Public versus Private Cost of Capital with State-Contingent Terminal Value

PublicversusPrivateCostofCapitalwithState-ContingentTerminalValue LucianoGrecoandMarianoMoszoro WP/23/56 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2023 MAR ©2023InternationalMonetaryFundWP/23/56 IMFWorkingPaper FiscalAffairsDepartment PublicversusPrivateCostofCapitalwithState-ContingentTerminalValuePreparedbyLucianoGrecoandMarianoMoszoro* AuthorizedfordistributionbyRodrigoCerdaMarch2023 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:Theeconomicdebateunderlinesthereasonswhydiscountratesofinfrastructureprojectsshouldbesimilar,regardlessthepublicorprivatesourceoffinancing,duringtheforecastperiodwhenflowsareriskybutpredictable.Incontrast,weshowthattheincompletenessofcontractsbetweengovernmentsandprivatefirmsbeyondtheforecastperiod(i.e.,whenflowsofnetsocialbenefitsarestate-contingent)entailsexpectedterminalvaluesthataresystematicallylargerundergovernmentratherthanprivatefinancing.Thiseffectprovidesanewrationaleforapplyingalowerdiscountrateintheassessmentofprojectsunderpublicfinancingascomparedtoprivatefinancing. RECOMMENDEDCITATION:Greco,Luciano,andMarianoMoszoro,“PublicversusPrivateCostofCapitalwithState-ContingentTerminalValue,”IMFWorkingPapers2023/056(Washington:InternationalMonetaryFund). JELClassificationNumbers: H43,L32,L97 Keywords: Socialdiscountrate;publicutilities;privatefinancingofinfrastructures;public-privatepartnerships Author’sE-MailAddress: Luciano.greco@unipd.it;Mmoszoro@imf.org *TheauthorsaregratefultoAnthonyBoardman,ChenChen,EduardoEngel,RonaldFischer,MikhailFreer,AlexanderGaletovic,VitorGaspar,RickGeddes,JoshuaGoldman,PaulGrout,XuehuiHan,ShafikHebous,DejanMakovsek,EmanueleMassetti,RyotaNakatani,SamPeltzman,JohnRyan,DavidVanSlyke,andJean-FrancoisWenforcomments,andtoseminaraudiencesatCornellUniversity,SciencesPo,SGH-WarsawSchoolofEconomics,andtheIMF.LucianoGrecoacknowledgesfinancialsupportfromCRIEP(Inter-UniversityResearchCentreonPublicEconomics),UniversityofPadua.MarianoMoszoroacknowledgesfinancialsupportfromthe“MIURProjectDepartmentofExcellence”ofthedSEA(DepartmentofEconomicsandManagement),UniversityofPadua.Datasharingisnotapplicabletothisarticleasnonewdatawerecreatedoranalyzedinthisstudy.TheviewsexpressedinthispaperarethoseoftheauthorsanddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. WORKINGPAPERS PublicversusPrivateCostofCapitalwithState-ContingentTerminalValue PreparedbyLucianoGrecoandMarianoMoszoro1 1TheauthorsaregratefultoAnthonyBoardman,ChenChen,EduardoEngel,RonaldFischer,MikhailFreer,AlexanderGaletovic,VitorGaspar,RickGeddes,JoshuaGoldman,PaulGrout,XuehuiHan,ShafikHebous,DejanMakovsek,EmanueleMassetti,RyotaNakatani,SamPeltzman,JohnRyan,DavidVanSlyke,andJean-FrancoisWenforcomments,andtoseminaraudiencesatCornellUniversity,SciencesPo,SGH-WarsawSchoolofEconomics,andtheIMF.LucianoGrecoacknowledgesfinancialsupportfromCRIEP(Inter-UniversityResearchCentreonPublicEconomics),UniversityofPadua.MarianoMoszoroacknowledgesfinancialsupportfromthe“MIURProjectDepartmentofExcellence”ofthedSEA(DepartmentofEconomicsandManagement),UniversityofPadua.Datasharingisnotapplicabletothisarticleasnonewdatawerecreatedoranalyzedinthisstudy.TheviewsexpressedinthispaperarethoseoftheauthorsanddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. Contents I.Introduction3 II.AFinancialModelofInfrastructureProjects7 III.ATheoryofEndogenousExpectedTerminalValue10 A.PublicFinancing11 A.1EfficientGovernment11 A.2InefficientPublicRevamping12 B.PrivateFinancing13 B.1UnverifiableState-ContingentInvestment14 B.2VerifiableState-ContingentInvestment15 B.3PublicVersusPrivateFinancingWhenPublicRevampingisInefficient17 CFinancialAssessmentofInfrastructureProjectsRevised18 IV.Conclusion19 References21 FIGURES 1.TheCycleofInvestmentinaPublicInfrastructure8 TABLES 1.DiscountRatesUsedinVfMbyPPPUnits4 I.Introduction Publicgoods,suchasservicesfrompublicinfrastructuresandutilities,canbealternativelyprovidedbygovernmentorprivatefirms.Thoughpublicprovision(orpublicfinancing)involvestraditionalprocurementofinputsoverthepublicinvestmentlifecyclefromdifferentprivatefirms––e.g.,constructionand,sometimes,operationservices––strategicmanagement,financing,andmostofinvestmentandoperationrisksremaintothepublicsector.Incontrast,withtheprivateprovisionofpublicinfrastructuresandutilities(orprivatefinancing)thegovernmentcontractsoutwithinasinglepublic-privatepartnership(PPP)contract––e.g.,toaconsortiumofprivatefirms––severalphasesoftheinvestmentcycle,includinglong-runmaintenanceandmostoffinancingneedsand,thus,transferstotheprivatesectoralargershareofinvestmentandoperationalrisks(Engel,FischerandG