PUBLIC - PRIVATE PARTNERSHIP PROJECTS – WHAT, WHY &

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PUBLIC - PRIVATEPARTNERSHIPPROJECTS –WHAT, WHY & HOWIS RISK ALLOCATED?A RESEARCH PERSPECTIVEISSUED BY THENAVIGANT CONSTRUCTIONFORUM JUNE 2016IMAGE COVER PAGE INCLUDED ONLY WHENDOCUMENT IS 8 PAGES. WHEN COVER USED,THE TYPICAL FRONT PAGE SHIFTS TO LEFTSIDE SPREAD AND HAS NO CHANGES.

NOTICECONSTRUCTIONThe opinions and information provided herein are offered with the understanding thatthey are general in nature, do not relate to any specific project or matter, and do notreflect the official policy or position of Navigant Consulting, Inc. (“Navigant”) or any ofMISBAH UDDINDirectorGlobal Construction PracticeNavigant ConsultingLondon, UKJAMES G. ZACK, JR.CCM, CFCC, FAACE, FFA, FRICS, PMPExecutive DirectorNavigant Construction Forum Boulder, Coloradonavigant.comour practitioners. Because each project and matter is unique and professionals may differin their opinions, the information presented herein should not be construed as beingrelevant or applicable for any/all individual project or matter.Navigant makes no representations or warranties, expressed or implied, and is notresponsible for the reader’s use of, or reliance upon, this research perspective or for anydecisions made based on this publication. No part of this publication may be reproducedor distributed in any form or by any means without written permission from the NavigantConstruction Forum . Requests for permission to reproduce content should be directedto Jim Zack at [email protected] OF RESEARCH PERSPECTIVEAbout NavigantNavigant Consulting, Inc. (NYSE: NCI) is aspecialized, global professional services firmthat helps clients take control of their future.Navigant’s professionals apply deep industryThe purpose of this quarterly research perspective is to explore various aspects ofPublic-Private Partnership (“P3” or “PPP”) projects. P3 projects are gaining in popularityin the U.S. and abroad. While many P3 projects have been delivered successfully anumber of other P3 projects failed in the long run. One study of P3 projects surveyedknowledge, substantive technical expertise,some twenty P3 projects in the U.S. Fourteen (70%) of the twenty projects included inand an enterprising approach to help clientsthis survey were either operational or under construction and nearly complete. However,build, manage and/or protect their businessthe report also revealed that the remaining six (30%) of these P3 projects were in defaultinterests. With a focus on markets and clientsor bankruptcy.1facing transformational change and significantregulatory or legal pressures, the Firm primarilyElsewhere, another report analyzed the failure of the three P3 projects on the Londonserves clients in the healthcare, energy andUnderground.2financial services industries. Across a rangeof advisory, consulting, outsourcing, and“Kwak et al. (2009) have determined through a literature survey that thetechnology/analytics services, Navigant’ssuccess or failure of a PPP project is dependent on four groups of factors: thepractitioners bring sharp insight that pinpointscompetence of the government, the selection of an appropriate concessionaire,opportunities and delivers powerful results.an appropriate risk allocation between the public and private sectors,3 and aMore information about Navigant can be foundsound financial package. The problems with the London Underground PPPsat navigant.com.centered on the allocation of risk between the government and private sectorand the ability of the government agencies to appropriately monitor the privateparticipants.”41.Kahlid Bekka, Public-Private Partnerships for Infrastructure Development: Acquiring New Skills for a New Age,HDR, Silver Spring, MD, May 2012.2.Trefor Williams, Analysis of the London Underground PPP Failure, Working Paper Proceedings: Engineering ProjectOrganizations Conference, South Lake Tahoe, CA, November 2010.3.It should be noted that the report points out that the failure of the London Underground PPP projects wasattributable to the lack of “appropriate risk allocation between the public and private sectors.”4.Ibid. Citing Young Hoon Kwak, Ying Yi Chih and C. William Ibbs, Towards a Comprehensive Understanding of PublicPrivate Partnerships for Infrastructure Development, California Management Review, Vol. 52, No. 2, Winter 2009and Antonia Solino and Jose Manuel Vassallo, Using Public-Private Partnerships to Expand Subways: MadridBarajas International Airport Case Study, Journal of Management in Engineering, Vol. 25, No. 1, American Society ofCivil Engineers, New York.

