Weekend reading

1. Talk about likely Cheshire cats and Uber edition, as the company prepares for its IPO,

Excluding certain one-time items, including the sale of some of its businesses, Uber’s losses for the quarter rose 88 percent from the previous year, to $842 million. The losses were a result of Uber’s increasing its spending as it tries to outmuscle competitors, many of which have intensified their efforts to add riders and drivers. Uber has responded by offering bigger incentives and more promotions to fend off rivals like DoorDash, Lyft and other ride-hailing and food-delivery services... Some of the company’s losses have been overshadowed by its explosive growth. In 2018, Uber increased its total bookings — what it charges customers for rides and food delivery — to $50 billion, up 45 percent from 2017. Net revenue was $11.3 billion, a 43 percent increase... But Uber’s profit margins have declined as it cut prices to match competitors and spent money on expanding its food-delivery business, Uber Eats. The margins are also smaller on Uber Eats orders because the company pays commissions to restaurants as well as delivery drivers.

Despite this the company is valued at $70 bn, with investment bankers suggesting even $120 bn.

More likely this is a pricing of Uber than its valuation. When asked about Uber's astronomical 'valuation', valuation guru Aswath Damodaran had this to say,

Pricing. It’s a pricing issue. The reason people pay $60 Billion for Uber is because they think that when it goes public it will be worth $100 Billion. There doesn’t need to be a fundamental rationale for value. All you need in the pricing game is someone else willing to pay a higher price for the company. As long as momentum is on their side, it’ll keep pushing the pricing up. It’s got very little to do with fundamentals, and everything to do with “is there somebody else out there who will pay me a higher price for this company”.

Btw, Aswath Damodaran values Uber at between $25 bn and $35 bn. 

Ahem!

2. So Amazon has pulled the plug on its Queens second head quarters which promised 25000 new jobs and $3bn in local tax concessions. What does it say about modern capitalism that its favourite corporate brand is forced to abandon its plans to establish its second headquarters in a city which is perhaps the capital of modern capitalism?

Now what happens to the vast trove of data that Amazon has accumulated about cities during the bidding process?

3. Special economic zones (SEZs) come in several forms, and there is little to suggest that, in general, they offer value for money. Consider this about 'opportunity zones' in the US, 

Based on recommendations from state governments, the United States Treasury has designated more than 8,700 eligible census tracts in urban, suburban and rural areas across the country. The opportunity funds are the vehicles for investing in these zones. The idea is that investors get federal tax breaks, while the neighborhoods get new businesses and upgraded properties, like apartment buildings, retail shops and hotels... Opportunity funds let investors postpone federal taxes on recent capital gains until the end of 2026; they can also reduce the taxable portion of those gains by as much as 15 percent, after seven years. Further, investors can eliminate taxes on additional gains from investing in the fund itself, if they hold the investment for 10 years. So, if you have investments that have appreciated, you can defer capital gains taxes by selling the investment and reinvesting the money into an opportunity fund within six months. Almost any sort of capital gain qualifies, whether from the sale of stocks or mutual funds, or other investments, including the sale of real estate or a business. Just the gains on an investment — rather than the entire proceeds of a sale — must be reinvested in the opportunity fund.

But the zones, notified last year, are already there are serious question marks about whether many of the notified zones deserved to get any fiscal concessions since they were already gentrifying. 

4. Leveraged loans, borrowings by those with relatively high debt, which has more than doubled to over $1 trillion since 2010, have for some time been signalling red. 

Highly leveraged loan deals (when debt is more than five times earnings before interest, tax, depreciation and amortisation) account for about half of new US corporate debt. That growth is partly a result of securitisation. Roughly half of investor demand today comes from packaging loans into collateralised loan obligations, or CLOs, and slicing them into different tranches of risk. Rising demand has shifted the balance of power from investors to borrowers, and contributed to a watering down of covenants embedded in loan agreements that traditionally protect investors. According to Moody’s, about 25 per cent of the leveraged loan market was considered “covenant-lite” before the global financial crisis. Now that figure is 80 per cent. The implications in a downturn could be severe. Covenant-lite lending is like swimming without the ability to spot seals (where there are seals, there are sharks looking to feed). Stricter covenants improve transparency and help investors identify underlying problems with borrowers; now some covenants are so weak that nothing short of insolvency will trigger a default. If problems finally show up, investors will stampede out of the asset class, creating a systemic liquidity crunch... Leveraged loans probably won’t spark the next recession, but they will almost certainly deepen it, because they are an important source of corporate funding for deals and share buybacks.

5. The debate about the merits and distortions associated with universal basic income (UBI) is likely an endless one. And it is also an activity that is likely to keep academics busy for generations. The present stage of evidence generation is focused on its efficacy, and given the need to tease out general equilibrium effects, this is the likely agenda for at least the coming decade. The evidence is likely, as is mostly the case with such problems, to be mixed. The next stage of debate will move to what is the right amount, then what is the right amount for a particular context, and so on.

Echoing this, a new paper for UBI in advanced countries finds,

A UBI would direct much larger shares of transfers to childless, non-elderly, non-disabled households than existing programs, and much more to middle-income rather than poor households. A UBI large enough to increase transfers to low-income families would be enormously expensive. We review the labor supply literature for evidence on the likely impacts of a UBI. We argue that the ongoing UBI pilot studies will do little to resolve the major outstanding questions.

6. It is a well-known fact that infrastructure contractors bid aggressively to bag the contract since they are confident that they can come back and renegotiate the contract. There is a massive body of literature on this. The latest addition is on the renegotiations in power generation contracts in India. 

7. What if users of Facebook were shut off from accessing the social media site? An RCT evaluation of the welfare effects of US Facebook users show,

Using a suite of outcomes from both surveys and direct measurement, we show that Facebook deactivation (i) reduced online activity, including other social media, while increasing offline activities such as watching TV alone and socializing with family and friends; (ii) reduced both factual news knowledge and political polarization; (iii) increased subjective well-being; and (iv) caused a large persistent reduction in Facebook use after the experiment.

8. Finally nice article by Pilita Clark bemoaning the disappearance of (now politically incorrect) bluntness in offices, and the mistaking of bluntness for unacceptable behaviour. 

Irrational Exuberance Redux?

There are no free lunches. Every time there is exuberance in any bidding for public contracts, it is prudent to step back and reflect. 

