Designing Public-Private Contracts for the Efficient Provision of Infrastructure Services
Draft
2006-03-31
Jan-Eric Nilsson
Dept. of Transport Economics
Swedish National Road and Transport Research Institute
Box 760
781 27 BORLÄNGE
Phone +46 243 736 79
Mobile +46 70 495 1531
E-mail [email protected]
Abstract: The purpose of this paper is to discuss contractual tradeoffs in the extended use of
private enterprises in the provision of infrastructure services, often referred to as Public Private Partnership (PPP): Which is the appropriate way to allocate responsibilities between the
public sector principal and the private sector agent, taking the nature of the underlying optimisation problem into account? To this end, both matters related to allocative and productive
efficiency are discussed. The former concerns the appropriateness of user charges to pay for
new infrastructure and ways and means for ascertaining that a contractor takes due account of
user effects in the design and maintenance of a new facility. The discussion of productive
efficiency focuses the design of contracts with respect to sharing of risk between the parties.
In addition, the incompleteness of the contracts and the concomitant risk for renegotiation is
dealt with. The overall conclusion is that there is no straightforward “yes” or “no” answer to
the question of whether PPP’s enhance welfare. Rather, the preconditions for projects differ,
calling for a wide variety of solutions tailored to circumstances.
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1. Introduction
Private-sector contractors have since long been used for building new infrastructure, contracts
being awarded after a tendering process. When the new facility has been completed the builder is compensated according to the terms established in the contract where after the relationship between the parties is concluded. In some countries, private contractors are now also
involved in the maintenance of existing roads and railways. (Reference?) Again, competitive
bidding replaces the use of in-house resources.
There is however a further international trend with respect to the relationship between a public-sector infrastructure agency and a private contractor. What is often referred to as a PublicPrivate Partnership (PPP) changes the parties´ position in at least two ways relative to standard procurement:

The contractor retains control over a construction project for a (long) pre-specified period of time and is made responsible for its maintenance before it is handed over to the
procuring agency.

The contractor may recover construction costs in non-standard ways, including tolls,
shadow tolls or down payments over the contract period.
The purpose of this paper is to address contractual tradeoffs inherent in this change of roles:
Which is the welfare maximising way to allocate responsibilities between the public sector
principal and the private sector agent, taking the nature of the underlying optimisation problem into account? The discussion primarily addresses road and railway infrastructure projects,
but much of the analysis generalises also to ports and airports. Most examples are, however,
from the road sector.
It will be demonstrated that different contexts require different contractual constructs. There is
therefore no single conclusion to be drawn with respect to the appropriateness of PPP’s. Rather, recommendations could range from using long contracting periods with user charging to
recover all costs, to situations where there is weak evidence in favour of changing the role of
the private sector as compared with today. A further conclusion is that the detailed design of
3
contracts to deal with differences with respect to risk concerns and other information incompleteness’s, is of paramount importance. The devil is in the contractual fine print.
We start by reviewing in section 2 the development behind this change of roles in the sector.
Section 3 focuses allocative efficiency and the need to account for the consequences for road
users and for the rest of the society of a new piece of infrastructure and its maintenance; how
can the agent be induced to take these effects into account. Section 4 addresses cost efficiency
issues: The more of the responsibility for a project that is being transferred to a contractor, the
greater is the chance that efficiency improves; but the higher responsibility also makes the
contractor carry more risk, which is costly. Moreover, contracts are often incomplete, which
may create incentives for costly renegotiation. The question is how these aspects are dealt
with when contracts are initially designed. Section 5 concludes. In addition, appendix A formalises a simple welfare maximisation model for efficient construction and maintenance of
new infrastructure.
2. Motives
There are several possible motives for the shift of roles between the public and the private
sectors. A first reason is that PPP’s can be a means to enhance cost efficiency. This is so if the
private sector is better at doing work that has previously been taken care of in the public sector. The principal-agent paradigm offers a motive. Within both sectors, any production process is plagued by incentive problems between “principal” and “agent”. In the public sector
the parties may be the government and the head of an agency; in the private the shareholders
and the manager of the firm. There are two reasons for these incentive problems: First, the
respective parties have different objectives, and secondly, there are information asymmetries
between them, making it possible for the more informed party, often the agent, to use this to
his or her advantage.
There is reason to believe that it is easier for a private firm to handle these agency problems.
One explanation is that the public sector principal tends to be more heterogeneous and dispersed; a private firm has one owner or a (relatively) homogenous board, while a publicsector agency formally is governed by a ministry but also has to account for its performance
in parliament and in the public debate. The public-sector agency moreover has more ambigu-
4
ous objectives with no single and clear measure against which to assess performance; a private firm is typically managed to maximise profits which can be relatively easier to monitor.
The public sector agency is also more likely to face a soft budget constraint, meaning that it
may be easier to make extra money available after budget overruns. An official who knows
this may act differently, for instance be less prone to take painful decisions to cut costs, than if
the budget constraint is absolute. Taken together, these reasons explain why it may be relatively easier for the private principal to discipline its agent into doing what it wants, in particular to be more efficient.
