The use of options in a model of public private partnership : incorporating flexibility into the contract design process

Miller, Thomas Robert John. (2006). The use of options in a model of public private partnership : incorporating flexibility into the contract design process Honours Thesis, School of Economics, The University of Queensland.

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Author Miller, Thomas Robert John.
Thesis Title The use of options in a model of public private partnership : incorporating flexibility into the contract design process
School, Centre or Institute School of Economics
Institution The University of Queensland
Publication date 2006
Thesis type Honours Thesis
Total pages 109
Language eng
Subjects 14 Economics
Formatted abstract
Reliance on the private sector for the procurement of social infrastructure through PPPs and related mechanisms has become increasingly popular. Although originally motivated by the desire to reduce measured levels of public debt, more recent literature has focused on the notion of an improved allocation of risk between the public and private sectors. It has been argued that despite these claims, many of the risks allocated to the parties involved have been poorly specified, and in some cases, have led to the breakdown of contracts. In respect to PPP arrangements, this misallocation is nowhere more prevalent than with toll road infrastructure projects.

One of the central problems is that of demand risk associated with inaccurate forecasts of traffic flows. Quiggin (2005) suggests that through the use of put and call option contracts, the risk associated with the imprecise ability to predict future revenue streams can be bounded, while still capturing the benefits of the contract tendering process. This thesis has provided a detailed analysis of this suggestion.

The first attempt to estimate the appropriate value for these options was derived through the use of the Black-Scholes option pricing model. Although relatively simple to calculate, this method relies on assumptions that may not be valid in more complex 'real world' situations. These problems were addressed by incorporating tools derived from the real option literature into the valuation of options. By including the flexibility of multiple exercise opportunities this approach allowed more accurate estimations of option values. While both methods showed that the inclusion of options offset the effect of demand risk on the contract design process, the models used different representations of the risk inherent in the project. The Black-Scholes model used the degree of traffic variability to derive its estimation of the insurance premium. The real option approach based its estimation on the same principle of variability - but allowed for a discrete initial error at the beginning of the project's life.

The key result is that flexibility has value. When calculating the appropriate premium for risk management purposes, it is important to ensure this value is included. It is in the best interest of both parties to choose appropriate strike prices for the options.

The inclusion of put and call options into the contract design process has produced a few key implications. The first, is that it is possible to entice the private sector out of the current PPP arrangement. The corresponding payoff diagrams suggest why this is the case. More importantly, the model can now ensure less provision of superficial infrastructure. The increased cost of entering this arrangement would require governments look closer at the profitability of each individual project, thereby ensuring an adequate use of public sector funds.

Document type: Thesis
Collection: UQ Theses (non-RHD) - UQ staff and students only
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Created: Wed, 01 Dec 2010, 18:51:39 EST by Ning Jing on behalf of The University of Queensland Library