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Topic: public-private partnership in infrastructure finance

Yerra subbarayudu

Ø Introduction Ø Public sector undertaking Ø Private member undertaking Ø Public-private partnership Ø Advantages of a public-private partnership Ø Infrastructure Ø Finance Ø Characteristics of infrastructure finance Ø Main financing mechanisms for infrastructure projects Ø Types of risk capital required Ø Disadvantages Ø Conclusion


INTRODUCTION:The use of Public-Private Partnerships (PPPs) to replace and complement the public provision of infrastructure has become common in recent years. Projects that require large upfront investments, such as highways, light rails, bridges, seaports and airports, water and sewage, hospitals and schools are now often provided via PPPs. A Public-private partnership bundles investment and service provision of infrastructure into a single long-term contract. A group of private investors finances and manages the construction of the project, then maintains and operates the facilities for a long period of usually 20 to 30 years and, at the end of the contract, transfers the assets to the government. During the operation of the project, the private partner receives a stream of payments as compensation. These payments cover both the initial investment the so-called capital expense and operation and maintenance expenses. Depending on the project and type of infrastructure, these revenues are obtained from user fees (as in a toll road), or from payments by the government’s procuring authority.

PUBLIC SECTOR UNDERTAKING:Is a legal entity created by a government to

undertake commercial activities on behalf of an owner government. Their legal status varies from being a part of government into stock companies with a state as a regular stockholder. And the development of the infrastructure or any other development taken up by the governments are done through the public sector companies In past the entire development of the infrastructure financing is done by the government itself and as the change in traditional approach the government of India had established Indian infrastructure finance company ltd. which regulates the infrastructure financing, funding for recognized projects and signing public-private partnerships for sustained economic development and improving the living standards of the population

PRIVATE MEMBER UNDERTAKING:The company established or acquired and

maintained by a private member other than government holding where there can be one or more people being the shareholders and the company can remain private or can list it in any of the stock market to become public company. In India they are some key players in the infrastructure financing along with the state owned companies like L&T Infra, IDFC and others which are operating under public-private partnership in recent years and there importance has grown significantly in this field

PUBLIC-PRIVATE PARTNERSHIP:Public–private partnership (PPP) describes a government service or private business venture which is funded and operated through a partnership of government and one or more sector companies. It involves a contract between a public sector authority and a private party, in which the private party provides a public service or project and assumes substantial financial, technical and operational risk in the project. In some types of PPP, the cost of using the service is borne exclusively by the users of the service and not by the taxpayer. The Government of India defines a PPP as "a

partnership between a public sector entity (sponsoring authority) and a private sector entity (a legal entity in which 51% or more of equity is with the private partner/s) for the creation and/or management of infrastructure for public purpose for a specified period of time (concession period) on commercial terms and in which the private partner has been procured through a transparent and open procurement system."


The advantages of Public Private Partnerships (PPP’s) include the following: Ø Speedy, efficient and cost effective delivery of projects Ø Value for money for the taxpayer through optimal risk transfer and risk management

Ø Efficiencies from integrating design and construction of public infrastructure with financing, operation and maintenance/upgrading Ø Creation of added value through synergies between public authorities and private sector companies, in particular, through the integration and cross transfer of public and private sector skills, knowledge and expertise Ø Alleviation of capacity constraints and bottlenecks in the economy through higher productivity of labor and capital resources in the delivery of projects Ø Competition and greater construction capacity (including the participation of overseas firms, especially in joint ventures and partnering arrangements) Ø Accountability for the provision and delivery of quality public services through an performance incentive management/regulatory regime Ø Innovation and diversity in the provision of public services Ø Effective utilization of state assets to the benefit of all users of public services

INFRASTRUCTURE:Is basic physical and organizational structures needed for the operation of a society or enterprise, or the services and facilities necessary for an economy to function. It can be generally defined as the set of interconnected structural elements that provide framework supporting an entire structure of development. It is an important term for judging a country or region's development. They include:

Ø Telecommunications (Wi-Fi, WiMax, Broadband, GSM and CDMA etc.)

Ø Social infrastructure (hospitals, modern prisons, courts, museums, schools and Council and Government Housing) Ø Energy (Renewable energy i.e. solar and wind, power generation, distribution, transmission and supply) Ø Transportation (light rail systems, bridges, tunnels and under-ground/overground high speed trains, toll roads etc.) Ø Water (Water supply, dams for irrigation, water, liquid and solid treatment plants, sewerage etc.)

