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Incentive Contracts in Transport Concessions, Litigation and Weak Institutions

By Juan Benavides, Alfredo Garcia, James Reitzes (12/03, En, Es) See also Infrastructure and Financial Markets

Renegotiation of infrastructure procurement contracts in Latin America and the Caribbean reached unexpectedly high levels during the nineties. There is nothing wrong about renegotiating a contract whenever unexpected and persistent shock affects chronically the finances of a project. This paper focuses, however, on renegotiations induced by the lack of contract enforcement. When the judiciary is weak, strategic investors optimize the combined value of project profits plus the expected value at stake (e.g., cost overruns not covered by contract) that could be derived by beating the granting authority in a legal dispute. By winning a concession contest, the concessionaire is also purchasing the real option of being reimbursed its costs, ex post. The key point is that the “right” to be reimbursed is the outcome of a legal struggle in which the probability of winning the dispute is endogenous: it will depend on the investment of both the government and the concessionaire on more and better legal services.

The study analyzes the consequences of setting up a legal fund to defend the public interest using the analytical tools of mechanism design. The study discusses the optimal contract structure (i.e., fixed payments vs. cost-based) when the legal fund is either high or low. The results of this paper imply that it is possible to create a policy instrument to supplement the short-run imperfect performance of the judiciary. Whenever deemed prudent in the context of infrastructure provision by private parties, a trust fund to retain high quality legal services for the government could be established. Clearly, this action should be considered as a component of a consistent program to strengthen the legal system in the long run.

This working paper is being published with the sole objective of contributing to the debate on a topic of importance to the region, and to elicit comments and suggestions from interested parties. This paper has not gone through the Department’s peer review process or undergone consideration by the SDS Management Team. As such, it does not reflect the official position of the Inter-American Development Bank.

To obtain a hard copy of this publication, please submit your request to:

IFM Publications
Infrastructure and Financial Markets Division
Inter-American Development Bank
1300 New York Avenue, N.W.
Washington, D.C. 20577
Mail Stop W-0508

E-mail: sds/ifm@iadb.org
Fax: 202-623-2157

Last updated: 10/28/04

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