The Length of a Concession Period in a BOT Project

Initially the concession period was fixed and this led to a number of problems. Three of the four franchises that France awarded in the early 1970s went bankrupt after the oil shock and were taken over by the government. In Mexico, excessively high tolls have led to empty highways and the renegotiation of the original franchise agreements. The duration of some of the road franchises have more than doubled, and the government had to pump US$2 billion to save firms (and the banks that made loans to them from bankruptcy.

Problems relating to Highway Franchises

Traffic forecast are usually very imprecise and it is very difficult to make accurate traffic predictions. Most highway franchises have been given for a fixed period of twenty years independent of demand realization. To overcome the problems of fixed term franchises, the least present value of revenue (LPVR) auction, has been developed that adjusts the duration of the franchise to the realization of demand.

Fixed Term Franchises

Fixed Term mechanisms may be of two kinds: The regulator fixes the term and the franchise is awarded to the firm that bids the lowest toll in a competitive auction. This is used in Chile. Tolls are fixed by the regulator, and the franchise is awarded to the firm asking for the shortest term. This is common in Mexico. The toll as well as the term is fixed by the regulator, the government awards the contract to the firm paying the highest license fee or asking for the least subsidy. The license model was adopted in telecom, but firms were not able to pay the agreed upon fees so the government shifted to a revenue sharing model.

Problems Associated with Fixed Term Franchises

Due to the high risks involved, operators demand a huge risk premium which translates into higher tolls, or high subsidy demands all of which finally is a burden to the tax payer. Because of the high risks associated with highway franchises, lenders have refused to grant loans unless governments guarantee the debt (as in Spain) or provide generous minimum toll revenue guarantees (as in Chile). Guarantees reduce the incentives for lenders to screen projects and monitor their performance, one of the basic arguments for highway franchises.

Problems Associated with Fixed Term Franchises

A consequence of high risk is that when demand turns out to be lower than expected, contracts are renegotiated and losses shifted to users or tax payers. The expectation of renegotiation prompts firms to bid artificially low tolls, expecting better terms after the contract has been awarded. Firms that are efficient in renegotiating may win the contract rather than firms which are more efficient in building, financing and operating highways. Advantages of privatization are lost: taxpayers and users pay for roads that are bad investments, inefficient firms win franchises, and firms do not mind building white elephants.

Problems Associated with Fixed Term Franchises

They increase the likelihood that the franchise will be awarded to the firm with the most optimistic traffic projection (the winners curse). Fixed term contracts are inflexible, which can be a serious problem if tolls turn out to be out of line or congestion makes it desirable to widen the highway. The problem arises because it is difficult to agree on the fair compensation- the expected income foregone over the remainder of the franchise- to be paid by the franchise holder in these cases.

LPVR franchises
The least-present-value-of-revenue mechanism corrects shortcomings of fixed term mechanisms. In this approach, The regulator sets a maximum toll. The franchise is won by the firm bidding the least present value of toll revenue. The franchise ends when the present value of toll revenue equals the franchise holders bid. Toll revenue is discounted at a predetermined rate specified in the franchise contract. The rate should be a good estimate of the loan rate faced by franchise holders. several

Advantages of the LPVR franchises

The basic principle underlying LPVR auctions is that the franchise holder should not make losses when the long-run demand for the highway is sufficient to pay all costs. For this reason, the franchise holder requires a smaller risk premium, and users pay less on average. The lower risk for the franchise holder also means that the winners curse is less likely, because bids are less dependent on demand projections. A further advantage of LPVR auctions is that competition for the franchise reveals, through the winners bid, the income required to earn a normal return. This reduces the scope for opportunism after the contract is awarded, because the winning bid can be used as a benchmark. Opportunistic renegotiations are not possible in this arrangement.

Limitations of the LPVR franchises

The main limitation of LPVR franchises compared with fixed term contracts is that they provide fewer incentives to engage in demand enhancing activities. Any expense that increases demand shortens the franchise and so increases profits less than it would under a fixed term contract.

As a result, the franchise holder may underinvest in road quality or maintenance, speedy attention at toll booths, or swift cleanup of accidents. For this reason, LPVR auctions require regulatory institutions that set and enforce minimum quality standards for franchise holders. Regulation need not be complicated. For example, independent agencies could monitor waiting times at toll booths, and the waiting times could be published in newspapers to make the regulators accountable to users.

