From fixed to state-dependent duration in public-private partnerships

A government delegates a build-operate-transfer project to a private firm. At the contracting stage, the operating cost is unknown. The firm can increase the likelihood of facing a low cost (the good state), rather than a high cost (the bad state), by exerting costly effort when building the infrastructure. Once this is in place, the firm learns the true cost and begins to operate. If some partner reneges on the contract thereafter, the court of justice has a limited ability to enforce penalties. Break-up of the partnership occasions a replacement cost for the government that is higher the earlier the contract is terminated. We show that the contract is self-enforcing, entailing no distortions away from effciency, only if the firm is instructed to invest both own and borrowed funds in the project, and the duration of the contract is set longer in the good state than in the bad state. The firm's investment should not be massive. The debt payment to the lender, which ultimately lies on the government, should be conditioned on the firm not defaulting on the project. The result that the contract should have a longer duration in the good state is at odds with the prescription of the literature on "flexible-term" contracts, which recommends a longer duration when the operating conditions are unfavourable.