EPEC Private Sector ForumEPEC Private Sector Forum02/06/201002/06/2010

FIEC presentation:FIEC presentation:

«  « Towards a common methodology Towards a common methodology for PPP projects »for PPP projects »

From: FIEC PPP Working GroupChairman: V. PIRON

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Introduction: state of play and typologyIntroduction: state of play and typology State of play:

Member States’ public debt expected to reach 100% of GDP (about 10,000 Bln. €) and growth rates to remain under 2% in the coming years

Constrained bank lending and increased cost of servicing debt for PPPs Substantially reduced maturities offered by banks

As stated in EC COM(2009)615, PPP schemes will participate in the economic recovery efforts and are therefore worth being promoted at European and national levels.

However, PPPs are complex contract schemes which have to be entered into with caution, on a case by case basis.Examples: 12 to 13% of public budget invested in PPPs in UK; 7 to 8% in FR

What FIEC expects from EPEC: develop & spread expertise in: How to make “good use of PPPs”? (In which areas? For what purpose?) How to implement them? (Under what conditions?) How to assist & train public clients?

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Introduction: state of play and typologyIntroduction: state of play and typology

« PPP » does not cover a homogeneous legal reality in EU law.

Currently, from an economic point of view, 2 types of long-term contracts are recognized:

Where: Investment is made by the private party; AND The private operator bears the demand risk (payment by users): E.g. works concessions (highway), services concessions (water

management). Where:

Investment is made by the private party; BUT The private party does not bear the demand risk (payment by taxpayers): E.g. PFIs, traditional works contracts.

The distinction based on risk criteria was confirmed by recent case law (C-451/08, « Helmut Müller c/ Bundesanstalt », 25/03/2010).

However, in practice, there is a continuum in public contracts.

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Introduction: State of play and typologyIntroduction: State of play and typologyThe vertical & horizontal continuum of PPPsThe vertical & horizontal continuum of PPPs

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Introduction: State of play and typologyIntroduction: State of play and typology

Our experience shows that there are 5 successive conditions of success, to be followed step by step:

Choice of project (part 1) Choice of funding & risk sharing (part 2) Choice of procurement procedure (part 3) Choice of financial structure (part 4) Management over-life of the whole contract (part 5)

FIEC suggests to follow this global methodology for each single project.

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1. Choosing the relevant projects1. Choosing the relevant projects

Decision makers must choose the projects that are desirable from the socio-economic point of view. e.g:

Which will enable the economic development of a market or a region; Which will save time and increase safety, in the case of a road; Which will save lives, in the case of a hospital, etc. Projects that correspond to real demand and needs.

What does a « desirable project » mean? Ex ante evaluation of the socio-economic utility = a high socio-economic IRR (Internal Rate of Return)

Some decision makers choose the project minimising the amount of € invested. Others suggest to minimize the amount of public €

invested.

A high socio-economic utility makes the payment of a tax or a toll politically more acceptable.

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1. Choosing the relevant projects1. Choosing the relevant projects

Experience shows that if contracts do not meet the condition of a high socio-economic IRR, problems necessarily arise:

Bankruptcy of operator (in case of traffic risk)

Skyrocketing public debt (if large grants are needed)

Political legitimacy problems as regards final users and tax payers

And in the end: reputation problems for both partners!

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1. Choosing the relevant projects1. Choosing the relevant projects

So, first, one must determine the socio-economic desirability of the project.

Only sustainable projects should be launched!

There cannot be a sound procurement procedure and a sound contract monitoring without a sound socio-economic analysis!

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2. Choosing the relevant funding2. Choosing the relevant funding

Funding = Who should bear the demand risk? Who will pay for the infrastructure/service?

1. Payment by users as the principal source of revenue for the private operator means that the operator bears the demand risk.

2. Payment by taxpayers (i.e. public budget) means that the demand risk is not transferred to the operator.

The choice of funding must be based on a trade-off between:

1. The marginal cost of public funds (distortion associated to tax collection, e.g. when 1€ collected → 0.8€ remains).

2. The willingness not to exclude users from the infrastructure (problem associated with the payment by users).

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3. Choosing the relevant procurement procedure3. Choosing the relevant procurement procedure

Procurement = procedure thanks to which a public authority selects a private operator: Classical competitive bidding aiming at minimising financial costs. PPPs are so complex, that many aspects, other than the price,

should be considered by the procurement procedure.

Yvrande [2005] shows that « classical » procurement procedures are not a guarantee for fair competition: bid rigging, strong first mover advantage (e.g. in the urban public transport sector, there is a probability of 80% that the incumbant's contract is renewed – no new operator), opportunistic bids, etc.

Opportunism costs!

→ case study n°1

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3. Choosing the relevant procurement 3. Choosing the relevant procurement procedureprocedure

Case study: Water concession in Buenos Aires, an example of agressive bidding [Alcazar, Abdala, Shirley, 2002]

In this case, awarding the contract under classical competitive bidding (to the lowest bid) did not prevent opportunistic behaviour by the bidder.