Infrastructure in India
State has played a dominant role in the provision of such services. Excessive dependence on the states fiscal resources is only one of the factors contributing to the poor state of the transport systems. There is inefficiency of operations, inadequate maintenance, financial inefficiency and unresponsiveness to user demand. Developing countries would need to make substantial investments in infrastructure to satisfy current demand for transport services and to support future economic growth. In India requirements of investment in roads are staggering, while that in the railway sector is much less.

Case Study: National Highway Development Programme

Initiatives Allocation of a part of the cess revenue from petrol and diesel to the National Highway Authority of India. Relying on Public Private Partnerships for implementation of highway projects.

Government Policies Relating to Private Sector Participation

The most important reason behind seeking private sector participation has been the problem of fiscal deficit and servicing the huge public debt of the past decade. With the amendment of the 1956 National Highways Act, private sector can now undertake NH projects and recover their costs through tolls on both public and privately funded roads. External funding is sought to be promoted by permitting 100% FDI in this sector.

Public and Private Sector Partnership in NHDP

The three most important forms of PPP are 1. Toll Based Build Operate and Transfer BOT (toll) system. 2. Annuity Based Build Operate and Transfer BOT annuity system.

3. Special Purpose Vehicles.

BOT Toll Project

Private parties undertake construction cum maintenance during the concession period at the expiry of which the assets are transferred to the government. Budgetary support for the project cannot be more than 40% of the cost of the subproject. Private funding is sustained by revenues from a specified toll structure over the concession period. Award for BOT (toll) are made through competitive bidding on the basis of the minimum grant required or the shortest concession period.

BOT Annuity

Under BOT (annuity) also concession includes building of the road network and maintenance for a fixed period, but the concessionaire does not receive any upfront tolling right.

It is NHAIs annuity payments over the concession period that makes private funding of the project financially viable.
Award of the project is made through competitive bidding in respect of the minimum annuity payments since NHAI fixes the concession period uniformly at 15 years.

Special Purpose Vehicle

A Special Purpose Vehicle is a joint venture company set up by two or more promoters to execute some project. SPVs are generally used for implementation of toll road projects for port connectivity and are partly funded by user entities. Finance is provided by insurance companies and pension funds and other institutions having long term funds at their disposal. Projects undertaken by SPVs include Moradabad Expressway, Jaipur bypass, and Ahmedabad Vadodra Expressway.

Special Purpose Vehicle

Till a few years back the government toyed with the idea of using SPVs as an important mode of implementing NHDP, but of late it is not so. The main reason of not relying on SPVs lies in the difficulty of garnering funds through this route. SPVs is a company formed exclusively for implementing a project, so that its commercial viability depends entirely on the success or failure of the project, providing finance to SPVs is too risky for insurance companies or pension funds. These financial intermediaries, it may be noted can extend loans only to companies having an investment grade rating from a credit rating agency and by their very nature, SPVs unless backed by government guarantees cannot aspire to be awarded such a rating.

Evaluation of the Highway Development Programme

The fixed cost component of investment on highways may be large, but the toll rate cannot exceed to the marginal benefit from road services. Commercial viability may not happen even if the total benefit exceeds the total cost. A well developed road may stimulate development of the region (reduced poverty, better literacy and health), which may not be captured by tolls.

Efficiency and Allocation of Risk under PPPs

Under both BOT (Toll) and BOT (Annuity), execution of highway projects is likely to gain in efficiency or cost effectiveness. But given oligopolistic markets in which bidders operate it is not clear whether the private participants margins are fair. A basic problem with the NHAI scheme is that there is no benchmark against which estimated costs of the bidders are judged. In the UK, projects under private finance initiative (PFI) are compared ex ante with a bench mark called Public Sector Comparator (PSC) and this acts as a check on rampant collusion and guarantees some minimum fair value for money.

