Pricing Out the Unrelieved Contract Hazards

Technical Notes

Nov 24, 2009 — Neil Boyle

Negotiations of the financial closure kind are often incomplete in PPP infrastructure deals; typically financial closure is considered the last step in deal-making. Incompleteness is due less to inadequate risk identification procedures and efforts than to the existence of different identification procedures altogether. Differences are between the firm as production function and the firm as governance structure; the former looks at input output efficiency; the latter at governance efficiency. Unknown to most, different detection and mitigation procedures arise because of the fundamental transformation that sets in once the contract is signed and autonomous parties realize specialized assets are exposed and protection depends on the cooperation of the other party—something that neither the parties nor the contract are prepared or designed to deal with. Bilaterally dependent parties have strong incentives to protect their specific assets and promote continuity but their incentives are misaligned under the circumstances and end up distorting performance even though scopes of work may be designed with utmost care. Misalignment generally arises because each party organizes under different assumptions and specifically because they design project management arrangements under the large-number exchange assumption of competitive markets while ignoring that the large number relationship turns into a small number exchange relation once the contract is signed. Another reason for misalignment is that most of the effort in contract design and in particular design of incentive structures is directed ex-ante; the incentives involved in ex-post contract and project administration and management are frequently glossed over or ignored.

Far-sighted parties are knowledgeable of these hazards and often view them as weaknesses to be exploited for personal gain, thus stimulating opportunistic and corrupt actions by these players, and increasing the probability of contract instability and/or revenue volatility. Under these circumstances, completing negotiations involves governance closure—the next step after financial closure.

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