## 1. The Toll Markup Due to the Free Transfer of the Facility ..........................................16

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### 1. The Toll Markup Due to the Free Transfer of the Facility ..........................................16

### 1. The Toll Markup Due to the Free Transfer of the Facility ..........................................16

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### References..............................................................................................................

### _wp0677 - References..............................................................................................................

### Introduction and overview
- PPPs originated in the United Kingdom in the early 1980s as part of broader privatization efforts.
- PPPs are distinct from routine outsourcing because they typically involve a sizable initial investment in a facility (road, bridge, airport, prison) followed by delivery of services from that facility.
- PPPs often persistently involve the state because many PPP activities exhibit public-good features (e.g., congested public goods with externalities and market failures).
- Early PPPs (PFIs) were criticized as mechanisms to “evade expenditure controls.” The paper notes that PPPs have evolved into arrangements that can better price scarce resources and share/manage risks.
- Typical PPP sectors: roads, bridges, tunnels, rail, air and sea ports; water, electricity, sewage, waste disposal; prisons; schools; hospitals.

### Scope of PPPs and governance principles
- No single universal PPP design is appropriate; design depends on the economic environment and project-specific uncertainties.
- Transparency is emphasized as crucial because PPPs can be used to channel public activities off budget.
- Public liabilities in PPPs may be:
  - direct or contingent;
  - explicit (legally binding) or implicit (norms, traditions).
- Common PPP contractual forms discussed:
  - design-build-finance-operate (DBFO)
  - build-operate-transfer (BOT)
  - build-operate (BO) combination features in most arrangements.

### Build-operate bundling (incentives and monitoring)
- Bundling construction and operation can change incentives relative to unbundled contracting:
  - Concessionaires internalize cost-reduction features but may not internalize quality-enhancing features, leading to potential underinvestment in productive investments and overinvestment in unproductive ones.
- When service-quality outcomes can be well specified and cheaply verified, PPPs can enforce appropriate facility quality without direct monitoring of construction inputs.
- PPP contracts can allow demand-driven expansion (e.g., add lanes when traffic surpasses a certain level) rather than prespecifying expansions.

### Exogenous and endogenous risks (identification)
- Procurement problems involve ex ante asymmetric information and moral hazard; however, evidence suggests little private information at project outset and more uncertainty about design changes and unforeseen site/regulatory conditions.
- Many uncertainties (design failures, site conditions, regulatory changes, demand fluctuations) are exogenous to both parties.
- Demand uncertainty examples: terrorism effects on subway use; fuel costs, GDP growth, population growth for highways; energy-saving technologies for power plant demand.

### PPPs as safeguards against “white elephants”
- Historical evidence shows systematic forecasting biases in infrastructure: costs often underestimated and benefits overestimated; “errors of 50 percent or more seem to be the rule rather than the exception.”
  - Example: Channel tunnel first-year passengers were less than 25 percent of the predicted levels; in 2003 actual toll revenues were about a third of predicted levels.
- Private-sector scrutiny under PPPs can act as a check on infeasible projects because private investors will not enter projects where they cannot expect to recover all costs.
- Even with government guarantees for some risks, concessionaires typically bear baseline cost/revenue risks and so will scrutinize public forecasts.

### Cost-benefit analysis: prices and discount rates
- Production efficiency arguments imply evaluation at private-sector prices (including before-tax wages) in cost-benefit analysis.
- Discount rates: private sector typically faces higher borrowing rates than a financially solvent government; evaluating projects at private discount rates can lead to rejection of projects that would appear viable to government when evaluated at a lower, risk-free rate.
- The paper argues projects should be evaluated at private-sector prices/discount rates because government borrowing effectively transfers risk to future taxpayers (contingent tax liabilities).

