Infrastructure Prioritization

As India moves in the next phase of development post 15th Lok Sabha elections, the Economic Survey just prior to the Budget clearly states "Economy is sound, let's push for reforms". Some reforms look difficult to deal with others look much easier. In the case of infrastructure, which is a priority area, certain reforms can look innocuous but would leave long term benefits to the economy.

One such area is "Infrastructure Prioritization". As mentioned above, this word looks innocuous. In layman's terms it would means that we need to prioritize our infrastructure spend. On a Policy front, this appears to be already done by the Planning Commission in their document "Projections in investments in Infrastructure during the Eleventh Plan" where sector wise infrastructure investments are detailed therein. In fact, the document also looks into the India's infrastructure requirements to be filled by the private sector during the Eleventh Plan which really goes beyond what is true Government planning. Having said that, it does not specify individual projects that constitute the US$ 500 billion requirements in the Eleventh Plan.

Infrastructure Priortization means that each or a group of projects that constitute a long term plan must be disclosed from various fronts (a) type of projects (b) how they fit into India's current and future needs and priorities relating to nationally significant infrastructure (c) how such infrastructure addresses the various needs of its users and the country at large and (d) possible mechanisms for financing investments in such infrastructure. Therefore it is a drill down of about two levels from what Planning Commission has done in their report "Projections in investments in Infrastructure during the Eleventh Plan".

Infarstructure Priortization is nothing new. The Australian Government has published a document called "Outline of Infrastructure Australia's prioritization methodology". This is an integral part of their National PPP Guidelines. In describing their prioritization methodology Infrastructure Australia states that "methodology provides an integrated framework that harmonises the information and data resulting in a balanced range of initiatives and uses cost benefit analysis (CBA) as the primary tool for prioritising initiatives." The aim of the methodology is to be:
• Logical and well defined – as it is systems focused and based on and conforms to Infrastructure Australia's aims, objectives, strategic priorities and principles;
• Clear and transparent – as it promotes the open sharing of information;
• Evidence driven – as it uses quality and suitable data and consistent tools; and;
• Robust – as it is comprehensive by looking though multi-lenses to solving a complex problem.
This prioritisation methodology provides a best-practice approach for infrastructure prioritisation and has been drawn from international and national based practices and research.

In India, prioritization process would help in evaluating competing projects for VGF or completion based on the CBA score. Currently, one could argue that a lack of projects being taken up on PPP basis by concessionaires makes priortization a redundant philosophy in the Indian context. However, prioritization does tell the Authority and public at large that certain projects need to be emphasized, given a special status etc etc based on certain criteria. In effect, they score well above the others and need to be given a special status. Example, currently whilst most infrastructure projects in India are critical, those linked with the Commomwealth Games have a special status because their completion has an impact on the country's pride and the smooth functioning of the Games. The recent collapse of the Delhi Metro Bridge is a clear case in the direction - had these projects been priortized such a mishap on account of the looming deadline wouldn't have occurred. This project woulsd have been completed much earlier. A project high on the Priority List requires more men, materials, faster clearances and therefore would require to be completed within schedule time and date.

The Priortization Methodology of Infrastructure Australia

The prioritisation methodology for Infrastructure Australia is one process incorporating three phases:

• profiling;
• appraisal; and
• selection

The profiling phase of the Infrastructure Australia’s prioritisation methodology assesses the compatibility of the range of initiatives to Infrastructure Australia's strategic priorities. A picture of the potential national productivity value of initiatives can be determined while producing a balanced view of the initiatives and their linkages and dependencies to other initiatives.

The profiling of initiatives needs to outline:
• rating of compatibility to Infrastructure Australia's strategic priorities;
• how the strategic priorities are to be addressed by the initiative, and;
• how the initiative is dependant on other complementary and dependant initiatives being policy, regulatory, demand and pricing solutions, enhancement and capital investment solutions.
Profiling creates the coherent argument as to why the initiative is being considered in the first place and what is it actually trying to achieve relative to Infrastructure Australia's strategic priorities. The simplicity of testing and reporting against the strategic priorities defines the appropriateness of any initiative at the outset.

