Effect of the internal agency problem on risk-sharing incentive contracts in public-private partnership projects

Through an appropriate risk-sharing arrangement between governments and private partners, public-private partnerships (PPPs) are justified because of their improved value for money (VFM). From the agency theory perspective, an agency problem may arise when private partners pursue self-interests opportunistically at the government's expense in the face of asymmetric information and conflicting interests. Transferring risk to private partners enables the government to encourage private partners to improve the performance of the project. The existing literature discussed the incentive mechanism of risk-sharing to resolve the external agency problem between the government and special purpose vehicles (SPVs) founded by private sponsors. However, the internal agency problem that occurs among private sponsors was not investigated. This study used an analytical framework based on the Nash bargaining game and principal-agent models to examine the effect of the internal agency problem on the optimality of risk-sharing between the government and SPVs. The findings indicate that the internal agency problem, which is characterized by the free-rider problem, can be mitigated through equity shareholdings negotiated by private sponsors. However, disregarding the internal agency problem leads the government to shift risk excessively or inadequately to the SPV. The results show that a government that acknowledges the internal agency problem determines the optimal risk-sharing with private partners, considering the dilution and squeezing effects brought about by privately negotiated shareholdings under different risk scenarios. This study contributes to the PPP knowledge body by introducing the internal agency problem into the incentive mechanism of risk-sharing between the government and SPVs. The findings also provide support for government to formulate risk-sharing strategies and shed light on the design of PPP incentive contracts.