Cost-plus payment

Under this payment mechanism, the public-sector party agrees to reimburse documented construction and operation costs associated with the infrastructure project plus a fixed and possibly a variable fee (thus giving rise to the name cost-plus). Formally, the payment P would be a linear function of the cost level P =F+(1+m)C, where C is cost, F≥0 is a fixed fee and m≥0 is the mark up the private-sector party can charge on each unit of documented cost. Since the private-sector party is fully insured against any cost increase that can happen in the construction and operation phases, a cost-plus payment gives no incentives to the private-sector party to exert any extra effort to reduce cost, as lower cost implies lower profits for the private-sector party (Albano et al., 2006a).

A cost-plus payment may therefore not be an appropriate mechanism when the project's total costs heavily depend on the private partner's actions, precisely because incentives to save on costs are weak. The mechanism has also a negative effect on the tendering process to select a private partner when there is a high degree of uncertainty about the bidders' efficiency. As long as the cost-plus payment reimburses all costs, both efficient and inefficient suppliers have an incentive to submit the same offer. But, because of the uncertainty, the public-sector party cannot distinguish between them. Hence, it is likely that the tendering process ends up selecting a private partner who is not the most efficient provider, which may increase total cost.

On the other hand, the cost-plus payment has an advantage in terms of flexibility to cope with uncertainty regarding circumstances that may arise during the project. Unforeseen changes in the environment and modifications in the output specification may call both parties for a contract revision. In the renegotiation, the private-sector party knows that any verifiable cost increase resulting from the new contract terms will be reimbursed by the public-sector party. Thus, the cost-plus mechanism narrows the scope for disputes and renegotiation costs (Bajari and Tadelis, 2001, 2006). Also, since the private partner does not bear the risk of cost overruns, to the extent that the firm is risk averse, payments to the private-sector party will not need to account for a risk premium and as such will be lower than when risk is transferred.

Finally, since the private-sector party is fully insured against any cost increase that can happen in the construction and operation phases, a cost-plus payment gives good incentives to the private-sector party to comply with the public sector needs and quality requirements. However, these incentives may not suffice so it is always preferable for the cost-plus payment to be adjusted for quality. To ensure incentives to deliver the quality standards contracted upon, a scheme of deductions must be in place. The payment scheme will comprise a component -d(Qs- Q) where (Qs-Q) is the difference between the agreed quality standard and the provided quality, and d is a parameter that determines the size of deductions, that should increase in the importance and costlyness of the quality dimension(s).

In the context of regulation of privatized utilities, the pricing rule in a rate of return regime resembles a cost-plus payment in procurement contracting. In this case, the tariff level set by the regulator is determined ensuring that the expected revenues at that price cover the expected operation costs plus a return on the capital invested by the private partner. Since the price received by the private-sector party covers its costs, the incentive structure of cost-plus also applies.

Fixed-price payment

In this case, the public-sector party agrees to pay the private-sector party a fixed amount for the service provision that must achieve certain quality standards. It is then critical that a scheme of deductions is in place to guarantee that the quality standard is respected, so that payment scheme will be P = F - d(Qs-Q), with the previously clarified notation. Since payment do not change with cost, the private partner bears all the costs associated with the project and fully appropriates the benefits of cost-savings activities. Hence, a fixed-price payment gives the private-sector party strong incentives to undertake cost-reducing efforts.

Fixed-price payments perform well when potential private partners are large companies with a diversified portfolio of activities (hence able to bear and manage substantial risk), and the quality dimensions important for the public sector are easy to monitor, so that deductions for quality below the standard are effective in guaranteeing that the quality standard will be respected. Fixed-price contracts with well specified output have the additional advantage to make competitive tendering processes extremely effective in terms of both selecting the most efficient private partner and reducing the cost of service for the public sector. In other words, well designed fixed-price contracts and competitive tendering go along very well. On the contrary, competitive tendering may even be harmful for the public sector when cost-plus contracts are adopted (Bajari and Tadelis, 2006).

A fixed-price payment may not be an appropriate mechanism when important quality dimensions are hard to monitor and sustain through payment deductions, so that cost-saving actions taken by the private-sector party are likely to cut down substantially the quality of service. Similarly, the fixed-price payment may discourage quality-enhancing efforts that raise the private-sector party's costs if these efforts or quality aspects are hard to observe and contract upon. On the other hand, if the quality dimension is easy to monitor also for third parties, an additional payment rewarding performance above standards could be added to the fixed-price contract, eliminating the drawback. Another advantage of fixed-price payment is that minimizes transaction costs as no cost information is required for its implementation.

