ECONOMIC REPORT OF THE PRESIDENT

user fees or shadow tolls.11 Through this mechanism, the government could
mitigate downside risks such as project cost overruns or revenue shortfalls,
thereby insulating the government from budgetary risks associated with
unexpected developments. However, private investors may require a higher
rate of return on their investment in exchange for being exposed to these
uncertainties.12
Another risk associated with PPPs is that by outsourcing some or all
elements of a project to private businesses, the government relinquishes
some of its control over planning, constructing, and potentially even operating
and maintaining the structure. Although this feature is often seen as
beneficial in that the private sector is perceived as being able to manage the
project more efficiently, there still exists the risk that the private firm will
fail to meet its obligations or that its efforts will lead to excessively high user
fees. Moreover, because of their large scale of operation, infrastructure assets
often have characteristics of natural monopolies: they can be unique in the
role they play for given transportation markets, which in turn may eliminate
the need or potential for competing options, which raises the possibility of
excessively high prices or profit. Finally, many of the same principal-agent
problems that arise in standard public finance, where officials may not make
the best decisions on behalf of the public, can arise in PPPs. For example,
if local authorities are myopic—with a horizon of the next election or next
budget cycle primarily on their minds—they could strike a sub-optimal deal
that casts them in a positive light in the short run, but is inefficient in the
long term.
While infrastructure assets procured through PPPs are usually returned
to public sector control after a contractually stipulated period, many of the
perceived risks mentioned above can be mitigated through effective contract
design. The government can retain a certain level of control—regulatory
or otherwise—over the private entity or entities. A contract can stipulate
quality levels that structures must satisfy, restrict the prices that can be
charged for using assets, and require sharing of excess revenues or profit
as well as shortfalls in order to achieve a balanced and mutually acceptable
11 Shadow tolls involve periodic payments from the government to the private firm based
on how many users the asset attracts per time period. Like user fees, shadow tolls provide an
incentive for the private party to construct and manage the asset efficiently, thus transferring
demand risk from the government to the private party. Shadow tolls differ though in that they
require that the government funds the private entity.
12 Importantly, paying a higher return to the private partner to bear the demand risk need not
result in the project realizing efficiency gains. In contrast to bundled design and construction
risk, for example, the transfer of demand risk to the private partner in and of itself will not
induce it to take actions that lower the overall cost of the project. This is due to the fact that
the private partner can do little to affect utilization, unlike the way in which its actions can
substantially affect overall design and construction costs.
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