Globalization and the State’s Sovereign Right to Regulate in the Public Interest: the Case of Public-Private Partnerships (PPPs) in Infrastructure

Almost everyone has an opinion about rising populism, disturbing election dynamics, increased racism and xenophobia, widespread migration, runaway climate change, and global trends toward authoritarianism and repression of civil society.  

For some or all of these reasons, many people are lashing out against economic integration and globalization.  In response, the financial establishment has concluded that it must improve its communications about the benefits of globalization as well as ensure that such benefits are widely shared.[1]  

However, there is little evidence that the plan of the international financial institutions and the G20 countries (among others) will reliably achieve either greater inclusion or environmental sustainability.  The plan, entitled “From billions to trillions,” uses public resources to leverage and dramatically scale-up private investment in infrastructure development, particularly through public-private partnerships (PPPs).  There are infrastructure master plans for each region of the world (e.g., the Programme for Infrastructure Development in Africa (PIDA); China’s Belt Road Initiative  (BRI)) which identify and prepare “pipelines” of projects in each of four primary sectors: transportation, energy, water, and information and cportuommunications technology (ICT).  All of the master plans, which rely on both fossil fuel and renewable energies, aim to rapidly scale up PPPs, especially by standardizing PPP project preparation processes and documents, such as the PPP contract.

This article describes some of the ways that the economic forces driving integration and globalization create exclusion and environmental degradation. Then, it focuses on one instrument which is being standardized – the PPP contract.  Biased contracts can result in gains for the private sector but in social and economic losses for the public by creating exclusion and jeopardizing state sovereignty, including the state’s “right to regulate” in the public interest, for instance, to protect human rights or curb global warming.

Economic Forces that Drive Integration and Globalization

It is not an accident that 8 men hold as much wealth as the 3.5 billion people who comprise the bottom 50% of humanity.  It is not an accident that corporate power has become highly concentrated, such that of the list of the top 100 economies, 69 are corporations and 31 are countries. 

The current economic paradigm is comprised of three policy pillars – privatization, liberalization, and budget discipline.  There is nothing intrinsically wrong with these policies.  However, with some exceptions, such as certain Scandinavian countries, the rules that guide the policies and the extreme manner in which they are implemented have caused inequality to skyrocket since 1980. 

On the whole, the paradigm has: 

• Treated the environment and the atmosphere as though they were limitless sinks for pollution and greenhouse gases (GHGs).
• Promoted budget discipline to a point of severe austerity that has stifled development and/or growth in many countries. 
• Liberalized financial markets to a degree that has turned the sector into a casino of speculation. 
• Liberalized labor markets in ways that have, at times, stripped workers – especially women -- of their rights and decent wages. [2]   For many, work is more precarious (e.g., short-term contracts or none at all) and, according to the IMF, there is less social protection for workers in the event of unemployment.[3] With a rise in automation, net job creation is a challenge. 
• Encouraged regressive tax policies that have risked disabling social welfare systems. 
• Promoted trade agreements that are often less about trade in goods than about securing intellectual property rights, shifting wealth to the owners of capital, liberalizing procurement, and shifting rights from states to investors. 

The excluded are angry and want radical change.  Yet more people need to challenge the economic paradigm and the resulting threat to state sovereignty, specifically the “right to regulate” in order to improve health, safety, environmental, and labor standards in every sector including agriculture, energy, water, transportation. 

Many democracies have fostered inclusiveness through the exercise of this “right to regulate”.  Governments forged “social compacts” with their citizens that call for legislation and regulation in the public interest.  This has also entailed using progressive taxation to assist in providing jobs and universal public services, such as education, training, health care, potable water and other essentials.  Providing social and economic infrastructure – including through cross-subsidies in which the rich pay more to assist the poor -- is necessary for inclusive development.

Yet, the paradigm driving economic integration and globalization is gathering speed.  Capitalism is seeking new frontiers for profit-making, beginning in the infrastructure sectors. 

