CHAPTER 19

FINANCING INFRASTRUCTURE PROJECTS

OUTLINE

• Private initiative

• Typical project configuration

• Key project parties

• Project contracts

• Financial structure and corporate governance

• Financing a power project

• Financing telecommunication projects

• Managing risks in private infrastructure projects

• Public private partnership

• Recommendations of the committee on infrastructure projects

PRIVATE INITIATIVE

Traditionally, infrastructure projects in India were owned and managed by Traditionally, infrastructure projects in India were owned and managed by the government or a government undertaking. Given the massive investments the government or a government undertaking. Given the massive investments required infrastructure, there is now a broad consensus that private sector required infrastructure, there is now a broad consensus that private sector participation in this activity must be encouragedparticipation in this activity must be encouraged

Private initiative in infrastructure projects can take many forms, ranging from Private initiative in infrastructure projects can take many forms, ranging from contracted operation of public utilities to full ownership, operation and contracted operation of public utilities to full ownership, operation and maintenance of these facilitiesmaintenance of these facilities

A typical example is an electricity generation project which the private sector A typical example is an electricity generation project which the private sector builds, owns, operates for a certain period of time (called the “Concession builds, owns, operates for a certain period of time (called the “Concession Period”) and finally transfers back to the government. This concept is called Period”) and finally transfers back to the government. This concept is called BOOT.BOOT.

For a road project, the private sector may be invited simply to build the For a road project, the private sector may be invited simply to build the facility, operate it during Concession Period and finally, at the end of the facility, operate it during Concession Period and finally, at the end of the concession period, transfer the facility back to the government (BOT) without concession period, transfer the facility back to the government (BOT) without actually ever owning the same.actually ever owning the same.

Typical Project Configuration

The project is implemented by a Special Purpose Vehicle, which is a distinct The project is implemented by a Special Purpose Vehicle, which is a distinct corporate entity.corporate entity.

Project sponsors take an equity stake in the SPV.Project sponsors take an equity stake in the SPV. The SPV enters into contractual arrangements with project contractors, The SPV enters into contractual arrangements with project contractors,

offtakers, operators, government, and project lenders.offtakers, operators, government, and project lenders. The dependence on debt is usually high and lenders generally lend on a non-The dependence on debt is usually high and lenders generally lend on a non-

recourse basis. This means that project lenders would not have any fall-back on recourse basis. This means that project lenders would not have any fall-back on the resources/assets of the sponsors if the SPV fails to meet debt servicing the resources/assets of the sponsors if the SPV fails to meet debt servicing obligations.obligations.

The contracts are as ironclad as possible and are less left to subjective The contracts are as ironclad as possible and are less left to subjective interpretation as possible.interpretation as possible.

Key Project Parties

• Project sponsors

• Project vehicle

• Project lenders

• EPC (engineering, procurement, and construction) contractor

• O & M (operations and maintenance) contractor

• Government

Project Contracts

Through a comprehensive web of contracts, every major risk inherent in Through a comprehensive web of contracts, every major risk inherent in the project is allocated to the party / parties that is best able to assess and the project is allocated to the party / parties that is best able to assess and manage the riskmanage the risk

The project contracts are:The project contracts are:

Shareholders AgreementShareholders Agreement

EPC ContractEPC Contract Project Loan AgreementsProject Loan Agreements

O & M Contract O & M Contract

Financial Structure and Corporate Governance

Many argue that the essence of project finance is the web of contracts meant Many argue that the essence of project finance is the web of contracts meant to ensure that all parties work in concert for the success of the project, to to ensure that all parties work in concert for the success of the project, to distribute risks efficiently, and to prevent the abuse of monopoly power.distribute risks efficiently, and to prevent the abuse of monopoly power.

