484. Default and Renegotiation in PPP Auctions

Flávio Menezes and Matthew Ryan, School of Economics Discussion Paper No. 484 August 2013, School of Economics, The University of Queensland. Australia.

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Abstract

The winners of auctions for PPP contracts, especially for major infrastructure projects such as highways, often enter financial distress, requiring the concession to either be re-allocated or re-negotiated. We build a simple model to identify the causes and consequences of such problems. In the model, firms bid toll charges for a fixed-term high- way concession, with the lowest bid winning the auction. The winner builds and operates the highway for the fixed concession period. Each bidder has a privately known construction cost and there is common uncertainty regarding the level of demand that will result for the com- pleted highway. Because it is costly for the Government to re-assign the concession, it is exposed to a hold-up problem, which bidders can exploit through the strategic use of debt. Each firm chooses its finan- cial structure to provide optimal insurance against downside demand risk: the credible threat of default is used to extort an additional transfer payment from the Government. We derive the optimal finan- cial structure and equilibrium bidding behaviour and show that (i) the auction remains efficient, but (ii) bids are lower than they would be if all bidders were cash financed, and (iii) the more efficient the winning firm, the more likely it is to require a Government bail-out.