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5 PPPs and Fiscal Risks: Should Governments Worry?

Author(s):
Ana Corbacho, Katja Funke, and Gerd Schwartz
Published Date:
July 2008
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Author(s)
Ana Corbacho and Gerd Schwartz1 

Public-private partnerships (PPPs) offer new opportunities to develop public infrastructure, but also bring in substantial fiscal risks. By involving management and innovation from the private sector, PPPs offer the promise of greater efficiency, better quality, and lower-cost services than traditional public procurement. However, PPPs also involve new and significant fiscal risks and can be used to bypass spending controls and move public investment off budget and debt off the government balance sheet. In fact, whether or not PPPs have achieved their efficiency objectives in practice remains an open question, although there is mounting evidence of fiscal risks associated with PPPs. Therefore, governments need to be proactive in managing these fiscal risks.

This chapter highlights key issues related to PPPs and fiscal risks. More precisely, it seeks to answer two questions: (i) what are PPPs and why should governments worry about them?; and (ii) how can fiscal risks from PPPs be managed? The chapter is organized as follows. The first section defines PPPs, the main motivations underlying the pursuit of PPPs, and the associated fiscal risks. The second section focuses on options for managing fiscal risks from PPPs. In this context, it discusses issues related to overall investment planning systems; the legal and institutional framework; and fiscal accounting, disclosure, and debt sustainability analysis (DSA). The final section draws some conclusions.

PPPs: what are they and why worry about them?

PPPs refer to arrangements in which the private sector supplies infrastructure assets and services traditionally provided by the government. Governments face different procurement options for infrastructure assets and services. At one end of the spectrum, the government retains all responsibilities and risks related to the project under standard public procurement. At the other end, the private sector assumes all responsibilities and risks. The majority of PPPs fall in the middle, with responsibilities and risks shared between partners (Figure 5.1). The typical PPP takes the form of a design-build-finance-operate (DBFO) scheme, but there are many variations. Although there is no clear-cut definition of a PPP, most definitions include three elements: (i) private execution and financing of public investment; (ii) an emphasis on both investment and service provision by the private sector; and (iii) risk transfer from the government to the private sector. Table 5.1 describes some of the essential and non-essential features of public provision, private provision, and PPPs.

Figure 5.1Procurement options and private sector participation

Source: Adapted from World Bank (2007).

Table 5.1Essential and non-essential features of different procurement options
Public ProvisionPrivate ProvisionPPPs
EssentialPublic sector:Private sector:Public and private sectors:
  • Owns asset

  • Does planning

  • Absorbs risks

  • Owns asset

  • Does planning

  • Absorbs risks

  • Receives user fees

  • Asset may be owned by private sector temporarily

  • Substantial public planning

  • Private financing, execution, and service provision

  • Risk sharing

Non-essential
  • User fees

  • Contracting out

  • Regulated prices

  • Regulated quality

  • Regulated prices

  • User fees

  • Special purpose vehicle

A key difference between PPPs and traditional public procurement is the structure of contracts involved (Figure 5.2).

Figure 5.2Contracts under traditional public procurement and PPPs: a comparison

Source: Based on Brixi and others (2005).

Whereas debt is incurred by the government under traditional procurement, it is incurred by the private sector under a PPP. Under a PPP, the government usually has a long-term service contract with a specific private sector partner—frequently (although not necessarily) a special purpose vehicle (SPV) set up to run the project—that defines all payment obligations and/or other responsibilities related to the project. The private sector partner can recover the investment and financing costs by charging fees to consumers (for example, tolls) or by charging fees to the government (for example, in the form of availability payments or shadow tolls paid through the budget or through revenue or income guarantees) or a combination of these various instruments. The private sector partner is typically the legal owner of PPP assets and liabilities for the duration of the contract. However, when PPPs involve limited risk transfer to the private sector, the government may be considered the economic (as distinct from legal) owner, in which case it can be argued that PPP assets and liabilities should be carried on the balance sheet of the government.2

PPPs have been pursued as an alternative to traditional procurement by different levels of government and in different sectors. PPPs have been implemented by central governments, local governments, and public enterprises3 and have been used in sectors as diverse as transportation (roads, railways, bridges, and tunnels), education (schools, museums, libraries), health (hospitals and clinics), water (sanitation plants, irrigation systems, pipelines), and public administration (courts, police stations, and prisons). Experiences of different countries suggest that economic infrastructure (for example, in transport) is usually a more straightforward candidate for PPPs than social infrastructure (for example, in health and education) for three main reasons (Hemming and others, 2006). First, sound projects that address clear bottlenecks in roads, railways, ports, power, and so on, are likely to have high economic rates of return, and therefore attract the private sector. Second, user charges are often both more feasible and more desirable in economic infrastructure projects. Third, economic infrastructure projects usually have a better-developed market for bundling construction with the provision of related services (for example, construction, and operation and maintenance of a toll road) than social infrastructure projects.

