More than ever budget pressure is strong in OECD countries and decision makers are focusing on short term financial resources. More than ever those countries need to invest to maintain their level of knowledge and consequently, their standard of living. Thanks to the long PPP financing contracts, decision makers can develop long term investments. However, the counterpart is that the public budgets are committed for a very long time. This game being potentially dangerous, projects analysis should take into account not only their economic viability but also the uncertainties inherent to them. And since there will always be great uncertainties about the future, shouldn’t the systems of reducing the economic impact of a forecast error be sought in the types of contract and in their wording? The extensive review of many PPP contracts, in parallel with the economic approach, provides some elements of answer.
Economy is not finance
Today, the main issues that we observe concern the worldwide systemic financing problem. However, the true economy is not so much discussed, probably because it is more difficult and more uncertain than ever in OECD countries. Nevertheless, long term contracts (PFI, concessions and the like) are also dealing with economy, not only with finance. The recent examples of Greece, Ireland and Portugal are showing that sooner or later the true economy catches up with the financial processes and create problems, once the investment was not a wise and efficient one.
After years of experience in the concession business we have developed a model which deals in parallel with economy and finance. A simple example is given hereunder to compare the economic analysis and the financial analysis for the same project (a bridge of about 800 M € of investment) according to two different processes: standard procurement for a toll free bridge and concession for the same bridge. The tables hereunder are showing the point of view of the public authority.
With such a model it is easy to make some tests, mainly for checking the consequences of an error on the “utility” forecast. The result is simple: for a concession contract a cumulative error of 2% per year (less than the expected utility) implies a IRR decrease from 12,4% to 10,3%, and a cumulative error of 5% would reduce the IRR to 7%! In traditional procurement would be even worse.
A new economical approach to long term contracts: influence of the type of contract on the behavior of the Parties
The analysis of more than 600 contracts has shown that it is possible to create an econometric model to represent the behavior of the Parties, each one looking for its own interest, for representing the observed situations. But from the global economic analysis, the problem should be observed from the point of view of the final user. And that new approach changes a lot the way contracts and mainly renegotiations are looked at. Three kinds of renegotiations have been identified:
- Non efficient renegotiation if the global economic surplus is negative after negotiation (one party increases its surplus but not enough to compensate the loss of the other);
- Pareto efficient when each party increases its surplus, given thus a global increase of the efficiency of the contract;
- Hicks-Kaldor improving if the global surplus increases but if only one of the parties benefits from this improvement
It is thus possible to show that renegotiations should be looked at not as a “mistake” done when signing the initial contract, which is always “incomplete” according to the contract theory, but as economic optimizations to take into account the variation of parameters all along the life of the contract. Therefore, this new approach should help to have a better view on the economical result of the long term contract and thus should help to choose the right type of contract at the beginning of the operation and the right type of negotiation during the life of the contract.
