Contract renegotiation in highways

The change in bidding conditions, including that by altering the timing of bid premiums, goes against the grain of bidding process, writes Rohit Chaturvedi.

The level of success of PPP in India has been a function of contract design, regulations, and implementation framework in the respective sectors. Road sector in India has attracted significant investment from private players through the PPP mechanism, especially in the construction of the national highways. It may be noted that the mechanism has evolved over a decade through continuous learning and as a response to the environmental changes.

Before we delve into the problems being faced by the national highways in the wake of changed socio-economic context, it is important to get a perspective on the scale of private investment and thus the importance. Investment in roads and highways sector increased at a CAGR of 11 per cent to Rs 827 billion in 2011-12 from Rs 500 billion in 2007-08. The interest of the private sector continuously deepened from a share of 25 per cent of total investment in 10th Plan to 36 per cent during the 11th Plan on the back of facilitative framework and belief in sustenance of such growth in the foreseeable future.

Although the private investment boosted the development, the bids have started witnessing ‘irrational exuberance’, which was exhibited in the vast overestimation of traffic with the concomitant high bids. The participation levels also saw a high, especially in 2011 and a part of 2012, where a sizable number of projects witnessed more than 20 bidders for each project, especially at the lower and medium ends of project size. The winning bids were then marred by ‘winner’s curse’, ie, the winner loses money despite winning the bid. The problems became acute with the slackening growth and the actual traffic numbers emerging to be far lower than the estimates, thereby jeopardising the entire economics and viability of the projects. The problems from regulatory and financing sides have not helped the matter either. On the regulatory front, the uncertainty over land acquisition and environmental concerns has delayed the projects, thus increasing the costs. The higher financing costs due to the inflation taming emphasis of RBI have also affected the projects negatively. The question now arises if the existing PPP framework is adequate in dealing with problems being faced, especially the projects already awarded. The quick answer will at best be cautiously affirmative. Since the existing contracts cannot address the problems in changed socio-economic paradigm, should the contracts be renegotiated? In theory, they could be.

However, any changes in the contractual obligations have to be put under the test of ‘fairness’, ie, bidding conditions ought not be changed post-award. At the same time, public interest cannot be overlooked. This adds another layer of complexity as public interests may not be protected without renegotiations of the existing contracts due to lack of financial wherewithal on part of the government to implement these projects. Reopening of bids may lead to delays. Also, lack of clarity on the regulatory front may again lower the interest, and perceived risks by the bidders will be high, resulting in more outgo for the implementing agency.

The answer lies in prioritising the requirements and looking at not only todayÂ’s requirements but also the impact of putative steps in future development of this sector.

Renegotiation of contracts has been done in many jurisdictions. The learning from such historical precedence could provide a possible solution to current problems and may provide a framework for future renegotiations. However, contracts should be renego­tiated ensuring that bailing out should not lead to unnecessary aggressive bidding and ‘moral hazards’ in future bidding.

Specifically discussing the recent instances of request for renegotiations, it may be observed that the developers did not opt out because of the failure of conditions precedent cited previously. Instead, the new proposal in certain cases requires commercial restructuring of the contract by back-ending the premiums committed during bidding.

Interesting perspectives emerge if we put this particular idea through the criteria of public interest and fairness.

First, it is simple to appreciate that projects of this sort are essential for the economy and, thus, renegotiation should pass the test of public interest. However, it has to be determined whether few monthsÂ’ delay in project (if they go for re-bidding) will really affect the public interest significantly, especially when the renegotiations are also likely to take some time.

Second, the principal of fairness also seems to be getting satisfied if the offer is net present value (NPV) neutral as apparently is the case. Once again, delving little deeper, it is important to understand the factors behind any bidding. These factors include not only expectation of positive NPV but also the timing of cash flows, which is particularly important for debt financing. Any bidder would take the liquidity issues into account while bidding. Thus, any change in the timing of premium payments amounts to changing the bidding condition post-award.

Moreover, the assessment of the discount factor is tricky and open for subjective interpretation. Another complexity is different bidders have different discount rates, and if the renegotiation terms were known to them, the premium amounts would have been different from what they have bid.

In the wake of the above mentioned problems, it may be noted that the change in bidding conditions, including that by altering the timing of bid premiums, go against the grain of bidding process.

Thus, in order to keep faith in the bidding process, re-bidding emerges as a better solution despite changed social and economic scenario for existing contracts. However, the bidding framework for future projects may incorporate the learning from the current issues. Of course, the principal of fairness should be upheld.

The author is Director – Transport & Logistics Practice, CRISIL Infrastructure Advisory. Views are personal.