The main argument in favor of PPPs relates to potential efficiency gains. In particular, it is often argued that, because they harness the power of private sector management and innovation, PPPs offer better value for money (VfM) than traditional public procurement of the same assets and services. While PPPs can deliver high-quality services at lower cost than traditional public investment, doing so generally requires efficiency gains to be large enough to cover (i) the typically higher private sector borrowing costs and (ii) the significantly higher transaction costs of PPPs,4 as these costs are passed on to the government in PPP contracts.

Whether or not PPPs have achieved their efficiency objectives in practice remains an open question. While there is evidence that PPPs have contributed to efficiency gains, particularly from the United Kingdom where PPPs have been used for quite some time now, there is also evidence to the contrary. Box 5.1 presents some selected real-world examples of fiscal risks. Also, reports from PPP audits in various countries, including the United Kingdom and Portugal, contain useful information on successes and failures of PPP projects, and demonstrate the significant fiscal risks faced by governments in carrying out PPPs.5 A recent study by European Investment Bank staff finds that PPP roads are more expensive than traditionally procured roads based on contractual (ex ante) cost estimates. This ex ante cost differential of PPP roads is roughly equal to the size of cost overruns in traditionally procured road projects.6

Like all projects, PPPs entail different types of risks. Some project-related risks encountered in PPPs include:7

  • Construction risk. Design problems as well as cost and schedule overruns.

  • Financial risk. The possibility that a project’s cash flow may fall short of the level needed to repay the project loans and capital invested, owing, for instance, to interest and exchange rate variability.

  • Demand risk. The possibility that the demand for the services provided declines, reducing the cash-flow generating potential of the project.

  • Availability risk. The possible lack of continuity and low quality of service provision.

  • Political risk. Situations where government actions could impair the private sector’s earnings potential.

  • Force majeure. Risks beyond the control of public and private partners (for example, natural disasters).

  • Residual value risk. Uncertainty regarding the market price of the infrastructure asset at the end of the contract period.

To achieve efficiency gains, each risk must be assigned to the party best equipped to manage it. Successful PPPs recognize that both partners have certain advantages relative to the other in performing certain tasks and managing certain risks. For example, the government will typically be in a better position to manage political risk, while the private sector can generally handle construction risk more efficiently. Shifting all risks to private partners is usually not the best solution: some risks ought to remain in the public sector, especially those that the private sector cannot control or affect (for example, political risk). However, risk transfer to the private sector is essential to the efficiency of a PPP, because it motivates the private sector partner to try to satisfy the public interest. The appropriate level of risk transfer from the government to the private sector will depend on the specifics of each project and country.

However, good contractual risk-sharing arrangements alone do not ensure that fiscal risks are averted. In many countries, PPPs are popular in part because they can be used to bypass normal budgetary procedures, a practice that itself exacerbates fiscal risks. In general, PPPs allow governments to avoid or defer spending on infrastructure without deferring its benefits. Independent of the VfM they promise to deliver, PPPs can be a tempting alternative for financially constrained governments, as they can support increases in infrastructure investment without immediately adding to government borrowing. Hence, while they have the potential to increase efficiency and ease fiscal constraints for infrastructure investment, PPPs can also simply be a tool for bypassing expenditure controls, delaying borrowing, and moving public investment off budget and debt off the government balance sheet. Sometimes, governments can still be left bearing most of the fiscal risk involved and facing potentially large fiscal costs over the medium to long term.

Specific fiscal risks from PPPs often involve the creation of government liabilities that can be direct or contingent, explicit or implicit, known or unexpected. Direct fiscal liabilities occur when the government has a fiscal obligation in any event, while contingent liabilities are triggered by a particular event. For example, contingent liabilities may include minimum income guarantees given to the private sector partner, or government guarantees to banks that finance a PPP. Explicit liabilities are those created by a law or contract, while implicit ones reflect public and interest-group pressures. For instance, an implicit liability would be a bailout that may need to be provided to the private partners in a PPP that is too big or politically sensitive to fail. Known fiscal consequences derive from contractual obligations under a PPP, but there is usually plenty of room for unexpected issues to arise, some of which may lead to contract renegotiations. Contract renegotiations are not uncommon and frequently favor the private partner.8 But even direct and known payment commitments by the government, such as availability payments, can lead to fiscal risk if these are not adequately disclosed or incorporated into medium-term fiscal considerations.

