Using new data, we show that construction risk in infrastructure project finance is well- managed and that project sponsors face very little construction risk compared to the well-documented, systematic and very large costs overruns found in traditional infrastructure project procurement.
We know from the project management literature that construction risk is significant in public infrastructure projects delivered through traditional procurement methods. We also know that, when similar projects are procured using project financing, construction risk is passed on through date-certain, fixed price contracts. However, there is, to our knowledge, no available empirical research on the significance of construction risk once it has been passed on.
We use standard results from agency theory to assess the ex ante and ex post efficiency of the fixed price risk transfer contracts used to procure public infrastructure under the Private Finance Initiative (PFI) in the United Kingdom. We argue that these contracts act as a revelation mechanism designed to improve ex ante contracting efficiency at the cost of ex post inefficiency: PFI contract are a case of solving the moral hazard problem (creating maximum incentives for cost reduction) at the expense of increasing the adverse selection problem and therefore the selected firm’s information rent. Hence, Risk transfer leads to ex post inefficient outcomes that are directly related to the distribution of firm type: the more this distribution is skewed in favour of a few efficient firms, the less competition there is for the risk transfer contract, the larger the rent of the efficient firm should be. Thus, the ex post inefficiency of PFI contracts may be heavily country dependent. Using a detailed database of individual construction contracts for standard and PFI school projects in the UK, we find that full risk transfer does indeed lead to self-selection by the efficient firm, and that the distribution of firm types is indeed skewed in this market. We also find evidence of lower unit construction costs for the firm under PFI contracts compared to traditional procurement, which supports the hypothesis of the self-selection of the efficient firm when the public sector creates a menu of contracts (PFI vs. TP).
This paper is the first of series discussing the opportunity for long-term institutional investors such as pension funds, insurance companies or sovereign wealth funds, to invest in large portfolios of infrastructure debt, both to manage their liabilities and to minimise their exposure to capital market volatility. Our analysis focuses on project finance debt since it represents the bulk of existing and, in all likelihood, future infrastructure debt.
In what follows, we review existing academic research on infrastructure project finance and propose a theoretical and empirical analysis of the role of credit risk in infrastructure debt from a portfolio standpoint, on a held-to-maturity basis.
Theoretical literature suggests higher asset construction costs in a public private partnership (PPP) than in traditional public procurement, due to the bundling of construction and operation and the transfer of construction risk, among other factors. Data on ex ante road construction prices in Europe suggest a PPP road to be 24% more expensive than a traditionally procured road, ceteris paribus. This estimate resembles reported ex post cost overruns in traditionally procured roads. Thus, the public sector seems to pay a premium on ex ante PPP construction contract prices mostly to cover construction risk transfer. Other reported sources of higher PPP road construction costs, including bundling, seem on average of lesser importance.