### Allocation of risk between public and private partners
- Distinguish exogenous risks (best borne by government/public at large) and endogenous risks (can be controlled by private partner and thus efficiently borne by private partner).
- Examples of exogenous or government-endogenous risks: general price level, construction index, oil prices, steel prices, design changes initiated by government, new environmental or safety regulations.
- Examples of risks endogenous to the private partner: production/construction input quantities and procurement choices, toll collection efficacy.
- Common contractual risk-sharing devices:
  - Fixed terminal date with revenue-sharing: if actual demand < benchmark, public pays fraction α of deficit; if actual demand > benchmark, private transfers fraction β of surplus (α and β need not be equal).
  - Variable terminal date (concession ends when discounted revenue reaches a benchmark) provides revenue sharing but weaker private incentives to boost demand compared with fixed-term revenue-sharing (paper suggests α in the order of magnitude of 0.7–0.8 and β in the order of magnitude of 0.5–0.6 as illustrative).
  - Quantity-based guarantees (e.g., traffic volume) are often more efficient than revenue-based guarantees because collection effort is endogenous to private partner.

### Transfer of facility and implications for pricing
- BOT and similar arrangements commonly transfer the facility to government at concession end, often “free of charge.”
- When users finance a facility that is later transferred “like new” to government, tolls may be set higher than socially efficient, because tolls are tasked with covering construction plus maintenance and operation in present value.
- Alternative: transfer-at-cost or public purchase/resale at market-equivalent cost would reduce tolls; comparison of annual payments shows substantial “markup” under free-transfer relative to transfer-at-cost.
- Illustrative table (toll markup due to free transfer; In percent) — examples preserved precisely:
  - Length of Concession Period (Years) 30 25 20 15 10
  - Interest Rate (Percent)
    - 3: 70.06 91.43 124.05 179.22 290.77
    - 4: 44.58 60.03 83.95 124.85 208.23
    - 5: 30.10 41.90 60.49 92.68 159.01
    - 6: 21.08 30.38 45.31 71.60 126.45
    - 7: 15.12 22.59 34.85 56.85 103.40
- Example conclusion: with an operation period of 20–25 years and a real interest rate of 4–5 percent per annum, the toll under the free-transfer alternative is about 42–84 percent higher than under the transfer-at-cost alternative.

### Pigouvian taxation and allocation distortions
- User charges in PPPs frequently are designed to cover costs in a stand-alone framework, but efficient user charges for congested local public goods must correct externalities (Pigouvian).
- An efficient congestion toll rarely covers full construction/maintenance/operation costs; thus PPP stand-alone finance can distort optimal pricing and allocation.
- Cross-subsidization across roads or a regional authority setting tolls across a network can achieve more efficient allocations (example: Cross-Israel Highway rarely congested vs. congested parallel coastal freeway).

### Off-budget investments and resource accounting
- PFIs can be used to shift investment off-budget by bundling financing with provision; resource accounting (accrual-based) records annual rental-equivalent costs rather than full upfront investment, reducing year-on-year headline investment outlays in transition.
- Example numerical illustration: if government invests $1000 each year and each facility lasts 10 years, annual competitive rent is $100; shifting fully to PFI shows year 1 outlay $100 (not $1000) but by year 10 steady-state annual outlay returns to $1000.
- PFIs can facilitate the use of debt for transitional acceleration of investment when closing an “infrastructure gap” (Bank of Israel example estimates infrastructure gap ~20 percent of GDP for Israel cited in the underlying text).
- Intergenerational justice and tax-smoothing arguments can support partial debt financing during transition periods.

### Political economy considerations
- PPPs may be politically attractive for governments facing coalition pressures or constrained budgets because PPPs can allow infrastructure projects to proceed without competing for current budgetary allocations.
- PPPs can increase political feasibility of imposing user charges when private financing is visible to users.
- Risk: unless all explicit and implicit government liabilities from PPPs are recorded and evaluated, fiscal responsibility may be impaired.

