Analysing Public Private Partnership - Master Thesis Msc In Finance And International Business

DEPART MENT OF BUSINESS ADMINISTRAT ION BUSINESS AND SOCIAL SCIENCES AARHUS UNIVERSIT Y Analysing Public-Private Partnership Master thesis MSc in Finance and International Business Author: Jurgita Jakutyte Student ID: JJ91185 Academic supervisor: Jingkun Li September, 2012 T ABLE OF C ONTE NTS Introduction Problem statement Structure Delimitations Literature review 11 1.1 Definition 11 1.2 Types of PPPs 16 1.3 Reasons for implementing PPPs 19 1.4 value for money 21 1.5 Advantages and disadvantages of PPP 26 1.6 Criticism of PPPs 29 Analysis 32 2.1 The project 32 2.2 Alternatives for project implementation 32 2.3 Identifying an appropriate PPP scheme 34 2.3.1 Overview of Lithuania’s legal PPP environment 34 2.3.2 Choosing a PPP scheme 38 2.4 Cost and benefit analysis 39 2.4.1 Assumptions overview 40 2.4.2 Data overview 46 2.4.3 Financial analysis 48 2.4.4 Socio-economic analysis 49 2.4.5 Sensitivity analysis 52 2.4.6 Overview and the discussion of the CBA results 56 2.5 Factors not covered by CBA 58 Conclusions 63 Bibliography 66 Appendices 73 Page | C ONTE NT OF F IGURES Figure European PPP trend, 1990-2009 Figure Cash flows in PPP and traditional procurement mode 16 Figure Structure of Public Sector Comparator 22 Figure Optimal risk allocation point 23 Figure Model for risk allocation 24 Figure Identifying Value for Money 26 Figure PPP scheme under economic activity 37 Figure PPP scheme under social activities 38 Figure Sensitivity analysis – FNPV on investment 53 Figure 10 Sensitivity analysis – FNPV on capital 54 Figure 11 Sensitivity analysis - Socio-economic results 55 C ONTE NT OF T ABLE S Table Distribution of investment costs, % 46 Table Financial return on the investment costs –PPP and traditional procurement approach 48 Table The structure of financing in PPP and traditional procurement approach 48 Table Financial return on capital – PPP and traditional procurement approach 49 Table Assumptions for the socio-economic analysis 51 Table Net benefits of non-market impact 51 Table Socio-economic analysis results 52 Table Sensitivity analysis – change in demand 55 Page | L IST OF A BBRE V IAT IONS BBO Buy-Build-Operate BOOT Build-Own-Operate-Transfer BOT Build-Operate-Transfer CBA Cost-Benefit Analysis CO2 Carbon dioxide CPVA Central Project Management Agency DBFO Design-Build-Finance-Operate DBOM Design-Build-Operate-Maintain EPEC European Public-Private Partnership Expertise Centre EIB European Investment Bank ENPV Economic net present value of investment EU15 European Union of 15 member states FNPV/C Financial Net Present Value of the Investment FNPV/K Financial Net Present Value of Capital FRR/C Financial Rate of Return of the Investment FRR/K Financial Rate of Return of Capital IMF International Monetary Fund Kg Kilogram Km Kilometre OECD Organization for Economic Co-operation and Development PPP (3P) Public-Private Partnership PSC Public Sector Comparator PwC PricewaterhouseCoopers SPV Special Purpose Vehicle STPR Social Time Preference Rate t tonne tkm tonne-kilometre VAT Value Added Tax VFM Value for Money WACC Weighted Average Cost of Capital Page | I NT RODUCTION PPP (3P) – public-private partnership – a concept used widely in the public procurement that lacks both clarity and united definition (Meidute & Paliulis, 2011) The concept has no clear boundaries for distinguishing what kind of private and public partnership is assumed to be a form of PPP or a form of a traditional procurement This results in some confusion, both in the academic literature, as well as within the international experiences Nevertheless, PPP, in general terms, could be defined as a long term contractual relationship between a public and private sectors, which is usually characterised by having features such as bundling of functions, exchange of resources, shared responsibility, risks and rewards, and is arranged with the aim to provide a public service/asset PPP is not a new phenomenon even though it is perceived as such due to its recent popularity Growing interest is a result of changing attitudes as well as expectations of the society towards the government and public services (Grimsey & Lewis, 2004) Today society expects to see the government more as a governor and regulator rather than the direct provider of public