Refining the PPP value proposition
Australia’s privately financed Public-Private Partnership (PPP) market is dying a slow death. The value of PPPs reaching financial close in 2024 was less than half the average value between 2014 and 2019. 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.
There is no denying that governments’ use of debt to invest in public infrastructure is sensible. The economic and other benefits of the project can be brought forward, and the financial burden of the investment can be spread over its economic life. However, Australian governments now have significantly greater access to debt finance than they did when modern privately financed PPPs emerged in Australia in the late 1980s and 1990s. State and territory governments can now access cheaper sources of debt directly. Why would an Australian government utilise expensive debt raised by a special purpose vehicle when it can borrow it directly at a lower cost? The former only makes financial sense if it significantly reduces the government’s risk profile with respect to the project, for example, when the private sector equity investors and financiers share the project’s demand risk.
This article seeks to refine the PPP value proposition by stripping away the benefits that can be achieved using other delivery models without private finance, and focusing on the unique value drivers that the use of private finance brings. A separate article on how infrastructure equity investors and project financiers can improve their value proposition will follow shortly.
The benefits of PPPs are usually overstated
Proponents of privately financed PPPs often argue that the benefits or drivers of value-for-money for privately financed PPPs are as follows:
Additional risk transfer: PPPs enable the transfer of additional risk to the private sector, particularly with respect to risks associated with service provision, asset ownership, and whole-of-life asset management.
Lower whole-of-life cost: Because one party is responsible for not only the design and construction but also operation, maintenance and service delivery, these activities are better integrated, resulting in a lower whole-of-life cost.
Improved innovation: The use of outcome/output specifications, rather than prescriptive input specifications, enables private parties to develop innovative solutions that meet the service specifications.
Private sector expertise: Government can access and harness the private sector’s expertise in project management, risk management and project financing.
Additional financial rigour: Private sector investors and financiers, whose capital is at risk, apply more rigorous, independent scrutiny to cost and revenue forecasts and the management of risks.
Long-term certainty: Long-term time and cost certainty for government decision-makers, from a long-term contract that bundles all required services.
Performance incentives: Strong availability and performance incentives, based on payment for good performance and abatement for poor performance.
Allowance for maintenance: The strong performance incentives encourage the private party to allow for the cost of adequately maintaining the infrastructure so that it can achieve the required levels of operational performance.
Asset utilisation: Greater third-party utilisation of the asset allows the cost to government of the project to be reduced.
But most of these benefits are overstated.
They are overstated because most of the benefits are not exclusive to the privately financed PPP model. Most of these benefits can be equally obtained using a publicly financed delivery model.
This can be best illustrated by comparing the benefits typically attributed to a privately financed PPP or DBFOM contract with those that can be achieved under a publicly financed DBOM model.
Both forms of contract bundle the design, construction, operation and/or maintenance activities into a single long-term contract and incentivise the contractor to optimise the whole-of-life cost of performing these activities. Both can achieve the same transfer of design, construction, operation, and maintenance risks, as well as availability and performance incentives via service payment deductions.
The only material difference between the two models is the requirement that the DBFOM contractor finances its activities under the contract pending payment by the government—the “F” in the acronym.
Under a DBOM contract, the government pays for design and construction services every month in arrears. Under a DBFOM contract, payments typically commence only when construction is completed and the operation-phase services have begun. As such, the DBFOM contractor must finance the cost of the design and construction services pending receipt of the operation-phase payments.
A government could achieve an equivalent financing outcome under a DBOM contract by directly borrowing the debt finance needed to progressively pay for the design and construction services as they are performed, and subsequently repaying the debt in line with the payment profile during the operation phase of a DBFOM contract.
The table reveals that the benefits that are unique to the PPP/DBFOM model are limited to:
access to private sector expertise in arranging project finance (debt and equity),
the application of additional financial rigour, from capital at risk, and
additional risk transfer.
Access to project financing expertise
Access to project financing expertise is usually of little to no value to Australian governments for most infrastructure projects, as they already possess the necessary expertise to arrange debt finance for their activities. It can, however, be of value if the government seeks to limit its liabilities in respect of a project and transfer risks that the PPP company’s subcontractors are unwilling to accept, such as demand risk.
Additional financial rigour
Applying additional financial rigour, through capital at risk, offers a genuine advantage. As already mentioned, equity investors and debt financiers independently scrutinise risks, revenue forecasts and cost estimates before financial close. Lenders also provide oversight during the construction phase as debt is progressively drawn down.
The use of a cost-to-complete test as a draw-stop event promotes early issue detection and swift resolution of construction phase cost overruns. If more funding will be required to achieve completion, the conversation starts with the PPP company and its equity investors, before the government is approached.
Similarly, lender restrictions on distributions to equity and lender step-in rights triggered by operation phase defaults promote faster, more decisive corrective action than occurs without this additional layer of oversight.
Construction phase oversight by the PPP company (equity investors) and the debt financiers also provides a second layer of quality control for government. The allowance for maintenance is also supported by the lenders’ requirements for reserve accounts to be adequately funded from project revenues before distributions can be paid to equity investors.
Governments may attempt to replicate the additional financial rigour by engaging specialist consultants; however, the lack of capital at risk among those assessing cost and revenue forecasts, as well as risk management strategies, diminishes the rigour applied to these evaluations. Government step-in is also politically challenging and risky.