FINANCE:There is a need for large and continuing amounts of investment in almost all areas of infrastructure the key issue is, while the need exists, it gets difficult for the projects to get financed. In the past the government has been the sole financier of these projects and has often taken responsibility for implementation, operations and maintenance as well. There is a gradual recognition that this may not be best way to execute/finance these projects. And the public-private partnership came into existence

CHARACTERISTICS OF INFRASTRUCTURE FINANCE:Infrastructure projects differ in some very significant ways from manufacturing projects and expansion and modernization projects undertaken by companies.

1. Longer Maturity: Infrastructure finance tends to have maturities between 5 years to 40 years. This reflects both the length of the construction period and the life of the underlying asset that is created. A hydro-electric power project for example may take as long as 5 years to construct but once constructed could have a life of as long as 100 years, or longer. 2. Larger Amounts: While there could be several exceptions to this rule, a meaningful sized infrastructure project could cost a great deal of money involved in it and this is a kind of characteristics which might or may not have much risk involved in it for example a kilometer of laying a highway road or construction of a power plant involves a huge amount 3. Higher Risk: Since large amounts are typically invested for long periods of time it is not surprising that the underlying risks are also quite high. The risks arise from a variety of factors including demand uncertainty, environmental surprises, technological obsolescence (in some industries such as telecommunications) and very importantly, political and policy related uncertainties. 4. Fixed and Low (but positive) Real Returns: Given the importance of these

investments and the cascading effect higher pricing here could have on the rest of the economy, annual returns here are often near zero in real terms. However, once again as in the case of demand, while real returns could be near zero they are unlikely to be negative for extended periods of time (which need not be the case

for manufactured goods.) Returns here need to be measured in real terms because often the revenue streams of the project are a function of the underlying rate of inflation

MAIN FINANCING MECHANISMS FOR INFRASTRUCTURE PROJECTS:A number of financing mechanisms are available for infrastructure projects and for Public-private partnership projects in particular.

1. Government Funding:

The Government may choose to fund some or all of the capital investment in a project and look to the private sector to bring expertise and efficiency. This is generally the case in a so-called Design Build Operate project where the operator is paid a lump sum(s) for completed stages of construction and will then receive an operating fee to cover operation and maintenance of the project. Another example would be where the Government chooses to source the civil works for the project through traditional procurement and then bring in a private operator to operate and maintain the facilities or provide the service. Even where Government’s prefer that financing is raised by the private sector, increasingly Governments are recognizing that there are some aspects of the project or some risks in a project that it may be easier or sensible for the Government to take.

2. Corporate or On-Balance Sheet Finance: The private operator may accept to finance some of the capital investment for the project and decide to fund the project through corporate financing – which would involve getting finance for the project based on the balance sheet of the private operator rather than the project itself. This is typically the mechanism used in lower value projects where the cost of the financing is not significant enough to warrant a project financing mechanism or where the operator is so large that it chooses to fund the project from its own balance sheet. The benefit of this is that the cost of funding will be the cost of funding of the private operator itself and so is typically lower than the cost of funding of project finance. It is also provably less complicated than project finance. However, there is an opportunity cost attached to corporate financing because the company will only be able to raise a limited level of finance against its equity (debt to equity ratio) and the more it invests in one project then less that will be available to fund or invest in other projects. 3. Project Finance: One of the most common, and often most efficient, financing arrangements for Public-private partnership projects is “project financing”, also known as “limited recourse” or “non-recourse” financing. Project financing normally takes the form of limited recourse lending to a specially created project vehicle (special purpose vehicle or “SPV”) which has the right to carry out the construction and operation of the project. It is typically used in a new build or extensive refurbishment situation and so the SPV has no existing business. The SPV will be dependent on revenue streams from the contractual arrangements and/ or from tariffs from end users which will only commence once construction has been completed and the project is in operation. It is therefore a risky enterprise

and before they agree to provide financing to the project the lenders will want to carry out extensive due diligence on the potential viability of the project and a detailed review of whether project risk allocation protects the project company sufficiently. This is known commonly as verifying the project’s “bankability”.

