The concept of a public-private partnership is certain to be a large part of any federal infrastructure bill passed this year. On the surface, the idea is solid: leverage private dollars with public dollars to accomplish infrastructure improvements that would not be possible with only one funding source. When put into practice, however, the results are decidedly mixed.
Google suggests that a partner is “a person who takes part in an undertaking with another or others, especially in a business or company with shared risks and profits.
Shared risks and profits. Most public-private partnerships are merely public handouts by a different name. Here are a few examples:
- A government selling public assets – such as a highway, parking garage, or even a state capitol building – to a private business, the latter of which will then make a profit charging those who use the asset. This is more like cashing out an annuity and is usually done to fill a current year budget gap.
- Giving money to a business without directly sharing in any of the potential gains of that business. This is simply a subsidy, not a partnership.
- Contracting with a business to construct an asset or perform a service that the government could otherwise do, but lacks the wherewithal, clout or desire to do it. This should be seen as a missed opportunity, particularly since the transaction is almost certainly profitable.
- Prioritizing a project that otherwise would not get done just because the private sector will kick in some money. Buying something that you don’t really want just because you can get it on sale is generally not a great financial strategy.
If we want to see the formation of real public-private partnerships where private businesses are truly sharing risks and profits with local governments, a few conditions must be met. Those are:
1. Limited and Quantifiable Risk
Private corporations of all types have a limit to their liability and risk. If things go horrifically bad, it might end in bankruptcy, but that is the end. The investment ceases and those involved salvage what they can and move on.
For local governments, the risk is much different. Many cities are not allowed to go bankrupt, and those that are will likely find that the downside cost of such an action far outweighs any benefit. In this sense, the government is an immortal partner, the one that will always be left standing no matter what, backed by the good faith and credit of taxpayers. There is no escape from the bad deal.
To enter into a public-private partnership, a local government has to know the absolute level of risk, particularly risks that feel like outliers. What is the absolute amount that can be lost – the greatest amount that the city and its taxpayers can be found liable for? Understand that humans are prone to severely underestimate tail risk (infrequent events). This is even more likely when it is a project we particularly desire; our human passions blind us to the risk.
When entering into a public-private partnership, cities need to get someone disconnected from the project to give an actuarial-like assessment of the risk – and not someone who will be compensated only if the project goes forward, like a bond counsel. Risk must be quantified. And unless the risk is as limited as the private sector investment is, there is very little compelling reason to enter into an agreement.
2. Mutual Skin in the Game
Later this month, the Patron Saint of Strong Towns Thinking, Nassim Taleb, is releasing a new book. It’s titled Skin in the Game: Hidden Asymmetries in Daily Life, and it’s going to be fantastic (much of it has been available on Medium as he’s been working on it). You don’t need Taleb’s insights, though, to understand the basic concept here: Risks must be shared mutually. A true partnership never allows a situation of heads-I-win-tails-you-lose. If the deal goes poorly, it needs to go poorly for each player in the partnership, at least to the degree that the upside gain is proportional to each player, too.
Ideally, the first losses are felt by the active partner – the one with the largest role in day-to-day execution of the agreement. In a public-private partnership, it’s very unlikely that the public partner will be fully aware of the strength, capacity and motivations of the private sector partner. Ensuring that the first losses accrue to the active partner is one way to overcome asymmetrical knowledge.
But at the very least, losses must be shared between partners. It is not acceptable in any public-private partnership for the local government to take on the losses while the private sector partner is able to walk away.
3. A Realistic Chance for a Positive Return
As we often discuss here at Strong Towns, almost all of our public infrastructure investments lose money. Local governments spend more money building, servicing, maintaining and replacing infrastructure than they receive in revenue for that task. The more infrastructure we build, the poorer we become.
This makes a lot of public-private partnerships into pure tragedy. It is, in fact, possible to make money on an infrastructure investment; if it wasn’t, private sector partners would not be involved. And cities running huge structural deficits on infrastructure maintenance desperately need positive-returning projects (projects that will generate more revenue than expense over the long term). So why do our local governments routinely give up this rare chance for a profit?
Our cities need to stop participating in projects that don’t offer a solid chance at a positive return on investment. Nebulous justifications like “it will create jobs (we hope)” or “it will grow the tax base (but only over the short term)” are not good enough – not when so much money is on the table.
No business would enter into a partnership which they knew they would lose them money. Local governments should not enter such partnerships either.
4. A Proportionate Share in the Gain
Whatever proportionate share of the risk a local government assumes, it should also be in line for a proportionate share of the gain. That’s real money they should receive, not some abstract social gain that may or may not have any real, tangible value. If things go really well for the private business, they need to go really well for taxpayers as well. Share in the risk, share in the reward.
For example, if a public-private partnership builds a bridge and charges tolls to recoup the cost, the deal needs to be structured so that each partner is compensated to the level of their investment. If all the money plus a profit margin is recouped, any additional profits should be split proportionate to the level of risk assumed. Unless there is a hard cap on risk, there should not be an instance where an investment by the public partner is retired and all further gains fall to the private partner.
It’s often stated that, in a public-private partnership, the government can be patient money. That is, the city’s investment can wait much longer for a return. That may be an acceptable approach, but the partnership needs to acknowledge the delayed recovery and compensate the city accordingly. The most patient money should be the most lucrative.