www.ifc.org/ThoughtLeadership Note 26 | December 2016 THE PRIVATE PROVISION OF INFRASTRUCTURE: OPPORTUNITIES FOR EMERGING MARKETS Infrastructure is the backbone of every economy. It delivers basic services critical to sustainable economic growth, improved living standards, and shared prosperity. The traditional role of financing and operating infrastructure projects has been shaken up in recent decades by the emergence of Public-Private Partnerships. Designed and implemented correctly, these partnerships can bring greater efficiency and sustainability to the provision of public services such as water and sanitation, electric power, transport, and telecommunications. Investments in infrastructure are often large, long-term delivery of widely consumed basic services. Yet some 2.4 undertakings, with the cost shared among large groups of users. billion people around the world lack access to basic sanitation Infrastructure takes up physical space, whether it is bandwidth services, at least 663 million are without access to improved in the radio spectrum, deep-water harbors, or rights of way on drinking water,1 and 1.2 billion live without electricity.2 land. And most infrastructure services do not easily lend themselves to competitive markets in which many producers Infrastructure is also a critical ingredient to other economic compete to sell products or services. Instead, they often require producers. Between 25 and 50 percent of manufacturers in low substantial financial resources to make large, lumpy and middle-income countries cite inadequate electric power as investments which are fixed by their structure and location. As a major concern, versus just 16 percent in OECD countries. 3 a result, sunk costs are important, and revenue models to cover Not only have infrastructure investments substantially the upfront investments can be challenging. The cost of serving contributed to increased economic growth in emerging market additional users declines with their number, but user payments economies (the exception is water and sanitation where the often only cover the costs of supply over the long term, if at all. evidence is mixed), they have helped to reduce poverty and And user payments may be difficult to impose where it is income inequality.4 impracticable to exclude non-paying users. The Role of Public-Private Partnerships. Governments have As a result of these constraints, funding infrastructure and limited fiscal space to finance infrastructure from taxation or organizing its operation and payments for its services has borrowing. Beyond that, the ability to generate sufficient user traditionally fallen to the state. In recent decades, however, fees or other revenue streams (from use of associated land, for many private firms have achieved a scale and sophistication that example) is critical to the viability of infrastructure enables them to manage the construction and operation of investments. Furthermore, governments typically have limited infrastructure assets. With a few exceptions, governments have capacity to design, construct, operate, and maintain continued to be involved in these private efforts, if only to set infrastructure, particularly in low-income countries, so private the terms within which private firms can operate. Infrastructure construction and operation of infrastructure can add value. is therefore a sector in which government and private Private investors can complement government investment, but enterprises have interacted in a wide variety of ways, depending the challenge of paying for infrastructure services—whether by on country contexts. taxpayers, users, or other beneficiaries—remains. Affordable, good quality physical infrastructure —roads and Private provision of infrastructure —of the construction of bridges, power grids, dams and power plants, water mains, physical structures and facilities and the delivery of attendant sewers, and phone networks—are key components of the services—ranges from independently owned, controlled and operated, fully private enterprises, commonly called The goal of universal access by 2030, proposed by the World privatization, to a variety of public-private partnerships, or Bank and the United Nations in 2011, remains a challenge that PPPs, in which various public services are contracted out to will require estimated expenditures of $45 billion annually, up private companies. Investment commitments to private from $9 billion spent in 2012, mostly in public funding.7 infrastructure projects in emerging markets totaled $111.6 billion in 2015.5 In order to achieve universal access, countries will need to expand electrification more rapidly than the growth of their It is important to understand the peculiar nature of competition populations. While eight of the 20 countries with the largest in network industries such as power, water, railroads, and roads. electric power deficits in 2010 managed to do so in 2012, Sub- It is often inefficient and impractical to have multiple power, Saharan Africa only managed to keep pace with population water or telephone networks, especially in small markets. In growth. The largest electrification spending deficits are in three these situations the scope for competition is often limited to regions: Sub-Saharan Africa, which needs an additional $17 bidding and contracting for services within a context of public- billion invested annually, South Asia needs $15 billion, and private partnerships in which local, provincial, or federal East Asia needs $8 billion. It is clear that public funding alone governments retain ownership and control. cannot achieve complete electrification.8 Water and sanitation, rail, and road are the network industries As with water and sanitation (discussed below), electric power least conducive to multiple providers. By contrast, electric infrastructure has three links in its supply chain—generation, power and telecommunications, spurred in