Do Exit Options Increase the Value-For-Money of Public-Private Partnerships?

Abstract

We study the effects of granting an exit option that enables the private party to early terminate a PPP project if it turns out to be financially loss-making. In a continuous-time setting with hidden information about operating profits, we show that an exit option, acting as a risk-sharing device, can soften agency problems and, in so doing, accelerate investment and increase the government's expected payoff, even while taking into account the costs that the public sector will have to meet in the future to take direct responsibility on service provision.

Excess returns in Public-Private Partnerships: Do governments pay too much?

“…2 6 We show that R > 0 in Section A.1 of the Appendix. 2 7 This result is standard in the literature: that is, combined with limited liability constraints, the problem of moral hazard generates an information transfer from the principal to the agent that distorts decisions concerning the optimal e¤ort (La¤ont and Martimort, 2002).…”

“…The principal delegates the decision to exercise this investment option to a private …rm (agent) who possesses a relevant expertise. 6 We assume that the construction of the facility can be carried out instantaneously and that the infrastructure has an in…nite life. 7 The project, once implemented, starts generating a public-bene…t ‡ow b and a cash ‡ow x t that are observable and contractible to both parties.…”

“…On the other hand, if the agent chooses not to exert e¤ort, then the probability of drawing 1 is q L 2 (0; 1) whereas the probability of drawing 2 is 1 q L , where q H > q L and terms of a PPP (Engel et al, 2014). 6 For the rest of the paper we use female pronouns for the principal and male pronouns for the agent.…”

“…On the other hand, there is a growing body of papers that study PPP projects emphasizing their real-option-like characteristics see, e.g., Alonso-Conde et al (2007), Brandao and Saraiva (2008), Martins et al (2015) and Blank et al (2016). Some scholars link these two literature strands see, e.g., Takashima et al (2010), Soumare and Lai (2016), Buso et al (2019) and Silaghi and Sarkar (2018). What distinguishes our work from these papers is that we present a real options model that accounts for both agency con ‡icts and agents with various levels of negotiating power.…”