rate

exaggerateshedifference.37

The secondpointwe wouldmakeabout he rates

at whichgovernment ndprivatepartiescan bor-

row, s thatwitha solid, long-term ontract roma

governmentuyeraprivate orroweranmost ikely

securea very goodrate fromprivateenders.Here

thegovernment'seliability s a buyer ubstitutesor

its reliability s a borrower, ith the result hat he

rateat which heprivate arty anborrows very ow.

Third, heprivateborrowers able to deduct n-

terestpayments ndso reduce ts taxburden.While

someof thissavingmay ustbe a transferrom he

very governmentwith which t is partnering,ome

couldbe from other evels of government. orex-

ample, n Canadahe tax savingscome, in part,at

theexpenseof the federal reasury,while thepublicsectorpartnermightbe a provincialor local gov-

ernment.While from the standpointof nationalwealth hese arenot realsavings n resources,rom

the perspectiveof the partners including he pro-

vincialor localgovernment),omeportions f them

are,and heyfunctionas a formof subsidy rom he

other level of governmentavailable only if the

project s privately inanced.

Fourth,when we recognizethatgovernments,

particularlyubnationale.g., provincial) nes,can

get themselvesinto serious financialtrouble and

even possiblyface bankruptcy, e knowthatthey

will often not be able to borrowat the risk-free

rate.38 Importantly, hey may face an upward-

slopingsupplyof capitalcurve suchthat themore

theyborrow he higherthe interestratetheymust

pay.Forexample,as a provincialgovernmentn-

creases borrowing t runs the risk of having its

debt-rating owngraded ndhavingto pay higher

rateson all of its borrowing.The implications a

familiaronefrommonopsonyheory thecostof

borrowingor the next project s higherthan ust

the interestrateyou pay for thatproject f it also

increasesthe rateyou pay for all yourother bor-

rowing.Fora government orrowing onsiderable

sumsofmoneyregularly,

hechanceof adowngrade

leading o the needtopayeven aquarter ercentage

pointmoreis a very seriousmatter.Thus,we can

havea situation n whicheven if the interestrate

charged o the government orrowingor the next

projects lower han hatwhichaprivateectorpart-

ner would haveto pay,the "full"marginal ost to

thegovernmentould be muchhigher.

Weconclude romthisreviewof the issues that

it is not at all clearthat hegovernmentwill be ableto borrowat a lower cost than heprivate ector.A

full evaluation f therelative ostswill haveto con-

sidersuch factorsas: (i) thecredit-worthinessf the

private orrowernd heprotectionsfferedn itscon-

tractwith thepublicsectorpartner;ii) the extent o

which axsavingsmaycome romother evelsofgov-

ernment;nd(iii) thedegree o whichthesupplyof

funds o thepublic ectorborrowersupward loping.

ComplementaritiesetweenFinancingandOtherTasks

Possiblymore mportanthan the relativecosts of

publicversusprivateectorborrowingre heeffects

thatbeing hedebtorhasonone's ncentives ohigh-levelperformance.39t is very ikelythat herewill

be importantcomplementaritiesassociated with

combining hefinancing askwith theconstruction

andpossiblyalso theoperation/maintenanceask.40

If a privatepartnerhargedwithconstructinghe

facilitymustalso provide ts ownfinancing,t will




148 Jean-Etienne e BettigniesandThomasW Ross

suffer he costs of delays.Since,of all theparties,the builderhas the greatestcontrolover the time-

to-completion, his provides strong ncentivesfor

thebuilder o finish on time andon budget.While

governmentsanalsoprovokedelays, through er-

mitting e.g., environmental,oning,etc.)problems

and design changes, the public sector decision-

makers are so far removed from theirprincipals

(taxpayers)hat whetheror not the governments

providinghefinancingmaynot mattero them.Add

to this thefact that nordinate elayscreated y gov-

ernmentsmightgivetheprivatepartnerheright o

recoverdamagesand it would not appear hatany

strongncentive oss is felt on the

governmentide

by moving inancing o theprivatepartner.41

SUMMARYNDDISCUSSION:ESSONS

LEARNEDOTHISPOINTANDQUESTIONSOR

FUTURE ESEARCH

Our review of the relevant heoryandexperiencehas suggesteda numberof lessons regarding he