This argument is valid but incomplete because it does not explain why a This argument is valid but incomplete because it does not explain why a project is handled as a separate company, why project parties participate in project is handled as a separate company, why project parties participate in the equity of the company, and why the project company relies heavily on the equity of the company, and why the project company relies heavily on debt in the form of non-recourse financing and limited recourse financingdebt in the form of non-recourse financing and limited recourse financing

Separate SPVs ensure that multiple concessions with different or conflicting Separate SPVs ensure that multiple concessions with different or conflicting terms are not imposed on the same SPV. It also enhances the trade ability of terms are not imposed on the same SPV. It also enhances the trade ability of these SPVs.these SPVs.

As it is not possible to write comprehensive contracts (which can envisage As it is not possible to write comprehensive contracts (which can envisage every possible contingency) and monitor them effectively, equity every possible contingency) and monitor them effectively, equity participation of various stakeholders makes them more committed to the participation of various stakeholders makes them more committed to the project.project.

Separately identifiable and assured cash flows facilitate a greater reliance Separately identifiable and assured cash flows facilitate a greater reliance on debt in the form of non-recourse or limited recourse financing.on debt in the form of non-recourse or limited recourse financing.

Parties in a Power Project

EPC Contractor

Sponsors/Other Shareholders

Fuel Supplier

State Electricity Board (Offtaker)Project Company (SPV)

O and M Contractor Project Lenders State Government

Features of a Power Purchase Agreement (PPA)

The PPA establishes the conditions under which the SPV would sell power to The PPA establishes the conditions under which the SPV would sell power to the SEBthe SEB

The SEB guarantees a minimum offtake from the SPV or, if it fails to do, a The SEB guarantees a minimum offtake from the SPV or, if it fails to do, a minimum paymentminimum payment

A payment mechanism and and a security mechanism that ensures availability A payment mechanism and and a security mechanism that ensures availability of payments on time is established. In India, several large projects have been of payments on time is established. In India, several large projects have been financed on the basis of a 3 tier security mechanismfinanced on the basis of a 3 tier security mechanism

Level 1 : Letter of creditLevel 1 : Letter of creditLevel 2 : Escrow accountLevel 2 : Escrow accountLevel 3 : Irrevocable guarantee of the state government Level 3 : Irrevocable guarantee of the state government

The formula for computing tariffsThe formula for computing tariffs

Termination under conditions of sustained default by either the SPV or the Termination under conditions of sustained default by either the SPV or the SEB.SEB.

Telecommunication Projects

Telecommunication projects are characterised by large project costs, a Telecommunication projects are characterised by large project costs, a virtually continuous project implementation (or roll–out), long gestation virtually continuous project implementation (or roll–out), long gestation periods, and a dispersed customer base that exposes the project to commercial periods, and a dispersed customer base that exposes the project to commercial risks and requires significant marketing and selling budgets. In telecom risks and requires significant marketing and selling budgets. In telecom projects, in practice there can be no single COD ( Commercial Operations projects, in practice there can be no single COD ( Commercial Operations Date).Date).

In general, telecom projects incur cash losses in initial years and these need to In general, telecom projects incur cash losses in initial years and these need to be funded. Unlike a power project which generates reasonably flat revenues be funded. Unlike a power project which generates reasonably flat revenues and profitability over its life, telecom projects, by virtue of their continued and profitability over its life, telecom projects, by virtue of their continued implementation and increase in subscriber base demonstrate increases in implementation and increase in subscriber base demonstrate increases in profitability over a period of time.profitability over a period of time.

Private telecom projects operate under a license from the Department of Private telecom projects operate under a license from the Department of Telecom and the projects framework is determined by the conditions of the Telecom and the projects framework is determined by the conditions of the license.license.

Factors considered by Project Financiers in a Telecommunication project

• Conditions imposed by the license

• Equipment supply contract(s)

• Financial strength of the project sponsors

• Business plan assumptions

• Competitive environment

Financing Telecommunication Projects

In general, telecom projects incur cash losses in initial years and these In general, telecom projects incur cash losses in initial years and these need to be funded. In determining a telecom project’s cost, lenders need to be funded. In determining a telecom project’s cost, lenders follow the concept of “ peak Negative Cash Flow Period,” which follow the concept of “ peak Negative Cash Flow Period,” which determines the maximum period over which the project requires determines the maximum period over which the project requires external cash infusion and the total external financing requirements external cash infusion and the total external financing requirements during the period.during the period.

