You are on page 1of 21

Canadian Public Policy

The Economics of Public-Private Partnerships Author(s): Jean-Etienne de Bettignies and Thomas W. Ross Reviewed work(s): Source: Canadian Public Policy / Analyse de Politiques, Vol. 30, No. 2 (Jun., 2004), pp. 135-154 Published by: University of Toronto Press on behalf of Canadian Public Policy Stable URL: . Accessed: 08/11/2011 14:41
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact

University of Toronto Press and Canadian Public Policy are collaborating with JSTOR to digitize, preserve and extend access to Canadian Public Policy / Analyse de Politiques.


Economics of




SauderSchoolof Business University BritishColumbia of BritishColumbia Vancouver,

le de et a du Les gouvernements, l'interieur Canada a travers monde,cherchent nouveaux moyensde fournir et aux contribuables aux usagersdes servicespublicsa moindrecofit. Beaucoupd'entreeux ont choisi de le secteurpublic/secteur formerdes partenariats priv6qui impliquent secteurpriv6dansunebien plus large et a d'uneiddologie mesure.Ce choix est souventcontrovers6 les debatsse constituent regulierement partir Cet au d'6tudes d'uneanalyseconsciencieuse. articleajoutenotrecontribution petitnombre partir plut6tqu'a' en a les consacr6es ce partenariat, examinant facteurs d'universitaires 6conomiques sonta la basede ces qui et benefices.L'objectifest de nous aidera mieux relations,de manierea decouvrirleurs v6ritables cofits peut constituer une m6thode efficace pour le comprendreoih et comment ce systeme de partenariat des ddveloppement servicespublics. Governments acrossCanadaand aroundthe worldare looking for new ways to deliverpublic services at and lowercosts to taxpayers users.Manyhavechosento formpublic-private (P3s), involving partnerships with the debatesroutinely the privatesector to a much greaterextent.This choice is often controversial, drivenby ideologymorethancarefulanalysis.This paperaddsto the limitedacademicliterature P3s by on to the economicsof theserelationships get at theirrealcosts andbenefits. underlying reviewing fundamental whereandhowP3s maybe an efficientmechanism the provision Thegoal is to helpus betterunderstand for of publicservices.


providemoreandbetterservicesto theircitizens on limitedbudgets,organizational innovation has cometo the deliveryof publicservices.Justlike their private sector counterparts,public sector are decisionmakers now askingjust what services themselves forwhichshould and theyshouldprovide contract with private sector partners.This they searchfor new methodsfor the production deand of publicserviceshas given us new concepts livery (or at least new labels) such as the more general


around worldstruggle the to governments

servicedelivery" "alternative (ASD), andthe more (PPPsorP3s). specific"public private partnerships" ASDrefersto thefull set of alternative arrangements thatcansupplygoodsandservicesthatwouldotherwise have been provided directly by public enterprisesalone. This will include P3s, but also of contracting-out services and outrightprivatization. The effort to find better ways to produce servicesis notmerenibbling around the government of government to some it represents sea a edges of it changein theverynature government; haseven been referred as "reinventing to (see, government" e.g., OsborneandGaebler1993;Trebilcock1994).


136 Jean-Etienne Bettigniesand ThomasW Ross de

Ourgoal in this paperis to worktowardan undereconomicsof P3s such standingof the underlying thatwe mightbe betterable to advisegovernments withrespectto whereandhow theymightrepresent betterways to deliverpublicservices. is The term public-private partnership used in ways with the resultthata precise slightlydifferent definitionto whichall will agreeis elusive.TheBC defiMinistryof Financeoffereda straightforward nition that focused on the use of P3s to replace traditional partner"Public-private publicprovision: between are contractual arrangements ships (P3s) and partyfor the provisionof government a private assets and the deliveryof services that have been traditionally by provided the publicsector"(2002). Allan (1999) reportsseven definitionshe has uncovered.' The central element reflected in these definitionsand others is the sharingof decisionmaking authority, which contrasts with the in decides "supplier" relationship whichgovernment exactly what it wants and buys it and the "public modelin whichthegovernment enterprise" produces the services with no private sector involvement. Many definitionsalso mentionthe sharingof rewardsandof risk.The sharingof rewards clearly is necessaryif the privatesectoris to be involvedvoluntarily,2and the idea thatP3s permitthe optimal allocationof risk is pervasivein the P3 industry's in literature will be addressed detailbelow. and Whilesome examplesof P3s go backdecadesor more, there can be little doubt that interestgrew rapidlyin the 1990s.3TheUnitedKingdom particufinance embracedwhat were called "private larly to get private in initiatives" (PFIs) participation the provisionof publicservicesbeginningabout1992. in InitialBritishPFIs were concentrated the transsector,but morerecentlythey have been portation used in a varietyof areas,includingroads,hospitals, andschools. Recent high-profileexamplesof public-private in partnerships Canadainclude the Confederation Bridge connecting New Brunswick and Prince EdwardIsland, completedin 1999; the 407 ETR Ontario (firststagecompleted highwayin Southern in 1998);andthe Charleswood Bridgein Winnipeg, in that completed 1995.It is clear,however, even in Canada havegone beyondroadsandbridgesto P3s include,forexample,airports, schools,incineration medical facilities, waterandwastewater treatment, facilities, recreationfacilities, propertymanagement, and utilities.4 In a numberof countriesand even someCanadian provinces,specialoffices have been createdwithinthe governments collect P3 to and promote the use of P3s in certain expertise classes of projects.5 While holding out the promiseof a more efficient allocationof society's resourcesand a better P3s "valuefor money"for taxpayers, arenot withouttheircritics.Publicsectorunionsareparticularly opposed to what they see as attemptsby governments to shift their work to private sector firms payinglowerwages andofferingan inferior quality of service (see, e.g., CUPE2002). And thereis no disputingthe fact that some P3s have not worked out as well as projected the partners. theirexIn by 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 they cite includelack of transparency accountabiland and the potentiallyserious problemsthat can ity, arisewhencontracts not well-designed. are This paperis at once an introduction an imto and increasinglyso, area of governmentportant, businessrelationsanda call for research. argue We thatbasic economictheoryis extremelyhelpfulin the understanding potentialfor costs and benefits from these new arrangements. While even a short or Web searchwill uncoverliterallythoulibrary sandsof pages writtenon P3s, thereis a surprising shortageof what we might call objectiveresearch on the topic,or independent evaluations the sucof cesses andfailures.Mostof whatis available comes


TheEconomics Public-Private of Partnerships 137 fromfirmsthatearntheirincomesfromP3s or government agencies charged with promoting and such projects.While some of this is implementing enormously helpful,therecan be no doubtthatinand analysesof the strengths weaknesses dependent of P3s are warranted.6 collectionprovided municipal by employeeswould be anexample. private The sector'sinvolvement here is limitedto selling collection trucksand gasoline to the local government sanitation department.

Fora number goods andservicesgovernments of would be unsatisfiedwith the quantity,qualityor distribution theoutputs of frompurelypriresulting THESCOPE PUBLIC-PRIVATE OF PARTNERSHIPS vate provision,andso they take a moreactiverole. It could be, for example,thatthereis a significant A SimpleFramework: Tasksand General social value to a moreequal access to some goods Policies thanfully privatemarkets wouldprovide- health The process throughwhich a projectis developed careandeducation come to mindas possibleexamto creategoodsandservicesmight,forourpurposes, ples. In othercases, it maybe thatthe good cannot be roughly broken downintofourprinciple "tasks":7 be providedeffectively by the marketbecause of public good and excludabilityproblems.Here the Task1: defininganddesigningthe project, classicexample national is defence,butroadswould be a relatedexample.8It may also be the case that 2: Task financing capitalcosts of theproject, the free market the outcome,in the presenceof significanteconomiesof scale relativeto market size, will Task3: buildingthe physicalassets (e.g., road, breakdown into a monopoly,as was the expectation with respectto manypublicutilities. school, etc.), and Task4: operating maintaining assets in and the orderto deliverthe product/service. One of the government's duties is to decide to whom these tasks shouldbe allocated;and in this they have essentiallythreegeneralpolicy options. Most commonly,they let free marketsdo all the work- people earnincome (usuallyin privatelabourmarkets)and go to outputmarketsto buy the goods and services they value from privatesector sellerswho perform tasks 1 to 4. The government's role in thesecases is limitedto providing framethe work laws and enforcement that make private markets workwell, includingcontract criminal law, law. law, andcompetition At the otherend of the spectrum purepublic is in enterprise, which the government producesthe secgood or serviceitself, withno particular private tor involvement except perhaps through the markets. Refuse provisionof inputssold in standard Government intervention thesecases cancome in in a number forms,differingin the allocationof of and responsibility controlovertasks1 to 4, between and government privatesector.Whenit assumesall the tasks,we have purepublicprovisionandwhen some tasks are delegatedto the privatesector we havevariousformsof contracting-out P3s. and

