AO T16 Viewpoint The World Bank Note No. 112 Privatizing Roads-A New Method for Auctioning Highways Eduardo Engel, This Note argues that many of the problems that have plagued highway privatization stem from Ronald Fischer, the combined effects of special features of the highway business and the type of contracts-fixed and Alexander Galetovic term franchises-that have typically been used. The Note proposes a new mechanism, the least- present-value-of-revenue (LPVR) auction, that corrects some of the shortcomings of the fixed term franchise. The new mechanism endogenously adjusts the duration of the franchise to the realization of demand: the term lengthens if traffic grows more slowly than expected and short- ens if it grows more rapidly than expected. There is widespread agreement that most devel- chises awarded by Spain before 1973 had build- oping countries urgently need massive highway ing costs four to five times higher than ex- construction programs. Traditionally, highways pected, but traffic about a third of original have been viewed as public goods that must projections. As a result, three firms went bank- be financed and operated by the public sector. rupt, two firms were absorbed by stronger fran- But in recent years many governments have chise holders, and the government granted toll neglected maintenance because of chronic bud- increases and term extensions. In Mexico, ex- getary problems, and traffic has grown well cessively high tolls have led to empty high- ahead of capacity. So, it has become increas- ways and the renegotiation of the original ingly accepted that highways should be built, franchise agreements. The duration of some of financed, and operated by private firms and the toll road franchises has more than doubled, that users should pay for using them. Several and the government has had to pump in US$2 advantages are claimed for privatized roads. billion to save firms (and the banks that made Private firms build highways faster because they loans to them) from bankruptcy. face fewer financing constraints, and they are more efficient than state-owned firms. Users This Note argues that many of the problems that are more likely to accept the concept of pay- have plagued highway franchises stem from the ing for roads owned by the private sector. And combined effects of special features of the high- franchising should prevent the building of way business and of the type of franchise con- "white elephants," since private firms do not tracts that have typically been used. First, traffic want to lose money. forecasts are notoriously imprecise; it is diffi- cult enough to make accurate traffic predictions Despite these avowed advantages, the experi- for the short run and much harder for the long ence with highway franchising has been far run (box 1). Moreover, demand for a highway from happy. Three of the four franchises that is largely beyond the control of the franchise France awarded in the early 1970s went bank- holder. Second, most franchises have been rupt after the oil shock and were taken over awarded for a fixed term (say, twenty years) by the government. Several of the twelve fran- that is independent of demand realization. In Private Sector Development Department * Finance, Private Sector, and Infrastructure Network Privatizing Roads-A New Method for Auctioning Highways what follows, this Note describes the main short- is paid by users (or, through government guar- comings of fixed term franchises and then antees, by taxpayers). For Chile, this risk pre- presents a new mechanism, the least-present- mium is estimated at about a third of the value-of-revenue (LPVR) auction, that endog- investment cost; for most developing countries, enously adjusts the duration of the franchise to it can be expected to be even larger. the realization of demand. The Note argues that this mechanism is far better than current systems. Because of the high risk associated with high- way franchises, lenders have refused to grant Fixed term franchises franchise holders loans unless governments guarantee the debt (as in Spain) or provide Fixed term mechanisms typically are one of generous minimum toll revenue guarantees (as two kinds. In the version now- used in Chile, in Chile). Guarantees reduce the incentives for the regulator fixes the term and the franchise lenders to screen projects and monitor their is awarded to the firm that bids the lowest toll performance, one of the basic arguments for in a competitive auction. In the version used highway franchises. A second consequence of in Mexico, tolls were fixed by the regulator high risk is that when demand turns out to be and the franchise was awarded to the firm ask- lower than expected, contracts are renegoti- ing for the shortest term. ated and losses shifted to users or taxpayers. The expectation of renegotiation prompts firms The main defect of fixed term mechanisms is to bid artificially low tolls (to lowball),' expect- that they create unnecessary risk for the fran- ing better terms after the contract has been chise holder. Since demand is uncertain and awarded. It also implies that firms that excel at competitive bidding dissipates ex ante rents, renegotiating contracts can compete with firms the winner of the franchise chooses a franchise that are considerably more efficient at build- term (or toll) such that it faces significant losses ing, financing, and operating highways. Thus, if traffic turns out to be considerably below with fixed term franchises, the advantages of expectations. This may happen even when traf- privatizing roads are easily lost: taxpayers and fic flows are sufficient to pay for the road in users pay for roads that are bad investments, the long run. Faced with high risk, the fran- inefficient firms win franchises, and firms do chise holder will demand a risk premium, which not mind building white elephants. Fixed term franchises have additional disadvan- smaller risk premium, and users pay less on tages. First, they increase the likelihood that the average. The lower risk for the franchise holder franchise will be awarded to the firm with the also means that the winner's curse is less likely, most optimistic traffic projection (the winner's because bids are less dependent on demand curse). Second, fixed term contracts are inflex- projections. ible, which can be a serious problem if tolls turn out to be out of line or congestion makes it With LPVR auctions, the franchise holder still desirable to widen the highway. The problem bears the risk that the road may not be self- arises