A second reason for using private companies to supply infrastructure services under contract
with the public sector is that it may save on costs to make one and the same decision maker
responsible for both construction and maintenance spending. This aspect is further developed
in sections 3 and 4 below. So is also a third explanation, namely that a government may want
to make users, not tax payers, foot the bill for a project and that it prefers having a privatesector agent take care of this task on its behalf.
A fourth motive can be identified when contrasting US and European transport sector policies
towards financing road sector activities. Although there are differences across the continent,
Europe seems to charge high taxes for all road use, with tolling used on an ad hoc basis. Taxes are levied both on fuel and vehicle ownership and increasingly also weight-distance taxes
are being introduced (Parry & Small 2005). The revenue from taxation of road transport goes
directly into the Finance ministry’s tax coffers rather than being earmarked for use in the sector.
America’s taxes are at a lower level but its fiscal paradigm is to earmark revenue from fuel
taxes etc. for use in the transport sector, buy way of a road fund. There is, in addition, a political reluctance against jacking up these taxes, constituting a threat that the road fund will not
suffice for maintaining and expanding the network in future.
The differences in taxation level could be expected to create a higher rate of traffic growth in
the US than in Europe. The current US debate seems to be how to generate resources for future road construction, in the crunch created by constant tax levels and increasing fuel efficiency on the one hand and a growing traffic volume on the other. Recent legislative changes,
and current actual examples, indicate a willingness to introduce road tolls as a means to solve
5
the crunch. This could be interpreted as a price discrimination mechanism, i.e. to charge a
premium rate for using uncongested sections of the network.1
A fifth possible motive for the development of PPP’s is well illustrated by the European Union’s Maastricht criteria. One of these fiscal rules caps the size of the public sector’s debt, and
a PPP project may provide a means for reaching this objective. In particular, a private firm or
a corporatised public body may take over debt and also raise capital for building the new infrastructure. It is thereafter reimbursed for these costs over a long period of time with tax revenue or with revenue from user charges. This provides a means for lifting off public debt and
provides one reason for the current development of an Austrian commercial road agency and
its interest also in PPP solutions (reference).
3. Allocative efficiency
Irrespective of the reason for interest in PPP contracts it is essential to design any deal between a public sector principal and a private profit maximising agent in order to provide infrastructure services so that social welfare is maximised. In particular, a contract that shall provide the agent with incentives for supplying efficient infrastructure services must account for
the consequences of alternative investment and maintenance strategies for the future users of
the new infrastructure and for society at large. If not, there is a risk that the agent minimises
its financial costs without due regard for the consequences for the outside society. In this section we will establish how the contract must account for user and third-party consequences of
the service provision.
There are two dimensions of relevance for others than the contracting parties. The first concerns whether the agent should be entitled to levy charges for using the services provided by
the new piece of infrastructure. This is the demand side of the project, further described in
section 3.1. Section 3.2 handles the cost side, i.e. the implications of alternative maintenance
strategies for road-user and third-party costs, and how this must be dealt with in the contract.
The discussion is based on the theoretical framework established in appendix A.
1
It would be interesting to compare traffic growth to see if there are any differences, or if the major consequence
– as suggested by Colin – is for the composition of the vehicle fleet.
6
3.1 How should infrastructure facilities be paid for?
It is well known, and also shown in appendix A, that the welfare maximising policy is to
charge the use of infrastructure facilities according to marginal costs. Users should pay for
congestion, wear-and-tear as well as accident and environmental costs emanating from marginal variations in traffic volumes. Not least when a new piece of infrastructure is opened for
traffic, capacity may be abundant, meaning that congestion is low. To the extent that the other
cost components are recovered through fuel taxation, the toll charged for using the infrastructure should therefore be set to zero. Positive tolls would scare users away from the new facility in spite of that they add little to costs, hampering allocative efficiency.2 This provides a
motive for not giving an agent the right to levy tolls.
But the alternative to charging users in order to pay for an investment is to use tax revenue.
This is also costly from a welfare perspective, since financing over the tax bill distorts consumption and production choices. The loss of consumer and producer surplus provides a
measure of that loss which should therefore be compared to the loss of surplus as a result of
tolling; if the efficiency loss from a toll is higher than the efficiency loss from marginal variations in the tax level, the project should be paid for by taxation, and the other way round.3
The size of the distortion from toll financing differs across circumstances. In particular, the
presence of good alternatives to the priced facility is the key to understanding whether the
choices of road users will be distorted, inducing them to use other “cheaper” routes. Several
tolled bridges, such as the Öresund bridge between Sweden and Denmark, have fairly poor
alternatives (reference) and so has many Norwegian toll roads where the topography makes
bypasses long and costly (cf. Bråthen 2004). Tolls on these links may therefore have small
distortionary consequences. Tolling of one link in a dense network, such as Hungary’s M1
motorway (reference) may, on the other hand, induce most traffic to use nearby alternatives,
generating much higher social costs than if the motorway was not tolled. Putting focus on this
substitution effect makes it feasible to discern on an early stage of an assessment whether a
project may be eligible for user funding.
