Balancing Incentives in Public-Private Partnerships: The Case of Toll Roads

Assuming that an adequate general framework is in place, the existence of adequate incentives addressing both developmental and commercial concerns are key to the creation of consistent and reliable partnership between private and public entities. Our main focus is to highlight different policy issues raised and results to be considered when a government is putting together a bidding proposal and a concession to develop a toll road project in partnership with the private sector. Transportation, and in particular toll road projects, has proved to be a difficult sector for both governments and private entrepreneurs to develop successful projects, due in large measure to misplaced incentives.

The Government's Ultimate Goal
When a government transfers activities to the private sector, it does so for one or more of the following reasons: (i) the need of major investments; (ii) the need to improve "value for money" in government procurement; (iii) limited tax revenues; and (iv) deterioration of services. Governments should consider the most efficient and rational approach to achieve the twofold goal of attracting private sector investment while ensuring the fulfillment of straightforward policy goals. Where risk is transferred from the public to the private sector, principles vary depending on the government's goals and the tools used to achieve them. An adequate balance in the incentives to the different parties is needed throughout the process of structuring the concession and offering for bid the underlying toll road project.

Governments have to take the necessary steps to understand what is needed to win the private sector's confidence and attract investment. By so doing, three principles should be considered: (i) continuity of the service; (ii) nondiscrimination between users of the service; and (iii) adaptability of the service to the needs of the public.

Balancing Multiple and Diverse Incentives
Any government supporting a project must demonstrate long-term commitment and willingness to provide a binding concession contract that satisfactorily shares the risks and obligations (see also the previous article in this issue). What follows is a discussion of the various variables that the government should take into consideration.

In long-term service relationships a well-staffed regulatory authority is essential to ensure appropriate balance between the interests and incentives of the parties involved and, more importantly, to facilitate the smooth performance of the concession. An independent regulatory authority with appropriate technical capabilities would contribute to a long-term and balanced partnership with the private sector, and would help address unanticipated developments. In addition, the presence of a well-structured regulatory authority may promote equitable mechanisms as a way to solve controversies throughout the life of the concession. Without a balance in power, it is unlikely that the partnership process will be equitable and sustainable.

Contracts should be awarded through competitive bidding rather than negotiated with a single entity. Negotiation may jeopardize the inherent benefits of the project due to the government's relative inexperience in provided services on a commercial basis. A competitive process offers transparency, ensures maximum efficiency and builds much needed public confidence. Governments may even consider private entities operating infrastructure services as "contracting authorities" so that they would be obliged to follow public procurement procedures in awarding their own contracts. Furthermore, governments should avoid rushing bids and the bid evaluation processes. Doing this often produces inaccurate traffic and revenue forecasts, which are key to the success of these types of ventures.

Governments must avoid burdening a project with profit restrictions or unrelated social development goals that would undermine commitment to project implementation. Indeed, the principal aim should be to ensure inexpensive and efficient service. On the other hand, concessionaires should be responsible for making cost and traffic estimates and, therefore, be held responsible for costs overruns.

Depending on the underlying project, governments may consider providing credit to support the revenue stream and ensure stable cash flows (which are quite sensitive to traffic), and as a mechanism to facilitate any potential bond issue backed by the project revenue stream (which may further contribute to develop the country's capital markets and facilitate project costs repayment). Alternatively, governments may ponder providing or facilitating the provision of indirect sovereign guarantees to mitigate political risks and other risks not attributable to the project company.

In certain instances, such as when traffic forecasts are unreliable, a government may have to provide project revenues through shadow tolls. Shadow tolls have some effects worth mentioning: they avert the diversionary effect of tolls on traffic since motorists are not affected by toll payments and enhancing-in certain instances- credit quality since the revenues are paid by governments. Nonetheless, some critics argue that the government ends up paying for the road and the additional cost of borrowing by the private sector. It would be necessary, therefore, for the efficiency of the investment and operation to compensate for this additional cost. In the end, investors admit that shadow tolls are less risky than consumer tolls because they do not have to bear the risk of diverting traffic to nontoll roads, contend with the administrative burden of cash collection, or the technical problems of electronic tolling. Perhaps the most serious problem of shadow tolls is that they do not affect users and, therefore, cannot affect their behavior.

Concessionaires must take sole charge of the cost and financial risk in a design, build, finance and operate (DBFO) contract promoted by the government. Special consideration must also be given to the toll structure to ensure the accomplishment of two essential goals: adequate compliance by the concessionaire and payment in proportion to the service rendered to the public. To that extent, a toll structure may include partial tolls during the construction period, with progressive increases upon the accomplishment of certain construction milestones, and reaching full payment levels at the completion of the construction. Moreover, during operation, tolls may be partially indexed to inflation and reduced as the project's debt is paid down. Governments may want to consider tolling mechanisms whereby tolls are lower at higher traffic levels, thereby reducing revenue risk compared to a flat toll structure.

Governments must ensure by multiple means that performance obligations are clearly established throughout the life of the concession and, therefore, that the concessionaire has the necessary technical "know-how" as well as long-term commitment.

Due to developmental interests, governments may attempt to include more than one toll road in a single concession, on a cross-subsidized basis. In such cases, financing for the multiple road projects may be raised through a newly created special purpose financing vehicle, controlled by the concessionaire, that provides funds to individual entities responsible for each road through "back-to-back" on-loans. Such an approach allows for: (i) cross-application of dividends so that one project can support another; (ii) diversified risk financing by combining several different roads; (iii) the issuance of project bonds large enough to be liquid; and (iv) a simplified corporate structure at the concessionaire level. This may enable coverage ratios to be tighter, thus lowering the cost of financing.

When considering the financing package of a concessionaire, governments should also take into account the contingent equity to be provided by the project's sponsors on a joint and several basis, their debt service reserve, reserve mechanism for major maintenance, letters of credit for scheduled equity contributions and selected other obligations, and operating and maintenance support agreements.

It is extremely important to ensure that strong and experienced shareholders are attracted to participate in the project. Their participation would serve to assure investors regarding the government's competence in necessary functions; its willingness to spend significant resources on bid and other costs; and its ability to provide "support" to the project. Recent experiences in some developing countries have demonstrated how detrimental it is to have as concessionaires construction companies which have secured high returns on their equity contributions by minimizing them. Domestic construction companies undertaking operating responsibility are unlikely to combine the three types of required skills: construction, operation and finance.

Conclusion
Overall, the process by which these concessions are granted and carried out must not only focus on getting investment costs off government's books, but also on getting efficient, competitive projects and making the public accept the payment of real prices for services. Such an approach would ensure a balanced private/public partnership. The foregoing review illustrates issues that governments must consider well before a toll road is offered for private sector participation. Lack of consideration to these balancing incentives, may jeopardize any well-intentioned effort to initiate and maintain a long-term partnership with the private sector.

Ex-post facto efforts to amend such pitfalls are indeed a limited alternative and a highly inefficient approach to properly balanced incentives.

-Fred Aarons, Attorney Legal Department/Private Sector Operations

Last updated: 01/16/07