TYPES OF RISK CAPITAL REQUIRED:There are two types of risk capital that are deployed in any project: 1. Explicit Capital: This is typically the equity that a developer or a sponsor commits to the project. Here while the downside is unlimited (to the full extent of the amount of money the sponsor has committed to the project), if the project does well, there is no limit on the upside either. The sponsor seeks to conserve his capital and maximize the returns on it by deploying unique and project specific skills and by managing the underlying risks associated with the project. Given a limited supply of capital, the promoter also tends to concentrate his energies and capital in a small number of relatively lumpy investments so that he does not spread himself and his resources too thinly. In a typical infrastructure project, the developer puts together a consortium of capital providers who not only commit capital to the overall project but also assume complete operational and financial responsibility for specific risks (such as engineering, procurement and construction; operations and maintenance; and fuel supply), thus, lowering the capital requirements from the developer.

2. Implicit Capital: This is typically the risk capital that is committed by a lender to the project. Loans have the characteristic that while the downside is unlimited (i.e., to the full extent of the amount lent - as in case of equity/explicit capital but with the cushion of the explicit capital), the upside is limited to the rate of interest charged on the loan. Secondly, the loans typically involve much larger amounts of money relative to the equity investments. Given the fact that a typical lender raises money from retail deposits (or bond holders) he needs to hold a reasonably high amount of capital to assure his depositors that irrespective of the fate of the project, he will be able to meet his obligations. Assuming that the desired rating aspiration for the lender is AAA (i.e., the lender would like to assure its depositors of a near zero default risk) an unsecured loan to a typical ten year infrastructure project (rated, say A-, with an average maturity of six years) could require as much as 25% tier 1 capital to be committed to it. Since the capital is required to cover the lender against all the uncertainties surrounding a specific project, the lender seeks to reduce the amount of capital deployed by diversifying across projects (unlike the promoter who seeks to specialize and concentrate his exposure) and by ensuring that to the extent possible, the explicit capital (brought in by the promoter) is sufficient to cover the risks beyond the worst-case scenarios. The lender seeks to be compensated for this capital through the rate of interest charged on the project loan. Given the relatively large amounts of funds required for each project and the comparatively smaller number of such providers, lenders in the past have typically not had the opportunity to sufficiently diversify their risks nor have they had a sufficient amount of tier 1 capital. Not unexpectedly, having held significantly less than the required amount of implicit capital, they have very quickly found

themselves undercapitalized relative to the level of credit rating that they had committed to their depositors and in some cases have even defaulted to them.

DISADVANTAGES:1. Tendering and negotiation: Public private partnership contracts are typically much more complicated than conventional procurement contracts. This is principally because of the need to anticipate all possible contingencies that could arise in such long-term contractual relationships. Each party bidding for a project spends considerable resources in designing and evaluating the project prior to submitting a tender. In addition, there are typically very significant legal costs in contract negotiation. Having several bidders do this involves a cost which can add up in total to tens of millions. It has been estimated that total tendering costs equal around 3% of total project costs as opposed to around 1% for conventional procurement. The cost of both successful and unsuccessful bids is, in effect, built into total project costs. 2. Contract re-negotiation: Given the length of the relationships created by PPPs and the difficulty in anticipating all contingencies, it is not unusual for aspects of the contracts to be renegotiated at some stage. Wherever possible, provisions are included in the contract that spells out how variations are to be priced. But, given the length of time spanned by the contract, it is almost inevitable that circumstances will arise which cannot be foreseen.

3. Performance enforcement: One of the difficulties with performance specification in the area of service delivery is that performance sometimes has dimensions which are hard to formulate in a way that is suitable for an arms-length contract. Examples include maintaining good customer relations, and not

creating public relations blunders which rebound on the government 4. Political acceptability: Given the difficulty in estimating financial outcomes over such long periods, there is a risk that the private sector party will either go bankrupt, or make very large profits. Both outcomes can create political problems for the government, causing it to intervene.

CONCLUSION:Infrastructure growth is a critical necessity to meet the growth requirements of the country. Government led infrastructure financing and execution cannot meet these needs in an optimal manner and there is a need to engage more investors for meeting these needs. And there is increase in the publicprivate partnerships compared to the past and governments should take initiative in making the procedures transparent and protect the interest of the public and the private company involved in the partnership.

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