by S. Ramann and Manish K. Singh.
An issue on the front burner for the Government today is how to raise financing for the trillion dollars of infrastructure investment required in India. The banking system is facing significant stress, and cannot finance the second wave of investment in infrastructure as it did with the first wave from 2002 to 2012. In this discourse, so far, the main strategy that has been emphasised is the development of the corporate bond market, which includes setting up trading infrastructure, removing capital controls, removing taxation of non-residents, removing barriers against currency derivatives, etc.
We would like to propose one additional element that could help infrastructure financing. We go back to infrastructure financing in the US in late 19th century, where future consumers of train trips became investors in railroad projects. This was done using a form of adebt instrument called User Rights (UR). In a recent paper, User right as a mezzanine capital investment: Innovations in infrastructure debt financing, we analyse this approach to infrastructure financing. In modern terminology, this is crowd-funding for infrastructure from potential consumers. The key insight is to harness users as financiers with a high yield, tradable debt instrument. For a price paid at the time of financing the project, the UR entitles the holder to a rebate on user charges for that project.
As one example, in the paper we analyse a UR that offers a 45\% rebate on fares for one-way journeys on Mumbai Metro Phase I, Line I, for a period of 30 years from the commencement of its operation.
Benefits to UR holders
The UR gives the holder the right to receive a fixed rebate for a fixed period of time when using a well-identified infrastructure facility. What is the fair value of such a right? The price is calculated as the Net Present Value (NPV) of the future stream of rebates. The discount factor would include a risk tolerance parameter based on the probability that the facility will become operational and on the probability distribution of the future price of the facility.
We calculate that it is possible to design a Mumbai Metro UR, priced at Rs.13,978, which gives a saving for the user that starts at Rs.1,381 in the first year, and steadily increases up to Rs.2,825 in the final year. The implied rate of return works out to 10.5 percent, which is higher than the return from investment in tax free PSU bonds at 8.7 percent. The tax free status is not mandated by the government: since no interest is paid to UR holders, there is no tax. The gain is solely from savings on ticket cost.
Since the UR holder is entitled to a rebate, the UR becomes like an insurance contract for the UR holder compared to non-UR holders who use the operational facility. In the paper, we demonstrate other situtations under which the URs can be used strategically to better manage the risk of future increases in the ticket price. The more the final price varies from the scheduled increase in ticket price, the larger is the benefit received by the holder of user rights.
Benefits to issuers
We use a simulation to estimate savings to the project by financing using URs. The simulation is calibrated using the financial information of other metro projects in India. The simulation shows that when the project collects money against sale of user rights at the start of the construction period, the saving in interest payments is high enough to improve project viability. In the Reliance Metro example, substituting a part of debt (which is loans at 11.25 percent) by the issue of user rights, improves the NPV by about 9 percent. The cost of servicing user rights is postponed to the revenue generating phase thereby reducing the required working capital.
Wider economic benefits of URs
Infrastructure financing through URs also has many other economic advantages:
Higher standardisation and simplicity - Unlike loans and bonds, URs are standardised and comprehensible, and lend themselves to be traded at exchanges. Easy entry and exit can facilitate wider investor interest, leading to a more heterogeneous participant base which can likely lead to more liquid markets compared to traditional bondsinstruments.
Better accountability - As UR-holders, consumers would have higher incentives to monitor infrastructure projects compared to traditional financial intermediaries. Consumers interests are better aligned with better monitoring of the project, which could impose better project governance, compared with banks and asset management companies who suffer from agency problems. Further, users as financiers to infrastructure projects may inject direct pressure on elected governments, and hold them to a higher standard of accountability on such projects.
Scalability across projects -- The UR as a financing instrument can span across any infrastructure project -- by the government, under a public-private partnership or even as a purely private initiative -- that produces a service that could be consumed by individuals. Examples include hospital services, community solar power plant or water and sewerage services. The degrees of assurance to the investing public may vary with the type of operator and arguably the degree of confidence in the operator.
Augment existing credit sources -- The government is hard pressed to turn to traditional sources of infrastructure financing in India. Commercial banks face high asset-liability mismatch from financing long term infrastructure projects. Bond-based financing is constrained by the lack of resolution when projects fail. Structural constraints of infrastructure projects lead to low ratings by credit rating agencies. This, in turn, poses a barrier for these new projects accessing debt financing from institutions with long term liabilities such as insurance and pension funds. Foreign currency denominated borrowing imposes forces additional mismatch of currency risk. URs avoid all these problems and could hence become one interesting component of infrastructure financing for some projects.
Challenges and Concerns
URs are of course not the panacea for all ills associated with infrastructure financing. Large initial investments, long gestation periods, unanticipated construction delays leading to incorrect projections, collection risk of payables and reneging of contracts are major risks in infrastructure projects. These factors also lead to higher uncertainty in assessing the discount rate used in the NPV calculation to price these instruments, and can lead to high price volatility. The advantage that URs have over the traditional credit instruments are that the risks are spread over a much larger audience, and that re-pricing of risk is transparent.
A key concern would be on protecting the rights of the UR holders if the project were to fail, and the facility failed to materialise. One approach could be to invoke an insurance mechanism or debt reserve ratio to repay the principal amount of the investors. Such a mechanism would not come for free and would be incorporated into the cost of the project, which in turn would be borne by the URs holders. This might have marginal price impact if such costs are priced across millions of URs issued. Another alternative that we may visualise is for agencies such IIFCL or LIC to provide a guarantee as part of the UR. This could be financed from an independent source.
In a country that faces multiple challenges in raising capital to support an escalating infrastructure financing requirement, URs can be a useful and innovative debt instrument to tap new funds. URs raise capital based on legitimate expectations of urban residents for consuming infrastructure services. More importantly, it empowers the consumer as a stakeholder which could lead to better governance of long term public goods projects compared to the traditional financial intermediaries as their agents.