Public-Private Partnership Contracts: A Tale of Two Cities with

Different Contractual Arrangements

Rui Cunha Marques Sanford V. Berg

Centre of Urban and Regional Systems Public Utility Research Center
Technical University of Lisbon University of Florida

January 6, 2010

Abstract

This paper analyses regulation by contract in public-private partnerships (PPPs) for

infrastructure services. Although the benefits of competition for the market and subsequent
regulatory contracts are recognised, the literature also identifies contract design failures.
When considering these limitations, it is useful to distinguish between contracts associated with
purely contractual PPPs (concessions) and contracts for institutionalised PPPs (mixed
company). Two cases from the Portuguese water sector are used to illustrate problems arising in
the preparation of public tender documents: the "best" bidder is often not the winner. Often,
risks are not allocated correctly nor is effective monitoring ensured. Comparisons between the
two types of contracts show how external regulation can be useful in mitigating contractual
problems. This examination of bidding procedures and contract design yields several
implications for policy-makers; in addition, the study presents recommendations for improving
regulatory contracts.

Keywords: public-private partnerships; water utilities; concessions; mixed companies; contract

design

This paper is a shortened and revised version of Public-Private Partnership Contracts:

A Tale of Two Cities (June 2009PURC Working Paper)
INTRODUCTION

Competition in the market is absent in many infrastructure services. Some segments of

network industries, particularly water utilities, are natural monopolies. To achieve
production efficiency, such markets should have a single operator. This situation can
harm the public interest when there are excess profits (redistributing income from
customers to the monopolist) and reduced output causing misallocations (deadweight
losses). Without pressure from the capital market, the monopolist prefers the quiet
life: incentives for production efficiency are blunted. One public policy response is to
create a sector regulator with the responsibility for promoting better performance and
meeting social concerns: ideally, to achieve levels of allocative efficiency comparable to
those arising in the competitive marketplace and to achieve public policy objectives. Of
course, the sector regulator faces significant problems related to expertise and
autonomy, information asymmetries, regulatory capture, opportunism and authority.

An alternative to competition in the market is competition for the market (Chadwick,

1859). In this case, the right to operate a monopoly is subject to an auction. The winning
bid would be the one to present the best offer (lower cost or higher rent), guaranteeing
that in a situation of sufficient competition (no collusive behaviour) the winner would
offer an average price close to the average cost, allowing for fair and reasonable profits
(Demsetz 1968). The conditions of operation (rights and duties) are signed in a written
contract, leading to the term regulation by contract. The modern version of this kind of
relationships is labelled public-private partnership (hereafter, PPP). Indeed, a PPP is a
form of public procurement with cooperation between a public authority and a private
partner aimed at ensuring the funding, construction, renewal, management and/or
maintenance of infrastructure, or the provision of a related service.

In the EU, PPPs are classified into institutionalised PPP (mixed companies) and purely
contractual PPPs [see about PPPs for infrastructures and provision of services in the EU
and their classification the COM(2004)327, COM(2005)569 or C(2007)6661]. These
two models have very different features which are studied here with reference to two
municipalities. Purely contractual PPPs comprise concession, affermage, and
management contracts. Note that outright divesture is not considered a PPP. Some
features of PPP contracts include the sharing of responsibilities and risks between the
public and private partners (in principle, risk is allocated to the partner better able to
manage and mitigate it), a project life-cycle approach, and incentive (output) payment
schemes.

The impact of private sector participation and PPP contracts in infrastructure, including
water, has been often positive (Gassner et al. 2009). Most PPP contracts have provided
value for money and have helped to solve serious problems of coverage and quality of
service both in the developed and developing world. However, some outcomes have
been problematic, with failures in many PPP contracts, including breakdowns and early
termination of contracts. In fact, most PPP contracts are renegotiated. In a study for
Latin America (sample of 1,000 contracts), Guasch discovered that 75% of the water
concession contracts were renegotiated on average 1.6 years after their signature
(Guasch 2004). Under this circumstance there is bilateral bargaining to restore a
mutually acceptable situation for the parties, which undermines the legitimacy of the

2
original contract award. Since there is no competitive environment at this stage, the
operator will always have more information on the implications of alternative
contractual arrangements, putting the private partners in a position to imposing their
will (Bajari et al. 2005).

Most of the literature has focused on developing countries, where often the lack of
transparency and expertise within newly democratic governments, lack of procedures to
prevent corruption, and a national focus on industrialization might contribute to
unsuccessful contractual arrangements. Nevertheless, experience around the world
suggests that the failures of contract regulation are not a matter of stage of development:
see, for example, the cases of Atlanta in the US water sector, the airport of Montreal in
Canada, or the London underground in England.

This study draws lessons from a detailed analysis of two PPP case-studies in Portugal,
one contractual (concession contract) and other institutionalised (mixed company) in the
local sector. The institutionalised PPPs have been little discussed in the literature but are
very important in some countries (e.g. the Socit deconomie mixte in France, the
Stadtwerke in Germany or the Empresa Mixte in Spain). This analysis represents a first-
step towards better understanding the full implications of widely-utilized institutional
arrangements. We conclude that in these cases the contract failures are even more
serious than is generally recognised.

