Quick Fixes for KAEC

By Jannis Koehn

King Abdullah Economic City (KAEC) is the first proper city that we discussed in the course. At least, it might eventually become one. Whether it qualifies as a sustainable city remains to be seen, and I do not want to get bogged down in the question what an economic city is exactly. So far the city developers are stuck with interdependency among sectors none of which yet exists, lack of capital, lack of knowledge and lack of a strategic plan. I want to suggest that a few adjustments may help the Protagonists to solve this Gordian Knot.

First, define strategy and focus. In my understanding, EEC is a publicly listed city developer, not a port developer or a power utility. In that role, EEC can provide seed funding if that is needed to attract further private or public capital; it should not be the primary investor as long as capital is scarce. That means no matter how value-creating and financially attractive the port may be, EEC should not invest more than the absolute minimum needed.

Second, engage expert companies through build-operate-transfer contracts. Allowing foreign construction companies to build new infrastructure at their cost reduces capital expenditures for EEC. Fees for operation can be paid either by users or by the city developer; while the first would free EEC entirely of the cost, the latter would leasing-like smoothen capital outflows. And after a pre-defined period, the asset would be transferred back to the city developer or the state. With lack of capital and expertise, that is the best way to go. The difficulty for greenfield cities like KAEC is guaranteeing sufficient demand should the operator be compensated by user fees. A minimum income guarantee or a Least Present Value model may help.

Third, become more flexible. Zoning shares like 38% for industrial and logistics or 16% for leisure are way too specific at this early stage. Even in a guided economy like Saudi Arabia, no-one knows what the actual demand for different industries, sectors and zones will look like years ahead. Even less so as the industrial focus of KAEC remains unclear (see last paragraph). What if labor-intense IT services turn out to be the dominating sector – would 27% for residential still be enough? These figures reveal a deeper problem: The city has been designed in all detail but not yet strategically planned.

Fourth, rethink the revenue model. It is very difficult to be profitable as the developer of an entire city. I see four sources of revenues:

1) Selling or leasing of property is the most straightforward way to go. I would suggest leasing out property as this reduces barriers to exit and thus increases the likelihood of influx of new citizens and businesses. One might experiment with leasing and selling according to demand. The overall problem: those revenues may not be enough.

2) Imposing taxes and fees is possible in principle; after all, that is what cities do. The problem is that Saudi Arabia is a country where taxes are highly uncommon. And even if not – taxes usually belong to the government, not a private entity. Alternatively, EEC could require a certain percentage of investment volume as a commission. Yet, this would discourage new investments that are urgently needed.

3) Own investment activity in assets and projects is restricted by limited capital and is not, as outlined above, the main objective of a city developer.

4) The only remaining option are government funds. In fact, if the Saudi government asks EEC to develop the city, and given the positive externalities the city is supposed to provide, the government should be willing to pay a development fee to EEC.

These initial steps may help KAEC to flourish. But also the King and his advisors need to act and reduce KAEC’s planning uncertainty. Let’s assume the country has identified a number of growth sectors to strategically transform the Saudi economy. Then some central authority should give guidance on which of the four Economic Cities should focus on which sectors. Otherwise the King may end up with four ports and no manufacturing or several universities but no tourism. For KAEC, for instance, he could define the port and the university as strategic sectors around which to develop the city. Such guidance should be based not only on what industries are needed in the country but also which location bears the best resources (trade routes for ports, beach and water quality for tourism). This bigger-picture view is called industrial policy may conflict with the libertarian idea of resource allocation through free markets. But in a guided economy that wants to develop strategic sectors, it is just good old portfolio management that would certainly help.

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4 thoughts on “Quick Fixes for KAEC

  1. By John Macomber

    Fahd El-Rasheed video in McKinsey Quarterly this week:

    Rethinking infrastructure: A megaproject executive’s view

    http://www.mckinsey.com/features/infrastructure/Fahd%20Al%20Rasheed

    Fahd Al-Rasheed—CEO and managing director of Saudi Arabia’s King Abdullah Economic City megaproject, on the shores of the Red Sea—describes the scope of and vision behind the building of a new city the size of Washington, DC, for a projected two million inhabitants. This video is part of our ongoing series, Rethinking infrastructure, on mckinsey.com.

  2. By Rami Sarafa

    I agree that some refinement measures are needed to make King Abdullah Economic City a viable, long-term development. However, I would be wary of engaging policies that would force the lead developers of the project to accept additional ‘private capital.’ KAEC was one of the largest IPO’s ever in the Middle East, and a great deal of the social and political capital raised (aside from financial) was the result of the development’s private-led, entrepreneurial nature. Accepting private capital would also be at odds with the developer’s ability to dictate future zoning, economic utilization and revenue models since the company’s fiduciary responsibilities would shift (and inevitably become more diverse).