The aggressive bids based on over-optimistic traffic growth and low fuel price forecasts associated with road and power sector PPPs of the last decade, the get-at-any-cost bids in telecom 3G spectrum auctions, and the race to the bottom with solar tariffs are some recent examples from India. In each case, the triumphalism following the contracting and resource mobilisation proved short-lived and the longer term costs were considerable. The legacy of the first was over-leveraged infrastructure companies and banks with non-performing assets, that of the second telecom companies with no option but to skimp on capacity investments, and the third one is currently playing itself out. 

Last week the National Highways Authority of India (NHAI) signed a 30 year concession agreement with Macquarie Infrastructure and Real Assets (MIRA), world's largest infrastructure fund manager, to monetise a bundle of nine fully operational highways involving 648 km in Andhra Pradesh and Gujarat. This is the first concession under the Toll-Operate-Transfer (TOT) model which was approved by the Cabinet in 2016 to monetise 75 national highway stretches of 4500 km. MIRA will make an upfront payment of Rs 96.815 billion in return for maintenance of the highways and the 30 year toll collection rights. 

MIRA's bid was striking in its exuberance. Against the NHAI concession value of Rs 62.58 bn (assuming an IRR of 12-13%), MIRA bid Rs 96.815 bn, a premium of 55%. It was also 30% higher than the next highest bid.

It is of course possible that this first bundle had all great highway assets with very high traffic growth potential and MIRA was only betting on its realisation. But that does raise the question of how the government, which technically has more information than the concessionaire, came out on the other side of the information asymmetry and left money on the table with its low concession value. Or was it done strategically to tantalise market interest in light of the big pipeline of such offerings?

How do we assess such deals? Is it a case of MIRA sensing money of the table that nobody else saw? Or one where MIRA bid sensed several attractive medium-term exit options?

The table below captures the spectrum of choices that governments and concessionaires have with such contracts.

Clearly, the overall welfare maximising option (option IV) is to have the concessionaire making a commercially viable enough bid and government being able to realise a reasonable price for the asset. Given the information symmetries and uncertainties of a long-term contract, this is difficult to achieve in the real world. In the circumstances, options II and III are practical realities, and the objective should be to get as close as possible to option IV. 

Based on the experience of such projects from across the world, let us get a few practical considerations out of the way. One, 30 years is a long period and will encompass multiple business cycles and their respective downturns. Traffic flows and interest costs will accordingly vary widely. The upsides have to more than compensate for the downsides. Two, if the downsides persist and in case of doubts on medium-term commercial viability, the concessionaire will invariably seek renegotiations, and most likely get it. Three, MIRA may be the current owner, but can and will exit (presumably there is a lock-in period) in due course and there will be multiple ownership transfers over the concession period. The MIRA Fund from which resources were drawn to pay for the monetised highways would typically have a ten year life, after which it pays out and closes.

In the circumstances, there are two concerns. The first concerns the discount factor and the second over likelihood of asset stripping.

Let us examine the first. The two biggest drivers of commercial viability are traffic projections and interest rates used to discount the cash flow. One can assume that MIRA has made its offer based on its best assumptions of the traffic projections (based also on data made available by NHAI), and to that extent is completely accountable for the associated risks. 

But the interest rate used in discounting is determined by NHAI and can be just as critical. As Ajay Jain of Indusbridge Capital Advisors has written in Bloomberg Quint, the nominal interest rates in India since the millennium have varied between 14.5% and 4.25%. Getting this right can be the difference between winner's curse (for the concessionaire) and leaving money on the table (for the government).

If the discount rates are too low, then this would imply a higher estimate of the Net Present Value (NPV) of the cumulative life-cycle cash flows. This, while giving governments high revenues would also force bids which tread on commercially questionable terrains. But, as experience from across the world and across sectors shows, it is only a matter of time before the concessionaire throw up their hands and seek renegotiations. And again experience shows, the net outcome is always bad for the tax payers. On the other hand if the discount rate used is on the higher side, the NPV estimate would be lower. This would leave money on the table and generate a windfall for the concessionaire.

In this context, the Value for Money (VfM) analysis of UK's Private Finance Initiative (PFI) projects by the country's National Audit Office is instructive,

Making changes to the discount rate applied to future costs can also affect which financing route is assessed as VfM. The VfM assessment compares private finance costs with a government discount rate of 3.5%, which is 6.09% with inflation, known as the Social Time Preference Rate (STPR), which is higher than government’s actual borrowing costs. The higher the rate applied, the lower the present value of future payments. For example a payment of £100 in 12 years will have a present value of just £49 when discounted by the STPR. Discounting using a lower discount rate, which compares private finance with the actual cost of government borrowing, results in fewer private finance deals being assessed as VfM. Using a fixed discount rate, set in 2003, means that the VfM assessment does not reflect the additional cost of private finance above the prevailing cost of government borrowing. In the current low-interest-rate environment it is possible to privately finance projects below the 6.09% rate. When this is the case private finance will be assessed as costing less than public finance even though the actual long-term cash costs of debt servicing and repayment will be higher than government debt costs.

As the graphic below shows, the government's actual cost of borrowing has consistently and significantly been lower than the discount factor used in making VfM assessments of PFI projects.

In summary, if the government has used a lower discount factor, it has inflated the cash flows estimates, and set the stage for renegotiations. In contrast, a higher discount factor deflates the cash flows, and leaves money on the table. Only time will tell which of these two scenarios best fit the first round of TOT roads monetisation.

This brings us to the second, and more important concern, around asset stripping. This can arise through multiple pathways. One way, as the example of UK's water utility privatisation shows, can be by leveraging up to finance opex and maintenance, making disproportionately large payouts to the investors from profits accrued, gradually diluting equity, and finally selling off to the next buyer and exiting with handsome returns. Another option is to cut down on expenses by skimping on operational expenses, socialising externalities wherever possible, and stretching the boundaries on the interpretation of the pre-defined maintenance schedules. 

Both approaches are straight out of the playbook of Macquarie itself during its ownership of Thames Water, UK's largest water utility with more than 9 million consumers. In the 2006-17 period of its ownership of Thames Water, "Macquarie paid itself and fellow investors £1.6bn in dividends, while Thames Water was loaded with £10.6bn of debt, ran up a £260m pension deficit and paid no UK corporation tax". Macquarie exited by progressively selling off its stake to an emergent group of private equity, pension funds, and sovereign wealth funds. 

