Legal Science(2016)
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Ⅳ.“Private Interest”Should Be Respected and Protected in the PPP Legal Institutions

In the 1970s, Britain put forward the Ryrie Rules, which established the standards for permitting the private sector to engage in the public services.One of the cores of the Ryrie Rules is to protect the private sector's cost-effectiveness in public service, which is the origin of the generally accepted “value for money”.In fact, the private sector engaging in PPP projects is often the market players, whose investing motive is to make profits; otherwise it will not participate in the facilities or services that are supposed to be provided by the public sector.Therefore, in order to achieve the effective supply of public services through the PPP mode, the government has to respect and protect the private sector's interests—i.e., by adopting some incentive measures to help the private sector realize the public interests at the same time bringing them reasonable capital returns.Only through these efforts can it lead to a continuous win-win partnership, and it is also an application of the “incentive regulation theory of new institutional economics”in the public sector.The incentive measures adopted in the PPP projects are mainly as follows: defining the reasonable investment returns, and fulfilling them by appropriately ensuring the market demands and fairly setting the price mechanism.

A.Investment Returns Should Be Reasonably Defined

At present, in the practice of the PPP projects, the investment returns for the private sector's engagement in the public projects are generally eight percent (8%).The proportion is based on consideration of the specific market environment.In fact, the investment returns should be dynamic in different industries and in different periods of economic period so as to reflect the change of the market; otherwise it will be difficult to recoup the private sector's investment.On the institutional level, although it is meaningless to discuss the specific investment returns, it is necessary, however, to determine the basic principles for setting the private sector's investment returns in the conclusion of a PPP franchise agreement.

To attract private finance to the PPP projects, the following two principles should be observed.First, on the basis of the average market yields of a specific economic background, the investment returns are set slightly lower than those of the market.The reason for referring to the average market yields is to attract the private finance to the projects; otherwise the target of fulfilling the government's public projects by means of private finance cannot be achieved.The reason for setting the rate slightly lower than that of the market lies in the nature of the investments: what the private sector invests in for the PPP projects are the infrastructures and public utilities, in which the government must also bear the risks; in addition, in many circumstances, incentives and subsidies are often granted to the private sector by the government.Second, in deciding the specific investment returns for a project, the private sector's capital sources and its input in skills and management should also be considered.If the private sector invests with self-owned capital, then for the government, the final price of purchasing the PPP projects will be relatively low, or the franchise period of the private sector will be relatively short.If the private sector invests with the finance of the capital market, which implies that it has to bear the burden of financing, then the financing costs will be considered in deciding the investment returns.Otherwise, with the fixed investment returns (at the current rate of 8%), only the cost of financing is covered, and it will by no means produce any profits; that is why the private sector is not stimulated to engage in PPP projects.Therefore, the government should take the above factors under consideration in the pre-bidding stage of the projects.If the private sector invests with the finance of the capital market, the quotations will be relatively high.The government should comprehensively compare the quotations submitted by different bidders so as to choose the best partner.Finally, the reason that the private sector's input in skills and management should be considered in deciding the investment returns is that such resources are also the main production elements invested in the projects by the sector, and they equally have remarkable economic profits and values, which are indeed the crucial cooperative conditions with which the government is concerned.Thus, this part of investment should also be reflected in the investment returns.

