Payment Mechanisms in Public-Private Partnerships

In every public-private partnership, it is the job of the public party to provide remuneration to the private party. There are various mechanisms in which this payment can be provided. In this article, we will discuss the mechanisms which are commonly used in public-private partnerships.

User Charges

User charges are a commonly used mechanism when it comes to providing compensation to private parties in a contract. Toll roads and bridges are the best examples of how user charges can be used to provide remuneration to private parties. This mechanism has limited usability since it can only be used when the number of users is expected to be significant.

In case, user charges are chosen to be the remuneration method, and the private party is given the authority to collect money from the common people. However, the rate cannot be fixed by the private party. Since toll roads and other infrastructure projects fall under the category of monopoly services, their prices are heavily regulated. Hence, the government fixed the prices even though the private party collects them.

The prices which can be charged in such projects are not fixed arbitrarily. Instead, they are charged based on a pre-agreed formula. This formula takes into account factors such as traffic and inflation in order to decide the rates which will be paid by the public. In other cases, the prices are decided by a government-appointed committee. In some cases, a combination of the two approaches mentioned above is used.

Revenue Based Payments

A major criticism of the user fees model is that it is used to line the pockets of private contractors. Critics of the model often say that the revenue formula shows unrealistically low assumptions. As a result, per unit charges are increased. In reality, the traffic is much higher than the projections. As a result, the higher unit charge multiplied by higher traffic creates massive revenue. This revenue is used to enrich a handful of contractors at the expense of the larger public.

To overcome the shortcomings of this model, revenue-based payments are often used. This model operates just like the user charges model. There is only one key difference. The difference is that a ceiling level is set. Once the ceiling is reached, the payments no longer go to the private sectors. Instead, the excess payments go to the government. The benefit is that the risks and rewards of both parties are managed. The private sector faces a lower risk since they have the first right to receive compensation.

Fixed Payments

In many cases, the government guarantees a fixed payment to the private sector. In such cases, the risk of the private sector virtually goes down to zero. This is because they have a predictable stream of cash flows, which they can look forward to as long as they perform the tasks which they are supposed to.

If the quality of the work is below the agreed-upon quality, then the contractor may have to face some fines and penalties.

Similarly, if the work is behind schedule, there may be some more fines and penalties. Thus the private party only carries execution risk.

On the other hand, the demand risk is managed by the government. If the demand is lower than expected, there is no impact on the private party since they still get paid. Such contracts are considered to be quite favorable to the private sector. Hence, they are usually awarded when the government is trying to encourage the private sector to invest in public works projects.

Tax Based Payments

In certain extraordinary cases, the payments related to an infrastructure project is not derived from the project. Instead, it is derived from a third-party source. This is often done when the project involves the use of a new or unproven technology where the financial inflows are difficult to predict. For instance, solar energy is a relatively new mode of energy. Hence, it would be incorrect to assume that it will be financially viable from day one.

In such cases, the government funds infrastructure projects related to solar energy by levying a tax on other goods and services. Commonly the tax is levied on the economic alternatives in order to make them more expensive. The money collected from these taxes is paid to the private party executing the project. Sometimes a fixed dollar amount is collected. At other times, private sector companies are willing to bear the risk of the uncertainty involved.

The bottom line is that the payment mechanism is considered to be vital for infrastructure projects. This is because of the fact that these mechanisms determine who will be bearing which risk. If the wrong payment mechanism is used, it creates a weak foundation for the entire project.