2
The loss of consumer surplus from too high charges provides an estimate of the magnitude of this loss.
Swedish infrastructure planning makes use of a marginal cost of public funds which is 30 percent, meaning that
any spending over the public budget is multiplied with the factor 1.3 in order to establish the real resource cost
from building and maintaining the facility. If the efficiency loss from toll financing is less than 30 percent it is
still efficiency enhancing.
3
7
A different sort of situation could be envisaged when a motorway is built in a town etc. with
high congestion on all or most streets. Under some circumstances it could be envisaged that
tolling of the additional capacity if welfare-enhancing compared to the no-tolled-motorway
benchmark. This is so if user benefits of the extra capacity, plus the benefits of reducing congestion on the non-tolled parts of the network, exceed costs for having it built. First best optimal would of course be to charge for short capacity in the whole network. Again, this illustrates that tolling may enhance efficiency under some circumstances while not in other.
This discussion is based on the premise that a private-sector agent manages tolling on behalf
of the government; this is, indeed, the whole purpose of this paper. This does not preclude that
the government charges tolls using in-house resources. The Öresund bridge is for instance
corporatised, the bridge company owned by the Danish and Swedish governments. This does
not change the basic arguments forwarded here.
3.2 Minimising social costs
Ignoring demand-side considerations and focusing instead on the cost side of the contract, the
problem is to provide a blueprint that induces the private-sector agent to design the project so
that investment and subsequent maintenance costs are minimised, taking its consequences for
the outside society into account. At least the following parameters will have to be specified in
the contract for a road project:

Availability: The purpose of a road is to facilitate transport. Payments from principal
to agent for a piece of new infrastructure should therefore be conditioned on lanes or
sections becoming available for use. In addition, poor availability due to maintenance
activities or because of poor maintenance (inappropriate ploughing during winter etc.)
should affect the payment for services. Appropriately designed availability clauses
could also provide incentives for undertaking maintenance activities during off-peak
periods of the day or of the year.

Road surface quality: The quality of travelling between Here and There deteriorates
when a road gets increasingly uneven. This includes consequences for the time of a
journey, for vehicle operating costs, riding comfort and possibly also for safety. The
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contract must make sure that the contractor accounts for these aspects when considering alternative maintenance standards.

Safety: Except for road surface quality, also other parameters controlled by the contractor may affect road safety; examples include snow clearance, maintenance of street
lights, road markings and side-rails as well as clearing of side areas in order to reduce
the risk for wildlife accidents. The contract must induce the contractor to choose
maintenance strategy in order to account also for these consequences of the activities.

Environmental concerns: The choice of material of a road’s top layer may have consequences both for noise from traffic and the extent of particles worn off by studded
tires. To the extent that the principal has information about these and other environmental externalities, this should be included in the contract.
Figure 1 provides an illustration of the tradeoffs involved. Efficiency calls for balancing the
agent’s own (higher or lower) maintenance costs, resulting in better or worse road quality (q),
against (lower or higher) costs for users and third parties. The quality which balances these
opposing forces, q*, might be higher than if the contract fails to condition the agent’s remuneration on infrastructure quality.
Costs
Infrastructure
cost (c)
User and third
party costs
(N*cu+c3)
q*
Infrastructure
standard
Figure 1: Balancing the agent’s maintenance costs against costs for users and third parties.
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In addition to interdependencies between private and social costs in the choice of maintenance
standards, there is a trade-off to be made between on the one hand (higher or lower) standard
and costs when investing in a new facility and on the other hand the concomitant (lower or
higher) future maintenance costs. Examples include the choice of thickness and the type of
stone used in the top layer of a new road; the thicker the asphalt and the better-quality stone
used, the more expensive will the investment become and the cheaper will future maintenance
be. Similarly, the thickness and standard of sub-structures will decide the pace with which a
road wears down and thereby also future maintenance costs.
This “externality” between spending on investment and future maintenance provides reason to
make one and the same entrepreneur responsible for both investment and maintenance activities in order to facilitate optimisation of resource use over the road’s life-cycle, or at least over
the life time of the contract (Martimont & Poyet 2006). A life-cycle contract for costs – sometimes referred to as a performance contract – focuses on the services provided by the final
product, including explicit allowances for third-party effects as enumerated above. This
means that when the agent builds and maintains the facility so that it provides satisfactory
services, as defined in the above contract clauses, the choice of construction and maintenance
design could be left to the discretion of the agent.
In particular, the contractor would not be obliged to abide by historic rules for construction
design.4 One purpose of long contracts is to free the imagination of contractors and to make
service quality the core decision parameter. The testing of construction designs that have not
been in use before is therefore at the core of performance contracting. This sovereignty will
only work if the contract formulates quality targets, establishes means to monitor these targets
and provides economic incentives to remunerate above-target, or punish inadequate performance according to the bullet-points enumerated above. The detailed crafting of these paragraphs is the only safeguard against prohibiting the road services from deteriorating in quality
from the user perspective, and the size of penalties and bonuses has to be calculated with
much prudence.