Portugal has a population of about 10.7 million inhabitants and is organized into
districts, municipalities (the basis of the countrys administrative structure), and
parishes. Currently, Portugal has 18 districts, 308 municipalities and 4,257 parishes. In
the European context, Portugal is highly centralized and local authorities expenditures
represent a smaller percentage when compared with Nordic countries which spend
about five times more. The responsibilities of municipalities are minor (mainly in
health, education and social protection areas) in Portugal. However, they are parallel to
the other countries in Europe concerning other infrastructures. For example,
responsibilities in the water sector are similar in all Europe (except UK, Netherlands
and a few other cases), with water services located within the sphere of municipalities
and the water policy in the regional or central governments. The Portuguese legislation
is deeply influenced by EU legislation, particularly in public procurement. The scarce
financial resources of municipalities have two important consequences. On the one
hand, they limit investment in human resources and administrative structures. In
addition, lack of financial resources leads to difficulty in contracting good consultancy
services (experts). On the other hand, they are the major reason for the foundation and
popularity of PPPs in the local administration in different sectors, since municipalities
are always under financial pressure. However, PPPs have been utilised more as a
financial tool than as a form of public procurement, which harms performance.

The remainder of this paper discusses PPPs in infrastructure, emphasising their

strengths and limitations, contract design issues and the common reasons why some
contracts fail. Next, it analyses different models of PPP and private sector participation
in the water sector, particularly, in Portugal. Then, two actual PPP contracts are
examined regarding two institutional arrangements. Key lessons for the design and
monitoring of PPP contracts are drawn in the final section.

3
PPPs IN INFRASTRUCTURE SERVICES

Strength and limitations

Implementation of PPP contracts in infrastructure public services has generated benefits

in terms of efficiency, service quality, and network expansion (Murphy 2008; Vining
and Boardman 2008 and Marques and Berg 2009). Compared with the full privatisation
option, PPPs do not require very detailed information about costs, demand and other
features of the projects, neither is a traditional regulatory agency or a contractual
management agency required (Viscusi et al. 1995). In addition, PPPs do not promote
overinvestment. During the contract length, the private partner is interested in
maintaining a good reputation which constrains possible hold-up behaviour by the
operator. The hypothesis of early termination of contract is possible and anticipated in
contracts. Compared with public provision (even without considering funding needs),
the advantages of PPPs are potentially greater. Beyond those anticipated in the contract,
the PPP-holder captures additional gains associated with efficiency improvements and
new service introductions (Crew and Zupan 1990). These profits will be passed on to
the customers when the PPP concludes. Expected rents are captured by customers
(government) in the competition for the market, where the abnormal profits were
eliminated by competition. Even without considering better efficiency in the private
sector (emphasised in some streams of literature), in fact the PPP-holder is more
accountable to customers and to the government since its duties are defined in the
contract, including penalties (and rewards). As a rule, the operator in a PPP provides a
higher quality of service, and will more likely meet the predicted budget and the
deadlines than a purely public organization. Furthermore, the (potential) better
allocation of risks leads to the development of risk mitigation strategies, cost savings,
and service quality improvements.

Supporters of both full divesture and public ownership provide a very different
characterisation of PPP contracts from those noted above (see Williamson 1976). Critics
point out the high information required, the need for a supervising entity responsible for
contract management, the issue of overinvestment (either by minimum investments
imposed or if the plan of investments was an award criterion), and the weak incentives
for efficiency and innovation due to the possibility of renegotiation and ex-post
opportunism. The PPP bidding stage is also criticised for being excessively complex
and very slow and for imposing high costs on those preparing bids. Gaining access to
the market is seen as an expensive game for participating bidders (often involving the
winners curse). Frequently, the best bid (when evaluated in a comprehensive fashion)
is not accepted. Strategies of low-balling, where the winner expects to seek a contract
renegotiation at a later stage, are common. Furthermore, the number of bidders is
usually small raising the potential for collusive behaviour.

Another weakness associated with PPP contracts involves contract monitoring.

Contracts are incomplete by nature. For example, supervising quality of service requires
expertise and careful auditing procedures for company-provided data. Moreover, PPP
providers will probably tend to underinvest and provide a lower quality of service.
Unpredicted events, the application of sanctions and the need for mediating conflicts

4
turn the monitoring of the contract into a fundamental task that should be performed by
an expert and independent body.
This critique of PPP contracts argues that they lead to higher costs, due to the search for
profits by private companies, the higher cost of private capital, and the increase in
procurement costs. In addition, service quality could be low due to underinvestment and
to the inability of the contract to specifically address all quality issues. Some argue that
there is also a loss of public sovereignty (flexibility, transparency and accountability)
with PPPs in practice (Phang 2007) and others point out that they can be controversial
(Reeves 2008). As we will see next, most of the problems are related to contract design
and can be addressed in a well-prepared contract.

Contract Design Issues

PPPs contracts can be classified into short-run and long-run (or incomplete) contracts
(Lane 2001). The former have a length between one and five years, possibly up to 10
years and the latter have a length greater than 12 years (Klein 1998). Designing PPP
contracts to be signed between the Government and the private operator is challenging
and requires legal and technical expertise. The main issue is balancing the initial
preparation costs (affecting the contract incompleteness) against the transaction costs
generated by probable renegotiation. As ex-post opportunism and renegotiation
represent major failures of a PPP contract, the public body should try to avoid this
contingency. In order to do so, the following procedures must be accomplished:
1. Allocating risks to appropriate parties;
2. Guaranteeing the economic and financial equilibrium only for the contingent
risks borne by the public partner;
3. Assigning payments based on outputs and performance;
4. Assuring that the winning bid is fulfilled when the contract is signed;
5. Constraining the possibility of bargaining after public bidding and contract
signature, and
6. Clarifying the terms of early contract termination.

