Privatization, Outsourcing and Risk

Privatization entails risks and rewardsIn negotiating a public-private partnership for building and operating improvements to the Interstate 66 corridor outside the Beltway, Transportation Secretary Aubrey Layne has created a new template for looking at privatization and outsourcing.

Traditionally, when government perceives a public need — building roads, educating children, running prisons — it undertakes to do the job itself. But government bureaucracies are prone to rigidity, bloat and overruns. As a corrective, Republicans and conservatives often propose outsourcing important functions to the private sector. But privatization is vulnerable to cronyism, favor-seeking and private enrichment at public expense.

A third way, Layne’s way, requires government to run more like a business — but not in the sense normally understood as a penny-pinching attention to costs. When businesses negotiate deals and contracts, they expend tremendous effort thinking about risks and contingencies. Government rarely does. That’s why privatization efforts often go awry. Private-sector negotiators take their public-sector counterparts to the cleaners by extracting concessions on obscure points in the contract that can lead to big payoffs down the road. Layne says government needs to develop a similar capacity to manage risk.

As I explained in the previous post, “How the McAuliffe Team Saved $2.5 Billion,” Layne adopted a new approach to project management for “Transform 66.” First, he developed a term sheet, a list of elements deemed essential from a public-policy perspective that could not be bartered away. In the case of I-66, these included park-n-ride lots, a mass-transit service, and future upgrades to the transportation corridor.

Then he established a baseline — what would it cost for the Virginia Department of Transportation to undertake the project itself? If VDOT could do the job for less, on a risk-adjusted basis, then there was no point in dishing off the work to the private sector. But if a private bidder could do the job for less, the public would benefit.

But those were just first steps. Layne analyzed transportation projects as a continuum of risks. For any large project, for instance, there is the risk that construction could run behind schedule or over cost. VDOT was once notoriously unreliable in delivering projects on schedule and on budget, although it has gotten much better. Also, there is O&M risk — the risk that operations & maintenance will cost more than assumed. This is particularly an issue if the condition of roads and bridges is to be maintained to specified performance standards. Then there is financial risk, critical in toll-financed projects. Financial models are predicated on assumptions of how many motorists will pay tolls and how much they will pay. If ridership and revenues fall short, the tolling entity, whether public or private, could wind up defaulting on its bonds — a highly visible event.

It is worthwhile noting that these risks exist whether VDOT explicitly recognizes them or not. For many years, construction delays and overruns were routinely buried in budgets that were impenetrable to the public. Maintenance costs were divorced from project costs and rolled into transportation district expenditures. No one bothered to check if actual ridership matched the projections that justified the project. If ridership fell short, there were no visible repercussions. Poor management might result in less money available for future construction projects, but it was invisible, so no one was held accountable.

Layne’s key insight is that different parties vary in their tolerance for taking different types of risk — for reasons often unknowable to the state. One player, for instance, might accept a lower return on investment in order to get a toehold in a strategic market. A corporation, facing zero-interest policies in the European Union, might wish to transfer assets to the U.S. Another player might have tax reasons for structuring an investment in a particular way.

Therefore, it is critical to bring as many players bidding on a project as possible, and not to settle upon a given approach right away. When discussing the I-66 project, five different consortia submitted five different design-build proposals (in which they would design and build the project, then turn it over to VDOT), five design-build-operate projects (leaving bond-financing and ridership risk with the state) and three outright concessions (in which the private parties would assume operational and financial risks).

Negotiations with multiple parties also creates what Layne calls “price discovery” — the state gains new insight into the economics of the project that allows it to push for better terms. Private consortia suggested opening HOT lanes to trucks to generate additional revenue. The idea added value to the deal, and Layne accepted it.

At the end of the I-66 process, Layne concluded that offering a 50-year concession to Express Mobility Partners offered the best deal to Virginia — $2.5 billion better than the deal offered when Governor Terry McAuliffe took office.

While the details of maintaining a transportation system differ from those of, say, a prison system, a school system, a prisoner recidivism-reduction program or a mental health program, I see no reason why Layne’s method couldn’t be applied to other government functions.

Layne had an advantage because Virginia has experimented with public-private partnerships for many years now. Even though the McDonnell administration made some blunders, it did introduce new thinking, it pushed the envelope, and it made mistakes from which Layne could learn. Outsourcing transportation projects has had a steep learning curve, as would privatization of prisons or any other government function. Any ambitious effort to re-think how government delivers services will experience bumps along the way but, as Layne has proven, the rewards could be tremendous.

