Valuing governmental support in infrastructure projects as real options using Monte Carlo simulation

In Build-Operate-Transfer (BOT) infrastructure projects, host governments often provide subsidies, guarantees or alternative forms of support as incentives to attract private sector participation. A guaranteed level of minimum revenue, for example, can be specially designed to alleviate the concern of demand risk. Although researchers have generally acknowledged the significance of subsidies and guarantees leading toward successful negotiation, there is a lack of attempt to evaluate these concessions quantitatively. Without a deeper understanding of the value of these concessions, risk and reward may not be equitably matched in the proposed terms and arrangements. In this paper, relevant elements of a contractual package are treated as a form of real options. A proposition is put forward to incorporate the value of such options into the negotiation framework. By relying on simplifying assumptions on risk preferences, these options can be evaluated using Monte Carlo simulation of a discounted cash flow (DCF) model. The methodology is applied to the case of the Malaysia-Singapore Second Crossing, which shows that the value of a guarantee can indeed be significant relative to the basic net present value. The case study also highlights other aspects of flexibility in the design and execution of a project.