Public–private partnerships and the privatization of financing: An incomplete contracts approach☆

a r t i c l e i n f o JEL classification: H11 G32 D23 L20 Keywords: Public–private partnerships Incomplete contracts Soft budget constraints Governments have begun to embrace public–private partnerships (P3s) as vehicles for providing public services. This paper considers the controversial question of when private financing of public projects is optimal. Private development can dominate public financing through more efficient termination decisions for bad projects, resolving soft budget constraint problems. Due to contractual incompleteness and externalities, on the other hand, private developers cannot commit to large debt repayments, and hence can finance only a subset of valuable projects. Public developers, who do not face the same commitment problems, can finance a larger set of projects. Over the last fifteen years, governments around the world have embraced public–private partnerships (P3s) as vehicles for the delivery of a wide variety of public services in major areas such as education, transportation, health care and corrections. Pioneered by the United Kingdom with its Private Finance Initiative of the early 1990s, the P3 approach is being adopted in countries of all wealth levels and on all continents. 1 To economists, P3s may be seen as a simple extension of vertical disintegration or contracting out by governments. Rather than simply contracting out the construction of a new bridge for a fixed price, for example, a government may contract for the provision of " bridge services " including the design, construction, operation, maintenance and even the financing of the bridge. The idea behind such projects is most often expressed in general language as harnessing the efficiencies and innovativeness associated with a competitive private sector to help government achieve its public service goals at lower cost. Our aim is to be more precise about some of the tradeoffs involved. In our view (de Bettignies and Ross, 2004), two features of modern P3s set them apart from simple contracting out. First, the number of tasks that are contracted out to the same party or consortium is larger, as in the bridge example just given. Second, the privatization of the finance function – i.e. the delegation of the financing responsibility to a private firm or consortium – at one time extremely rare, has more recently become a central feature of P3 projects. In this paper we focus on the second and most controversial feature of P3s — the privatization of the finance function. 2 Incorporating elements of …