Economic Analysis of Public-Private Partnerships in Japan: Theoretical and Empirical Analyses Focusing on Adverse Selection and Synergy Effect

In Japan, the national and local governments’ fiscal deficits are increasing, while public infrastructure systems remain old. To overcome these problems, the role of public-private partnerships (PPP), including the private finance initiative (PFI), is attracting increased attention. In the literature, emphasis has been placed only on improving fiscal efficiency, such as value for money (VFM). However, if differences in quality among private companies and the importance of incentive rewards are not considered, PPPs can end up creating inefficiencies in terms of social welfare. From this viewpoint, using theoretical and empirical analyses, our research’ examines the circumstances under which PFI projects work effectively. In the theoretical analysis, we consider PFI projects as a principal-agent relationship in which the public sector (principal) entrusts business operations to the private sector (agent) under an incomplete contract. Then, we conduct a comparison of projects under two types of contracts, namely build-operate-transfer (BOT) contract (the constructed facilities continue to be owned by the private sector until the expiry of the project) and the build-transfer- operate (BTO) contract (the ownership of constructed facilities is transferred to the public sector after construction). Through this comparison, we clarify the respective advantages and disadvantages of the two contract types due to the difference in the timing of ownership transfer. Moreover, regarding the quality of private companies, we point out the importance of setting the contractor’s reward at a sufficient level to avoid the adverse selection problem. In the empirical analysis, we estimate how the differences in the type of contract (BOT or BTO) and the level of VFM (which is negatively correlated with the contractor’s fixed compensation) at the planning stage affect the contractor quality and the efficiency improvement in the project. We use data on PFI projects implemented in Japan from fiscal year 1999 to 2018. We proxy the quality of contractors by the number of companies that applied for the project, the share capital of the selected core company, and whether the company is listed or unlisted. We also proxy the efficiency improvement of the project by the degree of improvement of VFM at the time of contracting, relative to the level at the planning stage. We find that even when changes in the macroeconomic situation and the circumstances surrounding the PFI during the analysis period are considered, BOT-type projects attract more applicant companies than BTO-type projects. Furthermore, the degree of improvement of VFM was larger for BOT-type projects. This implies that in practice, the BOT type is superior on average, as it is likely to generate a greater synergy effect between construction and operation. We also find that the higher the level of VFM at the planning stage (the lower the fixed contractor’s compensation), the lower the quality of the selected core company and the smaller the degree of improvement of VFM. These results indicate the importance of devising a suitable incentive mechanism to secure high-quality candidate companies and ensure appropriate behavior of the selected contractor.