Risk mitigation in urban bus concession contracts: Overcoming uncertainties with a real options model

In this paper, we analyzed a risk-sharing mechanism that can be used in urban bus public service contracts (PSC) to deal with demand uncertainty in the upcoming years. This mechanism is similar to a collar option: an MRG (Minimum Revenue Guarantee) combined with a revenue cap. We applied this mechanism to a case study, the Lisbon Metro Area bus contracts. We compared the chosen model (a gross cost contract) with a simulated scenario modeled as a collar option. To develop this scenario, we model the flexibilities applying Real options Analysis and the project uncertainty as a Geometric Brownian Motion (GBM). The calculations were performed using Monte Carlo simulation. The results show that, compared to the gross cost, the collar option model allows the private operator to benefit from a potential demand increase. In the case of a downturn, the loss is shared between the two sides, reducing the contract cost borne by the government. Furthermore, from a public policy perspective, contrary to the gross cost model, this model may incentivize the private partner to improve service quality as a strategy to increase demand and, consequently, revenues. In addition, if demand evolves in a different trend, the financial rebalance is made automatically, reducing litigation costs for both sides.