Saturday, April 20, 2013

Germany fact of the day

From a very good article by Edward Luce in FT which explores the attractions of German economic model as America grapples with stagnant or declining manufacturing and a crisis in its human skill development channels, 
Germany channels roughly half of all high-school students into the vocational education stream from the age of 16. In the US that would be seen as too divisive, even un-American. More than 40 per cent of Germans become apprentices.
As America suffers a big unemployment crisis, with no end in sight, structural issues like skills mismatches have been blamed as being responsible,
Almost half of Americans with a degree are in jobs that do not require one... Fifteen per cent of taxi drivers in the US have a degree, up from 1 per cent in 1970. Likewise, 25 per cent of sales clerks are graduates, against 5 per cent in 1970. An astonishing 5 per cent of janitors now have a bachelor’s degree. They must offer endless nocturnal moments to repent those student loans. 

Tuesday, April 16, 2013

Another PPP in renegotiations - Mysore Water Project

The Mysore Municipal Corporation's Rs 164 Cr PPP project to provide 24X7 water supply is the latest to fall victim to the curse of contract renegotiations. The Tata owned Jusco won the tender in November 2008 for a three-stage project, financed under the JNNURM, to rehabilitate the existing supply network, reduce non-revenue water, manage operation and maintenance, and deliver 24X7 water to the entire Mysore city over a six year period.

The project had three phases - preparation (1 year), rehabilitation (3 years), and O&M (2 years) - with clearly defined performance clauses. But now with rehabilitation period deadline having passed in January, just 61000 out of the 117000 services have been connected to the rehabilitated network and of them only 13000 have 24X7 supply. Now Jusco is seeking renegotiations. Livemint writes about the reasons,
First, Jusco found problems with the scope of the work defined in the project agreement. When the tripartite agreement was signed, the work was for laying a network of pipelines over 910km with 117,000 connections. During the initial survey done by Jusco, the length of the pipeline network that needs to be rehabilitated was found to be 1,910km with 1.74 lakh connections... With changes in the scope of the work, the estimated cost of the project shot up, and renegotiating became messy. The government does not have money to increase the cost of the project, and even if they did, it would lead to litigation... Jusco is in talks with the government to resolve the discrepancies in the initial surveys... The Planning Commission working group conceded in its report that the risk of data gaps is high and that guaranteeing performance is difficult if a project design is flawed. 
I haven't read the Jusco contract document. But it is clear that Jusco is following the same script as the numerous failed or failing utility PPPs across the world. In all such PPPs, conventional wisdom would have it that the public agency should design the tender in a manner as to align incentives. The most favored design in such water supply rehabilitation and O&M contracts is Engineering Procurement Contracts (EPCs) where the bidders study the network and offer their quotes. These quotes are invariably based on an estimate of how much it would take to rehabilitate, operate and maintain the network for a period of time (Jusco may not be an exact form of this). It is reasoned that this project design will align incentives and encourage bidders to adopt the most optimal rehabilitation and O&M plans and leverage the latest technology, thereby lowering costs and raising efficiency.

However in the real world, this approach rarely ever works, especially for utilities where massive legacy systems dominate. Even with the most comprehensive upfront surveys, baseline information collection, and O&M plans, it is impossible to reliably estimate the cost of any such project. In all such projects, the rehabilitation costs generally emerge in unpredictable manner, as the project work starts. Tailoring an incentive compatible contract becomes an imposing challenge.

In the circumstances, and especially when faced with competition, a market failure ensues. The bidders, eager to be the first-mover in an emerging market with great long-term potential, invariably under-estimate the costs and bid aggressively. Renegotiations are a fait-accompli. In fact, the window of renegotiations serve to generate the moral hazard that drives aggressive bidding. I am not aware of even a single such project which has been successful.

