How to fix PPP financing

Structuring infrastructure PPPs is complex. Optimal risk sharing among stakeholders is needed. Also, delays in achieving project milestones weaken project economics and reduce investor appetite

 

 Make in India" is the hallmark programme of Prime Minister Narendra Modi's administration. It envisages India increasingly becoming a global manufacturing hub, attracting investment, and generating the employment needed to grow the economy and power it to middle income status and beyond.

But the hard reality is that attracting investment in India will hinge on filling the sizable infrastructure investment gap. Whether to service the vast domestic market or target export markets, the success of "Make in India" will require overcoming delays in infrastructure investment and implementation.

Until recently, public investment has been the main vehicle for infrastructure development in India. Since 2012, however, the government has shifted some of the focus away from public spending. The Twelfth Five Year Plan envisages the private sector contributing $500 billion - about half of the $1 trillion of investment planned - primarily through public-private partnerships (PPPs).

However, structuring infrastructure PPPs is complex. Optimal risk sharing among stakeholders is needed to ensure a proper alignment of incentives. This is especially true in India where adequate project development requires detailed feasibility studies, negotiating complex land acquisition processes, obtaining environmental and forest clearances, and mobilising scarce equity. Delays in achieving project development milestones weaken project economics, resulting in completion delays and reduced investor appetite.

A recent study commissioned by the Asian Development Bank and undertaken by CRISIL Infrastructure Advisory found that on average 40 per cent of projects in major infrastructure sectors are delayed for reasons beyond the project's control. The reasons include delays in land acquisition and obtaining environmental and forest clearances beyond the time envisaged in the concession agreement, along with interstate coordination issues and local protests. Delays of two years are the norm, resulting in average cost increases of around 30 per cent - mostly due to accumulating interest costs during the delay period and cost escalation. These account roughly in equal measure for the resulting cost escalation.

Moreover, with infrastructure accounting for around 30 per cent of stressed assets, banks are increasingly unable and unwilling to lend further to infrastructure. While the Reserve Bank of India's (RBI) guidelines allow banks to fund additional "interest during construction" (IDC) to stressed projects, this still requires banks to take on additional risk exposure to stressed projects and fund accumulating costs.

This makes financing infrastructure a hard sell, given that banks are reaching exposure limits and face asset liability management mismatches on their balance sheets. Many banks in India have already begun to limit their infrastructure exposure. Against this backdrop, it is not surprising that the high-level Deepak Parekh committee on infrastructure has scaled down its achievable infrastructure investment estimate by nearly 40 per cent for the Twelfth Plan.

The good news is that there may be a solution. Drawing from global experiences in several PPP markets, notably in Latin America and Indonesia, a potential solution can be fashioned that could help both investors and lenders alike. The solution entails establishing a facility that guarantees servicing interest to banks during delay periods, so long as the delays are beyond the control of the project. Under this arrangement, the project developer would apply for a guarantee from the proposed facility against delayed interest payments by paying a fee prior to financial closing, and negotiate a reduction in bank charges that would compensate for the guarantee fee. Interestingly, this is also beneficial to banks because even though they are charging lower rates, they are no longer subject to completion delay risk. Subsequently, the facility becomes a lender to the project and recovers the paid-out amount by way of senior or subordinate debt. The advantage of the subordinate debt structure is that it reduces the additional equity needed to fund the cost escalation and to maintain a constant debt-equity ratio in accordance with RBI guidelines.

The proposed mechanism addresses several issues in one fell swoop. First, the facility would secure developers' interest obligations due to delays and potentially reduce the incremental equity needed to fund cost escalation. Second, because the risk profile of projects would improve, banks would be able to expand financing for guaranteed projects. Next, non-performing assets and restructuring would be reduced as interest payments would be serviced through the guarantee facility.

The proposed facility would also expedite financial closure and reduce delays resulting from re-negotiating bank lending to already stressed projects. Finally, the facility promises a more effective use of capital against reduced downside risks from adverse selection, which can be mitigated by pooling guaranteed projects.

The trick is of course in getting the pricing right. The guarantee fee and the terms of the subordinate debt must hold value for both the facility and the project developers.

For the government, getting investments into essential infrastructure projects will help it to deliver on the promise of "Make in India". But it will also require innovative solutions to significantly scale up investment. It cannot afford facing further delays in the drive to bridge the infrastructure investment gap. The proposed project completion risk guarantee scheme represents a win-win-win situation for government, financiers and developers alike and is worth pursuing in the interest of current and future generations of Indians.