Private Participation in Infrastructure Sector

A nations infrastructure development plays a significant role in its economic growth. A fast growing economy warrants an even faster development of infrastructure. Extensive and efficient infrastructure is critical for ensuring the effective functioning of the economy, as it is an important factor determining the location of economic activity and the kinds of activities or sectors that can develop in a particular economy. Well-developed infrastructure reduces the effect of distance between regions, integrating the national market and connecting it at low cost to markets in other countries and regions. In addition, the quality and extensiveness of infrastructure networks significantly impact economic growth and affect income inequalities and poverty in a variety of ways. Developing infrastructure entails huge investments and the major issue is to find means of funding these projects. Traditionally government has financed these projects but gradually the government is reversing the trend and encouraging more and more private partnership. This step is taken because of following considerations: Efficiency: Public Sector is notorious for its inefficiency and red-tapism. It is widely believed that privately implemented and managed projects are likely to have better chances of delivering services which are cheaper and of a higher quality.As per the India Infrastructure Report (2003) Indian economys growth rate would have been higher by about 2.5% if the delays and cost overruns in public sector projects had been managed efficiently. The reasons mentioned in the report for delays were: clearances, land acquisition problems, along with factors internal to the organisation handling the project. Equity Considerations: Infrastructure project do not provide uniform benefits to the entire population of the country, therefore, it may be more appropriate if only the actual users are charged for the cost of providing such services that too depending on their usage. If users are only to be charged as per their usage then these projects acquire a complete commercial character with the government only needed to act as a facilitator.

Allocational Efficiency: If the users of these services are charged as per their usage then they would only pay for those services they need the most and private sectors participation would ensure that the scarce resources are directed towards areas that need these services the most. Fiscal Prudence: There is a concern both at the centre and at the state levels that both the absolute and relative levels of fiscal deficit are very high. Thus, incurring more fiscal deficits to finance infrastructure projects is not a viable option. Therefore, private participation in such projects is being encouraged.

Financing for infrastructure is very different from financing other projects/ventures. It is different because of certain unique factors, which are: Longer Maturity Infrastructure finance tends to have long maturity periods ranging between 5 years to 40 years. This includes 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.

Larger Amounts Because of the magnitude and strategic importance of these projects, they entail huge investments. It is not possible for a single entity to bear such heavy burden, therefore the public sector has invited private sector to share the burden with them.

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.

Fixed and Low 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 . Types of Risk Capital Required There are two types of risk capital that are deployed in any project: 1. Explicit Capital: This comprises of the equity that a developer or a sponsor brings to the table. The flip side to this is that the sponsor has the risk of losing upto the full extent of his investment. On the positive side if the project does well, there is no limit on the upside either.a 2. Implicit Capital: This comprises of the borrowings i.e. money provided 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 but the upside is limited to the rate of interest charged on the loan.

Due to the unique features of infrastructure projects the risk capital and required for them is very hard to get and because of being scarce it is a very expensive resource Rate of returns on risk capital could well be north of 30% per annum. This has a significant bearing on the cost of the project as the risk capital required by such project is generally very high. To address this issue this paper focusses on four aspects: a) Reducing the amount of capital required by each project; b) Increasing the supply of this capital; c) Facilitating the ow of funds to this sector, and d) Enhancing the role of banks as inter mediaries. Reducing the Amount of Required Risk Capital Given the scarcity and high cost all efforts should be made to keep the requirement of risk capital down to minimum. To ensure this following steps ought to be followed: 1. Removal of the Effect of Controllable Uncertainties: Controllable uncertainties should either be eliminated or the government directly takes the nancial responsibility for them. This can be done by imposing a general tax on the entire country for these uncertainties and taking such uncertainties away from individual projects. 2. National Diversification Benefit : A developer might be limiting itself to a small project in a limited geographical area but if the vision is to ensure that the results measure upto the national benchmark set and that the regional variations are kept to minimum then the benefits of national diversification should be allowed to each and every project. Lenders should be allowed to use credit and equity derivatives to diversify risk.

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Global Diversication Benet : Several infrastructure projects involve exposure to global risks such as rainfall, temperature and fuel and other commodity prices. Permitting lender to access these markets directly or through brokers will allow them to reduce their exposure to many of these risks, thus once again, reducing their consumption of implicit capital.

New Sources of Risk Capital Introduction of more risk capital can be in two ways -Convincing current capital providers to commit more -Unearthing completely new sources For the latter option following ideas can be looked into

Securitisation: Large project loans could then be divided up into several smaller loans which could be taken up by insurance companies, individuals, banks, pension funds, etc. all these entities have investments diversified across various sectors and instruments. To appeal to risk averse lenders this would be done in collaboration with First Loss Default Guarantee Funds and this would make them investment grade. Creation of several very large intermediaries : Large intermediaries with capital bases in excess of USD 5 billion should be created. At present there are only two such entities namely: State Bank of India and Life Insurance Corporation. These intermediaries would be managing their risk by diversification, either across different activities or across projects. Such large entities can be formed by merging various smaller entities.