The problem with first right of refusals

The Tata-owned Indian Hotels Co Ltd (IHCL), whose 33 year lease on New Delhi's Taj Mansingh Hotel expired in 2011, had moved the Supreme Court of India to stall the auction of the hotel property by its owners, the New Delhi Municipal Corporation (NDMC). IHCL demands the right of first refusal in the auction. The Supreme Court's verdict will be critical for the future of infrastructure concessions in India. 

It does appear that the original concession did not have a right of first refusal. The NDMC, dictated by the Government of India's policy to divest stakes in hotels, was therefore well within its right, to pursue this course of action. Even if available, a first right of refusal would have obviously deterred competition and benefited IHCL just as much as it would have caused loss to NDMC. Why would any serious bidder spend non-trivial amounts and significant time and effort to bid for a project where the bid structure heavily favours the incumbent whose stakes in winning the bid are, in most cases, likely to be far higher than that of any bidder? No structuring, including reimbursing costs for the highest bidder, will mitigate this incentive problem. It is apparent that while giving concessions, all sides underestimate the challenge of re-possession. 

Thousands of long-term concessions of assets ranging from land to utilities have been given to private providers through PPP contracts across India. The bulk of these concessions have been given in the last decade and half. Local government and parastatals have been the biggest participants. Many of them will be expiring over the coming decade. The Supreme Court's decision will strongly influence and set expectations in all these cases. 

This also raises questions about the appropriateness of the concept of first right of refusal. Most concessions, especially on land assets, accord first right of refusal to the concessionaire. But as we know, first right of refusal effectively kills competition and prevents fair price discovery. So why should there at all be the first right of refusal?

After all, governments do such concessions with the financial calculation that they will earn royalty or lease revenues and be able to repossess the property with a depreciated asset (typically a building in case of land or a utility network or facility). The concessionaire makes the bid with an assessment that it will recover the cost of investment and make an acceptable profit. The concession is a self-enclosed financial transaction, one which equilibrates the returns of both parties. 

In the circumstances, given its strong likelihood of deterring competitive price discovery, a first right of refusal distorts incentives and favours the concessionaire. 

The argument in favour of the first right of refusal is, assuming the continuation of the activity, that the incumbent is best positioned to do it most efficiently. But what if the government does not wish to continue the activity? Or what if there are equal or more competent alternatives? 

In any case, I struggle to find a compelling case for the first right of refusal in long-term concessions.