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

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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.

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This paper studies the relationship between a government and private companies for the exploitation of an oilfield by means of concession-like contracts, i.e. concessions and Production Sharing Agreements. At this aim, we develop and solve a dynamic stochastic optimization problem in a real option framework. The model takes into account crucial as well as actual features of the real world, such as: the twofold goal of governments who must mediate between social interests and revenue maximization from concessions; the incentive for the private party to "over exploit" natural resources and uncertainty over future payoffs. The results obtained can help policy makers in pursuing the delicate task of setting the "right" terms of concession-like contracts, meaning that policy makers can have at least a benchmark to start interacting with private parties. This phase is particularly difficult for a number of reasons, such as the need to trade contrasting interests off, high risk of corruption and the fact that negotiations are made difficult by the high level of uncertainty due to incomplete or even faulty information.
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