B.Market Demands Should Be Appropriately Ensured

In a situation where the investment returns have been decided, what most concerns the private sector after the projects having been constructed is the demand assurance, for it directly determines the realization of investment returns.The demand assurance of the market closely relates to the allocation of the demand risk in the PPP projects.PPP projects are mainly the infrastructure projects in the fields of energy, transportation, and water conservancy, among others, the contracts of which are incomplete, large in investment and long in its lifecycle; thus, PPP projects have to encounter more risks than the general construction projects.The empirical data also shows that the demand risk is the most remarkable one among all the risks affecting the construction of PPP projects.[1]In practice, there are many cases illustrating this point.For example, in the case of the Lianjiang Sino-French water supply plant project, the validity of the Joint-Operation Contract of Lianjiang Sino-French Water Supply Co.Ltd.is 30 years.In accordance with the contract, Lianjiang Water Supply Company is supposed to purchase at least 60,000 cubic meters of water every day in the first year of the water plant's production, with the amount to be increased continuously thereafter.But it turned out that the consumption of Lianjiang City the first year was only 20,000 cubic meters, and the huge difference between the contract amount and the city's consumption made it impossible to fulfill the contract.[2]Another example lies in the case of Xinyuan Minjiang Fourth Bridge.The Fuzhou government used to promise that within nine years, all vehicles driving to Fuzhou city from the south would go through the toll station; if enough tolls could not be collected for some special reason, the government would compensate for the foreign investment, which is 18% each year.But on May 16, 2004, the third stage of Fuzhou No.2 Ring Road was officially put into use, and a large number of vehicles began by passing Minjiang Fourth Bridge Roll Station, resulting in its income declining dramatically and the possibility of recouping the money invested dropped to almost zero.In addition, the government did not keep its promise of buying back the company's management rights, and thus the case was brought to the arbitration tribunal.[3]The same problem exists in the Hangzhou Bay Cross-sea Bridge Project.Within two years of the project being commenced, Shangyu of Shaoxing city (50km away from the project site) began to construct Shaoxing-Hangzhou Bay Bridge,[4]and thus the risk of inadequate returns exists.The above aptly illustrates that the market demand risk of PPP projects directly relates to the realization of the private sector's investment returns.

For the risk allocation of the PPP projects, the public sector tends to hold a misunderstanding that to apply PPP is to transfer most risks to the private sector.[5]However, the fact is that the more risks the private sector takes, the more rights it will claim (such as the request to adjust the price or increase the risk premium), which will result in the decline of the project's capital value,[6]and which deviates from the intention of the government in its promotion of the PPP projects.Therefore, the government should realize that in designing the PPP projects, a reasonable allocation of the risks is the best choice for optimizing the resources.Against the background of a strong government, the reasonable allocation of the risks is more important for China to protect the private interest.

The same is true as to the allocation of the market demand risk.In practice, the demand risk should not be allocated wholly to the private sector; instead, we should distinguish the reasons for the risk, and allocate the risk in accordance with the fault principle and the principle of effective control of risks, so as to protect the proper rights of the private sector.Specifically, if the demand risk of the project is caused by the private sector itself due to a poor construction quality or a delay in the project, the private sector should bear the risk; if the demand risk is caused by the government, however, such as by breaking its commitment that the project is unique, the risk of the inadequate demand should surely be borne by the government.Moreover, for the risks that are caused neither by the private sector nor by the government (such as the public resistance risk), in consideration of the overall interest of the project, the government should volunteer to take them.[7]

In addition to the sharing of the demand risk, in the initial stage of promoting the PPP projects, the government can use one method to motivate the private sector to invest in the project—guaranteeing a minimum demand.If the market demand is more than or equal to the guaranteed minimum demand, the government does not have to give any subsidies; if it is lower than the guaranteed minimum demand, however, the government will have to compensate for the difference between the actual demand and the guaranteed demand.Previous projects indicate that this incentive measure is extraordinarily effective.In line with Article 11 of Operational Guide, the government must take the risk of the minimum demand, which should be supported and recognized.From the practical experiences home and abroad, the above measure has been extensively accepted and adopted.For example, in the 1998 franchise agreement of Chile's Santiago Valparaiso Vifiade road project, the government compensated the investors for the excessive costs of the project by means of assuring them of the minimum transport demand.[8]In Brazil's BR-163 road project, when the investment returns were severely lower than expected because the passenger flow was lower than expected, the government would provide a subsidy, the amount of which was in proportion to the reduction of the passenger flow.[9]There is a similar example in China, too.In the project of Laibin B power plant, the government promised to purchase a certain amount of the electricity, which assured the project company of making profits.[10]

In brief, the public sector in PPP should take more risks within its capability, thus to reduce the risks that the private sector is expected to take.In terms of the demand assurance, the means and the amount of the government subsidy should be put into details in the agreement; otherwise the private sector will still shoulder the risks.

