Under which conditions is a PPP relevant for public spending?

Abstract

Public authorities increasingly involve the private sector in financing, building and operating new infrastructures. Many reasons are usually given to justify private sector involvement. One of them claims that private operators can manage project construction and operation more efficiently. Nevertheless, whether a public or a private operator, there is a target IRR, very close to the standard notion of Weighted Average Capital Cost (WACC), which is higher in the case of the private alternative because it must also include the operator's profit. The fundamental issue is the result of two opposite effects: on the one hand, the effect of the higher efficiency of the private operator; on the other hand, the effect of a lower WACC for the public operator. This paper proposes a model of the determination of the need of public financing which formalizes these two effects and allows analysing the conditions under which the PPP would be advantageous for the public finances. Simulations estimate the efficiency gain from private operators needed to compensate their higher WACC. Results confirmed the so-called ‘paradox of financial profitability’: recourse to PPP is more relevant for public funds when the profitability of the project is lower.