How Do You Build Effective Public-Private Partnerships?

For governments seeking to expand infrastructure, the public-private partnership offers an option that lies somewhere between public procurement and privatization. Ideally, it brings private sector competencies, efficiencies, and capital to improving public assets or services when governments lack the upfront cash. Companies agree to take on risk and management responsibility in exchange for profits linked to performance.

“Infrastructure is difficult for the public sector to get right,” notes the World Bank. “Public-private partnerships can help; they can provide more efficient procurement, focus on consumer satisfaction and life cycle maintenance, and provide new sources of investment.” At the same time, PPPs typically cost more that straightforward public procurement: they only attract investors if the public pays both for the project and a profit for the private partners.

Research on PPPs published in the journal Sustainability traces the model back to 15th-century Italian city-states. Today, the researchers says, the model is effective for high-cost, high-visibility projects that involve social and technical complexities, with the potential to build in synergies, develop competencies, and create an effective framework for alliances and cooperation, especially when community stakeholders and experts are involved from the start.

Yale Insights talked with Isabel Marques de Sá, chief investment officer for public-private partnerships at the World Bank’s International Finance Corporation, about what it takes to successfully design PPPs and how they can be used creatively to fit a range of situations.

Q: What does a public-private partnership do?

A public-private partnership (PPP) is a very particular type of contract whereby the public partner (government entity) delegates some of its own responsibilities to a private partner under a long-term contract that defines the rights and obligations of each party during the term as well as the mechanisms for its financial re-equilibrium arising from unforeseen events or lack of compliance of the parties.

PPPs are an important tool for developing infrastructure and therefore fostering economic development. They are used with infrastructures like roads, airports, ports, power, water, and solid waste treatment and typically involve investment and operation and maintenance. PPPs are also used in social infrastructure like health and education, e.g.. construction and maintenance of a hospital or school facilities, but can also include total or partial clinical or education services.

There’s potential for PPPs in any sector. Interesting examples are agriculture or social housing. Regarding agriculture, in countries where government institutions have an important role in food security, such as India or Pakistan, PPPs in silos can be inserted in the production chain. Through controlling temperature and moisture and keeping pests out, silos generate savings that can easily pay the construction costs. The same applies to cold storage facilities. Regarding social housing, we are about to complete a project in India where a PPP is structured to provide housing to the poor, the government intervening through specific regulation and a land contribution to the project.

Q: How are PPPs structured?

These are complex long-term contracts. They typically span 15, 20, 25 years, sometimes more, depending on the nature of the project. In that period of time, technology, demographics, environment, and politics can all change, so contracts needs to be flexible to adjust to the project’s life cycle. The art of a PPP resides in the allocation of risks of the project and in the definition of the framework, principles, and rules to deal with change, because it will occur. So fundamentally in structuring a PPP contract we need to articulate a set of incentives and penalties to potential actions of the parties, so to ensure the stability and sustainability of the project.

PPPs always take place in the arena of the political economy because the parties contracting are not equal. One party is a government/public entity, and the other one is a private entity. Governments change and so do policies. And in countries where the rule of law is not enough established to maintain the stability of the contract, investors see a significant political risk that will need to be mitigated. This applies to termination of contracts but also to payment risks. A main risk is the regulatory one, e.g., the commitment of government to comply with a tariff law. Adjustment of tariffs can be highly political, particularly in electoral years, and therefore a private project can be easily politicized. Investors seek protection against such risks through guarantees, sometimes backed by a multilateral, international arbitration for dispute resolution and higher returns on equity.

The public party also needs protections from the private partner. Private investors typically provide performance guarantees, sometimes parent guarantees that can be unlimited or capped. If the company doesn’t deliver the product or service at the agreed level of quality or the timing contracted—if the building isn’t finished on time, if the water supply doesn’t meet the specified safety levels—the government draws on such guarantees.

Proportionality of penalties regarding the type of non-compliance is important for the sustainability of the contract over the long term. But contracts should mainly rule by incentives rather than penalties, giving both parties every reason to fulfill their obligations for the entire term of the contract.

Q: Where can things go wrong in designing a PPP?

