Value for Money (VfM) analysis helps governments decide whether it is more cost-effective to do a project through traditional procurement, or through PPPs. State government financial departments, project teams, and senior management can run this type of simplified VfM analysis with the help of a few consultants in order to select the ideal type of procurement project (traditional public works or PPPs). This will increase the probability that state governments will understand what kind of project they are structuring, and what the conditions are that make the project viable and cost-effective for taxpayers. With projects that are funded by capital markets, the undertaking becomes easier to finance (both equity and debt), less risky, and it is more likely to attract Wall Street funds in the future while boosting a virtuous cycle of investment growth.
Infrastructure as a Job Creation Tool
The idea that governments should invest in public infrastructure to stimulate economic growth is well-established. On the first half of the last century, economist John Maynard Keynes stated that the “problem of maintaining full employment is, therefore, the problem of ensuring that the scale of investment should be equal to the savings which may be expected to emerge.” This statement presents public investment as a tool of countercyclical fiscal policy, justifying public works programs during the Great Depression to stimulate aggregate demand and restore the economy to full employment.
According to the Brookings Institute, besides a weak economy and anemic job market, state governments across the country are shouldering reduced tax revenue combined with rising unemployment and increased welfare spending. One of the preferred methods of bringing private sector investment into infrastructure are PPPs. PPPs should be chosen over public works whenever a given state government decides that it is the cheapest, most efficient alternative to using taxpayer funds.
VfM Analysis Can Help Local Governments Invest Effectively in Infrastructure.
In this article we present a VfM analysis model that can help states, counties, and municipalities tackle their infrastructure needs. This model helps government officials make better and more informed decisions on how to finance infrastructure projects more efficiently by using VfM analysis. This will help governments decide between a PPP or traditional public procurement of an infrastructure project.
Traditional Public Procurement is how governments finance most infrastructure investments. From a budgetary perspective, governments must allocate all (or most) of the capital expenditure (CAPEX) upfront. The construction company that wins the bid is responsible for the construction of the asset within a contractual timeframe and expects payment in line with milestones agreed to in the construction contract. Hence, the public authority needs to have funds allocated for the construction of the project before signing the contract with the construction company. This normally will not consider the on-going operations and maintenance and renewal costs that will be dealt with in future budget requests.
PPPs are an alternative to public procurement, in which a concessionaire is awarded the right to build an infrastructure asset (road, bridge, power plant) and usually maintain it for an agreed-upon period of time (20 or 30 years). Governments sign these long-term contracts in the present, but only have to start paying the concessionaire after the CAPEX phase is completed and the asset is accepted by the procuring authority and operational. This allows governments to avoid paying up front. Instead, governments will make regular installments during the life of the projects, provided that the contractor is meeting performance requirements spelled out in the contract. If not, there could be liquidated damages or payment reductions until performance is rectified.
State Governments Should Use VfM Analysis
State governments have been doing a significant amount of PPP projects. As one can see from the table below, there are more than 100 PPP projects funded by state governments. Some states like Florida and Texas have done more than 14 percent of its projects via PPP, whereas California, Virginia, and North Carolina are around the 9 percent range. The vast majority of states though is around 2 percent, which means that there is still lots of room for growth in many states throughout the country.
Figure 1: PPPs as a share of total infrastructure spending (2000-2016)
Source: Author’s estimates based on DOI data
As one can see from Figure 1, a sizable share of infrastructure investment has been done through PPPs in the past years. Yet, a few cases show that there is definitely room for improvement in the structure of some of these PPP deals. For example, according to PWC, in 2015 Kentucky closed a US$ 275 million, 3,000-mile statewide broadband network. Miami invested in many P3 deals in wastewater projects. The city of Long Beach has built a US$ 530 million civic center.
Most importantly, the state of Maryland expansion of the Purple line for its D.C. area metro system was a US$ 2 billion, 36-year concession that has gone over budget by almost US$ 750 million and is coming to a halt. This PPP has all the characteristics of a bad deal (i.e., projects with these traits have a high likelihood of failure: a judge’s decision that stopped construction for a whole year and disrupted the viability of the financial model; local authorities signed the deal without understanding all the intricacies of the project, and most importantly, the risk evaluation and allocation was not properly done).
