Infrastructure development public vs private 2018

Private Sector Participation in Infrastructure Development 1 Infrastructure Development is traditionally the Government’s Responsibility; Public Sector Investment Justification is asso

Prof Koji FUJIMOTO

Class 9 Infrastructure Development in Asia -Public vs Private-

1 Definition of Infrastructure and Its Services and Projects

(1) Definition

The concept of infrastructure is not unambiguous, many definitions of infrastructure exit A few are introduced hereunder

→ Infrastructures are usually defined as underlying basic buildings, institutions

and facilities, as well as other essential elements that are necessary to sustain and enable the growth and development of a community

→ Infrastructure refers to the foundation or underlying framework of basic

services and facilities and upon which the growth and development of an area, community or system depends Infrastructure, therefore, includes a broad spectrum of services, institutions and facilities that range from transportation systems and public utilities to finance systems, laws and law enforcement, and education and research (Larimer 1994)

(2) Economic Infrastructure and Social Infrastructure

It is generally known that infrastructure is broadly divided into two groups,

“Economic” and “Social.” Today, however, other concepts such as

“environmental infrastructure” and “human infrastructure” are emerging

Economic Infrastructure includes the following

Energy……… Power plants, transmission and distribution lines,

etc

Transportation………… Roads, bridges, tunnels, rail tacks, ports, airports,

etc

Telecommunication…… Telephone exchanges, telephone lines, etc

Irrigation……… Dams, canals, etc

Water Supply……… Dams, reservoirs, pipes, treatment plants, etc Water Disposal……… Sewers, waste water treatment plants, etc

Garbage/Waste Disposal… Dumps, incinerators, compost units, etc

Social Infrastructure includes the following

Education……… All levels of school facilities, etc

Health and Sanitation……… Hospitals, rural clinics, primary health care, sanitary

facilities, family planning, nutrition programs, safe drinking water, etc

Others (Rural Dev., etc.)…… Rural roads, rural electrification, rural irrigation,

PPP: public- private partnership

Basic things

v ệ tinh

small-scale industry development, etc

In the above connection, the World Bank’s statistical categorization (“World

Bank Lending by Sector”) is of some reference as shown hereunder

Agriculture, Fishing, and Forestry

Education

Energy and Mining

Finance

Health and Other Social Services

Industry and Trade

Information and Communication

Law and Justice and Public Administration

Transportation

Water, Sanitation, and Flood Protection

2 Infrastructure and Development Issues

The development of infrastructure has a close relationship with a variety of development issues In pursuing development goals, special attention and understanding to them are needed

(1) Infrastructure and Economic Growth

(2) Infrastructure and Poverty Reduction

(3) Infrastructure and Environment

(i) Waste Disposal

(ii) Environmental Impact of Transport and Power Projects

3 Private Sector Participation in Infrastructure Development

(1) Infrastructure Development is traditionally the Government’s Responsibility;

Public Sector Investment

Justification is associated with market failures:

A natural monopoly is a monopoly that exists because the cost of producing the product (e.g., goods or services) is lower due to economics of scale if there is just a single producer than if there are several competing producers This is the state of natural monopoly and if market forces are introduced, this state cannot hold

(ii) Publicness in Nature (Public Goods)

The public desires certain goods and services that are either not being produced in the market, or that the market produces certain goods and services in quantities that are perceived as insufficient The government can only satisfy the public by producing sufficient quantities of such goods and services

Network effect is a characteristic that causes a service or good to have a value to a potential customer dependent on the number of customers already using that service or owning that good Infrastructure services have this type

of network effect The market is usually careless in this kind of effect

Merit goods are goods that would be provided in a free market system, but would almost certainly be under-provided Thus, the market fails

Infrastructure related services and their alleged market failures are sorted out in Table 1below

Table 1 Infrastructure Related Services and Alleged Market Failures

5 Garbage Collection and

Disposal

Pure Public Goods and Externalities

Source: Remy Prud’homme, “Infrastructure and Development,” 2004

(2) Recent Paradigm Change in Infrastructure Development

Since the 1970s, private sector participation in infrastructure started to be

justifiable on a variety of grounds

In line with the economic recession in European countries, the governments were forced to reduce their respective budgets, which in turn promoted

privatization of infrastructure facilities

Technological breakthroughs reduced costs of services dramatically and the private sector acquires such infrastructure as a regular business (ex mobile cell phones against copper line, etc)

