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Pricing Final Indemnification Payments to Private Sponsors in Project‐Financed Public‐Private Partnerships: An Application of Real Options Valuation

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  • Stefano Caselli
  • Stefano Gatti
  • Antonio Marciante

Abstract

The extraordinary global growth in the private funding of public infrastructure projects in the form of public‐private partnerships (or PPPs) is expected to have major social and economic benefits—benefits that result in large part from improving the allocation of project risks between the public and private sectors. But with the financial crisis and severe tightening of credit likely to limit the financing and delivery of new projects, both project participants and their financiers need to manage the technical, economic, legal, and political complexities of infrastructure projects more carefully, especially in less traditional infrastructure deals that involve complex operations, new assets, or emerging markets. This paper proposes and illustrates the application of the real options valuation approach to a critical feature of most PPPs: establishing the final “indemnification” amount to be paid by a public administration to private partners in the project financing of those PPPs that face substantial market risks. In demonstrating this approach, the authors use the case of the Pedemontana Lombarda toll road, a major transportation infrastructure project in Northern Italy for which financial plans have been filed and whose start is now pending. The main function of real options in this case is to capture the effects on value of the major market risk in such projects—namely, the uncertainty about volume of traffic on the new road. The authors interpret the final indemnification price as the value of a real put option sold by the awarding authority to private investors (in the case of a project that would otherwise be unprofitable and have a negative NPV). The put option takes the form of a clause in the concession contract that gives investors the right, under certain circumstances, to sell the toll road back to the government for a fixed sum (in this case, €2.9 billion). According to the authors, this valuation approach is likely to be helpful in any kind of infrastructure project that faces risk stemming from the unpredictability of market demand and future revenue streams.

Suggested Citation

  • Stefano Caselli & Stefano Gatti & Antonio Marciante, 2009. "Pricing Final Indemnification Payments to Private Sponsors in Project‐Financed Public‐Private Partnerships: An Application of Real Options Valuation," Journal of Applied Corporate Finance, Morgan Stanley, vol. 21(3), pages 95-106, June.
  • Handle: RePEc:bla:jacrfn:v:21:y:2009:i:3:p:95-106
    DOI: 10.1111/j.1745-6622.2009.00243.x
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    File URL: https://doi.org/10.1111/j.1745-6622.2009.00243.x
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    Citations

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    Cited by:

    1. João Adelino Ribeiro & Paulo Jorge Pereira & Elísio Brandão, 2013. "A Two-Factor Uncertainty Model to Determine the Optimal Contractual Penalty for a Build-Own-Transfer Project," CEF.UP Working Papers 1308, Universidade do Porto, Faculdade de Economia do Porto.
    2. Zihan Liu & Ju’e Guo & Shubin Wang & Hongtao Liu, 2018. "Government incentive strategies and private capital participation in China’s Shale gas development," Applied Economics, Taylor & Francis Journals, vol. 50(1), pages 51-64, January.
    3. Gabriel J Power & Charli D. Tandja M. & Josée Bastien & Philippe Grégoire, 2015. "Measuring infrastructure investment option value," Journal of Risk Finance, Emerald Group Publishing, vol. 16(1), pages 49-72, January.
    4. Ales S. Berk & Dejan Podhraski, 2018. "Superiority of Monte Carlo simulation in valuing real options within public–private partnerships," Risk Management, Palgrave Macmillan, vol. 20(1), pages 1-28, February.
    5. Vecchi, Veronica & Hellowell, Mark & Gatti, Stefano, 2013. "Does the private sector receive an excessive return from investments in health care infrastructure projects? Evidence from the UK," Health Policy, Elsevier, vol. 110(2), pages 243-270.

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