Category Archives: Private Infrastructure

India’s trillion dollar challenge

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Preparations for the Twelfth Five Year Plan have begun in India. Infrastructure will need trillion dollar investment if India is to nudge up its growth rate to 9-9.5% per year in the next plan. One of the usual questions puzzling the planners is whether we will find resources to create world class infrastructure. Similar concerns were also raised for the current, Eleventh Plan − will India be able to double infrastructure investments? Or will infrastructure become a binding constraint for accelerating economic growth?

As per the Mid Term Appraisal of the Eleventh Plan, there is nothing to worry. India has already invested $340 billion and with expected $117 billion of investments this year, actual will be $457 billion, missing the target by only $3-4 billion. And the role of the private sector has been an important one in meeting the current plan targets. Private sector will account for a significant share, 36% or $167 billion of total infrastructure investments during Eleventh Plan. No wonder, at yesterday’s Planning Commission meeting, the Prime Minister once again called on the private sector to supplement public resources. It will not be possible to meet India’s trillion dollar infrastructure challenge without active support from private sector.

Good News? Well, it depends on your perspective. I am very worried looking at a recent news item.

The economic regulator has agreed to the demand of Delhi International Airport Pvt. Limited for $225 million in additional passenger levies. The news report quotes regulator’s response from their website. “It is also noted that the project has already been implemented. Therefore, any corrections or remedial measures do not appear feasible at this completed stage of the project.” The regulator adds, “Further, the auditors have expressed their inability to assess the monetary impact of the issues raised by them…..”

In the past concerns were raised about rising costs of this project. The overall cost of the Delhi airport has gone up from Rs 3500 crores at the initial bid stage to, Rs 6000 crores in 2007 to Rs, 9000 crores in 2008. The current costs are estimated at Rs.12,700 crores. The government has already given a number of financial concessions in favor of the private sponsor. It is not clear whether such deals make economic sense at all for all the stakeholders.

Even 101 economics will tell us that in theory, PPI instruments offer value for money, provided the procurement process is efficient, and there is true competition to drive the overall costs down. Once the project is selected, government hands over a monopoly to the selected bidder for a long period of time. Competition for market does not ensure economic efficiency within the market, unless the underlying instrument, in this case, a contract is designed to ensure such efficiency. Such long duration contracts are bound to be renegotiated and hence the possibilities for moral hazard are very large indeed. It pays the bidder to get the contract at low price and then renegotiate. This seems to be a very common practice in PPIs and India is no exception.

It is important that planners worry on how to meet the trillion dollar challenge, but this time round, let us not focus on the quantity alone, we need to examine the price tag of this trillion dollar. The government or apex institutions in India are just not ready to deal with the complexity of PPI risks. Model concessions and bidding documents bring standardization, not necessarily economic efficiency.

Private Infrastructure: Too important to fail?

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With rapidly rising shares of private capital in infrastructure around the world, an interesting question is whether private capital is indeed more expensive when compared to public capital. Since the cost of capital reflects the underlying risks, an even more relevant question that needs to be answered is whether there are significant differences in the risk profiles of a privately funded infrastructure project compared to other alternatives.

Most PPP sponsors spend considerable time and effort to manage any potential downside risks that may arise. Usually, most countries have a set of policies to guide risk allocation between sponsors and governments, but getting it right is usually the biggest challenge facing policymakers. A lot of interesting analytical work on PPP risks and their allocation among different stakeholders is going on. We will discuss these some other time. In this entry, I want to draw attention to something quite different: whether or not infrastructure policy makers are learning risk management lessons from the financial crisis.

If you surveyed infrastructure policy makers today, especially those based in developing countries, and asked what similarities, if any, there appear between the current boom in private infrastructure and the way overall risks were addressed in the financial sector before the crisis, two possible types of answers are most likely to emerge. A large number of policy makers will point to their elaborate risk assessment and management processes, including best practices, institutions, databases, websites, and experts cells as evidence of their efforts to deal with PPP risks. Another group will deny that today’s PPPs involve significant risks for governments since the current trend is to move away from public guarantees and to transfer demand risks to markets as much as possible. Unlike the private infrastructure of the 1990s, current models of private infrastructure emphasize selecting the right type of private sector projects. Today’s mantra is to leave major demand risks to markets and keep government liabilities, if any, within limits. In India, for example, viability funding adopted for the private infrastructure model keeps overall liabilities under a tight cap. But both these answers miss the lessons from the recent crisis that are staring us in the face.