services In addition, it requires infrastructure of better quality, more efficient provision of public services, as well as better use of public money Considering all this, PPPs are seen as a procurement mode that may satisfy these changing needs Nevertheless, PPPs are not a ‘miracle’ solution (European Commission, 2003; Harris, 2004; Meidute & Paliulis, 2011) to the problems of the conventional procurement; they are complex and expensive and, as a result, only certain projects qualify for the use of publicprivate partnerships The figure below shows the trend of growing interest in the use of PPP within Europe for the period of 1990 – 2009 It is important to note that between 1990 and 2004 from all PPP projects more than half were arranged in the United Kingdom Only recently the trend has changed and other European countries have experienced increased use of PPPs (EIB, 2010) Page | 35.000 160 30.000 140 25.000 120 100 20.000 80 15.000 60 10.000 40 5.000 20 Number of projects Value of projects, mln € Figure European PPP trend, 1990-2009 Years Value of projects Nuber of projects Source: Adopted from EIB (2010, p 7) Even though, the numbers are increasing, the portion of PPP projects in the overall public procurement is still not that significant (Appendix 1) For example, in the United Kingdom, the biggest producer of PPP projects, public private partnerships represent only 10-13% of all public infrastructure projects (Deloitte Research, 2006) Having this in mind, the question rises, why PPPs represent such a small fraction of all public projects if they deliver benefits such as greater efficiency, timely delivery of public projects, better quality of service provision, etc.? In order to try to answer this, the paper examines the concept of public-private partnership and reviews the advantages, disadvantages, and the reasons why PPPs are implemented In addition, the case study is perf ormed where the conventional procurement approach is compared to public-private partnership The paper investigates what PPPs are, what they deliver and when they prevail over the conventional procurement approach P ROBLE M ST ATE ME NT The aim of the paper is to analyse the concept of public private partnership and its suitability for a procurement of a public project The objectives of the thesis are achieved by reviewing the relevant literature and performing an analysis on the Page | case study by examining the different procurement approaches available for the project: PPP and conventional procurement The analysis will answer which procurement approach should be the appropriate one for the case study concerned S T RUCTURE The paper is divided into two main parts The thesis is structured in the way that from the very beginning an understanding of the concept of PPP could be developed, which is used for the second part of the thesis, where the analysis is performed The first part of the thesis provides an extensive discussion on the theoretical foundations of public private partnerships It focuses on the discussion of the relevant concepts, characteristics, types, advantages and disadvantages of the PPP The first part of the paper answers questions, such as: what PPPs are, why such a procurement mode is practiced and how it differs from other procurement approaches, such as conventional procurement and privatisation The second part of the thesis is the analysis of the case study It is divided into two main sections The first section includes an overview of the project’s background and its adequacy for a PPP It further includes a review of the Lithuanian environment regarding PPP law and provides a discussion on the suitable PPP form for the infrastructure project concerned The second section of part two consists of the cost and benefit analysis, which involves the following steps:  Data overview (identification of costs and benefits, assumptions);  Financial analysis;  Socio-economic analysis;  Sensitivity analysis;  Overview of the results Page | In addition, the second part of the thesis is expanded with a discussion on other factors that are not covered by CBA, however, factors that are relevant when a PPP approach is considered The last part of the paper concludes the discussion on public-private partnerships and the analysis performed M ET HODOLOGY The paper is written by following the deductive, in other words, a “top-down” approach