Generally, the choice between short-run and long-run contracts depends on the up-front
investments or rents required. In the past, PPPs were often associated with long-run
contracts since financing was the major issue. Currently, financing continues to be
relevant but the risk associated with this type of contract has become more important,
especially in developing countries.

The Failures of Contracts

There are several reasons for the failure of PPP contracts. They can be sorted into three
groups, related to problems with conducting the bidding process, risk sharing, and
monitoring (Marques and Berg 2009). These major sources of failure are briefly
analysed below.

a) Conducting the Bidding Process

To avoid political favouritism, the choice of the private partner should be made by
public bidding. With enough competition, excess profits will be eliminated. Normally,

5
there are several criteria to award a PPP, leading to the application of multi-criteria
decision analysis to determine the winner. Unfortunately, rarely is the assessment
methodology provided in the public tender documents, which limits transparency and
unnecessarily reduces information available to bidders about what the PPP-granting
authority views as important. Most of the time, bids suffer from a number of problems,
such as (1) assumptions underlying the bids are not comparable, (2) superficial elements
are evaluated rather than the essential ones, (3) the principles initially proposed (in the
bidding documents) suffer changes at the evaluation stage (or in second stage when it
exists) or when the contract is signed; and (4) criteria like experience and financial
health are considered as evaluation criteria instead of standards for bidder qualification.

b) Managing and Sharing Risk

The main theoretical benefit from PPPs is that the risks would be assigned to the
contractual party that is best able to mitigate the risk or to bear it. The optimal allocation
of risks minimises economic costs. In the EU (Eurostat), the rule is not to consider the
PPPs charges in the public accounts if the private sector has to support at least two of
the three risks (construction risk, demand risk, and availability risk). Moreover, most
contracts have clauses protecting the private sector from bearing such risks while
ensuring economic and financial equilibrium.

c) Monitoring Contracts

The role of monitoring the contract is similar to the role performed by an external
regulator, though the former activity might involve a little less discretion. The major
problems of monitoring are related to supervising service quality, resolving contractual
disputes and customers complaints, applying sanctions and performance rewards,
participating in potential renegotiation, addressing early termination of contracts,
overseeing asset transfer, and specifying terms for the renewal of PPP contracts. The
bidding documents should identify the resources required to carry out the PPP
monitoring and be specific on how the monitoring will be performed, including (1) all
reporting procedures, (2) the amount and circumstances under which sanctions can be
applied, (3) procedures in the event of renegotiation, and (4) quality of service
supervision and, particularly, the handling of complaints. The public discussion of PPP
contract performance can be an effective tool (a name and shame policy) so that
performance results should be known publicly on a regular basis. Note, however, that
usually there is general legislation concerning customer complaints and contracts
normally impose sanctions when they are not adequately dealt with. Contract
monitoring is often omitted in the bidding documents, despite its centrality to PPP
contract success.

PPP IN WATER SECTOR

Different models

As mentioned above, models of privatisation (without full divesture) can be classified

into two major groups: contractual PPPs and institutionalised PPPs. In the first one, the

6
partnership between public and private sectors is based solely on contractual links,
whereas in a PPP of an institutional nature there is cooperation between the public and
the private sectors within a distinct entity. Both arrangements involve delegated
responsibility of production (operation), finance (although there are exceptions such as
the affermage contracts) and the collection of tariffs before the end-users (with some
exceptions like shadow tolls in transportation). In the first type of PPP, rights and
obligations are regulated by an administrative contract, while in the second, they are
guaranteed by the companys statutes and by the shareholder agreement. Contractual
PPPs include concession, affermage and management contracts. The focus here will be
on concession contracts since funding is frequently required and they are the ones most
often applied. Of course, this model can have complications as to whether the project is
bankable or not. Investor perceptions of associated commercial and operating risks
affect the cost of capital. Nevertheless, concessions have benefits to the extent that
equity can be leveraged and that private participation improves incentives for high
performance. Such arrangements are primarily adopted when large investments are
necessary or the governments are maximising up-front payments (rent-seeking). They
are used recurrently in the water sector, as well as in other sectors, like transportation.

In the second model, the institutionalised PPP, the public sector and a private company
usually create a third company to deliver an infrastructure service (although an existing
public company may also sell part of its shares to the private sector). Generally, the
public sector retains corporate control, while management of technical operations is
normally carried out by the private company. At first glance, the model has sound
principles, since sharing management responsibility can avoid some conflicts (Marra
2007). As the public sector is now more accountable, there is less imperfect information
and disputes can be resolved internally.

Participants from the public sector exercise their authority (and political power) over
infrastructure services by being able to appoint the board of directors, approve major
decisions and participate in daily management. However, companies jointly owned by
private shareholders and government can lead to the worst of both worlds, achieving
neither high profitability nor worthwhile social goals (Boardman and Vining 2008). In
institutionalised PPPs, only the statutes of the firm and a shareholder agreement
document regulate the relationships between the partners.

