Strategic review of Viability Gap Funding of Public Private Partnership arrangements

Introduction

Infrastructure projects are important from a development facilitation perspective and are highly capital intensive. Beyond certain size, these demand real commitment. Funding the critical infrastructure in a staggered manner with small budgets may defeat the purpose in two different manners. One is time and cost delays shall prove to be expensive from a project perspective. Secondly, the service delivery gets infinitely delayed when the capital flow is through a narrow nozzle. Then private sector participation becomes almost mandatory. One of the means of generating the interest of the private sector is through Public Private Partnership in which the government shall take care of certain essentials and expect the private sector company to bring-in the necessary capital and carry out the expert actions of designing, building, even financing, operating the venture. Eventually the venture may get transferred to the government who will be the owner. The above end-to-end spectrum can be simpler as well in build-operate-transfer (BOT), or build-own-operate-transfer (BOOT), or even build-own-least-transfer (BOLT) formats. Essentially, a major part of the value chain delivery is by the private sector player, and part happens on the part of the government. For the private organization it is a chance to stretch their businesses with reasonably moderate risks. For the government, it is expanding the infrastructure with little stress on its coffers. It can be a real win-win arrangement.

Understanding VGF through ‘chaiwallah’ example

As presented above, the infrastructure projects are economically desirable, capital intensive, and prime further downstream developmental activities. However, the financial viability of these may not be encouraging for the interested parties. In other words, facilitator of developmental activities viz. the government wants the projects to happen as there is huge requirement of services from this, but pricing constraints shall make the revenue stream not that attractive for the participating private company. We use ubiquitous ‘chaiwallah’ example to understand the concept of VGF. An illustration of the ‘economically attractive but financially unviable service’ is to set up a tea stall, make five hundred cups of ‘cutting chai’ per day for two years. The estimate for this in cost terms for private sector entrepreneur who is also ‘owner-manager’ is - (five lakh rupees of setup cost of initial Rs. One lakh capex plus rent @16K per month for 24 months + (2 years x 365 days x 500 cups x Rs. 9 per cup) + plus deemed wages of Rs. 15K per month for 24 months for the ‘owner-manager’) comes to rupees 40 lakhs. This is for the entire two-year period.

If the government imposes a price cap of Rs. Ten per cup of tea for the two-year period, then the executing private vendor may receive revenues to the tune of Rs. 35 lakhs only. He shall face a potential viability gap of Rs. Five lakhs. In other words, the contractor won’t find it attractive as spending forty and recovering thirty-five lakhs makes the proposal absolutely in the red. The government needs to motivate the vendor to take-up the project by ‘funding the gap in the viability of the project’. In other words, the government shall pay the difference of five lakh rupees to the vendor and ask him to start-up and operate the tea stall for the next two years, catering to five hundred people a day, and charging them only ten per cup of tea. The benefits are three-fold. First, customers are happy as there was no such tea stall facility earlier. Secondly, the vendor gets the additional business engagement and employment generation. Thirdly, the government fulfilled its ‘service delivery facilitation role’. All are winners in this arrangement. However, when the assumptions of number of cups of tea sold, revenue collected, cost of making an agreed quality of tea ‘go wrong’, the model gets ‘stressed’. Shake-up to survival have to happen then. ?

Gaining clarity on VGF through ‘Metro’ example

Metro rail networks have become popular across our states. A couple of dozen cities and scores more are contemplating on metro. Currently Delhi and Bengaluru are operating the two longest networks in the country. Mumbai may take a few years more to complete its planned five-hundred-fifty-kilometer network with about 350 stations. Literally over three lakhs of crores of rupees are involved in this metro network. Planning to implementation to operations, it has to happen with quality, and on time. It is known that the metro is highly capital intensive, and due to ticket price cap, it is also loss-making. Even if the entire ‘land’ is facilitated by the concerned state government, the design, building, buying costly rakes and needed infrastructure, manning the operations, doing the maintenance, paying for the electricity, taxes, and of course paying for the interest burden on the debt taken add up to huge amounts. Currently per kilometer benchmarked amount of Rs. 500-600 crores are making rounds. Thus, when a stretch of 30 kms is planned and needs to be ‘awarded’, the involved amount may be 15,000 to 20,000 crore rupees. Governments operating with high operating ratios can’t commit even a part of these amounts.