Consider this scorecard from the monetisation of UK's water utilities,

The owners of the nine companies — many of which are overseas investors, including sovereign wealth funds — paid out £18.1bn in dividends in the 10 years to 2016, even though post-tax profits amounted to £18.8bn during the decade, according to the Greenwich University researchers’ analysis of their financial reports... Consequently, almost all capital expenditure has been financed by adding to the companies’ debt piles. Collectively these now stand at a towering £42bn... Three companies — Anglian Water Group, Severn Trent Water and Yorkshire Water Services — have paid out more in dividends than their total pre-tax profits over the past decade... Greenwich researchers said the cost of maintaining and improving water and sewer infrastructure has been paid for almost entirely by an increase in debt, which has risen from almost zero at the time of privatisation to nearly £40bn in 2016. The interest payments on the debt are higher than what would be paid by the public sector, which can borrow more cheaply. Together, the £1.8bn in dividends and the extra £500m of debt interest payments each year pushed up bills for each of England’s 23m households by about £100 a year.

Now that asset monetisation is here to stay, what are the lessons? Some suggestions

1. For a start, it is important to attract the right kinds of investors in these assets. The financial logic of investing in such long-gestation assets is the relative stability and not the size of returns. Pension funds, insurers, sovereign wealth funds and so on, who value reasonable returns which are stable and long-term, are the most appropriate direct or indirect (through the likes of  infrastructure funds) investors in such assets. Private equity and other similar investors, who elevate returns over stability and tenor, are likely to have a different set of incentives with potential to engender distortions.

It is possible to encourage self-selection among investors by prioritising stability and tenor. Clarity in the principles of renegotiations, a very high likelihood event in long-term concessions and one fraught with significant uncertainties, can be an important signal to lower risk and promote stability. I had blogged earlier with a few suggestions on renegotiations. On the upside, it may also be useful to cap certain types of windfalls, like in the UK, by forcing the concessionaire share profits with the government. In simple terms, investments in operational infrastructure facilities should become a boring financial asset!

2. On a related note, the vast majority of capital for such monetised assets would and should come from domestic institutional investors and not foreign infrastructure funds. I have already blogged here, here, and here about the limited depth of dry powder among global infrastructure funds to invest in infrastructure in countries like India. More importantly, these assets generate revenues in rupee and it is only appropriate that they be financed by domestic capital, so as to avoid currency liability mismatches and the resultant higher cost of capital.

It is therefore an opportunity to deepen and broaden the financial markets, especially the pension and insurance businesses as well as the bond market. Complementary reforms to incentivise these market participants to absorb the supply of these instruments may be necessary. The promotion of Infrastructure Investment Trusts (InvITs), announced in the Union Budget 2018-19, is a step in the right direction. However, the government may need to walk the talk with this so as to ensure that this does not become one more in the long-list of less than effective reforms initiated over the last two decades to broaden and deepen the capital markets.

3. More specifically, given the experience of infrastructure privatisation and asset monetisation from across the developed world, the concession agreements should seek to build safeguards that explicitly guard against asset stripping. It may be useful to have clearly defined financial ratios and floors/thresholds to limit excessive debt accumulation and equity dilution, as well as maintain oversight on pension and other statutory payouts. 

4. It is never a good thing to base a 30 year contracting decision on a single discount factor. Given the impossibility of reliably predicting long-term rates, this is pretty much a lottery for both the government and the concessionaire. The longest credible enough measure of long-term interest rates are the 10 year Treasury bonds.

One option would be to do periodic discounting resets, say once in 7 years, based on the expected long-term interest rates (not the prevailing bank rates). The payouts could then be made as instalment bullet payments, which however may come in the way of meeting the government's fiscal requirements and may also not align life-cycle incentives. The other option would be to have the initial payment which is based on discounting with the rate for the ten-year T-Bonds and then adjust the initial payment every time the reset happens. The adjustment could be in the form of a one-off term payment (by either the government or the concessionaire) based on how the discount factor varies.

Update 1 (19.12.2018)
Expectedly, after the first flush of irrational exuberance and as reality dawns, the demand for the second round of bidding for the Toll-Operate-Transfer (TOT) roads appears to be muted. This round proposes to concession out 586 km of national highways across Rajasthan, Gujarat, W Bengal, and Bihar, at a base bid price of Rs 5362 Cr for a period of 30 years.

Supreme Court upholds sanctity of contracts

Two recent judgements of the Supreme Court of India may have contributed to restoring the sanctity of contracts in India's infrastructure sector, which had been seriously compromised by the spate of renegotiations across sectors. 

First, the Court overturned the 2016 decision by Appellate Tribunal for Electricity (Aptel) allowing Tata Power's Coastal Gujarat Power Ltd and Adani Power to charge compensatory tariffs on consumers of their respective 4000 MW and 3960 MW thermal power plants at Mundra. Aptel had ruled that the Indonesian government's decision in 2010 to link all exports of coal only at international prices was a force majeure event under the Power Purchase Agreement (PPA) signed by the two companies with the discoms of Rajasthan, Gujarat, Haryana, and Punjab. The Supreme Court has rejected that contention and disallowed any compensatory tariff levy on the PPA agreed tariffs. 

Tata Power's bid in February 2006 involved an agreement to sell 4000 MW for a 25 year period at a levellized tariff of Rs 2.26 per unit, and Adani Power's 3960 MW plant agreed to sell power to Gujarat and Haryana at Rs 2.34 per unit and Rs 2.94 per unit respectively. Tata Power claims that it will lose Rs 475 bn over the 25 year PPA through under-recoveries. 

The second judgement involved the Court upholding an earlier High Court order approving the e-auction by the New Delhi Municipal Council (NDMC) of the Taj Mansingh Hotel in Delhi. It rejected the claim of Tata's Indian Hotels Co Ltd (IHCL) to right of first refusal on the auction. NDMC had entered into a 33 year lease agreement with IHCL in 1976 to run a five-star hotel. This concluded in 2011 and since then after a series of ad hoc extensions, the NDMC had decided to not renew the license and re-auction the property. 

In the first case, the bid process for the Ultra Mega Power Plants (UMPP) allowed all bidders to either quote their tariffs as a fuel pass-through (payment on actuals for fuel) or at a fixed rate. Both Tata Power and Adani Power passed over the former despite firm knowledge about their coal import exposure and the possible fuel price risks. In fact, Adani Power quoted a nil tariff on the escalable fuel-risk component!

In other words, here was a textbook tender design, offering all the possible options. But the successful bidders preferred to assume the imported coal price risk and bid aggressively to win the tender. The presumption may have been that coal prices were low and likely to remain so, and more importantly perhaps, there was always the renegotiation window. From hindsight one could say that the government should have anticipated a market failure by way of irrational bidding and not offered the flat tariff option. Fuel price should have been a mandatory pass through.