Indeed, the renegotiation appeared to have been anticipated anyway by the operator, since he could not have paid off his loan otherwise.

In this case, users have borne the price for the opportunistic bid.

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3. Choosing the relevant procurement procedure3. Choosing the relevant procurement procedure

Procurement procedures should be adapted to the kind of project, in order to prevent opportunistic behaviour,and favour strict pre-qualification and additional award criteria.

Unsustainable offers should be legally excluded. There is a training necessity in order to identify unsustainable offers.

Bajari and Tadelis [2004] show that « classical » procurement prodecures (with price criterion only) fit well simple contracts, whereas negotiated procedures (e.g. through competitive dialogue / with a set of criteria) fit better complex contracts.

In terms of incentives, they also demonstrate that complex contracts fit with Cost Plus schemes and simple contracts better fit with fixed price regulation scheme.

4. Choosing the relevant financial structure

The financial structure of a project is usually composed of loans (banks or bonds), shareholder loans, equity and grants.

The crisis has shown that there should be a systematic follow-up of the main events occuring during the life of a contract, in order to balance spreads and risks:

During the crisis: spreads have skyrocketed projects became unfeasible.

« After » the crisis: spreads have recently gone back to correct levels. If spreads are too low, banks cannot pay for their risk.

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4. Choosing the relevant financial structure

One should also take into account the assymetry regarding the way public entities and private operators can absorb risks. The allocation of risks (risk matrix) must take into account this assymetry. Grants and/or guarantees should be adjusted accordingly.

Due to the financial crisis, loan maturity has been shortened. State support may be needed to extend them again.

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5. Managing the life of contracts5. Managing the life of contracts

PPPs are generally long term contracts.

All contingencies cannot be anticipated ex ante (innovation, investment, change in demand, change in the legal environment, force majeure, etc.) = contracts are incomplete!

The contract will necessarily evolve over time/be renegotiated.

Renegotiation clauses should be written in the contracts.

In order to avoid barriers and discrimination, conditions of execution should be specified in the contract – incl. clauses on adjustment over time: force majeure and unforeseen events, fait du prince and changes in environmental and technical constraints, development of demand by users, etc.

5. Managing the life of contracts5. Managing the life of contracts

Renegotiation should be viewed to the advantages of 3 parties:

Public entity Users Private operator

Fair and transparent renegociation is the essence of the contract.

→ case study n° 2

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5. Managing the life of contracts5. Managing the life of contracts Case study: Phnom-Penh airport,

a triple win renegotiation [de Brux, 2009]

Initially, this project presented major technical and institutional challenges, but it worked well during the first 2 years.

However, in 1997: local political trouble + Asian crisis starting to spread the concession approached bankruptcy.

There was the possibility to stop the contract completely (force majeure).

But the « spirit of the contract » prevailed over the « letter of the contract » [Mac Neil 1974]: an amendment was signed to avoid the desertion of the contract and led to a successful development of the project.

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5. Managing the life of contracts5. Managing the life of contracts

Case study: Phnom-Penh airport (conclusion)

The amendment was a compromise between: Compensation for the concessionaire’s losses; and Protection of Cambodia’s financial situation.

Only winners at stake in this renegotiation: Private operator: positive profits + reputation Public party: healthy public finance + government reputation Users: employment + growth

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5. Managing the life of contracts5. Managing the life of contracts

Necessary conditions for a good management of the life of the contract: Fair behaviour of both parties Technical skills Experience and capacity building Flexibility and adaptation to local customs

Desrieux and de Brux [2009] show that the probability of further contracts between the same partners over time provides incentives to the operator not to behave opportunistically :i.e. to look for a collective result, rather than an individual benefit!

The threat of sanction enables good practices to become self enforced.

The threat of sanction must be credible!

These conclusions show that « non written » aspects of the contractual relationship (trust, reputation, etc.) are key elements for success.

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SUMMARY SUMMARY

3 messages to sum up the proposed 5-step methodology:

Introducing socio-economic utility as prior criteria for the choice of projects.

Adapting financial structure, procurement procedure and monitoring to the type of project.

Accepting renegotiations to the benefit of 3 winners.

RECOMMENDATIONSRECOMMENDATIONS

EPEC has a major role to play in terms of capacity building of national administrations → training is essential for preparation, award and management of contracts!

Amaral [2009] empirically and theoretically shows that higher expertise capacities of local authorities systematically lead to sounder contracts in urban public transport services.

As stated by EPEC, the main driver of the PPP contract duration should remain technical (life-cycle and obsolescence considerations), rather than financial!

The legal framework of PPPs should remain flexible enough to meet the 5 « conditions » of success described all along this presentation.

Guarantees should be given more systematically to private operators, in order to have the best possible use of public funds.

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