The appraisal phase of the Infrastructure Australia’s prioritisation methodology adopts ‘monetised’ cost benefit analysis as its core tool. This is complemented by ‘non-monetised’ effects. Together, a picture of the wider economic, environmental and social merits of each initiative can be determined.

Infrastructure Australia
• Use objective cost-benefit analysis as the primary driver of decision making;
• Consider a wide range of benefits and costs – not just economic, but also social and
environmental;
• Give monetised CBA (through the benefit cost ratio) a key role in decision making;
• Ensure non-monetised effects are also taken into account; and;
• Consider both efficiency and equity impacts.

Finally, the selection phase of the Infrastructure Australia’s Prioritisation methodology integrates the profiling and appraisal assessments and other data and information. As such the national productivity impact of individual initiatives can be compared. Together, the picture of the national productivity impact of the entire range of solutions across all sectors can be created into the infrastructure priority.

The need to review the existing discount rate in PPP project evaluation in India

Public Private Partnerships in India are evaluated by professional firms called Transaction Advisors before they are cleared by the various committees empowered to clear such projects in the Centre and the States. This evaluation is generally funded by dedicated PPP project development funds either by the centre or states. This exercise of a financial, technical and legal feasibility is called a "Feasibility Report" which is of immense value to both Sponsoring Agencies, PPP Approving Authorities and finally the bidders who use this document as a base to bid for the project.

The financial feasibility exercise is key to a successful PPP bid outcome - it assesses the infrastructure project cost based on certain standard cost of an equivalent project adjusting the same to match the existing project cost requirements. The funding cost of the project is also based on a debt equity mix that is being generally followed by concessionaires in the project. Thereafter, based on sound principles the project traffic is assessed on a current basis and thereafter estimated on a future basis on growth in traffic, all of which have a sound basis of evaluation followed by the Transaction Advisors. The projected revenues and expenses (including capital cost) over the life of the concession are aggregated year on year to arrive at the net project cash flows.

The net cash is thereafter discounted to arrive at "discounted cash flows" where the time value of money is over the years is adjusted to the present scenario. This whole exercise is to determine (a) whether sufficient cash flows are generated by the project to make it financially feasible and (b) to what extent are project cash flows deficient in order for the Sponsoring Agency / Centre intervene by way of a Viability Gap Funding (VGF) to make the project financially feasible to concessionaires and bankable to funding agencies. The financial feasibility is based on target Net Present Value (NPV) that the project would return that makes the bidder comfortable to invest in such. Therefore in a financial feasibility report three critical elements are present that require in-depth understanding and evaluation:
a) Project Costs - in India project costs may vary but there is a clear understanding amongst the Authority and Developers as to what should be the costs. This is out of sheer experience in actual PPP project implementation. Project costs refer to both capital and recurring project costs.
b) Project Revenues - Like project costs, project revenues are based on traffic and other project revenue evaluation. Lots of studies have been conducted to evaluate traffic in the PPP project along with deeper understanding of how traffic is related to competition, economy growth in future, fuel prices currently and in future. There exists a fair method of evaluation of project revenues in India.
c) Discount rate on cash flows - in road PPPs the discount rate of 12% is used. However, very few studies have been done to justify this discount rate.

In other developed countries eg Australia where PPPs are practised over a long period of time high emphasis is given on discount rate used in project evaluation. In fact the National PPP Guidelines of Australia has a whole chapter on "Discount Rate Guidance Methodology". The principles for determining discount rates for DCF analysis, in Australia, are based on the theory used to calculate cost of capital represented by the capital asset pricing model (CAPM). In CAPM, the cost of capital reflects the return required by an investor to undertake or invest in a particular project. The required return is equal to the risk free rate, plus a risk premium for the systematic or market risks retained by the investor. This risk free rate, in the Australian context, is the recent average of the ten-year Commonwealth Bond rate. Systematic risks are risks that effect all assets within a diversified portfolio and therefore cannot be eliminated by holding such a portfolio. Systematic risks include (a) demand risk related to general economic activity (b) unexpected inflation (c) unexpected changes in interest rate or foreign exchange rates on asset values (d) unexpected obsolesence and (d) broad market risks such as material rise in bankruptcies affecting supply. In short, to arrive at a discount rate there is strong link to current market scenario. In other countries, the discount rate is specifically linked to risks envisaged in the particular sector and project affecting CAPM.