Infrastructure projects have fairly complex risk structures and each group of stakeholders needs to focus on their own risks. Let us look at typical risks faced by two major stakeholder groups, private sponsors and governments, used as a proxy for all infrastructure users. Fundamentally, the private sector is concerned with risks that adversely affect cash flows of projects from the base case on which the project was financed. Governments, on the other hand, are trying to guard against service disruptions, either in terms of quality or quantity. Governments would also like the private sector to deliver at the lowest possible costs, whereas project sponsors would like to keep adequate margins in their costs to deal with any unknowns. In most developing countries, risk assessment and management processes do not typically target both these risk perspectives, and so in reality it is difficult to reduce risks for both groups simultaneously and that too at a reasonable cost. Whichever groups have better skills, negotiation capabilities, and political clout will be able reduce their own risks. At the central level of governments, there are at least some mechanisms in place for appraisal and approval; At the state and local levels, the situation is much worse. In India, for example, there is one central project for every three at the state level. Do elaborate processes and institutions help to mitigate underlying risks for all stakeholders? No, it really is chaos out there.

What about the ability of markets to address other risks? If there are no guarantees given by governments at least on paper, the project sponsors and debt holders bear the actual market, and other, risks. This is where the macro-risks begin: A large number private infrastructure firms are growing very quickly on debt, as in India. The recent financial crisis has shown us that growth of size through rising indebtedness combined with a “will grow out” attitude contributes to moral hazard risks, as more and more firms assume non-sustainable growth strategies. Indian Planning Commission’s monitoring system, for example, has only physical and financial expenditure targets for the year; What about the impact of these PPPs on market structure? Even more importantly, what about the fiscal impact of such a structural change? And given that a large number of projects are now borrowing from outside India, what impact will the creation of large foreign exchange risks have?

There are also sector specific risks. For example, a large number of merchant power plants, sized to take advantages of economies of scale in India, are hoping to cash in on current power deficits and the resultant high prices prevailing in power exchanges to mitigate SEB non-payment risks. This may be possible for a few power plants, but this strategy cannot work for a large number of market players without dampening the power prices and creating bankruptcy risks.

The financial crisis demonstrated that, beyond project specific risks, benefits that arose out of scale economies (as was the case in large banks and other institutions) were offset by the risk of portfolio, that is, the cumulative impact of too many risky projects. While the merchant power plants may not be very large in terms of market share, externality risks created by their potential failure will be difficult to bear and governments will inevitably have to bail them out. The basic assumption then that markets can address risk in infrastructure is only feasible to some extent. Given the dependencies and linkages of infrastructure with economy, employment, and quality of life, governments, as in the case of India, are holding large residual risks, even if this is not readily apparent as yet.

The financial crisis is an important reminder that, more than the consequences of individual action or isolated regulation failure, the cumulative impacts of individually risky projects are much more serious and difficult to diffuse with potentially large growth penalties. So who is hedging against this cumulative risk when countries are embarking on large infrastructure programs? The financial crisis had to deal with the so called “too big to fail” risks; with large PPP project portfolios, governments will be called upon to rescue firms and projects because these are “too important to fail”.

India’s new normal: from public finance to project finance

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Today’s media is full of stories about the ‘new normal’. The high profile failed bombing attempt at Times Square this month was splashed across headlines as the new normal of home-grown terrorism. Two million Boston residents had to adjust to the new normal of life without safe drinking water after municipal mains ruptured. The Huffington Post’s Caroline Dowd-Higgins penned five tips for navigating the new normal in today’s job market. Time reports on the growing prevalence of memory-loss diseases like Alzheimer’s or other forms of dementia: clearly, forgetting is the new normal. For military families, the new normal is repeated redeployments of their loved ones to ever-increasingly dangerous zones. Much closer to home, Suman Bery highlighted the issue of exchange rate as part of the new normal monetary policy framework. Strangely enough, the Indian infrastructure story has not been phrased in the new normal rhetoric. At least not as yet.

