Pricing Mechanism of Early Termination of PPP Projects Based on Real Option Theory

Abstract

The early termination of public–private partnerships (PPP) frequently occurs in large infrastructure projects. Studies have analyzed the issue of compensation arising from early termination; however, most have ignored optionality in managing the risks and uncertainties embedded in these settings. Using real option theory, this paper examines pricing mechanisms for early termination under two different scenarios, namely, those of excessively high or excessively low cash flows, wherein early termination of PPP projects occurs during the stage of the operation prior to the final stage of asset transfer. The results show that while the pricing of early termination is mainly determined by the actual cash flow profile, it is also related to the level of total investment and return on investment. The final value of compensation agreed upon is also dependent on the bargaining power of each party. These findings contribute new insights into the pricing mechanisms of early termination used by governments and private investors. The quantification and derivation of early termination prices up front serves as a valuable benchmark and a good starting point for both governments and investors during negotiations and addresses the issue of compensation for early termination in a fair and reasonable manner.