Risk transfer in long-term public-private contracts an example from the European road sector

1. Risk transfer in long-term public-private contractsan example from the European road sector Frédéric Blanc-Brude

2. A Comparison of Construction Contract Prices for Traditionally Procured Roads and Public-Private Partnerships F. Blanc-Brude, H. Goldsmith and T. Välilä Review of Industrial Organization Vol. 35, No. 1-2, 2009

3. Some interesting questions • Why use risk transfer contracts to procure public services? • What drives the risks found in public procurement and can transferring risk also reduce total risk? (the case of construction risk) • What are the determinants of the price of risk transfer and how much does the public sector actually pay to transfer risk? • Is PPP risk transfer ex ante or ex post efficient? • What kind of firm is interested in becoming the counterparty to public service procurement risk transfer?

4. Agenda

5. 1 Empirical Study of Construction Risk pricing in European Roads

6. The empirical study • Construction Unit Costs in European Road Projects • Unique sample from EIB project files, 15 years of data (1990-2005) collected with a constant methodology and the same team of engineers Construction cost/km, in millions of 1999 € • Methodology: Ordinary Least Squares Regression • Dependent variable: unit costs in constant Euros • Control Variables: road types, length, terrain, proportion of bridges/ tunnels, number of lanes, mega- projects, country/year effects, cost of labour etc. • Flag PPPs with a dummy variable

7. Construction cost/km, in millions of 1999 € mid-50% of observations median The construction unit cost variable The ‘pure’ construction cost: the sum of design, supervision and building costs of a road project ex ante(when the contract is awarded); excludes all other costs especially land, legal fees, financing costs, start-up costs etc. all excluding VAT. most outliers are fixed links

8. Control variables: e.g. road length

9. Empirical Results • There is a systematic difference in the ex ante cost of construction between traditional and PPP procurement • The average premium is 24% • The range is 10-40% • Very good statistical results • Robustness tests (alternative samples) • BLUE estimators (homoscedatistic data, normal residuals) • Adjusted-R2: 70-80%

10. Why would the price of construction works be 24% higher at contract signature in PPPs? • Low number of bidders: In the UK, a third of projects after 2003 attracted no more than two bidders compared with just 15 per cent previously (Public accounts committee 2007). • Huge pipeline of projects in Europe: • 800 PPP projects planned in the next five years across sectors (Eur1,000bn capex) • 99 roads bridges and tunnels (capex of Eur94.9bn) • How many consortia can bid for these projects? • Business practices die hard: “The OFT’s investigation suggests that cover pricing was a widespread and endemic practice in the construction • industry. Indeed, the OFT uncovered evidence of cover pricing in over 4,000 tenders involving over 1,000 companies.” 22 Sep 2009 Example: A shadow toll road PPP in Portugal was finished within 2% of the initial budget but turned out to include extra works that had not been planned for the first phase of construction. The contractor decided to build extra lanes scheduled for phase 2 and managed to do it within the budget for phase 1. It also failed to mention it to the conceding authority or the project lenders, which eventually discovered this fact during a site visit. • Two cases can trigger cost inflation: • One or two comparatively large deals in a small market (e.g. in Poland, unit costs for the construction of motorways under PPP schemes have been some 30-50% above unit costs of the traditionally financed schemes.) • Numerous projects tendered all at the same time (e.g. DBFO shadow toll road progamme in Portugal) Risk premium • The maintenance of assets is better thought through at the design stage under a PPP scheme. Examples include: • fixed bridge decks rather than using bearings which have often given rise to disruptive maintenance, • choosing long-life pavement materials perhaps even eliminating the need for heavy renewal • drainage systems designed to be low maintenance eliminating or reducing need for manual intervention • etc... • Fixed-price, date-certain turnkey EPC contracts Procurement Process • Badly managed PPP program roll-out. • But our model controls for country effects • Segmented project market: many small firms can do traditional procurement and only a few can do PPPs Competition Investment in lower LCC • Investment upfront in lower life-cycle costs (better design, higher quality etc.) • ‘front-loaded’ profits/ inflated construction costs • Past bidding costs re-integrated in new bids • The rent of the efficient firm? A rent

11. 2 Characterising Construction Risk in Public Projects

12. Why does the public sector decide to enter into a risk-transfer contract to procure public services? • Risk neutrality of the public sector • The only reasons to use risk transfer contracts to procure infrastructure is if it can reduce expected procurement costs… • … which implies that risk in infrastructure projects in endogenous to the type of procurement contract used

13. Three stylised facts about construction risk in standard public procurement • Significant variance of ex post costs in public projects compared to ex ante estimates (-10% to +200%) • Systematic measurement error in ex ante cost estimates. In the Road sector: • National Audit Office (1998) for DoT : + 28% • Flyvbjerg (2002) for European roads: + 20.4% • Mott MacDonalds (2002) for UK roads: + 21% • The vast majority of public infrastructure projects are procured through a combination of low-powered or cost-plus contracts, which makes the public sector liable for the majority of cost overruns. See Levene (1995), Graves and Rowe (1999), HMT (2003), Flyvbjerget al (2003), Flyvbjerg (2007), NAO (2001; 2003; 2005), Bain & Wilkins (2005), Hinze (1993), Clough and Sears (1994), Bajari & Tadelis (2001), Gruneberg & Hughes (2004), Bajariet al (2006). • The question now is… • Since in a PPP there is full transfer of construction risk from public to private sector (fixed price EPC contract)… • … is the PPP construction premium roughly equal the average expected cost overrun under traditional procurement? The price of risk? • This is true if construction risk is the same under both traditional procurement and a PPP...