3These studies fly in the face of so many papers, articlescapability to absorb these risks. This can resultand presentations that tout P3 projects as “the way to go”.from a misunderstanding or disregard on the partNotwithstanding these project failures, research indicates thatof governments of the risk appetite, for instance, ofthere are many more P3 project successes than failures. P3private investors who are sensitive to the kinds ofprojects are often seen as a solution concerning major projectsrisks they accept and under what terms. Providers ofinsofar as their ability to defer capital expenditures; lowerfinance will often be the immediate losers from poorlywhole life cost through integrated and bundled contracts; andallocated or undermanaged risks. Even in public-introducing private sector expertise and innovation into publicprivate-partnership (PPP) structures, private risk takersprojects.and their management techniques are introduced toolate to the process to influence risk management andThe Navigant Construction Forum decided to look into thisrisk allocation, and therefore they cannot undo theapparent disparity in perceptions concerning P3 projects. Inmistakes already embedded in the projects. One crucialperforming our initial research, the Navigant Constructionconsequence is an increase in the cost of financing PPPForum concluded that, to date, the P3 project delivery methodprojects and a greater need for sovereign guarantees orseems to be utilized primarily on larger, more costly infrastructuremultilateral agency support. In the end, however, societyprojects. And, the Navigant Construction Forum knows fromat large bears the costs of failures or overruns, not leastexperience that larger infrastructure projects are more fraughtin the form of missed or slowed growth.”6with risk than smaller projects.Thus, the purpose of this quarterly research perspective is toThe Navigant Construction Forum located numerousexamine what are the typical risks P3 profects face and howstudies and articles suggesting that a lack of appropriate riskthese risks are, or should be, assessed, managed and allocatedmanagement and risk allocation may well be at the heart of theon typical P3 projects. The Navigant Construction Forum known P3 project failures.acknowledges at the outset that the risk management processon P3 projects is more complicated than the same process when“Many of the problems we observe are due to a lack ofemployed on D-B-B projects.professional, forward looking risk management. Directvalue losses due to undermanagement of risks fortoday’s pipeline of large scale projects may exceed 1.5INTRODUCTIONtrillion in the next five years, not to mention the loss inThe Navigant Construction Forum chose to research the topicGDP growth, as well as reputational and societal effects.of risk assessment, management and allocation on typical P3projects. As a starting point the Navigant Construction Forum Large infrastructure projects suffer from significanthad to determine what a P3 project is; what the characteristicsundermanagement of risk in practically all stages of theof the typical P3 project are; and what P3 projects are not. Thevalue chain and throughout the life cycle of a project.Navigant Construction Forum then looked into the various waysIn particular, poor risk assessment and risk allocation,P3 projects are typically structured, recognizing that differentfor example, through contracts with the builders andproject structures may well have different project risks.financiers, early on in the concept design phase lead tohigher materialized risks and private financing shortagesThe Navigant Construction Forum then researched whylater on.”5project owners decide to employ the P3 project deliverymethod including the perceived benefits and potential risks.This report continues by pointing out that poor assessment,In determining the above, the Navigant Construction Forum management and allocation of risk occurs on P3 projects as wellidentified a list of risks typical P3 projects must be prepared toas on the traditional design-bid-build (“D-B-B”) infrastructureaddress. Further, the Navigant Construction Forum was ableprojects stating the following.to identify how risks on a typical P3 project are, or should, beallocated in the P3 agreement. Finally, the Navigant Construction“Surprisingly, the risks of large infrastructure projectsForum identified some risk allocation clauses that seemdo not get properly allocated to the parties that areinappropriate in P3 projects and may ultimately lead to projectthe best ‘risk takers’ – those that have a superiorfailure if left intact in a P3 agreement.5.Frank Beckers, Nicola Chiara, Adam Flesch, Jiri Maly, Eber Silva and Uwe Stegermann, A Risk Management Approach To A Successful Infrastructure Project, McKinsey WorkingPapers on Risk, Number 52, McKinsey & Company, November 2013.6.Ibid.