### Case study: Cross-Israel Highway (CIH)
- CIH: first PPP in Israel, BOT type; central portion ~90 kilometer; four-lane toll highway.
- Initial construction and toll-collection equipment cost: about $1,200 million.
- Expansion when traffic warrants estimated at 25–30 percent of initial investment.
- Tender conditions:
  - No toll booths allowed; electronic license-plate identification and billing required.
  - No construction grant from government; highway to be transferred to government free of charge at concession end.
  - Concession period: 30 years including construction.
- Demand guarantees and sharing:
  - If actual traffic < baseline, government pays concessionaire tolls equivalent to 80 percent of shortfall.
  - If actual traffic > baseline, concessionaire pays government tolls equivalent to 57 percent of excess.
  - Guarantees defined in terms of traffic volume (quantity), not revenue, so collection risk was borne by concessionaire.
- Financing and indexation:
  - Financing included dollar-denominated loans and NIS loans linked to CPI; some loans fixed-rate, some variable-rate.
  - Toll linked to weighted index of Israeli CPI, dollar-NIS exchange rate, and interest rate on variable loans.
- Outcomes and incentives:
  - Construction completed ahead of schedule (a little over four years vs. five years estimated).
  - Concessionaire used discounts and prearranged electronic transponders to achieve near-100 percent collection rates.
  - Tender clauses that effectively transferred almost one-half of concessionaire profits to government (put option) and required toll reductions when traffic exceeded baseline (despite government receiving 57 percent of excess) are criticized as dampening private incentives and distorting efficiency.
- Institutional lessons: government officials may underappreciate private-sector profit motives; contractual clauses aimed at preventing “excessive” profits can undermine incentives and raise offered tolls.

### Conclusion: benefits, drawbacks, and design implications
- PPPs can:
  - act as imperfect safeguards against “white elephants” by subjecting projects to private-sector scrutiny;
  - improve resource allocation and service quality when risks are allocated appropriately;
  - enforce economically appropriate input prices and discounting by involving private financing and evaluation.
- Major drawbacks:
  - complexity and high transaction costs in time and money, making PPPs impractical for small projects;
  - potential for fiscal opacity and off-budget liabilities unless all obligations are fully evaluated and reported.
- Key design imperatives:
  - transparency and full accounting of government liabilities (explicit/implicit, direct/contingent);
  - careful identification and allocation of exogenous vs. endogenous risks;
  - remuneration and revenue-sharing schemes that preserve private incentives to enhance demand and maintain quality;
  - recognition that efficient user charges should reflect congestion externalities (Pigouvian taxation), not merely cost recovery.

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### References

### References

### Fiscal policy, public debt, and taxation
- Barro, Robert J., 1979, “On the Determination of the Public Debt,” The Journal of Political Economy, Vol. 87, pp. 940–71.
- Alesina, Alberto, and Roberto Perotti, 1995, “Political Economy of Budget Deficits,” Staff Papers, International Monetary Fund, Vol. 42, No. 1, pp. 1–31.
- Alesina, Alberto, and Roberto Perotti, 1996a, “Fiscal Discipline and the Budget Process,” The American Economic Review: Papers and Proceedings, Vol. 86, No. 2, pp. 401–7.
- Alesina, Alberto, and Roberto Perotti, 1996b, “Income Distribution, Political Instability, and Investment,” The European Economic Review, Vol. 40, pp. 1203–28.
- Lucas, Robert E., Jr., and Nancy L. Stokey, 1983, “Optimal Fiscal and Monetary Policy in an Economy Without Capital,” The Journal of Monetary Economics, Vol.12, No. 1, pp. 55–93.
- Musgrave, Richard A., and Peggy B. Musgrave, 1989, Public Finance in Theory and Practice (New York: McGraw-Hill, 5th Edition).
- Diamond, Peter A., and James A. Mirrlees, 1971, “Optimal Taxation and Public Production: I and II,” The American Economic Review.