Here the governments want the private sector to participate in the developmental endeavor and execute and operate these metro projects. Number of kilometers of route, number of stations, number of rakes, headway during peak and non-peak periods, safety standards, top speed, facilities like number of entry points, elevators, parking, landing for dependent last mile transport must be prior agreed. The vendor interested in getting awarded the project must work out financial commitments in terms of capex and opex, estimate the potential revenues, find a net of NPVs of these two and get satisfied. However, given the ‘elastic nature’ of the ticket pricing, there is always a ‘cap on price’, else popularity won’t be there. In other words, if operator prices services are high, the number of footfalls shall be low, and the overall revenue becomes low. Typically, a ticket of 20-30 may be acceptable to travelers but when the higher side crosses 50 or 60, it raises eyebrows. Ridership may be low at higher ticket prices. An optimum must be arrived at.

Why do VGF calculations go wrong?

In the case of ‘metro project of a metro city’, the VGF arrived for the first stage project was around Rs. 1,500 crores. Naturally it was based on certain assumptions. These assumptions are along the lines of number of services per day, total ridership per day and per year, ticket slabs, ticket sales called fare revenue, non-fare revenues like real estate sale/rentals, another non-fare revenue stream through advertising, cost of debt, manpower requirements (including safety factored-in number of security personnel etc.), and maintenance mandate agreed. Based on the original plans that are purely ‘estimates’, VGF is calculated. Empowered committee / ministers’ nods are taken, and the company concerned is given a go-ahead. The contract won company puts its own money as equity, brings in additional required as debt from typically a consortium of banks (huge amounts, so risk is born by multiple banks), and government too primes with ‘funding viability gap’ amount. Project kickstarts, and may get completed with or without reasonable delay, and then starts the operations.

When the delays are not reasonable, the project costs escalate. When debt funding happens at a higher interest rate, it shall affect. If equipment price escalation goes beyond agreed limits, it hurts its viability. If the real estate related estimated revenues don’t happen, the gulf increases. If the ‘path’ is not the frequented one, then advertisement rights may not get much money. Last mile connectivity, if is not enough, then overall metro ridership reduces, affecting fare revenues. All these hurt the revenue stream. If the level of automation doesn’t happen or one needs to still supplement with manpower inspite of the automation, the additional manpower cost naturally hurts the project viability. As in the case of airport bound metro in a large city, the ‘planned top speed’ could not be achieved as the vibrations were going off the safety thresholds. Thus, the number of ‘trips’ per day were lower with the same number of rakes, and hence overall ridership came to much lower number than the estimated number and hence the revenue was far short of the original mark. The viability was deeply hurt. The case ended up in bitter litigation is another matter, and beyond the scope of this discussion.

On an optimistic closing note

Infrastructure projects are a must. These are capital intensive is well known. The governments with huge expectations from different quarters are catering to those and are short of capital for the infra projects are also known. This makes the public-private partnerships almost mandatory. Private sector companies can’t absorb the losses from these infra projects and stay put in medium to long term. Only way out appears as of now is, may the projects be planned pragmatically, cost economics prudently worked out, ethical frameworks be implemented to avoid the asset bubbles, techno-commercially savvy professionals with high degree of integrity and professionalism be made leaders of these ventures, with time bound project implementation the operations be launched on-time.

With quality, integrity, and professionalism, VGF amount worked out shall be fair and pragmatic. When the projects won’t go into red inspite of the originally planned VGF, then further investments shall be contemplated by other private players who had not earlier participated in such. Infrastructure facilitates and boosts development. Infra and transport may not be ‘profitable’ in the first place. In such cases we may have to start the efforts with VGF. Often infra is the game changer, leading the facilitating eco-system building efforts. More development shall follow with the created ecosystem. We have many positive examples along these lines.? Hence, we may agree that this is the time to take off. May thousand developments happen is the prayer. Brighter tomorrows ahead.