When P3s are used primarily to deliver significant cost savings or risk transfer on an infrastructure project, the goal should be to “optimize” the result in the sense that it’s the first-best solution. In these situations, the private sector has some fundamental advantage in building or operating the project (e.g. proprietary technology or economies of scale in a specialized area of expertise) that the public sector can’t duplicate efficiently.

It’s a great story – and one that the P3 industry naturally likes to advertise.

But in many real-world situations, especially involving simple, low-risk social infrastructure, US state and local governments are interested in P3s for a quite different purpose – fiscal management. The contractual and financing forms of P3s can help officials cope with fiscal constraints that impede infrastructure investment like onerous procurement processes, statutory debt limits, volatile revenues and budget shortfalls.*

P3s for this purpose can in fact deliver a valuable result relative to the alternative of delayed investment or none at all, but it’s not a first-best solution (which would involve the really hard job of reforming the constraints themselves).

Worse, “coping” doesn’t sound very glamorous and, described without the context of results, can easily be characterized as gimmickry. So understandably, neither the P3 industry nor public-sector officials are enthusiastic about describing the coping function of P3s per se. Instead, it’s natural to try to spin the story in terms of the classic P3 first-best solution and find some sort of distant cost-savings or hypothetical risk transfer (however nebulous) to justify the deal.**

That’s a real problem, regardless of good intentions. Coping tactics can easily morph into dangerous and addictive gimmicks unless they’re kept on the straight and narrow path by transparency. Here’s a passage from a Volcker State Task Force white paper on budget reforms that puts the matter succinctly (emphasis added):

The budget process is most problematic during difficult fiscal times, especially recessions.
When a state resorts to such gimmicks as shifting payments from one year to the next, underestimating expenditures, or using inflated revenue estimates, it may be doing so both to cope and to preserve the illusion of budgetary balance without raising taxes or cutting programs.
But ensuring that budgets are realistic and that one-time actions are clearly described will
help guarantee those actions are used only when necessary and kept to a minimum.

This is all especially true for coping tactics using P3s because they are complex deals anyway and involve significant long-term commitments. It’s one thing to cope with a revenue shortfall by delaying spending that can made up in a year or two – it’s quite another thing to cope with a debt limit by entering into a 30-year P3 contract on a $250m project. It’s not necessarily bad – but the reasons for doing it that way and the real net benefits need to be clearly disclosed.

Clear disclosure and accessible transparency standards for fiscal management P3s will require some development, since the nature of the beast is somewhat different than usual public-sector commitment. But it’s eminently achievable since at the core of a P3 transaction there’s always a very detailed contract about every conceivable obligation that the public sponsor might have under the arrangement. That’s inevitable and automatic because the private-sector won’t invest otherwise.

So there’s plenty of raw material for transparency in a P3 contract. The challenge is to convert the multi-foot-high stack of paper into meaningful and relevant language and numbers, and then fit these into the standard context of public-sector budgeting and fiscal disclosure like GASB and CAFRs. It may take some work – but a small price to pay for using such a powerful tool as a P3 in a prudent and sustainable way.

The public policy case for more transparency with fiscal management P3s is clear. But the P3 industry should also support the effort. It’s in the industry’s long-term (and larger-scale) interest to ensure that P3s are seen as above suspicion when it comes to gimmickry. If the product really delivers value – even of the second-best, coping variety – then shine a light on it.

*/ Interesting that a former Governor of the Bank of England, Mervyn King, uses the same distinction between “optimizing” and “coping” in his recent book to describe the limits of central bank policy. His point is that in most cases it is impossible to optimize around economic risk using models and stochastic analysis – real-world is far too complex. Instead, central banks should focus on coping with uncertainty with simple robust tools.

**/ I think this is main reason that Value for Money P3 evaluations are often so convoluted and lacking in credibility. When the primary purpose of a P3 is fiscal management, cost savings and risk transfer by themselves are unlikely to make a compelling case when simply and honestly measured. In order to make the case only in those terms (instead of the fiscal management reality), requires unrealistic assumptions, arbitrary adjustments for hypothetical risks and opportunity costs, discount rate games and all the rest. The net result is no one believes the VfM study anyway.

