What is a PPP?
A PPP is a contract between a public sector institution/municipality and a private party, in which the private party assumes substantial financial, technical and operational risk in the design, financing, building and operation of a project.
Two types of PPPs are specifically defined:
- where the private party performs an institutional/municipal function
- where the private party acquires the use of state/municipal property for its own commercial purposes A PPP may also be a hybrid of these types.
Why use PPPs?
PPPs leverage private party capital to fund infrastructure In the most common form of a PPP, the private party will use its own money to build infrastructure on behalf of the procuring institution. Because the private party usually secures a loan, it is incentivised to complete the infrastructure on time and within budget. But the absence of a capital budget on the part of the procuring institution should not be the sole reason for entering into a PPP, as the infrastructure will still have to be paid for over the period of the PPP. One reason that an institution may require a private party to use its own funds is to ensure that there is a strong financial incentive to complete construction on time and within budget, as the private party will be keen to start servicing its debt.
PPPs leverage private sector skills In handing over certain responsibilities for a project, the procuring institution is using a range of skills offered by the private party. These include all the skills required in the development or upgrading of infrastructure, project management skills, contract management skills, and, if a service is being procured, particular service skills. Because of the acute skills shortage in South Africa, this is a particularly important criterion for choosing a PPP. The procuring institution needs to reflect honestly on its own track record of project delivery. Has it been able to deliver services on time and in budget? Does it have the necessary project management skills? If the institution is procuring a project requiring specialist skills, the private party which has these skills could supplement the institution’s existing in-house skills. Where the institution does not yet have the skills, the PPP can contribute to skills transfer and capacity building. Part of the PPP contract should also involve the private party transferring appropriate skills to the procuring institution.
PPPs can be good for project planning The PPP regulations require managers to go through a careful planning process centered around the project feasibility study. So PPPs are a good way for government institutions to plan projects, aligning them with their strategic delivery responsibilities using well developed business plans.
The private sector takes financial risk over the lifecycle of the project Sometimes the private party’s pricing structures in a PPP may seem more expensive than traditional procurement. A reason for this is that in calculating and designing its pricing, the private party is including the cost of the risks that it will be managing for the entire duration of the project. In some traditional procurement, not all the risks and their associated cost are reflected in a contractor/service provider’s upfront pricing. Rather, the procuring institution will be responsible for any unforeseen delays or hindrances and for any failure on its part to deliver the anticipated services, and it will be penalised accordingly.
Risks are allocated to the party best able to manage a particular risk PPPs are designed so that risks are allocated to the party best able to manage them. For example, if the private party has the right skills to manage a project over the long term and the procuring institution does not, it makes sense for the private party to take on the risks associated with project delivery.
PPPs deliver budgetary certainty When the PPP agreement is signed, the future cost of a PPP project is clear: the procuring institution will receive specific outputs at specific costs and will budget accordingly. In traditional procurement on the other hand, the costs of completing the project and maintaining the assets in the future are not certain, and are the responsibility of the procuring institution. Also, many institutions do not budget appropriately for the maintenance and operating costs of their assets.
The public sector pays only when services are delivered In a PPP, the procuring institution pays only when the private party starts to deliver the services. For example, if the private party is late, the institution does not pay, which means that the taxpayer does not carry the cost for a service that is not happening. The method of payment is carefully linked to the quality of services being provided. If services are not being delivered to the institution’s satisfaction and in line with the PPP agreement, the private party may also be liable to pay penalties. So it is in the private party’s interest to deliver quality services on time, which in turn benefits the end-user.
PPPs force the public sector to focus on outputs and benefits from the start When the procuring institution is working out what it needs to deliver and is considering a PPP as a possible vehicle, it has to specify the outputs of a service, and not concentrate so much on how the service is going to be delivered. The institution therefore focuses on service levels and the successful private party bidder is responsible for designing the details of the project.
The quality of service has to be maintained for the duration of the PPP The private party has to maintain the same standard of service delivery for the duration of the contract. This can contrast strongly with traditional procurement, when the condition of an asset declines as the asset gets older and so the service levels decline over time.
Specialist skills are developed and transferred to the public sector In a competitive environment, it is in the interests of the private sector to proactively develop skills that will benefit the project and the procuring institution. The PPP contract will specifically require skills to be transferred to the public sector.
