Private Ordering in PPP Infrastructure


Aug 29, 2017 — Neil Boyle

The Institutional Analysis of PPP Infrastructure
Private Ordering In PPP Infrastructure
08/29/2017Updated August 2017

Note: It is assumed that the posted document titled “Probing the World of PPP Infrastructure Incentives” has been read prior to reading this article.

1. This is about private ordering in the context of public private partnership in infrastructure (PPP) and suggests areas and means of application inspired by transaction cost economics. The goal is to introduce innovative and cost effective applications of TCE to the workaday world of development and implementation of PPP projects.  We hope to stimulate the use of private ordering and broaden the discussion in practice to focus on the economic organization and governance of PPP investment projects worldwide. The term “trader” refers to a party to a contract; the term “sponsor” refers to a principal equity investor who is typically either a buyer (a government entity) or a private supplier (a private operator).  In PPP projects they are both equity investors and owners of what is normally called a project company.  PPP projects are assumed to be project financed.

2. Self-help, avoidance, and diplomacy are often employed by private businesses rather than succumb to adopting the standard solutions that derive from adhering to costly regulations. As in-depth case analysis shows, private ordering in PPP is ubiquitous across time and space and constitutes evidence of the high transaction costs faced by investor/traders in the development and implementation of their projects.

3. PPPs are in need of remedial governance in four respects. For one, PPPs are not zero-sum propositions. Both principals are obliged to cooperate, share work plans, including risk management plans prior to negotiations with the counterparty. This is why it is important to economize on transaction costs and to select partners carefully. Do you want to be in business with this person indefinitely?

4. A second reason is protecting contractual relationships between sponsors and the project company are difficult to safeguard in a reliable manner that will not deteriorate over time. Monitoring the affairs of management is easy to do, but because of specialized human capital, replacing management is not so easy.  Governance structures for managers whose relation to the project company is highly specialized are not easy to design. The presence of management on the board of directors of the project company for information sharing purposes is acceptable; other purposes, however, are suspect.  (Williamson, 1985:324) What attributes does management have for either party in relationships with its project company, and what attributes should it have?

5. A third reason why PPP needs remedial governance is that the resolve of a regulator to set rates of return at a level that yields fair returns may weaken if the PPP does not have recurring needs to resort to capital markets for expansion and renewal capital. For example, a PPP Project Company that is financed by intermediate term debt that is continuously rolled-over is less subject to punitive rate setting than is an otherwise equivalent PPP that uses long-term debt and has no need for renewal financing. How rate setting processes are affected should enter into the ex-ante calculus of PPPs. (Williamson, 1985:321)

6. A fourth reason for remedial governance measures have to do with managerial discretion and organization form of the project company. M-form corporate structure is vastly superior to the usual U-form corporate structure of project companies for four reasons:

  • decision making is rationalized and the causality-responsibility relations are traceable and correctable;
  • purposes can be defined more sharply and transaction costs economized;
  • incentives are improved by separating the central banking function from general operating affairs; and
  • Inter-firm contracting is easier to execute via the M-form structure. (Williamson, 1985: 319)

7. Private ordering is widely used to govern complex contractual relations. A complex contractual relation is described using a two technology schema one of which is a general purpose technology, the other is specific technology. A manufacturer of election campaign badges is an example of the former. One such manufacturer is similar to any other manufacturer. The manufacturer incurs no exposure of transaction-specific assets, the assets it does have can be used over a broad range of business situations and the assets can be redeployed in the event current contracts with buyers are terminated. Such a manufacturer can adapt to changing market conditions quickly and set up shop elsewhere. The attributes of such assets conform to the attributes of thick market transactions where relations between producer and buyers are autonomous and unilateral. This is called a “market” governance structure, one of three structures. The second is called “hybrid”, a.k.a. a long-term contract; the third is called “hierarchy”, a.k.a. a firm governance structure. Governance structures vary according to the level of asset specificity.

