There are good reasons why privately financed infrastructure projects become significantly more expensive – and slower to complete – than planners anticipate. One solution is to bring in private financing only after a project is completed.

CAMBRIDGE – As an old tale has it, there once was a competition between two pianists. After listening to the first pianist, the jury awarded the prize to the second. There was no need to listen further, because who could possibly be worse?

The same logic may seem to apply to public-private partnerships (PPPs) to provide infrastructure such as roads, power, water, airports, or the development of major tourist areas. In fact, listening to both contestants, and assessing their strengths and weaknesses, is essential.

The first pianist is public provision, which faces two challenges: an incentive (or corruption) problem and a budget problem. The incentive problem stems from the fact that when governments procure a road project, the winning contractor may cut corners, because he gets to pocket the savings. He might even share those savings with the government officials supervising the contract. The budget problem stems from the fact that there is only so much that a government can safely borrow, because it will have to raise future taxes to repay the debt. As a consequence, many worthwhile projects must be postponed.

In comes the second pianist. Suppose the project is a highway structured as a toll road with a 20-year concession. This seems to solve both the incentive and budget problem. The contractor will be responsible for the increased maintenance cost if he cuts corners at the time of construction, presumably making him more likely to do high-quality work. He also would have an incentive to run an efficient operation, because he gets to keep the savings. In addition, because the project is financed by tolls, it need not be limited by fiscal constraints.

Liberating a project from budgetary and public debt constraints can work wonders. Some 73% of Liberia’s citizens have cell phones, but only 9.1% have electricity. This is because energy infrastructure is financed mainly with budgetary resources, whereas cellular telephony is provided privately. When projects are structured so that beneficiaries pay for them through service fees, markets can deliver them. When budgetary resources are needed, things move more slowly.

So it would seem that the second pianist wins. But life is more complicated than the story, owing to the problems that may arise over the course of a project.

The first challenge that a project must address is whether it is a good idea. Answering this question requires an appraisal or pre-investment process that can be very expensive, and the outcome may be no better than a good guess, leaving many uncertainties.

For example, in the early phase of a highway project, the geology relevant for road design and construction, the amount of future traffic, the environmental impact, and the public response are unknown or only partly known. Most developing countries I know spend too little money devising good projects. When the private sector does, transforming ideas into bankable projects is often very difficult because many difficult-to-coordinate public-sector decisions or actions are involved.

So, let’s assume that a toll road project is approved, a concession contract is prepared, and companies bid on it. The bidders need to plan for two phases: engineering, procurement, and construction (EPC), and a longer phase of operation when toll revenue is collected to recover incurred costs and expected returns.

There are plenty of uncertainties in both phases, but especially during EPC, which may last 3-7 years, depending on the project. Given the risks in this phase, capital markets demand that it be financed with more equity than debt and have an expected internal rate of return that often reaches 18% or higher. When construction is completed and the road put into operation, the lower risks and stable cash flows allow for more debt financing by a different set of more conservative investors, such as pension funds, which expect returns of 5-7%, allowing the initial investors to cash out.

So, the project involves quite sophisticated financial engineering. Almost always, such plans cannot be realized unless the government provides guarantees against geological or traffic risks. Negotiating such agreements often adds four years to the project – to get to the so-called financial closing – before any physical work is done. In addition, there are so many details to be negotiated and supervised that opportunities for malfeasance by government officials abound.

This means that neither the incentive/corruption problems nor the budget/public-debt problems that the second pianist was supposed to eliminate actually go away. It also means that there are good reasons why privately financed projects become significantly more expensive, given the higher cost of capital, and why completing them can be much, much slower. Moreover, the second pianist does not do away with the need for a capable and honest state, able to design and manage such complex projects. But this may not be the best way to deploy government capacity.

An alternative is to concentrate the role of the private sector in the latter phases of the project. The best option may be for the government to build the road and sell the concession for operation and maintenance. This allows the government to cash out and reinvest the resources in pre-investment and EPC, thus recycling scarce public capital more quickly while cutting out the most expensive and slowest parts of private involvement.1

For other projects, such as the development of major tourism areas, the government must incur significant pre-investment and public infrastructure costs if it is to make them bankable. Recovering these costs would require participating in the project or co-investing with the private sector through some financial vehicle that also manages the project on behalf of the government.

This requires institutional capabilities that many countries do not have and that the development community has not fostered. But these capabilities could make a very large difference. That is why Albania’s government, with the help of Harvard’s Center for International Development (which I direct), is planning to create the necessary investment vehicle. Given the stakes, the many challenges and difficulties ahead will be worth it. As the pianists would say: Stay tuned!

© Project Syndicate

This blog was originally published by Project Syndicate here.