Box 5.1Examples of fiscal risks and PPPs: country experiences

Selecting the wrong project. This is the risk of selecting a project that does not provide VfM or, more generally, a bad investment project. Since PPPs are embedded in long-term contracts that typically do not involve immediate budget payments, PPP selection processes often circumvent the (one-year) budget appropriation cycle. If a PPP is considered to be “zero cost” to the budget so that there is no specific PPP appropriation in the budget, there is a higher risk of lax project selection standards. For example, several highways in Portugal are considered to be low benefit/ high cost projects. Originally, they were approved and contracted only because they were perceived by decision-makers to be zero cost projects. If the projects’ life-cycle costs had been properly assessed, it is likely that other highway projects, with much lower cost-benefit ratios, would have been selected (see Monteiro in Part Two of this volume). Governments can usually mitigate project selection risks by strengthening their overall investment planning and selection processes.

Providing faulty design specifications. A main source of cost overruns in traditional procurement is project design errors. PPPs are typically supposed to transfer the design risk to the private partner. In practice, this may not be the case, particularly when the public partner sets certain design specifications or requirements that can later trigger legal claims from the private sector when mistakes occur. For example, the London University College Hospital, a PPP hospital inaugurated in 2005, required an additional payment of several million British pounds to the concessionaire after construction had been completed, when the ventilation system had to be changed to accommodate the most recent (but more heat-releasing) version of imaging equipment.

Facing bankruptcy risk. This is the risk that the concessionaire may go bankrupt, forcing the government to call immediately for a new tender or assume operations of the PPP. If contracts do not include provisions for the swift transfer of the PPP to another private partner, the prospect of the PPP operator going bankrupt will often induce governments to take costly ad hoc measures. For example, in Mexico, the government undertook an ambitious program of private toll road concessions in the early 1990s. Most concessionaires soon ran into financial difficulties owing to both cost overruns and traffic shortfalls, and requested relief from the government. These relief efforts took a variety of forms, including extension of the term of the concession, direct budget support, and income tax credits, but ultimately failed as many concessions remained in financial distress. In 1997, the government announced a new master restructuring plan, offering to take over the private concessions and assuming about US$7.7 billion in debt.

Handling multiple risks. In practice, risks tend to materialize jointly and/ or emanate from each other. The experience of Hungary illustrates some of the problems that can result from overly optimistic traffic forecasts, overestimation of users’ willingness to pay, and inefficient risk allocation. Hungary’s Ml PPP highway was heralded as Euromoney magazine’s 1995 “finance project of the year.” It quickly became clear that traffic forecasts had been too optimistic. There was a strong diversion of traffic to a toll-free parallel road. Moreover, several litigation procedures were initiated against the consortium holding the concession. By the time construction ended, the private partner had suffered major financial losses. In 1999, the project was renationalized. In the case of the M5 highway, also a PPP, the original contract was renegotiated in 1995, only a year after it was signed, to provide minimum revenue guarantees. When the first stretches of the M5 were opened, traffic was at 85 percent of the original forecast, requiring compensation from the budget. The contract was renegotiated again in 1997 with the government assuming traffic risk in full.

How can fiscal risks from PPPs be managed?

Managing fiscal risks from PPPs requires a sufficiently strong overall institutional framework. Fiscal risks are more likely to arise when investment projects are of poor quality, the legal and fiscal institutional frameworks for PPPs are weak, and accounting and reporting systems do not transparently disclose the fiscal implications of PPPs. Hence, effective management of fiscal risks from PPPs requires governments to focus on strengthening the overall framework for public investment planning, developing the legal and institutional framework to handle PPPs, and implementing transparent fiscal accounting and reporting. This section outlines best practices in these three areas that aim to limit fiscal risks and increase the benefits of PPPs.

Clearly, political commitment and good governance are overarching conditions for the success of PPPs. Pervasive corruption would be a serious obstacle to successful PPPs, just as it would be to successful privatization. Pursuing PPPs in the context of a weak institutional framework, coupled with poor governance and regulatory capacity, would not be advisable. Many countries, particularly those that are less developed, may find it difficult to comply with the institutional requirements for the effective management of fiscal risks from PPPs. This is likely to continue to be a constraint on the successful implementation of PPPs in low-income countries.

Overall framework for public investment planning

PPP projects should be integrated with the government’s investment strategy, its medium-term fiscal framework, and the budget cycle. PPP projects should be part of the government’s investment strategy and be pursued only when they offer VfM compared to standard public procurement. Determining this will typically be a two-stage process. The first stage involves deciding whether a particular project is worthwhile based on standard project appraisal techniques such as cost-benefit analysis (CBA), and within an overall investment planning framework. The second stage involves deciding whether a worthwhile project should be undertaken as a direct government investment or as a PPP. To ensure that the fiscal implications of PPPs are fully taken into consideration in the government’s medium-term fiscal framework and the budget, PPP projects should not be allowed to move forward outside the regular cycle of other investment projects.9

When discussing a PPP program or particular PPP projects, governments could begin by asking three questions:

  • Is there a solid investment planning system in place? Does the proposing ministry or agency make systematic use of project appraisal techniques to identify and prioritize public investment projects? Are there mechanisms to avoid a bias in favor of starting new projects (instead of maintaining existing infrastructure)? A strong investment planning system will typically require a central institution responsible for screening sectoral public investment projects; established mechanisms for project CBA, monitoring, and ex post evaluation; and medium-term fiscal frameworks that allow the appropriate reflection of the life-cycle costs of investment projects, including of operation and maintenance.

