Opportunism Focused Transaction Cost Analysis of Public-Private Partnership's Suitability Evaluation and Contract Modification Rules

While the higher efficiency due to better pooling of resources is greatly emphasized in public-private partnerships (PPPs) for infrastructure projects, the embedded transaction inefficiencies are often understated or even ignored. As a result, PPPs can be misused for unsuitable projects, and failure of the projects may thus be expected. Through the lens of transaction cost economics (TCE), this study aims to answer why and when PPPs may become a costly project governance structure. Furthermore, this research studies issues on the project demand risk. It analyzes various contract modification principles applied during the stage of contract performance, and identifies the legal rules under which the transaction costs arising out of demand risk may be efficiently minimized. Specifically, this study develops a TCE-based theory of PPPs as a governance structure. This theory suggests that three major opportunism problems embedded in infrastructure PPPs are possible to cause substantial transaction costs and render PPPs a costly governance structure. The three main opportunism problems are principal-principal problem, firm’s hold-up problem, and government-led hold-up problem. In addition, project and institutional characteristics that may lead to opportunism problems are identified. Based on these characteristics, an opportunism-focused transaction cost analysis (OTCA) of PPPs as a governance structure is proposed to supplement the current practice of PPP feasibility analysis. Furthermore, from the perspective of ex post management the demand risk can be one of the critical elements of PPP project success. If the actual demand during the project operation comes out to be less than the initial prediction, the resulting shortfalls in operating revenues may cause private promoters to request high risk premiums for future investment in PPP projects. On the other side, if the actual demand comes out to be higher than the initial prediction, excess profits that the concession company may earn from the project can impose political costs on the government. This study analyzes the applicable contract modification principles addressing the related problems of demand risk, and identifies the legal rules that may efficiently minimize the total transaction costs. In addition, as a part of theory development, this study uses case analysis to evaluate the proposed theory and to illustrate how the proposed OTCA can be applied in practice. Policies and administration strategies for infrastructure PPPs are derived based on the proposed theory.