QUESTION 2 ( 20 marks)

Contracting out public services can be divided into two types and it has helped in decision
making in most department. A senior official from the local government department would like
you to explain more on the above subject.

Required

i. Clearly explain the two types of contracting out public services and the conditions under
which they operate.
ii. Also elaborate on the various advantage and disadvantages of each of them

SUGGESTED SOLUTION
Introduction
Public expenditure has increased rapidly over the years due to the enlarged scope of public
sector activities over the past two decades. The scope of public finance traditionally was
confined to the traditional functions of the state, that is, provision of defence, law and order,
justice and civic amenities. But with the emergence of welfare states, the scope of public
finance has broadened. This has driven the demand for innovation in the efficient use of
resources and the achievement of a long-term financial sustainability for all public entities. One
suggested way of reducing public expenditure is through contracting out.

Definition of key terms

Contracting out

Contracting out or outsourcing is a part of public sector reform strategy wherein government
engages a private entity to provide a service within a set of specific conditions

Public services

Refers to a service intended to serve all members of a community either directly through public
sector agencies or by financing provision of services by private businesses or voluntary
organization. Such services include the fire brigade, police, security servives, ,education,
health and transportation.
Rationale behind the development of contracting out
Contracting out reduces the direct provision of services by the state; thus, rolling back the state
and creating more space for the market mechanisms to allocate society's resources. The purpose
of contracting is to exploit gains from co-operation. This requires aligning incentives of
different parties and mitigating conflict of interest through a well-designed contract.

Types of contracting out

There are generally two types of contracting out;

- public private partnerships (PPP); and

- private finance initiatives

Public private partnerships (ppp)

A public–private partnership (PPP, 3P, or P3) is a cooperative arrangement between two or

more public and private sectors, typically of a long-term nature. In other words, it involves
government(s) and business(es) that work together to complete a project and/or to provide
services to the population. Public–private partnerships have been implemented in multiple
countries, are primarily used for infrastructure projects, such as the building and equipping of
schools, hospitals, transport systems, and water and sewerage systems.

PPPs have been highly controversial as funding tools, largely over concerns that public return
on investment is lower than returns for the private funder. PPPs advocates highlight the sharing
of risk and the development of innovation, while critics decry their higher costs and issues
of accountability. Evidence of PPP performance in terms of value for money and efficiency,
for example, is mixed and often unavailable.

Forms
of PPPs
Public-private partnerships (PPPs) take a wide range of forms varying in the extent of
involvement of and risk taken by the private party. The terms of a PPP are typicaly set out in a
contract or agreement to outline the responsibilities of each party and clearly allocate
risk. There are many types and delivery models of PPPs, the following is a non-exhaustive list
of some of the designs:

Operation and maintenance contract (O & M)

A private economic agent, under a government contract, operates a publicly-owned asset for a
specific period of time. Formal, ownership of the asset remains with the public entity. In terms
of private-sector risk and involvement, this model is on the lower end of the spectrum for both
involvement and risk.

Build–finance (BF)

The private actor builds the asset and finances the cost during the construction period,
afterwards the responsibility is handed over to the public entity. In terms of private-sector risk
and involvement, this model is again on the lower end of the spectrum for both measures.

Build–operate–transfer (BOT)

Build–operate–transfer represents a complete integration of the project delivery: the same

contract governs the design, construction, operations, maintenance, and financing of the
project. After some concessionary period, the facility is transferred back to the owner.

Build–own–operate–transfer (BOOT)

A BOOT structure differs from BOT in that the private entity owns the works. During the
concession period, the private company owns and operates the facility with the prime goal to
recover the costs of investment and maintenance while trying to achieve a higher margin on
the project. BOOT has been used in projects like highways, roads mass transit, railway
transport and power generation.

Build–own–operate (BOO)

In a BOO project ownership of the project remains usually with the project company, such as
a mobile phone network. Therefore, the private company gets the benefits of any residual value
of the project. This framework is used when the physical life of the project coincides with the
concession period. A BOO scheme involves large amounts of finance and long payback period.
Some examples of BOO projects come from the water treatment plants.

Build–lease–transfer (BLT)

Under BLT, a private entity builds a complete project and leases it to the government. In this
way the control over the project is transferred from the project owner to a lessee. In other words,
the ownership remains by the shareholders but operation purposes are leased. After the expiry
of the leasing the ownership of the asset and the operational responsibility is transferred to the
government at a previously agreed price.

Design–build–finance–maintain (DBFM)

"The private sector designs, builds and finances an asset and provides hard facility management
or maintenance services under a long-term agreement." The owner (usually the public sector)
operates the facility. This model is in the middle of the spectrum for private sector risk and
involvement.