The Portuguese Experience

In Portugal, the responsibility for the water activities belongs to the municipalities.
There are 300 retail water utilities (for 308 municipalities and 10.7 million inhabitants)
and about 70% of the water is provided by 18 public wholesale companies.
Municipalities can opt for a number of arrangements, including the establishment of
private companies by means of concession contracts, municipal companies which can
include a (minority) private shareholder, semi-autonomous organizations, or direct
supply by the municipality. Private participation was not introduced in the sector until
1993. The enactment of legislation in that year allowed local municipal authorities to
delegate water service functions to private sector companies through a public tender by
concession contracts (purely contractual PPP). With the opening of the market to private
participation, it became necessary to monitor and supervise this activity so that the

7
national government created a regulator (Institute for Regulation of Water and Waste -
IRAR) although without substantial economic regulatory authority. In 1998, new
legislation allowed the creation of municipal companies, making it possible to found
mixed companies (institutionalised PPP). In order to safeguard the principle of local
autonomy, IRAR does not have authority over these companies or over the local
administrative bodies in charge of the systems direct management.

Until December 2008, 38 public tenders for PPP were launched in the water sector,
corresponding to more than 2.7 million inhabitants. As of that date, 29 contracts had
been signed, with five cancelled and the rest still in negotiation. Of the 29, 24
correspond to a purely contractual PPP and five to institutionalised PPPs. The average
length between the tender call notice and the contract signature was about 21 months.
The average number of bidders was four: more than 30 different private companies
participated in these public bidding procedures, including the well-known transnational
companies. As a result, now there are five major private players in the Portuguese water
sector; three are international operators. The water market in Portugal, despite being
small, has been very appealing and has shown reasonable competition between
tenderers. Furthermore, in line with earlier observations about the fragility of contracts,
50% of the PPPs have already been renegotiated. In the next subsections two empirical
examples will be provided (anonymous municipalities) to analyse in more detail the
causes for renegotiations and other failures. The authors had access the all documents
concerning the foundation of these PPP (public tender documents, bidders, awarding
and assessment reports, contract, shareholder agreement and others) because according
to Portuguese law, they are classified as administrative documents requiring public
access. Note that the problems identified and presented here do not necessarily mean
negative outcomes. Usually these companies have higher performance when compared
with the public ones in Portugal (Marques 2008).

CASE-STUDIES

Purely contractual PPP: Municipality A

The public tender documents and the signed contracts are quite similar in Portugal. The
municipalities generally do not have competencies to perform these tasks; consequently,
due to scarce resources, they hire local or low cost consultants with little experience in
PPPs. In addition, municipalities, and particularly the mayors, tend to favour consultants
they can trust politically. Frequently, the players themselves lobby the mayors and
provide them with draft public tender documents. Consider a recent bidding in
Municipality A which is similar to (or better than) typical biddings. Municipality A
launched a contractual PPP, a concession with the length of 30 years for water and
wastewater services. It embraced about 12,000 customers. The concession comprised
only the retail segment since the municipality imported water from a public wholesale
company and outsourced wastewater treatment. The municipality had a set of urgent
investments amounting to 10 million Euros. It also asked for an annual payment (rent)
which corresponded to a residual value (about 1 million Euros during the 30 year-
period). There were seven bidders: the public tender stage (including the design of
contract) took two years to complete.

8
a) Conducting the Bidding Process

One of the major problems of this particular PPP was the absence of an economic and
financial study of its viability. It is understandable that the municipality had not
performed a public sector comparator study, but at least the public documents should
have provided adequate elements about the operation and maintenance of the services
and infrastructure records. This lack of data complicates the bid preparation process and
increases the cost for bidders.

Table 1 presents the criteria for bid assessment and their weights. The average tariff
criterion was computed using a formula specified in the bidding documents attributing
100% for the minimum tariff proposed: all the remaining points were computed in
percentage terms according to this framework. The average tariff corresponds to the net
present value of the sum of projected revenues, divided by the volume of water billed
and by 30 (years). The remaining criteria were detailed during the public tender stage.

The methodology suffered from three very serious problems: lack of standardised
assumptions, inappropriate (sub)criteria, and lack of consideration of the probability of
renegotiation. First, the key-variables in the project were not standardised; thus, the bids
were based on very dissimilar assumptions regarding population and customer growth,
future consumption patterns, leakage targets, and macroeconomic variables. The
differences in some of these factors reached almost 50%: thus, the resulting bids were
not comparable. This inconsistency clearly led to the winners curse: the concession-
granting authority is likely to accept the most optimistic, rather than the best, proposal.
The second problem relates to non-economic (sub)criteria, which were inappropriate for
a PPP. Part of these subcriteria constituted risk to be borne by the private firm. In
addition, most of the other subcriteria (e.g. quality of service) should have been
imposed and not subject to competition. They led to excessive discretion and
complicated the evaluation process. The neutral criteria should also be avoided. Finally,
the subcriteria should be assessed with an output based approach rather than with one
that emphasises inputs.

At first glance we might think that the weights given to these subcriteria are small, so
these elements are unlikely to affect the choice of the winner. However, these
subcriteria are often evaluated in a comparative basis where there are usually 5
classifications, such as very good, good, reasonable, weak and very weak. The
difference between very good and very weak counts 100% of its weight. In the average
tariff, normally the one classified in first place gets 100% but the last one can have
nearly 90%; for this reason, the weight of 70% is not as relevant as it seems a priori.
The subcriteria (flawed as they are) did affect in the final evaluation.