The paper begins with the general overview of the theory and then narrows down to the analysis of a specific case study In addition, the paper is based on the secondary sources The first part of the paper emphasises on the literature review The literature review is based on the European Commission, EPEC, Hong Kong Efficient unit, Victoria Partnership guidance on PPPs, reports of OECD, IMF, PwC, Deloitte, and views provided by a variety of PPP researchers – such as Grimsey and Lewis, Akintoye, Hodge, etc The articles, books and reports used in the paper were accessed through a variety of research databases, such as OECD iLibrary, Science Direct, Business Source Complete, etc The second part of the paper emphasises on analysing a particular public-private partnership project The analysis is carried out by performing a cost-benefits analysis (CBA) while employing guidance of the European Commission: “Guide to Cost Benefit Analysis of Investment projects: Structural Funds, Cohesion Fund and Instrument for Pre-Accession” (2008) and “Guide to cost benefit analysis of investment projects” (2002) Some additional insights for the application of CBA have been adopted from OECD (2006), Boardman, Greenberg, and Vining (2011) and Campbell and Brown (2003) Cost and benefit analysis is a technique used to identify, measure and compare benefits and costs of an investment project and it is used to assist the decision maker in choosing the most beneficial project from the alternatives available Page | (Campbell & Brown, 2003) In this paper cost and benefit analysis is used as a tool to determine the main differences between procuring a project through a traditional procurement mode and a PPP It should be noted that the CBA used in this paper does not try to compare different project implementation alternatives The idea of the analysis is to compare the same project financed by public and private funds Therefore, it could be said that the aim the cost and benefit analysis performed in this paper is to understand whether the inclusion of the private partner in the public procurement influences the investment decision rule – whether to proceed with the project or abandon it instead The addition to CBA is an overview of other factors that are not incorporated in the aforementioned analysis, which, however, are influential when the choice of procurement approach is considered The discussion on these factors is performed in accordance to the theory overview of the first part of the thesis D ELIMIT AT IONS The concept of public-private partnership encompasses a variety of different partnerships and relationships, which are not covered fully in the thesis The paper focuses on one particular PPP infrastructure approach, within which the topic is analysed What concerns the second part of the paper, due to time constraints and size limitations, the CBA is performed only to the level that is enough to identify the most important points regarding the differences between procuring a project through PPP and conventional procurement approach In addition, due to the complexity and extent of the project, the analysis has been simplified and only most important impacts taken into account As a result, there is possibility for some divergence between results presented in the paper and the reality Further development on the CBA could be made if more specific studies were conducted: for example, a detailed market demand analysis or more specific environmental The paper does not intend to compare the usual cost and benefit analysis’ alternatives: “Business as usual”, “Do minimum”, “Do something”, “Do something else” (European Commission, 2008) Page | studies examining the CO emission, air pollution, etc Moreover, due to the lack of relevant information, which is a consequence of the absence of the analogues projects in Lithuania, most of the assumptions are based on the foreign countries’ experience, especially of the more developed Western economies, which might be highly inaccurate when situation in Lithuania is considered With addition to this, it is a nature of CBA to use a variety of assumptions, which might sometimes appear to be imprecise, in particularly, when a long term project is analysed Page | 10 A PPE NDIX 1: Comparison of public investment and PPP as a percentage of GDP in European countries Source: Adopted from EIB (2010, p 