Default and Renegotiation in Public‐Private Partnership Auctions

• Published date: 01 February 2015
• DOI: http://doi.org/10.1111/jpet.12102
• Date: 01 February 2015

DEFAULT AND RENEGOTIATION IN PUBLIC-PRIVATE

PARTNERSHIP AUCTIONS

FL ´

AVIO MENEZES

The University of Queensland

MATTHEW RYAN

The University of Auckland

Abstract

The winners of auctions for pubic-private partnership con-

tracts, especially for major infrastructure projects such as

highways, often enter financial distress, requiring the con-

cession to be reallocated or renegotiated. We build a sim-

ple model to identify the causes and consequences of such

problems. In the model, firms bid toll charges for a fixed-

term highway concession, with the lowest bid winning the

auction. The winner builds and operates the highway for

the fixed concession period. Each bidder has a privately

known construction cost and there is common uncertainty

regarding the level of demand that will result for the com-

pleted highway. Because it is costly for the government to

reassign the concession, it is exposed to a holdup problem,

which bidders can exploit through the strategic use of debt.

Each firm chooses its financial structure to provide opti-

mal insurance against downside demand risk: the credible

threat of default is used to extort an additional transfer pay-

ment from the government. We derive the optimal financial

structure and equilibrium bidding behavior and show that

Fl´

avio Menezes, School of Economics, The University of Queensland, St Lucia, QLD

4072, Australia (f.menezes@uq.edu.au). Matthew Ryan, Department of Economics,

Auckland University of Technology, Private Bag 92006, Auckland 1142, New Zealand

(matthew.ryan@aut.ac.nz).

We thank David Martimort and two anonymous referees for their careful reading of

the paper and for their many useful suggestions. The present version is much improved

as a result. We have also benefited from the comments of Jun Xiao and participants at

the following conferences: APET Workshop on PPPs (Brisbane), 31st Australasian Eco-

nomic Theory Workshop (University of Queensland), 12th SAET Conference (University

of Queensland), and the VUW Microeconomics Workshop (Wellington).

Received November 28, 2013; Accepted June 23, 2013.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (1), 2015, pp. 49–77.

49

50 Journal of Public Economic Theory

(i) the auction remains efficient, but (ii) bids are lower than

they would be if all bidders were cash-financed, and (iii) the

more efficient the winning firm, the more likely it is to re-

quire a government bailout and the higher the expected

transfer it extracts from the government. We discuss poten-

tial resolutions of this problem, including the use of least-

present-value-of-revenue auctions.

1. Introduction

Public-private partnerships (PPPs) are increasingly used to provide infras-

tructure services and other public goods. Thomsen (2005) reports that

worldwide investment in PPPs in the early 1990s had reached $131 billion,

whereas the World Bank PPP database suggests that their total value reached

nearly $1.2 trillion dollars globally as of 2006. The popularity of PPPs seems

to rest, at least among development circles, on their perceived ability to shift

risks from the public to the private sector. However, the implications of this

shift in risk are not well understood.

Bracey and Moldovan (2007) point out that about 50% of PPPs never

even reach the financing stage and, of those that do, about 50% are renego-

tiated during the building or implementation phases. This suggests that the

winners of PPP contracts, especially for major infrastructure projects such

as highways, frequently enter financial distress, requiring the concession to

be reallocated or renegotiated. Very often, these issues are due to revenue

falling short of expectations.

There are many examples of PPPs for the construction and operation of

highways that failed due to lower than expected demand. One such example

is the extension of the M1 Motorway in Hungary. Once the M1 was com-

pleted, it became clear that the project was at risk of default as traffic and toll

revenues were only half the amount forecast by investors, lenders, and the

Hungarian government. The final outcome was the renationalization of the

project. A successor PPP contract to build the M5 highway from Budapest

to Serbia also ran into trouble once it was realized that demand was lower

than expected. The outcome of renegotiation was the subsidization of the

toll by transfers from the government to the concessionaire.1Examples in

Australia include the cross-city tunnel in Sydney2and the Clem 7 tunnel in

Brisbane.3

Our main objective in this paper is to better understand the preva-

lence of bailouts under such arrangements. In our model, firms bid for

1See Bracey and Moldovan (2007).

2See http://www.tollroadsnews.com/node/1742

3See http://www.theaustralian.com.au/archive/business-old.end-of-the-road-as-rivercity-

motorway-sinks-owing-13bn/story-e6frg9i6-1226011606877