  • Why should the project be procured as a PPP rather than traditional public investment? Fiscal constraints should not be the deciding factor for a PPP. Yet, this is often the case when PPPs are used for “large projects that are too costly for the budget.” Instead, the decision to opt for a PPP should be based on VfM.

  • Is the legal and institutional framework to handle PPPs sufficiently developed? Once it can be demonstrated that the PPP is a good project and offers better VfM than traditional public procurement, it is important to evaluate whether the legal and institutional framework is equipped to handle PPPs in an efficient manner. This requires a careful analysis of several issues discussed in the next sections.

Legal and institutional framework for PPPs

Successful PPPs are supported by a legal framework that covers all major aspects of the PPP process and is conducive to private participation. International case studies have repeatedly demonstrated the importance of such a framework.10 Fiscal risks are more likely to arise in the absence of a comprehensive, clear, and stable body of legislation informed by common principles.11 A comprehensive and reasonably detailed legal framework can set the parameters for handling PPPs and also help to reassure the private sector that contracts will be honored. Countries should pay particular attention to the general principles of transparency, fairness, and long-term sustainability.12 In turn, the legal framework needs to be supported by effective dispute resolution mechanisms, as well as transparent and fair processes for the renegotiation of contracts and expropriation of assets.

A single PPP framework law is not an absolute requirement. Yet it is recommended in most cases, as consolidating the various laws and principles applicable to PPPs and explicitly resolving any existing conflicts makes the process simpler and clearer. Also, a comprehensive legal framework can help to reduce transaction costs in PPPs, that is, it avoids having to negotiate and then incorporate into project documents general stipulations that could be handled more efficiently by an overall legal framework.

PPP contracts should be awarded based on competitive bidding. Awarding construction and service contracts based on competition is crucial to reaping the benefits of private sector risk-taking, managerial skills, and innovative capacity. Incentive-based regulation is also important. Where a private operator can sell to consumers without much scope for competition, the government should regulate prices in a transparent, incentive-based manner. The challenge is to design well-functioning regulations that increase output, hold down prices, and limit monopoly profits, while preserving the incentive for private firms to be efficient and reduce costs.13

The link between service payments and service delivery must be clearly specified. The quality of services to be provided must be contractible if a PPP is to succeed. If the government can specify the quality of services it wants the private sector to supply and can translate these into measurable output indicators, it can then enter into a contract with the private sector which links service payments to service delivery. The less clearly specified the contract conditions are, the greater the risk of costly contract renegotiations down the road. Even if the quality of service can be appropriately built into a contract, ensuring construction quality may be more problematic. Shortcuts in construction quality can be hidden for many years, creating future liabilities for the government and possibly leading to costly renegotiation. The difficulty of building construction quality into a contract is a compelling argument for combining asset creation and operation (which is the defining feature of a typical PPP). Combining the two responsibilities motivates the contractor to build infrastructure of high-enough quality to prevent service delivery problems later on.

A strong institutional setup is needed to assess and manage fiscal risks. In particular, it can help the government build a reputation as a good partner and lower political and regulatory risks for the private sector, thereby increasing VfM. This requires a clear allocation of responsibilities within the government for dealing with PPPs. The institutional setup to handle PPPs varies by country and there is no single best model (Box 5.2). In general, it is useful to separate activities related to promoting PPPs from activities related to managing fiscal risks from PPPs. Each activity, however, should have its own central focal point within the government. A centralized PPP knowledge center can serve as a useful vehicle for facilitating PPPs by (i) creating a forum where expertise can be acquired, nurtured, and shared with other government agencies; (ii) providing centralized oversight for PPPs and reducing the duplication of efforts currently observed in some countries; and (iii) establishing a single contact point for the various operators (within and outside the government) involved in PPPs, contributing to cost savings over time.14 In addition, it is essential that the finance ministry be given a strong role in managing fiscal risks from PPP in order to safeguard public finances. In particular, the finance ministry should retain all gatekeeping functions related to PPPs; this is discussed further below.

The PPP process should be supported by appropriate gateway safeguards. Since PPPs entail long-term contracts that typically do not involve budget costs in the first few years, they may often circumvent the annual budget appropriation process. Additional safeguards are therefore needed to ensure that only good and affordable PPP projects are allowed to advance. A system of gateway safeguards formally gives the finance ministry the power to stop a PPP project that does not satisfy VfM and/or affordability considerations. Gateways need to be installed at specific stages of preparing and negotiating (or renegotiating) a PPP contract, since both VfM and affordability can change as a project advances from inception to execution. By allocating specific responsibilities to the finance ministry and other ministries involved in PPPs, the gateways ensure that key steps and decisions in the PPP process are communicated to the finance ministry on a systematic basis. Final approval by the finance ministry would be required before contract signature. A particularly useful example of a gateway process is provided by South Africa (Table 5.2). In some cases, limiting the government’s risk exposure to PPPs by establishing ceilings on the size of PPP operations may be advisable and can help guide affordability assessments.15 As the examples of both the United Kingdom and Brazil suggest, a floor on the size of PPP projects can also be useful to avoid overburdening the PPP process with small projects that may not be justified given the high transaction costs of PPPs.

