Government auctions of the right to build new UK electricity infrastructure now allow investors to submit bids for contracts of varying length, for example 20, 25 and 30 years. Writing in the October 2017 issue of the Economic Journal, the designers of the auction Thomas Greve and Michael Pollitt explain how allowing the length of the regulatory funding period to be determined via an auction can reduce the financing cost of infrastructure investments.
The auction is motivated by the auctions currently being undertaken by Ofgem, the UK energy regulator, for financing offshore transmission assets. Although the auction has been designed with electricity transmission in mind, it could be used in other areas of infrastructure investments or in areas where bidders are invited to submit bids on different versions or different qualities of an object for sale.
Governments have increasingly turned to the private sector to provide infrastructure services in road, railway, energy and water: sectors that were once delivered by the public sector. The private sector''s involvement has become attractive to governments as a mechanism for delivering infrastructure investment since it can be a tool to stimulate innovation and competition. Importantly, it also allows private finance to replace government spending.
Public-private partnership (PPP) models or competitive tender processes are often used to attract such private investment in infrastructure. Typical contract periods range from five to 50 years. For the duration of the contract, the private company provides the service in exchange for government guaranteed payments that compensate for upfront investments and other costs.
Auctions have successfully been applied in the awarding of these contracts. In the UK energy sector, the government has used tenders to allocate the right to own and operate offshore transmission assets linking offshore wind farms to the onshore grid.
The key feature of an infrastructure tendering process is the long-term nature of the contracts, 20 years for example, between the government and a private company. In offshore transmission, a successful bidder will receive a transmission licence and entitlement to an associated 20-year transfer value in return for purchasing the transmission assets from an offshore wind developer and operating them in accordance with the obligations of the licence.
For any long-lived infrastructure asset, a key driver of the costs is the availability of long-term finance and hence its attractiveness to the financial market. One way to make infrastructure investments more attractive to investors is to allow the market to decide the length of regulatory funding period within the auction process itself.
A longer period of guaranteed regulated revenue, say 25 or 30 years, may be desirable since a longer tender period gives investors the security of a long-term secured revenue arrangement.
A longer tender period means lower repayment per unit of debt in periods of underperformance and therefore, lowers probability of default. Hence, a longer tender period could result in a lower interest rate. But since the government has to offer a longer regulatory guarantee, longer regulatory funding periods may be seen as less desirable.
This study presents an auction design that can reduce the financing cost of infrastructure investments by allowing the length of the regulatory funding period to be determined via an auction. The auction allows bidders to submit bids against a payment for periods of varying length, for example 20, 25 and 30 years.
The researchers'' design allocates the contract to the bidder who values it the most, delivers the optimal length of contract (defined as where social value is maximised) and ensures lower financing costs compared with, for example, a fixed 20 years contract.
''Determining the Optimal Length of Regulatory Guarantee: A Length-of-Contract Auction'' by Thomas Greve and Michael Pollitt is published in the October 2017 issue of the Economic Journal. Thomas Greve and Michael Pollitt are at the University of Cambridge.