Improving the PPP value proposition
Australia’s privately financed Public-Private Partnership (PPP) market is dying a slow death. The risk transfer advantages that the model once offered, compared to traditional publicly financed delivery models, have mostly vanished. The whole-of-life benefits linked to the PPP model are now being realised through publicly financed Design-Build-Operate-Maintain (DBOM) contracts without the extra cost of private finance. And the additional funding benefits that user-charge PPPs previously provided are being replicated by applying user charges to new motorways built with public funding. As a result, government agencies have grown increasingly sceptical of the value-for-money claims associated with the availability payment PPP model. They see through the rhetoric promoted by private finance providers and question whether the advantages of private finance genuinely outweigh its costs, impact on flexibility, and other disadvantages.
This article is the second in a series that reflects on Australia’s privately financed PPP market. My earlier article critically examined the value proposition of privately financed PPPs. This article considers how infrastructure equity investors and project financiers can enhance their value proposition.
Demand risk
My earlier article noted that the transfer of demand risk was a significant driver of value for money in user-charge PPPs. So why has this value driver fallen out of favour?
The operating revenue stream on a PPP project comes from either (or both) of the following sources:
payments from the government in return for the PPP company’s provision of services utilising the infrastructure facility; or
payment from users of the infrastructure in return for such services.
The former are generally referred to as ‘service payments’ or ‘availability payments’. The latter are generally referred to as ‘user charges’. PPPs that involve the former are generally referred to as ‘service payment PPPs’ or ‘availability payment PPPs, whereas PPPs involving the latter are generally referred to as ‘user-charge PPPs’.
Service payments or availability payments are typically made monthly or quarterly in exchange for the infrastructure service being provided or made available, regardless of the number of users utilising it. In other words, the PPP company receives the same monthly or quarterly payment so long as it provides the service to the required standard, even if user demand for the services is well below forecast. Under this arrangement, the government bears the risk that user demand for the services will be greater or less than estimated.
User charges, on the other hand, are paid in return for each use of the infrastructure service. A common example is the toll paid by a motorist each time they use a toll road. Under this arrangement, the aggregate monthly user charge revenue depends upon the number of times the infrastructure service is used during the relevant month, or the ‘demand’ from users for the relevant infrastructure services. If the PPP company holds the right to collect and retain the user charges, then the demand risk is borne by the PPP company and, hence, its equity investors and debt financiers.
The government can retain the demand risk by retaining the right to collect and keep the user charges and paying a service payment to the PPP company. Alternatively, the demand risk can be shared between the government and the PPP company, for example:
the government agrees to ‘top up’ the monthly user charge revenue if it is below a guaranteed minimum amount; and
the PPP company agrees to share the excess revenue if the monthly user charge revenue exceeds a specified amount.
User-charge PPPs
User-charge PPPs once dominated the Australian PPP market. In the 1980s, 1990s, and 2000s governments in NSW and Victoria were highly attracted to user-charge PPPs because they enabled state governments to:
circumvent borrowing limits imposed by the Australian Loan Council until the mid-1990s;
‘bring forward’ capital works that would otherwise have to wait for government funding; and
transfer the demand and revenue risk associated with the user-charge transport projects to the private sector.
State governments prioritised projects that could be fully (or mostly) funded from user charges or from the development and subsequent leasing of land and/or airspace surrounding a public transport interchange because they enabled the government to develop public infrastructure (and be seen by voters as doing so) without placing additional burden on the relevant government’s budget. “No cost to government” has been a mantra espoused by many Australian governments.
The then inability of state governments to directly borrow the money needed to finance the construction of such projects without exceeding Australian Loan Council borrowing limits made it irrelevant to compare the costs and benefits of direct versus indirect borrowing.
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Each of these toll roads was wholly built with private sector money. No government funding was provided for these projects, aside from government money used to buy the land (or sub-surface stratum) which the government now owns. Indeed, the successful bidder on each project paid an upfront amount to the NSW Government for the concession to undertake the project.
The combined cost of constructing the Cross City Tunnel, Lane Cove Tunnel and M7 exceeded AUD3 billion. If that cost had been financed by state debt, annual interest costs would have been about AUD200 million, excluding principal repayments. It would have also cost the state about AUD120 million per annum to operate and maintain the three roads, which would have brought the total annual costs to the state to about AUD320 million (plus principal repayments).
Over the 10‑year period preceding the opening of the Cross City Tunnel, the total capital expenditure by the then Roads and Traffic Authority in the Sydney Metropolitan area (excluding toll roads) had been AUD3.4 billion, or an average of AUD340 million per year.
