Contract duration has implications on how market forces encourage efficiency and innovation. Economies of scale and scope leading to cost-efficiency are better exploited under a long-term contract when quantity follows duration. Also, long-term contracts reduce the frequency of interaction among competitors and may thereby hinder the formation of anticompetitive bidding agreements, fostering competition and efficiency (Calzolari and Spagnolo, 2006; Albano et al., 2006b).
On the other hand, in the absence of bidding rings a long-term contract reduces exposure of the incumbent to competition and market discipline. Then, incentives to increase efficiency result from the more competitive environment associated with short-term contract. If collusive agreements can be effectively prevented (something hard to achieve in the large concentrated markets where PPP are undertaken), frequent contract renewal and re-tendering impose market discipline on the incumbent and allow more efficient innovators or entrants to replace earlier a less efficient incumbent (Calzolari and Spagnolo, 2006). If shorter contracts induce a higher turnover among suppliers, they allow more experimentation and reduce the risk that an incumbent reaches too early a monopoly (lock-in) position, either taking all the market and causing the exit of competitors;56 or, thanks to the vantage accumulated through 'learning by doing' (Lewis and Yildrim, 2006; European Commission, 2003).57 A drawback against which this advantage must be weighted is that with short term contract and higher turnover there will be then less learning by doing in the short run, with consequent higher costs and lower quality (Lewis and Yildrim, 2006).
We mentioned that, to the extent that the private-sector party fears to be replaced in the next re-tendering before it recoups invested funds (because investments were specific and non-contractible), the private-sector party will have less incentive ex ante to undertake these investments. One proposed solution is to allow a compensation scheme where the winning competitor pays compensation to the incumbent (Guasch, 2004). When investment is not contractible, this compensation can be set as a proportion of the winning bid as this bid conveys information on the value of the underlying assets and thus on the investment made by the incumbent (Iossa and Legros, 2004). This allows the incumbent to receive remuneration for its investments.
This mechanism, however, implies a 'dangerous relationship' between incumbent and competitors. When the investment is directly contractible, it is preferable for the original contract to appropriately reward the investment without any linkage to the duration of the contract or it can provide for the public sector to act as intermediary.
In theory, a periodic re-tendering could enhance competition and induce the private operator to invest and improve efficiency while running the concession. The extent of this effect depends however on the number of potential competitors, given the size of the bundled PPP.
If the contract duration is to be managed as a means to foster competition and market discipline, it is important to consider the possibility of collusive agreements in a bidding ring, the transaction costs associated with a re-tendering, and the sources of static/dynamic efficiency gains.
For a sector having a largely concentrated market, where it is difficult to prevent the formation of anticompetitive bidding agreements, a long-term contract is advisable to reduce the frequency of interaction among competitors and thus the likelihood of such agreements. Besides, by lengthening the contract, the private partner is given an opportunity to increase the quantity supplied and to exploit possible economies of scale and scope. However, since a long-term contract protects the incumbent from being replaced until it expires, incentive devises should be carefully designed to discipline the private-sector party as if it were operating in a competitive environment. A possible device is an instance of re-tendering before the long-term contract expires.
On the other hand, if collusive agreements in a bidding ring can be effectively prevented and the transaction costs for switching providers are small, it is recommended to use a short-term contract that allows for frequent re-tendering and thus exposes the incumbent to competition and market discipline. In sectors with significant dynamic efficiency gains, using shorter contracts also encourages experimentation and innovation because a (potential) turnover among competitors enables a more efficient innovator to replace a less efficient incumbent. Nevertheless, cost reductions and quality improvements that result from 'learning by doing' may be lost if the incumbent is replaced too early, so contracts should not be too short.
Contract renewal is an in-kind reward for the current incumbent that encourages it to comply with the contract terms and to undertake non-contractible investments and quality-improving actions. Using contract renewal as a performance incentive requires the contract to be short-term so that the frequency of renewal increases. Moreover, a short-term contract provides the public-sector party with an outright exit option if the private partner performs poorly. The exit option could be valuable when it is costly to specify and enforce clauses for early contract termination aiming at penalizing the private sector for a systematic bad performance.
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56 The case of Valencia water concession illustrates this point. In a 1902 tender to provide water services in Valencia (Spain), the consortium Aguas de Valencia awarded a 99-year operation contract. In 1990, the local public sector began to draw up tender documents. Then, the consortium announced it would demand compensation for past investments should it not win the re-tendering. Since the compensation would have been substantial, there was not a single competing bid in the re-tendering process. Thus, the incumbent was granted a 50-year extension for the concession, and the city will have had 150 years of a water monopoly (Lobina and Hall, 2003).
57 To avoid this in some cases long-term concession contracts introduce an instance of re-tendering before the contracts expire. For example, in the Argentine power sector, concession were signed for 95 years entitling the public-sector party to re-tender facilities 15 and 25 years after the first tendering process (Guasch, 2004).