The current globalization forced open such public sector activities as infrastructure to the world market The public sector infrastructure of any developing country became a part of the integrated international infrastructure system Protective domestic regulations and rules became useless

Theories of public goods were developed and a variety of issues such as asymmetric information, rent caused by asymmetric information, and inefficiency caused by regulatory failure found practical solutions One typical solution is the “Price Cap Regulation”

4 Private Sector Participation in Infrastructure Development in Asia

In 1995, the World Bank published a paper entitled “Infrastructure Development in East Asia and the Pacific ~Towards a New Public-Private Partnership~,” which intensified world-wide discussions on the issue of private sector participation in infrastructure development in Asia The logic behind this debate is quite simple That

is, to sustain successful economic growth, the Asian countries need to invest huge amounts of funds in infrastructure development Can they secure funds by themselves?

It is impossible to do so unless they invite private sector participation

The followings are the major points of the aforesaid World Bank paper

(1) Investing and Financing Requirement in Developing East Asian Economies

In developing East Asian countries, total investments in infrastructure rose from 3.6% of GDP in the ‘70s to about 4.6% in the ‘80s and to between 5.0-5.5% of GDP in ’93

Towards the early 2000s, investment requirements were massive Four causes that lead to this investment have been pointed out as: (i) to make up for past under-investment, (ii) to sustain high economic growth rates, (iii) to cope with the expanding need for urban infrastructure caused by rapid urbanization, and (iv) to secure the need for world-class infrastructure services

The paper projected that the developing East Asian countries required

$1.3-1.5 trillion for the term 1995-2004 This suggested a need for a substantial increase

in the investment to GDP ratio from 5% to around 6.5-7%

(2) Why A New Public-Private Partnership Required?

(i) The projected massive investment needs cannot be met by the financial resources of the state alone, without reducing other priority social and economic spending

(ii) Managerially, there are capacity constraints within the public sector In other words, the state is not equipped to handle the ever challenging and complex managerial tasks in terms of quantity and quality

(iii) In parallel with (i) and (ii) above, East Asian countries need to raise the efficiency and quality of infrastructure services to compete in the global market Low cost and high quality services are indispensable

As a matter of fact, the World Bank’s World Development Report 1994

discussed these very issues in detail

(3) The Past Experiences of PPP in Infrastructure Development

Past experiences are characterized under the following six captions

(i) Experience in East Asia vs Latin America

Many countries in Latin America such as Chile, Argentina, Peru and Mexico started PPP by privatizing public monopolies: privatization efforts of public sector monopolies

In East Asia, by contrast, initial attempts to attract the private sector focused on helping private investment to build new capacity: development of new infrastructural facilities with the help of private sector funds

(It should be noted that recently these two approaches are starting to

converge.)

(ii) Sectoral Differences

There are major differences between the sectors in terms of the extent of private sector interest and the instruments used in its participation

Telecommunication: On the basis of rapid technological breakthroughs, high demand and the high return-to-risk ratio, the private sector’s investment

in this sector is commonly observed And governments are normally free from providing sovereign guarantees

Power: In this sector for East Asian countries, private investors are invited

to investments in Independent Power Projects (IPP), often under BOT arrangements The private sponsors finance, implement and operate power plants, with the state owned public utility undertaking to buy power under a

take or pay contract

Water Supply, Highways, Container Ports, Tunnels and Bridges: In these sectors, projects are undertaken on a BOT basis, but in a more limited way than with power projects

(iii) Financing Methods

Most privately funded infrastructure projects are being financed through limited or non-recourse project finance techniques, e.g., sponsors do not have recourse to the assets of the parents companies and instead rely primarily on cash flows generated by the project

Equity financing appears plentiful for financially viable projects in East Asia The main advantages of private equity over debt are twofold: it does not lead to an increase in fixed debt service obligations of a country and it brings private management skills to manage risks