4
Over the years, road administrations have come to develop rigid rules and regulations for how a new piece of
infrastructure is to be designed. Moreover, inquiries for quotes may even specify volumes of gravel, rock or
earth to be moved from one section of the project to another, the methods to be used, etc. leaving only unit costs
as the bidding parameter.
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4. Designing a contract to ascertain cost efficiency
Section 3 has established the (type of) parameters that have to be accounted for when designing a plan for infrastructure investment and maintenance. The purpose here is to discuss the
appropriate blueprint for a contract between the public sector principal and its private partner,
i.e. a contract which provide incentives for enhancing cost efficiency. Section 2 suggested that
the principal-agent paradigm provides reasons for believing that a private entrepreneur may
provide services at lower costs than if public-sector in-house resources are used. But the provision of incentives also means that the agent will have to bear the risk for cost overruns. Section 4.1 handles particular risk aspects of this risk transfer for the relevant types of contracts.
Section 4.2 takes the analysis a step further in considering the extent to which these contracts
are incomplete and what that might mean for contract design.
4.1 Allocating risk and the design of remuneration mechanism
During a preparation period, the principal has come to define a project that is to be procured.
The preceding analysis has sketched the design of a performance contract based on specific
services that a road shall perform and penalties and bonuses if the infrastructure does not perform these services. In equation (1), B represents the bid submitted (by the winning enterprise) for this project. The bid is based on the agent’s assessment of profits (π) which in turn
is a function of traffic (no. of vehicles; ti) and the price charged (pi) for using the facility during each year of the asset’s life-length (i=0,…,n). It is also based on an estimation of construction (ki) and maintenance (ci) costs for each year; all costs are assumed to be in present
value terms.5
B  f ( )
n
   ( p i ti  ki  ci )
(1)
i 0
5
If a railway station or an airport is part of the project, an operator may also earn revenue from licensing parking
lots, restaurants etc. In eq. (1) this could be added as a further source of revenue and it would boost the bid to be
submitted or alternatively make it necessary to ask for a smaller subsidy than would otherwise be necessary.
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Eq. (1) applies for several situations. Assume that the bid is for a project where the agent will
be entitled to charge users and that this revenue is expected to yield a profit; the winning bid
is then a positive amount of money that is paid to the principal that transfers the control of the
project to the agent (cf. the Chicago skybridge; reference). If expected revenue from users is
insufficient to recover costs, the winner of the contest is the consortium submitting the lowest
quote for compensation; this was the way that the auction for Sweden’s Arlanda railway link
was conducted (cf. Nilsson et al 2006 for detail).
The English shadow tolls provide another example of contractual situation encompassed by
eq. (1). To simplify a bit, the submitted bid is the unit price to be charged against usage,
meaning that the consortium asking for the lowest value of pi in the equation will be awarded
the contact. Even if it is the principal – the government and not the users – that pays the shadow toll the logic provided by the equation explains the bidders’ underlying considerations.
Finally, eq. (1) can also be used for a more standard procurement situation where there is no
user charging at all (pi=0), but where the firm asking for the lowest compensation for handling
the contract over a preset period of time will be the designated winner.
Irrespective of which application of eq. (1) that we think about, a convenient benchmark for
the analysis of the contract between principal and agent is that the payment between the two is
unequivocally decided by the bidding process: The winning bid (which may be a discounted
value over the contract period or an upfront payment) will once and for all specify which
compensation the agent will pay to the principal or vice versa. We are then talking about a
fixed-price contract, which has two essential features:

It provides maximum incentives for the agent to minimise costs and to maximise revenue, subject to any and all provisos made in the contract. Any extra revenue and/or
lower cost will end up as a better financial result for the agent.
 It leaves all risk with the agent. Any event not provided for in the contract that change
revenue or costs compared to projections made before submitting the bid will only
have consequences for the agent’s financial result.
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Risk is defined as any uncertain but quantifiable consequence of an activity, be it a project’s
costs or benefits.6 Outcomes are uncertain for numerous reasons; variations in interest rates
create an obvious financial risk; the construction of an asset may become much costlier than
expected; weather or poor construction design may make it impossible to use an asset; the
asset’s design might turn out to be inappropriate for the purpose it is built and the technological development may be so fast so that the asset is obsolete short after it has been completed;
there is also notorious uncertainty about the life length of an assets and – which is the mirror
image of this uncertainty – about the residual value of the asset at the end of a contract period
which is shorter than the life length.
If it is feasible for an agent to affect the probability of negative outcomes this is referred to as
internal project risk. This includes the ability to avoid or eliminate the source of the risk, to
reduce the likelihood of its occurrence, to mitigate its consequences (i.e. to establish contingency or treatment plans), or to transfer its consequences to another party (i.e. to insure against
negative outcomes). In contrast, features completely beyond the agent’s control are referred to
as external risk.
There are some basic welfare prescriptions with respect to allocating risk between the parties.
First, the more risk-averse party to a contract should – ceteris paribus – carry less risk than the
party that has higher ability to bear risk. Since the public sector sits with a huge portfolio of
different types of projects, this argument is commonly seen to indicate that much risk should
be allocated to the principal.
