With rapidly rising shares of private capital in infrastructure around the world, an interesting question is whether private capital is indeed more expensive when compared to public capital. Since the cost of capital reflects the underlying risks, an even more relevant question that needs to be answered is whether there are significant differences in the risk profiles of a privately funded infrastructure project compared to other alternatives.
Most PPP sponsors spend considerable time and effort to manage any potential downside risks that may arise. Usually, most countries have a set of policies to guide risk allocation between sponsors and governments, but getting it right is usually the biggest challenge facing policymakers. A lot of interesting analytical work on PPP risks and their allocation among different stakeholders is going on. We will discuss these some other time. In this entry, I want to draw attention to something quite different: whether or not infrastructure policy makers are learning risk management lessons from the financial crisis.
If you surveyed infrastructure policy makers today, especially those based in developing countries, and asked what similarities, if any, there appear between the current boom in private infrastructure and the way overall risks were addressed in the financial sector before the crisis, two possible types of answers are most likely to emerge. A large number of policy makers will point to their elaborate risk assessment and management processes, including best practices, institutions, databases, websites, and experts cells as evidence of their efforts to deal with PPP risks. Another group will deny that today’s PPPs involve significant risks for governments since the current trend is to move away from public guarantees and to transfer demand risks to markets as much as possible. Unlike the private infrastructure of the 1990s, current models of private infrastructure emphasize selecting the right type of private sector projects. Today’s mantra is to leave major demand risks to markets and keep government liabilities, if any, within limits. In India, for example, viability funding adopted for the private infrastructure model keeps overall liabilities under a tight cap. But both these answers miss the lessons from the recent crisis that are staring us in the face.
Infrastructure projects have fairly complex risk structures and each group of stakeholders needs to focus on their own risks. Let us look at typical risks faced by two major stakeholder groups, private sponsors and governments, used as a proxy for all infrastructure users. Fundamentally, the private sector is concerned with risks that adversely affect cash flows of projects from the base case on which the project was financed. Governments, on the other hand, are trying to guard against service disruptions, either in terms of quality or quantity. Governments would also like the private sector to deliver at the lowest possible costs, whereas project sponsors would like to keep adequate margins in their costs to deal with any unknowns. In most developing countries, risk assessment and management processes do not typically target both these risk perspectives, and so in reality it is difficult to reduce risks for both groups simultaneously and that too at a reasonable cost. Whichever groups have better skills, negotiation capabilities, and political clout will be able reduce their own risks. At the central level of governments, there are at least some mechanisms in place for appraisal and approval; At the state and local levels, the situation is much worse. In India, for example, there is one central project for every three at the state level. Do elaborate processes and institutions help to mitigate underlying risks for all stakeholders? No, it really is chaos out there.
What about the ability of markets to address other risks? If there are no guarantees given by governments at least on paper, the project sponsors and debt holders bear the actual market, and other, risks. This is where the macro-risks begin: A large number private infrastructure firms are growing very quickly on debt, as in India. The recent financial crisis has shown us that growth of size through rising indebtedness combined with a “will grow out” attitude contributes to moral hazard risks, as more and more firms assume non-sustainable growth strategies. Indian Planning Commission’s monitoring system, for example, has only physical and financial expenditure targets for the year; What about the impact of these PPPs on market structure? Even more importantly, what about the fiscal impact of such a structural change? And given that a large number of projects are now borrowing from outside India, what impact will the creation of large foreign exchange risks have?
There are also sector specific risks. For example, a large number of merchant power plants, sized to take advantages of economies of scale in India, are hoping to cash in on current power deficits and the resultant high prices prevailing in power exchanges to mitigate SEB non-payment risks. This may be possible for a few power plants, but this strategy cannot work for a large number of market players without dampening the power prices and creating bankruptcy risks.
The financial crisis demonstrated that, beyond project specific risks, benefits that arose out of scale economies (as was the case in large banks and other institutions) were offset by the risk of portfolio, that is, the cumulative impact of too many risky projects. While the merchant power plants may not be very large in terms of market share, externality risks created by their potential failure will be difficult to bear and governments will inevitably have to bail them out. The basic assumption then that markets can address risk in infrastructure is only feasible to some extent. Given the dependencies and linkages of infrastructure with economy, employment, and quality of life, governments, as in the case of India, are holding large residual risks, even if this is not readily apparent as yet.
The financial crisis is an important reminder that, more than the consequences of individual action or isolated regulation failure, the cumulative impacts of individually risky projects are much more serious and difficult to diffuse with potentially large growth penalties. So who is hedging against this cumulative risk when countries are embarking on large infrastructure programs? The financial crisis had to deal with the so called “too big to fail” risks; with large PPP project portfolios, governments will be called upon to rescue firms and projects because these are “too important to fail”.