Given the long gestation periods and the commercial risks, project Given the long gestation periods and the commercial risks, project lenders in India have funded telecom projects on a lower debt-equity lenders in India have funded telecom projects on a lower debt-equity ratio (DER) such as around 1:1ratio (DER) such as around 1:1

Infrastructure Financing Scenario in India Due to their complex nature, infrastructure projects have historically been funded by Due to their complex nature, infrastructure projects have historically been funded by

banks and financial institutions, SBI, IDFC, ICICI, IDBI, and PFC being the key banks and financial institutions, SBI, IDFC, ICICI, IDBI, and PFC being the key financiers.financiers.

In recent times, there has been an increasing interest from the capital markets in In recent times, there has been an increasing interest from the capital markets in financing equity requirements in well-structured infrastructure projects.financing equity requirements in well-structured infrastructure projects.

Banks have become more responsive and are now willing to lend upto tenors of 12 Banks have become more responsive and are now willing to lend upto tenors of 12 to 20 years. to 20 years.

A large part of the Golden Quadrilateral is based on a fixed annuity payment to A large part of the Golden Quadrilateral is based on a fixed annuity payment to contractors on a build-operate-transfer (BOT) model.contractors on a build-operate-transfer (BOT) model.

An operate-maintain-transfer (OMT) model is emerging for road financing. Under An operate-maintain-transfer (OMT) model is emerging for road financing. Under this arrangement, the government funds the road while the contractor operates and this arrangement, the government funds the road while the contractor operates and maintains it for a fee and then transfers it for a fee.maintains it for a fee and then transfers it for a fee.

There has been a fair amount of action in seaports in the last few yearsThere has been a fair amount of action in seaports in the last few years The Government of India has recently approved five ultra- mega power projects to The Government of India has recently approved five ultra- mega power projects to

come up in the private sector.come up in the private sector. Telecom operators in the private sector have been funded by debt and equity, Telecom operators in the private sector have been funded by debt and equity,

coming in good measure from foreign sources.coming in good measure from foreign sources.

Managing Risks in Private Infrastructure Projects

• Construction Risk

• Operating Risk

• Interest Rate Risk

• Foreign Exchange Risk

• Payment Risk

• Regulatory Risk

• Political Risk

What Is a PPP?Broadly a PPP refers to a contractual partnership between the public and private sector agencies in which the private sector is entrusted with the task of providing infrastructure facilities and services that were traditionally provided by the public sector. An example of a PPP is a toll expressway project financed, constructed, and operated by a private developer.

According to the Government of India, a PPP project is a project based on a contract or concession agreement between a government or statutory entity and a private sector company for delivering an infrastructure service on payment of user charges. A private sector company is a company in which 51 percent or more of equity is owned and controlled by a private entity.

Relevance of PPPs in IndiaIndia, the second fastest growing and the fourth largest economy of the world (in terms of PPP), faces huge gaps between the demand and supply of essential social and economic infrastructure and services. There is a shortage of power, roads, ports (airports and seaports), irrigation facilities, water and sanitation services, and so on. The deficient infrastructure is a major constraint in sustaining, deepening, and expanding India’s economic growth and competitiveness. It also impedes inclusive growth and poverty alleviation.

Recognising the importance of infrastructure, the Government of India (GOI) has stepped up its spending on infrastructure through a series of national programs such as the National Highway Development Program (NHDP), Bharath Nirman, Providing Urban Services in Rural Areas (PURA), Jawaharlal Nehru National Urban Renewal Mission (JNNURM), the Prime Minister’s Rural Road Program, National Rail Vikas Yojana, National Maritime Development Program (NMDP), airport expansion program, and so on. However, the estimated investment requirements are far greater than governmental resources. So, the Approach Paper to the Eleventh Plan has argued for reaching out to the private sector and private savings and aggressively promoting private partnership in infrastructure development. The National Development Council (NDC) has passed a resolution which says that “increased private sector participation has now become a necessity” for mobilising the resources required for infrastructure expansion and upgradation.