8. By contrast, specific purpose technology incorporates transaction-specific assets that cannot be redeployed should early termination occur or continuity of the transaction no longer be of value to the parties. A PPP investment in an electricity generation plant is an example. Transactions of this kind experience a Fundamental Transformation of the incentives of the parties involved and those incentives pose needs for specialized governance supports if efficiency is important. When this happens, bilateral dependency between the parties’ sets in, the buyer (the government) and the supplier (the private operator) are thus bilaterally dependent. PPP project companies are generally organized/structured for inter-firm or hybrid contracting because most infrastructure projects have asset specificities that are located mid-range on a spectrum from low to high where the actual asset specificity (k) will be between k* and k^, the so-called mid-range. (See “Probing the World of PPP Infrastructure Incentives.”) An unassisted market governance structure, however, poses hazards because it does not provide contractual safeguards, which consequentially show up in the price of the contract.

9. When the actual asset specificity (k) is greater than k^ the transaction is then governed by hierarchy a.k.a. a firm. According to Williamson, the rule of thumb is to try market first; if that does not work, try hybrid and if that does not work try hierarchy.

10. Going back to the mid-range of asset specificity, rather than employ a legal rules approach to contract, the concept of contract as framework is emphasized instead. Disputes are not routinely litigated; the courts are used for ultimate appeal. Such ultimate appeal affords protection against egregious abuses of which an unfound claim of corruption is an example. Private ordering is an institutional instrument that businessmen employ to economize on transaction costs in discriminating ways; it is not a construction out of some ivory tower.

11. There are two forms: of private ordering: ordinary and special. The ordinary form involves solutions to business problems to which businessmen must respond in real time to avoid economic costs. Problems include activities such as getting informed, obtaining licenses, qualifying for a loan, procuring and negotiating with suppliers, and writing and executing contracts, among other general ordering problems. In fact, if one were to write the job description for private traders, ordering tasks would be at the top of the list. In a sense, private ordering is what businessmen do best; this is the way they adapt to business environmental changes privately and efficiently. Their modus operandi is in keeping with how private markets work. Ideally, markets do most of the heavy lifting with government relegated to the periphery, and there to stand prepared to enable markets or when society’s welfare is threatened to step in and to remove the threat and repair the damage.

12. The special case of private ordering takes the form of solutions to complex contractual relations where the exchange assets are non-redeployable, the traders are engaged in autonomous bilateral relations, and the exchange process includes continuity. Voluntary arbitration and risk sharing are two examples of private ordering. Rather than submit to the inefficiencies of legal centralism and the courts, the parties attempt to craft private ordering. And if such efforts are resisted and defeated by the judiciary, the parties predictably respond by avoiding technologies and working relations in which continuity is valued.

13. PPP transactions typically comprise long-term contract (inter-firm) contracts that execute across markets but require transaction-specific contractual safeguards to relieve the hazards that frequently occur to these kinds of transactions.

14. NRA (non redeployable assets) and autonomous bilateral relations are major components of most PPP projects. PPP traders typically govern such transactions through interfirm contracting across a market and by utilizing transaction-specific safeguards to protect against adverse financial exposure (See sections 14-15). This mixture of market with hierarchy governance features constitutes an intermediate stage (i.e., the hybrid governance structure) that maintains the benefits of autonomous market relations while (i) averting the high cost of bureaucracy that is characteristic of the internal organization of joint ownership, and simultaneously (ii) acquiring the benefits of coordination through hierarchy. It is within this context of autonomous bilateral transaction and hybrid governance structure that private ordering is especially applicable.

15. PPP assets are almost always non-redeployable and non-redeployable assets are almost always major sources of hidden risks. Six types of NRAs comprise: physical asset specificity, human asset specificity, site specificity, dedicated assets, brand specificity, and temporal specificity. Non-redeployability is measured by asset specificity (k) which varies with the degree of specialization of the asset. Because NRAs are designed for specific purposes and effectively bolted to the ground, there are few exit strategies for investors save the successful completion of the project. Early termination is not a viable option and salvage value is often near zero. NRAs induce PPP traders to protect their assets from exposure and preserve their autonomy through autonomous bilateral trading, thus private ordering and continuity are high value measures.

16. NRAs challenge traders to adapt to economic disturbances in transaction-specific ways. Adaptation is the central problem of economic organization and concerns the manner (e.g., efficacy) in which economic agents respond to economic change. There are two kinds of adaptation: autonomous and cooperative. (Williamson, 1996, p. 26) Adaptation rarely occurs in a uniformly efficient manner across ex-ante and ex-post stages of the project cycle in PPP projects.

