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Published on: April 5, 2021, 7:29 a.m.
Infrastructure development: Restoring the family silver
  • HAM has been specifically designed for India’s highways, to provide early payback of capital to the private party

By Carlton Pereira. The author is managing director, Tano India Advisors Pvt Ltd

Since the early 1990s, India’s infrastructure has undergone a massive transformation in scale. While its power generation capacity increased from 69 GW in 1992 to 375 GW in 2020, its highway length went up from 52,000 km in 2000 to 142,000 km in 2020 and port cargo handling from 164 million tonnes in 1991 to 1,320 million tonnes in 2020. Infrastructure has a multiplier effect on economic growth, and such expansion has contributed to a 10-time increase in GDP, from $266 billion in 1991 to $2.7 trillion at present.

Despite the headline numbers, India is underdeveloped in infrastructure, due to its inability to sustain a cycle of investment. The rate of investment has declined, except for two short growth spurts: once in 1994-95, due to a large one-time inflow of upfront licence fees for telecom projects and, the other, in 2001-02, arising from the Golden Quadrilateral plan for four-lane major national highway networks.  By 2003-04, infrastructure spending, as a share of GDP, had dipped to a low of 3.3 per cent. The period from 1991 to 2011 also saw an exodus of almost all foreign investors in the power and telecom sectors, due to policy instability.

Private investment in infrastructure has had its share of problems. Project delays and cost over-runs are common and the resulting stress is visible on the balance sheets of private developers.  This stress creates Non-Performing Loans (NPLs), which seriously impact the banking sector.  Infrastructure NPLs are estimated at Rs1.35 lakh crore. 

Recognising the need for greater investment, the government has committed Rs5.54 lakh crore to infrastructure in the Budget of 2021-22 (against Rs4.39 lakh crore in 2020-21). It is estimated that India needs investment of Rs235 lakh crore on from 2021-30. This is more than three times the aggregate of the previous decade (Rs77 lakh crore). The government relies on Public-Private Partnership (PPP) to partly fund this need. However, increasing the availability of capital is not the only solution to the problem.  Private (and foreign) investment will need to be attracted by a stable policy framework, within which risks of project development are fairly allocated and mitigated by parties that are most competent to handle the relevant risk. The absence of this feature in the PPP model is the primary cause of the proliferation of NPLs and decline in private investment. 

Private participation

The government’s initiatives for the sector appear to be more transactional than strategic in orientation. Financing institutions have been established – the National Investment & Infrastructure Fund (NIIF) in 2015 (a quasi-sovereign fund) and the National Bank for Financing Infrastructure & Development (NaBFID) in 2021; however, a plan for their cohesive operation is not visible as yet.

In her Union Budget 2020 speech, the finance minister had invited Sovereign Wealth Funds to invest in infrastructure with a promise of tax incentives; however, there is no plan for similar incentives to Indian investors. Lastly, several PPP models have been pursued as financing structures for asset creation, whereas the larger issue of systematic risk allocation and mitigation remains unaddressed.

The cost of an infrastructure project has three elements – cost of construction, cost of capital; and cost of operations and maintenance (including profit for the operator). User charges in different PPP models are fixed to recover these costs (and profit).  India has generally adopted two models: Build Operate Transfer (BOT) and Hybrid Annuity Model (HAM). 

BOT is the conventional model, where the private party finances, builds, owns and operates an asset over the concession period (20-30 years). At the end of the concession, the asset reverts to the government or a government-owned entity. During this period, the private party is entitled to collect user charges. 

HAM has been specifically designed for India’s highways, to provide early payback of capital to the private party. The National Highway Authority of India (NHAI) is the implementing authority for HAM. As per HAM, the private party finances, builds and operates the asset, but NHAI collects user charges. NHAI pays 40 per cent of the private party’s investment (plus a return) over five years (annuity).  The remaining 60 per cent is paid over the concession period (20-30 years), based on actual usage of the asset (variable payments).

The PPP model has not succeeded because the fundamentals of risk allocation are not consistently applied. PPPs are natural monopolies and therefore subject to intense scrutiny and constant risk of derailment. Therefore, the government cannot afford to play a detached role while awarding a project, leaving the burden of risk on the private party. The government must ensure that its departments provide clearances for the project in a timely and co-ordinated manner.

Most delays are due to the time taken in obtaining clearances from various departments, which often work at cross-purposes. In addition, in the absence of clear rules for land acquisition, a private party assumes disproportionate risk on a task for which the government is better suited, using the doctrine of Eminent Domain. 

