IBLJ February 2016- Small Cities: Design and structure vital for success of PPP projects.

 

Hemant Sahai & Soumya Kanti De Mallik (Partner)

 

The Ministry of Urban Development’s Smart City Mission contemplates significant use of public-private partnership (PPP) structures for financing, developing and operating the smart city projects. In addition to the private capital needed to finance the mission, PPP structures will leverage efficiencies and technology of the private sector. However, to be able to attract private investment, PPP projects will need to be appropriately designed and structured to ensure viability and appropriate allocation of risks and, most importantly, to treat the private investor as an equal partner. Some key elements required to design an efficient PPP structure are analysed below.

 

Greater cooperation : A PPP project is a partnership between the public authority and the private entity to promote a project, while sharing the risks, costs and resources. A major reason for the failure of such partnerships is the failure of authorities to recognize the long-term risks undertaken by the private sector, leading to disputes.

 

In this context, the Kelkar Committee in its recent report commented that the success of deploying PPP projects will depend on whether public authorities can change their attitude and mind-set, and accept that uncertainties and appropriate adjustments are inherent in implementing long-term contracts. This change in mind-set needs to be reflected in the design of the project agreements.

 

A viable business opportunity : A PPP project will be successful only if it is commercially viable. While investors have their own threshold internal rate of return, accurate assumptions need to be made while designing the PPP structure to ensure that market driven returns for the particular sector are feasible. Sectoral regulators play a role in mitigating risks and losses arising due to abrupt changes in the economic or policy environment, but recourse to a regulator can pose unforeseen risks for an investor.

 

International best practices suggest that regulation by contract is the best form of regulation, provided the contracts are sophisticated, predictable, based on realistic assumptions and provide transparent mechanisms for addressing these risks. There are counter-arguments that in long-term contracts it is difficult to predict all uncertainties, however, an analysis of infrastructure contracts shows that the significant risk is in the initial development and construction stages, and post completion it is primarily “traffic” or “offtake” risk. Therefore, a balanced PPP structure always provides for development risk and “traffic” or “offtake” risk to be taken by the authority, and the construction and operations risk to be assumed by the private developer.

 

Efficient contractual framework : Related to both the above factors is the need for a robust and predictable contractual framework. The objective of the framework should be to increase visibility between the parties by allocating technical and commercial risks (thereby reducing scope for disputes and differences) and, at the same time, easing implementation of the project.

 

For instance, an effective contractual framework can enable private entities to raise debt finance from different classes of investors, by providing greater flexibility to raise equity and by including options to dilute ownership and/or exit completely from the project. The exit opportunity has to be in a predictable manner, particularly in the case of long-term investors (such as pension funds) that are not willing to take development risk but are willing to take operational risk.

 

Renegotiation of contracts : Lastly, developers argue that PPP contracts must have inherent scope to be renegotiated. This may be desirable to address long-term risks, however, flexible contracts that address such risks are preferred. While specific risks may be unforeseen, most can be captured within pre-defined categories of risks, such as change in law, etc. The Kelkar Committee report, while setting out benchmarks to be applied to renegotiation triggers, suggests that the authority should act within a governance arrangement that uses a facts-based objective assessment.

 

In our experience, amending or renegotiating contracts, even within an institutionalized framework, will always be a daunting task. It is difficult to address charges of subjectivity and arbitrariness, which can lead to disputes and consequences akin to the cancellation of 2G licences and coal block allocations. The alternative preferred approach is to create robust yet flexible concession agreements that address diverse categories of risk, without precipitating renegotiations.

 

To conclude, Finance Minister Arun Jaitley has remarked: “PPPs have delivered some of the iconic infrastructure like airports, ports and highways, which are seen as models for development globally. But we have also seen the weaknesses of the PPP framework, the rigidities in contractual arrangements, the need to develop more nuanced and sophisticated models of contracting and develop quick dispute redressal mechanisms.”

 

Today when India is looking towards the smart city revolution, there is no alternative to PPPs, however, the framework must incorporate learning from earlier experiences. HSA is engaged in drafting PPP concession agreements in diverse sectors and services, which will eventually also find a place in the smart cities framework.

 

Hemant Sahai is the managing partner and Soumya Kanti De Mallik is an associate partner at HSA Advocates. HSA is a full-service firm with offices in New Delhi, Mumbai and Kolkata, and with a correspondent relationship in Bangalore.

 

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