Lecture Notes on PPP Organization

Articles

Dec 8, 2016 — Neil Boyle

“The exchange between a buyer and a supplier is not merely about the exchange of commodities or of individual behaviors, but is instead the alienation and acquisition between individuals, of the rights of property and liberty created by society, which must therefore be negotiated between the parties concerned before labor can produce, or consumers can consume, or commodities can be physically exchanged.” (Commons, 1931:648-657, AER Vol. 21) Vol. 21)

 

A. Can anyone tell me what a PPP project is?

Public private partnerships (PPPs) are special partnerships between government and the private sector generally for the purpose of gaining private sector financing and/or technical and managerial knowhow from them. The partnership, often overlooked by analysts, actually is for attenuating the inherent tension and potential conflict that exists between government and the private operator. (Williamson, 2010) This is a principal reason that by itself has to do with the way PPPs are organized. The usual justification for employing PPPs is traced to a fiscal problem of government: the need for private sector finance are typically cited as the reason for a partnership. More specifically, it is an investment that is made by a government body in partnership with a private investor generally (or the other way around) for two primary purposes:

  1. For government, to invest in infrastructure services that the government cannot afford, and to receive technical and organizational knowhow that the government is not expert in; and
  2. For the private investor, as a vehicle for foreign (or domestic) direct investment that permits the firm to recover its costs and to grow and expand in a market of its choice.

PPPs are also useful mechanisms for three other important purposes among which are:

1. Scaling-up and rationalizing a fragmented multi-O&M-zoned utility (that may be organized as subordinate to multiple municipalities and/or cantonments) is achieved by aggregating economies of scale through mergers and acquisitions (Ms&As) and the creation of a holding company to oversee the bought-up multi-corporate divisions (the M-Form Corporate Structure) that are decentralized and now compete with each other, much as the automobile corporate divisions of General Motors Corporation does today. For further details, see paper on “The Three Part Workshop” online at www.infragov.com.

2. Financial sustainability is achieved by aggregating the fragmented and misaligned economies of scale to break the grip of fiscal dependence of KWSB (the main water authority serving metro Karachi, Pakistan) on the public purse. Achieving this is by attaining creditworthiness by aggregating sector demand under a single holding company of the corporatized version of KWSB. This won’t work if the utility is a single enterprise that is already exploiting its base and the problem has to do with the inefficiency of the internal organization of the utility and with a misaligned economic tariff structure. In the latter case, one might consider a government subsidy that phases out after a period of time after credibly committed reforms have completed.

3. An extractive political economy is difficult to reform, but not impossible. Transforming an extractive political economy into an inclusive one is achieved by removing politicians control over the setting of water tariffs and user charges to buy votes. This shift is accomplished by delivering demand-certainty to consumers through reliable service delivery mechanisms that align what consumers want with what they are willing to pay for on a continuing basis. When alignment is achieved, consumer loyalty shifts away from politicians and moves towards serving consumers by preserving the aligned performance of the WSS sector.1 (see footnote)

A successful reform program will influence the WSS sector political economy in two ways:

  1. the hurdle for extractive decisions is made more difficult by decentralizing the authority for tariff setting among numerous autonomous corporatized water utilities that experience centralized oversight from its “mother” holding company, KWSC; and
  2. The hurdle for inclusive decisions is made easier by the strong links established between the decentralized corporatized utility divisions of the holding company and their customer base.

B. How are PPP investments made?

Can anyone describe what happens between the government and the private investor? I am principally interested in the economic, legal, and organizational relations between the two parties.

An agreement is negotiated that specifies the terms and conditions as follows of the contract on which:

1. Numerous references are made to the contract such that it necessitates a definition. To make the contract more operational, it is defined as a triple comprising three components: the price (p) of the transaction; the specificity of the exchange asset (k), and the specialized safeguard (s) that protects the contractual agreement from any unintended modification. The components of the triple are interactive, therefore, they are negotiated simultaneously along with the establishment of the quantity, quality, and duration of the transaction.