Accordingly, these three user-charge toll roads represented the equivalent of 10 years of spending from the public purse.
Source: Review of Future Provision of Motorways in NSW Report (Richmond Review), December 2005
Declining investor appetite for demand risk
It was only after the interest of private sector investors in taking demand risk evaporated in the mid-2000s, following the failure of several toll roads in Sydney, Melbourne, and Brisbane to achieve traffic forecasts, that the current preference for service payment PPPs—even for economic infrastructure—emerged. The turning point was in 2009 when the privately financed PPP/DBFOM model proposed for the Legacy Way project (then known as the Northern Motorway) was replaced with a publicly financed DBOM contract mid-way through the procurement process after only one bidder could obtain private finance. Every subsequent transport project involving user charges has been procured using a service payment PPP model or a publicly financed delivery model. The only new user-charge projects to be built under a privately financed user-charge PPP model have been unsolicited proposals.
Loss of network flexibility
The decline in the use of privately financed user-charge PPPs is not solely due to the loss of the private sector's appetite for demand risk. Another key factor has been the desire of governments to retain flexibility over the future development of the transport network and the prices that users pay to use it. This is perhaps best illustrated by the current NSW Government’s desire to implement a new network tolling regime to address the equity and affordability issues that have arisen in Sydney due to the privately financed user-charge PPP contracts under which most sections of the Sydney motorway network have been delivered.
Each PPP contract set the initial toll that the concessionaire could charge when the road opened and how the toll would increase over time, by reference to the Consumer Price Index (which measures inflation). In each case, the initial toll level was set by the government of the day, with a view to minimising the financial contribution that the government would need to make towards the project's capital costs whilst keeping the toll at a level that most motorists would be willing to pay. In some cases, the government also agreed to a cap on the annual toll escalation rate, with the same objectives.
The progressive development of the motorway network using these contracts has resulted in a tolling regime that is complex, inequitable, and increasingly unaffordable for some users. The Minns Labor Government would like to replace the existing ‘patchwork’ of tolling regimes with a new network tolling regime that addresses these issues but can only do either:
with the agreement of all existing toll road concessionaires, who expect to be kept ‘whole’ (i.e. compensated for any loss of toll revenue they suffer); or
by passing legislation that overrides each concessionaire’s contractual tolling rights but includes a mechanism that ensures each concessionaire nonetheless receives a similar amount of revenue as it would have received under the existing contractual arrangements.
Any attempt by the government to expropriate a concessionaire’s contractual tolling rights without adequate compensation is likely to impair the state’s ability to attract future private sector investment or increase the returns demanded on such investment.
Consequently, reforming Sydney’s tolling regime in a way that delivers reduced tolls for some motorists (such as those in Western Sydney) will be costly for the NSW Government – either financially (to the extent that any reduction to a concessionaire’s revenue is compensated by the Government) or politically (to the extent that the reduction is funded by more or higher tolls for other motorists).
Integrated ticketing
The application of integrated ticketing technology across multiple public transport modes in Sydney (buses, trains, light rail and ferries) has significantly improved the convenience of public transport for users and positively impacted patronage.
The privately financed user-charge PPP contracts used for the Sydney Monorail, Pyrmont Light Rail, and Sydney Airport Rail Line projects resulted in ticket pricing regimes that could not be integrated with those on other parts of the public transport network, contributing to suboptimal outcomes on these projects.
The NSW Government’s desire to retain control over ticket prices for the Sydney metro and light rail services so that they could be integrated with those charged for using other parts of the network would have been a significant factor in the NSW Government’s decision to adopt a service payment PPP for the Sydney Metro Northwest, CBD Light Rail and Inner West Light Rail extension projects.
Value for money impact
The above factors have collectively eliminated one of the primary value drivers for privately financed PPPs: the transfer of demand risk for economic infrastructure. This has made it considerably harder for privately financed PPPs to justify the additional expense of using private finance.
Improving the value proposition
For privately financed PPPs to survive in Australia, the value-for-money case must improve. There must be an increase in the benefits provided by private finance, or a decrease in costs and other disbenefits.
Reducing costs by minimising the amount of private finance needed
State government PPP units have sought to reduce the cost of using private sector finance. They have achieved this by ‘bringing forward’ the government’s contribution towards the capital cost of a project, thereby reducing the amount of private sector debt and equity required to finance the remaining capital cost and/or the period for which it is required. For example, it has become common for the government party to:
pay significant contributions towards the cost of designing and constructing the infrastructure during the design and construction phase of the project; and/or
make a significant payment when construction of the facility is completed, or its operational performance has been proven, which the PPP company must then use to pay down its debt.