conditionsunderwhichP3s becomea particularlydesirablealternative o traditionalmethods or the

provisionof publicservices.To brieflyrepeat he

mostsignificanthere:42

Ex ante competition.A substantial ractionof

the benefits romprivate rovision omes rommar-

shallingthe pro-efficiency orces of competition.Since the ultimateprovider f anyserviceswill al-

most certainly become a monopolist, this

competitionwill have to be ex ante- at the bid-dingstage. ftherearenotenough ompetent idders

orbiddingconsortia o maketheprocesscompeti-

tive, there s less of a guaranteehattaxpayerswill

get value formoney.43

Scarce skills. In manycases the privatesector

will have skills notavailablen thepublicsector. f

these skills will be required hroughouthe life of

the projectand it is hard o separate heprovision

of these skills from heoperation f theproject, hegovernmentmay need to allocate these tasks to a

privatepartnerwho notonlyhas theskills,but(be-

cause of its "ownership"f the project)also the

incentive o perform t a highlevel.44

Poor labourrelations.Where hepublicsector

labour-managementnvironment asnot producedanappropriately-skilled,fficientandflexible abour

force,theprivate ector again hroughheforcesof

competition)mayofferconsiderabledvantages.

Innovation.When the projectcalls for innova-

tive thinkingandnewapproaches,mostwouldturn

to privateproviders.Of course,it is possiblethat

onlysome

partsof the

project, aythe

architecture,needbe innovative. nsuch a case it maybebestto

contract utonlythatpart.Theextent o whichthe

wholeprojectshouldbe a P3 will depend, n part,on thecomplementaritiesetween he tasks(seethe

pointson complementarities).

Risks.Whenmost of the majorrisksarethingstheprivate ectorcanmanageas well orbetter han

thepublicsector,P3s become moreattractive.For

example,construction-delayisk is something hatthe contractor an managebetter thanthe public

partner nda P3 in which thecontractorora con-

sortiumpartner) lso becomes theoperator ivesit

the incentive o minimize such risk. On the other

hand,"political isk" s bettermanagedby thepub-lic sector.

Economiesof scale. If the privateprovider an

takeadvantage f economiesof scale (andperhaps

scope) rom heoperationf similarprojectsnother(perhapsnearby) urisdictions, he P3 optionbe-

comes more attractive.45

Observabilityndmeasurability f quality.Muchof the opposition o privatesectorprovisionofpublicservicesrevolvesaround oncernshat he

quality f servicewill fall.Inorder oprotect gainst

such quality erosion, the partnershipagreement

shouldspecifytherequired uality,provide or the

measurement ndverificationof quality,andpro-vide forenforcement f thecontract's equirements.

CANADIANUBLICPOLICY ANALYSE EPOLITIQUES,OL.XXX,NO. 2 2004




In somecases, however, t will be verydifficultto

define,measure,andverifyquality evels, making

theprivateparticipation roblematic.

Complementarities. When physical facilities

such asbridgesorbuildingsneed to be constructed,

it is prettymuchstandard ractice orgovernmentsto turn o private ontractorso do thework, aking

advantageof their economies of scale. In some

cases, the constructions the only task contracted

out, but when there are strong complementaritieswith other tasks it becomesefficient to have one

provider ortightlyorganized onsortium) espon-

sible for the setof connected tasks. This is most

frequentlyobservedwith the design task (or parts

of it) tied to theconstruction, ut ncreasingly ther

complementaritiesrebeingrecognized.

Constraints on public sector borrowing. We

have seen that f furtherborrowing isks a deterio-

rationof a government'sreditrating, hemarginalcostofborrowinganbecomeveryhigh.In thiscase,

allocating he financing asks to the private ector,

whichmightface a lowermarginalborrowing ate(even though ts averageborrowing atemightbe

higher),may owerborrowing osts. Cases n which

thegovernmentimplycannotborrowat all (aswith

somedeveloping ountries arrying normousdebt

loads)areobvious, f extreme,examples.

