by S. Ramann and Manish Kumar 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.
Conclusion
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.
