Separating infrastructure construction and O&M, and mitigating the risks

This post revisits a contentious strategy in infrastructure finance: separating the contracting of construction and operation phases (as against life-cycle contracting). 

This blog has long held the view that, given the inherent time and cost overrun risks associated with the construction phase, which cannot be borne by private investors, and the much lower cost of public finance, infrastructure assets should be created with public financing. Once the construction risk is shed, the asset should be transferred to private operators through long-term concessions to fund their operation and maintenance (O&M). 

As early as 2013, we had advocated this two-stage strategy in a co-authored oped: 

In the first stage,a professionally managed special purpose vehicle (SPV) could be established to construct the project using short-term bank loans or through takeout financing by a consortium of banks. This may require the government to provide some form of guarantee or credit enhancement. Once the construction risk is offloaded,short-term loans can be swapped for long-tenor debt. Private participation can be introduced either through long-term concession grants to operate the entire project or parts or it,or by outsourcing certain services. Another strategy would be to capitalise the assets by taking the SPV public.

Let the state bear construction risk cheaply, then sell the de-risked operating asset to patient capital. In other words, use public finance to create infrastructure assets, and then fund their lifecycle using private capital. 

But it can be argued that this creates two problems. One, public financing comes with the risk of compromising on the design and quality of construction. Second, this risk is worsened if construction and O&M are separated. 

Clearly, we have a financing dilemma. The most appropriate risk allocation and lower cost of public finance trade off against the problems arising from the separation of construction and O&M. 

How do we reconcile the dilemma?

If there is one constant that infrastructure construction globally teaches us, it is that cost and time overruns happen over and over again, and are therefore unavoidable. Given the uncertainties involved, most often beyond the control of contractors, it is unfair that this risk be borne by them. Only the contracting agency of government can bear this risk. Further, it is unavoidable that financiers will hedge for those risks and price the capital accordingly, saddling the asset with prohibitive life-cycle costs. It is also virtually impossible to write contracts with such risk allocations that absolve the construction contractors. 

In the circumstances, the only option left is to assume the construction delay risks on the public balance sheet and finance the asset from the budget, and then monetise the asset. 

So if we make a conscious choice for public finance, how to mitigate the risks? How do we reconcile the apparently conflicting requirements of using public finance to construct infrastructure assets and ensuring life cycle quality?

This is a contractual matter, albeit one that is challenging but not insurmountable. The construction contract between the state and the contractor must do the alignment work that ownership bundling would otherwise do. It should specify construction design and quality conditions, validated through independent technical audits at transfer, with financial penalties for any shortfall to be clawed back from performance guarantees. Further, instead of waiting till the end, an independent engineer, appointed jointly but reporting to the grantor, should have enforceable sign-off rights at key construction milestones before disbursements are released. Done carefully, this shifts the incentive problem from ownership to contract design, which is solvable with the right institutional capacity.

All this requires a state with strong enough technical capacity to write demanding output specifications, enforce defect liability, and audit asset condition through the operational period. The bundled PPPs are an admission that since the state is weak and therefore cannot do the above, it must outsource the incentive problem by making the private party bear the whole lifecycle, even with the higher funding cost. 

This fatalism is the wrong long-run equilibrium, also because bundled PPPs, as we have seen, are prone to renegotiations, which themselves require high state capability. Accepting that the state must always bundle to avoid quality risks locks in a model where public borrowing costs are foregone forever, because the state never builds the contract-writing and monitoring capabilities to hold separated delivery accountable.

The better path is to treat the separation as a governance and capacity challenge, invest in that capacity, and capture the financing advantage of public capital as a permanent feature of the model rather than conceding it to the private sector in perpetuity. 

This is the standard approach followed historically in countries like Germany, Japan, and Singapore. The canonical example is Germany’s Autobahn model, followed by the National Highways Authority of India (NHAI), where the federal government finances motorways cheaply through public borrowing, while construction is let to private contractors under demanding output specifications with long liability tails. It is just as applicable to many infrastructure segments, such as urban infrastructure.