Attaining Credibly Committed PPP Infrastructure Deals

Mar 22, 2010 — Neil Boyle

August 2007

Studies in cognitive psychology support the development of credible commitment and private ordering in three respects: (i) that people’s responses to risky situations depend directly on emotional influences such as worry, dread, or anxiety, which are responses of the primitive part of the brain rather than the cortex [1] (Shiller, 2003, p. 88); (ii) that people have a preference for consistency, a fundamental urge to be true to their principles and beliefs, and tend to experience negative emotion when they feel that they have been inconsistent. This tendency was discovered and named by psychologist Leon Festinger, 1957) “cognitive dissonance” as cited in Shiller, 2003, p. 91); and (iii) that a basic human behavior pattern is a preference for reciprocity. [2] People tend to want to do kind acts if they view themselves as treated kindly, and to do hostile acts if they view themselves as treated badly. A sense of reciprocity is important for many financial innovations for it can enhance stability through time. (Shiller, 2003, p. 92).

Attaining credibly committed PPP is more than hammering out tightly crafted contractual agreements supported by hostage arrangements. To be sure, it is that too but the tough negotiating comes in the third of a three step process of: first, creating good order, second, attaining agreement, and third, attaining credible commitment.

Creating good order – Private ordering and credible commitment go hand in hand as credible commitment requires first being perceived as credible by the counterparty. During the early stages of building harmonious relations, it is costly to focus exclusively on the regulatory regime ahead of attaining harmony with the counterparty. A harmoniously perceived level of credibility perforce speaks of the existence of private ordering in the histories of the parties involved where private ordering involves sharing the common experience of creating good order. The question is how to create these histories? The answer is for one party to initiate giving credible commitment to the other by making an offer and waiting for a reply (the absence of a reply is information that was unavailable before the offer). Offers are similar to strategic investments with a risk return trade-off associated with each offer. An example would be relief of an already negotiated obligation that reduces production costs, or assistance to achieve something that increases revenues the counterparty might not achieve on its own without high search costs. Offers are made with the proviso that they be affordable and reciprocable, and they involve durable specialized assets and result in enabling the recipient to economize on project production costs and/or increase project revenues.

Empirically, harmonius relations between suppliers and buyers mirror the incentive structure involved in giving and taking credible commitments: market exchange buyers secure better terms from suppliers by giving suppliers relief from demand cancellation penalties.  Once the parties are reasonably on their way to perceiving each other as having achieved  good order, recruitment of private solutions is made feasible in that each party possesses a vital part of the knowledge resources that are needed to solve ordering problems and for which private ordering is suited.  

Attaining agreement – Creating a credibly committed agreement depends on the quality of negotiations and the competence of negotiators and their knowledge and skill in applying the negotiations triple, that is, where price, technology, and safeguards are negotiated simultaneously as each is interactive with the other. PPP investments are hybrid transactions across a market interface that is protected by transaction specific safeguards that are designed and negotiated ex-ante and/or ex-post against the ubiquitous hazards that occur in the hybrid spectrum involving both autonomous and coordination adaptive needs.  Safeguards are cost effective institutional instruments or mechanisms that mitigate contract hazards by way of negotiated contract clauses. Contractual agreements will also include a general clause that describes the procedures for filling-in gaps that are not anticipated. The remediableness rule of [A]TCE comes into play wherein ideal comparisons are avoided and workable alternatives selected where no other alternative from this feasible set has superior net gains and where all are flawed. Negotiating skill lies with the number and quality of alternative trade-offs that are discussed and acknowledged and accepted by the counterparty. Positive sum rather than a zero sum agreement is the object of negotiations. The time and creativity invested in sharing information and explanation will pay dividends in the implementation of a PPP project. 

Attaining credible commitment – Despite the opinion held by some that the posting of hostages is difficult, that difficulty is a matter of skill and training. Two skill areas are highlighted: in-depth knowledge of the incremental trade-offs between each element of the negotiation triple: price, technology induced hazard, and safeguard; and deep capacity to empathize with the situation of the agents representing the counterparty.

Knowledgeable negotiators are able to tap into a large number of high quality options for each difficult trade-off encountered in negotiations; the higher the number, the better chance there will be for achieving solid agreements. What is important is how to attain a credibly committed agreement; one which will stick under stress. Hostage arrangements are particularly secure safeguards such that compensation for the aggreieved party is enforced should performance not materialize. Such hostage agreement should be used sparingly, only after clear evidence has been made available, and only in situations that matter where no other means have worked.   

Empathic negotiators are able to immerse themselves into the issues of economic governance within and between markets and firms over time. The more sustained the immersion, the greater the insights into the incentive structures at play. The farsighted negotiator works to achieve a high level of competence in gaining these insights, testing and adjusting them in real situations, and applying the results in future projects.

Space for private ordering already exists in developing countries. Only when compared with a developed country does space turn out to be limited for the range of orderings required. There are several methods for creating the desired space: (i) by changing laws that are restrictive of private ordering; (ii) by changing the regulations of existing laws to make them more elastic and amenable to private ordering; or (iii) working within existing laws and regulations including regulations that regulate contracts through carefully crafted writing of specific contract terms and conditions that permit private ordering and that would be upheld in court in the event of a dispute.

 


[1] Purely intellectual recognition of risks does not lead to action against the risk but must be accompanied by emotional content. The frontal lobe of the cortex transforms images of absent events into experiences of pleasure or discomfort. Frontal lobotomy patients, for whom part of the brain in this area has been removed, seem always confined in their attention to the present, blithely unconcerned about any distant risks.

[2] See Ernst Fehr and Urs Fischbaher, “Why Social Preferences Matter—The Impact of Non-Selfish Motives on Competition, Cooperation and Incentives,” paper presented at Nobel Symposium on Behavioral and Experimental Economics, 2001.

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