Contracts in Natural Resources: What Does Contract Theory Tell Us?

Similar documents
Rethinking Incomplete Contracts

CONTRACT THEORY. Patrick Bolton and Mathias Dewatripont. The MIT Press Cambridge, Massachusetts London, England

Incomplete Contracts and Ownership: Some New Thoughts. Oliver Hart and John Moore*

Definition of Incomplete Contracts

Up-front payment under RD rule

ECON 4245 ECONOMICS OF THE FIRM

OWNERSHIP AND RESIDUAL RIGHTS OF CONTROL Ownership is usually considered the best way to incentivize economic agents:

Short-term, Long-term, and Continuing Contracts

Asset specificity and holdups. Benjamin Klein 1

Theories of the Firm. Dr. Margaret Meyer Nuffield College

Theories of the Firm. Dr. Margaret Meyer Nuffield College

The inadequacy of specificity and role of importance in explaining hold-up

The Fundamental Transformation Reconsidered: Dixit vs. Williamson

A Back-up Quarterback View of Mezzanine Finance

Economics 101A (Lecture 25) Stefano DellaVigna

University of New South Wales School of Economics

Entry Barriers. Özlem Bedre-Defolie. July 6, European School of Management and Technology

Microeconomics II Lecture 8: Bargaining + Theory of the Firm 1 Karl Wärneryd Stockholm School of Economics December 2016

Contracts, Reference Points, and Competition

Discussion Liquidity requirements, liquidity choice and financial stability by Doug Diamond

Triparty Contracts in Long Term Financing

Game-Theoretic Approach to Bank Loan Repayment. Andrzej Paliński

Topics in Contract Theory Lecture 5. Property Rights Theory. The key question we are staring from is: What are ownership/property rights?

CAN BLOCKCHAIN SOLVE THE HOLD-UP PROBLEM? RICHARD HOLDEN AND ANUP MALANI UNSW AND UNIVERSITY OF CHICAGO

Sequential Investment, Hold-up, and Strategic Delay

Online Appendix. Bankruptcy Law and Bank Financing

NBER WORKING PAPER SERIES HOLD-UP, ASSET OWNERSHIP, AND REFERENCE POINTS. Oliver Hart. Working Paper

CONTRACTS AS REFERENCE POINTS* Oliver Hart and John Moore. July 2006, revised March 2007

Simple Efficient Contracts in Complex Environments

NBER WORKING PAPER SERIES HOW DO INFORMAL AGREEMENTS AND RENEGOTIATION SHAPE CONTRACTUAL REFERENCE POINTS? Ernst Fehr Oliver D. Hart Christian Zehnder

Diskussionsbeiträge des Fachbereichs Wirtschaftswissenschaft der Freien Universität Berlin. The allocation of authority under limited liability

Optimal deterrence of collusion in the presence of agency problems within firms. Cédric Argenton Eric van Damme TILEC & CentER - Tilburg University

MAIN TYPES OF INFORMATION ASYMMETRY (names from insurance industry jargon)

Incomplete Contracts, Control Rights and Integration Decisions in Economic Organisations. Philip lestyn Williams. London School of Economics

THE MIRRLEES APPROACH TO MECHANISM DESIGN WITH RENEGOTIATION (WITH APPLICATIONS TO HOLD-UP AND RISK SHARING) By Ilya Segal and Michael D.

Lecture 1: Introduction, Optimal financing contracts, Debt

Discussion of Limited Partners and the LB0 Process by Paul Schultz and Sophie Shive

Practice Problems 1: Moral Hazard

The Importance of Hold-up in Contracting: Evidence from a Field Experiment. Rajkamal Iyer and Antoinette Schoar *

Lecture 14. Multinational Firms. 2. Dunning's OLI, joint inputs, firm versus plant-level scale economies

Chapter 16: Financial Distress, Managerial Incentives, and Information

Beyond the Coasian Irrelevance: Externalities

Delegated Monitoring, Legal Protection, Runs and Commitment

A Theory of Favoritism

Lecture 14. Multinational Firms. 2. Dunning's OLI, joint inputs, firm versus plant-level scale economies

Debunking Traffic & Revenue Risk in Highway PPP Projects Different Perspectives

Procurement Contracts: Traditional Versus PPPs

FIN CORPORATE FINANCE Spring Office: CBA 6.246, Phone: ,

RUSSIAN FEDERATION GLOBAL GUIDE TO M&A TAX: 2017 EDITION

Delegation and incentives

Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts

Moral hazard, hold-up, and the optimal allocation of control rights

Finance Science, Financial Innovation and Long-Term Asset Management

Moral Hazard Example. 1. The Agent s Problem. contract C = (w, w) that offers the same wage w regardless of the project s outcome.