14. Construction risk in public procurement • What should we expect? • Independent events; the distribution of cost overruns should be ‘quasi-normal’ i.e. mean = 0 and a ‘bell curve’ • Existing data on public cost overruns suggests however that, • The distribution is not centred on zero: estimation error • And it has a ‘long right tail’ (positive skew): unexpected costs (when some things go wrong in a project and there was no contingency, other things go wrong as well i.e. spiralling costs) • The cost overrun lottery is in part a function of the procurement route and not all construction risk is found at the project level. Is this what the construction risk of the firm looks like under a PPP?

15. Construction risk in PPPs? Ex ante Unit Cost vs. Ex post Unit costs in EurM/km New, 4-lane motorway with no bridges or tunnels and outside or urban or mountainous environments • Of course the PPP firm faces ‘risks’ (ground conditions, weather, etc.) • But these well-known risks (in standard projects the firm has private information) are included in the contingencies of the project’s budget • ex post data for standard road sections (not mega-projects) • PPPs are usually on target and there is no ‘size effect’ • Non-PPPs face great cost uncertainty and there is a significant size effect: more expensive projects ex ante face higher cost overruns

16. 3 The agency problem: information about risk

17. The risk of the firm under a PPP contract • When the firm has incentives not to underestimate costs (because of the fixed price construction contract under a PPP) … • … then the ‘unexpected costs’ of traditional procurement (the long right tail) can be avoided • In standard projects, the risk of cost overruns is different (most likely lower) under a PPP than under traditional procurement: private information • So when entering into a risk transfer contract to procure infrastructure, the firm knows something that the public sector does not.

18. The agency problem • The agency problem arises because the firms known something (about costs & risk) that the public sector does not • A principal (the public sector) needs to delegate a task to an agent (the firm) • Adverse selection: There are different types of agents (inefficient vs. efficient risk managers) with different expected costs and different variance of costs (cost lotteries) • Moral hazard: Agents can also decide to make an effort to change the cost lottery but this effort is costly • e.g. invest now in better design to reduce O&M costs variance later • If the principal offers to cover all the risks associated with the task then the efficient risk managers will be content with mimicking the inefficient ones and – because their costs are lower – receive a risk-free profit • Meanwhile the cost of procurement is high for the principal

19. 4 Solving the agency problem

20. The solution to the agency problem • What the principal needs is a way to make the efficient agent(s) step forward and deliver their services at the best expected cost: • A ‘menu of contracts’ acts as ‘revelation mechanism’ • The principal can offer various combinations of risk sharing, remuneration schemes and output volume to make the best firms step forward and behave according to their ‘type’ • To make this menu of contract ‘incentive compatible’ and make the efficient firm(s) reveal their ‘type’, the principal must pay them an ‘information rent’ • Unless competition is perfect, firms are not willing to reveal how efficient they can be for free. • A typical result: (Laffont & Martimort 2002) • Two agents, one efficient, one not, the principal offers a two-contracts menu, one with risk sharing and one without • The efficient agent chooses to share some risk, exerts optimal cost reduction efforts and received an information rent • The inefficient agent chooses shares no risk, exerts no effort and receives no rent • The role of commitment in long-term contracts • If the contract has several periods, the principal has to commit ex ante not to expropriate the rent of the efficient firm later, otherwise the efficient firm is likely to anticipate renegotiation and still fail to reveal its true cost lottery.

21. The components of the price of risk transfer • Using risk transfer contracts as a way to make the efficient risk manager step forward and deliver infrastructure projects at the best cost demands… • Paying a risk premium • Paying an information rent to the ‘efficient type’ • This use of long-term risk transfer contracts amount to achieving ex ante efficiency at the cost of ex post inefficiency (the rent of the efficient firm survives the tender)

22. A formalisation of risk transfer in long-term public-private contracts • A public-private risk transfer contracts in which a service is delivered by the firm on the basis of a pre-agreed output specification in exchange for a fixed pre-agreed payment, typically called unitary charge or availability payment. • Most popular type of PPP by number (UK PFI template) • Focus on delivering standardised units of public service at a fixed price: full risk transfer of standard delivery cost (design, construction, O&M) • Long-term commitment to purchase/ deliver • Assume that output is easy to specify and verify ex post (e.g. a school building) • The procurement choice is either to transfer standard risks in full (PPP) or not transfer risk at all and go back to standard public procurement (PPP vs. PSC) • From the point of view of the public sector, these contracts amount to swapping the unlimited liability of the public sector (per unit of public service delivered) for a fixed one. In essence, the public sector is entering into a total-rate-of-return swap contract by which it will receive a fixed return (unitary payment over standardized unit of public service received) and the firm a variable one (the firm’s cost of delivering one unit of public service over the fixed income received)

