Biases, loss leads, competition constraints and all the other reasons I want to take a more collaborative, holistic approach to PPP projects—and what’s been stopping me.
Though it is always a topic of thought, more recently the idea of value for money has been on my mind. I’ve been more acutely exploring why the statistical objectives of corporations bring optimism bias into the picture, at what points biases are not deliberate by the contractor, and how the biases of the government come into play.
This next statement shouldn’t shock any of my peers reading this: Clients want the lowest possible price. But when do constraints from inflation and budget have to stop us? How do we compete with contractors willing to look the other way? Willing to loss lead?
I’ve come to the conclusion there is no solution other than awareness that can hopefully lead to create a different competition than the current competition, which awards whatever is the lowest price—despite full understanding that the project will be over budget and involve legal litigation.
It’s so difficult to change these systematic issues, but I believe thinking long term and focusing on the later problems and consequences opposed to living in this “only right now matters” thinking, is the only way to push our industry forward.
It is important to frame the commercial environment around major programmes. Klagegg defines projects as being “… fundamentally about creating value for stakeholders”. Furthermore, Klagegg set up a framework of theories that govern the events of project delivery. In order to achieve this outcome for stakeholders, contracts are used to manage the interactions between the involved parties. In accordance with economic theory, in order to create the most value for all stakeholders, competition is introduced among parties with the goal of driving down costs and increasing value.
Game theory will then set up a zero-sum game between the parties, backed up by contract theory, which mandates that risk be allocated to the party best able to manage it. This framework has guided major programme decision-making over the last few decades despite not creating positive outcomes for major programmes. In fact, it has left this model very exposed to the traditional practice of “bid low, claim later,” catching many programme sponsors unprepared because they expected the private sector to be responsible for managing risk. Governments are always the “insurer of last resort” and, therefore, ultimately own all of the risks, even those that have been transferred.
Lowest Cost (And Lowest Cost of Capital)
PPP requires a significant amount of private capital, and the cost of private public capital is directly connected to the default risk associated with the borrower. Because government entities have a lower default risk level than private-sector companies (government can raise taxes to increase revenues, making them better able to repay their debt obligations), these entities can borrow funds at lower rates than private-sector entities. This market reality makes the cost of delivering a major programme using the PPP model more expensive than if the project were to be delivered using publicly borrowed funds.
During my dissertation for Oxford’s Saïd Business School, I had the opportunity to speak to many of my peers and leaders in the industry on this topic–the majority of whom highlighted this as one of the main causes of public sector PPP programme sponsors’ focus on prioritizing the lowest possible cost of capital. It is important to re-state that on a cost basis, the PPP delivery model is more expensive than more traditional delivery models. For this reason, jurisdictions around the world, starting with the UK in the late ‘90s, evaluate value rather than cost when appraising major programmes that use the PPP model; this approach allows the funding authority to include retained risk in the value for financial calculation.
The below graph sourced from Infrastructure Ontario (2007) shows how funding authorities compare the costs associated with project delivery using a traditional framework versus project delivery using a PPP framework. The costs associated with the traditional framework are represented by the Public Sector Comparator, while the costs associated with the PPP framework are captured in the Alternative Shadow Bid. As evident below, the fundamental cornerstone of achieving value for money relies on the ability to transfer risk to the private sector.
For this reason, public-sector project sponsors that utilize a PPP delivery model face significant political pressure to transfer risk and reduce costs in order to demonstrate value for money to taxpayers. This is achieved in two ways when it comes to PPP. First, the programme sponsors design a procurement process that selects the lowest cost proponent.
Second, the project sponsor aims to transfer risk in order to achieve value for money and some degree of apparent cost certainty following the procurement. There are few flaws in this approach, the main issue being the fact that government programme sponsors are the insurers of last resort, so risks can never be truly transferred to another party. Therefore, this approach works well when program complexity is low, but PPP projects are typical large, complex programmes where this approach cannot be implemented effectively.
It is important we ask ourselves how does the selection mechanism used for PPP and the pursuit of risk transfer incentivized capital providers to create a very efficient yet arguably cumbersome structure. In order to do that, we must compare the typical capital structure and cost of capital associated with Project Finance (PF) non-recourse debt versus the PPP non-recourse debt. It is not uncommon for PF to have a lower debt-to-equity ratio than PPP (75:25 versus 90:10, respectively), making a PPP less resilient to financial shocks. Furthermore, the capital structure of a PPP, particularly in Canada, has three capital providers: debt, equity, and government, with the government contributing up to 50% of the capital in the form of a grant. This feature reduces the weighted average cost of capital but also removes the financial cushion for debt lenders since the public capital is not callable. By comparison, for every $100 in traditional PF, there would be $25 of equity for every 75% of debt, providing a financial cushion to absorb equity risks.
In a PPP where the government contributes, say, 50% of the capital, there is only a 5% financial cushion, significantly reducing the financial resiliency of the project. The risk has been effectively transferred further down in the structure to the EPC contractor, who now bears all the risk transferred from the authority to the SPV and then further down to the contractor. Loosely speaking, a PPP framework shifts the risks off the balance sheet of the government and the SPV into the balance sheet of the EPC contractor. It is unclear how much risk contractors are actually absorbing, but it must be significant because a large number of contractors are exiting this segment of the market.
This key finding confirms the initial hypothesis that PPP non-recourse structuring is inherently incompatible with a collaborative framework between the SPV and the EPC contractor; this is mostly due to the fact that the latter is expected to absorb all of the risks, thereby removing any potential for a collaborative framework. In order to remove this incompatibility, the selection of proponents should not be based on lowest cost but rather on financial resiliency. This approach would fundamentally alter the internal structure of the private sector consortium so that more collaborative approaches can be implemented with the PPP structure.
If we all work to move the needle little by little, I do believe we could tackle these major issues. But it’s not a simple one sentence solution—it is and will continue to be, a process. So let’s start with a conversation: Do you believe a holistic approach is required for PPP projects? What is the private sector doing right that we implement into our approach to PPP projects?