Financing of Infrastructure Projects - An Overview


By

Prof. Sudhindra Bhat
MBA, MFM, PGDIR & PM, PGDS & MM, M..Phil, PhD
Associate Professor
Institute of Finance and International Management
# 8p & 9p, KIADB Industrial Area, Electronic City 2nd Phase,
Bangalore-560 100
 


Abstract

Development of proper infrastructure is vital for economic growth of any country. Investors will like to put the capital only in those countries where there is developed infrastructure. Infrastructure consists of many things such as Road, Railway, Port and harbour, airport, electricity, telecommunication, water supply etc., Development of infrastructure is capital intensive and gestation period is high. At the same time return on capital in case of infrastructure projects is small as well as slow. Hence, investors are shy in investing capital in infrastructure projects unless some special incentives and privileges are provided.

Rakesh Mohan committee report Central and state governments in India were solely responsible for development of infrastructure in India. Ministries used to do the planning and execution was done through contractors by Government agencies and total money used to come from budget. Slowly the Government funding has shrunk whereas need for development of infrastructure has grown by leaps and bounds. Fund requirement is so huge for proper development of infrastructure that it is impossible task for Government. The expert group on commercialization of infrastructure projects constituted by Government of India under the leadership of Rakesh Mohas has pointed out that during the period of transition from 100% state investment in infrastructure towards increasing privatization of private sector; there will be continued need for state support. To meet the present gap in the fund requirement of the infrastructure sector, it is imperative to promote public and private partnership. The committee has advocated conscious use of available Government Resources to take significant equity positions in infrastructure projects. This investment should be used as a trigger to attract commercial equity funds as well as debt from different sources. The Government. Should essentially act as a catalyst and facilitates instead of a builder by providing seed-capital.

1. Introduction

Development of proper infrastructure is vital for economic growth of any country. Investors will like to put the capital only in those countries where there is developed infrastructure. Infrastructure consists of many things such as Road, Railway, Port and harbour, airport, electricity, telecommunication, water supply etc., Development of infrastructure is capital intensive and gestation period is high. At the same time return on capital in case of infrastructure projects is small as well as slow. Hence, investors are shy in investing capital in infrastructure projects unless some special incentives and privileges are provided.

2. Special features of infrastructure projects

(i) Large Capital requirement
(ii) High sunk cost. A large proportion of the cost has to be irrevocably committed upfront before the project becomes operative
(iii) Long gestation periods
(iv) Returns are slow to pass in
(v) Availability of foreign funds is poor
(vi) Sector is sensitive to political environment and policy changes
(vii) The services produced are non tradable. The excess services generated can not be stored or exported and deficiency in service can not be met with by imports except for certain exceptions

No single solution applies to different projects as characteristics is different from sector to sector. What applies to road sector does not apply to railways and what applies to railways can not apply to telecommunications sector as the capital requirements are different and so is the method of revenue collection.

Rakesh Mohan committee report Central and state governments in India were solely responsible for development of infrastructure in India. Ministries used to do the planning and execution was done through contractors by Government agencies and total money used to come from budget. Slowly the Government funding has shrunk whereas need for development of infrastructure has grown by leaps and bounds. Fund requirement is so huge for proper development of infrastructure that it is impossible task for Government. The expert group on commercialization of infrastructure projects constituted by Government of India under the leadership of Rakesh Mohas has pointed out that during the period of transition from 100% state investment in infrastructure towards increasing privatization of private sector; there will be continued need for state support. To meet the present gap in the fund requirement of the infrastructure sector, it is imperative to promote public and private partnership. The committee has advocated conscious use of available Government. Resources to take significant equity positions in infrastructure projects. This investment should be used as a trigger to attract commercial equity funds as well as debt from different sources. The Government. Should essentially act as a catalyst and facilitates instead of a builder by providing seed-capital.

2. Types of privatization

Following models for privatization of road infrastructure is available.

