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Cullen Speech to National Press Club

Cullen Speech to National Press Club/ British NZ Trade Council

Good morning. I thought that today I would try and get behind the retail media interest in Ross Armstrong’s recent foray into public policy and open up on some of the more substantial policy issues that surround discussion on what are generally known as public private partnerships.

First, though, I need to put the issue in context.

The government puts a lot of store, and a high priority, on lifting New Zealand’s sustainable growth rate. In number terms, we have talked about moving to a four percent per annum sustainable growth track, and through that of eventually moving back into the top half of the OECD in terms of per capita living standards.

If we look at the New Zealand of today, our standards of living are vastly higher than they were fifty years ago. It doesn’t matter what indicator you use: life expectancy; years spent in education; cars per head of population; proportion of income spent on recreation; the purchasing power of the state pension; per capita spending on health or whatever.

The problem is that even though our absolute standard of living has been steadily rising, our relative standard of living has been slipping: other countries, and in our case especially Australia, have been improving their material living standards at a faster rate.

If this continues, the income structure that the better performing economies can sustain opens up a gap on our own. People, and especially the skilled and employable, move away seeking to improve their lot. As they locate in the higher income centres, business follows them: that is where best market and profit opportunity resides. We end up with a negative cycle: labour and capital relocating in the better performing economies, further driving that better performance and widening the relative income gap.

Of course we need to avoid the doomsaying aspect of this. People will not only live here, but will seek to come here, because it is a great place to live. Not only is it still a developed high-income country in the broader global scheme of things, but New Zealand has many non-tangible quality of life aspects that both retain and attract its citizenry.

The problem is that society builds expectations around what other people have: in things like access to health services, and about what constitutes a decent level of consumption of goods and services. If growth does not enable those expectations to be met, the result is an internal squabble over bigger bits of the inadequate pie. So we must grow.

There has, of course, been quite a bit of theoretical argument and empirical questioning about what causes growth. The conclusion is that there is no magical formula, and no single answer. Both high and low tax countries have shown good and bad growth performances. Highly centralised and highly decentralised wage fixing regimes have co-existed with both high and low growth. So with light and relatively heavy regulation.

There is probably a consensus around the necessary conditions for growth. No economy with persistent inflation, or with chronic imbalances in its public finances, can grow for long. Clearly defined property rights and a well functioning legal system to enforce them are essential. We need administrative systems, in private as well as public organisations, that are transparent and free of corruption. The question is what more is needed.

The growth literature I have seen identifies two other preconditions that are reasonably consistent across most nations: energetic investment in collective goods and a national consensus for growth.

I will start with public investment. This fell away sharply during the 1990s, and the associated short-term savings were essentially dissipated through rounds of tax cuts. There is no evidence that this lifted our sustainable growth rate. There is plenty of evidence that it left the incoming government with a massive bill for deferred maintenance.

We have had to rebuild and re-equip across the spectrum of collective goods: public housing, schools, hospitals, roads, defence force equipment, corrections facilities and the list goes on.

This has put a lot of pressure on our capital budget, and has meant that if we are to keep debt under control we need to run operating surpluses large enough to finance at least a part of the capital spending and/or find other ways of financing the programme.

A robust infrastructure is an essential contribution to improved productivity: a fact that our Australian neighbours never tire of gloating about.

Our programme for growth is therefore based on sound fundamentals, a commitment to energetic investment in collective goods and on the need to build and maintain a broad social consensus around not only the need for growth, but on an acceptance that contributions to and rewards from growth are fairly shared.

It also rests on an explicit belief that economic growth does not simply happen. It has to be nurtured. While the government does not deliver economic growth, it both makes a contribution to growth and fosters and facilitates growth by coordinating and supporting the actions of private sector players.

That role was specified in the growth and innovation framework that was published earlier this year.

I am not going to describe the whole framework, but want to give some overview of it. We get to a higher growth plane by lifting the quantity and quality of our labour force, by increasing the capital stock, and by improving productivity.

Productivity will improve if we lift our game in four key areas: skills, new investment, improved infrastructure and broader export opportunities.

It will improve further if we do two things well: strengthen the foundations of a modern economy and work on our natural advantages and aptitudes. The framework identifies three areas where this competitive advantage needs to be developed: biotechnology, communications and information technologies and the creative industries.