While ex-post this appears an entirely reasonable argument, ex-ante (or at least immediately after the bid is finalised) it would have been criticised by both the experts and the bidders. The government should, or so the critics would have argued, make available all the options and leave it to the market and bidders to determine what is in their best commercial interest. After all these large business groups have the expertise to hedge for such risks and generate all round efficient outcomes. Further, the media, most likely at the instigation of one or some of the disgruntled bidders, would have carried the counterfactual story of the government's faulty bid design causing massive presumptive loss to the consumers by foregoing ultra-cheap tariffs that some of the bidders (there would be "reliable sources") would have offered by assuming the fuel price risk. The most likely sequence of events post-bid would have been - an RTI application (to find out who took the decision on the bid parameters) or CAG audit, consequent media leaks which gloss over the nuance and sensationalise (say, the presumptive loss figure), vigilance enquiry and CBI investigation.

There are also issues of ownership of the Indonesian mines and cross-holdings which need to be explored before the full extent of any loss or gains can be established. Has anyone examined the ownership of the Indonesian mines? After all, the bidders could have hedged for some of the price risks by assuming an ownership stake in the mines. I have blogged in detail about these issues here. 

In case of the Taj Mansingh Hotel, the lease agreement did not provide for a first right of refusal and the NDMC was only exercising its rightful option. In the absence of a first right of refusal, the IHCL's financial quotes in 1976 were on the basis of a 33 year contract period. In the circumstances, it had no right to claim a first right of refusal. In fact, that IHCL claimed a first right of refusal without any such contractual provision, and the matter was litigated before the High Court and Supreme Court (instead of being dismissed at admission stage) is itself a matter of concern. I have blogged here why the concept of first right of refusal itself is questionable. 

In both cases, allowing the claims would have engendered serious moral hazard and eroded the sanctity of contracts even more. Contract negotiations have been a serious problem in power and roads sectors, and are likely to surface soon in ports and solar sectors. This is a much needed reality check on the solar generation bubble. The Supreme Court's decisions have hopefully recovered some lost ground.

Monetizing road projects

Conventional wisdom would have it that infrastructure contracts should be structured in a manner that bundles construction with long-term maintenance so as to minimize life-cycle costs and maximize efficiency gains. Accordingly, the orthodox approach for PPP contracting in roads, that hitherto pursued by India, has been to allot projects as long-term Build-Operate-Transfer (BOT) concessions. It was hoped that this would align the incentives of the concessionaires to construct the project in a manner that minimizes maintenance costs. 

But this search for first-best contract structuring betrays an ignorance of the complex dynamics that drive long-term infrastructure contracting, especially in certain sectors like transportation and urban infrastructure. I have written about incentive distortions that detract from the achievement of desired objectives and how it squares up with global experience. This blog has therefore consistently, for a very long time now, held the view that infrastructure contracts should preferably be constructed through arms-length public procurement, construction risk off-loaded, concessioned out as long-term contracts, and be supported with an incentive compatible renegotiations framework.  

The Ministry of Road Transport in India embraced the public procurement based EPC model last year after the classic PPP BOT models failed to generated bidder interest. Now, the Ministry has apparently identified 104 commissioned toll roads for monetization and hopes to earn Rs 800-1000 bn from these public funded projects over the next 20-25 years. What remains is the adoption of enabling renegotiation frameworks. 

As to the present proposal to monetize toll roads, there are certain concerns that should be addressed. I had co-written earlier about them here, describing them as second generation issues. One in particular assumes significance. A 20-30 year operation and maintenance (O&M) concession naturally raises the issue of mid-term upgradation of the asset. There is ample evidence that concessionaires generally tend to skimp on this or demand renegotiations when the time comes. It is therefore essential that the bids can accommodate the resources required for such capital investment. Further, project lenders should ensure that the project cash-flow waterfall be structured accordingly. 

Renegotiating infrastructure contracts

Contract renegotiations are passé. The challenge today is not so much to prevent renegotiations by trying to write complete contracts, but to manage them effectively. It is an acknowledgement of this reality that the Union Budget has proposed the enactment of a Public Contracts (Resolution of Disputes) Act.

Experience from several decades of concession contracts from across the world and in different sectors shows that incomplete contracts are the norm. In a famous analysis of over 1300 concession contracts in Latin America, World Bank economist Luis Guasch has shown that 54% of them ended up being re-negotiated within 18 months. In India too, the vast majority of national highways and all the ultra-mega power projects (UMPP) which were allotted through competitive bids are now being re-negotiated. 

This should come as no surprise given the deep uncertainty that is sought to be tamed by such contracts. It is extremely difficult, even impossible, to conceive of all possible contingencies which can possibly derail a contract over a 20-30 year period of time. There are simply too many unknown unknowns for anybody to write a reasonably credible contract for such a long duration. Renegotiations become inevitable. 

Concessionaires demand tariff increases, extension of concession tenure, back-loading or reduction in their investment obligations, and adjustment of periodic fees payable. But re-negotiations detract from the sanctity of the original contract and generate moral hazard. 

In the circumstances, the objective should be to minimize the distortion of incentives, given the strong likelihood of renegotiations. Adhering to a few principles during contracting can minimize moral hazard, align incentives, and reduce uncertainty. 

One, the rigor of technical and commercial feasibility analysis of the project should not be compromised for constraint of time. Unrealistic demand and traffic forecasts, tariff assumptions, and maintenance estimates – most often the result of hurried project preparation - are the commonest causes for renegotiations. 

Two, any contracting process should focus on prudent risk allocation. It should not encumber concessionaires with risks whose realization is high and which cannot be diversified. The example of Case I bids for UMPPs, where aggressive developers passed over the option of imported fuel price pass-through and preferred to quote levellized tariffs involving fixed-price for fuel is a case in point. It was ex-ante evident that developers were assuming a huge price risk they could not control. Similarly price-cap regulated contracts (tariff is regulated), though politically acceptable because they shift risk allocation from consumers to operators, are more vulnerable to re-negotiations than cost-plus regulated (tariff calculated based on rate of return) contracts. 

Three, sanctity of contracts should be protected. Contract re-negotiations should be explicitly prohibited in cases where the risks were clearly defined and voluntarily borne by the concessionaire. This of course raises the important issue of clear risk allocation in public private partnership (PPP) contracts. In the aforementioned case of UMPPs in India, the concessionaire knew about the real risks and consciously chose to quote the risky option. Any renegotiations then become untenable. One way to approach this problem would be to have a negative list of considerations which cannot merit re-negotiations. 