PPPs in India also require such a detailed "discount rate study". The other critical reason for having a proven discount rate is because it directly impacts VGF. Suppose road project A after having been discounted at discount rate of 12% has a positive NPV of say Rs x crores. However, considering a CAPM method the discount rate is estimated at 8.5% leaving an NPV of Rs (x+y) crores. This means the project is far more attractive than earlier projected. Therefore, the target IRR of say 18% need not be achieved but a lower IRR can be targetted to achieve the same NPV and therefore quantum of VGF, if any, would reduce. However, in a high inflation scenario the converse may be true - discount rates could be higher than 12%. In my personal opinion, discount rate of 12% used presently in road projects is on the higher side as compared with the present Indian inflation rate and world economic scenario of falling interest rates.

One can argue that such discount calculations may not affect bid price, but the counter argument would be that seeing the Govt. discount rate the private sector could be tempted to use a similar rate to arrive at a more realistic NPV. Otherwise, why would Australia and other Developing Countries need to have a Guidance Note on Discount rate methodology for PPPs? It would definitely merit a relook at our discount rate processes and put in line with International Best Practices.

For PPPs to develop in India, apart from financial incentives that are currently in place some non-financial processes (like discount rate review) need to be strengthened that could have a direct and potent impact on the financial outflows of the Government. At a time when the India's fiscal deficit is high, any measure that may have a positive impact in reducing such deficit should be a welcome step.

Why Risk Assessment and the Public Sector Comparator are important for India

Public Private Partnerships have commenced their second journey in the Indian context. The first journey was commenced somewhere in the mid nineties where the PPP concept was being understood and found its feet thereafter in certain doable sectors like roads - 4 laning / 6 laning, some port projects and fairly popular and visible sector like airports. At present 300 odd PPP projects valued at Rs 135, 876 crores (or US$ 30 billion approximately) as per PPPinIndia database represents a sizable number of projects achieved in India since inception of the concept.

The post 15th Lok Sabha elections defines PPPs in their second phase of growth and importance in the Indian infrastructure scenario. The President in her speech to Parliament on June 4, 2009, has clearly outlined the role of "Infrastructure as a fundamental enabler for a modern economy and infrastructure development will be a key focus area for the next five years of the Government". The President stated "Public-private partnership (PPP) projects are a key element of the strategy (on infrastructure creation). A large number of PPP projects in different areas currently awaiting government approval would be cleared expeditiously." The President further stated "The regulatory and legal framework for PPPs would be made more investment friendly."

There is more than a subtle hint in the President' speech. In effect the incumbent Government has made PPPs core to its infrastructure creation. There is much to be read in the statement " The regulatory and legal framework for PPPs would be made more investment friendly." At present there is no PPP regulator for various sectors and the absence of a Regulator makes the Government who is the sponsorer of a PPP a party to the regulation process. The regulation, if any, is at best through the Concession Agreement ie, regulation by contract. This requires to change in order to make PPPs more transparent and meaningful to investors.

Regulation begins from the germination of a PPP idea. Once the idea is conceived by the Sponsoring Government Authority it must pass the PPP Test. This means that a technical, financial, legal and economic review must be done to verify the doability of the project. Whilst it can be argued that the current process of PPP project assessment does all three, it must be understood that there is no reference point against which such assessment is conducted. It means that the Indian public / Authority / participant Concessionaire is not made aware that (a) this project is done a PPP basis because it is cheaper to instead of the public sector(b) the efficiency gains in doing so exceeds the public sector. This assumption in today's context is based on the premise that the private sector is more efficient both in creation and maintenance of a public infrastructure project. This assumption would need to be validated through a financial exercise wherein "a Public Sector Comparator" is created where the project costs as done by public sector is compared to a possible bid scenario by the private sector.