4WHAT IS A P3 PROJECT?P3 projects are not new nor was this project delivery methodcreated in the U.S. It has been reported that the first “concession”project7 was granted in 1782 to Perrier in France. This concessioninvolved the distribution of water.8 During the 1800’s many canalsmanage a facility or system. The public sector retainsownership of the facility; however, the private party maybe given additional decision rights in determining howthe project or task will be completed.”13Two other generalized definitions of P3 projects follow:and railroads in the U.S. were designed and constructed withprivate European investments.9 Moving to more modern times,“ an arrangement of roles and relationships in whichin the late 1950’s the government of Hong Kong explored thetwo or more public and private entities coordinate in apossibility of a privatized vehicle tunnel as a concession. The firstcomplementary way to achieve their separate objectivesmention of the Build-Operate-Transfer (“BOT”) project deliverythrough the joint pursuit of one or more commonmethod can be traced back to Targut Ozal, the Prime Minister ofobjectives.”14Turkey in the early 1980’s. In Australia, P3 infrastructure projects10date back to 1988 and in the UK, the Private Financing Initiative“ a long term contract between the public and private(“PFI”) was introduced by the government in 1992.11sectors where mutual benefits are sought and whereultimately the private sector provides operating servicesHaving provided some background on P3 projects, let’s examineor puts private finance at risk.”15some definitions. It appears from the Navigant ConstructionForum ’s research that there is no one single definition thatThe most thorough definition of a P3 project the Navigantencompasses all aspects of a P3 project and can be put forth as aConstruction Forum located is the following:standard definition. Two of the more general definitions from theU.S. are set forth below:“Fundamentally, a PPP is a long term contract betweena government (the local or national government) or“A contractual arrangement between a public agencygovernment owned entity (hereinafter referred to as a(federal, state or local) and a private sector entity.public agency) and a private sector party (typically aThrough this agreement, the skills and assets of eachconsortium) in which:sector (public and private) are shared in delivering aservice or facility for the use of the general public. In The public agency leverages the private sectoraddition to the sharing of resources, each party sharesparty’s skills and assets to perform all or significantin the risks and rewards potential in the delivery of theaspects of a project (for example, financing, design,services and/or facility.”construction and/or O&M).12 The public agency and the private sector party share“A contractual agreement formed between publicin some fashion or another the risks and rewards ofand private sector partners, which includes privatethe project.sector financing, and allows for more private sectorparticipation than what is traditional. The agreementsinvolve a government agency contracting with a privatecompany to renovate, construct, operate, maintain, or The public agency retains some measure of controlover the project (either through ownership of theproject or contractual provisions binding the privatesector party).7.The term “concession” is defined as “A P3 project delivery structure involving a lease of an existing or to be constructed public asset to a private concessionaire for a specifiedperiod of time. In general, the concessionaire will receive the right to collect availability payments or direct revenue generated by the asset over the life of the contract inexchange for agreeing to construct or operate and maintain or improve the facility during the terms of the lease.” See Public-Private Partnership Concessions for HighwayProjects: A Primer, FHWA Office of Innovative Program Delivery, U.S. Department of Transportation, Washington, D.C., October 2010.8.J. Monod, The Private Sector and the Management of Public Drinking Water Supply, World Bank, Washington, D.C., 1982.9.Kahlid Bekka, Public-Private Partnerships for Infrastructure Development: Acquiring New Skills for a New Age, HDR, Silver Spring, MD, May 2012.10. Mark Augenblick and B. Scott Custer, Jr., The Build, Operate, and Transfer (BOT) Approach to Infrastructure Projects in Developing Countries, World Bank, Washington, D.C.,August 1990.11.G. Owen and A. Merna, The Private Financing Initiative, Engineering, Construction and Architectural Management, Vol. 4, No. 3, 1997.12. Testing Tradition: Assessing the Value of Public-Private Partnerships, The National Council for Public-Private Partnerships, Arlington, VA, 2012.13. Public-Private Partnership Concessions for Highway Projects: A Primer, FHWA Office of Innovative Program Delivery, U.S. Department of Transportation, Washington, D.C.,October 2010.14. Wendell C. Lawther, Contracting for the 21st Century: A Partnership Model, The PricewaterhouseCoopers Endowment for the Business of Government, Arlington, VA, 2002.15. Michael J. Garvin, Enabling Development of the Transportation Public-Private Partnership Market in the United States, Journal of Construction Engineering and Management, Vol.36, No. 4, American Society of Civil Engineers, New York, 2010.