As a result, the need for VfM analysis (amongst other types of careful review which must be shared at all levels of decision-making) is needed more than ever at the state level. There are other examples of infrastructure projects that end up in renegotiation and extra expenses for state governments.
The basic distinction in project finance is between PPPs and traditional procurement. In traditional procurement, government takes most of the risk, and hires out construction to the private sector. In a PPP, the government shares risks with the private sector, including management and construction of the asset.
As an example of a PPP project, let us assume that a state expects that a construction company should take on average three years to build a road. If the state decides to do a project through traditional procurement, the construction company will be fully paid at the end of year three, US$ 100 million per year. In a PPP project, the concessionaire will only start to be paid after year four, when the road is fully built and is already operating. Over the 30-year life of a typical contract, the government would be responsible for the cost of operations and maintenance, debt service, and the IRR (internal rate of return) to the concessionaire in regular installments from year four until year 30. As a result, the state does not have to have funds upfront allocated in the budget to build the asset.
Usually, a government can build the asset now and the next government will have to start paying for it. For this reason, governments should allocate resources for these future expenses in their budget forecasts to ensure fiscal sustainability. Taking into account the need for fiscal sustainability, one of the many advantages of PPPs is delayed payments, as one can see in Table 1.
Table 1: Sample Government Payment Structure for a Road Under Public Works Vs. PPPs
|Government payments to the private sector firm||Year 1||Year 2||Year 3||Year 4||Year 5 (…)||(…) Year 28||Year 29||Year 30|
Source: Author’s estimates
In essence, public procurement stacks up payments upfront, whereas PPP smooths payments over time. One could argue that the government can issue debt and smooth this cost over time, but that would assume that no government would have a problem in issuing additional debt, or that additional debt issued would not weight on its total cost of borrowing. Hence, accessing private sector capital increases total funds available to infrastructure and eases investment costs impact on budget over time.
As one can see in Table 1, public payments to the construction company occur in the first three years, while the road is being built, whereas in the PPP, payments happen over a longer period of time. The government will then be liable for a stream of payments from year four to 30, which will have real fiscal impacts for future administrations.
Additional advantages of PPPs over public procurement
Since the concessionaire will build and maintain the asset, it is in its best interest to reduce maintenance costs by building it with high-quality materials and the latest technology. This is referred to as “life cycle costing” and is a major driver of PPP efficiency. The public authority will normally allow the private sector to design the project based on output and performance specifications developed by government in the tender documents. Since the private sector designs, builds and maintains the project and payments are linked to performance, it has the incentive to deliver a well-built asset at the lowest costs.
Since PPPs are very long-term contracts, they allow for very strong and rational risk-allocation models that maximize value creation. If a concessionaire is better equipped to retain a certain risk, (e.g., demand risk), then it should. After all, it will generate value to the PPP project. Ideally, governments should pay a risk premium to the concessionaire that should be less than the government’s cost to retain that risk. This refers to the risk allocation process, where all the risks are priced and evaluated, and the party better equipped to retain a given risk should do so and be rewarded for that.
Value for Money Analysis – Step by Step
Step by Step in three easy steps: (1) Design a Public Sector Comparator, (i.e. an estimate of how much a similar project done using public procurement would cost); (2) Estimate the shadow Bid; and (3) Run Qualitative VfM, adjust for risk, and finally conduct a quantitative VfM analysis. Figure 2 below details the necessary steps.
Figure 2: PPP VfM Analysis in 3 Steps
Source: Author’s analysis
As one can see in Figure 2 above, a public authority should have feasibility studies estimating the cost of the project. This exercise should be followed by a Shadow Bid, which includes the additional costs of a PPP. Finally, one must adjust for risk in order to conduct qualitative and quantitative analyses. But how should the government design its public sector comparator? Figure 3 below shows it step by step:
Figure 3: Public Sector Comparator step by step
After the PSC, a public authority should draft the qualitative section of the analysis which requires that government officials should answer the following 27 questions by conducting interviews and doing research on previous similar projects in the state or neighboring similar states. In order to have a PPP, you would like to have as many “yes” answers as possible. Here is the full list of questions developed by the author for this VfM model. It should be filled out as seen in Table 2.
