Opportunities Beckon, But Where Are The Funds?
The construction industry has made rapid strides over the last 5 years at an annual 12.28% growth rate [RBI]. In its India Infrastructure report for Q2, 2010, Business Monitor International [BMI] estimates that growth would peak in 2010-11 and continue thereafter – in short, the industry value, currently at Rs 5174 bn would double by 2015!
Expectedly, ‘infrastructure’ accounts for a bulk of the construction industry value in India. Hence growth in infrastructure and population would imply concurrent growth in EPC activities.
The estimates given out by a McKinsey survey in April 2010 on urbanization in India are staggering. Sample these:
• By 2030, Indian cities will host 590 million residents, which is nearly double the population of the US today
• USD 1.2 trillion is the estimated amount required to meet projected infrastructure demand in Indian cities alone over the next two decades
• During this period, 700-900 million square metres of commercial and residential space would have to be constructed [which is a new Chicago every year!]
• 2.5 billion square metres of road and 7400 kms of metros and subways are required, 20 times the capacity added over the last decade
What would happen if the required investment does not happen at all or happens at a slower pace? The predicted consequences are grim indeed – Indian cities, already falling short of delivering even the basic standard of living for residents, cracking at the seams with tattered infrastructure, will witness drastic deterioration in quality of life. Link these predictions to economic growth, and one sees India’s superpower dreams vanish rapidly.
Infrastructure – perpetual demand
Since the major potential for EPC activity stems from infrastructure development in India, let us look at some estimates for required infrastructure investment. There are several such estimates made by world class institutions and agencies, yet they can be taken as benchmarks alone. The demand for infrastructure is perpetual.
This brings us to the question – What is infrastructure? Infrastructure includes ‘utility networks’ [energy – electricity, oil and gas – or water supply], ‘resource extraction facilities’ [mining, offshore platforms or pipelines], ‘technology platforms’ [such as those required for information and communication], ‘transportation assets’ [roads, ports, airports, railways], and ‘social assets’ [ such as sanitation and other services, including hospitals, schools and even prisons].
Perpetual demand for infrastructure assets arises since they are key components of basic needs of the population and the socio-technical systems that support these needs – such as healthcare, education, travel and hospitality, energy, and so on. These systems, when constructed, support a wide range of production activities and delivery of services that are essential for the growth of communities and the country as a whole.
Infrastructure development needs funds
Here lies the catch. Who will build and finance the infrastructure that a country needs?
‘Private investment in infrastructure’ is the readily offered panacea to resolve these issues. This is easier said than done. While in government built and owned infrastructure, the private sector was awarded works contracts for EPC or other related tasks, the new paradigm of ‘Public Private Partnerships’ requires active involvement by the private sector. An important part of the active involvement is ‘financing’ the infrastructure project.
In traditional models of infrastructure development, the government allocated funds out of its budget for specific sectors and projects, and awarded works contracts involving EPC to qualified firms. In doing so, the government bore the major risks, including financing risks. The major risk the EPC contractor bore was timely completion of construction, within the allocated budget, and in accordance with the quality parameters. These requirements posed little challenge to experienced and skilled EPC companies.
However, as one moves along the spectrum [see figure 1] of increasing private participation, the risks allocated to the private sector also increase.
Here we are talking about very large projects, where the funding requirements are also very high. We are talking about sectors where the entire investment and construction have to be completed before projects begin generating the first rupee of cash flow. These cash flows have to be generated over a long period of time for the investor to realize desired returns. In short, we are talking of risky projects and assets.
Project finance
If infrastructure projects are so risky, what is the incentive for private investors or lenders to invest in projects for public good? The answer lies in ‘structuring’ the project so that major risks are mitigated, and lenders feel comfortable with financing the project. A satisfactory answer lies in ‘Project finance’.
To understand how this preferred mode of financing large projects works, we compare two Greenfield projects, the first of their kind in PPP in India:
The common features observed in the two representative projects are as follows:
1. Separate incorporation, that is, an identity separate from the equity investors [sponsors]
2. Multiple equity sponsors
3. High proportion of debt in project value
4. Debt by a group of lenders
5. Debt non recourse to project sponsors
6. Long ‘concession period’ agreement with the government, and various other contracts
7. Innovative financing instruments were used for financing the projects
Project finance volumes in India – 2009
In a year when global project finance was down by almost 10%, Asian and particularly Indian project finance volumes showed substantial spurt of 57% and a whopping 189% respectively. More remarkable was the fact that India was also the leading nation globally, with 3 of the 10 largest projects in the world being implemented in India. Does this mean that India’s infrastructure growth goals would be met? The yawning gap between targeted growth and achievement continues to widen, as huge shortfalls in performance keep mounting. The Economic Survey draws attention to the dismal track record of project implementation, with almost a third of the projects reporting cost and time overruns.
Role of debt in Project finance
Moreover, funding sources for long term projects are limited. RBI data shows that compared with the Planning Commission’s 11th Plan estimate of Rs 988035 crore [at 2006-07 prices] debt, or an annual average of roughly Rs 200000 crore, there seems to be substantial shortfall of debt funding. Given the current inflation, and the 10th Plan deficit in infrastructure investment, the actual debt requirement would be substantially higher.
Funding options
The McKinsey report makes the following recommendations to enhance financing sources for urban infrastructure projects:
1. Monetize land assets
2. Maximize the potential of property tax and user charges
3. Create a formula based grant system from State and Central governments
4. Use debt and private sector participation appropriately
5. Create enabling mechanisms such as Special Purpose Vehicles [SPVs] and city development funds
The report notes that India has not been able to capitalize on the above funding sources so far.
The Bond-Credit-Derivatives [BCD] nexus – the critical issue
In addition to the above, there is an urgent need for long term funding sources, such as vibrant corporate bond markets. Banks, by virtue of the composition of their balance sheets, cannot always lend for longer tenures.
However, since 2003, when draft guidelines were first released by RBI, credit derivatives have been frequently figuring in policy discussions, with no implementation in sight. Similarly, since 2005, the Patil committee report is being discussed for bond market development, but the long term bond market is still in a rut.
As the potential for infrastructure and construction activity booms across India, it is imperative that the unique financing needs of these sectors are addressed immediately.
The post Construction Equipment and Finance Projects In India News – June 2010 appeared first on EPC World.