D’Alpaos C., Moretto M. (2013).

Optimal penalty in concession contracts: a dynamic perspective. Proceedings of the 1st Annual International Conference on Architecture and Civil Engineering, pp. 443-449.

Abstract:

Concession contracts are agreements granting the right to construct public works, operate and provide a service/good. The main advantage of a these contracts is that they pass full responsibility for investment and operations to a private provider and consequently provide incentives for efficiency. Although most contracts include penalties to avoid delays, evidence from ongoing contracts shows that delays are widespread. In executing a contract, i.e. in making an irreversible investment, concessionaires may find it optimal to delay the performance of the works in the hope of gaining higher payoffs in the future. This investment timing flexibility increases the contract value and should be taken into account when determining the penalty. In this paper we investigate how penalty rules should be designed in order to avoid delays. Following the real option approach we show that the optimal penalty is higher than the penalty set according to the NPV rule. The higher the uncertainty over future payoffs, and the higher the investment costs, the higher the concessionaire’s option value to delay and consequently the higher the optimal penalty to be set.