Table 2: List of Questions – VfM Quantitative Analysis
|1||Does the contract change market supply, leads to price reduction and more efficiency?||YES|
|2||Does the contract maximize asset value at the lowest construction cost?||YES|
|3||Does the contract provide well-coordinated decentralization that might reduce costs?||YES|
|4||Does total cost go down if more infrastructure assets are built, or services provided?||YES|
|5||Does the contract drive concessionaire to overbuild, or over-provide?||YES|
|6||Are risks allocated over to the party better prepared to handle them?||YES|
|7||How flexible is this contract to demand charges with political cycle instability?||YES|
|8||Can investors manage risks that the government needs to be transferred?||YES|
|9||Is the contract flexible according to the type of concession?||NO|
|10||Can both the Public and Private sector handle well the risks that were transferred?||NO|
|11||Is the private sector capable to deliver the expected results?||YES|
|12||Is it possible to integrate design, construction, and operation of these projects?||NO|
|13||Is the contract’s total value large enough to justify transaction costs?||YES|
|14||Does it really leverage private sector financing, thus freeing public sector funds?||YES|
|15||Can risk transfer/financing make this project more expensive than public procurement?||YES|
|16||Are local capital markets, banking sector mature enough to fund long-term projects?||NO|
|17||Are service standards measurable and objective?||YES|
|18||Are PPPs the best, simplest way to implement this business model?||NO|
|19||Does the contract require heavy regulation? “Yes” means low regulation.||NO|
|20||Is there much resistance from market players and stakeholders?||NO|
|21||How complex is the contract? “Yes” is a simple contract.||YES|
|22||Can the government do this, or is it available in the market at reasonable prices?||YES|
|23||Is there operational capacity to make decisions? Can that be found in the market?||YES|
|24||Is there institutional capacity on the technical side to supervise the contract?||NO|
|25||Is it possible to sign the contract during the current government?||YES|
|26||Is it government responsibility or legal mandate to provide these services directly?||YES|
|27||Is the new technology able to access certain population groups?||NO|
The quantitative section computes the present value of discounted cash flows between the PPP option and economic costs and benefits and the public sector comparator (PSC). It assumes that revenues will likely be the same on both models. The only difference will be related to the cost structure of these two types of projects: cost of capital, project duration, maintenance cost, operational costs, and other costs including tax payments. The final result, together with a priced risk allocation, should determine which project type is more cost-effective for the government.
Since this VfM answer is an exact numeric figure, a risk analysis simulation is warranted. Once the information is entered, the Crystal Ball model automatically runs 100,000 simulations and comes up with a probability that the PPP project will produce VfM (see Figure 4).
Figure 4: Crystal Ball Risk Analysis
The Importance of Crystal Ball – Example
For a given US$ 20 billion urban rail project in California, for instance, the quantitative analysis might determine that this public transportation plan will cost US$ 6,606 million less if done through PPP rather than public works (US$ 6,606 VfM if done as PPPs). As the analysis continues, Crystal Ball indicates that there is a 20 percent probability that the urban rail project will actually generate negative VfM as a PPP. Thus, although it seems that there is US$ 6,606 million VfM if done as PPPs, i.e., government would save that much money, there is still a 20 percent chance that government will lose money if it does it as a PPP. Thus, it is important to estimate how much certainty one has on a given value assumption, before advising decision makers.
State governments are expected to continue to take an important role in infrastructure finance. Due to the Covid-19 crisis, many states are expected to turn to PPPs and other ways to boost private sector financing. Value for Money analysis helps governments decide whether to do a PPP or a traditional public procurement project. This specific VfM analysis is a simplified and yet highly effective model that can be used in state governments. The qualitative section with 27 questions help government officials to sense or feel whether there is something that numbers themselves are not explaining on a given project. As it uses Crystal Ball, it helps decision makers understand a range of solutions to each decision, instead of relying on a single number. If state governments are able to produce good PPP projects, private sector investors might be interested in buying reliable, less risky, infrastructure bonds and equity. As a result, the U.S. economy might be able to have a stronger rebound from the Covid-19 crisis, less reliant on the Federal government, and less dependent on state budgets, both severely affected by this global pandemic that has impacted the U.S. above most other countries.