Matthew Ryan and Flávio Menezes, School of Economics Discussion Paper No. 499 February 2014, School of Economics, The University of Queensland and The University of Auckland.

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This paper models a Public-Private Partnership (PPP) to construct a highway. It captures some of the key features of the Transmission Gully PPP. The winner of the tender recovers its costs (including capital costs) via an availability payment rather than toll revenue. While the availability payment eliminates demand risk, the winner of the tender faces cost risk: maintenance costs are only learned after construction is complete. The winning firm can make investments during the construction phase that reduce subsequent maintenance costs. As the government faces transaction costs to replace the successful bidder, firms use debt strategically to pass on some of the cost risk to the government. This distorts incentives to invest in maintenance cost reduction. Private financing therefore undermines some of the benefits from bundling construction and maintenance, which is often mentioned as an important advantage of PPPs.