Probing the World of PPP Incentives

Articles

Dec 8, 2016 — Neil Boyle

Introduction

This essay is about the incentives of PPP infrastructure projects. It is based on the analytical framework called Transaction Cost Economics or TCE. TCE represents the empirical work of a number of preeminent economists worldwide (e.g., four Nobel Laureates in 20 years), but it was brilliantly researched and brought together into a powerful and illuminating framework that filled a gaping hole in neoclassical economics by 2009 Nobel Laureate Professor Emeritus Oliver E. Williamson of Berkeley. Some liberties were taken by the author to operationalize the TCE theoretical framework to conform to PPP projects worldwide. This was done without modification of TCE theory. The following five elemental parts of the TCE framework are brought forward and highlighted for emphasis.

1. A substantive partnership, a hidden third-party, and the adoption of risk neutrality. A public private partnership (PPP) in revenue generating infrastructure is foremost a partnership, in which the goals of the partners are not only identical, but are also remunerative to each of them. Financial success critically depends on the cooperation of both parties, so much so that in the absence of real and credible cooperation the partners are in peril of losing a substantial portion of their investment. The partnership is also unique in that there is a hidden third party—the consuming and paying community-at-large—that must be incorporated at least as a working partner. Staff- and time-intensive community organization activities will be necessary to accomplish this goal to identify leadership and representative governing bodies so that interaction with the other partners is meaningful. There are service areas where this might not be necessary, for example, in high income areas where income is sufficiently high that household members have other interests and preferences and are willing to trust the operator’s firm to deliver on its promises. These presumptions will need to be verified. Risk neutrality is the preferred approach on matters of risk. Risk aversion is replaced because “efficient risk bearing”, the main instrument of risk aversion, succumbs to the guile of a self-interest seeking economic agent. Because all agents are vulnerable to guileful behavior and therefore contract hazards, risk neutrality was adopted as the better alternative. (See page 10 for further details.)

2. A more appropriate paradigm for neoclassical economics. Recall that the neoclassical economic system has two subsystems: the subsystem of production and the subsystem called industrial organization (IO). In recent research, both subsystems were found to be governed by the same economics, namely price theory, which caused much analytical dissonance and error particularly for the industrial organization subsystem of neoclassical economics. (Williamson, 2010) Furthermore, the research revealed that while the economics of production is still very much price theory, the economics of organizing production differs considerably and is called contract theory. This essay deals primarily with contract theory—an economic theory of the human organization of production. A consequence of contract theory is that the contract takes on a more critical role in the management and implementation of projects. Any difference between contract administration and contract management that might have existed previously no longer holds under contract theory; the two procedures are now indistinguishable and staffing will need to be carried out accordingly. Traditionally, neoclassical economics was concerned with both production and its organization. It still is, except that the organization of production subsystem and contract theory are now coherent with the human organizational phenomena they deal with, whereas previously neoclassical economics was not, as implied above.

3. The regularization of positive transaction costs. No longer is economic analysis done on the basis of zero transaction costs because TCE changed the economic paradigm of industrial organization and regularized positive transaction costs in future analyses. Among the modifications, the change in paradigm was accomplished by inserting the twin assumptions of human behavior and “man” directly into the analytical framework that gave the framework a human face. This human face is not to be mistaken for a “touchy feel” economics. The human face fills another gaping hole in traditional neoclassical economics, in that, the absence of the human dimension has been around since Ronald Coase published his seminal paper in 1937 titled “The Nature of the Firm”. What is needed is the learning and testing that comes with greater application of TCE in real world problems.

The twin assumptions of bounded rationality and opportunism are now a part of the analytical framework and makes hazards a constant operational feature of all PPP projects; in fact, all projects. If there is any doubt about replacing the super rationality and simple (naive) self-interest of traditional neoclassical economics with the more realistic bounded rationality (a.k.a. limited cognitive capability) and opportunism (a.k.a. guileful self-interest) of TCE, one should read Daniel Kahneman’s (a distinguished psychologist and a Princeton University professor) book “Thinking, Fast and Slow” about human decision-making. Kahneman and Twersky (his close co-researcher who died before Kahneman wrote the book) demonstrate that decision-making is systematically biased in predictable ways. (2011).

