Putting PPP Government Bureaucratic Problems into an Analytical Framework — PART – I

Jun 17, 2010 — Neil Boyle

Updated in red on May 15, 2010. This problem was brought to my attention by Hector Florento, Governance Advisor for the Philippine government and Dr. Ramon Clarete, Professor of Economics at the University of the Philippines in Manila, both of whom are Associates of Infragov LLC (you can read their profiles in About Us on this website). Because it recurs in much of the developing world, I thought a series on the subject would be worth pursuing. The following paper has benefited from the review of Sharon Poczter (see her profile in About Us), and from inputs submitted each by Messrs. Florento and Clarete (See archive of “Other Articles” on this website for Clarete’s study.) Ultimate responsibility for all errors of fact or fabrication, however, lies with the author. Part II is under preparation and subsequent parts will follow as further data and information are collected from the field.

Due to their complexity, PPP government bureaucratic problems are often identified in a piecemeal fashion without the benefit of a coherent scientific framework.  Generally, inadequate systems and procedures for project planning, procurement and implementation of PPPs make it difficult for line agencies to tender viable infrastructure projects and help ensure that awarded contracts are properly managed. Issues in project management – political interference, the lack of proper standards and guidelines, and poor understanding of private sector needs – coupled with regulatory and legal risks in the business environment can lead to poor decision-making by bureaucrats and create contractual hazards. Due to the lack of a coherent and effective scientific framework, PPPs have not necessarily brought about the intended benefits – enhanced service delivery, value for money and improved resource allocation. As a result, common public knowledge about PPP bureaucracy is inconsistent and accrues insufficiently across time and space; thus the generation of productive knowledge on this topic is limited.  A pertinent question is: how can these problems be analyzed and treated within the framework of economic theory?  This is Part – I of a series that will address this issue in greater depth in subsequent updates of this website.

The immediate answer is that economic theory can help identify the incentives of economic agents who are engaged in the provision of infrastructure services. This can be used in calibrating incentive alignments between government developers and, for example, engineering design consultancies or foreign direct investors to achieve optimal efficiency given the constraints of the other parties’ incentives. The initial task for the analyst is to 1) define what government intends to procure: infrastructure assets or a stream of infrastructure services, or both; and 2) properly outline the economic organization of the problem project. Government procurement options imply alternative economic organizations and thus partnership agreements for the project. For the present discussion, government procures both infrastructure assets and its stream of services through a BOT project financed arrangement with a private foreign investor.

The economic organization of this hypothetical infrastructure project consists of a project company at the center of a network of direct and indirect stakeholders that are linked together by the series of contracts of an industrial supply chain. Provision of infrastructure services moves through phases of project planning, design, construction, and operations. The transactions between counterparties in each phase consist of discrete inter-firm bilateral transactions supported by the intra-firm organizational exchanges that occur within each firm in the chain. These bilateral transactions have three components: (i) the interaction of the contract triple of price (p), asset specificity (k), and safeguard (s) that make up the principal dimensions of negotiated trade-offs; (ii) the legal and regulatory regime of the institutional environment at a particular time and place, changes in which, change the cost of governing these transactions; and (iii) the contextual human and variable environmental risk factors of the agents and market parameters involved, respectively, including those in the internal organizations of relevant government bureaus and agencies.

This theory embraces the term trading parties to include government internal decision-makers, who while not directly participating in the exchange across a market interface, nonetheless can significantly disable the market transaction by corrupting task completion within the internal organizations of the government bodies of the supply chain. Production cost and revenue considerations in each phase are thus impacted by the transaction costs that arise from these corrupting influences. Exchange is inclusive of the costs of transacting (i.e., contracting) among the trading parties in all of the primary transaction interfaces. Total costs are thus the sum of production and transaction costs throughout the industrial supply chain. The added transaction costs in each phase should directly shape the resource allocation decisions of each phase. Because each phase needs to be evaluated on a case by case basis, each phase of infrastructure provision is individually negotiated and contracted.