because it is difficult to agree on the fair financing in the long run-that is, that it will compensation-the expected income forgone turn out to be a white elephant. But since white over the remainder of the franchise-to be paid elephants are usually the result of lobbying by to the franchise holder in these cases. pressure groups, they should be easily detected by potential bidders. LPVR franchises The least-present-value-of-revenue mechanism 7be basic principle uniderlyinig LPVR corrects several shortcomings of fixed term mechanisms. In this approach, auctions is that thefranchise holder * The regulator sets a maximum toll. * The franchise is won by the firm bidding the should not make losses when the long- least present value of toll revenue. * The franchise ends when the present value of run demand for the highway is toll revenue equals the franchise holder's bid. * Toll revenue is discounted at a predetermined sufficient to pay all costs. rate specified in the franchise contract. The rate should be a good estimate of the loan rate faced by franchise holders. A further advantage of LPVR auctions is that cormpetition for the franchise reveals, through As an example, consider an auction with two the winner's bid, the income required to earn firms. The first firm estimates costs of $100 a normal return. This reduces the scope for million and bids $112 million, while the sec- opportunism after the contract is awarded, be- ond estimates costs of $99 million and bids cause the winning bid can be used as a bench- $110 million. The second firm wins and oper- mark. In the case of government opportunism ates the franchise until the present value of leading to a regulatory taking, the franchise toll revenue is $110 million. holder can go to court, asking for fair compen- sation equal to the difference between its bid Advantages and the present value of toll revenues already received. The basic principle underlying LPVR auctions is that the franchise holder should not make Opportunistic renegotiations that favor the losses when the long-run demand for the high- franchise holder are also less likely, for three way is sufficient to pay all costs. Thus, the term reasons. First, because the term automatically lengthens when traffic grows more slowly than lengthens if demand grows more slowly than expected, and it shortens when traffic grows expected, it is less likely that franchise holders more rapidly than expected. Revenues are the will face financial distress and therefore demand same even when demand realizations are dif- renegotiation. Second, renegotiations in favor ferent, so the risk borne by the franchise holder of the franchise holders are explicit wealth trans- is far smaller than under fixed term franchises. fers: term extensions are impossible by defini- For this reason, the franchise holder requires a tion, and the only effect of a toll increase is to Privatizing Roads-A New Method for Auctioning Highways shorten the term of the franchise. Since explicit Conclusion wealth transfers are easier for the public and the media to understand, they are less likely. LPVR auctions are a promising mechanism for Third, the government can discourage lowballing privatizing not only highways but also other by bidders by threatening to end the franchise infrastructure projects. They are attractive for if the franchise holder asks for a renegotiation, projects requiring large investments up front compensating the franchise holder with what- and in which demand is unresponsive to ef- ever sum remains to be collected. forts by the franchise holder. They also require a low-cost capability to verify revenues, the The winning bid determines the fair compen- quality of service, and the residual value of sation for termination of the contract at any investments. time as the difference between the present value of revenue earned and the original bid. For further reading see Eduardo Engel, Ronald Fischer and Alexander This ensures flexibility in LPVR contracts. If Galerovic, "Highway Franchising: Pitfalls and Opportunities," Ameri- demand exceeds expectations and requires an can Economic Review 87 (2): 68-72 (May 1997). expansion of the highway, the franchise holder can be paid the fair compensation and the fran- Eduardo Engel, Ronald Fischer and Alexander chise reauctioned. It is also easy to adjust tolls. Galetovic, Centro de Economfa Aplicada, If tolls need to be raised because of conges- Departamento de Ingenierfa Industrial, Viewpoint is an . tion, the only effect is that the franchise ends Universidad de Chile, Santiago (eengel@ forum intended to earlier. If demand for the highway is highly dii.uchile.cl, rfischer@dii.uchile.cl, or encourage dissemina- uncertain before it is built (as is often the case agaletolfdii.uchile.cl) lion of and debate on for new highways), the setting of tolls can be ideas, innovations, and best practices for postponed until after construction. expanding the private sector. The views Limitations published are those of the authors and should not be attributed to the The main limitation of LPVR franchises com- World Bank or any of its pared with fixed term contracts is that they affiliated organizations. Nor do any of the con- provide fewer incentives to engage in demand- clusions represent enhancing activities. Any expense that increases official policy of the demand shortens the franchise and so increases World Bank or of its Executive Directors profits less than it would under a fixed term or the countries they contract. As a result, the franchise holder may represent. underinvest in road quality or maintenance, To order additional speedy attention at toll booths, or swift cleanup copies please call 202- of accidents. For this reason, LPVR auctions 458-1111 or contact require regulatory institutions that set and en- Sazanne Smith, editor, Room 68105, The World force minimum quality standards for franchise Bank, 1818 H Street, holders. Regulation need not be complicated. NW, Washington, D.C. For example, independent agencies could 20433, or Internet address ssmith7@ monitor waiting times at toll booths, and the worldbank.org. waiting times could be published in newspa- The series is also pers to make the regulators accountable to available on-line (www.worldbank. users. (Even with fixed term franchises, it be- org/html/fpd/notes/ comes necessary to monitor quality as the end notelist.html). of the term approaches.) This defect of LPVR SPrinted on recycled auctions can be mitigated by rewarding fran- paper. chise holders that achieve short franchises.