This means that a reference points of "Costs" would have to created for the public sector to verify the bid of the private sector on the project. However, this is not that simple - as the project risks in a PPP would be transferred to the private sector the bid price of the private sector would not only include the project costs risks but the risks it perceives it faces during the course of the PPP concession period.

These risks would be in the form of - traffic risk, interest rate risk, change of government policy risk, land acquisition risk, environmental risks to name a few. If some risks are to be borne by the Sponsoring Authority it would not be priced to the project bid. Therefore to make the PSC comparable, similar risks must be added to the PSC costs to make it equivalent to the bid price of the concessionaire (in some countries Govt advantages in the form of lower taxes, duties are also added to PSC to make the comparison effective). If this risk assessment is done in a transparent manner for the PSC, then the bid value of the concessionaire can be better understood from the project cost quoted and the risk value (type and quantum) added to its bid price.

This kind of comparison helps in (a) transparent assessment of bid price by a variety of concessionaires (b) their cost and risk perceptions on the project (c) whether Value for Money (VfM) is achieved on the project ie, where VfM = Risk adjusted PSC less Bid Price. This exercise would certainly make "The regulatory and legal framework for PPPs more investment friendly" as stated by the President of India.

The PSC model is being practised by other nations following the PPP route to finance infrastructure particularly - South Africa and the UK. It is more than comparative financial exercise but a political one where the doability of a PPP would not be questioned any time during its concession period if VfM is achieved through the PSC model. Australia too has vigorously adopted the PSC model.

For India the PSC will bring in credibility to the bid process. The possibilty of getting irresponsible bids would be eliminated and competition would be structured around project implementation and risk mitigation efficiencies. Let us hope this happens sooner than later..........

Infrastructure Saga in India Begins

Indian Infrastructure sector is in a vibrant mood now. And manifested as below.

- More domestic and global investment pouring in into India
- Infrastructure and related consulting companies flocking to India
- In 2006, an investment in transport sector reached a whopping sum of $7 billion
- Companies started adding - infrastructure to their name
- A $500 billion infrastructure target fixed for 2012.
- Private, Public and PPP Projects are coming up in queue
- Active involvement by Government of India to promote investment in -infrastructure through public private partnership mode. Global best practices are being harnessed.
- Infrastructure based mutual funds generated a very high return in 2007 and almost all of them achieves an appreciation above 50 percent.

PPP in the Water Sector in Central Asia

Central Asian countries like Uzbekistan and Kazaksthan are experimenting with PPPs in the Water Sector - rural and urban water supply. However, the private partner does not fund construction of water supply systems or rehabilitate it. For funding requirements, it is done through Donor Agencies like ADB and World Bank. Privatization assistance or PPPs as they term it is in the form of contracting out of management especially maintenance and recovery. However, this form of PPP has not found great success so far. One good reason being that better maintenance and service reflects on costs and therefore require tariff enhancements. This is not forthcoming from the Government as it could be a political disaster. Therefore the private sector has to make ado with scrimpy margins which is not a great incentive for them to continue. In India water supply has not taken off as a PPP route as yet as it is politically sensitive. These countries require to follow the India model where the more easily acceptable areas will have to be explored first. However, they do not have the high consumer volumes to justify such sectors like airports, roads etc. Therefore PPP will continue to be experimented in the water sector where the consumer base is large and hopefully acceptable to tariff revisions.

Health & Education PPP

The Health and Education Sectors in India hold a good promise for future PPPs. However, PPPs in the Health and Education sector is not exactly similar to that of other infrastructure. There are two types of infrastructure here - hard wrt buildings and equipment and soft wrt to the knowledge domain. Both these have to co-joined subtlely with the private sector contributing to the knowledge and skills domain whereas the public sector responsible for the hard infrastructure.

PPP Inititiatives in India

Government of India is pushing ahead the idea of using public private partnerships for meeting its USD 500 billion infrastructure projection till 2012. Various activities are initiated by the Govermnet of India and the State Govermenments. The webportal www.pppinindia.com is a knwoledge dissemination vehicle in this regard and gives an update on the subject.