Public-Private and Partnerships Optimal PrivateversusPublicInvolvement

Even standard publicprovisionof serviceshas trawith the private ditionally involved partnerships sector to at least a limited extent.9 However,as in have mentioned, recentyearsmanygovernments the begunto considerexpanding use of the private sector in the production public services. In the of broadestsense of the termthis is privatization, that the assignment, the privatesector,of control to is, over some decisionspreviouslymadeby the public sector.10 It is common for the public sector to performtasks 1, 2, and 4, possibly leaving task 3


138 Jean-Etienne Bettigniesand ThomasW Ross de

to of (construction) the privatesector.Construction for example,is usually done by public buildings, And for privatecontractors.1" it is not uncommon the government "contract-out," to refusecollection; thatis, to put a collectioncontract for bids and out to payfor the serviceson behalfof local citizens.In such a case, the governmentspecifies a required level of service, solicits bids or proposalsand selects a "winner."'2 privatesectorprovider The then hasconsiderable controloverhowtheserviceis provided: for example,what routes will be operated, whatequipment be used,whowill be employed, will etc.13 using privatesector financingand experimenting with P3s to provideroads,bridges,hospitals,airport terminals, schools, prisons, passenger rail services (heavyand light rail), and waterservices, to namesome of the mostcommon.Thesekindsof and fundsusedto financethem, projects, theprivate have so dominated P3 landscapethat in some the circles this arrangement becomethe very defihas nitionof a P3, andthey will be our focus here. In the next three sections, we discuss in detail these threecharacteristics P3s: contracting-out, of andthe bundling tasks. of privatefinancing,

P3s lie somewhere betweensimplecontractingout and a fully private marketin the spectrumof THE CONTRACTING-OUT: FOUNDATION P3s OF The versuspublicinvolvement. moreprivate private relativeto public involvement, more "private" In the last 20 years, dissatisfaction the with the costs associated withgovernment the public-private has production led many partnership. to considerexpandeduse of the prigovernments We suggest there are threemain characteristics vate sector in the production of certain public of thenewwaveof P3s.First,all P3s arereallyexten- services.14 sions of contracting-out a largernumber(and to different of the taskslistedabove.Thus,theconConstruction the task mostoften delegatedto is set) is of the privatesector, in fact it is the normin North tracting-out relationship the foundation theP3. America.While governments may retaincrews to Thesecondmaincharacteristic to do withthe has and renovatephysical facilities, maintain,repair, of or seldom do they undertake "bundling" responsibilities, the allocationof large-scaleconstruction two or more tasks to a unique (consortium of) Whether projectinvolvesthe constructhe projects. It partner(s). is very typicalto have the same part- tionof a bridge,school,hospitalor prison,thenorm ner in chargeof the construction the operation is that privatecontractors and will do the work. It is of a bridge, for example;indeed thatpartner worthremembering this, as it remindsus that the may well have previouslydevelopedthe design for the currentwave of P3s is not really so revolutionary - the privatesector has always been engagedin bridgeandprovidedthe financing. manypartsof the provisionof public services,inof workand construction. What Finally,the thirdnotablecharacteristic many cludingarchitectural modernP3s is the allocationof the financingtask is neweris the largernumberof tasks assignedto to the privatepartner. recentincreasein inter- the publicsectorand the way they arebundledtoThe est in public-private has remainsthe foundation of partnerships been focused gether.Contracting-out on projectsinvolving a significantcapital investmodern P3s. ment- typicallyneededto cover the construction While the experiences of governments with costs of some new buildingor piece of infrastructure.Thenoveltyof P3s is thegovernment's recourse contracting-out certainly are the varied, evidence sugto privatefundsto structure theseinvestments. it costsand/or for Spegeststhat canreduce provide superior aroundthe worldhave been levelsof servicerelative publicprovision."15 to cifically, governments

TheEconomics Public-Private Partnerships 139 of Ex Ante Competition at A key reasonfor the success of contracting-out while reducing costs appearsto be competition: there will ultimatelybe only one providerof the no servicefor a certain period- andtherefore com"in the market"- the bidding process petition As "forthe market." pointedout allowscompetition Demsetz (1968) years ago, ex ante competition by for the projectcan replacecompetitionin the market to forcebiddersto lowercosts, raisequalityand contracwith be innovative. Unhappiness theprivate tor can be punished the way the private sector for punishes:termination cause, lawsuitsfor conand to tractbreach, damage reputation, loss of future withpublicsecbusiness,etc. This does not happen of tor provision the service(whereeach department of hasmonopoly powerwithinits sphere influence).16

and to In addition ex ante competition optimalallocationsof risks,thereareothergoodreasonsto hire facilities.The most to privatecontractors construct relates to economies of scale. Governimportant mentstypicallydo nothaveenoughworkto generate the volumes of business needed to allow a fullto serviceconstruction company get unitcostsdown scale or learningeconoto theirminimum, through mies.21 As Williamson (1979) pointed out with reference the choice firmshaveto makebetween to and of internal external (i.e., market) provision goods andservices,the advantage to the market when goes therearesignificant scaleor learning economies that be of cannot achieved thevolume business by required thebuyer(in thiscase the government).22 by

Incentivesand OptimalRisk High-powered Allocation

The otherkey reasonfor the success of contracting The at reducingcosts is incentives-related. private as abilsectoris generallyregarded havinga greater morequickly, to delivermoreinnovative products ity with more flexibility,and at a lower cost (not necessarily at a lower price) thanks to its access to incentives.17 higher-powered The oft-cited claim that P3s allow for a better allocationof risks is but an exampleof the benefits of higher-powered incentives.The ideais thatsome kindsof risks are best assignedto one partyor another.'8 In our view, optimalrisk allocationis all aboutincentivemanagement, partiesshouldbe exto riskto the extenttheycanbest manage that posed where manage meanmeasure through we risk, and, by their minimize risk.19 allriskwerepurely the If actions, it to like exogenous, theweather, wouldbe hard argue in it thatthereis anyadvantage shifting to theprivate are sector (giventhat governments likelytohavedeeper The to pockets)exceptperhaps insurance companies. to shifting, construction to thepririsk advantage say, vate sectorpartner thatbearing riskgives it a this is careful to incentive control thoserisksthrough strong andhighqualityconstruction.20

and Contracting-out Theory,Efficiency, Incentives

Muchof the theoryon contracting-out focused has on the relationshipbetween ownershipstructure, efficiency,and incentives,and in that sense relates the earlier. Here to, andformalizes, ideasdescribed we presentthe main directionsof researchon the topic in recentyears. Relationship-specificInvestmentsand ContractualIncompleteness Ex Post Inefficiencies. Considerthe design, construction,and operationof a bridge, hospital, or school.23Whatdo these projectshavein common? Onecommonality thatonce theprovider govis (the ernment employeeor privatesector company)and the customer(the government taxpayer)startto or that is, start to work together towardthe trade, of, completion say,a bridge,theyarebetteroff completing the project together than terminatingthe and to relationship starting tradewithotherparties. The reasonis that both the providerand the customer make relationship-specific investmentsthat are morevaluableif the projectis broughtto completion than if trade breaks down. The provider invests in buildinga bridge that corresponds specustomer'srequest (in cifically to that particular termsof location,design,equipment, timing,etc.).


