Expertspeak: How to determine premium

Planning and projection will be in sharp focus in an increasingly competitive environment while determining costs and benefits in NVGF road projects. M Murali helps us understand what variables constitute a framework of factors while doing so.

Compared to the public sector, private sector firms have a better structure of incentives and san­c­tions, and stronger motivation to earn good ret­urns on the investment. The private sector also has greater flexibility in adjusting its resources – personnel, equipments and materials-to constantly changing circumstances. Private firms optimise resource allocation in the initial construction and the later operation and maintenance (O&M) phases. This is the philosophy behind the success of Public-Private Partnership (PPP) in infrastructure.

Government of India has established a Viability Gap Fund (VGF) to aid the infrastructure projects under PPP that face a gap in projected revenues simply because charges may not be levied on the general public or can­not be recovered adequately. The VGF Scheme adminis­tered by the Ministry of Finance provides financial sup­port in the form of grants, one-time or deferred, with a view to make them commercially viable.

REVERSE FUND FLOW

Under Negative VGF, or Premium, the payment from the constructor can be either in the form of an up­front premium or revenue share. Better efficiencies and better flexibility to manoeuvre financial ups and downs mean that wherever there is scope for financing a project through direct user-fee, investors can use toll-fee more efficiently to recover their money. In some cases, reall­ocation of risk has the potential to lower overall costs for the society.

Variables for premium: The following project variables are likely to help determine project viability.

• Economic variables: Higher the demand and willin­gness to pay for a better road service, more likely the project will attract private investment. Similarly, greater is the profitability or lower is the risk profile of a project.
• Local infrastructure: A higher level of economic acti­vity in general is likely to result in a greater demand as well as ability to pay for better road facility. Moreover, enabling infrastructure can facilitate a project during construction as well as the O&M phases. It can also considered infrastructural index of the district in which the road project is located as an explanatory variable. The main components of the index are power, communication and transport.
• Vehicular population of the state: The benefits in terms of reduced travel time and lower risk of accidents are proportional to the level of congestion on the alternative routes and have better driving conditions. Therefore, such road facilities are likely to be in greater demand in states with high traffic density.
• Per capita State GDP: A higher per capita State SGDP is indicative of income and hence demands for transport services of the state. States with higher per capita SGDP are also the states with larger number of economic activities that involve intensive use of surface transport, and vice-versa. Moreover, when average per capita income is high, average road user will be more willing and able to pay for the services of BOT toll roads. Therefore, states with relatively high per capita income are likely to attract more PPP projects than states with relatively low per-capita GDP.
• Per capita State GDP of neighbouring states: A sign­ificant proportion of traffic plying on National Highways is inter-state. This is especially true of com­mercial and goods/freight vehicles. Therefore, in addition to the local demand, income level and int­ensity of economic activity in the neighbouring sta­tes also affects traffic density and hence the pro­fitability of BOT toll projects.
• Project cost: Project cost captures the financial stakes involved in the project. However, a project cost per se is not an indicator of financial viability of a project. Several factors such as length of road project and availability of an alternative road facility affect returns from a project.
• Time factor: When PPP policy was introduced in 1995, the policy makers as well as investors were inexperienced. The risk profile of projects was unknown. With the passage of time, both have bec­ome better informed about the strengths and wea­knesses of PPPs in India. So, some learning has taken place overtime.
• Distance from mega city: Big cities are hubs of comm­ercial activity. These cities act as growth pole for many of industrial and commercial activities. A lot of freight and passenger traffic on National High­ways move to and from these cities. Road segments closer to mega cities experience denser traffic as opp­osed to projects tucked away from cities.

Factors for premium: The various factors, derived from the variables,
that may be taken into consideration for determining Premium for road
projects are as follows:

• The higher the value of local infrastructure, better are chances of viability.
• The closer a project to a mega city, the better the viability.
• Higher value of transport vehicle indicates a larger number of vehicles in the state.
• The higher the per capita State GDP, ie, the richer the state's populace, the better the chances of PPP.
• The richer the neighbouring states, the better are the chances of forming PPP.
• Cost to concessionaires/contractor due to idle man­power, machinery.
• Slow progress in other infra sectors.
• Political will, structural and policy changes.
• Confidence of Financers and renewed interest of FDI, PE investors.

The policy and regulatory framework has undergone a sea change in the past 10 years, in which time funding share of private investment has registered a marked increase and share of traditional sources declined drastically.

NHAI's target for FY12 is to award 7,300 km (have identified 7,994 km of projects for award during FY12) of projects compared to 5,083 km awarded in FY11 and 3,360 km in FY10. Though the project awarded by NHAI has been below the initial hyped exceptions,
road segment remains one of the exceptions in infra­structure space with decent project award track record in last two years and a visibility for upcoming years. Competition has been stiff in the last few months which encourage but it is likely to come down as a large num­ber of the infrastructure companies will start bidding conservatively after achieving their target of investment in road sector.

But the road sector, which has already seen a massive shift in the process and mindset, is expected to undergo a further change in the next couple of years. New dom­estic companies are expected to foray into road develo­pment, international players are also expected to enter the Indian road sector and existing players are churning out new strategies to retain their stronghold. With inc­reasing competition, only players with strong organi­sational structures and project management capabilities are expected to gain ground in the long term.

VGF: A PRIMER

Provision has been made to provide upto 20 per cent of total project cost as capital grant to meet the funding gap. In such a project, the sponsoring agency/department/state can give an additional 20 per cent of the project cost as VGF support. A transparent and open competitive bidding pro­cess is a key mandate in this process. The criterion for bidding shall be the amount of viability gap funding required for implementing the project where all other parameters are comparable.

The following sectors are eligible:

• Roads and bridges, railways, seaports, airports, inland waterways
• Power
• Urban transport, water supply, sewerage, solid waste management and other physical infrastructure in urban areas
• Infrastructure projects in Special Economic Zones
• International convention centres and other tourism infrastructure projects

The project should provide a service against payment of a pre-determined tariff or user charge, and the concerned Government or statutory entity should certify with reasons the following:

• The tariff / user charge cannot be increased to eliminate or reduce the viability gap of the PPP
• The Project Term cannot be increased for reducing the viability gap
• The capital costs are reasonable and based on standards and specifications normally applicable to such projects and the capital cost cannot be further restricted for reducing the viability gap.

This scheme will apply only if the contract/ concession is awarded in favour of a private sector company in which 51 per cent or more of the subscribed and paid up equity is owned and controlled by a private entity.

The author is Director General, National Highways Builders Federation.