September 24, 2020 11:55AM

Public‐​Private Partnerships and Demand Uncertainty

By Peter Van Doren and David Kemp

This summer, a Washington Post article described the large reduction in toll‐​road revenue caused by the coronavirus pandemic. As of July, less traffic had resulted in more than a $9 billion shortfall. Both public and private operators have lobbied for increased federal and state assistance to offset the reduction in revenue. But properly designed public‐​private partnership (PPP) contracts offer an alternative to manage demand shocks.

While PPPs have been relatively rare in the U.S., over the last three decades there has been €203 billion of PPP investment in Europe and $525 billion in developing countries. In the fall issue of Regulation, Eduardo Engel, Ronald Fischer, and Alexander Galetovic revisit the international experience with PPPs. They argue that although the overall experience with PPPs has been positive, “good governance and careful contract design are necessary to reap the benefits from PPPs.”

A common problem with PPPs is that after contracts are awarded they are routinely renegotiated, often in ways that benefit concessionaires at the expense of taxpayers. These renegotiations arise because of the incentives embedded in the PPP contracts. Traditionally, PPP contracts are fixed term. The concessionaire is guaranteed the toll revenues collected over a pre‐​established time period. If demand is less than anticipated, the concessionaire will receive less revenue. Concessionaires respond by requesting more favorable terms than offered by the original contract.

Engel, Fischer, and Galetovic argue that present‐​value‐​of‐​revenue (PVR) contracts solve the problem of demand uncertainty. As Peter Van Doren and Thomas Firey summarized in a blog several years ago:

In a PVR auction, it is understood that the private company will only operate the road for a time, and then it will be returned to the public. Regulators set a maximum toll level that motorists will be charged to use the road. Private companies then bid on the amount of toll revenue, measured in present value terms, they would want to receive before the road is returned to the public. The lowest PV bid wins. The winner collects revenues and pays for the maintenance of the road until it has earned the revenue that it bid in present value, regardless of whether it takes five years or 50. Thus, the term of the franchise is variable depending on road usage; if usage is less than expected, the lease extends. If usage is greater than expected, the lease is shorter‐​term. The private company won’t “lose,” but it won’t make a windfall either.

By allowing the lease term to fluctuate with changes in demand, PVR contracts eliminate demand risk and reduce the incentive for renegotiations. Chile’s experience with PPPs exemplifies this effect: while almost 60 percent of fixed‐​term PPP contracts in Chile have been renegotiated, only 6 percent of PVR contracts have been.

Infrastructure should be paid for by those who use it. The Chilean experience with PPP projects using PVR contracts should be emulated by the U.S.