TCE is a substantial time saver, analysts no longer have to compute the probability of contingencies occurring in their risk management plans because under the current paradigm, risks are constant and always occur. The reason is bounded rationality and opportunism are constant assumptions of human behavior, but are contextual with regard to the objective market parameters that make bounded rationality and opportunism function as intervening variables. What needs to be done is to appropriately provision contracts with the right special clause. (More on operationalizing the twin assumptions of human behavior on pages 16-17.)

4. The internalization of organization. The subsystem of organizing production has been internalized into the analytical framework, whereas formerly it was external. No longer is the firm a “black box”; henceforth, the firm (a.k.a. hierarchy) is one of three generic governance structures: market is another, and long-term contract (a.k.a. hybrid) is the third so that the three modes of governance (called governance structures) are markets, hybrids, and hierarchies.

5. The essence of cooperation. Surprisingly, credible commitment between the partners is the basis for cooperation between the public and private partners. At first, this seems contradictory like mixing the enforcement methods of “carrot and stick with reason”. But, it is not contradictory because the two are in some ways similar. Credible commitment can best be effective if trust exists between the two partners, so it is obligatory for the parties to seek ways of gaining the trust of the other party. Implementing credible commitment and demonstrating through results is a proven way to obtain the trust of the counterparty. Besides, the conditions of cooperation are pre-existing rules of the game, which would be lost and likely turn into costs in the event of uncooperative behavior on the part of any of the partners. (See section titled Cooperation for further details.)

The world of organizational incentives

When analyzing how a PPP project is organized, the first thing to zero-in-on is the transaction itself—and within the transaction—the incentives of the project because we know so little about them and they are critical to understanding how the neoclassical economic system works. Incentives originate mainly from what economists call “asset specificity”, which refers to the degree of specialization of an asset that a buyer and a supplier wish to exchange between them. It is known that the greater the specialized technology of the asset, the greater the asset specificity, the more nuanced and complex will be the incentives of the project, and therefore, the more contract hazards there will be.

This dynamic of asset specificity’s effect on incentives may be seen more clearly as a spectrum of asset specificity from negligible on one end to high on the other end, with markets on the negligible end to firms (a.k.a. hierarchies) on the high end. Thus, the spectrum between the three governance structures mentioned earlier would then be: markets on the negligible end, firms on the opposite high end of the spectrum and long-term contracts (a.k.a. hybrid) in between the two, partly market and partly firm. The framework for explaining the organizational subsystem is quite comprehensive compared to what it was in the IO days. Asset specificity varies systematically with governance structure as shown in the table and graph on page 19. Refutable hypotheses are now the default output of the framework, which makes well prepared hypotheses predictable. With specialiszed knowledge on project evaluation and skills in TCE in the hands of competent international technicians found in business and economic faculties from around the world and located in an international science foundation similar to the U.S. National Science Foundation, they would respond to proposals to evaluate projects from all points of the compass. New energy might be tapped for the future benefit of Multinational Development Banks and International Finance Institutions.

To alleviate these hazards before they are triggered and become transaction costs, the affected party needs either the cooperation of the counterparty, or a contract with the counterparty in which it is held hostage to its promises. This process is called a credible commitment; a subject that will be discussed on page 10. In the absence of credible commitment, the guile of the counterparty can trigger a transaction cost by activating an opportunity for private gain. Economists call the relations that lead-up-to, and especially the outcome, “holdups”. We will return to holdups later. The rationale and mechanism for relieving these hazards are explained next.

When an asset is to be exchanged between a supplier and a buyer, the asset is usually either a commodity that is standardized in all of its measurable features and, therefore, its property rights are pretty much aligned, or the asset is specialized technology such as one finds in most infrastructure projects where too many of the property rights are in the public domain and thus unprotected from predation. Property rights are in the public domain because complex contracts are unavoidably incomplete due to the fact that men and women worldwide are cognitively limited (i.e., bounded rationality) and universally so and therefore property rights are necessarily misaligned or malassigned.