Table 5.2The gateway process in South Africa
Project Preparation PeriodPhase 1: INCEPTION
  • Register project with the finance ministry

  • Appoint project officer

  • Appoint transaction advisor

Phase 2: FEASIBILITY STUDY
  • Prepare a feasibility study comprising the following:

  • → Needs analysis

  • → Options analysis

  • → Project due diligence

  • → Value assessment

  • → Economic valuation

  • → Procurement plan

Gateway: Approval No. 1 by the finance ministry
Phase 3: PROCUREMENT
  • Design procurement process to be fair, equitable, transparent, competitive, and cost-effective

  • Prepare bid documents, including draft PPP agreement

Gateway: Approval No. 2a by the finance ministry
  • Pre-qualify parties

  • Issue request for proposals with draft PPP agreement

  • Receive bids

  • Compare bids with feasibility study and each other

  • Select preferred bidder

  • Prepare VfM report

Gateway: Approval No. 2b by the finance ministry
  • Negotiate with preferred bidder

  • Finalize PPP agreement management plan

Gateway: Approval No. 3 by the finance ministry
Project PeriodPhase 4: DEVELOPMENTPPP agreement signed
• Measure outputs, monitor and regulate performance, liaise effectively, settle disputes
Phase 5: DELIVERY• Report progress in the annual report
Phase 6: EXIT• Scrutiny by the Auditor-General’s Office
Source: Based on National Treasury (2004).

Governments may have to develop specific technical expertise for PPPs. As shown in Figure 5.2, PPPs combine asset creation and management, and involve longer-term and more complex contracts and financing schemes than traditional public procurement. Therefore, the government needs to build specific expertise to handle PPPs effectively. In particular, the government has to be able to conduct thorough project appraisals (including VfM assessments), prioritize and manage projects, assess and price risks involved in PPP projects, negotiate and deal with the private sector in an effective manner, and ensure that PPPs are consistent with broader fiscal and economic policy objectives.

Box 5.2Examples of the institutional setup for PPPs in selected countries

Institutional arrangements to handle PPPs typically strike some balance between centralization and decentralization. Decentralization can be assessed along two dimensions: the degree of autonomy of different levels of government to legislate, grant, and administer PPPs, and the degree of autonomy of different ministries/sectors within one level of government. Both vary across countries:

  • In New Zealand, the central government has the main responsibility for PPPs, but sectoral departments have the lead on PPPs pertaining to their sector.

  • In South Africa, the central government has oversight and approval responsibilities for PPPs developed in local governments. Treasury approval of proposed PPP projects is done at three stages or gateways: (i) feasibility stage; (ii) bid documents and VfM assessment of the preferred bid; and (iii) approval of the final contract terms.

  • In Australia, state governments have the main responsibility for most infrastructure sectors. Project responsibility is assigned to a single minister in each case. This minister is then responsible for facilitating consultation with the other government departments involved in the project and with the department of treasury and finance. States and the Commonwealth have been working through the Heads of Treasuries Forum to promote consistent approaches to PPPs. Key principles for PPPs are outlined in the “Commonwealth Policy Principles for the Use of Private Financing.”

  • In the Philippines, the institutional structure comprises sectoral agencies, where a specialized PPP Unit is responsible for coordinating the design and implementation of its projects. National, provincial, and municipal authorities select and award projects under the framework. Priority projects must be approved by either the Investment Coordination Committee of the National Economic Development Authority, or by local or regional councils, depending on the conceding jurisdiction and the cost of proposed projects. There is also a PPP Center involved in marketing the PPP concept to private investors.

  • In Brazil, a federal law governs PPPs at all levels of government. Sub-national laws have to be consistent with the federal law, and the federal government can withhold voluntary transfers in case of noncompliance. The federal PPP program is managed by a council formed by the ministers of finance and planning, and the president’s chief of staff. The council is in charge of establishing the criteria for selecting projects and designing contracts.

Fiscal accounting, disclosure, and debt sustainability analysis

There are currently no internationally accepted comprehensive accounting and reporting standards in place for PPPs.16 Country accounting practices for PPPs differ significantly and are often characterized by fairly lax standards. As a result, the use of PPPs has often been motivated by a desire to circumvent fiscal controls, including moving public investment off budget and debt off the government balance sheet. This has gone hand-in-hand with the emergence of government guarantees and contractual obligations that give rise to contingent liabilities that imply significant fiscal risks, but which are often not adequately accounted for or disclosed.