2. Negotiations are based on the contract triple and the objective of credible commitment. Negotiations are based on the extent that trade-offs are agreed between the combination of the price (p) of the transaction and the asset specificity (k) of the exchange asset (i.e., of p&k), leveraged against the special purpose transaction safeguard (s). The safeguard is a negotiated contract clause that ensures that this agreed specific triple will raise the present value of net revenues.

Footnote: 1 This was the case observed in the nine case studies of the WSS PPP utilities dispersed over several provinces in the Philippines that attained international standards such as overage area, non-revenue water, operating ratio, and administrative efficiency, among several others. For details see case study Performance and Renegotiation in Public Procurement and PPP in website www.infragov.com

3. A jointly-held for-profit project company is formed by the existing enabling law or by a special purpose vehicle (SPV) through executive order or legislation if the project company needs features that the existing law does not support. Features that are not supported by local laws might be the following: expanded managerial discretion and a special compensation package for a foreign partner despite a legal restriction on his ownership shares. Foreign firms are often restricted to minority ownership by foreign national constitutional law because of location (e.g., within 50 miles of a coastline) or other national security factor or constitutional principle.

4. Ownership shares are determined on the basis of shares of investments made by each party into the jointly held for-profit project company. The project company owns the assets. From this point on, bargaining costs should be negligible, if not nil, because shares are predetermined.

5. The project company may be managed in the traditional sense of a board of directors who appoint a president who then employs his staff, or managed in a non-traditional sense as the 9 WSS utilities in the Philippines where the government buyer handed over total managerial discretion to the operator.

6. Partnership incentives are transformed from their maligned initial condition to the crafted alignment of the government buyer and the private operator supplier. Here is why. The assets invested by each partner are different in asset specificity, that is, the extent to which they can be redeployed to another use or another user; or the extent to which their use outside of the transaction is greater than zero. This asymmetry affects the differential, which carries over to the incentives affecting human behavior. Government typically invests in relative low-value low-risk off-site infra-structure; on the other hand, the private operator invests in on-site infrastructure, the investment itself, high-value high-risk specialized physical investments accompanied by their intellectual property rights. Unless the asymmetry is negotiated to equilibrium (i.e., equilibrated), the party with the higher asset specificity carries the higher level of contract hazards.

7. A specialized durable (e.g., water supply system) investment, is made in exchange for future performance, the value of which depends on the fulfillment of the promises made by the counterparty, which takes place over the duration of the project. However, promises are vitiated by the guile of opportunism and must be relieved by the provisioning of appropriate contract clauses.

8. The duration of the project is counted in years, during which anything can happen and usually does, mainly because of the nature of the twin behavioral assumptions of humans.

9. The twin assumptions of humans are bounded rationality and opportunism. Bounded rationality is a constant characteristic of all human agents’ worldwide meaning that they are “rational but only limitedly so”, (Simon, 1963). The implication of bounded rationality is that all complex contracts are unavoidably incomplete. (Williamson, 1985) Not everything is known about complex contracts in all states of nature. Uncertainty makes bounded rationality worse.

10. Opportunism is also a constant characteristic of the self-interest of all human agents’ worldwide–not the simple self-interest of orthodoxy–but rather takes the strategic nature of man into account when she considers the value of his immediate surroundings, best articulated as “guileful self-interest. Most people are self-interested, but not all are guile-fully self-interested, however, the cost of determining who is and who is not is prohibitive. The implication for opportunism is that individual and contractual promises are not self-enforceable because the guile of opportunism vitiates the sanctity of the promise. Small number exchange makes opportunism worse.

C. Organizational Structure

1. This description of the functioning of the WSS organization system is a heuristic that helps explain the WSS system, as well as helps to optimize the cost of governing the system. Its special features are due to its discovery by a distinguished organizational theorist by the name of Chester Barnard of Harvard and General Motors. We know from the Philippine cases and the literature that PPPs operate in a problematic dynamic of constant incomplete contracting whose survival depends on the “maintenance of equilibrium of complex character…[This] calls for readjustment of processes internal to the organization…,[whence] the center of our interest is the processes by which [adaptation] is accomplished”. (Barnard, 1938:6. emphasis added).

2. The main case of economic organization is “economizing”. The principal concern is the efficiency of running the water supply system (taken organizationally and productively) by focusing on the efficiency of transactions and economic organization rather than on composites of goods and services, which are left to the production side of the framework.