Four, the concessionaire should internalize the cost of re-negotiations. For example, in annuity or toll-based highway contracts which go for renegotiations, any changes to the contract tenure or schedule of payments should not modify the contracted net present value of the payments payable or receivable. A toll contract where the successful bidder is one who bids the lowest net present value of revenues (to recover his investments and make a profit), for example, allow for such renegotiations. 

Five, the Guasch study shows that contracts which have investment obligations and those under price-cap regulations are most vulnerable to renegotiations. They generally result in either delays or reduction in investment obligation targets and tariff increases. Transport, water and sewerage sector contracts dominate these. Such contracts would benefit from a built-in provision for periodic reviews, with clearly defined contingencies that demand such reviews as well as their scope. In such projects, the British model of price-cap regulation – where tariff increases are capped based on inflation, efficiency improvements and capital investments, where the bid values are valid for only the initial few years, and is followed by regulatory reviews over 5-7 year periods - may be more appropriate.

Six, the process of renegotiations should be apolitical and institutionalized. The original mandates of regulators should clearly outline the scope, terms, and protocols for any re-negotiations. The legal basis of the entire renegotiations and its appellate processes should be clear and strong and insulated from the government. And all this should be reflected in the contract. Further, regulatory autonomy is critical to curbing both political opportunism and corporate greed, besides creating institutional credibility surrounding such contracts. This credibility can be enhanced by involving a panel of reputed sector specialists in the renegotiations process. 

Seven, in cases where the project valuation is clear, governments should also consider buying out the developer’s investments and then re-contract it out. In such cases, in order to avoid the moral hazard, the amount payable for termination should be contingent on the bids received during the re-tenders. 

Eight, cost over-runs during construction phase is a common cause for renegotiations. Since many public transit and utilities contracts are price-cap regulated, cost over-runs invariably result in demand for price/tariff increases. The case of Mumbai metro is just the latest. In this regard, the practice in Australia and UK of adjusting for an “optimism bias”, calculated based on the history of cost over-runs in all projects in the sector, while writing contracts can be useful. Scenario planning that accommodates various contingencies of risk materialization and the action thereon would help mitigate its adverse consequences. 

Finally, renegotiations are more likely when competition is intense and on contracts negotiated in good times when plentiful credit is available. Just as investors pour money into asset classes driving up valuations and inflating bubbles, developers throw caution to the wind and low-ball bids with excessively optimistic revenue projections that reflect the euphoria of the boom. In such times, financial markets fail to do the due diligence that prevents excessive risk-taking by euphoric developers. Once the business cycle turns downward, affecting the project’s commercial viability, the developer is left with no option but seek renegotiations. Governments would therefore do well to be cautious with excessively attractive bids that get made in such times and when competition is high. The real cost of such apparent “free lunches” follow, but much later.

Winner's curse in auctions - minerals and telecom spectrum in India

It was inevitable and it now has surfaced on the horizon. Livemint points to a PwC/CII report that the power project developers who bid aggressively to secure coal blocks in recent auctions are reluctant to mine them on the face of the government's decision to cap fixed charges based on regulatory considerations. 

All the power sector coal-block auctions had gone into forward-bids, where not only would developers not pass on the cost of coal to customers, but, in some cases, even pay the government an additional premium (over and above the mandatory royalty and reserve price). It was claimed that the 66 blocks, awarded through auctions and allotments to state-owned firms, will generate revenues of Rs 3.35 trillion and electricity tariff benefits worth Rs 693 bn to consumers. Power producers, instead of bidding at a discount on the reserve price, even offered to give money to the government. Since you cannot buy something and give that free for 25-30 years, these bidders, all of whom have sunk investments in plants which are currently idle and bleeding money, were presumably betting on "smuggling" in the fuel costs elsewhere.

It was abundantly clear during the auctions that the developers had bid aggressively for fuel in the hope that they could recover the costs by transferring it into the fixed capacity charges for the untied part of the plant capacity (aside from the already existing PPA) and/or by the sale of the 15% of generation capacity as merchant power. Livemint also points to an ICRA report which estimated the under-recovery in fuel cost in the range from Rs.0.39/kwh to Rs.1.02/kwh on a levelized basis over a 25-year period and the aggregate under-recovery for the bidders at Rs.8 billion in FY2015-16 and about Rs.18 billion by FY 2017-18. 

At that time, Partha Bhattacharyya, who knows a thing or two about coal mining, had this interesting observation in an oped,

However, whether it is conducive to promoting sustainable mining depends only on the premise that the bidders be fully aware of the implications of their actions. Unfortunately, self-destructive bidding is not unknown in the Indian context. Bidding for ultra mega power projects (UMPPs) has provided examples in the not too distant past, with winners throwing up their hands after finding it impossible to deliver power at the offered price. Analyses of the root cause in all of these cases indicate an inadequate core competence in coal mining or coal sourcing as the underlying reason. In the present case of bidding among end-users, the possibility of a similar inadequacy cannot be ruled out.

Now that the government has capped the fixed capacity charges and the spot markets are down on their knees, the developers have no choice but to take unsustainable losses. In fact, even if the government had not capped the fixed charges, it is unlikely that developers would have been able to realize higher charges given the perilous state of discom finances. It is undeniable that the lack of clarity in the tender documents on the calculation of capacity charges and the failure to quell the doubts in unambiguous terms before the auctions encouraged the aggressive bids.

Much the same story is repeating in telecommunications, with call drops being the commonest manifestation. Irrespective of whether the spectrum available is adequate or not, it cannot be denied that telecom operators, who bid very aggressively in the 3G auctions, have, for some time now, been skimping on capacity improvement investments. As Shyam Ponappa describes, there are other failures arising from the quest for revenues maximization,  India's telecoms spectrum market,

India brought in more operators than other markets, didn't provide as much commercial spectrum, fragmented what it had, and priced it out of sight. Consequently, substantial spectrum is idle with the government, while large operators with very little spectrum and the legacy of underdeveloped fixed networks have over 100 million customers each, with high voice and growing data usage. This situation is likely to worsen as more spectrum holdings come up for renewal.

The widely acclaimed telecoms spectrum auctions realized revenues worth nearly $17 bn. Unlike with coal, spectrum already under use by incumbents was re-allocated through auctions. This left existing operators, who have massive fixed investments, with little choice but to bid aggressively to retain their spectrum. The net result is that India has become one of the costliest telecoms spectrum markets.