A second insight is that, for equal attitude towards risk, risky features should be allocated to
the partner who is in the best position to affect the risky outcome and minimise any negative
impact of the underlying uncertainty on the project. But third, leaving risk with the agent does
not come for free; the higher the risk, the more height must be taken in the initial bid for unexpected outcomes, making risk transfer costly for the principal. Fourth, and a direct corollary
of the qualities of the fixed-priced contract established above, the more risk that is being lifted
off the agent, the lower are the incentives to economise. And fifth, the contract should be
6
Risk is, according to this definition, something that can be quantified, a numerical calculation of an uncertain
benefit or uncertain cost in terms of its magnitude, timing and probability of occurrence. Uncertainty is a wider
concept which also includes risks that can not be quantified or where the probability for different outcomes can
not be estimated. It is the transfer of a vague uncertainty into a precise risk that makes it possible for a private
sector partner to accept that the risk is handed over from the public agency.
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based on all variables that provide information about the agent’s actions.7 As always, the
question is therefore to establish an efficient trade-off between delegating much risk to the
agent, which provides strong cost efficiency incentives but that may cost much up-front, and a
contract design with less risk with the agent but with worse motives to be cost efficient.
Many truly external risks are impossible to eliminate, or indeed even anticipate at the contracting stage; the September 11 terrorist attack, the SARS epidemic or the bird flu or the
wreckage of Estonia provide examples. The feature of risk being external does however not
eliminate the possibility that the agent is better able than the principal to hedge against these
outcomes, for instance by designing more cost-efficient safeguards against terrorist attacks
than if the principal takes the full responsibility for these tasks.
There are other examples where intricate considerations relative to the importance of internal
and external risk have to be weighted against each other. Traffic demand provides an example. For any particular infrastructure investment project, future traffic is uncertain which also
makes the benefits of a new piece of infrastructure uncertain. To the extent that the traffic
flow is decided by factors such as economic growth, fuel prices etc., any agent in charge of a
single link of the whole network is not able to influence the demand side of the business deal;
this is therefore a global risk. England’s shadow tolls seem to be moving away from linking
agent compensation to traffic flow towards a more traditional procurement contract. One reason may be that the agent is not seen as having any control over traffic flows and should
therefore not be left with the consequences of traffic uncertainty.
But to the extent that the agent controls the price – the toll – for using the facilities, there is a
degree of control of the number of users of the facility. The agent’s advertising and other activities to counter an unexpected slump in demand provides additional logic for making the
agent assume demand side risk. An example of this allocation of risk is the private Arlanda
airport railway consortium which has to carry the full risk for unexpected drops in demand for
the rail shuttle’s services. This demand is very much related to the total number of airline passengers at the airport, a statistic outside the control of the consortium. It does, however, control the price charged for a trip between Stockholm and the airport (cf. Nilsson et al. 2006).
7
These conclusions are partly based on Bolton & Dewatripont (2005); see in particular section 4.7.
14
Construction costs provide another example of the ambiguity. One reason for cost uncertainty
may emanate from the geotechnical preconditions for a project. To the extent that the quality
of the rock in a tunnel project turns out to be worse than expected, costs may swell. This risk
is the same for any potential contractor, and to that extent external to the project. It is, however, feasible to spend more or less on pre-studies in order to reduce the risk for unpleasant surprises but these are of course costly to undertake. But cost overdraws can also emanate from
the project being built in a less diligent way. This dimension of uncertainty is individual and
differs according to how careful different managers are. It may be difficult ex post to disentangle cost overruns due to external and internal risk.
The design of how risk should be allocated between the parties is therefore a delicate tradeoff. There are, however, several different mechanisms to share risk. The extreme alternative to
a fixed price contract is to pay for costs on going concern, i.e. using cost plus contracts, with
small incentives for cost reduction but also small risk costs allocated to the agent. An incentive contract provides for in-between solutions. The parties will then share cost overruns, i.e.
they agree ex ante on how to split deviations from a target level (Laffont & Tirole 1993).
Yet another twist of the two extremes is to disentangle some cost or revenue components from
a fixed-price contract. One way to do so is to sign a contract with no entitlement for the agent
to charge users, meaning that the principal retains the full uncertainty related to future usage
and benefits of the facility. A less extreme version is the English shadow-toll roads, remunerating the contractor based on how much traffic that actually use the facilities. In order to cap
the size of the payment, there are “bands” within which per-vehicle payment varies, the unit
price getting lower the higher the use of the road (cf. Edwards et al 2004). This reduces the
risk from the perspective of the principal, i.e. it avoids making the contractor earn much money if traffic is higher than expected.
Rather than basing compensation for some component such as maintenance costs on a fixed
ex ante amount, it can be linked to some price index.8 Any indexing of costs is a means to
relieve the contractor of price level uncertainties. There are also examples where payment for
8
An example of omitting particularly risky components from a fixed price contract is given by subsidised ferry
services, such as that between Sweden’s mainland and the island of Gotland. This service is procured on the
basis of lowest subsidy quote. The cost for bunker oil is, however a large chunk of total costs and difficult for the
service operator to control. The contract therefore contains a specific clause making the payment contingent of
the oil price trajectory, shifting this risk from operator to procurer.
