Misconceptions of P3 projects – and an explanation of what P3s are
Posted March 5, 2009 by Sacha Peter - Link
Category: Transportation
Comments (8)
This article is a rather long-winded 1700 word discussion, so you have been warned.
Introduction
On February 27, 2009, the Ministry of Transportation announced that financing arrangements with a private partner fell through and that the government was going to finance the Port Mann Bridge on their own. The funding arrangement to build the bridge, instead of a Public-Private Partnership (P3) would be through a “conventional” build contract.
This news wasn’t too surprising considering that credit markets for companies with other than absolutely pristine credit records and unquestionable ability to pay has absolutely collapsed – financing costs have been prohibitive for the past 6 to 9 months. This will likely be the case for at least the next three months, and probably the next six after. However, things can thaw out as fast as they froze. While elected officials would like you to believe that they know where the economy is going, they are grasping at straws just like the rest of us (with slightly better data made available to them). As a side note, professional straw pickers become market forecasters.
The purpose of this post is not political, but before this announcement the NDP were deriding the P3 structure of the project (essentially a “we’re giving away the province” argument), while after this press release they changed their tune to “How much did it cost you to investigate the P3 option?”, and also claiming that the switch will cost time to complete the bridge. Both arguments are the best of a weak set of arguments that could be taken from the events that have transpired, and this should be the last the NDP will mention of the Port Mann this election – as it caused significant disruption within the Metro Vancouver caucus. Probably the better angle will be the proposed tolls on the bridge, but this is a 2013 election issue.
This issue about P3s has been so maligned by both parties and the media – the BC Liberals saying it will save the province billions of dollars, while the NDP saying they cause cost overruns and thus are the root of all evil – that I think it is time to give the issue deserves a bit of discussion since I haven’t seen it cleanly explained anywhere (Wikipedia gives it an attempt). The reason why there is such a misconception on P3s is because some finance knowledge is required to appreciate them and why they are used.
What P3s are
First, P3s can save money, or they can cost more money than going through the “conventional” approach. It depends on how the P3 was structured contractually – and this requires a lot of business and financial acumen, two items in short supply in a lot of governments. It really depends on the deputy ministers to draft up (or delegate) good agreements that cover the scope of what is required, and how it will be paid. The publicly elected officials will always take the heat if the deal turns out sour, or take the credit when things go right – if they’re still in office to see the results.
What P3s attempt to do is reduce the overall project and/or maintenance costs by allowing companies (the ‘private’ in P3) to bid on certain aspects of the contract. The theory is that the companies are better operators of those project components, thus being able to bid a lower price – a lower price than if the government went out on its own and bidding for the service itself or even performed the service directly. What typically happens is that companies would bid on the rights to a revenue stream contingent to completing their part of the P3 – in the event of the Port Mann construction, companies would be bidding for the rights to receive toll revenues, providing that they could finish the bridge and operate the toll system. The province in exchange would have a net capital outlay less than if they just did it directly.
This is how some of the theory works, while in practice it is much more complicated. I will try to trivialize the above with a simple example, involving some down-to-earth numbers.
A trivial lemonade stand example of a P3
Let’s pretend I wanted to build a lemonade stand and sell lemonade, and I figured I could do it for $200 in setup costs, and I would receive $20 in profit each week in the summer for sales. Remember that summer season is 13 weeks, so I am looking for $260 in profit minus $200 in expected setup costs. However, I am horrible with wood and nails (so there is a huge construction risk, hence the $200 setup cost), but I am OK with preparing and selling lemonade (the $20 profit is likely, as long as I can build that stand). I want to reduce the construction risk of my lemonade stand, so I decide to put this to a P3 tender – I try will sell a 30% stake of my expected lemonade profits ($78) and see who bids on this lucrative contract.
So Glen Clark’s next door neighbour puts in a bid and says – even though you’re not the Premier I’ll build the stand for you for $60. In fact, I guarantee I will be able to build the stand for you before summer starts, otherwise I’ll pay you a $200 penalty fee so you can do it yourself.
