Contract duration can affect the investment decisions of the private-sector party both when investments are contractible (or verifiable) and therefore describable in the initial contract, and when they are not observable and therefore non-contractible.
Consider first the case of verifiable investment. With projects where the public-sector party can pay a contribution to the private-sector party, contract duration should play a limited role on investment levels since investment levels can be specified in the contract and adequate payments by the public-sector party can ensure the project bankability whatever the contract length. Any changes in the duration of the contract can be accompanied by changes in the payment by the public-sector party to the private-sector party that leaves the level of bankability unchanged.
With financially free standing projects the private-sector party does not receive contributions or payments from the public-sector party, and its sole source of revenues is the cash flow that the project can generate through user charges. In these cases, the duration of the contract must ensure bankability and thus be consistent with expected cash flows and the time needed to recoup invested funds. As long as supplied quantity and correspondent revenue increase with contract duration, the larger the investment, the longer the optimal contract duration. If the contract is shortened, then user charges are modified so as to ensure greater revenues to the private-sector party, or the investment obligation is reduced.
However, contract duration could be determined endogenously. Engel et al. (2000, 2001) develop an award criterion based on the Least Present Value of Revenues (LPVR) that bidders must submit when tendering. The contract lasts until the winner private partner receives the LPVR it had submitted. In LAC countries, this criterion was used in highway concessions, one in Chile and three in Peru (Guasch, 2004). A similar scheme has been used also for the Dartford Tunnel in the UK (Klein, 1998). The advantage of this scheme is that it reduces the demand risk for the private-sector party as a fall in demand and hence in revenues immediately translates into a lengthening of the contract. The disadvantage is that by being more protected against demand risk, the private-sector party has less incentive to make investment that can help to control demand risk.
Consider now the case of unverifiable investment, where the investment is not itself directly contracted/contractible upon and therefore cannot be described and protected in a specific clause in the contract. If the investment is at least partly specific to the public sector's needs or to the project (we refer to this as 'specific investment') it will have limited value for the private-sector party if used for alternative purposes outside the contractual relationship. In this case, if the investment helps the private-sector party to increase its profits (say by reducing the costs of the project) and if the private-sector party can appropriate (at least some) of these increase in profits (say because the original contract is fixed price), then a long-term contract provides more incentives to undertake unverifiable investments.
This is because specific investments imply larger losses for the incumbent in case of terminating the relationship with the public sector. In particular, when both parties negotiate a renewal of a short-term contract, the public sector can hold up the private-sector party by the threat of terminating the relationship, asking for price reductions or changes in the original contract terms. To the extent that the private-sector party fears holdups that reduce investment returns in the future, it has then less incentive ex ante to undertake specific investments. Since a long-term contract fixes the contract terms, it protects the incumbent against holdup. In this respect, the higher the investment specificity, the longer the optimal contract duration (see Ellman, 2006 for an in depth discussion). 51
If the contract duration is to be determined with the purpose of providing appropriate investment incentives, it is important to take into account the contractibility and specificity of investments and the payment mechanism used in the project.
For a project involving contractible investments and unitary payments made by the public-sector party, the duration of the contract should be determined ensuring a balance between the future certain payments and the funds invested by the private-sector party, taking into account the residual value of the asset.
In particular, assets should be kept by the private-sector party after contract expiration provided that they have a residual value (and thus could provide the private partner with revenues in an alternative use) and the public sector does not need them to ensure service continuation. The contract should then balance the unitary payments with the invested funds net of the residual value of the assets. Thus, for a given payment per unit of time, the contract duration should be shortened when the project's assets have residual value and will be retained by the private sector; alternatively, for a given contract length, the payment per unit of time should be reduced.
In this regard, it is important to properly design the payment profile, i.e. the stream of outlays by the public-sector party: if payments are concentrated at the back-end, PPP turns into an expensive way of financing public infrastructure, with a negative effect on welfare across generations; on the other hand, if payments are concentrated at the front-end, the private partner faces weak incentives to perform in the long term.
If, instead of unitary payments, user charges constitute the payment mechanism, the length of the contract should be such that expected revenues to be collected from final users over the contract life are sufficient to recoup the invested funds.52 Therefore, designing a long-term contract is recommended for a project requiring a large volume of contractible investment. Besides, for any volume of investment, the longer the contract, the lower the service charge that allows recovering the invested funds. Hence, a long-term contract is advisable to ensure affordability of the project by both the public-sector party and the final users.
On the other hand, for a project involving non-contractible investments, the contract duration should carefully consider the assets specificity. When a non-contractible, highly specific investment that increases the project's profits is available, as it is generally the case in DBFO contracts where the quality of the facility has a significant impact on the operation and maintenance costs, it is advisable to lengthen the duration of the contract to encourage the private-sector partner to undertake it (assuming the specific investment raises the private profits as well).
By ensuring a protracted contractual relationship, a long-term contract allows the private partner to recover the funds invested in specific assets, and protects him from holdups by the other party that could arise in renewing short-term contracts. Hence, a long-term contract should be used to provide incentives to undertake non-contractible specific investment and ensure the benefits of the whole-life costing approach, although for the reasons discussed below, excessively long contracts should be avoided. There are indeed often legal constraints on the contract length. For example, the maximum length of concession in Chile is 50 years, and of a PPP contract using private finance in Italy is 30 years.
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51 Ellman (2006) warns that self-investments may raise the private partner's payoffs but in an inefficient way, e.g. resources are wasted in trying to hide low quality aspects of the services.
52 It should be noticed that, in principle, expected revenues are higher for a longer contract, but also the forecasts of demand and costs are less accurate for a long time horizon, thus increasing the project's risks.