PPP: The Structure or Business Case

We said that PPP does not work for all government projects; that it only works for profitable ones, especially to the private sector.  Then we knew that in essence, it’s a reallocation of returns and risks, offering the private sector a higher return in exchange for downloading to them as much risks as possible.  Lastly, we realize that it has to be balanced – if we gave too much return to the private partner, the contract would be onerous and disadvantageous to government; if we allow too little while passing on the risks, there will be no takers and we fail.

To strike a balance, we have to go back to some previous discussion regarding the basic difference between economic feasibility and financial feasibility.  Economic analysis is macro – we look at a project’s net contribution to the economy, no matter who does it.  At present, a project cannot pass government approval if its Economic Internal Rate of Return (EIRR) falls below 15%.  That’s the general rule, its either pass or fail, any higher EIRR will only increase its desirability and priority over other government projects.

Financial viability is different and micro – and is more reflective of the private sector’s interests since it shows profitability.  Most government projects are not financially feasible – like lighthouses, ordinary roads, public buildings, etc.  But a few are profitable to varying degrees – toll roads, airports, ports, markets, and other systems which has the capability to collect fees and generate revenues.  But they’re all not the same, too, some projects have the potential to rake in huge amounts of money; others can barely break even.

So when we decide to do a project under PPP, we must know its profitability.  And it’s imperative that we understand operational profitability versus total profitability.  Many transport infrastructure seems profitable in operations, meaning the fare box collection in a year exceeds the operational cost of running them, but that’s because we exclude the capital cost of the asset and its depreciation over time.  Rail projects are almost always subsidized by government.  A subsidized infrastructure is not attractive to PPP unless the government retains and guarantees the subsidy.

In an ideal build-operate-transfer (BOT) situation, a project may be such that it earns a decent return.  Thus, private sector can come in, build the asset and operate it for, say 20 years, turning it over back to the government after that.  They get all the revenues, the government, thus, has fulfilled its duty to provide the service without spending any budget but it also foregoes any collection over the contract period.  Everybody is happy, the public more so because of the efficiency of the private sector.

If the project is so profitable, the bidding parameters change.  It will be given to the one who can do all of the above, plus, the highest concession fees to the government.  Minimum standards will be provided for their performance, so bidders will be competing on the most efficient way they can operate and thus give the biggest share to government.  It’s actually an added feature of the PPP to give additional cash flow to government, something it could not have achieve were it was to do the infrastructure, and the service, itself.

If a project is overall, less profitable, such that it’s a negative cash flow to government to operate, it might still be negative to the private sector.  The only way it can go into PPP with sufficient takers is for government to sink in a counterpart, called the infrastructure investment gap financing.  It’s called that because that fund necessary to make it attractive to the private sector is the gap to make it profitable.  In the Philippine setting, it’s called the Viability Gap Funding (VGF).  The bidding parameters will thus change – the one requires the least VGF, wins the bid and the right to build and operate the system.

Whatever the case, it augers well for the government and the public as a whole – More efficient services and less funds to appropriate, leaving more money to allocate to other social services for the people.