140 Jean-Etienne Bettigniesand ThomasW Ross de

If the negotiationsbetween the providerand the customer breakdown,theprovider indeedhave may customerfor thatbridge. troublefindinganother The initial customeralso makes relationshipeffort,time,design specificinvestments (e.g., search thatareworthmorewiththecurrent effort) provider for thanwith another designer/builder/operator the The investmentto find the provider,or to bridge. collaborateon the design, may be worthlittle if a new provider mustbe found,andthatnew provider capamay have completelydifferenttechnological bilities andrequirea very differentdesign. Thus, the consequenceof relationship-specific of fromtrade. is investments the formation a surplus Transaction costs arise because both the provider that and the customerwant to appropriate surplus from trade, and the bargainingand opportunistic that behaviour is generated may in itself be costly. Oneway to mitigatetheseso-calledex post ineffor ficiencies is to limit opportunities negotiations We andbargaining writinglong-termcontracts. by costs by reducingthe numberof limit transaction can In transactions. our example,the government costs by writing a long-term mitigatetransaction and contractwith the (private)bridgeoperator, by contracts betweentheoperalong-term encouraging tor andothersuppliers,such as the designerand/or for the contractor, example.Thisis theP3 scenario. are traderelationships oftenverycomHowever, Thislevel of complexity implies plex anduncertain. thatfirst,it is impossibleto planfor everypotential and contingency, second,even if everycontingency it be couldbe predicted, wouldprobably difficultto write down these plans in a contractbetween the and that customer theprovider is enforceable law. by In that case, long-termcontractssuch as the ones just describedare less helpfulbecausethey cannot we be madeto bindin somecircumstances: say that are the contracts incomplete.Coase(1937) was the first to recognize the economic consequencesof and contractual incompleteness, his ideas, as well as those of Williamson (1975, 1979, 1985), and a and Klein,Crawford Alchian(1978), sparked new literature the subject.It was argued because that on of theirincomplete contracts mustconstantly nature, be revisedand/or as renegotiated timegoes on (longtermcontractsare infeasible),and the problemof ex post inefficiency generated by relationshipcannotbe easily mitigated. specific investments Hence when contractsare highly incomplete, verticalintegration, avoidingrenegotiation altoby In offerthe best alternative. suchcases gether,may it maybe optimalto putthe sameparty(thegovernof tasks,suchas design, ment)in charge thedifferent and It construction, operation. avoidsthe financing, if cost thatwouldbe generated the tasks bargaining were allocatedto differentparties.Thisis the public provisionscenario. Crocker Masten and (1996)makethiscomparison contracts verticalintegration and betweenlong-term in the contextof franchise versusregulation. bidding the summarize choicesveryclearlyin Figure1, They which we replicate it below,adapting slightlyto fit ourP3 versus context. publicprovision

Procurement Services of Public Optimal
RelationshipAssets? specific No Yes or Complex Uncertain Exchange Environment? No Yes


Contracts Vertical Long-term Integration [P3] [Public Provision]


TheEconomics Public-Private of Partnerships 141 there Withoutrelationship-specific investments, costs and spot market are no transaction provision is thebettersolution:it allowsmoreflexibilityrelative to long-term contracts and it permits the withcompetition private and efficienciesassociated A good exampleof this would be food provision. providesa product(food) stamps:the government that requiresno specific investment,via the spot market(supermarkets). When there are switching costs, two subcontracts offerthebest possibilitiesarise:long-term whenthe relationships remainrelatively alternative simple (e.g., building a bridge) such that writing effective contractsis possible,but verticalintegration is sometimes necessary when transactional complexitiesmake ex post inefficienciestoo large (e.g., perhaps,some types of healthcare). Ex Ante Inefficiencies. Note that although the theoryon ex post inefficienciesprovidespowerful of contracts insightsinto the advantages long-term relativeto spot markets, of integration and relative to long-term contracts, respectively(the mitigation and/oreliminationof ex post transaction costs), it remainsmore vague as to their disadvantages (inThe following discussion flexibility,bureaucracy). of ex ante inefficienciesshouldclarifythese issues by formalizingthe trade-offbetweenbenefits and costs for each organizational structure. Recall that with relationship-specific investments, a situationof bilateralmonopolyarises, in whicha surplus fromtradeis created; thatwhen and contracts incomplete, trading are the partiesbehave in theirattempt appropriate to that opportunistically The abilityto behaveopportunistically desurplus. on ex post bargaining which pends greatly power, on itself depends theparty'soutsidealternative, that break is, thatparty's payoffin theeventnegotiations has down.Whena party an attractive outsidealternativerelative a trading to he partner, orsheis in a better bargaining position,sufferinga smallerpenaltyfor than leavingtherelationship does the otherparty. In the late 1980s Grossman Hart(1986) and and HartandMoore(1990) gave new impetusto the literatureby underlining importance property the of rights.Property rightsover an asset conferex post bargaining power,because the owner of the asset control over the asset, and can preventthe keeps otherpartyfromusingit, shouldnegotiations break down.In otherwords,property rightsincreaseone's outside alternative relativeto thatof one's trading andthatputsone in a betterbargaining partner, position. Consideragainthe relationship betweenthe customer (the government)and the providerinvolved in the development of a bridge. If the is firm/consortium pri(the provider anindependent vate sector) trading at arm's length with the (e.g., P3), he or she has some bargaingovernment in renegotiation becausetheykeepaccess ing power to assetsif tradebreaksdown,andthushave an attractive outsidealternative. contrast, the assets In if usedby the provider ownedby the government, are the publicsectoressentiallybuildsthe bridge(public provision), with the provider as government the employee.In case of disagreement government canjust fire the individual,andthus the provider's outsidealternative thatcase is muchless attracin tive,andhe orshe is in a weaker bargaining position. Bargainingpower in renegotiation,and hence asset ownership, important is becauseit affectsinvestmentincentives.The more ex post bargaining the powerthe provider anticipates, less likely he or she is to be "held-up," largerthe fractionof the the created and surplus theywill be ableto appropriate, thegreater incentivetheyhaveto makerelationshipspecific investmentsin the first place. Of course, morebargaining powerto the providermeansless and bargaining powerto the government, thus less incentivesand less investment the public sector by customer. choosesa P3 Thus,whenthe government contract with a private for provider the designand/ or construction a bridgeinsteadof publicproviof sion, it transferspropertyrights and bargaining This increasesthe provider's powerto the provider. incentivesto invest,butreducesits own incentives.


142 Jean-Etienne Bettigniesand ThomasW Ross de

The insight of Grossmanand Hart (1986) and HartandMoore(1990) is thatproperty rightsover an asset should be allocated to the agent whose of is marginal product ex ante investment the highest. The governmentshould use a private sector task (e.g., design, financproviderfor a particular for or ing, construction, serviceprovision a hospital) into efficiencyof the provider only if the marginal is this"relationship"higherthanthatof thecustomer because the transferleads to a net (government), efficiency improvement. Public versus Private Ownership In the descriptionof the literatureon incomplete contractsofferedearlier,we adaptedthe theoryto the relationshipbetween the governmentand the provider.These models, however,were originally of to developed explaintheboundaries privatefirms. In the past few years, economistshave startedto applyincompletecontracttheorymorespecifically to policy surrounding publicversusprivateownership. Schmidt(1996) was amongthe first to investigate the trade-off between public and private ownershipin an incompletecontractsframework. His model is based on the following assumptions: can effortto (i) the manager exertan unobservable reduceproduction receivesa costs, (ii) the manager and privatebenefit from production, (iii) property rights confer better information:the government knows aboutcosts andprofitsin the case of public provision,but not in the case of privateprovision. These assumptions results. yield two interesting First,with privateprovision,the associatedlack enablesthe government credibly to of information commit to an incentive scheme for the manager. Based on a revelationgame, this incentivescheme punishes the managerwith low productionwhen cost is revealedto be high. In contrast, production with publicprovision,the government cannotcredcommitnot to renegeon production decisions, ibly has and thus the manager lowerincentivesandexthus ertslowereffort.Publicprovision leadsto lower efficiency. productive the Second,withprivate provision, government's to whencosts are high commitment cut production to leads to too low a level of production compared Public provision thus leads to public provision. higherallocativeefficiency. Schmidtthus defines the trade-off betweenpublicandprivateownership as follows: althoughprivateprovision generates higherproductive efficiency,publicprovisiongeneratesgreaterallocativeefficiency. Hart,Schleiferand Vishny(1997) focus on the muchdebated betweenlowercost andlowtrade-off ering quality of service provision. Indeed, they for that providethe formalfoundation the argument lead to moreefficiencyin reprovisionmay private relative public to ducingthecostof serviceprovision off butthismustbe traded againsta lower provision, qualityof service. incomTheirresulthinges on two assumptions: contractsand a positiverelationship between plete cost of serviceprovisionandqualityof service;that cost has a negativeeffect on the quality is, lowering of the service provided.The incompletecontracts makesownership assumption important: private provision impliesthattheprovider ownsits production and has technology therefore morebargaining power relativeto government thanif the service was provided by a governmentemployee. Thus, if the serviceprovider the privatesector,it will have a is incentiveto investin cost reduction ante, ex greater and in equilibrium service is providedat a lower cost by the privatesector.On the other hand, the the privatesectorfails to internalize negativeeffect thatcost reduction on servicequality, therehas and fore has too muchincentiveto reducecosts, to the detriment servicequality.In Hart,Schleiferand of Vishny(1997), the privatesector has more incentive to produce moreefficiently,butso muchso that which affects quality.The it tries to "cutcorners," choicebetween and private publicprovision depends


