A defining characteristic of PPPs is the integration within a private sector party of all (or most of) the functions of design, building, financing, operating and maintenance of the facility in question, often in the form of a special purpose vehicle (or virtual corporation) created for the specific project. Some writers (e.g. Daniels and Trebilcock, 1996; Trujillo et al., 1998; Hart, 2003;
and Quiggin, 2003) have questioned whether this is a cost-effective arrange- ment.
Consider, first, the analysis by Hart (2003), who develops a theoretical model to examine the economic efficiency of ‘bundling’ from an ‘incomplete’
contracting perspective, in which imperfections arise because it is hard to fore- see and contract about uncertain future events. PPPs are generally entered into for a lengthy period of time, usually 20 to 30 years, and are developed in an environment of uncertainty. As such they exhibit, as Hart suggests, the char- acteristics of ‘incomplete’ contracts, and their usefulness as integrated arrangements hinges on the nature of contracting costs. His model compares a
‘bundled’ contract for facility construction and service provision with ‘unbun- dled’ conventional public procurement in which the government first contracts with a builder to construct the facility and then later contracts with another private sector party to operate and run the facility. The choice between the two alternatives, bundled versus unbundled, turns on whether it is easier to write contracts on service provision than on building provision.
Hart’s model leads to a straightforward result. Under the assumed conditions, conventional provision (‘unbundling’) is better if the quality of the building can be clearly specified, whereas the quality of the service cannot. In contrast, PPP is better if the quality of the service can be well specified in the initial contract (or, more generally, there are good performance indicators that can be used to reward or penalize the service provider), whereas the quality of the building cannot. Hart surmises that schools may fall into the first category. Contracting on the building is relatively simple, while contracting on the service may not be.
On the other hand, hospitals may fall into the second category in that although
specifying service quality is far from straightforward, it may be easier to come up with reasonable performance measures concerning how patients are treated than it is to specify what may be a very complex building (2003, pp. 73–4).
Quiggin (2003) comes to much the same conclusion, in that he sees merit in a fully integrated (bundled) approach where construction incorporates a particularly innovative special-purpose design, leading to an integration between construction risk and operating risk. But, with most public projects following well-established design principles, such cases are regarded as rare.
His particular concern is that in many PPP projects that are ‘financier-led’, a financial institution devotes substantial resources to putting together a consor- tium to make a bid, only to ‘unbundle’ the components as soon as the bid is successful. In these circumstances, Quiggin considers that the government would do better by contracting directly with the private parties that ultimately bear the risk rather than contracting through the financial intermediary.
Daniels and Trebilcock (1996) visualize a more limited potential for
‘unbundling’, with potential gains for the public sector in partly decoupling, say, design from other functions if a consortium with an inferior design but superior construction and other capabilities won the integrated bid. In prin- ciple, the government stands to realize efficiency gains from contracting out the design function and, effectively, creating a competition for ideas.
Trujillo et al. (1998) explore the potential for ‘unbundled mechanisms’ in the case of BOT-type projects such as toll roads, although they consider that many other PPPs could be unbundled. Bundling is normally argued for on the grounds of enhancing the potential to realize economies of scale and scope along with innovations in design, pricing and risk-sharing. Usually, however, the BOT concessionaires are joint ventures of a number of private companies which agree in advance to subcontract each of the different activities and take equity stakes in the SPV to cement the relationship. The authors argue that two problems are thereby introduced. First, good constructors may be teamed with less good financiers. Superior knowledge of one activity may not carry over to other activities. Second, competition is limited to those bodies which are part of the group. Companies, especially local entities, with perhaps good techni- cal know-how but poor financial capability are unable to bid because the activ- ities are jointly, rather than separately, auctioned. Transparency and competitiveness in the bidding process are lost, or more correctly traded-off for innovation opportunities, which the authors consider may not always be the best solution.
For these reasons, Trujillo et al. (1998) examine the case for unbundling.
They recognize that the costs of unbundling (e.g. creating different entities, and monitoring the specifications in the different stages) may be considerable, but may be offset by an improved allocation of risk. There is then the question of how the unbundling is to be done. The authors consider two possibilities.
One is for a public sector agency to play the role of the concessionaire in BOT projects. However, the lack of qualified public sector institutions capable of articulating the project and supervising the private sector participants limits this option. As an alternative, the authors suggest appointing a private company to carry out the job. Subject to the conditions established by the public sponsor, the private agent would subcontract and monitor the arrange- ments, while simultaneously structuring and launching the joint venture or special purpose vehicle needed for financing. That is, a private company acts as a service company for the project but without assuming the project risks.
In this latter case, it might be argued that this type of ‘unbundling’ is effec- tively what happens already under a PPP since the concessionaire rarely assumes all the project risks and many are put out to a range of specialist contractors.1Yet there is an important difference between the two situations – incentives are stronger when the supplier is bearing at least some of the risks of supply. The assumption of overall responsibility prior to risk transfer gives the concession winner the appropriate incentives to do the job properly, which may not be present to the same degree when there is a nexus between the prin- cipal (the public body) and the agent (the private sector service company co- ordinating entity).2Also, a feature of PPPs is that risks are usually shared between the private sector and the public sector, with the government ‘taking back’ some risks for which private bodies would charge ‘too much’. For this risk allocation process, the public sector entity might find it less costly to negotiate with a single body rather than with a host of individual subcontrac- tors, either directly or by proxy through the coordinating company.
Daniels and Trebilcock (1996), after raising the question of unbundling, and considering it at some length, reach a similar conclusion. They argue that the case for bundling and vertical integration is much the same as that for the existence of firms in economic theory, and rests on the presence not only of contracting costs (examined by Hart), but also information costs and economies of scale and scope.3Essentially, the case for integrating design, construction, finance, operations and maintenance is that private firms can coordinate these activities at lower cost than can government, and they are better able to respond to economic incentives.
In our view, the question of the incentive structure is central to the issue of bundling. As Grout (1997) has observed, when contracts are incomplete, and not every eventuality can be covered, incentives pose a particular problem and it is important to get them correct. For instance, there are large information difficulties surrounding construction contracts, and determining the responsi- bility for cost overruns is a serious source of conflict when there are design changes and other unexpected developments. However, writing the contract in terms of the flow of services from the infrastructure facility rather than the process of construction can change the incentive system. If, for example, the
same entity is responsible for both construction and supplying the services, but is remunerated only for the successful provision of services of a suitable qual- ity, it is important for the entity to build the correct facility, get the process of delivery right, and contain costs while not sacrificing quality. Financiers also have incentives to make sure that services are supplied on time and to the requisite standard when the revenue stream that is generated represents the main source for repaying debt. It is the welding of upfront design and finan- cial engineering to downstream management of the construction costs and revenue flow that gives the PPP its distinctive incentive compatibility charac- teristics.
Without wishing to trivialize the argument, there are some similarities between the ‘unbundling’ issue and the decision of whether to employ a builder for home construction or subcontract oneself the functions of brick- laying, carpentry, roof construction, plumbing, electrical wiring, and so on.
Anyone who has tried to do their own subcontracting would probably agree that it is a difficult route. As in the building trade, there are a host of informal links that bind the subcontractors and the project sponsors together, and these enable the job to be done.