Finding a way to ensure that the contract is enforced even in environments in which the partners are unable to commit is an intriguing challenge. The appropriate recipe depends on the particular context and issues to which it is tailored.
With regard to ex-ante contracting and information issues on the firm's side, Danau and Vinella (2014) suggest a strategy to tackle enforcement problems that rests on a proper choice of the PPP project's financial structure.
First, to induce the firm to honor the contract, it must (1) be required to invest a sufficiently significant amount of money upfront, and (2) be allowed to recover that investment during the implementation period. As the firm is aware that breaking up the partnership would impede recovery of its initial investment, it will have an incentive to preserve the relationship with the government. Indeed, this means that the private partner must be able to provide as large a contribution as necessary to motivate it to honor the contract. The bottom line is that private firms must be well end owed to be allowed to participate in the partnerships. This should deter the speculative and likely volatile investors.
Second, the firm's own investment should be complemented with the injection of some external/debt capital, regardless of whether this is truly necessary to complete the investment. In other words, even a wealthy firm that could finance the investment entirely should be instructed to take a loan. This may look counterintuitive, but debt finance can play a strategic role. Danau and Vinella (2014) show how a beneficial outcome can be attained by such a step. Specifically, the government should provide guarantees for the firm's debt. It should be stipulated, in addition, that the guarantees will operate conditionally on the partnership continuing under either the initial contract or a new deal. However, the guarantees are not necessarily of equal magnitude in the two cases. The guarantees provided for the hypothetical new deal should be sufficiently large to eliminate any benefit that the firm and/or government could obtain by renegotiating. As a result, renegotiation would not be in the partners' interests. Accordingly, breakup of the partnership would represent the only real alternative to honoring the contract. As far as the firm is concerned, we know that this option is not appealing-provided that the firm is required to put sufficient money on the table at the outset of the project. Thus, the only remaining concern is to find a way to make the option equally unattractive for the government.
As Danau and Vinella (2014) show, the government may be tempted to terminate the partnership when the private investment is large and hence there is much to appropriate if the relationship breaks up. The gain would include not only the firm's investment but also the external capital, which is not covered by governmental guarantees when the PPP is prematurely terminated. Indeed, the government trades this expropriation gain against any cost that interrupting the partnership would generate.
A cost would arise for the government in the form of a loss of reputation and/or credibility. Reasonably enough, this may follow from the government not being sufficiently authoritative to have the contract honored by the private firm, despite the fact that the latter invested in the project upfront (Guasch, Laffont and Straub 2006). It may also follow from the government's inability to keep its own promises to the private financiers involved in the project and other potential investors, customers, and voters (Irwin 2007). Clearly, the gain must be made small relative to the costs associated with the partnership's failure to incentivize the government to honor the contract.
This leads to the third ingredient of the Danau-Vinella recipe: private liabilities should be contained to a sufficiently small size. In addition to requiring that the firm should not invest too much in the project, regardless of its wealth, this requires that the firm should not rely massively on debt, even if it has unlimited access to the credit market. In other words, PPP projects that are likely to be efficiently run should not be excessively leveraged.
In sum, the project's financial structure, and, in particular, the exact mix of private and public funds (i.e., own funds of the firm, funds provided by external sponsors and, possibly, governmental transfers) to be used to cover the investment becomes the instrument for boosting commitment to contractual obligations and promoting contract enforcement.