In the case of a commodity exchange asset, the opportunity for private gain is slim and contract hazards are not much of a concern because market mediation is simple and fast like one finds in a spot market. The intense incentives of the market transaction overrides most mediation hurdles, and thick markets provide ample alternatives and simple trading with others. If one trade is unsatisfactory, there will always be another one with a competitive price, which by the way is the only thing one needs to look for in a commodity market transaction to separate one trade from another. The operator’s incentive would have been to find the best competitive price for the good or service among numerous competing traders assuming a thick market. Moreover, the value of continuing with the project once the bill is paid diminishes to almost zero because general purpose assets do not need to be constructed, commissioned, or operated; there is generally no long-term continuity like there is in a special purpose transaction. Once the bill is paid, the technology operates on its own; this is generally quick, if not instantaneous in spot markets. Maintenance of generic assets, however, may be needed.

However, in the case when special-purpose technology is exchanged and the asset is therefore non-redeployable and specific to its particular transaction and a holdup is expected, the opportunity for private gain is influential because enforcement is either nonexistent or weak and the cooperation of the counterparty is required because the counterparty’s guile poses a threat to the successful completion of the project. Of special note here is that the governance structures of long-term contract (hybrid) and firm (hierarchy) occur only for special purpose exchange assets and not for market exchanges. Market exchanges are mediated by an entirely different process. Holdups are named for good reason because they have a tendency to bring the entire enterprise to a stop. By the way, in a special-purpose transaction, one needs to separate one trade from another by looking for value in other facets than a competitive price.

In both the commodity market transaction and the special-purpose transaction, the operator’s business purpose is always to maintain or increase the financial net present value of the transaction so that the project company benefits financially and, hence in the case of PPPs, both partners gain according to pre-agreed shares that are memorialized in the contract. This means that for every managerial move by the operator, his choice must underpin and influence a positive financial NPV of the transaction. This further means that the manager must be farsighted. He must look ahead and choose his move so that it will have a positive influence on the financial NPV of the project company.

There are three other reasons why specialized exchange assets create incentives. The first is all complex contracts (i.e., contracts where specialized exchange assets are in play) are unavoidably incomplete. This is due to the accepted condition of bounded rationality (i.e., that all humans are cognitively limited, Williamson, 1985) The ramification is that we know from the Philippine cases (See www.infragov.com paper titled “Performance and Renegotiation in Public Procurement and PPP”) and the economic literature that PPPs operate in a problematic dynamic of constant incomplete contracting whose survival depends on the “maintenance of equilibrium of complex character…[This] calls for readjustment of processes internal to the organization…,[whence] the center of our interest is the processes by which [adaptation] is accomplished”. (Barnard, 1938:6. emphasis added) The “maintenance of equilibrium of complex character” (ibid) is accomplished through negotiations of credible commitment. How this is done is explained in the section titled Credible Commitment.

The second is specialized exchange assets have negligible productive value outside of the transaction for which they were intended; they are non-redeployable durable assets; in financial terms, they are sunk costs. For the investor, the asset must complete its work in its intended transaction or it is likely to be scrap and its value near salvage levels in the event the project is terminated, therefore, continuity of the project has high value.

And the third reason is the assets are unprotected from the guile of the counterparty so the investor requires a creditble commitment from the counterparty to protect his asset. This means the two parties to the contract are bilaterally dependent and autonomous at the same time; they are dependent and independent simultaneously. Autonomous bilaterally dependent incentives (i.e., as activated by trading) have profound implications on PPP water supply and urban systems.

When complex contract incentive structures (e.g., autonomous bilateral trading and incomplete contract) are present, disruptions will most certainly occur and measures must be taken to mitigate them. (You can bank on distruptions occurring.) Rather than increase search costs, for example by estimating the probability of every contingency through “blackboard economics” (as mentioned by a conferee at the Coase conference, Washington, DC, June 2015), insertion of superior institutional arrangements as special clauses to the contract should be initiated promptly without further delay. These measures are called the “provisioning of contracts”. Special purpose contract clauses that have the potential of changing property rights of counterparty bureaucratic structures are thus obtained.

