How not to argue against prison privatisation

From Stuff we learn that

Prime Minister John Key has confirmed old regional prisons are set to close and be replaced with a new privately-built prison at Wiri, in South Auckland.

I have written on prison privatisation before, see for example here, and have pointed out the good and bad points of prison privatisation.

I just wish Charles Chauvel had read my posts. If he has he would have have argued as follows,

Labour's justice spokesman Charles Chauvel said Wiri was expected to cost the taxpayer about $1 billion over 25 years but its "indirect" costs were becoming clear and were "disturbing".

"National seems to have made a decision that, rather than refurbish many regional state-owned institutions, it will simply close them. Prison closures will be a big blow to regional economies. Job losses will be significant."

Indirect costs? And how are these "costs" disturbing?

The overall number of jobs in the economy will not be much affected by the privatisation plan. There will be fewer jobs in some sectors of the economy and regions of New Zealand, but there will be more jobs in other sectors and other regions. Also seeing prisons as some sort of regional development plan seems weird, it makes imprisoning people look like a good thing that should be encouraged!

The questions Chauvel should be asking are to do with what can be contracted upon. The issues with prison privatisation arise because of the incomplete nature of the contract the government will sign with the prison provider.

More on PPPs: theory this time

The basic problem with PPPs is the writing of the contract for whatever project is being undertaken. Depending on what can be contracted on and what can't, PPPs may or may not be the way to go. To, hopefully, make this a little clearer a look at a paper by Oliver Hart is useful.

In Hart (2003) Hart put forward a simple incomplete contracts model of PPPs. Consider a situation where, for example, a government wants a new prison built and run. Lets assume there are two periods, the “build” period followed by the “operate” period. There are (unverifiable) social benefits from the prison which we will call B. The (unverifiable) costs of the prison are denoted C. Both B and C are affected by investments that the builder can make. There are two forms of investment available to the builder, i and e. An increase in i increases B and decreases C and so is beneficial all round, while an increase in e decreases both B and C. This means the builder gains from e and “society” doesn’t. Therefore we will call i productive investment and e unproductive investment. The total costs of investment for the builder are i+e. i and e are unverifiable and thus can not be contracted on.

Now consider types of contracts for building and operating the prison. First, separate contracts for building and operating the prison. Call this unbundling. Second, a PPP contract, where the builder both builds and runs the prison. This is bundling. Under unbundling, the builder sets i=e=0. That is the builder builds the cheapest prison possible while staying within the contract. Under bundling the builder sets the marginal decrease in his costs, C, due to an increase in both e and i each equal to 1.

The trade-off between unbundling and bundling is simple. Under unbundling, the builder internalises neither the social benefit B nor the operating cost C. By setting i=e=0, he does too little of the productive investment, i, but the right amount of the unproductive investment, e. In contrast, under bundling or PPP, the builder again does not internalise B, but does internalise C. As a result, he does more of the productive investment, although still too little, but also more of the unproductive investment.

The model yields a simple conclusion. Conventional provision (‘unbundling’) is good if the quality of the building can be well specified, whereas the quality of the service cannot be. Under these conditions, inderinvestment in i under conventional provision is not a serious issue, whereas overinvestment in e under PPP may be. In contrast, PPP is good if the quality of the service can be well specified in the initial contract (or, more generally, there are good performance measures which can be used to reward or penalise the service provider), whereas the quality of the building cannot be. Under these conditions, underinvestment in i under conventional provision may be a serious issue, while overinvestment in e under PPP is not.

The upsot of all of this is that the choice between a conventional unbundled contract and a PPP bundled contract turns on whether it is easier to write contracts on the operating phase of the prisons life than on the building phase. So the usefulness of PPPs depends on what can or can't be contracted on.

• Hart, Oliver (2003). ‘Incomplete Contracts and Public Ownership: Remarks, and an Application to Public-Private Partnerships’, The Economic Journal, 113 (March), C69-C76.

PPPs

At his blog Roger Kerr asks PPPs: Do They Work? His answer discusses an article on public-private partnerships by economic consultant, Phil Barry, of Taylor Duignan Barry Ltd.

Kerr writes

But do PPPs work? Here is Phil Barry’s assessment:

The formal studies that have been undertaken generally provide a qualified “yes” to that question. I say qualified because the PPPs don’t always work. And even when they do work, the PPPs are by no means perfect.

A study by the UK National Audit Office [...] provided one of the most comprehensive independent evaluations of PPPs. That study found PPPs had their flaws: of the 37 PPP projects evaluated, 9 of the projects (24%) were late and the projects incurred cost-overruns, on average, of 22%. But the experience in the public sector was a lot worse: 70% of the projects were delivered late and the cost overruns averaged 73%.