India has moved rapidly from public finance to project finance in infrastructure. In the first quarter of 2010, India topped the Asia Pacific region with eight out of the ten largest project deals, amounting to $15.2 billion or 46% of market share. Seven out of these are infrastructure projects. Globally too, India accounts for five out of the top ten projects. 2009 was a turning point: When the world responded to the financial meltdown with a 44% decline in project deals, India came out as the most active country for project finance with 72 deals totaling $30 billion, leaving the runners-up Australia ($12.6 billion) and Spain ($11 billion) far behind.  Moreover, the 2009 PFI award for Bank of the Year for Asia was taken by the State Bank of India. So what drives this new normal of Indian infrastructure?

A push from the highest quarter of the Indian government is surely a factor. The high profile Infrastructure Committee is chaired by the Prime Minister and is guided by the Deputy Chairman of the Planning Commission. There is also a bottom-up cry for more infrastructure services. Power availability in April was 14.6% short of demand at the all-India level, and seven states faced a peak deficit of more than 20%. High macroeconomic growth at home, global financial troubles, and PPP mania are some of the other impulses driving this new normal.

Most of these deals are highly leveraged: A typical PPP project has less than 10% equity from the promoter. But this is precisely what has changed globally after the collapse of Lehman Brothers. In March 2009, Ian Davis, the Worldwide Managing Director of McKinsey, characterized the new normal world as having two distinct features: It involves a fundamental restructuring of the economic order with, firstly, significantly less financial leverage and, secondly, a much greater role for government. So is there a quiet disconnect from the global new normal? Easy availability of project finance has made it possible to add infrastructure capacity without dealing with the much-needed sector reforms. Take the example of the Indian power sector: Overall subsidy which was $6.2 billion last year is expected to rise to $26 billion by 2014-2015, despite some moderate improvements anticipated in the next few years. The Indian states carry huge contingent liabilities because of power, and other, demands. Overall efficiency of the SEBs remains low and increasing the share of private providers in the sector will not change this. In fact it may even exaggerate fiscal problems, at least in the medium term. For example, SEBs which have not planned for capacity addition or taken steps for load management will end up relying on short term power exchange at a much higher rate than the cost of new capacity. The open access policy will allow the paying private sector users to contract with the new PPPs directly, leaving SEBs with loads that imply large subsidies under the current regimes.

One should always remember that PPPs carry much larger foreign exchange and fiscal risks compared to government financed projects. The new infrastructure model can work, provided the government undertakes important sector reforms, particularly tariff reforms, now. Let us not forget that the last two centuries have seen many waves of private infrastructure followed by state solutions that levied huge fiscal costs for tax payers. And most of the time, it is these highly leveraged infrastructure projects that were responsible for such swings. India’s new normal looks great at the moment, but how long will it last?

Infrastructure: what is right?

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Most of the current debates on infrastructure financing focus on two very different aspects: the enormous size of infrastructure investment demand, and the critical need to invest in what is considered the ‘right type of infrastructure’. There are multiple ways of looking at demand for infrastructure and so depending on the underlying assumptions and models, it is quite natural that there will be multiple estimates. It is hard to get a consensus on a single number. But once the numbers are in trillions, why waste time arguing about methodological purities? Whatever the differences, these would be well within a reasonable margin of error in any case.

And so this entry is about a long list of attributes that are currently used to illustrate the ‘right way to invest in infrastructure’. Local money for local infrastructure – which means no bailouts by Washington – is considered right. Emphasis on asset maintenance gets high marks. Partnerships with the private sector are essential elements of the right strategy. Mass-transit to reduce urban congestion costs and modernization of transport system are integral parts of right infrastructure investments. Information infrastructure, especially creating high-speed broadband is supposed to benefit innovation and so must be right. Green energy, clean technology, smart grid and other tools that modernize the energy sector are encouraged too. Reduced logistic cost, efficient and intelligent transport, including freight modernization, would benefit local industries and so are usually considered right. And for developing countries the right kind of infrastructure is, among others, inclusive, market expansive, regionally integrative, and sustainable.