There is an important distinction to be made here. The difficulty that lies in a bilateral relationship is due to the relationship itself and not necessarily in the individuals, per se. Autonomous individuals can handle most disruptions (by definition), but in the autonomous bilateral interaction, and in the absence of a sequential decision-making apparatus (e.g., a project management unit or PMU), parties do not know or cannot rely on what the other is doing because information flow is erratic, especially when the stakes are not trivial. This is a principal characteristic of complex contract.

Take for example, the following vignette. Two parties in a PPP relationship are charged with managing a water supply system (usually small and unsophisticated but specialized technology) over the life of a concession of 10 years during which time the investors (the PPP partnership in the form of a jointly owned limited liability public corporation project company) want to recover their costs: operational and capital. Assuming the parties have entered into an agreement over ownership shares and a non-redeployable durable asset is invested in exchange for future performances on the part of both parties, the values of which are dependent on the promises they have made to each other. But promises are not self-enforcing. Promises run throughout from the agreement on ownership shares through to procurement to any number of expost (after contract signing) implementation promises, all resulting in contract hazards if these promises are reneged, which studies and direct experiences have shown are likely.

Risk neutrality

However, efficient risk bearing is problematic; it succumbs to the guile of self-interest—a universal characteristic of human behavior, namely bounded rationality and opportunism. As mentioned earlier, TCE adheres to a risk neutral position rather than to risk aversion.

Credible commitment and its negotiation

We learned from organization theorist/economist Herbert Simon (_____) and Oliver Williamson (1985) that promises were never self-enforcing and therefore not credible without more, but because we glossed over this fact, it was easy to continue rather than find a solution such as “credible commitment”. Instead, as mentioned above, we tended to rely on “efficient risk bearing” and risk aversion to mitigate any risk we identified. This was convenient to do at the time and under the circumstances, but it was wrong.

Credible commitment is a negotiated outcome. To negotiate credible commitment, the Contract Triple is brought into play. The Contract Triple defines the contract as comprised of three components: the price (p) of the transaction, the asset specificity (k) of the exchange asset, and the safeguard (s) of the principal partys’ agreement against any change, along with the quantity, quality, and duration of the transaction. The three components are interactive and therefore must be negotiated symultaneously.

Credible commitment is negotiated in the following manner. Let us suppose the operator wants government approval to reform the internal organization of the jointly-owned project company. The operator wants this done in the light of Chester Barnard’s instructive theory of how complex transactions operate in the context of incomplete contract and adapt by maintenance of a complex equilibrium of the economic organization of the transaction. Let us further suppose that this is an initiative of the operator keeping in mind that reform of this kind is something that borders on intrusive intervention into government sovereignty so that governent is reluctant because it is likely to disrupt a host of business rules that might upset the so-called “income streams” of certain employees. For obvious reasons, government does not disclose these details. At this point, the scenario is only speculation by the operator. Nonetheless, given this possibility and that the twin assumptions of human behavior are constant (until changed by objective market parameters. (See pages 16-17 ) Negotiations start by understanding that the price (p) of the transaction and the asset specificity (k) of the exchange asset are negotiated together as a single item for the purpose of leveraging the safeguard (s) that represents government’s reform, which the operator believes is crucial to the financial success of the project and has the financial analysis to prove his assumptions. The operator explains that the trade-off or the price of government’s reform, is equivalent to a combination of a decrease in the price (p) of the transaction plus a reduction in a key technological component of the exchange asset (k). At first, government does not believe the statement of the operator. However, after the operator discloses sufficient information to justify his numbers to assuage any distrust or suspicion on the part of government, government is convinced and agrees to reform the internal organization. Beforehand, the operator must plan diligently to have his proposal priced right from the beginning. His planning has to be thorough; he should know more about the operations and finance of the government entity than the entity itself. The operator, in order to be practical, then or in parallel with negotiations, offers to assist the government entity in doing what is necessary. To make the reform more palatable to the employees and to reduce their risk of taking on the endeavor, the operator offers that any change in the so-called “income stream” of employees would be compensated by a comensurate amount through a productive salary increase that would be determined by full financial analysis. Keep in-mind that the employees are likely to be unionized. The operator makes his proposal to assist the employees only after deep study of the finances of the government entity.