The following glossary of terms and concepts is offered.

PPP infrastructure. The meaning of this term is often unclear. Does PPP infrastructure refer to government procurement of the infrastructure assets that will deliver a certain stream of infrastructure services, or does it mean government is purchasing just the stream of services according to certain terms and conditions leaving the private sector full responsibility to handle design and procurement of the assets? These two options imply different levels of government involvement, risk exposures, and costs and benefits in each of the stages of project development. It also implies differing economic organizations of the project depending on which development stages of the supply chain are inter-firm market transactions and which are vertically integrated. Different economic organization structures also imply different terms and conditions for partnership agreements among principles.    

The transaction is the basic unit of analysis of [A]TCE; it is the relation between a buyer and a supplier in which a potential conflict threatens to undo an opportunity to realize mutual gains. It not only defines trade between a buyer and a supplier, but also governance is the means by which order is achieved in the relation. (Williamson, 1996) Depending on several dimensions of the transaction (e.g., the specificity of the exchange assets and credible commitment of the parties to the various contract agreements), the transaction may help increase confidence and trust between the engaged parties, providing the potential for continuity of the relationship.

Human and environmental risk factors. Economic governance involves the interactions of human agents. This raises one human and one environmental condition of the supply chain. First, the constant cognitive limitations (i.e., the bounded rationality) of the agents to the task at hand and their constant propensity for guileful self-interest (i.e., their opportunism) are human contextual conditions of governing the transactions of the supply chain; they are always present. Second, the market parameters of uncertainty and the extent the exchange process is comprised of small numbers of traders are variable environmental risk factors. When the environmental factor of uncertainty is impacted by the contextual human condition of bounded rationality, uncertainty impacts the transaction in the form of transaction costs due to market/organizational failure. When the environmental factor of small number exchange is impacted by the contextual human condition of opportunism, small number exchange impacts the transaction in the form of transaction costs due to market/organizational failure. The overall lesson is that market failure does not occur in a vacuum; it takes the impact of the human risk factors of bounded rationality and/or opportunism on uncertainty and/or small number exchange to create a transaction cost that impacts the integrity of the transaction. Transaction integrity is improved by contract clauses that economize on one or both human risk factors. Transaction integrity deteriorates and maladaptation sets in when contract clauses ignore or avoid dealing with human risk factors. Proper design and insertion of carefully crafted and negotiated clauses backed up by credible commitment are critical.

An economic organization is on the whole a large network of inter-firm contracts each of which forms an interface with the external commercial world on one end and on the other forms a chain of intra-firm (employment) relations each of which is a part of the internal organization of a firm or government body in the supply chain. The problem of economic organization is a problem of contracting; contracts are the operational expressions of economic exchange; contracts give dimension, structure, and a framework to an agreement that has economic organization implications.  The economic organization of infrastructure projects is prone to transaction costs because of the transaction specificity of infrastructure assets. These assets are specific to this transaction and to no other such that investing in continuity is likely to have high returns. Because infrastructure assets are non-redeployable, returns to these assets outside of the transaction are negligible.

The economic governance of the inter-firm contracts of infrastructure projects is defined by identifying governance structures, which differ in discreet structural ways (e.g., in costs and competencies), as means by which to manage transactions, and joining these two in a discriminating transaction cost economizing way. It is worth noting that governance structures are of two kinds for the project financed BOT project under discussion: the generic governance structures of markets, hierarchies, and hybrids; and the financial governance structures of debt and equity. Debt and equity governance structures for financial transactions are analogous to market and hierarchy governance structures for generic transactions, both have unique costs and competencies, as indicated below.