Key Government Initiatives

To give impetus to PPPs several initiatives have been taken. The GOI has established a Cabinet Committee on Infrastructure (COI), a high-level Committee of Secretaries, a PPP Appraisal Committee (PPPAC) on the model of the Public Investment Board (PIB), and several task forces to streamline decision making and operationalise PPPs. It has established the Viability Gap Funding (VGF) scheme and the India Infrastructure Finance Company Limited (IIFCL) to provide long-term finance to PPP projects.

The GOI is working on several initiatives to assist and encourage capacity building at the state and central levels. It is providing assistance for creating state level PPP cells as nodal agency, streamlining their approval process, and developing PPP toolkits (model concession agreements, project manuals, bidding documents, and project preparation manuals).

The Way ForwardIn order to accelerate PPPs the following are needed:

A stronger policy and regulatory framework has to be created, both at the centre A stronger policy and regulatory framework has to be created, both at the centre and the states. The US-India CEO forum has called for a policy and regulatory and the states. The US-India CEO forum has called for a policy and regulatory framework that fosters efficiency and transparency in the bidding process, framework that fosters efficiency and transparency in the bidding process, ensures sanctity of contracts, encourages competition, promotes market-driven ensures sanctity of contracts, encourages competition, promotes market-driven tariffs, and separates regulatory and adjudication authorities.tariffs, and separates regulatory and adjudication authorities.

The availability of long term equity and debt for PPPs has to be augmented The availability of long term equity and debt for PPPs has to be augmented through suitable instruments and mechanisms.through suitable instruments and mechanisms.

The shelf of bankable PPP projects has to be expanded.The shelf of bankable PPP projects has to be expanded.

The capacity of the government to manage PPP projects has to be substantially The capacity of the government to manage PPP projects has to be substantially strengthened.strengthened.

The government should expeditiously award contracts, facilitate land acquisition, The government should expeditiously award contracts, facilitate land acquisition, and ensure better coordination between the centre and states. In particular, large and ensure better coordination between the centre and states. In particular, large size PPP projects may be put out for bidding after obtaining mandatory size PPP projects may be put out for bidding after obtaining mandatory clearances and approvals, preferably through a Shell Company / Special Purpose clearances and approvals, preferably through a Shell Company / Special Purpose Vehicle as was done recently in the case of Ultra Mega Power Projects.Vehicle as was done recently in the case of Ultra Mega Power Projects.

Recommendations of the Committee on Infrastructure Financing

1.1. Develop a deep and robust debt marketDevelop a deep and robust debt market

2.2. Tap the potential of insurance sectorTap the potential of insurance sector

3.3. Enhance the participation of banks, financial institutions and large NBFCsEnhance the participation of banks, financial institutions and large NBFCs

4.4. Provide fiscal incentivesProvide fiscal incentives

5.5. Facilitate equity flowsFacilitate equity flows

6.6. Induce foreign investmentsInduce foreign investments

7.7. Utilise a small portion of foreign exchange reserves for infrastructure Utilise a small portion of foreign exchange reserves for infrastructure developmentdevelopment

SUMMARY While traditionally infrastructure projects in India were owned and managed by the While traditionally infrastructure projects in India were owned and managed by the

government undertaking, there is now a broad consensus that private sector government undertaking, there is now a broad consensus that private sector participation in this activity must be encouraged.participation in this activity must be encouraged.

