Updated – Tougher yet Flexible Implementation and the 32 Year Old Coal Supply Contract- PART – II

Aug 27, 2010 — Neil Boyle

1.     Tougher implementation also means tougher and more open negotiations. Tougher negotiations mean smarter trade-offs are made between the negotiations triple of price (higher or lower), technology (from generic to specialized), and contractual safeguards (less rigid and not reformative to more rigid and reformative). Smart trade-offs induce credible commitment between two parties. For example, giving economic ground to your counterparty is not likely to go unappreciated and when it is reciprocated it signals the initiation of a credibly committed relationship between the principals because giving economic ground is not gratuitous. To  be credible, offers must be seen to produce real impacts on financial bottom lines of both parties.

2.     Technology is measured by asset specificity (k) which is an economic measure of how transaction specific or specialized is the technology of the exchange asset. There are numerous ways to trade-off degrees of asset specificity and price with safeguards that have reforming characteristics to them. All three components are interactive, are negotiated simultaneously, and are scaled along a single dimension of higher-lower, or in the case of safeguards tougher-looser. The higher the asset specificity (k), the more specialized, costly and complex is the asset’s technology, and the more exposed it is, as not all of its property rights will be secured so that residual rights remain exposed, everything else equal.  

3.     Contractual safeguards are negotiated agreements that sustainably relieve specific contractual hazards. This is where the reforming characteristic of safeguards come into playIn the absence of a “reforming” safeguard (i.e., s = 0), the trade-off is a higher price for the same level of asset specificity of the technology and excess profits, or the same price for a lower level of asset specificity and inferior technology and possibly negative profits. For example, say the hazard is the encroachment on the ROW due to inferior enforcement of the counterparty. Whatever safeguard ends up being negotiated it must be financially and technically coherent with the difference between the contract price and the specificity of the technology before and after the encroachment eventuates. Hazard relief comes in accordance with the actions of a potentially aggravating party (e.g., the non-performing enforcing party) who has promised to mitigate the enforcement hazard during negotiations. In the contrary event that the party does not keep his promise (a condition of loss mitigation) the aggrieved party is left with bearing the cost of the unrelieved hazard and may not be compensated by appropriate adjustments in price and/or technology. Such unrelieved hazards I also call unpriced hazards.

4.     The general rule to guide negotiations is to negotiate on the basis of the negotiations triple of price (p), technology (k), and safeguard (s). To do this well requires a considerable degree of inter-disciplinary knowledge and competence on the part of the negotiator in that he must know how each component of the triple interacts economically, financially, technically, legally and institutionally. Feasible sets of all three are interactive and are addressed simultaneously in project design and negotiations. The intelligence that goes into trading-off one item of the triple for the foregone value of another triple item is where a good deal of good governance design and credible commitment takes place.

5.     Safeguards are particularly important in that; they must be negotiated with credible commitment by government; i.e., agreements should be designed to hold government to its promises or else face a consequence, one that should be compatible with the cost of the hazard if it eventuates. Examples of credible commitment mechanisms are: posting a hostage, e.g., for costly hazards an escrowed off-shore account is triggered to make the promissor pay; bonding is another form of hostage contracting which can be either a positive incentive as in stock options or a negative one as in a performance bond; changing the B/C calculus of the counterparty where gain is accomplished by giving up economic ground to the counterparty, e.g., offering Technical Assistance to rectify a particular implementation problem of the counterparty, one that impacts the counterparty’s production costs or its revenues.  Such giving of TA is a form of giving credible commitment as an inducement to reciprocation from the counterparty; requiring a penalty payment for failure to achieve an agreed indicator of performance; and naming a government executing unit that is accountable and making this knowledge public and subject to NGO scrutiny through monitoring by a civil society NGO; among others. Once credible commitment is reciprocated a significant step has been achieved in attaining credible commitment.

6.     Tougher negotiations that runs throughout the project cycle is government negotiations that involve helping its bilaterally dependent counterparty monitor and enforce government’s own promise.  For example, government presents the foreign investor with a detailed action enforcement plan that identifies the organizational unit involved, the person in charge, and so forth, in an agreement that itself is subject to penalty of some kind if not performed correctly with the expected outcome.

7.     Tougher negotiations also mean negotiating to the source of the risk. In WWS and energy/electricity projects, the source of most governance risks is the absence of credible commitment (i.e., parties not keeping their promises). Negotiations often stop short of pursing the source and in so doing, opportunities to establish credible commitment are foregone resulting in a high cost to the taxpayer.

8.     Open negotiations mean that prenegotiation meetings should be held whereby both parties disclose their risk management and negotiating plans and strategies. The former “hell or high water” mode of negotiating creates more problems than it solves (there is ample literature on this).  Because contracts are incomplete and because contracting parties are typically far-sighted (incomplete contracting and farsightedness are explained elsewhere, see keywords or tags). There must be space in the contract for resolving unanticipated risks in real time when they occur in a manner such that the parties are willing and competent to share the costs of fixing the problem. (See PART I)  Such a condition describes two autonomous parties in a bilateral relationship wherein decisions are made by mutual consent. (This last sentence articulates the experience of much of what actually happens in the field. I say this because this begins to identify what the governance problems are and what possible solutions might look like.)

9.     Complete negotiations mean first, that incomplete contracts lead (backward) to incomplete negotiations, as logic goes negotiations are a precursor of contracting; and second, that complete negotiations occurs when equilibrium in negotiations resides in the appropriate trade-offs of the three elements of the triple and where an appropriate trade-off means consideration of as many attributes of the negotiated asset as possible and a high level of coherence of the triple items among both parties. Incomplete negotiations are important because they create the impression that all risks have been identified and assigned thus leaving unpriced hazards and possibly unowned economic attributes of real property; i.e., residual hazards.

10.   Complete negotiations also mean paying more attention to the variation between the cost of writing and executing complex hybrid contracts across a market interface and the constant risk factors of the human decision makers who are involved with the transaction on the one hand, and the objective environmental properties of the market on the other; i.e., uncertainty and small number exchange.

11.   Incomplete negotiations occur when there is a great difference in the capacities of trading organizations—where one side is farsighted and the other side is less so. Far-sighted traders typically negotiate on the basis of the triple mentioned earlier while less farsighted traders tend to negotiate with less than a full hand, and predominantly on the basis of price and perhaps with a modicum of technology although this latter requires specialized technical knowhow in terms of trading off price and/or safeguards for variations in the attributes of special purpose assets. A level of deep and broad knowledge is required to do justice to the negotiations triple.

12.   Farsighted investors tend to make more complete trade-offs within the full triple and hence are able to price out hidden risks inclusive of a full range of the attributes worth negotiating in the situation under consideration. Counterparties, however, are disadvantaged because of bounded rationality and inability to fully price out hidden risks unilaterally; consequently they are left to deal with the residual hazards in isolation and the uneven and soured contractual relations that result.

13.   An additional point is that the diseconomies of asymmetric information at negotiations do not cease at the time of award of contract to the winning bidder, but are worsened (or created) during the project cycle as in the case of negotiations and during implementation. In this respect, disclosure takes on special meaning.

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