A merging of the public and private rivers of development

By Deepa

In class, we discussed whether there were guidelines for purely private or public deals. The professor’s response was that, from the public side, the government was interested in policies that would not break their limited budgets, but which would be able to bring jobs and vibrancy to their countries. Governments have the ability to decide zoning and floor area ratio to help determine density. They can also provide the essential infrastructure that attracts businesses, such as electricity, water and transit (many of these can be in the form of PPPs or private entities regulated by the government).

However, there seemed to be a sense that the primary role of government is to promote business investment. It is important to remember that while development is an important goal, the main role of government is, arguably, to promote the interests of citizens. In our discussion on Friday, we seemed overlook this. The question, “Was It Worth It [for the promoters to make the long term investment in HCMC]?” came back as a negative in the long term because the government eventually caused problems for the promoters. It surprises me to hear this sense of unfairness and betrayal when governments no longer extend the benefits they had previously extended. Their economies are maturing and the situation evolves. The government’s concern should be to represent the people and to do what is best for its citizens. At times this is to focus on economic development and easing the private sector entry, and at other times this role is to put into place a system that ensures a smoother transition from aid to trade. Just as shareholders expect a return on their investment and risk appetite, citizens expect a return on government policies and GDP growth. Continue reading

Large Scale Public Projects

By Ilya Minevich

After our class discussion on Poland’s A2 Motorway, I thought more about other ways to arrange participants to better align interests.  A fundamental question was whether risks inherent in the 2 major project phases (construction and operation) could be compartmentalized and assigned to different principals who had a comparatively superior skill set in each stage.

The confluence of several factors we discussed in class made me think that a private entity would not be the desired owner during construction. First, uncertainty about the revenue streams in the operational stage created a lot of upfront risk for the equity owner and also affected the amount that commercial banks could initially lend for construction.  Second, project cash flows were also interdependent with unpredictable macroeconomic and political risks.  Finally, there was a long construction period prior to any cash flows. With these factors in mind, AWSA no doubt priced in a much higher return in its bidding to try to create more buffer for risks that it largely couldn’t control.

To be clear, I’m not suggesting that private entities are never right to undertake large scale public projects.  A quick comparison to energy project construction illustrates how projects regularly get built by private entities.  With a shorter construction time and also increasing salvage value during construction, an energy project allows private entities to get favorable terms from commercial banks which consider the loan on an asset basis rather than relying on far in the future cash flows as potential collateral for sizing the debt amount.

These observations lead me to consider the possibility of government ownership during the construction phase.  With the Polish government aligned with EU on this as a model public goods project benefiting trade in neighboring countries, a low interest rate loan from an EU program should be a less expensive financing source which should also largely limit the upfront contribution by the Polish government.  After construction and one year of operating data, a private owner would be in a position to step in and buy the de-risked project at a reasonable yield.  In the operations phase, a private entity will be much more efficient at generating maximum revenue while dealing with risks that it can control such as maintenance of the roads and determining price elasticity for figuring out the right toll price.  Furthermore, by selling a concession for the operation of the project, the initial government funds can be recycled to build out the other phases without need of further capital.  Or if the model reaches a level of standardization, the financial structure could revert to the one in the case in order to be able to build the different phases simultaneously.

For projects of this type, that have several phases to them and are located in countries that don’t yet have the experience of having done these in the past, the model could be set up as: build – transfer to private to recoup capital and learn best practices for operation – and then own after concession is over.

The Quest of Costa Rican Buses

By Jannis Koehn

Last spring, I visited Costa Rica for the first time after more than ten years. What I found most astounding was that the buses that took me through San José and across the country seemed to be the same old models I had seen back in 2000. Haven’t oil prices soared from $10-20 then to $90-110 today? Haven’t manufacturers developed modern fuel-efficient engines since? So why did operators not invest in more fuel-efficient buses? Costa Rica is proud of its 90% renewable power sector and successfully developed an image as a heaven for eco-tourism. Yet, the country’s public transport system lags these ambitions. Today, Costa Rica imports 15-20 million barrels of petroleum products annually, spending around $2-3 billion, and the air in San José is full of diesel soot. The paradox of old buses is a widespread phenomenon in the developing world – and, one could argue, even in some developed countries.