recent decades by transmission, and retail delivery—each of which historically competition and “creative destruction” from private, profit - has been a natural monopoly in most of the world. That view driven investors and new technological advances, have in many however, began to change when first the United Kingdom and places found room for multiple providers to compete. Chile in the early 1980s, followed by several countries in Latin America and the Caribbean, started to open their markets to competition and partial privatization. Since that time more than Electric Power: A New, Competitive Paradigm half of advanced, industrialized nations have introduced various An estimated 1.2 billion people globally, or about 17 percent of degrees of competition in this sector, generally accompanied by the world’s population living mostly in rural regions of improvements in performance, labor productivity, higher emerging markets, lacked basic access to electric power as capacity utilization, and lower system losses. 9 Increased recently as 2013.6 Service is unreliable for hundreds of millions competition has also reduced pricing disparities between more. As noted earlier, between 25 and 50 percent of industrial and household sectors, bringing them closer to manufacturers in emerging markets cite inadequate power underlying costs of generation and delivery. 10 infrastructure as a major concern, and it is a major cost driver Though the matter is not settled and remains subject to some and an overall handicap to business in general. debate, one study finds that the greatest successes have This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. occurred where there has been privatization coupled with assumes the risk of building and operating costly power plants. performance-based regulation, and where unbundled, separate If expected demand fails to materialize, the utility absorbs the markets for each of the three links in the supply chain are market risk and is required to either take the minimum opened to competition.11 contractually required amount of power or pay for it in the absence of anticipated demand. It is important to have in place a set of commercial laws and institutions that protect electric power as well as When there is competition provided by multiple independent telecommunications investors. Private investors are reluctant to power producers, there is no longer a need for any of them to enter into contracts that lack transparency and cannot be negotiate detailed long-term contract specifications that expose enforced. However, the problem is not as severe in the case of them to the long-term risks of building and operating plants electric power as in transport and water. Due to increased when demand fails to materialize. Instead they operate under a competition and multiple provision, governments don’t require “merchant power plant” mode in which they sell their electric long-term contracts that detail everything that can and cannot power on short term spot markets to multiple buyers who are no be done under every conceivable contingency. longer required to take on downside long-term market risks. To date, the most extensive reforms and greatest successes in the electric power sector have been achieved in Europe, the Transport, Water, and Sanitation—Competition through a United States, Canada, Australia, and parts of Latin America. Contract Changes have been slower and less stable in Eastern Europe and Asia, and have been highly problematic in much of Africa. 12 The water and sanitation and transport sectors are characterized by strong network externalities that often preclude the existence Historically, single-buyer electric power utilities negotiated of more than a single provider. To achieve competitive long-term “take-or-pay” contracts with independent power pressures for performance while involving private firms and producers. Under these contracts, the independent producer investors in construction and operation, governments may EAP=East Asia/Pacific, ECA=Europe/Central Asia, LAC=Latin America/Caribbean, MNA=Middle East/North Africa, SAR=South Asia, AFR=Africa This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. introduce a limited form of competition in which they seek the functions performed by a vertically integrated provider.16 competitive contract bidding while maintaining ownership and The ideal risk-sharing arrangement holds the private partner ultimate control. responsible for contingencies it can reasonably anticipate (for example, annually occurring hard freezes or floods that can be This approach can be called “competition through a contract” expected to affect the maintenance of a road or water and (or “competition for the market” in comparison to “competition sanitation facility), while the government partner takes on the in the market”), which is characteristic of many PPPs. These risk of an earthquake, tsunami, or other uncertain and extreme partnerships typically consist of a long-term contract for some events that are difficult to anticipate. combination of design, construction, operation, and maintenance, with each partner sharing in the risks and rewards PPPs can be established with multiple private parties with some associated with the project. They can be a source of financial guaranteed share of the market, with another part awarded by resources for investment in new capacity, and they can improve measurable quality of service. Such partnerships must be well the quality, efficiency, and performance of the particular designed, taking into account the potential for opportunistic infrastructure provision. When successful, a PPP can generate behavior. Examples of such behavior include a private provider long-run benefits for all parties, including governments, private underestimating costs in order to win a contract, or a investors, and end users. government partner expanding the scope of required services beyond