In terms of debt financing, commercial bank lending is not yet the major source of funding So far, most private projects have relied on suppliers or export credits Attempts are underway to tap the bond market

(iv) Cost of Private Finance vs Sovereign Debt

The average nominal cost of private financing (equity and debt) is clearly higher than the cost of sovereign debt But there are three offsetting reasons why private funded projects may still be more attractive in economic terms The first is the difference in risk sharing In a typical public sector project, the state assumes most of the associated risks, while in a well-structured private sector project the sponsors assume project completion and commercial risks The second is that there are often efficiency gains (in terms of project costs and higher operating efficiency) that may more than offset the higher cost of financing The third is that many countries need to and would like to limit sovereign debt as a matter of policy to avoid debt accumulation

(v) Competition between Countries

To up-grade “Country Competitiveness” or to promote economic development faster, more efficiently and more economically, countries are being compelled

to compete with each other to attract quality investors into infrastructure

In order to yield expected results, it is obvious that infrastructure projects must be designed, implemented and managed by sponsors who are technically competent, managerially strong, possess substantial financial strength and see investments in developing countries as a long term commitment In reality, however, there are a limited number of sponsors who meet all the above

mentioned criteria

(vi) Overall Progress

In spite of the original high expectations of the host countries and the private sponsors, the number of projects under actual implementation is not so many (4) Critical Constraints and Risks towards Enhanced Private Participation in Infrastructure Development

There are various reasons why the overall progress of PPP in infrastructure development is slow The following seven major constrains and risks are commonly perceived

(i) Gap in Expectations and Perceptions of Risks

One fundamental reason for protracted negotiations and frustrations on all stakeholders is the misunderstanding about the degree of perceived and real risks in a particular project; who should bear these risks; and what returns are reasonable

Host countries and parastatal organizations, private sponsors and lenders are the major players of the project And, generally speaking, there are two kinds of risks involved Political risks (non-commercial risks) and commercial risks

The political risks consist of “Confiscation of Fixed or Mobile Assets by the Host Government such as deprivation, nationalization, creeping, expropriation, selective discrimination, forced abandonment and forced divestiture,” “Political Violence such as war on land and terrorism,” “Inability

to Convert and Transfer Currency” and “Changes in Economic Policies and Regulations by the Host Government”

The commercial risks consist of “Under-developed Infrastructure,”

“Construction Completion Risk,” “Raw Materials and Energy Resources Procurement Risk,” “Operation Risk,” “Demand Fluctuation Risk” and

“Financial Risk such as exchange risk and sudden hike of interest rate” Generally speaking, the responsibility of the political risks rests on the host country government, while that of the commercial risks rests on the private sector only particularly when sponsors are allowed to deal directly with consumers

Host countries tend to perceive in a project a much lower risk than do sponsors and lenders in the private sector Countries expect companies to accept uncertainties about future sector and regulatory policies, to conform to government decisions in the key technical and managerial areas and to assume

modest returns, e.g., 10-12%

Private sponsors, on the other hand, seek very high returns, while wanting

to leave as many of the risks to the country as possible

(ii) Lack of Clear Government Objectives, Commitment and Processes

Another fundamental constraint in many countries is the lack of clarity about the government’s objectives and commitment, and the complex decision-making processes This not only discourages private participation, but also leads to excessive transaction costs This constraint is, as a matter of fact, one

of the political risks on the part of the private sector

(iii) Lack of Consolidated Sector Policies, and a Legal and Regulatory Framework Lack of appropriate sector policies and a transparent, stable, credible and enforceable legal and regulatory framework is another critical barrier to attracting -and sustaining- substantial private investment Indeed, such a framework is a pre-requisite for the country to capture efficiency gains associated with competition and private sector management

This constraint has to be handled by the host government and, therefore, is again one of the political risks for the private sector

(iv) Unbundling, Mitigation and Managing of Risks

How to handle risks among stakeholders is one of the primary issues in nearly all the countries and projects The basic approach to risks should be based on the principle that the stakeholder best able to manage a risk at least cost should take care of it The private sector stakeholders (sponsors, financiers, insurance companies) should be asked to bear commercial risks, while the public sector assumes non-commercial and political risks