So what is wrong with labeling everything ‘right’? Nothing, except that all these statements allude more to a religious discourse driven by faith and belief rather than professional substance. And this gives very little guidance to policy makers about the underlying trade-offs that need to be evaluated before making the ‘right’ choice. For China, which is spending heavily on infrastructure, the fear is the possible overheating of the economy – which is energised by infrastructure investment, but is in reality paid for by the enormous value generated by labor arbitrage.

And the Indian infrastructure investment model may end up paying a much, much higher fiscal cost of going the PPP route which, once embarked on, may be very difficult to regulate in the future, at least in the medium term. Rent seeking and corruption will proliferate because it is difficult to design the ‘right’ types of incentives for infrastructure. Is this a story of any one country in particular? Not really. PPPs bring additional resources for infrastructure investments, but often, elaborate financing structures divert policy makers from the fundamental issue of how new services are going to be paid for today and in the longer term.

Unfortunately, there are very large gaps in the analytics surrounding the current choices countries make. There is a fundamental asymmetry of skills, information, and incentives between the two deal-negotiating parties, at least in developing countries: the private sector use all three to ensure that they maximise value for themselves in any investment proposal; government representatives, on the other hand, often lack all three but do have the exclusive right to grant market access. And as elaborated earlier (infra101), market access alone has high potential for super normal profits. This, coupled with the high transaction costs of closing a single deal, is nothing short of a perfect recipe for rent seeking.

So, if you go back to the basics, ‘right’ infrastructure means remembering that there are only two possible ways to fund infrastructure: either by the service users, or by citizens at large through tax and other indirect payments. The third way, (i.e., paying for infrastructure with vast tracks of land and thereby allowing the private sector to create value from idle resources) is an option unlikely to be available in many countries today given the extreme pressures on land resources. Investing right is thus not a mantra, but instead detailed and often dangerous work for policy makers, who must examine counterfactuals and choose projects that generate maximum value for infrastructure consumers. So it’s not about faith or beliefs, you can’t simply wish a project ‘right’. It’s all about hard facts and figures.

Lost Decades?

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The fortunes of PPIs (private participation in infrastructure) move in line with the health of global finances: Last year, financial and real assets amounting to nearly $29 trillion have been wiped out globally. (MGI Capital Report, 2009). Cross-border flows too have declined by over 80% reversing the fast pace of financial globalization that began in 2002. Compared to $10.5 trillion in 2007, cross-border financial flows plummeted to $1.9 trillion in 2008. A major casualty of financial turmoil usually is private infrastructure and this crisis is no exception. Overall project finance volumes came crashing down by 58% in the 12 months from September 2008. If it was not for the dominance of Indian deals, accounting for a quarter of total global volumes, project finance would have been back to 2004 levels.

It was only recently that investors had begun to return to PPIs after the 1997 Asian financial crisis. According to the World Bank’s PPI database, it took nearly a decade to come close to the global private interest in infrastructure achieved in 1997 and yet, the peak of 351 projects closed in 1997 is not surpassed since then. The 1997 crisis impacted PPIs at three different levels: The projects that were in the pipeline remained so for a long time; many projects that were under construction slowed down with significant cost implications; whereas those under operations were put up for re-negotiations on a large scale.

A fundamental difference between the 1997 financial crisis and today is the importance policy makers and politicians alike attach to infrastructure investments. In 1997, PPIs were seen as the only politically acceptable instrument for investing in infrastructure, and hence, at least in Asia, the 1997 crisis led to shrinking fiscal space available for new investments. The governments stepped in much later to reverse the decline in infrastructure investments when PPIs paused. This time, infrastructure, public, private, any infrastructure is seen as the savior of the economy. Private sector’s role in infrastructure is supported in almost all countries, be that USA or China, but the actual cash for projects is coming largely from the public purse.

This trend is indeed a worrisome development since the history of PPIs is curiously discontinuous. Different forms of private infrastructure investments were so common in the pre World War I era. For six decades, however, PPIs disappeared until their reemergence in the late 1980s. Are there similarities between the problems being faced by investors then and now? What should be appropriate public policy response to ensure that PPIs continue to remain as alternative model for infrastructure investments?