Globalization and Infrastructure Development

As described above, in both developed and developing countries, financiers have agreed to accelerate the shift away from the public provision of services and, instead, use public resources to leverage massive private investment in infrastructure, often megaprojects that take the form of PPPs.  In PPPs, governments procure infrastructure services (e.g., health care or water services) from domestic and/or foreign private firms for use by citizens.

When included in pooled investment vehicles (or co-investment platforms) – PPPs are intended to attract investors, especially long-term institutional investors such as pension funds, that are looking for a high and reliable revenue stream.   If sufficient risk is offset, PPPs will be of particular interest to pension funds, which are in crisis due to low return earnings and in danger of failing to meet their obligations to retirees unless they invest in higher return ventures.

One can choose the lens through which one views the massive shift to investing in infrastructure.  Citizens see certain types of infrastructure as necessary to deliver not only key services, but also a low- or no-carbon future that can help avert climate disaster.  Global finance titans see this shift as necessary to stimulate global and national economic growth.  Political leaders see the shift as necessary to achieve the infrastructure needed to compete with China and other nations for access to natural resources and markets. 

From any perspective, the stakes in infrastructure investment are high. As Christine Lagarde, Managing Director of the International Monetary Fund says:

Over the next 15 years, we may be looking at up to $90 trillion in global infrastructure investment, mostly in emerging and developing economies that will see a massive increase in urbanization  Just think about the risk if this investment is done in the wrong way—for example, if it locks in carbon-intensive energy and transportation structures in these mega-cities. This could radically affect the quality of life on the planet—for all of us. [4]

With so much at stake, it is crucial that PPPs fairly balance public and private sector interests.  Yet, by their very nature, PPPs often present a clash between these interests.  Private investors have an obligation to return profits to their shareholders, not to serve the public good.  Of course, it is possible to profit from serving the public good, but the public and private sectors' respective goals do not always overlap. 

It is necessary, therefore, to reframe the conversation about scaling up PPPs.  With regard to the quantity of infrastructure financing, governments are being misled.  They are told that, since public budgets are so tight, they need private sector “additionality.”  Yet, an independent evaluation of ten years of World Bank support to PPPs finds that, “PPPs generally do not provide additional resources to the public sector.”  At most, estimates suggest that the private sector will contribute 30% of infrastructure development costs. 

Governments are drawn to use of PPPs not only because of the lure of additional resources, but also because the PPP liabilities are put “off-budget”, which gives national authorities the illusion of having a larger budget than they actually do.  Therefore, it is essential that governments heed the calls for open budgets and open contracting.  Openness also curtails corruption for which infrastructure projects are notorious.  Otherwise, PPP liabilities can swamp a government, as was the case with Portugal.  See below.

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Quotes from two IMF Documents Assessing PPP-Related Liabilities

Portugal: Selected Issues Paper IMF Country Report No. 13/19 January 2013
Relative to its GDP, Portugal had the highest cumulative investment in PPPs in the EU in the past decade by far.  (Cyprus is #2.)  Investment was primarily in the road sector. In looking back, the IMF stated, “The deterioration of the fiscal accounts was accompanied by aggressive off-budget spending, leading to a buildup of substantial contingent liabilities. The most important of these off-balance transactions was capital spending implemented through PPPs (15 percent of GDP in cumulative investment at 2012 prices, substantially above international practice)…” (p. 80, emphasis added)

Portugal Fiscal Transparency Evaluation, IMF Country Report No. 14/306, October 2014
“PPPs are still a significant source of fiscal risks in Portugal …the estimated present value of central government’s recorded financial commitments was about 6 percent of GDP at end-2013 … Not included in this estimate, however, are any projected payments undertaken by local governments and the regions or many concessions in the water waste and energy sector. “ (p. 69)  “Little or no information is provided on the 75 central government concessions or on PPPs at the local level which represent €21.3 billion (13 percent of GDP).” (p. 71)  “Moreover, general government debt in Portugal has increased from the real-time reported 76 percent of GDP in 2009 to a forecast 130 percent of GDP in 2014.” (p. 15) “Contingent liabilities, related to law suits, which on December 31, 2012, amounted to 2.1 € billions (1.3 percent of GDP).”  