17) *FR – France, DE – Germany, EL – Greece, ES – Spain, HU – Hungary, IE – Ireland, IT – Italy, NL – Netherlands, PT – Portugal, UK – United Kingdom; **UK/1 estimate of EIB, UK/2 estimate of HMT Page | 74 A PPE NDIX 2: Relationship structure of a conventional procurement approach and PPP In the traditional procurement in order to deliver the services and infrastructure required, the government acts as an intermedeary – on the one side it deals with direct users of the services, taxpayers, and financial markets, and on the other side – with other private companies (the scheme represented below) The idea behind such a flow of relationships is that the government gathers financing from side A and uses it to remunerate side B which provides capital goods necessary for the public service provision and infrastructure development Source: OECD (2008, p 41) If the project is handled through a public-private partnership, the intermediary role of the government is decreased – public authority deals with the taxpayers and the single private operator only The role of the private operator, on the other hand, is enhanced: private operator becomes responsible for handling relationships between side A and side B Here private operator takes the main role of the intermediary – it collects financing from side A (direct users of the service and financial market) and remunerates side B (other private companies) for the capital goods provided (the scheme represented below) If the private operator acts in Page | 75 accordance to the performance standard specified, in some of the cases 21, it receives additional payment from the government (Maski & Tirole, 2008) Source: OECD (2008, p 41) 21 The private operator may be remunerated in three ways: through direct user charges only, through government payment only, or through a combination of both of the payments (Grimsey & Lewis, 2004) Page | 76 A PPE NDIX 3: The structure of PPP agreements: turnkey delivery and concession Source: European Commission (2003, p 18) Page | 77 A PPE NDIX 4: Risk allocation model adopted from Chan et al (2011, p 140): Risk group Political risks Risk Risk description Systematic risk category The behaviour of the corruption of government officials will increase the cost of keeping the relationships between the government and the project company Meanwhile, it will increase the risk of contract breaking by the government Government officials intervene in the project operations directly, which will affect the autonomy of private investors’ decision making Risk allocation Nationalization/expropriation Central or local government seizes the projects Public Public credit The rejection of government to implement the responsibilities agreed in the contract, which brings direct or indirect damages Non-standardized procedures, bureaucracy, lacking of PPP project experience and ability, insufficient preparation and information asymmetry, leading to poor decision making Public The loss of PPP projects arising from the uncertainties of the interest rate volatility The risk of the variability of foreign currencies exchange and the foreign currencies exchangeability risk The increase of the price level of the commodities, the decrease of purchasing power of currencies, which cause the increase of cost and other consequence Private Government corruption Government intervention Poor public decision-making process Economic risks Interest rate fluctuation Foreign exchange fluctuation Inflation Public Public Public Private Private Page | 78 Financing risk Legal risks Social risks Natural risks The risk arising from the irrational financing structure, unsound financial market, and difficulty in financing Legislation change Change of law and regulations and other government macroscopic economic policies will cause the increase in project costs and decrease in revenue, etc Imperfect law and supervision The damage arising from the current PPP system legislation which is low level, low effectiveness, conflict bearing, and poor operability Change in tax regulation The change in tax regulation of central or local government Political/public opposition For various reasons leading to the public interest being unprotected and damaged, which, as a consequence, causes political and even public opposition to the risk of the project construction Force majeure Before signing contract, the