Determining the Value of Standby Letter of Credit in Transfer Stage of a PPP Project to Control Concessionaire’s Opportunistic Behavior

Abstract

Most public–private partnership (PPP) projects would be transferred back to the government at the end of the concession period. To pursue maximum profit, the concessionaire may overuse the facilities without proper maintenance during the concession period. Such opportunistic behavior is likely detrimental to public interests. To address this issue, a common practice is the government requiring a standby letter of credit in the transfer stage (SLOT) from the concessionaire to guarantee the project’s performance during the warranty period. If operational accidents occur during the warranty period, the government will issue a performance bond to cover the damages according to SLOT. A higher value of SLOT will prevent the concessionaire from behaving opportunistically (i.e., the compatibility constraint is satisfied) but may cause the concessionaire to refuse the contract (i.e., the participation constraint may not be met), and vice versa. In this study, a principal–agent model was developed to determine the reasonable value of SLOT by analyzing the incentive compatibility constraint for the concessionaire and the participation constraint for the government. This model offers a useful reference for the government to undertake business negotiations with the concessionaire toward the objective of avoiding opportunistic behavior and improving project performance. A case study was conducted with a PPP waste-to-energy incineration project located in Nanjing, China, to illustrate the model.