There are no easy solutions. The legacy risks inherent in rehabilitation of existing networks cannot be borne by private operators. It has to be dealt separate from O&M. Its entrustment to private operators poses the aforementioned difficulties. However, once the rehabilitation is done, the performance contracts to monitor O&M is a much more tractable and realistic window to bring in private capital, management, and technology.

Wednesday, April 10, 2013

Is India's power crisis, also a case of foreign policy failure?

In 2010 the Indonesian government decided to annually benchmark all coal exports to international market price and also announced the levy of higher royalty and income tax on these exports. It has adversely affected the operationalization of 20000 MW of power capacity addition projects in India, including two of the Ultra Mega Power Plants (UMPPs). In 2012, Indonesia accounted for 79% of all thermal coal imports, of which 93% were made by private generators.

One could take the view that these projects were awarded to private generators through global open competitive bidding and it was their responsibility to have hedged for such risks. But, given the strategic nature of these economic transactions, there is a compelling case for the government's close involvement in such transactions. In other words, shouldn't all such transactions, private and public, which impinge on India's energy security be facilitate and underpinned by the umbrella of India's strategic diplomacy?

If one were to step back and analyze this, certain important questions arise. When the private generators were aggressively pursuing coal mines acquisitions in Indonesia in mid-2000 and developing large country-risk exposure, how actively was the government engaged with the process? Did this form an important part of India's diplomatic engagement with Indonesia? Couldn't we have got early warning signals about the impending policy change and advised power regulators and private generators accordingly? Once the Indonesian government announced its policy, what could have been done to mitigate its adverse impact on India's power generation program?

In the years ahead, given India's ambitious infrastructure upgradation targets, our country-risk exposure in strategic minerals, oil, and gas will increase dramatically. The increasingly widespread trend of resource nationalizations means that expropriation risks are very high in these sectors. We cannot afford to leave such risks in the hands of the private sector, who are in no position to hedge against them. It requires active, often aggressive, support from India's foreign policy establishment.

Tuesday, April 9, 2013

Corporate India's Woes

I was struck by this graphic of the changes in the distribution of ratings of India's business firms done by CRISIL. In many ways, it is a nice reflection of the fortunes of corporate India during the period. Clearly ratings downgrades continue to outnumber upgrades.

Construction and infrastructure sector firms are the worst affected, with the highest ratings downgrades and corporate debt restructurings. The graphic shows that a very high proportion of firms from these sector have suffered ratings downgrades and their credit ratio (ratio of upgrades to downgrades) is extremely low.

Thanks to declining economic growth, project delays, cost over-runs, high interest rates, and slow revenues growthtotal restructured loans crossed Rs. 2.27 trillion, or 4.4% of the total loans given by Indian banks, and is rising. This may be an underestimate given the bilateral restructurings and the true estimate may be around Rs 4 trillion. Iron and Steel (23%), infrastructure (9.65%) and power (8.13%) were top of the pile in the Rs 77,101 Cr worth loans restructured in 2012-13.

Friday, April 5, 2013

Moral hazard from CERC ruling is a reflection of India's corporate culture

India's Central Electricity Regulatory Commission (CERC) has ruled in favor of a bailout to Adani Power for its 4260 MW UMPP to offset the losses on account of the unexpected increase in the prices of coal imported from Indonesia. It has agreed for a "compensatory tariff" to allow the developer to pass-through the fuel price increase.

In 2007, in a Case I bid, Adani Power had won the global bid to supply power to Gujarat Urja Vikas Nigam Lt (GUVNL), and in 2008 to Haryana's Uttar Haryana Bijli Vitaran Nigam Ltd (UHBVNL) and Dakshin Haryana Bijli Vitaran Nigam Ltd (DHBVNL). The PPAs signed with Gujarat government was to supply 1000 MW each at a levellized tariff of Rs 2.35 per unit and Rs 2.89 per unit respectively, and with Haryana government for 1424 MW at Rs 2.94 per unit. The buyers, Gujarat and Haryana, had refused to bear the fuel supply risk and offered the bidders the option to quote an "escalable" component to hedge fuel risk. But Adani, bidding aggressively, offered a nil tariff on this head.