In the context of regulation, the pricing rule in a price cap regime resembles a fixed-price payment in procurement contracting. In this case, the tariff level is chosen by the private partner subject to a maximum cap imposed by the regulator. The private-sector party is allowed to appropriate all the benefits resulting from cost-saving actions. Thus, price cap regulation attempts to overcome the inefficiency in rate of return regulation that arises from the weak incentive to undertake cost-reducing efforts when the price review is frequent and backward-looking.43 A pure version of price cap regulation has no price review, and thus the regulatory lag is of an infinite length. On the contrary, a pure rate of return regulation would allow the regulator to examine cost and profitability of the private-sector party on a continuous basis (Armstrong et al., 1998).44

Incentive payment

An incentive payment lies between the extreme cases of cost-plus and fixed-price. In general, for a given quality standard the incentive payment is the sum of two components: a fixed-amount plus a variable payment that partially compensates for the costs incurred. For example, the payment P can be a linear function of the cost level P = F + bC. When the public-sector party bears all costs and the private-sector party is fully reimbursed, b=1 and the incentive payment becomes a cost-plus. In contrast, the when the public-sector party bears no cost and the private-sector party is not reimbursed, b=0 and the incentive payment becomes a fixed-price.

By partially transferring the cost overruns risk to the private-sector party, the incentive payment encourages it to undertake cost-reducing efforts. Since these efforts reduce both cost and payment, but the payment decreases less than the cost, the private partner's profits increase. Therefore, the parameter b representing the fraction of costs born by the public-sector party turns out to be a key element to induce the private partner to save on costs. In particular, the lower the value of b, the larger the private-sector party's responsibility for cost overruns; thus, the more the private-sector party benefits from cost-reducing efforts, the higher the power of the incentive scheme.

The public sector's choice of the cost-sharing parameter b depends mainly on three factors. The first factor is the ability of the private partner to bear the cost overruns risk resulting from his degree of risk aversion. To the extent that the private-sector party is risk averse, it will require higher overall compensation for bearing the risk of suffering unexpected cost increases. The second factor relates to the predictability of shocks affecting the project's costs, which determines overall risk. When these shocks are largely unpredictable, the private-sector party will be less willing to accept an incentive payment with a low cost-sharing parameter b that transfers it the bulk of the cost overruns risk. It will then require higher payments for bearing risk. The final factor is the degree in which the private partner's cost-reducing activities impact on the actual cost structure. The larger the expected effect of cost-reducing activities on the project's costs, the lower will be the payment required by the private-sector party.

Implementing an incentive payment mechanism typically involves transaction costs. For instance, it is costly to collect the information needed to compute the payment, to provide accounting measures of the costs incurred, and to measure the quality of service. Thus, it may happen that transaction costs are so large that outweigh the expected benefits of setting an incentive payment mechanism. Under these circumstances, the public sector itself would prefer to save on transaction costs and adopt an alternative payment scheme. For instance, it may consider a payment mechanism easier to manage and less costly in terms of information, such as a fixed-price payment.

Of course, also in the case of incentive contracts the private-sector party has incentives to reduce the provision of costly quality, so that a quality standard should be established and 'defended' by an appropriate set of deductions. Taking into account deductions for quality supplied below the contracted standard the payment scheme would be something like P = F + bC - d(Qs-Q), where all symbols have the meaning explained earlier.

An incentive payment mechanism can also target quality-enhancing activities rather than cost-reducing efforts for a given quality standard. Analogously to cost incentive payments, quality incentive schemes may be used to encourage high quality in service provision and good performance on the part of the private partner. In general, a quality-oriented payment specifies a fixed amount for a low minimum performance level guaranteed by harsh sanctions, like very high (total) deductions or even private-sector party replacement in case of violation, and in addition different bonuses corresponding to higher quality levels. Formally, the contract would look like this: P = 0 if Q<Qm;

P = F + bC +β(Q-Qm) if Q>Qm, where Qm is the minimum performance level and β is the bonus increasing with the quality actually provided.

One benefit of using positive rewards for higher quality, in contrast to deductions (or liquidated damages, were present) for lower quality, is that the latter appear highly 'punitive' for the private-sector party - who sees its payment reduced, although as agreed upon in the contract - while the former does not.45 Deductions for low quality are often not exercised by public sector buyers. Some official argue this is also because of the fear to 'spoil the relationship' with the supplier. Recasting the incentives in positive terms may not have this drawback: the bonus may be seen as 'something more' the private-sector party gets only if particularly high quality is effectively delivered, while if it is not nothing is 'taken away' from the supplier.