Bundling and Alliancing

The concept of bundling management and ownership into a single contract may prevent non-verifiable outcomes and reduce moral hazard, but it can also have negative consequences by delivering services that do not meet social welfare objectives. Under moral hazard, there is a trade-off between providing incentives to the builder to improve the quality of infrastructure and giving him insurance against adverse shocks on the realized quality. This decrease quality of assets may excessively increase operating costs and this exerts a negative externality on the operator if building and managing assets are unbundled. So the design of the contract has powerful consequences on efficiency through incentives because the contract also determines the degree in which risks are allocated between public and private parties. But in complex environments it is difficult to make complete contracts that can anticipate all endogenous and exogenous shocks, and that distribute risks evenly. Complete contracts cannot anticipate quality attributes of infrastructure interventions, and thus ownership can provide the incentives to improve quality.

Bundling contracts may be taken carefully when designing them since the may indeed provide efficiency gains, but such gains may be offset by influence costs and other intrinsic costs. In fact, bundled or unbundled contracts could be optimal depending on the type of externality between tasks and industry attributes. Inefficiencies in assets quality-enhancing and cost-reducing tasks stem from the hold-up problem that arises when no contract can be written and only ex-post negotiation between the government and the private party is feasible.

Holmstron and Milgrom (1991) showed that incentives in one task may destroy incentive in another when tasks are substitutes in agent's cost function. In many infrastructure concessions many tasks tend to be substitutes, which then put pressure on costs. Martimot and Pouyet (2008) found that higher quality induces positive externalities when building infrastructure projects and thus reduces operating costs to the agent. This happens when, for instance, roads are build with design standards makes it easy to reduce accidents and enhance safety. In the case of negative externalities, novel infrastructure design calls for innovating in most operating tasks, giving up routines and learning to new processes. For example, airports that have designs that facilitate passengers to access terminals and other services may nevertheless be accompanied by increased costs in providing such services. Therefore, trade-offs in externalities deal with risk-averse agents and thus require the adequate incentives to exert effort on agent's tasks in order to reduce the risk he bears for insurance purposes.

When positive externalities are lower than costs, bundling concessions may be an adequate option for delivering certain infrastructure services. This is when consortiums are created to align risk profiles into a one-risk entity. Merging two agents may be better to share risk because benefits are a coordinated choice which may dissipate agency problems. This is true only when riskiness is different for both agents. When agents have identical risk-averse firms, efforts are mutually observable and benefits perfectly distributed. The presence of production externality between building and operating assets raises the issue of optimal organization of such tasks. Bundling allows to better internalize externalities and improves incentives when the externalities are positive. When externality is negative, unbundling in different agents reduces agency costs and is socially preferable. Bundling or unbundling becomes then a crucial issue when designing a contract.

Regardless of the short-term political motives, the value for the public sponsor of a PPP lies on the cost and the quality of service, with cost and quality depending on the financing, bundling, and operation of the project There are clear links between financing, building, and operating infrastructure concessions, but inefficiencies may arise unless the party responsible for building is induced to internalize possible externalities on the operating phase. The potential costs of these inefficiencies can be large if, for instance, poor construction raises the risk of a bridge collapsing during a storm. As recent work has shown the builder has an incentive to internalize externalities if he also has the right to operate and maintain infrastructure.

In choosing between bundling or unbundling of soft (organization, costumer service) and hard (works, maintenance) services, there is a trade off to consider. Bundling soft and hard facility-management services in the contract has the advantage that, being responsible for providing both soft and hard services, the private sector party cannot argue availability failures are not its fault but an otherwise independent soft service provider's. On the other hand, there are benefits for the public-sector party in unbundling soft and hard services, and thus in dealing with separate soft-service providers. These benefits arise, for example, because soft-services provision generally requires less capital investment (if any) than hard-services provision. A decision to unbundle services is to be made considering not only the above trade off, but also other sector- and country-specific factors.

Risk Classifications

Source: Adapted from Iossa, Spagnollo and Vellez (2007)

Novel mechanisms can provide governance and managerial incentives to increase the value of infrastructure concessions under complex regulatory contexts. Alliance contracting of PPP/PFI can result in improved long-term service outcomes through enhanced governance structures and management, which in turn lead to greater value for money over the long-run. Alliance contracting is referred as an agreement between parties to work cooperatively to achieve agreed outcomes on the basis of sharing risks and rewards (Clifton and Duffield, 2006). There are certain features that differentiate alliances from conventional partnerships regarding risk allocation structures:

a)  Instead of a conventional requirement for the owner to reimburse project costs (which inherently always rest with one party) performance obligations are stated to be collective. In that way, the regulations are determined in order to maximize efficiency in operation because excessive regulations can enhance costs. In addition, social costs are internalized more efficiently since performance obligations depend on common objectives.

b)  All parties win and loose together. Reimbursement to the non-owner participants (NOPs) is 100% open book and structured so that NOPs receive an equitable sharing of gain and loss depending on how actual outcomes compare to pre-agreed targets in cost and non-cost performance areas.

c)  Alliances provide better legal ground to reduce probabilities of litigation which can be costly and can undermine projects' efficiency. The strong commitment of shared interest reduces friction between the parties and induces more cooperation to take corrective decisions.