15
maintenance costs are linked to actual traffic volumes. If the actual traffic growth turns out to
be higher that indicated by a forecast, the extra wear and tear and the higher maintenance
costs induced by the extra traffic can be capped by creating a proviso in the contract.
Roads, like much other infrastructure, last for very long. For several reasons, a PPP contract
may cover a shorter period of time than the life-time of a road, however that is defined. This
may jeopardise the effort spent on maintaining the road’s quality, in particular towards the
end of the contracting period. The reason is that preventive maintenance activities that affect
the pace with which a road deteriorates can be scaled down if the responsibility for the road
and therefore the benefits of the activities is going to be transferred to someone else, resulting
in suboptimal standard at the time of the transfer. Many long-term infrastructure contracts
have been signed over the last 10 years or so, meaning that few of them have yet come to the
end of their respective contracting periods. It is therefore to be expected that this issue will
come to the surface when contracts start to closing in on their termination date. In order to
avoid any problems in this respect, the targeted infrastructure standard at the end of the contracting period must be detailed in the initial contract and must be monitored before transfer.
The overall conclusion of this discussion is that the detailed design of the contract between
government and contractor is complex. In order to minimise costs for contracting out the responsibility for an infrastructure investment over a longer period of time, there are different
contexts that require different designs. It must therefore be considered on a case by case basis
which parameters that are most important to consider for each particular project.
4.2 Incomplete contracting
A complete contract regulates in detail the parties’ obligations in each possible future situation. The complete contract will for instance list what the consequences would be if the rock
in a tunnel construction turns out to be of worse quality than anticipated: who should do what
and which party should bear the extra costs in the new situation? With complete contracts
conflicts never have to surface and the power of the parties after that the contract has been
signed is of no importance since any violations of the contractual terms would result in huge
penalties.
16
Complete contracts are impossible or at least very costly do design. Instead, the principal typically signs an incomplete contract with the agent, specifying the provision of services only to
an incomplete extent. When events that are not controlled for in the contract turn up, they
have to be determined by the parties at some later stage. Many construction contracts are sorted out in court since the parties are unable to settle who is to be responsible for the consequences of an unpredicted event after that it has happened. The general question is then to
establish principles for who is entitled to make these decisions.
The literature dealing with incomplete contracts pays relatively little attention to making
compensation contingent on outcomes, i.e. the form of the contract, including the allocation of
risk between the parties. Focus is rather on the allocation of control and ownership between
the parties in situations where unexpected events occur and on the protection of ownership
rights. In this sense, the analysis of incomplete contracting offers a vehicle to explore the
analysis of economic institutions and organisations systematically (Bolton & Dewatripont
2005, section 1.6).
Ownership is per se an evasive concept, but we will elaborate on one aspect where an infrastructure contract between government principal and private-sector agent can be considered
from an ownership perspective. Consider in particular the link between (high/lo’) spending on
the initial investment and the subsequent (lo’/high) spending on future maintenance. Assume
a contractual relationship where the firm builds a project and then takes care of its maintenance for a specific period of time. It is paid for its construction costs when the project is
made available for use and it is annually remunerated for its spending on maintenance activities according to the preconditions specified in the contract (cf. ki and ci in eq. 1 above). We
can think about this as the principal retaining the ownership of the facility and the agent being
the designated caretaker.
Assume further that the agent who won the bidding contest did so due to making a substantial
cost saving during the investment phase, but without properly accounting for the resulting
higher future spending on maintenance. When maintenance costs after some time start to increase, the compensation from the principal may be insufficient to recover costs. The firm can
then press for renegotiation of the contract in order to secure a higher remuneration as a prerequisite for not reneging. Bankruptcy may be preferable to continuing loss-making maintenance activities. From the principal’s perspective, the options are to either pay more to the
17
original agent for handling maintenance or to re-let the contract to some other agent. Transfer
of the contract generates administrative costs and it is uncertain ex ante whether a new operator would be cheaper than the original. The principal may therefore be inclined to accept renegotiation of the original contract.
What seemed to be a cheap contract when the deal was signed has turned out to be expensive
since the principal is unable to prevent renegotiation and to stop the costs for handling the
project from increasing. This is so if the initial bid was submitted in good faith and it is a
forteriori a problem if an agent deliberately holds back on investment spending in order to
sweeten the deal, anticipating that future renegotiation is feasible.
In situations with substantial incompleteness in contracts it is therefore necessary ex ante, i.e.
before that the contract is to be signed, to consider ways and means to committing the parties.
One way to do so may be to transfer ownership of the project to the agent and to repay its
investment costs during the contract’s life-time.9 This means that if maintenance costs start to
grow – i.e. increase compared to the initial estimate – there is still a substantial debt outstanding. Presumably, part of this debt is pure profit from the perspective of the agent. Going bankrupt would then mean that the agent’s aggregate profit would be lower than anticipated. Since
bankruptcy is now a less credible threat, this provides incentives against bad-faith rebalancing of costs between the investment and maintenance phases of the project.