Additional risk transfer
It is often asserted that the privately financed PPP model transfers additional risk to the private sector because the PPP company’s equity investors and debt financiers are exposed to the risk of poor project performance. This is true, but the additional risk transfer is not as significant as suggested.
The reality is that all (or almost all) of the project risks assumed by the PPP company under a PPP contract are transferred from the PPP company to the D&C subcontractor or O&M subcontractor, and the PPP company (and, consequently, its equity investors and debt financiers) usually retains minimal risk.
Design and construction risks
For example, the PPP company will transfer most of the risks associated with the design and construction of the new infrastructure facility to the D&C subcontractor and most of the risks associated with the operation and/or maintenance of the facility to the O&M subcontractor, so the PPP company’s equity investors and debt financiers will not be exposed to these risks. While the government can withhold service payments under the PPP contract if the facility is delivered late, the PPP company transfers this risk to the D&C contractor via the liquidated damages for delay regime in the D&C subcontract. The government can achieve the same transfer of design, construction, operation and maintenance risks by contracting directly with a DBOM contractor.
Operation and maintenance risks
Similarly, on a service payment PPP, the risk of abatements to the service payment is generally transferred to the O&M subcontractor with little (if any) retained by the PPP company’s equity investors and debt financiers. Abatements for poor service performance are generally:
sized to eat into the O&M subcontractor’s profit margin and only eat into its cost recovery, including debt service obligations, if its performance is abysmal for sustained periods; and
passed through in full by the PPP company to the O&M subcontractor.
Accordingly, even though the O&M payments under a privately financed PPP/DBFOM contract include a significant component on account of the capital costs and are therefore higher than the O&M payments under a DBOM contract, which do not include this component, the abatement amounts do not increase proportionately under a PPP to put the capital cost component of the O&M payment at risk.
Sometimes, the PPP company retains a portion of the abatement, which its equity investors consequently bear via lower equity distributions. But even when this occurs, performance abatements rarely reach a level where the PPP company cannot meet its debt service obligations.
Buffer against insolvent or defaulting contractors
The additional risks transferred to the equity investors and debt financiers under a service payment PPP/DBFOM are often limited to the ‘buffer’ that the PPP company provides against the risk of:
the D&C or O&M subcontractor becoming insolvent; or
a default of the D&C or O&M subcontractor that causes loss to the PPP company for which the subcontractor is not liable due to liability caps and/or liability exclusions.
Any additional costs arising from these risks will be borne by the PPP company initially, until its available funding (equity and debt finance) for such risks is fully exhausted.
Once the available funding for risk contingencies is exhausted, creating a funding gap, the equity investors and debt financiers may be willing to fill the gap with additional equity and/or debt, but are not obliged to do so. If the funding gap isn’t filled and the PPP company thus becomes insolvent, then although its equity investors and debt financiers may lose the value of their equity or debt interest in the PPP company, the government bears the risk of interruption to the services that the PPP company was supposed to provide. As a result, the possibility of the PPP company becoming insolvent can prompt the government to provide additional financial support to the PPP company, to prevent the service interruption that its insolvency would cause.
An Australian example of this scenario is provided by the Hopkins Correctional Centre (formerly Ararat Prison), where the PPP company was placed into voluntary administration following the financial collapse of its joint venture D&C subcontractor. The PPP company’s financiers subsequently agreed to a financial restructuring, including the accelerated payment of the capital component of the service payments by the State, which enabled the PPP company to exit administration and complete construction with a replacement D&C subcontractor.
The 2018 insolvency of the Carillion group of companies, a significant player in the UK’s privately financed PPP market (referred to in the UK as the PFI (Private Finance Initiative) market), provides a further example of how the risk of subcontractor insolvency ends up being shared between the government and the PPP company’s equity investors and debt financiers.
Demand risk
The additional risk transfer position differs for user-charge PPPs, as these PPPs enable governments to transfer revenue/demand risk to the PPP company. The PPP company’s subcontractors will not accept this risk; therefore, it is retained by the PPP company and, consequently, its equity investors and debt financiers. However, user-charge PPPs that transfer demand risk on greenfield projects have become increasingly rare. The last one signed in Australia was the Brisbane Airport Link PPP awarded to BrisConnections in 2008 – more than 15 years ago. (NorthConnex is a more recent user-charge PPP, but it resulted from an unsolicited proposal from the operator of a connecting toll road, who could therefore predict demand with a high degree of certainty, and so is considered an exception.)
To summarise, the extra risk transfer that a government can achieve on a service-payment PPP is mainly limited to the ‘buffer’ that the PPP company offers for the risk of subcontractor insolvency and liability exceeding the caps and exclusions on the relevant subcontractor’s liability. Considerable additional risk transfer can occur under a user-charge PPP when revenue/demand risk is transferred to the PPP company, but such PPPs have become rare in the Australian market.
Conclusion
It can be seen from the above analysis that most of the benefits generally attributed to the privately financed PPP model can be achieved without the use of private finance, and that the additional benefits that are associated with the use of private finance are limited to:
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.
For projects involving a construction task that can’t be ‘wrapped’ by a single D&C subcontractor, the use of private finance could provide further value by managing the integration risk between two or more D&C packages, but we have yet to see PPP equity investors offer this value-add.
It is these benefits that providers of private finance should focus on when advocating for the use of the privately financed PPP model.