Design–build–finance–maintain–operate (DBFMO)
Design–build–finance–operate is a project delivery method very similar to BOOT except that
there is no actual ownership transfer. Moreover, the contractor assumes the risk of financing
until the end of the contract period. The owner then assumes the responsibility for maintenance

and operation. This model is extensively used in specific infrastructure projects such as toll
roads. The private construction company is responsible for the design and construction of a
piece of infrastructure for the government, which is the true owner. Moreover, the private entity
has the responsibility to raise finance during the construction and the exploitation period.
Usually, the public sector begins payments to the private sector for use of the asset post-
construction. This is the most commonly used model in the EU according to the European
Court of Auditors.

Design–build–operate–transfer (DBOT)

This funding option is common when the client has no knowledge of what the project entails.
Hence they contracts the project to a company to design, build, operate, and then transfer it.
Examples of such projects are refinery constructions.

Design–construct–manage–finance (DCMF)

A private entity is entrusted to design, construct, manage, and finance a facility, based on the
specifications of the government. Project cash flows result from the government's payment for
the rent of the facility. Some examples of the DCMF model are prisons or public hospitals.

Concession

A concession is a grant of rights, land or property by a government, local authority, corporation,

individual or other legal entity.Public services such as water supply may be operated as a
concession. In the case of a public service concession, a private company enters into an
agreement with the government to have the exclusive right to operate, maintain and carry out
investment in a public utility (such as a water privatization) for a given number of years

Private Finance initiatives

A private finance initiative (PFI) is a way of financing public sector projects through the private
sector. PFIs alleviate the government and taxpayers of the immediate burden of coming up with
the capital for these projects.

Under a private finance initiative, the private company handles the up-front costs instead of the
government. The project is then leased to the public and the government authority makes
annual payments to the private company. These contracts are typically given to construction
firms and can last as long as 30 years or more.
Advantages of PPP
PPPs can have major benefits for both sides — public and private:
1. Access to finance
When governments are cash poor, PPPs can offer access to private capital. It gives the
government an opportunity to reallocate resources that would otherwise be devoted purely to
building a school, for example. The government can actually use that budget to focus on
educational needs and outcomes — and to have more people looking at educational
requirements — rather than on building maintenance.
2. Access to technology, people and skills
For the public sector, one of the greatest advantages of a PPP is the access it provides to modern
technology, management and skills from the private sector. For the private sector, it is an
opportunity for increased innovation. With a PPP, the private sector can own and operate the
facility to deliver a service to the governments. It can build in synergies and innovative ways
of delivering the infrastructure required to meet the service outcomes.
3. Transfer of risk
The balance between cost and risk for the public sector and risk and reward for the private
sector is the nub of all PPP projects. The public sector body avoids bearing any risk inherent
in the ownership of physical assets, which is wholly borne by the private sector company. The
higher cost of private finance is offset by the transfer of risk out of the public sector. In the
education sector in particular, the PPP model has been popular for this reason. In any
government, you typically find that the education department is the largest land owner with the
largest number of buildings. With that, comes a lot of bureaucracy. This bureaucracy can use
a great deal of government budget. So if the operation and maintenance is transferred to the
private sector, resources can be freed.
4. Investment opportunities
Without PPPs, few private companies would have the chance to work on major capital
infrastructure projects, helping them to develop knowledge, experience and skills, which they
can then constructively reapply back into the private sector. When projects are well executed,
the monetary rewards for companies involved in PPPs are significant and long-lasting.
5. Business development
When partnering with the public sector, companies can work with courts, prisons, schools or
waste management services. And if projects are well run and they achieve their stated aims,
these partnerships can last for decades.
Public-Private Partnership Disadvantages

PPPs also have some drawbacks:

1. Every public-private partnership involves risks for the private participant, who reasonably
expects to be compensated for accepting those risks. This can increase government costs.

2. When there are only a limited number of private entities that have the capability to complete
a project, such as constructing a high-speed rail system, the relatively small field of bidders
might mean less competition and thus less cost-effective partnering.
3. Profits of the projects can vary depending on the assumed risk, the level of competition,
and the complexity and scope of the project.

4. If the expertise in the partnership lies heavily on the private side, the government is at an
inherent disadvantage. For example, it might be unable to accurately assess the proposed
costs

Advantages of PFI
1. PFIs are intended to improve on-time project completion and also transfer some of
the risks associated with constructing and maintaining these projects from the public
sector to the private sector.
2. Financial advisers such as investment banks help manage the bidding, negotiating,
and financing processes.
3. PFIs also improve the relationship between the public and private sector, while providing
both long-term advantages. Through this relationship, both sectors can
share knowledge and resources.

Disadvantages of PFI
1. A key drawback is that since the repayment terms include payments plus interest,
the burden may end up being transferred to future taxpayers.
2. In addition, the arrangements sometimes include not only construction but
ongoing maintenance once the projects are complete, which further increases
a project's future cost and tax burden.

Factors that affect whether public services can be contracted out

1. National security considerations
2. Nature of public service
3. Availability of contractors
4. Public policy