The Present-Value-of-Revenue contract

For various infrastructure services that are financed by means of service fees, demand risk is large. Assuming quality standards can be contracted and supervised, this risk is exogenous to the firm and arises because demand forecasts are unreliable. As discussed above, the Dulles Greenway, the Camino Colombia Toll Road, and the Greenville Southern Connector are among many U.S. examples that illustrate the difficulty of making accurate demand forecasts, even in the short run. It follows that risk sharing is an essential part of the problem when designing a public-private contract.

The fact that opportunistic renegotiations have been a major problem under PPPs suggests using contractual forms where the firm bears little demand risk. This will provide fewer excuses to renegotiate the contract in the event of low usage.

Despite the usage uncertainty faced by many PPP contracts, it is often the case that user fees will eventually pay for the project; the question is how long it will take for that to happen. For example, even though demand for the Dulles Greenway turned out to be much lower than expected, accumulated toll revenue would have eventually paid for capital and operating expenses. For projects like these-we refer to them as "high-demand" projects-we argue next that flexible-term contracts, more precisely a PVR contract, offer a number of attractive properties.13 Under a PVR contract, the regulator sets the discount rate and user-fee schedule, and firms bid the present value of user fee revenue they desire. The firm that makes the lowest bid wins and the contract term lasts until the winning firm collects the user fee revenue it demanded in its bid.

The first advantage of a PVR contract is that it reduces risk: When demand is lower than expected, the franchise period is longer, whereas the period is shorter if demand is unexpectedly high. Under the assumption that the project is profitable in the long run so that repayment eventually can occur, all demand-side risks have been eliminated. This reduces the risk premium demanded by firms when compared to fixed-term concessions (e.g., by one-third in the case considered by Engel et al. 2001). This should attract investors at lower interest rates than are found in traditional Demsetz franchises with fixed terms.14 Annual user fee revenues are the same under both franchises, but the franchise term is variable under a PVR. If demand is low, the franchise holder of a fixed-term contract may default; in contrast, a PVR concession is extended until user fee revenue equals the bid, which rules out default. Of course, under a PVR the bondholders do not know when they will be repaid, but that is less costly than not being paid at all. PVR schemes also reduce the need for guarantees because the risk to investors is much smaller.

The United Kingdom was probably the first country to use a contract similar to a PVR. Both the Queen Elizabeth II Bridge over the Tames River and the Second Severn bridges on the Severn estuary were franchised for variable terms. The franchises will last until toll collections pay of the debt issued to finance the bridges and are predicted to do so several years before the maximum franchise period.

Chile was the first country to use an outright PVR auction.15 In February of 1998, a franchise to improve the Santiago-Valparaiso-Vina del Mar highway was assigned in a PVR auction. The reason for choosing the PVR option was that it would be easy to calculate fair compensation for the concessionaire if early termination of the contract was desirable for the government (see Box 2). Beginning in 2008, PVR auctions became the standard to auction highway PPPs in Chile: seven highway PPPs have been auctioned using this approach, with winning bids adding up to close to $2 billion

TABLE 3 Present-Value-of-Revenue Highway Concessions in Chile and Winning Bids

Source: Dirección de Concesiones, Ministerio de Obras Públicas, Chile.

Exchange rate: 1UF = US$43. (UF [Unidad de Fomento] is a unit of account that is used in Chile.)

MM = millions.