Contract theory predicts that as long as the contract is complete, i.e. it specifies all possible contingencies and includes a full description of the renegotiation process, the contract will never actually need to be renegotiated (it is renegotiation-proof). This result does not depend on the ability of both parties to commit not to renegotiate the contract in the future, but in reality it is hard to imagine a complete contract, particularly for complex and long-lasting business relations. Renegotiation, therefore, cannot be excluded. When it is not abused, renegotiation is efficiency-enhancing an typically arises because the contract is incomplete to some extent, as not all possible future contingencies can be forecasted and regulated by the contract at reasonable cost.
The literature offers a number of reasons why contracts are incomplete and they cannot specify all possible contingencies. First, some circumstances that may affect the contract terms are not predictable ex ante, so unforeseen events cannot be incorporated in the initial contract. Second, there may be some non-contractible contingencies, either because they depend on non-observable variables, such as effort exerted by the private-sector party, or because they are non-verifiable by third parties and thus cannot be enforced in court. Third, it may be too costly to write down clauses accounting for all possible events affecting the contractual relation, so the parties must decide which contingencies to include and which not, in order to save transaction costs. Fourth, economic agents may display bounded rationality, being unable to identify and order all the contingencies that are truly relevant for the contractual relation. In this regard, agents may learn along the contract period and rely on renegotiation or additional side-contracting to correct past decisions that turned out to be wrong or to complete aspects that were left unregulated.
In a context of incomplete contracts, and looking at it ex post, renegotiation is a 'Pareto-improving' mechanism to redress inefficiencies caused by incompleteness or mistakes. To be specific, renegotiation provides the parties with the opportunity to adequate the original contract terms when unforeseen events occur, agents learn more on project design, new information becomes available, etc.66 Thus, the higher the degree of contract incompleteness, the more likely renegotiations or additional side (complementary) contracting will occur.
Contract renegotiations are also affected by the interactions between project complexity, contract incompleteness, and features of the payment mechanisms. In this regard, Bajari and Tadelis (2001, 2006) argue that, in an optimal contract design, there is a trade off between the costs of ex post renegotiation of contracts with different payment mechanisms, and the ex ante incentives provided by these mechanisms. According to the authors, contract design costs are increasing both in the desired degree of completeness and in the complexity of the project to be implemented.
Consider two possible payment mechanisms for any given contract: a fixed-price and a cost-plus payment scheme. It has been discussed in section 4 that the fixed-price mechanism is a high-powered incentive scheme, but it makes renegotiations more costly: for the public-sector party, locked-in by the well specified contractual obligations of fixed-price contracts; and in general, because asymmetric information and haggling over prices cause efficiency losses. In contrast, the cost-plus mechanism is a low-powered incentive scheme, pushing less towards cost-efficiency but facilitating contract revisions because the public-sector party reimburses any cost increase resulting from changes in the contract terms. Hence, when choosing the contract design, the public-sector party faces a trade-off between providing incentives to reduce costs (in fixed-price) and facilitating efficient contract revisions and information sharing (in cost-plus).
In this context, the authors characterize the optimal contract design. A fixed-price payment is optimal for a project of low complexity that has a design with low degree of incompleteness, and where renegotiation is less likely. In other words, when the project is not too complex and/or uncertain, it is better not to save on design costs and write a more complete contract; as a consequence, renegotiation is less likely, allowing to take advantage of the fixed-price mechanism in terms of incentives.
On the other hand, a cost-plus payment is optimal for a project of high complexity and subject to high uncertainty that has a design with high degree of incompleteness, and where renegotiation is more likely. In other words, when the project is highly complex, it may be better to save on design costs and write a less complete contract; as a consequence, renegotiation is more likely, but the cost-plus mechanism ensures it won't be too costly.
Despite the benefits of contract renegotiation in terms of improving the original contract terms ex post to cope with unforeseen events or to introduce learning, there are many undesirable outcomes that typically arise when revisions take place or are expected in a context of imperfect enforcement and opportunistic behavior by the contracting parties, including rent-shifting activities, politically-motivated investments and corruption. All these negative effects, even if only anticipated, tend then to distort bidding behavior during the private partner selection phase and thereby to generate an inefficient selection of private partners and terms of trade (overly aggressive bids).
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66 Despite the fact that revisions due to unforeseen events allow for improving the contract terms, the negotiations may fail to accomplish this aim, and end up terminating the contractual relation. For instance, in a tender to manage a motorway in Hungary, a key variable in the award criteria was the tariff level required by the private partner. Thus, the DBFO contract was expected to allocate the traffic risk to the private-sector party. However, the award criteria induced excessively optimistic forecasts on traffic volume, and the private partner's revenues happened to be half of what had been estimated. This led to litigation on tolls, suspension of investment and loan disbursements, and a default on the private-sector party debt. Both the concession and debt obligations were taken over by the public sector (European Commission, 2004).