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

12 Pages Posted: 2 Nov 2009

See all articles by Stefano Caselli

Stefano Caselli

Bocconi University - Department of Finance

Antonio Marciante

KPMG Corporate Finance

Stefano Gatti

Bocconi University - Department of Finance

Abstract

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.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 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

Caselli, Stefano and Marciante, Antonio and Gatti, Stefano, Pricing Final Indemnification Payments to Private Sponsors in Project-Financed Public-Private Partnerships: An Application of Real Options Valuation. Journal of Applied Corporate Finance, Vol. 21, Issue 3, pp. 95-106, Summer 2009. Available at SSRN: https://ssrn.com/abstract=1495299 or http://dx.doi.org/10.1111/j.1745-6622.2009.00243.x

Stefano Caselli (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Antonio Marciante

KPMG Corporate Finance ( email )

Via V. Pisani 27
Milan
Italy
0039 348 0995008 (Phone)

Stefano Gatti

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

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