Finally, the criteria evaluated did not consider common problems of PPPs, like the
probability of renegotiation. The robustness of the business case to potential adverse
situations was not evaluated and the associated adjustments required for restoring the
financial equilibrium were not considered (e.g. internal rate of return of shareholders).
The documentation required in the subcriteria related to financial and contractual
strength mainly focused on the equity put into the project by the private firm and on the

9
letters from banks regarding project financing. These elements are indeed important, but
the former is nearly always neutral because rather than a firm commitment, the bidder
only makes known its financing intention.

b) Managing and sharing the risk

The second major failure of this regulatory contract is that the risk is not shared
appropriately with the private sector. If we examine the clause regarding the restoration
of economic and financial equilibrium in the public tender, translated in the signed
contract (see Table 2) , we observe that the most important risks are transferred to the
municipality, and part of them are later transferred to the customers directly. Thus, as
presented in Table 2 (and with some exceptions), the major risks are not borne by the
private sector, penalising the public interest.

If we consider the consumption risk, the scheme displayed in Table 2 is highly perverse:
encouraging excessive optimism and exacerbating the winners curse. The PPP granting
authority is doubly penalised: the best bidder may not be chosen if it predicts an
optimistic volume and there is a high probability of needing to revise the contract to
achieve its financial and economic equilibrium. Most of the other risks, except those
related to unilateral changes by the municipality, should be borne by the private sector.
For example, with this contractual clause, the private firm does not have incentives to
predict other investments beyond those compulsory in the public tender documents. The
consequences are quite visible since their inclusion in the bid diminishes the likelihood
of the concession being awarded. The best strategy for the bidder is to negotiate directly
with the municipality without competition after winning the bid. Of course, legal and
the regulatory risks can be allocated to the public sector, or preferably passed onto
customers. For such contingencies, it may not be necessary to deal with a negotiation.
The contract signed between the private company and Municipality A also allocates
rights of way or eminent domain (expropriation) and force majeure risks to the
municipality.

c) Monitoring Contracts

This contract has problems with the application of sanctions. In addition to the reduced
values (the most serious correspond to about 1% of an annual turnover), the scheme
presumes that the public sector will actually apply a sanction to the private firm which
has available a set of appeal mechanisms that may stop the process. An example of this
difficulty is found in Portugal, where no sanction has ever been applied fifteen years
after the first concession contract signature.

The major explanation for the absence of sanctions is that the burden of proof resides
with the public sector rather than with the private operator. It is reasonable for the
private firm to have various ways to defend itself, but the application of sanctions
should be automatic, particularly those related to quality of service (e.g. customers
receive a payment if a complaint is not handled adequately). Note that the issue of
service quality monitoring is particularly troublesome under regulation by contract. In
Portugal, it is mitigated by the existence of an external regulator (IRAR).

10
A second issue is the possibility of earlier termination of the contract at the initiative of
the public partner. The conditions of early termination tend to be draconian, including
significant compensation for the operator or reducing the value of this mechanism for
the public partner. Consequently, in Portugal there has never been a PPP contract
termination in any sector! The particular contract for Operator A includes return of
not only the non-depreciated investments made and the debt payment, but also the net
present value of the annual lost returns on equity for all years between the moment of
termination and the end of the contract and 20% of technical assistance contract for that
period. Since the technical assistance contract represents about 4% of the turnover, it
corresponds to 0.8% of the turnover in each remaining year. This weakens the
performance of PPP projects and is detrimental to the public interest.

Finally, the supervision of the investment plan and the quality of the assets deserve
attention. There are clauses in the contract which regulate the transference and the state
of the assets (particularly the renewal), imposing a requirement that investments should
be maintained to have a life expectancy comparable to two thirds of their life cycle. This
implies significant investments that should be supervised by the public authority.
Nevertheless, this particular contract did not determine how this would be done; nor did
it specify the consequences if the private sector was unable to fulfil its investment
obligations. In the authors opinion, outcome targets should be imposed rather than
investment obligations. However, if minimum investments were predictable, at least in
the renewal period, there would be the possibility of mitigating conflicts, discretion and
misunderstandings in future bidding processes.

An Institutionalised PPP: Municipality B

Only seven public biddings of institutionalised PPPs were launched between 1998 and
2008. Although the public tender documents were similar, some of them allowed for a
second stage of explicit negotiation. When both partners fully understand the project the
two bids which pass into the second stage improve significantly their proposals: they
have more time to conduct more studies and therefore gain better insight into the
project. The fierce competitive environment often generated is highly positive. Usually,
in the second stage the criteria negotiated consist of the value of shares sold by the
municipality (usually representing 49% of shares) if the bids are similar. However, the
bidder(s) might be asked to improve a particular criteria to a higher desired level or, at
least, to the level of the other bidder.

Municipality B called for an institutionalised PPP (mixed company) which included

water, wastewater and stormwater services. The private firm would have 49% of the
shares and the municipality would retain the remaining 51%. The term of the PPP was
indefinite (on the whole it is established for a specific period, for example 30 or 40
years); the municipality would only negotiate with the firm classified in second place if
the negotiation with the winner was not successful. Having a potential rival in the
wings puts some pressure on the first stage winning bidder to bargain in a reasonable
manner. The PPP encompassed more than 30,000 customers and included wholesale
and retail segments. The municipality had a set of critical investments to be carried out
representing about 60 million Euros. The municipality also asked for an up-front single

11
payment of 18 million Euros (for 49% of shares). Six bidders participated in the public
tender.

a) Conducting the Bidding Process

To create the mixed company (and to call for bidding) it is necessary to present an
economic and financial viability study to allow the municipality to better understand its
situation; similarly, the information provides bidders with substantial data. Yet, the
process can have a perverse effect, as occurred in this case. For example, the up-front
payment to the municipality did not include a commensurate increase in the average
price. The evaluation criteria, despite having a better structure than in typical concession
contracts, still had problems (see Table 3).

