Valuing the right to operate: an economic perspective on concession disputes

What is the value of the right to operate a regulated asset for a finite period of time? And how should that value account for the power of the state or the regulator to alter its terms? These are questions that often sits at the heart of disputes involving a concession agreement to operate infrastructure assets.

Concession disputes can take many forms (e.g. the dispute may be about a government decision, or an investor may allege that the state has undermined the commercial purposes of an agreed arrangement). However, they usually sit at the intersection of economic regulation, public law and financial valuation. The assets involved are often natural monopolies; one of the parties involved in the dispute is frequently the state; the revenues earned by the concessionaire are typically determined by a regulator; and the time horizons of the concessions can span decades but are generally not indefinite. These features, taken together, create valuation complexities that are different from those of other types of dispute, and require careful consideration when assessing damages.

Drawing on established principles in economic regulation and damages quantification, this article examines the key analytical challenges that arise in concession disputes involving infrastructure assets—from the nature of the right itself, to the choice of valuation methodology, and to the often contested question of what the world would have looked like had the alleged wrongdoing not occurred (i.e. the appropriate counterfactual scenario).

What is a concession?

A concession is a contractual instrument by which a public authority grants a third party (usually a private investor) the right to develop, operate and/or maintain an asset or network that serves a public function, typically in exchange for the right to collect revenues from users over a defined period. Common examples include motorways, airports, energy and water networks, and rail.

The economic rationale for the concession model is well established:

• by attracting private investment, concessions ease the burden on government budgets, allowing public authorities to mobilise capital for infrastructure development without committing their own fiscal resources directly;
• private companies typically bring specialised expertise in project management, construction and efficient operations, which can lead to faster project completion, improved service delivery and the adoption of new technologies that a public authority might lack the capacity or incentive to develop in house;
• from an economic perspective, concessions create a structured framework for risk-sharing between the public and private sectors—the concessionaire bears a defined share of the construction, demand and operating risks, which incentivises efficient project management and aligns the private party’s commercial interests with the delivery of a well-functioning public service. The public authority, in turn, typically bears the risks that fall outside the concessionaire’s control, such as force majeure events.

In the case of infrastructure assets, concessions also usually include some form of economic regulation to allow the government to retain a certain degree of control over pricing, the level of investments and quality standards. In return, the concessionaire is guaranteed a degree of revenue certainty over the concession period, enabling it to recover its (efficient) costs and earn a regulated return.

Therefore, in the context of infrastructure assets, the concession is not a simple contractual licence. It is a structured economic relationship in which the commercial position of the concessionaire is inseparable from the regulatory framework in which it operates. It is precisely the interplay between the concession contract, regulation and public law that raises interesting and challenging issues when quantifying damages in the context of concession disputes.

The landscape of concession disputes

Concession disputes arise across a variety of legal contexts.

Investor–state disputes. These cases arise when a foreign investor alleges that the state has breached one or more protections afforded to the investor under a bilateral or multilateral investment treaty, such as guarantees of fair and equitable treatment, protection against expropriation, or the assurance of a stable legal and business environment. The concession is the investment, and the alleged wrongdoing is typically some governmental or regulatory act that has affected its value.

Contractual disputes. Many disputes involving concessions arise from claims of breach of contract, where one party alleges that the other has failed to perform its obligations under the concession agreement. For example, a grantor may seek to terminate a concession agreement for alleged non-performance, or a concessionaire may challenge the lawfulness of legal and/or regulatory changes affecting the economic and financial equilibrium of the concession.

Post-M&A disputes. Companies holding concession rights over infrastructure assets are frequently the subject of acquisition transactions. In these instances, the purchase price reflects certain assumptions about the future performance of the concession and the evolution of the regulatory framework, as well as the representations and warranties provided by the seller. Post-M&A disputes can take the form of breach of representations and warranties, disputes over purchase price adjustment mechanisms, or earn-out disagreements.

Choosing the right valuation methodology

As with other types of dispute, one fundamental aspect is the choice of the valuation methodology. In the context of concession disputes, three broad approaches are commonly considered.

The income approach. The discounted cash flow (‘DCF’) method estimates the present value of projected cash flows that the concession would generate over its remaining life, discounted at a rate that reflects the time value of money and the risk characteristics of those cash flows. The DCF method is well suited to concessions that are operational, generating revenues, and governed by a regulatory framework that provides a degree of forward visibility on those revenues.

At the same time, the DCF method is highly sensitive to its inputs, and changes to key assumptions can produce significant changes to its outcome. This sensitivity is not unique to concession disputes, but it is heightened by the typically long duration of concessions.