contract party cannot control or prevent reasonably When the events happen, the situation cannot be escaped or conquered, such as a worker strike, or other unforeseen items that are not “natural” risks Unforeseen Because of the project site’s bad natural weather/geotechnical conditions, for example, climate condition, special conditions geographical environment, and poor site conditions, etc Environment risk Because of the increasing requirement of the government or social organization regarding the environment protection, risk generated from the project cost increase, delay in work schedule, or other loss Specific project risk category Private Public Public Public Public Public Private Equally shared Page | 79 Construction risks Completion risk Material/labour non-availability Unproven engineering techniques Operation risks Project/operation changes Operation cost overrun Price change Expense payment risk Market risks Market competition (uniqueness) Project delay and cost overrun, etc., which cause insufficient cash flow and inability to pay off debts on time Loss because of delay in raw materials, resources, machines and equipment, or energy supply The techniques adopted are immature and cannot fulfil the standards and requirements as expected, or the techniques are of poor applicability which makes private investors to reinvest for the technology improvement Poor constructability in design phase, design error or vagueness, standards and contracts variation, owners’ variation leading to the project, or operation changes Government raises the standard of the products or services leading to the cost overrun by the noncommercial factors such as increase in interest rates, exchange rates or force majeure, or poor operation management Price of PPP products or services are too high, too low, or inflexible to adjust, leading to the revenue of the project company lower than expected Infrastructure of the project or the process of the service provision is affected by other factors which prevents the timely payment of the client’s (or government’s) fees An actual market competition of the existing project caused by the new project or rebuild project of government or other investors Private Private Private Private Private Private Private Public Page | 80 Change in market demand Relationship risks Third-party delay/violation Organization and coordination risk Inability of the concessionaire Other risks Land acquisition Delay in project approvals and permits Conflicting or imperfect contract Lack of supporting infrastructure Apart from the risk from arising from market competition, factors attributed to macroeconomics, social environment, change in population, adjustment of laws, and regulations leading to the change in market demand Apart from government or private investors, other project participants not implement the responsibilities agreed in the contract or project delay Because of the insufficient coordination ability of project company, the cost of communication among project participants increases and conflicts occurs The insufficient ability of the concessionaire leading to low productivity of project construction and operation The increase in project cost and extension of project duration caused by the difficulty of acquiring the rights of the land The cost and time for land acquisition exceeds the original plans Complicated procedures are required for project approval with high cost and long time Upon approval, it is very difficult to proceed business adjustments regarding the project scope and nature The risk of the contract with inaccuracy, vagueness, inflexibility, inconsistency, inequitable risk-sharing, unclear division of responsibility, etc The risks generated by the unavailability of the supporting facilities of the project Private Private Private Private Public Public Private Public Page | 81 Residual risk Inadequate competition for tender Investors overuse the resources like equipment or other technical conditions, etc., which cause insufficient materials and equipment with depreciation at the end of the concession period As a consequence, it affects the continuous operation of the projects The risk includes unfair, non-transparent tendering process, incomplete tender information, insufficient number of tenders, vicious market competition, and bidding lowest price to win the tenders Private Public