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A real options based traffic risk mitigation model for build-operate-transfer highway projects in India

K.C. Iyer and Mohammed Sagheer

Construction Management and Economics, 2011, vol. 29, issue 8, pages 771-779

Abstract: Build-operate-transfer (BOT) has been one of the preferred models of public--private partnership (PPP) for attracting private capital in the Indian highway sector. In BOT projects the traffic demand is considered a critical risk. Through a concession agreement called the model concession agreement (MCA) a standardized risk allocation framework has been adopted for BOT highway projects in India. If the actual traffic volume deviates from the projected traffic, the MCA suggests varying the length of the concession period (by a pre-agreed formula) to mitigate the traffic demand risk. This arrangement has the limitation of guaranteeing the concessionaire against the shortfall in traffic demand while it bestows unlimited gain otherwise. Past researchers have also examined only the possibility of revenue guarantees to protect the concessionaire from downside risks due to variation in traffic. Therefore, a traffic band is proposed: a combination of traffic floor and traffic cap—which can ensure certainty as to the revenue streams of the private investor, while preventing him from appropriating windfall gains due to higher-than-expected traffic demand through an equitable risk and revenue sharing mechanism. A traffic band being quite analogous to financial options, the paper suggests use of a ‘put’ option held by the concessionaire to determine the traffic floor, while a ‘call’ option held by the government serves as the traffic ceiling. Application of the real options analogy to a real life case study using binomial lattice method indicates enhancement to the net present value of the project.

Date: 2011
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