Whilewe wouldargue hatpartnershipshould

be embraced nly whentheyallowgovernmentso

provideservicesof an acceptablequalityat lower

cost totaxpayers/consumers,ther sometimesessnoble- objectives refrequently ttributedo gov-

ernmentsdopting 3programs.tmaybeargued,or

example,hatP3s areawayforgovernmentsoavoid

publicsector labourunions,to move debt off the

government'sbalance sheet, to hide information

fromthepublic,or to deflectblame.46

Despite this learningthereis much we do not

knowabout heoptimaldesignof P3s andtheir rue

efficiencybenefitsor costs. Tostimulate urther e-

search in this importantarea we suggest a few

importantquestionswhich we feel warrant tten-

tion.Somearedirected tsolidifyingourconfidence

of the lessons alreadydiscussed,otherspushinto

newerareas.

First, here s considerable xperiencewith con-

tracting-out n Canadaand elsewhere;does this

experience upporthetheorydescribedn thispa-

per?Then a similarquestionmust be asked for

completedP3s,where here s much ess independ-ent research.

Second,when s thecost of borrowing, roperly

evaluated,rulyower for the

publicsector?A full

analysisherewouldhavetoconsider lements uch

as: (i) tax issues andtaxshiftingbetween evels of

government;ii) the marginalversusaveragecost

of borrowingorgovernments;iii) the valueof the

put option;and(iv) bankruptcyosts.

Finally,moredetailedmodellingof the basicP3

trade-off thatis, with a P3 structure hepublicsectorgets greater fficiencybutexercises ess con-

trol- couldprovideadditionalnsightsabout heconditionsunderwhichtheP3will be thepreferred

approacho publicserviceprovision.

Supporterslaim hatP3srepresent trueorgani-zational innovation for the efficient delivery of

public services.Opponents rguethatthey are an

ideologicallydrivenplanto reducewagesto publicsector workers;one that threatens he qualityof

publicservices citizenshave come to expectfrom

theirgovernments.t is time for more ndependentresearch o determinehetruebenefitsandcostsof

public-private artnerships.

NOTES

Theauthorswould iketo thankNeilAlexander,onyBoardman, onGiammarino,icholasHann,Robert

Helsley, sur omervillendparticipantst heUBCCen-

trefortheStudyof GovernmentndbusinessPublic

PolicyLuncheon23April 003) orhelpful iscussions.

Veryuseful ommentsndguidance erealsoprovided

CANADIANUBLICOLICY ANALYSEEPOLITIQUES,OL.XXX,NO.22004



150 Jean-Etienne e Bettigniesand ThomasWRoss

by two anonymous efereesand the editor.The veryca-

pableresearchassistanceprovidedby JenniferNg and

Ann-BrittEverettandtheresearch upport rom the So-

cialSciencesandHumanities esearchCouncilofCanada

and the UBC Centre or the Studyof Government ndBusinessaregratefullyacknowledged.

'Two of the morerepresentative efinitions:(i) "A

public-private artnershipis] a cooperative enturebe-

tween hepublicandprivate ectors,builton theexpertise

of each partner, hat best meets clearly definedpublic

needs through he appropriate llocation of resources,

risks andrewards"CanadianCouncil or PublicPrivate

Partnerships).ii) "The erm"public-privateartnerships"

has taken on a very broadmeaning.The key element,

however,s theexistenceof a 'partnership'tyleapproachto theprovisionof infrastructuresopposed o an arm's-

length'supplier' elationship.. a P3 involves a sharingof risk,responsibility ndreward,and is undertakenn

those circumstanceswhen there s valueformoneyben-

efit to the taxpayers"(BC. Ministryof Finance and

CorporateRelations1996, 8).

2It s worthnotingthat he rewards eed not be meas-

uredin directprofits.Some "private" artnersmay be

not-for-profitnterpriseswhichmeasure ewardsn terms

otherthan directprofits.Forexample,a numberof air-

port authorities in Canada today are operated as

not-for-profitorporationsn "partnership"ithvarious

governmentsand government gencies (e.g., Transport

Canada).

3Under ome definitions,regulatedprivatelyowned

utilities e.g., electricity)mightbe seen as P3s,or atleast

as examplesof anASD.

4See, for example,the informationprovidedon the

Website of the Public-Privateartnership

Office of In-

dustry Canada,http://strategis.ic.gc.ca/epic/internet/

inpupr-dpr.nsf/vwGeneratedlnterE/Home

5For xample,heUnitedKingdomreated PartnershipsUK" n 1999,BritishColumbia reated heCrown orpora-

tion, "PartnershipsC" in 2002, and Ontario reateda

specialagency"OntariouperBuild orporation"n 1999.