The exorbitant cost of spectrum adds to other headwinds that telecoms operators have to navigate. Though one of the fastest growing telecoms market in the world by customer-base, operator margins are squeezed by the lowest average revenue per user (ARPU) of about $3, less than a tenth elsewhere. This is exacerbated by cut-throat competition, with nearly ten operators in each circle. And now, the high cost of spectrum has sharply increased the debt burden of  operators, leaving them with little room to raise resources to invest on network expansion, maintenance, and upgradation.

This leaves operators with no option but to raise tariffs significantly, which will certainly constrain demand, and thereby work against the government's ambitious Digital India objectives. In a highly price-sensitive market where just one in hundred have access to high-speed broadband, and where the baseline penetration of data-services is very small, affordable prices are critical to expanding both customer base and services. 

The aggressive bids made both in the reverse auction (for coal blocks designated for power plants) and forward auction (for non-use specified blocks), and telecoms spectrum, and the attendant squeezing of possible margins, raises more questions about the unqualified acceptance of auctions in the allocations of natural resources.

There is a compelling argument that in the spectrum and mineral allocation auctions, government's immediate fiscal considerations have crowded-out larger sectoral objectives. In other words, the details of the auction design may have been skewed towards maximizing auction revenues than sustainable introduction of new technologies into the telecoms market or delivery of power at a reasonable price and rate of return. 

Interestingly, this skew may reflect the institutional power balance within the Ministries of Government of India, in particular the balance between the Ministry of Finance (MoF) and the respective line Ministries, Power and Telecommunications in this case. The MoF has a very hands-on approach in any such contract formulation, applying due diligence that invariably revolves around the binary "public interest" touchstones of expenditure control and/or revenues maximization. The recommendations of the respective regulatory commissions tend to get sidelined in the face of "public interest". The recent history of scandals and the chaotic investigations and prosecutions that followed, may have only amplified this trend. Not only have the advocates of "public interest" become stronger, the voices of the primary stakeholders, the respective Ministries, have become more wary of being seen to be doing anything which would appear to support the private market participants.  

To the extent that the operator or developer's cost is directly translated as the government's revenues, the MoF's role is clearly that of an agent of the government. Therefore, if the MoF prevails in setting the terms of contracting in such auctions and the departments abdicate their responsibilities as neutral arbiters in the auction, it necessarily becomes an one-sided contract. Winner's curse and renegotiations invariably follow.   

One of the oldest axioms of life is that there is no free lunch. The examples of natural resource auctions and public private partnerships (PPPs), which governments have come to view as as a resource mobilization opportunity and the latter as a means to avoid committing large resources for infrastructure investments, and their respective failings, are forceful reiteration of this axiom.

Restructuring stalled infrastructure projects

The massive numbers of stalled infrastructure projects constrain India's economic growth on multiple fronts. Apart from preventing downstream economic activity (even sunk investments), it acts as a huge drag on the balance sheets of infrastructure firms and lending institutions. The Economic Survey has an analysis of such projects. Here is a graphical illustration of the magnitude of the problem.

The decline in new investments coincided with sharply rising volumes of stalled projects since 2009.

A high-level Project Monitoring Group (PMG), established mid-2013, was entrusted the responsibility of de-clogging 437 major stalled projects (342 with investments above Rs 1000 Cr) worth Rs 21 lakh Cr (or Rs 21 trillion). The sector-wise projects break up reveals that power, steel, and petroleum and natural gas make up Rs 17 trillion of these projects.

The Department-wise break-up indicates that Environment and Coal Ministries made up 60% of the projects.

In late-2014, the Planning Commission presented to the Prime Minister that an additional Rs 5.7 trillion would be required to complete 738 central government funded infrastructure projects on which already Rs 5.6 trillion has been expended. It also said that 83% of these projects were delayed, resulting in cost over-run of Rs 1.89 trillion. Interestingly, 274 out of the 289 railway projects were delayed, mainly due to financial constraints.

The delays with railway projects are surprising since many of them involves gauge conversion or additional lines, which have limited land acquisition requirements. Financing problems and equally importantly, implementation inefficiencies and contractor delays, are likely reasons for the delays.

In March 2015, the Ministry of Statistics and Program Implementation placed details of these 738 projects being monitored before the Parliament. It stated that 315 of these projects had passed their implementation deadline. Road Transport and power formed nearly half these projects and railway projects formed eight of the ten most delayed projects.

As to the major reasons for the delays, an HSBC study of the top 100 largest stalled projects in the CMIE records found that site acquisition make up a third.

In contrast, another analysis of stalled projects, based on data for 804 such projects provided by the Ministry of Finance, appears to contradict the claim that land acquisition problems are holding back projects. The MoF data informs that just 8% of the projects are stalled due to land acquisition problems and 39% are due to unfavorable market conditions. Interestingly, the reasons for delays in about a third of the stalled projects is unclear.

There are significant variations across sources about the reasons for delays. It is clearly not as simple as the conventional wisdom that land procurement and environmental clearances have derailed many of these projects. My own belief is that a large numbers of these projects were initiated without rigorous due diligence and at a time when credit was easily available. Therefore, commercially unviability may be the under-stated real contributor to delays in the majority of cases.

Even assuming expedited clearances and site procurement, itself no mean task, given the delays that have already happened, those projects too would undergo cost-escalation. In the circumstances, there are only two solutions - restructuring or scrapping. The former assumes that the project can be salvaged by changing its terms.

Such changes in terms can potentially come in three forms. In purely private projects - steel, telecoms, petroleum, manufacturing, real estate etc - the developers should find the present market conditions commercially viable enough even with the increased investments required. In infrastructure projects - power, roads, railways, mass transit etc - the governments should finance the cost-escalation either by agreeing to pass-through some of the costs (through higher tariffs or tolls) or provide budgetary support for the increased expenditure. Finally, in certain cases, especially roads where traffic forecasts were optimistic, it may be possible to restructure the project merely by increasing the project tenure and without any additional financial burden.

This assessment in turn critically depends on the sunk investments made in those projects. In projects where significant investments have already been made, restructuring becomes more likely, whereas those where investments made are marginal, developers may prefer to wait out or scrap the project.

It may be necessary to carry out detailed analysis along these lines before we embark on any restructuring of projects. If the developers of purely private projects find them commercially unviable given the prevailing market conditions and government is in no position to bear the fiscal burden, then the possibility of restructuring diminishes dramatically. In that case, all talk of restructuring stalled projects is barking up the wrong tree. In that case, scrapping becomes the only alternative. 