I quickly make the agreement, and the contract is abided by and the stand is built. At the end of summer, the neighbour has $18 in his pocket (reflecting $78 in lemonade profits minus $60 costs of building the stand), while I have $122 (this is $260 in lemonade profits, minus $138 to the private partner) in my pocket. This was far better than the $60 profit than I was expecting if I did everything by myself – the reason is because I found somebody that was willing to take on the risk of building the lemonade stand.
Of course, things can go wrong.
What if lemonade sales weren’t the risk-free promise I made it out to be? This is like estimating the traffic that goes across the toll bridge.
What if the contractor has to borrow money to build the stand? If interest rates are too high, than his $60 bid will likely be higher (and in the case of a project the size of the Port Mann, a couple percentage points does make a very large difference).
What if this was a 3-year agreement, how do I value the money coming in year 1 vs. year 2 vs year 3? (The original proposals I read had a 40-year toll period with the private partner).
Does my partner have any say on how much I charge for lemonade? (or road tolls?)
What construction standards are to be used for my lemonade stand, and who will be responsible for maintaining it? (or maintaining a bridge crossing the Fraser River?)
These are a few simple variables that go into the thinking that would have to be structured in a P3 contract, and you can see how easy it would be to draft something that would be disadvantageous to either side.
A note on interest rates
The province of BC will have no difficulty raising money, even in this economic environment. Ironically, if the economy wasn’t so sour at this time, the province would likely have to be paying higher rates. Right now, the debt management branch (a very transparent but not publicly visible part of the Ministry of Finance) tracks all debt issuances out of BC. The last initial issue to come out was a 32 year debt for a 4.95% coupon. I don’t know if this was the yield they received, but it should be roughly that amount if not lower – 4.95% is about 1.3% over what the Government of Canada can receive.
In either case, there is no way a construction company would currently be able to get a 5% rate on 32 year debt, making funding such projects more expensive.
P3s and Transparency
This is where most political attacks should be directed, but are not. It is not easy to determine whether both sides can win (a good structured P3) even if you possess complete information on the agreement. Just like dissecting the provincial budget, certain assumptions are made, and if those assumptions come close during the actual conduct of the contract, everything works. If not, then one side will profit at the other’s expense.
One major issue of P3s in the political realm is that it is difficult for members of the public (or the opposition) to properly evaluate the contracts until they are done. It takes a lot of specialized knowledge (not to mention time) in order to come up with the variables and risk factors in order to measure the relative positions of the parties involved in a P3 agreement. Inevitably, government officials get professional help to come up with these variable estimates and it is unlikely that any other professionals would significantly deviate from such projections – except budgets during election years.
The Evergreen Line and the P3
The previous day the Prime Minister announced that Canada was chipping in an extra $350 million for the Evergreen Line. At the end of the press release was:
The remaining $173 million will be funded by project partners, including a possible Public-Private Partnership and potentially through transit-oriented land development.
The Canada Line was partially funded with a P3 that gave its private partner a share of the operating revenues for 35 years. You can read some variables of the agreement here. It’s not just ridership estimates that are important – the discount factor (one fancy way of saying the cost of capital – extremely high if you’re not the government at this moment) is also a crucial variable in determining “who wins”, or whether both win.
I think it is safe to say that even Translink doesn’t know (to precision) what the ridership of the Canada Line will be, so how would potential drafters for a P3 do the same for the Evergreen Line? For $173 million, it’s probably best that the province just swallowed up the remaining difference and just go for a conventional arrangement if they want to see the project fully funded.
Closing thoughts
P3s are very complex and are risk transfer tools. This doesn’t mean that they’re good or bad, but that they can be structured in both ways. They can also be difficult to value.
This is probably why it is easier to explain to the public the funding of projects through “conventional” deals, rather than going through P3s, which seems to be an unnecessary amount of effort. Properly structured P3s can save money, but they require good people behind both the engineering and negotiation tables in order to succeed.
Yeah, P-3’s are very complex and are way over most of the public’s head.
