Redistributing risks

India’s infrastructure needs are well documented. While some of these are being addressed, the challenges of upgrading and developing much-needed highways across India continue to be complex.

Presenting the budget on 29 February, the finance minister spoke of 70 projects – 8,300 kilometres of roads – that had been “languishing … due to legacy factors” at the beginning of the 2015-16 financial year. While 85% of these projects are said to be back on track, the government aims to approve the development of nearly 10,000 kilometres of national highways in the current financial year. In addition, nearly 50,000 kilometres of state highways are to be upgraded as national highways.

Renewed vigour

While between 13 and 17 kilometres of highways a day were being constructed over the past two years, in September 2015 the government set itself the ambitious target of building 30 kilometres of highways a day.

Then on 27 January the Cabinet Committee on Economic Affairs approved a new structure under which public-private partnership (PPP) projects are to be executed in the highways sector – the so-called hybrid annuity model.

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Highways have so far been built either through public funding on an engineering, procurement and construction (EPC) basis or through PPPs on a build-operate-transfer (BOT) basis. In a BOT project the developer expects to be paid either through annuity payments from the government or toll collections. Either way, developers and investors have often lacked the appetite to take on highways projects.

The possibilities presented by the hybrid annuity model have injected a sense of renewed optimism among developers and investors. To illustrate these possibilities, we have put together a hypothetical case study as a medium to explore some of the strategic, legal and financial considerations that are relevant for any new highway investments being undertaken in India today.

Case study: A new player

Roadroller, a hypothetical developer of highway projects, believes the situation on the ground in India has changed and that there is scope to bid for and execute a project in the country. While the company is aware of the challenges with regards to obtaining clearances, acquiring land, resolving disputes and obtaining credit, it is encouraged by statements from the government about the hybrid annuity model and the manner in which it modifies the allocation of risk in a project.

As is typical, Roadroller has shortlisted a few potential projects for further evaluation from a list of projects that the National Highways Authority of India (NHAI) is looking to develop. The NHAI is the agency entrusted with developing, maintaining and managing the country’s network of national highways. In all the projects identified, Roadroller, or the consortium of developers it puts together, will be responsible for design, engineering, financing, procurement, construction, operation and maintenance of the project according to the provisions of a concession agreement stipulated by the NHAI. While each project shortlisted presents different opportunities and challenges, all are to be developed on a hybrid annuity basis.

The first project shortlisted is for the construction of a four-lane bridge, and its approaches, on a highway in a state with a reasonably good track record on highway development. Roadroller is aware that the possibility of winning this contract is slim as the developer of the highway on which this bridge is situated has the option of matching the lowest bid for the bridge project, and thereby being awarded the project.

The second project involves converting a 120-kilometre section of a highway into a two-lane highway with a paved shoulder in a state with what can be a challenging environment. The third project Roadroller shortlists is for the construction of a 13-kilometre four-lane elevated highway in a densely populated and politically charged state.

Pros and cons

As part of its initial research, Roadroller undertook an analysis of the hybrid annuity model to map a risk-reward matrix.

One of the major changes that the model will bring about is that Roadroller, or the consortium it puts together, is assured of having vacant possession and right of way to at least 80% of the land over which the highway is to be built by the date of commencement of the project. It could expect to receive possession and right of way to the remainder of the land within 90 days of commencement.

In addition, as stated in the conditions precedent to the concession agreement (based on the central government’s model concession agreement for PPP projects dated 8 February), the NHAI is responsible for the procurement of all permits and approvals relating to environmental protection and conservation, forest clearance, bridge design, etc. This is a relief for Roadroller as it is aware that obtaining such clearances resulted in project delays under earlier frameworks.

As the NHAI will receive the toll revenue under the hybrid annuity model, Roadroller is assured that its revenue will not depend on the quantum of traffic. Roadroller, or the consortium building the highway, will receive 40% of the bid project cost (after adjustments for inflation) in five equal instalments during the construction period. The NHAI will pay the developer the remaining bid project cost over 30 instalments at six-month intervals according to a schedule specified in the concession agreement.

The financing risk of taking on such a project is considerably reduced as the government will finance 40% of the bid cost. Under the earlier framework, viability gap funding was limited to 20% of project costs.

Other risks

What is the risk of the government reneging on its financial commitments? Roadroller seeks advice on this and is told that legally there should not be a problem as the concession agreements are watertight. The company is however cautioned that on a practical level obtaining payments from a government agency may involve delays and prove to be complicated.

Roadroller has to factor in the considerable challenge of obtaining credit from banks to finance the projects. The company is aware that bank credit for highway projects is not readily available given the chronic delays in such projects – often on account of shortage of funds, land acquisition problems, construction disputes, etc.

