Real Option Approach to Sharing Privatization Risk in Underground Infrastructures

Abstract

Over the last two decades, more than 100 water and sewer systems have been sold or leased to private entities in the United States due to shortages in government funding. While privatization has allowed governments to relieve their financial difficulties, users have taken on such risks in the form of high rates and poor service. When compared to other infrastructures, water and sewer systems generate somewhat stable revenue. However, water and sewer systems are also characterized by the hardly predictable operation and maintenance (O&M) expenses. Such characteristics make it difficult to devise a proper contract that satisfies the interested parties, such as governments, private operators, and users. By investigating the deficiencies of previous privatization contracts, this study presents a real option–based contract model to ensure appropriate risk sharing between private entities and governments. Simulation results based on three different O&M expense scenarios (best, moderate, and worst) indicate that the proposed contract model would provide a win-win situation for all related parties.