Sl
No

NAME

Description

1

Build operate transfer (BOT)

Concession is given to private party to finance, build, operate and maintain the facility. Investors collect the user fee during the concession to recover the cost of construction, debt servicing and operation cost. At the end of the concession, the facility reverts back to Govt. who has given the concession.

2

Build own operate (BOO)

Similar to the BOT but without the transfer of ownership

3

Build own operate transfer
(BOOT)

Same as BOT but the project is transferred to the Govt. after a negotiated period.

4

Build transfer lease operate
(BTLO)

Govt. provides the right of way on which the highway is built. Private party has to pay a nominal rent of payment for the use of the land

5

Develop build operate (DBO)

This is a new concept. Initially the company does not assume commercial risk but is financially accountable for building and operating the system as per specification. Later on the company assumes commercial risk as per the appropriate regulations laid by Govt.


4. Why Private projects like BOT are costly?

BOT projects are normally costlier if it is compared with the project report prepared by Govt. departments.

Following are the causes:-

(i). Full funding is to be done by the private company and hence full project cost is required to be mobilised whereas the Govt. department does not need to mobilise full money in one go.
(ii). Burden of interest during the construction on loans is required which is absent in cash funded govt. projects.
(iii). Cash flow is a major problem for BOT project as whole investment is to be done upfront and investments are regulated by investors. Each and everything has to be fully insured and sometimes multilayer insurance which increases the cost of financing. In case of Govt projects money comes as and when it is required as per budgeting allocation.
(iv). Returns are not assured
(v). All liabilities of debt service and equity return commence after physical completion of project, which is absent in case of Govt. projects.
(vi). Pre bid /post bid award expenses are high such as
     (a). Expenditure on conducting feasibility study, engineering survey and preparation of concept
          design & drawing
     (b). Expenditure on financial viability analysis
     (c ). Legal expenses on formation of companies
     (d). Travel cost of overseas partners and other bid documentation
     (e). Negotiation cost, cost of bid bonds, performance and other costs
     (f). Detailed engineering cost such as design, drawing, survey legal & financial management cost.
     (g). Higher staff cost as Indian and foreign specialists have to be hired
     (h). Cost of escalation
     (i). Higher operation maintenance and repair cost
     (j). Project management fee
     (k). Rupee devaluation; inflation and interest rate fluctuation
     (l). cost of risk during construction stage such as cost and time over runs, drying up of finances during construction, law & order Problem created by local influential people and political Uncertainty
(vii) Cost all risk taken by entrepreneur
(viii) Contingencies on legal, political & technical including business development cost

5. Financing and subsidy for BOT Projects

Normal source for financing of private infrastructure projects are debt and equity. Govt.of India has allowed debt-equity ratio in such cases as 5:1 but financer always like to have bigger equity participation and it may go up to 2:1 or even 1:1. As these projects are of unknown risk, financier always like to have higher equity participation. One specialty of infrastructure project is that it has a monopolistic market and hence much more assured future revenue stream. Thus risk of equity is of much lower scale than that would be needed in case of industrial projects which are open to market fluctuations. The rate of interest should be kept low almost equal to PLR.

Sources of Debt

(i) Sources of debt are as follow:-
(ii) All India financial institution (AIFIS). They are the long term lending institution in India . They are IDBI, ICICI, IL&FS, IDFC etc.,
(iii) Scheduled Commercial banks They are traditional sources of working capital funding for Indian projects but now Government is encouraging them to lend long term funds for infrastructure projects either singly or as consortium. However, appraisal for the project has to be done by special agencies as they do not possess such capabilities.
(iv) Dedicated road fund: A dedicated central road fund has been created under the control road fund Oct 2000 by levying a cess of petrol and diesel.
(v) Cess on turn over
(vi) Betterment levy through venture capital mechanism
(vii) Shops and establishment levy
(viii) Tax on employment
(ix) Municipal bonds
(x) Real estate development

Normally Govt of India allows "Real State development" in the project which is actually sub project of bigger project and the debt equity ratio of such sub projects may be different. Real problem is to arrange equity for such projects which have large gestation period. Equity requirements for the project can be met from "Infrastructure funds" specially created by Govt. or other agencies. Venture capitalists do not like to have equity participation in case of such projects. Many countries have created such " Infrastructure fund" and are useful for providing equity finances. Banks are normally not very keen to finance such projects in the form of equity because these need long term financing and they are constrained by the time profile of their deposits. Institutional financiers such as insurance companies, provident fund, gratuity fund and superannuation fund can be source of such financing if allowed so as to ensure that cash flow is comfortable in each financial year.

