Amid rising costs, contractors increasingly wary of entering into P3s

Infrastructure projects delivered as public-private partnerships have so far been protected from punishing construction cost increases because the contractors are legally on the hook for cost overruns and have been healthy enough to absorb the blows.

But inflation, coupled with material and labor shortages, are prompting some contractors to exit the space, and accelerating a P3 trend of bringing in the private team before pricing is finalized, Fitch Ratings said in an August 11 commentary on the impact of inflation on P3 projects in the U.S.

"As long as the credit profiles of the contractors not affected, the P3s are entirely insulated from price risk," Anubhav Arora, Fitch's director of global infrastructure and project finance, said in an interview. "Contractors are taking the brunt of the increased costs, but the fallout is that contractors may be more wary to enter into P3s going forward."

Construction services firm Turner estimated that non-residential building construction costs in the U.S. rose more than 8% year-over-year in the second quarter of 2022 and up 2.23% from the first quarter.

Inflation is accelerating a trend in the public private partnership space to hire contractors before pricing is finalized, said Anubhav Arora, Fitch Ratings' director of global infrastructure and project finance.
Fitch Ratings

Rising costs have battered infrastructure plans across the U.S., prompting many states and cities to delay or downsize projects. But current projects structured as P3s have largely been protected from credit fallout because the private team is legally required to take on risks associated with cost and schedule. That's considered a chief benefit for issuers and bond investors of traditional P3s.

"We've been seeing this push toward progressive models already happening and now we're seeing them more and more," Arora said. "These are more collaborative models where the contractor won't be solely responsible for the entire price risk at financial  close."

Contractors can be brought in early under so-called progressive design-build models, where the price is not yet fixed at financial close but later, once the design has sufficiently progressed.

Another model is so-called predevelopment agreement procurement models, or progressive P3s, wherein the government brings a private partner on board early to help design and price a project, often while pursuing environmental reviews and approvals.

Examples of PDAs in the U.S. include Pennsylvania's P3 bridge program, which faces obstacles, and L.A. Metro's $9.5 billion high-speed transit line in the Sepulveda Transit Corridor. The model is also relatively common in the water and wastewater space, Arora said.

The PDA can provide "greater clarity on project costs and reduces risk/liability," Fitch's commentary said.

Under a PDA model, the project would likely come to market with pricing largely set, Arora said. "They would probably come to market once they have more clarity on what the final agreement would look like," he said, adding that Fitch currently does not rate any PDA-based projects.

But under the progressive design-build model, a project may be looking for financing without a final price tag, Arora said.

"That could expose the P3 project to a price escalation risk — where would they get the additional financing?" Arora said. "That would become a cost-escalation risk that you don't see in traditional P3s."

From a credit perspective, Fitch would then likely consider which contingencies are in place to cover cost escalation, as well as the timeline for a final price, and what is being financed in the first market foray.

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