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Discount Rates for the Evaluation of Public Private Partnerships.

Discount Rates for the Evaluation of Public Private Partnerships

Edited by DAVID F. BURGESS and GLENN P. JENKINS. Montreal and Kingston: McGill-Queen's University Press, for the John Deutsch Institute for the Study of Economic Policy, Queen's University, 2010. Pp. viii, 336, bibliographical references.

This volume is a compendium of the papers and commentaries presented at the John Deutsch Institute Conference on Public Private Partnerships, held at Queen's University, Kingston, Ontario, on 2 and 3 October 2008. Public administration practitioners will find the reading of this timely collection of papers difficult but rewarding. Why should they bother reading it?

"Public-private partnerships" (PPP, or P3s)--long-term contractual arrangements with private-sector companies--have become an important approach to the development and building of public infrastructure and the delivery of some government programs. Recently, for example, the Canadian federal government created PPP Canada, a Crown corporation that encourages and facilitates the use of public-private partnerships for public infrastructure. The objective of the conference was to work towards a synthesis of finance and economics as they relate to the selection of the appropriate discount rate for public-sector decision-making. Discount rates are used to assess the opportunity cost associated with any particular investment or expenditure choice relative to all other alternatives.

With the continuing requirement to invest in public infrastructure and governments looking for ways to economize, public servants must present objectively the economic and social impacts of proposed public investments. This volume provides a basic understanding of the underlying theory and practice involved in the use of particular discount rates for evaluating public-sector investments. However, as the papers make clear, the difficulties inherent in how to assess and evaluate any one particular public-private partnership are compounded by confusion over what appropriate discount rates should be applied.

From a public policy perspective, decisions on public-sector investments are a complex mix of political, social and economic considerations. Understanding the economic impacts of investments in long-term public-sector infrastructure projects requires an understanding of discount rates. In this respect, traditional policy analysis must rely on a conceptual foundation that is based, at least in part, on economic theory.

The selection of a discount rate is a necessary step in the evaluation of the costs and benefits of a proposed capital investment. Consider an investment that will generate a stream of benefits for forty years into the future. How do you value the stream of benefits on the basis of a current value? That stream of benefits is discounted at a particular rate, and this is referred to as the discount rate. This discounting recognizes that a benefit that arrives many years into the future is worth less than a benefit received today.

The key presumption underlying the economic analysis of the discount rate is that the government should consider not just its financial cost of borrowing but also the economic impact of that investment relative to alternative rates of return earned by capital invested in the general economy. Should society devote its capital to this investment, or should it alternatively use it for consumption or an alternative investment? With respect to public-private partnerships, one is comparing the merits of the partnership to that of an alternative approach to a project that is financed and procured differently with different cash flows.

This book is divided into four parts: Part One is an overview of the theory and practice with respect to discount rates; Part Two looks at the theoretical approaches to the discounting of benefits and costs; Part Three looks at the empirical estimation of the discount rate in Canada; and Part IV provides a roundtable discussion by the participants that took place at the end of the conference.

An important feature adding considerably to the book's usefulness is the summary at the end of each paper that also reports the questions and comments from other contributors to the author of the paper.

The first paper, "PPPs--The public sector comparator and discount rates: key issues for developing countries," by Chris Shugart, is important because it presents a conceptual framework and practical advice. What I particularly liked was the section "Questions and puzzles" and examples of practical approaches for calculating and making choices between public-private partnerships and the public-sector comparator--the PSC being the risk-adjusted cost of the most efficient form of public procurement if the project were to be entirely financed, owned and implemented by government. As Shugart points out, "The quantitative findings of the PPP-PSC comparison should not necessarily be decisive in themselves. They will be one factor to examine, along with others" (p. 65).

The next paper, "Time preference, the cost of capital and PPPs," by Michael Spackman, delves into the theoretical basis for different discount rates, together with a discussion of the strengths and weaknesses of each discount rate. This analysis makes reference to discussions in Ontario of the nuclear power option versus other technologies for power generation.

Part Two deals with more theoretical approaches to discounting of benefits and costs. The first paper, "Toward a reconciliation of alternative views on the social discount rate," by David E Burgess, addresses the arguments for different calculations of the social discount rate and the economic cost of capital. The second paper, written by Graham Glenday, "The new (but old) approach to the economic opportunity cost of capital," elaborates on the calculation of the economic cost of capital and discusses how risk should be addressed. It recognizes the limitations of the approach when considering truly long-term investments with unknown scientific facts such as the effects of climate change. Finally, Antal Deutsch's "What is risk?" reminds us just how unmeasurable risk is and, consequently, how cautious one should be about trying to incorporate it into the estimate of the discount rate.

The first two papers in Part Three of the book look at empirical estimates of the adjusted rate-of-return to various industries, including the transportation industry. Here, reference is made to the recommended discount rate of the Treasury Board of Canada Secretariat--that is, the rate the Government of Canada uses in the analysis of investment proposals. The Secretariat recommendation is to use a discount rate of ten per cent. The analysis and calculations in the third paper, by G. Jenkins and Chun-Yan

Kuo, lead to a recommended discount rate of seven per cent. This is similar to the rate calculated by a different methodology in the paper that follows, "The social discount rate for provincial government investment projects," by Peter S. Spiro. The author directly addresses the rationale as to why simply using the government cost-of-borrowing rate is not a sound approach. Simply put, government investment should meet a rate-of-return hurdle similar to what investment earns in the private sector. If it cannot meet that criterion, Spiro suggests that further investment would mis-allocate resources between the private and public sectors. He also recognizes that, from time to time, when there is excess capacity, the opportunity cost of capital will drop.

I found Part Four of the book, "The path to best practice," the least satisfactory of all the parts. It is somewhat misnamed because it presents the participants' summary remarks, which, in many cases, simply repeat points made earlier. This part would have been far more useful if the editors had written it as a section integrating the key issues and findings.

Because the volume includes contributions from both practitioners and academics, a healthy dynamic is established. The academic analysis makes one aware of the theoretical issues imbedded in different approaches for determining the discount rate. Here, one sees that selection of a technique can sometimes rely on philosophical perspectives about the use of capital in society, the role of government, and the preferences of taxpayers and consumers. On the other hand, the practitioners draw attention to the need to select an optimal rate that allows decisions to be made, recognizing that this is only one factor in evaluating a particular project.

I have a final comment regarding the title of the book. It is a bit of a misnomer because much of the discussion in this volume is around the discount rate used for government investment relative to private-sector investment--that is, the viability of a project overall. Only some chapters discuss the discount rate that should be used to assess the relative merits of public-private partnerships versus other procurement approaches.

Phil Charko is Executive Director of the Canada Employment Insurance Financing Board.
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Author:Charko, Phil
Publication:Canadian Public Administration
Article Type:Book review
Date:Mar 1, 2011
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