For generic transactions, costs and competencies vary according to asset specificity in the following manner, for: 1. market governance structures — low cost, incentive intensity, and autonomous adaptation; 2. hierarchy governance structures — administrative control and cooperative adaptation; and 3. hybrid governance structures — the mixed market autonomous (A) and hierarchy cooperative (C) kinds of adaptation. For financial transactions, costs and competencies vary according to debt and equity shares; equity has few if not zero contractual constraints while debt has many; security is preemptive for debt but residual claimant for equity owners; and active management is nil for debt but extensive for equity.  Higher shares of debt financing lead to an increased number of contractual constraints, an increased sensitivity of creditors to terminate a project, and an increase in the constraints placed upon equity owners regarding active management of the project. Together, these hazards are indicative of misaligned financial and generic governance incentives and potential maladaptation of the transaction. (For more detail about the way the cost of governance varies with asset specificity and the governance structures of markets, hierarchies and hybrids, the topic of economic governance will be presented in mathematical terms in a future update of this website.)

The attributes of transactions are uncertainty, frequency and asset specificity, of which asset specificity is the most important. Governance of the intra-firm (employment) relations in infrastructure projects is determined by attributes of the administrative organization of hierarchy and sequential decision-making.

 Transaction costs are the “costs of running the economic system.” (Arrow, 1969, p.48); the economic system is a nexus of contracts comprised of the economic incentives of the agents involved. Viewing the economic system from the perspective of contract, transaction costs are the cost of contracting. (Williamson, 1996, p.5) Transaction costs come into sharper focus for designing treatment remedies when thought of in combination with the human risk factors of bounded rationality and opportunism and their impact on the market parameters of uncertainty and small number exchange. Economizing on these human risk factors by way of inserting attenuating institutions or mechanisms into contract clauses relieves the specific contract hazard, particularly if credible commitment by both parties is present. Thinking of these clauses as plausible assignments in property rights helps to clarify the economic utility of these insertions as well as shed light on any complementary design measures that are needed to make certain performance occurs as expected.

Transaction cost analysis is the “examination of the comparative costs of planning, adapting, and monitoring task completion under alternative governance structures.” (1996, p. 58)  More generally, economic governance is concerned with the identification, explication, and mitigation of all forms of contractual hazards.

Governance structure is a general term for the institutions and mechanisms which are inserted into contracts to enable risk mitigation and greater exchange efficiency and effectiveness.  Look upon the three generic governance structures of markets, hierarchy and hybrid (the same can be said of the financial governance structures of debt and equity) as unfinished institutions that will need additional mechanisms inserted as clauses into the transaction contract to enable satisfying the specialized demands of the transaction under review. There are different forms of governance structures, as there are different kinds of transactions and contracts. 

All complex contracts are incomplete due to the constant human limitations of cognitive capacity (technically referred to as bounded rationality), making it costly to write a contingent contract under all states of the world.  (See item immediately following.) (Interestingly, most PPP infrastructure contracts are contingent contracts written under all states of the world and carry large hazard premiums.)

Contracts are effectively incomplete if (i) not all relevant future contingencies can be imagined; (ii) the details of some of the future contingencies are obscure; (iii) a common understanding of the nature of the future contingencies cannot be reached; (iv) a common and complete understanding of the appropriate adaptations to future contingencies cannot be reached; (v) the parties are unable to agree on whether actual adaptations to realized contingencies correspond to those specified in the contract; and (vi) even though both the parties may be fully apprised of the realized contingency and the actual adaptations that have been made, third parties (e.g., the courts) may be fully apprised of neither, in which case costly haggling between bilaterally dependent parties may ensure. (Williamson, 1996)

 Contract promises are not self-enforcing due to the constant existence of guileful self-interest (technically referred to as opportunism), making it costly to write a contract based on promises without more than reliance on the courts, domestic or international as final arbiters. (Interestingly, most PPP infrastructure contracts are of the contract-as-promise kind and also carry large hazard premiums.)  

Farsighted contracting occurs when counterparties operate out of an incomplete contracting setup, but who adopt a contracting-in-its-entirety approach and insert superior institutions and mechanisms into their contracts to fill gaps and mitigate against contract hazards.

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