The former are generally called government capital contributions, and the latter a conditional debt paydown amount.
In effect, state governments have been minimising the amount of private sector finance within their PPP projects. They want ‘just enough’ — ‘enough’ to obtain the ‘financial rigour’ and other benefits that using private sector finance brings to the project, but ‘no more than necessary’ because of its additional cost.
This is hardly a good outcome for private finance providers.
Improving the benefits
The greatest potential for improving the value proposition of PPPs lies in enhancing the benefits derived from the use of private finance. The principal opportunity lies in greater risk sharing by the PPP company’s equity investors.
Demand/revenue risk
The imposition of user charges on projects provides government with an additional source of funding, which can help accelerate the delivery of projects and their associated economic benefits. User-charges can be imposed on publicly funded projects, but the politics of imposing user charges tends to be easier for governments to navigate if the project is built using private finance. More importantly, the use of private finance provides a mechanism by which the demand risk associated with the user-charge revenue can be transferred from government to private sector equity investors and lenders.
DBOM contractors generally lack the balance sheet capacity to take on demand/revenue risk. Therefore, if PPP equity investors and lenders could once again assume demand risk on projects that can generate user charge revenue, this would substantially enhance the value proposition of a PPP/DBFOM contract compared to a DBOM.
The value proposition will suffer, however, if the assumption or sharing of demand risk is conditional on material impediments to the government’s ability to develop the network surrounding the project or network charging arrangements. Accordingly, it is suggested that equity investors should instead propose user-charge revenue-sharing arrangements that will better align the interests of the government with the equity return objectives of the equity investors. If the government is receiving a share of the user charge revenue generated, it will be less inclined to take actions that would jeopardise that revenue stream.
The opportunity here is not limited to toll roads or farebox revenue on transport projects. Projects with a property development component are also good candidates for the sharing of demand risk, especially when there is likely to be a close relationship between the quality of the public domain component (in which the government typically has a political interest) and demand for the property development component. By sharing the revenue risks and opportunities of the property development with the government, the equity investors can create incentives for the government to optimise its requirements for the public domain component. Such an approach also aligns with the ‘place-making’ objectives that public transport agencies have embraced.
Integration risk
Integration risk offers another opportunity for PPP equity investors to enhance their value proposition. Traditionally, PPP equity investors aim to transfer this risk to a single D&C subcontractor responsible for integrating all systems necessary to commission the facility and start operations. But for some projects, it has become impossible or too expensive to transfer this risk via a single D&C contract. If the government were to contract directly with several D&C contractors, it would assume the integration risk. A PPP company can relieve government of this risk by assuming and managing the integration risks between two or more D&C packages.
Don’t use the model on projects that need flexibility
Loss of flexibility is now widely recognised as a significant downside associated with privately financed PPPs. PPP proponents have sought to address this by providing the government agency with pre-priced options and enhanced variation powers. But these measures amount to ‘tinkering at the edges’. Pre-priced options rarely deliver the level of flexibility that the government ultimately requires, and a variation power can’t deliver the price certainty that the government desires.
The need to negotiate on a sole-source basis with incumbent operators, investors, and financiers of PPP projects that require expansion or extension to achieve the government’s network objectives destroys the value for money that the initial PPP may have delivered.
If an infrastructure facility is likely to need expansion, modification, or connection to other facilities during its life cycle, then a privately financed PPP is unlikely to provide the best value for money over the longer term. An alternative delivery model that doesn’t involve the use of private finance is likely to deliver superior value for money in such situations. The use of a PPP on such projects may be good for the investors, financiers and operators of that project, but it’s bad for the PPP industry because it will ultimately bring the model into disrepute.
Conclusion
For the privately financed PPP model to survive, it needs to ensure that the benefits of utilising private finance outweigh the additional costs. The value proposition that proponents of PPPs have traditionally advocated is flawed because it relies on benefits that can be achieved without the use of private finance.
PPP proponents need to, instead, refocus on the benefits that are unique to the privately financed PPP model and cannot be replicated without private finance, such as:
the ability to transfer demand risk on user-charge PPPs;
the buffer that the debt financiers and equity investors provide against the risk of subcontractor insolvency and default; and
the additional financial rigour that private sector investors and financiers with capital at risk bring to the project; and
the management of integration risk when the design and construction task is spread across more than one contract package.