6Anumber f governmentuditors aveproduced ery

useful reviewsof P3s in their urisdictions.The UK of-

fice is particularlytrong n this regard.See also Grout

(1997) foranexcellent"economic" ccountof P3sin theUnitedKingdom.A usefulcollectionof papersonpublic

policy partnershipss containedn Rosenau 2000).

7Acomplementaryiscussion ocusedon P3s for in-

frastructures found n Daniels andTrebilcock1996).

8With heabilityto costlesslyassess tolls for roador

bridgeuse, theseproblemsneed not arise.However,at

least untilrecently, he cost of collecting olls intermsof

manpower/administrationnd lost time to travellerswas

substantial.

91fwhatthepublicsector s buying s a moreor less

standardproduct,buying constructionservices is not

reallydifferent rombuyingofficesupplies n theregular

market,with theimplication hat heterm"partnership"is probably otappropriate.

'00f course, f it is a new service not previouslyof-

feredby governmentt is privatizationnly in thesense

that t involvesgreater rivateectordecision-makinghan

thepublicenterprise lternative.

"In some cases, the publicsectormay even do the

construction: ome governmentshave road crews for

buildingandmaintainingoads, or example,andmanywill havecrewscapableof at least small-scale onstruc-

tion and renovation rojects.

'2Thesurveys,for American arge cities by Dilger,MoffettandStruyk 1997)andforBritishColumbiamu-

nicipalitiesby McDavidand Clemens 1995) showthat

themostcommonly ontracted-outervices nclude: olid

wastecollection,vehicletowing,streetrepair, anitorial

services,and egal services.

31In rinciple,all of these could be specifiedin the

contractwith the sponsoringgovernment,butcertainlysomedecisionswill remainwiththeprivateprovider.

"Whilestill not without omecontroversy,here s aconsiderableiteratureomparinghe costsof publicver-

susprivateprovision f goodsandservices,and hemass

of evidencewouldseem to suggest hat heprivate ector

canproduce t lowercost. See, for example,Viningand

Boardman1992).

'5See,forexample,McDavidandClemens 1995) on

the experienceof local governmentsn BritishColum-

bia;Dilger,MoffettandStruyk 1997)on theexperience

of thelargestUScities;andDombergerndJensen 1997)

who reviewstudies roma number f countries.Some ofthesestudiesaresummarizedn McFetridge1997).





16However,n somecases, the traditional ublicsec-

torprovidermaybe permittedo bid for contracts gainst

the private ectorproviders.Forexample,UnitedKing-

dom(2003b)reports hat, orthemanagementf prisons

in the UnitedKingdom, he PrisonService has recently

accepted n-house bids (in competition) o replacepri-vate sectormanagementt twoprisons.Thesebidswere

successful, npartbecausemore lexiblestaffingpermit-tedthein-housebidder o lower ts price.

'7Theres some evidencethat theprivate ectordoes

infactdeliverprojects.moreuickly, sproponentslaim.

TwoUKstudiesareworthmentioningn thisregard.The

first, by the NationalAuditoffice is discussedfurther

below(UK2003a).Thesecond,preparedorHMTreas-

ury by MottMacDonald2002) studied"optimism ias"("thetendency or a project'scosts andduration o be

underestimatednd/orbenefits o beoverestimated")nd

found ess bias in P3projects.

'18Examples f thekindsof risks to be allocated n in-

frastructurerojects,as describedn Poschmann2003),

include: i) technical isk e.g.,engineering rdesign ail-

ures); (ii) construction isk (e.g., higherthanexpected

costs); (iii) operating isk(e.g., morecostly or difficult

to operate hanexpected); iv) revenuerisk (e.g., lower

thananticipatedevelsof demand);v) financial isk e.g.,inappropriateebtmanagement);vi) forcemajeure isk

(e.g., acts of war,naturaldisasters); vii) regulatory/po-litical risk (e.g., changesin laws thatmakecontinued

operationess profitable);viii) environmentalisk(e.g.,risk of significantenvironmentalamageandliability);and ix)projectdefault isk e.g.,failure hrough nycom-

binationof theserisks).

