Why PPPs may offer poor value for money

For several decades the British economy has been hampered by the poor quality of its infrastructure. Whether in transport, education or health, investment has typically been low by international standards and levels of service have suffered as a result.

Public-private partnerships (PPPs) seemed to offer a solution to this problem. Private capital would be used to fund much-needed projects. Better still, private companies could build and operate the new infrastructure, bringing, it was hoped, huge cost savings.

New investment could be detached from the purse strings of the Treasury. It would no longer be so dependent on the short-term imperatives of the public finances. And because the money was borrowed privately, there was no need, at least initially, to count it as public debt.

Moreover, contracts could be written to incentivise firms to complete schemes on time and on budget. The main pitfalls of public-sector procurement – the delays and mammoth cost overruns – could be avoided.

The first modern PPPs were began in the 1980s under what became known as the Private Finance Initiative (PFI). Their numbers grew during the early-mid 1990s, with several design, build, finance and operate (DBFO) road schemes, as well as the construction of a number of privately-operated prisons. These projects were generally viewed as successful within government – a higher proportion were delivered on time and on budget than would have been expected using traditional procurement methods.

Building on these foundations, the election of a New Labour government saw a rapid expansion in the number of PPPs. The model fitted well with Labour’s ‘Third-Way’ approach to the economy. Instead of outright nationalisation, with its well-documented ineffiencies, the dynamism of the private sector would be harnessed for social objectives. 

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Richard,Astute as usual. But there is another fundamental problem, which PPP has in common with government procurement and many government interventions. The government aggregates the purchasing power in the market. In letting a contract for the whole of the aggregated demand, it creates a situation where suppliers cannot afford not to win the contract. And they know their competitors will see it similarly. So they underbid, because their losses will be smaller if they win than if they lose and have to spread their overheads over decimated revenue. And they hope that, possession being 9/10s of the law, they can find ways to screw more out of the contract later.

Of course, the winner is usually over-optimistic, and it comes down to whether their balance sheet and their profits on their other contracts can cover their losses on the government contracts. Meanwhile, their more realistic (and probably better-run and more viable) competitors, who more accurately assessed what they could afford to bid and therefore lost the contract, are decimated by the loss, and many of them also drop out of the business.

Monopsony and oligopsony are as toxic as monopoly and oligopoly. Government is the worst offender. The answer is for government to leave as much as possible to the market, and where it judges it must intervene, to adjust the institutional framework so markets take account (impartially and unbureaucratically) of the externality, not to involve itself directly as purchaser, auctioneer, financier or other market protagonist. It should limit its procurement activities to those things (defence, law & order, etc) that cannot be privatised, and where procuring, should devolve the purchasing responsibility to the lowest, smallest and most directly-involved unit of the bureaucracy.

Bruno – your comments are very perceptive. The PPP market is dysfunctional in many ways and the high costs/risks of bidding for contracts stifle competition. There is strong empirical evidence to support your first point in the high proportion of contracts that are renegotiated once a project has been commenced. The supplier may hope to make money when the original specification is changed, which happens frequently.

Richard,Astute as usual. But there is another fundamental problem, which PPP has in common with government procurement and many government interventions. The government aggregates the purchasing power in the market. In letting a contract for the whole of the aggregated demand, it creates a situation where suppliers cannot afford not to win the contract. And they know their competitors will see it similarly. So they underbid, because their losses will be smaller if they win than if they lose and have to spread their overheads over decimated revenue. And they hope that, possession being 9/10s of the law, they can find ways to screw more out of the contract later.

Of course, the winner is usually over-optimistic, and it comes down to whether their balance sheet and their profits on their other contracts can cover their losses on the government contracts. Meanwhile, their more realistic (and probably better-run and more viable) competitors, who more accurately assessed what they could afford to bid and therefore lost the contract, are decimated by the loss, and many of them also drop out of the business.

Monopsony and oligopsony are as toxic as monopoly and oligopoly. Government is the worst offender. The answer is for government to leave as much as possible to the market, and where it judges it must intervene, to adjust the institutional framework so markets take account (impartially and unbureaucratically) of the externality, not to involve itself directly as purchaser, auctioneer, financier or other market protagonist. It should limit its procurement activities to those things (defence, law & order, etc) that cannot be privatised, and where procuring, should devolve the purchasing responsibility to the lowest, smallest and most directly-involved unit of the bureaucracy.

Bruno – your comments are very perceptive. The PPP market is dysfunctional in many ways and the high costs/risks of bidding for contracts stifle competition. There is strong empirical evidence to support your first point in the high proportion of contracts that are renegotiated once a project has been commenced. The supplier may hope to make money when the original specification is changed, which happens frequently.

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