The importance of incentives in making public private partnerships (PPP) work

By Nour El Hoda Farrag

Governments’ objectives have been called into question regarding capital intensive infrastructure projects in which private sector investors participate. At least two cases we’ve studied, Poland’s A2 Motorway and India’s Dharavi, allude to such tension. The cases, however, also establish governments’ inability to undertake such projects on their own, and the importance of the private sector in securing financing needed and ensuring coordinated, efficient execution. The purpose of this blog is not to evaluate governments’ decision to implement such projects, but to highlight challenges faced by the government once the decision has been made and to defend incentives offered to attract private sector players.

In India’s Dharavi case, improvement/redevelopment of India’s largest slum was product of a long iterative process; the idea has been around since the 1970’s. The final and only successful attempt to get traction from private sector participants was based on a strong incentive scheme, which leveraged booming real estate prices. The project’s economics as set forth in the case suggest that real estate developers can only benefit from the gain achieved on the sale of commercial projects. At a profit margin of 10%, the project’s economics are unattractive against a system lending rate of 13% for 2008. After incorporating “bidder’s premium” captured by the government, net profit represented 39% (not taking into account time value of money) of the equity tranche contributed by the private sector. This implies that in order to recover their equity and earn a profit, private investors might need to refinance the loan portion as the underlying value of the project increases, and dividend out proceeds. Alternatively, private sector developers can employ creative design (increased tower/unit density) to maximize profit, but this is subject to government limits/ratio of commercial to residential land utilization. Accordingly, government’s bidder’s premium, representing 6% of total cost and revenue, is relatively insignificant. In my view, the purpose of such premium is to fend off public criticism of squandering/giving away public assets, and not to profit from the slum’s redevelopment.

Similarly, in the case of Poland’s A2 Motorway, private investors’/industrials’ estimated financial IRR was 10% over 23 years of the 40-year “build-operate-transfer” (BOT) contract, according to my calculation (assuming no increase in revenue beyond year 23, IRR falls to 8%). Against a backdrop of 10% inflation rate and 17% bank lending rate for 1999; such returns are not attractive. However, aggregated with income earned from actual development enhances the project’s feasibility for private investors, while their equity contribution (“skin in the game”) hedges execution risk.

Coming from a developing country, I have witnessed government-promoted developments that came under public pressure. Especially in real estate projects, critics fail to attribute improved conditions/land prices to the projects’ success with the benefit of hindsight. In one example, the government had offered land at discounted prices to a real estate developer who in turn had transformed it into high-profile and over-subscribed developments for middle-income households. The developer introduced basic infrastructure to what otherwise would have remained a desert. Had he not been properly incentivized to do so, none of his successful projects would have come to fruition. Granted, the project was a for-profit development, it contributed to the country’s much-needed sustainable urban development, while the government earned a mild return in-kind, and through taxes post-completion.

If we agree that such infrastructure projects are critical from a sustainable development point of view, creating an offer that private sector investors can’t refuse is critical to successful implementation, which in turn should be the government’s main objective.  Because long-term government backing in such projects is essential, private investors also bear significant political risk, which should be acknowledged and compensated for.