Since different or new ways of doing things are often controversial in the beginning, the public-private partnership (P3) delivery mechanism is often misunderstood in the American context. This analysis will define P3s, compare them to the traditional procurement methods in the U.S., and discuss the potential advantages of the public-private partnership framework.
To some, the word “private” connotes a private sector takeover, conjuring images of a rapacious foreign entity acquiring an infrastructure asset. Many in the United States misunderstand this newer infrastructure delivery mechanism, particularly what public-private partnership are and what benefits they can offer.
As defined by the Federal Highway Administration’s Center for Innovative Finance Support, public-private partnerships are “contractual agreements between a public agency and a private entity that allow for greater private participation in the delivery of projects.” Within the transportation sector, the P3 framework has been used to develop not only highway projects, but transit and airports as well. In every P3, the different project delivery functions are shared between the public and private sectors. The exact structure differs for each project, as each sector may adopt varying levels of responsibility depending on the project’s goals.
The most common delivery P3 methods are:
- DBFOM: Design-Build-Finance-Operate-Maintain
- DBFM: Design-Build-Finance-Maintain
- DBOM: Design-Build-Operate-Maintain
- DBF: Design-Build-Finance
While all P3 structures have advantages, DBFOMs are the gold standard. In a DBFOM, the private sector, composed of a consortium of several firms, is responsible for designing, building, financing, operating and maintaining the asset.
For instance, the Colorado I-70 East project is being delivered as a DBFOM P3. With financial close in December 2017, the six firms that compose the winning consortium, Colorado Bridge Enterprise, each address a different project function. For example, Kiewit and Meridiam Infrastructure North America II invested in the project’s equity piece, with Jacobs Engineering Group and WSP serving as the lead engineers. Under the DBFOM framework, the private sector is intimately involved in each project function, but it is important to note that the private sector does not own the asset. The private sector is responsible for the outlined functions only during the life of the contract, which typically ranges from 30 to 70 years. At the end of the contract’s life, responsibility for the asset reverts to the public sector, unless the contract is renewed. The other delivery structures involve varying levels of private sector participation.
There are several key differences between a P3 framework and traditional procurement, the most common infrastructure delivery method in the United States for the last century. Traditional procurement can be defined as design-bid-build, where the public sector partner bids out separate, sequential contracts for the project’s design and then construction. The public sector partner owns, operates, finances and maintains the asset indefinitely. Municipal debt is sometimes used to finance the asset, but most projects are paid for out of that department of transportation’s annual cash flow. By contrast, DBFOM P3s employ long-term financing, based on a combination of equity and different types of debt (i.e. private activity bonds or Transportation Infrastructure Finance and Innovation Act, TIFIA, loans).
There are two different models for DBFOM projects: revenue-risk and availability payment. In a revenue-risk project, the primary revenue source is tolls paid directly to the concessionaire. In an availability payment project, the government entity provides payments to the concessionaire at predetermined, regular intervals based on the project’s availability at specified performance levels.
An availability payment (AP) model gives the private partner regular payments based on conformance to contractual specifications rather than direct payment from tolling and is therefore independent of revenue generated by that tolling. In the AP model, the public and private sector clearly outline the conditions in which the private partner will receive the full amount of each payment for every year of the concession agreement. In the case of a highway, the contract’s terms could refer to the pavement condition. For example, once pavement roughness reaches a certain level, such as 171 on the international roughness index (IRI), the private partner is required to improve pavement quality. Another example could be grass height on the shoulder. If the grass is not mowed once it reaches a certain height, the private sector could receive less of its availability payment. More than a certain number of hours of lane closure would also lead to a lower payment for that time period.
The Goethals Bridge P3 project provides an illustrative example. Reaching financial close in December 2013, the $1.5 billion DBFM P3 project (for the Port Authority of New York and New Jersey) effectively spread risk between the public and private sectors. Delivered under an AP structure, the winning concession, NYNJ Link Partnership, can earn an annual availability payment of $56.5 million from the Port Authority over the 40-year contract. The public sector partner (Port Authority) will operate the bridge’s tolling facilities, set the rate, and collect the money. With the Port Authority retaining the toll-setting ability, the public sector can ultimately change the price to comport with broader organizational policy goals.
One major difference between the two P3 models is the extent of equity typically invested in each type of transaction. On average, private sector equity in the revenue-risk model forms 28 percent of the project’s total budget, versus 6 percent for an AP project. In revenue-risk projects, this greater investment usually results in the private partner seeking a higher upside to offset the larger risk it takes on. This larger equity investment puts more investor “skin” in the game, promoting a deeper commitment to project success. In contrast, an availability payment project caps the private sector’s return, reflecting less equity and lower risk on its part.
The next set of questions about public-private partnerships should focus on potential advantages — What are the advantages of the P3 delivery mechanism? Why is more private sector participation in the process advantageous?
Public-private partnerships have three key advantages: risk transfer, bundling project delivery components and expanded capital access.