### Contingent liabilities, fiscal risk, and government guarantees
- Brixi, Hana Polackova, and Ashoka Mody, 2002, “Dealing with Government Fiscal Risk: An Overview,” in Government at Risk: Contingent Liabilities and Fiscal Risk, ed. by Hana Polackova Brixi and Allen Schick (Washington: World Bank; New York: Oxford University Press).
- Echevery, Juan Carlos, Veronica Navas, Juan Camilo Gitierrez, and Jorge Enrique Cardona, 2002, “Dealing with Contingent Liabilities in Colombia,” in Government at Risk: Contingent Liabilities and Fiscal Risk, ed. by Hana Polackova Brixi and Allen Schick (Washington: World Bank; New York: Oxford University Press).
- International Monetary Fund, 2006, Public-Private Partnerships, Government Guarantees, and Fiscal Risk (forthcoming; Washington: International Monetary Fund).

### Public-Private Partnerships (PPPs), procurement, and contract design
- Grout, Paul A., 1997, “The Economics of the Private Finance Initiative,” Oxford Review of Economic Policy, Vol. 13, No. 4, pp.53–66.
- Dewatripont, Mathias, and Patrick Legros, 2005, “PPPs: Contract Design and Risk Transfer,” European Investment Bank Papers, Vol. 10, No. 1, pp. 120–41.
- Hart, Oliver, 2003, “Incomplete Contracts and Public Ownership: Remarks, and an Application to PPPs,” The Economic Journal, Vol. 113 (March), pp. C69–76.
- Spackman, Michael, 2002, “PPPs: Lessons from the British Approach,” Economic Systems, Vol. 26, No. 3, pp. 283–301.
- Riess, Armin, 2005, “Is the PPP Model Applicable across Sectors?” The European Investment Bank Papers, Vol. 10, No. 2, pp. 10–31.
- Valila, Timo, 2005 “How Expensive Are Cost Savings? On the Economics of PPPs,” The European Investment Bank Papers, Vol. 10, No. 1, pp. 94–119.
- McAfee, R. Preston, and John McMillan, 1987, Incentives in Government Contracting (Toronto: University of Toronto Press).
- Laffont, Jean-Jacques, and Jean Tirole, 1993, A Theory of Incentives in Procurement and Regulation, (Cambridge, Massachusetts: MIT Press).
- Bajari, Patrick, and Steven Tadelis, 2001, “Incentives versus Transaction Costs: A Theory of Procurement Contracts,” The Rand Journal of Economics, Vol. 32, No. 3, pp. 387–407.
- National Treasury PPP Unit, 2004, Public Private Partnership Manual (Pretoria: Governmernt of South Africa).

### Infrastructure, public capital, and development
- Kamps, Christophe, 2005, “Is There a Lack of Public Capital in the European Union?” The European Investment Bank Papers, Vol. 10, No. 1, pp. 72–93.
- Romp, Ward, and Jakob de Haan, 2005, “Public Capital and Economic Growth: A Critical Survey,” The European Investment Bank Papers, Vol. 10, No. 1, pp. 40–71.
- Prud’homme, Remy, 2004, “Infrastructure and Development,” paper prepared for the Annual World Bank Conference on Development Economics, Washington.
- Strong, John S., Jose-Luis Guasch, and Juan Benavides, 2004, “Managing Risk of Infrastructural Investment in Latin America: Lessons, Issues, and Prescriptions,” IDB Working Paper (Washington: InterAmerican Development Bank).
- Tanzi, Vito, 2005, “Building Regional Infrastructure in Latin America,” IDB Occasional Paper SITI-10 (Washington: InterAmerican Development Bank).

### Public goods, welfare economics, and congestion
- Davis, Otto A., and Andrew B. Whinston, 1965, “Welfare Economics and the Theory of Second Best,” The Review of Economic Studies, Vol. 32, pp. 1–13.
- Oakland, William H., 1972, “Congestion, Public Goods, and Welfare,” The Journal of Public Economics,” pp. 239–257.
- Oakland, William H., 1974, “Public Goods, Perfect Competition, and Under-Production,” The Journal of Political Economy, pp. 927–939.

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