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6 responses to “Privatization, Outsourcing and Risk

  1. I think Layne must have some secret sauce because P3 is now fairly common across the country – and there are some less than wonderful outcomes… as you’re basically taking a design/build model and adding on finance and operate and the trick is not only to share risk but a lot depends on the performance of the private entity – as well as factors that might be beyond their control.

    So you’re sharing the risk or moving it to the contractor -but that dont mean there’s still not risk – and if the contractor goes belly up – as several have done – it’s not all honky dorry for the govt… because ownership of a failed project is not the same as ownership of a functioning project….

    Having said all of that -Layne seems to be smarter than the average guy – so far and he’s the same guy that got Smart Scale/HB2 implemented so he’s the real thing.

    The really important thing that the has done though is to address the congestion/demand issue in urban commuting areas and VDOT has decided that they no longer will try to build their way out of congestion and now will manage it – with variable tolls.

    The funny thing – people do not understand the concept – of peak hour tolling and they’ll complain about the fact that tolls go up just when things get bad and they want to use the toll lanes!!!

    they see it as some kind of private company “rip-off”!!!!

    Little do they seem to know that the basic concept of congestion tolling came from no other than Heritage, CATO, and the GMU Mercatus folks!

    see: Tolling the Freeway: Congestion Pricing and the Economics of Managing Traffic

    https://www.mercatus.org/publication/tolling-freeway-congestion-pricing-and-economics-managing-traffic

  2. re: ” VDOT was once notoriously unreliable in delivering projects on schedule and on budget, although it has gotten much better.”

    that was back when they had more projects started than they had funding to move them all so they played a form of “whack a mole” to decide which projects got funding and which did not.. for a given budget cycle.

    And that was driven by politics …to get projects “started” even if there was no funding ..once started political forces would gobble up money for their favored projects and strand the ones that had less political support. some projects would sit for a decade or more – and ultimately were removed when VDOT was forced to flush a good number…there was no hope of funding.

    Smart Scale has (in theory) changed all of that. Once a project scores high enough and gets approved, supposedly – it’s guaranteed funding for all phases… til completion – no delays or short funding.

    But for a project to get approved – it’s got to be “ready” – not just a concept or else it cannot get into the candidates to be scored. That’s put a major hitch in the giddy-up of some politically-driven projects.

    We’ve got a couple of “concept” projects in the Fredericksburg area that have perennially been politically supported in years past and now they are zombie dead.. … just about stake-through-the-heart dead… it would take an herculean effort to get them to the stage they could get into Smart Scale -and even then – they’d crash and burn on the scoring process…

    Virginia’s Smart Scale is so highly thought of that Maryland is considering adopting it … and getting rid of their current method.

    https://www.washingtonpost.com/local/md-politics/md-lawmakers-signal-interest-in-va-model-for-transportation-funding/2016/11/18/996d0b1c-adbe-11e6-a31b-4b6397e625d0_story.html

  3. re: definition of “ready” –

    In order for project to be evaluated, scored and become a chooseable candidate for Smart Scale –

    it cannot be an evolving concept, something still changing. The design – the concept have to have reached a steady state and it’s that state that is evaluated and scored and if it changes it has to be re-scored.

    that’s a sea change – a game changer for the way that transportation has been done in Virginia and it really inhibits politically inspired projects that try to get approved as initial concepts with fuzzy cost data, then once put on the 6yr plan – continue to evolve further. That’s no longer easy to do.

    Projects driven by speculative land development, owned land trying to be developed and/or political support — are harder to promote in the new “ecosystem” … not impossible but much harder and it would be very apparent if changes made after selection especially if funding is involved.

    Saw this first hand in Spotsylvania on what seemed to be a fairly routine road improvement from 2 lanes to 4 lanes in a busy and expanding business area just off the Interstate.

    The project scored high because it had a raised median between the lanes and a minimal number of breaks for left turns.

    So the project got approved and got it’s funding and got programmed but then the local businesses and prospective businesses did not like the restrictions on the median and lobbied the BOS to seek to change it and add more crossovers.

    In the past -that would ended up with meetings with VDOT and eventually if higher level political influence was brought to bear – VDOT would have to give in and do it.

    in the new environment – those changes would require the project to be re-scored – and re-scoring would show that more cross-overs will increase accidents – as well as congestion and in turn capacity – the ability of the road to move vehicles efficiently without cross traffic.

