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.
Grout and also Klein argue that what is important is the ‘true’ risk of the project, which is independent of whether the public sector or the private sector provides the funding. What differs is that the private provision of finance; that is, the PFI/PPP route, explicitly builds the risk into the cost of funds. By contrast, traditional public procurement masks the risk because the government can fund the project at a risk-free rate independent of the actual risk position. As John Kay has remarked: ‘we would lend to the government even if we thought it would burn the money or fire it off into space’ (Kay, 1993, p. 63).
But why can government borrow at a risk-free rate of interest? This reflects the fact that (and again we quote John Kay) ‘the cost of debt both to governments and to private firms is influenced predominately by the perceived risk of default rather than an assessment of the quality of returns from the specific investment’ (1993, p. 63). For private debt there is a risk of default, whereas for government debt there is little or none (at least in the case of governments of most developed countries) because the government can raise the taxes to meet the obligation. The government is risk-free in the eyes of the investor lending funds because the risk is transferred to the taxpayers, who bear the cost through the risk of higher future tax payments and different consumption outcomes. In Klein’s words, taxpayers have assumed a contingent liability for which they are not remunerated. They have become, in effect, shadow equity providers. This residual risk imposed on taxpayers is a cost, which ought to enter into any cost–benefit analysis. If this were done, the real cost of government borrowing would be the same as the private sector if the underlying risk of the projects were the same. Taken to its limit, the lower government borrowing cost argument would seem to imply that all activities should be undertaken by government as the cost of capital is so low. Were this to happen, would the debt then still be regarded as riskless?
Obviously, public debt is not riskless. For central government debt there is the risk that debt can be monetized, while at the regional level of government there is the risk of adverse economic performance. Nevertheless, in compar- ison with private bodies, governments enjoy near risk-free status because they can resort to general taxes and ‘inflation’ taxation to avoid bankruptcy.
The private sector is, however, exposed to this ‘taxation risk’, an externality that is ignored in risk evaluation but which needs to be built into social risk calculations.
The corollary is that the higher credit rating of governments, and hence their lower borrowing rates, is largely irrelevant to the choice between public and private provision of infrastructure. Argy et al. (1999) argue that, subject to three conditions, the cost of capital should be assumed to be the same for both the public and private sectors. These conditions are:
1. that the risks associated with the specific project (variance in returns) are mainly ‘commercial’ rather than policy-related in character;
2. that the private capital market is reasonably efficient; and
3. that private sector financing transaction costs (being on a smaller scale) are not overwhelmingly large relative to those usually incurred by the public sector.
According to the authors, these three conditions probably do hold for many new infrastructure projects so that, provided the rewards match the risk, reliance on the private sector for provision should not entail any extra capital cost (and indeed if the private sector is more efficient at project design and managing the capital, the capital cost should be lower). This position probably oversimplifies matters – a more complete comparison of public and private borrowing cost has been made by PricewaterhouseCoopers (2002), and we consider this study later in the chapter.
In summary, most PPP/PFI projects involve substantial private sector finance and, in all but very exceptional circumstances, this finance in itself will be more costly than public sector borrowing, although there are many hidden costs in the latter. Clearly, governments are not immune from fiscal difficulties, which can lead to credit rating downgrades and higher project costs, but the main reason why the government’s cost of borrowing is low is that it can levy taxation to repay the debt. Due to these taxing powers, lenders to government consider that it is unlikely to default, and so demand a lower interest rate risk premium. But having the true risks hidden and passed on to taxpayers in the form of a contingent liability does not mean that public invest- ments are risk-free. Project risks depend more on the project’s design than on the specific financing mechanism (Flemming and Mayer, 1997).
For a long time it was argued that the cost of capital of publicly funded projects is below that of private, not due to lower borrowing costs but because, through the tax base, the government can achieve better risk-sharing and pool- ing than is possible in the private sector (Arrow and Lind, 1970). This position has been replaced by a new view that the cost of capital of equivalent projects is the same in the private and public sector when account is taken of taxpay- ers shedding their contingent liability through the capital markets (Brealey et al., 1997).4The new orthodoxy sees a project’s cost of capital as being set by the cost of bearing the market risk of the project which, according to standard finance theory,5 can be established by adding to the risk-free rate a risk premium dependent on the extent to which the asset’s returns are co-variant with market returns (the asset’s ‘beta’).
There may be grounds for questioning how appropriate a market-based analysis such as the capital asset pricing model (CAPM) is for dealing with projects where there can be a divergence between market and social risks, as
a result of externalities and distributional considerations (Flemming and Mayer, 1997). Taxation also drives a wedge into cost of capital calculations, with the private sector evaluating projects at an after-tax cost of capital, and the government at pre-tax costs (Brealey et al., 1997). Some of these issues are taken up again when we examine the question of the appropriate discount rate and the returns to PFI projects.