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Friday, September 19, 2014

User rights as a novel instrument for infrastructure financing

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.


  1. this can only work if the instruments are issued after the construction period - the project completion risk is too high in India for such instruments to underwritten or credit enhanced before that - especially when there are no lender rights available for such instruments. In many ways, project SPVs going public (IPO) like the Delhi Noida Tollways Limited would be a simpler way of acheiving similar objectives (but I guess now there are legal challenges to such heavily indebted companies going public).

    1. Equity is risk capital and cannot incorporate lender rights into the financial contract. Forms of innovative debt have this ability of writing in specific access rights to information and monitoring of progress. Yields in user rights could go as high as 17% and if government were to provide a backstop to such instruments in large public projects, as they should honestly do since it is their primary responsibility to do so, then project completion risk could be mitigated.

  2. What % of the largely urban poor that use Mumbai rail/metro will subscribe to these User Right instruments you think? In a country that still has only 30-40mn tax payers, which can be used as a rough proxy to estimate the % of population that can/will subscribe to these financial instruments. Every morning that driver who takes the Metro to his work place will buy a full price ticket and a software professional sitting next to him will encash his user rights to buy a discounted ticket? How does that work in a country such as ours, you think? As always, this blog is devoid of any sense of pragmatism and exhibits utter lack of understanding of ground realities of the country.

    1. If one thinks about the growing demand for basic infrastructure then potential for innovative structures is limitless. Who buys user rights for eg the car owner, and who uses it in this case the driver, is a matter of detail. Banks could even structure loans for workers that may find use of superior transport systems beneficial to their daily routine. The instrument is both flexible in creation, distribution and use. The larger picture is that of the failure of governments that have the primary responsibility to provide basic infrastructure, and providing an instrument in the hands of the public as an expression of demand for the same. Yes, the government may have to backstop such an instrument, given the direct existence of pubic interest. The instrument could be created with a high yield of even 17%. Both put together could mitigate project completion risk.

    2. Who are the "Users" that will buy "User Rights" is not a matter of detail but one of a core design element. The larger point being those that primarily use these public citizen infrastructure projects such as Metro in India are not the ones that participate in financial investing. If the government were to finance these for the large percentage of users to buy User Rights, then they might as well fund the project directly. The policy need for the country in financial investing and savings is to get more people into the system, not to keep designing exotic western style products for the tiny percentage that are already in the system. Its a message that this blog will do well to imbibe as demonstrated in its naive arguments for Uber, derivatives and now User Rights.

  3. The technical point being made was the matter of detail is the separation of purchaser and user and NOT that the purchaser is unimportant. In fact the paper elaborates upon possible segmentation of the potential market of buyers of URs.
    It is argued that the actual user could be incentivised to put money down when the accompanying conditions are made more favourable to such an investment decision. Government cannot finance such projects fully and therefore the pivotal argument of the paper is that innovative instruments are also needed to overcome the current disadvantages in traditional debt instruments, including the aspect of taxation. Accountability of such project operators. be they govt or not, is another strongly argued aspect of this paper, given the experience of community based projects around the world. What is considered an abstraction of reality or naive at a point of time has been found to have become popular at a later point of time through the confluence of innovations in financial contracts and technology. A simple analogy being that of the badla system in the equity markets failing due to poor contracting between parties and then gaining immense popularity when re-written as a derivative contract that is supported by technology advances in the field of settlement and clearing.
    Our quest for meeting the legitimate expectations of our population must keep rolling and will probably witness several aborted experiments till one of them clicks for reasons that are at times inexplicable.

    1. badla replaced as derivatives and hence successful is a disingenuous myth propogated by the establishment. research and various articles even recently have shown using credible data from the two exchanges that capital market pariticpation in India has remained stagnant in the last decade. A small number of sophiaticated investors betting heavily using derivatives is deemed a success by you. Then it is evident that your benchmark for success in User Rights will be similar - few sophiaticated "Users" subscribing to these and not millions of "actual users". Is that the public policy choice you want or advocate? Answer with candour and honesty.


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