As always, there is a downside with this construction. This is so if the agent arranges for
(parts of) the project financing by way of external debt. Presumably, the commercial agent is
a larger risk for banks than the government would be, indicating that the costs for taking up
the loan would be higher for the agent that it would be for the principal. A well-designed project would, however, have a certain income stream with annual payments from principal to
agent specified in a contract which can be used as collateral. This may reduce the gap between
interest rate paid by a private and a public borrower. At the end of the day, the overall tradeoff that has to be made is between all the offsetting aspects enumerated above.10
9
In the world of management acronyms this is referred to as DBFO (Design-Build-Finance-Operate) in contrast
to the alternative DBO (Design-Build-Operate) contractual design.
10
Cf. Dewatripont & Legros (2006) section 4.2 for a discussion of the pros and cons of external finance for
PPPs.
18
6. Conclusions
PPP’s differ from many other forms of private sector involvement in the financing and provision of infrastructure services in that it establishes a long-term, often interactive partnership
between the two sectors. We have also argued that the public sector should purchase infrastructure services rather than the physical infrastructure itself; contracts should therefore be
signed on the outcome of the construction and maintenance activities, not to specify the input
used in the process. Another feature of PPP’s is the necessity of crafting a premeditated allocation of risk between the parties, ideally making each partner assuming those risks it can
control and manage better than the other partner.
We have discussed the details of these and other aspects of PPP’s and in summary the following basic conclusions have emerged.

There are strong motives for bundling investment and maintenance activities into
“long” contracts.

The contract must detail the way in which the agent shall account for the consequences of its choice of investment and maintenance policy for users of the facilities; penalties and bonuses could be used for this purpose.

There are examples of situations where the private agent can be allowed to levy charges for using the facilities.

The following aspects decide whether the principal or the agent should carry risk more
generally: the ability of the agent
o to avoid or eliminate the source of the risk,
o to minimise it, i.e. to reduce the likelihood of its occurrence,
o to mitigate its consequences, i.e. establish contingency or treatment plans, or
o to transfer its consequences to another party (insurer).

The tradeoff between providing cost reduction incentives and risk can in a technical
sense be dealt with in different ways. Cost components that are obviously uncertain
due to external risk could be compensated on going concern. Indexing costs to price
levels of other external aspects is another feature for shifting risk, as is incentive contracts

Contracts should be designed with the risk for renegotiation in mind meaning that the
contractor might be made the owner of the project until the original debt is repaid.
19
Taken together, these conclusions indicate that different projects should be dealt with and
contracted for in different ways. The precise nature of the situation with respect to demand
and cost uncertainty, the availability of alternative routes etc. means that there is no one single
recommendation to be given; it is “horses for courses, not one size fits all”
We have devoted little attention to the tendering process. It is, however, obvious that ever
more cleaver contractual designs may prove to be of limited practical use if the competitive
pressure is insufficient during the bidding process. An adequate number of bidders – irrespective of how many that may be – is therefore a pre-requisite for that the process towards devolving work from the public to the private sector shall be of any use.
Quality control and performance monitoring are further prerequisites to make sure that the
concessionaire really delivers what has been stipulated in the contract. We can think about
this as part of the larger concept of “procurer competence”: A competent public-sector designer of the whole process is an absolute prerequisite for transforming a grand scheme into
successful implementation. This includes the very choice between standard and off-budget
financing by way of some comparator mechanism. The following quote from a recent EIB
report formulates the challenge:
“”…, both theoretical considerations and practical experience suggest that the seeds of success or failure are sown early on in the procurement phase. The soundness of the framework
for appraising value for money; the transparency and competitiveness of the bidding process;
the importance of getting the contractual relationship, especially risk transfer right; and the
need to keep in check the additional transaction costs of setting up and following through a
PPP receive ample attention across contributions [in the report]. Get these prerequisites right,
and a PPP is an attractive route to follow. Get them wrong, and the public sector is in for an
expensive ride.” Riess and Välilä (2005, p. 16.)
20
References
Bolton, p. & M. Dewatripont (2005). Contract Theory. The MIT Press.
Bråthen, Svein (2004). Financing and regulating highway construction in Scandinavia – experiences and perspectives. Working Paper, Molde University College, presented at the international workshop “Highways: Costs and Regulation in Europe”, Bergamo University,
Italy
Dewatripont, M. & P Legros (2005). Public-private partnerships: Contract design and risk
transfer. In European Investment Bank (2005). Innovative financing of infrastructure – the
role of public-private partnerships: Infrastructure, economic growth, and the economics of
PPPs. EIB Papers Volume 10. n°1/2005.
Edwards P, Shaoul J, Stafford A and Arblaster L (2004). Evaluating the operation of PFI in
roads and hospitals. ACCA Research Report 84, Certified Accountants Educational Trust,
2004, www.accaglobal.com
Laffont, J-J. & J. Tirole (1993). A Theory of Incentives in Procurement and Regulation. The
MIT Press.
Mackie, P. & N. Smith (2004). Financing Roads in Great Britain. Working Paper, Institute for
Transport Studies, University of Leeds.