TheEconomics Public-Private Partnerships 143 of of on the importance production efficiencyrelative to this "corner-cutting."'24 The Special Case of Public Goods (2001) focus on the provisionof Besley andGhatak a public good. They ask whether a public good shouldbe provided the publicsector,orby a priby vateentitysuchas a non-governmental organization (NGO),for example.The two partiesinvest in the of production the good and negotiateover the surIn by plus created. the simplestframework provided Grossman Hart and andHart Moore and (1990), (1986) if negotiations breakdown,theownergets somebenefitwhiletheother Because that, of party nothing. gets theownerof theassethasmorebargaining powerand to higherincentives,and transferring ownership the with highestmarginal in investment agent efficiency the maximizes totalsurplus is optimal. and When the good is public, however,both parties break down.Even enjoysomebenefitif negotiations if tradebreaksdownbetweentheNGOandthe governmentand the NGO is no longerinvolvedin the of development the good, it still gets an "alternative"benefit, due to the publicnatureof the good. Forexample,the NGOwithaneducational mandate a benefitfromthe creationof a new school mayget even if it is not involvedwith its operation. Besley and Ghatakdevelop a model where an increasein the alternative benefit(dueto investment by one or bothpartiesex ante)raisesthe caringparbenefit morethan ty's valuationof that alternative the non-caring valuation.Consequently, an party's increasein the alternative benefitimprovesthe caring party'sbargaining positionandexpectedpayoff, relativeto the partythatcaresless, whose bargainTo ing positionandexpectedpayoffhaveworsened. maximizethe total benefitin equilibrium, allothe cation of property rights must thereforemaximize the marginalimpactof investmenton the alternative benefitfor the morecaringparty,andminimize the marginalimpactof investmenton the alternative benefitfor the least caringparty. The key assumption this model is thatgiving in to a partymaximizesits marginal prodownership uct of investmenton the alternativebenefit, and minimizesthe otherparty'smarginal of product inbenefit.In otherwords, vestmenton the alternative of of "apartof the return the investment a playeris embodiedin humancapitalandcannotbe realized if theindividual fired" is, if negotiations is that break downandtheindividual does notownthe asset. It thenfollowsthatownership shouldbe allocated to the partywith the highestvaluation.If the NGO values the school more than the government,it shouldbe granted ownership the the rightto provide service.An interestingimplicationof the model is that the efficiency result arguedby Grossman and HartandHartandMooremay not hold with public valuesthe public goods. Indeed,if the government morethanthe private it good provider, is optimalto havepublicprovisionevenif the government less is efficientthanthe privateprovider.


to DelegatingDesignand/orOperations the PrivateBuilder

As mentioned one previously, of the key characteristics of P3s is that responsibility two or more for tasksmaybe given to the samepartner. particuIn the design of the projectpriorto construction, lar, for and/orthe responsibility operationand service afterconstruction, be allocated the to provision may builder. The advantages privatizing of tasks 1 and4 may be similarto those associatedwith contracting-out whichweredescribed earlier. Consider construction, scale and/orlearningeconomies,for example.It is of certainlytruethata number P3s (e.g., highways withnewelectronic involveprojects are that tolling) novel for the government questionbut may be in familiarto a largemultinational contractor has that workedon similarprojectsin otherjurisdictions.25


144 Jean-Etienne Bettigniesand ThomasW Ross de

In sucha case, the government chooseto payto can be educatedandthenperform operations the itself, that or it canjust contract serviceout. Contractingattractive out will be particularly undertwo condiwill tions: (i) when the government not be able to amortize expenseof the education the acrossmultiand (ii) when the operationsactivity ple projects; will benefitfromongoingresearch development and thatcannotbe effectivelyreplicated government. by Another fromhanding possibleadvantage design and/oroperations over to the privatesectorderives efficienciesthatmaybe attainable fromthe greater withprivate ex sectorproduction, through antecomandthe presenceof a incentives, petition,improved marketfor corporatecontrol.26The extensiveliterature,referredto above, comparingpublic and private provision of services and the effects of has contracting-out, generallyfoundthattheprivate sector will deliver services at a lower cost. However, the most commonly cited advantage of allocating design and/oroperationto the builder derives from complementaritiesassociated with combiningdesign,construction, financing,andopThe erationwithinone firm(or consortium). ideais that by combiningthese functions,the consortium will have an incentiveto minimizethe full lifetime This costs associatedwith providing service.27 the involve spendingmore in construction reto may duce maintenance operation or costs later,an effect the consortium internalize. can There is likely to be a certain technological complementarityor economy of scope between buildingand designing,and betweenbuildingand service provision.28The complementarity enis hancedby the incentiveadvantages combining of these tasks- if you have to build the projectand your reputation dependsin part on the qualityof the outcome,you have a strongincentiveto see it well designed.29 Similarly,if the privatepartner is doing the construction also going to operateand maintain facility,it will be bearingall the costs the of the serviceandso will havean incentiveto minimize those costs. It makessense in a case like this to bringthispartner the designprocessas well, into since otherwiseit risksliving with a poordesign. Contrast situationwith the one in whichthe this governmentdesigns, finances, and arrangesthe buildingof the facility,but lets someoneelse operate andmaintain The facilitycanbe builtso as to it. or lowerlevels of maintenance it and require higher is far from clear that with decision-making separated betweentheparties efficientdecisionswill that be taken.Construction firmsbiddingon thecontract to buildthe facility,in an effortto appear be proto viding their services at lower costs, will not necessarilyadvocatefor more durableand expensive construction. on the other hand, they are If, biddingto providethe servicesthey havean incentive to propose designandplanfor construction a to minimize costsof the serviceoverthefull life of the the facility(orat leastthelengthof thecontract).30

and Privatizing Operation the Government's Loss of Control

the Operating asset and providingthe service are the publicface of a P3: the highlyvisible attributes to whichpeoplemost frequently respond. The majorconcernof opponents contractingof out in general, and P3s in particular, typically is aboutthe loss of controlassociatedwithgivingprivate providerscertaincontractual rights.The fear is thatthe perfectcontract neverbe writtenand can cannotbe perthat, even if it could, performance monitored. negativeimplications Two follow: fectly meansthatwhenchanging first,the incompleteness circumstances necessitatechangesin the behaviour of the privatefirm, this will have to be negotiated situation,i.e., with(in a smallnumbers bargaining outbenefitof competition) thiscouldbe costly; and andsecond,theimperfect meansthatthe monitoring can cheat on qualityor some other privatepartner non-contractual element.31It is concernover the qualityof servicesthatwill be provided the priby vatesectorin say,jails, hospitalsor schools,thatis the major hurdleP3s haveto overcometo gainpublic confidencein theirabilityto meetpublicneeds.


TheEconomics Public-Private of Partnerships 145 The challenge,when the privatesectoris to use the facility to provide the service, is in carefully of specifyingthe characteristics the servicethatthe cares aboutso that thereis no misungovernment of (or derstanding deliberate exploitation incomplete betweentheparties. withmanyaspects As contracts) of P3s, the contracting challengeshere are significant - important characteristics servicequality of must be measuredand verifiablestandards acof For established.32 thisreason ceptableperformance it is notsurprising see thatmany to have jurisdictions created and specialized agenciesto reviewproposals lay out contracttermsfor P3s. These groupsoften functionas within-government consultants P3s, on andas repositories knowledge experience and of that provide governmentswith the skills they need to structure to theirmaximum P3s benefit. contracts with the builderto both construct opand erate the prison.34The builderanticipates will he be able to reapsome benefitsfrominvesting- in termsof lower operatingcosts - and thus makes positive investmentsin both building quality and Therefore,relativeto P3s, convencorner-cutting. tional provisionleads to more underinvestment in effortbuildingquality,while P3s lead to productive overinvestments corner-cutting. in Hartconcludes that P3s may be optimal when building quality cannotbe well specifiedandcorner-cutting investmentsarerelativelyeasy to monitor, becausein that case both overinvestmentsin corner-cuttingand underinvestment building quality are relatively in low. Bundlingand AsymmetricInformation In contrast with the previousmodels,which started froman incompletecontractsframework, most the recentpaperon P3s takes a completecontracting whereagencyproblems betweenthe cusapproach tomer(government) the provider agent,the and (the information privatesector) stem from asymmetric and non-observability effort. Bentz, Groutand of Halonen(2002) considerthe construction servand ice provisionrelatedto a productsuch as a school. shouldopt for They analyzewhethera government - in whichcase it contracts "conventional delivery" with a builder,takes possessionof the school, and then writes a separatecontractwith a service provider- or for a P3, in whichcase thereis a unique contractbetween the governmentand a "consortium"thatbuildsandmanagesthe school. and assumethatthebuilder Bentz,Grout Halonen canexerteffortto improve efficiencyof serviceproandthatthis efficiencyis observable vision, only to the serviceprovider not to the government. but With P3s, thereis a uniquecontractand the model simplifies to a standardadverse selection set-up in which the builder/serviceprovideris induced to truthfullyreveal whether service provision effirent ciencyis high or low. The information given to the agentto inducetruth-telling also generatesincentivesto exerteffortat thebuilding stage,andthus

