Whilst in the previous section we have highlighted the 'Pareto efficient' side of renegotiation, it is important to note that renegotiations can have negative consequences on ex ante efficiency because, when the private-sector party anticipates future contract revisions, it faces distorted incentives and misbehaves in the tendering process. This line of reasoning is akin to the soft budget constraint problem (Kornai, 1986; Rajan, 1992; Dewatripont and Maskin, 1995), which may also lead to inefficient project being financed.
The literature on soft budget constraint (SBC) helps in identifying negative effects of recurrent, and thus expected, contract renegotiations on the private partner's incentives and risk exposure. The original formulation of the SBC problem by Kornai (1979, 1980, 1986) was developed to explain the survival of persistent money-losing state-owned enterprises in socialist and transition economies. The interpretation of SBC as a dynamic commitment problem, due to Dewatripont and Maskin (1995), asserts that entrepreneurial incentives are distorted by the managers' belief that the public sector will bail out firms in the future if they fail or underperform. This belief is supported by an objective fact: it is often in the interest of the public sector to rescue firms to avoid the social costs of investment project termination. Ex ante, the public sector should commit not to bail out firms in order to get entrepreneurial incentives right and to discourage entrepreneurs from undertaking bad investment projects. However, such a commitment is not credible because ex post the public sector will do better by bailing out all bad projects already undertaken. Thus soft budget constraint may lead to more bad projects being financed.
The SBC problem provides an insight to account for the pattern of PPP renegotiations in LAC countries. According to the empirical evidence reported below, concession revisions changed essential contract terms and tended to benefit the private partners by reducing or rescheduling investment requirements, increasing tariffs, granting subsidies or tax exemptions, lengthening the contract duration, etc. Ex ante, private partners expecting future renegotiations to favor them face weak incentives to perform, to reduce costs, to improve quality of service, and to innovate.
In addition, they enjoy a de facto low exposure to risks leading to financial disequilibrium. For these reasons, ex ante a benevolent public sector wishes to commit itself not to change the original contract terms in the future, at least not in a way that simply benefits the concessionaire and do not address Pareto-improving issues resulting from contract incompleteness. But the public sector's threat of no-renegotiation may be empty to the extent that, ex post, the public sector prefers to rescue the firm and avoid contract disruptions. Under these circumstances, the private partners' expectative on future contract revisions is strong, and thus incentive distortions and risk misallocation arise at the outset. Furthermore, renegotiation brings about a cost in terms of commitment loss: if abused in the past, the public sector's reputation may be ruined, and this can reduce the incentive power of future contracts and distort competition in future tenders.
There are a number of reasons why ex post the public sector may prefer to support a concessionaire calling for a contract revision. For instance, if an unfavorable event occurs and the private-sector party undergoes financial stress, it could threaten to abandon the concession unless the public sector accepts to change the original contract terms.67 The concessionaire's threat is effective when it has an informational advantage in the operation of infrastructure and the provision of service that renders it difficult to substitute, or when its sunk costs and specific investment are not large, so its losses are not heavy if it leaves the concession.
On the other hand, the public sector's bargaining position is weak when arranging a re-tendering to select a new private operator involves time and large transaction costs, even more when the market structure is not competitive and few operators are ready to take over the concession (Kerf, 1998). Thus, a public sector refusing to renegotiate takes the risk of suffering disruptions in the service provision when the private-sector party abandons the concession. Therefore, the public-sector party is likely to accept the private partner's demands regarding changes in the contract.68
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67 There are cases in which the public-sector party refused to renegotiate the contract terms precisely because the bidding behavior of the private partner seemed to be strategically aggressive. For instance, in a tender to provide water services in Buenos Aires, a key variable was the lump-sum fee due to the provincial public sector. The winner offered to pay a fee 18 times larger than the strongest competitor's, but soon after awarding the concession it sought to renegotiate the contract terms. Cross accusations of non-compliance led the public sector to refuse revising the original contract terms. Then, the private partner abandoned the concession and the public authorities reassumed responsibility for providing water services (Guasch, 2004). Another case is the electricity distribution privatization in Peru. The public authority sold 30 % of the state-owned enterprises' assets to the private sector, planning to divestiture the remaining assets in subsequent phases. The winning bid exceeded the other competing offers by such a large amount that some analysts estimated that current tariffs would be insufficient for the private-sector party to recover its initial investment. After winning the privatization, the private partner requested both a tariff increase and a valuation of her assets based on the large amount she had paid in the privatization. Since regulators refused to change the established valuation criteria, the firm refused to purchase an additional 30 % of shares and sued the public sector for breach of contract. Subsequently, the public sector regained control of the distribution companies (Guasch, 2004).
68 Outright political affiliation between the public sector and the concessionaire also explains the willingness of the former to favor the latter in a contract revision. In fact, contract revisions were observed in sectors like highways where the private-sector party did not have an advantage in terms of know-how, and thus could have been replaced at no significant costs for the public sector, i.e. there was no information-related hold up problem (Engel et al., 2006).