Tuesday, April 1, 2008

Entry Barriers in Infrastructure contracting

Two observations about the urban infrastructure contracting market in India.
1. The VMC had called tenders for outsourcing the Operation and Maintenance (O&M) of its entire sewerage network. After a long drawn out National Competitive Bidding process, one of India's leading sewerage contractors emerged as the successful bidder. It had quoted Rs 10.8 Cr in its financial bid. But after negotiations they lowered the bid value to Rs 3.9 Cr, without altering any of the contract conditions. The actual cost incurred by the VMC in doing this work is Rs 1.6 Cr!

2. There are only a handful of qualified contractors and suppliers for major water, sewerage, solid waste, and urban tranpsort contracts. Therefore, in the context of the massive boom in such works and the consequent spurt in demand for these services and equipments, sub-contracting of work has become a common practice. In many cases, the involvement of the primary contractors, who are invariably a major infrastructure company, are confined to merely pocketing a commission from the sub-contractor.

These two observations give a fair assessment of the Indian market for urban infrastructure services. Despite the rapidly increasing policy focus on investments in urban infrastructure, the market for these services remain under developed and in its incipient stages. At a time when it is estimated that over $200 bn will be invested in urban infrastructure over the next five years, it is therefore imperative that there be rapid development of the market for urban infrastructure contracting and the proliferation of such contractors. This post will focus on the second problem.

This nascent market in urban infrastructure contracting is populated by a very few major contractors, with many of them not meeting all the basic requirements of professionalism and expertise. But unfortunately, instead of encouraging the development of this market by encouraging more competition, government regulations may actually be stifling its development. Very high entry barriers have constrained competition and prevented the expansion of the numbers of contractors beyond the limited pool of those presently eligible.

Government agencies have to follow a process of tendering for sourcing any service, contracting any work, or procuring any material. The entire bid process, with all the steps involved and the specifications and requirements, are outlined in detail in numerous Government Orders. The typical bidder pre-qualification norms for any Government tender are
1. Financial qualification for similar category of work - generally 50% of the Estimated Contract Value (ECV) over any one of the previous three years
2. Technical qualification for similar category of work - generally 50% of the contract volume over any one of the previous three years
3. Financial eligibility of the contractor, quantified in terms of the total turnover to be a minimum amount.

In an emerging market for urban infrastructure services, there are very few contractors who meet these stiff requirements. A virtually closed group of few contractors alone become eligible and corner all the contracts.

As already mentioned, the major contractor bids and then sub-contracts it out to a sub-contractor, who though capable of doing the work, fails to meet the financial and technical requirements. The primary contractor charges anywhere between 2-5% of the ECV as his profit. This is effectively an unearned increment, or a backdoor subsidy, arising from the rigid government regulations. In a few other cases, the ineligible sub-contractor seeks out big primary contractors and enters into joint venture with them. This will help them gain valuable experience, which can be used for future works. But the profit margins demanded by the primary contractors for such arrangement are higher and goes upto 10% of ECV.

This seller's market has boosted the margins available and the major contractors are no longer satisfied with the regular 15-25% profits. This partially explains why our publicly listed infrastructure majors are the hottest scrips in the equity markets and private equity majors are chasing them.

The differences in contracting procedures across states, and even departments in the same state, is another cause of major market distortions. For example, while some states like Rajasthan follow the World Bank norms and do not place any limits on the tender premiums, others like Andhra Pradesh impose a 5% limit. While some states like Tamil Nadu permit taking into account private sector experience for financial and technical qualifications, others like Andhra Pradesh insist on Government sector experience. Some states allow for only manual earth excavation work, while others permit machine excavation. Some departments provide for additional contractors profit margin in the Estimated Contract Value (ECV), while others disallow the same. These distortions in a seller's market ensures that contractors gravitate towards where the profit margins are the maximum.

All this ensures that the market for urban infrastructure contracting does not expand to keep pace with the rapidly growing demand. As Eco 101 teaches us, a market with the same limited suppliers and fast growing demand, and inhibited by high barriers for entry, will give rise to monopoly pricing and economic inefficiency.

I have tried to list out a few other problems being increasingly felt in procuring services and materials
1. There are no standard model contracts or concession agreements for outsourcing civic services. So, every city invariably ends up re-inventing the wheel and preparing their own RFQ and RFP documents. Very often, such agreements are prepared by the bidder(s) and i many cases, accepted in full, by the Government agency. As can be expected, such agreements fail to fully take into account the interests of the Government and thereby produce incomplete contracts.

2. The pre-qualification norms in many states do not take into account the experience of works done in private sector. Thus we have ridiculous situations where some of the biggest real estate developers in the country do not qualify to bid for much smaller housing projects of the Government.

3. Many services like use of energy saving devices in streetlighting, Supervisory Control and Data Accquisition (SCADA) in water supply and sewerage, intelligent transport systems etc involve procuring sophisticated equipments and devices whose specifications and rates are not available in the SSR. Given the huge value of such contracts and the absence of standards, it becomes difficult to scrutinize the tenders and finalize their procurement.

4. Many services like hiring a professsional communication strategist or a consultant to manage a Project Management Unit (PMU), cannot be fitted into the traditional unit rate procurement process. These are all human resource dependent services, which are extremely expensive. Government procurement guidelines do not account for the high premium commanded by quality HR personnel. There are serious audit related limitations on such procurements.

5. Contracts do not factor in the volatility in prices. Steel prices rose from Rs 34,502 per tonne for the 16 mm steel in December 2007 to Rs 39,390 per tonne in February 2008, to Rs 56,000 per tonne in second week of March 2008. Cement and Bitumin prices have also been showing siognificant volatility. Contractors, who bid for a long construction period contract, ends up bearing the entire price risk. The price escalation provisions introduced by a few states like Andhra Pradesh (price escalation based on the WPI) and Tamil Nadu (price escalation once a quarter, to be decided by a Committee) are at best feeble efforts at reflecting the market prices. It is necessary for contracts to accurately reflect the market rates, especially in times of high market volatility, at least for the mandated construction period.

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