TheoreticalLiteratureon P3s as the Privatization Both Construction of and Operation

Therecentresearch withP3shas dealingspecifically definedthem,really,as thedelegation twoormore of to tasks, "bundling," the privatesector.Herewe review the mainarticlesandpresenttheirkey results. Bundlingand IncompleteContracting In a recent article, Hart (2003) adaptedthe Hart, SchleiferandVishny(1997) model to analyzeP3s is with the specifically.The government concerned of buildingandthe operation an asset, say a hospital or a prison.The buildercan maketwo types of investmentsat the time of construction which affect the operation of the asset. The productive investment increasesthebenefitandreduces cost the of operation(e.g., investmentin buildingquality), while the unproductive investment reducesoperating cost but also its benefit (e.g., investmentin similar to Hart, Schleifer and "corner-cutting," With "conventional the Vishny).33 provision," governmentcontractsseparatelythe buildingand then the operation the prison.Thebuilderis thuspaid of beforethe fruitof his two investments realized. are this, the builderinvestsnothingin the Anticipating first place. In contrast,with a P3, the government


146 Jean-Etienne Bettigniesand ThomasW.Ross de

providingincentivesis relativelycheapwith P3: it to allows the government "hit two birds with one stone."Conventionaldelivery does not have this and advantage thereforethe paymentmadeby the to government inducehigheffortis higherwithconventionaldelivery. On the otherhand,compensation to be paid has withconventional less frequently deliverythanwith P3. Indeedefficiencymaybe high due to the builder's effort, or simply due to the forces of nature. Withconventional must delivery,the agent/builder be compensated whenefforthas beenexerted, only fromthe government whereaswithP3s the payment is madewheneverefficiencyis revealedto be high, whichincludesthe case wherehighefficiencyis the resultof nature. Thusis the trade-off betweenconventional delivery and P3s in this paper: to compensation theagentis higherbutless frequent in the formerthanin the latter. privatefirms.They arguethat such P3s are a trick employedby governments wantingto fool taxpayers into thinkingthey are holding down levels of to services. publicdebtwhilecontinuing offerdesired We agreethatthe use of P3s to "hide"debtis a concern.Herewejust makethe fairlyobviouspoint that undercertainassumptions thereis a financial between a policy in which a governequivalence mentborrowsto pay for a projectand thenrepays the loan over some periodand a policy in which a lets government a private pay party forandconstruct the asset and then pays that party back through "lease"payments overseveralyears.In bothcases, the government gets the benefitof using someone else's money (the lender'sor the privatedevelopand er's)to secureconstruction, thenpaysit off over time. Dependingon how the accountingis done, however,the P3 may not show up as debt on the books and for governments government's looking to convincetaxpayers they are not overspendthat can ing, this may be a good thing,if the taxpayers be so fooled.36 However,thereare a numberof reasonswhy it may make sense for the financingto be done by parties other than the government.A careful response addressestwo points:first, that it is not at all clearthatgovernments borrow can morecheaply; and second, that there may be complementarities betweenfinancingandthe othertaskssuch thatwe look should atthecombined of having costs thosetasks not in performed, thecost of financing isolation.


financed Traditionally, governments publicprojects eitherfromcurrenttax revenuesor by themselves, borrowing. Perhapsthe most strikingaspectof the new wave of P3s is the extentto which the financing is being handledby the privatesector.Indeed, one of the most frequent emreasonsgovernments ploy to justify theiruse of P3s is thatthey arecashand already,and therefore strapped too debt-laded need an infusionof capitalfromthe privatesector if the projectis to proceed.While almostcertainly true for many underdeveloped and developing economies (where P3s have been used for some time), the argumentis made more and more frein quentlyby governments developedeconomiesas well.35 Criticsof P3s ask how it can be betterto let the privatesector finance projectswhen governments and (at least thosein Canada mostof the developed world) can borrowat lower rates of interestthan

Canthe Government BorrowMore Cheaply?

To begin, we note that a comparison betweenthe rates charged to governmentsand to borrowing is partners notnecessarily private comparing apples with apples,as the privateborrower acquiring is a putoptionwith its loan andthis mustcost it something.To see this, assumethatbecauseof its very low probability bankruptcy, government of the can borrowat the risk-freerateof interest,say this is 5 had percentover 20 years.If a privateborrower an it of equallylow probability bankruptcy wouldalso


TheEconomics Public-Private Partnerships 147 of be able to borrowat 5 percent,but in fact over the chance courseof 20 yearsthereis a not-insignificant it will be unableto meet its debtobligations. Thus, a loan contractwith this privateborrower, at 7 say of percent,is actuallya combination a loan plus an to "put"the remainingportionof the debt option backto the originallender. here is thatthe govobservation The important does not get this putoptionwhenit pays 5 ernment percent,it must repay the loan in full, no matter what.This is not to say thatthe cost of borrowing has to be identicalwhenwe takethe putoptioninto account,it is just to point out that the listed rate exaggeratesthe difference.37 The secondpointwe wouldmakeaboutthe rates and at which government privatepartiescan borcontractfroma row,is thatwith a solid, long-term can a private borrower mostlikely buyer government securea very good rate fromprivatelenders.Here for as thegovernment's reliability a buyersubstitutes with the resultthatthe as its reliability a borrower, is can rateat whichtheprivate party borrow verylow. is Third,the privateborrower able to deductinWhile and terestpayments so reduceits tax burden. fromthe some of this savingmayjust be a transfer with whichit is partnering, some very government For could be fromotherlevels of government. exthe ample,in Canada tax savingscome, in part,at while the public the expenseof the federaltreasury, sector partner mightbe a provincialor local government.While from the standpointof national from wealththese arenot real savingsin resources, the perspectiveof the partners (includingthe proof someportions them vincialor local government), are,andtheyfunctionas a formof subsidyfromthe other level of governmentavailable only if the projectis privatelyfinanced. Fourth,when we recognize that governments, subnational ones, can (e.g., provincial) particularly get themselves into serious financial troubleand we even possibly face bankruptcy, know thatthey will often not be able to borrowat the risk-free rate.38 Importantly,they may face an upwardsloping supplyof capitalcurvesuch thatthe more they borrowthe higherthe interestrate they must inpay. For example,as a provincialgovernment creases borrowingit runs the risk of having its and debt-rating downgraded having to pay higher The implicationis a rates on all of its borrowing. familiarone frommonopsony theory- the cost of for the next projectis higherthanjust borrowing the interestrate you pay for that projectif it also increasesthe rate you pay for all your otherborconsiderable rowing.For a government borrowing the sumsof moneyregularly, chanceof a downgrade percentage leadingto theneedto payevena quarter Thus, we can point more is a very serious matter. have a situationin which even if the interestrate for borrowing the next chargedto the government sectorpartis project lowerthanthatwhicha private cost to ner wouldhave to pay, the "full"marginal could be muchhigher. the government We concludefromthis reviewof the issues that will it is not at all clearthatthe government be able to borrowat a lowercost thanthe privatesector.A full evaluation therelativecosts will haveto conof of sidersuchfactorsas: (i) the credit-worthiness the in borrower theprotections and offered its conprivate tractwiththe publicsectorpartner; the extentto (ii) whichtaxsavings levelsof govmaycomefromother and ernment; (iii) the degreeto whichthe supplyof borrower upward fundsto thepublicsector is sloping.

