Sunday, September 6, 2009

Infrastructure contract re-negotiations and incentive distortions

I had blogged earlier about the moral hazard generated by a slew of contract re-negotiation in concession agreements and PPP projects in recent years, as potential bidders realize that they can bid low in order to bag the project and then re-negotiate more favorable terms later.

A World Bank study which examined 1,000 Latin American concession contracts awarded between the mid 1980s and 2000, found that 30% of all contracts were renegotiated, with the renegotiations most often favoring the concessionaire - in 62% of the cases they led to tariff increases, in 38% to extensions of the concession term and in 62% to reductions in investment obligations.

In a recent NBER working paper, Eduardo Engel, Ronald Fischer, and Alexander Galetovic examined data on Chilean experience with re-negotiations of 50 PPP projects in the 1993-2006 period and finds four observable predictions - "(i) in a competitive market, firms lowball their offers, expecting to break even through renegotiation, (ii) renegotiations compensate lowballing and pay for additional expenditure, (iii) governments use renegotiation to increase spending and shift the burden of payments to future administrations, and (iv) there are significant renegotiations in the early stages of the contract, e.g. during construction."

The 50 PPP projects - 26 roads, 10 airports, three jails, two water reservoirs, five public transportation infrastructure projects and four other miscellaneous projects - were renegotiated 148 times in the period, boosting the committed investments from $8.5 bn to $11.3 bn. They find that the overwhelming majority (83% of the total amount or $2.3 bn) of the re-negotiations was the result of 78 bilateral renegotiations (and rest through arbitration panels), and only 35% of the additional cost (or payments to the concessionaire) was paid by the administration that renegotiated. Of the $2.3 bn re-negotiated and awarded bilaterally, 84% corresponds to payments for additional works, while the remaining 16% correspond to additional payments for works included in the original contract. The largest share of renegotiations are in urban highway projects. It was found that 73% of the total amount was renegotiated shortly after the concession was auctioned, that is during the construction phase.

While I had highlighted the incentives for private partners to quote low and bag the project under whatever conditions and then re-negotiatiate favorable terms, the authors focus attention on government's use rengotiations to circumvent budgetary constraints. They force re-negotiations to broaden the scope of the projects to include newer components and activities or expansion of the concessions to cover more areas.

As the Chilean examples demonstrates, such re-negotiations enables the government to shift the burden of expenditure on an immediately needed infrastructure work (say on an extension of the road or water supply network) to the concessionaire, though at considerable cost to the public exchequer. During these rengotiations, the concessionaires typically wring out much more favorable terms than granted in the original concession agreement. Not only does the present administration evade the need to commit to additional spending on important infrastructure requirements, it also shifts the burden of these current spending expenditures to the latter governments. In other words, the concessionaire ends up "lending to" the present government by renegotiating the contract in return for payments made by future administrations.

Though re-negotiations in India have hitherto been driven more by the concessionaires forcing the issue of incomplete contracts or changes in the contract (and market) environment, it is only a matter of time before governments take the lead in re-negotiating PPP contracts. And given the natural advantage held by the concessionaire in such renegotiations, it is only to be expected that the concessionaires will be only too happy to oblige.

Power generation projects are a fertile ground for such re-negotiations. In view of the massive power deficits, it is natural to expect governments to offer proposals for capacity expansions after the Power Purchase Agreements (PPAs) are signed for a particular generation capacity. The considerable time that typically elapses between the signing of the PPAs and the start of construction (due to various delays like handing over of site and financial closure) only increases the possibility of such offers.

With demand increasing at a staggering pace, governments will find it convenient to request the existing developer to increase the capacity of the project under construction rather than wait to complete the entire bidding process for a new project. Further, in order to get the concessionaire to accept the proposal, governments are most likely to be ready to revise the terms of the original PPA with more attractive terms.

And even if governments, by themselves, will not take the initiative to make these offers, it is clearly in the interest of the private concesssionaire to get governments to put forward such re-negotiation proposals. Such incentives opens up possibilities for corruption and rent-seeking on a massive scale. Either way, there exists strong incentives to renegotiate PPP and other types of projects in power generation (and many other sectors).

The authors suggest that if PPP investments (including the renegotiated amounts) are counted as current government spending, the incentives to renegotiate contracts to increase spending is minimized.

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