The market approach. The market approach values the concession by reference to observable transactions involving publicly listed or otherwise comparable assets. This approach is grounded in actual market behaviour rather than modelling assumptions. However, the unique characteristics of infrastructure assets mean that it is challenging to apply this approach in disputes. Concession assets are highly idiosyncratic, with their values shaped by the specific terms of the concession agreement, type of infrastructure, and regulatory environment. For example, an airport concession in a high-growth emerging market jurisdiction is not straightforwardly comparable to an airport concession in a mature, heavily regulated European context, despite the two sharing the same sector. In this context, it is therefore necessary to assess carefully whether the observable transactions or publicly listed companies are truly comparable to the concession that is the subject of the dispute.

Cost-based approaches: replacement cost and sunk cost. If the asset has not reached the revenue generation phase, or the investment was disrupted at an early stage before any operational track record was established, it may be difficult to implement the income approach. In those circumstances, cost-based approaches can be used to assess the value of the concession.

There are two main cost-based approaches—the replacement cost and the sunk cost. These two approaches rest on different conceptual foundations and have different strengths and limitations.

The replacement cost approach estimates the cost that a hypothetical third party would incur to replicate the exact same asset as at the valuation date, typically adjusted for depreciation or obsolescence. This approach ensures that the estimated value of the concession reflects what the market considers to be required to recreate an equivalent asset. However, this approach does not reflect the value generated by the exclusive right to operate the asset, which is a significant part of the concession’s total economic value.

The sunk cost approach measures what the concessionaire actually invested up to the valuation date. This approach provides a backward-looking and investor-specific valuation and is often considered as a floor for the value of the concession.

For operating concessions, the DCF method is usually the preferred and primary approach used by valuation experts, with the market approach used as a cross-check where sufficiently comparable transactions and publicly listed companies exist. Cost-based approaches are most relevant either as a cross-check on the reasonableness of the DCF method when the market approach is not possible, or as the primary method in cases where the concession was pre-operational and the income approach is not possible.

A related but distinct concept to the cost-based approaches is the regulatory asset base (‘RAB’), which represents the value of the assets on which the concessionaire is allowed to earn a return. The value of the RAB reflects the accounting value of the assets from a regulatory perspective, rather than the economic value of the assets. Therefore, the RAB does not capture the value of the concessionaire’s exclusive right to operate the asset. For this reason, the RAB is generally not an appropriate measure of the concession’s value.

The peculiarities of damages quantification in concession disputes

Beyond the choice of the valuation methodology, quantifying damages in the context of concession disputes requires careful consideration of certain features that are specific to this type of asset.

The bounded life of the concession and the role of terminal value. In most DCF valuations of going-concern businesses, a significant proportion of the value is attributed to the terminal value. This reflects the assumption that the company will continue to generate cash flows in perpetuity after the initial forecast period used in the DCF analysis. However, concessions do not work this way. Because the right to operate expires at the end of the concession period, the underlying assets revert to the grantor and the concessionaire’s right to generate revenues is therefore extinguished. This means that the conventional terminal value calculation, which implies a perpetual stream of cash flows, is not applicable.

In some cases, however, the concession agreement or the applicable regulatory framework may provide for a takeover value to be paid to the concessionaire at the end of the concession, reflecting the value of assets that have not yet been fully depreciated by the end of the concession term. Where such a provision exists, this residual value needs to be taken into account in the valuation, even though it is conceptually distinct from a perpetuity-based terminal value.

The regulatory framework as both a revenue driver and a constraint. The revenues of infrastructure assets are usually determined by a regulatory mechanism rather than freely set by the concessionaire. Typically, allowed revenues are a function of the RAB, the allowed return on those assets, planned investments, operating costs, and efficiency assumptions. Many of these parameters are recalibrated periodically to reflect contemporaneous market conditions and the concessionaire’s specific circumstances.

It is therefore pivotal, in the context of concession disputes, to understand the key principles of the relevant regulatory framework and what building blocks are considered by the regulator when setting the concessionaire’s allowed revenues. For example, the way in which revenues are shared between the concessionaire and the grantor, volume risk-sharing provisions, and the treatment of cost overruns or investment delays are regulatory aspects that significantly affect the concessionaire’s cash flows, and which must be taken into account when assessing damages.

