Thursday, January 2, 2014

Re-negotiations and the "bid premium"

Aggressive bidding by developers has been one of the features of private participation in India's infrastructure projects in recent years. All but a few of these projects end up in re-negotiations. Such re-negotiations, which post-facto accounts the unhedged risks in the original bid, invariably lead to much favorable terms for the developer, most often at the cost of the tax payer or user. Further, the inherently non-transparent manner of re-negotiations, engenders a culture of crony capitalism that favors politically connected firms and vitiates the contract environment. Most worryingly, all this generates a moral hazard that erodes the sanctity of the tender process and makes developers bid aggressively safe in the assurance that they can change the rules of the game during the re-negotiations.

So how do we curb aggressive bids? How about a "bid premium" for each bid that would normalize each bid? This "bid premium", unique for each developer, could be calculated based on the  developer's prior history of re-negotiations. The difference between the original and re-negotiated bids is a measure of the mis-pricing of risks (a sector premium) and the degree of aggression in the bid (a bid premium).

The former can be adjusted by discounting for the same difference for all the projects that have been bid out in the sector. The excess difference, that remains after subtracting the sector premium, belongs to the firm and is a measure of the firm's aggressive bidding. Each project would have a bid premium. Some weighted average of the bid premiums of all projects undertaken by the same promoter in that sector can be used to calculate his project bid premium. This bid premium can then be added to his present bid so as to discount his current bid for any aggressive practice when evaluating the bids. 

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