The key features of project finance which appears to be the principal arrangement The key features of project finance which appears to be the principal arrangement for private sector participation in infrastructure projects are as follows: (i) The for private sector participation in infrastructure projects are as follows: (i) The project is set up as a separate company which is granted a concession by the project is set up as a separate company which is granted a concession by the government. (ii) The sponsor company which promotes the project usually takes a government. (ii) The sponsor company which promotes the project usually takes a substantial stake in the equity of the project and enjoys the overall responsibility substantial stake in the equity of the project and enjoys the overall responsibility for running the project. (iii) The project company enters into comprehensive for running the project. (iii) The project company enters into comprehensive contractual arrangements with various parties like contractors, suppliers, and contractual arrangements with various parties like contractors, suppliers, and customers. (iv) The project company employs a high debt-equity ratio, with customers. (iv) The project company employs a high debt-equity ratio, with lenders having no recourse or limited recourse to the sponsor company or to the lenders having no recourse or limited recourse to the sponsor company or to the government in the event of default. government in the event of default.

The key differentiating feature of project finance is the manner in which project The key differentiating feature of project finance is the manner in which project risks are allocated to various parties involved in the project. Through a risks are allocated to various parties involved in the project. Through a comprehensive web of contracts, every major risk inherent in the project is comprehensive web of contracts, every major risk inherent in the project is allocated to the party/parties that is best able to assess and manage that risk.allocated to the party/parties that is best able to assess and manage that risk.

The key project parties are project sponsors, project vehicle, project lenders, EPC The key project parties are project sponsors, project vehicle, project lenders, EPC contractors, O & M contractor, and the government.contractors, O & M contractor, and the government.

The main project contracts are : shareholders agreement, EPC contract, project The main project contracts are : shareholders agreement, EPC contract, project loan agreements, and O & M contract.loan agreements, and O & M contract.

In the case of a power project, the power purchase agreement (PPA) establishes the In the case of a power project, the power purchase agreement (PPA) establishes the conditions under which the SPV would sell power to the SEB, the SEB guarantee conditions under which the SPV would sell power to the SEB, the SEB guarantee for a minimum takeoff, the payment and security mechanism, the formula for for a minimum takeoff, the payment and security mechanism, the formula for computing tariffs, and the provision for termination.computing tariffs, and the provision for termination.

Financiers of a telecommunication project consider the following factors: Financiers of a telecommunication project consider the following factors: conditions imposed by the license, equipment supply contract (s), financial conditions imposed by the license, equipment supply contract (s), financial strength of the project sponsors, business plan assumptions, and competitive strength of the project sponsors, business plan assumptions, and competitive environmentenvironment

Due to their complex nature, infrastructure projects have historically been funded Due to their complex nature, infrastructure projects have historically been funded by banks and financial institutions. In recent times, there has been an increasing by banks and financial institutions. In recent times, there has been an increasing interest from the capital markets in financing equity requirements in well-interest from the capital markets in financing equity requirements in well-structured infrastructure projects.structured infrastructure projects.

Broadly, a PPP refers to a contractual partnership between the public and private Broadly, a PPP refers to a contractual partnership between the public and private sector agencies in which the private sector is entrusted with the task of providing sector agencies in which the private sector is entrusted with the task of providing infrastructure facilities and services that were traditionally provided by the public.infrastructure facilities and services that were traditionally provided by the public.

To give impetus to PPPs in India, several initiatives have been taken. However, a To give impetus to PPPs in India, several initiatives have been taken. However, a lot more needs to be done.lot more needs to be done.

The Committee on Infrastructure Financing has made several recommendations: The Committee on Infrastructure Financing has made several recommendations: (a) Develop a deep and robust corporate debt market. (b) Tap the insurance (a) Develop a deep and robust corporate debt market. (b) Tap the insurance companies. (c) Enhance the participation of banks, financial institutions, and large companies. (c) Enhance the participation of banks, financial institutions, and large NBFCs. (d) Provide fiscal incentives. (e) Facilitate greater equity flows. (f) NBFCs. (d) Provide fiscal incentives. (e) Facilitate greater equity flows. (f) Induce foreign investments. (g) Utilise a small portion of foreign exchange Induce foreign investments. (g) Utilise a small portion of foreign exchange reserves for infrastructure developments.reserves for infrastructure developments.