The need for research in innovation in public finance

Citation

Monda, B. and Giorgino, M. (2014), "The need for research in innovation in public finance", Managerial Finance, Vol. 40 No. 11. https://doi.org/10.1108/MF-06-2014-0157

The need for research in innovation in public finance

Article Type: Guest editorial From: Managerial Finance, Volume 40, Issue 11

Public finance is a strategic issue for any country, as it provides the resources needed to build infrastructures and to supply services to the entire population and consequently to contribute to the economic development of the country. Public accounts throughout Europe have been tried by the recent economic crisis, and this condition is particularly critical in a period when demands for public services are increasing in developed countries, especially because of demographic changes leading to increasingly elderly populations with their high care and pension costs. However, availability of public resources is diminishing, especially as a result of the financial crises in the private and public sectors, the ensuing economic downturn and the consequent fall in tax revenues from incomes, profits and expenditures. The result is that the public sector has become incapable of doing its duties.

For such reasons it is crucial to promote innovation in public finance so as to help the public sector optimize the allocation of its resources to finance public services infrastructures. In particular, an important need arises to optimize certain existing operating instruments and to develop innovative instruments that can allow the public sector to efficiently allocate its resources and leverage them with private ones, both to finance infrastructures and public services (Public-Private Partnerships (PPP)) and to support entrepreneurship by financing enterprises and start-ups (Public-Private Initiatives (PPI)).

In fact, in this context, the involvement of the private sector in funding and managing public services can increase spending capacity and efficiency in the management of projects and services. Public resources can be used more effectively, by leveraging private resources, to achieve additionality in co-designed and co-funded schemes to promote cost containment, to reduce wasteful spending and to improve service quality. These outcomes can, in principle, be made possible by the for-profit approach of the private sector promoting the financial sustainability of initiatives in which it partners the public sector.

PPPs/Private Finance Initiatives (PFIs) are possible solutions. They are a particular form of public procurement characterized by the involvement of the private sector, at different stages and with different roles, in the construction of public service infrastructure (railways, roads, hospitals, schools, renewable energy power plants, etc.) and the subsequent delivery of services.

Many countries already have extensive experience in these kinds of projects but experience suggests that the solution is not straightforward because there is a track record of failures where value for money has not been achieved. In particular, containing costs, reducing wasteful spending and improving service quality have not always been secured. PPP/PFI schemes have to be designed very carefully if they are to achieve desired public policy outcomes. Close attention has to be paid to the details of contracting, risk management, financial structure, etc. without forgetting to take into consideration local parameters such as culture, institutions, professional practices, financial markets, governance systems and policy.

Innovation in public finance is fast becoming an increasingly dynamic area of study in terms of both policy and practice. Classic public finance has been concerned with the economic effects of taxes and public expenditures on private sector activities, a relatively theoretical field concerned with "crowding in" vs "crowding out," optimal taxation and allocation of responsibilities across levels of government (fiscal federalism). In contrast, today scholars are called to examine recent and ongoing innovations in public finance, including new ways of planning, financing and delivering public sector infrastructure and related services via PPP and more recent developments.

The international literature on PPP is vast, and can be grouped in a number of key areas of investigation, namely definition, classification, value, concession periods, critical success factors (CSF), risk management, valuation models and methods. The research question of whether PPP brings more or less value for money than more traditional public services funding and management is frequently asked and has been answered by many scholars in different ways. Some of the benefits usually associated with PPP are economic efficiency, reducing government overload, levering of public funds, better management and allocation of risk, improved effectiveness, alternative revenue sources, access to economies of scale or scope, encouragement of multi-use infrastructure, improved service responsiveness.

Some opponents to PPP see it only as a way to relieve the public sector of its responsibilities, that it is a form of off-balance sheet financing, thus reducing transparency of public accounting. Other problems reported include high costs in tendering, complex negotiation, cost restraints on innovation and differing or conflicting objectives among the project stakeholders. A purely financial set-back of PPP is reported to be the fact that it implies higher cost of borrowing of the private compared to the public sector (government bonds), thus reducing potential benefits. Most authors agree that, provided the project is well designed and certain conditions are respected, benefits largely overcome disadvantages.

The identification of CSF is important because it helps us to understand which factors authorities designing a PPP project should focus on to secure the two objectives that any public authority should pursue: high quality services and economic efficiency. The identification of CFS has been viewed as the first important step toward the development of a workable and efficient PPP procurement protocol. Researchers have proposed various lists of CSF for PPP projects, they differ for some factors but they all seem to agree on a few factors, including a detailed risk analysis and appropriate risk allocation, and thorough and realistic cost/benefit assessment which or, in other terms, economic viability and an attractive financial package.

Therefore for governments to increase value and achieve the objectives they pursue with PPP, it is crucial to be able to correctly design the project with respect to optimal risk sharing and optimal financial structure, and to be able to correctly evaluate the project while varying these parameters (in a scenario analysis). Only projects with a positive risk-adjusted NPV should be undertaken, and among different configurations, the one with the highest IRR should be chosen.