Eurostat has issued a decision classifying the assets of PPP projects as either public or private based on risk transfer, with implications for the accounting treatment. Eurostat’s decision covers long-term contracts in areas where the private sector builds an asset and delivers services mainly to the government. According to Eurostat, PPP projects should be classified as non-government assets and recorded off balance sheet for the government when (i) the private partner bears the construction risk and (ii) the private partner bears either availability or demand risk.17 When PPP projects involve limited risk transfer to the private sector, the project’s assets would be classified as government assets. National statistics offices are responsible for adopting and implementing the Eurostat decision, based on information from project contracts.18

Eurostat’s decision provides only a minimum standard and may foster moral hazard. The application of the Eurostat standard will likely result in the majority of PPP projects being recorded as private investment, as the private sector typically bears construction and availability risk. Hence, applying Eurostat’s standard without additional safeguards would result in the potential fiscal implications of PPP projects going unrecorded. The simple “on-budget/off-budget” treatment provides strong incentives to design PPPs to “pass” the Eurostat test (that is, bring about moral hazard), allowing them to be recorded off budget, rather than to gear the project design toward the most efficient and appropriate allocation of risk, so as to achieve VfM. If a PPP project does not provide good VfM, that is, if it is at least as costly as traditional public investment, it simply postpones expenditure but at a higher overall cost over time. From an economic perspective, it would be difficult to justify the recording of such a project off budget.

Hence, additional disclosure requirements should be met even if a PPP project is recorded as a private investment. In many cases, the government makes a long-term commitment under PPP contracts, even when these are counted as private investment (for example, availability payments). Since such contractual obligations can limit fiscal policy flexibility in the future, the IMF has proposed that they should be disclosed in the budget and end-year financial reports (Box 5.3). Fiscal risk statements in annual budgets should also include PPPs, which are auxiliary and complementary to accounting/financial statements.18 The challenge of PPPs is not only accounting for and reporting past events appropriately, but also recording future actual or contingent financial transactions.

Box 5.3Disclosure requirements for PPPs and guarantees

PPPs

For each PPP project or group of similar projects, budget documents and end-year financial statements should provide information on the following:

  • Future service payments and receipts (such as concession and operating lease fees) by government specified in PPP contracts over the following 5–30 years.

  • Details of contract provisions that give rise to contingent or variable payments or receipts (for example, guarantees, shadow tolls, profit sharing arrangements, events triggering contract renegotiation), which need to be valued to the extent feasible.

  • Amount and terms of financing and other support for PPPs provided through government on-lending or via public financial institutions and other entities (such as SPVs owned or controlled by the government).

  • Information on how the project affects the reported fiscal balance and public debt, and whether PPP assets are recognized as assets in the government balance sheet. It should be noted whether PPP assets are recognized as assets on the balance sheet of any SPV or private sector partner.a

Guarantees

Irrespective of the basis of accounting, information on guarantees should be disclosed in budget documents, within-year fiscal reports, and end-year financial statements. Guarantees should ideally be reported in a Statement of Contingent Liabilities, which is part of the budget documentation and accompanies financial statements, with updates provided in fiscal reports. Information to be disclosed annually for each guarantee or guarantee program includes:

  • A brief description of its nature, intended purpose, beneficiaries, and expected duration.

  • The government’s gross financial exposure and, where feasible, an estimate of the likely fiscal cost of called guarantees.

  • Payments made, reimbursements, recoveries, financial claims established against beneficiaries, and any waivers of such claims.

  • Guarantee fees or other revenue received.

In addition, budget documents should provide:

  • An indication of the allowance made in the budget for expected calls on guarantees, and its form (for example, an appropriation, a contingency).

  • A forecast and explanation of new guarantees to be issued in the budget year.

During the year, details of new guarantees issued should be published (for example, in the Government Gazette). Within-year fiscal reports should indicate new guarantees issued during the period, payments made on called guarantees, and the status of claims on beneficiaries, and update the forecast of new guarantees to be issued in the budget year and the estimate of the likely fiscal cost of called guarantees.

Finally, a reconciliation of the change in the stock of public debt between the start and end of the year should be provided, showing separately that part of the change attributable to the assumption of debt arising from called guarantees.b

a The suggested disclosure of the private sector partner’s accounting treatment has been made by Heald (2003).b From Hemming and others (2006).

In addition to disclosure requirements, the IMF has also proposed that PPP-related risks should be reflected in DSA and medium-term budgets for policy analysis. To perform DSA and policy analysis, the IMF recommends the following treatment of government obligations (contingent or certain) that arise in PPP contracts:

  • For projects recorded as private investment, future payments by the government (contingent or certain) should be counted toward primary spending, that is, they reduce the primary balance. The stream of payments is not included in the stock of debt at the time the contract is signed. Instead, payments are counted as expenditure in the year they take place, and therefore impact the fiscal balance in that year. However, for statistical purposes, to facilitate policy analysis, and to enhance transparency, the stream of future payments should be disclosed and incorporated in medium-term budgets and DSA.

