Public-Private Partnerships Are A Valuable Tool for Government, Though Not A Panacea
By Nicole Gelinas
As tax revenues fall and stagnate, states, cities, and other
municipalities are searching for ways to save money, deliver
better service, and make investments in public infrastructure.
Many are taking a fresh eye to public-private partnerships
(PPP), which involve the private sector in traditional public-sector
work. Once unusual in the United States, PPPs have increasingly
become an option for governments here, particularly in the
transportation and transit infrastructure arena.
Under a PPP, a government entity transfers some aspect or
aspects of a responsibility traditionally performed by the
public sector to a private-sector partner under a well-defined,
long-term contract. Some such transactions involve an up-front
payment from the private-sector partner to the public-sector
entity. In return, the private-sector partner receives rights
to a future revenue streamsuch as monies from toll collectionover
a defined time frame. Other PPP structures involve a private-sector
pledge to provide a service, such as operating and maintaining
a free road or a subset of bus lines, in return for a regular
payment from the government entity. In general, the government
retains ownership of any physical infrastructure asset.
PPPs differ from traditional government contracts in that
the private-sector partner shoulders some uncertainty in return
for an uncertain future reward. The private sector takes on
significant long-term control, as well as the peril of failure,
for some aspect of a project, such as running bus lines or
toll roads, or rehabilitating a subway station, in exchange
for a profit that depends on careful private-sector management
of costs. In some cases, control includes the right to increase
revenue through toll or other fee hikes. Under traditional
contracts, by contrast, uncertainties such as cost and schedule
overruns and control over fee structures generally remain
with the public sector, while the private sector earns a reasonably
certain profit, often a percentage of costs incurred.
PPPs originated in Europe and have been popular in Australia;
they have come to the United States only over the past decade
or so. Recent PPP transactions have included a ninety-nine-year
agreement between Chicago and private operators to lease and
operate a major toll road and a five-year agreement between
New Orleans and a private operator to run a bus and light-rail
The PPP model can be a valuable tool for the public sector,
as long as government officials understand the complexities
and risks involved. Allocating risk and responsibility to
a private-sector partner is just as complex as directly running
every aspect of a project. In many cases, it is more complex.
Every PPP is different, as is every market environment; properly
assessing the risks and getting each contract right matter.
Though each PPP is unique, broad principles can help guide
the process. The discussion below uses examples largely from
transportation and transit infrastructure to illustrate the
principles; however, the principles apply to other PPP sectors.
On each project, local and state governments must understand
which risks the private-sector partner can reasonably take
and which risks the public sector must retain. In general,
a private-sector partner will not take on unlimited technological,
engineering, or financial riskat least, not for a price
that is economical to the government. Government entities
should be wary of a potential private-sector partner that
says that it will take on unlimited risk.
For example, in 2003, the British government tried to offload
the financial and technical risks of maintaining and improving
its 100-year-old subway system to two private-sector consortia
for a fixed pricethat is, eliminating cost-overrun risks
to the governmentwith fixed performance benchmarks.
The private-sector groups, which included Bombardier Inc.,
nominally took on open-ended technical and financial risks.
But as one group realized that it had underestimated the scope
and cost of the project, the private-sector partners eventually
decided that the risks were too much to bear and opted to cut
their losses, a rational business decision. The soured
venture will cost the British government hundreds of billions
of pounds in guarantees offered to the private partners' lenders,
a poor decision on the part of the government.
Even on projects that involve straightforward engineering
and construction risks, private-sector partners may be unwilling
to take open-ended financial risks for a price that is reasonable
to the government, including, for example, the risk that a
new toll road won't generate enough traffic in its first years
of operation to cover its debt-financing costs. For a project
that represents many "firsts"whether it's
a state's first toll road in a rural area or its first use
of a new construction techniquethe government may have
to continue to shoulder some of the costs of uncertainty to
get the job done.
By contrast, the private sector can be well suited to take
on tasks that are finite, easily defined, technologically
straightforward, measurable, and comparable with other jobs.
These tasks can include managing bus lines, taking construction
cost and completion risks, or operating and maintaining a
road within certain performance standards.