5PPPs can be used to: Construct or develop a wide range of physical andsocial infrastructure16 projects, including highways,power plants, bridges, prisons, pipelines, ports, wastetreatment facilities, schools and hospitals. Modify, rehabilitate or expand existing infrastructuremaintenance (“O&M”) phases – bundled into a single project.Such bundling offers the contractor the opportunity to bemuch more involved in the design process than is typical onmany other project delivery methods. Further, such bundlingalso allows the contractor to employ innovative methodsto deliver the P3 project. Most P3 projects are a singleintegrated project versus separate contracts for constructionprojects. When used for this purpose, theand O&M. This integration of project elements and contractsmodification, rehabilitation or expansion is typically(construction and operation combined) potentially offerssignificant, requiring substantial new capitallower whole life cost compared to traditional projectinvestment to justify the costs of structuring theprocurement where the public owner takes control of theproject as a PPP.asset. Monetize underperforming infrastructure assets to Incentivized Performance Based / Output Specificationprovide governments with much needed capital.Approach – In P3 projects public owners set forthWhen used for this purpose, the revenues theperformance standards and requirements for the completedgovernment earns from selling the right to operateprojects. This approach leaves the contractor free to selectthe project (often referred to as a concession) musttheir own means and methods on how to meet these contractbe sufficient to justify the PPP process and the lossrequirements. The concept underlying the output specificationof the project’s ongoing revenues.”17approach utilized on P3 projects is to provide an incentive forThe commonalities among these definitions are summarizedbelow: Contractual arrangement(s); Between government and a private company or companies; Involving renovation, construction, operation, maintenanceand/or management;such innovations based on the contractor’s skill, knowledgeand experience to be brought to bear on all phases of theproject – particularly the project design phase. And, most P3contracts provide for service oriented payments – that is, noservice, no payment! When P3 projects are successful, theyresult in better on time, in budget project delivery. Large Size – Most P3 projects are large projects (upwardsof US 500 million or more in cost). Part of the reason P3 Of a project or a facility;projects are often large in size is because P3 projects often Where risk and rewards are shared;have a much longer lead time for procurement and because Generally financed by long term project specific equity andof this factor larger projects potentially have a greater valuedebt (Project Financing); and, Where the public owner maintains the ultimate ownership.for money (“VfM”)18 than smaller projects. On these largerprojects, the additional cost involved in P3 procurement canbe justified against the overall project value. Additionally, inCHARACTERISTICS OFA TYPICAL P3 PROJECTthe public sector, such projects tend to be good candidatesSince there appears to be no uniform definition of a P3 project,own. Not only does the P3 project structure allow the publicthe Navigant Construction Forum reviewed the literature toentity to defer capital funds spend, but it only spends whendetermine the characteristics common to most P3 projectsthe project is operational and delivering the project benefitsglobally. The Navigant Construction Forum ’s literature review(i.e., payments linked to the “availability” of the asset.) Fromindicates that the following are the characteristics of a typical P3the private sector perspective, large projects are much moreproject:likely to provide profit sufficient to warrant their investment into be delivered using the P3 process as public entities oftenlack the capability to finance or manage the project on theirthe project. All Project Phases Bundled Into a Single Contract – Typically,P3 projects have all project phases – financing, design,construction, commissioning and, often, the operation and Complex Projects – Public owners may consider certainprojects to be complex, thus justifying use of the P3 project16. Social Infrastructure is a subset of the infrastructure sector and typically includes assets that accommodate social services. Examples of Social Infrastructure assets includeschools, universities, hospitals, prisons and community housing.17. Public Private Partnerships: Issues and Considerations, Practical Law Company, Thomson Reuters, New York, 201318. ‘Value for money’ (“VFM”) is a term used to assess whether or not an organization has obtained the maximum benefit from the goods and services it both acquires and provides,within the resources available to it. Some elements may be subjective, difficult to measure, intangible and misunderstood. A utility derived from every purchase or every sum ofmoney spent. Value for money is based not only on the minimum purchase price (economy) but also on the maximum efficiency and effectiveness of the purchase. Read value-for-money-VFM.html#ixzz4DZYCW3LT