Risk Transfer. A major advantage of P3s is the transferring of financial risk from taxpayers to investors. Under traditional procurement, a project’s risks are entirely shouldered by the taxpayer. If the project experiences cost overruns, change orders, delays or anything else that increases costs, the public sector—which means taxpayers—foot the bill. The private sector is typically better equipped and more motivated to assume these financial risks since they affect the private partner’s bottom line.
Since the private sector is contractually obligated to deliver the project on-time and on-budget or suffer financial consequences, it has greater incentives to stick to the schedule and budget. The private sector answers to shareholders, and earning a solid return on their invested equity is usually paramount. Cost overruns and delays erode the private sector’s potential return on investment (ROI) and depending on the contract’s structure, it can be penalized for not managing risk correctly.
The highest amount of risk transfer occurs in revenue-risk models, as they shoulder more risk due to their higher percentage of investment in the project’s total budget and because their payments are tied directly to project revenue generation.
Some risks can also be transferred in a public-private partnership delivered under an availability payment structure. In an AP structure, the private sector bears risks of construction cost overruns, late completion, and poor operations and maintenance. Since earning the planned return on the invested equity in the project is of utmost importance, the private sector is incentivized to operate and maintain the asset to a high standard.
Because the revenue-risk model transfers more risk from the public sector to private investors, it can provide the greatest advantages to taxpayers. For example, in the case of a toll road, due to the private sector’s payments coming directly from tolls, if the user fees fail to generate sufficient revenue to service the debt and provide a return on the invested equity, the investors would shoulder that risk. That directly contrasts to an availability payment P3. In the case of revenue shortfalls, the public sector must secure funds from other sources. This risk ultimately falls on taxpayers, since they would have to cover the difference between what was collected and what is owed.
Bundling. In a DBFOM P3, the private sector partner is responsible for designing, building, financing, operating and maintaining the project. Grouping all these functions together is referred to as bundling. In traditional procurement, firms bid on the project’s design contract, and others bid on the project’s construction contract, and still others on the operations contract. The winning firms specialize in only their own field and are not incentivized to work together since the builder’s involvement begins only after the designer’s contract is finished, and the operator’s begins after the construction is complete. This is counter-productive since a project’s design and construction are inherently linked, and its operability and maintenance are greatly affected by how well it is designed and constructed.
Bundling a P3 helps address this. The private firms that compose the consortium will work together over the duration of the project’s life, so there is a shared interest in ensuring a synergistic approach to the project’s delivery. The firms responsible for operating and maintaining the project over the contract’s life want to ensure high-quality design and construction, since poor quality work can increase maintenance costs and create operational challenges later in the project’s life. Each of these functions is linked, and a P3 structure bundles them together to ensure a synergistic delivery approach.
Bundling was used effectively in the Automated People Mover (APM) project at Los Angeles International Airport (LAX). The consortium, LAX Integrated Express Solutions (LINXS), comprises 22 firms, with each responsible for a different aspect of the project’s delivery. LINXS’ public sector counterpart was Los Angeles World Airports (LAWA). LINXS is an example of a Special Purpose Vehicle (SPV), which is an overarching entity consisting of the different participating firms. For example, five of the 22 firms invested in the project’s equity component, and two were responsible for the project’s design. Deborah Flint, LAWA’s CEO, was on record as saying “The DBFOM approach emphasizes working with the private sector to drive innovation and quality. It’s reflective of a 21st-century solution that is value-based and will create an exceptional guest experience and cement LAX’s competitiveness in the global aviation marketplace.” This is why bundling is advantageous: it creates synergies across the project’s delivery functions.
Expanded Capital Opportunities. P3s are financed using a blend of equity and debt, unlike traditional procurement, which only utilizes annual agency revenues, federal grants or municipal bonds. Financing infrastructure projects exclusively through government revenue may limit the ability to raise the appropriate amount of capital required, since the entity issuing the debt may not have enough bonding capacity to sufficiently finance the project. Introducing equity can not only increase a project’s potential size, but it taps institutional, insurance, pension and private equity funds looking to deploy capital in infrastructure projects. Many fund managers view infrastructure as an asset capable of producing solid cash flow, matching the fund’s liabilities over a longer-term time horizon.
For example, the LaGuardia Airport Terminal B P3 project leveraged a significant equity investment to expand the project’s scope. Meridiam Infrastructure North America II, Skanska, and Vantage Airport Group each invested $66.66 million in the project, totaling $200 million. After the financial close in June 2016, an additional equity partner, JLC Infrastructure, invested another $10 million in the project. These investments represent an additional $210 million in capital that would not have been available had the project been delivered through traditional procurement. The private sector usually invests in projects where it sees the potential for a financially-viable, long-term sustainable and effective project.
The appetite for infrastructure investment expands beyond U.S. borders, as international funds have invested in and continue to show significant interest in American infrastructure projects. As P3s become more prevalent in the American infrastructure market, increased foreign capital—in both equity and debt—could see its way into future projects.
Public-private partnerships are a project delivery option that local, state and federal officials should have in their arsenal when considering ways to deliver major infrastructure projects. P3s are not appropriate for all projects, but, in many cases, they can add value by transferring risk from taxpayers to the private sector, bundling core delivery functions, and expanding the capital base available for infrastructure projects.