Governments should encourage competition, often by starting
small and keeping contracts short. A government entity
should do its best to ensure that its private-sector partners
are unable to use a lengthy or overly broad contract to gain
a monopoly over certain functions.
Bus service lends itself well to the PPP model because governments
can easily protect themselves and their citizens against monopoly,
collusion, and poor work. As Baruch College professor E. S.
Savas has noted: "Major cities in the United States and
EuropeLos Angeles, San Diego, London, and Copenhagen,
for exampleintroduced bus competition several decades
ago and saw spectacular success in reducing costs," along
the lines of 20 to 51 percent. Even
in a medium-size city with a dozen or more routes, government
officials can bid out multiple contracts-under which bidders
usually compete for the lowest government subsidy required
to provide servicesto prevent any one private-sector
partner from dominating. A well-designed bid can attract a
deep pool of competitors because barriers to entry are low.
With bus PPPs, it's easy for the public sector to assess
whether it's getting a good deal for its subsidy, too, relative
to the cost of doing the work in-house: citizens can tell
whether bus service is better or worse than it once was, and
can compare service across lines, while the government can
tell whether it costs more or less, often through running
its own cluster of lines.
So that the government can maintain consistent control over
the quality of important public infrastructure and make it
more likely that taxpayers and users get a good price, the
length of a contract is important, as well. During the credit
bubble that burst in 2007, two of the first-ever PPPs to be
done in the United Statesthe Chicago Skyway and the
Indiana Toll Road privatizationsoffered unusually long
terms. In 2005, Chicago leased its Skyway toll road to an
international consortium led by Australia's Macquarie Group
in exchange for a $1.8 billion up-front payment. The transaction
was completed after the city had completed a $250 million
rehab program on the road. The consortium is responsible for
running the road with no state subsidy, with toll revenues
as its main source of revenue. A year later, the state of
Indiana leased its own toll-road system to an international
consortium, also led by Macquarie, for a $3.9 billion up-front
payment. Similarly, earlier this year, Chicago leased its
parking meters and the rights to their revenues to a consortium
led by Morgan Stanley. The consortium received a seventy-five-year
lease, in return for an up-front payment of $1.2 billion.
But the best PPPs have shorter terms, optimally thirty years
at the longest, similar to the longest-dated bonds that commonly
trade in the markets. Because investors' ability to estimate
costs and risks diminishes with time, the money they offer
to the government for an asset also diminishes, per year,
with time. Thus, absent a crefit bubble, the risk on a decades-long
agreement is that the government is handing out free bonus
years to a bidder for an asset that comes with its own valuable
source of revenues. Furthermore, an overlong lease involves
surrendering direct control of a public asset across several
generations, raising issues of generational equity.
One example of a right-size contract: the city of New Orleans,
still struggling after Hurricane Katrina hit in 2005, has
recently decided to experiment with a public-private partnership
to run its bus and light-rail service. The city awarded only
one contract for the entire city, to France's Veolia Environnement
SA, and was unable to attract a large bid pool. However, the
contractor has pledged to save 20 percent of New Orleans's
previous annual costs while improving service. The government
and the public can easily measure the cost savings, while
the five-year contract length means that the city hasn't locked
itself into a decades-long bad deal. Veolia will save the
public money partly by offering transit workers a 401(k) plan,
rather than the guaranteed pension plan that most public-sector
Market conditions for the private sector fluctuate while
govenment must steadily plan infrastructure investments.
Earlier in this decade, the high-profile "privatizations"
that made headlines for offering governments a huge new pot
of money with which to make badly needed infrastructure investments,
including the Chicago and Indiana road privatizations, may
have given governments a skewed view of the PPP world. In
retrospect, the transactions were evidence of a global credit
bubble that allowed the private-sector partners to think that
they could borrow at abnormally low rates over the life of
the lease. The Indiana project, in particular, looks increasingly
uneconomical for Macquarie, as its interest costs may soon
rise. Such deals may not be repeated
on the same lucrative terms for the public sector.
Government officials should, of course, take advantage of
any great one-off opportunities that come their way (provided
that they don't contain hidden risks); but in this financial
environment, they should not simply sit back and wait for
them. In general, governments shouldn't rely on market cycles
to provide money for critical infrastructure. States and cities
should not depend on exuberant market conditions to find sources
of infrastructure investment, but rather should budget reasonably
for such investments.
