6  Uncertainty, Flexibility and the Costs of PPPs

PPP agreements are output-based in the sense that the public-sector party specifies basic capacity and quality standards (such as heating and lighting levels, quality of cleaning and availability of rooms) but the private-sector party assumes responsibility over how to meet the output specified. PPP agreements also develop along a long-time horizon, typically 20-35 years. Both these features imply that the provisions set in the initial contract are likely to become obsolete during the life of the contract. The need for flexibility and adaptation of the contractual relationship is then far greater than in a more traditional types of procurement where provisions are input-based and contracts are short-term.28

When the factors that affect the suitability of the initial contractual clauses are anticipated, they can be regulated by the initial contract (e.g. changes in capacity). Other possible changes, however, may be unexpected and hard to specify in advance. Changes in society preferences, such as desirable standards for educational, clinical and prison services, are typically hard to anticipate. Contract flexibility is then key for PPP agreements in fast-moving sectors such as the health sector and the IT sector where preferences and/or technology change quickly.

When the original output specifications become obsolete, the contractual agreement can be modified by the mutual consent of the parties. Flexibility may then be achievable through well-designed "change the mechanism-clauses" that regulate the possibility of renegotiation of contract terms. However, contract renegotiation typically occurs in a bilateral "lock-in" situation rather than in the multilateral competitive one as under original contract drafting and awarding. The risk is twofold: The contractor can exploit its now strong bargaining position or the government can expropriate the contractor of its past investment. Thus both when renegotiation occurs and new contract terms are drafted and when the contract is rigid and no change occurs, PPP might deal inefficiently with uncertainty on future demand. This induces a cost of PPPs that we now study. For simplicity we focus on the case where the contract fails to adapt to uncertainty on future demand and renegotiation does not occur.

Let us come back on the basic model but assume that the inelastic demand for the services can be written as:

C = θ0 - e - δa + ε

where  is a positive͇͇ random variable with E() = 1 and we assume a positive externality δ>0.

Had  been common knowledge at the time of contracting, our previous result would go through and bundling design and operation would dominate strictly unbundling.

Suppose now that the bundling contract (viewed as a PPP) is offered before  is realized and cannot be made contingent on that parameter, assumed unverifiable.29 In other words, G ties his hands with such a contract and loses any flexibility. Alternatively consider unbundling tasks. Contracting with the operator might be delayed up to the point where  becomes verifiable. Of course there is no quality-enhancing investment but the operator's incentive scheme can be tailored to the particular realization of . This captures the value of information that comes with unbundling. We have:

Result 10 Unbundling dominates bundling for small positive externality in the case of uncertainty.

The point is that unbundling tasks allows to enjoy the value of information on  and that it is not possible under bundling. This points at the cost of PPPs in very uncertain environments. A reinterpretation of our framework also suggests that long-term contracts are unsuitable in uncertain environments.30 Consider the framework of Section 7.1 but now let period-2 cost be given by

C2 = θ0- e2 - δa + ε2

Assume that  is realized during period 1 and that a two-period contract covering both periods 1 and 2 cannot be made contingent on the realized . It is easy to show that with a low externality (δ small) a one-period contract becomes preferable to a contract covering both periods. This is because when the externality is small, the loss from not internalizing period 2 cost at the time of choosing asset quality a is small and the one-period contract allows to enjoy the value of information on  whilst the two-period contract cannot.

Literature: Bajari and Tadelis (2001) discussed the cost of renegotiating design under fixed-price and cost-plus contracts. When the firm has private information on the cost of the new design, cost-plus contracts are cheaper to renegotiate than fixed-price ones. In this respect, sectors where changes in demand are highly expected may be better procured through cost-plus contracts in spite of fixed-price contracts being preferable for inducing the agent's cost reducing effort.

Our results emphasize that the long-term nature of PPP contracts favors incentives for cost reducing effort but it has a cost in terms of reduced flexibility. The trade-off between incentives and flexibility was recently examined by Ellman (2006) though his focus was on investment by the government rather than by the firm. He showed that a longer contract length helps to protect the contractor from his investment being expropriated by the government but it reduces the incentives of the government to discover new service innovations since changes are costly to renegotiate.

Applications : Our results point to the unsuitability of PPP for fast-moving sectors. This is in line with empirical evidence. Several recent reports on PPP contracting highlight the cost of changes in user needs that - in the presence of rigid contracts - have sometimes triggered very costly renegotiation (see e.g. HM Treasury 2006). In the UK it was reported that changes occurred during negotiations with the contractors for 33% of Central Government Departments PFI projects signed between 2004 and 2006. The changes amounted to a value of over £4m per project per year equivalent to about 17% of the value of the project (NAO, 2007). Illustrative is also the case of specialized IT provision where the appropriate use of the facility involves continuous adaptation. Following performance failure and costly contract renegotiation, the HM Treasury in the UK now recommends against the use of PPPs for IT projects (see HM Treasury 2006). Examples of PPP failures in IT include the £400m Libra project to provide IT systems for magistrates' courts.

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28 The literature on contracts and adaptation is rather thin. Arve (2007) analyzes the incentives to build-up investment over time as more of the initial uncertainty on demand gets realized both under full and limited commitment.

29 We are assuming also that it is not possible to write a revelation mechanism that would make the cost-sharing scheme contingent on any announcement that the firm and the government could be making when informed about 7. In other words, we are considering here an incomplete contracts environment.

30However, under certain conditions, short-term contracts perform as well as long-term contracts (see e.g. Rey and Salanie (1996)).