In sectors with a rapid pace of technological change and changing user needs, the public-sector party may prefer to have flexibility to modify the contract terms adapting the service provision to the incoming innovations (HM Treasury, 2007).53 In order to adapt the service provision as required by the public sector, the private-sector party would undertake investments referred to as adaptation investment.54 The contract must then provide for the right of the public-sector party to demand changes in service provision and for the right of the private-sector party to be adequately rewarded for his adaptation investment.
In practice, requiring changes in service provision so as to adapt the service to new user needs can be very costly for the public sector as it needs to bargain with the private-sector party for the implementation and remuneration of these changes. Contract duration is then important as it affects the bargaining position of the public-sector party and thus the cost the public sector will have to pay for adaptation investment. This in turn affects the net gain for the public sector from adapting the contract to new user needs and thus the flexibility of the contract.
In particular, a long-term contract implies less flexibility because the public sector has to wait longer if it wants to switch provider. The availability of alternative providers improves the bargaining position of the public sector when requiring service adaptation from the current provider. In addition, with a long-term contract the public-sector party's threat of no renewal during the contract is less powerful because a long-term contract implies the realization of the threat would occur far in the future, and thus the present discounted value of the cost of failing to renew the contract is negligible for the incumbent. Therefore, for the public sector a long-term contract also increases the cost renegotiating efficient adaptations within the contract period.
On the contrary, when the contract is short-term, the public-sector party's threat to contract with a competitor when the current contract expires can be more powerful and induce the private-sector party to accept to make the changes for a more reasonable remuneration. Furthermore, the cost of waiting for the end of the contract to adapt service provision to new user needs is lower the shorter the contract. Once the contract expires, the public sector is indeed free to redraft a new contract with another provider under more competitive conditions. For these reasons, short-term contracts provide flexibility to the public-sector party and facilitate efficient adaptation to changes of needs.55
These observations suggest that the larger the flexibility and adaptation investment sought by the public sector, the shorter the optimal contract duration, at least for the dimension of the contract subject to demand changes (Calzolari and Spagnolo, 2006; Ellman, 2006; HM Treasury, 2007). If a shorter contract without public-sector party contributions does not ensure bankability, then public-sector party contributions might be sought. Sectors where user needs change rapidly over time should be characterized by shorter contracts. In light of the earlier discussion of the effect of contract duration on investment, it then follows that a optimal contract design may require a different contract duration for different parts of the supply, longer where non-contractible specific investment are needed, shorter or more frequently open to structured renegotiation where they are not (Albano et al. 2006a). In no case should contract duration be chosen simply on the basis of financing considerations.
The duration of the contract affects the flexibility to modify the contract terms adapting the service provision to incoming innovations in user needs and technologies. In principle, it is advisable for the public-sector party to enjoy a high degree of flexibility when the project develops in a sector characterized by a rapid pace of change in user needs and technologies. Thus, it may be confidently expected that the service initially contracted will become outdated or redundant in the future, so adaptations whose nature is yet unknown, and hence non-contractible, are likely to be needed. But it may happen that adapting the service provision at the time innovations arise is costly for both the public-sector party (who should require and negotiate changes in the contract terms), and the private-sector party (who would have to undertake adaptation investment). Under these circumstances, the bargaining power of both parties heavily depends on the contract duration.
The contract should be short-term if a high degree of flexibility is to be given to the public-sector party. Having a chance to switch provider when the contract expires, the public-sector party holds a strong bargain position and thus can induce the private partner to accept contract changes and undertake adaptation investment for a reasonable remuneration. Moreover, if no agreement is reached on the proposed changes, the public-sector party has the option to wait little time until it can redraft a new contract with another provider introducing efficient adaptations (rather than commencing a dispute resolution procedure).
| Case Study: The London Underground (UK) (Part IV) The PPP contracts awarded by the consortiums Tube Lines and Metronet to rehabilitate and upgrade the underground networks have a duration of 30 years. Periodic contract revisions were envisage every seven-and-a-half-years, so the contracts were implicitly divided in four periods. The PPP agreements included special provisions allowing LUL to require additional works from the Infracos that could not be fully contracted upon in the original contracts. The possibility of reviewing the contract every seven-and-a-half years intended to give flexibility to LUL since service requirements and the infrastructure service charge (ISC) could be modified. Also, the consortiums' performance was to be evaluated in the review periods. But this flexibility may have been costly for the project: the uncertainty about what could happen in the future periodic reviews may have increased the cost of capital for the Infracos. Sources: see London Underground (Part VII). |
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53 Hospitals and health services are typical examples of highly innovative sectors where PPPs have been implemented and where user needs evolve rapidly over time.
54 Adaptation investment is a term coined by Ellman (2006).
55 However, transaction costs are involved in short-term contract renewal, re-tendering, and switching private partners (Calzolari and Spagnolo, 2006). Given these costs, it is often difficult and sometimes inefficient for the public sector to credibly commit to replacing the current private partner (Lewis and Yildrim, 2006).