BetweenFinancingand Complementarities OtherTasks

thanthe relativecosts of Possibly moreimportant sectorborrowing theeffects are publicversusprivate thatbeingthedebtor on one'sincentives highhas to level performance.39 is verylikely thattherewill It be importantcomplementaritiesassociated with combiningthe financingtask with the construction task.40 andpossiblyalso theoperation/maintenance withconstructing the If a private charged partner facility mustalso provideits own financing,it will


de 148 Jean-Etienne Bettigniesand ThomasW Ross sufferthe costs of delays. Since, of all the parties, the builderhas the greatestcontrolover the timeto-completion,this provides strongincentivesfor the builderto finish on time and on budget.While can pergovernments also provokedelays,through environmental, zoning,etc.) problems mitting(e.g., and design changes, the public sector decisionmakers are so far removedfrom their principals is (taxpayers)that whetheror not the government to thefinancing notmatter them.Add may providing to thisthefactthatinordinate by delayscreated govthe ernments mightgive the privatepartner rightto recoverdamagesand it would not appearthat any side strongincentiveloss is felt on the government by movingfinancingto the privatepartner.41 who not only has the skills, but (beprivatepartner cause of its "ownership" the project)also the of incentiveto perform a high level.44 at Poor labour relations. Wherethe publicsector has environment not produced labour-management efficientandflexiblelabour an appropriately-skilled, sector(againthrough forcesof the force,the private may advantages. competition) offerconsiderable Innovation.Whenthe projectcalls for innovative thinkingandnew approaches, mostwouldturn to privateproviders.Of course, it is possible that only somepartsof the project,say the architecture, In needbe innovative. such a case it maybe best to out contract only thatpart.The extentto whichthe whole projectshouldbe a P3 will depend,in part, on thecomplementarities betweenthe tasks(see the pointson complementarities). Risks. Whenmost of the majorrisks are things the privatesectorcan manageas well or betterthan the public sector,P3s become moreattractive. For risk is somethingthat example,construction-delay the contractor can managebetter than the public and (or partner a P3 in which the contractor a consortium also partner) becomesthe operator gives it the incentiveto minimize such risk. On the other risk"is bettermanaged the pubhand,"political by lic sector. Economies of scale. If the privateprovider can take advantage economiesof scale (andperhaps of of in scope)fromtheoperation similarprojects other the P3 option be(perhapsnearby)jurisdictions, comes more attractive.45

SUMMARY DISCUSSION: AND LESSONS LEARNED THIS TO ANDQUESTIONS POINT FOR FUTURE RESEARCH Our review of the relevanttheory and experience has suggested a numberof lessons regardingthe conditionsunderwhich P3s become a particularly desirablealternative traditional to methodsfor the provisionof public services. To briefly repeatthe most significanthere:42 Ex ante competition. A substantial fractionof thebenefitsfromprivate comesfrommarprovision shalling the pro-efficiencyforces of competition. Since the ultimateprovider any serviceswill alof most certainly become a monopolist, this competitionwill have to be ex ante - at the bidbidders dingstage.If therearenotenoughcompetent or biddingconsortiato makethe processcompetithat will tive, thereis less of a guarantee taxpayers get value for money.43 Scarce skills. In many cases the privatesector will have skills not availablein the publicsector.If these skills will be required the throughout life of the projectand it is hardto separatethe provision of these skills fromthe operation the project,the of government may need to allocate these tasks to a

and of Observability measurability quality.

Muchof the oppositionto privatesectorprovision of publicservicesrevolvesaround concerns the that to qualityof servicewill fall. Inorder protect against such quality erosion, the partnershipagreement shouldspecify the required quality,providefor the measurement verificationof quality,and proand vide for enforcement thecontract's of requirements.


TheEconomics Public-Private Partnerships 149 of In some cases, however,it will be very difficultto define, measure,and verify qualitylevels, making the privateparticipation problematic. Complementarities. When physical facilities suchas bridgesor buildingsneed to be constructed, it is prettymuchstandard practicefor governments to to turnto privatecontractors do the work,taking of their economies of scale. In some advantage is cases, the construction the only task contracted out, but when there are strong complementarities with other tasks it becomes efficient to have one responprovider(or tightlyorganizedconsortium) sible for the set of connectedtasks. This is most frequentlyobservedwith the design task (or parts other but of it) tied to the construction, increasingly are being recognized. complementarities Constraints on public sector borrowing. We risks a deteriohave seen thatif further borrowing creditrating,the marginal rationof a government's can cost of borrowing becomeveryhigh.Inthiscase, allocatingthe financingtasks to the privatesector, which might face a lower marginal rate borrowing its averageborrowingrate might be (even though costs. Casesin which higher),maylowerborrowing thegovernment cannotborrowat all (as with simply debt some developingcountriescarryingenormous loads) are obvious,if extreme,examples. While we would arguethat partnerships should be embraced when they allow governments to only provideservices of an acceptablequalityat lower cost to taxpayers/consumers, - sometimes other less noble- objectives frequently are attributed govto P3 It for ernments adopting programs. maybe argued, that to example, P3s area wayforgovernments avoid public sector labourunions, to move debt off the government'sbalance sheet, to hide information fromthe public,or to deflect blame.46 Despite this learning there is much we do not knowaboutthe optimaldesign of P3s andtheirtrue reefficiencybenefitsor costs. To stimulatefurther search in this importantarea we suggest a few attenimportant questionswhich we feel warrant at tion.Somearedirected solidifyingourconfidence of the lessons alreadydiscussed,otherspush into newerareas. First,thereis considerable experiencewith conin Canadaand elsewhere; does this tracting-out the experiencesupport theorydescribedin this paThen a similar question must be asked for per? completedP3s, wherethereis muchless independent research. Second,whenis the cost of borrowing, properly evaluated,trulylower for the publicsector?A full analysisherewouldhaveto considerelementssuch as: (i) tax issues andtax shiftingbetweenlevels of (ii) government; the marginalversus averagecost for of borrowing governments; the valueof the (iii) costs. put option;and(iv) bankruptcy Finally,moredetailedmodellingof the basic P3 trade-off- that is, with a P3 structure public the sectorgets greater efficiencybutexercisesless control - could provideadditional insightsaboutthe the P3 will be thepreferred conditionsunderwhich to approach publicservice provision. claimthatP3s represent trueorgania Supporters zational innovation for the efficient delivery of public services. Opponents arguethat they are an drivenplanto reducewages to public ideologically sector workers;one that threatensthe quality of public services citizens have come to expect from theirgovernments. is time for moreindependent It research determine truebenefitsandcosts of to the public-private partnerships.

NOTES Theauthors wouldlike to thank Neil Alexander, Tony RonGiammarino, NicholasHann,Robert Boardman, Tsur and atthe CenHelsley, Somerville participants UBC tre for the Studyof Government businessPublic and Luncheon April discussions. (23 2003)forhelpful Policy usefulcomments guidance alsoprovided and were Very


150 Jean-Etienne Bettigniesand ThomasW Ross de

refereesand the editor.The very caby two anonymous pable researchassistanceprovidedby JenniferNg and Ann-Britt Everettand the researchsupportfromthe Social SciencesandHumanities Research Councilof Canada and the UBC Centrefor the Study of Government and Businessare gratefullyacknowledged. 'Two of the more representative definitions:(i) "A a cooperative venturebe[is] public-private partnership tweenthepublicandprivate sectors,builton theexpertise of each partner,that best meets clearly defined public needs throughthe appropriate allocation of resources, risks andrewards" Councilfor PublicPrivate (Canadian (ii) Partnerships). "Theterm"public-private partnerships" has taken on a very broadmeaning.The key element, is however, theexistenceof a 'partnership' approach style to the provisionof infrastructure opposedto an arm'sas length 'supplier'relationship... a P3 involvesa sharing of risk, responsibilityand reward,and is undertaken in those circumstances when thereis valuefor moneybenefit to the taxpayers"(BC. Ministry of Finance and Relations1996, 8). Corporate need not be meas2Itis worthnotingthatthe rewards ured in direct profits. Some "private" partnersmay be in whichmeasure rewards terms not-for-profit enterprises otherthandirectprofits.For example,a numberof airport authorities in Canada today are operated as in with corporations "partnership" various not-for-profit governmentsand governmentagencies (e.g., Transport Canada). 3Undersome definitions,regulatedprivatelyowned utilities(e.g., electricity)mightbe seen as P3s, or at least as examplesof an ASD. 4See, for example, the informationprovidedon the Web site of the Public-Private Office of InPartnership dustry Canada, inpupr-dpr.nsf/vwGeneratedlnterE/Home is policy partnerships containedin Rosenau(2000). discussionfocusedon P3s for in7A complementary frastructure foundin DanielsandTrebilcock is (1996). 8With abilityto costlessly assess tolls for roador the bridgeuse, these problemsneed not arise. However,at leastuntilrecently,thecost of collectingtolls in termsof and was manpower/administration lost time to travellers substantial. 91fwhatthe public sectoris buyingis a moreor less standardproduct,buying constructionservices is not frombuyingoffice suppliesin the regular reallydifferent with the implicationthatthe term"partnership" market, is probably appropriate. not '00f course,if it is a new service not previouslyofferedby government is privatization it only in the sense thatit involvesgreater sectordecision-making than private the publicenterprise alternative. "In some cases, the public sector may even do the construction:some governmentshave road crews for roads,for example,and many buildingand maintaining will havecrewscapableof at least small-scaleconstruction andrenovation projects. '2Thesurveys, for Americanlarge cities by Dilger, MoffettandStruyk mu(1997) andfor BritishColumbia McDavidand Clemens(1995) show that nicipalitiesby themostcommonly contracted-out servicesinclude: solid waste collection,vehicle towing,streetrepair, janitorial services,andlegal services. principle,all of these could be specified in the 31In contractwith the sponsoringgovernment, certainly but some decisionswill remainwith the privateprovider.