6delivery method. This thinking is likely to be prevalentof infrastructure. As the program has evolved, bothon projects of the kind that the public entity has neverTxDOT and the private sector have moved to betterconstructed. And, from the private sector perspective complexmanage the risks, and the public has benefittedprojects tend to offer contractors a greater ability to utilizegreatly from the new availability of infrastructure.”20innovative ways to deliver the project that, in turn, mayincrease potential project profitability. P3 Agreements Tailored to Fit the Situation – Since P3projects are not “cookie cutter” projects, generally there is nostandard set of contract documents commonly used on suchprojects in the U.S. In the authors’ experience every P3 projecthas a different, uniquely crafted, and negotiated contract. In a2009 survey of P3 transportation projects the authors, ManjuChandrasekhar and Charles Nicholas recommended that eachparty should: Reliable Revenue Source(s) – P3 projects tend to have reliablerevenue sources (whether the project itself will produce newrevenue or, as in a concession project, the municipality paysthe P3 contractor from user fees as in a Lease, Develop andOperate project) – or at least, reliable revenue forecasts asthese are necessary to show the project’s capacity to generatereturn on investment (“ROI”) sufficient to entice the privatesector to participate in the P3 process.21 However, as notedearlier in this research perspective, the Navigant ConstructionForum notes one study of some 20 P3 infrastructure projects“ insist on the importance of recognizing the uniquedocumented that 6 of these projects were either in defaultcircumstances of each individual case when craftingof their financial obligations or were actually bankrupt.22 So,a PPP agreement. Chandrasekhar declares that ‘therewhile there is a perception of a reliable revenue source atis no silver bullet or one size fits all approach’ forthe outset of the project, that perception may not become aPPPs, while Nicholas expresses concern that newreality when the project is completed and put into operation.PPP practitioners fail to recognize how complexthe process can be, where ‘every location, every Completed or Near Completed Environmental Process – MostP3 projects typically have completed or are nearly completejurisdiction, has its different political and legalwith the required environmental process as this status givesproblems.”19the private sector some assurance that the project will, inThe Navigant Construction Forum notes that some countries– such as the UK – have tried to standardize P3 agreements tohelp stakeholders become familiar with P3 agreements (e.g.,Standardization of PFI contracts [“SOPC”]. The latest iterationis SOPC 4.) Strong Public Support – Perhaps due to the intense publicfact, move ahead. Further, if the P3 project has completedthe environmental process the private sector has furtherassurances of no project delays and no changes as a resultof the environmental process. Thus, the completion of theenvironmental process prior to seeking a P3 contractorremoves a good deal of the project risk up front. Trust Based Governance Mechanisms – The owner’s initialscrutiny of large, complex projects, public sector ownerstrust and the selection process seem to facilitate trust andtend to employ the P3 project delivery method only on thoseincrease the focus on project success as opposed to the moreprojects that have gained widespread public support. Fromtypical “us versus them” mentality on all too many projects.the perspective of the private sector contractors, such publicThis mutual trust plays into the P3 contract responsibilitiessupport is typically perceived as easing the project through allin that public owners specify exactly what they want whenof the needed political approvals. A recent article concerningthe project is completed (output specifications) and the P3P3 projects in Engineering News-Record commented on thiscontractor focuses on delivering on that specification. Mutualvery point by highlighting the manner in which the Texascooperation and continual interactions between the ownerDepartment of Transportation (“TxDOT”) has taken a veryand the contractor during the planning and design phaseproactive approach to P3 procurement, as follows:should help increase the level of trust between the project“This approach provides the public with earlieraccess to corridor improvements that may haveotherwise been delayed for decades. While someprojects have not performed as financially projected,the public has still benefited from the availabilityparticipants. Reasonable to High Level of Risk Transferred to theContractor – P3 projects are most often characterized bya higher level of risk transfer from the public owner to thecontractor than is typical on other forms of project delivery.19. Public-Private Partnership: Accelerating Transportation Infrastructure Investment, SmartMarket Report, McGraw Hill Construction, Bedford, MA, 2009.20. P3 Progress Marks New Era, Engineering News-Record, Vol. 276, No. 17, June 13, 2016.21. The issue of a “reliable revenue source” depends upon which party to the agreement holds the demand/revenue risk. The end user may not pay, as it may be the governmentpaying for the use of the asset on behalf of the public end user. In such a payment mechanism, potential P3 contractors must, at the very least, look for certainty of payment orgovernment backing.22. Kahlid Bekka, Public-Private Partnerships for Infrastructure Development: Acquiring New Skills for a New Age, HDR, Silver Spring, MD, and May 2012.

