Australia: PPPs - Can The Higher Cost Of Private Finance Be Justified?

Last Updated: 16 September 2008
Article by Steven Power

Key Point

  • When undertaking major equipment acquisition or infrastructure projects, agencies should consider a range of both publicly and privately financed project delivery models.

Recent Ministerial statements on infrastructure development and major procurement by the new Federal Labor Government have emphasised that all possible project delivery models should be considered when undertaking major equipment acquisition or infrastructure projects in order to achieve the best value for money outcome. This includes consideration of a variety of both publicly and privately financed delivery models and an assessment of the relative potential for each of these models to deliver value for money outcomes.

Privately financed delivery models do not often receive detailed consideration on the basis that they are believed to be too expensive given the higher cost of private finance compared to the cost of direct Commonwealth funding, and due to the reduced flexibility and increased complexity associated with having a third party financier involved in the project. There are, however, a number of potential benefits associated with the use of private finance and, in this article, we will look at what those benefits are. The challenge for any given project is being able to assess whether these benefits are likely to outweigh the additional cost, reduced flexibility and increased complexity associated with using private finance and, whether taking all factors into account, the use of private finance is likely to represent better value for money. The benefits associated with using private finance include:

Availability of government funds: The use of private finance enables projects to be delivered earlier than would otherwise be the case where public funds are not available or, where public funds are available, the use of private finance frees up public funds for use on other projects.

On time delivery: As the contractor generally does not receive any payments until the equipment or infrastructure has been delivered, there is a significant incentive for the contractor to deliver the equipment or infrastructure on time. Any delay results in additional finance costs being incurred by the contractor. These will generally not be recoverable from government unless the delay is caused by government or the delay results from a risk which is borne by government under the contract.

In addition, the financier will generally take an active role in monitoring the performance of the contractor. The financier has a vested interest in ensuring timely delivery by the contractor as its funds are at risk and repayment is generally tied to delivery.

Risk transfer: Similar to publicly financed projects, privately financed projects often allow government to transfer risks to the contractor which the contractor is better able to manage. Given that its funds are at risk, the financier will generally require the contractor to carry out a rigorous risk assessment for the project during the tender phase to ensure that the project risks have been properly priced and to assess whether the project risks are manageable. Accordingly, government is likely to be more comfortable where the contractor has properly assessed and priced the project risks and will be able to manage the project risks if they arise.

Whole of life costing: The long-term nature of privately financed projects often requires the contractor to assume responsibility not only for the design and construction of the equipment or infrastructure, but also for their operation and through life support. This provides a commercial incentive for the contractor to adopt design and construction methodologies which minimise the overall cost of the equipment or infrastructure through life.

The existence of private finance provides an added incentive for the contractor to effectively manage whole-of-life costs given that all or a significant portion of the payments to the contractor are at risk following delivery of the equipment or infrastructure.

Innovation: Privately financed projects often focus on output - rather than input-based specifications, thereby providing contractors with the opportunity to develop innovative design and other solutions to meet government's requirements at lower cost. Further, the contractor has an incentive to create innovative solutions to address unforeseen risks as they emerge.

Third party revenue: Some privately financed projects provide opportunities for third party use of the equipment or infrastructure. Revenues arising from third party use can reduce the cost government would otherwise pay as sole user of the equipment or infrastructure or, alternatively, open up opportunities for upside revenue sharing.

Performance-based contracting: Privately financed projects typically adopt an output focused performance based contract. Payments are generally linked to the provision of the service providing a significant incentive for the contractor to provide the services in accordance with the requirements of the contract. The existence of private finance provides an additional incentive as all or a significant proportion of the payments to the contractor are at risk following delivery of the equipment or infrastructure.

Financier step-in: The financier will generally have a right to step-in to rectify any failure on the part of the contractor to comply with the contract with such right generally being triggered prior to the government's right of termination being triggered. This provides additional comfort to government that the financier will do what it can to keep the project running in order to protect its investment in the project.

Failure to deliver during the delivery phase: Any failure by the contractor to deliver the equipment or infrastructure will mean that government will be entitled to withhold payment to the contractor. As government is unlikely to have made any payments to the contractor prior to delivery of the equipment or infrastructure, government will not be in a position of having to try to recover payments made.

The proper consideration of the potential value for money outcomes of the different types of project delivery models should include consideration of the advantages of privately financed delivery models. However, whether the use of private finance will provide better value for money than publicly funded project delivery models will often largely depend upon the kind of project being undertaken and whether the additional cost of private finance can be justified, having regard to the benefits which private finance can deliver.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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