17. Private ordering is discriminating in that its primary value appears mainly in complex transactions of which PPP investment is one. While private ordering is generic and basically what autonomous traders do spontaneously all of the time, its principal value is to transactions where autonomous traders are bilaterally dependent on one another and who must adapt to complex trading problems where governance costs are not trivial since both parties have transaction-specific interest in the project continuing and have strong incentives to persevere even if the rules of the game are unclear as they are most of the time in developing countries. Regulators are as human as traders and both are subject to bounded rationality; regulators failing to write the rules of the game for every situation with sufficient clarity; and traders failing to keep the conduct of their business aligned with the contract curve. Private ordering works when regulators and traders are themselves in alignment and both are sufficiently farsighted to understand that agents will economize on transaction costs before they willfully break the law or seek solutions in the shadow of the law.

18. But what happens when traders face transaction costs that are difficult to avoid. The case described and summarized below illustrates the main points.

19. Contract parties frequently face a problem for which neither contract regulations nor BOT investment regulations of the host country offer specific guidance. The regulations, however, state the principles upon which the regulations were based. Lacking more specific guidance, the parties refer to the constitution and there find a guideline that states ‘no foreigner shall own more than 40 percent of the assets of a commercial enterprise.’ While this is an improvement over the regulations, the guideline is still general and lacking in specifics. The missing detail which could not have been predicted beforehand is that the sponsors were only able to raise 40 percent of the needed equity and needed to find a partner experienced with building and managing large investments that serve high volume traffic. The local group found what they were seeking in an international company. The question was how to deal with the constitutional restriction on the degree of foreign ownership.

20. The private solution proposed by the local group was to limit the foreign investor to 40 percent of equity ownership in the project company and receive the remaining 20 percent as a loan to the company. With total project cost unchanged, the sources of financing were duly adjusted to reflect the privately ordered solution to what could have been a deal breaker otherwise. The capital structure was adjusted accordingly by the accountants employed by the sponsors.

21. Private ordering is neither new nor theoretical for either economics or the law. The assumption that enforcement of the law by the courts is cost-less relieves economists and lawyers of the need to examine the variety of ways by which individual parties to an exchange “contract out of or away from” the governance structures of the state by devising private orderings.

22. Law professors Harry Schulman and Archibald Cox of Harvard University and Clyde Summers of the University of Pennsylvania Law School were asked to assist in deciding how to implement collective bargaining contracts as regulated by the Wagner Act of 1935. This entailed an assessment of the relative merits of private ordering versus court ordering. Here are some of their comments. Schulman urged that the Act be interpreted as a “bare legal framework” within which private ordering between management and labor would operate. (1955, p. 1000) The grievance and arbitration procedure was thus favored over judicial disposition of disputes because of the corrosive effects on continuing relationships that adversary proceedings encouraged. (Shulman, 1955, p. 1024) Cox likewise held that the collective bargaining agreement should be understood as an instrument of governance: “The collective agreement governs complex, many-sided relations between large numbers of people in a going concern for very substantial periods of time”. (1958, p. 22) Provision for unforeseen contingencies is made by writing the contract in general, flexible terms and supplying the parties with a special arbitration machinery. “One cannot spell out every detail of life in an industrial establishment, or even of that portion which both management and labor agree is a matter of mutual concern”. (Cox, 1958. p. 23) Summers distinguished between “black letter law” on the one hand and a more circumstantial approach to law on the other. He argued that “black letter law” could not provide a “framework for integrating rules and principles applicable to all contractual transactions”. (Summers, 1969, p. 566) Summers elaborated that “[T]he epitome of abstraction is the [legal contract doctrine] Restatement, which illustrates its black letter rules by transactions suspended in midair, creating the illusion that contract rules can be stated without reference to surrounding circumstances and are therefore generally applicable to all contractual transactions”. (Summers, 1969, p. 566) Such a conception does not and cannot provide a “framework for integrating rules and principles applicable to all contractual transactions. (Summers, 1969, p. 566) Summers conjectured in this connection that “the principles common to the whole range of contractual transactions are relatively few and of such generality and competing character that they should not be stated as legal rules at all”. (1969, p. 527)

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