Some state and local government planners, with continued
federal support, may prove adept at dialing back expectations
in a muted financial environment. In early 2009, Florida completed
a transaction creating a private-public partnership that will
rehabilitate and expand a 10.5-mile section of an urban interstate,
I-595. Though the state is keeping traffic riskthat
is, it will pay the private partnership a fixed payment that
is not dependent on the road's toll revenuethe private
partners, led by Spain's Grupo ACS, are responsible for design,
construction, and maintenance costs over thirty-five years.
The deal, the first in the nation, eventually could prove
an optimal allocation of public and private risk. However,
it would not have been possible without cheap federal financing;
the private financing market showed itself less amenable in
2009 to taking creative risks than it may have been in 2005
Potential private-sector partners cannot act rationally
unless government first creates a rational, consistent, predictable
environment for infrastructure investment in which they can
do business. If private-sector bidders are not confident
that a state or local government fully understands or supports
the benefits and limitations of the PPP structure or are worried
that the support will erode after a change in administration,
this political uncertainty will mean fewer quality bidders
and higher costs for the government.
For example, infrastructure companies and their financiers
learned a harsh lesson from Pennsylvania's effort to sign
a long-term lease for the Pennsylvania Turnpike in 2007 and
2008. Potential bidders devoted money and other resources
to submit bids only to see the government abandon the long
process at a late stage as its political support eroded. In
a bubble environment, potential private-sector partners might
forgive political uncertainty, but it becomes a bigger factor,
and a more expensive cost for governments, in more difficult
Private-sector involvement does not guarantee a good deal.
Government entities must carefully assess whether their
taxpayers are getting good value on a case-by-case basis,
particularly on a complex, long-term contract. When a contract
requires the private partner to borrow extensively, for example,
the private partner may be at a disadvantage compared with
what the government's direct cost of borrowing would be, because
the government benefits from its taxing power and from an
investor perception that municipalities generally do not go
bankrupt as well as federal tax policy toward municipal debt.
The private sector could pass its higher cost down to taxpayers
and users in the form of higher bids. It's a case-by-case
empirical question as to whether higher borrowing costs can
be outweighed by the efficiencies that private-sector partners
bring to the table.
Though government likely got the better end of the deal in
the Indiana toll-road case, there's no guarantee that it won't
get the bad end of the deal in another, similar case. In the
Chicago parking-meter transaction, for example, it's not entirely
clear that the government will save any money. In some cases,
it may be better for the government to focus directly on cutting
its own labor and other costs to achieve savings, rather than
enter into complex contracts whose successful outcome depends
on intricate assumptions projected over decades.
Likewise, government officials should be wary of potential
PPPs that do not attract wide bidding pools. If two or three
major companies dominate worldwide in one particular function,
it is difficult to ascertain if a fair market really exists.
Again, bus service is optimal for contracting here, because
the barriers to entry are low.
The private sector can't save the public sector from itself.
Government cannot use PPPs to avoid decisions on spending
priorities, such as deciding whether to expend finite resources
on social-services growth or infrastructure investment. Public
infrastructure is, more often than not, a task that is not
explicitly profitable, meaning that private partners require
public subsidies to do the job even under PPP structures.
The public sector can cut some costs by structuring effective
PPPs, but it cannot eliminate them.
Similarly, PPPs are not a way for government to avoid decisions
on issues like public-sector pension and other labor-cost
reforms. PPPs are of no help to the government if, for example,
the government simply requires private-sector bidders on a
particular project to transfer unreformed public-sector labor
to the new partnership, as New Jersey moved to do two years
ago, and as New York State may do, as well. Government cannot
avoid unpalatable conflicts with union labor and other special
interests via the PPP model; in some states, including New
York, public officials must enact legislation or agreements
with unions before they can broadly employ the PPP model in
the first place.
PPP structures will not change a government that has a habit
and history of tolerating contractors with political ties
or contracts assigned via kickbacks or collusion. Ethical
bidders will simply stay away, and unethical bidders will
do business as usual through the PPP structure. PPPs are no
guarantee against corruption; only public-sector willpower
and vigilance, as well as independent scrutiny on the part
of the public and the press, can do that.