What to expect from mega construction projects

The Times carries an excellent story of yet another grandiose trophy project - the nearly $4 bn World Trade Center Transportation Hub - which is facing massive cost over-run and execution delay.

The Hub, with its winged "Oculus" pavilion, designed by the famed architect Santiago Calatrava, is being developed by the Port Authority of New York and New Jersey. It is estimated to cost about $3.7 bn when it is likely to open in 2015, many years delayed and at more than twice the original estimate when the project was unveiled in 2004. After all this spending, it turns out that instead of being a predominantly transportation hub, the project would in all likelihood end up being a "high-priced mall, attracting more shoppers than commuters".

The experience from this and numerous other similar projects points to a few important lessons that appear universal for such projects

1. Cost over-runs and time delays are unavoidable, unless you are doing it in China. It is therefore appropriate to factor in this at the beginning using some form of "optimism bias" to accommodate the inevitability of delays and cost over-runs. This would help all parties - government agencies, developers, financiers, and citizens - appreciate the real challenge, instead of being misled by the highly deceptive initial estimations.

2. Star planners, designers, and architects are more likely than not to disappoint. However, this cannot be a reason for not considering them. They are essential to meet the client's (a political leader or a wealthy promoter) aspirational hubris, atleast when the project is initiated. It is just that the hype surrounding any sales pitch has a dynamic of its own which camouflages reality and most often fuels excessive expectations. Even other wise, plans submitted by them are likely to run into technical (it is rarely possible to literally translate the design into physical structure - any change to the design, which is mostly inevitable, to get it to suit field conditions is most likely to disrupt/compromise the original promised effect) and financial (it is too expensive to translate the design literally) challenges. Either ways, when the promised effect does not materialize and disappointment sets in, the architect/planner would blame it on the developer/government failing to keep its side of the contractual bargain.

A rigorous enough analysis of the design/plan (so as to test its aforementioned technical and financial dimensions) that can anticipate all possible technical/financial contingencies is almost impossible at the initial stages of a project. The emergent dynamics of these large projects are difficult to anticipate. So being disappointed with the work of star architects/designers is par for the course.

3. Much the same fate is likely with other important external service providers like project managers, owner's engineers, master planners, and construction contractors. This assumes significance since almost $655 million of the $3.7 bn for this project will be spent on such administrative costs. Disputes, like with the Hub's construction contractor Phoenix, are commonplace. It is difficult to write complete contracts that define the scope to last detail and capture all contingencies. The scope of work undergoes continuous changes at the different stages of execution for a variety of unforeseeable reasons. The best that can be done to mitigate this is too have in place enough flexibility within the contract to deal with such contingencies and attendance disputes, given the inevitability of it surfacing.

4. The emergent dynamics of such projects necessitate several decisions which are not easily justified on terms of objectivity. For example, from hindsight one gets the (mistaken) impression that in the Hub project, given the exorbitant increases in cost, there were occasions when the design could have been junked for a more prudent and financially viable one. But the reality is that the option value of shifting to a new design is most often zero, even negative, given the different types of sunk-costs associated with the original design. Or the decisions to agree for expensive sub-contracts to expedite the work, or the

This raises the question of how do public managers, especially in countries where post-construction audits are done with the apparent wisdom of hindsight, take decisions that do not fall foul with such auditors. This assumes great significance for India where audits-induced decision paralysis has become an important problem in recent years. In fact, a business as usual audit of this project in India could have incrimated all the concerned, including Mayor Bloomberg, of causing loss to public exchequer and even left many in jail. 

A "re-negotiations policy" for road projects?

I have blogged extensively on the moral hazard that have been unleashed with the widespread trend of re-negotiations that have gripped the infrastructure sector. Private infrastructure developers have internalized the norm that they can bid aggressively and irresponsibly, as many have done, with the assurance that they can always go back to re-negotiate the terms. India's pernicious culture of crony capitalism encourages the trend.

In this context, the Roads Ministry has proposed to break the gridlock with stalled National Highway Authority of India (NHAI) road projects by restructuring them. There are currently 48 road project developers who are renegotiating the restructuring of premium payments with the NHAI. However, instead of re-negotiating on a project-by-project basis, newspapers report that the Roads Ministry has effectively proposed a blanket policy (I am not aware of the details though) for restructuring premium payments owed by developers. It proposes that the premium payments of developers whose projects are stressed, mainly due to traffic shortfalls, be restructured in accordance with a general policy. The Mint reports on the crux of the Ministry's restructuring policy,

In principle, the roads ministry’s recommended restructuring involves back-ending the agreements with developers to reduce their payments to the government in the initial years of the contract—a move that could help them complete the projects. The ministry and its arm, NHAI, are worried that if projects are stuck on account of financing troubles, developers could start walking out of projects—resulting in a delay in building required infrastructure and losses on account of unpaid premiums. These projects will also have to be re-bid.

It immediately raises the question about why the same internal restructuring of its cash-flows cannot be done by the developers themselves. It needs to be borne in mind that most road developers have a portfolio of projects, with varying levels of profitability, which would facilitate the process of such re-balancing. In fact, the very objective of firms specializing in infrastructure and accumulating a portfolio of projects with a diverse risk-profile and cash-flow patterns, is to leverage their overall balance sheet and mitigate their individual project risks. GMR and the like have clearly internalized the norm that they will view each project as a stand-alone entity, and transfer commercial risks on to the government through the process of re-negotiations.

In simple terms, the Ministry is effectively proposing a re-negotiations policy for all road projects. It is a virtual fait accompli that developers will internalize this policy into their bids, thereby distorting the process of efficient price discovery in the forthcoming tenders. The tendering process would then become just a transit point in the process of arriving at the final contract conditions.

I have been thinking for sometime that, given the inevitability of re-negotiations with many infrastructure projects, it may be an efficient second-best approach, to transparently outline the principles that would define any process of re-negotiations. But we should be careful that it does not become codified into some policy, which would take away from the process of competitive bids that allot these projects. Re-negotiations should be done on a project-by-project basis, and not through a routine application of rules to qualify projects and renegotiate their terms.

Further, in order to discourage any moral hazard, the process has to be accompanied with prohibitive enough haircuts on equity holders. Promoters who bid irresponsibly or with other, less than transparent, considerations have to pay with their capital, and that too a prohibitive enough amount. It will be interesting to see what the Rangarajan Committee, entrusted with formulating a restructuring policy, comes out with. 