The WACC, regulatory return and the discount rate. In the context of concession disputes, the regulatory weighted average cost of capital (‘WACC’) is set periodically by the regulator to determine the allowed returns that a concessionaire is able to generate on its investments, and therefore feeds into the concessionaire’s total revenues. However, this regulatory WACC is not necessarily appropriate to use as a discount rate when valuing the concession. This is particularly the case when the regulatory WACC is set by the regulator with reference to the entire sector or a so-called notional company (i.e. a hypothetical efficient company managing the asset), which means that the regulatory WACC reflects a different financial structure and cost of debt compared with that of the concessionaire. Therefore, it may be necessary to rely on the concessionaire’s own WACC as a discount rate, separately from the regulatory WACC used to determine the concessionaire’s revenues.

Revenue concentration and volume risk. Unlike a diversified business, a concession typically generates revenue from a single source—the users of the relevant infrastructure. Where that revenue is volume-dependent, as in the case of airports or motorways, the valuation depends critically on the extent to which the concessionaire is exposed to volume risk from a regulatory perspective, and on the accuracy of the volume forecasts. Volume forecasts are, in turn, sensitive to macroeconomic conditions, competing infrastructure and long-run demographic trends, all of which need to be reflected consistently between the factual and counterfactual scenarios.

Constructing the counterfactual: what would have happened absent the alleged wrongdoing?

Damages in concession disputes are generally assessed by reference to a counterfactual scenario—the position that the claimant would have been in absent the alleged wrongdoing. Constructing a credible, robust and coherent counterfactual in the context of concessions raises challenges that go beyond those commonly encountered in other types of dispute.

The stability of the regulatory framework. In a conventional commercial dispute, it is often assumed that the operating environment would remain broadly stable absent the specific wrongdoing giving rise to the dispute. In a concession dispute, the approach is more nuanced, because not all regulatory frameworks are designed in the same way. Some regulatory frameworks include specific periodic reviews that can bring substantial changes to the framework; others are designed to remain stable for the duration of the concession and will be updated once the concession ends. This has direct implications for how the counterfactual is constructed. Where the regulatory framework is designed to remain stable for the duration of the concession, the counterfactual can reasonably assume that the original terms would have continued unchanged, since stability is the very feature that the framework was designed to deliver. Where the framework instead provides for periodic reviews, the counterfactual should reflect a reasonable estimate of how the framework would have evolved through those scheduled reviews, drawing on the criteria applied at each review and the treatment of comparable concessions.

Unforeseeable external events. Concessions are long-lived instruments. Over a concession period of 20 to 40 years, the operating environment is likely to change in ways that could hardly have been anticipated at the time of signing. Economic recessions, pandemics and shifts in demand could significantly affect the concession over its duration. The counterfactual must account for these events to the extent that they are unrelated to the alleged wrongdoing. The general principle is that the counterfactual should reflect the best estimate of what would have occurred absent the alleged wrongdoing, rather than a scenario in which all adverse developments are excluded. However, where an adverse development is itself a consequence of the event giving rise to the claim (for example, a reduction in volumes caused by the wrongdoing itself), that development should not be assumed to occur in the counterfactual scenario.

Conclusion: principles for evaluating concession disputes

Concession disputes involving infrastructure assets present distinct and complex valuation challenges. As illustrated in this article, these challenges are not simply the product of the financial scale of the assets involved. Instead, they arise from the structural features of the concession itself—its bounded life, its regulated environment, its dependence on the conduct of a public authority, and the long time horizon over which its economics must be assessed.

Some broad principles can be applied across this type of dispute.

First, the choice of valuation methodology should be considered carefully. The DCF approach is the most commonly used primary method for operational concessions, but its sensitivity to key assumptions means that the market approach and, where relevant, cost-based approaches should be considered as cross-checks.

Second, the regulatory framework governing the concession’s revenues must be carefully considered when assessing damages. A valuation that treats the concession’s revenues as a free commercial variable is unlikely to yield a reliable damages estimate.

Third, the treatment of the terminal value must be carefully considered. The absence of a perpetuity in a finite concession does not mean that the end-of-concession value is irrelevant; it means that the treatment of residual assets, depreciation methodologies and any contractually agreed terminal value must be addressed explicitly and consistently.

Fourth, the construction of the counterfactual scenario is rarely simple. Questions about regulatory stability and the extent to which unforeseeable events should be considered are crucial aspects that require careful consideration.

As concession infrastructure continues to attract private capital, the demand for rigorous economic analysis in this field is likely to grow. The quality of that analysis will depend largely on whether the assumptions that underpin it appropriately reflect the regulatory, contractual and commercial realities of this distinctive asset class.