The real option value of renegotiation in public-private partnerships

Public-private partnerships (PPP) are contracts with a long-lasting period, huge relationship-specific investment, and great uncertainties. In many PPP projects, it is difficult or even impossible to write a complete contract that specifies all contingencies, so a renegotiation-allowed contract could be better than a renegotiation-proof one. Under a renegotiation-allowed PPP agreement, renegotiations can significantly influence the interests of both the private party and the government, so they have to evaluate the benefit and cost of renegotiations ex ante and consider them in the tender price. This study considers renegotiations as real options that are embodied to provide flexibilities for PPP contracts, and develops a model to capture the value of renegotiation based on real option theory. The model is proposed in three steps, including modeling underlying risk, bargaining renegotiation payoffs, and determining real option value. An illustration case is presented to demonstrate the applicability of the model. The case study shows that if a renegotiation-allowed contract is used, then (1) contractor-led renegotiation is very likely to occur, especially at the early stage of concession while government-led renegotiation is less likely to occur, and if any, it should occur at the middle stage of concession; (2) one party could use opportunistic renegotiation to hold the other party up and ask for excessive compensation, so renegotiations must be regulated; and (3) renegotiation in a PPP project may have a huge real option value, and the higher the uncertainty, the higher the renegotiation value.