3. We are more concerned with tracing out the ramifications of bounded rationality. Greater respect is required for organizational (as against technological) features and for efficiency (as opposed to monopoly). Williamson, 2005)

4. The organizational structure of a PPP investment can be large or small depending on the scope of the operations and maintenance (O&M) zone, which for successful power generation and WSS services, sources of funds should line up with the uses of funds, otherwise misalignment and transaction costs will occur because the incentives of the agents are misaligned.

5. Theoretically, there is no limit to the size of a PPP project in terms of the number of customers. Size depends on the organizational structure and the extent and the quality to which decentralization can be effectively considered. Decentralization can be in either a hybrid form of governance structure (aka, a long-term contract) that governs an interfirm procured market interface, or a hierarchical governance structure (aka, a vertically integrated firm) that governs a uniform intrafirm interface whereby both supplier and buyer are governed by the same firm, which commonly is a holding company.

6. It is this hierarchical governance structure that forms the basis of multiple corporate divisions similar to AT&T in the first 8 months of the 20 century and that competed with one another. GMC divisions are similar, but have not ceased to compete as AT&T has. Choice between the hybrid and hierarchy depends on the size and number of the O&M zones and the economies of scale that lie within them. Scaling-up, financial unsustainability, and extractive political economy are three principal problems when multiple O&M zones and competing corporate divisions are involved.

7. An example of the hybrid model of decentralization is depicted by the nine (9) WSS PPP utilities and their eight case studies on Metro Manila and the Philippine WSS sector. An example of the vertically integrated model of decentralization is summarized next and in the case study titled “The Three Part Workshop”. The case study can be read online at www.infragov.com.

8. Let’s assume the case is the Karachi Water and Sewerage Board (KWSB) and that the object of government is for KWSB to achieve creditworthiness and access to capital markets and in so doing, it becomes sustainable. This can be accomplished by centralizing sector oversight in a corporatized KWSB called KWSC as a holding company of its 16 corporatized divisions by expanding the sector’s economies of scale under one corporate roof through a program of mergers and acquisitions of the 16 utilities that operate there (8 municipal utilities and 8 cantonment utilities) [2 see footnote]. The holding company then would decentralize its 16 holdings as corporate divisions free to compete with one another and operate with market based benchmarks. Because of the potential for disinvestment, KWSC would not decentralize retained earnings and strategic planning at the sector level. To ensure sector coordination it would keep its central banking function.

D. Risk

1. There is usually a transfer of risk from government to the private investor and therein lies some of the performance difficulty that is experienced by PPP projects. The difficulty is twofold. The first lies in the intent to transfer risk rather than the intent to balance the asymmetry that exists between the parties that prevents a true partnership and the giving and taking of credible commitments from each other. True partnerships are supported by an autonomous bilateral dependency between the contractual parties. Bilateral dependency sets in when the following conditions are joined: incomplete contract, specialized exchange assets, and uncertainty. Asymmetry obtains between parties and is relieved by the mutual consent of both parties. When parties are coping with the conflict that is inherent in the transaction in this manner, a form of credible commitment is exchanged.

2. The second is the adoption of risk aversion and the efficient risk bearing that supports its enforcement. Efficient risk bearing is a promise that is vitiated by the guile of self-interested agents. The alternative is risk neutrality. Its advantage is risks are constantly present due to the guileful nature of human agents. Whenever risk markers are detected, they are immediately mitigated as a matter of bounded rationality through contract provisioning and testing refutable hypotheses. As part of its procurement plan, government launches an “Expression of Interest” solicitation to the private sector in search of qualified companies who are interested and capable of entering into a true partnership with government. Before selecting the shortlisted firms, the government should inform bidders of the requirement of a pre-bid conference, the purpose of which is to explain the details of PPP financing and organization and especially the need for renegotiation whenever one party sees a need for adjustment to the basic agreement between them.

Footnote: 2 A cantonment in modern Pakistan is typically a residential district that was specifically set aside for a specific group of government functionary, e.g., military, railroad, civil service, among others. Cantonments have their own legal and physical jurisdictions, often containing their own infrastructure.

