The City Accelerator cohort on Urban Infrastructure Finance focused on innovative tools, models and revenue sources that can help cities across the country address their infrastructure challenges while promoting equity for diverse communities and incorporating the realities of climate change. This is the first installment of a three-part series exploring some of the ways in which cities can allocate infrastructure project risks to the private sector through innovative use of public-private partnerships (P3s).
When people talk about infrastructure finance challenges, public-private partnerships (P3s) can seem like an obvious solution. P3s are long-term, performance-based agreements between public and private entities, in which the private-sector partner performs some functions normally undertaken by the government in exchange for some form of compensation. While P3s may involve higher overall costs, in a well-structured P3, governments may be able to achieve greater value, including transferring much of the risk involved in a complex infrastructure project to the private sector.
There are billions of dollars in needs, and billions of dollars in private capital available to invest. Put the two together, and the problem is solved, right?
The reality is not so simple. Private capital is always invested with the expectation of repayment at a premium. While P3s can be structured so that the timing and size of repayments is more even and predictable than in a typical financing, it’s important to note that P3s don’t make money, they require it. Compounding the challenge, local governments often lack the resources and experience to effectively structure and manage a P3. In other words, there’s still no such thing as a free lunch. They can make sense, however, when governments can obtain greater value for their money than by undertaking a project in a more conventional way.
So if P3s don’t provide funding or low-cost financing, why would cities do them? Most cities don’t do P3s for cheaper financing, but for better performance. By and large, state and local governments still award contracts based on the lowest construction bid for a fixed design. That works, if the project is straightforward, and the asset that’s created isn’t likely to have problems in the future. It can also safeguard against corruption, since it makes bids easily comparable.
But low-bid, short-term, construction-only contracts aren’t the best model for creating innovation, ensuring long-term performance, and optimizing lifecycle costs. As astronaut Alan Shepard, America’s first man in space, once nervously joked, “It’s a very sobering feeling to be up in space and realize that one’s safety factor was determined by the lowest bidder on a government contract.”
One performance benefit that P3s can provide is an implied long-term warranty. It is an insanity of our current system that the bridge you are driving on probably has a shorter warranty than the car you are driving in. Most construction firms don’t have the financial ability to offer a long-term warranty, and a low-bid contract typically doesn’t include long-term performance standards. If problems happen five or ten years down the road, the construction consortium who built the project may no longer even exist, and clawing back any part of the construction cost will involve an expensive legal battle. Simply put, the public sector is in a better position when it still has some leverage over the project in the form of ongoing future payments to a private-sector partner who is still on the hook to perform.
For example, in 2006, part of the ceiling of a tunnel in the recently completed Central Artery in Boston collapsed and a driver was killed. The failure was attributed to use of a short-term construction adhesive that cost approximately $1,200. Massachusetts spent more than $54 million to inspect and repair the other portals in the wake of the accident. If this had been a P3, the failure might not have occurred (since the contractor would have been incentivized to use more expensive and longer-lasting materials). But even if it had, the government would have had a more ready source of remedy by terminating a long-term performance contract. As it was, the state recovered only $16 million a few years later from one of the companies involved, and has since discovered additional problems, including collapsing lighting fixtures, that will likely require more than $50 million to correct.
A long-term, performance-based P3 can ensure that the private partner is motivated to optimize lifecycle costs and build projects that are cheaper or easier to maintain. It also gives the private sector the chance to propose innovations that might not pay off over a short construction term. The public sector still has to identify revenues to pay off these long-term arrangements, and private financing has to be at least somewhat competitive with the cost of public financing to make these arrangements viable. But a P3 may enable a project with greater overall value. When considering this, governments often conduct studies called “Value for Money” (VfM) analyses that analyze the long-term costs and benefits of P3s vs. more traditional approaches.
Since most P3s are long-term arrangements, they are typically analyzed over the term of an anticipated contract (which can be 25 to 50 years). In a long-term P3, the public sector has to contractually commit to set aside the funding needed for the long-term maintenance and operation of a facility. (Ironically, there is no similar provision for committed maintenance and operation funding if the project is done on a traditional basis– in fact, funding for operations and maintenance is often the first to get slashed in a budget crunch, since it is not immediately apparent when maintenance is delayed.) Sometimes, after a careful analysis, a government determines that the public sector can do the required work itself more cheaply and effectively– assuming it is provided the needed funding to do so. Even when a P3 is ultimately not the answer, just having gone through the analysis can be helpful to a city in marshalling support for sufficient long-term resources to maintain and operate a complex project– without the expense of private finance.
Thinking through these key questions about whether, and how, to leverage P3s in service of funding both existing and new infrastructure projects presents cities with challenges, as well as an opportunity. In the face of aging infrastructure and contracting state and federal revenues, cities are looking for new ways to finance needed improvements and deliver innovation and efficiency to their citizens.
Through the City Accelerator’s third cohort, the District of Columbia’s recently-launched Office of Public Private Partnerships (OP3) is examining how best to plan and prioritize projects, in order to identify and secure executable financing options. In our next installment, we will explore some of these options in greater detail.