The art of negotiation is important. Negotiation of the type described here may be lengthy (time consuming) and require the assistance of technical working committees from both sides to work together and make inputs into negotiations periodically. Keep in mind that the objective of negotiation is not merely to reach agreement, but it is to have the other party understand “why” the specific agreement is important. For example, to understand that it is efficiency and not necessarily only price that counts. There is research that correlates longer negotiation processes with higher success. (See Kroc Institute, University of Notre Dame regarding their Peace Accord Matrix database.)

The following example in brief form describes the workings of a trade-off. To get the counterparty to reform its internal organization, the proposing party (i.e., the operator/supplier) needs either the cooperation (see section below) of the counterparty and/or a contract with the counterparty (i.e., the government/buyer) in which its promises are held hostage to the fulfillment of the proposed reform program. This involves the duration of the contract so that a clause is provisioned into the contract such that a credible threat remains en vigor until the reform is complete and the operator is satisfied. Should the reform be delayed for any length of time, the threat is enforced. However, the key message to the government/buyer is that it is efficiency that gives the PPP its productive value and that the internal reform is important because it represented a huge economic burden and drain of much needed cash flow of the project. Various formulations of risk relief could be worked out through financial analysis and discussed to the satisfaction of both parties

The main question is getting the government entity to reform for the right reason—for efficiencies sake where the reduced price is only a manifestation. Recall that all managerial moves (including those that are negotiated) must show that the move will result in an equal-to or greater-than change in the NPV of the transaction. If the NPV shows a positive result, then the counterparty should accept the proposal to reform its internal organization. If not, then further discussion and financial analysis should be considered. In sum, the price of government reform is equal to the credible threat the operator/supplier proposes—that is, a combination of an decreased price (p) and reduction of the exchange asset (k). The main question could be worded differently depending on the objective of negotiations: to relieve a holdup; or accept the promises of the government.

Renegotiations

There might be times when the above scenario occurs during project implementation that calls for the project to be renegotiated. Renegotiations is an instrument that should be used sparingly until more experience with its use has been obtained. When it is used, beware of the potential moral hazard. Government buyers issue Requests for Expressions of Interest (REOIs) to the private sector because that are interested in obtaining the assistance of private firm’s finance and/or in transferring risks to the private sector.
Renegotiations, without more, comes with the moral hazard of a low-balled bid price. Meaning, the bidder bids low in the hopes of recovering lost profits from change orders during implementation. To maintain the capacity to renegotiate, moral hazard must be eliminated. Elimination is made plausible by taking steps to relieve the suspicion by provisioning specific clauses in the contract that:

a) Limit change orders to acceptable levels, both in number and in costs through verifiable bills of quantities; and
b) Limit bid prices to be within 0.5 to one (1.0) standard deviation of the mean of the price of the shortlisted distribution of bids. (The SD is a suggestion.)

In a highly competitive environment, bid prices should be reasonably close to one another. One would expect a different result in a developing country where competition is not keen or well-honed in developing industry. Nonetheless, a distribution can be fashioned and a mean calculated from which a standard deviation is computed by reviewing the spread of bid prices of shortlisted firms and choosing, if necessary, an appropriate sample. Once a shortlist of qualified firms have been identified and vetted, government will then ask the shortlisted firms to respond to a Request for Proposal (RFP).

The transfer of risk is a highly problematic area because of subtlety and misinterpretation. Government wants to transfer risk to the private sector and the private sector wants to equilibrate and or mitigate and relieve risks. However, mitigation and equilibration of risks involve the keeping of promises made over long periods and both are vitiated by opportunism and guileful self-interest. So what is wanted by one party is not credible to the other party. We have already seen how this conflict can be resolved by credible commitment.

