Recovery Risk and Labor Costs in Public–Private Partnerships: Contractual Choice in the US Water Industry

TL;DR: In this paper, the authors use an ordered logistic model to empirically examine the factors that explain varying degrees of private involvement in the US water sector through public-private partnerships and find that the risk to private participants regarding cost recovery is an important driver of private participation.

Abstract: We use an ordered logistic model to empirically examine the factors that explain varying degrees of private involvement in the US water sector through public–private partnerships. Our estimates suggest that a variety of factors help explain greater private participation in this sector. We find that the risk to private participants regarding cost recovery is an important driver of private participation. The relative cost of labour is also a key factor in determining the degree of private involvement in the contract choice. When public wages are high relative to private wages, private participation is viewed as a source of cost savings. We thus find two main drivers of greater private involvement: one encouraging private participation by reducing risk, and another encouraging government to seek out private participation in lowering costs.

Summary

Introduction

• Institut de Recerca en Economia Aplicada Regional i Pública Document de Treball 2012/22 33 pàg. Research Institute of Applied Economics Working Paper 2012/22 33 pag.
• “Recovery Risk and Labor Costs in Public-Private-.

Partnerships: Contractual Choice

• In the U.S. Water industry” Daniel Albalate, Germà Bel and R. Richard Geddes WEBSITE: www.ub.edu/irea/ CONTACT: irea@ub.edu The Research Institute of Applied Economics (IREA) in Barcelona was founded in 2005, as a research institute in applied economics.
• Three consolidated research groups make up the institute: AQR, RISK and GiM, and a large number of members are involved in the Institute.
• IREA Working Papers often represent preliminary work and are circulated to encourage discussion.
• Any opinions expressed here are those of the author(s) and not those of IREA.
• The authors thus find two main drivers of greater private involvement: one encouraging private participation by reducing risk, and another encouraging government to seek out private participation in lowering costs.

Data

• The authors main data source is the International Major Projects Survey 2008 from Public Works Financing (October 2008 issue).
• This survey contains information on 165 PPP projects signed from 1988 to 2008 between local governments and private firms for the production and delivery of water services in the United States.
• The authors sample is distributed almost evenly between water delivery and water treatment services.
• PPPs are concentrated in two main contract types: Management contracts and build-operate-transfer (BOT) contracts.
• These contract types imply different degrees of private participation and risk transfer.

Variables

• This is an ordered categorical variable that assigns low values to PPP project types featuring relatively low private involvement and low risk transfer, and high values to project types featuring relatively high private participation and greater risk transfer.
• Concessions and BOT contracts add demand risk to the construction risk typically assumed by the private partner under DB contracts.
• The authors discuss the motivation behind each regressor, focusing on the role played by relative public-sector salaries as a key driver of the level of private PPP participation and risk transfer.
• The source for this variable is The Tax Foundation, tables entitled “State and Local Tax Burdens: All Years, One State 1977-2008.4 Spending_Limits: Binary variable equal to one if the State in which the municipality resides has a law constraining public spending at the municipal level.
• These limits generate more willingness to rely on the private sector.

Methods

• The authors use different estimation models to evaluate the impact of these regressors on the extent of private participation in completed PPPs.
• Monetary variables are not affected by this time difference because they are ratios where both monetary values are measured in the same time period.
• The authors first use an ordered logit model to estimate the Ordered Contract dependent variable.
• The authors also consider the concentration of contract types within the Management Contracts and Concession/BOT categories, which leads us to utilize a binary variable distinguishing between large and small private involvement.
• The second test for multicollinearity (variance inflation factors) finds no significant collinearity in their specification.

Estimation Results

• Table 3 below displays their main estimates.
• This allows us to identify the magnitude of the effects produced by statistically significant coefficients.
• The authors estimates indicate no differences across political parties.
• The authors contribute to the literature by empirically analyzing factors explaining different degrees of private involvement through PPPs in the water sector.
• The authors also find that the relative cost of labor is another key factor explaining the extent of private involvement in the contract choice.