As infrastructure projects are very costly, Govt has felt the need for giving some sort of subsidy in the form of "Real state development". Govt. of India has allowed to acquire extra land on the route of road and have also allowed to develop these land for making shopping mall,motels, garages etc., so that income from these development becomes another source of revenue for the project. However, the projected returns from real estate developed in the area may also be affected by money factors such as,

(i). Land acquisition to be done by Govt or private project
(ii). Local permission for commercial and industrial activities
(iii). FSI allowed by Govt.
(iv). Provision of facilities like water, electricity, telephone etc.,
(v). cost of construction
(vi). Proportion of land to be sold after development and their value
(vii).Expected demand or sale price
(viii).Change in Govt.rules and regulations

Other forms of subsidy may also be considered to make the infrastructure project viable such as

(i). Tax waiver for the import of construction equipment
(ii). Remission of sales tax for a limited period
(iii).Incentive in the form of no tax on real Estate income for a limited period.
(iv).Provision of low interest loan
(v).Tax holiday period for income should be available till loan has been repaid.

6. Encouragement to entrepreneurs by Government

Road infrastructure projects are highly capital intensive with long gestation period. Risk factor is also very high and hence very few entrepreneur (either Indian or foreign) come up for taking up such projects. This is a totally new concept in India and hence Government must treat these projects in a new way and not like any conventional PWD project. The attitude of government must be different. It should be based on the concept of partners for development and not as contractor. In fact is should be a win-win situation for all three involved parties ie., government, entrepreneur and user. If the project is not cost effective from user'' point of view then the project will not be successful. Therefore, their interests should also be seen. At the same time entrepreneur must be assured a minimum return on his investment. Government should consider following points to encourage entrepreneurs:-

(i). Land acquisition for the project is one of the most important part of the project. Government should acquire the land for the whole project at a time along with the land for "Real estate development", In fact in case of new alignment 250 meters of land on both sides should be earmarked for future expansion of road and real state development. In course of time these land will generate good revenue. One of the major causes for time over run and cost over run of the project is delay in land acquisition and removal of encroachments. This will decrease the initial investment in land.
(ii). Government should consider BTLO mode i..e, build, transfer, lease and operate so that Govt. also gets revenue during the operation.
(iii). Government may think of giving special laws for financing, tax incentives and resource mobilization
(iv). Various alternate sources of fund generation should be searched
(v). Real Estate Development site should be carefully monitored by Govt. They should allow liberae FSI and should provide facilities like water, electricity, telecon upto the boundary of site. They should allow the entrepreneur a mix of residential, commercial and industrial activities on both sides of alignment of road.
(vi). Timely environmental clearance should be given so that project is not delayed.
(vii). Rehabilitation of displaced persons should be taken care by the Govt.
(viii). Development site on both sides of road should be considered as backward area for industrial development.
(ix). Tax concessions should be given
(x). Proper security during the construction should be provided by Govt.
(xi). There should be "single window clearance" system for all statutory clearance
(xii). Agreements should be drawn in a balanced manner where risks are duly shared which needs attitudinal change in Govt. thinking.
(xiii). Govt. should allow advertisement right to entrepreneur and the lease of land should be for 90 years.

Types of infrastructure project

i) Construction of Roads, bridges, highways etc. Large number of roads, by pass, bridges etc. have been constructed by government agencies as well as private agencies specially in Gujarat & Maharashtra. Some of them are pretty successful but many have difficulties in achieving the goal.

ii) Construction of Railways Konkan Railway is an example in railway construction in India although most of the funding came only through government agencies. If the project would not have been delayed unduly, it should have started paying back by this time.