Efficiency and Allocation of Risk under PPPs

Under BOT (Toll), revenues depend on traffic, the awardee of a highway project cannot reduce risk through diversification, risk premia under BOT (Toll), cannot but be exceptionally high Under BO (Annuity), the concessionaire does not face demand risk, risks due to inflation can be included and taken care of. The main risk under, relate due to delays and cost overruns, something that the private entrepreneur can manage much better than the public sector counterpart. Annuity payments are calculated on the basis of a 15% internal rate of return over a length of 15 years in all contracts. Given that the major risk is borne by the concessionaire during the construction period, and hence in the short run, the IRR is double the interest rate on long term government securities, the high cost of debt servicing ultimately has to be paid by road users or tax payers.

Some Remarks on Road Financing

Private instead of public financing of highway projects for reducing fiscal deficit leads to suboptimal allocation on investment in infrastructure projects. Building and maintenance should be clubbed under the same contract and compensation should be in the form of pre-specified annual payments with suitable escalator clauses. Profit maximizing tolls would leave a large part of the costs uncovered, apart from the fact that such tolls reduce the benefits of the highway their potential.

Tolls may be imposed to reduce congestion, pollution, the major cost of highways may be met through (a) auctioning of adjoining roads; (b) parts of motor vehicles tax and capital tax on land; and general revenue if necessary.

B. K. Chaturvedi Committee Report (2009)

The committee was informed that as per NHAIs experience of recently bid out packages, not many projects were found commercially viable resulting in very poor or no response from the bidders. In the last financial year NHAI placed some 60 projects for bidding under BOT Toll mode.

Unfortunately, the financial crisis from October, 2008 onwards resulted in a poor response from the market.
NHAI received a total of 22 responses to the bidding, of which only 12 could be awarded, the reason being that six of the balance 10 were single bids which were not allowed as per policy. 4 were bids for NHDP Phase V packages where the demands for grant was much higher than the 10% which could be given as VGF as per Government decision.

B. K. Chaturvedi Committee Report (2009)

As per existing Government policy all projects are to be first bid out as BOT Toll and on failure are to be then offered under BOT Annuity and if this also fails, then they are to be taken under EPC (Engineering, Procurement and Construction contract) after taking specific approval from CCEA (Cabinet Committee on Economic Affairs. Under the earlier Clause 29, if the actual traffic happens to be less (greater) than the predictions, the concession period will be increased reduced proportionately. The Committee recommended that in order to make it attractive to private investors, the concession period will be increased, in case of high traffic. This has been criticized, since there will be a tendency of underproviding initial capacity to get the concession period increased later.

B. K. Chaturvedi Committee Report (2009)

Access to Viability Grant Funcing (VGF) has now been made much easier, and it is now possible to meet 70% of the cost using grant and other funds raised by public sector entities. This has been criticized since a VGF grant was to make a socially desirable but unprofitable project attractive for investors. The underlying objective of the grant is not and should not be to provide upfront financing that is the responsibility of the private sector.

Regulatory and Contractual Framework

Introduction

Over the last few years there have been attempts to attract private finance in infrastructure without welcoming private entrepreneurship. The government while attempting to withdraw from the financing of infrastructure, has sought to retain the decision making role in the selection, design, and operation of infrastructure projects.

This means that even today capital markets have not been assigned much of a role in allocating capital to the infrastructure sector. There has not been much room for entrepreneurs willing to take large risks in anticipation of large rewards.
The net effect is there have been sporadic success in attracting private finance to infrastructure projects, there has been little success in transferring the risks to the private sector.

Introduction
As long as the government continues to assume the principal risks of the projects, the only effect of the so called private finance is to convert what would have been an immediate borrowing requirement to an offbalance sheet liability. This kind of private finance neither contributes to fiscal stabilization nor promotes allocative efficiency. On the other hand, private entrepreneurship in infrastructure could give large benefits in terms of fiscal consolidation and allocative efficiency. To do this the government needs to Give private sector the freedom to identify and design profitable infrastructure projects. Adopt broad based non-distorting incentives and Desist from premature and excessively rigid sectoral regulation.

Introduction
There would remain a class of infrastructure projects that the government may consider of strategic importance but which entrepreneurs do not find it profitable to invest in.

These would require an outright subsidy (a negative licence fee established through a competitive auction) or some form of credit enhancement. But these would be more an exception than a rule.

Market Driven Resource Allocation:

Pitfalls in the Current Approach

Much of the attempts to attract private capital into infrastructure have involved inviting private participation in projects that have been identified and designed by the government.

