Tuesday, January 1, 2013

Moral Hazard and Time Inconsistency in NHAI Projects

I have blogged earlier here, here, and here, about the moral hazard concerns unleashed by contract re-negotiations and how the power sector in India has been badly affected by it. Now comes news that some of the aggressive bidders for road projects bid out by the National Highways Authority of India (NHAI) may be thinking of pulling out of their contracts.


The Times of India has a report on GMR which had won the 555 km Kishangarh-Udaipur-Ahmedabad by quoting Rs 636 Cr in annual premium payable to the NHAI. This meant that instead of receiving annuity payments from the government, GMR would assume the traffic risks and make annuity payments to the government. In a public auction in 2011, GMR had offered to pay NHAI Rs 636 Cr every year for 26 years, to win the four-lane to six-lane conversion project estimated at Rs 5387 Cr tender. GVK Power was the next highest bidder at Rs 516 Cr. It writes,
This particular case and the trend of several top highway builders struggling to tie up funds for their projects are signals of tough times ahead. Though GMR has cited delay in getting environmental clearance for the project to start its expansion as the main reason to walk out of the project, highway ministry sources called this an indication of early "course correction" to "aggressive bidding" that happened during the last financial year. There were around a dozen projects where almost all bidders quoted high premium (upfront revenue to NHAI that increases by 5% annually) and doubts were raised whether this would be sustainable. At present, about 35 projects are awaiting financial closure... GMR's move could have been because of many other reasons including the project's financial viability considering  the high premium offered.
Now, it is quite possible that GMR have a genuine reason for seeking a termination of the contract. But it is also clear that such aggressive bidding, where concessionaires assume all sorts of market risks and also provide handsome premiums, was not exactly fundamentals-driven. Atleast some of the bidders were clearly aware of the risks they were taking and also knew how to mitigate them, legally or through the backdoor. Some others saw benefits from adding one more project to their project portfolio, especially in leveraging their balance sheets.

Site clearance problems and environmental clearance delays are inevitable parts of any such project in India. They should not form the reason for bidders to renege on their contracts. Most of these contracts would already contain cost-escalation and other provisions that would largely insulate the contractors from such risks. If they do not, then future contracts should incorporate these provisions.

But allowing such contracts to be terminated, especially for non-regulatory reasons, is certain to unleash moral hazard concerns and vitiate the bidding environment for the upcoming tenders. It will entrench expectations within contractors about the inviolability of contractual obligations and encourage similar aggressive bidding in the forthcoming bids.

Further, this will also aggravate the time-inconsistency problems that contractors face when bidding for such long-gestation infrastructure projects. Ex-ante, the contractors will bid aggressively without much regard for market risks so as to win the bid. Some of them presumably realize that they could re-negotiate and wrest a more favorable deal from the government agency. But ex-post, after all due-diligence and covering for risks, they will decide to pursue only those contracts with large margins and low risk. In other words, this practice will also allow contractors to cherry-pick on their public projects portfolio.

All this negates the very purpose of open competitive tendering, which seeks to address precisely such problems.

Update 1 (14/1/2013)

After GMR walked out of the Kishanpur Project, GVK has decided to terminate its 12 January 2012 BOT contract for four-laning of the Shivpuri-Dewas section of the NH 3 in Madhya Pradesh. The two to four-lane conversion of 332.46 k of the Delhi-Agra NH had a concession period of 30 years and construction period of 2.5 years at an estimated cost of Rs 3300 Cr. It invoked the Clause 34.8 of the concession agreement, citing delays in site handing over and environmental clearances. However, aggressive bidding where the contractor over-committed annuity payments to the government may be the real reason for the pull-out.

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