In a very, *very* simple sense, I’ve always looked at P-3’s this way: I’ve got some cash… now do I buy a car outright, do I place a down-payment on a car and a bank loan for the remainder, or do I lease the car with no down-payment. From my perspective, I might be able to buy one car outright, buy two cars with a bank loan, or lease 3 cars with the same cash/cash flow. In a sense, government internally looks at its financial options in this manner.
Regarding the Port Mann Bridge two figures have been bandied about – ~$2.4 billion and ~$3.3 billion leaving people scratching their heads.
The first ~$2.4 billion figure is the actual capital cost. The second figure includes all other costs incurred over the duration of the P-3 contract. Simply put (as I heard elsewhere), it’s like buying a house with a capital cost of $500,000. But over the next 25 years other costs are also included such as mortgage payments, heating/electricity bills, maintenance/repair and upgrades, etc. And that’s how one can differentiate, in a sense, between the ~$2.4 billion figure and the $~3.3 billion figure.
Additionally, with a P-3, government also transfers over construction risk as well as toll revenue risk (in the PMB case). With the government now going it alone, they still have the construction risk covered under the consortium design/builder, sans MacQuarrie, under the terms of the P-3 contract with those parties, but revenue or toll risk has now been transferred to the government.
My two cents.
As I understand P3’s to operate, the P3 consortium borrows and builds the project then leases back to government the project over a term of 35 years (approx.) at cost plus a profit margin – compared to the traditional model where government borrows and builds the project (ammortized over 25 years). In my view, the traditional model saves money to taxpayers on several fronts. One: government can borrow money at a far lower interest rate than anyone in the private sector – so financing costs drop significantly. Two: the project is paid off in 25 years as opposed to 35 years – saving 10 years of payments. Three: no profit margin built into the lease payments – taxpayers paying only the actual costs of borrowing to build the project. Four: total public ownership – after the 35 years of lease payments are done, you still have to pay out the outstanding balance (try ‘buying’ a car on a lease payment – even when you’re done paying the lease, you still owe).
The only advantage to P3 is that the private sector assumes the debt load…but not really – if a P3 falls through, then taxpayers are still on the hook…just like Port Mann and the athletes village in Vancouver.
Lets face it, P3’s are merely a political tool invented by opponents of public borrowing. But in the long run, when all the bills are paid and the taxpayer has concluded his 25 year mortgage or the 35 year P3 obligation, its the P3 that drains the taxpayer more than public financing.
P-3’s/ government financed, it’s all complex financial stuff.
In one way, the P-3 concessionaire takes on both “construction risk” and “financial risk”. Let’s say that the provincial government is able to access credit by several percentage points less.
Theoretically, that might save the government over the long-term, but they would also be tied up with those entire funds and likely would not be able to construct another similar project within the same time frame. The 1-full purchase price, 2-part purchase priced, 3-leased vehicle scenario.
Again with the lower government financing costs. The Vancouver Trade and Convention Centre had an initial capital cost of $495 million but came in over budget by an approximate amount of $380 million. If that project had been a P-3, the concessionaire would have had to bight that over-run, not the taxpayer.
And under contractual arrangements, had the P-3 concessionaire gone under in that scenario, the government would have an unfinished asset under its belt without paying out a single taxpayer’s dime. Of course, the remaining completion costs would have been at the government’s expense. It’s akin to picking up an asset at 50 cents on the dollar.
Government financing costs of a couple of percentage points lower, than a P-3 concessionaire, would have been peanuts in comparison.
Same withe the Port Mann Bridge. The government will now finance same. Without the lock-in cost proviso of the design/builders (Kiewit et al) the government would also have to take over “construction cost” risk. Who knows what unanticipated over-runs might occur due to soft soils, delays, etc.
In addition, “revenue risk” from tolls has now also passed to government. If population projections are not met or traffic projections are not met that risk is now passed on to taxpayers. And that “risk cost factor” may well be in excess of any savings that the government might incur due to lower short term interest rates.
Again, it involves very complex financial and risk analysis. Not politics.
BTW, the Vancouver Olympic Village was *not* a P-3. It was a complexly-structured land sale. Big difference.
