Infrastructure Franchising and Government Guarantees

Eduardo Engel, Ronald Fischer, Alexander Galetovic

Abstract


Government guarantees for private infrastructure projects reduce the incentives of firms to perform efficiently, weaken the incentives to screen projects for white elephants, and shift government obligations to future periods. Thus the use of guarantees needs to be limited, and they need to be carefully designed.

Franchising schemes should in principle assign risks to the parties best able to manage and control them. The mechanisms by which contracts are awarded should be simple, so that possibilities for evaluator subjectivity are reduced, the award process remains as transparent as possible, and the likelihood of having to renegotiate is minimized.

Infrastructure franchises have usually been awarded on a fixed-term basis. Such contracts expose franchise holders to considerable demand risk, which investors are often unwilling to assume without government guarantees. These contracts are also inflexible, since it is difficult to determine a fair level of compensation to the franchise holder if the contract is terminated early or modified.

Under an alternative mechanism, the franchise is awarded to the firm that asks for the least present value of user fee revenue for a given tariff structure, and the franchise ends when the present value of user fee revenues is equal to the franchise holder's bid. Such contracts reduce the demand risk borne by the franchise holder (and the concomitant demand for government guarantees). They also make fair compensation of franchise holders in the event of early termination straightforward, since the level of fair compensation is equal to the revenue remaining to be collected.

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