Cooperation

Credible commitment between the partners is the basis for cooperation between the government buyer and the private operator supplier. The conditions are the pre-existing rules of the game, which would be lost in the event of uncooperative behavior on the part of the partners. The pre-existing conditions are:

  1. A PPP is a jointly held public private corporation in which ownership shares are pre-agreed due to the high cost of bargaining.
  2. All managerial moves must result in positive financial NPVs in which gains are divided equitably according to pre-agreed shares.
  3. Partners are bilaterally dependent, therefore their decisions are guided by mutual consent.
  4. At the end of the concession period, the PPP corporation could be sold on the local stock exchange and publicly held through an IPO.

Transaction attributes and production opportunities

Transaction attributes and production opportunities of PPP transactions create incentive structures through their adaptive needs. There are two transaction attributes: asset specificity and uncertainty. For example, as mentioned previously, the greater the transaction attribute of asset specificity, the stronger are the incentives of owners to protect their special purpose assets through the cooperation of the counterparty, or by holding the counterparty hostage contractually to keep her promise(s). Specialized durable assets are exposed to the guile of counterparties because agents are guileful and a provisioned contract clause does not always cover every guileful act. Mitigation (or relief) of hazards are required for production to be efficient because the full value of the asset depends on the fulfillment of the promises of the counterparty, which takes place over the duration of the contract. This creates a bilaterally dependent relationship between the autonomous contractual parties—a state in which misalignment and thus misunderstanding reign, or malalignment and thus maladaptation reign. This bilaterally dependent relationship contrasts with the transaction relation itself where conflict threatens to undo the opportunity to realize mutual gains. (Commons, 1934) This inherent threat supports the incentive to attenuate the hazards between the parties in a PPP partnership in a bilaterally dependent manner.
Uncertainty is a transaction attribute that has a unique adaptive need for additional information that comes with the associated cost of its absence. For example, in the absence of needed information, an autonomous bilaterally dependent relation is seriously compromised, leading to heightened mistrust, misalignment and transaction costs.

Twin assumptions of human behavior

Within all of the above, the twin assumptions of human behavior of agents who design and manage transactions are constant contextual conditions of limited cognitive capacity (bounded rationality) and guileful self-interest (opportunism), the effects of which always require safeguarding the agreement in project design, implementation, and enforcement. Similarly, politics must be taken into account in ex-ante contract design and ex-post implementation because property rights are defined through democratic politics and democratic politics takes place constantly—all of the time; for example, negotiation is a political act. One implication of this is that while changing property rights is well known among organizational theorists, another change process may be through the machinery of politics.

The operationalization of bounded rationality and opportunism is special and needs to be understood in order to have incentives and the PPP operate correctly; after all, incentives are key. Bounded rationality and opportunism are what organizational theorists call intervening variables; they are not independent variables. They are once removed from being the primary active variable. Here is how this works empirically and operationally. Intervening variables work through what is called objective market parameters of which there are two, namely uncertainty and small number exchange. These are the primary active variables. Small number exchange is the mediation that goes on between two people or two entities, a dyad. Large number exchange is the opposite because it is the mediation that occurs among a large group of competing bidders (let’s say), as occurs in international competitive bidding (ICB). Objective market parameters act on the twin behavioral assumptions of bounded rationality and opportunism.

Bounded rationality is always combined with uncertainty (this comes from empirical research), when this occurs, bounded rationality is heightened. The greater the uncertainty, the greater is the bounded rationality. Uncertainty, here is the active agent, not bounded rationality. Later, we will see that the independent variable is asset specificity and uncertainty, which varies with the changes in uncertainty acting through bounded rationality. When uncertainty changes, the cost of governance also changes.

Operational descriptions for small number exchange are similar to the description above for uncertainty the first of the objective market parameters. International competitive bidding or ICB is a large number exchange whereby large numbers of competitors bid on the same tender in the market place. The large number of competitors are seen as making sure there is no corruption in the bidding and award process, and the transaction is considered free of opportunism due to the effects of transparency. However, once the tender has been awarded and the contract signed, the transaction and contract changes from a large number exchange into a supply dyad relation between the buyer and the supplier without the prior advantage of transparency. The two parties might be seen as exchanging intellectual property rights for money and the opportunity to transform their property into durable goods and services for a designated constituency. Small number exchanges come without transparency. The larger the number of small number exchanges there are in the transaction, the greater the chance that opportunism will occur and/or the greater the opportunism event. Similar to uncertainty, small number exchange is the active agent and opportunism is an intervening variable. Small number exchange worsens the condition of opportunism.

