The dangers of relying on PPP

 

With private investments failing to pick up speed, and with its own finances under strain because of increased payments, the government has to budget for its employees. The Union government is likely to emphasize public-private partnership (PPP) projects to make up for a shortfall in investment spending in the Union budget, according to a recent Mint report.

In theory, the idea seems attractive: PPP investments can spur infrastructure development and growth without much fiscal pain. The actual experience of many countries, including India, however, suggests the need for greater caution.

It is easy to understand why policymakers are turning to the PPP route in India despite its pitfalls. One of the most important fetters to India’s economic development is the dearth of quality infrastructure. The country’s performance in infrastructure is worse than its overall performance vis-à-vis top performing countries, according to the latest Global Competitiveness Rankings released by the World Economic Forum, showed a Mint analysis published last year.

The 12th five-year plan made by the erstwhile Planning Commission had targeted an investment of Rs55.75 trillion (at current prices) for the period 2012-17. A policy brief prepared by its successor, the NITI Aayog, notes that there has been an estimated shortfall of 30% in infrastructure investment during the first two years of the 12th plan period, and estimated it would continue in the third year as well.

Because of the high expectations for investments through the PPP route, the shortfall is higher on account of the private sector than the public sector, the figures being 43% and 20%, respectively.

The reason for the lacklustre performance by PPPs go beyond usual market conditions. PPP projects have been mired in issues such as disputes in existing contracts, non-availability of capital and regulatory hurdles related to the acquisition of land. To be fair, PPPs are not facing problems in India alone. Across the world, the record of PPPs has been very mixed, according to a wide body of research.

The involvement of private firms in infrastructure building or other public sector activities through contracting is not a new phenomenon. What distinguishes PPP from such models is the fact that the private sector is given a role in planning the project and risk sharing, which takes place on the lines of a build-operate-transfer, build-operate-own-transfer or build-operate-own model. For example, the government can decide to get a highway built by a private firm, which can recover its costs by levying tolls on user vehicles for an agreed period of time.

While these models can be used to describe simple PPP projects, there are many in which the expected revenues might not be sufficient to recover the costs. In that case, there is a clause of capital grant from the public sector partner to ensure profitability, referred to as viability gap funding.

In more complex and capital-intensive projects, the government might share the capital cost to attract private partners who might not be willing to undertake the entire investment themselves.

What is the justification for this increased role for the private sector, from being mere contractors to partners? A 2004 paper by economists Jean-Etienne de Bettignies and Thomas W. Ross at the University of British Columbia on the economics of PPPs lists nine reasons that have been used to justify their use.

Allowing for private sector participation can generate more efficiencies by creating more competition, realization of economies of scale and greater flexibility than is available to the public sector, the authors suggest. The PPP route is also seen as an attractive alternative in developing countries where governments are faced with constraints on borrowing money for expensive projects and may not have the required expertise in planning or executing large projects.

Private firms such as large transnational corporations often may have significant expertise and efficiency in implementing such projects because of previous experience. Another advantage highlighted by the proponents of PPP projects, especially in infrastructure, is that their costs can be recovered from those who use them, rather than putting the burden on everybody, which would happen if it were to be financed by tax collections.

There are differing views on the novelty of this concept as well as its virtues. A 2007 paper on the international performance review of PPPs suggests that in many cases, classification of projects under the PPP category might simple comprise a “language game” by governments who find it relatively difficult to push privatization, or when contracting out is more difficult politically.

The authors also argue that some of the promised benefits under the PPP route might get jeopardized due to what they term as the private finance initiative tail wagging the planning dog to make such projects investor friendly by guaranteeing greater profits.

The paper lists many reasons why PPPs might not lead to unambiguous benefits, such as the lack of independent evaluation or limited ability of auditors to question government policy, wrong assumptions about future income stream that form the premise of the project, and inaccurate estimate of risk transfers from the public to the private sector.

Many studies have pointed out that some of these problems might get compounded due to the fact that in many PPP projects, the public sector partner is a local or decentralized entity, which is ill-equipped to meet the requirements of designing and supervising the project or handling disputes that arise later.

An apt example of such a case is the experience of a road bridge—popularly known as the DND flyway—connecting New Delhi with Noida, one of the first large infrastructure projects taken up under the PPP route in India.

A 2007 review of the project commissioned by the Planning Commission concluded that the promise of a 20% return over the cost of project and not equity to the private party in the contract led to a perverted cost-sharing model with large gains for the private operator over a long period. The study further notes that the terms of the contract were such that the private party had no incentive to cut costs in the project.

The study observed that many of the loopholes in the original contract might have been because of the lack of experience on the part of the public sector partners in planning and executing PPPs.

A similar problem was underlined in a 2008 paper by Satish Bagal, then associated with the Mumbai Metropolitan Regional Development Authority, which states that government departments are ill-equipped to handle even simple cash contracts, let alone complex PPP negotiations that involve designing long-term contracts and handling numerous uncertainties.

In many instances, it is not only the public partner that is left holding the can but also the banks that provide funding to such projects. With a contraction in development finance institutions in India, commercial banks became the main source of credit to long-gestation infrastructure projects, both private and PPP.

Non-realization of loans to infrastructure projects is believed to comprise a large chunk of the non-performing asset portfolio of public sector banks in India. Here too, the reasons might be systemic, as was pointed out by K.C. Chakrabarty, then deputy governor of the Reserve Bank of India, in May 2013.

Chakrabarty noted that an over-reliance on debt and lack of substantial equity stakes for the private firms create a situation where the promoter has little “skin in the game” and limited motivation to work towards the success of the venture.

In many sectors, PPP projects have turned into conduits of crony capitalism. It is worth noting that a large chunk of “politically connected firms” in India are in the infrastructure sector, which have used political connections to win contracts in the past.

While private firms accept stringent terms of PPP contracts with great alacrity, they lose no opportunity for renegotiating contracts (e.g., by citing lower revenue realization or unexpected rise in costs), in effect garnering a larger share of public resources than originally planned. This creates a problem of moral hazard since it becomes common knowledge that a firm can bid low and recover later just by demanding the renegotiation of a contract. Rather than being an exceptional clause, renegotiation has become the norm in PPP projects in India.

In a 2014 Economic & Political Weekly article, Indian Economic Service officer Kumar V. Pratap argued that a large number of such cases are because of “opportunistic behaviour” by private sector partners who indulge in aggressive bidding and portray bloated gains to public sector to garner contracts and then try to renegotiate contracts. Pratap argued that in order to create a healthy PPP policy environment, the government should cancel such contracts instead of entertaining renegotiations in the spirit of market discipline, which is the basis of private sector participation in such projects.

Pratap also underlined the importance of separating the role of independent regulators from those who are involved in formulating the terms of contracts, referred to as model concession agreements. The thumb rule for awarding PPPs has to be value for money from the government’s perspective, the very premise of PPPs, which has been undermined in many projects, the article argues.

The recently published report by the committee on PPPs headed by Vijay Kelkar accepts many of these criticisms and recommends tweaks in the way PPPs are designed, with greater emphasis on user services rather than fiscal savings.

The report emphasizes the “criticality of setting up of independent regulators in sectors that are going in for PPPs”. It also suggests that with adequate trust between public and private partners, it is possible to make PPPs work in India. Yet, rebuilding trust will not be easy after a decade of mismanagement.

The past decade has been one of failed experiments with PPP projects. It is time to learn from those mistakes if we are to avoid repeating them.