"While still not withoutsome controversy, thereis a considerable literature thecosts of publicvercomparing sus private of provision goodsandservices,andthe mass sector 5For the created example, United Kingdom "Partnerships of evidencewouldseem to suggestthatthe private can produceat lowercost. See, for example,Viningand UK"in 1999,British Columbia created Crown the corporaBoardman (1992). BC" tion, "Partnerships in 2002, and Ontariocreateda in specialagency"Ontario SuperBuild Corporation" 1999. '5See,for example,McDavidandClemens(1995) on the experienceof local governments BritishColumin 6Anumber government of haveproduced auditors very bia; Dilger,MoffettandStruyk(1997) on the experience useful reviewsof P3s in theirjurisdictions. The UK ofof the largest cities;andDomberger Jensen(1997) US and fice is particularly strongin this regard.See also Grout who reviewstudiesfroma number countries.Someof of accountof P3s in the (1997) for an excellent"economic" these studiesare summarized McFetridge in (1997). UnitedKingdom. usefulcollectionof paperson public A


TheEconomics Public-Private of Partnerships 151

in 16However, some cases, the traditional publicsectorprovider be permitted bid for contracts to may against the privatesector providers.For example,UnitedKingdom (2003b)reportsthat,for the management prisons of in the United Kingdom,the PrisonService has recently acceptedin-house bids (in competition)to replaceprivate sectormanagement two prisons.These bids were at successful,in partbecausemoreflexible staffingpermitted the in-housebidderto lowerits price. '7Thereis some evidencethatthe privatesectordoes in factdeliverprojects.more claim. quickly,as proponents TwoUK studiesareworthmentioning this regard. in The the NationalAudit office is discussed further first, by below (UK 2003a). The second,prepared HMTreasfor MottMacDonald (2002) studied"optimism uryby bias" ("the tendencyfor a project'scosts and durationto be underestimated and/or benefitsto be overestimated") and foundless bias in P3 projects. of '18Examples the kindsof risksto be allocatedin infrastructure (2003), projects,as describedin Poschmann include:(i) technical (e.g., engineering designfailrisk or ures); (ii) constructionrisk (e.g., higher than expected costs); (iii) operatingrisk (e.g., morecostly or difficult to operatethanexpected);(iv) revenuerisk (e.g., lower thananticipated levelsof demand); financial (e.g., risk (v) debt risk (vi) inappropriate management); force majeure (e.g., acts of war,naturaldisasters);(vii) regulatory/political risk (e.g., changes in laws that make continued less risk (viii) environmental (e.g., operation profitable); risk of significantenvironmental damageand liability); and(ix) project defaultrisk(e.g., failurethrough comany binationof these risks). are 19We hardlythe first to makethis point,thoughit is often moreimplicitthanexplicitin materials produced Nova Scotia (1997) is quite good on by the P3 industry. this point.Inpreparing financialcase for a P3 it clearly a becomesimportant puta valueon riskstransferred to and thiscanbe contentious. forexample,Pollock,Shaoul See, andVickers(2002) who claim thatthe financialcase for a number hospitalP3s in Britainwas basedon suspect of valuations risk transfer. of a of commitment, course,some 20In worldof imperfect riskscannotbe transferred completelyto the privatesector, even if that would give the privatepartnerstrong incentivesto effort.Projectdefaultriskmaybe an examcan ple. Private partners typicallywalkawayfromprojects thathavebecomeunprofitable (thoughif theyhaveposted a bondof some sort, this too will carrya cost), butat the end of the day it is the publicpartner has to see the that service provided.Thus the privatepartner cannotcredibly committo providethe service in all circumstances andthepublicpartner cannotcrediblycommitto not provide the service underany circumstances. is 211t important recognize that there is a "local" to to markets. wouldnot be easy It component construction to move crews and equipment across vast distancesjust to keepthembusy.Thus,evenif a government enough had businessin total to allow a firmto achieveefficient levels of production,the costs of moving the capacityto whereit was neededcould well be prohibitive. 22There the possibility,of course,of a governmentis owned construction company achieving its scale or learningeconomiesby takingon additionalbusinessin the private sector.(This was the conceptbehindthe British Columbiagovernment'sill-fated attemptto build BC high-speedferries for its own Crowncorporation, around world.)This is a the Ferries,andalso for markets to good way for a government makeenemiesin the private sectoras those firmsare likely to find it unfairthat they competeagainsta firmfor privatesectorwork,but they arenot allowedto bid on publicprojects. 23SeeHart(1995), Hartand Holmstrom (1987), and Holmstrom Tirole(1989) forexcellentsurveysof this and literature. 24SeeKingand Pitchford (2000). They too deal with in reoptimal(publicor private) ownership a framework lated to that of Hart, Schleifer and Vishny. King and Pitchford's contribution comesfromthegenerality their of model whichenables themto determine optimalownership as a functionof (i) the marginal impactof efforton asset value, which can be positive or negative,and (ii) positiveor negativeexternalities. 25Thisrole of the privatecontractor bringingexpertise - is especially critical in less developed and developingcountrieswherethe necessaryexpertisemay just not be easily acquiredwithin government any(or wherewithinthe country). Fourie Burger and suggestthat in South in Africa,"alackof management capacity governmentis a primeargument a PPPinitiative" for (2000,715). 261n private the sector,firmsthatareunderperforming can be sold to otherownerswho can profitby fixing the


de 152 Jean-Etienne Bettigniesand ThomasW Ross

Thisis notpossiblewithpublicsectorprovision. problems. 27See,e.g., United Kingdom,NationalAudit Office (2003a, 1) andMcFetridge (1997, 43-44). This is one of has of thereasonsthecontract to be for a largefraction the claimsthat assets.McFetridge usefullife of theconstructed mainteminimizingthe combinedcosts of construction, is nance,andoperation thebenefitmostrecognized the by privatized prisonsin the UnitedStates. literature studiedthe "bundling" has theoretical 28The of construction serviceprovisionas a definingcharand acteristicof P3s. See our discussionof Hart(2003) and Bentz, GroutandHalonen(2002) below. if incentiveeffect is magnified the samefirmis 29This to providingthe financingfor the project.We return this below. faciliof contracts substantial of 30Most the operation ties are very long term - 20 years and longer is not unusual.In partthe reasonis thatthis allowsthe governmenta longerperiodto payoff thecapital expensethrough lease payments.However,this point also illustratesthe of lengthroughlyequivaadvantage makingthe contract lent to the useful life of the facility. is ever 31Related theconcernthatif the private partner founditself in financialdistress,it wouldbe temptedto levels of quality.As the failure cheateven on contracted of the privatecontractor be chaotic for customers, can will to the publicpartner be reluctant enforcecontractual at obligationsthatput the contractor riskof failure.This is like a situationin which both sides beganwith "hostages" to enforce mutualcontractcompliance,but the hostageheld by the publicsector(profitsfromcontinued operationunderthe contract)lost its value. The use of hostages to support exchange was described by Williamson(1983). 32Ithas been suggestedthat some aspects of quality partsof a conmay be very difficultto makeenforceable this tract and, if they are very important, may mitigate againstusing the P3 form. See, e.g., Hart,Schleiferand Vishny(1997). are parameters chosensuchthatin the first-best 33The investment shouldbe set to zero. the unproductive and (2000), andBennett 34Seealso KingandPitchford Iossa(2003) for moregeneralanalysesof bundling two of activities, which share similaritieswith Hart,Schleifer andVishny(1997) andHart(2003). WorldBankhas an activeP3 program 35The supportfor ing partnerships infrastructure projects. auditors 36lndependent government maynot be fooled and can represent check on this behaviour. a 371n simplest case, there should be no difference the in the "true" cost of capitalbetweenthe publicand private sector.This point was madeby Grout(1997) with a veryelegantexample.However,if thereis a differencein the cost of liquidatinga failed projectdepending who on providedthe financing,this could createsome difference in borrowing costs betweenpublicandprivate borrowers. 3Ilndeed, in less-developed countries, large private corporations may be more reliable debtorsthan the nations in which they are working. 39Thiswas also very clearly noted by Daniels and Trebilcock(1996, 409).
40A relatedissue, which we do not take up here, involves the question of how the privatepartnershould financea P3; thatis, whatproportions debt andequity of are optimalfrom the public's perspective. The answeris not as simple as it might be for privatefirmsin unregulatedmarkets. example,if a P3 providing essential For an the publicservicerunsinto seriousfinancialtrouble, governmentwill be underconsiderablepressureto bail out the privatepartnerso that the service flow is not interrupted.A cushionprovidedby substantial privateequity reducesthe probability that risks will be shiftedback to the government this way. in

41Inits surveyof P3s in the UnitedKingdom(2003a, 3, Table 1), the National Audit office reportedthat 22 percentof surveyed PFI (P3) constructionprojectsexceededprojected costs (some with good reason)while in an earlierstudy it had foundthat 73 percentof government construction projectsmanagedin traditional ways hadgone overbudget.Further, theirsamples,about76 in percentof PFIprojectswere deliveredon time (or early) methods. comparedto about 30 percentfor traditional Without clearideaof howtheestimates cost andtimea of are we to-completion prepared cannotconcludefromthis thatPFI projectswere really less costly or morequickly delivered,so this questionneeds furtherwork.


