4.5 Real options and public-sector investment decisions

Real options analysis was developed to analyze the investment behaviour of value-maximizing private-sector firms. However, in principle, it is easily modified to analyze investment (and other) behaviour by the public sector. Whereas a private-sector firm maximizes its market value, which is taken to be the present value of the flow of surplus to the firm's owners, a public-sector organisation can be charged with maximizing the present value of the flow of total surplus. The mechanics of real options analysis are unchanged: the flow of producer surplus is simply replaced with the flow of total surplus.[14]

In a static setting, this will mean that a private-sector entity will tend to under-invest relative to the public sector. This will happen whenever the required investment expenditure is greater than the present value of the flow of that part of the surplus received by the entity's owners (so that the private-sector entity would not invest) but less than the present value of the flow of total surplus (so that the public sector would invest). A similar result holds when there is timing flexibility, except now instead of “under-investment” the problem is “investing too late.” That is, the investment policy that maximizes the present value of the public investment payoff will feature earlier investment than the policy that maximizes the present value of the private payoff.

The situation becomes more complex when the public and private sectors interact. For example, infrastructure might be owned and operated by a regulated monopolist, in which case some decisions are made in the public sector (e.g. the level at which prices are capped) and other decisions are made by the firm (e.g. the timing and scale of investment and the level of spending on maintenance). Even if infrastructure is owned and operated by a public-sector organisation, particular tasks (and the associated decisions) might be outsourced to the private sector. Real options analysis can still be applied in such situations, but now at each decision node the decision-maker chooses an action that maximizes its own objective function shaped by the allocation of ownership. Thus, decisions that are the responsibility of the public-sector organisation are made in order to maximize the present value of total surplus, and decisions that are the responsibility of the private-sector organisation are made in order to maximize the present value of the surplus received by its owners: in each case the actual objectives will be shaped by contracted terms and the allocation of ownership.[15]

Allowance for flexible decision-making (as occurs with real options analysis) is especially important in situations where the private and public sectors interact. The incomplete nature of the contracts involved means that both parties retain some flexibility in how they carry out their assigned tasks. For example, while a private contractor may be required to complete construction of a project within a particular time frame, crucial decisions during the construction process are delegated to it. It will have some freedom regarding the rate at which particular stages of the project are completed, the materials used, the quality of the work done, and so on.

The actions taken by public and private-sector decision-makers will depend on the value of flexibility, such as the option value of delaying taking an action. These option values depend on the volatility of the decision-maker's payoff, and the level of this volatility will depend on how risk is allocated. That is, when evaluating projects in which the public and private sector interact, we need to be concerned not just about project risk, but also about how that risk is allocated. Below we consider three different types of interaction between the public and private sectors through the lens of real options analysis.

Risk aversion

Ultimately the actions undertaken by organisations will be determined by the decisions made by individuals (or groups of individuals) within those organisations. For example, while the objective function of a private-sector firm may be the present value of the flow of the surplus received by its owners, the decision maker(s) will maximize their own utility function. Similarly, while a public-sector organisation may have the present value of the flow of total surplus as its objective function, the decision-makers—politicians or bureaucrats—will maximize their own utility function. The overarching objective of private-sector managers could be argued to be narrower and thus admit clearer incentives for managers. In contrast, in public-sector organisations the combination of multiple goals and risk associated with political as well as financial capital means that the risk considered in relation to public-sector investment will be different, and possibly also that public-sector decision-makers will be more risk averse than private-sector decision-makers.

Private-sector managers can be incentivized by basing their compensation on project outcomes. The corporate finance literature makes this assumption, and treats the individual's utility function as a concave function of this compensation (or of the consumption that it can purchase) when it examines the effect of risk aversion on investment behaviour. This approach is more problematic when applied to public-sector decision-makers since such explicit sharing rules are ruled out for public-sector agents. However, the lessons of the corporate finance literature can be applied, if public-sector managers are risk averse regarding project outcomes: for example, they might perceive that their career prospects will suffer a relatively large negative shock from a worse-than-expected project outcome and a relatively small positive shock from a corresponding better-than-expected project.