The context for PPPs is what sort of contribution they can make in improving the quality of new infrastructure, in expanding the quantity of infrastructural investment or in bringing forward the timing of that investment. Improved infrastructural investment boosts the rate of growth of productivity and that in turn lifts the growth rate.

It is a part of the framework. It isn’t the new big idea. It doesn’t do away with the need to improve skills, to attract new investment and to expand trade opportunities. There is one body of thought that there is nothing new about PPPs. We have always had contractors on public works. Some would see this as a “partnership”.

The reference to PPP in the current literature and policy debate usually refers to more than conventional contracting. It involves the delivery of assets in an integrated service fashion over some concession period and can engage private sector participation in any combination of design and construction, financing, operations and maintenance and other value adding related services.

Where asset delivery involves private ownership this is generally no longer regarded as a PPP but a BOOT (build, own, operate, toll). There is a continuum. At one end is traditional contracting. At the other there is the BOOT. In between are so-called D&Cs (design and construct) and PPPs.

There are six factors that influence the attractiveness or otherwise of the different procurement options.

First, public acceptance of user fees like tolls. Where public acceptance is low, D&Cs tend to be favoured. Where it is high, BOOTs become more likely.

Secondly, there is the issue of transparency, or certainty of regulation. If it is possible to specify the standard of service level required at a high level, or to regulate clearly, there is not the same risk of cutting corners by lowering standards, and the BOOT/PPP end of the spectrum is more attractive.

Where it is hard to close all loopholes as far as standards are concerned, governments have little option but to own and operate facilities, and hence private participation is restricted to design and construct.

The third variable is stakeholder acceptance. This is not limited to paying user fees and tolls. Acceptance also involves comfort with standards of service that can be expected in the future.

If there is entrenched suspicion about future performance, the D&C is the only effective option open to governments. As acceptance increases, it is possible to move towards the other end of the spectrum. This means that PPPs tend to become more common as experience with them builds. They are not the unknown devils of yesteryear.

It also means that there is a lot of pressure on private participants to make early projects work. If there are perceptions of profit gouging or shoddy service delivery, stakeholder acceptance will grow slowly.

The fourth factor is project size and complexity. If a project is small and straightforward, there is not much to gain by moving away from traditional contracting. The private participant can’t add much value by way of innovative design. There is not the same level of risk to transfer.

The contract size tends to limit how much can realistically be spent on developing the construction, service, and funding contracts, so there is more risk of sloppy performance specification. The prize is not valued so there is less competition in the tender process.

I get very large variations in what advocates of PPPs say is the minimum size to be viable candidates for these new approaches to service delivery. It is not only size, but frequency. A steady stream of smaller projects can be as attractive – from both the government’ and the contractors’ point of view – as one large one.

The fifth factor is the potential for private sector innovation. It also depends a bit on where that potential exists. If it is at the design end the D&C is favoured. If it is in service delivery after construction, we move more towards BOOT type arrangements because the owner will have the greater incentive to search out the innovative opportunities.

Finally, there is the opportunity for risk transfer, over things like construction problems, design variations, level of usage after construction and so on. The benefits and costs of many infrastructure projects are highly dependent on assumptions made about whether or not the project comes in on time, on budget, encounters limited engineering complications, requires fewer design variations and has the expected use when it is completed. With some projects – like the Sydney harbour tunnel – almost all of these risks were transferred to the private participant in the venture.

It is important not to go overboard here – return is the flip side of risk. In some cases, the government may be better placed to carry risk. Transferring it can require too high a premium to be built into the project specification. Also, if a project turns out to be problem free and attracts high uses, the public misses out on too much of the windfall benefit.

This list of factors that influence the attractiveness of different ways of delivering infrastructural services implicitly identifies their strengths and weaknesses, but I will list them explicitly.

We need to remember that what we are talking about are infrastructural services. We tend to think of infrastructure as physical: a road or school or hospital. But that physical presence is only needed because of the service it provides – a corridor down which a car may be driven, a place in which to learn and so on.

This realisation leads to the first potential advantage: innovation in design. There are different ways to structure the way a service is delivered, and in particular how it interfaces with other existing facilities. PPPs allow fertile minds to explore profitable ways to achieve a given end. Related to this is innovation in construction.

