Friday, July 4, 2008

Infrastructure financing models

Standard financing pattern prescribed for greenfield Public Private Partnership (PPP) projects in infrastructure sector involves accessing long-term structured debt. The developers identify their financiers, do the financial closure and then start the construction. The financial risks are therefore borne by the developer from the very beginning.

The entire project - starting from Detailed Project Report (DPR) preparation, financial and social/environmental impact assessment, financial closure, project construction, operation and maintenance - is therefore seen as a single, integrated process. This approach, while being logically sound, suffers from a few practical problems.

Construction risks in PPP projects are generally borne by the private developers, who are the more qualified and capable of bearing it than Government or its agencies. However, in many infrastructure projects, these risks are substantial, especially in those involving land acquisition, relief and rehabilitation (R&R) and other construction related interface with the Government agencies.

It is therefore not surprising that such projects suffer from time and cost over-runs. The legacy of laggardness and delays associated with Government agencies only exacerbates the risk perception. Quantifying these risks are difficult and even impossible, and therefore most often the private developers hedge for the worst scenario. Lenders and investors internalize these uncertainties by charging a higher risk premium, which increases the cost of capital and thereby adversely affects the financial status of the project.

In view of the aforementioned, it may be much cheaper and economically efficient to construct the project with short term bank loans, which come at lower rates. After construction, the short term loan can be swapped or rolled over with long tenor structured credit. Once the construction risks associated with the project are removed, the project is certain to get capital at far better terms.

In fact, it makes great economic sense to go one step further and construct these projects with Government guaranteed short term loans from commercial banks. Such loans come at even cheaper rates, thereby minimizing the financial burden on the project, especially in its initial stages. Such financial arbitraging could ultimately end up shaving off 150 to 200 basis points from the cost of financing the project debt. In many cases, this margin could be the crucial determinant which decides the success or otherwise of the project.

For example, a year back when the Vijayawada Municipal Corporation explored options of raising debt for some water and sewerage projects, the local commercial banks agreed to lend short term (3 to 7 years) at 7.25% to 8%. At the same time, long term (15-20 years) structured credit would have cost atleast 10%, given the significant constructions risks associated with those projects. However, a long term structured loan with the construction risk offloaded, could have been sourced for 8.5% to 9%. The same differentials would apply to financing similar projects even today.

However, abundant caution and due diligence will have to be exercised in selecting the projects for such financing. Further, in such cases it may be prudent to complete the process of selecting the O&M contractor well in advance, so as to ensure easy and seamless transfer once the construction is completed. This would go a long way in mitigating operational risks and reducing the cost of capital for the project.

In a few sectors like roads and power generation, where there have been a number of successful PPP projects, there may be no need to experiment with this model. But in sectors like water and sewerage, solid waste, power distribution, public transport etc, where the construction risks are substantial and most often outside the control of the private developer, the aforementioned model may be more economically efficient.

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