Monday, March 16, 2015

The flawed orthodoxy - case of infrastructure contracting

The Economic Survey's advocacy for a strategy of "combining construction and maintenance responsibilities to incentivize building quality" in infrastructure asset creation is classic example of theory sans reality. It is also an example of how orthodox approaches can end up costing more than prudent strategies designed based on the existing market structure.

The fundamental assumption is unexceptionable - good building quality is critical to life-cycle costs, and a combination of building and construction aligns incentives to minimize life-cycle costs. But a first order requirement for this assumption to hold is that the construction contractor has a stake in operation.

In an ideal world, life-cycle costs minimization can be achieved by assembling a project development consortium of construction and operation and maintenance (O&M) contractors as well as financiers. As construction is completed, the construction contractor gradually exits, allowing the O&M contractor take over the project. But in the real world, especially in developing markets like India where the distinction between construction and O&M contractors is blurred, such tight alignment and seamless transitions rarely, if any, happen. Here, a GMR or HCC, after outsourcing the O&M to smaller contractors, sells their assets to infrastructure funds like SBI Macquarie or IDFC India Infra Fund and abruptly exits the project. This does little to align incentives towards minimizing life-cycle costs since the project developer predominantly performs the role of a construction contractor.

Conditional on the difficulty of combining construction and maintenance responsibilities, the most optimal strategy would be to de-couple the two activities. The road map,
  1. Establish a Special Purpose Vehicle (SPV)
  2. Put in place professional management and good governance practices (arms-length relationship with the government department/ministry)
  3. Construct, using mainly public funds, and off-load construction risk
  4. Stabilize the project and lower commissioning risks
  5. Contract out O&M as long-term concession
  6. Regulate the concession
The benefits are substantial. Public financing lowers the cost of capital for construction. Once the project is commissioned, real project information becomes available, which enables concessionaires to bid with far greater assurance. It also enables government agencies to write more complete contracts, which minimize re-negotiation risks. All this enhances transparency and limits political risks. On the other side of the risk assessment ledger, the biggest downside risk, which assumes significance given the country's state capability deficit, involves the governance of the SPV which is critical for both construction time and its quality. 

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