PPP procurements often develop along a long time horizon, 25-30 years or more. In such long period many things can change, so that there is a need for flexibility and adaptation of the contractual relationship far greater than in a more standard type of procurement. Some of the possible changes can be anticipated, in which case they may be specified in and regulated by the initial contract (e.g. changes in capacity). Other possible changes, however, may be hard to specify in the original contract, or may be totally unexpected (e.g. new incoming technologies that change substantially users' needs).
Contracts are legally binding instruments that prescribe a course of action the contracting parties agreed upon, and that make it costly for each party to unilaterally change that course (i.e. contracts make it costly to violate the promises they contain). Contracts, therefore, have the precise objective to reduce the parties' ability to choose in the future, to 'reduce their flexibility', in order to increase the predictability of the future actions. This ensures that each party can better foresee what the other party will do, and so can act relying on that forecast rather than under a much higher uncertainty.
In particular, when a party must undertake non-contractible investments that are specific to the business relationship, a contract protects it by limiting the other party's ability to 'hold up' the investing party asking for new terms of trade after the first party has committed its investment and is 'locked in' with the contractual relationship.
Moreover, the benefits of competition between potential sellers/suppliers at the selection stage can only accrue to a buyer when the object of the competition - be it a good or a service - is well defined and cannot be easily modified after the competitive process is over. In procurement, in particular, a contractual definition of the procured good or service that is as clear and complete as possible, along with a strong and credible commitment not to change that definition after the contract is awarded unless extreme unexpected events occur, are essential requirements for a competitive bidding process to be effective in selecting the best supplier and offer at the efficient terms of trade (i.e., the so called 'sanctity of the bid' is crucial to the whole procurement).
Besides the benefits of generating certainty, fostering investments, and allowing for effective competition, the rigidity generated by contracts also brings about the costs resulting from reducing the parties' ability to adapt to novel circumstances that could not be envisaged at the contract drafting stage.
The costs of reduced flexibility are larger the less the contract itself is adaptable to changes in the environment, that is, the fewer possible contingencies have been anticipated, described and regulated by the initial contract; and the more the environment and the parties' objectives may change in an unanticipated way along the contract life. An important trade off between the benefits from contractual protection and the predictability and costs of contractual rigidity is therefore present in any long-term transaction and is inevitable.
The larger the investment required from the parties, the larger the benefits from contract rigidity relative to the cost of lost flexibility. As will be discussed in section 6 on contract duration, the longer the duration of a contract and the large the scope for unforecastable changes in the environment and the objectives of the parties, the larger the cost of lost flexibility relative to the benefits from enhanced predictability.
In PPPs, in particular, the large investment at the core of the project is the source of gains from contractual completeness and rigidity, while the long horizon for the service provision is at the root of the need for enhanced flexibility.
This trade off can be softened by increasing the initial investment in forecasting future contingencies (e.g. possible changes in knowledge or technology) and in describing and regulating them in the contract. That is, the flexibility/predictability trade off can be attenuated by incurring in the cost of increasing built-in flexibility/adaptability of the contract. An example of this are the built-in adjustment mechanisms for tariffs and other payments, like the indexation clauses linking payments to price or cost indexes.
There are limits, however, to what a costly investment in a more complex, complete, and adaptable contract design can do to enhance flexibility, because the kind of built-in flexibility obtained by enriching a contract can only adapt to changes in the environment that are verifiable by a third party like a court.
In particular, when the need for flexibility derives from changes in the contracting parties objectives/preferences, that are hard and sometimes impossible to verify by a court, then there is little more that a contract can do than allocating all authority to one of the parties (i.e. the right to decide what to do) and prescribing limits to what can be required to the other party and to cost-based compensation.
Of course, when substantial changes occur that make the original plan technologically or economically inappropriate, any contractual agreement can be modified by the mutual consent of the parties. Contract renegotiation is a (set of) change(s) in the original contract terms that is agreed upon by both parties and formalized by legally binding changes in the contract terms, and is an element that can always increase flexibility if the parties agree it is needed.65
However, contract renegotiation typically occurs in a very different situation than the original contract drafting and awarding did, in particular in a bilateral 'lock-in' rather than in a multilateral competitive situation. Because of this, contract renegotiation, as well as any analogous form of contractual change (modification or simply enrichment) taking place after the contract is signed, are subject to the risk of abuse either from the private partner (thanks to its now strong bargaining position) or from both contracting parties when one of them is a public entity managing third party money (see the section below).
Moreover, potential private partners' expectation or even hope to abuse renegotiation tends to distort the functioning of the competitive selection process, thereby implying high costs in terms of wrong selection of supplier, projects, and terms of trade. Therefore, as we will argue, contracts need to be carefully drafted to prevent renegotiation and analogous contractual changes as far as feasible. In addition, when flexibility in terms of contractual changes is absolutely necessary, contracts need to be carefully drafted to prevent abuses through such contract changes, and more importantly, to prevent the expectation or hope of such abuses from potential private partners.
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65 Renegotiation may also include additional (complementary) contracting which completes and integrates the original contract.