PPPs encourage the injection of private sector capital The use of borrowed private sector capital for a project means that the lenders of the capital will apply rigorous measures to make sure that a project is viable and stays on track. These include a due diligence, and rigorous monitoring and control mechanisms throughout the project. In addition, returns on debt and equity are only secured if a project is successfully completed and operating properly. This provides an incentive to the private party to implement and manage the project well.
Value for Money
To decide whether or not to procure infrastructure through a normal tender process or through a PPP, a value-for-money test needs to be applied. How much will it cost for the institution to provide infrastructure and services itself compared to the costs of providing the same infrastructure and services through a PPP? If the comparison shows that a PPP is more cost-effective, the difference in cost between the two scenarios is known as value for money. If the value-for-money test shows that the traditional procurement method is more cost-effective, the PPP option will not be pursued.
Traditional Procurement vs PPPs
PPPs or public private partnerships are long-term contracts between the public and private sector. The main objective of PPPs all over the world is to ensure the delivery of well maintained, cost-effective public infrastructure or services, by leveraging private sector expertise and transferring risk to the private sector.
In traditional procurement of public services or infrastructure, government pays for capital and operating costs and carries the risks associated with cost overruns and late delivery. While the expertise and experience of a private company may be procured for the design and construction of infrastructure, once the asset is delivered the private company is paid and then leaves. The public sector is then responsible for staffing, maintenance, and operation.
In PPP procurement on the other hand, the public sector buys a full set of services, including infrastructure and other services, from the private sector. It pays for these over the term of the PPP agreement, based on successful delivery. The private sector typically puts its own capital at risk, funding its investment in the project with debt and shareholder equity. Because of the financial risk the private sector takes, it is motivated to provide a high level of service, as good returns on equity will depend on the quality of services it delivers.
Some PPPs, where fees are generated on a user-pay basis, derive income from which government departments or municipalities can share benefits.
PPPs are also a good vehicle for other social objectives, such as economic empowerment, through aligning the incentives of the private party with those objectives.
The public sector does not always manage risk well. For example, if an institution is building infrastructure, construction may be completed late and budgets may be overspent. This is not in the public interest. A key characteristic of PPPs is the transfer of risk from the public sector to the private sector. If the private sector does not complete construction on time and within budget, it will not be paid by the procuring institution. This principle also applies to the provision of services. If the agreed upon services are not available or do not meet the agreed upon standards, the private party faces financial penalties.
However, it is important to understand that the institution does not transfer all the risks to the private sector. Only those risks that the private party is best able to manage are transferred.
Payment in any scenario involves one of the three mechanisms
- the institution/municipality paying the private party for the delivery of the service, or
- the private party collecting fees or charges from users of the service, or
- a combination of these
Beneficial Characteristics of PPPs
A PPP is a clearly defined project, where the procuring institution carefully defines its objectives.
- The contractual relationship spans a set length of time, which may range from 5 to 30 years.
- The private party plays a key role at each stage of the project: funding, development, design, completion and implementation.
- The funding structures of a PPP sometimes combine public and private funds.
- Payment arrangements in PPPs are based on outputs, related to the provision of services and/or infrastructure and services.
- PPPs are not a way of avoiding payment for capital projects. They allow the procuring institution to spread payments for large projects over the project’s lifetime.
- Direct user charges, like road tolls or water fees, may also contribute to a project’s revenue.
- Risks are allocated to the party most able to carry them. This means mitigating their impact and/or being able to absorb the consequences.
- Fixed and operational assets are adequately maintained over the project’s lifetime.
Three Basic Tests for PPPs
There are three internationally applied standard tests to determine whether a PPP is the appropriate vehicle for procuring a public asset or service:
Can substantial risk be transferred to the private sector?
Is the project affordable to the procuring institution?
Does a PPP procurement option show value for money?
One of the most important tests for a PPP is whether the procuring institution can afford it, given its available budgets.
Sometimes, institutions have not budgeted adequately for their infrastructure and service delivery needs. Budgets may need to be reviewed once proper business cases have been prepared and evaluated.
A PPP Is Not
The way a PPP is defined makes it clear that:
- A PPP is not a simple outsourcing of functions where substantial financial, technical and operational risk is retained by the institution
- A PPP is not a donation by a private party for a public good
- A PPP is not the 'commercialisation' of a public function by the creation of a state-owned enterprise
- A PPP does not constitute borrowing by the state.