From fixed to state-dependent duration in public-private partnerships

A government delegates a build‐operate‐transfer project to a private firm. In the contracting stage, the operating cost is unknown. The firm can increase the likelihood of facing a low cost, rather than a high cost, by exerting costly effort when building the infrastructure. Once the infrastructure is in place, the firm learns the true cost and begins to operate. Under limited commitment, either partner may renege on the contract at any moment thereafter. The novelty with respect to incentive theory is that the contractual length is stipulated in the contract in such a way that it depends on the cost realization. Our main result is that, if the break‐up of the partnership is sufficiently costly to the government and/or adverse selection and moral hazard are sufficiently severe, then the efficient contract is not robust to renegotiation unless it has a longer duration when the realized cost is low. This result is at odds with the literature on flexible‐term contracts, which recommends a longer duration when operating conditions are unfavorable, yet, with regard to a different setting, where the demand is uncertain and the cash‐flow is exogenous.