Policy Implications and Recommendations

Although numerous public-private partnership (PPP) projects have undergone stern tests in terms of changes in government, tariff freezes and renegotiations, PPP remains resilient, alive, and well in many parts of the world. For the most part, governments have remained supportive of PPP. Project firms and governments have adapted in several ways to stress, including renegotiation and (unfortunately) early divestments.

However, PPP faces great peril in countries ravaged by crisis, or in countries trying to expand and improve infrastructure with the social goal of making them affordable. In these countries, broadly-defined political risk also tends to be highest. Political risk also tends to be high in countries where governments are sufficiently strong to dictate pricing for large infrastructure proponents.

One can explain recent investment trends in PPP in light of political risks. In Asia and Latin America, PPP has declined in recent years due to massive realized political risk stemming from successive macroeconomic crises exacerbated by poor project procurement and contracting systems. Thus, part of the strategy for stimulating PPP investment in the Asian region requires addressing fragilities in regional economies first. In this way, endogenous political risks can be mitigated, even in the absence of political risk insurance.

The recent increase in global PPP has been driven by a migration towards markets where perceived political risk is lower (or has not been realized). However, the recent surge in commodities prices and the global financial crisis threaten to reverse this trend, especially in areas where PPP is already fragile. As such, early-warning indicators of increased political risk must include price and macroeconomic shocks (both domestic and global), large payments imbalances, sizeable fiscal deficits, and discrete currency devaluations. The extent of political risk in PPP also suggests that countries should undergo a period of thorough preparation for PPP, with all its possible concomitant economic and political consequences. This is particularly essential for countries which have a long tradition of price controls on utilities or other essential public services.

The gap between pre-privatization tariffs and cost recovery tariffs may be positively related to potential political risk in PPP, and may be a binding constraint to investment in PPP. Multilateral financial institutions (MFIs) should be very careful about their encouragement of PPPs, as project failure often produces negative externalities that can affect other investments, the country, and indeed the MFI itself. Well-designed pricing mechanisms can cushion the effects of privatization on the most vulnerable, while reducing the risk of tariff freezing and political risk. Some countries, notably in Latin America, can benefit from welldesigned targeted subsidy mechanisms in order to reconcile cost recovery objectives with social protection concerns (Foster and Yepes 2006).

The analysis of endogenous political risk has yielded an important lesson: the best way to reduce political risk is to properly manage the macroeconomy. Since political risk is correlated with prior realizations of currency and demand risk, good macroeconomic management would probably reduce political risk exponentially; it would lower the probability of sudden and discrete changes in demand, exchange rates, and inflation—the costs of which could be passed onto consumers (or firms, depending on the government's disposition). Good global and regional macroeconomic management would prevent or mitigate external shocks from affecting the sustainability of PPP.

Although political risk is pervasive in PPP, the fact that many projects have managed to survive (even in instances of macroeconomic instability) speaks volumes about the ability of firms and investors to cope (even without political risk guarantees from MFIs). Therefore, a deeper review of the best practices could be undertaken. Based on the results of the qualitative analysis, it appears critical for project firms to develop quick and innovative methods for enhancing efficiency and productivity²⁰. This could temper the need for large and continuous changes in tariffs, thus also reducing political risk.

For better or for worse, the following general factors have the biggest impacts on PPP outcomes: pricing and regulation; type of government (federal or local); openness to trade; market growth and macroeconomic conditions; moral hazard and adverse selection; and capacity constraints. Investment environments most conducive to sustainable PPP are those where:

