Default and Renegotiation in Public‐Private Partnership Auctions

Abstract

AbstractThe winners of auctions for pubic‐private partnership contracts, especially for major infrastructure projects such as highways, often enter financial distress, requiring the concession to be reallocated or renegotiated. 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 highway 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 completed highway. Because it is costly for the government to reassign the concession, it is exposed to a holdup problem, which bidders can exploit through the strategic use of debt. Each firm chooses its financial 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 financial structure and equilibrium bidding behavior 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 bailout and the higher the expected transfer it extracts from the government. We discuss potential resolutions of this problem, including the use of least‐present‐value‐of‐revenue auctions.