How does opportunism affect performance under short and long term contracts?

[Response by Rui Cunha Marques and Sanford Berg, February 2010]

Opportunism is defined as “the practice of taking advantage of opportunities or circumstances, or of seeking immediate strategic advantage with little regard for ultimate consequences to potentially affected parties”. Since contracts in infrastructure sectors establish performance incentives and allocate responsibility for making decisions, the danger of opportunism must be anticipated and addressed in contracts. PPP infrastructure contracts can be divided into short or long term, where each time span has advantages and disadvantages; short-term or long-term contracts should be utilized according to the nature of the problems the contracts are addressing. Issues such as promotion of competition, uncertainty about the future, unpredictable events, renegotiation risk, and asset transfer between succeeding contracts are very important issues in decision-making. Since infrastructure generally involves long-lived and sunk assets, once a contract is signed, one party or the other could act strategically—to the detriment of sector performance.

a) Recurrent Short Term Contracts

Short term contracts, usually less than 8 years (often 1 to 3 years) have three main advantages when compared with the long term contracts. First, short term contracts encourage competition. Since there are more tenders or opportunities of renegotiation, prices tend to get closer to those that are fair and reasonable. Second, the transaction costs involved are a priori lower since the level of detail in the tender documents are less and are periodically reviewed. Finally, these contracts do not require so demanding tailored mechanisms by the public partner for contract management or, particularly, for quality of service supervision. As contracts are short term, if poor performance by a private operator is observed, that will reduce the likelihood of its winning renewal of its contract. In addition, the need for economic and financial adjustments within the contract (triggered by unanticipated developments) is less likely due to the shorter time frames.

Short term contracts have, on the other hand, two great disadvantages. First, they are not appropriate when high infrastructure investments are needed. The infrastructure life cycle perspective or, at least, the amortization of a significant part of its assets presents severe problems. The existence of (and potential dispute over) a residual value promotes contract extension ex post and makes the competition for the access to the market difficult for the new entrants. Thus, this type of contracts does not promote incentives, since managers do not want to invest much effort and time if they risk losing the operation and returns after a few years. The second disadvantage is related to contract renewal process and lack of parity among bidders. (This problem also arises in long term contracts but to a lesser degree.) For short term contracts, the current operator has informational advantages in comparison to the other bidders. The incumbent is in an advantageous position because managers have acquired better knowledge of the operating characteristics of the infrastructures, including existing demand patterns, growth prospects, and the cost structure. Incumbent managers are responsible for the staff that operates the service and politicians and bureaucrats are reluctant to change arrangements that seem to be working. In addition, there is evidence that short term contracts result in a higher cost (summing up all the contracts). Thus, short-term contracts can hinder efficiency, can stifle innovation, and reduce long term investments by the operators given that the return on the investments made, reward for managerial effort, and/or the recovery of the amounts spent may not occur over the short time frame.

b) Long Term Contracts

Long term contracts are incomplete by definition since they cannot include all contingencies: adjustments to unpredictable developments are negotiated as issues arise according to pre-specified rules. The main advantage of this type of contract is its appropriateness when large investments in long-lived and sunk infrastructure assets with long payback periods are needed. Nonetheless, a number of disadvantages characterize this type of contract:

1. Risk assumption: Both parties must assume risks which might be ill-defined and not well understood given necessary uncertainty over long periods of time.
2. Renegotiation: The empirical evidence indicates widespread renegotiation of long term contracts—often in the first few years of the contract’s life (Guasch, 2004).
3. Complexity of Contracts: The difficulty of writing contracts of this kind is widely acknowledged; the more complete they are the higher the transaction costs. In developing countries, the public partner is often at a disadvantage in the area of hiring legal expertise to prepare appropriate documents (Williamson, 1976).
4. Automatic Adjustment Mechanisms: Parties need to incorporate automated mechanisms so that prices can reflect general inflation and changes in cost conditions that are beyond management’s control. Those mechanisms may need to be altered as circumstances change.
5. Service Quality: Experience indicates that public partners have difficulty monitoring and rewarding service quality. The imposition of fines or penalties is particularly problematic if the public partner identifies excessively with the financial needs of the private party.

c) Ex post opportunism

Opportunism ex post may result from the behavior of either the private party or the public party (public authority). On the one hand, the operator wants to renegotiate the contract, even if some item was agreed upon ex ante, arguing that demand/consumption is lower or costs are higher than expected: exogenous factors that were not anticipated by those preparing the contract change the financials for the private partner, leading to renegotiation. This renegotiation process can be long and complex, giving rise to deviations from original arrangements. Now that the private partner has been selected by public tender with competition, the renegotiation process is less transparent and involves bilateral discussions. The public partner’s negotiating power (and leverage) is usually less after the private partner has been awarded the initial contract. The danger during the bidding process is the submission of a bid involving excessive quality or prices lower than the average cost. Such bidders are betting on the renegotiation process restoring its financial viability—leading to underbidding or low-balling.

Unless the cost of a new bidding process is very low, the operator has room for negotiation, especially if it has already made some investment. The threat of service interruption, often essential for the citizens and society, allows the private partner to put pressure on the public authority. Of course, opportunism is controlled in part by the desire of the project company to maintain its reputation in future negotiations and other contracts.

The public authority can also behave opportunistically; it may take advantage of the fact that the private partner has made large investments in long-lived and sunk infrastructures. The authority (or contract regulator) could force the operator to keep prices below average costs, denying the need for renegotiation. If the private partner initially bids an excessively low price, in the hope of re-gaining profits at the renegotiation stage, managers can find themselves in serious difficulties. The sunk investments and potential loss of reputation may force him to stay on the market. Of course, such politically-driven opportunism will raise the cost of capital for other infrastructure projects in the economy—as the public partner (or regulator) gains a reputation for unreasonable and/or unpredictable behavior.