Public‐Private Contracting under Limited Commitment

• Author: DANIEL DANAU,ANNALISA VINELLA
• Date: 01 February 2015
• Published date: 01 February 2015
• DOI: http://doi.org/10.1111/jpet.12113

PUBLIC-PRIVATE CONTRACTING UNDER LIMITED

COMMITMENT

DANIEL DANAU

Universit´

e de Caen Basse-Normandie

ANNALISA VINELLA

Universit`

a degli Studi di Bari “Aldo Moro”

Abstract

A government delegates a build-operate-transfer project to

a private firm in a limited-commitment framework. When

the contract is signed, parties are uncertain about the oper-

ating cost. The firm can increase the likelihood of facing

a low cost by exerting some noncontractible effort while

building the facility. Once the facility is in place, the firm

learns the marginal cost and begins to operate. We charac-

terize the contract which stipulates the efficient allocation.

We study the financial structure and duration that secure its

enforcement. To this end, we take into account that break-

up of the partnership occasions a replacement cost for the

government and an expropriation cost for the firm and its

lender. Furthermore, both these costs are higher the ear-

lier the contract is terminated. Enforcement is achieved as

follows. The firm is instructed to invest some intermediate

amount of own and borrowed funds. Under the aegis of a

third party that can commit, the government provides guar-

antees to the lender, conditional on continuation of the

Daniel Danau, Universit´

e de Caen Basse–Normandie – Centre de Recherche en Economie

et Management, 19 rue Claude Bloch, 14000 Caen, France (daniel.danau@unicaen.fr).

Annalisa Vinella, Universit`

a degli Studi di Bari “Aldo Moro” – Dipartimento di Scienze

economiche e metodi matematici, Largo Abbazia S. Scolastica 53, 70124 Bari, Italy

(annalisa.vinella@uniba.it).

We are indebted to Elisabetta Iossa, David Martimort, Flavio Menezes, an Associate Ed-

itor, and two anonymous reviewers for very useful comments and suggestions. We thank

the audiences at the 2012 APET Workshop on Public-Private Partnerships (Brisbane), the

27th EEA Congress (Malaga), and the 39th EARIE Conference (Rome).

Received September 14, 2013; Accepted November 10, 2013.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (1), 2015, pp. 78–110.

78

Public-Private Contracting 79

partnership. Duration may be shortened, though not to the

point where the initial effort of the firm is uncompensated.

1. Introduction

Public-private partnerships in infrastructure projects are typically character-

ized by two features. First, private firms are required to undertake signif-

icant investments in the initial stage and, sometimes, at specific contract

milestones. Second, projects are highly leveraged.1These two features of

public-private partnerships, in turn, raise two important questions. The first

is whether private rather than public investment is desirable. As governments

usually face a lower cost of capital than private firms, this question is prob-

lematic, and the answer is far from obvious. The second question concerns

the role of debt finance. While firms are not always cash-constrained to the

point of justifying massive reliance on debt, highly leveraged projects tend to

be vulnerable to default. Thus, one may wonder whether there is a strategic

scope for debt finance, particularly as it affects the possibility and the out-

come of later renegotiation, which is one of the most pervasive difficulties of

public-private contracts.2The objective of this study is to suggest answers to

these questions.

To this end, we rely on a model in which contractual parties have differ-

ent information about relevant aspects of the project and, in addition, lack

the ability to commit to particular actions. Adoption of such a model enables

us to consider both information and enforcement issues. Specifically, follow-

ing Laffont (2003) and the related studies of Guasch, Laffont, and Straub

(2006, 2008), we assume that, at the contracting stage, neither the govern-

ment nor the firm knows the production cost. The firm discovers this as soon

as the facility is in place. Furthermore, we allow for the contract to be re-

neged upon during operation. The model is, however, innovative in a variety

of ways. First, the length of the contract is not exogenously given. Second, at

the construction stage, the firm decides whether or not to exert some non-

contractible effort that makes a low operating cost more likely. This is simi-

lar to studies of public-private partnerships in which there are synergies be-

tween phases of projects (e.g., Bennett and Iossa 2006; Hart 2003; Iossa and

1In June 2008, The Economist reported that infrastructure spending was mainly funded with

corporate bonds issued by private firms running the projects before the economic crisis,

and with senior debt after the crisis. According to Sader (1999), in developing countries

debt covers three-quarters of the costs of a typical build-operate-transfer infrastructure

project. See also Ehrhardt and Irwin (2004) and Flyvbjerg, Garbuio, and Lovallo (2009)

on debt finance in large public projects.

2Although renegotiation occurs mostly in developing countries (Banerjee, Oetzel, and

Ranganathan 2006, Estache and Wren-Lewis 2009, Guasch 2004, Guasch, Laffont, and

Straub 2006, 2008), it is also widespread in transition economies (Brench et al. 2005) and

even in developed countries (Gagnepain, Ivaldi, and Martimort 2009).

80 Journal of Public Economic Theory

Martimort 2008, 2009; Martimort and Pouyet 2008). Third, instead of fo-

cusing alternatively on firm-led or government-led renegotiation, we assume

that either party may attempt to renegotiate. Finally, we let private capital

be used to finance the project, possibly together with public funds. While

in Guasch, Laffont, and Straub (2006) private capital can only come from

bank finance, we also allow the firm to invest its own resources up front. This

representation is consistent with real-world evidence that construction ex-

penses are generally financed with firms’ own funds and bank loans, some-

times complemented by governmental subsidies (Engel, Fischer, and Gale-

tovic 2010).

We first establish a benchmark. Under full commitment, the financial

structure of the project does not matter. Information issues are addressed by

means of a reward-and-punishment compensation scheme and a sufficiently

long contract duration. A contract with these characteristics retains all sur-

plus ex ante and yields the efficient output level. Under limited commitment,

by contrast, enforcement of that contract may be difficult. Once information

is revealed, some party may seek to renegotiate. In that case, the financial

structure of the project matters. We show that, with an appropriate mix of

funds and contract duration, incentives to behave opportunistically do not

arise and the contract is honored.

To understand our findings, it is useful to consider what would happen

if the parties were to return to the contracting table. One possibility is that

renegotiation fails, the partnership breaks up, and the government replaces

the firm with a new operator. Alternatively, renegotiation succeeds, and the

partnership continues under a new contract. Break-up is not costless for ei-

ther party. The government incurs a replacement cost, that is, a loss of repu-

tation/credibility vis-`

a-vis current and prospective partners, customers, and

voters. The firm incurs an expropriation cost, i.e., the initial investment is

(partially) foregone. Rebus sic stantibus, both parties are more prone to reach

a new agreement than to break up the relationship because, under a new

agreement, they could share what the government saves by not replacing the

firm. Moreover,given the stipulated contract duration, both the replacement

and expropriation costs are larger, the earlier the interruption. Hence, the

incentive to sign a new agreement becomes stronger as the residual contrac-

tual period lengthens. These considerations suggest that enforcing the con-

tract is more difficult in two cases: first, when parties anticipate that, should

either party renege, a new deal would be reached; second, when a long dura-

tion is initially agreed upon. Consequently, two steps can be taken to ease the

task: first, ensure parties’ anticipation that any renegotiation attempt would

lead to break-up; second, shorten the contract duration in the first place.

The first step may appear difficult to implement. However, the follow-

ing procedure will accomplish this task. The government instructs the firm

to take a loan to run the project. As the firm does not commit to reim-

burse the lender, the government provides conditional guarantees, which

would take effect only if the partnership is preserved. These guarantees