A New Mechanism to Auction Highway Franchises

Most developing-country governments lack resources to undertake urgent highway construction programs. This has led to the suggestion that private firms should be given franchises to build, finance, operate and transfer (BOT) highways in exchange for toll revenues. We build a conceptual framework in which we analyze the virtues and limitations of different mechanisms that could be used to auction a highway. Using this framework, we argue that current mechanisms, which fix the term of the franchise, create unnecessary risk and facilitate post-contract opportunism by the regulator and the franchise holder. We propose a new mechanism that allocates the franchise to the firm that bids the least present value of toll revenue (LVPR). We argue that the LVPR mechanism (1) eliminates most of demand risk; (2) moderates the "winner's curse"; (3) reduces post-contract opportunism by the regulator and the franchise holder; (4) discourages artificially low bids in the expectation of renegotiating opportunistically; and (5) proviedes flexibility to adapt to increases in demand. We estimate that in the case of Chile, the benefits stemming solely from the reduction in demand risk by switching to LVPR auctions would save road users about one-third of the cost of building the highways. Similar estimates for other developing countries may be expected to be alt least as large.