C.The Price Mechanism Should Be Fairly Set

A mature market mechanism will result in both a reasonable market price and contribute to reasonable profits.The former is what the government and the consumers require, while the latter is what the enterprises desire.The key factor of the PPP price mechanism is in the balance of the interests: on the one hand, the consumers are assured of attaining the public service with a relatively low price; on the other hand, the private sector is satisfied with the investment returns.

The price mechanism for the projects of the infrastructure and public utilities includes the pricing level and the price-adjustment mechanism.To stimulate the private sector to participate in the projects, the pricing level must cover both the initial costs of the investment and the reasonable returns to be made.What is more, during the long-term lifecycle of the PPP projects, the operation costs and the profits of the project may be affected by many risks, such as the operation risk, maintenance risk, increasing costs, the growth of labor costs, the fluctuation of both the main raw materials and the equipment, a change in inflation, and so forth.To avoid the private sector taking excessive risks, a reasonable price-adjustment mechanism should be designed to cope with all the risks, so as to achieve the effect of stimulating the private sector.

Because the infrastructure projects are quasi-public goods, the private sector is not permitted to adjust the price randomly, which is an essential protection of the public interest.However, it does not prevent the establishment of a reasonable price-adjustment mechanism in the PPP projects.The government should realize that within an incomplete PPP franchise agreement, the pricing structure of a construction project is complicated in that, besides the initial investment costs, there are ongoing maintenance costs and management costs, too, both of which are likely to be increased later on.Therefore, a price-adjustment mechanism should be adopted to coordinate the interests.The role of the price-adjustment mechanism is to transfer the change in the costs or that in the profits, which are caused by the above risks, into the allowable change in price in the operation of the PPP projects; and thus the private sector, though bearing the stress to manage the risks, will be able to take the proper returns at the same time.[11]

The factors that will result in the price risk are the inflation rate, labor costs, maintenance costs, and operation costs.Meanwhile, what the private sector supplies to the public is the infrastructure—the quasi-public goods, the price of which cannot be adjusted by the private sector itself according to market risks, and thus a loss caused by these risks should not be borne by the private sector only.In accordance with the basic principles of risk sharing in the PPP projects, the government should take more responsibility for this type of the price risk out of the following reasons.First, risk sharing is supposed to be in proportion with the rights of control,[12]i.e.the risks should be allocated to the party who can best control them.The private sector is expected to take the risks that it can control, such as the risks of financing, construction, and operation; but it does not have to take the risks that go beyond its control, such as the risks resulting from changes in the laws and the public policies.As to the above risks which tend to give rise to a change in price, the government, in comparison with the private sector, is better able to manage and control the risks.Second, risks should be allocated to the party who can best foresee them,[13]and thus the party who takes the risks will make every effort to avoid them.To the various factors which result in a change in price, it is obvious that the possibility that the government takes effective actions to avoid the risks is much higher than that the private sector does.Third, risk sharing is supposed to be correlated with the risk-bearing capacity.As for some factors which result in a change in price, neither the government nor the private sector should take the blame.Then we should focus on the overall benefits, and allocate the risks to the government, because the government has the better risk-bearing capacity.Therefore, it can be concluded that the price-adjustment mechanism is actually the government's rational risk-taking of the PPP projects.