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Cost overruns and benefit shortfalls are more common than not, according to Oxford University’s Said School of Business.  It cites the high frequency of cost overruns in roads (20%), energy (36%), railways (45%), dams (90%) and IT (107%).  There needs to be a conversation about these predictable losses can be avoided or absorbed in an equitable manner.With regard to the quality of infrastructure (which is UN Sustainable Development Goal (SDG) #9), it is essential that governments eliminate fossil fuel subsidies and radically shift to renewable sources of energy and transport. Then, before being scaled up, there should be evidence that they can enhance the access to and affordability of infrastructure services.  Instead, user fees for basic services often place them out of reach for poor communities.  Moreover, low-income countries lack the capacity to deliver targeted subsidies to needy citizens.  (On this and related questions, see the author’s recent article, “Infrastructure Investment and PPPs”). 

The Case of Standardizing Project Preparation, including PPP Contracts.

To avoid adverse outcomes, it is necessary to examine the effort that financiers are undertaking to standardize PPPs for the stated purpose of accelerating and replicating model PPPs around the world.  Among other things, the effort involves standardizing feasibility studies, impact assessments, the host country’s enabling environmental and PPP laws, procurement rules, an array of financial instruments and guarantees, and the provisions of PPP contracts.  Financiers estimate that, once standardization is complete, project preparation will take only about 3 years rather than the historically-required 7 years, thus expediting the process of filling infrastructure “pipelines” with “bankable projects.”

Successful standardization should take into account impacts on human rights, the natural environment, income inequality, and social requirements and realities.  Yet, it seldom does. 

Consider the simple example of a PPP for transportation. A private investor benefits from policies including:  a) siting transportation systems, such as motorways, in prosperous, higher income regions; b) charging high fees or tolls; and c) obtaining tax exemptions and government subsidies.  But lower-income persons may not be able to access or afford such transportation and the lower the usage of a motorway, the more those using the motorway must pay more to produce the desired revenue stream for the investor. When governments build toll roads, they often fail to consider that the demand by drivers is “elastic” – the very existence of tolls is enough to deter some drivers from using the road.  In the U.S. state of Texas, Democrats and even some Republicans have said that [public-private partnerships] don’t work in rural or low-income areas that can’t support tolls or a predictable revenue stream.[5]

Worse still, to protect their revenue streams, many firms entering into PPPs demand non-compete clauses in their PPP contracts “that reduce competition and require government to make them whole financially when policy changes or parallel infrastructure investment alter project revenues.  These provisions are smart business, but often bad public policy.”[6]  It is common knowledge that capitalism does not work without competition, yet it is becoming fashionable to prohibit it.

Private investors can petition or sue the government for lost revenue especially, when the PPP contract provides a guarantee that the government will supplement revenue from fees and tolls with payments from its budget so that the investor can reach its revenue target.  Such promises are called “minimum revenue guarantees” (MRGs). To government budgets, the MRGs are weapons of mass destruction, as was discovered in South Korea, Portugal and elsewhere, yet their use continues unabated. They obligate the government to provide corporate subsidies, if necessary, to ensure that the investors meets their minimum revenue targets.  The MRG is one of many types of guarantees that a PPP contract can offer.  In corrupt schemes, the private investor may hide certain revenue from the government in order to obtain payments.  And even when corruption is not involved, the diversion of government funds to such guarantees depletes the funds available to meet fundamental social needs. 

Investors sometimes also engage in “dive” bidding to compete for a contract award.  That is, they lowball the bid for a contract with either the explicit assurance or the (undisclosed) plan that, after the award, they can renegotiate contracts again and again, each time extracting more benefits from the government, to the detriment of the public sector.  According to the IMF, 55% of PPPs are renegotiated (approximately every 2 years) to increase tariffs (62%), decrease obligations of private sector (69%); or decrease concession fees paid to government (31%).

Government Sovereignty and the Right to Regulate. 