Production opportunities

Production opportunities that interact with the transaction’s asset specificity and uncertainty create incentive structures. For example, production price is a common incentive setter (as it is in a market transaction), but may be misrepresented when price is not the sole determiner of transaction value, as it is with firm (a.k.a. hierarchy) and long-term contract (a.k.a. hybrid) transactions. Production quantity and related contingencies are also incentive setters. A cost plus contract sets up different incentives than say a lump sum contract. The former gives budgetary discretion to the winning bidder, while the latter limits the winning bidder to execution within a specified budget. The former is used in technologically complex projects where advanced technological engineering studies are incomplete and on-going. The combination of price and contingency is akin to reducing the certainty of the established price. The latter raises the question of contract agents’ staying-on-the contract curve (i.e., sticking to the agreement and the contract Triple). Other combinations of production opportunities and the attributes of transactions can also create incentive structures. For example, the market buy-price for a farmer’s crop sets-up different incentive structures than an administratively set buy-price for the same crop.

Summary recommendations

When doing a PPP project, whether that entails design, implementation or supervion, the things to focus on and plausible remedies are as follows:

1. Determine what type of goods and services are being exchanged. This is the caution in the text that says to determine the asset specificity of the exchange process before anything else. This will tell you what you are dealing with: a general purpose technology or a special purpose technology. Each will point to different incentives and to what comes next.

2. Determine which governance structure you will be using or what you may have to change in case the existing one is wrong. Check what the implications are if change is called for. Pursue the change if the benefits outweigh the costs; and vice versa, otherwise. Note: asset specificity and governance structures are lined up according to a matrix arrangement shown immediately below.

GOVERNANCE 

STRUCTURES

MARKET

HYBRID (long-term contract)

HIERARCHY (firm)

General purpose technology

k = < k*

Special purpose techology

k* < k > k^

 Special purpose technoloty

k > k^

Where: k = actual; k* =  k asterisk; and k^ = k hat

3. Identify the principals involved—both buyer/government and supplier/operator and get to know about their economic identity. This includes: credit rating, work history, banking history, education, etceteras—everything that pertains to their qualification to take on the task before them. Are you comfortable or nervous with what you have learned about each?

4. Determine what needs to be done that will inform and orient the principals of key TCE concepts so they are aware of what is to come.

5. If the project involves the hidden third party (partner), the consuming community, prepare what is needed to employ a local NGO to assist with community organization activities.

6. Don’t drop the community organization activities but learn as much as you can about its social identity. How allied is the community with its leader/spokesperson? What is their view of the service they are receiving from the infrastructure be it water or sewerage services, electricity, roads, transport, housing, a bridge, etceteras? What is their view of the operator, do they trust him?

7. Determine what is involved in the exchange process. What are the stages or phases, the schedule, its feasibility, contracting, procurement documents that need preparation?

8. Identify the economic organization of the main transaction and make a sketch of it. Identify the main players and the relations among them. Keep in mind there are two kinds of relations: the technical and micro analytical. Technical relations will be informed from project documents. Microanalytical relations will require your analysis using TCE theory.

9. Identify the relations between the main transaction and the subsidiary transaction (these could be a financing link with a development bank or a commercial bank, or other types of relationships) and check which type of asset specificity motivates them. You already know that the relationship is defined by “incomplete contract” so the relationship will be unstable until it is alleviated by being brought into equilibrium as explained in the sections on credible commitment and/or renegotiation.

10. Tentatively, list the contract hazards and where and when they will occur. Review each for appropriateness and significance.

11. Tentatively, list the special contract clauses that will need to be negotiated and provisioned in the contract. Review each for appropriateness and significance. This one is especially important because getting it wrong has cost (e.g., delays that could lead to cost overruns) implications for the project company.

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