Wednesday, June 28, 2017

Revisiting the debate on PPPs

The Economist has this critique of the calls for re-nationalisation of public services in UK. In contrast, Nina Shapiro has this to say in Naked Capitalism on public private partnerships (PPPs),
... the greater efficiency of private enterprise and the consequent cost savings of public-private partnerships. Yet, studies of their use in infrastructure investment provide little support for this presumed cost saving, and, as the critics of these partnerships argue, there is little reason to believe that they would save money. Governments can finance investment at a lower cost than private companies can, and, unlike the investments of governments, those of private concerns must earn a profit. Their capital costs for the same investment will be higher than that of the government’s, and the government must cover all of these in its payments to them. And since private enterprises can fail, and some of those partnered by governments have failed, bail out money has to be factored in as well. The government... cannot allow the disruption of essential services (such as air traffic control), and thus must bail out the firms providing them.
Private enterprises may be more efficient than governments, but for a public-private partnership to save taxpayer money, the efficiency of the private firm has to be high enough to offset the higher capital costs of its investment, as well as the cost of enforcing its contract and risk of its failure. And, here, we must remember that the cost savings of private firms can come at the expense of employees and suppliers – governments generally pay more – and at the cost of the services provided as well... Costs can be reduced in ways other than through productivity increases. Their reduction may have more to do with the reduction of services or incomes than with efficiency gains, and the profit that drives the economizing of private firms is not received by the people that actually fulfill the government contracts either...

Public-private partnerships conflate public and private interests, and in conflicts between them, the private interests win out... Private interests dominate the affairs of nations, and public-private partnerships not only reflect the influence of these interests, they also increase it. Government is run more like a business. Investments become “assets”, and citizens “customers”, officials are elected (and appointed) because of their success in business, and services decided by profitability. And since the profitability of a service depends on the relation between benefits and costs, values have to be placed on benefits to the public. The worth of these, in monetary terms, has to be determined, and this requires valuing such invaluable products as clean air and water, healthy and cultured lives.
If we were to do an evidence-based assessment of PPPs in developed countries in recent times, there is now a rich body of examples that illustrate many of the concerns raised in the above three paragraphs.

Only recently I blogged about the increasingly negative experience of water sector privatisation in UK. In the latest comes news that Ofwat, the water regulator, has found Thames Water, the country's largest water company, guilty of "unacceptable failure" to control water leakages resulting in a fine of £8.55 m. This comes on top of the company being fined £20 m by Ofwat for releasing 1.4 bn litres of sewage water between 2012 and 2014 into London's main water supply source. This comes even as the company paid out £100 m in dividends in the year to March 2017. An FT report writes,
Thames Water investors include pension and sovereign wealth funds, such as the Abu Dhabi Investment Authority and the China Investment Corporation, and since May — when Australian infrastructure bank Macquarie sold its final stake in Thames Water for £1.35bn — the Canadian pension fund Omers and the Kuwait Investment Authority. In the decade between 2006-16, Macquarie paid itself and fellow investors £1.6bn in dividends, while Thames Water was loaded with £10.6bn of debt, ran up a £260m pension deficit and paid no UK corporation tax, according to research by the Financial Times. At the same time it has in effect forced the Treasury and taxpayers to contribute to the cost of London’s new super-sewer or Thames Tideway tunnel, which started construction last year.
This comes in the backdrop of new rounds of privatisations in these countries. In the US, President Trump has initiated a proposal to privatise air-traffic controllers in the US, currently with the Federal Aviation Authority (FAA). Prisons privatisation is being widened, with the latest being the 20 year £1.5 bn contract bagged by Serco to run the largest prison in Australia, the Grafton Correctional Centre in New South Wales from 2020. 

The case for prison privatisation runs against a growing body of global experience that caution against it. In 2015, Serco was stripped off running the Mt Eden prison in Auckland, the largest prison in New Zealand, on allegations of ill-treatment and allowing "organised fight clubs" between inmates. In the UK, both Serco and G4S, the two largest prison operators globally, were found guilty of overcharging the government for electronic tagging of offenders.  

In a famous paper, Oliver Hart, Andrei Shleifer, and Robert Vishny examined the trade-off in delivering public services between improving service quality and cost reduction. Examining specifically the case of prisons, they wrote,
If contracts are incomplete, the private provider has a stronger incentive to engage in both quality improvement and cost reduction than a government employee. However, the private contractor's incentive to engage in cost reduction is typically too strong because he ignores the adverse effect on non-contractible quality... We have examined the conditions that determine the relative efficiency of in-house provision versus outside contracting of government services. Our theoretical arguments suggest that the case for in-house provision is generally stronger when non- contractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem. In contrast, the case for privatization is stronger when quality- reducing cost reductions can be controlled through contract or competition, when quality innovations are important, and when patronage and powerful unions are a severe problem inside the government...