Table 3 highlights that some criteria are inappropriate (they do not differentiate among
bidders or merely complicate the evaluation process) and, consequently, the selection of
the winning bid that is not necessarily the best. Most of the subcriteria for B
(appropriateness of the proposed investment plan) and C (quality of bid) are either
arbitrary or non-informative. Additional items only increase the complexity of
evaluation, foster undue discretion, and raise the cost of bid preparation. However, the
most serious problems occur with the more important criteria: A (average tariff), D
(economic and financial viability) and E (governance and shareholder benefits).

The average tariff is computed as usual: the ratio of the net present value of revenues
and the cumulative volume of water billed. However, only the revenues of water and
wastewater activities were included; stormwater revenues, which by law are not directly
billed to the customers, were not incorporated. Nevertheless, the municipality (with
taxpayer funds) can transfer to the mixed company the amount corresponding to
stormwater cost. For this particular bid process, this portion was not evaluated; yet, this
component differs dramatically among bidders (a fivefold difference between the best
and the worst bid). Since some bidders recognised this inconsistency, they took
advantage of the scoring system by increasing substantially payments for this particular
service.

The viability study of the company comprises part of the bidding document; therefore
all bids should be based on its pre-specified assumptions, including population forecasts
and expected trends in consumption per capita. Nevertheless, there was room for
creative accounting in the evolution of these variables between the first and the last
year. Furthermore, the bidding document (base case) study and associated assumptions
justifying the 18 million Euro payment (and only a small price change) was very
optimistic, leading to unrealistic volumes of water billed. Consequently, the business
case would need to be altered within a few years of the partnership. Hence, it would be
crucial to give greater weight to the conditions demanded by the private firms to
participate in this game, for example the internal rate of return of shareholders and other
financial indicators that make the mixed company vulnerable. By de-emphasising
relevant factors and giving weight to less important (or less discriminating elements),
the system seems designed to fail in the search for the best bid.

12
One critically important aspect of the evaluation is the cost structure, which is only
worth 1% of this particular evaluation scheme. In addition to the traditional costs, which
should be analysed, particular features determine whether a bid is good (realistic) or bad
(likely to lead to renegotiation). For example, the charges for the stormwater activity
and all the fees related to management, technical assistance and other charges (which
can amount to substantial sums) are evaluated here with a weight of 1%. Other concerns
include the structure of financing and the end-point.

Last (but not the least) the weight given to the proposal of statutes and shareholders
agreement is unreasonably low (only 5%). In this kind of PPP, the regulatory contract
corresponds to the shareholders agreement (and also to the statutes) where the
relationship between the partners is established, and the operating rules for the company
are defined (including the allowed rate of return and the financial indicators that affect
tariff reviews). In addition, the shareholders agreement specifies the nature of the call
option, which corresponds to an early termination of the contract required by the
municipality. As time passes, the winners initial bid loses importance as investments,
tariffs and other conditions are changed. However, the statutes and the shareholders
agreement remain in force. These documents regulate the PPP: they should not be of
minor importance in the evaluation.

b) Managing and sharing the risk

The problem of risk sharing is more serious in the case of institutionalised PPPs.
Indeed, mixed companies do not bear risks: they are transferred to customers. The
bidding documents identify the situations that constitute the causes for restoring the
financial and economic equilibrium of the mixed company considered here, as shown in
Table 4.

These clauses relate to almost all the risky situations, though with some imprecision.
However, the shareholder agreement document clarifies these circumstances by
establishing the conditions where a change in the proposed main financial indicators is
recovered in the next tariff review (annual). Thus, the rate of return and other indicators
are always guaranteed. The risks are not supported directly by the municipality and the
benefits of this arrangement belong to the municipality as well (51%), although
management and other fees paid directly by the mixed company accrue to the private
firm and its managers. However, customers bear the risk and costs can drift upwards,
leading the authors to conclude that the public interest is harmed by poor contract
design in this instance.

In line with the literature, these PPP contracts show a high failure probability
(Boardman and Vining 1989; Jamison et al. 2005). Since the municipality is inside the
mixed company, political and ethical difficulties may generate controversies due to the
duty of protecting the public interest and simultaneously remaining loyal to its partner,
(especially because of its co-responsibility for key decisions). Furthermore, a dispute
leading to a deadlock may compel the municipality to purchase shares under the call
option, which is unacceptably costly in economic terms. So, there is a tendency for the
public partner to accept all the requirements of the private partner and transfers to the
customers the risks that should be borne by the private partner or assumes them

13
straightforwardly. This category of PPP, in general, yields an inferior performance
when compared with the other kinds of PPPs or even with direct public sector provision.
This is in accordance with a recent study that found negative productivity growth for
Portuguese municipal companies, including mixed ones; this performance is worse than
under either public or private service provision (Cruz and Marques 2009).

c) Monitoring the contracts

The public partner responsible for monitoring is part of the process and has more
responsibilities than the private partner. Hence, it is unlikely that it will apply sanctions
or take measures against itself. As it is co-responsible for the activity of the mixed
company, it tends to accept proposals to raise tariffs without much resistance. The
answer to the complaints is also penalised (due to the partiality in dealing with them) as
there is no municipality to complain about in the first instance. The existence of an
external regulator provides oversight in some countries; however, in Portugal, such
regulation is not possible yet because it interferes with local autonomy. Service quality
is not so troublesome since the private firm is interested in increasing capital expenses
and in over-capitalisation if the return is greater than the cost of capital (Averch-
Johnson Effect). Moreover, there is often a contractor who promotes investments
because of its higher profit margins. Experience indicates that contractors have
abnormally high margins (50 to 100% more than traditional public works procurement).
One alternative would be to have two contracts, one for investments in infrastructures
and other for operating the service (Hart 2003). Another possibility would be making
the public tender compulsory for all new works that may occur ex-post (Chong et al.
2006).

