Public Incentives as Real Options

Public Incentives as Real Options

 

In general, huge infrastructure projects like toll road, power plants, railways and alike are very risky since they involve high investment costs in the beginning and high maintenance and management costs during the long period of concession, which is usually 25–30 years. In such a long period quite a lot might turn wrong, such as changes in quantities (demand for the product/service), prices of inputs and outputs, political and economic situation, etc. The benefits of such projects are public, though. Because of their riskiness public tenders for an infrastructure concession right may not result in successful bids.

In such situations the individual government (i.e. the public partner) either postpones granting a project to a later, perhaps more convenient moment or grants the project a subsidy or guarantee and thus makes it more attractive to potential private partners. Incentives can take various forms like input subsidies, redemption subsidies, exchange rate subsidies, put options, lump-sum subsidies to minimum revenue guarantees, etc.

And what does the public partner get in return for granting an incentive? First of all, the project will be built which benefits all the users of public services, whether it is toll roads, railways, cleaning plants with sewage systems or any other infrastructure. In addition, new infrastructure can accelerate the development of a certain geographical area and improve general well-being.

Incentives that the public partner grants to the private partner in order to make the project more attractive, like the minimum revenue guarantee, the put option, the abandonment option, the extension option, input subsidies and others are in their essence real options, which means that Real Option Analysis can be applied to their valuation.

With classical valuation techniques these incentives were hard to value if not impossible at all, but with Real Option Analysis we can define their price precisely. Knowing what is the exact value of an incentive granted to the project is crucial for establishing how feasible a specific project is and what financial consequences each of the partners may expect in the project’s life.

In other words, the value of an incentive as a real option will reveal to the public partner what financial burden he may anticipate in the long term, while the private partner will know what his profit in the project will be. These answers are crucial to both partners.

In our work we use Real Option Analysis as well as classical valuation techniques depending on the project’s features. Thus we provide our clients with the most accurate valuations of their projects.

REAL OPTIONS CONSULTING

At Real Options Consulting Ltd, we are merging real options and PPP.

Company

Real Options Consulting Ltd is a company specialized in the valuation of risks and real options in infrastructure Public-Private Partnership projects.

We bring to our clients the best of theory and practice of Real Options and Public-Private Partnership with the purpose of creating the most suitable solutions for them.

Contact Us

Real Options Consulting Ltd 20-22 Wenlock Road, London, N1 7GU
United Kingdom
Website: http://www.ppp-infrastructure.com
Email: [email protected]
Phone: +44 70 2403 4340