The present problem arose when in 2010 the Indonesian government suddenly superseded all long-term coal export contracts and started levying higher royalty and taxes, reasoning that all exports should be bench-marked to international market rates. Many power generators in India, including Adani, Reliance Power and Tata for their UMPP, clearly overlooked this risk and bid aggressively offering very low levellized tariffs.

The CERC has now allowed Adani Power to temporarily charge a higher tariff but directed the generator and the buyer state governments to sit down and arrive at a mutually agreeable long-term tariff rate. The dissenting CERC member, Mr Jayaraman has raised several very valid issues in his dissent note. In this context, here are a few more observations

1. The moral hazard concerns arising from this decision are quite obvious. In this case, the developer clearly ignored the option of bidding with an "escalable" fuel price and bid very low with the intention of bagging the contract. It is not a stretch to believe that this aggressive bid was driven by the firm belief that they could re-negotiate their way out if the discounted risks surfaced. Clearly, the central principle of a transparent competitive bidding process was compromised. Whatever spin one gives it, the CERC ruling will only exacerbate the moral hazard. This becomes a matter of great concern given the large number of power and other infrastructure projects proposed to be contracted out to private developers.

2. As the financial market bailouts and the resultant "too-big-to-fail" problems among big banks in US indicates, bailouts can quickly transmit and entrench moral hazard risks that socialize private losses. In the circumstances, it is imperative that the Power Ministry and regulator step in with measures that will atleast partially mitigate the moral hazard risks. Apart from other measures, the only effective way in which such risks can be mitigated is by making the bidder internalize some share of the social cost inflicted by his irresponsible bid. The CERC order is conspicuously silent on this. Is the Rs 1350 Cr of loss apparently accumulated by Adani Power going to be the penalty? Or is there some definite amount of liquidated damages that will be imposed? Or should some share of the profits from the merchant power sales from Mundra now be ploughed back to re-compensate the PPA consumers? Whatever the penalty, it is important to specify it upfront, since it would carry considerable signalling effect on potential bidders and thereby contribute to mitigating the moral hazard unleashed.

3. The CERC directive to re-negotiate a mutually agreeable tariff is filled with several dangers. Discretionary decisions on such matters are very likely to benefit the private developer at the cost of the consumers. Since a number of other generators will now invoke the precedent to seek renegotiation for similar "compensatory tariffs", it is important that the CERC issue clear guidelines that guide any re-negotiation process.

4. Further, if it is a wholesale re-negotiation, then we need to explore a formal bankruptcy of the existing promoters. It may be even worth exploring the possibility that the project entity be taken into a form of temporary receivership and then ownership resolved through a formal process. After all the worst scenario from the moral hazard perspective would be for the project to be renegotiated on commercially attractive terms with the same developer who would escape with a small one-time penalty. That would be a recipe for similar irresponsibility in bidding and seriously undermine India's massive infrastructure investment ambitions.

5. This is a strong reminder on the need for adequately mitigating commercial risks on projects of such long-term nature and the adage that "risk allocation should be to those who can bear it best". In the euphoria surrounding PPPs, in the guise of aligning incentives, mainstream debates have encouraged governments to structure contracts in a manner that bundles such non-diversifiable risks on the private promoter. The private sector has most often played along, in the firm belief that they could escape through re-negotiations. Fuel price pass-through should be mandatory in all power generation contracts. Similarly, foreign exchange risks should be a mandatory pass-through in contracts with import requirements.

6. Another issue that needs to be examined is the contract based on which Adani Power purchases coal from Indonesia. This is because the Indonesian government order only says that exports can be done at international prices and does not expropriate foreign ownership of the mine. In other words, if the Adani Power has a 74% ownership of the mine, there is a strong possibility that, as the dissenting member in the CERC order wrote, "the Adani Group as a whole may be the ultimate beneficiary of the Indonesian regulations". In fact, as this Mint report writes, if we take a holistic view of the ownership of the coal mine and the power plant, the net cash flows would be affected only to the extent of additional royalty and tax payments.