Government should not use the money extracted from PPPs as
a way to avoid budget realities. Chicago, for example, has
used some of the proceeds of its Skyway and other long-term
asset leases to fill deficits in its operating budget. The
state of Arizona is now looking to do the same, planning to
sell its office buildings to a third party for a big up-front
payment and then rent the office space back from the new owner.
New York is looking at asset sales, as well. This strategy
is no different from that of a government that borrows bonds
long-term to spend money in the short term. Both strategies
only allow government to avoid questions on spending levels
versus resource levels. This is particularly dangerous in
the current economic environment, in which it is unclear whether
the tax slump is temporary or indefinite. Once a government
leases off a valuable asset for an up-front payment by transferring
that asset's future revenues to a private partner, as with
the Chicago toll-road and parking-meter PPPs, the money that
the government would have earned from that asset over time
is gone forever.
Finally, governments can never transfer their ultimate
responsibility to plan, build, manage, and finance core government
functions to the private sector. As governments consider
PPPs, they can learn from an unlikely example: the recent
attempt by aircraft giant Boeingplaying the role of
a local or state government in this analogyto pioneer
an innovative way to design and build its next airplane, the
In an approach similar to that of the most ambitious PPP
projects, Boeing abandoned its traditional role as the sole
designer, financier, and manufacturer of its new planes, and
instead adopted the role of project manager, outsourcing much
of the actual design, construction, and financing work to
new contractor "partners" around the world. Boeing's
experienced executives were confident that they could break
the Dreamliner down into a "portfolio" of measurable
parts, assess the value of each part, and determine which
of its partners could appropriately take on responsibility
for that part and at what price.
Boeing's strategy did not deliver as intended, as its management
has forthrightly acknowledged. The
company has had to offer its supposedly autonomous smaller
partners extra time and money, has had to purchase one major
supplier outright to keep it afloat, and has had to take some
major work back in-house to get the job-now years behind schedule
and up to 100 percent over its initial $8-$10 billion development
Boeing has learned something valuable in salvaging the project,
a lesson that the public sector should heed in pursuing PPPs.
In the end, when it came to technical, financial, or scheduling
difficulties, no matter how carefully Boeing tried to measure
and allocate risk among third-party partners, much of the
risk boomeranged right back to Boeing, the strongest party
and the one with the most to lose in terms of its reputation
and a new generation's worth of profits.
With PPPs, if the government and the private-sector partner
misjudge the private-sector partner's capacity to do the job,
the private-sector partner always has default or bankruptcy
as a last resort; the government, on the other hand, just
like Boeing, has no choice but to complete the critical job
for which it is ultimately responsible. Further, if the government
misjudges the value added by the private sector, it could
be making a bad deal for taxpayers and infrastructure users.
Governments can use the private sector to help achieve public
purposes. Though this evolution can transform the scope of
a government's responsibility, it will not-and should not-eliminate
- E. S. Savas, "Competition
Can Make Bus Service Better," City Journal,
special issue 2009.
- Nicole Gelinas, "Brazilian
Electricity and New York Buses," nyfiscalwatch.com,
December 8, 2008.
- Idem, "Progress
on Transit Pensions, but Not in New York," nyfiscalwatch.com,
September 16, 2009, and "New
Orleans' Mass-Transit Deal Is Good, but Insufficient,"
nyfiscalwatch.com, July 13, 2009.
- Idem, "Toll
Road Intrigue, Part II," nyfiscalwatch.com, February
20, 2009; "Toll
Road Intrigue: The Indiana Deal Could Set a Different Precedent
," nyfiscalwatch.com, January 28, 2009; "The
Brutal Reality Is that Most Private Sector Toll Operators
Are a Shambles," nyfiscalwatch.com, January 16,
2009; and "Macquarie's
Toll-Road Pothole," nyfiscalwatch.com, December
- "ACS Finances Florida I-595 Availability-Pay Project,"
Public Works Finance 235 (February 2009): page 1.
- Christopher Drew, "The
787 Dreamliner: A Dream Interrupted at Boeing,"
New York Times, September 6, 2009.