Thursday, April 20, 2006

Brian Fallow: Take your seats for the Arena showdown

The Vector Arena fiasco is the kind of thing that gives public-private partnerships a bad name.

Defenders of this model for delivering public amenities or infrastructure would no doubt regard that conclusion as premature. After all, they might argue, the multi-million-dollar cost over-runs and litigious argy-bargy are all between the council's private sector partners, their contractors and the architects.

It will not, Mayor Dick Hubbard assures us, cost ratepayers a cent. Apart from the $68 million they have already paid, of course.

And Hubbard's assurance assumes the council's private sector partners will not go belly-up. The Auditor-General's office says that business failure would mean the council would have to take over the Arena, using its step-in or termination rights under the agreement.

Public-private partnerships (PPPs) are much more common in Australia and Britain than they are here. They can take various forms, of which the build, own, operate and transfer model adopted in the Arena case is only one.

Typically, they involve a public agency contracting with a private company or consortium to provide finance and arrange design, construction and ongoing operation or maintenance of the facility.

Typically, the contract spans a large part of the life of the facility, often decades. At the end of the contract, control of the facility is returned to the Government or local body.

A paper by Treasury official Dieter Katz sprays cold water on the concept (although it is worth noting that he says the usual disclaimer that these are his views and not unnecessarily the Treasury's are "particularly pertinent in this case").

Two main benefits are commonly ascribed to PPPs. One is that the use of private money allows infrastructure to be built sooner than would otherwise be the case. The other is that they are better value for money because of the incentives the private sector partners have to be innovative and minimise cost over the whole life of the asset.

But there are other ways of accessing private sector finance, Katz says, and most of the advantages of private sector construction and management can also be obtained from conventional procurement methods, where the project is financed by the Government and construction and management are contracted out separately.

As it is, design and construction are almost always contracted out to the private sector, there being no Ministry of Works any longer and, in the case of the highways, Transit NZ contracts out maintenance, too.

Defining PPPs more broadly, as the Auditor-General does, they include project alliances such as that Transit used successfully for the Grafton Gully project and is using again for the northern motorway extension at Orewa.

Instead of the conventional model of a fixed-price contract, which can set up an adversarial relationship between the funding agency and the contractors, the aim of an alliance is to foster a team approach in which risks, rewards and responsibility for solving problems are shared.

Only after the preferred team is chosen is a target cost negotiated, including what an external auditor considers is a normal profit margin for the private partners.

And, crucially, a formula is agreed for sharing among the partners the gain or pain if the project comes in over or under target.

Because of the substantial set-up costs, it is a model better suited to large and complex undertakings - $100 million rather than $2 million projects.

High tendering and contracting costs count against the PPP model generally. That is especially likely where there is to be a long-term relationship between the partners and a need, therefore, to anticipate all the possible things that could go wrong.

Katz cites estimates that tendering costs represent about 3 per cent of the total costs of a project, compared with about 1 per cent for conventional procurement.

Where the service delivery elements of a partnership extend over decades, there are risks that the private sector partner will either go under or make very large profits, creating problems for the Government partner either way.

Melbourne's tram and train services were contracted out in 1999 but patronage did not increase as much as expected. The operator threatened to fail and the Government had to increase its operating subsidy.

The Auditor-General quotes his Victorian counterpart reflecting on a PPP for Latrobe Regional Hospital: "The social responsibilities of the State meant that any threat to public health and safety or hospital service provision could not be allowed to occur ... The State stepped in when it appeared a risk to ongoing hospital services was increasing. The final outcome was that [the private sector consortium] was able to avoid the full financial risk obligations embodied under the contractual arrangements."

Katz argues the risks of commercial failure and excessive profits can be mitigated by writing profit- and loss-sharing provisions into the contract, but that reduces the very risk transfer from the public to the private partners, which is one of PPPs' advantages.

He concludes that the transfer of risk made possible by PPPs results in better project evaluation and stronger incentives to to innovate and minimise costs over the whole life of the asset.

"But these advantages must be balanced against the large contract negotiation costs, the inflexibilities of a long-term contract and the reduced competitive pressures on performance after the contact has been entered into, compared with a situation where the contact is re-tendered periodically over the life of the infrastructure."

And of course the private sector partners face risks as well, as the Auditor-General points out. Political control of the public entity may change and affect the partnering arrangement.

Papakura District Council's contracting out for 30 years the operation of its water and waste water services is a case in point.

None of this is likely to cut much ice if you are on the wrong end of some roading bottleneck or antiquated infrastructure that is languishing down the list of priorities.

But before latching on to PPPs, it is important to identify where the constraint lies. If it is a finance, is the real problem the Government's unwillingness to loosen the fiscal purse strings? Relaxing its debt-to-GDP target sufficiently to release more funding for capital projects may well be a better solution than having to devise a long-term dedicated revenue stream to service project-specific private investment.

Or is the problem a shortage of the expertise, skills and capital equipment needed to design and build the infrastructure? In that case it is not clear PPPs will help much.

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