Back in 2009 I said this about the UK's experience with PPPs

Public-private partnerships (PPPs) seem to offer a solution to a common problem for economies which have been hampered by the poor quality of their infrastructure. PPPs mean, it is argued, that private capital would be used to fund much-needed projects, whether it be in transport, education, health or whatever. Better still, it was further argued, private companies could build and operate the new infrastructure, bringing large cost savings.

At the IEA website Richard Wellings discusses the British experience with PPPs. He explains Why PPPs may offer poor value for money.

Wellings writes that in the UK,

The first modern PPPs were began in the 1980s under what became known as the Private Finance Initiative (PFI). Their numbers grew during the early-mid 1990s, with several design, build, finance and operate (DBFO) road schemes, as well as the construction of a number of privately-operated prisons. These projects were generally viewed as successful within government - a higher proportion were delivered on time and on budget than would have been expected using traditional procurement methods.

Building on these foundations, the election of a New Labour government saw a rapid expansion in the number of PPPs. The model fitted well with Labour’s ‘Third-Way’ approach to the economy. Instead of outright nationalisation, with its well-documented ineffiencies, the dynamism of the private sector would be harnessed for social objectives.

By 2003/04 PPP schemes accounted for 39% of capital spending by UK government departments. And by January 2008 there were over 500 operational PPP projects with a total capital value of around £44 billion and a further number in the pipeline. Their scope was also widened, with a higher proportion used to build new schools and hospitals. Public transport became a major investment priority rather than roads.

But Wellings argues this expansion of PPPs may have been misguided. Indeed, it was arguably when partnerships started to go wrong. In particular, unlike the earlier schemes, the new projects were more likely to be in fields marked by a high level of political sensitivity. Wellings gives as an example of the problems, the London Underground PPP. He writes,

This huge project, designed to upgrade the Tube, required an annual subsidy of £1 billion. Fiercely resisted by the Greater London Authority under Ken Livingstone, who favoured an alternative bond finance scheme, it was imposed on the capital by central government with heavy Treasury backing. So even before it started the process was marked by a high level of controversy.

Extremely complex 30-year contracts were drawn up, at a cost of £455 million in consultancy fees, and the Rail Regulator was appointed as ‘PPP Arbiter’ to adjudicate any disputes. Two consortiums were selected to upgrade and maintain different sections of the network.

In 2003 the Metronet consortium began a £17 billion project covering nine out of twelve tube lines. It soon got into difficulties. In April 2004 it was fined £11 million for poor performance, but this was just the start.

Further fines followed and in June 2007 Metronet, concerned about cost escalation, requested an extraordinary review by the PPP Arbiter. A short-term cost overrun of £551 million was predicted, rising to £2 billion by 2010, and this was blamed on additional demands made by Transport for London.

But the Arbiter had a different view – most of the cost escalation could be explained by Metronet’s inefficiency and only a small fraction of the requested extra payments would be forthcoming. Faced with huge losses, the company went into administration.

The government tried to find private bidders for the Metronet contracts but failed – unsurprisingly given the uncertainty concerning costs. The public sector then became responsible for the upgrades and maintenance. Taxpayers would now pick up the bill for any cost overruns.

The events just described illustrate a key weakness of PPPs. When they involve essential infrastructure that government will not allow to fail (too big to fail?), it is clear that a high proportion of a project’s risk remains with the public sector. But such an acknowledgment undermines one of the major rationales for having PPPs in the first place, that they are good value for money despite apparently higher financing costs, because of their ability to transfer risk to private investors. A transfer that doesn't appear to have taken place.

Wellings goes on to explain that the UK experience thus far suggests that PPP schemes have failed to live up to their early promise. He offers several explanations for this:

Firstly, comparisons with public finance may understate the true cost of government funding. While it may be possible to borrow at low interest rates this is only because potential risks and losses have been offloaded on to taxpayers.

Secondly, a high proportion of recent PPPs have been plagued by high ‘transaction costs’. They have involved tortuous bidding processes and the creation of complex contractual agreements and regulatory frameworks, which have created additional costs and risks for the private-sector partners involved. Value for money has been reduced as a result.

Finally, the operation and outputs of PPP schemes have often been subject to substantial political and bureaucratic intervention. As seen with some of the public transport PPPs, a hostile relationship may develop between the counterparties. There can even be politically-motivated attempts to subvert the viability of projects. This makes it more difficult both to raise private finance and transfer risk. Investors are more likely demand a premium and contractual guarantees if they perceive political risks as high.

Wellings concludes by saying,

Accordingly, PPPs may not be a suitable funding model for some projects. The risks are particularly high in situations when government is unwilling to take a ‘hands-off’ approach. At the same time, if government will stand aside, perhaps after setting a loose regulatory framework, then depoliticisation through full-blooded privatisation may be the best option.

So overall, there are warnings from the UK experience of PPPs for countries like New Zealand who may be thinking of going down this route. PPPs do not always work and much thought must go into when and why they are used. Hopefully these warnings will be heeded. If they are there is no reason that PPPs could be a good model for some projects.

