Value of Investors’ Escalation of Commitment in PPP Projects Using Real Option Thinking

Abstract

Escalation of commitment (EOC) is a common behavior among investors who receive negative feedback (NF) in public-private partnership (PPP) projects, and this behavior typically leads to sizable losses. Recognizing this, investors set a mental threshold and track investments for escalation. Once losses reach the threshold, investors will terminate the escalation behavior, namely, they will transfer projects to governments to obtain compensation or residual asset value. This paper analyzes the maximum amount of NF that investors can sustain based on a belief-adjustment model, followed by the analysis of the greatest loss degree. Then, a threshold model for EOC is constructed using real option thinking. Different from the usual judgment criteria of the traditional option method, the threshold is less than zero in the EOC scenario. The results show that the threshold correlates with the initial generative cognition, the sunk cost level, the degree of the government guarantee and investors’ behavioral preferences as well as with total investment and return on investment. These findings serve as a reference for governments to de-escalate investors’ commitment in PPP projects.

Investors’ exit timing of PPP projects based on escalation of commitment

“…According to the model, the research conclusion is as follows: when the actual value of the project (including static financial value and option value) is higher than the project cost, the decision maker should choose commitment escalation; when the actual value of the project is lower than the cost of the project, the decision maker should choose to exit early rather than continue to commit to escalate. This conclusion improves the exit mechanism of PPP projects and provides decision makers with a clear and specific exit evaluation standard to avoid falling into an irrational dilemma because they cannot accurately judge the actual value of the project [ 19 ].…”

Essays in Infrastructure Economics

“…We perform the same analysis to investigate which infrastructure projects are evaluated in these reviewed papers. As we expected, most of the sample (47%) evaluates road projects, such as toll roads (Blank et al, 2016;Liu et al, 2020); bridges ; and motorways . Percentage values indicate the proportion of studies identifying a particular source of uncertainty.…”