The concept of private funding has been introduced in railways basically in two areas wagons and railway track. Own your wagon scheme is one such area where private parties are encouraged to buy wagons and handed over to railways. Indian railways pay lease charges to the party. Already 14000 wagons are running under this scheme.

iii) Urban transport sector Urban population is growing rapidly in India. The number of cities having population more than a million is about 50. Mass transport demand is estimated to grow rapidly. To meet this enormous demand, apart from other modes of Public transport; urban transport projects whether rail based or bus based has to be implemented. Metro rail, Mass transit system etc. will have to be executed in a big way. Delhi Metro rail has already been executed with the help of international agencies. Bangalore and Chennai is also going to have metro or mass transit system. This needs investment and financing can be done even through municipal bonds.

iv) Waterways India has large river system besides it is surrounded on three sides by waterways. Inland shipping and coastal shipping is a big area where large-scale transportation can be accomplished by encouraging private participants. Infrastructure for Jetty construction, ship repair facility etc has to be developed in a big way.

v) Airport Air traffic is playing an important role in both passenger as well as cargo improvement inside the country as well as outside the country. Large numbers of airports have to be developed, improved and maintained in a professional way. A number of project with private international participation has already been started.

vi) Sea port There are a large number of major as well as minor ports in India which need improvement in port facilities, emerging ship technology, deeper draughts, container handling system, large cargo movement. Private participation on sea port is going to improve the export potential of this country. Privatization of port development is comparatively easier.

vii) Pipeline transportation Transportation of gas through pipeline has been started in India and GAIL has already done good jobs. Gas pipeline transportation in Russia, Germany, France etc. has been done in big way as this is the cheapest and most energy efficient and risk free transportation system. Even coal can be transported in slurry form through this system.

viii) Power generation There is shortage of power generation in each and every state of India. Hence, power is a big necessity. A large number of private power producers were invited. Enron was one of the first power producer who started power production in Dabhol. Other power producers in Orissa, Karnataka and other places have also started production. Unfortunately the experiments with private power producers have not been very good because of inherent shortcomings with State Electricity Boards. Fortunately now Electricity Boards have separated power generation and transmission. Some of the States are improving the system and new model for power production / distribution has to be developed which will prove to be more successful. Politicization of power subsidy has to be done away with.

At the end it can be said very boldly that private participation in infrastructure projects can be fully successful and financier will also come forward. In Tokyo more than five private companies are running metro rail and is being run very successfully.

References:

1. Reforms Learning from Latin America Experience (The World Bank) Washington, D.C. February 2002.
2. CRIS-INFAC (January 2003) Roads and Highways
3. Dhameja Nand City Bus Transport Privatisation Its Impact with special reference to Delhi Transport Corporation, Kanishka Publishers, 2002.
4. Economic Survey Ministry of Finance, Government of India
5. GaryBond & Laurence Carlee (1994), Finance for Private Infrastructure, Project Discussion Paper, 23 (Washington D.C.) (International Finance Cup)
6. GOI Standing Committee on Energy (1995-96), Twenty Sixth Report, Lok Sabha Secretariat
7. Indian Infrastructure Various Issues (September 2001)
8. Rakesh Mohan Committee Report (May 1995) India Infrastructure Report Policy Imperatives for Growth & Welfare, Ministry of Finance, Govt. of India (1996).
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14. World Health Report, 1999 World Health Organization. Chapter 3: p 37.
15. Duckett, Stephen. "Government Strategies for improving Quality." Journal of the Consumers' Health Forum of Australia 36 (January 1996) : 13.
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Prof. Sudhindra Bhat
MBA, MFM, PGDIR & PM, PGDS & MM, M..Phil, PhD
Associate Professor
Institute of Finance and International Management
# 8p & 9p, KIADB Industrial Area, Electronic City 2nd Phase,
Bangalore-560 100
 

Source: E-mail May 31, 2006

     

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