Public-private partnerships

Public-private partnerships (PPPs) seem to offer a solution to a common problem for economies which have been hampered by the poor quality of their infrastructure. PPPs mean, it is argued, that private capital would be used to fund much-needed projects, whether it be in transport, education, health or whatever. Better still, it was further argued, private companies could build and operate the new infrastructure, bringing large cost savings.

At the IEA website Richard Wellings discusses the British experience with PPPs. He explains Why PPPs may offer poor value for money.

Wellings writes that in the UK,

The first modern PPPs were began in the 1980s under what became known as the Private Finance Initiative (PFI). Their numbers grew during the early-mid 1990s, with several design, build, finance and operate (DBFO) road schemes, as well as the construction of a number of privately-operated prisons. These projects were generally viewed as successful within government - a higher proportion were delivered on time and on budget than would have been expected using traditional procurement methods.

Building on these foundations, the election of a New Labour government saw a rapid expansion in the number of PPPs. The model fitted well with Labour’s ‘Third-Way’ approach to the economy. Instead of outright nationalisation, with its well-documented ineffiencies, the dynamism of the private sector would be harnessed for social objectives.

By 2003/04 PPP schemes accounted for 39% of capital spending by UK government departments. And by January 2008 there were over 500 operational PPP projects with a total capital value of around £44 billion and a further number in the pipeline. Their scope was also widened, with a higher proportion used to build new schools and hospitals. Public transport became a major investment priority rather than roads.

But Wellings argues this expansion of PPPs may have been misguided. Indeed, it was arguably when partnerships started to go wrong. In particular, unlike the earlier schemes, the new projects were more likely to be in fields marked by a high level of political sensitivity. Wellings gives as an example of the problems, the London Underground PPP. He writes,

This huge project, designed to upgrade the Tube, required an annual subsidy of £1 billion. Fiercely resisted by the Greater London Authority under Ken Livingstone, who favoured an alternative bond finance scheme, it was imposed on the capital by central government with heavy Treasury backing. So even before it started the process was marked by a high level of controversy.

Extremely complex 30-year contracts were drawn up, at a cost of £455 million in consultancy fees, and the Rail Regulator was appointed as ‘PPP Arbiter’ to adjudicate any disputes. Two consortiums were selected to upgrade and maintain different sections of the network.

In 2003 the Metronet consortium began a £17 billion project covering nine out of twelve tube lines. It soon got into difficulties. In April 2004 it was fined £11 million for poor performance, but this was just the start.

Further fines followed and in June 2007 Metronet, concerned about cost escalation, requested an extraordinary review by the PPP Arbiter. A short-term cost overrun of £551 million was predicted, rising to £2 billion by 2010, and this was blamed on additional demands made by Transport for London.

But the Arbiter had a different view – most of the cost escalation could be explained by Metronet’s inefficiency and only a small fraction of the requested extra payments would be forthcoming. Faced with huge losses, the company went into administration.

The government tried to find private bidders for the Metronet contracts but failed – unsurprisingly given the uncertainty concerning costs. The public sector then became responsible for the upgrades and maintenance. Taxpayers would now pick up the bill for any cost overruns.

The events just described illustrate a key weakness of PPPs. When they involve essential infrastructure that government will not allow to fail (too big to fail?), it is clear that a high proportion of a project’s risk remains with the public sector. But such an acknowledgment undermines one of the major rationales for having PPPs in the first place, that they are good value for money despite apparently higher financing costs, because of their ability to transfer risk to private investors. A transfer that doesn't appear to have taken place.

Wellings goes on to explain that the UK experience thus far suggests that PPP schemes have failed to live up to their early promise. He offers several explanations for this:

Firstly, comparisons with public finance may understate the true cost of government funding. While it may be possible to borrow at low interest rates this is only because potential risks and losses have been offloaded on to taxpayers.

Secondly, a high proportion of recent PPPs have been plagued by high ‘transaction costs’. They have involved tortuous bidding processes and the creation of complex contractual agreements and regulatory frameworks, which have created additional costs and risks for the private-sector partners involved. Value for money has been reduced as a result.

Finally, the operation and outputs of PPP schemes have often been subject to substantial political and bureaucratic intervention. As seen with some of the public transport PPPs, a hostile relationship may develop between the counterparties. There can even be politically-motivated attempts to subvert the viability of projects. This makes it more difficult both to raise private finance and transfer risk. Investors are more likely demand a premium and contractual guarantees if they perceive political risks as high.

Wellings concludes by saying,

Accordingly, PPPs may not be a suitable funding model for some projects. The risks are particularly high in situations when government is unwilling to take a ‘hands-off’ approach. At the same time, if government will stand aside, perhaps after setting a loose regulatory framework, then depoliticisation through full-blooded privatisation may be the best option.

There are warnings from the UK experience of PPPs for other countries, New Zealand?, thinking of going down this route. Hopefully these warnings will be heeded.