Contracting arrangements and public private partnerships for sustainable development

* This paper was prepared at the request of the G24 Secretariat, and is being published with their permission. We are grateful to participants at a G24 Seminar in Addis Ababa in February 2017, and to Marilou Uy and Aldo Caliari for very helpful comments. The authors would also like to thank two anonymous referees for useful comments and suggestions. All errors are ours.

¹ While the share of PPPs in total infrastructure investment in China is very small, it needs to be kept in mind that China invests 8.6% of GDP in public infrastructure, more than North America and Western Europe combined.

² The latest World Bank figures suggest a sharp increase in PPPs in roads and ICT in Latin America as well as East Asia and the Pacific after 2015.

³ This outcome arises when, as considered by Hoppe and Schmitz (2010), the parties agree on setting the quantity (not excessively) below the efficient level in the contracting stage. That quantity can then be upgraded to the efficient level in a later renegotiation. This possibility looks highly plausible ass, in practice, it is often the case that the scope of the project is revised and scaled up during its development. If the quantity is set to the efficient level already in the initial contract, then overinvestment in cost innovations arises under private ownership, because, as found in Hart, Shleifer and Vishny (1997), the side effect of the cost-reducing activities on quality is not internalized. On the other hand, too small a quantity leads to underinvestment, because the manager does not fully appropriate the benefits generated by the investment in the renegotiation stage. An important lesson arises from these results. Extending the scope of public projects during their development and, hence, letting the projects become less cheap than initially planned, may be a deliberate choice to address the overinvestment problems that would arise if a bigger size were fixed up-front.

⁴ The same observation on the choice of the quantity level applies in this case.

⁵ Again, this is related to the quantity choice made by the parties in the initial contract. In this case, the quantity is a single incentive tool to be used to pursue two goals, namely induce an efficient investment in cost reduction and quality enhancement. In general, the quantity that secures the former goal differs from the quantity that secures the latter, and none of the two goals is achieved as a result of the bargaining process between the parties.

⁶ Projects are said to be greenfield when they are totally new. They require designing, financing and building in the early stages; and operating and maintaining in the late stages (these tasks can, of course, be accomplished under different possible institutional arrangements). By contrast, brownfield projects rest on previously existing assets so that such tasks as design and construction are of a more limited importance. As developing countries are very poorly endowed with existing infrastructure they are much in need of greenfield projects. The conclusions presented in the text are therefore potentially very relevant for developing countries.

⁷ Recall that in PPPs the private partner is often a consortium of private firms (rather than a single firm), and that it is in charge of all the phases of the project (rather than solely the construction phase).

⁸ Hoppe and Schmitz ( 2013) point out that these results are robust to the possibility that the government does not observe information gathering. However, in that case ex-post inefficiencies may arise under PPP. Che, Iossa and Rey (2017) also conclude that rents matter. They consider an environment where the procurer pursues two goals: incentivizing research effort to create a new idea, and implementing the new idea in a least costly manner. Provided that the research effort is unverifiable and that the cost of implementing the innovation is privately known, the procurer faces moral hazard ex ante and adverse selection ex post. The implementation of the idea should be assigned to the innovator (that is, the follow-up should be bundled with the initial contractor) when the value of the innovation is sufficiently high. In that case, the rents accruing to the innovator represent a powerful incentive tool. By contrast, the implementation of the idea should be assigned to a contractor other than the innovator (that is, the follow-up should be separated with a new contractor) when the value of the innovation is low. In that case, the rents accruing to the innovator are greater than incentives to innovate, raising the opportunity cost of favouring the innovator.

⁹ The authors point out that what they refer to are investments intended to raise the efficiency (or quality) of the project, in addition to any well-defined investment related to, say, the contractually specified size of the physical assets. This latter kind of investment is verifiable and, hence, could be disciplined through the contract. One might expect the moral hazard problem associated with non-contractible investments to be especially severe when the physical assets to which the contractible investments pertain are network infrastructures (such as rail and road systems) rather than stand-alone facilities (such as schools and hospitals) and point-to-point infrastructures (such as ports and airports). This is because the former are more complex systems, require higher sunk costs, and are exposed to less competition. Considerations of this kind lead Albalate, Bel and Geddes (2015) to suggest that jurisdictions inexperienced in contracting out infrastructure projects begin with stand-alone facilities and point-to-point infrastructures, and move to network infrastructures only after acquiring sufficient expertise.

¹⁰ Mechanisms of this kind are already in use in many utilities and projects such as greenfield concessions for toll highways, as reported in Iossa (2015). Of course, this calls for fine-tuning complementary institutional mechanisms and raises potential concerns related to social equality considerations.