For example, the government decides on a road project, lays down the specifications, and calls for bids from the private sector.
Typically, in this approach, the private sector bidder demands a traffic guarantee, or even worse a revenue guarantee as in the annuity model. At this stage, the private sector bears very little of the demand side risk of the project.

Market Driven Resource Allocation:

Pitfalls in the Current Approach

Fiscal Deterioration: Private financing of infrastructure in this model offers an advantage to the government only if the revenue guarantees that it provides are less than the debt service obligations that would have come under straight borrowing. But the reverse is certain to be the case. Domestic borrowers regard government debt as risk free and may be prepared to accept low rates of interest. The guarantees provided under infrastructure projects involve a wide variety of legal, operational, and regulatory risks for which any rational investor would demand a large risk premium. Thus, private sector financing in this model only substitutes low cost debt with high cost off-balance sheet borrowing. Fiscal deficit may show an improvement, but this improvement is wholly illusionary and is the result of faulty accounting techniques that are used to measure these quantities.

Market Driven Resource Allocation:

Pitfalls in the Current Approach

Politicization of the Investment Decision: The flip side of this fiscal burden is that the government has not surrendered its role in resource allocation.

Projects are chosen and designed not according to rules of the market economy, but according to dictates of the political and bureaucratic considerations that underlie resource allocation by the state.
The current model fails to achieve de-politicizing infrastructure investment decisions and subjecting them to the discipline of market economics. Public sector infrastructure investment decisions are often guided by the lobbying power of the various political constituencies that influence the decision making process. They often have very little to do with the actual demand scenarios and the true demand supply gaps in the economy.

Market Driven Resource Allocation:

Pitfalls in the Current Approach

Unregulated Monopolies: In most sectors, regulation was not considered necessary in the past as service providers were all in the public sector. Private participation under a weak regulatory regime carries the danger of unregulated monopolies, subject only to written contracts which are incomplete or deficient, and there is scope for monopolistic behaviour. What is worse by the time the sectoral regulator starts functioning effectively, the pre-existing contracts with the private sector participants in the infrastructure projects could become an effective barrier to the creation of a fair and effective regulatory regime. Even where the industry has the potential to be competitive, pre-existing contracts may come in the way of adopting the ideal structure due to the pre-existing rights the incumbent already enjoys.

Reasons for the Emergence of the Current Model

Exclusive Government Privileges: Quite often the public sector is invited to participate in some infrastructure activities, many of the related activities are reserved for the government.

Many infrastructure projects are land intensive and the private sector may rely on land acquisition by the state. Under the antiquated land acquisition laws, the state pays compensation far below fair value in the name of public interest. The alternative is the private sector buying its land at market prices thus becomes unviable. It is not true that compulsory land acquisition is necessary even for location sensitive projects like roads and railways. In the US, land for railroads were done by private acquisition at moderate prices.

Reasons for the Emergence of the Current Model

Ideological Commitment: In many cases, the reluctance of the government to give up control over the decision making process in favour of the market is driven the ideological commitment of large sections of the political establishment that the public sector should have the commanding heights in the economy. There is an ideological aversion to profiteering, large profits are seen as accruing through unfair means. It is difficult for large sections of the political establishment accept that in a competitive entrepreneurial economy, large profits can be the reward for risk taking or innovation.

The Way Forward: From Government to Markets

The way forward is clearly for the state to withdraw from its earlier role in identifying and designing infrastructure projects. Ideally, an entrepreneur desiring to implement a project identified by him would not need too many regulatory and government approvals than he would need to set up a normal manufacturing project. He would make an assessment of the demand, prices and costs, identify projects which appear profitable, and proceed to implement them. He would then have to negotiate with private owners or local authorities for various resources needed to implement the project and pay the going market rate for them. The role of the state in all these cases would only be to provide a transparent and neutral framework within which all these entrepreneurs would operate. For all this to happen, the government may have to give up many of the controls and exclusive privileges that it has established for itself.

Instances of Market Distorting Incentives

Distortionary Tax Incentives: The government allows some entities mainly in the public sector to issue tax-free bonds. It is available only to the private sector, it is highly discretionary and there is no transparent and objective criterion by which this incentive is extended to different entities. There is an incentive to the investor rather than the entity itself, it applies differentially to different investors depending on their tax status and tax bracket. This kind of incentive weakens the ability of capital markets to allocate resources optimally. Infrastructure companies receive a tax holiday under section 80-IA of the Income Tax Act. This comes closest to a non-distorting incentive. The tax break to the infrastructure enterprise itself and is thus non discriminatory between the kind of lenders. The entire profits of infrastructure business are exempt for a period of ten years. Examples: Roads, highway and water.

