Monday, April 11th, 2011

Does Privatization Actually Transfer Risk Away from Government?

One of the reasons I’ve always liked privatization is that done right it can transfer a lot of risk from the government to the private sector. When I consider the Chicago Skyway or Indiana Toll Road leases, one of the things I liked about them is that there seemed to be an embedded hedge that more or less provided certainty over future financial performance. Travel volumes fall because gas goes through the roof? Not the government’s problem. Construction costs increase faster than inflation? Not the government’s problem. We really do stop driving so much as a society? Not the government’s problem.

Now, this hedge obviously has a value, so there was some price put on it. That’s one reason I don’t think it’s fair to compare some theoretically ideal value the government could have realized internally if a bunch of assumptions were met to an actual market price that reflects risk adjustment. Of course, that’s not to say it is worth paying for that protection, but I always thought there was real value there.

Then I actually started reading some of these contracts.

I paid more attention to the actual contract language in these deals when I dug into the Indianapolis parking meter lease. Upon further review, it is very clear that these asset leases really transfer few risks to the private sector. Basically the vendor is taking on two key risks: cost risk and demand risk. Pretty much everything else is retained by the public.

On the cost front, the privatized systems could cost more than anticipated to run. But that seems unlikely. Most of these vendor teams include operators with years of experience in running these types assets. I would suspect they are probably pretty good at projecting costs.

Demand risk is basically the big one. This is the risk that the public doesn’t dump their quarters in the toll booth or the parking meter. Now, that’s a very real risk. There’s no doubt that the toll roads that were privatized at the peak of the bubble have under performed, as VMT actually dropped during the Great Recession. With the time value of money, this is particularly painful in the early years of the deal.

(One might also include financing risk, as many of these deals assume a future refinancing).

The problem is that there are a ton of other risks out there. The contracts are worded in such a way that basically the government is boxed in such that if any of the deal assumptions ever need to change, the public is going to have to be the one to pay. For example, with parking meters, if the meters have to be taken out of service greater than a specified closure allowance – for any reason at all, including emergencies – the government has to provide compensation for this. Another example: on the Indiana Toll Road when the Borman Expressway flooded, the state implemented a temporary toll holiday, but this required vendor compensation as well.

As I have noted previously, it is extremely difficult to predict future conditions, so when you create a rigid deal structure that lasts decades, it is almost inevitable that the public is going to have to pay up to make changes, or else just suffer from not being able to respond to conditions.

I don’t necessarily fault privatization itself for this. All of these deals were set up by the government in this way in order to maximize the near term payout. By retaining so much risk, this frees bidders to put more cash on the table, since they don’t have to price in that risk. But it’s a real cost nevertheless. It’s just hidden until the future reveals it.

Many of these aren’t horrible, awful things in the grand scheme of things, but they do generate a large amount of headline risk among other problems. I would suggest that a more robust discussion needs to take place about retained vs. outsourced risk, and what levels of flexibility need to be built into the contracts to allow the public to respond to future needs, and to properly set expectations about the real cost of risk. Perhaps different types of deal structures should be considered such as a gain sharing model where the vendor and government can collaborate on the best responses to changing market conditions and public needs over time instead of a one and done shot. I can’t say for sure, but clearly the public has gotten skeptical of the current approach, and significant thinking needs to be applied to this area.

17 Comments
Topics: Public Policy

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17 Responses to “Does Privatization Actually Transfer Risk Away from Government?”

  1. John Morris says:

    “I don’t necessarily fault privatization itself for this. All of these deals were set up by the government in this way in order to maximize the near term payout.”

    Well then perhaps your headline is misleading. Perhaps the whole term “privatization” is also in this context. In fact the way our country now works–the whole term, “private sector” is misleading.

  2. BrianTH says:

    I agree a robust discussion about these issues is very much needed.

    In furtherance of that goal, I would point out it probably makes sense to keep The Winner’s Curse firmly in mind to the extent the price is set in a competitive auction. Even though these are sophisticated players, the expected financial benefit of these long-term deals is going to be highly dependent on your specific assumptions/models, and so there is often going to be good reason to believe the relevant situation is subject to The Winner’s Curse.

    Of course there are well-known things bidders can do to try to avoid the Curse, but also things the seller can do to try to defeat those measures. In fact, regardless of its other merits, the failed Pittsburgh parking lease was bid out in a very clever two-step process that I strongly suspect was designed for such a purpose.

