Highways will continue to be sluggish until the unattractive Phase IV projects are completed. With the road sector is poised to undergo a further change in the coming years, the industry as a whole, needs to continue tapping the advantages of road transportation more efficiently and optimally than ever before, writes Bhavik Damodar.The road transportation sector continues to struggle to cater to the country’s size and widely spread consumption hubs. With the second largest road network in the world, the development of India’s roads is an area of increasing opportunity. Setting up of an effective public-private partnership (PPP) model by the government to expand road networks, the sector has witnessed rapid growth in the past few years and it has become the top contributor to the construction industry. The roads sector has the highest number of projects under construction, under bidding and second highest share in the under operation stage as of August 2012.2011-12—A landmark yearIn 2011-12, the Ministry of Road Transport and Highways had awarded a total of 62 projects measuring 7,957 km in length. Of these, 49 projects measuring 6,491 km in length were awarded by the National Highways Authority of India (NHAI) while the other 13 projects comprising 1,466 km were awarded through state agencies. Out of the projects awarded by the NHAI during the last financial year, as many as 32 fetched premium. The total premium offered by developers was Rs 3,000 crore. In case of the projects awarded through state agencies, the premium totalled Rs 38 crore for five projects.2012-13—Decline in awardsBuoyed by the uptick in awarding activity in FY12, NHAI set an ambitious target of awarding 8,800 km of projects in FY13, which was later revised upwards to 9,500 km by the Prime Minister Manmohan Singh. Of the total awards, around 4,000 km were expected to be bid out under the Engineering, Procurement and Construction model (EPC).However, in the first six months of this financial year starting April 1, 2012, NHAI handed out contracts to build just over 500 km of roads. The government issued tenders for 1,297 km, but it received bids only for 562 km, according to NHAI Chief General Manager G Suresh. The key reasons attributable to a decline in project awards are the recent global economic slowdown, challenges in project financing, land acquisition and arbitration claims.Reasons for declineA key reason for the decline in awards is that developers have found it increasingly difficult to tie up funds for the projects that were awarded under the PPP route in FY12. Liquidity is a concern, as a number of projects for which funds have already been tied up might also face difficulty in drawing down as the risk perception of the sector has risen. Recent reports suggest that as many as 20 road projects awarded last year are yet to tie up requisite funds.The NHAI allows developers six months to arrange funds from banks and financial institutions for all build, operate and transfer (BOT) projects. Developers of these projects have sought more time to arrange funds. A lot of companies that were awarded projects recently are busy arranging funds for projects won in FY12 and are not expected to display much interest in upcoming projects, unless funding for their (earlier) projects is ensured. Reports prepared by NHAI and consultants differ, making banks reluctant to lend.Part of the reason for the inability to close financing for projects is that some of the bids have been perceived as aggressive by lenders in terms of traffic estimates and bidders have offered payments of hefty premium to the government. Given the current economic slowdown and reduction in growth estimates, over optimistic revenue models for projects awarded have come under scrutiny by banks. According to bankers and financial experts, such aggressive bidding might result in the project becoming financially unviable. Two projects worth about Rs 2,450 crore awarded last year were terminated due to failure to achieve financial closure.Financing of road projects has become an issue because the balance sheets of road construction companies are heavily leveraged. Banks circumspect by slowing economic growth and long delays in the implementation of road projects are carry out detailed diligence prior to disbursing finances for new projects. Further, financial institutions are asking for companies to put higher equity contributions and in some cases the entire commitment upfront. Lastly, some banks are already close to their internal funding limits for the highways sector.Phase IV projects less attractiveIn FY12, there was a high proportion of Phase V (six laning) and Phase III (four laning) projects which were awarded by NHAI. Of the ~6,500 km of projects awarded by NHAI, approximately 4,000 km comprised Phase III and Phase V projects, which had some past traffic history and accordingly these were attractive to developers. Demand for Phase V projects was high because traffic estimates were less of a concern and developers are allowed to start tolling at completion. A majority of the projects in the pipeline for FY13 are Phase IV projects. Phase IV projects are essentially two laning projects with limited traffic history and lower overall traffic as compared to phase III or Phase V projects where the traffic density is higher. There are only a few Phase V projects lined up for award in FY13 where the developers have a right to collect toll the date of completion.EPC awards yet to take offThe government was also expected to award 4,000 km of highway projects under the EPC model in FY13. Part of the 9,500 km target set for the National Highways by Prime Minister Dr Manmohan Singh. Given the poor response to Toll and Annuity projects in the first six months of FY13, the government is now focusing on EPC route to award a reasonable number of contracts in FY13. Awarding contracts under the EPC method will eliminate the financing and traffic risk for developers. NHAI also feels that EPC contracts will minimise, if not eliminate, the time and cost over-runs characteristic of the item rate contracts.However, framing of a Model Concession Agreement (MCA) for EPC projects has been delayed by disagreement between the road transport ministry and the Planning Commission. While the Cabinet Committee for Infrastructure approved the MCA for two laning projects in August 2012, there has been little activity in terms of awarding contracts under the EPC route. It is likely that awarding of these contracts will begin towards the end of FY13.Policy frameworkNHAI has recently formulated a roadmap to facilitate an exit for developers on completion of the contract. Rules introduced in 2009 allowed developers to exit two years after project completion. However, a recent proposal by NHAI allows developers to sell their stake as soon as tolling on the project starts.Developers who won projects before 2009 do not have the option to exit after two years of completion. In addition, developers had to keep a minimum of 26 per cent equity stake in the project till the end of the contract. If these developers are allowed to exit projects upon completing two years of tolling, it would increase capital flows to the sector, enabling companies to better manage cash flows and have the requisite equity contributions to bid for new projects. This would also ease liquidity concerns of banks that are more likely to fund projects that have higher equity contributions.ConclusionThe roads sector is poised to undergo a further change in the coming years with new domestic companies foraying into the sector, international players entering the market and existing players revamping their strategies to retain their stronghold. With increasing competition, only players with strong organisational structures and project management capabilities are expected to profit.While the quality of road infrastructure is certainly likely to improve, the pace of infrastructure development is critical to minimise losses, both economic and environmental. In particular, given that only around 52 per cent (10.39 km as against the target 20 km in 2011-12) of the daily target of average road length to be constructed has been met, the government is actively working on moving towards its original target.The number of expressways and highways has increased; many roads have been widened; electronic toll collection is becoming increasingly common; the ‘green channel’ concept is gaining ground, and inter-state check posts are becoming automated, with Gujarat serving as an example. Thus, against the backdrop of positive initiatives led by industry stakeholders, the industry needs to continue tapping the advantages of road transportation more efficiently and optimally than ever before.The author is Partner, KPMG in India.