5.4 The trade-off between scale and flexibility in construction and operation of facilities
Unbundling a project into separate construction and operating phases restricts the time during which the construction phase of a project must be completed. This will motivate (perhaps even compel) the builder to favour scale over flexibility, since it will be difficult, if not impossible, for the builder to spread construction of a project over time, building successive stages, if and when they are necessary. In contrast, a PPP-style arrangement would open up the possibility of staged investment, allowing the decision maker to use all available information when managing the construction phase.
One situation when the trade-off between scale and flexibility arises is when services can be provided using various combinations of (low cost) irreversible and (high cost) reversible investment (in their simplest form, “capital” and “labour”). In the early stages of a project, for example, it might be optimal to undertake reversible investment because, even though this will be more costly in the short-run, it can be redeployed if demand growth is lower than expected. If strong demand growth does occur, then the cheaper irreversible investment can be made without the risk that it will be stranded. When such investment strategies are feasible and attractive, bundling the construction and operating stages together via a PPP is attractive, as it allows the building party to delay committing to irreversible investment until well into the operating phase. This is most likely to occur in situations where the real option to delay undertaking irreversible investment is most valuable, which will tend to occur in situations when demand volatility (or other sources of uncertainty) is relatively high.[27]
Notes
- [27]Kandel and Pearson (2002) present a model of investment using a mix of reversible and irreversible technologies, and use it to examine the role that demand volatility plays in the optimal investment policy and the overall cost of investment.