  • For projects recorded as public investment, the service component of future payments by the government should be recorded as primary spending, while the debt service component should be separated out and included in the overall projected interest and amortization payments. All debt is recorded as a liability of the public sector and added to the government’s debt stock.

This will require governments to strengthen their ability to assess risks from contingent obligations. For contingent obligations (for example, minimum revenue guarantees provided by the public sector), it will be important to assess the expected value of the obligations and then count it as primary spending. For instance, Chile and Colombia have made considerable progress in developing models to value contingent liabilities associated with PPPs and budget for these accordingly. Peru is also advancing in this direction. When contingent liabilities associated with PPP projects cannot be reliably quantified, the emphasis should be on scenario analysis corresponding to alternative degrees of risk exposure of the government.20

Until comprehensive accounting and reporting standards for PPPs are put in place, existing good accounting and reporting practices should be followed. Adherence to International Public Sector Accounting Standards (IPSAS), on either a cash or an accrual basis, would lead to disclosure of various items related to PPPs that are relevant for fiscal policy, such as commitments and contingent liabilities.21 Unfortunately, many governments do not currently follow these standards, although the governments of the state of Victoria (Australia) and the United Kingdom provide good examples of accounting and reporting practices.22 Chile also presents detailed information about PPP contingent liabilities in budget documents.23

Conclusions

PPPs can potentially be more efficient than traditional public procurement of assets and services, but can also entail substantial fiscal risks. By involving management and innovation from the private sector, PPPs offer the promise of greater efficiency, better quality, and lower-cost services than traditional public procurement; that is, they can offer VfM. However, PPPs also involve new and significant fiscal risks, and can be used to bypass spending controls and move public investment off budget and debt off the government balance sheet.

Governments need to be proactive in managing fiscal risks from PPPs. By nature, PPPs are risk-sharing arrangements and the government will always assume risks, implicitly or explicitly. The goal is therefore not to eliminate risk but rather to achieve optimal risk sharing, with each partner bearing the risk it can manage most effectively. However, optimal risk sharing will likely be distorted, and fiscal risks exacerbated, when PPPs are pursued to move investment off budget rather than to achieve VfM. To prevent this, governments should aim for: (i) investment planning systems that lead to the selection of sound projects and procurement options based on economic and VfM considerations rather than fiscal accounting issues; (ii) a legal and institutional framework sufficiently developed to handle PPPs and supported by the right technical expertise in the public sector; and (iii) transparent fiscal accounting and reporting practices that allow the appropriate disclosure and policy analysis of the fiscal implications of PPPs.

In assessing the fiscal risks posed by PPPs, governments should proceed judiciously. In particular, there is a need to quantify and assess the extent of PPP-related fiscal risks under different scenarios and report on PPP operations and their associated fiscal risks in budget documents. At the same time, there is a need to perform DSA that fully reflects PPP operations, particularly when PPPs are perceived to threaten fiscal and macroeconomic stability. In countries where valuation of guarantees and contingent liabilities is feasible, known and expected costs of PPPs should be counted as primary spending. In countries where valuation is not feasible, scenario analysis should be performed. This can include, for example, DSA on the consolidated position of the government and the SPV created for the PPP project. Finally, specific benchmarks for strengthening the institutional framework as well as specific ceilings on exposure to PPP operations can be considered. The former could entail specific reforms and structures that need to be implemented before implementing PPPs (for example, creation of a gateway process within the finance ministry). Also, the increasing use of PPPs, and the evidence on the substantial fiscal risks, and, ultimately, fiscal costs they can entail, will likely require limits on PPP operations to safeguard macro-fiscal sustainability.

Notes

The authors gratefully acknowledge the valuable contributions from Alex Segura-Ubiergo to an early draft and the excellent research support from Victoria Gunnarsson and Larry Cui. The chapter also draws on insights provided by colleagues who participated in IMF technical assistance missions that looked at issues related to managing fiscal risks from PPPs in various IMF member countries.

See Part Four in this volume for further discussion.

For instance, local governments in Brazil and Australia and public enterprises in Mexico have acted as the public partner in PPPs. PPPs at the federal level have been used in many countries around the world.

Higher transaction costs arise from the complexity of PPP contracts compared with traditional public procurement. Dudkin and Välilä (2005) show that total transaction costs (bidding and negotiation) during the procurement stage average 10 percent of a project’s capital value. Higher transaction costs led the United Kingdom to set a floor on the size of PPP projects of £21 million. Brazil’s PPP law also sets a floor on the size of PPPs.