The process of structuring a PPP involves a large number of people, often takes many years, and is expensive in itself. I’d say 50% of proposed projects fail and are never implemented. That is the nature of the business.

PPPs require a lot of business developer skills which need to be interdisciplinary, often drawing in people with expertise in finance, economics, law, engineering, environment, accounting/taxes, etc. Projects move ahead slowly, first to establish sound engineering and economics, then financial and legal feasibility, and finally political will to insert private-sector participation. Private-sector participation typically introduces new governance rules in a sector, externalizing costs or processes hidden until then. These projects can therefore awake unions or specific interest groups and rapidly become very politicized.

Without a government champion, PPPs rarely succeed. In any case they require a lot of negotiation and consensus building in order to develop a common understanding of the project at each phase among main stakeholders. It’s common for contracts to include requirements that address the concerns of a multitude of stakeholders and there is debate at each stage. In the later phases of a project, the private sector is invited to comment on the draft contracts. In some cases there are unresolvable differences (e.g., government refusal to provide certain guarantees or unacceptable risk allocation) or particular interests at stake, and projects fail.

Environment and social considerations are always important but more critical in certain projects. For example, building a road or a dam might require resettling some families or communities and this can negatively affect the project, if not properly managed and addressed. In certain cases, these issues can become very, very complicated and politically challenging. Transparency, engagement with affected communities, and communication is key.

As mentioned, to succeed in a PPP, a political champion is critical. It might be a key minister. In certain countries, it requires firm commitment of the president of the country. It has to be someone who can bring the stakeholders along and has the power to make decisions. Another critical key for success is the speed of a project since they need to be structured and awarded within a political cycle–and those are quite short, since governments change every four or five years.

And something not always well understood is the issue of affordability of users and/or government. Often government projects are overdesigned or built for capacity not materializing in the medium term. The externalization of costs of PPPs often makes these projects unfeasible because they are not financeable without a substantial government subsidy. So when designing PPPs, a particular attention is given to demand analysis and costing, so that a project is economically feasible. We have many cases where we proposed substantial changes to design, such has reducing the footprint of an airport, changing the number of stations in a metro, etc.

Part of why it’s important to do things well up front, with all the roles and risks clearly laid out in the contract, is because if there are problems, there’s nothing more financially costly and politically embarrassing than interrupting a PPP.

Q: Is there any part of this that is one size fits all?

Not really. There are best practices leading to standard legal clauses, but PPPs are specific. Each project is specific, even if in the same sector, and certain risks change depending on the country. All projects are very specific, economics are specific, the political economy is specific, and the capacity and policies of institutions as well as the laws are specific to a given country.

Of course there is some level of similarity within a sector but a lot of difference between sectors. For example, projects in airports and ports have a different risk profile from projects involving natural monopolies, like a water distribution system (power distribution is much more competitive mainly today with distributed generation).

Q: Are there environments where a PPP isn’t possible?

There are certainly environments where the risks make PPP not advisable due to the return a private investor would require, potential non bankability, and probable lack of local capacity to administer complex contracts. So everything can be done, but comes at a cost that is probably not reasonable.

But there are also ways to structure a partnership to allow incremental private engagement. In Liberia, a few years ago, after the war, the electrical infrastructure had been destroyed. A private company wasn’t going to assume the risk of rebuilding a whole new system with its own funds, but it was possible to create a management contract with an utility to manage and train the local utility, the works being funded by donors.

That starts a process where, hopefully, in in the medium term, the private sector can appreciate the track record of government institutions and operations which can be of enough comfort to justify a moderate level of investment. So, in fragile environments, one needs to be creative and design projects allowing the improvement of a sector in view of potential future investment.

Q: What’s the role of financing?

At the end of the day, PPPs need to be financed, so bankability is key. For that, a contract must allocate risk properly. The tools for financing keep developing and adjusting. These days, there is a lot of attention on project bonds for middle-income markets.

In places where you have a lot of liquidity, we see participation of local banks. In some developing economies, private banks will not be able to finance with long terms, so financing will depend on leveraging or simply mobilizing organizations like the World Bank’s International Finance Corporation or others. Guarantees for a project can leverage private lenders and lower the cost of financing, but it’s very specific to the country and the structure of the project.