Public Finance’s Function in PPPs
The Government can partially finance PPP projects. Therefore the use of private capital exclusively is not a defining feature of a PPP. Reducing the amount of capital investment required from private entities lessens the scope of risk transfer, weakening the incentives for the private sector to produce value for money and making it more straightforward for the private sector to exit the project if things go wrong. However, there are several reasons governments can decide to finance PPP initiatives. These consist of the following:
- Avoiding excessive risk premiums: The Government may believe that the risk premium charged by the private sector for the project is unreasonable given the project’s hazards. Since financial markets are typically better at estimating risk than governments, this can be a tough decision. However, it might be relevant, especially for new initiatives or needs and during financial market disturbances.
- Reducing government risk: In cases where project profits depend on regular payments from the Government, the private party will estimate the risk of a government default and factor it into the project cost. Giving subsidies or payments upfront in the form of loan or grant money, as opposed to ongoing payments, could increase bankability and reduce the project’s cost, where the consistency of government payments may be questioned.
Increasing accessibility or lowering the cost of financing—especially when the capital markets are underdeveloped or unstable, long-term funding may not be as readily available. Governments may decide to offer to finance at rates that are otherwise inaccessible. Certain governments have access to financing in favorable conditions to reduce the cost of infrastructure projects. It may also be a component of a larger strategy to use state financing institutions to offer long-term loans for economic development.
Governments can contribute in several different ways to a PPP’s funding system. Governments can directly loan money or give grants to the project firm, or they can guarantee a commercial loan. Financing PPPs can also involve government-owned development banks or other financial institutions as part of a broader portfolio or by being explicitly established to support the PPP program. The APMG PPP Certification Guide discusses de-risking approaches and credit enhancement instruments. Finally, governments may choose to retain ongoing control over capital expenditures rather than handing over the funding of the PPP project to the private sector. More information about these choices is provided in the section below.
During moments of disruption in the capital markets, the case for government financial support of PPPs may be increased, and many governments provide particular types of financial support in response.
Direct government funding for a project enterprise in the form of loans or grants
A PPP may get funding directly from the Government through loans or upfront grant subsidies. When income estimates indicate a project is unlikely financially feasible without government financing, these can be crucial for project viability. By making the funding accessible at better terms than would otherwise be achievable, capital contributions can help lower the project’s expenses to the Government. For instance:
- The Transportation Infrastructure Finance and Innovation Act (TIFIA) created a flexible framework for the US Department of Transportation to offer loans (as well as loan guarantees) to private and state project shareholders for qualified projects. The flexible conditions of the lending support and the usual subordinated position make it simpler to attract additional personal debt.
- According to The Viability Gap Fund Program in India, India’s Viability Gap Fund uses funds appropriated from the national budget to give upfront capital subsidies for PPP projects. More information on this program can be found in the Indian Government’s guidelines on financial support for PPP in infrastructure.
The public sector’s readiness to contribute money can also signal private investors, fostering their confidence. For instance, the United Kingdom’s Treasury realized several infrastructure projects could struggle to raise loans and were in danger of being shelved after the 2008 financial crisis. The Treasury established the Treasury Infrastructure Finance Unit (TIFU) to provide loans to PPP projects that couldn’t secure enough commercial bank financing at commercial rates. In April 2009, the unit provided considerable funding for the Greater Manchester Water project. According to a report by the UK’s National Audit Office, the Treasury’s willingness to lend increased market confidence. As of July 2010, 35 further projects had been agreed upon without public lending.
Government-provided equity for SPVs
The Treasury may contribute a small portion of the equity in PF2 projects under the new PPP policy for the British Government that was established in 2012 and is known as Private Finance 2, or PF2. The goal was to increase value for money by allowing Government to participate more actively in strategic decision-making and improve access to project information, especially information about the company’s financial performance. Several other administrations have utilized an identical framework, including the Regional Government of Flanders in Belgium.
However, public equity in a PPP may also result in conflicts of interest within the public sector and may make private investors warier about taking a risk. Private investors may be concerned that the Government may be tempted to interfere in the management of the PPP contract within the SPV if some decisions need to be made to maximize shareholder value but are not always in the best interests of the public sector. In particular, government ownership can result in conflicts of interest with its regulatory function. This possible conflict of interest is reduced under the PF2 policy of the United Kingdom by separating the ownership role from the contract management function. As a result, a department in the Treasury independent of the procuring authority manages equity shareholdings. France adopts a similar strategy.
Government support for a project’s commercial borrowing
If the private party defaults, governments may choose to guarantee repayment of debt provided by commercial sources rather than direct lending. According to Farquharson et al., the risk transfer to the private sector is undermined when project debt is guaranteed. Because of this, governments frequently only offer partial credit guarantees or a promise to pay back only a portion of the overall loan.
Both governments of wealthy and developing nations have used partial credit guarantees to assist their PPP initiatives. For instance:
- Korea’s Infrastructure Credit Guarantee Fund guarantees project debt through a counter-guarantee arrangement. To put it another way, the Fund backs an on-demand term loan given by a bank that the project business can use to make senior debt service payments.
- Kazakhstan has given guarantees regarding infrastructure bonds issued for its PPPs in transportation. Pension funds could invest in the projects with confidence because of the Government’s promises on the bonds.
- According to Budgeting for Government Commitments to PPPs, Indonesia created IIGF.
Guarantees should only be used when the Government is in the best position to handle the risk. As risk is transferred to the private sector and value for money is reduced, improper use of guarantees can increase the Government’s fiscal exposure. Considerations for the Government, which focuses on the risks of excessive leverage, and Insufficient Funds, which discusses the dangers related to the lack of budgetary certainty from PPPs, provide further in-depth discussions on this subject. Public Financial Management Frameworks for PPPs provide more excellent details on government guarantees and public financial management for PPPs.