23. 5 Interpretation

24. Interpretation • PPP procurement boils down to a binary menu of contracts: either the firm(s) agrees to full risk transfer of all ‘standard costs’ or the public sector has to resort to standard public procurement. In practice, the use of ‘public sector comparators’ often corresponds to the attempt by the public sector to ‘separate the types’ with a PPP tender by simulating what the inefficient type of firm would deliver under a zero risk transfer contract. • Such contracts also represent a commitment mechanism through which the public sector agrees ex ante the price it will pay ex post and for the whole duration of the contract. Whatever information rent the agent has secured at the time of contract signature is guaranteed not to be expropriated by the principal. PPP contracts are thus a case of ex ante efficiency achieved at the cost ex post inefficiency.

25. Interpretation • Elimination of the moral hazard problem (100% incentives to reduce cost) at the cost of maintaining the adverse selection problem • The ex post inefficiency of procurement through risk transfer contracts like PPPs means that the government can only rely on competition for the risk-transfer contract to minimize the efficient firm’s information rent.

26. Separating the types • How much competition is there to capture the rent of the ‘efficient firm’? • What do we know about the different types of firms that are involved in public procurement projects? • The ‘shallowness’ of the PPP market (S&P): few companies can endeavour to undertake complex projects like PPPs, especially ones that combine construction and long-term operation and maintenance phases as well as complex project management and financing structures (House of Commons 2005). • Firms capable of winning PPP bids also needs to be large because they have to manage and carry risks so that their private cost of risk bearing does not more than offset whatever efficiency gains they can realize compared to traditional procurement • Larger firms can diversify their losses over many projects and thus demand a lower risk premium. If they are very good at what they do, their risk might actually be quite limited. • A segmented construction sector with a few large firms and many small ones. • It is thus reasonable to assume that even if a lot of firms compete in the construction sector (Langford and Male 1991; Betts and Ofori 1994), amongst the firms that bid for public projects, many are of the inefficient type and few of the efficient one (Hillebrandt 1984; Ball 1988). • If the market for procuring infrastructure projects is divided between many inefficient firms which cannot reduce the expected value of cost below that of the PSC, and a few (maybe just one) efficient firm, then even at the ‘preferred bidder’ stage, the adverse selection problem is likely to survive... • ...and with it the firm’s rent.

27. Separation requires well differentiated firm types

28. The lowest risk adjusted price is not necessarily the lowest expected cost

29. Self insurance vs. self protection

30. What’s in a rent? • The lowest bid is likely to be a combination of the efficient firm’s expected costs, risk aversion and subjective risk • The lowest bid could be a large firm using conservative technology with a well-known cost variance. • The 24% construction premium we see in PPP roads is thus likely to be a combination of risk premium and rent • Too high to explain upfront investment in the life-cycle alone • And we now know that the cost overrun lottery of the firm under a PPP is not that of the public sector under traditional procurement. • In effect, the 24% looks like the public sector’s willingness to pay for risk transfer • ‘Actuarially fair’ price of risk given the subjective probability of cost overrun of the public sector • So that’s what bidders ask for e.g. the common practice of benchmarking bids just below the PSC • Is this a problem? • Giving a rent to the efficient firm is the solution to the agency problem… • … but in the case of PPPs the rent is paid for by tax payers! • The public sector should thus has a responsibility to keep it to a minimum.

31. Interesting answers? • Why use risk transfer contracts to procure public services? • What drives the risks found in public procurement and can transferring risk also reduce total risk? (the case of construction risk) • What are the determinants of the price of risk transfer and how much does the public sector actually pay to transfer risk? • Is PPP risk transfer ex ante or ex post efficient? • What kind of firm is interested in becoming the counterparty to public service procurement risk transfer?

32. Conclusions • Information asymmetry and endogeneity are what justifies the existence of public-private risk transfer contracts like PPPs, it is also what makes them most problematic, since principal and agent may have different views and different sensitivities to certain risks. This is likely to make the discovery of the efficient price of risk transfer difficult. • As long as competition for carrying infrastructure service cost delivery risk is imperfect, the principal’s commitment to pay an information rent is necessary to make the efficient firm choose the risk transfer contract. Procuring public services at a fixed price is thus, by construction, a case of ex ante efficiency (at the procurement stage) achieved at the cost of ex post inefficiency (during the service period). • These finding have several implications: • It helps understand the oft-mentioned perception that PPPs are ‘expensive’ since this outcome is built in the procurement method (assuming imperfect competition) • It suggests that the principal decides to enter into such contracts with the full knowledge that the efficient agent will receive a rent. • In effect, the rent received by the agent in a public-private risk transfer contract should not be seen as an undesirable by-product of inefficient procurement that that the principal should aim to eliminate but as an important mechanism ensuring the incentive-compatibility of the binary menu of contracts PPP/PSC (shutdown) • It remains that the principal should try to minimize the rent of the efficient firm in a public-private risk transfer contract, which militates for some kind of ex post economic regulation of such contracts.

33. Thank you frederic@infrastructureeconomics.org