1. there is a supportive civic and political attitude towards privatization;
2. reforms and privatization are done gradually and deliberately, but with enough flexibility to allow for quick and unequivocal policy adjustments, when and where they are needed;
3. the finance ministry is deeply involved in the process to strengthen screening and provide proper incentives for project monitoring;
4. the government, investors, and customers are able to form realistic expectations of PPP;
5. there is good macro-prudential economic policy, coupled with flexible exchange rates that serve as a transparent component of the tariff;
6. investor and government executives refrain from acting opportunistically;
7. firms that are contracted have competent and innovative management and employees, to temper costs and enhance efficiency and productivity;
8. government executives refrain from using their discretionary powers to make sweeping changes in the business, tariff, and legal environment;
9. all stakeholders refrain from acting opportunistically, and are aware of the consequences of doing so;
10. proper pricing policies and realistic subsidy schemes are developed for PPP, since political risk may be positively correlated with mean prevailing tariffs and cost recovery tariffs;
11. price cap regulation can adapt quickly enough to changing crisis situations;
12. the economy is oriented towards trade as much as possible;
13. procurement and proponent selection is performed transparently and following a rigorous criteria, especially during periods of high growth;
14. policies are designed to help investors achieve peak efficiency and productivity as soon as operations commence;
15. projects are designed and planned with sufficient public consultation and with adequate transparency;
16. contracting is done with the federal instead of local governments;
17. well-designed and well-targeted political risk guarantees are made available and provided by agencies that are capable of providing good advice to strengthen the project;
18. renegotiation is available as an option, but is used discriminately;
19. there is some restraint to fiscal risk bearing and to the number and size of PPP investments;
20. there are less fiscal liquidity constraints;
21. there are institutions to monitor systemic risks in the country's entire PPP portfolio and off-taking institutions (to be able to anticipate where price shocks might arise), and there is transparency in reporting fiscal and other risks;
22. the ministry of finance plays a strong role in monitoring and regulating both systemic and project-specific risks;
23. investors are encouraged to perform thorough project design and planning;
24. domestic financing is available, to reduce not only currency risk, but also political risk;
25. geo-political conditions are favorable, and there is a low risk that the infrastructure service will be expropriated for strategic political reasons; and
26. divestment is available as an option, especially since investment horizons have shortened.

Controlling for all other factors, moderate but stable growth provides better conditions for project designers, operators, and governments to make realistic demand projections. Thus, project design is best performed assuming moderate economic conditions, with an eye towards worst-case scenarios. High growth countries are more likely to experience adverse selection and moral hazard in project design, procurement, and contracting. Thus, governments in high growth economies would find it in their best interests to strengthen screening procedures; project developers, on the other hand, would do well to strengthen due diligence. Slower growth automatically imposes discipline on the project cycle, and may therefore occasion a relaxation in standards (but not by much).

Given the nature of the risks involved, and the negative demonstration effects of project failure, there also needs to be a proper sequencing of activities to prepare the country for PPP. While macro stability should be the most fundamental step, subsequent activities could include educating citizens, politicians, and policymakers regarding PPP, and establishing the centrality of the ministry of finance in the process of approving, regulating, and monitoring PPP. There must be greater transparency in monitoring contracts, implementing projects, as well as determining systemic and project-specific risks. Proper intra-government coordination is crucial in this regard.

A culture of price controls may be detrimental to PPP, even if the country is growing rapidly. This is especially true since investment horizons have shortened. Experience has shown that strict tariff controls and tariff freezes lead to deterioration in supply, which in turn lead to shortages (or blackouts in the case of power). Thus, tariff freezes in a rapidly growing economy will cause more acute shortages than in a slower-growing one.

PPP tends to thrive better in environments that have more flexible tariffs and exchange rates. Not only does flexibility reduce moral hazard in project design, it also prepares politicians and the general public for the possibility of tariff adjustments. Where there is a huge difference between state-controlled prices and market tariffs, some pre-privatization market reforms could be implemented to push prices closer to market levels—but only if the country is prepared to make that transition. Proper transition pricing issues should be studied, to minimize political risk.

The political nature of risks suggests that domestic investors may hold inherent advantages over foreign firms in PPP. This highlights a very important synergy between foreign and domestic investors: while the former can help bring in capital, the latter can help mitigate political risks. Efforts should be made to strengthen domestic investors and augment their resources (for example, by offering more political risk guarantees to domestic financial institutions).

Even after controlling for other factors that make open economies good investment destinations, openness to trade still emerges as a significant determinant of favorable project outcomes. This is probably due to the complementarity between trade and infrastructure. Thus, PPP works best when it supports commerce and trade (as commerce and trade create a natural demand for infrastructure). Openness to trade also tends to insulate PPP investments from uncertainties facing domestic markets.

Project outcomes depend greatly on firm-specific traits, such as the quality of management and personnel. The ability to innovate is particularly important, especially in sectors where achieving short-run efficiency (i.e., achieving rapid reductions in system losses, or improving customer service) is key to sustaining investment and keeping price pressures in check (such as in water supply and electric distribution concessions). The ability to innovate would also improve collection and reduce temptations for theft and illegal connections. Innate firm capability matters as well, as this could help create efficiencies that could keep prices in check and increase public acceptance of the project, thereby lowering political risk. As such, project firms should not only be selected on the basis of price, but on basis of their innate capabilities as well.

