Overcoming the moral hazard from contract renegotiations

I had blogged earlier about the increasing trend of contract renegotiations in infrastructure concessions and the moral hazard generated by it. Such re-negotiations generate inefficiencies in multiple dimensions.

Assured of the possibility of re-negotiations, bidders offer excessive bids to win the tender. This often screens out the best developers or operators who lose out to those with the political muscle to wring out favorable terms during re-negotiations. More importantly, it results in considerable cost escalation, as the re-negotiated terms are certain to be in favor of the bidder. In simple terms, re-negotiations fritter away the efficiency and cost-effectiveness gains that come from a competitive bidding process.

This assumes significance in view of the decision of National Highways Authority of India (NHAI) to focus more on BOT Toll contracts instead of annuity concessions. BOT Toll concessions carries the risk of over/under-estimation of traffic, which in turn often opens up contract re-negotiations. Experience from such re-negotiations show that they are neither transparent nor conclusive. The controversy surrounding the re-negotiations of the Delhi-Noida Toll Bridge is a case in point.

In this context, a recent report on infrastructure public private partnerships (PPP) in the US advocates the use of present value of revenues (PVR) contracts as a means to mitigate the risk of contract renegotiations. Such renegotiations are common in infrastructure contracts which are financed with service fees, like tolls and user charges. The demand (or traffic) risk associated with such contracts is generally borne by the bidders, who cite the shortfalls to re-negotiatee contracts.

It is in this context that flexible-term contracts like PVR contracts assume relevance. In a PVR contract, the regulator sets the discount rate and the user-fee schedule, and bidders bid the present value of the user fee revenue they desire. The firm that makes the lowest bid wins and the contract term lasts until the winning firm collects the user fee revenue it demanded in its bid.

If the demand is lower than expected, the concession period is longer, and vice-versa. The resultant elimination of demand-side risks reduces the risk-premiums demanded by the concessionaires and would attract investors at lower interest rates. The UK was the first to use such variable term contracts, for the Queen Elizabeth II Bridge over the Thames River and the Second Severn bridges on the Severn estuary. Both contracts will continue till the toll collections pay off the debt issued to finance the bridges and are predicted to do so several years before the maximum franchise period.

Chile used a PVR auction to contract out the improvement of the Santiago-Valparaíso-Viña del Mar highway in 1998. It has since adopted PVR auctions as the standard to auction highway PPPs.

The report points to two other important advantages with PVR. One, it provides for a natural fair compensation payable, if the government decides to terminate the contract early. It can buy out the franchise by paying the difference between the winning bid and the discounted value of collected toll revenue at the point of repurchase (minus a simple estimate of savings in maintenance and operations expenditures due to early termination).

Second, unlike fixed term contracts, variable term contracts are especially useful in urban highways, where ex-ante fixation of tolls carries considerable risks - either too high (which causes under-utilization and reduces revenues) or too low (which results in over-use and congestion, generates a windfall for the concessionaire, and distorts his incentive to make investments in improvements). In a PVR contract, the regulator could set the toll rate efficiently to alleviate congestion (by raising or lowering it), without causing any harm to the concessionaire.

Apart from highways, port infrastructure, water reservoirs, and airport landing fields are natural candidates for a PVR. However, the real world risk with PVR contracts is the possibility that regulators will be forced into keeping user fees or toll rates low for political considerations (to not alientate the voters). This would generate sub-optimal outcomes, with the concessionaire having a longer than optimal concession period.