7The level of risk transfer varies from project to project (as will Constructed Asset Returned to Owner at End of Contract –be discussed further later in this research perspective). Risk isFinally, the constructed project on a P3 project is returned togenerally allocated to the contractor through incentives andthe owner at the end of the contract term which may includedisincentives (penalties) embodied in the P3 agreement.23a period of full operation and maintenance. Additionally, there Private Financing – P3 projects always involve privateare often clearly defined clawback or handback provisions infinancing in the form of project specific debt and, generally,P3 agreements that state the expected condition of the asseta small amount of equity. This business model is used toat the end of the agreement term to ensure the P3 contractorensure that the risks transferred to the contractor are bornehas properly maintained the asset.and managed by the contractor. This financing method is injuxtaposition to typical D-B-B contracts where the contractoris paid monthly on the basis of the percentage of workcompleted. The additional scrutiny or due diligence by lendershelps give the public sector reassurance of the commercialviability of the project and the investor. Financed by Project Specific Equity and Debt – As theSOME COMMON MISCONCEPTIONSABOUT P3 PROJECTSNow that the Navigant Construction Forum has explored thedefinitions and generally discussed the characteristics of P3projects a discussion of common misconceptions concerning P3projects seems appropriate.private sector contractor has their own money invested in P3projects, the contractor has a financial stake in the outcome Private Financing Saves Money For The Public – Oneof the project beyond that which is typical on most projects.controversial aspect of P3 projects is the perception that theEssentially, the contractor’s equity in the P3 project is akinutilization of private financing is always a cost savings overto having “skin in the game” which tends to increase thegovernment financing. For public owners it is important tolikelihood of project success. P3 contractor project financingundertake a VfM analysis of utilizing the P3 delivery methodmeans that debt and equity are raised at the project levelversus a more traditional project procurement strategy. Publicand ring fenced.owners need to assess both expected cost and quality of the24As such, there is limited recourse to theshareholders if the P3 project defaults. Long Term Contract Duration – Due primarily to the largeP3 proposition. One author who studied the financial aspectsof P3 projects offers the following observation:costs of most P3 projects and payback schedules, most“You’ll often find public quotes saying that the PPP orP3 projects generally have very long term contracts (oftenPFI enables the private sector to step in and providebetween 15 and 30 years). Concession contracts are frequentlyinfrastructure that the taxpayer cannot afford linked to the economic life of the asset. Such long termWhether it’s deliberate or not, I don’t know, but it’scontracts tend to increase the level of financial involvement ofa delusion. What you are doing is delaying payingthe contractors. At the end of the contract, the public ownerfor something – it’s like public borrowing of otherregains possession of the project and its assets and may, atkinds, where the state issues gilt edged securities buttheir discretion, bid various aspects of the operations andrepays them out of future taxation.”25maintenance to other contractors or manage these serviceswith their own staff. Payment Upon Delivery – P3 projects often employ paymentIn this report Williams argues that the cost of privateborrowing through the P3 or PFI process far exceeds theupon delivery somewhat similar to the older turnkey projectgoing rate for government bond issues. Based on this analysisdelivery method. Under this method the contractor is paidP3 projects are not necessarily a way to save money for publiconly for defined assets or services once construction isowners and their constituents. The Navigant Constructioncompleted (although some P3 contracts provide for

Public-Private Partnership (“P3” or “PPP”) projects. P3 projects are gaining in popularity in the U.S. and abroad. While many P3 projects have been delivered successfully a number of other P3 projects failed in the long run. One study of P3 projects surveyed some twenty P3 proje