In terms of risk mitigation, for instance, the private sector should be willing

to accept lower returns, while risk related to the estimation of demand in the BOT-type of project should stay with the public sector

Some of the real projects or cases illustrate more clearly that significant differences exist between sectors as to which stakeholder is best placed to manage a particular risk An independent telecommunications company is able

to assume nearly all project completion and commercial risks and may require assurances from the government only on its future ability to repatriate capital

to overseas investors and lenders and that tariffs will be adjusted in a timely and acceptable manner In the case of IPP, an independent power producer typically wants several additional assurances such as that the local utility will

be able to honor its obligations under the take-or-pay contract and that fuel

will be available, etc Toll highway and bridge projects typically require more assurances from the state (e.g land acquisition, assignment of revenues from existing facilities)

(v) Low Level of Development in Domestic Capital Markets

The financing requirements for infrastructure development are massive and no country can rely on foreign currency investments forever There is, thus, both the scope and need to develop financial instruments and a market infrastructure

to tap into domestic capital markets to finance infrastructure projects

There are various financial instruments such as bonds, convertible securities, private placements and the like that provide long-term debt financing through securitization of future cash flows A few countries in East Asia are trying to develop such instruments to attract institutional investors such as pension and provident funds, insurance companies and so forth But domestic private markets are not yet capable of supplying much long-term financing, especially debt financing

(vi) Lack of Long-Term Debt Finance

Lack of appropriate term financing is widely considered a binding constraint Because of the nature of their assets, most infrastructure projects require long maturity of 15 to 20 years-debt financing In developed countries, infrastructure projects and utilities raise such financing from institutional investors such as insurance companies, pension funds and endowments But these sources of funds are not available in East Asian countries One of the reasons is that those institutional investors buy fixed-income, long-maturity securities and are much more anxious to seek protection against downside risks than equity investors In this connection, international rating agencies may play an important role in their judgment Involvement of multilateral institutions such as the World Bank and guarantee institutions may make long-term debt financing in East Asian countries a possibility

It may be thinkable to establish a privately controlled and managed institution that would raise funds from institutional investors world-wide and invest in a variety of commercially viable infrastructure projects rated high by the market One of the major advantages of such an institution would be the reduction of high transaction cost (up to $5-10 million per project for bid preparation, etc plus the cost of raising finance)

(vii) Lack of Transparency and Competition, and High Transaction Costs

In the past, the initial projects of most countries were handled on an unsolicited

project basis This practice resulted in a lack of transparency, a lack of competition that caused high transaction costs and occasional questions about whether the country received the best possible deal

Asian countries are moving towards the “Solicited Project Basis,” which contribute to a competitive process to maintain transparency, attain maximum efficiency and build public confidence

5 Case Studies of Early BOT Infrastructure Projects in Asia

(1) Typical Structure of BOT

In an attempt to help understand a BOT infrastructure project, a typical BOT structure is shown in Figure 1 The structure was developed by taking into account various kinds of actual contracts/agreements concluded in the past between various stakeholders Needless to say, however, all the BOT projects do not necessarily have the same structure as shown in the figure

(2) The Pagbilao Power Project (The Philippines)

The very characteristics of early BOT projects in the region is that many

governments have assumed most of the risks, including commercial risk that the private sector normally assumes in market economies The Pagbilao Project shown in Figure 2 was not an exception to this condition

A variety of risk hedge contracts and agreements were concluded as follows

(i) Performance Undertaking between the Government of the Philippines and the National Power Corporation for non-fulfillment or nonperformance of the agreement between the Power Corp and the J/V Project Company (ii) Energy Conversion Agreement between the National Power Corp and J/V Project Company for non-fulfillment of fuel supply, power purchase, etc

(iii) MITI Insurance between MITI and Japanese Lenders for political risks (iv) Trust and Retention Agreement between the Government of the

Philippines and the J/V Project Company for foreign exchange and overseas remittance risks

(v) Operation and Maintenance Agreement between the Operator Company and the J/V Project Company for operational risks

(vi) Turnkey Contract between the Contractor and the J/V Project Company for plant construction risks

(3) Other Projects

BOT power projects were realized in several other Asian countries A few such