7. Finally, this and others that I have blogged here, here, here, and here about recently are an accurate reflection of the irresponsible and even predatory nature of India's high-corporate culture. When they were formulated, the UMPP tender documents were acclaimed. It provided an elaborate formula, using a diverse basket of domestic and international indices, to allow the bidder to pass-through any increases in fuel prices. And, by allowing for both fuelprice escalation and fixed price bids, it followed the principles of a classic textbook bidding mechanism. In the circumstances, it is easy to blame the government, as is the wont now on anything, without shining the torchlight on corporate India.

Update 1 (5/4/2013)

As if to underline the issue of cross-ownership of mines and power company, Tata Power decided to transfer its 75% share in Indonesian mines to fully owned subsidiary Coastal Gujarat Power Ltd (CGPL), which runs the Mundra Project. This is to ensure that the cash flows of CGPL is not heavily squeezed by the tariff problem. In 2007, Tata Power had bought a 30% stake in Indonesian mining company PT Bumi Resources and inked long-term contracts for supply of coal to Mundra project.

It would have been logical to have the ownership integrated with CGPL from the beginning. But firms resort to such cross-holdings to minimize tax exposures as well as to maximize profitability of their investments. In the event of re-negotiations, it is important that all such cross-holdings be removed and costs internalized to the fullest extent possible.

Wednesday, April 3, 2013

Monetizing project assets

The Hindu reports that IVRCL Ltd has signed an agreement with TRIL Roads Private Ltd (TRPL), a TATA enterprise, to divest its stake in three highway projects - Salem Tollways Ltd (STL), Kumarapalayam Tollways Ltd (KTL) and IVRCL Chengapally Tollways Ltd (ICTL) - with a total project cost of Rs 2200 Cr and monetize these BOT assets.

STL had commenced commercial operations on the 53 km stretch of NH-47 from Salem to Kumarapalayam in Tamil Nadu from June 2010, KTL was operating another 47 km stretch on the same highway from Kumarapalayam to Chengapally from August 2009, and ICTL is planning to commence commercial operations on 54.83 km stretch of NH-47 from Chengapalli to Walayar via Coimbatore in the first half of 2013-14.

I have two observations on this practice. 

1. As India sets out on its massive $1 trillion infrastructure investment plan for the 12th Plan period, monetization of infrastructure assets is an attractive proposition. It frees up the balance sheet of infrastructure construction firms to take up newer projects. However, it is important that there be a sufficiently developed market in the management of the assets that are being monetized. Apart from outright sale, monetization can be done by securitizing the project asset either in the bond market or in equity market. 

2. A more important issue is what happens to the original financial structuring of a PPP project once its financing pattern is changed. For example, in BOT toll roads, the financial structuring is generally done on a 70-30 or 80-20 debt-to-equity model with 16-20% return to equity for a 25-30 year period. But once the construction and commissioning risks are off-loaded and the project asset transacted, it is certain to attract debt at much lower rate and allow for much higher debt-to-equity ratios. In other words, while the project cash flows remain unaffected by the changes in ownership pattern, its cost of financing comes down. This invariably benefits the original developer who, as with IVRCL, would either dilute his equity or even exit, and pocket a handsome rent in the process. 

I have blogged about this practice earlier. The British infrastructure regulation expert Dieter Helm has documented this trend in British government's concession agreements. He believes that it is costing the government atleast one billion pounds annually in funds siphoned away by enterprising concessionaires who dilute or divest their equity stakes for more debt. 

Monday, April 1, 2013

China Vs India banking fact of the day

India’s commercial banking system has assets of about $1.5tn, according to the Reserve Bank of India, less than those held by any one of the four largest Chinese banks.
(HT: FT)