The main difference that has not been addressed here is that in P3, having ownership of the project with the bottom line the ultimate decider, makes the builder extremely careful not to introduce inefficiencies, errors, waste, and mismanagement into the project. This is where the real savings are. All other considerations such as interest rates, who gets to operate the stuff, etc. are secondary.
Example:
BC Hydro, a crown corporation requires between 5 to 8 million dollars per MW to construct a hydro project.
An IPP requires between 2 to 3 million for the same project.
The difference is in waste, corruption, gold-plating, and mismanagement. For example, salaries at BC Hydro average $100,000 a year. For an IPP, salaries are more like $40,000 to $50,000 a year on the average.
When you have your own money at risk, you will be twice as vigilant. That is the core to small-scale capitalism.
Glass, you confuse some facts when defending P3’s. A contracter is a contractor and pays their workers whether its a P3 paying the bills or directly from the ministry or crown corporation. The P3 however has their own expenses to add to the costs as they add in their own fees and the inherent costs of higher interest rates compared to the government credit rates.
As an example, both the athletes village and Port Mann P3’s upon going back to the crown turned into dramatic savings of hundreds of millions – just from the switch.
My point still stands – P3’s cost taxpayers more in the long run as opposed to public financed projects under the traditional model.
Sorry p kelly, but you dont make sense. A contractor is not the same as a government run inefficient make-work scheme.
A contractor as he is risking his own money will be extra vigilant not to introduce inefficiencies, because any $ of inefficiency comes out of his own pocket. Therefore, when such contractors bid for the same job, they take their own skills and merits into consideration, that they will be able to avoid mismanagement. The result is a better value/cost ratio, and on top of that the risk lies with the private contractor and not with the taxpayer.
On the other hand, BC Hydro for example pays its own unionized people $100,000 or more to do the same job as a private contractor who pays $50,000. This, plus the fact that the risk lies with the taxpayer and not the management, and the taxpayer who is the owner of the project has no say in the manner that the project is executed, results in easily doubling the cost to the taxpayer.
Pls. show your source that the athletes village increased the margins of the project by going to the City. You are just making this up, or you are comparing apples to oranges. In any case, lefties are generally economically illiterate, but lets say that does not apply to you.
The higher cost of interest for P3 reflects the higher risk that the P3 is taking. When the government goldplates the project and is willing to pay double the cost to basically buy insurance, and any risk has to be covered by the taxpayer by fiat, of course their interest rate will be lower.
But when their costs are double the private sector, the project is a disaster and a load on society, even though there has been a bit of savings on the interest side. You have to look at the bottom line and not just one item in the balance sheet.
From what you write I gather you have no experience in executing a project and how the real world works.
Ok…lets just clarify some facts when it comes to P3’s vs. government financed projects.
The general contractor is the one who actually builds the project. They get their funding from either the government directly (Ministry of Highways – for new bridges/freeways, Health – for new hospitals….etc) OR the P3 consortium who is financing the project under contract with whatever Ministry requests the project.
The General Contractor hasn’t changed when it comes to the Port Mann project, but changing it from P3 to public financing saved taxpayers hundreds of millions of dollars in finance charges with its lower interest rates. Again with the Athletes village in Vancouver – when the city took over the financing from the P3 consortium, it saved hundreds of millions of dollars. It was already overbudget before the change, but with the City’s lower interest rates, they saved the city ratepayers a lot of cash on their property taxes.
Again. Its the General Contractor that builds the project – not government, not the P3 consortium.
The difference between P3 and the public model is who carries the debt. With P3’s, its the consortium – so they charge a premium for borrowing and building the project. The taxpayer carries the debt when government borrows money, but its at cost.
Either way, taxpayers end up paying for it, as they support the P3 fees through government spending, or directly from debt payments in the provincial budget.
The public model just ensures that taxpayers only pay for the debt servicing for the project and not dividends for the shareholders who own P3 consortiums who build the project.
[...] Here’s a great article from BC Election 2009. While I found it a little long, the in-depth analysis gave me a better understanding of how risk is transferred from the public to the private sector. [...]