The Principal-Agent Problem in Finance: Performance Clauses in Shipping Charterparties : The misalignment of incentives for performance between shipowners and charterers regarding ‘Good weather conditions’ in time charter contracts

Abstract

This study investigates how definitions of ‘Good weather conditions’ influence speed and fuel consumption claims in dry bulk shipping time charter contracts. Using observed weather data, we simulate various definitions to model the relationship between ‘Good weather conditions’ and the expected number of good weather days. We examine the four key parameters defining a ‘Good weather day’ through a random forest model and assess the financial implications of varying these definitions through a case study. The analysis shows that charterparties tend to define the threshold for what is considered ‘Good weather conditions’ too strict in relation to the intended threshold for weather so heavy that the warranted vessel speed and fuel consumption cannot be reasonably expected. Further, the results show that whether to allow for periods where the vessel is negatively influenced by currents (that is, a negative current factor) or not has the largest impact on the expected number of good weather days. Additionally, results suggest that a 2.4 m significant wave height limit is the optimal limit to use when intending to describe Douglas sea state 3 in conjunction with Beaufort limit 4. Alternatively, results show that a combined sea and swell limit of 3.25 m can resemble the same definition of weather conditions; however, we argue that the significant wave height is more precise in its ability to describe the weather that affects a vessel’s performance. Further, a case study suggests that the increasing practice of including the ‘no extrapolation’ wording in present charterparties significantly influences the financial implications of claims for underperformance. This trend makes the definition of ‘Good weather conditions’ even more critical for claim potential. The study points to a misalignment of incentives between charterers and shipowners when setting good weather definitions in time charter contracts. This misalignment represents a principal-agent problem and can lead to speculative behaviour and less effective clauses. We argue that a more objective definition of good weather in performance clauses is more efficient for both shipowners, charterers, and the environment.