Investment treaties between countries are similar to PPP contracts between investors and government authorities in the sense that both are agreements through which states seek to attract investment by offering investors a variety of rights, protections, and benefits.  One right given to foreign (but not domestic) investors is the ability to challenge state conduct in international tribunals if the state takes actions that are perceived to be contrary to those agreements.  These investor-state dispute settlement (ISDS) processes are controversial because they jeopardize governments’ “right to regulate”.  See attachment for cases in which the governments of Germany, Uruguay and El Salvador were challenged by private investors.

ISDS processes permit foreign investors to sue governments for compensation not only if an asset is seized—or expropriated—by the government, but also if a change in law or regulation reduces a firm’s profits.  For instance, an investor can file a claim under the arbitration provisions of the relevant treaty alleging that a government has undercut its profits by failing to provide “fair and equitable treatment”—a nebulous requirement under international law that is concerned with the governments’ decision-making process and the investors’ “legitimate expectations”—or by “indirectly” expropriating its investment by taking regulatory actions that significantly reduce the investment’s value. Similarly, an investor could file a proceeding under the dispute resolution provisions of the contract if a change in law or regulation is alleged to negatively impact the investor's earnings.

The World Bank Group’s proposed contractual provisions. 

The World Bank Group’s draft 2016 edition of Recommended PPP Contractual Provisions (“Provisions”) is an example of provisions that favor the investor over the citizen and the environment.  These Provisions are more pro-investor than actual and proposed international investment treaties that have been hotly contested recently, such as the TTIP.  For instance, the section of the Provisions titled “change in law” obligates governments to compensate a PPP investor if -- after the bidding stage -- there is any change in the law that increases the investor’s costs. In addition, the Bank’s model language entitles a PPP investor to terminate the contract due to a change in law. This gives the PPP investor tremendous leverage and places all of the risk of subsequent changes in law on the government and its peoples: The investor may threaten to terminate, or actually terminate, the contract unless the government promptly compensates it for the costs of compliance with a new law, even if that law is non-discriminatory such that it impacts all sector participants equally.

Over at least the next two decades, governments will hopefully begin to adopt new laws that will apply to investors and other private participants in key sectors, such as laws to: 

• Implement the Paris Accord, including carbon pricing through cap-and-trade markets, carbon taxes, or other mechanisms.
• Enhance the environmental standards to which businesses are required to meet.
• Impose new taxes or fees on businesses for the purpose of addressing environmental concerns or funding social benefits.
• Implement the UN Guiding Principles on Business and Human Rights, including supply-chain transparency, monitoring systems, and remedies. 

But because PPP contracts often run for one or two decades, and sometimes longer, the change of law provisions they contain have the potential to impede governments from implementing the aforementioned laws out of fear of being challenged in court or arbitration for violating their commitments under the PPP contracts. 

The Bank’s model Provisions are also blind to Principle 8 of the UN Guiding Principles on Business and Human Rights, which urges governments to “maintain adequate domestic policy space to meet their human rights obligations … , for instance through investment treaties or contracts.”

The Provisions also undercut democracy by requiring governments to compensate the investor for the costs of project delays arising from citizen protest or obstruction of a project or workers’ strikes.  Consequently, the proposed clauses could require governments to mobilize a police or military response to citizens who are exercising their freedom of expression and association in order to avoid having to compensate an investor, even in circumstances in which the investor itself created the circumstances that led to the protest, obstruction or strike.

It is promising that citizens are mobilizing to prevent global warming, social exclusion, and the violation of human rights.  At the same time, it is crucial to call for fundamental changes in the economic paradigm that drives corporate- and financial institution-led globalization. Among other things, that means delving deeply into the details of contract provisions that would lock-in such negative impacts as dirty technology for generations, increase inequality by diverting all or the large majority of financial gains to the private sector, placing losses on civil society, and denying essential services to those who cannot afford them.  To prevent such outcomes, the standards for projects, including PPP contracts, must be overhauled in ways that promote a transparent and fair allocation of risks between states and investors and, in particular, the sovereign right of the state to act on behalf of its citizens.