Audit reports for the United Kingdom are available at http://www.nao.org.uk, and for Portugal at http://www.tcontas.pt.

These various main risks can be further subdivided. Detailed risk matrices, together with indications of who should bear each type of risk, are provided, for example, in South Africa (http://www.ppp.gov.za) and the state of Victoria, Australia (http://www.partnerships.vic.gov.au/).

For further discussion see Tandberg in Part One of this volume.

The success of Chile’s concessions program also relates to the fact that it is backed by a comprehensive concessions law that addresses basic requirements for effective concessions (the bidding process, rights and obligations of parties, property appropriation, and so on), handling of possible disputes, and the cancellation and transfer of contracts. See IMF (2005).

The importance of a robust and clear legal framework is also evidenced by the finding that concession contracts have been relatively less likely to get renegotiated when the overall regulatory framework for PPPs was embedded in a law (17 percent of signed contracts were renegotiated) than when it was embedded in the contract itself (40 percent) or in a decree (28 percent). See Guasch (2004).

The legal framework should cover at a minimum: (i) the assignment of roles and responsibilities for PPPs; (ii) a clear definition of PPPs and their scope; (iii) fair and transparent procurement rules; (iv) basic elements for conclusion, renegotiation, and termination of PPP contracts, including dispute resolution mechanisms; (v) financial management and audit procedures; and (vi) general accounting and reporting requirements. For details see United Nations Commission on International Trade Law (UNCITRAL) (2000).

The two most common forms of regulation include rate of return regulation and price regulation. Other types include yardstick competition and profit sharing. See Hemming and others (2006).

One of the major recent institutional changes in Portugal consisted of setting up a PPP unit at Parpública, which is responsible for overseeing public-private relationships, collecting, analyzing, and disseminating information on PPPs, and advising sectoral ministries. Another example of a PPP unit is that of the National Treasury of South Africa, which also provides detailed guidance and technical assistance to agencies related to the feasibility and management of PPPs. Partnerships UK, a specialized agency in the United Kingdom, promotes PPP projects within the government by providing financial, legal, and technical advice and assistance to support contract negotiations and procurement.

A ceiling on annual PPP-related payments (for example, relative to tax revenues) would provide a clear budget constraint. This could be complemented by a ceiling on the net present value of all PPP-related commitments to cap obligations over the life cycle of the PPP program. For example, Brazil’s PPP law limits the total financial commitments that can be undertaken in PPP contracts to a maximum of 1 percent of annual net revenue for all levels of government. The law also sets limits on financing for PPP projects that can be provided by public institutions (for example, the National Development Bank or public pension funds). Hungary has also built into its budget process ceilings on the long-term commitments the government can undertake, including in PPP projects.

See Part Four for further elaboration on accounting and reporting issues.

If the government pays the private partner irrespective of the state of the asset, the government would be bearing most of the construction risk. If the government makes payments independent of service delivery, the government would be bearing most of the availability risk. If the government makes payments irrespective of demand, it is bearing most of the demand risk.

The first important analytical decision in considering PPPs relates to sectorization, which precedes a decision on recording related transactions. Statistical guidelines require that all entities be investigated to determine whether they are institutional units, and, if so, whether they constitute a general government unit, a public corporation, or a private corporation. In determining whether an entity constitutes an institutional unit, autonomy of decision plays a key role. If the PPP’s ability to make economic decisions is so limited that it cannot be regarded as an institutional unit, it should be classified with the government entity that initiated the PPP and all transactions recorded as if they were transactions of the government unit itself.

Assessing risk transfer is difficult given the multitude of risks and the complexity of PPP contracts. Certainly, full disclosure of original and renegotiated contracts, along with simplification and standardization, is essential. However, the legal complexity of PPP contracts means that they will always be difficult to interpret, complicating the assessment of risk transfer. Moreover, PPP contracts may inform only the extent of ex ante risk transfer. Political pressure to bail out PPP projects (for example, because they are too large to fail or provide essential services) may expose the government to more risk than what is suggested by the legal contract.

Under certain circumstances, for example, when a PPP is considered “risky” or when the economic beneficiary of the PPP is the public sector, it would be advisable to consolidate the operations of the SPV, set up for the PPP, with the government accounts, and perform DSA on this basis.

The IPSAS framework mandates that a number of qualitative characteristics of information be included in financial statements. For instance, one of the mandated qualitative characteristics is “substance over form/’ which could be used to require recognition or disclosure of the true risks associated with PPP contracts, even if these are not explicitly incorporated in formal contractual documents.

Victoria’s financial statements contain detailed information about commitments and contingent assets and liabilities under all contracts, including PPPs, and this information is subject to independent audit by the supreme audit institution.

In 2006, an annex to the budget summarized the PPP contracts within the public works concession system and presented estimates of the contingent liabilities in PPP contracts, including minimum revenue and exchange rate guarantees.

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