    A measure that can be engaged within KAEC’s existing context is involving counterparties with greater expertise. The developer should not forfeit future cash flow unless the arrangement is absolutely necessary to meet short-term financing needs of core projects (i.e. the port). A lesson derived from the Dubai World debacle was that Sheikh Mohamed’s “ring fencing” of the emirate’s core assets (Dubai Ports, Jebel Ali, Dubai Aluminum, Jumeirah Hospitality) despite significant indebtedness proved to be the right move. In other words, if centrally important and revenue-generating businesses can be built and managed independently, they present massive upside (and can serve as a catalyst for the entire planned city. Less lucrative projects and “soft infrastructure” such as schools and hospitals should first be targeted for potential partnerships.

    Finally, KAEC should seek a revenue model that’s independently sustainable, but cannot pursue tax policies that would deter future settlement. Considering “synthetic taxes” that other Gulf city-states have engaged such as toll roads, registration fees and utility surcharges could be a potential solution.

    Ultimately, KAEC’s silver bullet is government support. The next few years are essential in proving to the government that the development is being competently managed and can produce future economic and social benefits for the kingdom. The successful execution and management of a revenue-generating project like the port would help solidify the apparent goodwill the developers have with the government (i.e. highlighted by the royal family’s high-profile visit to KAEC). Saudi Arabia’s acute housing shortage, diversification needs and the exodus of citizens who seek education, employment opportunity or alternative lifestyles abroad can surely help persuade the government for strategic financial and political support.

    • By John Macomber

      The last week in particular has drawn out some super interesting aspects of student’s cultural and also academic backgrounds, as well as a lot of their passion points! (even I had to look up mutatis mutandis). I’m sorry we are ending now just as we are getting rolling.

      As an aside, my perception of the Dubai real estate tangle was that the sheikh – and for the most part the sovereign fund – did ok in terms of protecting assets and did great in terms of getting the nation on the map of global awareness….and most of the losses were borne by the private sector or speculators (or the apocryphal Russian oligarchs). The principality will be fine.

      I am curious about who is going to pay to demolish those half built 80 story towers near the Marina where the rumor is the Russians left and nobody knows who even owns these structures! Every time I go I look to see if the cranes have budged…

      Among other topics we did not have time to consider was how the emirates appear to be differentiating and competing based on competition among soft infra partners… Dubai for financial clearing, Bahrain for health care, Abu Dhabi for education, Qatar I guess for sports. There is probably a lot of research on that topic which could be drawn out too. Of course that’s arguably “Macroeconomics of Competitivess,” and the amount of a/c needed to coax Europeans to these venues make them not all models of resource efficiency.

      Dubai and Singapore (and New York) are admirable but they are hard to draw a lot of lessons from which apply to the next urban three billion in low-lying, non-oil non-coal non-copper non-diamond non-reserve-currency nations.

      • By Rami Sarafa

        Thank you for your thoughtful comments and response. I have a few points with respect to the issues you raise:

        – The Sheikh did do a great job of protecting what he viewed as “core” Dubai assets vs. speculative real estate projects. His resistance to bailing out Nakheel (the developer that built the palm islands) cemented the notion that “Dubai Inc” had distinct, unique entities with different fiduciary responsibilities. Most losses were indeed borne by individual investors, the private sector and commercial banks/lenders who were looped into the boom. The latter, however, were recapitalized aggressively through collaboration with Abu Dhabi (to the tune of around $20 billion) so the Dubai financial system remained intact despite accumulated debt. The balance sheet of the largest such party in question (the National Bank of Dubai) has remarkably recovered (albeit it’s now called Emirates NBD instead..)

        – In terms of the “ghost town” perception people have of Dubai…there aren’t really many towers to tear down. When the debt standstill happened, any project less than 20% complete was effectively scrapped and the others were mostly completed. There is significant vacancy in non-core areas of the emirate, but in the main built-up areas downtown, in the marina, barsha, media city etc… you’d be hard-pressed to find a building below 80% occupancy. I own a home in the marina and rents are around 2008 levels again and I just sent a notice to my tenant that I’m raising his rent by 10% and he didn’t even blink. It’s a testament that Dubai’s model is a highly-leveraged, beta play on the globale economy (which seems to be breathing again somewhat). But the recovery has shown there is a very real and robust business model in place despite “the demise” journalists raved about in 2008.

        – The Arabian Gulf entering an era of “cluster competitiveness” and greater integration is long overdue. Dubai has raised the bar for the whole region, and the Arab Spring has slapped governments in the face to get their acts together…FAST. I think major shifts in how these countries absorb foreign populations, trade with another and harness their hydrocarbon wealth are coming in the very near future.. the writing is already on the wall. The next few years will be spent “selling” the next era of development to citizens and stakeholders, and hopefully paving the way for long-term, sustainable development. That might explain why tiny Qatar is spending $20 billion to host a few soccer games… an excuse or impetus to build, change, liberalize and globalize is priceless in this part of the world.

        I’ve enjoyed the class as well and please feel free to post our conversation on the blog if others may find it useful.

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