Option Values and Penalty Fees in Concession Contracts: a Real Option Approach

Abstract

Concession contracts are agreements granting
the right to construct public works, operate and provide a
service or a good.
Although most contracts include penalties for delays,
evidence from ongoing concession contracts shows that time
overruns are widespread. Uncertainty over future payoffs
generates investment timing flexibility that, if optimally
exercised, can increase the contract value for the contractor
firm. Therefore concessionaires may find it optimal to delay
irreversible investments regardless the presence of penalty
clauses. This investment timing flexibility should be taken
into account when determining the penalty fees. Following
the Real Option Approach we model the concessionaire’s
optimal investment strategy and determine the optimal
penalty fee that induces the concessionaire to comply with
contract provisions on time. The higher the concessionaire’s
option value to delay, the higher the optimal penalty to be
set.