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

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.