On the basis of the above principles of risk allocation, some countries have established the assurance mechanism of the price adjustment; that is, the government makes commitments to the private sector, allowing the latter to adjust the price of the infrastructure expenses based on certain rules and within a certain time.If the petition for the price adjustment is not accepted due to the procedure for adjusting the prices of the quasi-public goods, the government will make a compensation accordingly.For example, in the PPP project of Dartfokl Bridge, the British government assures the private sector that the price for the bridge tolls will correspond with the domestic retail price index.[14]

However, it would be unfair if all the risks which result in the price changes were allocated to the government only.As for the private sector, even if it invests in the other industries instead of the PPP projects, it will still encounter the risks of inflation or labor costs, which are likely to cause the losses of profits.Although the private sector in that case may defuse the risks with the marketized price-adjustment mechanism, it is uncertain as to whether the marketized mechanism can defuse all the risks or not.Therefore, from the aspect of equity, the price risk of the PPP projects should be jointly taken by both the government and the private sector.But what should be noted is that the government should take the main the price risks, based on the above principles of risk sharing in the PPP projects.

[1] See Hammami, Ruhashyankiko & Yehoue, Determinants of Public-Private Partnerships in Infrastructure, IMF Working papers, 06/99, 2006.

[2] See Attracting $16690,000 to Build the Water Plant in Lianjiang Guangdong, But Not Put Into Production for 8 Years Afterwards, http://news.163.com/07/0619/01/3HAJKBAR0001124J.html, visited on Jul.8, 2015.

[3] See Blind Commitments Result in the Serious Consequence: Hong Kong Businessman Claims for 900000,000 RMB, http://news.xinhuanet.com/comments/2004-08/04/content_1708128.html, visited on Jul.8, 2015.

[4] See Who Moved the Cheese of Hangzhou Bay Cross-sea Bridge?, http://www.zjol.com.cn/05delta/system/2005/03/03/0004356436.shtml, visited on Jul.8, 2015.

[5] See Ke Yongjian, Wang Shouqing, Chen Bingquan, Failure of the Channel Tunnel and Its Enlightenment to PPP Risk Sharing, China Civil Engineering Journal, Issue 12, 2008.

[6] See Pollock A., Price D., Public Risk for Private Gain: The Public Audit Implications of Risk Transfer and Private Finance, Public Health Policy Unit, School of Public Policy, London's Global University, UK, 2004.

[7] In the case of South Sydney New Railway Project, to attract the private finance, the public sector guaranteed to compensate the private investor for the differences between the actual incomes and the expected incomes.When the project was put into service, however, due to the low demand, the government closed the route of the airport shuttles so as to force people to choose the railway route, which aroused people's protest.The demand of the railway was continuously going down due to public resistance.Under the public pressure, the government had to abandon the coercive policy and continue to compensate the private sector.See Loosemore, A.M., Risk Allocation in the Private Provision of Public Infrastructure, International Journal of Project Management, 2007, 25(1), pp.66-76.

[8] See He Tao, Study on Rational Risk Sharing of the Transport Infrastructure Project in PPP, Doctoral Dissertation of Tianjin University, 2011, p.66.

[9] See Brandao, L.E., Saraiva, E., The Option Value of Government Guarantees in Infrastructure Projects, Construction Management and Economics, 2008, 26(11), pp.1171-1180.

[10] See Wang, SQ., Tiong, LK., Case Study of Government Initiatives for PRC's BOT Power Plant Project, International Journal of Project Management, 2000, 18(1), pp.69-78.

[11] See He Tao, Study on Rational Risk Sharing of the Transport Infrastructure Project in PPP, Doctoral Dissertation of Tianjin University, 2011, p.66.

[12] See Rutgers, J.A., Haley, H.D., Project Risks and Risk Allocation, Cost Engineering, 1996, 38(9), pp.27-30.

[13] See Irwin, T.C., Government Guarantees: Allocating and Valuing Risk in Privately Financed Infrastructure Projects, World Bank, 2007.

[14] See Sun Yan, Guo Ju'e, Gao Feng, et al., Influence Factors of the Government Guarantees in Infrastructure Project's Financing, Statistics and Decision, Issue 20, 2007.