All else equal, greater risk aversion lowers the present value of a risky flow of future surplus. In a static setting (that is, one in which investment is “now-or-never”), this means that some risky investments with the potential to provide quality-enhancing and/or cost-reducing innovations will not be approved by a public entity even though they would maximize the present value of the flow of total surplus. For such projects, the public-sector decision-maker attaches a (personal) value to the flow of benefits that is less than the required expenditure, even though the present value of the flow of total surplus is greater than the (same) required expenditure. Similarly, there will be situations in which investments will not be approved by a private entity even though they would maximize the present value of the flow of surplus to the entity's owners.

However, this result can change when there is flexibility regarding the timing of investment. In this case greater risk aversion has been shown to lead to accelerated investment.[16] This happens because, although greater risk aversion reduces the payoff from immediate investment, it reduces the value of the option to wait by a larger amount. The decision-maker is able to reduce its exposure to risk by investing immediately, since this eliminates the possibility that conditions will change while it waits to invest: post-investment uncertainty remains, but pre-investment uncertainty has been eliminated.

A similar result holds when investment involves exercising learning options. Specifically, when the cost of completing a project is uncertain and this uncertainty is only resolved by completing construction of the project, Whalley (2010) shows that greater risk aversion leads to earlier abandonment of the project.

It follows that if a manager is risk averse with respect to his or her employing organisation's investment payoff, then investment will generally start too soon, and be abandoned too quickly, to maximize the present value of that payoff.

Financing constraints

Standard capital budgeting theory assumes that there are no frictions involved in raising the financial capital needed to undertake investment. This assumption is reasonable at government level and for private-sector firms with strong credit ratings. However, public-sector entities with restrictions on the transfer of unspent funds from one financial year to the next and private-sector firms carrying high debt loads, may find it unusually costly (or even impossible) to raise the capital needed to undertake projects, even if those projects have a positive net payoff. In such situations, the standard results from capital budgeting theory need to be modified.

In a static setting, the presence of frictions in external capital markets can lead to underinvestment. However, when there is flexibility regarding the timing of investment, such frictions can actually lead to accelerated investment.[17] The intuition for this result is that delaying investment exposes the entity to the risk that when it does eventually want to invest in the project it might not be able to access sufficient external capital to make up for any shortfall of capital from internal sources. This risk lowers the value of waiting and, all else equal, means that entities with temporal funding constraints such as those in the public-sector budget process may invest too soon to maximize overall welfare.

Limited liability

The interests of bondholders and shareholders in a private-sector firm diverge because shareholders are exposed to both the upside risk and the downside risk of investment, but due to limited liability their downside risk is capped. In contrast, bondholders have no exposure to upside risk (their return is fixed) but they bear a share of the downside risk (where losses exceed the capital of the firm). This conflict can lead to asset substitution (where a manager working in shareholders' best interests adopts high-risk projects, transferring wealth from bondholders to shareholders) and debt overhang (where a manager working in shareholders' best interests forgoes value-increasing investments that transfer wealth from shareholders to bondholders).

When there is flexibility regarding the timing of investment, debt financing induces the manager to accelerate investment relative to the investment policy that maximizes the value of the firm as a whole (that is, the sum of the values of debt and equity).[18] This allows shareholders to start receiving dividends sooner, but exposes the firm to the risk of poor future outcomes—which may impose losses on bondholders.[19] The New Zealand government may not in practice have limited liability in respect of the financing of individual projects (it is unlikely to be politically feasible to leave private bondholders with losses after it had induced them to invest in a public project), so it does not have the incentive to accelerate investment because some of the losses will be carried by bondholders. However, soft budget constraints; (the power to tax to raise funds to subsidise projects) may induce early investment by providing a softer constraint on early investment than is true for private-sector firms.