E. Renegotiation

1. Renegotiations, without more, comes with the moral hazard of a low-balled bid price. Meaning, the bidder bids low in the hopes of recovering lost profits from change orders during implementation. To maintain the capacity to renegotiate, moral hazard must be eliminated. Elimination is made plausible by assuming “suspicion”, then taking steps to relieve the suspicion by provisioning specific clauses in the contract that:
a) Limit change orders to acceptable levels, both in number and in costs through verifiable bills of quantities; and
b) Limit bid prices to be within one-half (0.5) standard deviation of the mean of the distribution of bids. (The SD is a suggestion.)

2. In a highly competitive environment, bid prices should be reasonably close to one another. One would expect a different result in a developing country where competition is not keen or well-honed in industry. Nonetheless, a distribution can be fashioned and a mean calculated from which a standard deviation is computed.

3. Once a shortlist of qualified firms have been identified and vetted, government will then ask the shortlisted firms to respond to a Request for Proposal (RFP).

4. What three things do we notice in these statements:

First, is that we are taking a micro-analytic view of the situation. What do I mean by micro-analytic? The analysis of some small part of something larger necessitating greater magnification of the phenomenon and treatment of anomalies that are found there. What is the small part? The main transaction; the quantifiable relations between the buyer and the supplier. What is the larger part? The economic system, or if that is too large, the economic organization is the larger part of which the transaction is a part, and both are parts of the economic system. In fact, Kenneth Arrow describes transaction cost as “the cost of running the economic system”. (1969)

Second, are the levels of uncertainty and small number exchange. These are referred to as “objective market parameters”. Objective market parameters act on the twin behavioral assumptions and both are addressed specifically in operational terms. When bounded rationality is combined with uncertainty, bounded rationality is heightened; the greater the uncertainty, the greater is the bounded rationality. Uncertainty, here is the active agent, not bounded rationality. Bounded rationality is the intervening variable rather than the independent variable. Later, we will see that the independent variable is asset specificity, which varies with the changes in uncertainty acting through bounded rationality. When uncertainty changes (through bounded rationality), the cost of governance also changes.

Operational terms for small number exchange and their effect on the guile of opportunism are similar to uncertainty, in fact, like uncertainty it is an objective market parameter. Here is an example of a small number exchange by contrasting it to large number exchange. International competitive bidding or ICB is a large number exchange whereby large numbers of competitors bid on the same tender in the market place. The large number of competitors are seen as making sure there is no corruption in the process, and the transaction is considered free of opportunism due to the effects of transparency. However, once that tender has been awarded and the contract signed, that transaction changes from a large number exchange into a small number exchange (a supply dyad) relation between the buyer and the supplier without the prior advantage of transparency. Organizational theorists call this a Fundamental Transformation, a process incentive. The two parties might be seen as exchanging intellectual property for money and the opportunity to transform their property into durable goods and services. Small number exchanges come without transparency. Generally, large number exchanges are the opposite and come with transparency. The larger the number of small number exchanges there are in the transaction, the greater the chance that opportunism will occur and/or the greater the opportunism event. Similar to uncertainty, small number exchange is the active agent and opportunism is an intervening variable; small number exchange worsens the condition of opportunism.

Third, is the agreement that is the basis for the legal contract (or concession) between the two parties. All contracts are defined by their terms and conditions, which imply that there is no one single type of contract because there is no one single type of governance structure (this is the term used to describe the way a particular transaction is governed). As we will learn later, contractual doctrines vary with the way transactions are governed. Therefore, there are different contractual doctrines for each of the ways transactions are governed.

  • Markets are governed quickly and fast and are supported by classical economic and legal doctrines.
  • Hybrids are governed in a mixed market and hierarchy way, i.e., through long-term contracts and are supported by the legal doctrine of “framework” whereby the contract serves more as a guide toward completion mainly because hybrid is complex and it relies on private ordering, reserving court ordering for ultimate relief.
  • Finally, hierarchy is governed in a measured and controlled manner through hierarchical authority, i.e., by firms) and that is supported by the legal doctrine of “forbearance” where restraint is manifest because firms have their own court of ultimate appeal where the courts are maintained for ultimate conflict cases.

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