    So I think that if you do it right, there is a decent chance the public authority is going to be the beneficiary of a Winner’s Curse, even on a risk-adjusted basis and assuming sophisticated bidders. Of course that doesn’t undermine the point about being clear with respect to what risks you are offloading and what risks you are not, which has independent merit even if the price being paid is likely a decent one.

  3. nick bilz says:

    “All of these deals were set up by the government in this way in order to maximize the near term payout.”? Really? It seems to me that most of these deals are set up by private companies to maximize profit at the expense of the public. Profit is Private; Cost is Social. I for one intend never to put a coin or card into one of the new meters. I would have gladly paid the increased rates if all the money were going to the City instead of increasing the profit margin of some corporation from, where was it, Texas? I wish I could say this parking meter business had so outraged me that I had given up driving and started riding IndyGo, but really it’s just forced me to park a few blocks away and walk.

  4. Attrill says:

    This is a great post that raises a lot of good questions. I think there are a number of other issues that need to be looked at in provatization deals:

    – The costs of the deals. It is easy for the public to see the total dollars that a city gets when it signs a deal, but the costs are almost never analyzed. The deals are treated as windfall profits when in reality they always have some cost associated with them. When you compare that to how a city’s budget can be analyzed down to the minutest detail (i.e how much garbage collectors get paid and how much was spent on office supplies) we are creating a culture that discourages normal day to day expenditures and rewards unexamined deals. Systems need to be put in place to examine the returns on privatization deals over the life of the contract – not just before they are signed.

    – Corruption. Local officials can be bought for very little money, and frequently that money is not illegal, it is just business as usual. I don’t think every deal is corrupt, but I do think there are plenty of opportunities for businesses to make a few thousand dollars in campaign contributions in order to get a couple obscure lines added to a contract that will cost a city millions. Everyone complains about corruption as a problem of government entities, but forgets that there are private companies on the other side of the coin that are instigating (and profiting from) the corruption.

    – Incompetence/Lack of resources. If a Wall Street fund is working with a local government to write up a contract – who do you think has the better contract lawyers? In the cases where there is no corruption city lawyers can easily be overwhelmed by the resources a private firm can throw at the contract. City governments are not properly staffed to get a fair deal in most privatization deals.

    In general I’m wary of Chicago entering into any new privatization deals until the mechanisms are in place to make sure the city isn’t getting screwed over (through incompetence, corruption, lack of foresight, etc.). The first step is to create a neutral method for analyzing the return of past contracts to figure out what they cost the city. At this point in history it seems that all discussions of government budgets only address expenditures, when revenues (and the loss of them through privatization contracts) need to be just as important a piece of the discussion.

  5. qwertyuiop says:

    The Indiana Toll Road lease may be an exception to your rule. In addition to the $3 billion the consortium paid up front, it and not the Toll Road is responsible for maintenance of the road for the next 70+ years. That represents a considerable transfer of risk from the public sector to the private.

  6. KurtL says:

    That is, of course, if they properly maintain it, qwertyuiop. I wouldn’t bet on that, though.

  7. George Mattei says:

    That was my thought exactly. I think the quality of maintenance is an risk to the vendor that can be externalized, and this could show up in these models. I’m sure there’s some language about maintenance in the contract, but if their revenue projections don’t pan out, there’s a point where any company is going to drop their maintenance levels to be unsustainable. It could be cheaper for them to stop maintenance and fight endless legal battles than to feed a beast that has an unlimited appetite.

    The externality here is that societies rely on these assets for economic well-being. So if the Indiana Toll Roads are not maintained, it’s the people of Indiana that can suffer. The vendor already suffered and they are trying to limit their losses, so they have every economic motivation to reduce that loss.

    That’s not to say that these deals can always be bad, but I do think the Bidder’s Curse, as mentioned above, could affect society as well as the bidder.

  8. George Mattei says:

    Sorry, it was the “Winner’s Curse” not the Bidder’s Curse.

  9. Thanks for the comments, everybody.

    For the record, I’m a huge fan of the Indiana Toll Road and Skyway leases.

  10. BrianTH says:

    nick,

    Do you refuse to use public services whenever the public authority in question takes out debt, or purchases anything from private firms? Would you use a for-profit establishment that was leasing space in a public park? Would you refuse to use the park?