what was initially agreed upon (scope creep).17 These benefits derive from several sources, the most important of which is competition. While PPPs do not offer either the full- Accordingly, the most successful partnership contracts are blown benefits of daily competition among multiple those that minimize the opportunity for either party to engage competitors or the ongoing threat of entry from would-be in such behaviors. Contracts must be transparent and competitors, they do allow for competition in the contract enforceable, and backed by a sound set of legal institutions —a bidding phase. Ideally, the bidder that offers the most and best- condition absent in many low-income countries. quality services at the lowest cost earns the right to design, build, operate and/or maintain the public good. Such The Importance of Transportation. Transport is absolutely competition, while never perfect, can provide strong incentives critical to an economy, as it provides access to a spectrum of to cost and performance innovations that are often lacking market actors looking to interact and compete. Today, through within perpetual in-house monopolies.13 Well-designed PPPs the power of the Internet, telecommunications has taken its exploit two major sources of competitive advantage vis-à-vis place alongside transport as another source of competition. publically built and operated monopolies: risk-sharing with private investors, and bundling. Bundling allows private investors to profit from synergies among the joint design, construction, maintenance, and management phases of an infrastructure project. Well-designed, well-built roadways and water and sanitation systems improve the performance and lower the costs of operation and maintenance. Such incentives are much weaker for government providers that don’t have the same profit-seeking incentives and who suffer from the problem of time inconsistency, that is, the behavior of governments inclined to pursue short-term goals ahead of long-term welfare maximization.14 For example, the state can skimp on infrastructure construction and maintenance because the effects of reduced service quality will not be immediately visible, and use the money saved for popular short- term priorities such as tax cuts. The problem of time inconsistency also explains why contracts for PPPs must be of long duration—as long as 20 to 35 years for transportation infrastructure. If a contract’s duration is too short, the private partner will not have the incentive to internalize the available (Numbers from 2015) synergies and will consequently underinvest.15 Yet roughly one billion people in emerging countries today— Bundling can also reduce coordination costs that various about 40 percent of the rural population in low-income government departments or agencies face in undertaking all of countries—lack direct access to all-season roads.18 There is This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. enormous untapped potential for increased construction of Water and sanitation infrastructure, like transport, is roads, railways, and other forms of transport infrastructure to characterized by network externalities and attendant natural expand economic growth and development in these countries. monopolies at all three links in its supply chain—water and waste treatment facilities, water and sewer mains, and pipes Roads and highways are the dominant transport mode for many leading to and from homes and businesses. PPPs dominate emerging markets, accounting for more than 80 percent of the private provision for the same reasons as transport, and distance traveled by individuals and more than half of the competition is mostly limited to what can be achieved through distance traveled by goods.19 Numerous quantitative studies a contract. show that road construction has made substantial contributions to economic growth and poverty reduction everywhere in the In emerging economies, private investment in water and world. China’s construction of roads and highways has been sanitation is less than 10 percent of that for transport, amounting integral to its strong economic growth since 1978, which over to just $4 billion in 2012, with 44 percent of investments in East two decades lifted more than 200 million rural Chinese out of Asia and the Pacific. Total investments, however, have risen poverty.20 noticeably in the past decade.25 There have been a limited number of PPPs in Sub-Saharan Africa—just 51 from 1992 to PPPs are the dominant form of private investment in transport 2012,26 and significant additional investment, both private and infrastructure worldwide. The sector also has more such public, is desperately needed. Nearly one-fifth of the five billion arrangements than any other type of infrastructure. From 1986 people in low-income and middle-income countries today lack to 2010 some 1,000 highways, bridges, railways, urban transit access to safe drinking water, including six in ten residents of lines, seaports, and airports were built or rehabilitated through Sub-Saharan Africa. Some 2.4 billion people in these countries such partnerships, with a capital value of over $650 billion lack access to modern sanitation facilities. (including all transport projects, public and private). 21 Effective PPPs for transport and water and sanitation Throughout the industrialized and developing worlds, modern infrastructure investments in emerging countries are required to transport PPPs began to take off in the 1980s and 1990s; with help address the basic needs of billions of people. Economic Chile, China, Brazil and Hungary becoming market leaders research points to efficiency gains across sectors when among emerging countries.22 Since that time private investment provision of these services moves from the state to PPPs. Still, in infrastructure projects in low-income countries has amounted such partnerships remain a relatively small share of total to $180 billion.23 In 2012, the latest year for which data is infrastructure and are now concentrated in more prosperous available, investments in all forms of transport infrastructure countries. 