    When VDOT was challenged with respect to access for businesses – they suggested that – that was not a transportation issue but a local access issue and it could be solved with intra-parcel connections between the properties.

    That did not go over good but unlike the past – this time VDOT said they could make the cross-over changes in the design – but it WOULD affect the SCORE and they predicted that it would lower their score significantly and cause the project to lose funding and even though it would stay on the list of projects – it would be out-scored in the future by other more cost-effective projects.

    Now – multiply that idea – across the state – for all new or improved road proposals where the ones that deliver the safest and most efficient designs – get scored high and funded – and ones that don’t sit on lists and never advance or do so at a much slower rate.

    Multiply that same idea for big new road projects… a much tougher standard to meet in order to score high and advance….

    Smart Scale is just starting to be recognized by political and developer forces and they are not happy and almost surely will work to figure out how to re-assert their influence over the transportation planning process – I suspect they will hire their own consultants to challenge the scoring criteria and process… but it’s
    going to be not easy as VDOT is using industry-standard data as the basis for their scoring elements…for things like accident data and road performance , etc.

  4. The principals announced in this article have been in common practice in the negotiation, structuring, and regulating of major commercial transactions for as long as I can remember – from 1970 forward.

    If now these traditional principles and standards are being deployed in the Virginia public infrastructure sector in 2016 I welcome it, while I suggest the use of these long established and basic practices is long past due.

    I also add a cautionary note. These principles easily become platitudes. Principles are easy to state. But they are far more difficult to successfully build into a many complex commercial transactions. Most particularly those dictate long term complex concrete action on the part of numerous parties doing interrelated and often speculative tasks. Here principles are only as good as the people who claim deploy them. Indeed principles do not work until one learns from experience how to effectively incorporate them into each and every individual transaction, and all its myriad of details. Here there is a vast distance between the lip and cup. For one of endless examples, the introduction of novelties into each deal to meet the challenges posed by the anomalies and peculiarities inherent in each major transaction.

    So success, if declared up front, is always false.

    Anyone who harps on success until time reveals them is blowing smoke to obscure truth. The length of time needed to flush out the success from failure of a transaction, varies enormously – both as to consequences seen and unforeseen that arise from the transaction, and indeed even know how its success can be defined.

    • Comment properly restated and elaborated:

      The principals announced in this article have been in common practice in the negotiation, structuring, and regulating of major commercial transactions for as long as I can remember – from 1970 forward.

      If now these traditional principles and standards are being deployed in the Virginia public infrastructure sector in 2016, then I welcome it. But I suggest the use of these long established and basic practices is long past due.

      I also add a cautionary note. These principles easily become platitudes. Principles, although easy to state, are far more difficult to successfully build into many complex transactions. This is particularly so in transactions that dictate a series of long term, complex, and speculative concrete actions. The more people involved in accomplishing such actions, particularly inter-related actions, the more difficult the task is to incorporate the right mix of principles into the complexities of the transaction.

      Here principles are only as good as the people who claim to deploy them. Here principles do not work until one learns from hard experience how to effectively incorporate them into each and every individual transaction, and all its myriad details. Here there is a vast distance between the lip and cup. For one of endless examples, the introduction of novelties and nuance into each deal to best meet the challenges posed by its anomalies and peculiarities, and balance all these provisions against all the rest of the transaction, including taking best advantage of opportunities as well as mitigating risk.

      Always in these transactions remember that:

      Success, if declared up front, is always false.

      Anyone who harps on their success until enough time has elapsed to reveal a transactions successes and failures is blowing smoke to obscure truth.

      The length of time needed to flush out the success from failure of a any particular transaction varies enormously – both as to consequences seen and unforeseen that arise from the transaction, and indeed also to truly know even know how its successes and failures can be defined.

  5. VDOT has long put out for bid their projects for the private sector to build. Then they added design/build…

    but finance, operate and maintain (p3) while perhaps common in the private sector is somewhat new to the world of transportation as well as other govt – as here’s a map of these current projects:

    and the problem as I understand it is that the govt has not typically employed folks who were skilled at finance and risk management or even if they contracted that – still did not have staff to competently monitor the contractors performance.

    that’s part of why I think Layne has a bit of “secret sauce” as other prior P3 projects in Va and other states do not have a unblemished record.

    surely we can give some credit when govt does succeed .. even grudgingly , right?

    😉

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