TheEconomics Public-Private of Partnerships 153

lesson not listed below,becauseit has moreto 42One do with political thaneconomicconsiderations, may be worthnoting nonetheless.To the extent that voterswill acceptuser-paysystemssuch as tolls morereadilyif the toll revenueis going to a privateconcessionairerather thantheirgovernment, to publicofficialscommitted userpay to finance the project may determine that a P3 structure meet less publicresistance. will The Boase, J.P.2000. "BeyondGovernment? Appealof Public-Private Canadian PublicAdminPartnerships," istration43:75-92. British Columbia.Ministry of Finance and Corporate Relations.1996. Reportof the TaskForceon PrivatePublicPartnerships: Victoria: BuildingPartnerships. Relations. Ministryof FinanceandCorporate
2002. An Introduction to Public-Private Partner-

ships. Victoria:Ministryof Finance and Corporate 430f course, if the privateprovidercan producethe Relations. service moreefficiently,thereis still a social gain to alCanadian Unionof PublicEmployees (CUPE).2002. The locatingit the task, even if its priceis high. In this case, Facts, May. while taxpayersmay not save any money,the economy Coase, R. 1937. "TheNatureof the Firm,"Economica still conservesresources. 4:386-405. and Crocker,K. and S. Masten. 1996. "Regulation Adneed for the continuingapplicationof scarce 44The ministered Contracts Revisited: Lessons from skills likely has muchto do with the popularity P3s in of Transaction-Cost Economicsfor PublicUtility Regudevelopingcountries. Journalof Regulatory Economics9:5-40. lation," 45For example,the Frenchwatergiants like Vivendi, Provision Daniels,R. and M. Trebilcock.1996. "Private whichprovide services many to in and municipalities France of Public Infrastructure: Organizational An Analysis elsewhere,can spreadsome of the fixed costs of design, of the Next Privatization Frontier," University Toof acrossa largenumber projects. of R&D,andmaintenance rontoLawJournal46:375-426. Demsetz,H. 1968. "WhyRegulateUtilities,"Journalof review of the Britishexperiencewith 46Spackman's Lawand Economics11:55-65. P3s leads him to believe that "the main driversappear Dilger,R.J., R.R. Moffettand L. Struyk.1997. "Privatistill to be ideology and accounting" (2002, 283). That zation of MunicipalServices in America's Largest said, he sees potentialbenefitsfrom P3s and believes a Population Cities," Public AdministrationReview numberof important lessons have been learnedin Brit57:21-26. ain (e.g., 297-98). S. Out Domberger, andP. Jensen.1997. "Contracting by the PublicSector:Theory,Evidence,Prospects," OxReviewof EconomicPolicy 13:67-78. REFERENCES ford Fourie, F. C.v.N. and P. Burger.2000. "An Economic A Allan,J.R. 1999. "Public-Private Partnerships: Review PartnerAnalysis and Assessmentof Public-Private of the Literature Practice." and Public Policy Paper ships (PPPs),"SouthAfricanJournal of Economics No. 4. Regina: Saskatchewan Institute PublicPolicy, of 68:693-725. Universityof Regina.(Withan additionalsection of Grossman,S. and 0. Hart. 1986. "TheCosts and Bencase studiesprepared MichaelTrottier Jeffrey and by efits of Ownership: Theoryof VerticalandLateral A Maguire.) Journal PoliticalEconomy 94:691-719. Integration," of Bennett,J. and E. Iossa. 2003. "BuildingandManaging Grout,P. 1997. "TheEconomicsof PrivateFinanceIniFacilitiesfor PublicServices." Brunel Working Paper, tiative," Oxford Review of Economic Policy University. 13(4):53-66. and 2002. "Public-Private Hart,0. 1995.Firms, Bentz,A., P.Grout M. Halonen. and Contracts, FinancialStructure. What Should the State Buy?"CMPO Partnerships: Oxford:Clarendon Press. WorkingPaperNo. 01/40. Bristol, UK: Leverhulme 2003. "Incomplete Contracts and Public OwnerCentrefor Marketand Public Organisation, Univerand ship: Remarks, an Applicationto Public-Private sity of Bristol. The Partnerships," EconomicJournal113:C69-C73. 2001. "Government versusPriBesley,T. andM. Ghatak. 1987. "TheTheoryof ConHart,O. and B. Holmstrom. vate Ownership PublicGoods,"Quarterly of Journal tracts,"in Advances in Economic Theory,ed. T.F. of Economics116(4):1343-72. Bewley. New York:Cambridge UniversityPress.

de 154 Jean-Etienne Bettigniesand ThomasW.Ross

Hart,0. and J. Moore. 1990. "Property Rights and the Nature of the Firm,"Journal of Political Economy 98:1119-58. Hart,O., A. Schleiferand R. Vishny.1997. "TheProper Theory and Applicationsto Scope of Government: Prisons," Quarterly Journal of Economics 112(4):1127-61. Holmstrom,B. and J. Tirole. 1989. "TheTheoryof the vol. Firm,"in Handbookof IndustrialOrganization, Handbooks in Economics, no. 10, ed. R. 1, Schlemanseeand R. Willig. NorthHolland:Elsevier Science PublishingCompany. or King, S. and R. Pitchford.2000. "Private Public?A of OptimalOwnershipand Management Taxonomy Universityof Regimes."WorkingPaper.Melbourne: Melbourne. and Klein, B., R. Crawford A. Alchian. 1978. "Vertical Rents,andthe Competitive Integration, Appropriable Journalof Lawand Economics Process," Contracting 21:297-326. J.C. Out McDavid, andE.G.Clemens.1995."Contracting Local Government Services: The B.C. Experience," CanadianPublicAdministration 38:177-93. McFetridge,D. 1997. The Economicsof Privatization. C.D. Howe Institute BenefactorsLecture.Toronto: C.D. Howe Institute. MottMacDonald. 2002. Reviewof LargePublicProcurement in the UK. Reportpreparedfor HM Treasury, July. Nova Scotia.Department Finance.1997. Transferring of Halifax:DeRisk in the Public/Private Partnerships. partmentof Finance. p3guide/p3g.htm. GovernOsborne,D. andT. Gaebler.1993. Reinventing ment.New York:Plume. FiPollock,A., J. ShaoulandN. Vickers.2002. "Private nance and 'Value for Money' in NHS Hospitals:A JourBritish Medical Policyin Searchof a Rationale?" nal 324:1205-09. F. Poschmann, 2003. PrivateMeansto PublicEnds:The Futureof Public-Private C.D. HoweInPartnerships. stituteCommentary. Toronto: C.D. Howe Institute. Rosenau, ed. 2000. Public-Private P., PolicyPartnerships. MA: MITPress. Cambridge, Schmidt,K. 1996. "TheCosts and Benefitsof Privatization:An Incomplete Contracts Journalof Approach," 12:1-24. Economicsand Organization Law, LesSpackman,M. 2002. "Public-Private Partnerships: sons from the BritishApproach," EconomicSystems 26:283-301. M. GovTrebilcock, 1994. TheProspectsforReinventing ernment. Toronto: C.D. Howe Institute. United Kingdom.National Audit Office. 2003a, PFI: Construction Performance. Reportby the Comptroller andAuditorGeneral,HC 371, Session 2002-2003. London:HMSO. 2003b. The Operationand Performance PFI of Prisons.Reportby the Comptroller AuditorGenand HMSO. eral, HC 700, Session 2002-2003. London: 1992. "Ownership versus Vining, A. and A. Boardman. Public Efficiencyin PublicEnterprise," Competition: Choice73:205-39. 0. and Williamson, 1975.Markets Hierarchies Analysis andAntitrust A Implications: Study theEconomics of of Internal New The Organization. York: FreePress. 1979. "Transaction-Cost Economics:The Governanceof Contractual Journalof Law Relationships," and Economics22:233-61. 1983. "Credible Commitments: Using Hostages to SupportExchange,"AmericanEconomicReview 73:519-40. 1985. The EconomicInstitutions Capitalism: of New York: Firms, Markets,Relational Contracting. The FreePress.