Two much in one

Two much in one

The Delhi Airport Metro project frames the distortions in PPP projects where construction and operational activities are bundled into one contract

The Delhi Airport Metro project frames the distortions in PPP projects where construction and operational activities are bundled into one contract

Some recent performance audit reports of the Comptroller and Auditor General (CAG) of India have been acclaimed for their exposure of egregious corruption. A more important but less-discussed contribution has been to shine a light on critical instances of largescale incomplete contracts with private agencies in the infrastructure sector. The just announced end to the tortured relationship between the Reliance-Infrastructure-promoted Delhi Airport Metro Express Private Ltd (DAMEPL) and the Delhi Metro Rail Corporation (DMRC) is a case in point.

In a recent audit of the DAMEPL,the CAG has found large equity dilution by the private concessionaire. Similar equity restructuring has been observed in projects in other states too. This is representative of the distortions that arise in public-private partnership (PPP) projects where construction and operational activities are bundled into one contract.

The 22.7 kilometre metro rail linking the Indira Gandhi International Airport was built as a PPP at a cost of Rs 5,780 crore,of which nearly 54 per cent was financed by the government and 46 per cent by DAMEPL,a private consortium led by Reliance Infrastructure. Operations started in February 2011. The CAG has found that DAMEPL had diluted its debt-equity ratio from the mandated 70:30 to 43,218:1,2,30,907:1 and 2,75,205:1 for 2009-10,2010-11,and 2011-12 respectively. Thus,the project had been leveraged to an extent farbeyond what was initially envisaged,and indeed far beyond any prudent level. Reliance Infrastructure,for its part,contends that the concession agreement allows the concessionaire to restructure its equity holdings after two years of the agreement.


The significance of this equity dilution goes beyond concerns that the concessionaire now has limited financial exposure or fears that Reliance Infrastructure may slowly exit the project itself. An important lesson is that since the returns on project investments,both debt and equity,have been calculated assuming a debt-equity ratio of 70:30,any dilution of equity will benefit the equity holder.

Consider the example of a metro rail project awarded to a private concessionaire on a 30-year Build-Operate-Transfer contract. The project has been structured with a 70:30 debt-to-equity ratio,and returns to equity and debt of 18 per cent and 14 per cent,respectively. After operations begin and the project stabilises,its long-term regulated revenue stream (like passenger revenues) — now shorn of risk from construction delays and cost overruns,and protected by a strong regulatory regime from any threat of expropriation by the government — immediately attracts the interest of debt market investors.

The concessionaire has the opportunity to replace his equity with debt by various means,and thereby make easy profits from the interest differential. Therefore,once these risks are sufficiently addressed,there is limited reason for equity to command a hefty premium on return over debt,and that too for the long lifecycle of the project. The true price of the risk is reflected in the market’s willingness to replace higher cost equity with lower cost debt. The equity holder continues to enjoy the equity return over the project cycle while accessing capital at lower cost,thereby earning a virtual “risk-free” rent.

When viewed in this context,Reliance Infrastructure was merely doing what any private concessionaire would have done. It is,of course,another matter that prudent lenders would normally not have allowed such a massive debt-equity ratio — how that happened is a riddle that is beyond the scope of this article.

In the absence of regulatory due diligence,the market effectively forces the revised financial structuring. But it comes at considerable public cost. It is possible that in this case,the contract with DAMEPL minimised such profiteering opportunities. But such deficiencies are pervasive in large end-to-end contracting of utility services across the world.

Further,stripped of its equity portion,the project assets get effectively securitised in the debt market. Left with no skin in the game by way of sunk costs and having made handsome upfront profits from equity dilution,the concessionaire now has limited incentive to invest for the long-term health of the project. Safe in the realisation that he could easily walk away with minimal losses at any time,the operator’s incentives get aligned towards minimising operation and maintenance (O&M) and capital expenditures,running down existing assets,and cutting corners on quality. This consideration doubtless played a part in DAMEPL’s exit from the Delhi Airport metro project.

Dieter Helm,one of the leading British infrastructure regulation experts,has highlighted several such instances in Britain. He estimates such financial arbitraging to cost British customers more than a billion pounds every year. He therefore advocates splitting the asset creation part of any such large project from its operation,maintenance,and coordination activities.

Such risks are more prevalent in distributed asset projects like mass transit and urban civic utilities,where asset creation and O&M are evidently distinct activities. In India,in any case,since the major portion of construction financing for such projects comes from nationalised banks,such projects effectively become a form of public financing.

In the circumstances,it is imperative that appropriate regulations be put in place to pre-empt such perverse incentives. One way to address this would be to explicitly mandate a floor-level debt-to-equity ratio for the project,which cannot be breached,and which financial institutions too have to monitor. Another approach,like that followed in the UK,would be to force the concessionaire to share profits from any such equity dilution with the government.

Finally,in view of all these,it does raise the question of whether a more effective approach to structuring such projects should explicitly seek to split

asset creation from its O&M activities. This is important to mitigate moral hazard concerns and eliminate easy financial arbitraging at public cost.


Natarajan and Somanathan are members of the IAS,from the 1999 and 1987 batches respectively. Views are personal