Notes

• It is worth noting that other non empirical papers have provided interesting insights in factors influencing privatization of water services, as that of interest groups and institutional structures of power (Fitch, 2007).
• Bel and Fageda (2008) conduct an empirical analysis where they merge data on solid waste and on water.
• Data for this variable were obtained from Table 1: Tax and Expenditure Limitations Currently Imposed Statewide on Local Governments, in Mullins and Wallin (2004).
• There are, however, several other variables included in the Public Works Financing database, such as contract duration and private firm identification, which cannot be exploited due to the number of missing values such that the number of observations would be significantly reduced.

Figures

Table 2. Categorical dependent variable construction

Table 3. Ordered logistic and logistic estimates for PPP contract choice. Regressors Ordered

Table 1. The Distribution of PPPs by Type of Contract in the 2008 International Major Projects Survey for Water Services

Full text

Institut de Recerca en Economia Aplicada Regional i Pública Document de Treball 2011/07 pàg. 1
Research Institute of Applied Economics Working Paper 2011/07 pag .1
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Institut de Recerca en Economia Aplicada Regional i Pública Document de Treball 2012/22 33 pàg.
Research Institute of Applied Economics Working Paper 2012/22 33 pag
.
“Recovery Risk and Labor Costs in Public-Private-
Partnerships: Contractual Choice
in the U.S. Water industry”
Daniel Albalate, Germà Bel and R. Richard Geddes

Institut de Recerca en Economia Aplicada Regional i Pública Document de Treball 2012/22 pàg. 2
Research Institute of Applied Economics Working Paper 2012/22 pag. 2
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WEBSITE: www.ub.edu/irea/ • CONTACT: irea@ub.edu
The Research Institute of Applied Economics (IREA) in Barcelona was founded in 2005, as a
research institute in applied
economics
. Three consolidated research groups make up the
institute: AQR, RISK and GiM, and a large number of members are involved in the Institute. IREA
focuses on four priority lines of investigation: (i) the quantitative study of regional and urban
economic activity and analysis of regional and local economic policies, (ii) study of public
economic activity in markets, particularly in the fields of empirical evaluation of privatization, the
regulation and competition in the markets of public services using state of industrial economy, (iii)
risk analysis in finance and insurance, and (iv) the development of micro and macro econometrics
applied for the analysis of economic activity, particularly for quantitative evaluation of public
policies.
IREA Working Papers often represent preliminary work and are circulated to encourage
discussion. Citation of such a paper should account for its provisional character. For that reason,
IREA Working Papers may not be reproduced or distributed without the written consent of the
author. A revised version may be available directly from the author.
Any opinions expressed here are those of the author(s) and not those of IREA. Research
published in this series may include views on policy, but the institute itself takes no institutional
policy positions.

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Research Institute of Applied Economics Working Paper 2012/22 pag. 3
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Abstract
We use an ordered logistic model to empirically examine the
factors that explain varying degrees of private involvement
in the U.S. water sector through public-private partnerships.
Our estimates suggest that a variety of factors help explain
greater private participation in this sector. We find that the
risk to private participants regarding cost recovery is an
important driver of private participation. The relative cost of
labor is also a key factor in determining the degree of private
involvement in the contract choice. When public wages are
high relative to private wages, private participation is viewed
as a source of cost savings. We thus find two main drivers of
greater private involvement: one encouraging private
participation by reducing risk, and another encouraging
government to seek out private participation in lowering
costs.
JEL classification: H4; H54; H7; L88; L9
Keywords: Privatization, Public-Private Partnerships, Water, Contracting out.
Daniel Albalate: Department of Economic Policy & GiM-IREA, Universitat de Barcelona (Barcelona,
Spain) (albalate@ub.edu
).
Germà Bel: Department of Economic Policy & GiM-IREA, Universitat de Barcelona, (Barcelona,
Spain) and City and Regional Planning, Cornell University (Ithaca, NY, USA) (gbel@ub.edu
)
R. Richard Geddes: Department of Policy Analysis & Management, College of Human Ecology,
Cornell University (Ithaca, NY, USA) (rrg24@cornell.edu
)
Acknowledgements:
This research received financial help from the Spanish Government under Projects ECO2009-06946
and ECO2012-38004, the Regional Government of Catalonia under project SGR2009-1066. Germà
Bel acknowledges as well support from ICREA-Academia..