However this is another area where Roadroller is advised that change may be on its way. Recent reports suggest that the government is persuading the Reserve Bank of India (RBI) to declare roads as a priority sector. Including roads in this category should boost lending for highways projects as RBI norms require that 40% of credit provided by banks must be directed to priority sectors.

Roadroller realizes that government action such as this can make all the difference. A few years ago the government moved to ease the flow of credit to the highway sector by directing banks to lower the land acquisition requirement for disbursing loans to road projects from 100% to 80%. The requirement that 100% of the land be acquired before bank credit was provided had virtually halted all lending to the sector.

As for possibilities of exit from the project, Roadroller was aware that the NHAI eased its lock-in conditions and allowed concessionaires to completely divest their equity in road projects built on a BOT basis, two years after the completion of construction, provided that the divested equity was reinvested in the concessionaire’s own incomplete NHAI projects. However, an NHAI circular in September 2015 stipulates that the divested equity can be reinvested in incomplete NHAI projects, other highway projects, or power projects. It can also be used to retire debt owed to financial institutions in road or other infrastructure projects.

This is a significant change as earlier it would have been impossible for a first-time investor in the infrastructure sector such as Roadroller to take advantage of the above easing of lock-in conditions.

Forging partnerships

Roadroller is keen to enter into preliminary agreements with contractors and other suppliers on the three shortlisted projects. In extensive discussions, the contractors stress their familiarity with local conditions and local governments. This will be vital as cooperation and coordination with municipal, state and other authorities is key to the successful implementation of a highway project.

One contractor indicated that it is part of the consortium building the highway on which the four-lane bridge that Roadroller has shortlisted is being built. Another contractor raised the possibility of taking an equity interest in the special purpose vehicle to be set up for the projects.

From discussions with contractors, Roadroller has learned that bidding for the 120-kilometre section of highway that is to be converted into a two-lane highway with a paved shoulder may be extremely competitive. However, the viability of the project will need to ascertained to ensure that traffic volume will be sufficient as revenue limitations will be reflected in a lower estimated project cost by the NHAI.

Roadroller needs to identify experienced contractors for the 13-kilometre elevated highway project, given the technical and logistical risks of undertaking the project in a densely populated area. In addition, there is the likelihood of frequent socio-political interventions in the politically charged environment. Managing the situation on the ground will need experience and local knowledge, even with the NHAI taking on the responsibility of obtaining substantial clearances.

Planning for rough times

Roadroller is aware that putting robust dispute resolution measures in place will be critical. Disputes between developers and the NHAI, contractors and other players clog courts across India and arbitration is the preferred option for resolving such disputes. Roadroller’s advisers say that arbitration in India has been transformed following the December 2015 amendment of the Arbitration and Conciliation Act, 1996. A strict timeline of 12 months (extendable by mutual agreement to 18 months) for arbitral awards to be made has been set. In addition, India has adopted a cost-follows-event regime or loser pays principle. This will be a deterrent to frivolous actions.

While mulling over whether arbitration in India is a good option, Roadroller ensures that dispute resolution is provided for early on in its interactions with various parties. It insists on inserting arbitration clauses at the memorandum of understanding stages of key relationships with other parties. Its advisers suggest that the dispute resolution environment is set to improve further, particularly in the infrastructure sector. They point to the recent budget speech, in which the finance minister said the government was going to introduce a Public Utility (Resolution of Disputes) Bill during 2016-17 “to streamline institutional arrangements for resolution of disputes in infrastructure related construction contracts, PPP and public utility contracts”. However, the advisers are unable to provide details or to say when this new legislation will be passed or implemented.

Maintaining standards

Finally, Roadroller is conscious of its image as a good corporate citizen. It needs to consider whether its involvement in the highways sector will expose it to reputational risks. The risk of potential accidents at construction sites in India is high and it will need to ensure robust health and safety standards are maintained.

In addition, corrupt practices continue to flourish especially at the grass-roots level and implementing a highways project without running such risks will be a challenge. All bidders for NHAI projects are required to enter into an integrity pact, committing to not exercise any corrupt influence on any aspect of the contract. An independent external monitor will evaluate to what extent parties have adhered to the pact.

Will this be sufficient to protect Roadroller from being liable under anti-corruption legislation in other jurisdictions?

The recent checks and balances put in place by the government to encourage activity in the highways sector have encouraged Roadroller to take the projects forward. The process of tying up the financing and other details necessary to put together bids for the three projects identified can now begin in earnest.

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Discussions with Anjan Dasgupta at HSA Advocates, Akshay Jaitly at Trilegal and Qais Jamal at AZB & Partners were useful in the compilation of this hypothetical case study.