Contract renegotiations are passé. The challenge today is not so much to prevent renegotiations by trying to write complete contracts, but to manage them effectively. It is an acknowledgement of this reality that the Union Budget has proposed the enactment of a Public Contracts (Resolution of Disputes) Act.
Experience from several decades of concession contracts from across the world and in different sectors shows that incomplete contracts are the norm. In a famous analysis of over 1300 concession contracts in Latin America, World Bank economist Luis Guasch has shown that 54% of them ended up being re-negotiated within 18 months. In India too, the vast majority of national highways and all the ultra-mega power projects (UMPP) which were allotted through competitive bids are now being re-negotiated.
This should come as no surprise given the deep uncertainty that is sought to be tamed by such contracts. It is extremely difficult, even impossible, to conceive of all possible contingencies which can possibly derail a contract over a 20-30 year period of time. There are simply too many unknown unknowns for anybody to write a reasonably credible contract for such a long duration. Renegotiations become inevitable.
Concessionaires demand tariff increases, extension of concession tenure, back-loading or reduction in their investment obligations, and adjustment of periodic fees payable. But re-negotiations detract from the sanctity of the original contract and generate moral hazard.
In the circumstances, the objective should be to minimize the distortion of incentives, given the strong likelihood of renegotiations. Adhering to a few principles during contracting can minimize moral hazard, align incentives, and reduce uncertainty.
One, the rigor of technical and commercial feasibility analysis of the project should not be compromised for constraint of time. Unrealistic demand and traffic forecasts, tariff assumptions, and maintenance estimates – most often the result of hurried project preparation - are the commonest causes for renegotiations.
Two, any contracting process should focus on prudent risk allocation. It should not encumber concessionaires with risks whose realization is high and which cannot be diversified. The example of Case I bids for UMPPs, where aggressive developers passed over the option of imported fuel price pass-through and preferred to quote levellized tariffs involving fixed-price for fuel is a case in point. It was ex-ante evident that developers were assuming a huge price risk they could not control. Similarly price-cap regulated contracts (tariff is regulated), though politically acceptable because they shift risk allocation from consumers to operators, are more vulnerable to re-negotiations than cost-plus regulated (tariff calculated based on rate of return) contracts.
Three, sanctity of contracts should be protected. Contract re-negotiations should be explicitly prohibited in cases where the risks were clearly defined and voluntarily borne by the concessionaire. This of course raises the important issue of clear risk allocation in public private partnership (PPP) contracts. In the aforementioned case of UMPPs in India, the concessionaire knew about the real risks and consciously chose to quote the risky option. Any renegotiations then become untenable. One way to approach this problem would be to have a negative list of considerations which cannot merit re-negotiations.
Four, the concessionaire should internalize the cost of re-negotiations. For example, in annuity or toll-based highway contracts which go for renegotiations, any changes to the contract tenure or schedule of payments should not modify the contracted net present value of the payments payable or receivable. A toll contract where the successful bidder is one who bids the lowest net present value of revenues (to recover his investments and make a profit), for example, allow for such renegotiations.
Five, the Guasch study shows that contracts which have investment obligations and those under price-cap regulations are most vulnerable to renegotiations. They generally result in either delays or reduction in investment obligation targets and tariff increases. Transport, water and sewerage sector contracts dominate these. Such contracts would benefit from a built-in provision for periodic reviews, with clearly defined contingencies that demand such reviews as well as their scope. In such projects, the British model of price-cap regulation – where tariff increases are capped based on inflation, efficiency improvements and capital investments, where the bid values are valid for only the initial few years, and is followed by regulatory reviews over 5-7 year periods - may be more appropriate.
Six, the process of renegotiations should be apolitical and institutionalized. The original mandates of regulators should clearly outline the scope, terms, and protocols for any re-negotiations. The legal basis of the entire renegotiations and its appellate processes should be clear and strong and insulated from the government. And all this should be reflected in the contract. Further, regulatory autonomy is critical to curbing both political opportunism and corporate greed, besides creating institutional credibility surrounding such contracts. This credibility can be enhanced by involving a panel of reputed sector specialists in the renegotiations process.
Seven, in cases where the project valuation is clear, governments should also consider buying out the developer’s investments and then re-contract it out. In such cases, in order to avoid the moral hazard, the amount payable for termination should be contingent on the bids received during the re-tenders.
Eight, cost over-runs during construction phase is a common cause for renegotiations. Since many public transit and utilities contracts are price-cap regulated, cost over-runs invariably result in demand for price/tariff increases. The case of Mumbai metro is just the latest. In this regard, the practice in Australia and UK of adjusting for an “optimism bias”, calculated based on the history of cost over-runs in all projects in the sector, while writing contracts can be useful. Scenario planning that accommodates various contingencies of risk materialization and the action thereon would help mitigate its adverse consequences.
Finally, renegotiations are more likely when competition is intense and on contracts negotiated in good times when plentiful credit is available. Just as investors pour money into asset classes driving up valuations and inflating bubbles, developers throw caution to the wind and low-ball bids with excessively optimistic revenue projections that reflect the euphoria of the boom. In such times, financial markets fail to do the due diligence that prevents excessive risk-taking by euphoric developers. Once the business cycle turns downward, affecting the project’s commercial viability, the developer is left with no option but seek renegotiations. Governments would therefore do well to be cautious with excessively attractive bids that get made in such times and when competition is high. The real cost of such apparent “free lunches” follow, but much later.