Creating growth: the challenge of buying well in today s market

Exit Options in Incomplete Contracts with Asymmetric Information

Price Theory of Two-Sided Markets

Financial Contracting with Adverse Selection and Moral Hazard

Incomplete Contracting, Renegotiation, and. Expectation-Based Loss Aversion

Theory of the firm transactions costs

DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 21. Dartmouth College, Department of Economics: Economics 21, Summer 02. Topic 5: Information

Can Contracts Solve the Hold-Up Problem? Experimental Evidence

Prof. Bryan Caplan Econ 812

Improving the Use of Discretion in Monetary Policy

PERSPECTIVES ON MECHANISM DESIGN IN ECONOMIC THEORY Roger Myerson, 8 Dec

Answer Key: Problem Set 4

Assessing the Impact of Alternative Fair Value Measures on the Efficiency of Project Selection and Continuation *

The role of dynamic renegotiation and asymmetric information in financial contracting

Discussion of Liquidity, Moral Hazard, and Interbank Market Collapse

Economics 101A (Lecture 26) Stefano DellaVigna

Moral Hazard: Dynamic Models. Preliminary Lecture Notes

Relational Contracts and the Value of Loyalty

Tough Private Lenders Competing Against Soft State Banks

As shown in chapter 2, output volatility continues to

PROBLEM SET 7 ANSWERS: Answers to Exercises in Jean Tirole s Theory of Industrial Organization

RISK MANAGEMENT AND VALUE CREATION

Reputation and Securitization

Rules versus discretion in bank resolution

International Lender of Last Resort and Debt Restructuring

Asymmetric Information and the Role of Financial intermediaries

What has been missing

Auctions. MSc Finance Theory of Finance 1: Financial Topics Autumn Arup Daripa Birkbeck College. The background

Presidential Address, Committing to Commit: Short-term Debt When Enforcement Is Costly

Comparative statics of monopoly pricing

What we know about monetary policy

Contracting between Firms: Empirical Evidence

Sovereign Debt and CDS

Managing through incentives

October 9. The problem of ties (i.e., = ) will not matter here because it will occur with probability

Auction Theory: Some Basics

Sequential Investment, Hold-up, and Strategic Delay

ECONOMY IN THE LONG RUN. Chapter 6. Unemployment. October 23, Chapter 6: Unemployment. ECON204 (A01). Fall 2012

BBK3253 Risk Management Prepared by Dr Khairul Anuar

Incomplete contracts and optimal ownership of public goods

EC3115 Monetary Economics

Internet Appendix for Financial Contracting and Organizational Form: Evidence from the Regulation of Trade Credit

agency problems P makes a take-it-or-leave-it offer of a contract to A that specifies a schedule of outputcontingent

Monetary credibility problems. 1. In ation and discretionary monetary policy. 2. Reputational solution to credibility problems

Optimal Soft or Tough Bankruptcy Procedures

Economic Theory and Lender of Last Resort Policy

Transcription:

1 Contracts in Natural Resources: What Does Contract Theory Tell Us? Philippe Aghion November 1, 2007

Introduction Some governments (e.g in Latin America) are forcing renegotiation on previous contracts with oil and gas companies What does contract theory tell us about: 1. why this may happen? 2. is this legitimate? 3. to which extent contract better contract design can avoid such events? 4. potential role for complementary institutions?

Asimpleframework Two parties, the country and the oil company Two or three periods: contracting period and one or two revenue periods The project entails some initial investment I 0 and yields uncertain profit flow π 1,π 2 Contract specifies distribution of control rights and sharing rule over profits

Contracts between countries and oil companies There are two prevailing forms of contracts between countries and oil companies (e.g Total) 1. Concession contracts : the oil company owns the assets and plants, and receives the whole production the company bears all the risks and incurs all investment and exploitation costs the company pays a preset dividend R to the country each period, plus local taxes

2. Production sharing contracts production is shared between the company and the country according to a preset (linear) rule the country is usually represented by a national company the national company participates to operational decision making the oil company commits to finance investments and production in exchange, the company has priority claim on the production this claim is the cost oil production minus the cost oil is shared between the oil company and the country (or thenationalcompany)

thus country gets r 1 =min(0,α(π 1 C 1 ) + ), and r 2 =min(0,α(π 2 [C 1 π 1 ] + ) C 2 ) + )

