Thursday, August 24, 2017

PPPs in infrastructure - finance operating assets

Finance 101 teaches us that life-cycle costs of infrastructure projects are optimised by financing them as end-to-end projects, from construction to operation and maintenance (O&M), since it aligns the incentives of the private operator to design and construct in the most efficient manner. Never mind the overwhelming evidence to the contrary. 

This blog has consistently taken the contrary view that the cleanest and most practical approach to leveraging private capital into infrastructure is to channel them into the O&M of commissioned infrastructure assets.

The reasons are simple. One, large infrastructure projects are exposed to very high constructions risks, mostly arising from factors that private operators cannot control. Only governments can control those risks. Two, construction risks induce delays and cost over-runs, which in turn add to the already higher cost of capital that private operators face when compared to governments. Three, post-construction, there are significant uncertainties associated with commissioning - e.g.. traffic realisation in transportation, tariff/user-fee realisation in utility services etc. Again, these risks are better managed by governments than private parties. Four, once constructed and commissioned, the O&M risks are far less and the revenue stream is more predictable. 

In simple terms, the risk allocation and financing terms for construction and commissioning, and O&M are qualitatively different. They demand different types of financing. Accordingly, it is better that construction and commissioning is done by one agency, preferably a government owned but autonomous entity, and a private concessionaire to do the O&M.

An acknowledgement of this comes from two of the most ardent upholders of free-markets and private participation, and that too highlighting the woes facing infrastructure projects on both sides of the Atlantic. 

The FT, which has featured several articles critical of PPPs in recent months, has this to say, in the context of UK's struggle with trying to attract funding to infrastructure projects,
“The big difficulty is in getting investors to take on the risk of major new standalone or bespoke projects”, says Andy Rose, chief executive of the Global Infrastructure Investor Association. “When people talk about a wall of money wanting to invest in infrastructure it is primarily for operating assets.”
And The Economist, in the context of declining infrastructure spending in the US, writes,
Anton Pil of J.P. Morgan points out that most large infrastructure projects in America need at least some federal funding to succeed. Unless the federal government leads the way, there is unlikely to be much new activity... It is easier, it seems, to raise money to invest in infrastructure than to spend it.
Finally, the FT's editorial view on PPPs is very clear,
To insist on the private sector stepping up to finance grand projects with huge construction risks and long-term pay-offs — beyond most investors’ time horizon — is a recipe for failure. There is undoubtedly a role for the private sector in financing smaller projects, those where assets are already in operation or where the future income stream is clear. But the government is the best risk-taker for long-term projects.
How long will it take for governments in countries like India to realise the need to exercise caution in relying on PPPs to stoke infrastructure spending?


Anonymous said...

Dear Gulzar, recently AAI has outbid GMR for the Bhogapuram project.

How do you reconcile the fact although this is named as a PPP project, the project can go to Sovereign entity for execution? Where is the private participation in the project?

Gulzar Natarajan said...

Thanks for pointing that out. Did not know.

At one level, there is a positive dimension. Strong public operators may be necessary to keep private operators honest. Markets don't necessarily do that. In fact, they rarely do in such markets. A recent example. Vijay Mallaya's Goa property was put on auction a few times and found no takers. Then some of the government institutions decided to bid, and immdly we saw market interest and the property got snapped up.

But the real problem, a practical one, is that, without major reforms, AAI is most likely to do a shoddy job of the airport and then, being a public agency, the state government will treat it with kid gloves. And if AAI uses this moral hazard to undercut private parties with low-ball bids and displace them, and deliver poor quality infrastructure, we then have a problem. Further, AAI is unlikely to bring in any expertise to improving the efficiency of airport operations. So, I guess there is a case for preventing AAI from making such bids.

One way would be to have technical pre-qualification norms that demand a premium on world-class expertise, which would end up disqualifying the likes of AAI.

There will also be another dimension. Creating entry barriers to keep out AAI, can be potentially harmful for the officers concerned. Five years down the line, if the private operator makes money, a CAG report can find fault with the tender process and blame the officials concerned for having prevented a public agency from bidding and having conspired to hand over the airport to a private operator!

William Moore said...

Great article. I learned a lot from reading contents on your page.