Implementing PPPs to fund infrastructure

23 January 2020
Privatisation can provide vital infrastructure investment, but how can public-private partnerships best be effected?

The UAE has embraced public-private partnerships (PPPs). In line with the country’s vision to generate at least 27 per cent of power via low-carbon technologies by 2021, several sustainable PPP projects have been initiated, including Abu Dhabi’s Masdar solar and wind projects and Dubai Electricity & Water Authority’s solar projects.

The Route 2020 project, which is extending Dubai Metro from Jebel Ali to the Expo 2020 site, will also reduce carbon emissions, and is expected to operate on a PPP model.

KPMGOn a global scale, although it appears that there is sufficient capital available, projects are frequently not completed satisfactorily due to incorrect risk allocation. However, while risk considerations are the crux of the matter, public policy and the ‘unbundling’ of infrastructure must also be taken into account.

Unbundling involves breaking up the individual elements of the infrastructure chain into those that are monopolistic in nature – which require regulation – and those that fall under the umbrella of a free market. Incorrect unbundling, which often leads to regulating the wrong element of the chain, can be the downfall of privatisation schemes.

For instance, the power sector can broadly be split into generation, transmission and distribution. In most cases, the three components are controlled by one organisation – a government entity. Privatising it would require breaking up the process into disparate elements, or unbundling. The nature of each component must subsequently be analysed to determine the extent of regulation it requires.

In this example, the transmission sector needs the most regulation as it is monopolistic and capital intensive. Generation, however, is significantly less capital intensive, so a free-market approach is considered more appropriate.

steps to successful privatisation

Unbundling methods

Once authorities have determined what should be unbundled, they must consider how the unbundling should be carried out. There are two main methods: vertical and horizontal.

Vertical unbundling is the separation of functions, as in the power sector. The UK, for example, implemented vertical unbundling when it privatised its rail sector, allocating train tracks across the entire network to one operator, signalling to another and rolling stock to multiple operators divided along geographical lines. This resulted in poor operating efficiencies and multiple accidents, as often the rolling stock operators tended not to fully cooperate with the track or signals operators.

The horizontal method is a topographical separation: all functions within a particular area are controlled by a single entity, with another entity controlling all functions in a different geographical location. Japan and Argentina opted for this method when they overhauled their railway systems with structural reforms.

Horizontal unbundling may generally be more effective. It is safer for the power sector, especially for the generation component. Transmission, however, can be unbundled vertically, as power lines run across large swathes of land and an excess of interface transfer costs could cause complications.

Monopolistic elements of the chain are those that require regulation and where the barriers to entry are high. Regulation may take one of two forms: cost-push inflation, or price-cap regulation.

With the cost-push inflation method, the capital cost of the entity is calculated and the return is determined. This method can be problematic when it comes to arriving at the cost of capital, which may be subject to over-exaggeration. Regulators can become locked in a battle, trying to reduce the estimated cost of capital while the accuracy of the calculated return may be debated by the operators’ lawyers and accountants. Cost-push inflation occurs when supply costs rise or supply levels decrease, driving up prices if demand is a constant.

Meanwhile price-cap regulation, or CPI-X, subtracts the expected efficiency savings from the rate of inflation, measured by the Consumer Price Index (CPI). As the CPI takes into consideration a range of organisations within the economy, it is a valid comparative measure and the preferred method of regulation in most jurisdictions.

True value

Before capital is deployed, appropriate regulations must be imposed on relevant elements of the chain. Governments must perform value-for-money calculations to assess whether privatisation is financially viable and advantageous, and analyse efficiencies including the cost of capital to determine whether monetary value is created.

Besides pecuniary considerations, a project should be analysed to determine its ‘true value’, which can include a wide range of societal, environmental and other less tangible impacts. Every privatisation initiative has winners and losers. An analysis of true value provides a framework for balancing the needs of both society and shareholders.

Project financing

Financing is derived from a variety of sources: conventional banks, pension funds, infrastructure funds, export credit agencies and project bonds – with a significant amount flowing in from government privatisations. There is a shift taking place in the structure of project financing due to the challenges introduced by new banking standards and regulations, but bank finance will continue to be important.

In the future, infrastructure funds and pension funds are more likely to directly finance projects as they are cost-effective and represent a good liability-asset match. This is a healthy transition as there will therefore be adequate capital available to meet global infrastructure requirements, but insufficient risk mitigation often hampers projects’ ability to achieve financial closure.

By holding all of this in mind – carefully considering public policy and the unbundling of infrastructure prior to undertaking privatisation schemes, mitigating risks to optimise project finance, identifying suitable sources of finance, and assessing both value for money and the true value of projects – regional governments can greatly contribute to economic and social development.

About the author

Ravi Suri is global head of infrastructure finance and regional head of infrastructure advisory at KPMG

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