P3 101: Comparing infrastructure procurement models
October 26, 2017
Already a common means of delivering infrastructure in many countries, public-private partnerships are growing in importance in the United States. Generally referred to as a P3 or PPP, this procurement model allows governments to use private-sector expertise and financing to deliver infrastructure ranging from bridges to water systems to public buildings.
Outside of specialist circles, however, most people know little about P3s. This month, Doggerel features a series of conversations with members of our advisory team exploring the basic concepts behind P3s. In this third installment, Arup transaction advice specialists Alfonso Mendez, Roberto Sierra, and Jorge Valenzuela discuss how P3s compare to other project delivery models.
Can you give an overview of the differences between P3s and other common models?
Mendez: In the US, most infrastructure projects use design-build (DB) or design-bid-build (DBB) delivery methods, where you basically hire somebody to build a project for you and then they hand it back to you when it’s completed. In both cases the owner makes periodic progress payments, typically monthly.
With a P3, on the other hand, the company designs and builds the project, but they’re also in charge of financing it, keeping it up, and operating it for the next 30 to 40 years, until they give it back to the owner on the date specified in the contract and under certain conditions. That means all the additional capital investments that are required during that time will be in their court. The owner will only make payments, if any were agreed to in the contract, upon project completion. If it’s a revenue-generating P3 deal, such as a toll road, the private investment is instead paid back by the project’s revenues.
The P3 developers know this when they’re building the project, and as a result they do their best to ensure the quality of the initial construction and minimize future life-cycle investment costs — optimizing their financial returns over the project’s life span. That might mean that they have to spend more money up front during construction, but they’re incentivized to do so as it saves them money in the long run during operations.
That’s the biggest difference between PPPs and the traditional DB or DBB model, where the builder is instead incentivized to lower up-front construction costs as much as possible because they won’t have to deal with any of the resulting life-cycle problems. In the DB or DBB model, once the owner starts making payments during construction, they accept the construction works incrementally as they are completed, including any quality issues. It’s usually hard, and expensive, to correct those problems later on, and even harder to recover associated costs from the builder.
The extra investment that is needed during the construction phase to achieve good quality and make good life-cycle decisions is particularly important.
The extra investment that is needed during the construction phase to achieve good quality and make good life-cycle decisions is particularly important because the public sector often just can’t devote the funds needed to do the project right the first time. There’s always something more urgent to spend the money on: social requirements in the city, employee pension funds, even other infrastructure projects.
And that’s only on the front end. It’s even more difficult for governments to find money for ongoing maintenance after the project opens. Normally public-sector infrastructure portfolios have a very high amount of deferred maintenance. In some states, the deferred maintenance needs add up to tens of billions of dollars. In today’s political environment, where is that money going to come from? The American Society of Civil Engineers’ current “report card” gives the overall state of infrastructure a D+ grade, with an investment deficit of over $200 billion annually for the US as a whole — this is the unfunded need to simply bring the existing infrastructure up to a state of good repair, not including the need to modernize and expand it.
So for certain kinds of projects, the only way for politicians to cover themselves is to have a private-sector partner who agrees up front to handle all the maintenance for the next few decades. And if that partner doesn’t handle it in the way their contract specifies, they either won’t get paid or will be otherwise penalized.
Valenzuela: But at the same time, PPPs aren’t the only way to do things; they’re not the perfect way for every project.
In general, when we do consulting work for governments, we advise them to do a study to see what delivery method would be best for their project. For some types of projects, the best way to deliver them is a traditional DB or DBB model. This can often be the case for smaller and less complex projects, or for projects with very unique situations that make it hard to structure the transaction.
It’s worth remembering that even though modern P3s came to the US only recently, private investment in public infrastructure has a long history in the country. Think about the transcontinental railroad, for example, which was built by private companies over public lands provided by US land grants. Construction was financed by both state and US government subsidy bonds as well as by company-issued mortgage bonds.
P3s bring innovation from the private sector and transfer risks to a private developer and operator.
So what variables should governments keep in mind when choosing between different models?
Sierra: The first thing they should be looking at is project size. Are you talking about a regular project or what we call a megaproject?
The line between the two can be hard to determine because it varies from agency to agency, depending on that agency’s procurement track record. How large have your cost overruns been historically? What kind of technical and institutional capacity do you have to manage big projects?
The second factor to consider is complexity. The differences between building a subway versus building a building are obviously substantial.
We also ask clients how often they’ve done this kind of project. For instance, in South America you have a lot of subways being developed, but there are very few locals there who have experience actually building the subways.
Valenzuela: P3s bring innovation from the private sector and transfer risks to a private developer and operator. Consequently, governments should consider P3s for projects that have a potential for innovation. This innovation can be related to improving the quality of the service, developing new revenues that the public sector is not well positioned to develop, or reducing construction and operational expenditures.
In addition, by transferring the design, construction, and operations to a private party, the government and the users will benefit from project cost certainty.
Questions or comments for Alfonso Mendez, Roberto Sierra, or Jorge Valenzuela? Contact firstname.lastname@example.org, email@example.com, or firstname.lastname@example.org. Want to learn more about Arup’s transaction advice services? Contact email@example.com.
This is post 3 of 4 in the P3 101 series
- APP 101: Un nuevo modelo para infraestructura en los Estados Unidos / Nov 15, 2017
- P3 101: Comparing infrastructure procurement models / Oct 26, 2017
- P3 101: International mixing / Oct 16, 2017
- P3 101: A new model for US infrastructure / Oct 6, 2017