What Happened To The SPV Model In PPP Projects?
A simple tool could help lower the risk in the development phase of greenfield infrastructure projects, writes Akshay Jaitly.
The last installment of this column suggested removing the equity lock-in to promote merger and acquisition activity in Indian infrastructure projects. In passing, the column mentioned that the risk of investing in greenfield projects was high and required wide reform.
This time, we look at the importance of allocating risk appropriately in public-private partnership contracts. The column suggests a simple tool that could help to lower the risk in the development phase of greenfield infrastructure projects, potentially increasing investors' interest in bidding for them. This involves the resurrection of what was called the special purpose vehicle model, last meaningfully used for the Ultra Mega Power Projects of the 2010s.
Risk Allocation In Contracts
A basic principle of risk allocation in contracts is that risks should be allocated to the party that is best placed to manage them. An appropriately allocated risk incentivises and enables a party to manage that risk efficiently.
For instance, in a construction contract between two private parties, damage to the property or person of third parties is typically allocated to the contractor because it is practical to do so. The contractor is in charge of the site, carrying out the works, and is incentivised to minimise this risk through tools such as safety protocols, insurance, etc. For an owner to take this risk is impractical and expensive. The owner is not in control of the building site and does not have the skills required to keep it safe. Insurance will cost more as a consequence.
Risk Allocation In PPP Projects
The principle of risk allocation for PPP projects is the same as for any other contract. The party best placed to manage risk should take it. In fact, the operation of this principle is arguably more important in PPP projects, where one of the parties is a government instrumentality and a representative of the sovereign.
The risks that the government typically takes in these projects are upfront risks in the development phase, the risk of construction cost overruns brought about by a failure of the government agency to perform its obligations, and very long-term risks that are hard to predict.
The best practice in countries like the United Kingdom and Australia with established PPP sectors is an approach that mandates that this model of procurement be used when it delivers ‘value for money’ – defined as the most good for society at the lowest cost. As far back as the year 2000, this well-known report identified optimal risk allocation as being the key to delivering value for money in UK PPP projects.
Allocating Risk In Indian PPPs
We do not have a robust process to conceptualise and allocate risks for PPP projects in India. Risk allocation is determined by bureaucrats, with the prevailing attitude being to shovel off as many risks as possible to the private sector. Unlike in private infrastructure contracts, where the negotiation process leads to a better risk allocation, PPP contracts in India are not negotiated and are issued following public consultation processes that are perfunctory at best. More of this in another piece.
One of the riskiest phases of a PPP project in India is the development period: the phase in which a project is bid out, approvals and consents, including environmental consents, obtained, and land secured.
A bridge over the Indus river connects with the Zanskar Highway, an under construction road, in Leh on Sept. 23, 2021. (Photographer: Sumit Dayal/Bloomberg)
The government is best placed to take these risks as they involve dealing with another instrumentality of itself, potentially leading to significant reductions in uncertainty, time, and cost. However, these risks, or at least significant aspects of them, are often left to the private developer.
Even when the concessioning authority does take the risk of some of these activities, it rarely commits to a specific time frame within which to perform them and does not provide financial relief for the delay in fulfilling its obligations.
What Happens When Risk Is Not Properly Allocated
There are negative consequences to risks being sub-optimally allocated. Poor risk allocation renders uncompetitive bids of stable, long-term players who evaluate and price risk seriously. As a consequence, many projects are won by lowball bids that do not price risk appropriately, on the basis that they will be able to manage the environment in the development phase. Such players are incentivised to squeeze as much out of the project in its early years as they can and neglect or abandon it when the going gets tough or once they have made an acceptable return on their money. In the long run, this discourages serious bidders from bidding at all. Debt financing also becomes harder and more expensive to obtain. At times, improper risk allocation can mean that a project may be awarded but never built.
A cement mixer stands at an abandoned construction site in a property development in Noida, Uttar Pradesh, on Jan. 20, 2020. (Photographer: Prashanth Vishwanathan/Bloomberg)
The UMPP Model
At least some policymakers are aware of this. In the 2010s, the Government of India deployed what was referred to as the SPV model for the Ultra Mega Power Projects. Here, two wholly-owned subsidiaries were established as SPVs for each UMPP by the Power Finance Corporation Ltd., the public sector company with the responsibility for husbanding the project in its early stages. One SPV would obtain and hold all statutory approvals and clearances and carry out the bidding process. The second SPV held the captive coal block and associated land and the land for the power project. Both SPVs, with all the approvals and infrastructure they embodied, were to be transferred to the winning bidder.
Two projects were awarded using this model – Mundra UMPP which went to Tata Power, and Sasan UMPP which went to Reliance Power.
Still Relevant
It is easy to see how this model is well suited for large and complex projects such as major ports and airports, which involve securing a raft of approvals from both state and central governments, in addition to land and other transport linkages. It would also be particularly useful in untested sectors, for instance, the proposed offshore wind projects. These projects will require environmental, coastal, and wildlife clearances, land for onshore substations, rights of way for transmission lines, interconnection, and potential coordination with offshore oil and gas field operators. It is easy to envisage a dramatic reduction of risk for bidders if these critical elements are dealt with by the government, packaged into an SPV, and sold to the highest (or lowest) bidder.
It is not clear why this model fell out of favour, but it is worth reconsidering seriously. There is little doubt that it will help in reducing time, cost, and uncertainty for large infrastructure projects built as public-private partnerships, attracting a better quality of investors as a result.
Akshay Jaitly is Principal, 262 Advisors; and co-founder of Trilegal.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.