The problem of contract renegotiation and tariff adjustment is also related to the call
option. In mixed companies, the specified compensation arrangements greatly penalise
the public partner and the threat of ending the PPP does not exist. Normally, besides
reimbursing the private partner for non-depreciated investments and existing debt, the
compensation includes the discounted sum of shareholder net cash-flows which are yet
to be received (say, for 30 years), plus the discounted residual value plus a percentage
of the turnover of previous or subsequent years. To complicate the situation, every time
parties disagree, there could be a deadlock. The shareholder agreement document states
that if the dispute is not resolved within a short deadline (30 days), the public partner
must exercise the call option. Thus, the contract is structured so that the private firm is
likely to attain its objectives.

CONCLUDING REMARKS

This paper discussed the regulatory contracts for PPPs in infrastructure industries.
Using two cases from the Portuguese water sector, two approaches of PPP and
regulation by contract were compared: the purely contractual PPP (concession) and the
institutionalised PPP (mixed firm).

The theoretical model of institutionalised PPPs is not reflected in the contracts as they
are actually being drawn up. The authors acknowledge the soundness of the theoretical

14
principles, but the problems of designing and implementing regulatory contracts are
much more serious than generally recognised in the literature. What can be done? First,
it is important to recognise the role of an external regulator from the very start of the
tender design process. Second, the design of public tender documents should include
automatic mechanisms related to contract monitoring (e.g. penalties). Third, at all
stages, procedures should ensure transparency and accountability. For example, tariff
proposals should be subject to a standard administrative procedure, including customer
and other stakeholder participation; major decisions should be publicly approved in the
Municipal Parliament, not in closed meetings between self-interested parties. Finally, in
addition to being subject to corporate law, the mixed company should fulfil the major
principles related to public law, such as publicising public access to reports.

The two different PPPs analysed above (contractual and institutionalised PPPs) suggest
some key lessons for the future. One can identify eight key principles that are
fundamental for successful PPPs and effective regulation by contract. Notice that in
municipalities (and other local bodies) these PPP tenders are, a priori, only launched
once and therefore it is difficult to have a learning process here. Thus, the fulfilment of
these principles becomes even more important.

1. Design Tender Documents with Great Care: The design of public tender
documents is the cornerstone of a successful PPP. The signed regulatory
contract is constrained by the bid itself, which (in turn) depends on the tender
documents. Inappropriate simplifications and poor design at this stage jeopardise
the success of the PPP over its economic life. Sometimes, politicians seek
discretion in the bid evaluation process, which runs counter to designing and
awarding a contract whose aim is to protect the public interest. Template
documents should be defined, recognising that one size fits all is not
acceptable. The draft of a proposed contract design should be provided as an
annex in the public tender documents.

2. Establish Accountability to an External Regulator: Having an external

independent entity (regulator) monitoring the PPP benefits citizens. Its
involvement should begin with the design of tender documents, since local
authorities granting the PPPs are unlikely to have the experience, resources, and
expertise required for such work. Even when the law gives final authority to
local municipalities, the external regulator can provide a reality-check on the
terms and conditions of the contract and can support the municipality in
evaluating the performance of the PPP.

3. Prepare Baseline Studies: There is strong evidence of the need for more
comprehensive studies prior to launching a PPP. It is likely that one more Euro
spent at this stage represents savings of several Euros in the future. The optimal
situation should involve developing a public sector comparator (a baseline) and
providing bidders with a template for a business plan that would pass a benefit-
cost test. The analysis of municipalities associations, which allow for savings
via economies of scale and scope, should also be carried out. At a minimum, the
documents should provide complete information about trends in infrastructure

15
 system operations and the objectives of the PPP. Samples of the kinds of
information required during the monitoring process are important as well.

4. Priorise Selection Criteria: The cases underscore the importance of choosing

the right criteria for selecting a private partner. A PPP contract is different from
traditional procurement (public works or outsourcing contracts). Since the
probability of renegotiation and alteration of the initial regulatory premise is
substantial, the criteria should include an analysis of how such situations are to
be mitigated and when disputes occur, how the public interest is to be defended.
In addition, some of the technical and quality criteria should be imposed, and not
be subject to competition.

5. Facilitate Competitive Bidding: Competition should be facilitated since

competition for the market is one of the most important benefits of this model.
Preferential treatment of particular competitors is totally inappropriate. More
bidders for the PPP imply more value for money. Only the documentation
strictly necessary should be required, reducing the high costs for participating in
the bidding process.