We concluded that the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for pri- vatization is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools. In some other services, such as provision of health care, an analysis of the efficiency of alternative arrange- ments is a great deal more complicated. 
Eduardo Porter has the best summary of the incentive mis-alignment in the case of prisons,
Private prison operators who bid for government contracts by offering the lowest cost per inmate will most likely focus on cutting costs rather than tightening security. 
Alex Tabarrok has this critique of the Hart et al paper. His primary arguments being that cost reduction can come not just from cutting something but also from quality improvements themselves, and weak incentives (as with public bureaucracies) do not encourage improving quality. Both these arguments appear far less compelling when seen in light of experience. In developed economies, the cost reduction gains from incremental quality improvements, even in the long-run, is likely to be marginal. And, nor do stronger incentives, when coupled with incomplete contracts (on non-contractible quality) and far larger cost-reduction opportunities (by lay-offs and skimping on investments), necessarily encourage improving quality in all its dimensions.

Another less appreciated problem with such contracts that differentiate them from any other competitively procured services comes from the nature of these services. These are essential public services and it is very difficult to cancel a contract, force losses and bankruptcy of the provider, and transfer the same to another operator without unacceptable levels of disruption. The operators know this leverage and position themselves to extract the maximum leverage from this reality. In fact, even the technical challenge associated with shifting operators is non-trivial. The monopolistic dimension to such contracts come more from these considerations than the pure monopoly arguments of Econ 101.

So does this mean we should step away from PPPs? Far from it! My assessment of PPPs hinge on "the efficiency of the private firm has to be high enough to offset the higher capital costs of its investment, as well as the cost of enforcing its contract and risk of its failure". As I have written earlier, while there is scope for PPPs, they have to be chosen for the right reasons - efficiency improvements and not fiscal considerations, and for O&M and not construction-cum-management.

But I see at least three dimensions to this challenge - which sector is amenable to private service delivery, state capacity, and the nature of the private investor. Let's examine each.

The identification of activities appropriate for privatisation has to revolve around Hart and Co's analysis of private contractors incentive to ignore non-contractible quality. In case of activities like prisons and air traffic controllers, there are either too many dimensions of quality or externalities generated that, their capture in a contract poses prohibitive transaction costs and detracts from the provider's operational control. But without their inclusion, the private operators will doubtless be incentivised to skimp on investments or ignore those dimensions so as to reduce costs.

I am inclined to argue that the costs-benefits assessment makes many current PPPs less favourable in developed countries. In these countries, state capacity is strong and local governments  are reasonably capable of managing large utility systems - after all UK is the only country with a fully private water and sewerage utility. The efficiency gains from private transfers is likely to be small enough to off-set the countervailing costs. At best management contracts may be the more prudent option for these countries.

For example, in case of the air-traffic control privatisation, of which Serco is incidentally one of the big operators, there may be reasons to question the rationale. US air-traffic controllers, though with an excellent safety record, have often been blamed for persisting with antiquated technologies and not shifting to the satellite GPS-based NextGen system. Lack of adequate funding and slow-moving bureaucracy have been blamed for this, though the persistence with old technologies for this long period has to be attributed more to the former than the latter. In that case, and especially since FAA is even today funded with passenger fees (by way of a taxes on tickets) and recent safety record has been excellent, it is not clear where private providers will be able to find the resources and have the incentive to make significant investments in air-traffic control systems. In the circumstances, lay-offs will be inevitable and efficiency gains questionable. And, if experience elsewhere and across sectors is a marker, then price increases for travellers is also inevitable. After all, now while the passenger fees is collected as a tax on tickets, once privatised, it will be levied as a user fee by private negotiations with Airlines. 

In contrast, in developing countries state capacity is extremely weak. Public service delivery is, in most cases, of very poor quality - leakages, contamination, interruptions, unreliable, poor safety and so on. Most egregiously, public systems are over-staffed and with limited accountability to deliver on outcomes. The scope for efficiency improvements from private operation and management can be very high, though it often comes at a steep and unaffordable price for consumers. But this has to be traded-off with the state's weak capacity to manage even simple contracts, with the attendant risk of having lopsided contracts or its management which ends up causing private benefit at public cost. 

Finally, as to the capital, the failings with private equity investments in public services in the US are well-documented. Unlike a specialised private provider, a PE firm has less incentive to protect its industry reputation, an important ingredient to aligning incentives to ensuring quality and limiting skimping. To that extent, President Trump's proposal which mandates that the private entity should be a non-profit appears a good decision.

In other words, any decision on privatisation should preferably be done on efficiency considerations, and an examination of, among other things, the type of activity, state capacity, and nature of the capital. Unfortunately, this is easier said than done, and demands both vast experience (of actual implementation, and not mere theoretical knowledge) and exercise of very sound judgement. 

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