    My point is that public authorities partner in various ways with for-profit firms all the time, and it would be virtually impossible to cut yourself off from supporting such partnerships.

    Of course that doesn’t mean public authorities should form such partnerships willy-nilly. But I don’t think you can rule them out either.

  11. John Morris says:

    George Mattei says,

    “The externality here is that societies rely on these assets for economic well-being. So if the Indiana Toll Roads are not maintained, it’s the people of Indiana that can suffer. The vendor already suffered and they are trying to limit their losses, so they have every economic motivation to reduce that loss.”

    Somewhat true. Let’s look for a moment at how well public entities have done at keeping up these responsibilities? I can’t speak for Indiana, but in most states, the so called “trust fund” money went into the general fund and was spent on whatever was popular at the moment and the roads are in bad or terrible shape.

    It’s a clue that they don’t exactly think about these things, since the government doesn’t even use accrual accounting.

    But there’s a deeperproblem, which is the issue of economic calculation. Suppose, for example demand drops steeply because of high fuel prices and sustained changes in behavior towards urbanism, rail freight, local production or even a very poor economy.

    Why in that case, would it be in “the public interest” to keep on maintaining capacity far beyond demand? Isn’t it better in that case, that the road is cut back or closed and the money invested in other places?

    This is of course the issue with the long term parking leases. If demand drops for parking and better uses are available for the land, it would be better if the parking was gone.

  12. John Morris says:

    In almost all these cases, including the toll roads, it seems much more logical to sell the asset–outright, leaving the buyers to use as they judge best as conditions change.

  13. John Morris says:

    The whole idea of fixing uses out as far as 70 years is absurd. We have no clue as to conditions or technology that far in the future.

    It’s one thing to build something based on a certain lifespan and projected demand and something totally different to fix this into a binding contract or law.

  14. BrianTH says:

    John Morris,

    One reason to lease rather than sell is that private firm discount rates tend to get rather high once you get past 20 years or so. So they won’t give you full value (using a lower long term discount rate appropriate for a public entity) for property rights past that point. Note this isn’t an issue in a transaction between two firms with similar discount rates–it depends on the (well-grounded) assumption that public authorities have lower discount rates past the relevant point.

    Of course this is also a reason to keep lease terms short, say in that same approximately 20-year range. But public authorities often push it to maximize present cash flows.

  15. nick bilz says:

    BrianTH,
    to answer all the questions in your first paragraph: no. i am not fundamentally opposed to public-private partnerships and think they can often do a lot of good. i’ve shopped at Circle Center Mall; i use the toll road when visiting friends in northern Indiana or Chicago; i;ve even eaten at the little snack shacks associated with some of Indy Park’s public pools, which are operated by a private vendor. your point that “public authorities partner in various ways with for-profit firms all the time, and it would be virtually impossible to cut yourself off from supporting such partnerships” is a true and valid one. However, IMHO, the parking meter lease does not fall into the category of “partnership.” to me, a partnership suggest mutual benefit and obligation for both parties, but as i understand this deal, the vendor gets a majority of the profit and power while the city is stuck with the majority of the risk and obligation. this plan essentially locks the city into its existing street scape and design for the next 50 years. what if in a decade Indy finally gets its act together and decides to move forward with some form of mass transit that would require the reconfiguration of several downtown streets? a busway or light rail line along the curb lane could eat up hundreds of parking meters along dozens of city blocks and could require months or even years of meter bagging during construction. how much more will that cost us? what would have happend if this deal had been in place before the Cultural Trail or Georgia Street improvements got underway? how does signing a 50 year contract to provide a private vendor full use and access to our public streets ahead of the public’s need for dynamic control over it’s most vital of assets constitute a “partnership”? i don’t think it does, and since voicing my opinion to my elected officials and local media outlets failed to stop this corporate give away, the least i can do is withhold my quarters.

  16. When anything from government is outsourced, accountability and civic flexibility declines. Government provides particular services for a reason — the private sector doesn’t provide a service the public needs in the responsive, cost-controlled (non-profit) way it needs to be configured.

  17. clever title says:

    Investment banks and equity groups have teams of risk analysts and lawyers assigned to the task of mimimizing the firm’s risk. Since they have a financial incentive in minimizing their risk, they’ll write clauses in the contract to do that.
    The pols and city employees are generally not evenly matched in this negotiation, nor do they have a personal satke on offloading the city’s risk.
    The poor results are not surprising.

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