Risk Management is crucial for PPP. Much of what differentiates the various types of PPP is the level and nature of risk that is shifted to the private sector. A successful PPP requires the design of contractual arrangements prior to competitive tendering that allocate risk burdens appropriately. However, such risk allocation should not be done with the aim to transfer all the risk away from the public sector, instead aiming to allocate each project risk to the party which is best capable of managing it. Risks that should be allocated to the public sector include nationalization/expropriation, poor political decision-making process, political opposition, site availability and government stability. Some risks (e.g. tax regulation change, inflation, influential economic events, etc.) are preferably allocated primarily to the private sector, but with perceived opportunities for sharing with the public sector; other risks (e.g. force majeure and legislation risk) should be shared.

Proper risk allocation allows governments to better tailor PPP approaches to specific situations and infrastructure sectors. For a correct allocation of risks and a correct evaluation of the project, all risks should be identified and quantified.

Although detailed guidelines regarding the adoption of PPP and the notion of risks have been produced, there are still areas of uncertainty and assumptions made that require further investigation. For example, there is no one acceptable method for valuing certain risk-transfers, indirect costs of the government agency and competitive neutrality adjustments.

As noted by some authors, it is crucial to create risk assessment models to incorporate different types of risks (such as technical and legal risks). Such models should not only be accurate, but should also be easier to use.

Existing studies have shown that achieving a suitable balance of private resources and governmental guarantee or support is not straightforward and failing in doing so may result in a low value for money; especially when the government provides too much guarantee, it would be easy for the concessionaire to get the benefit from the contract at the expense of the public.

As in any project, also in PPP it is not possible to leave economic viability out of consideration. A sound finance plan for a PPP should have an appropriate mix of equity and debt and a financing strategy that is based on the considerations of project risks, project conditions, and financing sources. In order to assure economic viability, a sound method is essential to correctly evaluate such long-term and complex projects, taking into accounts all the major parameters (risk/dispersion of returns, confidence levels, time value, financing methods, and alternative options/decision trees). Some authors have proposed innovative models which cover some of these requirements (e.g. NPV-at-risk, applications of VaR), but none of them represent a really comprehensive framework. For example, they all lack the ability to evaluate the different alternative options that may arise at different stages of the project.

With this perspective in mind and moving from the key open topics in public finance innovation and PPPs, this Special Issue of Managerial Finance has selected the best papers from the conference 2013 Innovation in Public Finance (IPF) held at Politecnico di Milano from 17 to 19 June 2013. Each of the selected papers gives an original contribution to a specific point of view of the complex theme of PPP, from the value for money improvement to fiscal aspects, strategic alliances and country/sector specific case studies.

The Guest Editors and Chairs of the 2013 Innovation in Public Finance conference wish to thank all those who have contributed to the success of the conference, from the scientific and organizing committee members to all the participants who positively contributed to the debate, including the practitioners who presented their cases in the Case Studies Showcase session and helped closing the gap between theory and practice of PPP.

Dr Barbara Monda and Professor Marco Giorgino, Politecnico di Milano, Milano, Italy

About the Guest Editors

Dr Barbara Monda, with a Master Degree in Mathematics, after serving in the Project Management area of some multinational groups in the engineering and contracting industry, received a Diploma of Master in Business Administration from the MIP School of Management (Equis Accredited, MBA FT Business School Rankings). She is the Deputy Director at Risk Governance – Politecnico di Milano, where she is engaged in research, training and consultancy activities on risk management and corporate governance topics in financial and industrial organizations. She lectures in Corporate Finance, Global Risk Management and Corporate & Investment Banking undergraduate courses at Politecnico di Milano and in several graduate and executive programs, including the EMBA program, at the MIP School of Management. She served as a Consultant in M&A transactions and fund raising activities for start-ups, performing firm valuations and business planning. She has also collaborated with the incubator of the Polytechnic University of Milan in coaching activities for young entrepreneurs. She is the Founder of Finance Channel, a not-for-profit association dedicated to research and dissemination of financial themes and Editor of The Journal of Enterprise Risk Management. Dr Barbara Monda is the corresponding author and can be contacted at: mailto:bmonda@mip.polimi.it

Marco Giorgino, 44 years old, is a Full Professor of Finance and Global Risk Management at the Polytechnic University of Milan, the Head of the Banking and Finance area at the MIP School of Management (Equis Accredited, MBA FT Business School Rankings) and the Director of Risk Governance – Politecnico di Milano. Since 1992 he teaches corporate finance, financial institutions and markets and risk management courses in undergraduate and graduate programs, including MBA, Executive MBA and PhD. He has also served as the Director of master programs, including the international MBA program and a number of masters in financial topics, and participates in and coordinates several scientific projects and research activities. He is author of more than 80 scientific publications; recently his research activities have been focussed mainly on topics in corporate governance, enterprise risk management and public finance. He is also a Trainer and a Consultant for banking groups, institutional investors and industrial groups. His consulting activities include business and investments valuations, M&A advisory, corporate governance and risk management planning. Marco Giorgino also serves as an independent Non-Executive Director for financial and industrial firms in Italy.