Koehn typical city bus  Koehn long distance bus

Pictures: Typical city bus (left) and relatively modern long-distance bus in Costa Rica

As an ordinary citizen, I cannot change government policy. But there may be scope for entrepreneurship, social or for-profit. On a lengthy bus trip to the country’s North, I started wondering what the economic rationale for bus operators was that prevented them from investing in new models, and I did some basic calculations. Factoring in basic variables such as annual mileage, fuel economy, diesel prices, bus prices and capital costs, I concluded that investing in more efficient buses would for many operators be economically favorable, at least for long distances. Given that most buses around were still old and inefficient, and unless diesel subsidies or import duties on buses distorted the market, operators may simply not have access to sufficient capital to buy new buses – that is where a startup, a bank or an international institution may help out.

For this article, I researched government policies and refined my assumptions, but the results did not change. Import duties on buses are negligible (<5%[1]), and I did not find evidence for diesel subsidies despite prices of USD 5.00 per gallon. So, long distances more than for city routes, and with used rather than new buses, replacing old buses seems to make sense. Here are the results for different capital costs in one graph.

Koehn savings estimate

The underlying back-of-the-envelope calculations look as follows:

Koehn savings calculation

So, what can businesses and entrepreneurs do to enable Costa Rican bus operators to make investments that are economically and socially beneficial? As a bus manufacturer, one could provide leasing arrangement to alleviate upfront capital constraints. Volvo or Daimler might also partner with the World Bank or other development institutions to create a fund that bridges capital needs. As an entrepreneur, one may set up a small investment fund, or tap crowd-funding as a source of capital, and lease out the buses. As a Harvard student, one may engage HU’s Shuttle Service and encourage a renewal of buses on campus, recycling the current ones cheaply to Costa Rica. That would also solve another problem: Noisy buses that inhibit quality of sleep here in Cambridge.

###

The importance of incentives in making public private partnerships (PPP) work

By Nour El Hoda Farrag

Governments’ objectives have been called into question regarding capital intensive infrastructure projects in which private sector investors participate. At least two cases we’ve studied, Poland’s A2 Motorway and India’s Dharavi, allude to such tension. The cases, however, also establish governments’ inability to undertake such projects on their own, and the importance of the private sector in securing financing needed and ensuring coordinated, efficient execution. The purpose of this blog is not to evaluate governments’ decision to implement such projects, but to highlight challenges faced by the government once the decision has been made and to defend incentives offered to attract private sector players.

In India’s Dharavi case, improvement/redevelopment of India’s largest slum was product of a long iterative process; the idea has been around since the 1970’s. The final and only successful attempt to get traction from private sector participants was based on a strong incentive scheme, which leveraged booming real estate prices. The project’s economics as set forth in the case suggest that real estate developers can only benefit from the gain achieved on the sale of commercial projects. At a profit margin of 10%, the project’s economics are unattractive against a system lending rate of 13% for 2008. After incorporating “bidder’s premium” captured by the government, net profit represented 39% (not taking into account time value of money) of the equity tranche contributed by the private sector. This implies that in order to recover their equity and earn a profit, private investors might need to refinance the loan portion as the underlying value of the project increases, and dividend out proceeds. Alternatively, private sector developers can employ creative design (increased tower/unit density) to maximize profit, but this is subject to government limits/ratio of commercial to residential land utilization. Accordingly, government’s bidder’s premium, representing 6% of total cost and revenue, is relatively insignificant. In my view, the purpose of such premium is to fend off public criticism of squandering/giving away public assets, and not to profit from the slum’s redevelopment.

Similarly, in the case of Poland’s A2 Motorway, private investors’/industrials’ estimated financial IRR was 10% over 23 years of the 40-year “build-operate-transfer” (BOT) contract, according to my calculation (assuming no increase in revenue beyond year 23, IRR falls to 8%). Against a backdrop of 10% inflation rate and 17% bank lending rate for 1999; such returns are not attractive. However, aggregated with income earned from actual development enhances the project’s feasibility for private investors, while their equity contribution (“skin in the game”) hedges execution risk.

Coming from a developing country, I have witnessed government-promoted developments that came under public pressure. Especially in real estate projects, critics fail to attribute improved conditions/land prices to the projects’ success with the benefit of hindsight. In one example, the government had offered land at discounted prices to a real estate developer who in turn had transformed it into high-profile and over-subscribed developments for middle-income households. The developer introduced basic infrastructure to what otherwise would have remained a desert. Had he not been properly incentivized to do so, none of his successful projects would have come to fruition. Granted, the project was a for-profit development, it contributed to the country’s much-needed sustainable urban development, while the government earned a mild return in-kind, and through taxes post-completion.

If we agree that such infrastructure projects are critical from a sustainable development point of view, creating an offer that private sector investors can’t refuse is critical to successful implementation, which in turn should be the government’s main objective.  Because long-term government backing in such projects is essential, private investors also bear significant political risk, which should be acknowledged and compensated for.

###