As I have canvassed earlier, PPPs allow for a reallocation of risk, in its various dimensions. This is an aspect of policy that we need to be very careful about. We can offload too much risk – and have to pay too much for the other party to accept. We can offload too much risk and shut ourselves out of the upside on the risk-return frontier.

But another factor is overburdening the private consortium with risk. If too much risk is loaded on the provider, and the outturn is negative, the provider collapses. There is a risk of long project delays as litigation unfolds and re-tendering starts. Many in this audience will remember the Clyde Dam. With that project, I wonder if any contracting process could possibly have led to an appropriate distribution of risk ex ante. And I have no idea what would have happened ex post.

Innovation in operation is another advantage often cited for PPPs. I have some difficulty with this: the operation is largely determined at the design stage, so I see this as an offshoot of the “other ways to skin a cat” virtue.

Some supporters of PPPs see this as a good way of prising loose private sector finances for public sector projects, and of stretching the government’s otherwise available budget. The jury is out on this.

Free lunches are notoriously scarce in economics. If, say, a road is built, and the government pays a developer an annual lease fee, it is still money. The money has to cover the developer’s cost of capital as well as the other costs, and is not really different to paying interest on a government loan.

All other things being equal the government should be able to borrow at a more advantageous rate than a private consortium, so from a fiscal point of view the fee is likely to be higher than the debt servicing costs. The loan doesn’t show up on the government’s balance sheet, but this is probably not all that material.

The point about debt burdens and debt ratios is that the higher they are, the harder it is to service any extra borrowing. A contractual commitment to lease payments commits future revenue flows in exactly the same way as a loan does, so off balance sheet financing does not really increase the government’s marginal capacity to borrow.

Private funding may – and I stress may – allow for more projects to start earlier. That is still being evaluated. If they do, there is potentially a dynamic fiscal advantage: more growth earlier expands the revenue base and expands the capacity to borrow and/or meet PPP lease obligations.

The other argument is that PPPs allow extra revenues to be generated to service the private loans – tolls for example. This is essentially a separate policy decision: tolls could just as easily be levied on a road that is government owned. Third party funding of a part of infrastructure development is an important, but distinct policy question. There is merit in the argument that under certain circumstances they should be seen as a natural way of financing what appears to be a global demand for more and better and faster access to services.

As long as there is an alternative route, the user is not forced to pay a higher tax. There is private benefit in the choice of the toll road, otherwise the driver would not have gone that way. There is third party benefit – there is less congestion on the freeway. The road may not have been built if there was no extra revenue available to fund it, so in one sense there is a windfall expansion of opportunity.

The problem is in defining the counter-factual: what sort of upgrade that the government would have been forced to fund was delayed or abandoned because the toll road was built?

I suspect that in New Zealand these questions will never be as simple as the free road/ toll road portrayal. We have low population densities, a wide spread and an uneven terrain. In almost every case it will not be a case of you build a toll road, but a case of how much do we have to put in up front to make your toll road viable.

That up front money clearly does have alternative uses, and the public- private benefit and public choice issues are much more muddy.

There is a lot here to work through. As ever, the devil is in the detail. It is neither a case of full steam ahead for PPPs, nor one of the door closing on the option. We need a framework that everyone is comfortable with. In the past few weeks there has been a hint that it is somehow improper to have people who might be involved in PPP projects involved in the policy debate. This is not so. I cannot think of a major area of public policy where we have not refined the design of the framework by discussing it with those who might have a direct interest in what comes out at the other end.

This would cover industrial relations legislation, tax policy, policy on global warming, the approach to genetic modification and so on. The key here is that there is no exclusion of any valid perspective, no skewing of policy design away from public interest and towards sectional interest, no bypassing of proper processes of consultation and no favouritism for any party that took part in the policy process.

We get the best policy design we can by talking to those who know about the subject, and all operate to best advantage once the policy framework is settled.

One of the advantages we have with PPPs is that we can learn from the successes and failures of others. One thing we have to make sure of is that we don’t shut ourselves off from potential gains by taking pre-determined dogmatic positions. I look forward to this debate as it unfolds over the next year.

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