India can solve the problem of its infrastructure deficit by following a plan for systematic de-risking of PPP projects, thereby allowing different long-term investors (retail investors, pension and sovereign funds) to invest at various stages of a project. This method is described in the following three parts.

De-risking by up-front preparation

The viability of an infrastructure project is time-sensitive. Delays during construction escalate project cost and impacts financial viability. Delays occur in: land acquisition, clearances, and unclear parameters, resulting in disputes which stall execution. Projects can be de-risked from delays by pre-conditioning the following actions in the preparatory stage:

Feasibility. In addition to economic viability assessment, feasibility should be completed only after all risks are determined as addressable and conformity with law is established. A project should be allowed to proceed to the next stage of development only after such determination.

Development. This is the project detailing stage – technical parameters, financial projections, capital structuring, contract documentation and clearances. At this stage, a project company should be formed by the government (or its agency) to receive project clearances and later, to raise capital and execute contracts.  All clearances should be delivered to the project company, before awarding the project to a private party. Contracts should be drawn with clearly defined responsibility allocation.  Bidding should only commence after completing these actions.

Bidding and financial closure. Once a private party wins a bid, they should be required to obtain binding commitments to finance the project within a specified time – this milestone is defined as financial closure. Project construction must not commence until financial closure is achieved.

Land acquisition

The government amended the land acquisition law in 2014, to make the process more transparent and fairer in compensation. However, instead of a set of uniform guidelines, the law gives states the right to make their own rules to acquire land. The result is a set of vastly differing practices in the states, which is not conducive to instilling confidence in the process.  Instead of burdening the private party with the task and associated risk, completion of land acquisition by the government should be a precondition to inviting private parties to a PPP project. Land will be the government’s equity in the project and can be refinanced on financial closure, to release the government’s capital.

Dynamic capital structure

A dynamic capital structure in a PPP model evolves over the development, construction and operation stages of the project. Investment at different stages should be provided by lenders or investors best suited to meet the requirements of that stage. The sequence is described below.

(a) Initially, the government provides equity to fund land acquisition and the expense of bringing a project to the bidding stage, where all clearances have been procured and all contracts drawn up. Such equity should be provided through the NIIF or NaBFID. This will reduce the load on the budget and enable activation of a larger number of projects, via release of equity in phase (b).

(b) When the project reaches financial closure, a part of the phase (a) equity can be released with bank loans of a three- to five-year tenor. A risk-mitigated financial closure (based on completed land acquisition, established feasibility, binding clearances and project contracts) will reduce NPLs on banks, with the shorter tenor of three to five years being more in tune with their lending capabilities. The three- to five-year tenor of debt coincides with the time for construction and stabilisation of operations.

(c) The cost of equity would be the highest, if provided by private investors in the project company. Servicing private equity would escalate project cost and consequently, user charges.  Therefore, instead of equity, the private party should provide financial guarantees for their obligation to execute the project. In a dynamic capital plan, the role of the private party will be to build and operate the asset, within a system of incentives and penalties at all stages. 

(d) Once construction is completed and a level of operational stability is achieved, long term capital (repayable over 15-20 years) can take out bank loans. For long-term investors, risk mitigation occurs when investment is made after pre-operative and construction risks are eliminated and the project is commercialised.

(e) The end result of a dynamic capital structure is that the government (or its designated agency) will be the only equity owner of the project. After servicing long-term investors in phase (d), all user charges from a project will accrue to the government’s coffers. This becomes a source to finance other PPP projects, without depending on budget resources.

Thus, in project financing, a reduction of risks translates into a lower cost of capital. In a dynamic capital structure, the government’s equity is limited to land acquisition costs and development expenditure. The bulk of the capital is accessed from banks and investors, based on systematic risk allocation. As such, a reduction in the need for budget resources can be achieved, apart from a lower cost of capital.  Direct investment by long-term investors costs far less than equity investment by private developers.

The attention of the government must be focussed on the physical processes of risk allocation and mitigation. Risk mitigation translates into lower sector NPLs for banks. In a dynamic capital structure, investors can earn long-term fixed income returns – a new avenue, which can move long-term savings away from risky equity markets towards stable public assets.

For the government, apart from project earnings, PSU divestment proceeds can also be partly used to fund infrastructure equity. Such reallocation would be an ideal diversification away from PSU equity ownership in favour of a direct and permanent ownership of public assets. There are few better ways than this to restore the national family silver.

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