The gas price debate - a problem of information asymmetry?

I can't get a proper handle on the controversy surrounding the government's recent decision to increase the regulated price of natural gas. In this I share Anantha Nageswaran's ambiguity.

For the record, the government has accepted the recommendations of the Rangarajan Committee, which has been variously estimated to virtually double the domestic price of natural gas to about $8.4 per million BTu by 1 April 2014. The Business Standard has a nice summary of its implications, especially on fertilizer and power prices. The Rangarajan Committee had proposed a pricing mechanism that took a simple average of US's Henry Hub, UK's National Balancing Point, Japan's JCC, and the 12-month average of imported LNG prices. It also suggested that the prices be revised every quarter and this arrangement itself be reviewed after five years.

The government has also decided to do away with the earlier practice of revenue-sharing (with government) after cost of exploitation is fully recovered (by the field developer) in the production sharing contracts. Under the earlier arrangement, the government would get a share of the profits only after the developer recovers all its capital investments. In this case, there are strong reasons, as the CAG has pointed out, to believe that Reliance Industries (RIL) has gold-plated its capital investments, so as to defer the sharing of revenues with government.

The government's decision has apparently been motivated by two considerations. The first being that the gas price was, in any case, up for review on 1 April, 2014. The second, more substantive reason, being that it was thought necessary to encourage upstream investments, especially by foreign investors, which is necessary to raise oil and gas output and thereby ensure energy security as well as balance our current account.

It is clear that  RIL is going to be the biggest private beneficiary of this decision. It is also probable that RIL played hardball with the government, by "reducing" production from nearly 70 million metric standards cubic metres per day (mmscmpd) in 2010 to just 15 mmscmpd today. So the accusations of crony capitalism are inevitable.

But there are several areas where clarity is at a premium. In the circumstances, a more meaningful debate is possible only with more information. What is the realizable output from the field? What is the cost of realization? What is the capital investment made by the firm? What are the problems that hinder exploitation of the field? What are the additional investments required? A best estimate for each of these questions is necessary to clear the air and ensure fairness in pricing decisions.

In other words, oil and gas exploration sector suffers from the problems associated with information asymmetry. The exploration firm has the best answer to all the aforementioned questions. The regulator, whose responsibility is it to determine price based on the cost of exploitation, has access only to secondary information, which too comes mainly from the explorer firm. Fair price discovery is virtually impossible in these circumstances. It is also an invitation to cronyism and corruption. In the circumstances, any reform should push for an immediate institutionalization of a system of periodic technical performance audit of all oil and gas fields which have been leased out by the government.

There is also a need for greater debate on the best possible pricing model for gas producers. Is marginal cost pricing, at import prices, desirable? Given our scarce readily exploitable oil and gas reserves, what is the opportunity cost of inviting investments by foreign private developers? Does this, atleast partially, explain the reason why the large foreign firms have stayed out of Indian market? Needless to say, even this debate depends on answers to the questions raised earlier.

Unfortunately, a lot of the mainstream criticisms of the government's decision - here, here, here, and here - do not address any of these relevant issues. These critiques are focused on its impact on downstream fertilizer and power consumers, increased subsidy burden if government decides to absorb this impact, and most often, the inevitable availability bias that a corruption tainted government (and equally corruption-scarred RIL) engenders. In fact, it also highlights the difficulty of taking such decisions in an environment that has been vitiated by populist rhetoric of political parties and lazy analysis of mainstream opinion makers.

The most compelling critique of the government's decision comes from Surya Sethi. While his first two reasons are more rhetorical and speculative, the argument against raising prices for an "existing field" appears compelling,

What is the justification for raising the price of gas from existing fields? We can always pay a higher price for more difficult horizons provided the duly approved and audited costs of exploration and production warrant that. The current production was realized with no prospect of getting $8.4/MMBtu.

Here too it needs to be borne in mind that the agreement with RIL (and I am not fully aware of its details) does talk about periodic price revisions, as can be construed from the fact that the price was up for revision from April 2014. This article in Hindu does raise this issue and indicates that the production sharing agreements signed by the Government of India mandates arms-length market based pricing. So while an increase in prices may have been perfectly legal, though the magnitude of increase would be a matter of debate. But this too appears to have missed the radar of informed opinion makers.

In fact, even accepting Mr Sethi's very logical argument about revisions being applicable only for newer fields and cost-plus pricing of gas, we also appear to have missed an opportunity to debate the fundamental issue of pricing dry natural gas at the well-head. What are the different approaches to gas pricing across the world? Which of them, or their variants, is relevant for India and why? Is the Rangarajan Committee's recommendations the most appropriate pricing model for India? Should India adopt the marginal pricing (at well-head import prices) or pricing indexed to global petroleum prices or a cost-plus pricing model based on the cost of recovery from respective gas fields? Here too Mr Sethi has important points to make, none of which get carried forward into mainstream debates about reforming gas pricing.

What complicates matters is that natural gas markets are fragmented and prices vary widely and are volatile. In fact, current prices vary from 75 cents per thousand cubic feet in Saudi Arabia, $3-$4 in the US, around $12 in Europe, and as high as $16-$17 in Japan. The inherent difficulties associated with transporting natural gas has been a major contributor to the market fragmentation. In addition, the implicit US natural gas export curbs (by limiting the development of off-shore LNG terminals), have acted as a major deterrent to convergence in global prices.

I am inclined to agree with Mr Sethi that marginal pricing, based on import prices, may not be an appropriate price signal at a time when natural gas markets are extremely fragmented and prices vary widely across the world, being dictated by local factors than any objective market considerations. But this does not mean that cost-plus pricing is the natural alternative. We need to bear in mind that while this is the present state of global natural gas market, these arbitrage opportunities are too large and strategically sensitive to persist for too long. Therefore a pricing mechanism which overlooks global prices, while likely to be appropriate for now, may not be so in the future. Regulators and policy makers will need to respond dynamically to emergent scenarios.

In any case, three things, not substantively related to the particular issue, stand out from this. One, decision making on important issues with high stakes has become a treacherous activity, with politicians and opinion makers trying to outbid each other with populist rhetoric. Two, related to the first, with the media debates on important issues being disappointingly sub-standard, a critical forum to debate and contribute to the design of important reforms and build public support for them appears to have become superfluous. Three, one cannot but get the distinct feeling that the gas-price decision itself appears to be in keeping with the practice of re-negotiations that have become a feature of private participation in India's infrastructure sector.

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.