Monday, April 11th, 2011
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.