Cyclical Accrual and the Counter-Cyclical Borrowing Facility are based on solid theory and detailed technical evaluation.  But the relevant story really can be told in a five pictures.

1)  US state and local governments face revenue volatility, low growth and general uncertainty — and it’s not getting better.

2)  Uncertainty makes it hard to manage budgets, which leads to using addictive and expensive “credit cards from hell” to plug shortfalls by deferring needed spending — with really bad results.

3)  Budget and fiscal reform should remain the long-term objective, but “cold turkey” change is neither efficient or realistic.  For critical infrastructure investment in the near-term, P3s can provide a framework to utilize inexpensive and disciplined financing that covers project costs during budget shortfalls (as determined by an objective index) but absolutely, positively requires repayment when budget is less constrained  — in effect a “Tough Love” credit card that works like a built-in rainy-day fund:

4)  Federal and state infrastructure loan programs or infrastructure banks could dramatically expand the size and acceptability of P3 Tough Love cards — but at low risk and low cost to taxpayers due to high credit quality of P3 contracts and collateral and private-sector skin in the game.  No Solyndras here:

5)  This type of P3 could also be used for sale/leasebacks or similar concession sales of existing assets — with proceeds used to address deferred maintenance on the asset itself and to pay off other expensive credit cards from hell balances:

New column in Governing today.

Larry Summers uses the deferred-maintenance-as-expensive-debt in recent post:

“Borrowing to finance maintenance should not be viewed as incurring a new cost but as shifting from the fast-compounding liability of maintenance to the slowly compounding liability of explicit debt.”

OK, I certainly agree with the debt analogy. But regarding the proposed (implicitly obvious) solution that on-balance sheet borrowing is cheaper, this is true but an ivory-tower observation. The problem is that although “explicit debt” will almost certainly have a much lower interest rate than deferred maintenance accrual cost, it is also on-balance sheet (using up statutory debt capacity), requires fixed repayment and is less flexible.

And not as if budget flexibility is getting less important – here’s Moody’s view in a recent Governing column:

“As a result, revenues become more unpredictable and policymakers have to become more cautious. Unfortunately, it looks like that dynamic is here to stay.”

I think “more cautious” does not mean “more prudent” in the long run but is in fact consistent with leaving expensive liabilities in place if they’re off-balance and flexible and the only alternative is traditional debt.

Both of these observations point to possible role for innovative P3s that are debt-like (i.e. cheap like an availability payment) but also flexible for in effect refinancing deferred maintenance (along with financing upgrade/expansions too) on existing social infrastructure.

So I guess that’s the case for brownfield P3s — not really a “sale”, or a “monetization” or “asset recycle” — but in fact more like transferring credit card balances from a stupidly-expensive card to some other relatively flexible (but much cheaper) form of borrowing.  Not exactly complicated?

One quick clarification when I refer to P3s as a ‘second-best’ solution to revenue volatility in various places – I don’t mean they should be considered a ‘less-bad gimmick’ than real outside-fiscal-constraints culprits like deferred maintenance and underfunding pensions.

Those gimmicks are bad because they’re expensive and opaque. P3s can and should be consciously structured to be cost-efficient, transparent and discipline-enforcing, even if part of their purpose is to provide some down-cycle relief to fiscal constraints. Explicitly measuring P3 value in that way also highlights why first-best solutions for revenue volatility (e.g. bigger rainy-day funds, more stable mix of revenues etc.) should be the ultimate goal, especially if the real cost of the current set of gimmicks is further exposed in the process.

So I think P3s done primarily for fiscal constraint relief can be put on the good-guy side of public policy if (and maybe only if) they’re done correctly.  Since you can’t really hide something as big and obvious — and usually controversial — as a P3, I think a lot of people will be making sure that happens.  Contrast that to just sweeping deferred maintenance under the fraying rug.