Private capital. A resource for building

When the private sector acts as an investor in the construction of public works, it takes on a crucial role that is very often considered only for its monetary aspect and thus, not easily understood. This is why it is necessary to talk about the benefits and what should change.

When teaching issues related to public service contracts, students sometimes initially forget they are training to be economists and let themselves be persuaded by what some journalists have hurriedly written or by some biased website, promoting projects rather than social welfare.
Students, required to make some initial reflections, often make hasty statements about some well-known infrastructure project, and some political ideology can creep insidiously into their logical reasoning.
So, as teachers and researchers, we note down these observations at the beginning of the course, in the hope that, after dozens of hours of lessons and pure reasoning with the students, we can go back to those initial statements and state that the time spent together has not been in vain.
The first frequent error is thinking that the role of the private party in the infrastructure sector stems from the need to find private funding to cover the costs of the projects that the public sector may find difficult to cover, due to budget constraints. In fact, private capital is typically more expensive than public capital, because it requires a return that covers the business risk.
So recourse to private capital is justifiable not as such, but because it becomes the instrument through which one can obtain an efficient allocation of risks. Investing equity capital and becoming responsible for the construction and management of an infrastructure, the private contractor acquires incentives for the proper implementation of the project, aligning their interests with those of the public contractor and the users.
Whoever thinks it is necessary to resort to private capital to overcome public budget constraints also typically tends to make a second, consequential error, that is, thinking that it is necessary to ensure the return to the investor, through favorable contract terms. This approach undermines the very reason why we resort to private capital. Ensuring a return to the entrepreneur means isolating the risks of construction and infrastructure management, and acting to provide performance incentives. Furthermore, without the transfer of these risks to the contractor, there is a lack of any incentive for the latter to choose to invest in projects based on a realistic and accurate financial plan. Contract and Procurement Design for PPPs in Highways: the Road Ahead, by the IEFE research center of Bocconi University, has examined the international practice in highway contracts, in the light of the economic theory of incentives, procurement, and regulation, and it emphasized that in the absence of a proper allocation of risks, the use of private capital will necessarily lead to increased construction and infrastructure management costs. It also highlighted that it is also appropriate to transfer some of the traffic risk (i.e. the financial risk associated with incorrect predictions about traffic and the earnings that come from it, on the road under consideration) to the contractor, proposing, however, that it be lower in the first period of the contract, especially for greenfield projects – referring to works yet to be built – where initially little information on the traffic is available. The third mistake that is often made is thinking that the State, as regulator, can intervene to change the rules of the market whenever the economic conditions make it desirable or when the preferences of the population change. If there is no guarantee of a return to the private investor, nevertheless, compliance with the signed agreement must be ensured, since that is what the private party bases its estimates of expenditure, income, and investment on. Respecting the contract is a prerequisite for efficient market development.
The highway contracts awarded over the years in Italy have had different approaches on key issues, and there are currently about six different formulas for tariff regulation. For those to come, we should think about introducing different rates depending on the date of purchase, frequency of use or time, and revising the tariff regulation, so as to prevent the traffic risk from being transferred to the users. Today, the ‘rebalancing’ contracts provide for tariff increases when the traffic level is low (in order to compensate the contractor for the loss of earnings), further worsening the conditions of the demand and acting unacceptably, both economically and socially.
There also needs to be some serious reflection on the phase of the contract award. A well-designed call for tenders that is accompanied by a proper risk allocation allows selecting companies that are able to build and manage lowcost high-quality infrastructures. Inappropriate guarantees for investments or allocations of risk alter the selection phase, leading to the choice of not the highest bidder but the company that is best able to predict how to take advantage of the guarantees and obtain affordable variations during construction. Contracts with standard clauses, freely available to the public sector, are a necessary step for a healthy development of the market.
There is a long road ahead, but the path is shown by the economic studies based on pure reasoning and empirical data. When teaching issues related to public service contracts, by the end of the course, it is also common for students to express some enthusiasm about converging toward these same positions.


(Abstract from Autostrade per l'Italia's Magazine "Agorà")