Potential sources of contractual inefficiencies 1. bad distribution of risks between contracting parties 2. inadequate balance between risks and incentives...basic moral hazard model 3. hold up (by the country) and underinvestment (by the oil company)...basic hold up model 4. ex post inefficiencies and grievance (country may not cooperate ex post, as in Hart and Moore (2007) s Contract as a Reference Point paper) 5. poor enforcement (no powerful court like for foreign debt)

At first sight: 1. 2 is not really a problem if effort is incurred by oil company which is essentially risk-neutral 2. 1 can be potentially solved by proper contract design main issues are 3, 4 and 5

Hold-up problem (Williamson, 1975) The problem: once investment is sunk, country can hold up the company anticipating this, company may underinvest Ways around the problem: 1. renegotiation design (Aghion-Dewatripont-Rey, 1994) 2. vertical integration (Grossman-Hart, 1986)

Problem is that contracts between country and foreign company are not fully enforceable Three potential mitigators: 1. reputation, however governments are shortlived 2. company s threat of not reinvesting in the country (as non-refinancing threat for dynamic debt contracts in Bolton-Scharfstein,1990) Additional mitigator: establishment of a credible and fair third party

Ex post uncertainty and grievance (Hart-Moore, 2007; Hart, 2007) idea 1: for contractual relationship to work, the parties need to cooperate ex post, and this is not contractible idea 2: one party may decide not to cooperate if it feels aggrieved ex post

Flexible versus rigid contracts in Hart-Moore (2007) Rigid contract: specifies a fixed price p, like concession contract problem is that ex post cost/valuation may fall so much out of range that one party finds it optimal to force renegotiation for example in buyer/seller relationship: if p<p L where p L c = r s + 1 2 G, then seller forces renegotiation similarly, if p>p H where v p H = r b + 1 2 G, then buyer forces renegotiation if p / [p L,p H ], then renegotiation is forced with resulting grievance.

Flexible contracts: specify a range of prices [p, p]fromwhichone party can pick ex post the advantage is that ex post uncertainty has more chance to not result in forced renegotiation no renegotiation as long as H =[p L,p H ] [p, p] isnon-empty However flexibility may itself be a source of grievance the party that did not pick the price might feel aggrieved by the other party

Back to the concession contracts Plus: the exploitation risk is borne entirely by oil company...country gets fixed R...which seems right since oil company can diversify risks and incurs the investment Minus: this contract is rigid country more likely to tear up the initial contract to force renegotiation e.g if at interim period new information flows in that π i >> R Forced renegotiation 1. forced renegotiation amounts to breach of contract 2. hard to prevent such breach in absence of credible third party 3. in fact breach of concession contract is similar to debt repudiation... 4....there are no international courts to deal with such breach

Another justification for forced renegotiation contract was initially negotiated by a bad government previous government signed a disadvantageous deal for the country but which yielded personal advantages why should new government feel committed by such agreements? parallel with political economy literature on public debt and defaults (Persson and Svensson (1988)) an international court might conclude that the responsibility is shared between the country and the oil company

Back to the production sharing contracts Plus: more flexible than concession contract therefore less prone to forced renegotiation ex post also, country shares control rights and therefore has the potential to benefit morefromtech- nology transfers. Minus: country faces more risk than under concession contract namely, country bears most of the risk on costs e.g when oil cost rises, it takes longer before the country perceives its share of oil revenues if C 2 too high, then country ends up with π 2 =0 country may end up feeling even more grieved than under concession contract

Questions: 1. can one reduce scope for ex post grievance in production sharing contracts by introducing more profit-contingent nonlinear sharing schemes through more short-term contracts whereby governments share upfront investments 2. since countries decide about local taxes, does incentive scheme in the contract really matter and in fact does contractual form matter at all? parallel with debate on sovereign debt and exchange rate policy (Tirole (2003)) 3. are costs and/or profits truly verifiable (Russia, Angola contested costs)?

First question: complicated contracts may be hard to enforce, and short term contracts may deter investments; investments may not be verifiable; countries may not be able to finance a sizeable share of investment Second question: taxes only apply to profit oil,notto cost oil country may want to commit not to change tax rule all the time in order not to discourage investment Third question: tough international audits are generally used to assess costs and therefore profits

Remaining question: how can a country minimize the risks of collusion between oil companies and bad governments? role of international courts...who controls them?

Natural resources, quality of government, and growth Interesting fact: 1. natural resources seem to be growth enhancing in autocracies... 2....but not in democracies