Page | 82 A PPE NDIX 5: Location of a wharf The wharf is going to be located in Kaunas (green star in the figure), in such a way connecting Kaunas and Klaipėda, where the most important Lithuanian transport point, connecting road, rail and sea transport, locates Source: Adopted from Lithuanian Inland Waterway Authority (2008) Page | 83 A PPE NDIX 6: The average cost of equity (rate of return) 10 Company name TEO LT Klaipėdos Nafta Utenos Trikotažas Lietuovs Dujos Apranga Rokiškio sūris Grigiškės City Service Kauno energija Vilniaus baldai Average ROE, 2011 m 15,4% 9,5% 16,4% 4,6% 20,2% 9,6% 13,8% 16,5% 5,1% 31,9% 14,3% *All data has been extracted from the financial accounts of the corresponding companies, available at http://www.nasdaqomxbaltic.com Page | 84 A PPE NDIX 7: GDP deflator and the average growth of per capita consumption I GDP deflator: GDP deflator Year Base year 2000* 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 70.353 84.548 95.044 99.647 98.812 100.000 99.745 99.795 98.875 101.510 107.259 114.314 124.171 136.122 145.416 151.438 155.944 161.418 165.556 Base year 2000* 0,436 0,524 0,589 0,617 0,612 0,620 0,618 0,618 0,613 0,629 0,664 0,708 0,769 0,843 0,901 0,938 0,966 1,000 1,026 * Data is extracted from Data and Statistics database of the International Monetary Fund (http://www.imf.org) ; ** Own calculations based on the data extracted from International Monetary Fund database II The average growth of per capita consumption: Year 1995 1996 1997 1998 1999 2000 2001 2002 Household Household Household consumption consumption Average income per Change, at current at constant prices number of capita, % prices, (base year - 2012 ), inhabitants* Mln LTL Mln LTL* Mln LTL** 17.051 39.122 3.629.100 0,010780 21.792 41.605 3.601.600 0,011552 7% 25.025 42.501 3.575.200 0,011888 3% 28.132 45.571 3.549.300 0,012840 8% 29.220 47.733 3.524.200 0,013544 5% 30.437 49.131 3.499.500 0,014040 4% 32.572 52.712 3.481.300 0,015142 8% 34.583 55.938 3.469.100 0,016125 6% Page | 85 2003 2004 2005 2006 2007 2008 2009 2010 37.709 41.819 47.578 54.329 63.153 72.285 62.605 61.101 61.562 66.499 71.602 76.716 82.097 85.718 69.494 65.128 3.454.200 3.435.600 3.414.300 3.394.100 3.375.600 3.358.100 3.339.400 3.286.800 0,017822 0,019356 0,020971 0,022603 0,024321 0,025526 0,020810 0,019815 Average 11% 9% 8% 8% 8% 5% -18% -5% 4,41% * Data extracted from The Lithuanian Department of Statistics (Statistics Lithuania) at http://www.stat.gov.lt/lt/; ** Own calculations based on data extracted from The Lithuanian Department of Statistics Page | 86 A PPE NDIX 8: Sensitivity analysis Change in discount rate: Traditional PPP procurement Discount rate, % 5% Financial return on investment FRR/C , % 11,2% 11,2% FNPV/C, thou LTL 23.812,1 23.812,1 Financial return on capital FRR/K , % 11,6% 14,1% FNPV/K, thou LTL 26.158,1 25.047,8 Economic performance indicators ERR, % 108,8% ENPV, thou LTL 595.602,5 Discounted B/C index 7,91 Traditional procurement 10% PPP 11,2% 2.843,2 11,2% 2.843,2 11,6% 3.868,2 14,1% 6.478,7 108,8% 329.770,3 6,51 Changes in demand, PPP and traditional procurement approach: Change in demand Base scenario 5% -5% 10% -10% Traditional Procurement FRR/C 11,2% 12,2% 10,2% 13,2% 9,1% FNPV/C, thou LTL 18.494 22.353 14.636 26.212 10.780 FRR/K 11,6% 12,6% 10,6% 13,6% 9,5% FNPV/K, thou LTL 20.522 24.547 16.497 28.573 12.474 ERR 108,8% 113,1% 104,3% 117,4% 99,8% ENPV, thou LTL 531.594 560.717 502.471 589.840 473.349 Discounted B/C index 7,63 7,91 7,35 8,18 7,06 Difference from the base scenario FNPV/C 20,86% -20,86% 41,73% -41,71% FNPV/C 19,61% -19,61% 39,23% -39,21% ENPV 5,48% -5,48% 10,96% -10,96% Public-private partnership FRR/C 11,2% 12,2% 10,2% 13,2% 9,1% FNPV/C, thou LTL 6.364 9.150 3.578 11.937 793 FRR/K on national capital 14,1% 15,7% 12,5% 17,3% 10,9% FNPV/K on national capital, thou LTL 20.269 24.295 16.245 28.321 12.222 FRR/K on private equity 14,1% 15,7% 12,5% 17,3% 10,9% FNPV/K on private equity, thou LTL 9.537 12.435 6.640 15.333 3.743 ERR 108,8% 113,1% 104,3% 117,4% 99,8% Page | 87 ENPV, thou LTL 531.594 Discounted B/C index 7,63 Difference from the base scenario FNPV (C) FNPV (K) on national capital FNPV (K) on private equity ENPV 560.717 7,91 502.471 7,35 589.840 8,18 473.349 7,06 43,78% -43,77% 19,86% -19,85% 30,38% -30,38% 5,48% -5,48% 87,58% 39,72% 60,78% 10,96% -87,53% -39,70% -60,75% -10,96% Page | 88