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Politics, proceduralisation and infrastructure finance

April 2019  |  SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2019 Issue


Political risks have received raw treatment in infrastructure project finance. Generally, political risks are reduced to tail events (i.e., low probability/high impact events, like civil unrest and expropriation), or secluded to residual explanations (i.e., hazards not modelled in a formal fashion). In this article, we look at how politics affects ‘proceduralisation’ (i.e., ‘red tape’) in infrastructure provision.

Building and financing infrastructure can be described as a bundle of formal agreements between public-sector contractees (i.e., politicians and public managers) and private-sector contractors. Third parties are the players tacitly involved in the contractual relationship – e.g., watchdogs, advocacy groups, competitors to the contractor, and political opponents to the incumbent politicians and public managers – who may challenge, either through the media or in a court, the legitimacy of the transaction.

The extant view is that third parties are desirable instruments of oversight, which utilise procedural mechanisms (i.e., ‘fire alarms’) designed to hold politicians and public managers accountable. Less obvious are the pernicious effects of ‘opportunistic third parties’ (a phenomenon first described by Pablo Spiller in a seminal NBER paper in 2008) who increase the political risks of the incumbent politician. In anticipation of opportunistic third parties, politicians increase contractual proceduralisation to avoid challenges of misuse of public monies, while externalising the increased contractual costs to the public at large.

Second-best choices

Consider the following cases where political risks may propel public managers into second-best economic solutions: (i) privatisation and public-private partnerships; (ii) external consultants and certification of contractors; and (iii) fixed-price versus cost-plus contracts.

Privatisation and public-private partnerships. Privatisations of government-owned companies are typically subject to clauses of commitment by the private-sector investor concerning labour retention, modernisation and other politically-sensitive issues that impose contracting and adaptation costs. On the one hand, politicians deploy rigid privatisation clauses to minimise challenges from labour unions, the local community and the political opposition. On the other hand, such privatisation clauses curb the company’s governance and consequently lower its value. The corollary is that in politically contestable markets, privatisations appear either too costly politically from the politician’s standpoint or too restrictive from a private investor’s perspective. Thus, privatisations and public-private partnerships are less likely to occur in politically contested markets.

External consultants and certification of contractors. Engaging external consultants (including multilateral development banks, particularly in countries with weak legal systems) strengthens the objectivity of procurement processes and prevents third-party challenges. Using external consultants, however, comes at a financial cost. Similarly, many public bids require the certification of contractors, which increases contract proceduralisation and the price of the bid. With external consultants and the certification of contractors, the implicit aim is to decrease the likelihood of opportunistic challenges. In other words, there is a trade-off for the incumbent politician between lower political hazards and the additional contracting costs of external consultants and certification. Therefore, politicians will over-employ external consultants and require additional certifications when these provisions decrease political risks compared to the additional contracting costs.

Fixed-price versus cost-plus contracts. In theory, fixed-price contracts are preferable when the adverse selection problem decreases relative to the moral hazard problem (e.g., in the procurement of standardised goods and services or in projects involving a low level of informational asymmetry between the contracting parties), whereas cost-plus contracts are preferable in complex projects when the adverse selection problem increases relative to the moral hazard problem (that is, when uncertainties related to technological requirements are unknown and bigger than the inefficiencies arising from incomplete monitoring and insulation of the contractor from cost overruns). In practice, cost-plus contracts in the public sphere have been criticised for frequent and substantial cost overruns in government spending. Cost-plus contracts are more adaptable but also more vulnerable to abuse: fixed-price contracts do not provide adaptable risk-sharing mechanisms and may lead to an unintended increase in government payments. With closer third-party oversight and a fear of opportunistic challenges, politicians will prefer fixed-price contracts in settings in which cost-plus contracts could prove to be more efficient.

When is more information disclosure economically beneficial?

Common wisdom suggests that transparency around public transactions is always beneficial. When third parties are involved, however, more information may backfire for the public at large.

An increase in scrutiny reduces the informational asymmetry between the third parties’ expected and actual benefits from an opportunistic challenge in two ways. First, an increase in scrutiny fine-tunes third parties’ beliefs about expected benefits from an opportunistic challenge (lower standard deviation). Enhanced transparency creates symmetry between the information of the incumbent politician and the third parties. Consequently, the agent can better forecast third parties’ reaction to her project and better craft contractual terms.

Second, an increase in scrutiny updates the scope of benefits third parties believe they may derive from an opportunistic challenge. If potential benefits from an opportunistic challenge were underestimated (downwardly biased) by third parties, more information would upwardly adjust their beliefs; correspondingly, if potential benefits from an opportunistic challenge were overestimated (upwardly biased) by third parties, more information would downwardly adjust their beliefs.

Overall, an increase in scrutiny will lead to a decrease in the likelihood of opportunistic third-party challenges in costly litigation environments and with downwardly-adjusted beliefs about possible benefits from a challenge. However, if there is an increase in scrutiny where litigation costs are low, or if beliefs about potential benefits from opportunistic challenges were underestimated and then upwardly adjusted, this will lead to an increase in the likelihood of opportunistic challenges. In the latter case, public agents will increase contractual proceduralisation. The economic effect of an increase in scrutiny on contract features depends, therefore, on the litigation costs and the adjustments to third parties’ beliefs.

On the one hand, scrutiny increases the level of internalisation of adaptation costs by politicians and leads, ceteris paribus, to a gain in efficiency due to lower optimal contract proceduralisation and contracting price. On the other hand, from scrutiny calibration and update effects, informed third parties either increase or decrease the likelihood of opportunistic challenges depending on litigation costs. Hence, it is equivocal whether open information policies lead to efficient contracts. The policy implication is that increased transparency should be accompanied by an increase in litigation costs to avoid opportunistic challenges.

Conclusions

The interplay of third-party oversight and proceduralisation costs explains the apparent inefficiencies in public contract design. High payment volatility and flexibility in implementation triggers drawbacks that lead to contract failures or costly adaptations by politicians subject to public scrutiny.

The upshot is that costly proceduralisation increases with political competition and is not directly remediable. Therefore, infrastructure contracts cannot be compared with purely private contracts. Instead, they should be compared with contracts in analogous institutional environments. In other words, efficiency analysis should factor in economic and political transaction costs.

 

Dr Marian Moszoro is a former undersecretary of finance of Poland, an economist at the Inter-American Development Bank and a professor at George Mason University. He can be contacted by email: mmoszoro@gmu.edu.

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