Nilsson, J-E., L. Hultkrantz, & U. Karlström, (2006). The Arlanda Airport Rail Link – lessons
learned from a Swedish PPP project. Working Paper, VTI.
Parry, Ian W.H. & Kenneth A. Small (2005). Does Britain or the United States Have the Right
Gasoline Tax? American Economic Review, Vol. 95, No. 4, September, pp. 1276-1289.
Riess, A. & T. Välilä (2005). Editors introduction. In European Investment Bank (2005). Innovative financing of infrastructure – the role of public-private partnerships: Infrastructure, economic growth, and the economics of PPPs. EIB Papers Volume 10. n°1/2005.
Verhoef, E.T. (2005). Transport Infrastructure Charges and Capacity Choice. Paper prepared
for the European Conference of Ministers of Transport. CEMT/OECD/JTRC/TR(2005)15
21
Appendix A
The Welfare Maximisation Problem
To establish the optimal capacity K and usage N for a certain road, given that optimal road
pricing is implemented, social welfare S is to be maximised:11
N
Max S  B  Cu  C3  Ccap   D(n)dn  N * cu ( N , K )  c3 ( N )  Ccap ( N , K )
N ,K
(1)
0
s.t. Cu  C3  Ccap    D()  0
Here, social welfare is the difference between benefits (B) and costs (C) associated with the
road. Costs comprise three components: costs for the N identical users (Cu=cu(N,K), i.e. time,
vehicle operating costs etc); for third parties (C3=C3(N), external accident risks, environmental harms etc) and for providing capacity (C(K)). K=1 if the road is to be built, and zero otherwise, and all costs are assumed to be related to the road’s traffic (N). D(•) is the inverse demand for trips which at the margin coincides with the willingness to pay for using a road. τ is
the toll – if any – to be paid for using the facilities and the restriction ascertains that supply is
equal to demand in equilibrium.
The optimality conditions are given in equations (2a and 2b). The optimal toll should be set
equal to marginal costs for users and third parties from variations in road traffic (2a). In addition, capacity should be chosen in order to equalise marginal costs from building more road
capacity to marginal benefits of further capacity expansion (2b).
  N*
Ccap
K
11
(Cu  C3  Ccap )
 N *
N
(Cu  C3  Ccap )
K
The notation in this section is based on Verhoef (2005).
(2a)
(2b)
22
These results would change if the toll is not set at the optimum level but at some arbitrary
level τA>τ. Eq. (1) is then reformulated as (1’). The Lagrange multiplier λ represents the social cost coming from sub-optimal pricing, i.e. the equilibrium wedge between benefits and
costs.
N
 D(n)dn  N * c ( N , K )  c ( N )  C
u
3
cap
( N , K )  [(Cu  C3  Ccap )   A  D(n)]
(1’)
0
Assume now that this analysis has lead to the decision to invest in a particular road, i.e. that
K=1. It is then possible to reformulate the objective function in order to assess tradeoffs in the
construction and maintenance of this road, given a certain projection N̂ for current and future
demand. We then would want to minimise (3), where the issue of construction or not (the
choice of K) has been suppressed but where instead the choice of quality (q) is lifted in. Quality refers to the standard of the infrastructure that is used, measured for instance as a roads rut
depth or safety record. (4) is the optimality condition where superscripts denotes the derivative with respect to q:
Min C  N * cu ( Nˆ , q)  c3 ( Nˆ , q)  Ccap ( Nˆ , q)
(3)
Nˆ * cuq  c3q  C q  0
(4)
q
The better the quality of a road, i.e. the smoother and more convenient a trip is, the lower are
user costs; cuq  0 . Third party costs refer to emissions from car traffic affecting both car users
and society at large. It could also be particles from studded tires or noise, in particular from
heavy vehicles. We assume that it is feasible to build and maintain the road in ways that reduce these costs. Certain pavements are harder than others, emitting fewer particles; some
pavements are less noisy, meaning that (costly) higher quality results in lower third-party
costs, i.e. c3q  0 .
Capacity cost here refers to the resources allocated to building the facility (k) and for delivering its services to users; Ccap=k(q)+c(q). Construction costs increase in quality since a better –
i.e. a straighter and wider road – is more expensive to build than a curvier and narrower road.
Moreover, the better the quality of the pavement (the better drainage, the harder the stones in
23
the bitumen mix), the higher are its costs; kq>0. Maintenance costs, c, also increase in quality;
better winter maintenance and a smoother road surface etc. cause higher maintenance costs;
cq>0.
In all decisions relative to the choice of a road’s quality, expression (4) points to the trade-offs
that must be borne in mind in order to ascertain the best use of available resources. Efficiency,
illustrated as q* in Figure 1 (cf. main text), calls for balancing higher or lower maintenance
costs against lower or higher costs for users and third parties.
A further trade-off, not illustrated by the figure, lies in the interdependence between construction and maintenance costs. The higher the quality of a new road, the lower may future
maintenance costs be, and vice versa. A thicker sub-structure is costly today but may reduce
future spending; c(k(q)) with cq>0.