The option value of government guarantees in infrastructure projects

Abstract

The participation of private capital in public infrastructure investment projects has been sought by many governments who perceive this as a way to overcome budgetary constraints and foster economic growth. For some types of projects, this investment may require government participation in the form of project guarantees in order to reduce the risk to the private investor, and as a consequence, the government assumes a contingent liability which may have significant future budgetary impacts. We present a minimum traffic guarantee (MTG) real options model that differs from most of the literature in the field by using market data to determine stochastic project parameters. This model can be used to assess the value of these guarantees, allows the government to analyse the cost-benefit of each level of support, and proposes an alternative to limit the exposure of the government while still maintaining the benefits to the private investor. We apply this model to the projected 1000 mile long BR-163 toll road that will link the Brazilian Midwest to the Amazon River. We conclude that the use of public-private partnerships (PPP) with guarantees and caps on total government outlays can be modelled effectively using option pricing methods and can be a solution to attract private investment to high risk public infrastructure projects.