# **Risk Shifting and Long-Term Contracts: Evidence from the Ras Gas Project**

## _1._ **_Introduction_**

The presence of risky debt in a firm's capital structure is<sup>known to lead to</sup><sup>_ex post_</sup> conflicts of interests between the firm's equity holders and<sup>bondholders.' Given eguity's convex</sup> pay-off profile, firms that are managed in the interest of equity holders<sup>have an incentive to shift</sup> risk to their bondholder. Excessive risk taking, if not controlled<sup>through contractual and pre-</sup> commitment devices, could result in suboptimal investment<sup>decisions (over- or under-</sup> investment). The associated investment distortions cause deadweight<sup>losses to the economy. The</sup> risk shifting incentives of risky debt and the associated suboptimal<sup>investment problem arise</sup> from the interplay of pay-off profiles and informational asymmetries between<sup>equity holders and</sup> bondholders, e.g., in circumstances where monitoring and contracting<sup>costs prevent bondholders</sup> from sufficiently observing investment choices made by inside<sup>managers.</sup> To address such agency problems, recent research has advanced a<sup>variety of incentive</sup> compatible solutions, including financial contracting (restrictive<sup>bond covenants, and</sup> convertibility clauses, Kahan and Yermack, 1998), project finance<sup>(Berkovitch and Kim, 1990),</sup> tax policy (John, John and Senbet 1991), and reform of bankruptcy<sup>procedures (Schwartz, 1997).</sup> Through or because of such devices, it is claimed, borrowers can<sup>credibly signal to lenders that</sup> they choose efficient levels of risk. This strand of literature, however,<sup>neglects a further source of</sup> risk shifting that has a direct incidence on debt finance: _contractual_<sup>_incompleteness._Thus, in</sup> markets where transactions are characterized by a high degree<sup>of uncertainty and relationship</sup> specificity conditions, contracting parties often have to leave<sup>many contingencies and provisions</sup> out of _ex ante_ agreements, creating incomplete contracts. Prime<sup>examples of such transactions</sup> are investments in large scale projects, i.e., power plants, oil<sup>and gas pipelines, and lquified</sup> natural gas (LNG) facilities.

In this paper, we analyze risk shifting as a consequence of contractual<sup>incompleteness2</sup> and relate its sources to the price of risky debt in the context of<sup>project finance. The project in</sup> question is the Ras Laffan Natural Liquified Gas Company (Ras<sup>Gas), set up to extract, process</sup> and sell liquefied natural gas from a field off the shore of Qatar.<sup>Ras Gas signed a 25 year supply</sup> 'See Jensen and Meckling (1976), Myers (1977), Smith and Warner<sup>(1979), John (1987), Green (1984).</sup> 2 The theoretical underpinnings of contractual incompleteness are well<sup>understood in the literature on contract the-</sup> ory, whether in its principal-agent or transaction cost setting. According<sup>to the transaction-cost approach, contract</sup> incompleteness is attributed to high transaction costs of writing, negotiating of<sup>contracts, and costs associated with</sup> monitoring of contractual performance. (See, for instance, Joskow<sup>(1987, 1988), Hart (1988), and Aghion and Bol-</sup> ton (1992).