Achieving efficiency early in the life of a project is key to keeping tariff pressures in check. Thus, regulation must be responsive to efficiency considerations. The empirical results suggest that rate of return regulation prevent stress better than price cap regulation. At the very least, countries currently implementing price cap regimes should consider switching to hybrid systems of price regulation, with elements of both price cap and rate of return regulation.

While the empirical results suggest that MFI equity, loans, and risk management services do not significantly affect project outcomes, political risk guarantees (PRGs) seem to have a positive impact. This may be due to the quality of advice given by PRG providers, which is support additional to the PRG itself. Because of their benefits, PRGs should be more accessible to stakeholders. The application of PRGs could also broadened; PRGs could be offered to stimulate PPP investment and financing from domestic markets and financial institutions. While PRGs may perhaps raise costs in the short-run, they could be used in combination with MFI loans or equity. Unfortunately, despite their obvious benefits, PRGs are not widely utilized. This implies that stakeholders grossly underestimate the value of PRGs (or perhaps some form of PRG mis-targeting occurs). It may also imply that PRGs are simply too expensive to purchase. Whatever the reason, it does seem like multilaterals need to (i) examine PRGs more closely; (ii) market them more effectively; (iii) re-engineer them to apply to a broader set of circumstances; (iv) calibrate their pricing and adjust such pricing for risk while minimizing incentive problems in PPP; and (v) adapt them to recent changes in the global, regional, and domestic investment environment and making them supportive of domestic capital market development.

Since the empirical work in this study allows one to discriminate between more and less risky PPP environments, it is conceivable that PRG providers can use the analysis in this study to develop more finely calibrated risk-adjusted pricing strategies, making PRGs more affordable in countries where, for example, macroeconomic risks are low, so that the risk of tariff-freezing is also low. Guarantee premia can then be adjusted to reflect changes in economic and political environments in discrete time periods. The robustness of the beneficial effects of PRGs cannot be ignored. While PRGs may raise costs to the proponent in the short-run, they could be used on their own, or in combination with MFI loans or equity (interacting PRG with loans and equity in regressions produced favorable results).

Broad political risk can also be mitigated by strengthening or reforming political and executive institutions to reduce opportunism. Multilateral institutions can help reduce risk by providing better education for government executives and politicians regarding PPP, and by surveying politicians about their views regarding PPP. The decision to implement PPP is itself a political decision. Therefore, the views of politicians are crucial. Proper project planning should take into account mechanisms, practices, and policies affecting economic and political decision-making in the economy. Signs of past opportunism should be noted.

Countries wishing to expand their portfolio of PPP projects must be prepared to improve macroeconomic management, absorb additional explicit and implicit fiscal risks, and strengthen political and executive institutions involved in the project cycle. PPP projects cannot survive a static government environment, much less an environment that simply looks at PPP as a tool for relieving budget constraints.

What creates negative outcomes in PPP, political risk, is also what discourages investment. The recent decline in PPP in Asia and Latin America is a reflection of realized political risks. PPP governance starts with improving long-run macroeconomic governance; but it also involves strengthening firm and government decision-making processes for project screening and development, as well as regulation and pricing. PPP is a complicated activity; to reduce political risk, it is essential to have not only capable, well-informed, and credible political leaders, but also a strong and well-educated bureaucracy that is able to understand and manage PPP risk; promote political stability; and create a consultative environment. Attention also needs to be given to adequate contingency planning for PPP, especially in response to crisis. Reforms along these lines therefore need to be implemented, to ensure the long-run viability of PPP.

Finally, it is clear that accelerating the development of long-term domestic capital markets is a critical element of a long-term privatization and PPP strategy. This is especially crucial for domestic investors. This is easier said than done, however. The instability of PPP contracts implies that the real assets used to generate revenues to pay off bond and equity owners are themselves highly uncertain, limiting demand for such securities. Long-term capital market development may thus itself be endogenous to political risk. With such unstable contracts, securities markets backed by cash flows from PPP projects may also be undermined. Fundamental reforms need to occur: macroeconomic stabilization, fortification of the bureaucracy, and the creation of mechanisms for decision-making, especially with respect to project planning and tariff management.

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