19We rehardly hefirstto make hispoint, hough t

is oftenmore mplicit hanexplicit nmaterials roduced

by the P3 industry.NovaScotia(1997) is quite goodonthispoint.Inpreparing financial ase fora P3 it clearlybecomes mportantoputa valueon risks ransferrednd

thiscan becontentious. ee, forexample,Pollock,Shaoul

andVickers 2002) whoclaimthatthefinancial ase for

a number f hospitalP3s in Britainwasbasedonsuspectvaluations f risktransfer.

20In worldof imperfectommitment,f course, ome

riskscannotbe transferredompletely o theprivate ec-

tor, even if that would give the privatepartner trong

incentives o effort.Projectdefaultriskmaybe anexam-ple.Private artnersantypicallywalkaway romprojects

thathavebecomeunprofitablethoughf theyhaveposted

a bondof somesort,this too will carryacost), butat the

endof theday it is thepublic partnerhathas to see the

serviceprovided.Thusthe privatepartner annotcred-

ibly committo provide he servicein all circumstancesand hepublicpartnerannot redibly ommit o notpro-videthe serviceunderanycircumstances.

211ts importanto recognizethatthere is a "local"

componentoconstructionmarkets. t wouldnot be easy

to movecrewsandequipment crossvast distances usttokeep hembusy.Thus, ven f agovernmentadenough

business n total to allowa firmto achieveefficientlev-

els of production, he costs of movingthe capacityto

where t was neededcould well be prohibitive.

22Theres thepossibility,of course,of a government-

owned construction company achieving its scale or

learningeconomiesby takingon additionalbusiness n

theprivate ector. Thiswastheconceptbehind heBrit-

ish Columbiagovernment's ll-fated attemptto build

high-speedferriesfor its own Crowncorporation,BC

Ferries,andalso for markets roundheworld.)This is a

good wayfor a governmento makeenemies n the pri-vate sectoras thosefirms arelikelyto findit unfair hat

they competeagainsta firmfor private ectorwork,but

theyare not allowed o bid on publicprojects.

23SeeHart(1995), HartandHolmstrom1987), and

HolmstromndTirole 1989)forexcellentsurveysof this

literature.

24SeeKingandPitchford2000). Theytoo deal with

optimal publicorprivate) wnershipn a frameworke-

lated to thatof Hart,Schleifer and Vishny. King and

Pitchford'sontributionomes rom hegenerality f their

modelwhichenablesthem to determine ptimalowner-

shipas a functionof

(i)the

marginalmpactof efforton

asset value,whichcan be positiveor negative,and (ii)

positiveor negativeexternalities.

25This ole of the privatecontractor bringingex-

pertise- is especially critical in less developedand

developing ountrieswhere henecessaryexpertisemay

just not be easily acquiredwithingovernmentor any-wherewithin hecountry).Fourie ndBurger uggest hat

inSouthAfrica,"a ackof managementapacityngovern-

ment s aprimeargumentor a PPP nitiative"2000,715).

261nheprivate ector, irms hatareunderperforming

canbe sold to otherownerswho canprofitby fixingthe

CANADIANUBLIC OLICY ANALYSE EPOLITIQUES,OL.XXX,NO. 2 2004




problems. his s notpossiblewithpublic ectorprovision.

27See,e.g., UnitedKingdom,NationalAuditOffice

(2003a, 1) andMcFetridge1997, 43-44). Thisis one of

the reasons he contract as to be foralarge

raction f the

useful ifeof theconstructedssets.McFetridgelaims hat

minimizing he combined osts of construction,mainte-

nance,andoperations the benefitmostrecognized y the

privatized risonsn the UnitedStates.

28Theheoreticaliterature as studied he"bundling"

of construction ndserviceprovisionas a definingchar-

acteristicof P3s. See ourdiscussionof Hart 2003) and

Bentz,Groutand Halonen 2002)below.

29Thisncentiveeffect is magnifiedf the same irm s

providing hefinancing ortheproject.We return o this

below.

30Most f theoperation ontracts f substantialacili-

ties are very long term- 20 years and longer is not

unusual. npart hereason s that his allows thegovern-

mentalongerperiod opayoffthecapital xpense hrough

lease payments.However, hispointalso illustrates he

advantage f making he contractengthroughlyequiva-

lentto the useful life of thefacility.