Instances of Market Distorting Incentives

Discretionary access to foreign borrowing: In India access to foreign borrowing can be a powerful incentive for infrastructure projects. Many infrastructure projects lack the credit standing to access foreign capital market directly, guarantees by domestic financial institutions for foreign borrowing also act as a powerful incentive. However, the permission to tap foreign borrowing and guarantees by domestic financial institutions are governed by highly non transparent and done on a case by case procedure. Discretionary access to Restricted Savings Pool: Pension, provident funds, charitable trusts and several other institutions that control vast amounts of funds are subject to government regulations that limit their investments to approved trust securities. That is these savings are protected from imprudent investments. Bonds issued by public sector bodies have often received trust security status regardless of their credit worthiness.

Instances of Market Distorting Incentives

Closure of existing infrastructure to make new project viable: One of the incentives being sought by private developers is that existing facilities that could compete with the proposed new project be shut down to make the project viable. When this is done costs should be internalized, that is the revenues generated from the old facility should be included as costs in the new one. Closure of the existing facility without internalizing the costs of such closure in some manner would lead to faulty resource allocation and suboptimal utilization of existing resources. Anti-competitive contracts that make subsequent deregulation difficult: While attracting private participation in infrastructure, care must be taken to ensure that the contractual terms are fully consistent with the competitive free market regime that would be the end result of all the reforms.

Effects of Premature Regulation

Freezes Poor Technological Choices: In the initial stages of infrastructure development, optimal technological choices are not clear, and there is a process of trial and error that goes on. The regulator can easily freeze the technological choice that might be an inefficient one. Discourages entrepreneurs willing to take internalize risk: In the initial stages of development of the industry, the demand risks and the technology risks are much greater than in a mature industry. An entrepreneur may be willing to internalize these risks by vertical integration. However, regulatory practices may not allow him to do so. Facilitates regulatory capture: It is easy for incumbents to persuade regulators that various anti-competitive practices that they may adopt are necessary from a systematic point of view to ensure healthy growth.

Strategic Infrastructure Projects

It is possible that there would remain a set of infrastructure projects that do not attract entrepreneurial interest but are believed to be of strategic importance. This situation may arise because of large externalities that project developers are unable to internalize. Some of the projects may have large benefits that are not economic in nature. It is conceivable that a state may want to promote such a project even though it does not attract private sector interest without additional government support. However, even in these cases, it does not follow that the current model of risk transfer to the government is a good solution.

Strategic Infrastructure Projects

Two options are available. The first is to build the project entirely in the public sector. For projects that are primarily strategic and whose direct economic payoffs are relatively small, this might be the best solution. In case where direct payoffs are substantial and strategic considerations make relatively small contribution to the viability of the project, private sector participation is possible with some government support. Private sector participation can be achieved by a negative license fee and through credit enhancement.

Negative License Fee

If an infrastructure project has a high social rate of return but an unacceptable private rate of return, the socially desirable level of investment, can be achieved by a transfer payment from the state to the private sector. This is a standard prescription in economic theory, and it suggests that payment should not exceed the amount of the externality itself. If this is violated, then projects which earn an unacceptable social rate of return may be undertaken. The negative license fee arrived through a bidding process can potentially achieve this transfer payment. The auction process must include a reservation price to set a ceiling on the transfer payment and ensure that it does not exceed the externality.

Credit Enhancement
There is evidence that privately financed infrastructure of the 19th century, made substantial use of public funds. In the US governments provided financial support by subscribing to some of the railway bonds, guaranteeing interest on some of the bonds, and provided a collateral for many of the bonds through their land grants. All these forms of credit enhancement, made infrastructure bonds more easily marketable to domestic and foreign investors. It is important from a moral hazard perspective to keep guarantee limited in scope. If the guarantee covers the bulk of the present value of the debt service obligations, the bondholders have little incentive to monitor the project and to make a careful assessment of its creditworthiness.