27 amounted to $46 billion, an increase of 25 percent from 2002; Brazil and India accounted for nearly 80 percent of A primary reason is a lack of legal and regulatory institutions investments.24 in many low and middle-income countries. Private investors are wary of taking on projects without certain protections from opportunistic behavior. Of course, other factors, including This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. political and economic instability, are also problematic and are a year currently.28 Roughly two-thirds of private infrastructure closely related to the dearth of institutions promoting good investment in emerging market is spent in just two sectors, governance and the rule of law. transportation and power generation.29 Conclusion The infrastructure gap can be closed more quickly with the help Physical infrastructure is critical to economic growth and of private enterprises, markets, and competition, all working in development. Yet there is an enormous infrastructure gap in a complementary way with the state. And new technologies can much of the world, and it is particularly acute in emerging provide paths that—through creative destruction—can markets. In these markets more infrastructure is needed to circumvent traditional state monopolies for many basic accommodate economic growth, population growth, and services, opening new opportunities for private participation.  urbanization. At the same time, new infrastructure investments are needed to transition to a lower carbon economy and to make infrastructure more resilient to the effects of climate change. Vadim Grishin, Consultant, IFC (Vgrishin@ifc.org) The World Bank has estimated that emerging markets need to Tom Walton, Consultant, Defour Group, LLC spend approximately $2 trillion a year to meet their (Tom.f.walton@gmail.com) infrastructure needs by 2030, but are only spending $1 trillion      Notes challenges.” Asia Research Centre Working Paper 67, London Sc hool of 1 Based on data from the United Nations website at Economics. See page 8. http://www.un.org/sustainabledevelopment/water-and-sanitation/. 16Trebilcock, and Mota Prado. 2014. Advanced Introduction to Law and 2 Based on data from the International Energy Agency at Development. http://www.iea.org/topics/energypoverty/. 17 Makovsek, Perkins, and Hasselgren 2014, see page 9. 3 Based on data from World Bank’s Enterprise Surveys, see 18 World Bank 2014. “Transport: Sector Results Profile.” April 9. http://www.enterprisesurveys.org/data/exploretopics/infrastructure. http://www.worldbank.org/en/results/2013/04/14/transport-results- 4 For more information on how infrastructure investment has a positive profile. impact on reducing income inequality, see Calderón and Servén. 2008. 19 For more information on highways, see Public-Private Infrastructure “Infrastructure and Economic Development in Sub-Saharan Africa.” Policy Advisory Facility’s website at http://www.ppiaf.org/node/767. Research Working Paper 4712, World Bank. 20 Fan and Chan-Kang. 2005. “Road Development, Economic Growth, and 5 Kasper and Saha. 2015. “2015 Global PPI Update.” World Bank. Poverty Reduction in China.” Research Report 138, International Food 6 IEA 2015. World Energy Outlook. Policy Research Insitut. See page 9. 7 IEA and World Bank 2015. Sustainable Energy for All 2015: Progress 21 Siemiatycki, Matti. 2013. “Public -private partnerships in mega-projects: Toward Sustainable Energy, see page 21. For more information on success and tensions.” In International Handbook on Mega-Projects, edited sustainable energy financing, see World Bank’s website at by Priemus and van Wee, 133-157. http://www.worldbank.org/en/news/press-release/2015/07/10/se4all- 22PPIAF (Public-Private Infrastructure Advisory Facility). 2009. “Toolkit for expert-report-details-concrete-ways-to-boost-finance-for-sustainable- Public-Private Partnerships in Roads and Highways.” Washington, DC: energy. PPIAF. http://ppp.worldbank.org/public-private- 8 Bhatia and Angelou. 2015. Beyond connections – energy access redefined: partnership/library/toolkit-public-private-partnerships-roads-and- Conceptualization report. Energy Sector Management Assitant Program highways. (ESMAP). World Bank. See also, IEA and World Bank 2015. 23 Ahmad et al. 2015, see page 9. 9 Kessides, Ioannis. 2012. “The Impacts of Electricity Sector Reforms in 24 Ahmad et al. 2015, see page 3. Developing Countries.” The Electrcity Journal 25 (6): 79-88. 25 Ahmad et al. 2015, see page 3. 10Andrés, Biller, and Herrera Dappe. 2013. “Reducing Poverty by Closing 26 World Bank 2014. “Water PPPs in Africa.” Washington, DC: World Bank. South Asia's Infrastructure Gap.” World Bank. https://ppp.worldbank.org/public-private- 11 Kessides 2012. partnership/sites/ppp.worldbank.org/files/ppp_testdumb/documents/afri 12 IEA and World Bank 2015. ca_water_ppps_in_africa_en.pdf. 13Makovsek, Hasselgren, and Perkins. 2014. “Public Private Partnership for 27 Trebilcock and Rosenstock. 2015. “Infrastructure Public -Private Transport Infrastructure: Renogitations, How to Approach them and Partnerships in the Developing World: Lessons from Recent Experience.” Economic Outcomes.” Roundtable Summary and Conlusions, Discussion The Journal of Development Studies 51 (4): 335-54. Paper 2014/25. See page 4. 28 Ruiz-Nuńez and Wei. 2015. “Infrastructure Investment Demands in 14 Makovsek, Perkins, and Hasselgren 2014, see page 4. Emerging Markets and Developing Economies.” Policy Research Working 15 Ahmad, Bhattacharya, Vinella, and Xiao. 2014. “Involving the Private Paper 7414, World Bank. Sector and PPPs in Financing Public Investment: Some opportunities and 29 Trebilcock and Rosenstock 2015, see page 341. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.