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1. Introduction
After several decades of water delivery privatization, a widespread view among scholars is
that water delivery is a complex service featuring high contracting costs. In his study of
concession contract renegotiation, Guasch (2004) documents the high frequency of renegotiation
in Latin America and the Caribbean water and sanitation services between the mid-eighties and
2000. Renegotiation affected 74.4 percent of concession contracts in the sector, significantly
higher than in other important sectors, such as transportation. Moreover, the period of time
between contract award and renegotiation was only 1.7 years on average (Guasch, 2004).
Although overall favorable to privatization, Megginson (2005) considers water to be the clearest
case among user-paid services where privatization has failed to deliver clear welfare
improvements.
There is now a substantial empirical literature showing that water private delivery has not
provided superior efficiency and productivity relative to public delivery in most developed
countries (e.g., Warner and Bel 2008). However, because private participation allows access to
additional expertise and greater financial capabilities, studies suggest that private participation in
less-developed countries has delivered improvements in quality and accessibility. Mixed effects of
privatization in several services have led to reforms that go beyond a pure public/pure private split
(Warner and Bel, 2008; Bel and Fageda, 2010). Greater use of public-private partnerships (PPPs)
is one result of such a trend. In fact, PPPs can be viewed as a way to extend a standard
procurement method, similar to contracting out. Moral hazard and quality measurement problems,
among others, have arisen in contracting out (Levin and Tadelis, 2010). Contracting out has
evolved to include high-powered incentives, which require shifting substantial risk to the private
partner, to help address those problems. The private partner demands compensation to bear that
risk however, which requires the public sponsor to pay a risk premium.
The term “public-private partnership” has evolved to encompass any contractual framework
allowing for greater private sector participation in infrastructure projects than under a traditional
approach. PPPs range from relatively simple management contracts to complex design-build-
finance-operate (DFBO) contracts, to outright asset sales.

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Under a traditional design-build (DB) approach, for example, private firms design and
construct an infrastructure facility on behalf of a public sponsor. The sponsor remains responsible
for financing, operating, and maintaining the facility. A greater degree of private involvement is
found in design-build-operate-maintain (DBOM) contracts. Under DBOM, the additional duties of
the private partner(s) include operating and maintaining the facility after it has been built. Both DB
and DBOM contracts take advantage of private sector incentives and expertise to design and
build facilities so as to minimize operation and maintenance costs.
Greater private involvement also occurs through design-build-finance-operate-maintain
(DBFOM) contracts, which extends private participation to the project’s financing. In a typical
DBFOM contract, the private partner uses some combination of debt and equity to design and
build a new facility, and then operates and maintains it for a specified time period in exchange for
the right to collect revenues from facility users over the lease term. Two versions of this project
type are (a) a greenfield PPP, through which the private partner builds a new facility; and (b) a
brownfield PPP, through which an upfront concession fee is paid by the private partner in order to
lease a pre- existing facility. Other contractual types include build-transfer-operate (BTO)
agreements, under which the private partner owns the facility until its ownership rights are
transferred to the public sector when construction is finished. Similarly, under a build-operate-
transfer (BOT) agreement, the private partner retains ownership rights until title is transferred at
the end of the specified operation and maintenance period. In a build-own-operate (BOO)
agreement, ownership remains with the private partner unless the public sector purchases it.
The contractual diversity facilitated by PPPs has increased the array of types and degrees of
private involvement in public infrastructure delivery. However, empirical analysis of the motivation
behind public services privatization has remained largely focused on a clear bifurcation between
pure-public and pure-private delivery (Bel and Fageda 2007, 2009), with few extensions to other
mixed forms such as mixed public-private firms (Bel and Fageda, 2010).
We contribute to the literature by empirically analyzing the factors that explain varying degrees
of private involvement through PPPs in the water sector. The water sector provides insights
relevant for the study of PPPs more broadly. First, water distribution involves large investments in
networks, which makes this sector subject to financial constraints. Second, water sector
investments typically require long amortization schedules. There is great uncertainty associated
with long-term changes in demand and other variables. Risk sharing and risk transfer over the life
of the contract are more important in the water sector than in many other local services. Water