Public-Private Contracting under Limited Commitment

A government delegates a build-operate-transfer project to a private firm in a limited-commitment framework. When the contract is signed, parties are uncertain about the operating cost. The firm can increase the likelihood of facing a low cost by exerting some noncontractible effort while building the facility. Once the facility is in place, the firm learns the marginal cost and begins to operate. We characterize the contract which stipulates the efficient allocation. We study the financial structure and duration that secure its enforcement. To this end, we take into account that break-up of the partnership occasions a replacement cost for the government and an expropriation cost for the firm and its lender. Furthermore, both these costs are higher the earlier the contract is terminated. Enforcement is achieved as follows. The firm is instructed to invest some intermediate amount of own and borrowed funds. Under the aegis of a third party that can commit, the government provides guarantees to the lender, conditional on continuation of the partnership. Duration may be shortened, though not to the point where the initial effort of the firm is uncompensated.