6. Allocate Risks in an Explicit Manner: An appropriate allocation of risks is

fundamental for the success of the PPP, not only to minimise the likelihood of
renegotiation but also to save money (mitigating risks, thus reducing the
economic cost of bearing risk). Thus, the contract should provide the right
incentives to the private partner. A risk matrix should be provided as an annex in
the public tender documents, allocating each risk to the respective contractual
clause.

7. Simplify Monitoring and Sanction Procedures: The process of monitoring

must be simplified (to reduce red tape and to identify clear contract violations).
Therefore, the application of sanctions related to customer service quality should
be implemented automatically, along with performance rewards at the
organizational level.

8. Ensure Transparency: All the activity of a PPP-holder should be endowed with

transparency. For example, procedural transparency should be present during the
process of setting prices, evaluating metrics, and approving business plans: all
the stakeholders deserve to be informed of actions affecting their welfare.
Publicising PPP firm activity promotes accountability and facilitates yardstick
comparisons (which are essential for public input).

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enterprises, Journal of Law and Economics, 32, 1, 1-33.

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Chadwick, E. 1859. Results of different principles of legislation and administration in
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17
Table 1 Criteria and Weights for a Purely Contractual PPP

Criteria Subcriteria Weighting

A) Average tariff 70%
B) Quality of service 10%
B.1) Quality of studies 25%
B.2) Procedures of operation, maintenance and control 25%
B.3) Procedures of reading, billing and collection 15%
B.4) Procedures of supervision and control of works 20%
B.5) Procedures and schedule of quality certifications 15%
C) Safety of the provision 10%
C.1) Technical staff and their organization structure 35%
C.2) Capability to respond in emergencies 50%
C.3) Access to technical resources and their
15%
appropriateness to their investment plan
D) Strength of financial and contractual structure proposed 4%
D.1) Proposal of tariff system 50%
D.2) Financing model 25%
D.3) Appropriateness of the financial projections
25%
considering the plan of proposed investments
E) Quality and appropriateness of the plan of proposed investments 4%
E.1) Ability to meet the service coverage targets 60%
E.2) Scheduling of the tasks 40%
F) Payment to the municipality and its temporal distribution 2%

Table 2 Risks leading to PPP financial and economic equilibrium restoration

Changes requiring restoration of financial/economic equilibrium Risk
Change greater than 20 % (up or down) of the annual volume of
Consumption
water distributed predicted by the bidder
Change greater than 20 % (up or down) of the annual volume of
Consumption
wastewater collected predicted by the bidder
Expansion or reduction of the system scope concerning the works
Several
predicted by the concessionaire
Change of the amount of investments proposed by the business case
Several
of concessionaire
Meaningful change of the rules or legislation which leads to the
Legal/regulation/operation
alteration in equipments and procedures
If the concessionaire has to bear charges related to the factors that
could not be predicted at the date of contract signature as, for Legal/regulation
example, new taxes, tariffs or taxes determined by new legislation
Change greater than 20% of the annual average value of Euribor (6
Financing
months) when compared with the previous year
If the price of wholesale services (water and wastewater) suffer a
change different from the one proposed at the date of public Operation
tender

18
Table 3 Criteria and weights for an institutionalised PPP

Criteria Subcriteria Weighting

A) Average tariff 50%
B) Appropriateness of plan the investments proposed 20%
B.1) Technical quality of designs 30%
B.1.1) General design of the infrastructure 60%
B.1.2) Survey of current situation and description of
40%
infrastructures assets
B.2) Scheduling of work tasks 40%
B.2.1) Management, supervision and control of work 60%
B.2.2) Management of contingencies in work 40%
B.3) Specifying the required service coverage targets
30%
and linking these to compulsory investments
C) Quality of bid 10%
C.1) Procedures for meter reading, billing and collection 20%
C.2) Procedures for receiving, processing, and
20%
addressing complaints
C.3) Control of quality 20%
C.4) Training plan 20%
C.5) Information System 10 %
C.6) Strategy to pick up new customers 10%
D) Economic and financial viability study for a period of 30 years 10%
D.1) IRR of the project 40%
D.2) Equity to total assets evolution 20%
D.3) Return on equity evolution 10%
D.4) Appropriateness of the structure of costs 10%
D.5) Financing structure 10%
D.6) Appropriateness of the financial projections,
10%
considering the proposed investment plan
E) Proposal of statutes and shareholders agreement 5%
E.1) Company governance structure and conditions for
50%
nominating members of governing bodies
E.2) Conditions for the municipality call option 30%
E.3) Proposal of fair distribution between shareholders 20%
F) Statements of commitments of guarantee of investments 5%
F.1) Quality of bank which provides the letter of credit 50%
F.2) Quality of the letter of credit 50%

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Table 4 Risks leading to PPP financial and economic equilibrium restoration
Changes requiring restoration of financial/economic equilibrium Risk
Abnormal change of volumes not predicted in the economic and
Consumption
financial viability study of the public tender
Significant expansion of capacity requirements not predicted in the
Several
Plan of Investments
Meaningful change of the rules or legislation which leads to the
Legal/regulation
alteration of the conditions reflected in the initial bid
If the mixed company has to bear charges related to the factors that
could not be predicted at the date of shareholder agreement
Legal/regulation
signature as, for example, new taxes, tariffs or taxes determined
by new legislation
Change greater than 30% of the annual average value of Euribor (6
Financing
months) relative to the date of signature of financing contract
If there is any unilateral change initiated by the municipality,
Unilateral changes
implying changes in the business case of contract
If some form of force majeure takes place Force majeure

20