31Relateds theconcern hat f theprivate artnerverfound tself in financialdistress, t wouldbe tempted o

cheat even on contractedevels of quality.As thefailure

of the privatecontractor an be chaotic for customers,

thepublicpartnerwill be reluctant o enforcecontractual

obligations hatputthecontractor t risk of failure.This

is like a situation n whichboth sides beganwith"hos-

tages" to enforce mutualcontractcompliance,but the

hostageheldby thepublicsector profits romcontinued

operationunder he contract) ost its value.The use of

hostages to support exchange was described by

Williamson 1983).

32Ithas been suggestedthat someaspectsof quality

maybe verydifficult o makeenforceable artsof a con-

tractand, if they are very important,his may mitigate

againstusingtheP3 form.See, e.g., Hart,Schleiferand

Vishny(1997).

33The arametersrechosensuch that n the first-best

the unproductivenvestment houldbe set to zero.

34See lsoKingandPitchford2000),andBennett nd

Iossa(2003)for moregeneral nalysesof bundling f two

activities,which sharesimilaritieswith Hart,Schleifer

andVishny 1997) and Hart 2003).

35TheWorldBankhas an activeP3 program upport-

ing partnershipsor infrastructure

rojects.

36lndependentovernment uditorsmaynot befooled

and canrepresent check on this behaviour.

371nhe simplestcase, thereshould be no difference

in the "true" ost of capitalbetweenthe publicandpri-

vate sector.Thispointwas madeby Grout 1997) with a

veryelegantexample.However, f there s a differencen

thecostof liquidating failedprojectdepending n who

provided hefinancing, hiscouldcreate ome difference

inborrowingostsbetweenpublicandprivate orrowers.

3Ilndeed,in less-developedcountries,large private

corporationsmaybe morereliable debtors han the na-

tions in whichtheyareworking.

39Thiswas also very clearly noted by Daniels and

Trebilcock 1996, 409).

40A related ssue, whichwe do not takeup here,in-

volves the questionof how the privatepartner hould

financeaP3;that s, whatproportions f debt andequityareoptimal rom thepublic's perspective.The answer s

not as simpleas it mightbe for private irms n unregu-latedmarkets.Forexample, f a P3providing nessential

publicserviceruns nto serious inancial rouble,hegov-ernmentwill be underconsiderablepressure o bail out

the privatepartner o that the service flow is not inter-

rupted.A cushionprovidedby substantial rivate quityreduces he probabilityhat riskswill be shiftedback to

thegovernmentn this way.

41Ints surveyof P3s in the UnitedKingdom 2003a,

3, Table 1), the National Audit office reported hat22

percentof surveyedPFI (P3) constructionprojectsex-

ceededprojected osts (somewithgoodreason)while in

an earlierstudyit had found that 73 percentof govern-ment constructionprojectsmanaged n traditionalwayshadgoneoverbudget.Further,n theirsamples,about76

percentof PFIprojectsweredeliveredontime(orearly)

compared o about30 percentfor traditionalmethods.

Without clear deaof howtheestimates f costand ime-

to-completion repreparedwe cannotconclude rom his

thatPFIprojectswerereallyless costly or morequickly

delivered,so this

questionneeds furtherwork.





42Oneessonnot listedbelow,because t has more o

do withpoliticalthan economicconsiderations,maybe

worthnotingnonetheless.To the extent that voterswill

accept user-pay ystemssuch as tolls morereadily f the

toll revenue s going to a privateconcessionaire atherthan heirgovernment, ublicofficialscommittedouser-

pay to finance the project may determine that a P3

structurewill meetless publicresistance.

430f course,if the privateprovidercan produce he

service moreefficiently, here s still a socialgainto al-

locating t thetask,evenif its price s high.Inthiscase,

while taxpayersmaynot save any money,the economy

still conservesresources.

44Theneed for the

continuingapplicationof scarce

skills likelyhas much o do with thepopularity f P3sin

developingcountries.

45For xample, he FrenchwatergiantslikeVivendi,

whichprovideervices omanymunicipalitiesnFrance nd

elsewhere, an spread ome of the fixed costs of design,

R&D,andmaintenancecrossa largenumber f projects.

46Spackman'seviewof the Britishexperiencewith

P3s leads him to believe that "the maindriversappearstill to be ideology and accounting"2002, 283). That

said, he sees potentialbenefits fromP3s and believes anumberof importantessonshave been learned n Brit-

ain (e.g., 297-98).

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